<PAGE> 1
Filed Pursuant to Rule 424(b)(4)
Registration no. 333-47307
3,125,722 SHARES
[N2K INC. LOGO]
COMMON STOCK
------------------------
Of the 3,125,722 shares of Common Stock offered hereby, 2,000,000 are being
offered by N2K Inc. ("N2K" or the "Company") and 1,125,722 are being offered by
the Selling Stockholders. See "Principal and Selling Stockholders." The Company
will not receive any proceeds from the sale of shares by the Selling
Stockholders.
The Common Stock is quoted on the Nasdaq National Market under the trading
symbol "NTKI." On April 14, 1998, the last sale price of the Common Stock as
reported on the Nasdaq National Market was $34.63 per share. See "Price Range of
Common Stock."
THESE SECURITIES INVOLVE A HIGH DEGREE OF RISK. SEE "RISK FACTORS"
BEGINNING ON PAGE 8 OF THIS PROSPECTUS FOR A DISCUSSION OF CERTAIN FACTORS THAT
SHOULD BE CONSIDERED BY PROSPECTIVE INVESTORS.
------------------------
THESE SECURITIES HAVE NOT BEEN APPROVED OR DISAPPROVED BY THE
SECURITIES AND EXCHANGE COMMISSION OR ANY STATE SECURITIES
COMMISSION NOR HAS THE SECURITIES AND EXCHANGE COMMISSION OR
ANY STATE SECURITIES COMMISSION PASSED UPON THE ACCURACY
OR ADEQUACY OF THIS PROSPECTUS. ANY REPRESENTATION TO
THE CONTRARY IS A CRIMINAL OFFENSE.
<TABLE>
<CAPTION>
==============================================================================================================================
Underwriting Discounts Proceeds to Proceeds to Selling
Price to Public and Commissions Company(1) Stockholders
- ------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
Per Share......................... $33.00 $1.81 $31.19 $31.19
- ------------------------------------------------------------------------------------------------------------------------------
Total............................. $103,148,826 $5,657,557 $62,380,000 $35,111,269
- ------------------------------------------------------------------------------------------------------------------------------
Total Assuming Full Exercise of
Over-Allotment Option(2)........ $118,621,140 $6,506,190 $77,003,681 $35,111,269
==============================================================================================================================
</TABLE>
(1) Before deducting expenses estimated at $800,000, which are payable by the
Company. Proceeds to Company do not include the receipt of $4,000,
representing the aggregate exercise price of certain options to be exercised
by a Selling Stockholder in connection with this offering.
(2) Assuming exercise in full of the 30-day option granted by the Company to the
Underwriters to purchase up to 468,858 additional shares, on the same terms,
solely to cover over-allotments. See "Underwriting."
------------------------
The shares of Common Stock are offered by the Underwriters, subject to
prior sale, when, as and if delivered to and accepted by the Underwriters, and
subject to their right to reject orders in whole or in part. It is expected that
delivery of the shares of Common Stock will be made in New York City on or about
April 20, 1998.
------------------------
PAINEWEBBER INCORPORATED
ALLEN & COMPANY INCORPORATED
BEAR, STEARNS & CO. INC.
------------------------
THE DATE OF THIS PROSPECTUS IS APRIL 14, 1998
<PAGE> 2
[INSIDE FRONT COVER--GRAPHIC INCORPORATING THE MUSIC BOULEVARD CORE
PRODUCTS AND DISTRIBUTION PARTNERS.]
[INSIDE FRONT COVER GATEFOLD--GRAPHIC INCORPORATING THE N2K LOGO AND
FEATURING THE MUSIC BOULEVARD WEBSITE AS THE CENTRAL LINK FOR THE FOLLOWING
ELEMENTS: (1) N2K ENCODED MUSIC, (2) THE JAZZ CENTRAL STATION WEBSITE
(INCLUDING PHOTOS REPRESENTING ARTIST AREAS), (3) THE CLASSICAL INSITES
WEBSITES (INCLUDING THE LEONARD BERNSTEIN WEBSITE), (4) THE ROCKTROPOLIS
WEBSITE (INCLUDING THE ALLSTAR MAGAZINE WEBSITE), (5) WEBSITES OF DAVID BOWIE
AND THE ROLLING STONES (INCLUDING ARTIST PHOTOS OR LOGOS) AND (6) THE CONCEPT
OF INTERNET ACCESS FOR USERS OF THE INTERNET.]
CERTAIN PERSONS PARTICIPATING IN THIS OFFERING MAY ENGAGE IN TRANSACTIONS
THAT STABILIZE, MAINTAIN, OR OTHERWISE AFFECT THE PRICE OF THE COMMON STOCK,
INCLUDING OVER-ALLOTMENT, ENTERING STABILIZING BIDS, EFFECTING SYNDICATE
COVERING TRANSACTIONS, AND IMPOSING PENALTY BIDS. FOR A DESCRIPTION OF THESE
ACTIVITIES, SEE "UNDERWRITING."
IN CONNECTION WITH THIS OFFERING, CERTAIN UNDERWRITERS AND SELLING GROUP
MEMBERS MAY ENGAGE IN PASSIVE MARKET MAKING TRANSACTIONS IN THE COMMON STOCK ON
THE NASDAQ NATIONAL MARKET IN ACCORDANCE WITH RULE 103 UNDER REGULATION M. SEE
"UNDERWRITING."
<PAGE> 3
PROSPECTUS SUMMARY
Unless otherwise indicated, all information in this Prospectus assumes that
the Underwriters' over-allotment option will not be exercised. Fiscal year
references are to the respective fiscal years ended December 31.
THE COMPANY
N2K is one of the leading on-line music entertainment companies using the
Internet as a global platform for promoting, marketing and selling music and
related merchandise. The Company's strategy is to build loyal user communities
around genre-specific websites that provide music content and enable consumers
to purchase compact discs ("CDs"), cassettes and related merchandise. The
Company believes that as its user base continues to grow, it will be able to
increase revenues from sales of music, related merchandise, advertising and
sponsorship programs.
The Company's music retail website is Music Boulevard (MUSICBLVD.COM),
around which the Company organizes its genre-specific music websites,
Rocktropolis (ROCKTROPOLIS.COM), Jazz Central Station (JAZZCENTRALSTATION.COM)
and Classical Insites (CLASSICALINSITES.COM). In addition to these genre
websites, the Company also operates websites for such artists as David Bowie,
The Rolling Stones and Leonard Bernstein. The Company's websites allow users to
view current music news, reviews, artist biographies and discographies,
musicians' favorite artist recordings and historical and educational
information, and to hear and view cybercasts and recording and video samples.
Consumers may search, browse and purchase music recordings from a database of
over 200,000 CDs, cassettes, LPs, videos and related music items, digitally
access 30-second music samples from a selection of over 350,000 songs, read from
over 60,000 reviews and related articles and view music video clips. (See
"Technology -- Audio Encoding and Delivery" for information regarding the
minimum hardware and software requirements to access the Company's audio
formats.) In July 1997, the Company introduced its e
- -mod system, which allows consumers to purchase and digitally download from a
collection of music singles. All product purchases are coordinated through Music
Boulevard, which acts as the Company's on-line retail store. The Company
believes that by providing a wealth of information in a highly personalized,
interactive context, it creates an entertaining environment that attracts
traffic to its websites, fosters brand awareness and encourages purchases of
music and related merchandise.
As part of its growth strategy, the Company seeks to establish strategic
alliances with global on-line, music and media companies to attract additional
users to, and increase brand awareness of, the Company's websites. For example,
the Company has formed a strategic alliance with America Online, Inc. ("AOL")
under an interactive marketing agreement (the "AOL Contract"), pursuant to
which, among other things, Music Boulevard is featured as the exclusive on-line
music retailer within AOL's MusicSpace channel, receives an anchor tenant
position on AOL's Shopping channel, participates in a variety of banner
advertising opportunities and is assigned specific keywords within the AOL
service. AOL shares in a portion of the Company's revenues generated from sales,
advertising and sponsorships through AOL. The AOL Contract also provides for
promotional and anchor tenant buttons on aol.com's home and principal shopping
pages. Similarly, the Company has entered agreements with Excite, Inc.
("Excite") and Netscape Communications Corporation ("Netscape"), pursuant to
which visitors to the websites of Excite and Netscape may access a co-branded
Music Boulevard service. From this service, visitors may purchase music products
and access music content and related information. N2K has established strategic
agreements as most prominently featured music content provider and on-line music
retailer for WebTV Networks ("WebTV"), as most prominently featured music
content provider and exclusive music retailing anchor tenant for At Home
Corporation's ("@Home") @Home Shopping Guide, as exclusive on-line product
fulfillment source for the Virgin Records America, Inc. ("Virgin Records")
website and, subject to a memorandum of understanding, to become the advertising
music sponsor and a prominently featured on-line music retailer for the
PointCast, Inc. ("PointCast") Network. In addition, the Company recently entered
into an exclusive agreement with CBS Cable, owner and operator of The Nashville
Network ("TNN") and Country Music Television ("CMT"), to create and promote
country music retailing through its website, country.com, and to create a
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<PAGE> 4
special co-branded area called Country Music Boulevard which will become the
exclusive on-line country music store on country.com and Music Boulevard.
The Company intends to capitalize on the global nature of the Internet to
build an international user base by creating local language versions of, and
localized content for, the Company's websites. Currently, approximately 26% of
the Company's on-line revenues are generated from sales of CDs, cassettes and
related merchandise outside of the U.S. The Company has established a
wholly-owned subsidiary in Japan, the world's second largest market for recorded
music sales, and has launched Japanese versions of Music Boulevard
(MUSICBLVD.COM/JP) and Jazz Central Station (JP.JAZZCENTRALSTATION.COM). The
Company has expanded the number of titles offered and has provided more
localized product to international markets through creating alliances with
international fulfillment operations. The Company recently entered into an
exclusive agreement with Shinseido Inc., a leading music retail chain in Japan,
to add more than 175,000 new local-language music titles to the Japanese version
of Music Boulevard beginning in the fourth quarter of 1998. The Company has
entered into an agreement with MSI of Miami Corp. ("MSI") whereby MSI will
provide at least 150,000 international titles to Music Boulevard's catalog of
offerings and create a fulfillment center in the Netherlands to serve European
markets commencing in the second quarter of 1998. The Company has an agreement
with MTV Networks, on behalf of MTV International Networks, to create localized
MTV - Music Boulevard sites for Europe, Brazil, Japan and Asia. The Company also
offers registration and ordering instructions on Music Boulevard in English,
Japanese, German, French and Spanish.
The Company has also established its own record label, N2K Encoded Music,
under the direction of Grammy Award-winning producer Phil Ramone who has
produced records for such artists as Billy Joel, Paul Simon, Chicago, Barbra
Streisand, Paul McCartney, Elton John and Frank Sinatra. N2K Encoded Music uses
the Company's websites, as well as record stores and other traditional
distribution channels, to promote, distribute and sell original and licensed
artist recordings. Since January 1997, the Company has released 13 recordings on
the N2K Encoded Music label. The Company currently has agreements with 12
artists for future recordings. Traditional domestic distribution for the
Company's record label is handled by Sony Music Entertainment, Inc.'s
distribution company, RED Distribution, Inc. ("Sony's RED Distribution").
The Company's management team has significant experience in managing music
industry and artist relationships, promoting and marketing recorded music and
developing state-of-the-art music recordings. Larry Rosen and Dave Grusin
founded and, together with Jon Diamond, built GRP Records, Inc. ("GRP") into one
of the largest independent record labels and one of the first to digitally
produce music titles from concept through finished recording in CD format. With
more than 75 Grammy Award nominations and 20 Grammy Awards to its credit, GRP
was purchased by MCA Inc. in 1990.
The Company's executive offices are located at 55 Broad Street, New York,
New York 10004, its telephone number is 212-378-5555 and its Internet address is
n2k.com.
4
<PAGE> 5
THE OFFERING
Common Stock Offered by:
The Company................ 2,000,000 shares
The Selling Stockholders... 1,125,722 shares(1)
Common Stock to be
Outstanding After the
Offering(2)................ 14,158,100 shares
Use of Proceeds.............. The $61.6 million estimated net proceeds to the
Company from this offering will be used by the
Company as follows: (i) approximately $15.0
million to fund increased marketing expenses,
including print and television advertising; (ii)
approximately $5.0 million to expand the
Company's technical infrastructure; and (iii) the
balance of $41.6 million for working capital and
other general corporate purposes, including
possible future strategic alliances and
acquisitions. See "Use of Proceeds."
Nasdaq National Market
symbol....................... NTKI
- ------------------------
(1) Of the shares of Common Stock to be sold by the Selling Stockholders, 1,250
shares are being sold upon exercise of options to purchase Common Stock at
an exercise price of $3.20 per share.
(2) As of February 28, 1998, excludes (i) 2,100,616 shares of Common Stock
issuable upon exercise of outstanding stock options (excluding the options
for 1,250 shares being exercised by a Selling Stockholder in this offering),
(ii) 2,133,409 shares of Common Stock reserved for future grants under the
Company's stock option and purchase plans, (iii) 414,818 shares of Common
Stock reserved for issuance pursuant to the exercise of outstanding warrants
and (iv) 184,736 shares of Common Stock reserved for issuance pursuant to
the exercise of a warrant issued to AOL for the future purchase of shares of
Common Stock at an exercise price of $19.00 per share (the "AOL Warrant").
The weighted average exercise price of all outstanding options and warrants
is $10.77 per share. See "Management -- Stock Plans," "Certain
Transactions," "Description of Capital Stock" and Note 8 of Notes to
Consolidated Financial Statements. Also excludes 169,779 shares of Common
Stock that AOL agreed to purchase simultaneously with the IPO, which are
subject to a put arrangement. See Note 1 of Notes to Consolidated Financial
Statements.
RISK FACTORS
In connection with this offering, prospective investors should carefully
consider the factors set forth under "Risk Factors," including historical and
anticipated losses; uncertainty of future results; new business challenges;
competition; dependence upon strategic alliances; dependence on key suppliers
and distributors; Internet-related risks (including dependence on the Internet;
uncertain acceptance of the Internet as a medium for commerce; uncertain
acceptance of the Company's Internet content; uncertain acceptance of the
Internet as a medium for advertising; security risks; government regulation and
legal uncertainties; and liability for information retrieved from the Internet);
management of growth; dependence on key personnel; risks inherent in the record
label industry; potential fluctuations in quarterly results; risk of system
failure or inadequacy; risks of technology trends and evolving industry
standards; risks associated with global expansion; possible need for additional
funds; control by management; anti-takeover provisions; shares eligible for
future sale; registration rights; volatility of stock price; immediate and
substantial dilution; absence of dividends; and no specific use of certain
proceeds.
5
<PAGE> 6
SUMMARY FINANCIAL INFORMATION
The following summary financial information should be read in conjunction
with the Consolidated Financial Statements of the Company and the notes thereto,
"Selected Consolidated Financial Data" and "Management's Discussion and Analysis
of Financial Condition and Results of Operations" included elsewhere in this
Prospectus.
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
----------------------------------------------------------
1994 1995 1996 1997
----------- ----------- ------------ ------------
<S> <C> <C> <C> <C>
STATEMENT OF OPERATIONS DATA(1):
Net revenues.................................. $ -- $ 96,505 $ 1,655,704 $ 11,262,788
Cost of revenues.............................. -- 85,176 1,493,764 9,393,539
----------- ----------- ------------ ------------
Gross profit................................ -- 11,329 161,940 1,869,249
Operating expenses............................ 1,327,436 2,983,933 18,401,425 31,164,657
----------- ----------- ------------ ------------
Operating loss(2)............................. (1,327,436) (2,972,604) (18,239,485) (29,295,408)
Income (loss):
Continuing operations....................... (1,302,475) (2,884,471) (17,939,235) (29,255,497)
Discontinued operations(3).................. 1,444,885 1,289,671 (968,674) 1,158,523
Extraordinary item(4)......................... -- -- -- (639,262)
Net income (loss)............................. 142,410 (1,594,800) (18,907,909) (28,736,236)
Basic and diluted income (loss) per common
share(5):
Continuing operations....................... $ (0.83) $ (1.84) $ (6.50) $ (5.99)
Discontinued operations..................... (0.92) 0.82 (0.35) 0.24
Extraordinary item.......................... -- -- -- (0.13)
----------- ----------- ------------ ------------
Basic and diluted net income (loss) per
common share.............................. $ 0.09 $ (1.02) $ (6.85) $ (5.88)
=========== =========== ============ ============
Shares used in computing basic and diluted net
income (loss) per common share(5)........... 1,566,936 1,566,955 2,760,948 4,885,556
=========== =========== ============ ============
</TABLE>
<TABLE>
<CAPTION>
DECEMBER 31, 1997
-----------------------------
ACTUAL AS ADJUSTED(6)
----------- --------------
<S> <C> <C>
BALANCE SHEET DATA:
Cash and cash equivalents................................... $36,831,748 $ 98,411,748
Working capital............................................. 49,442,561 111,022,561
Total assets................................................ 64,880,217 126,460,217
Stockholders' equity........................................ 53,147,935 114,727,935
</TABLE>
- ---------------
(1) Telebase Systems, Inc. ("Telebase") was founded in 1984 as a provider of
on-line information services. In 1994, Telebase expanded its on-line
business strategy to include music entertainment and began expending
significant resources to enter this market. In 1995, the Company began
offering on-line sales of music through its Music Boulevard website. On
February 13, 1996, Telebase merged with N2K Inc., a New York corporation
("New York N2K"), and changed its name to N2K Inc. (the "Merger"). In April
1997, the Company decided to discontinue its on-line information services
business to focus exclusively on its music entertainment business. See note
(3) below.
(2) Included in the 1996 operating loss are aggregate one-time charges totaling
$5.2 million for purchased research and development incurred in connection
with the acquisitions of New York N2K ($4.1 million in February 1996) and
the rock website, Rocktropolis ($1.1 million in June 1996). See Notes 1 and
2 of Notes to Consolidated Financial Statements.
(3) In April 1997, the Company's board of directors (the "Board of Directors")
approved a formal plan of disposal for its on-line information services
business and in August 1997, the Company sold substantially all of the net
assets of this business. Accordingly, the operating results and assets and
liabilities of this business have been accounted for as a discontinued
operation and reflected separately from continuing operations. See Note 3 of
Notes to Consolidated Financial Statements.
(4) The Company incurred an extraordinary charge to its statement of operations
equal to the unamortized portion of the discount associated with the fair
value of the warrants that were issued in connection with the Management and
Senior Notes (as defined). The extraordinary charge was incurred when the
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<PAGE> 7
outstanding balance on the Management and Senior Notes was satisfied prior to
maturity upon consummation of the Company's initial public offering in October
1997 (the "IPO").
(5) See Note 1 of Notes to Consolidated Financial Statements.
(6) As adjusted to give effect to the sale of the shares of Common Stock offered
by the Company hereby after deducting underwriting discounts and commissions
and estimated offering expenses. See "Use of Proceeds" and "Capitalization."
------------------------
The preceding summary is qualified in its entirety by, and should be read
in conjunction with, the more detailed information and Consolidated Financial
Statements of the Company and the notes thereto appearing elsewhere in this
Prospectus. This Prospectus contains forward-looking statements within the
meaning of the Private Securities Litigation Reform Act of 1995 with respect to
the financial condition, results of operations and business of the Company,
including statements relating to (i) the adequacy of the net proceeds of the
offering to fund the Company's operations, (ii) the Company's business
objectives and strategy, (iii) the Company's planned websites and (iv) the
development of the N2K Encoded Music label. These forward-looking statements
involve risks and uncertainties that could cause actual results to differ
materially from those contemplated. Such risks and uncertainties include, but
are not limited to, the impact from competition for Internet content,
merchandise and recorded music; dependence on strategic alliance partners,
suppliers and distributors; market acceptance of the Internet for commerce and
as a medium for advertising; technological changes and difficulties; and other
risks detailed in this Prospectus.
------------------------
Music Boulevard(R) (and its related logo) is a registered service mark of
the Company. The Company has also applied for trademark and/or service mark
registrations for Music Blvd.(TM), N2K Encoded(TM) and Rocktropolis(TM). In
addition, the Company is also using allstar(TM), Classical Insites(TM), e
- -mod(TM), Jazz Central Station(TM) (and its related logo), N2K(TM), Need To
Know(TM) and RAM(TM) as trademarks and/or service marks. All other trademarks or
service marks appearing in this Prospectus are the property of their respective
holders.
7
<PAGE> 8
RISK FACTORS
An investment in the shares of Common Stock offered hereby involves a high
degree of risk. Prospective investors should consider carefully the following
risk factors, in addition to the other information set forth in this Prospectus,
before purchasing any of the shares of Common Stock offered hereby.
HISTORICAL AND ANTICIPATED LOSSES; UNCERTAINTY OF FUTURE RESULTS
The Company has incurred significant losses and expects to continue to
incur significant losses on a quarterly and annual basis for the foreseeable
future. As of December 31, 1997, the Company had an accumulated deficit of $56.1
million. The Company has incurred losses from continuing operations of $17.9
million and $29.3 million for the years ended December 31, 1996 and 1997,
respectively. Since its inception, the Company has incurred costs to develop and
enhance its technology, to create, introduce and enhance its websites, to
establish marketing and distribution relationships and to build an
administrative organization. The Company currently intends to increase
substantially its operating expenses as a result of the Company's strategic
alliances, to fund increased sales and marketing, to enhance existing websites
and to implement strategic relationships important to the success of the
Company. To the extent that such expenses precede or are not subsequently
followed by increased revenues, the Company's business, results of operations
and financial condition will be materially adversely affected. There can be no
assurance that the Company will be able to generate sufficient revenues from the
sale of music recordings, related merchandise, advertising and sponsorships to
achieve or maintain profitability on a quarterly or annual basis in the future.
The Company expects negative cash flow from operations to continue for the
foreseeable future as it continues to develop and market its business. See
"Selected Consolidated Financial Data" and "Management's Discussion and Analysis
of Financial Condition and Results of Operations."
NEW BUSINESS CHALLENGES
Although the Company was founded in 1984 and has been conducting an on-line
information services business for more than ten years, it began development of
its central website, Music Boulevard, in 1994. To date, the Company has only a
limited operating history in its music entertainment business upon which an
evaluation of N2K and its prospects can be based. The Company's prospects must
be considered in light of the risks, expenses and difficulties frequently
encountered by companies in new, unproven and rapidly evolving markets. To
address these risks, the Company must, among other things, expand its customer
base, respond to competitive developments, continue to attract, retain and
motivate qualified employees and continue to upgrade its technologies. There can
be no assurance that the Company will be successful in addressing such risks. If
the Company is not successful in developing and expanding its music
entertainment business, including its N2K Encoded Music label, sales of
advertising on its websites and development of related business opportunities,
the Company's ability to achieve profitability will be materially adversely
affected. See "Management's Discussion and Analysis of Financial Condition and
Results of Operations."
COMPETITION
The market for Internet content providers is highly competitive and rapidly
changing. Since the Internet's commercialization in the early 1990's, the number
of websites on the Internet competing for consumers' attention and spending has
proliferated. With no substantial barriers to entry, the Company expects that
competition will continue to intensify. With respect to competition for
consumers' attention, in addition to intense competition from Internet content
providers, the Company also faces competition from traditional media such as
radio, television and print. N2K Encoded Music competes with the major, and
other independent, record labels. See "-- Risks Inherent in the Record Label
Industry." With respect to recorded music sales, the Company competes with
numerous Internet retailers, including traditional music retail chains, record
labels and independents with websites on the Internet. In addition, the Company
competes with traditional retail stores, including chains and megastores, mass
merchandisers, consumer electronics stores and music clubs. The Company believes
that the primary competitive factors in providing music entertainment products
and services via the Internet are name recognition, variety of value-added
services, ease of use, price, quality of service, availability of customer
support, reliability, technical expertise and experience. The
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<PAGE> 9
Company's success will depend heavily upon its ability to provide high quality,
entertaining content, along with cutting-edge technology and value-added
Internet services. Other factors that will affect the Company's success include
the Company's continued ability to attract experienced marketing, sales and
management talent. The Company's failure to compete successfully in the music
entertainment business would have a material adverse effect on the Company's
business, results of operations and financial condition. In addition, the
competition for advertising revenues, both on Internet websites and in more
traditional media, is intense. To the extent the Company is not able to attract
significant sources of revenues from paid advertisements and sponsorships on its
websites, the Company's business, results of operations and financial condition
will be materially adversely affected.
Many of the Company's current and potential competitors in the Internet and
music entertainment businesses have longer operating histories, significantly
greater financial, technical and marketing resources, greater name recognition
and larger existing customer bases than the Company. These competitors may be
able to respond more quickly to new or emerging technologies and changes in
customer requirements and to devote greater resources to the development,
promotion and sale of their products or services than the Company. There can be
no assurance that the Company will be able to compete successfully. See
"Business -- Competition."
DEPENDENCE UPON STRATEGIC ALLIANCES
The Company relies on certain strategic alliances to attract users to its
websites to purchase recorded music and related merchandise, as well as to
attract paid advertising to its websites. The Company's ability to generate
revenues from Internet commerce may depend on the increased traffic, purchases,
advertising and sponsorships that the Company expects to generate through such
strategic alliances. There can be no assurance that the Company's infrastructure
will be sufficient to handle the expected increased traffic from such alliances.
There can also be no assurance that these relationships will be maintained
through their initial terms or that additional third-party alliances will be
available to the Company on acceptable commercial terms or at all. The Company
and MTV Networks entered into an agreement on December 17, 1996, which had an
initial term of two years from March 1, 1997, the date of launch of the MTV CD
Lounge service on Music Boulevard. MTV Networks recently exercised its right to
terminate the agreement at the end of the first year of the service. On March 3,
1998, MTV Networks granted the Company a 60-day extension of the agreement in
exchange for the Company's commitment to purchase advertising on MTV Networks of
at least $40,000 per month during the extension period. There can be no
assurance that the agreement with MTV Networks will not terminate after the
extension period. The inability to enter into new, and to maintain any one or
more of its existing, strategic alliances could have a material adverse effect
on the Company's business, results of operations and financial condition.
DEPENDENCE ON KEY SUPPLIERS AND DISTRIBUTORS
The Company has no fulfillment operation or facility of its own and,
accordingly, is dependent upon maintaining its existing relationship with Valley
Record Distributors ("Valley"), the Company's primary provider of order
fulfillment for direct-to-consumer music products, or establishing a new
fulfillment relationship with one of the few other fulfillment operations. There
can be no assurance that the Company will maintain its relationship with Valley
(the current term of which expires in February 2000) or that it will be able to
find an alternative, comparable supplier capable of providing fulfillment
services on terms satisfactory to the Company should its relationship with
Valley terminate. An unanticipated termination of the Company's relationship
with Valley, particularly during the fourth quarter of the calendar year in
which a high percentage of recorded music sales are made, could materially
adversely affect the Company's results of operations for the quarter in which
such termination occurred even if the Company was able to establish a
relationship with an alternative fulfillment house. Valley may terminate its
existing agreement with the Company upon 30 days' written notice, in the event
that Valley decides to discontinue providing services to all of Valley's on-line
service customers. To date, Valley has satisfied the Company's requirements on a
timely basis. However, to the extent that Valley does not have sufficient
capacity and is unable to satisfy on a timely basis increasing
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<PAGE> 10
requirements of the Company, such capacity constraint would have a material
adverse effect on the Company's business, results of operations and financial
condition.
The Company does not have a distribution operation of its own for the N2K
Encoded Music label and, accordingly, is dependent upon maintaining its existing
relationship with Sony's RED Distribution or establishing a new distribution
relationship with a comparable distributor. There can be no assurance that the
Company will maintain its relationship with Sony's RED Distribution (the current
term of which expires in October 1999). The termination of such relationship
would, absent establishing a substitute relationship with another distributor,
have a material adverse effect on the Company's business, results of operations
and financial condition. See "Business -- N2K Encoded Music" and
"Business -- Ordering, Fulfillment and Customer Service."
INTERNET-RELATED RISKS
Dependence on the Internet; Uncertain 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. The Company's future success will depend on its ability to
significantly increase revenues, which will require the development and
widespread acceptance of the Internet as a medium for commerce. There can be no
assurance that the Internet will be a successful retailing channel. The Internet
may not prove to be a viable commercial marketplace because of inadequate
development of the necessary infrastructure, such as reliable network backbones,
or complementary services, such as high speed modems and security procedures for
financial transactions. The viability of the Internet may prove uncertain due to
delays in the development and adoption of new standards and protocols (for
example, the next generation Internet Protocol) to handle increased levels of
Internet activity or due to increased government regulation. If use of the
Internet does not continue to grow, or if the necessary Internet infrastructure
or complementary services are not developed to effectively support growth that
may occur, the Company's business, results of operations and financial condition
could be materially adversely affected. See "Business -- On-line Music
Industry."
Uncertain Acceptance of the Company's Internet Content
The Company's future success will be significantly dependent upon its
ability to create, license and deliver entertaining and compelling Internet
music-related content in order to attract users to its websites to purchase
recorded music and related merchandise and to attract advertisers to its
websites. The Company launched its first music website, Music Boulevard, in
August 1995 and has limited experience in the on-line music entertainment
business. There can be no assurance that the Company's content will be
attractive to a sufficient number of users to generate significant revenues.
There can also be no assurance that the Company will be able to anticipate,
monitor and successfully respond to rapidly changing consumer tastes and
preferences so as to continually attract a sufficient number of users to its
websites. If the Company is unable to develop Internet content that allows it to
attract, retain and expand a loyal user base, its business, results of
operations and financial condition will be materially adversely affected.
Uncertain Acceptance of the Internet as a Medium for Advertising
In order for the Company to generate advertising revenues, advertisers and
advertising agencies must direct a portion of their budgets to the Internet and,
specifically, to the Company's Internet websites. To date, sales of Internet
advertising represent only a small percentage of total advertising sales. The
Company has begun to sell advertising on its websites but has not recognized
material advertising revenues to date. There can be no assurance that
advertisers and advertising agencies will accept the Internet as a medium. If
Internet advertising is not widely accepted by, or if the Company is not
successful in generating significant advertising revenues from, advertisers and
advertising agencies, the Company's business, results of operations and
financial condition could be materially adversely affected. See
"Business -- On-line Music Industry."
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<PAGE> 11
Security Risks
Despite the implementation of network security measures by the Company, its
infrastructure is potentially vulnerable to computer break-ins and similar
disruptive problems caused by its customers or others. Consumer concern over
Internet security has been, and could continue to be, a barrier to commercial
activities requiring consumers to send their credit card information over the
Internet. Computer viruses, break-ins or other security problems could lead to
misappropriation of proprietary information and interruptions, delays or
cessation in service to the Company's customers. Moreover, until more
comprehensive security technologies are developed, the security and privacy
concerns of existing and potential customers may inhibit the growth of the
Internet as a merchandising medium.
Government Regulation and Legal Uncertainties
The Company is subject, both directly and indirectly, to various laws and
governmental regulations relating to its business. The Company believes it is
currently in compliance with such laws and that they do not have a material
impact on its operations. Moreover, there are currently few laws or regulations
directly applicable to access to or commerce on the Internet. However, due to
the increasing popularity and use of the Internet, it is possible that a number
of laws and regulations may be adopted with respect to the Internet. Such laws
and regulations may cover issues such as user privacy, pricing and
characteristics and quality of products and services. The enactment of any such
laws or regulations in the future may slow the growth of the Internet, which
could in turn decrease the demand for the Company's services and increase the
Company's cost of doing business or otherwise have an adverse effect on the
Company's business, results of operations and financial condition. Moreover, the
applicability to the Internet of existing laws governing issues such as property
ownership, libel and personal privacy is uncertain and could expose the Company
to substantial liability for which the Company might not be indemnified by
content providers. See "-- Liability for Information Retrieved from the
Internet." The Company believes that its use of material on its websites is
protected under current provisions of copyright law. However, legal rights to
certain aspects of Internet content and commerce are not clearly settled. There
can be no assurance that the Company will be able to continue to maintain rights
to information, including downloadable music samples and artist, record and
other information. The failure to be able to offer such information would have a
material adverse effect on the Company's business, results of operations and
financial condition.
Liability for Information Retrieved from the Internet
Due to the fact that material may be downloaded from websites and may be
subsequently distributed to others, there is a potential that claims will be
made against the Company for defamation, negligence, copyright or trademark
infringement or other theories based on the nature and content of such material.
Such claims have been brought, and sometimes successfully pressed, against
on-line services in the past. In addition, the Company could be exposed to
liability with respect to the material that may be accessible through the
Company's branded products and websites. For example, claims could be made
against the Company if material deemed inappropriate for viewing by children
could be accessed through the Company's websites. Although the Company carries
general liability insurance, the Company's insurance may not cover potential
claims of this type or may not be adequate to cover all costs incurred in
defense of potential claims or to indemnify the Company for all liability that
may be imposed. Any costs or imposition of liability that is not covered by
insurance or in excess of insurance coverage could have a material adverse
effect on the Company's business, results of operations and financial condition.
The Company is currently not aware of any such claims.
MANAGEMENT OF GROWTH
The Company has recently experienced a period of rapid and significant
growth, including a substantial increase in the number of its employees. Such
growth has placed, and may continue to place, significant demands on the
Company's management, operations and systems. To the extent that the Company
continues to grow internally, through strategic alliances or through
acquisitions, the Company will be faced with risks, including risks associated
with the assimilation of new operations, websites and personnel, the diversion
of resources from the Company's existing business and the inability of
management to integrate any acquired
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<PAGE> 12
businesses. The Company's ability to compete effectively will depend, in part,
upon its ability to overcome these risks and to revise, improve and effectively
use its operational, management, marketing and financial systems, both
domestically and on an international basis, as necessitated by changes in the
Company's business. There can be no assurance that the Company will be able to
effectively manage such growth and changes. Any failure of the Company to
effectively manage its growth and to respond to changes in its business would
have a material adverse effect on the Company's business, results of operations
and financial condition.
DEPENDENCE ON KEY PERSONNEL
The Company's success depends to a significant extent on the continued
contributions of its senior management team, and technical and marketing
personnel. In particular, the Company's business is highly dependent upon the
services and music industry expertise of Larry Rosen, Dave Grusin, Jon Diamond
and Phil Ramone. The Company does not maintain "key man" life insurance for any
of its employees. The Company does have employment agreements with Messrs.
Rosen, Grusin, Diamond and Ramone and certain other members of senior
management. However, such employment agreements do not assure the services of
such employees. Despite employment agreements and non-competition arrangements
with certain members of management, the Company's employees may voluntarily
terminate their employment with the Company at any time. The Company's success
also depends on its ability to attract and retain additional qualified
employees. Competition for qualified personnel is intense and there are a
limited number of persons with knowledge of and experience in the Internet and
music entertainment industries. There can be no assurance that the Company will
be able to attract and retain key personnel. The loss of one or more key
employees could have a material adverse effect on the Company. See
"Business -- Employees" and "Management."
RISKS INHERENT IN THE RECORD LABEL INDUSTRY
The record label industry, like other creative industries, involves a
substantial degree of risk. Each recording is an individual artistic work, and
its commercial success is primarily determined by consumer taste, which is
unpredictable and constantly changing. Accordingly, there can be no assurance as
to the financial success of any particular release, the timing of any such
success or the popularity of any particular artist, or the Company's ability to
attract and sign artists to the N2K Encoded Music label. Furthermore, the
Company believes that it is standard practice for record companies to pay
substantial advances to artists. The Company may incur significant expenses in
connection with paying its artists such advances, which could materially
adversely affect the Company's results of operations. In circumstances when the
Company does not pay such advances, it will be competing for artistic talent at
a disadvantage to other record labels that do pay such advances. There can be no
assurance that the Company will be able to generate sufficient revenues from
successful releases to cover the costs of unsuccessful releases. The record
label industry is dominated by a small number of large record companies that
have significantly greater experience and financial, marketing and distribution
resources than the Company. There can be no assurance of the Company's ability
to compete effectively in that market. The failure of the Company to grow N2K
Encoded Music would have a material adverse effect on the Company's growth,
financial condition and results of operations. See "Business -- N2K Encoded
Music."
POTENTIAL FLUCTUATIONS IN QUARTERLY RESULTS
The Company expects to experience significant fluctuations in future
quarterly operating results that may be caused by a variety of factors, many of
which are outside the Company's control. Factors that may affect the Company's
quarterly operating results include, without limitation, (i) the Company's
ability to retain existing customers, attract new customers at a steady rate and
maintain customer satisfaction, (ii) the announcement or introduction of new or
enhanced websites, products and strategic alliances by the Company and its
competitors, (iii) the mix of products sold by the Company, (iv) seasonality of
the recorded music industry, (v) seasonality of advertising sales, (vi) Company
promotions and sales programs, (vii) price competition or higher recorded music
prices in the industry, (viii) the level of use of the Internet and increasing
consumer acceptance of the Internet for the purchase of consumer products such
as those offered
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<PAGE> 13
by the Company, (ix) the Company's ability to upgrade and develop its systems
and infrastructure in a timely and effective manner, (x) the level of traffic on
the Company's websites, (xi) technical difficulties, system downtime or Internet
brownouts, (xii) the amount and timing of operating costs and capital
expenditures relating to expansion of the Company's business, operations and
infrastructure and the implementation of marketing programs, key agreements and
strategic alliances, (xiii) the number of recorded music releases introduced
during the period, (xiv) the level of merchandise returns experienced by the
Company and (xv) general economic conditions and economic conditions specific to
the Internet, on-line commerce and the recorded music industry. While the
Company has a limited operating history in the music entertainment business, it
anticipates that revenues will eventually track traditional music purchase and
advertising sales patterns. As a result, the Company believes that
period-to-period comparisons of its results of operations are not and will not
necessarily be meaningful and should not be relied upon as an indication of
future performance. Due to all of the foregoing factors, it is possible that in
some future quarter or quarters the Company's operating results will be below
the expectations of securities analysts and investors. In such event, the price
of the Common Stock would likely be materially adversely affected. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations."
RISK OF SYSTEM FAILURE OR INADEQUACY
The Company's operations are dependent on its ability to maintain its
computer and telecommunications equipment in effective working order and to
protect its systems against damage from fire, natural disaster, power loss,
telecommunications failure or similar events. In addition, the growth of the
Company's customer base may strain or exceed the capacity of its computer and
telecommunications systems and lead to degradations in performance or systems
failure. From time to time, the Company has experienced capacity constraints and
failure of its information systems which have resulted in decreased levels of
service delivery or interruptions in service to its customers. While the Company
continually reviews and seeks to upgrade its technical infrastructure and
provides for certain system redundancies and backup power to limit the
likelihood of systems overload or failure, any damage, failure or delay that
causes interruptions in the Company's operations could have a material adverse
effect on the Company's business, results of operations and financial condition.
In addition, substantially all of the Company's computer and telecommunications
operations, including its processing operations, are located at its facility in
Wayne, Pennsylvania. In the event of a catastrophic loss at the Wayne,
Pennsylvania facility resulting in the destruction of the Company's computer and
telecommunications operations, the Company would experience a significant
interruption of its business. Although the Company maintains insurance, such
insurance may not be adequate to compensate the Company for all property damage
and business interruption losses that may occur.
RISKS OF TECHNOLOGY TRENDS AND EVOLVING INDUSTRY STANDARDS
The Company's success will depend upon its ability to develop and provide
new services that meet customers' changing requirements. The music entertainment
industry has been characterized by significant technological changes, such as
the introduction of CDs which have had a significant impact on the industry and
industry participants, and further technological changes are expected to occur.
The Internet is characterized by rapidly changing technology, evolving industry
standards, changes in customer needs and frequent new service and product
introductions. The Company's future success will depend, in part, on its ability
to effectively use leading technologies, to continue to develop its
technological expertise, to enhance its current services, to develop new
services that meet changing customer needs and to influence and respond to
emerging industry standards and other technological changes on a timely and
cost-effective basis. See "Business -- Technology."
RISKS ASSOCIATED WITH GLOBAL EXPANSION
An important component of the Company's growth strategy is its planned
expansion into global markets. The Company has established a wholly-owned
subsidiary in Japan. There can be no assurance that the Company will be able to
successfully market, sell and distribute its products in global markets due to
legal, contractual and practical considerations. In addition, there are certain
risks inherent in doing business on a
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<PAGE> 14
global level, such as unexpected changes in regulatory requirements, export
restrictions, tariffs and other trade barriers, difficulties in staffing and
managing foreign operations, difficulties in protecting intellectual property
rights, longer payment cycles, problems in collecting accounts receivable,
political instability, fluctuations in currency exchange rates and potentially
adverse tax consequences, which could adversely impact the success of the
Company's global operations. There can be no assurance that one or more of such
factors will not have a material adverse effect on the Company's future global
operations, and consequently, on the Company's business, results of operations
and financial condition.
POSSIBLE NEED FOR ADDITIONAL FUNDS
The Company may well require additional funds to sustain and expand its
sales and marketing and research and development activities and its strategic
alliances, particularly if a well-financed competitor emerges or if there is a
shift in the type of Internet services that are developed and ultimately receive
customer acceptance. Adequate funds for these and other purposes on terms
acceptable to the Company, whether through additional equity financing, debt
financing or other sources, may not be available when needed or may result in
significant dilution to existing stockholders. The inability to obtain
sufficient funds from operations and external sources would have a material
adverse effect on the Company's business, results of operations and financial
condition. See "Management's Discussion and Analysis of Financial Condition and
Results of Operations -- Liquidity and Capital Resources."
CONTROL BY MANAGEMENT
Upon completion of this offering, the Company's executive officers and
directors and their respective affiliates will beneficially own an aggregate of
26.9% of the Company's outstanding shares of Common Stock (26.0% if the
Underwriters' over-allotment option is exercised in full). Such stockholders if
voting together may, as a practical matter, have sufficient voting power to
elect the Board of Directors, exercise significant control over the business,
policies and affairs of the Company and, in general, determine the outcome of
any corporate transaction or other matters submitted to the stockholders for
approval, such as any amendment to the certificate of incorporation of the
Company (the "Certificate of Incorporation"), any merger, consolidation, sale of
all or substantially all of the Company's assets or "going private" transactions
and prevent or cause a change in control of the Company, all of which may
adversely affect the market price of the Common Stock. See "Principal and
Selling Stockholders."
ANTI-TAKEOVER PROVISIONS
Certain provisions of the Delaware General Corporation Law (the "Delaware
GCL") may delay, discourage or prevent a change in control of the Company. Such
provisions may discourage bids for the Common Stock at a premium over the market
price of the Common Stock and may adversely affect the market price and the
voting and other rights of the holders of Common Stock. In addition, the Board
of Directors has the authority without action by the Company's stockholders to
fix the rights, privileges and preferences of, and to issue shares of, the
Preferred Stock, which may have the effect of delaying, deterring or preventing
a change in control of the Company. See "Description of Capital
Stock -- Preferred Stock" and "-- Anti-Takeover Effects of Delaware Law."
SHARES ELIGIBLE FOR FUTURE SALE; REGISTRATION RIGHTS
Immediately following this offering, the Company will have outstanding
14,158,100 shares of Common Stock. Of these shares, the 3,125,722 shares of
Common Stock sold in this offering (assuming no exercise of the Underwriters'
over-allotment option), the 3,829,754 shares of Common Stock sold in the IPO and
any shares sold under Rule 144 since the IPO will be freely tradable in the
public market without restriction under the Securities Act, except that any
shares purchased by "affiliates" of the Company may generally only be sold in
compliance with the applicable provisions of Rule 144. The directors and
executive officers of the Company and certain other stockholders of the Company,
who collectively hold 3,315,087 of the outstanding shares of Common Stock, have
agreed not to offer to sell, sell, contract to sell, grant any option to sell,
encumber, pledge or otherwise dispose of, or exercise any demand rights with
respect to, any Common Stock or securities convertible into or exercisable or
exchangeable for Common Stock for a period of 90 days, in the case of directors
and executive officers, and 45 days, in the case of such other stockholders,
after the date of this
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<PAGE> 15
Prospectus without the prior written consent of PaineWebber Incorporated. Of the
remaining 3,886,287 outstanding shares of Common Stock that are "restricted
securities" not being sold in this offering, 1,182,875 shares may be publicly
resold pursuant to the current public information, manner of sale and volume
limitations of Rule 144 and 2,132,024 shares may be publicly resold without
limitation pursuant to Rule 144(k). The Company has granted to holders of
4,403,388 shares of Common Stock not being sold in this offering certain demand
and incidental registration rights, which rights, in general, may be exercised
at any time beginning April 16, 1998, unless such holders agree to the lockup
arrangement described in this paragraph or otherwise voluntarily agree to limit
such registration rights. The Company has granted AOL certain registration
rights with respect to the 169,779 shares that AOL agreed to purchase
simultaneously with the IPO (the "AOL Shares"), including incidental
registration rights if the Company files a registration statement covering any
of its securities under the Securities Act (with the exception of an offering
pursuant to a registration statement on Form S-8 or S-4). Accordingly, AOL has
the right to require the Company to use its best efforts to register and include
any or all of the AOL Shares in this offering. The Company has also granted AOL
the right to require the Company to register the AOL Shares for resale by filing
a shelf registration statement; to have such registration statement declared
effective no later than April 16, 1998 (or such earlier date as the underwriters
of the IPO agree to release the stockholders of the Company from the lock-up
arrangements entered into in connection with the IPO (the "Lock-up Release
Date")); and to use its best efforts to continuously maintain the effectiveness
of such registration statement until October 22, 1999. In the event that the
Company fails to cause such registration statement to be declared effective by
April 16, 1998 (or, if earlier, by the Lock-up Release Date), AOL will have the
right to require the Company to repurchase the AOL Shares for cash at a price
equal to the greater of $3.0 million or the value of the AOL Shares based on the
closing price of the Company's shares on the trading day immediately preceding
the day notice of the desired repurchase was given to the Company by AOL. The
Company's repurchase obligation is supported by an escrow arrangement currently
secured by the $3.0 million purchase price of such shares and requiring the
periodic delivery by the Company of additional funds in the form of cash and/or
irrevocable letter of credit calculated with reference to the market value of
the Company's shares, subject to a minimum of $3.0 million and a maximum of $7.5
million. The Company plans to file a registration statement soon after the
consummation of this offering to register the AOL Shares. However, at any time
after April 16, 1998, AOL can require the Company to repurchase the AOL Shares
as discussed above, and, in such event, the Company will honor the terms of its
repurchase obligation to AOL and may use a portion of the net proceeds of this
offering to fund this obligation. If the Company is required to purchase the AOL
Shares, the Common Stock subject to put rights on the Company's consolidated
balance sheets will be accreted to its fair value based upon the price of the
Company's Common Stock at each reporting date and will be recorded as a charge
to the Company's statements of operations at each reporting date. As of
March 31, 1998, this accretion is approximately $1,850,000. In addition, AOL was
granted registration rights comparable to those of other holders who have
registration rights with respect to the shares of Common Stock for which the AOL
Warrant is exercisable. The Company has filed registration statements on Form
S-8 under the Securities Act to register an aggregate of 4,080,632 shares of
Common Stock pursuant to certain employee stock option and purchase plans which
will thereafter be available for sale in the public market, subject to the
resale limitations of Rule 144 applicable to "affiliates" of the Company. As a
result of these factors, a large number of shares of Common Stock could be sold
in the public market and could have an adverse effect on the market price of the
Common Stock. No prediction can be made as to the effect, if any, that future
sales of Common Stock, or the availability of shares for future sale, will have
on the market price of the Common Stock prevailing from time to time. Sales of
substantial amounts of Common Stock, or the perception that such sales could
occur, could adversely affect the prevailing market price of the Common Stock.
See "Description of Capital Stock -- Registration Rights," "Shares Eligible for
Future Sale" and "Underwriting."
VOLATILITY OF STOCK PRICE
The trading price of the Common Stock has been and could continue to be
subject to fluctuations in response to quarterly variations in results of
operations, announcements of technological innovations or new services or
products by the Company or its competitors, changes in financial estimates by
securities analysts and other events or factors. See "-- Potential Fluctuations
in Quarterly Results." Recent history relating to the market prices of other
recently public companies indicates that the market price of the Common Stock
may be highly volatile. In addition, the stock
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<PAGE> 16
market has experienced significant price and volume fluctuations that have
particularly affected the market prices of equity securities of many high
technology companies, particularly Internet-related companies, and that often
have been unrelated to the operating performance of such companies. These broad
market fluctuations may adversely affect the market price of the Common Stock.
IMMEDIATE AND SUBSTANTIAL DILUTION
Purchasers of the Common Stock offered hereby will experience immediate and
substantial dilution in the net tangible book value per share of $24.89 after
deducting underwriting discounts and commissions and estimated offering
expenses. In addition, as of February 28, 1998, the Company had issued warrants
to purchase 599,554 shares of Common Stock and options to purchase 2,101,866
shares of Common Stock. If such warrants and options are exercised in full,
purchasers of the Common Stock offered hereby would experience an immediate and
substantial dilution in the net tangible book value per share of $24.48. See
"Dilution."
ABSENCE OF DIVIDENDS
The Company has never declared or paid any dividends on the Common Stock
and does not anticipate paying any cash dividends on the Common Stock in the
foreseeable future. See "Dividend Policy."
NO SPECIFIC USE OF CERTAIN PROCEEDS
The Company has designated $20.0 million of the net proceeds to the Company
of this offering for specific uses, including marketing expenses for print and
television advertising and expansion of the Company's technical infrastructure.
The balance of the net proceeds to the Company, approximately $41.6 million
after deducting underwriting discounts and commissions and estimated offering
expenses (approximately $56.2 million if the Underwriters' over-allotment option
is exercised in full), will be used for working capital and other general
corporate purposes, including possible future strategic alliances and
acquisitions. Accordingly, management will have significant flexibility in
applying such balance of the net proceeds to the Company of this offering.
PRICE RANGE OF COMMON STOCK
The Company's Common Stock has been quoted on the Nasdaq National Market
since October 17, 1997. The following table sets forth, for the periods
indicated, the high and low sales prices for Common Stock on the Nasdaq National
Market.
<TABLE>
<CAPTION>
HIGH LOW
------ ------
<S> <C> <C>
1997
Fourth Quarter (beginning October 17, 1997)................ $30.75 $13.06
1998
First Quarter.............................................. $32.50 $16.00
Second Quarter (through April 14, 1998).................... $34.63 $28.94
</TABLE>
On April 14, 1998, the last reported sale price of the Common Stock on the
Nasdaq National Market was $34.63 per share. As of February 28, 1998, there were
12,156,850 shares of Common Stock outstanding, held by approximately 306 holders
of record. This figure does not reflect beneficial ownership of shares held in
street or nominee name.
DIVIDEND POLICY
The Company has never declared or paid any dividends on its Common Stock.
The Company does not anticipate paying any dividends on the Common Stock in the
foreseeable future and intends to retain all available funds for use in the
operation and development of its business. The Board of Directors intends to
review the Company's dividend policy from time to time. Any payment of dividends
in the future will be at the
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<PAGE> 17
discretion of the Board of Directors and will be dependent on the earnings and
financial requirements of the Company and other factors, including restrictions
imposed by the Delaware GCL on the payment of dividends, covenants restricting
the payment of dividends in future loan agreements and such other factors as the
Board of Directors deem relevant.
USE OF PROCEEDS
The net proceeds to the Company from the sale of the 2,000,000 shares of
the Common Stock offered by the Company hereby, after deducting underwriting
discounts and commissions and estimated offering expenses, are estimated to be
approximately $61.6 million (approximately $76.2 million if the Underwriters'
over-allotment option is exercised in full). The $61.6 million of estimated net
proceeds to the Company will be used by the Company as follows: (i)
approximately $15.0 million to fund increased marketing expenses, including
print and television advertising; (ii) approximately $5.0 million to expand the
Company's technical infrastructure; and (iii) the balance of $41.6 million for
working capital and other general corporate purposes, including possible future
strategic alliances and acquisitions. A portion of the net proceeds may be used
by the Company to fund its obligation to repurchase shares from AOL under
certain circumstances and/or to secure such obligation by establishing an escrow
account, in each case, as more fully described under "Description of Capital
Stock -- Registration Rights." See "Risk Factors -- No Specific Use of Certain
Proceeds." The Company will not receive any of the net proceeds from the sale of
Common Stock by the Selling Stockholders.
From time to time, in the ordinary course of business, the Company
evaluates possible acquisitions of, or investments in, businesses, products and
technologies that are complementary to those of the Company. A portion of the
net proceeds may therefore be used to fund acquisitions or investments. The
Company currently has no arrangements, agreements or understandings, and is not
engaged in active negotiations, with respect to any such acquisition or
investment.
Pending the application of the net proceeds to the Company from this
offering, the Company intends to invest the net proceeds in short-term,
investment-grade, instruments or money market funds. To the extent necessary to
avoid being subject to the registration requirements of the Investment Company
Act of 1940, as amended, the Company would invest the balance in U.S. Treasury
obligations. Returns on such investments may be less than those that might
otherwise result if the Company were able to use such funds immediately in its
operations.
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CAPITALIZATION
The following table sets forth (i) the capitalization of the Company as of
December 31, 1997, and (ii) the capitalization of the Company as adjusted to
give effect to the sale of the Common Stock offered by the Company hereby after
deducting underwriting discounts and commissions and estimated offering
expenses. This table should be read in conjunction with the Consolidated
Financial Statements of the Company and notes thereto included elsewhere in this
Prospectus. See "Description of Capital Stock."
<TABLE>
<CAPTION>
DECEMBER 31, 1997
----------------------------
ACTUAL AS ADJUSTED
------------ ------------
<S> <C> <C>
Common stock subject to put rights(2)....................... $ 2,999,995 $ 2,999,995
------------ ------------
Stockholders' equity:
Common stock, $0.001 par value; 100,000,000 shares
authorized; 12,118,100 shares issued and outstanding,
actual; 14,118,100 shares issued and outstanding, as
adjusted(1)............................................ 12,118 14,118
Additional paid-in capital................................ 109,197,798 170,775,798
Accumulated deficit....................................... (56,061,981) (56,061,981)
------------ ------------
Total stockholders' equity............................. 53,147,935 114,727,935
------------ ------------
Total capitalization.............................. $ 56,147,930 $117,727,930
============ ============
</TABLE>
- ---------------
(1) As of February 28, 1998, excludes (i) 2,101,866 shares of Common Stock
issuable upon exercise of outstanding stock options (including the options
for 1,250 shares being exercised by a Selling Stockholder in this offering),
(ii) 2,133,409 shares of Common Stock reserved for future grants under the
Company's stock option and purchase plans, (iii) 414,818 shares of Common
Stock reserved for issuance pursuant to the exercise of outstanding warrants
and (iv) 184,736 shares of Common Stock reserved for issuance pursuant to
the exercise of the AOL Warrant. The weighted average exercise price of all
outstanding options and warrants is $10.77 per share. See "Management --
Stock Plans," "Certain Transactions," "Description of Capital Stock" and
Note 8 of Notes to Consolidated Financial Statements. Also excludes 38,750
shares of Common Stock issued since December 31, 1997 and 169,779 shares of
Common Stock that AOL agreed to purchase simultaneously with the IPO, which
are subject to a put arrangement. See Note 1 of Notes to Consolidated
Financial Statements. See note (2) below.
(2) Represents shares of Common Stock which are subject to certain put rights of
AOL. See "Description of Capital Stock -- Registration Rights" and Note 1 of
Notes to Consolidated Financial Statements.
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<PAGE> 19
DILUTION
The net tangible book value of the Company at December 31, 1997 was $52.9
million or $4.37 per share. Net tangible book value per share is determined by
dividing the net tangible book value of the Company (total tangible assets less
total liabilities) by the number of shares of Common Stock outstanding. Giving
effect to the sale of the Common Stock offered hereby after deducting
underwriting discounts and commissions and estimated offering expenses, the
Company's adjusted net tangible book value as of December 31, 1997 would have
been $114.5 million or $8.11 per share representing an immediate increase in net
tangible book value of $3.74 per share to the existing stockholders and an
immediate dilution to new investors of $24.89 per share. The following table
illustrates the dilution to new investors:
<TABLE>
<S> <C> <C>
Offering price per share.................................... $33.00
Net tangible book value per share before this offering.... $4.37
Net increase in net tangible book value per share
attributable to this offering.......................... 3.74
-----
Net tangible book value per share after this offering..... 8.11
------
Dilution per share to new investors in this offering(1)..... $24.89
======
</TABLE>
- ---------------
(1) Based on the assumptions set forth above, the dilution to new investors
would be $24.48 per share if all outstanding warrants and options to
purchase shares of Common Stock were exercised in full.
The above table, as of February 28, 1998, excludes (i) 2,101,866 shares of
Common Stock issuable upon exercise of outstanding stock options (including the
options for 1,250 shares being exercised by a Selling Stockholder in this
offering), (ii) 2,133,409 shares of Common Stock reserved for future grants
under the Company's stock option and purchase plans, (iii) 414,818 shares of
Common Stock reserved for issuance pursuant to the exercise of outstanding
warrants and (iv) 184,736 shares of Common Stock reserved for issuance pursuant
to the exercise of the AOL Warrant. The weighted average exercise price of all
outstanding options and warrants is $10.77 per share. See "Management -- Stock
Plans," "Certain Transactions," "Description of Capital Stock" and Note 8 of
Notes to Consolidated Financial Statements. Also excludes 38,750 shares of
Common Stock issued since December 31, 1997 and 169,779 shares of Common Stock
that AOL agreed to purchase simultaneously with the IPO, which are subject to a
put arrangement. See Note 1 of Notes to Consolidated Financial Statements.
19
<PAGE> 20
SELECTED CONSOLIDATED FINANCIAL DATA
The selected consolidated financial data set forth below as of and for the
years ended December 31, 1993, 1994, 1995, 1996 and 1997 have been derived from
the Company's financial statements, which have been audited by Arthur Andersen
LLP, independent public accountants. The consolidated financial statements of
the Company for each of the three years in the period ended December 31, 1997
and the related balance sheets at December 31, 1996 and 1997, which have been
audited by Arthur Andersen LLP, have been included elsewhere in this Prospectus.
The selected consolidated financial data set forth below should be read in
conjunction with "Management's Discussion and Analysis of Financial Condition
and Results of Operations" and the Consolidated Financial Statements of the
Company and the notes thereto included elsewhere in this Prospectus.
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
--------------------------------------------------------------------
1993 1994 1995 1996 1997
---------- ----------- ----------- ------------ ------------
<S> <C> <C> <C> <C> <C>
STATEMENT OF OPERATIONS
DATA(1):
Net revenues................... $ -- $ -- $ 96,505 $ 1,655,704 $ 11,262,788
Cost of revenues............... -- -- 85,176 1,493,764 9,393,539
---------- ----------- ----------- ------------ ------------
Gross profit................. -- -- 11,329 161,940 1,869,249
Operating expenses:
Operating and
development(2)............ -- 257,826 1,034,617 7,954,616 14,851,666
Sales and marketing.......... -- 173,415 1,077,649 2,726,291 11,470,149
General and administrative... 541,241 896,195 871,667 2,477,995 4,842,842
Charge for purchased research
and development(3)........ -- -- -- 5,242,523 --
---------- ----------- ----------- ------------ ------------
Operating loss............... (541,241) (1,327,436) (2,972,604) (18,239,485) (29,295,408)
Interest and other income...... 43,761 73,359 106,370 352,531 693,881
Interest expense............... (82,890) (48,398) (18,237) (52,281) (653,970)
---------- ----------- ----------- ------------ ------------
Loss from continuing
operations................... (580,370) (1,302,475) (2,884,471) (17,939,235) (29,255,497)
Income (loss) from discontinued
operations(4)................ 1,085,256 1,444,885 1,289,671 (968,674) (415,970)
Gain on disposal of
discontinued operations(4)... -- -- -- -- 1,574,493
---------- ----------- ----------- ------------ ------------
Income (loss) before
extraordinary item........... 504,886 142,410 (1,594,800) (18,907,909) (28,096,974)
Extraordinary item(5).......... -- -- -- -- (639,262)
---------- ----------- ----------- ------------ ------------
Net income (loss).............. $ 504,886 $ 142,410 $(1,594,800) $(18,907,909) $(28,736,236)
========== =========== =========== ============ ============
Basic and diluted income (loss)
per common share(6):
Continuing operations........ $ (0.37) $ (0.83) $ (1.84) $ (6.50) $ (5.99)
Discontinued operations...... 0.69 0.92 0.82 (0.35) (0.08)
Gain on disposal of
discontinued operations... -- -- -- -- 0.32
Extraordinary item........... -- -- -- -- (0.13)
---------- ----------- ----------- ------------ ------------
Basic and diluted net income
(loss) per common share... $ 0.32 $ 0.09 $ (1.02) $ (6.85) $ (5.88)
========== =========== =========== ============ ============
Shares used in computing basic
and diluted net income (loss)
per common share(6).......... 1,566,917 1,566,936 1,566,955 2,760,948 4,885,556
========== =========== =========== ============ ============
</TABLE>
20
<PAGE> 21
<TABLE>
<CAPTION>
DECEMBER 31,
-------------------------------------------------------------------
1993 1994 1995 1996 1997
---------- ---------- ---------- ---------- -----------
<S> <C> <C> <C> <C> <C>
BALANCE SHEET DATA:
Cash and cash equivalents... $ 858,272 $1,469,764 $ 547,624 $4,483,450 $36,831,748
Working capital............. 543,947 1,756,815 3,960 2,054,665 49,442,561
Total assets................ 1,645,275 2,685,317 1,973,332 9,386,470 64,880,217
Stockholders' equity........ 542,130 2,243,704 648,984 4,908,379 53,147,935
</TABLE>
- ---------------
(1) Telebase was founded in 1984 as a provider of on-line information services.
In 1994, Telebase expanded its on-line business strategy to include music
entertainment and began expending significant resources to enter this
market. In 1995, the Company began offering on-line sales of music through
its Music Boulevard website. In 1993, the Company's costs consisted
primarily of corporate expenses, i.e., the salaries of the Company's
officers and other general overhead expenses. On February 13, 1996, Telebase
merged with New York N2K, and changed its name to N2K Inc. In April 1997,
the Company decided to discontinue its on-line information services business
to focus exclusively on its music entertainment business. See note (4)
below.
(2) For the years ended December 31, 1995, 1996 and 1997, the Company incurred
costs of $0.7 million, $3.1 million and $4.1 million, respectively, relating
to research and development. These amounts are included in operating and
development expenses. Research and development costs in 1994 were
immaterial.
(3) In 1996, aggregate one-time charges of $5.2 million for purchased research
and development were incurred in connection with the acquisitions of New
York N2K ($4.1 million in February 1996) and the rock website, Rocktropolis
($1.1 million in June 1996). See Notes 1 and 2 of Notes to Consolidated
Financial Statements.
(4) In April 1997, the Board of Directors approved a formal plan of disposal for
its on-line information services business and in August 1997, the Company
sold substantially all of the net assets of this business. Accordingly, the
operating results and assets and liabilities of this business have been
accounted for as a discontinued operation and reflected separately from
continuing operations. See Note 3 of Notes to Consolidated Financial
Statements.
(5) The Company incurred an extraordinary charge to its statement of operations
equal to the unamortized portion of the discount associated with the fair
value of the warrants that were issued in connection with the Management and
Senior Notes. The extraordinary charge was incurred when the outstanding
balance on the Management and Senior Notes was satisfied prior to maturity
upon consummation of the Company's IPO.
(6) See Note 1 of Notes to Consolidated Financial Statements.
21
<PAGE> 22
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
OVERVIEW
N2K is a music entertainment company using the Internet as a global
platform for promoting, marketing and selling music and related merchandise. The
Company's strategy is to build loyal user communities around genre-specific
websites that provide music content and enable consumers to purchase CDs,
cassettes, LPs, videos and related music items. The Company has also established
its own record label, N2K Encoded Music, which uses the Company's websites, as
well as record stores and other traditional distribution channels, to promote,
distribute and sell original and licensed artist recordings.
The Company was founded as Telebase in 1984 as a provider of on-line
information services. In 1994, recognizing increasing opportunities in the
consumer entertainment market, Telebase expanded its on-line business strategy
to include music entertainment and began expending significant resources to
enter this market. Telebase launched its Music Boulevard website and began
selling recorded music and related merchandise in 1995. In February 1996,
Telebase merged with New York N2K, a New York corporation founded in 1995 as a
developer of on-line music entertainment content, and the merged entity changed
its name to N2K Inc. In April 1997, the Company decided to focus exclusively on
its music entertainment business and, accordingly, the Board of Directors
approved a formal plan of disposal for its on-line information services
business. In August 1997, the Company sold substantially all of the net assets
of this business. See "-- Discontinued Operations." In October 1997, the
Company, which had previously been incorporated in Pennsylvania, was
reincorporated as a Delaware corporation and consummated the IPO.
The Company launched its first Internet website, Music Boulevard, in August
1995, and introduced its first music genre website, Jazz Central Station, in
January 1996. In January 1997, the Company launched its first release on the N2K
Encoded Music label. Company revenues have grown from $97,000 for 1995 to $11.3
million for 1997 while the Company incurred net losses for 1995, 1996 and 1997
as it built its business. The Company is currently generating revenues from the
sale of CDs and cassettes produced by others, N2K Encoded Music CDs, the sale of
advertising on its websites and the sale of related merchandise. The Company
believes that increased sales of N2K Encoded Music CDs and advertising on its
websites will contribute to higher margins in the future. The margins from the
sale of CDs and cassettes produced by others are affected by product costs,
shipping and handling fees, credit card fees and promotional discounts, such as
discounted selling prices and free shipping and handling. The Company believes
that frequent promotional discounts will be necessary to build repeat customer
traffic to its websites, which will reduce its gross margins. The Company
believes that its future financial performance will be determined by its success
in improving margins on the sale of CDs and cassettes produced by others,
introducing new products and services, selling advertising and sponsorship
programs on its websites and by selling recorded music under its N2K Encoded
Music label. Management has increased the resources within the Company to
support these functions.
The Company's strategy to develop products and services for the music
entertainment business was primarily responsible for the decline in net income
and increase in net loss for the years ended December 31, 1994, 1995, 1996 and
1997. See "Risk Factors -- Historical and Anticipated Losses; Uncertainty of
Future Results," "-- New Business Challenges" and "-- Management of Growth." The
Company has only a limited operating history in its continuing operations upon
which an evaluation of N2K and its prospects can be based. Accordingly, N2K
believes that the results of its operations for the past five years, during
which time the Company had minimal revenues, are not meaningful indications of
future performance. The Company incurred losses from continuing operations of
$2.9 million for the year ended December 31, 1995 and $17.9 million for the year
ended December 31, 1996, of which $5.2 million represents aggregate one-time
charges in connection with the write-off of purchased research and development.
The Company incurred a loss from continuing operations of $29.3 million for the
year ended December 31, 1997.
The Company currently intends to increase substantially its operating
expenses as a result of the Company's strategic alliances, to fund increased
sales and marketing, to enhance existing websites and to complete strategic
relationships important to the success of the Company. To the extent that such
expenses precede or are not subsequently followed by increased revenues, the
Company's business, results of operations and financial condition will be
materially adversely affected. There can be no assurance that the Company will
22
<PAGE> 23
be able to generate sufficient revenues from the sale of music recordings,
related merchandise, advertising and sponsorship programs to achieve or maintain
profitability on a quarterly or annual basis in the future. The Company expects
negative cash flow from operations to continue for the foreseeable future as it
continues to develop and market its business.
Pursuant to the Merger, the shareholders of New York N2K received an
aggregate of 1,684,819 shares of Common Stock valued at $4.2 million. The Merger
was accounted for as a purchase transaction with a total purchase price,
including transaction costs, of approximately $4.4 million. In connection with
the Merger, $4.1 million was charged to expense as of the date of the
transaction as it represented purchased research and development. The Company
allocated the remainder of the purchase price ($280,000) to acquired technology
costs which is being amortized over five years on a straight-line basis. The
results of the acquired business and the shares issued in connection with the
transaction have been included in the Company's financial statements since
February 13, 1996.
On June 21, 1996, the Company acquired the rock website, Rocktropolis, from
Rocktropolis Enterprises, LLC, for $633,000 in cash and 44,790 shares of Common
Stock. The acquisition has been accounted for as a purchase. The Company
incurred a one-time charge of $1.1 million for purchased research and
development. The Company also recorded an intangible asset (tradename) of
$100,000 that is being amortized over five years on a straight-line basis.
RESULTS OF OPERATIONS
Fiscal 1997 Compared with Fiscal 1996
Net Revenues. Net revenues for 1997 totaled $11.3 million compared to $1.7
million for 1996. Net revenues for 1997 and 1996 consisted primarily of sales of
CDs and cassettes produced by others. Net sales of CDs produced by the Company,
which began in 1997, totaled $3.2 million.
Cost of Revenues. Cost of revenues totaled $9.4 million for 1997 compared
to $1.5 million for 1996. Cost of revenues consists of payments to third parties
for distribution of CDs and cassettes, fulfillment of customer orders,
manufacturing expenses, royalties, copyrights, credit card processing charges
and profit participations payable to strategic alliance partners. The Company's
gross profit as a percentage of revenues increased due to the sale of
advertising, as well as the sale of CDs produced by the Company which began in
1997. The Company expects revenues from the sale of CDs produced by the Company,
as well as the sale of advertising and related merchandise to increase in future
periods, which the Company believes will contribute to higher margins and reduce
the cost of revenues as a percentage of revenues.
Operating and Development Expenses. Operating and development expenses
increased from $8.0 million for 1996 to $14.9 million for 1997, due to costs
incurred in connection with advances and recoupable costs related to projects of
artists or producers with no past recording history. Additionally, the increase
was due to increased staffing as the Company expanded its operations. Operating
and development personnel totaled 139 full-time employees as of December 31,
1997 compared to 102 full-time employees as of December 31, 1996. Operating and
development expenses consist primarily of software engineering, multimedia
production, graphic design, certain nonrecoverable advances and recoupable
costs, artist relations, telecommunications charges, inventory management and
computer operations which support the Company's music entertainment business.
This infrastructure is sufficient to support higher revenues and, accordingly,
the Company expects that, as revenues increase, operating and development
expenses will decrease as a percentage of revenues.
Sales and Marketing Expenses. Sales and marketing expenses increased from
$2.7 million for 1996 to $11.5 million for 1997. The increase in sales and
marketing expenses was primarily attributable to the amortization of the costs
associated with the Company's various strategic alliances, the expansion of the
Company's on-line and print advertising, public relations and other promotional
expenditures, as well as increased personnel and related expenses required to
implement the Company's marketing strategy. Sales and marketing personnel
totaled 39 full-time employees as of December 31, 1997 compared to 24 full-time
employees as of December 31, 1996. Sales and marketing expenses consist
primarily of the amortization of the costs associated with the Company's various
strategic alliances, external advertising, promotion, trade show, advertising
sales and personnel expenses associated with marketing of the Company's websites
and N2K
23
<PAGE> 24
Encoded Music CDs. The Company expects that levels of sales and marketing
expenditures will increase in future periods due to the execution of new
advertising programs to promote the Company's websites and N2K Encoded Music
releases, but total sales and marketing expenses will decline as a percentage of
revenues.
General and Administrative Expenses. General and administrative expenses
increased from $2.5 million for 1996 to $4.8 million for 1997, primarily due to
increased staffing and overhead expenses. General and administrative personnel
totaled 30 full-time employees as of December 31, 1997 compared to 18 full-time
employees as of December 31, 1996. General and administrative expenses consist
of executive management, accounting and human resources personnel, and
expenditures for applicable overhead costs. The Company expects general and
administrative expenses to continue to increase in absolute dollars as the
Company expands its staff and incurs additional costs related to the growth of
its business and being a public company.
Interest and Other Income and Interest Expense. Interest and other income
and interest expense consists of interest income on short-term liquid
investments of the Company's excess cash and interest expense incurred as a
result of the financing of equipment through capital leases, the use of the
Company's revolving credit line and interest incurred on the Management and
Senior Notes. Interest income for 1997 and 1996 related to the Company investing
the proceeds of equity financings received in 1997 and 1996.
Extraordinary Item. The Company incurred an extraordinary charge to its
statement of operations equal to the unamortized portion of the discount
associated with the fair value of the warrants that were issued in connection
with the Management and Senior Notes. The extraordinary charge was incurred when
the outstanding balance on the Management and Senior Notes was satisfied prior
to maturity upon consummation of the Company's IPO.
Fiscal 1996 Compared with Fiscal 1995
Net Revenues. Net revenues for 1996 totaled $1.7 million compared to
$97,000 for 1995. Net revenues in 1996 and 1995 consisted primarily of sales of
CDs and cassettes produced by others and a limited amount of advertising
revenues. The Company did not have any revenues from continuing operations prior
to August 1995 when the Company launched Music Boulevard.
Cost of Revenues. Cost of revenues totaled $1.5 million for 1996 compared
to $85,000 for 1995. Cost of revenues consists of payments to a third-party
fulfillment operation for the shipment to the Company's customers of music CDs
and cassettes produced by others, credit card processing charges and profit
participations payable to strategic alliance partners.
Operating and Development Expenses. Operating and development expenses
increased from $1.0 million for 1995 to $8.0 million for 1996 due to increased
staffing resulting from the Merger and an increased development effort for the
Company's music websites. Operating and development personnel increased from 26
as of December 31, 1995 to 102 as of December 31, 1996. The Company believes
that costs associated with the development and maintenance of its websites will
continue to increase in absolute dollars.
Sales and Marketing Expenses. Sales and marketing expenses increased from
$1.1 million for 1995 to $2.7 million for 1996 due to increased staffing and
supporting higher levels of sales. Sales and marketing personnel increased from
two as of December 31, 1995 to 24 as of December 31, 1996. Advertising and
promotional costs increased from $389,000 for the year ended December 31, 1995
to $1.8 million for the year ended December 31, 1996.
General and Administrative Expenses. General and administrative expenses
increased from $872,000 for 1995 to $2.5 million for 1996 due to the addition of
personnel as a result of the Merger. General and administrative personnel
increased from 11 as of December 31, 1995 to 18 as of December 31, 1996.
Interest Income and Expense. Interest income increased from $106,000 for
1995 to $353,000 for 1996 due to the Company investing the proceeds of equity
financings received in 1996. Interest expense increased from $18,000 for 1995 to
$52,000 for 1996 due to the addition of capital leases from the Merger and the
use of the Company's revolving credit line in 1996 to fund working capital.
Quarterly Results
The following table sets forth certain financial information for each of
the last eight quarters. This unaudited quarterly information has been prepared
on the same basis as the audited financial statements
24
<PAGE> 25
included elsewhere in this Prospectus and, in the opinion of the Company's
management, reflects all adjustments (consisting only of normal, recurring
adjustments) necessary for a fair presentation of the information for the
periods covered. The table should be read in conjunction with the Consolidated
Financial Statements of the Company and the notes thereto included elsewhere in
this Prospectus. The operating results for any quarter are not necessarily
indicative of results for any future period.
<TABLE>
<CAPTION>
THREE MONTHS ENDED
------------------------------------------------------------------------------------
MARCH 31, JUNE 30, SEPTEMBER 30, DECEMBER 31, MARCH 31, JUNE 30,
1996 1996 1996 1996 1997 1997
----------- ----------- ------------- ------------ ----------- -----------
<S> <C> <C> <C> <C> <C> <C>
Net revenues.................. $ 216,800 $ 312,779 $ 446,889 $ 679,236 $ 1,115,897 $ 1,820,998
Cost of revenues.............. 196,745 272,337 397,800 626,882 890,202 1,307,065
----------- ----------- ----------- ----------- ----------- -----------
Gross profit.................. 20,055 40,442 49,089 52,354 225,695 513,933
Operating expenses:
Operating and development.... 751,924 1,442,452 1,973,770 3,786,470 2,601,838 3,222,558
Sales and marketing.......... 254,223 489,142 825,506 1,157,420 1,065,838 1,600,048
General and administrative... 433,500 564,332 596,275 883,888 945,357 1,088,293
Charge for purchased research
and development............ 4,133,281 1,109,242 -- -- -- --
----------- ----------- ----------- ----------- ----------- -----------
Operating loss................ (5,552,873) (3,564,726) (3,346,462) (5,775,424) (4,387,338) (5,396,966)
Interest and other income..... 24,903 80,298 155,472 91,858 47,890 37,531
Interest expense.............. (16,551) (14,351) (11,191) (10,188) (18,942) (31,158)
----------- ----------- ----------- ----------- ----------- -----------
Loss from continuing
operations................... (5,544,521) (3,498,779) (3,202,181) (5,693,754) (4,358,390) (5,390,593)
Income (loss) from
discontinued operations...... 160,309 (3,038) (363,455) (762,490) (159,943) (256,027)
Gain on disposal of
discontinued operations...... -- -- -- -- -- --
----------- ----------- ----------- ----------- ----------- -----------
Net loss before extraordinary
item......................... (5,384,212) (3,501,817) (3,565,636) (6,456,244) (4,518,333) (5,646,620)
Extraordinary item............ -- -- -- -- -- --
----------- ----------- ----------- ----------- ----------- -----------
Net loss...................... $(5,384,212) $(3,501,817) $(3,565,636) $(6,456,244) $(4,518,333) $(5,646,620)
=========== =========== =========== =========== =========== ===========
<CAPTION>
THREE MONTHS ENDED
----------------------------
SEPTEMBER 30, DECEMBER 31,
1997 1997
------------- ------------
<S> <C> <C>
Net revenues.................. $ 3,569,969 $ 4,755,924
Cost of revenues.............. 2,866,281 4,329,991
----------- ------------
Gross profit.................. 703,688 425,933
Operating expenses:
Operating and development.... 3,514,269 5,513,001
Sales and marketing.......... 2,557,674 6,246,589
General and administrative... 1,227,684 1,581,508
Charge for purchased research
and development............ -- --
----------- ------------
Operating loss................ (6,595,939) (12,915,165)
Interest and other income..... 80,891 527,569
Interest expense.............. (434,386) (169,484)
----------- ------------
Loss from continuing
operations................... (6,949,434) (12,557,080)
Income (loss) from
discontinued operations...... -- --
Gain on disposal of
discontinued operations...... 1,574,493 --
----------- ------------
Net loss before extraordinary
item......................... (5,374,941) (12,557,080)
Extraordinary item............ -- (639,262)
----------- ------------
Net loss...................... $(5,374,941) $(13,196,342)
=========== ============
</TABLE>
In August 1995, the Company launched its first Internet website, Music
Boulevard, and in January 1996, introduced Jazz Central Station, its first music
genre website. The Company released its initial recordings on the N2K Encoded
Music label during the first quarter of 1997.
The Company expects to experience significant fluctuations in future
quarterly operating results that may be caused by a variety of factors,
including, without limitation, (i) the Company's ability to retain existing
customers, attract new customers at a steady rate and maintain customer
satisfaction, (ii) the announcement or introduction of new or enhanced websites,
products and strategic alliances by the Company and its competitors, (iii) the
mix of products sold by the Company, (iv) seasonality of the recorded music
industry, (v) seasonality of advertising sales, (vi) Company promotions and
sales programs, (vii) price competition or higher recorded music prices in the
industry, (viii) the level of use of the Internet and increasing consumer
acceptance of the Internet for the purchase of consumer products such as those
offered by the Company, (ix) the Company's ability to upgrade and develop its
systems and infrastructure in a timely and effective manner, (x) the level of
traffic on the Company's websites, (xi) technical difficulties, system downtime
or Internet brownouts, (xii) the amount and timing of operating costs and
capital expenditures relating to expansion of the Company's business, operations
and infrastructure and the implementation of marketing programs, key agreements
and strategic alliances, (xiii) the number of recorded music releases introduced
during the period, (xiv) the level of merchandise returns experienced by the
Company and (xv) general economic conditions and economic conditions specific to
the Internet, on-line commerce and the recorded music industry. While the
Company has a limited operating history in the music entertainment business, it
anticipates that revenues will eventually track traditional music purchase and
advertising sales patterns. As a result, the Company believes that
period-to-period comparisons of its results of operations are not and will not
necessarily be meaningful and should not be relied upon as an indication of
future performance. See "Risk Factors -- Potential Fluctuations in Quarterly
Results."
LIQUIDITY AND CAPITAL RESOURCES
The Company has financed its operations and capital expenditures primarily
from equity financings, lease financings, a revolving bank credit line and
short-term loans described herein. At December 31, 1997, the Company had a cash
balance of $36.8 million. The Company believes that the proceeds of this
offering,
25
<PAGE> 26
together with the current cash balance, will be sufficient to finance the
Company's planned operations and capital expenditures until at least December
1999. The Company expects negative cash flow from operations to continue for the
foreseeable future, as it continues to develop and market its operations.
Inflation has not had any material impact on the Company's operations. See "Risk
Factors -- Historical and Anticipated Losses; Uncertainty of Future Results" and
"-- Possible Need for Additional Funds."
Net cash of $874,000, $10.7 million and $43.7 million was used for
operating activities for the years ended December 31, 1995, 1996 and 1997,
respectively, primarily as a result of the net losses generated during those
periods. During 1997, the Company made payments of $18.3 million to AOL, Excite
and Netscape under the AOL, Excite and Netscape contracts which are reflected in
the increase in prepaid expenses. The Company financed these activities through
the private placement of three series of preferred stock, which yielded net
proceeds of $19.0 million in 1996 and $7.2 million in 1997. In July and August
1997, the Company received $7.8 million from the issuance of the Management and
Senior Notes. In August 1997, the Company also sold substantially all of the net
assets of its discontinued operations and received $3.0 million, which was paid
in cash at closing. In October 1997, the Company received net proceeds of $65.3
million from the IPO. The Company also borrowed $400,000 under its revolving
line of credit in 1995 to fund operating activities, which was repaid in 1996
with the proceeds of the sale of preferred stock. The Company borrowed $850,000
under its revolving credit line in the first half of 1997 to fund operating
activities, the outstanding balance of which was repaid with the proceeds of the
IPO.
Purchases of property and equipment totaled $339,000, $2.9 million and $4.3
million for the years ended December 31, 1995, 1996 and 1997, respectively. The
Company projects that total purchases of property and equipment will be
approximately $6.4 million in 1998, which includes $2.5 million for the creation
of a redundant system and $3.9 million to support the expansion of facilities
and operating systems for its websites and obtain computer-related equipment to
support increased personnel levels. The Company also invested cash of $672,000
to acquire the rock website, Rocktropolis, in June 1996.
In July 1997, the Company issued $1.75 million aggregate principal amount
of promissory notes to Lawrence L. Rosen, Jonathan V. Diamond and Robert David
Grusin (the "Management Notes"), each of whom loaned the Company $583,333. The
Management Notes bore interest at 14% per annum and were due on the earlier of
(i) a change of control of the Company, as defined, and (ii) March 31, 1998. The
Management Notes, including interest, converted into an aggregate of 95,354
shares of Common Stock upon the consummation of the IPO in October 1997 (the
"Management Note Conversion"). In consideration for these loans, the Company
issued an aggregate of 48,609 warrants to purchase 48,609 shares of Common
Stock, representing 16,203 warrants to each of Messrs. Rosen, Diamond and
Grusin. The warrants are exercisable at a price of $12.00 per share and expire
in July 2004. The Management Notes were recorded net of the value ($150,000)
associated with these warrants. This discount was being amortized over the term
of the debt through March 31, 1998. When the Management Notes were converted
into Common Stock in October 1997, the Company recorded an extraordinary charge
to its statement of operations which was equal to the unamortized portion of the
discount (approximately $102,000).
In August 1997, the Company issued $6,021,600 aggregate principal amount of
Senior Notes (the "Senior Notes") to a group of five institutional investors
affiliated with an insurance company and one existing stockholder of the Company
in return for loans in that amount to the Company. The Senior Notes bore
interest at 14% per annum and were due on the earlier of (i) consummation of the
Company's initial public offering, (ii) a change of control of the Company, as
defined, and (iii) March 31, 1998. In consideration for these loans, the Company
issued an aggregate of 167,266 warrants to purchase 167,266 shares of Common
Stock. The warrants are exercisable at a price of $12.00 per share and expire in
August 2004. The Senior Notes were recorded net of the value ($800,000)
associated with these warrants. This discount was being amortized over the term
of the debt through March 31, 1998. In connection with the early repayment of
the Senior Notes upon the consummation of the IPO, the Company recorded an
extraordinary charge to its statement of operations equal to the unamortized
portion of the discount (approximately $537,000). In addition, the Company
issued warrants to purchase 83,389 shares of Common stock at an exercise price
of $12.00 per share as a placement fee relating to this transaction.
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<PAGE> 27
N2K and AOL formed a strategic alliance as of September 1, 1997 under the
AOL Contract, pursuant to which N2K is featured as the exclusive on-line music
retailer within the MusicSpace channel of AOL's on-line service. In addition,
pursuant to the terms of the AOL Contract, an N2K banner continuously appears in
a prominent place on the main screen of the MusicSpace channel and links to a
customized Music Boulevard website. N2K also receives an anchor tenant position
in the music retailing department of AOL's Shopping channel. Although a limited
number of other music retailers may appear in the Shopping channel, none will be
featured or promoted more prominently than N2K. The AOL Contract also provides
for an integrated package of placements, promotions and links through aol.com,
linking to the customized Music Boulevard website. N2K is also promoted on the
results pages for certain music-related searches conducted through the AOL
NetFind search engine on aol.com. N2K and AOL have also agreed to cooperate in
the sale of advertising on the websites governed by the terms of the AOL
Contract. Each party has the first right to sell any advertising or promotional
spaces which reside on their servers. In consideration of the marketing,
promotion, advertising and other services AOL provides under the AOL Contract,
N2K agreed to pay AOL a total of $18.0 million over a three-year contract term,
of which an aggregate of $12.0 million has been paid, with additional payments
of $3.0 million to be made on each of November 1, 1998 and November 1, 1999. On
November 1, 1997, the Company amended the AOL Contract to provide for
promotional and anchor tenant buttons on aol.com's home and principal shopping
pages with a guaranteed minimum number of impressions for a one-year term in
exchange for a fee of $4.0 million to be paid on November 1, 2000, and revenue
sharing on sales and advertising resulting from button-generated traffic to
Music Boulevard. The Company is amortizing the costs associated with the AOL
Contract over the contract terms of one to three years, primarily on a straight-
line basis. The Company will continually evaluate the realizability of this
asset and if necessary, write down the asset to its net realizable value. After
the initial three year term, the AOL Contract may be renewed at the option of
AOL for additional one-year terms. In connection with the agreement by AOL to
purchase $3.0 million in aggregate value of the Company's Common Stock
simultaneously with the IPO, the Company granted the AOL Warrant for the future
purchase of up to 184,736 additional shares of Common Stock. The Company has
granted AOL certain registration rights with respect to the AOL Shares,
including incidental registration rights if the Company files a registration
statement covering any of its securities under the Securities Act (with the
exception of an offering pursuant to a registration statement on Form S-8 or
S-4). Accordingly, AOL has the right to require the Company to use its best
efforts to register and include any or all of the AOL Shares in this offering.
The Company has also granted AOL the right to require the Company to register
the AOL Shares for resale by filing a shelf registration statement; to have such
registration statement declared effective no later than April 16, 1998 (or, if
earlier, the Lock-up Release Date); and to use its best efforts to continuously
maintain the effectiveness of such registration statement until October 22,
1999. In the event that the Company fails to cause such registration statement
to be declared effective by April 16, 1998 (or, if earlier, by the Lock-up
Release Date), AOL will have the right to require the Company to repurchase the
AOL Shares for cash at a price equal to the greater of $3.0 million or the value
of the AOL Shares based on the closing price of the Company's shares on the
trading day immediately preceding the day notice of the desired repurchase was
given to the Company by AOL. The Company's repurchase obligation is supported by
an escrow arrangement currently secured by the $3.0 million purchase price of
such shares and requiring the periodic delivery by the Company of additional
funds in the form of cash and/or irrevocable letter of credit calculated with
reference to the market value of the Company's shares, subject to a minimum of
$3.0 million and a maximum of $7.5 million. The Company plans to file a
registration statement soon after the consummation of this offering to register
the AOL Shares. However, at any time after April 16, 1998, AOL can require the
Company to repurchase the AOL Shares as discussed above, and, in such event, the
Company will honor the terms of its repurchase obligation to AOL and may use a
portion of the net proceeds of this offering to fund this obligation. If the
Company is required to purchase the AOL Shares, the Common Stock subject to put
rights on the Company's consolidated balance sheets will be accreted to its fair
value based upon the price of the Company's Common Stock at each reporting date
and will be recorded as a charge to the Company's statements of operations at
each reporting date. As of March 31, 1998, this accretion is approximately
$1,850,000. See "Description of Capital Stock -- Registration Rights" and Note 1
of Notes to Consolidated Financial Statements.
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<PAGE> 28
On September 23, 1997, N2K entered into a sponsorship agreement with Excite
(the "Excite Contract") pursuant to which N2K is the exclusive retail music
store sponsor of the excite.com website, provides certain music-related content
to the excite.com website, created a co-branded area of Music Boulevard, the
Company's website, and participates in joint promotions to customers of this
co-branded area. The Excite Contract provides for the Company to pay Excite an
initiation fee, an annual exclusivity fee and an annual sponsorship fee for
on-going programming, links, placements, advertisements and promotions. Under
the terms of the Excite Contract, the Company also pays Excite a specified share
of gross margins realized by the Company on transactions, advertising,
sponsorship, promotions and other revenues generated during the term of the
Excite Contract on Music Boulevard as a result of users referred from the
excite.com website. In consideration of the sponsorship opportunity afforded to
the Company under the Excite Contract, N2K agreed to pay Excite a guaranteed
minimum total of $9.8 million over a two-year contract term, of which $3.3
million has been paid, with additional payments of $2.4 million to be paid
during 1998 and $4.1 million to be paid during 1999. The Company is amortizing
the costs associated with the Excite Contract over the initial contract term
which expires on November 17, 1999. The amortization method is primarily based
upon the number of impressions received during the contract term. The Company
will continually evaluate the realizability of this asset and, if necessary,
write down the asset to its net realizable value. Pursuant to the terms of the
Excite Contract, Excite is obligated to offer the Company the right of first
refusal to negotiate with Excite for renewal of the Excite Contract.
On September 27, 1997, N2K entered into a website services agreement with
Netscape (the "Netscape Services Agreement") pursuant to which the Company
produced, developed and manages a retail website, maintained on the Company's
servers and linked to Netscape's website, modeled after, but differentiated
from, the Company's Music Boulevard website. Under this Netscape Services
Agreement, visitors to Netscape's website may readily access the retail website,
which is promoted by Netscape using content provided by the Company, for the
on-line purchase of music products and access to related information. The
Netscape Services Agreement provides for the Company to pay Netscape $1.0
million on December 18, 1998, 12 months after the date on which the service was
fully functional and accessible to end users, and a second payment of $1.0
million on June 18, 1999, 18 months after such date. The Company is amortizing
this cost, primarily as impressions are received during the two-year contract
term. In addition, over the two-year contract term, Netscape and the Company
will share net revenues from the sale of certain music products, advertising
services, subscriptions to content, fees paid by content providers for the
provision of pay-per-view access to end users and sponsorships. N2K has entered
into one additional agreement with Netscape. Under a trademark license agreement
(the "Netscape License Agreement") effective as of September 28, 1997, Netscape
granted to the Company a license to use Netscape's trademark in connection with
the retail website that, in part, promotes Netscape's products and services. In
exchange for the rights granted to the Company under the license, the Company
has agreed to pay Netscape a one-time license fee of $4.0 million, $3.0 million
of which was paid and the remainder of which is outstanding pending the outcome
of current negotiations. The Company is amortizing this cost over the two-year
contract term, primarily on a straight-line basis. The Company will continually
evaluate the realizability of these assets and, if necessary, write down the
asset to its net realizable value. Pursuant to the terms of the Netscape License
Agreement, Netscape is obligated to offer the Company the right of first refusal
to negotiate with Netscape for its renewal.
The Company has a commitment for a $2.0 million revolving line of credit
with CoreStates Bank, N.A. (the "CoreStates Facility"), which will expire on
June 30, 1998. The CoreStates Facility bears interest at the bank's prime rate
and is secured by a security interest in substantially all of the Company's
assets. Maximum borrowings under the CoreStates Facility are limited to certain
percentages of eligible accounts receivable. The CoreStates Facility is subject
to an unused commitment fee in the amount of 0.5% of the unused portion of the
facility on a quarterly basis. As of December 31, 1997, the Company did not have
any outstanding borrowings under the CoreStates Facility.
From time to time, in the ordinary course of business, the Company
evaluates possible acquisitions of, or investments in, businesses, products and
technologies that are complementary to those of the Company. A portion of the
Company's cash resources may therefore be used to fund acquisitions or
investments. The Company currently has no arrangements, agreements or
understandings, and is not engaged in active negotiations, with respect to any
such acquisition or investment. See "Risk Factors -- Management of Growth."
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<PAGE> 29
DISCONTINUED OPERATIONS
Beginning in 1984, the Company operated an on-line information services
business. In 1994, the Company expanded its business strategy to include music
entertainment. In April 1997, the Company decided to focus exclusively on its
music entertainment business, and, as such, elected to discontinue its on-line
information services business. At that time, the Board of Directors approved a
formal plan of disposal for its on-line information services business. In August
1997, the Company sold substantially all of the net assets of this business.
The on-line information services business has been accounted for as a
discontinued operation. Accordingly, the operating results and assets and
liabilities of this business have been reflected separately from continuing
operations. The sale of the on-line information services business in August 1997
resulted in a gain of approximately $1.6 million, which was recorded in the
period ended September 30, 1997. See Note 3 of Notes to Consolidated Financial
Statements.
For the years ended December 31, 1995, 1996 and 1997, the discontinued
operations generated revenues of $11.0 million, $7.9 million, and $2.4 million,
respectively. The discontinued operations generated net income of $1.3 million
in 1995, and a net loss of $969,000 in 1996 and $416,000 in 1997.
RECENT ACCOUNTING PRONOUNCEMENTS
In June 1997, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards ("SFAS") No. 130, "Reporting Comprehensive
Income" and SFAS No. 131, "Disclosures about Segments of an Enterprise and
Related Information." SFAS No. 130 establishes standards for reporting and
display of comprehensive income and its components (revenues, expenses, gains
and losses) in a full set of general-purpose financial statements and 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. SFAS No. 130
is required to be adopted for the Company's fiscal year ending December 31,
1998. The adoption of this pronouncement is expected to have no impact on the
Company's financial position or results of operations. SFAS No. 131 establishes
standards for the way that public business enterprises report information about
operating segments in annual financial statements and requires that those
enterprises report selected information about operating segments in interim
financial reports issued to stockholders. It also establishes standards for
related disclosures about products and services, geographic areas, and major
customers. SFAS No. 131 is required to be adopted for the Company's 1998
year-end financial statements. The Company is evaluating the impact, if any, of
the adoption of this pronouncement on the Company's existing disclosures.
RISKS ASSOCIATED WITH THE YEAR 2000
The Year 2000 issue is the result of computer programs being written using
two digits rather than four to define the applicable year. In other words,
date-sensitive software may recognize a date using "00" as the year 1900 rather
than the year 2000. This could result in system failures or miscalculations
causing disruptions of operations, including, among others, a temporary
inability to process transactions, send invoices or engage in similar normal
business activities.
The Company does not believe that it has material exposure to the Year 2000
issue with respect to its own information systems since its existing systems
correctly define the Year 2000. The Company intends to conduct an analysis in
1998 to determine the extent to which its major suppliers' systems (insofar as
they relate to the Company's business) are subject to the Year 2000 issue. The
Company is currently unable to predict the extent to which the Year 2000 issue
will affect its suppliers, or the extent to which it would be vulnerable to its
suppliers' failure to remediate any Year 2000 issues on a timely basis. The
failure of a major supplier subject to the Year 2000 issue to convert its
systems on a timely basis or a conversion that is incompatible with the
Company's systems could have a material adverse effect on the Company. In
addition, most of the purchases from Music Boulevard are made with credit cards,
and the Company's operations may be materially adversely affected to the extent
its customers are unable to use their credit cards due to Year 2000 issues that
are not rectified by their credit card providers.
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<PAGE> 30
BUSINESS
N2K is one of the leading on-line music entertainment companies using the
Internet as a global platform for promoting, marketing and selling music and
related merchandise. The Company's strategy is to build loyal user communities
around genre-specific websites that provide music content and enable consumers
to purchase CDs, cassettes and related merchandise. The Company believes that as
its user base continues to grow, it will be able to increase revenues from sales
of music, related merchandise, advertising and sponsorship programs.
The Company's music retail website is Music Boulevard (MUSICBLVD.COM),
around which the Company organizes its genre-specific music websites,
Rocktropolis (ROCKTROPOLIS.COM), Jazz Central Station (JAZZCENTRALSTATION.COM)
and Classical Insites (CLASSICALINSITES.COM). In addition to these genre
websites, the Company also operates websites for such artists as David Bowie,
The Rolling Stones and Leonard Bernstein. The Company's websites allow users to
view current music news, reviews, artist biographies and discographies,
musicians' favorite artist recordings and historical and educational
information, and to hear and view cybercasts and recording and video samples.
Consumers may search, browse and purchase music recordings from a database of
over 200,000 CDs, cassettes, LPs, videos and related music items, digitally
access 30-second music samples from a selection of over 350,000 songs, read from
over 60,000 reviews and related articles and view music video clips. In July
1997, the Company introduced its e
- -mod system, which allows consumers to purchase and digitally download from a
collection of music singles. All product purchases are coordinated through Music
Boulevard, which acts as the Company's on-line retail store. The Company
believes that by providing a wealth of information in a highly personalized,
interactive context, it creates an entertaining environment that attracts
traffic to its websites, fosters brand awareness and encourages purchases of
music and related merchandise.
As part of its growth strategy, the Company seeks to establish strategic
alliances with global on-line, music and media companies to attract additional
users to, and increase brand awareness of, the Company's websites. For example,
the Company has formed a strategic alliance with AOL under an interactive
marketing agreement, pursuant to which, among other things, Music Boulevard is
featured as the exclusive on-line music retailer within AOL's MusicSpace
channel, receives an anchor tenant position on AOL's Shopping channel,
participates in a variety of banner advertising opportunities and is assigned
specific keywords within the AOL service. The AOL Contract also provides for
promotional and anchor tenant buttons on aol.com's home and principal shopping
pages. Similarly, the Company has entered agreements with Excite and Netscape,
pursuant to which visitors to the websites of Excite and Netscape may access a
co-branded Music Boulevard service. From this service, visitors may purchase
music and related products and access music content and related information. N2K
has established strategic agreements as most prominently featured music content
provider and on-line music retailer for WebTV, as most prominently featured
music content provider and exclusive music retailing anchor tenant for @Home, as
exclusive on-line product fulfillment source for the Virgin Records website and
the advertising music sponsor and a prominently featured on-line music retailer
for the PointCast Network. In addition, the Company has entered into an
exclusive agreement with CBS Cable, owner and operator of TNN and CMT, to create
and promote country music retailing through its website, country.com, and to
create a special co-branded area called Country Music Boulevard which will
become the exclusive on-line country music store on country.com and Music
Boulevard.
The Company intends to capitalize on the global nature of the Internet to
build an international user base by creating local language versions of, and
localized content for, the Company's websites. The Company has established a
wholly-owned subsidiary in Japan, the world's second largest market for recorded
music sales, and has launched Japanese versions of Music Boulevard
(MUSICBLVD.COM/JP) and Jazz Central Station (JP.JAZZCENTRALSTATION.COM). The
Company has expanded the number of titles offered and has provided more
localized product to international markets through creating alliances with
international fulfillment operations. The Company has entered into an exclusive
agreement with Shinseido Inc., the leading music retail chain in Japan, to add
more than 175,000 new local-language music titles to the Japanese version of
Music Boulevard beginning in the fourth quarter of 1998. The Company has entered
into an agreement with MSI whereby MSI will provide at least 150,000
international titles to Music Boulevard's catalog of offerings and create a
fulfillment center in the Netherlands to serve European markets commencing in
the second quarter of 1998.
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The Company has an agreement with MTV Networks, on behalf of MTV International
Networks, to create localized MTV-Music Boulevard sites for Europe, Brazil,
Japan and Asia. The Company also offers registration and ordering instructions
on Music Boulevard in English, Japanese, German, French and Spanish.
The Company has also established its own record label, N2K Encoded Music,
under the direction of Grammy Award-winning producer Phil Ramone. N2K Encoded
Music uses the Company's websites, as well as record stores and other
traditional distribution channels, to promote, distribute and sell original and
licensed artist recordings. Traditional domestic distribution for the Company's
record label is handled by Sony's RED Distribution.
ON-LINE MUSIC INDUSTRY
The Company believes that substantial growth opportunities exist in the
on-line music industry. According to Jupiter Communications ("Jupiter"), total
on-line music revenues, which include prerecorded music sales, music related
merchandising, advertising and concert ticketing, are expected to grow to $2.8
billion by the year 2002, up from an estimated $22.5 million in 1996 and $71.0
million in 1997. Jupiter estimates that the number of on-line households making
purchases is expected to grow from an estimated 15.2 million households in 1996
to 57.0 million households, representing over 50% of U.S. households, by the
year 2002. During the same time period, Jupiter estimates that the percentage of
on-line households making on-line purchases annually is expected to grow from
approximately 20% to 70%.
The Company believes that the multimedia features available through the
Internet, including audio, video and graphics, make it an ideal medium for
promoting, marketing and selling music and related merchandise. Potential
purchasers of music recordings can preview their purchases by listening to
high-quality sound samples, viewing text and video clips (including cover art,
artists' discographies, music videos and reviews) and searching from an
extensive catalog of available titles. The Internet and current technologies
also allow users to digitally download music in a compressed format to a
personal computer ("PC") and store it on a CD using a read/write CD-ROM drive.
Internet users can also search for music by genre or artist, access a wealth of
information and events, including music history and news, artists' biographies,
cybercast concerts and radio broadcasts, and participate in live interviews with
artists. Because the Internet is a highly interactive medium and user responses
can be tracked, the Company believes that advertisers will become increasingly
attracted to opportunities to focus their marketing efforts on specific user
groups and individuals.
The Company believes that Internet-based retailers have certain advantages
over traditional retail channels. Traditional retail stores limit the amount of
inventory they carry and tend to focus on carrying a greater percentage of hit
releases. The Company estimates that a traditional retail store stocks an
average of 10,000 stock keeping units ("SKUs") and megastores stock an average
of approximately 39,000 SKUs out of a total of more than 200,000 SKUs generally
available in the U.S. and offered by the Company. According to SoundScan, Inc.
("SoundScan"), a retail audio sales data collection company, the number of new
releases in 1996 alone was more than 28,000 titles. According to Jupiter, 80% of
unit sales at traditional retail stores come from only 20% of available titles.
The Company believes that traditional retail stores do not have the same
capability to track individual customer purchases and demographic data for use
in direct marketing programs and in developing a one-to-one relationship with
the consumer. Internet-based stores can operate 24-hours a day, seven days a
week, and are not limited by geographic boundaries.
An individual electronic commerce website can maximize its awareness and
traffic through the use of strategic alliances with other websites having high
user traffic. Through the use of embedded hyperlinks, higher traffic websites
can refer potential customers to electronic commerce websites for potential
purchases of goods or services. These agreements generally involve economic
arrangements including upfront payments or commissions on the dollar volume of
goods sold. These payments are analogous to rent paid by traditional "brick and
mortar" retail locations, and can be critical to an electronic commerce
website's ability to expand.
The Company believes that the demographic profile of consumers of recorded
music has aged along with the population. According to the Recording Industry
Association of America ("RIAA"), domestic purchases of recorded music by those
30 and over have increased from approximately 34% of U.S. sales in 1986 to
approximately 47% of sales, or approximately $5.9 billion, in 1996. The Company
believes that the Internet
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<PAGE> 32
represents an attractive retail and promotion medium for customers in this age
group as they are less "hits-driven" than younger age groups, typically can
afford to buy more titles at one time, often own PCs and generally have credit
cards, which are generally used to make electronic payments.
Historically, the music industry has benefited from innovations in
technology, such as the introduction of the CD in 1983. Over the last ten years,
much of the industry's growth resulted from consumers replacing existing music
collections with the CD format. According to the RIAA, domestic music sales grew
from $5.6 billion in 1987 to $12.5 billion in 1996. In recent years, however,
music sales growth has slowed due to a number of factors, including a shortage
of major releases by new artists and a slowdown in the rate of growth of CD
sales, as consumers have replaced most of their music collections. Nevertheless,
the number of retailers distributing music during this time period has
increased, resulting in greater competition and the closure of a number of
traditional record stores. For example, according to the RIAA, traditional
record stores' market share of music sales dropped from a peak of 72% in 1989 to
50% in 1996. During the same time period, stores such as mass merchandisers,
discount chains and consumer electronics stores have increased their market
share from 16% to 32% and music clubs have increased their market share from 8%
to 14%.
BUSINESS STRATEGY
The Company's strategy includes the following key elements:
Create Strong Brand Awareness. The Company believes that building brand
awareness of the N2K websites is critical to attracting and expanding its global
Internet user base. N2K promotes its brand identities through on-line and
traditional media, event sponsorships and other marketing activities. The
Company enhances brand awareness of its individual websites by providing
original and proprietary content, providing consumers the ability to purchase
music and related merchandise and establishing strategic and bounty
relationships whereby other websites engage Music Boulevard as their on-line
music retailer and content provider.
Develop Key Industry and Website Alliances. The Company seeks to establish
strategic alliances with global music and media companies to attract additional
users to, and increase brand awareness of, the Company's websites. Strategic
alliances include those with AOL, Excite, Netscape, WebTV, @Home, CBS Cable
(country.com), Virgin Records and PointCast, pursuant to which N2K is the
exclusive or a prominently featured on-line music retailer or fulfillment source
for each of these companies' respective websites. The Company views these
agreements as a significant competitive advantage. In addition, N2K has
established its Remote Access Music ("RAM") program, whereby third-party
websites may register with N2K and establish hyperlinks to Music Boulevard for
on-line music retailing.
Offer Largest Selection of Music and Related Merchandise. The Company's
merchandising strategy centers around offering users one of the largest
collections of music and related items (including over 200,000 CDs, cassettes,
LPs, videos, and related music items) in a multimedia, interactive and
personalized environment. Through the Company's e
- -mod system, users can also digitally download a select number of singles. The
Company believes that its extensive music catalog, combined with specific artist
features, music reviews, sound samples and music videos, draws users into areas
of personal interest and generates incremental sales by exposing consumers to
music for which their knowledge or access may be limited or which may be
unavailable in traditional retail environments.
Build User Communities and Attract Advertising. The Company's strategy is
to build global on-line communities around specific genres of music, all of
which link to the Company's retail website, Music Boulevard. The Company
believes that organizing its websites by music genres such as rock, jazz,
country and classical music parallels traditional radio and other media formats
as well as consumer buying patterns. By organizing its websites by music genre,
the Company is able to aggregate targeted demographic user groups, thereby
offering advertisers and sponsors access to highly defined audiences. These
targeted user groups enable advertisers and sponsors to customize their messages
through banner advertisements, event and program sponsorships and music
recording promotions. The Company provides its advertisers and sponsors with
quantitative feedback on the effectiveness of their website advertising and
sponsorship programs.
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Expand International Presence. The Company intends to capitalize on the
global nature of the Internet to build an international user base by creating
local language versions of, and culture-specific content for, the Company's
websites. The Company has established a wholly-owned subsidiary in Japan, the
world's second largest market for recorded music sales, and has launched
Japanese versions of Music Boulevard and Jazz Central Station. The Company has
also entered into other agreements with Shinseido, Inc. and MSI to provide a
significant number of additional local-content music titles in Japan and
European markets. The Company has also entered into an agreement with MTV
Networks, on behalf of MTV International Networks, to create localized MTV-Music
Boulevard sites for Europe, Brazil, Japan and Asia.
Leverage Infrastructure Through Multiple Websites. The Company intends to
utilize its current infrastructure to enhance existing, and add new, genre and
artist websites. Retailing components in each genre website are dynamically
driven from Music Boulevard databases, and are presented within the interface
and design of the genre website. The Company believes that both users and
advertisers prefer websites designed for specific audiences and that a multiple
website approach enhances the Company's ability to promote content within each
website, encourages more users to bookmark the Company's websites and attracts
greater numbers of third-party hyperlinks to the Company's websites.
Build and Leverage N2K Encoded Music Label. The Company has established
its own record label, N2K Encoded Music, which uses the Company's websites, as
well as record stores and other traditional distribution channels, to promote,
distribute and sell original and licensed artist recordings. The Company
believes that it can leverage its Internet platform by promoting and selling its
own proprietary titles produced by N2K Encoded Music. The artists and products
of N2K Encoded Music also provide an additional source of engaging content for
the Company's genre websites.
N2K WEBSITES
The Company's music retail website is Music Boulevard (MUSICBLVD.COM),
around which the Company organizes its genre-specific music websites,
Rocktropolis (ROCKTROPOLIS.COM), Jazz Central Station (JAZZCENTRALSTATION.COM)
and Classical Insites (CLASSICALINSITES.COM). In addition to these genre
websites, the Company also hosts websites for such artists as David Bowie
(DAVIDBOWIE.COM), The Rolling Stones (STONESWORLD.COM) and Leonard Bernstein
(LEONARDBERNSTEIN.COM). As part of its multiple website strategy, the Company
assigns, whenever possible, a separate universal resource locator or "URL" to
each of its genre and artist websites, and continually reviews and revises these
websites to provide both an interesting and easy to use on-line experience. The
Company believes that both users and advertisers prefer websites with distinct
URLs designed for specific audiences.
Music Retail and Genre Websites. The Company believes that by providing a
wealth of information in a highly personalized, interactive context, it creates
an entertaining environment that attracts traffic to its websites, fosters brand
awareness and encourages purchases of music and related merchandise. The
Company's existing music retail and genre websites include the following:
MUSICBLVD.COM
Music Boulevard is the Company's flagship website, featuring a rich
graphical and musical environment containing over 75,000 graphic images and
offering over 200,000 CDs, cassettes, LPs, videos and related music items. The
Music Boulevard URL leads to a home page containing site navigation, featured
store specials, site features, search capability and links to genre-specific
store departments. Users may choose desired locations by clicking on a
navigation bar or hyperlinked text allowing them to begin (i) purchasing music
items on-line and checking their order status; (ii) searching for artists,
titles, songs or compositions; (iii) accessing specials and sales promotions;
(iv) linking to genre departments including Rock/Pop, Alternative, R&B/Hip-Hop,
Jazz, Classical, Country, World Music, Shows & Soundtracks and Various & Family;
(v) accessing features such as music news, pre-release ordering section,
Billboard and Music Boulevard charts, over 60,000 reviews and features from
allstar, Jazz Track (news from Jazz Central Station) and CI Classical Review
(news from Classical Insites), and articles from SPIN, JazzTimes, Puncture,
Fanfare, Dirty Linen, Relix, Blues Access and IAJE Jazz Educators Journal
magazines; (vi) joining the Frequent Buyer's Club; (vii) linking to the area
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containing the most recently purchased albums in each genre; and (viii)
listening to sound samples in MPEG, RealAudio or Liquid Audio formats.
A personal shopping cart allows the user to select merchandise for purchase
while navigating through Music Boulevard. Items can be added to or subtracted
from a shopping cart at any time. As a user completes a search, similar or
complementary artists and titles are suggested. By pressing the "buy" button,
the customer completes the ordering process. See "-- Ordering, Fulfillment and
Customer Service." Music Boulevard customers can join a Frequent Buyers Club and
receive a free CD after purchasing a certain quantity of CDs. To join the
Frequent Buyers Club, customers complete a brief survey which provides valuable
demographic data. The Company currently utilizes the Frequent Buyers Club data
to analyze customer shopping trends and demographics, and is evaluating ways in
which it may utilize this data to customize marketing programs. Each Music
Boulevard department contains new releases, on sale items, daily and weekly
featured reviews, a sales promotion billboard and virtual endcaps with sale
pricing, icons for audio samples and short editorial copy.
ROCKTROPOLIS.COM
The Rocktropolis website is an in-depth, multimedia entertainment and
information resource for the global rock and pop music communities. Rocktropolis
offers a comprehensive guide to the world of rock and pop music, enabling users
to listen to live performances, discuss their favorite artists and access music
reviews on-line. Each area of Rocktropolis has a unique design and advanced
multimedia elements, as well as engaging content. Rocktropolis' primary areas
include: Events, Talk, Search, Rocktropolis Radio and News. Events features live
and archived cybercasts of artist concerts and interviews. Featured artists have
included David Bowie, Sting, Beck, Sex Pistols, Porno for Pyros, Bush, The
Tragically Hip, Chemical Brothers, Motley Crue, Los Lobos and Sheryl Crow. Talk
features special-event chats, 24-hour chat rooms and bulletin boards. Search
enables users to retrieve news stories, gossip items, album reviews and other
information about their favorite artists. Search also features links to the
Company's artist websites, including the David Bowie and Rolling Stones
websites. Rocktropolis Radio features four separate pre-selected streaming audio
stations covering Rock, Electronic, Punk and College genres. News is the home of
the award-winning allstar on-line music magazine, which provides daily music
news and gossip. allstar features album and live reviews, as well as in-depth
interviews with some of rock music's most important musicians.
JAZZCENTRALSTATION.COM
Jazz Central Station is an in-depth jazz, multimedia music entertainment
and information resource bringing together jazz fans, musicians, educators and
industry leaders from around the globe. Jazz Central Station features live chats
with renowned artists, in-depth information, artist interviews, sound clips and
educational resources for music students. The site spotlights a rotating roster
of jazz artists as well as listings of current and upcoming album releases, tour
schedules, concerts and festivals worldwide. Jazz Central Station is home to the
Chick Corea website, and official sites for Miles Davis (milesdavis.com)and
Wynton Marsalis (wyntonmarsalis.com) are expected to be launched in mid-1998.
Jazz Central Station also hosts artist sites for Joshua Redman and Gerry
Mulligan. Additionally, Jazz Central Station is the only website to offer a
continuous audio stream of WBGO 88.3 FM, a leading jazz radio station.
Jazz Central Station is the official website for JazzTimes magazine, the
International Association of Jazz Educators (IAJE), George Wein's Festival
Productions (producer of the JVC Jazz Festival), the Playboy Jazz Festival and
the North Sea Jazz Festival. In 1996, Jazz Central Station inaugurated the first
annual JCS Global Jazz Poll.
Jazz Central Station has an acclaimed Board of Advisors, including Chick
Corea, Quincy Jones, Ramsey Lewis, Bruce Lundvall, Dan Morgenstern and George
Wein.
CLASSICALINSITES.COM
Classical Insites is an in-depth, multimedia music entertainment and
information resource for the global classical music community. Classical Insites
offers a comprehensive guide to the world of classical music, enabling users to
explore the history and personalities of classical music, listen to performances
and
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discussions by legendary artists, seek out worldwide classical music events and
purchase music and related merchandise on-line. In addition to text, features
are enhanced by graphic and multimedia elements. Classical Insites' primary
areas include: The Hall of Fame, a gallery of great classical composers and
performers (including recent inductees Luciano Pavarotti, Leontyne Price, Yo-Yo
Ma and Pierre Boulez); and The Performance Center, including a concert hall
(featuring broadcasts, performances and other events), a spotlight area
(introducing the work of important, lesser-known composers and performers), an
information booth (providing links to performing organizations around the world)
and a screening room (featuring exciting new films and great film scores). Other
highlights of Classical Insites include the official website of Leonard
Bernstein (leonardbernstein.com).
Classical Insites also hosts the official website of WQXR (96.3 FM), one of
the country's leading classical music radio stations, offering music listings,
program information and a live audio stream to allow users worldwide to hear
WQXR's classical programming. Classical Insites' users can enjoy on-line
editions of Fanfare Magazine (a leading classical music publication) and CI
Classical Review (an in-house publication of CD reviews and feature articles).
Among its plans for 1998, Classical Insites intends to launch the official
website of Cecilia Bartoli (ceciliabartoli.com), one of the world's renowned
mezzo-sopranos, and to produce and present special on-line programming through
the Company's new relationship with the Library of Congress. Classical Insites
will also announce the winners of its first Global Classical Music Poll, in
which users voted for their favorite artists. The Lifetime Achievement category
of this award is being voted on by Classical Insites' distinguished Board of
Advisors, which includes Betty Allen, Marilyn Bergman, Nina Bernstein, John
Corigliano, Peter Gelb, Charles Hamlen, Omus Hirschbein, Bobby McFerrin, Arnold
Steinhardt, Michael Tilson Thomas and Charles Webb. The Board of Advisors is
composed of artists and industry leaders that as a whole represent the various
aspects of the diverse classical music community.
Artist Websites. The Company's artist websites include interviews,
discographies, sound and video samples, artists' best recordings, artists'
recommended listening and touring and biographical information. These artist
websites each have a separate URL.
DAVIDBOWIE.COM
The David Bowie website contains many features on the artist, including an
exploration of his latest album releases, Outside and Earthling. The website
also takes visitors inside the murder-mystery world explored in Bowie's short
story, "The Diaries of Nathan Adler." The website features sound samples, band
biographies, concert clips and information, interviews, cover art, the full text
of "The Diaries of Nathan Adler" and information on Bowie's latest releases and
tours (including coverage of his 50th Birthday Concert at Madison Square
Garden). David Bowie's Telling Lies was one of the first singles to be released
exclusively on the Internet. The single has been digitally downloaded over
300,000 times by website visitors. In addition, the website contains a special
section featuring the artist's selected websites and samples of his digital art.
Bowie fans can communicate with each other and with the artist via the website's
Message Board.
STONESWORLD.COM
Stones World is a Rolling Stones website that features an extensive
overview of the band. The website features a comprehensive catalog of the
Rolling Stones' music, comprised of five separate sections: Discography, Down on
the Corner, Mile Stones, Index and a welcome message from Mick Jagger and Keith
Richards. This website incorporates sound samples, live concert clips, band and
concert information, interviews, archival photos, full lyrics and an interactive
poker game. Stones fans can communicate with each other via the website's
Message Board.
LEONARDBERNSTEIN.COM
The Leonard Bernstein website is the official website celebrating Leonard
Bernstein's life and legacy, developed in conjunction with the Bernstein family
and estate. Drawing primarily on the vast archive of Bernstein materials left to
the Library of Congress, this website presents a multifaceted portrait of
Leonard Bernstein through an extensive collection of rare documents,
photographs, interview excerpts, audio samples
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and video material. Visitors to the Leonard Bernstein website enter a virtual
rendition of Bernstein's actual studio and can explore "themes" that offer
unique insight into this great American musician's creative mind. The website
offers users the opportunity to read from a selection of Leonard Bernstein's
private letters and peruse his manuscript scores, working notes, rare
photographs, programs and more. Among some of the website's offerings were
exhibits featuring West Side Story (including documentation of its long and
complicated genesis), The Young People's Concerts with the New York Philharmonic
(including letters from devoted fans of all ages whose lives were changed by
these ground-breaking educational programs) and Bernstein's 1943 debut with the
New York Philharmonic. Many of the elements featured on the website have never
before been available to the public. Special Leonard Bernstein recordings and
related merchandise are available exclusively through Music Boulevard.
International Websites. The Company intends to capitalize on the global
nature of the Internet to build an international user base by creating local
language versions of, and localized content for, the Company's websites. The
Company has established a wholly-owned subsidiary in Japan, the world's second
largest market for recorded music sales, and has launched Japanese versions of
Music Boulevard (musicblvd.com/jp) and Jazz Central Station
(jp.jazzcentralstation.com). The Company has expanded the number of titles
offered and has provided more localized product to international markets through
creating alliances with international fulfillment operations. The Company has
entered into an exclusive agreement with Shinseido Inc., the leading music
retail chain in Japan, to add more than 175,000 new local-language music titles
to the Japanese version of Music Boulevard beginning in the fourth quarter of
1998. The Company has entered into an agreement with MSI whereby MSI will
provide at least 150,000 international titles to Music Boulevard's catalog of
offerings and create a fulfillment center in the Netherlands to serve European
markets commencing in the second quarter of 1998. The Company has an agreement
with MTV Networks, on behalf of MTV International Networks, to create localized
MTV-Music Boulevard sites for Europe, Brazil, Japan and Asia. The Company also
offers registration and ordering instructions on Music Boulevard in English,
Japanese, German, French and Spanish.
N2K ENCODED MUSIC
In January 1997, the Company launched its own record label, N2K Encoded
Music, to create, produce, license, acquire and market high-quality recorded
music, which is distributed through the Company's websites as well as through
record stores and other traditional retail and distribution channels. N2K
Encoded Music currently produces recordings across several music genres,
including rock, pop, jazz, classical and blues. In building and expanding the
N2K Encoded Music record label, the Company licenses master recordings from
other record labels, acquires master recordings and publishing catalogs and
signs artists to the record label. Through its websites, the Company features
and promotes individual artists who are signed to the N2K Encoded Music label.
The Company anticipates that in the short-term the majority of N2K Encoded
Music's new recordings will be sold in traditional record stores.
Phil Ramone, a noted independent record producer, is the President of N2K
Encoded Music. In such capacity, Mr. Ramone is responsible for managing,
conducting and developing the business of N2K Encoded Music, including signing
recording artists to perform for the N2K Encoded Music label and serving as
Producer or Executive Producer for one or more of its albums. Mr. Ramone has
produced albums for a variety of well-known recording artists, including Billy
Joel, Paul Simon, Chicago, Barbra Streisand, Paul McCartney, Elton John and
Frank Sinatra, among many others. He has also produced soundtracks or albums for
the following films: A Star is Born, Flashdance, Ghostbusters, On Her Majesty's
Secret Service, Midnight Cowboy, Reds, Shampoo, Stand By Me, White Nights and
Yentl, as well as sixteen Broadway plays including Chicago, A Funny Thing
Happened on the Way to the Forum, Hair, Passion, The Wiz, Starlight Express and
Promises, Promises. In addition to numerous platinum and gold albums and
singles, Mr. Ramone has received eight Grammy Awards and many other music
awards. See "Management -- Employment Agreements."
On October 16, 1996, the Company and Sony's RED Distribution entered into a
letter agreement providing that Sony's RED Distribution will be the exclusive
distribution agent in the United States for the N2K Encoded Music label. The
agreement has a three-year term which expires on October 15, 1999 and provides
for payment to Sony's RED Distribution of a distribution fee equal to a
graduated percentage of net
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sales. The agreement also provides that the Company will deliver at least 12
previously unreleased, newly compiled or recorded studio albums during each year
of the term of the agreement.
N2K Encoded Music promotes its image as a multimedia, Internet-oriented
label. The Company uses its websites to promote the N2K Encoded Music label and
intends to create a website or featured artist area within an existing N2K
website for each of its recording artists.
For each artist recording, N2K Encoded Music creates a tailored marketing
plan. In conjunction with an artist's release, N2K Encoded Music employs
traditional marketing efforts, including the coordination of radio
advertisements, distribution of CDs to radio syndicates to encourage air-time
play, distribution of point-of-purchase displays to retail locations and
organization of live performances and appearances for the artist. The Company
also uses its websites to promote artists' releases. Users are directed to an
artist's website or featured area for editorial content, sound and video
samples, digital downloading of singles and samples and artist cybercasts. The
Company also creates banner ads on its websites announcing an artist's release
and intends to utilize its strategic partners for co-marketing. The Company
believes that these promotional tactics differentiate N2K Encoded Music from
other labels.
STRATEGIC ALLIANCES
The Company has formed a strategic alliance with AOL under an interactive
marketing agreement, pursuant to which, among other things, N2K is featured as
the exclusive on-line music retailer within AOL's MusicSpace channel, receives
an anchor tenant position on AOL's Shopping channel, participates in a variety
of banner advertising opportunities and is assigned specific keywords within the
AOL service. In addition, AOL shares in a portion of the Company's sales
proceeds and advertising revenues. The Company has also entered into an
agreement with AOL for promotional and anchor tenant buttons on aol.com's home
and principal shopping pages. Similarly, the Company has entered into the Excite
Contract, pursuant to which Music Boulevard is the exclusive retail music store
sponsor of the excite.com website, provides certain music-related content to the
excite.com website, created a co-branded area of Music Boulevard and
participates in joint promotions to customers of this co-branded area. The
Company has also entered into the Netscape Services Agreement, pursuant to which
the Company produced, developed and manages a retail website modeled after Music
Boulevard that is promoted by Netscape and is readily accessible by visitors to
Netscape's website to purchase music products and access related information.
N2K has established strategic agreements as most prominently featured music
content provider and on-line music retailer for WebTV, as most prominently
featured music content provider and exclusive music retailing anchor tenant for
@Home, as exclusive on-line product fulfillment source for the Virgin Records
website, and the advertising music sponsor and a prominently featured on-line
music retailer for the PointCast Network.
Some of the key aspects of the Company's strategic alliances include the
following:
- Under the terms of the AOL Contract, N2K and AOL share revenues generated
from the sale of advertising, sponsorships, CDs and related merchandise.
Music Boulevard is featured as the exclusive on-line music retailer
within AOL's MusicSpace channel, receives an anchor tenant position on
AOL's Shopping channel, participates in a variety of banner advertising
opportunities and is assigned specific keywords within the AOL service.
The AOL Contract has a term of three years and is renewable at the option
of AOL for additional one-year terms. The AOL Contract also provides for
promotional and anchor tenant buttons on aol.com's home and principal
shopping pages for a one-year term. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations."
- Under the terms of the Excite Contract, N2K and Excite share the gross
margins realized by the Company on revenues generated from transactions,
advertising, sponsorship and promotions on Music Boulevard as a result of
users referred from the excite.com website. The Excite Contract provides
for the Company to pay Excite an initiation fee and an annual exclusivity
fee, as well as an annual sponsorship fee for on-going programming,
links, placements, advertisements and promotions. The Excite Contract has
an initial term which expires on November 17, 1999. Pursuant to the terms
of the agreement, Excite is obligated to offer the Company the right of
first refusal to negotiate with Excite
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for renewal of the Excite Contract. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations."
- Under the terms of the Netscape Services Agreement, N2K and Netscape
share revenues from the sale of certain music products, advertising
services, subscriptions to content, fees paid by content providers for
the provision of pay-per-view access to end users and sponsorships over
the two-year contract term. The Netscape Services Agreement provides for
the Company to pay Netscape $1.0 million on December 18, 1998, 12 months
after the date on which the service was fully functional and accessible
to end users and a second payment of $1.0 million 18 months after such
date. Under the Netscape License Agreement, the Company has agreed to pay
Netscape a one-time license fee of $4.0 million, $3.0 million of which
was paid in 1997 and the remainder of which is outstanding pending the
outcome of current negotiations.
- The Company's agreement with WebTV involves the sharing of revenue
generated as a result of traffic on the Company's pages within the WebTV
Network, including net revenues and royalties from advertising, premium
services (including, but not limited to, periodic pay-per-view or
pay-per-play programs) and transactions (including, but not limited to,
revenues from merchandising products/services, other promotions and
follow-on transactions). The WebTV agreement expires in September 1998.
- The agreement between the Company and @Home requires the Company to share
net revenues with @Home from the sale of both music products and
non-music products such as clothing, videotapes and computer accessories.
Any net fees or net advertising revenues generated from any of the five
exclusive events to be created annually by the Company for @Home
customers only are shared. The agreement with @Home is for an initial
term of one year, expiring June 6, 1998, and provides for an automatic
renewal for an additional one-year term.
- The Company's agreement with CBS Cable, owner and operator of TNN, CMT,
and its website, country.com, requires the Company to share (i) net
revenues with CBS Cable from the sale of both music products and
non-music products, such as apparel, video tapes, and other music related
products and (ii) any net fees or net advertising revenues generated from
advertising placed on any of the co-branded pages on both Country Music
Boulevard and country.com. The agreement expires five years following the
launch date of the co-branded site named Country Music Boulevard and can
be terminated earlier by either party in the event that certain revenue
targets are not achieved.
- The Company's agreement with Virgin Records involves the payment by the
Company to Virgin Records of a royalty on sales of all products sold by
the Company to customers who have linked from the Virgin Records website
prior to making a purchase. The agreement with Virgin Records had an
initial term of one year, was extended for one year on October 27, 1997,
and has automatic renewal terms.
- The Company has an agreement with MTV Networks, on behalf of MTV
International Networks, to create localized MTV-Music Boulevard sites for
Europe, Brazil, Japan and Asia. The agreement involves the payment of a
royalty on sales of all products coming through the local MTV-Music
Boulevard sites. The Company has one year from the date of the agreement
(July 29, 1997) to launch each local Music Boulevard site, and the
agreement has a one-year term from the launch date of each site.
- The Company pays an annual sponsorship fee to PointCast and also pays
PointCast a royalty on the sales of all products sold by the Company to
designated PointCast users.
- The Company receives an administration fee based on a percent of gross
advertising revenues, and shares net advertising revenues with WBGO. The
Company is required to incur certain non-material development and
maintenance expenses for the related website during the contract term.
The agreement expires in September 1999, with automatic one-year
renewals.
- Pursuant to the Company's website development agreement with Interstate
Broadcasting Company, Inc., the licensee of WQXR, the Company is required
to pay for all design and production costs related to the development and
maintenance of the WQXR website. The WQXR agreement provides for an
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initial contract term which extends one year from the website's launch
date of November 14, 1996, with one automatic one-year renewal.
SALES AND MARKETING
The Company's overall sales and marketing strategy is designed to
effectively merchandise music and related products sold through Music Boulevard
by building brand awareness, attracting repeat users and driving traffic to
N2K's websites. The Company utilizes a combination of external advertising and
promotion, internal promotion and product merchandising and on-line partnering
programs, including the RAM program, to accomplish these objectives. The Company
currently employs approximately 48 people in its sales and marketing department.
Website Promotion
The Company utilizes strategic alliances to increase brand awareness and
drive traffic to Music Boulevard. In addition, the RAM program enables
independent websites to offer their users the ability to purchase CDs, cassettes
and music-related merchandise through a link to Music Boulevard, earning a
commission on items sold through their website. The Company also employs a
combination of on-line and off-line advertising and promotion campaigns to
stimulate traffic to its websites. The Company purchases targeted "keyword"
advertising on search engines and directories such as Lycos, Hot Bot and
Infoseek, and on selected destination websites such as E!Online, Billboard.com
and PointCast, which have targeted demographics similar to those of N2K's users.
In addition, the Company attracts customers through negotiated cost-per-lead and
cost-per-click arrangements with such sites as AudioNet, Preview Travel, Big
Yellow and the DoubleClick Direct network. Generally, these advertisements are
in the form of interactive banners. The Company establishes hyperlinks between
N2K websites and artist and fan club websites, posts in music-related newsgroups
and secures reviews and event notices in appropriate directory websites.
The Company is building its brand awareness through television and print
advertising. The Company expects to spend between $5.0 million and $8.0 million
in traditional advertising during the 1998 calendar year. The Company also
intends to run an extensive print advertising campaign in appropriately targeted
publications in the late spring and summer months of 1998. The Company has a
proactive public relations program and participates in trade shows, conferences
and speaking engagements.
The Company also promotes its Music Boulevard website through hyperlinks
from record label websites and through its relationship with SoundScan. The
Company believes that hyperlinks between Music Boulevard and record label
websites are attractive to record companies who do not sell to consumers
directly on their own websites because of conflicts with retailers. In its
relationship with SoundScan, the Company reports its weekly recorded music
transactions taking place on its Music Boulevard website. SoundScan uses this
information, along with data from the vast majority of music retail locations
nationwide, to tally U.S. music sales. This data is the exclusive criteria for
compiling the Billboard charts, and qualifies the N2K network of websites as a
potential advertising medium for record labels.
Merchandising and Customer Programs
A key part of the Company's merchandising and customer acquisition and
retention strategies is its ability to link its music genre, artist and
title-specific content, such as record reviews, artist profiles and special
promotions, to the music ordering section of Music Boulevard and stimulate and
facilitate consumer purchases of CDs, cassettes and related merchandise.
Pricing. The Company adjusts pricing strategies and tactics as necessary
to maintain competitiveness. The Company's strategy is to price aggressively all
recent releases and popular titles. The Company seeks to encourage the purchase
of multiple titles by capping shipping costs and guaranteeing two-day delivery
within the U.S. for purchases of five titles or more.
In-Store Merchandising. The Company utilizes numerous merchandising
features to encourage and enhance a consumer's buying experience. The Company
believes that the user's ability to listen to audio
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samples from a selection of over 350,000 songs is a significant incentive to
purchase. Prior to making a purchase on Music Boulevard, a consumer can also
access a variety of information about an artist, music group, album or music
genre.
The Company regularly creates artist and sales programs on its music
websites to maximize visibility and sell-through. The Company contracts with
Billboard to display the top selling music charts on the Music Boulevard
website, which the Company believes provides the consumer with an effective
resource for locating samples and sale pricing. The Company has enabled its
customers to purchase upcoming popular album releases not yet appearing in
conventional retail stores. These titles are delivered to Music Boulevard
customers on their respective titles' release dates. The Company promotes these
sales events via ad banners both on N2K websites and others' websites.
Exclusive Product Distribution. Through its relationships with music
artists and their business representatives, N2K has in the past made
arrangements with several well known artists to sell selected recordings
exclusively through the Music Boulevard distribution channel. The Company
intends to continue to pursue such relationships in the future. In addition to
generating a higher profit margin, these exclusive releases are not available
through any other music retailers, giving Music Boulevard a significant
competitive advantage.
Push Marketing. The Company has created virtual listening posts, which
consist of CD covers prominently displayed with audio samples in multiple
formats, competitive sale pricing and "Order Now" buttons on Music Boulevard and
in the individual music genre department storefronts. The Company believes that
record labels find the virtual listening posts attractive for promoting new CD
releases.
Customer Acquisition and Conversion. The Company collects user information
through a variety of programs which require registration on both Music Boulevard
and the genre websites and enable the Company to collect demographic data which
can be used to market directly to the Company's customer base. Such programs
include sweepstakes, contests, coupon giveaways, free shipping and other sales
promotions to generate new business.
Customer Retention. The Company has implemented a Frequent Buyers Club
membership program, allowing members to receive a free CD after a certain number
of purchases. The Company believes that a major benefit of this club is the
ability to collect user demographics and attempt to capture all or a greater
portion of a member's on-line music purchases. The Company uses an existing
technology, known as "cookies," to keep track of basic user actions and sessions
on the Music Boulevard website. The Music Boulevard cookie is able to restore a
customer's shopping basket and on-line session, even if the customer leaves the
website and returns later. The Company believes the use of this technology
facilitates and encourages customers to spontaneously visit N2K's websites.
One-To-One Marketing. The Company believes that database marketing
enhances its ability to know its customers' music and lifestyle preferences
which provides its customers with a more personal and enhanced experience. After
collecting consumer data, the Company uses e-mail to send customers compelling
messages of discount coupons, new releases and special sales, among other
things, depending on the customer's previous purchasing and browsing behavior.
The Company is implementing Collaborative Filtering software developed by Net
Perceptions Inc. to personalize the Music Boulevard website to each individual
customer and provide CD recommendations derived from past buying behavior and
buying patterns among the entire Music Boulevard community of customers.
ADVERTISING SALES AND SPONSORSHIPS
The Company has positioned its websites as an interconnected on-line music
network, offering advertisers and marketers the ability to reach highly targeted
communities of music fans worldwide. Advertisers on the Company's websites have
included MCA Records, Intel, Microsoft Corp., Sony Online Ventures, IBM and
MasterCard, among others. Advertisers are offered a variety of advertising
options which can be combined in different percentages to reach the desired
advertising mix. The Company has implemented NetGravity's software package for
advertising space management, tracking of page impressions and reporting to
advertisers.
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The Company utilizes various advertising models to allow for a high degree
of flexibility in responding to individual advertisers' needs. The Company has
implemented a graduated cost per thousand ("CPM") rate structure, charging a
higher CPM for its more highly targeted audiences. The Company intends to
reserve a portion of its available advertising inventory in order to promote the
sale of merchandise and to feature content and events on its websites.
The forms of advertising currently offered on the Company's websites
include banners, virtual endcaps, featured content presentations and integrated
page icons. Advertisements are displayed on home pages, store departments,
search results, artist discographies and on sale and new release listings, among
other high traffic Music Boulevard locations. These advertising spaces can be
dynamically served through the use of NetGravity software to rotate, change or
target existing messages or increase the number of advertisements delivered in a
given space.
The Company also offers advertisers and marketers alternative forms of
website advertising. The Company's advertising model includes sponsorship
packages to encourage users to associate specific content with an identified
sponsor. Sponsorship fees are fixed according to time-based arrangements. The
Company utilizes a combination of internal direct sales personnel and external
agencies to solicit and service advertisers on the Company's websites.
ORDERING, FULFILLMENT AND CUSTOMER SERVICE
The Company has designed its ordering system to be easy-to-use and simple
to understand. In order to maintain high customer satisfaction and price
competitiveness, the Company places an emphasis on reliable product fulfillment.
At any time during a visit to Music Boulevard, a customer can click on the
"Order Now" button to place an item in his or her personal shopping basket. The
customer can continue to shop the website, adding chosen items. When the
customer is ready to submit an order, he or she simply returns to the order
page, chooses a shipping method (U.S. Mail, 2-Day Federal Express or Federal
Express Overnight to customers from the U.S. and air mail and DHL Express to
non-U.S. customers) and a payment method. If not previously registered with
Music Boulevard, a customer is prompted to register at the time of purchase and
to enter his or her name, address and password. The customer then has the option
of securely submitting credit card information on-line or calling or faxing the
information to the Music Boulevard Customer Service Department. Music Boulevard
also provides the option of payment by check or money order. By assigning a
password to every buyer, the Music Boulevard ordering process facilitates repeat
purchases by eliminating the need to re-submit credit card and shipping
information for subsequent orders. The Company keeps customers informed
regarding the status of their orders by sending e-mail messages, including
notification of the receipt and shipment of each order and whether an item is
back-ordered.
The Company primarily uses Valley, a third-party fulfillment operation, to
ship CDs, cassettes, LPs, videos and related music items. All inventory is owned
and stored by Valley. Four times daily, the Company batches customer orders and
electronically transmits them to Valley. The Company uses a secure network
through which it transmits data to Valley, thereby helping to ensure customer
security as well as data integrity. Valley picks, packs and ships customer
orders and charges the Company negotiated rates for merchandise, shipping and
handling. Customer billing is performed by the Company, which utilizes a
third-party credit card processor, First USA, Inc. If a customer's selection is
not in stock, Music Boulevard sends an e-mail to notify the customer of the
backlogged items. To date, the Company has experienced a return rate of
approximately 1% of all CDs and cassettes sold.
The Company has expanded the number of titles offered and has provided more
localized product to international markets through creating alliances with
international fulfillment operations. The Company has entered into an exclusive
agreement with Shinseido Inc., a leading music retail chain in Japan, to add
more than 175,000 new local-language music titles to the Japanese version of
Music Boulevard beginning in the fourth quarter of 1998. The Company has entered
into an agreement with MSI whereby MSI will provide at least 150,000
international titles to Music Boulevard's catalog of offerings and create a
fulfillment center in the Netherlands to serve European markets commencing in
the second quarter of 1998. The Company also offers registration and ordering
instructions on Music Boulevard in English, Japanese, German, French and
Spanish.
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<PAGE> 42
The Company believes that high levels of customer service and support are
critical to the value of its services and to retaining and expanding its user
base. Accordingly, the Company has significantly increased its staffing levels
in the Customer Service Department and currently employs 25 representatives on a
full-time basis and 7 representatives on a part-time basis. Music Boulevard
Customer Service representatives are available 24 hours a day on weekdays, and
10:00 AM to 6:00 PM EST on weekends for customer service through a combination
of e-mail, fax and a toll free telephone number, 1-800-99MUSIC. Customer service
is assisted by automated e-mail notifications which greatly assist in keeping
customers up-to-date on the status of their orders. Company representatives
handle general questions about the service as well as register customers' credit
card information over the phone. The Company believes that these representatives
are a valuable source of feedback regarding user satisfaction, which the Company
uses to improve its services. Customers of the Company are not charged for
service and support.
TECHNOLOGY
The Company has developed sophisticated information services delivery and
user tracking systems by integrating third-party systems, when available, and by
developing proprietary tools. The Company's integrated systems and tools provide
functionality in seven primary areas: (i) multimedia asset management, (ii)
website development, (iii) audio encoding and on-line delivery, (iv) fault
tolerance, (v) security, (vi) scalability and (vii) advanced technologies. At
the same time, the systems and tools provide scalability to maintain performance
as the number of users of the system and the amount of data processed increases
and to add new functionality as new needs and technologies emerge.
Multimedia Asset Management. Central to the Company's system is a database
management system necessary to index, retrieve and manipulate the Company's
continuously growing multimedia content. The database management system allows
for rapid searching, sorting, viewing and distribution of, among other things,
audio samples, video clips, cover art and photos. The Company has chosen Oracle
7.3 as its database management system. Based on the quality and creativity of
the Company's interfaces, Oracle Corporation selected the Company as one of its
featured developers for Oracle Open World, its infomercial and international
product roadshow which was introduced in 1996.
Website Development. The catalog of CDs and cassettes, stored in an Oracle
database, forms the core of the music entertainment content collection and
contains links to related content (e.g., audio samples, images, editorial
content and charts). Each individual page of the Company's Music Boulevard
website is built dynamically from these elements using a proprietary web page
template technology. This template technology results in the separation of the
page look and feel from the individual data elements, which eliminates software
updates for page layout changes and greatly reduces the programming required to
maintain a growing amount of content. Templates also enable websites with
different formats to seamlessly integrate Music Boulevard store elements such as
"search" and "discography" pages. The Company has developed software
specifically to enable its editorial and creative staff to develop content
tightly linked into this environment. As a result, the Company can efficiently
import editorial content from third-party sources such as magazines. For high-
volume, non-secure Web transactions the Company uses the Apache web server, a
modular, high-performance server.
Audio Encoding and Delivery. The Company uses a variety of audio
compression technologies for its audio samples and downloads, tailoring them to
specific applications. In light of current user patterns, the Company uses the
popular RealNetworks' RealAudio format for delivering realtime streaming
30-second audio previews and feature-length web broadcasts. The Liquid Audio
streaming format, which employs high quality DOLBY Digital compression, is used
for realtime preview samples for those tracks which are available for digital
distribution. Thirty-second downloadable preview samples are also available in
the industry standard MPEG format.
Each of the Company's audio formats has certain minimum system requirements
for hardware and software in order for a user to listen to the audio samples on
Music Boulevard. A user must have a multimedia-equipped personal computer and
must download software in each format. For example, the minimum system PC
requirements for a user desiring to play an audio sample in the MPEG audio
format are
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<PAGE> 43
an MPEG Audio Player and a 386/40mhz CPU on a Windows 3.1 operating system with
eight megabytes of random access memory.
The Company is also actively pursuing new and emerging audio compression
technologies for the digital distribution of music. Full-length downloadable
master recordings, available via the Company's e
- -mod system, are available as DOLBY Digital downloads suitable for transfer to
standard audio CDs. e
- -mod is the Company's delivery system developed using Music Boulevard's secure
transaction engine and music database in tandem with Liquid Audio's encoding and
digital distribution systems. The e
- -mod system makes it possible to deliver high quality audio on-line to
consumers.
Fault Tolerance. The Company has operated a 24-hour a day, seven-day a
week computing facility in the on-line information industry for over ten years.
Drawing on this experience, the Company's website architecture uses redundant
servers and RAID (redundant array of independent drives) storage systems so that
downtime due to system outages or maintenance needs is minimized. The Company is
deploying an architecture in which all components of the on-line systems are
redundant, allowing continuous operation even in the event of occasional
component failures. The Company runs its Oracle database on the Sun Enterprise
4000 server because of its fault tolerant characteristics including redundant,
hotswappable components.
Security. The Company employs a combination of proprietary and
commercially available firewalls to keep its Internet connections secure. The
Company uses the Apache SSL Server for secure electronic transactions over the
Internet. It uses proprietary EDI (electronic data interchange) interfaces and
private networks to ensure the security of customer credit card transactions and
other order information shared with the Company's fulfillment partners and third
party billing company. The Company plans to implement standardized electronic
transaction mechanisms (such as Secure Electronic Transaction technology, the
standard being developed by major credit card companies) as they become
commercially available.
Scalability. The structure of the Company's hardware and software is built
upon a distributed transaction processing model which allows software to be
distributed among multiple parallel servers. This architecture allows the
Company to scale by either adding new servers or increasing the capacity of
existing servers. The current system is designed to scale from 4,000
simultaneous users currently to at least 20,000 users, while maintaining both
user performance and cost per transaction. In the rapidly changing Internet
environment, the ability to update the application system to stay current with
new technologies is important. The system's template technology and modular
database design allow the addition or replacement of server-based applications
such as multimedia formats and delivery systems, additional EDI-based
fulfillment partners and search and retrieval engines. This architecture also
enables low-cost, rapid deployment of additional websites that integrate with
the shopping and genre websites.
Advanced Technologies. The Company continually evaluates emerging
technologies, new developments in web technologies and CD/DVD (digital video
disc) multimedia authoring. Technologies with which the Company is currently
working include Sun's Java language, electronic payment and transaction systems
in the service of an international multiple fulfillment distribution system,
Real Time Streaming Protocol (RTSP) for the orderly delivery of multimedia
content over the Internet. The Company is implementing Collaborative Filtering
software developed by Net Perceptions Inc. to personalize the Music Boulevard
website to each individual customer and provide CD recommendations derived from
past buying behavior and buying patterns among the entire Music Boulevard
community of customers.
COMPETITION
The market for Internet content providers is highly competitive and rapidly
changing. Since the Internet's commercialization in the early 1990's, the number
of websites on the Internet competing for consumers' attention and spending has
proliferated. With no substantial barriers to entry, the Company expects that
competition will continue to intensify. Currently, there are more than one
hundred music retailing websites on the Internet. With respect to competing for
consumers' attention, in addition to intense competition from Internet content
providers, the Company also faces competition from traditional media such as
radio, television and print. N2K Encoded Music competes with the major, and
other independent, record labels. With respect to recorded music sales, the
Company competes with numerous Internet retailers, including traditional music
retail chains, record labels and independents with websites on the Internet. In
addition, the
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<PAGE> 44
Company competes with traditional retail stores, including chains and
megastores, mass merchandisers, consumer electronics stores and music clubs.
The Company believes that the primary competitive factors in providing
music entertainment products and services via the Internet are name recognition,
variety of value-added services, ease of use, price, quality of service,
availability of customer support, reliability, technical expertise and
experience. The Company's success in this market will depend heavily upon its
ability to provide high quality, entertaining content, along with cutting-edge
technology and value-added Internet services. Other factors that will affect the
Company's success include the Company's continued ability to attract experienced
marketing, sales and management talent. In addition, the competition for
advertising revenues, both on Internet websites and in more traditional media,
is intense. The Company believes that its high-quality music-related content,
offered free of charge, is an important differentiation from other music-related
and music-merchandising websites.
Many of the Company's current and potential competitors in the Internet and
music entertainment businesses have longer operating histories, significantly
greater financial, technical and marketing resources, greater name recognition
and larger existing customer bases than the Company. These competitors may be
able to respond more quickly to new or emerging technologies and changes in
customer requirements and to devote greater resources to the development,
promotion and sale of their products or services than the Company. There can be
no assurance that the Company will be able to compete successfully against
current or future competitors.
EMPLOYEES
As of February 28, 1998, the Company had 246 full-time employees, including
161 in operations and development, 48 in sales and marketing and 37 in general
and administrative. As of February 28, 1998, the Company also had 21 part-time
employees, primarily focused on customer service and 6 consultants, primarily
focused on the Company's music entertainment business. The Company's future
success depends, in significant part, upon the continued service of its key
technical, editorial, sales, product development and senior management personnel
and on its ability to attract and retain highly qualified employees. There is no
assurance that the Company will continue to attract and retain high-caliber
employees, as competition for such personnel is intense. The Company's employees
are not represented by any collective bargaining organization. The Company has
never experienced a work stoppage and considers relations with its employees to
be good.
TRADEMARKS AND PATENTS
Music Boulevard(R) (and its related logo) is a registered service mark of
the Company. The Company has also applied for trademark and/or service mark
registrations for Music Blvd.(TM), N2K Encoded(TM) and Rocktropolis(TM). In
addition, the Company is using allstar(TM), Classical Insites(TM), e
- -mod(TM), Jazz Central Station(TM) (and its related logo), N2K(TM), Need To
Know(TM) and RAM(TM) as trademarks and/or service marks.
FACILITIES
The Company's corporate headquarters are located in the New York
Information Technology Center in New York, New York. The Company leases its
facilities and certain other equipment under operating and capital lease
agreements. The Company leases approximately 52,000 square feet of office space
at these facilities. The leases for approximately 44,000 square feet, 6,000
square feet and 2,000 square feet expire on August 31, 2002, December 31, 2002
and January 31, 2003, respectively. These facilities offer advanced technology
amenities including state-of-the-art voice, video and data transmission and
advanced telecom and data security. The Company leases an additional 21,400
square foot facility in Wayne, Pennsylvania which houses the Company's main
computer operations. The term of the lease expires on August 31, 2001. There can
be no assurance that a system failure at this location would not adversely
affect the performance of the Company's services. The Company leases
approximately 2,000 square feet of office space in Los Angeles, California. The
Company believes that its existing facilities are adequate for its current
requirements and that additional space can be obtained to meet its requirements
for the foreseeable future.
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<PAGE> 45
LITIGATION
The Company and 17 other entities have been named as defendants in a civil
action captioned Interactive Gift Express v. Compuserve, Inc. et al., which is
pending in the U.S. District Court, Southern District of New York, Docket 95 CV
6871 (BSJ). The Company has also been named as defendant in a civil action
captioned Parsec Sight/Sound, Inc. v. N2K Inc. which is pending in the U.S.
District Court of Pennsylvania, Western District, Docket 98 CV 0118. The
plaintiffs in each of these actions allege infringement of certain intellectual
property rights, and each seeks treble damages and costs in an unspecified
amount, as well as other declaratory and injunctive relief. The Company believes
that the claims against it in each action are without merit and intends to
vigorously defend against each of them. Moreover, the Company believes that
these lawsuits, even if adversely determined, will not have a material adverse
effect on the Company's business, financial condition or results of operations.
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<PAGE> 46
MANAGEMENT
OFFICERS AND DIRECTORS
The following table sets forth the names, ages and positions of the
Company's executive officers and members of the Board of Directors as of the
date of this Prospectus:
<TABLE>
<CAPTION>
NAME AGE POSITION
---- --- --------
<S> <C> <C>
Lawrence L. Rosen(1)................. 57 Chairman of the Board of Directors and Chief Executive
Officer
Jonathan V. Diamond.................. 38 Vice Chairman and Director
Robert David Grusin.................. 63 Vice Chairman and Director
James E. Coane....................... 57 President, Chief Operating Officer and Director
Philip Ramone........................ 59 President, N2K Encoded Music
Jerold L. Rosen...................... 29 President, On-line Entertainment
Bruce Johnson........................ 47 Senior Vice President, Secretary, Treasurer, Chief
Financial Officer and Director
Arthur S. Weiner..................... 54 Senior Vice President, Corporate Development and
General Counsel
Robert C. Harris, Jr.(1)(2)(3)....... 51 Director
Susanne Harrison(1)(2)(3)............ 53 Director
</TABLE>
- ---------------
(1) A member of the Compensation Committee.
(2) A member of the Audit Committee.
(3) A member of the Stock Option Committee.
Prior to the Merger, certain of the individuals listed below served as
executive officers and directors of New York N2K, while others served as
executive officers and directors of Telebase.
LAWRENCE L. ROSEN has served as Chairman of the Board of Directors since
the Merger. Mr. Rosen has also served as Chief Executive Officer of the Company
since the Merger. From June 1995 until the Merger, Mr. Rosen was Co-Chairman of
New York N2K. Previously, Mr. Rosen and Mr. Grusin formed Grusin/ Rosen
Productions in 1976 to produce artists' recordings for major record labels.
Between 1978 and 1982, Mr. Rosen served as producer, recording engineer and as
President of Arista/GRP Records under a global label distribution agreement with
Arista Records. In 1982, Mr. Rosen co-founded GRP as an independent label with
Mr. Grusin, and it became one of the first record labels to digitally produce
music titles from concept through finished recording in CD format, with Mr.
Rosen as its Co-President. In 1990, GRP was acquired by MCA Inc. and Mr. Rosen
served as President and Chief Executive Officer of GRP, which was operated as a
division of the MCA Music Entertainment Group, until 1995. Mr. Rosen has served
as a member of the Board of Governors of the New York Chapter of the National
Association of Recording Arts and Sciences, is a member of the Grammy Screening
Committee and serves on the Board of the National Foundation for the Advancement
of the Arts. Mr. Rosen attended the Manhattan School of Music. In 1997, Mr.
Rosen was named Entrepreneur of the Year by Ernst & Young LLP in the
Entertainment and New Media category.
JONATHAN V. DIAMOND has served as Vice Chairman and a director of the
Company since the Merger. From June 1995 to the Merger, Mr. Diamond served as
Co-Chairman of New York N2K. Mr. Diamond was an investor in and director of
Telebase from September 1994 to the Merger. Mr. Diamond founded and was
Chairman, from 1991 to 1995, of the J. Diamond Group, a holding company which
acquired and launched six media and entertainment companies in the U.S. and the
U.K., including Vermilion Films, which produced the feature film, Let Him Have
It. From 1984 to 1990, Mr. Diamond served as a director and Executive Vice
President of GRP, where he was responsible for its business and financial
strategy. Prior to his association with GRP, Mr. Diamond founded Diamond
Investments, his own investment firm, which acquired or launched companies in
the media, entertainment and broadcasting areas. Mr. Diamond currently serves on
the Board of
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<PAGE> 47
Directors of The Alliance for Downtown New York and The Lower Manhattan Cultural
Council, and is a member of the Corporate Council of the Whitney Museum and
co-founder of the Whitney Museum's New Media Committee. Mr. Diamond serves as
the Chairman of Opus 118, an inner city music education program in Harlem. Mr.
Diamond holds a B.A. in Economics and Music from the Honors College of the
University of Michigan and a M.B.A. from Columbia University's Graduate School
of Business.
ROBERT DAVID GRUSIN has served as Vice Chairman and a director of the
Company since the Merger. From June 1995 to the Merger, Mr. Grusin served as a
director of New York N2K. In 1976, Mr. Grusin and Mr. Rosen formed Grusin/Rosen
Productions to produce artist recordings for major record labels, which led to a
production agreement with Arista in 1978. In 1982, Mr. Grusin and Mr. Rosen
founded GRP as an independent record company with Mr. Grusin as Co-President. In
1990, GRP was acquired by MCA Inc. and Mr. Grusin served as Executive Vice
President of GRP, which became a division of the MCA Music Entertainment Group,
until 1995. Mr. Grusin, a composer, producer and musician, is the recipient of
ten Grammy Awards and one Academy Award. Mr. Grusin serves on the College of
Music Advisory Board at the University of Colorado, and has received honorary
doctorates from both Berkelee College of Music and the University of Colorado.
JAMES E. COANE has served as President, Chief Operating Officer and a
director of the Company since the Merger. From April 1987 to the Merger, Mr.
Coane served as President and Chief Executive Officer of the Company and as
Chairman of the Board of Directors from 1993 until the Merger. Previously, from
1984 to 1987, Mr. Coane served as President and Chief Operating Officer of
Morris Decision Systems, Inc., a marketer and supplier of microcomputers and
related peripherals. Mr. Coane serves on the Board of Directors of the
Information Industry Association, the Ben Franklin Technology Council and The
Council of Growing Companies. Mr. Coane is a Phi Beta Kappa graduate of Duke
University with an A.B. in Economics and Business Administration.
PHILIP RAMONE has served as President, N2K Encoded Music, since October
1996. From 1973 to 1996, Mr. Ramone was President of Phil Ramone, Inc., a
company he formed to produce artist recordings for major record labels. Mr.
Ramone has received eight grammy awards and produced numerous platinum and gold
albums and singles. Mr. Ramone attended the Julliard School of Music and has
received an honorary doctorate from Berkelee College of Music.
JEROLD L. ROSEN has served as President, On-line Entertainment since
January 1998. From the Merger to January 1998, Mr. Rosen served as Senior Vice
President and General Manager, On-line Entertainment. From June 1995 to the
Merger, Mr. Rosen served as President of New York N2K. From 1988 to 1992, Mr.
Rosen served in various capacities at GRP, including serving as head of its
music licensing department. Mr. Rosen holds a B.A. in Political Economics from
Tulane University and a M.B.A. in Finance from Rutgers University. Jerold Rosen
is the son of Lawrence L. Rosen.
BRUCE JOHNSON has served as Secretary, Treasurer, Vice President and Chief
Financial Officer of the Company since 1988 and as Senior Vice President since
January 1998. Mr. Johnson has served as a director since January 1997. Mr.
Johnson has sixteen years of previous experience in public accounting and
financial management with positions at Arthur Andersen & Co., Marriott Corp. and
SEI Corp. Mr. Johnson holds a degree in Accounting from St. Joseph's University
and a M.B.A. in Finance from Drexel University and is a Certified Public
Accountant.
ARTHUR S. WEINER has served as General Counsel and Senior Vice President,
Corporate Development since November 1997. Before joining the Company, he
provided outside legal services to N2K for approximately two years through his
own law office. From 1986 to 1995, he was General Counsel and Vice President of
Legal & Business Affairs for GRP Records. Mr. Weiner holds a B.A. in Political
Science from Hunter College and a J.D. degree from the Benjamin Cardozo School
of Law.
ROBERT C. HARRIS, JR. has served as a director of the Company since
February 1996. Mr. Harris is a Senior Managing Director of Bear, Stearns & Co.
Inc. From 1989 to October 1997, he was a co-founder and Managing Director of
Unterberg Harris. From 1984 to 1989, he was a General Partner, Managing Director
and Director of Alex. Brown & Sons Incorporated. From 1979 to 1984, he was a
Partner of Robertson
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<PAGE> 48
Stephens & Company. Mr. Harris is a Director of Mobile Data Solutions Inc. and a
number of private companies. Mr. Harris is a graduate of the University of
California at Berkeley, where he received B.S. and M.B.A. degrees.
SUSANNE HARRISON has served as a director of the Company since 1993. Ms.
Harrison has been General Partner of the high technology venture capital funds,
Poly Ventures, Limited Partnership and Poly Ventures II, Limited Partnership,
since 1989 and 1991, respectively. Prior to joining Poly Ventures, Ms. Harrison
was Vice President for Technology Investment Banking at Steinberg and Lyman Inc.
from 1983 to 1987. From 1977 to 1982, she held various management positions at
Symbol Technologies, Inc., a supplier of bar-code laser scanners and portable
terminals. Ms. Harrison serves as a director of several privately held high
technology portfolio companies, as well as a Director of the Long Island Venture
Group. Ms. Harrison holds a B.A. from Hunter College, a M.A. from the State
University of New York and a M.B.A. from Adelphi University.
Each director holds office until the next annual meeting of stockholders or
until a successor has been duly elected and qualifies, or until his or her
earlier death, resignation or removal. The Company's executive officers are
appointed annually by the Board of Directors and serve at the discretion of the
Board of Directors.
LIMITATIONS ON DIRECTORS' LIABILITY
Liability Limitation. The Company's Certificate of Incorporation provides
that a director of the Company shall not be personally liable to it or its
stockholders for monetary damages to the fullest extent permitted by the
Delaware GCL. Section 102(b)(7) of the Delaware GCL currently provides that a
director's liability for breach of fiduciary duty to a corporation may be
eliminated except for liability (i) for any breach of the director's duty of
loyalty to the corporation or its stockholders, (ii) for acts or omissions not
in good faith or which involve intentional misconduct or a knowing violation of
law, (iii) under Section 174 of the Delaware GCL, for unlawful dividends or
unlawful stock repurchases or redemptions, and (iv) for any transaction from
which the director derives an improper personal benefit. The Delaware GCL does
afford persons who serve on the board of directors of a Delaware corporation
protection against awards of monetary damages for negligence in the performance
of their duties as directors. The Delaware GCL does not affect the availability
of equitable remedies such as an injunction or rescission based upon a
director's breach of his duty of care. Any amendment to these provisions of the
Delaware GCL will automatically be incorporated by reference into the Company's
Certificate of Incorporation, without any vote on the part of its stockholders,
unless otherwise required.
Indemnification Agreements. The Company and each of its directors entered
into indemnification agreements providing that the Company will indemnify the
directors against certain liabilities (including settlements) and expenses
actually and reasonably incurred by them in connection with any threatened,
pending or completed legal action, proceeding or investigation (other than
actions brought by or in the right of the Company) to which any of them was, is
or is threatened to be made a party by reason of his or her status as a
director, officer or agent of the Company or his or her serving at the request
of the Company in any other capacity for or on behalf of the Company, provided
that (i) such director acted in good faith and in a manner at least not opposed
to the best interests of the Company, (ii) with respect to any criminal
proceedings, such director had no reasonable cause to believe his or her conduct
was unlawful, (iii) such director is not finally adjudged to be liable for
negligence or misconduct in the performance of his or her duty to the Company,
unless the court views in light of the circumstances that the director is
nevertheless entitled to indemnification, and (iv) the indemnification does not
relate to any liability arising under Section 16(b) of the Securities Exchange
Act of 1934, as amended (the "Exchange Act"), or the rules or regulations
promulgated thereunder. With respect to any action brought by or in the right of
the Company, directors may also be indemnified, to the extent not prohibited by
applicable laws or as determined by a court of competent jurisdiction, against
reasonable costs and expenses incurred by them in connection with such action if
they acted in good faith and in a manner they reasonably believed to be in or
not opposed to the best interests of the Company.
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<PAGE> 49
COMMITTEES OF THE BOARD OF DIRECTORS
The Board of Directors has standing Audit, Compensation and Stock Option
Committees. The Audit Committee consists of Mr. Harris and Ms. Harrison. Among
other functions, the Audit Committee makes recommendations to the Board of
Directors regarding the selection of independent auditors, reviews the results
and scope of the audit and other services provided by the Company's independent
auditors, reviews the Company's financial statements and reviews and evaluates
the Company's internal control functions. The Compensation Committee consists of
Messrs. Harris and Rosen and Ms. Harrison. The Compensation Committee determines
executive compensation and makes recommendations to the Board of Directors
concerning salaries and incentive compensation for employees and consultants of
the Company. The Stock Option Committee consists of Mr. Harris and Ms. Harrison.
The Stock Option Committee administers the Company's stock option and stock
purchase plans in accordance with the terms and conditions set forth therein.
COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION
Mr. Harris, Ms. Harrison and Mr. Rosen served as members of the Company's
Compensation Committee during fiscal year 1997. Other than Mr. Rosen, who served
as the Company's Chairman and Chief Executive Officer during 1997, no committee
member is or has been an officer or employee of the Company. Mr. Rosen serves
only as a non-voting member of the Compensation Committee.
COMPENSATION OF DIRECTORS
Non-employee directors currently receive a fee of $250 per meeting for
their service on the Board of Directors or any committee thereof. Directors are
eligible to receive options under the Company's Directors' Stock Option Plan.
49
<PAGE> 50
EXECUTIVE COMPENSATION
The following table sets forth a summary of certain information regarding
compensation paid or accrued by the Company during 1996 and 1997 to the
Company's chief executive officer and the other executive officers of the
Company whose total annual salary and bonus exceeded $100,000 during such period
(collectively, the "Named Executives"). The current positions of the Named
Executives are also included in the table.
SUMMARY COMPENSATION TABLE
<TABLE>
<CAPTION>
LONG-TERM
COMPENSATION
---------------------------
ANNUAL COMPENSATION SECURITIES
-------------------- UNDERLYING ALL OTHER
NAME AND PRINCIPAL POSITION YEAR SALARY BONUS OPTIONS/SARS COMPENSATION
- --------------------------- ---- --------- -------- ------------ ------------
<S> <C> <C> <C> <C> <C>
Lawrence L. Rosen(1).................... 1996 $175,000 $50,000 220,274 $10,062(4)
Chairman of the Board of Directors 1997 100,000 25,000 166,666 6,752(4)
and Chief Executive Officer
Jonathan V. Diamond(2).................. 1996 175,000 50,000 220,274 11,031(5)
Vice Chairman 1997 100,000 25,000 166,666 6,695(5)
James E. Coane.......................... 1996 171,695 -- 31,250 12,100(6)
President and Chief Operating Officer 1997 175,000 -- 50,000 12,100(6)
Phil Ramone(3).......................... 1996 93,750 -- 73,677 --
President, N2K Encoded Music 1997 470,833 -- -- 15,100(7)
Bruce Johnson........................... 1996 114,375 -- 12,500 2,059(8)
Senior Vice President and 1997 132,167 -- 37,500 2,364(8)
Chief Financial Officer
</TABLE>
- ---------------
(1) On February 13, 1996, Mr. Rosen entered into an employment agreement with
the Company which provides for an annual base salary of $200,000 and a
guaranteed bonus of $50,000 for fiscal year 1997. See "-- Employment
Agreements." As of July 1, 1997, Mr. Rosen agreed not to receive
compensation from the Company (in the form of either salary or bonus)
through the end of fiscal year 1997.
(2) On February 13, 1996, Mr. Diamond entered into an employment agreement with
the Company which provides for an annual base salary of $200,000 and a
guaranteed bonus of $50,000 for fiscal year 1997. See "-- Employment
Agreements." As of July 1, 1997, Mr. Diamond agreed not to receive
compensation from the Company (in the form of either salary or bonus)
through the end of fiscal year 1997.
(3) On October 15, 1996, Mr. Ramone entered into an employment agreement with
the Company which provides for an annual base salary of $450,000 from the
period October 15, 1996 to October 14, 1997 and $550,000 from the period
October 15, 1997 to October 14, 1998. See "-- Employment Agreements."
(4) Represents a car allowance of $8,400 and $4,800 in 1996 and 1997,
respectively, and Company matching contributions under its 401(k) Matched
Savings Plan of $1,662 and $1,952 in 1996 and 1997, respectively.
(5) Represents a car allowance of $8,400 and $4,800 in 1996 and 1997,
respectively, and Company matching contributions under its 401(k) Matched
Savings Plan of $2,631 and $1,895 in 1996 and 1997, respectively.
(6) Represents a car lease valued at $9,250 in both 1996 and 1997 and Company
matching contributions under its 401(k) Matched Savings Plan of $2,850 in
both 1996 and 1997.
(7) Represents a car lease valued at $12,250 and Company matching contributions
under its 401(k) Matched Savings Plan of $2,850.
(8) Represents Company matching contributions under its 401(k) Matched Savings
Plan in 1996 and 1997.
50
<PAGE> 51
OPTION GRANTS IN LAST FISCAL YEAR
The following table summarizes certain information with respect to Company
stock options granted to the Named Executives during the fiscal year ended
December 31, 1997.
<TABLE>
<CAPTION>
INDIVIDUAL GRANTS
----------------- POTENTIAL REALIZABLE VALUE
PERCENT OF AT ASSUMED ANNUAL RATES
NUMBER OF TOTAL OPTIONS OF STOCK PRICE
SECURITIES GRANTED TO EXERCISE APPRECIATION FOR OPTION
UNDERLYING EMPLOYEES IN PRICE TERM(3)
OPTIONS FISCAL YEAR PER ---------------------------
NAME GRANTED 1997 SHARE EXPIRATION DATE 5% 10%
---- ---------- ------------------ -------- --------------- ----------- -------------
<S> <C> <C> <C> <C> <C> <C>
Lawrence L. Rosen.......... 21,052(1) 2.5% $20.90 10/16/2007 $276,623 $ 701,242
37,281(1) 4.4 19.00 10/16/2007 445,508 1,128,869
108,333(2) 12.7 12.00 7/30/2004 528,665 1,232,830
Jonathan V. Diamond........ 21,052(1) 2.5 20.90 10/16/2007 276,623 701,242
37,281(1) 4.4 19.00 10/16/2007 445,508 1,128,869
108,333(2) 12.7 12.00 7/30/2004 528,665 1,232,830
James E. Coane............. 50,000(1) 5.9 19.00 10/16/2007 597,500 1,514,000
Phil Ramone................ -- -- -- -- -- --
Bruce Johnson.............. 37,500(1) 4.4 19.00 10/16/2007 448,125 1,135,500
</TABLE>
- ---------------
(1) Stock options reported were granted pursuant to the 1996 Stock Option Plan
at exercise prices equal to at least the fair market value of the Common
Stock at the time of grant. The options vest ratably over a four-year period
on each anniversary of the date of grant and have a ten-year term.
(2) Stock Options reported were granted at exercise prices equal to the fair
market value of the Common Stock at the time of grant. This fair market
value determination was based upon transactions relating to the purchase of
the Company's preferred stock by third parties on or near the grant date.
The options automatically vest on the date of grant and have a seven-year
term. These options were not granted under any of the Company's plans.
(3) This column shows the hypothetical gains on the options granted based on
assumed annual compound stock appreciation rates of 5% and 10% over the full
ten-year or seven-year term of the option. The assumed rates of appreciation
are mandated by the rules of the Securities and Exchange Commission (the
"Commission") and do not represent the Company's estimate or projection of
future Common Stock prices.
AGGREGATED OPTION EXERCISES IN LAST FISCAL YEAR AND FISCAL YEAR-END OPTION
VALUES
The following table shows the number of shares covered by both exercisable
and unexercisable stock options as of fiscal year-end, and the values for
exercisable and unexercisable options.
<TABLE>
<CAPTION>
NUMBER OF SECURITIES
UNDERLYING UNEXERCISED VALUE OF UNEXERCISED
SHARES OPTIONS AT IN-THE-MONEY OPTIONS AT
ACQUIRED DECEMBER 31, 1997 DECEMBER 31, 1997(1)
ON VALUE ---------------------------- ----------------------------
NAME EXERCISE REALIZED EXERCISABLE UNEXERCISABLE EXERCISABLE UNEXERCISABLE
---- --------- -------- ----------- ------------- ----------- -------------
<S> <C> <C> <C> <C> <C> <C>
Lawrence L. Rosen........ -- $ -- 163,402 223,538 $903,532 $1,857,473
Jonathan V. Diamond...... -- -- 164,652 223,538 918,563 1,857,473
James E. Coane........... 100,000 800,000 44,925 85,937 519,491 412,461
Phil Ramone.............. -- -- 36,839 36,838 96,701 96,701
Bruce Johnson............ 33,750 270,000 24,340 56,250 284,123 216,094
</TABLE>
- ---------------
(1) Based on the difference between $14.63, the fair market value of the Common
Stock on December 31, 1997, and the option exercise price for each
above-stated option. The above valuation may not reflect the actual value of
unexercised options as the value of unexercised options will fluctuate with
market activity.
51
<PAGE> 52
EMPLOYMENT AGREEMENTS
On February 13, 1996, the Company entered into employment agreements with
Lawrence L. Rosen, Jonathan V. Diamond and Robert David Grusin (the "Rosen
Employment Agreement," the "Diamond Employment Agreement" and the "Grusin
Employment Agreement", respectively) to provide for service in the capacities of
Chairman and Chief Executive Officer, Vice Chairman and Vice Chairman,
respectively, and base salaries of $200,000, $200,000 and $100,000,
respectively, which salaries may be increased as determined by the Compensation
Committee of the Board of Directors. Each of the Rosen Employment Agreement and
the Diamond Employment Agreement provides for payment of an annual bonus of not
less than $50,000, until such time as such executive's base salary is at least
$250,000. The Grusin Employment Agreement provides for an annual bonus in an
amount to be determined by the Board of Directors.
In connection with the Rosen Employment Agreement, Diamond Employment
Agreement and Grusin Employment Agreement, the Company also agreed to grant
incentive stock options to each of the executives to purchase 125,000 shares of
Common Stock and additional nonqualified options to purchase 95,274 shares of
Common Stock at an exercise price of $3.20 per share (or such higher exercise
price as may be required under Section 422 of the Internal Revenue Code), which
vest ratably over a four-year period.
Each of the Rosen Employment Agreement, Diamond Employment Agreement and
Grusin Employment Agreement is for a two-year term, but absent notice of
termination by either the Company or the executive, shall be automatically
renewed for consecutive one-year periods. If the Company terminates any of such
executive's employment other than for "cause" or due to "disability" or there
occurs a "change in control" (each as defined in the Rosen Employment Agreement,
the Diamond Employment Agreement and the Grusin Employment Agreement), such
executive will generally be entitled to (i) eighteen months severance plus an
amount equal to his average annual bonus over the prior three years (or such
lesser number of years if employed for less than three years) multiplied by 1.5,
and paid out, at the election of such executive, in a lump sum or in equal
installments over the 18 months following termination and (ii) the immediate
vesting of any unexercised stock options. In accordance with the Rosen
Employment Agreement, Diamond Employment Agreement and Grusin Employment
Agreement, each executive has agreed not to disclose any of the Company's
confidential information and not to compete with the Company for an
eighteen-month period following termination of his employment with the Company.
On May 1, 1987, the Company entered into an employment agreement with Mr.
Coane (as amended, the "Coane Employment Agreement") that provides for a base
salary of $115,000 until September 30, 1987, and a base salary of $125,000
thereafter, subject to salary increases or other compensation at the discretion
of the Board of Directors. The Company also granted, and Mr. Coane exercised in
May 1997, an option to purchase 100,000 shares of Common Stock of the Company at
an exercise price of $3.20 per share. Pursuant to the terms of the Coane
Employment Agreement, Mr. Coane agreed to serve as President and Chief Executive
Officer, pursuant to election or appointment to those positions, and to perform
such other duties as shall be assigned to him during the continuance of such
agreement. The Coane Employment Agreement was for an initial term of three
years, but absent notice of termination by either the Company or Mr. Coane, the
agreement shall be automatically renewed for consecutive one-year periods. If
the Company terminates Mr. Coane's employment other than for "cause" or due to
"disability" or there occurs a "change in control" (each as defined in the Coane
Employment Agreement), Mr. Coane shall be entitled to severance for eighteen
months. In accordance with the Coane Employment Agreement, Mr. Coane has agreed
not to compete with the Company during the term of his employment or for any
period during which he receives severance pay or acts, pursuant to the
agreement, as a consultant to the Company.
On February 8, 1988, the Company entered into an employment agreement with
Bruce Johnson (the "Johnson Employment Agreement") that provides for a base
salary of $75,000, participation in a bonus plan and salary increases or other
compensation at the discretion of the Board of Directors. The Company also
granted, and Mr. Johnson exercised in May 1997, an option to purchase 31,250
shares of Common Stock of the Company at an exercise price of $3.20 per share.
Pursuant to the terms of the Johnson Employment Agreement, Mr. Johnson agreed to
serve as Vice President and Chief Financial Officer, pursuant to election or
appointment to those positions, and to perform such other duties as shall be
assigned to him during the
52
<PAGE> 53
continuance of such agreement. The Johnson Employment Agreement was for an
initial term of three years, but absent notice of termination by either the
Company or Mr. Johnson, the agreement shall be automatically renewed for
consecutive one-year periods. If the Company terminates Mr. Johnson's employment
other than for "cause" or due to "disability," or there occurs a "change in
control" (each as defined in the Johnson Employment Agreement), Mr. Johnson
shall be entitled to severance for twelve months. In accordance with the terms
of the Johnson Employment Agreement, Mr. Johnson has agreed not to compete with
the Company during the term of his employment or for any period during which he
receives severance pay or acts, pursuant to the agreement, as a consultant to
the Company.
On October 15, 1996, the Company entered into an employment agreement with
Phil Ramone (the "Ramone Employment Agreement") to provide for his service as
President of N2K Encoded Music. The initial term of the Ramone Employment
Agreement is three years (the "Initial Term"), with an option for an additional
two-year period at the Company's discretion (the "Option Period"). The Ramone
Employment Agreement provides for a base salary of $450,000 for the first year,
increasing to $550,000 for the remainder of the Initial Term. If Mr. Ramone's
employment continues after the Initial Term, he will receive $650,000 for the
first year of the Option Period, with the salary for the second year to be
negotiated in good faith upon commencement of the Option Period. Notwithstanding
the foregoing, in the event that the Company and Mr. Ramone are unable to agree
on the amount of Mr. Ramone's annual salary during the Option Period after 30
days' good faith negotiations, then the Company's option will be treated as if
it had not been exercised. The Ramone Employment Agreement also provides for (a)
a one-time $100,000 bonus payable on October 1, 1997 in the form of a loan from
the Company, the principal of and the interest on which will be forgiven
(assuming no termination for cause) over a 12-month period beginning on October
1, 1998 and (b) an annual performance bonus in the amount of (i) $50,000 if the
gross revenues of N2K Encoded Music are at least $8 million but not in excess of
$10 million during such fiscal year or (ii) $100,000 if such gross revenues
exceed $10 million during such fiscal year. As of February 28, 1998, the
$100,000 one-time bonus has not yet been paid. The Ramone Employment Agreement
also provides that Mr. Ramone is entitled to 10% of the after-tax net profit
attributable to N2K Encoded Music's operations in any fiscal year, including
participation in the proceeds of a sale of N2K Encoded Music as if he were a 5%
(during the Initial Term) or a 7.5% (during the Option Period) equity owner of
N2K Encoded Music. Mr. Ramone was granted qualified and nonqualified options
under the terms of the Ramone Employment Agreement to purchase 73,677 shares of
Common Stock at $12.00 per share. Such options expire on October 15, 2002, but
not later than one year from the date Mr. Ramone's employment with the Company
terminates. One quarter of Mr. Ramone's options vested at the beginning of his
employment on October 15, 1996, with the balance to vest ratably over a
three-year period. Should Mr. Ramone's employment with the Company be
terminated, the Company at its option may repurchase any or all shares of Common
Stock issued to Mr. Ramone upon his exercise of any of his options held by him
on the date of such termination at fair market value (or, if such termination is
for cause, at the price paid by Mr. Ramone for such shares). The Company may
elect to pay for these shares in three equal annual installments by delivery of
a promissory note with an interest rate of 8% per annum.
The Company has loaned Mr. Ramone $100,000 pursuant to the Ramone
Employment Agreement. The promissory note related to this loan (the "Ramone
Note") is due on October 1, 2000 and is interest-free unless an event of default
(as defined therein) occurs, in which case the interest rate shall become 15%
until such default is cured. The terms of the Ramone Note give the Company the
right to deduct and withhold certain compensation owed by the Company to Mr.
Ramone under either of the Ramone Employment Agreement or the Producer's
Agreement (as defined below).
Simultaneously with the execution of the Ramone Employment Agreement, the
Company also entered into a Music Producer's Agreement (the "Producer's
Agreement") with Mr. Ramone (through a personal corporation) providing for the
recording and production of master recordings of one or more of the Company's
recording artists. The term of the Producer's Agreement is coextensive with the
term of the Ramone Employment Agreement. Pursuant to the terms of the Producer's
Agreement, Mr. Ramone will receive a percentage of royalties based on agreed
upon formulas. No payments under the Producer's Agreement shall be made to Mr.
Ramone until such time that the Ramone Note has been repaid.
53
<PAGE> 54
STOCK PLANS
The Company has historically utilized stock options as an integral
component of its compensation program for directors, officers and key employees
of the Company. The Company believes that stock options provide long-term
incentives to such persons and encourage the ownership of the Common Stock.
1987 Employee Incentive Stock Option Plan. The Company's 1987 Employee
Incentive Stock Option Plan (the "1987 Option Plan") provided for the grant of
stock options to certain officers and key executive employees of the Company.
The options granted under the 1987 Option Plan were intended to qualify as
incentive stock options under Section 422 of the Internal Revenue Code. As of
February 28, 1998, a total of 190,187 options for Common Stock were outstanding
under the 1987 Option Plan. Generally, options granted under the 1987 Option
Plan vest ratably over a four-year period on each anniversary of the date of
grant and have a ten-year term. No further stock options will be granted under
the 1987 Option Plan.
Under the 1987 Option Plan, options are not assignable or transferable
except by will or under the laws of descent and distribution. In the event of an
offer to acquire all or substantially all of the assets or stock of the Company,
all options granted under the 1987 Option Plan shall automatically become
immediately exercisable in full without regard to the provisions relating to
installment exercises or vesting periods.
1996 Stock Option Plan. The 1996 Option Plan was adopted in February 1996.
In June 1996, the Board of Directors of the Company adopted, and in July 1996
the stockholders of the Company approved, the Company's Amended and Restated
1996 Stock Option Plan (the "1996 Option Plan"). The 1987 Option Plan, the 1996
Option Plan and the Directors' Plan (as hereinafter defined) are collectively
referred to as the "Stock Option Plans." Under the 1996 Option Plan, stock
options may be granted to directors, executives and other key employees of the
Company and its subsidiaries. All options granted under the 1996 Option Plan are
not assignable or transferable except by will or under the laws of descent and
distribution. As of February 28, 1998, a total of 1,484,748 options for Common
Stock were outstanding under the 1996 Option Plan.
The 1996 Option Plan is administered by the Stock Option Committee of the
Board of Directors. Subject to the limitations set forth in the 1996 Option
Plan, the Stock Option Committee has the sole and complete authority to select
participants, grant options to participants, impose restrictions and conditions
upon each option, modify or amend the terms of each outstanding option, reduce
the exercise price per share of unexercised options, accelerate or defer the
exercise price per share of any outstanding option and make all other
determinations and take all other actions necessary for the administration of
the plan. The Stock Option Committee may amend or modify the terms of any option
agreement in any manner to the extent that it would have had the authority
initially to grant an option with such amended terms; provided, that no such
amendment or modification shall impair the rights of any participant under any
outstanding option without the consent of such participant.
Options granted under the 1996 Option Plan may be either incentive stock
options which are intended to satisfy the requirements of Section 422 of the
Internal Revenue Code, or options that do not qualify as incentive stock
options. Generally, options granted under the 1996 Option Plan vest ratably over
a four-year period on each anniversary of the date of grant. At the Stock Option
Committee's discretion, however, options may be made exercisable at any other
time or upon the occurrence of certain events or the achievement of certain
conditions or performance goals. Options granted under the 1996 Option Plan are
exercisable for a period not to exceed ten years from the date of grant, except
that upon a participant's termination of employment for any reason, all vested
options shall expire 90 days following such termination date and any nonvested
options shall be immediately forfeited. Pursuant to the terms of the 1996 Option
Plan, the exercise price of all incentive stock options and nonqualified stock
options granted under the Plan shall not be less than the fair market value of
the Common Stock at the time of grant. In the event of a "change of control" of
the Company (as defined in the 1996 Option Plan) or the termination of a
participant's employment other than for cause, death, disability or voluntary
departure, the Stock Option Committee may provide that unvested stock options
previously granted shall be immediately exercisable and that such options, if
not exercised by a prescribed date, shall terminate.
54
<PAGE> 55
The Company has authorized and reserved 1,650,000 shares of Common Stock
for issuance under the 1996 Option Plan. The shares may be unissued shares or
treasury shares. If any options that are the subject of an award are not
exercised prior to their expiration or are cancelled, terminated or forfeited
without the issuance of Common Stock thereunder, such shares will no longer be
charged against such maximum share limitation and may again be made subject to
award under the 1996 Option Plan. In the event of certain corporate
reorganizations, recapitalizations or other specified corporate transactions
affecting the Common Stock of the Company, proportionate adjustments may be made
to the number of shares available for grant and to the number of shares and
price of outstanding awards made before the event. The 1996 Option Plan has a
term of ten years, subject to earlier termination or amendment by the Board of
Directors. All awards granted under the 1996 Option Plan prior to its
termination remain outstanding until exercised, paid or terminated in accordance
with their terms. The Board of Directors may amend the 1996 Option Plan at any
time, except that stockholder approval is required for certain amendments to the
extent it is required by law, agreement or the rules of any exchange upon which
the Common Stock is listed.
The grant of a stock option under the 1996 Option Plan will not generally
result in taxable income for the participant, nor in a deductible compensation
expense for the Company, at the time of grant. The participant will have no
taxable income upon exercising an incentive stock option (except that the
alternative minimum tax may apply), and the Company will receive no deduction
when an incentive stock option is exercised. Upon exercising a nonqualified
stock option, the participant will recognize ordinary income in the amount by
which the fair market value of the Common Stock on the date of exercise exceeds
the exercise price, and the Company will generally be entitled to a
corresponding deduction. The treatment of a participant's disposition of shares
of Common Stock acquired upon the exercise of an option is dependent upon the
length of time the shares have been held and on whether such shares were
acquired by exercising an incentive stock option or a nonqualified stock option.
Generally, there will be no tax consequence to the Company in connection with
the disposition of shares acquired under an option except that the Company may
be entitled to a deduction in the case of a disposition of shares acquired upon
exercise of an incentive stock option before the applicable incentive stock
option holding period has been satisfied.
Stock options previously granted under the 1996 Option Plan to the Named
Executives and directors are described above under "--Executive Compensation."
The number of shares of Common Stock that may be subject to options granted in
the future to executive officers and other officers, key employees and directors
of the Company under the 1996 Option Plan is not determinable at this time.
1996 Employee Stock Purchase Plan. In June 1996, the Board of Directors of
the Company adopted and the stockholders of the Company approved, the Company's
1996 Employee Stock Purchase Plan (the "Purchase Plan"). The Purchase Plan is
intended to satisfy the requirements of Section 423 of the Internal Revenue
Code. The Purchase Plan is administered by the Stock Option Committee. Any
employee of the Company or any subsidiary designated by the Stock Option
Committee who customarily works at least 20 hours per week and more than five
months per year is eligible to participate in the Purchase Plan after having
worked for the Company for six months. Approximately 145 employees currently are
eligible to participate in the Purchase Plan. Non-employee directors of the
Company are not eligible to participate in the Purchase Plan. Each employee
eligible to participate in the Purchase Plan will be granted an option to
contribute between one and ten percent of the employee's compensation towards
the purchase of the Common Stock at a purchase price for each three-month
purchase period (a "Purchase Period") equal to the lower of (x) 85% of the fair
market value of a share of the Common Stock on the first day of the Purchase
Period and (y) 85% of the fair market value of a share of the Common Stock on
the last day of the Purchase Period. The amount to be contributed by a
participant will be deducted from each paycheck, held for the participant during
a Purchase Period and applied towards the purchase of the Common Stock on the
last day of the Purchase Period. A participant may change the percentage of his
or her compensation to be contributed for any given purchase period prior to the
beginning of that period and may elect not to participate with respect to one or
more plan periods, but then must wait until the next calendar year before
participating again. The number of shares available for purchase under the
Purchase Plan is 1,500,000. The Board at any time may amend, suspend or
discontinue the Purchase Plan, in whole or in part.
55
<PAGE> 56
Directors' Stock Option Plan. In April 1997, the Board of Directors
adopted and the stockholders of the Company approved, the 1997 Directors' Stock
Option Plan (the "Directors' Plan") pursuant to which each member of the Board
of Directors who is not an employee of the Company who is elected or continues
as a member of the Board of Directors is entitled to receive annually options to
purchase 12,500 shares of Common Stock at an exercise price equal to fair market
value; provided, however, that no director may receive under the Directors' Plan
options to purchase an aggregate of more than 125,000 shares of Common Stock.
The Stock Option Committee of the Board of Directors administers the Directors'
Plan; however, it cannot direct the number, timing or price of options granted
to eligible recipients thereunder.
Each option grant under the Directors' Plan vests after the first
anniversary of the date of grant and expires three years thereafter. The number
of shares of Common Stock related to awards that expire unexercised or are
forfeited, surrendered, terminated or cancelled are available for future awards
under the Directors' Plan. If a director's service on the Board of Directors
terminates for any reason other than death, all vested options may be exercised
by such director until the earlier of his or her death and the expiration date
of the option grant. In the event of a director's death, any options which such
director was entitled to exercise on the date immediately preceding his or her
death may be exercised by a transferee of such director for the six-month period
after the date of the director's death. Pursuant to the Directors' Plan, in the
case of a director who represents an institutional investor, such as a venture
capital fund, option grants may be made directly to the institutional investor
on whose behalf a director serves on the Board of Directors.
The maximum number of shares of Common Stock reserved for issuance under
the Directors' Plan is 500,000 shares (subject to adjustment for certain events
such as stock splits and stock dividends). Pursuant to the terms of the
Directors' Plan, on the effective date in April 1997, a total of 25,000 options
were granted to non-employee directors under the Directors' Plan at an exercise
price per share equal to $19.00.
CERTAIN TRANSACTIONS
STOCK PURCHASES
In February 1996, as consideration for all of the outstanding shares of
common stock of New York N2K in the Merger, the shareholders of New York N2K
received shares of the Company. The shareholders of New York N2K at the time of
the Merger included Lawrence L. Rosen, Jonathan V. Diamond, Robert David Grusin
and Jerold L. Rosen. Each of these individuals received the number of shares of
Common Stock set forth immediately following his or her name: Lawrence L. Rosen
(488,598); Jonathan V. Diamond (488,598); Robert David Grusin (488,598); and
Jerold L. Rosen (134,785). Also in February 1996, entities affiliated with
Robert C. Harris, Jr. and Susanne Harrison, directors of the Company, and
Messrs. Diamond, Grusin, L. Rosen and J. Rosen purchased an aggregate of 762,500
shares of Common Stock at a purchase price of $3.20 per share. Each of these
individuals (and/or their affiliated entities) purchased the number of shares of
Common Stock set forth immediately following his or her name: Robert C. Harris,
Jr. (129,687); Susanne Harrison (125,000); Lawrence L. Rosen (164,063); Jonathan
V. Diamond (179,688); Robert David Grusin (156,250); and Jerold Rosen (7,812).
In May 1996, Mr. Harris purchased an additional 31,250 shares of Common Stock at
a purchase price per share of $3.20.
In April 1997, Lawrence L. Rosen, Jonathan V. Diamond and Robert David
Grusin, directors and executive officers of the Company, purchased an aggregate
of 83,331 shares of Common Stock. The purchase price per share of Common Stock
was $12.00. Each of these individuals purchased the number of shares of Common
Stock set forth immediately following his name: Lawrence L. Rosen (27,777);
Jonathan V. Diamond (27,777); and Robert David Grusin (27,777).
MANAGEMENT NOTES
In July 1997, the Company issued $1.75 million aggregate principal amount
of Management Notes to Lawrence L. Rosen, Jonathan V. Diamond and Robert David
Grusin, each of whom loaned the Company $583,333. The Management Notes,
including interest, were converted into 95,354 shares of Common Stock at $19.00
per share. In consideration for these loans, the Company issued warrants to
purchase an aggregate of
56
<PAGE> 57
48,609 shares of Common Stock, representing warrants to purchase 16,203 shares
to each of Messrs. Rosen, Diamond and Grusin. The warrants are exercisable at a
price of $12.00 per share and expire in July 2004.
OPTION GRANTS TO INSIDERS
The Company has granted options to purchase shares of Common Stock to
certain of its executive officers and directors. See "Management -- Employment
Agreements," "-- Compensation of Directors," and "-- Executive Compensation."
EMPLOYMENT AGREEMENTS
The Company has entered into employment agreements with certain of its
executive officers as described under "Management -- Employment Agreements."
INDEMNIFICATION AGREEMENTS
The Company entered into Indemnification Agreements with each of its
directors and executive officers whereby the Company agreed, subject to certain
limitations, to indemnify and hold harmless each director and executive officer
from liabilities incurred as a result of such person's status as a director of
the Company. See "Management -- Limitations on Directors'
Liability -- Indemnification Agreements."
FUTURE INTERESTED TRANSACTIONS
The Board of Directors has adopted a policy to provide that future
transactions between the Company and its officers, directors and other
affiliates must (i) be approved by a majority of the members of the Board of
Directors and by a majority of the disinterested members of the Board of
Directors, (ii) be on terms no less favorable to the Company than could be
obtained from unaffiliated third parties and (iii) be for bona fide business
purposes only.
57
<PAGE> 58
PRINCIPAL AND SELLING STOCKHOLDERS
The table below sets forth, as of February 28, 1998, certain information
regarding beneficial ownership of Common Stock held by (i) each director and
each of the Named Executives who own shares of Common Stock, (ii) all directors
and executive officers of the Company as a group and (iii) each Selling
Stockholder and (iv) each person known by the Company to own beneficially more
than 5% of the Common Stock. Each individual or entity named has sole investment
and voting power with respect to shares of Common Stock beneficially owned by
them, except where otherwise noted.
<TABLE>
<CAPTION>
SHARES BENEFICIALLY SHARES BENEFICIALLY
OWNED PRIOR TO OFFERING OWNED AFTER OFFERING
------------------------ SHARES TO BE --------------------
NAME NUMBER(1) PERCENT SOLD NUMBER(1) PERCENT
---- ----------- --------- ------------ --------- -------
<S> <C> <C> <C> <C> <C>
EXECUTIVE OFFICERS AND DIRECTORS:
Jonathan V. Diamond(2)................. 1,035,449 8.4% -- 1,035,449 7.2
Lawrence L. Rosen(3)................... 958,323 7.7 -- 958,323 6.7
Robert David Grusin(4)................. 939,093 7.6 -- 939,093 6.5
Susanne Harrison(5).................... 598,067 4.9 -- 401,817 2.8
Jerold L. Rosen(6)..................... 150,097 1.2 -- 150,097 1.1
James E. Coane(7)...................... 152,737 1.3 -- 152,737 1.1
Robert C. Harris, Jr.(8)............... 71,875 * -- 71,875 *
Bruce Johnson(9)....................... 61,740 * -- 61,740 *
Philip Ramone(10)...................... 36,839 * -- 36,839 *
Arthur S. Weiner(11)................... 2,500 * -- 2,500 *
ALL DIRECTORS AND EXECUTIVE OFFICERS
AS A GROUP (10 PERSONS):............. 4,006,720 30.8 -- 3,810,470 25.3
OTHER PRINCIPAL STOCKHOLDERS:
Poly Ventures II, Limited
Partnership(5)....................... 585,567 4.8 196,250 389,317 2.7
901 Route 110
Farmingdale, NY 11735
OTHER SELLING STOCKHOLDERS:
Robert Allan........................... 3,189 * 3,189 -- --
Leslie Avakian......................... 1,200 * 600 600 *
Beagle Limited......................... 138,889 1.1 138,889 -- --
Sandra Buehler......................... 62,500 * 62,500 -- --
Clovelly Investments Limited........... 12,500 * 12,500 -- --
Robert M. Coane........................ 26,500 * 9,312 17,188 *
Albert Coles........................... 5,000 * 2,500 2,500 *
Jeff Cutler............................ 3,750 * 3,750 -- --
David M. Darst......................... 7,812 * 7,812 -- --
Robert F. Denny........................ 12,500 * 12,500 -- --
Draper & Co. FBO Donald Strumpf........ 9,634 * 9,634 -- --
Lars Enochson.......................... 41,666 * 20,866 20,800 *
Gerald A. Francis(12).................. 43,035 * 30,000 13,035 *
Global Technology Fund................. 167,965 1.4 67,965 100,000 *
Robert D. Goodale...................... 19,701 * 19,701 -- --
Chadwick Gore.......................... 11,509 * 3,009 8,500 *
David U. Greevy........................ 24,146 * 3,146 21,000 *
Robert Hemmes.......................... 6,831 * 5,831 1,000 *
David E. Hershberg..................... 2,500 * 2,500 -- --
Elaine Hills........................... 125 * 125 -- --
Howard Hirschman....................... 750 * 750 -- --
Andrew and Nancy Kessler............... 3,125 * 3,125 -- --
Robert D. Klineman, Sr................. 1,250 * 1,248 2 *
Michael Koenig......................... 3,125 * 1,500 1,625 *
Richard P. Kollin(13).................. 101,142 * 88,642 12,680 *
Gary Lauder............................ 143,246 1.2 100,000 43,246 *
Ludivine Holdings Limited.............. 12,500 * 12,500 -- --
Israel & Esther Melman, JTWROS......... 45,322 * 26,861 18,461 *
Daniel Meyer........................... 99,354 * 20,000 79,354 *
Salvatore Mignone...................... 5,000 * 2,500 2,500 *
Wendy A. Moss.......................... 1,544 * 1,544 -- --
Jack Newsholme......................... 7,812 * 1,171 6,641 *
Pryor, Cashman, Sherman & Flynn........ 6,250 * 6,250 -- --
</TABLE>
58
<PAGE> 59
<TABLE>
<CAPTION>
SHARES BENEFICIALLY SHARES BENEFICIALLY
OWNED PRIOR TO OFFERING OWNED AFTER OFFERING
------------------------ SHARES TO BE --------------------
NAME NUMBER(1) PERCENT SOLD NUMBER(1) PERCENT
---- ----------- --------- ------------ --------- -------
<S> <C> <C> <C> <C> <C>
Raptor Global Fund, LP. ............... 54,000 * 9,555 44,445 *
Raptor Global Fund, Ltd. .............. 28,666 * 18,000 10,666 --
Joseph Rascoff......................... 13,587 * 13,587 -- --
Howard Reiss........................... 2,500 * 2,500 -- --
Phillip B. Rooney...................... 83,333 * 83,333 -- --
Herbert Rosenfeld...................... 7,812 * 5,000 2,812 *
June Taube Schechter................... 3,750 * 1,750 2,000 *
Kate Schechter......................... 1,250 * 600 650 *
Rachel Schechter....................... 1,250 * 600 650 *
Stuart A. & Evelyn Schechter, JT TEN
W/R/O/S.............................. 3,750 * 1,750 2,000 *
David Scheinman........................ 1,250 * 1,250 -- --
Abel Jack Schwartz..................... 2,500 * 2,500 -- --
James E. Shea(14)...................... 39,810 * 20,000 19,810 *
Donald Strumpf(15)..................... 40,818 * 11,847 28,971 *
Russ Titelman(16)...................... 4,150 * 1,200 2,950 *
Tudor Arbitrage Partners, LP........... 11,166 * 3,722 7,444 *
Tudor BVI Futures Ltd. ................ 72,833 * 24,278 48,555 *
Unterberg Harris 401k Profit Sharing
FBO Andrew Kessler................... 4,687 * 4,687 -- --
Henrick Vanderlip...................... 6,666 * 6,666 -- --
Vanderlip's Children 1988 Trust........ 6,666 * 6,666 -- --
James Weil............................. 3,125 * 3,125 -- --
Steve Weiner, MD....................... 2,571 * 350 2,221 *
Roger O. Wilcox........................ 29,587 * 8,000 21,587 *
Judith I. Wolf......................... 2,500 * 2,500 --
William Zysblat........................ 13,586 * 13,586 -- --
</TABLE>
- ---------------
* Indicates beneficial ownership of less than 1.0% of the outstanding shares
of Common Stock.
(1) Calculated pursuant to Rule 13d-3(d) of the Exchange Act. Under Rule
13d-3(d), shares not outstanding which are subject to options, warrants,
rights or conversion privileges exercisable within 60 days are deemed
outstanding for the purpose of calculating the number and percentage owned
by such person, but not deemed outstanding for the purpose of calculating
the percentage owned by any other person listed. As of February 28, 1998,
the Company had 12,156,850 shares of Common Stock outstanding.
(2) Represents 799,526 shares of Common Stock and exercisable options to
purchase 235,923 shares of Common Stock.
(3) Represents 536,150 shares of Common Stock and 187,500 shares of Common
Stock held by the Lawrence L. Rosen Family Trust, and exercisable options
to purchase 234,673 shares of Common Stock. Mr. Rosen disclaims beneficial
ownership of the Lawrence L. Rosen Family Trust.
(4) Represents 704,420 shares of Common Stock and exercisable options to
purchase 234,673 shares of Common Stock.
(5) Represents exercisable options to purchase 1,250 shares of Common Stock,
which options will be exercised in connection with this offering, and
584,317 shares of Common Stock owned by Poly Ventures II, Limited
Partnership of which Ms. Harrison is a general partner and options to
purchase 12,500 shares of Common Stock owned by Ms. Harrison. Ms. Harrison
disclaims beneficial ownership of all shares owned by Poly Ventures II,
Limited Partnership.
(6) Represents 142,597 shares of Common Stock and exercisable options to
purchase 7,500 shares of Common Stock.
(7) Represents 75,000 shares of Common Stock and 25,000 shares of Common Stock
owned by JoAnn Coane, Mr. Coane's spouse, and exercisable options to
purchase 52,737 shares of Common Stock.
(8) Represents 59,375 shares of Common Stock and exercisable options to
purchase 12,500 shares of Common Stock.
(9) Represents 34,275 shares of Common Stock and an exercisable option to
purchase 27,465 shares of Common Stock.
(10) Represents exercisable options to purchase 36,839 shares of Common Stock.
(11) Represents 2,500 shares of Common Stock.
(12) Represents 38,689 shares of Common Stock and exercisable options to
purchase 4,166 shares of Common Stock.
(13) Represents 88,642 shares of Common Stock and exercisable options to
purchase 12,500 shares of Common Stock.
(14) Represents 35,644 shares of Common Stock and exercisable options to
purchase 4,166 shares of Common Stock.
(15) Represents 36,652 shares of Common Stock and exercisable options to
purchase 4,166 shares of Common Stock.
(16) Represents 2,500 shares of Common Stock and exercisable options to
purchase 1,650 shares of Common Stock.
59
<PAGE> 60
DESCRIPTION OF CAPITAL STOCK
The following summarizes the material provisions of the Certificate of
Incorporation and Bylaws. Such summaries do not purport to be complete and are
subject to, and are qualified in their entirety by reference to, all of the
provisions of the Certificate of Incorporation and the Bylaws, copies of which
have been filed as exhibits to the Registration Statement of which this
Prospectus is a part.
GENERAL
The authorized capital stock of the Company is comprised of 100,000,000
shares of Common Stock and 40,000,000 shares of Preferred Stock.
COMMON STOCK
On February 28, 1998, there were 12,156,850 shares of Common Stock
outstanding. All of the issued and outstanding shares of Common Stock are fully
paid and non-assessable. Each holder of shares of Common Stock is entitled to
one vote per share on all matters to be voted on by stockholders generally,
including the election of directors. There are no cumulative voting rights. The
holders of Common Stock are entitled to dividends and other distributions as may
be declared from time to time by the Board of Directors out of funds legally
available therefor, if any. See "Dividend Policy." Upon the liquidation,
dissolution or winding up of the Company, the holders of shares of Common Stock
would be entitled to share ratably in the distribution of all of the Company's
assets remaining available for distribution after satisfaction of all its
liabilities and the payment of the liquidation preference of any outstanding
Preferred Stock as described below. The holders of Common Stock have no
preemptive or other subscription rights to purchase shares of stock of the
Company, nor are such holders entitled to the benefits of any redemption or
sinking fund provisions. As of February 28, 1998, there were approximately 306
beneficial owners of Common Stock.
PREFERRED STOCK
The Certificate of Incorporation authorizes the Board of Directors to
create and issue one or more series of Preferred Stock and determine the rights
and preferences of each series, to the extent permitted by the Certificate of
Incorporation and applicable law. Among other rights, the Board of Directors may
determine, without the further vote or action by the Company's stockholders, (i)
the number of shares constituting the series and the distinctive designation of
the series; (ii) the dividend rate on the shares of the series, whether
dividends will be cumulative, and if so, from which date or dates, and the
relative rights of priority, if any, of payment of dividends on shares of the
series; (iii) whether the series shall have voting rights, in addition to the
voting rights provided by law and, if so, the terms of such voting rights; (iv)
whether the series shall have conversion privileges, and, if so, the terms and
conditions of such conversion, including provision for adjustment of the
conversion rate in such events as the Board of Directors shall determine; (v)
whether or not the shares of that series shall be redeemable or exchangeable,
and, if so, the terms and conditions of such redemption or exchange, as the case
may be, including the date or dates upon or after which they shall be redeemable
or exchangeable, as the case may be, and the amount per share payable in case of
redemption, which amount may vary under different conditions and at different
redemption dates; (vi) whether the series shall have a sinking fund for the
redemption or purchase of shares of that series and, if so, the terms and amount
of such sinking fund; and (vii) the rights of the shares of the series in the
event of voluntary or involuntary liquidation, dissolution or winding up of the
Company and the relative rights or priority, if any, of payment of shares of the
series. Except for any difference so provided by the Board of Directors, the
shares of all series of Preferred Stock will rank on a parity with respect to
the payment of dividends and to the distribution of assets upon liquidation.
Although the Company has no present plans to issue any shares of Preferred
Stock, the issuance of shares of Preferred Stock, or the issuance of rights to
purchase such shares, may have the effect of delaying, deterring or preventing a
change of control of the Company or an unsolicited acquisition proposal. See
"Risk Factors -- Anti-Takeover Provisions."
60
<PAGE> 61
REGISTRATION RIGHTS
The holders of an aggregate of 4,403,388 shares of the Common Stock not
being sold in this offering (collectively, the "Registration Rights Holders")
have been granted by the Company certain demand and incidental registration
rights. In general, the Registration Rights Holders have the right at any time
beginning April 16, 1998 until the time that the Company shall have qualified
for the use of Form S-2 or S-3, on one occasion, to cause the Company to
register their holdings of Common Stock under the Securities Act (such right
being referred to as a "demand registration right"). The Registration Rights
Holders are also entitled, if the Company determines to file a registration
statement covering any of its securities under the Securities Act (with the
exception of an offering pursuant to a registration statement on Form S-8 or
S-4) to require the Company to use its best efforts to include a requested
amount of their shares of Common Stock in the Company's registered offering
(such right being referred to as an "incidental registration right"), subject to
reduction if the managing underwriter for the offering determines that the
inclusion of such shares would interfere with the successful marketing of the
offering. Furthermore, at such time as the Company shall have qualified for the
use of Form S-2 or S-3, the Registration Rights Holders, and their permitted
transferees, have the right to make one demand registration request annually,
subject to certain marketing restrictions. The Company has granted AOL certain
registration rights with respect to the AOL Shares, including incidental
registration rights if the Company files a registration statement covering any
of its securities under the Securities Act (with the exception of an offering
pursuant to a registration statement on Form S-8 or S-4). Accordingly, AOL has
the right to require the Company to use its best efforts to register and include
any or all of the AOL Shares in this offering. The Company has also granted AOL
the right to require the Company to register the AOL Shares for resale by filing
a shelf registration statement; to have such registration statement declared
effective no later than April 16, 1998 (or, if earlier, the Lock-up Release
Date); and to use its best efforts to continuously maintain the effectiveness of
such registration statement until October 22, 1999. In the event that the
Company fails to cause such registration statement to be declared effective by
April 16, 1998 (or, if earlier, by the Lock-up Release Date), AOL will have the
right to require the Company to repurchase the AOL Shares for cash at a price
equal to the greater of $3.0 million or the value of the AOL Shares based on the
closing price of the Company's shares on the trading day immediately preceding
the day notice of the desired repurchase was given to the Company by AOL. The
Company's repurchase obligation is supported by an escrow arrangement currently
secured by the $3.0 million purchase price of such shares and requiring the
periodic delivery by the Company of additional funds in the form of cash and/or
irrevocable letter of credit calculated with reference to the market value of
the Company's shares, subject to a minimum of $3.0 million and a maximum of $7.5
million. The Company plans to file a registration statement soon after the
consummation of this offering to register the AOL Shares. However, at any time
after April 16, 1998, AOL can require the Company to repurchase the AOL Shares
as discussed above, and, in such event, the Company will honor the terms of its
repurchase obligation to AOL and may use a portion of the net proceeds of this
offering to fund this obligation. If the Company is required to purchase the AOL
Shares, the Common Stock subject to put rights on the Company's consolidated
balance sheets will be accreted to its fair value based upon the price of the
Company's Common Stock at each reporting date and will be recorded as a charge
to the Company's statements of operations at each reporting date. As of
March 31, 1998, this accretion is approximately $1,850,000. In addition, AOL was
granted registration rights comparable to those held by the Registration Rights
Holders with respect to the shares of Common Stock for which the AOL Warrant is
exercisable.
The Company is required to bear all registration expenses (other than
underwriting discounts and commissions and fees, and certain fees and
disbursements of counsel of the Registration Rights Holders and AOL) and has
agreed to indemnify the Registration Rights Holders and AOL against, and provide
contribution with respect to, certain liabilities under the Securities Act in
connection with incidental and demand registrations. The Registration Rights
Holders have agreed not to exercise their demand registration rights prior to
April 16, 1998.
WARRANTS
As of February 28, 1998, there were warrants outstanding (including the AOL
Warrant) to purchase an aggregate of 599,554 shares of Common Stock at an
average exercise price of $14.16 per share, expiring at
61
<PAGE> 62
various dates ending in October 2004, and options to purchase an aggregate of
2,101,866 shares of Common Stock at an average exercise price of $9.80 per
share, expiring at various dates ending in January 2008. The AOL Warrant is for
the purchase of 184,736 shares of Common Stock at an exercise price of $19.00
per share. The AOL Warrant is exercisable as to one-half of the total shares on
October 17, 1998 and as to the balance of the shares on October 17, 1999; such
warrant expires seven years from the date of issuance. The exercise price and
number of shares of Common Stock issuable upon exercise of the aforementioned
warrants are subject to adjustment upon the occurrence of certain events,
including stock splits; stock dividends; reorganizations; recapitalizations;
consolidations or mergers; sales; certain issuances of capital stock, rights,
options, warrants or convertible securities; distributions of the capital stock
or evidences of indebtedness; and extraordinary dividends or distributions. The
AOL Warrant is subject to certain conversion rights, at the election of the
holder. The AOL Warrant and shares of Common Stock issuable upon exercise of the
AOL Warrant are subject to certain registration rights.
ANTI-TAKEOVER EFFECTS OF DELAWARE LAW
Section 203 of the Delaware GCL contains certain provisions that may make
more difficult the acquisition of control of the Company by means of a tender
offer, open-market purchase, a proxy fight or otherwise. These provisions are
designed to encourage persons seeking to acquire control of the Company to
negotiate with the Board of Directors. However, these provisions could have the
effect of discouraging a prospective acquiror from making a tender offer or
otherwise attempting to obtain control of the Company. To the extent that these
provisions discourage takeover attempts, they could deprive stockholders of
opportunities to realize takeover premiums for their shares or could depress the
market price of the Common Stock.
Set forth below is a description of the relevant provisions of Section 203
of the Delaware GCL. The description is intended as a summary only and is
qualified in its entirety by reference to Section 203 of the Delaware GCL.
Section 203 of the Delaware GCL prohibits certain "business combination"
transactions between a publicly held Delaware corporation and any "interested
stockholder" for a period of three years after the date on which the latter
became an interested stockholder, unless (i) prior to that date either the
proposed business combination or the proposed acquisition of stock resulting in
its becoming an interested stockholder is approved by the board of directors of
the corporation, (ii) in the same transaction in which it becomes an interested
stockholder, the interested stockholder acquires at least 85% of those shares of
the voting stock of the corporation which are not held by the directors,
officers or certain employee stock plans or (iii) the business combination with
the interested stockholder is approved by the Board of Directors and also
approved at a stockholders' meeting by the affirmative vote of the holders of at
least two-thirds of the outstanding shares of the corporation's voting stock
other than shares held by the interested stockholder.
NASDAQ NATIONAL MARKET LISTING
The Common Stock is quoted on the Nasdaq National Market under the trading
symbol "NTKI."
TRANSFER AGENT AND REGISTRAR
The transfer agent and registrar for the Common Stock is American Stock
Transfer & Trust Company.
62
<PAGE> 63
SHARES ELIGIBLE FOR FUTURE SALE
Immediately following this offering, the Company will have outstanding
14,158,100 shares of Common Stock. Of these shares, the 3,125,722 shares of
Common Stock sold in this offering (assuming no exercise of the Underwriters'
over-allotment option), the 3,829,754 shares of Common Stock sold in the IPO and
any shares sold under Rule 144 since the IPO will be freely tradable in the
public market without restriction under the Securities Act, except that any
shares purchased by affiliates of the Company, as that term is defined in Rule
144 adopted under the Securities Act ("Affiliates"), may generally only be sold
in compliance with the applicable provisions of Rule 144.
In general, under Rule 144, a person (or persons whose shares are
aggregated) who has beneficially owned "restricted securities" for at least one
year, including a person who may be deemed an Affiliate of the Company, is
entitled to sell within any three-month period a number of shares of Common
Stock that does not exceed the greater of 1% of the then-outstanding shares of
Common Stock of the Company, or the average weekly trading volume of Common
Stock on the Nasdaq National Market during the four calendar weeks preceding the
date on which notice of the sale is filed with the Commission. Sales under Rule
144 are subject to certain restrictions relating to manner of sale, notice and
the availability of current public information about the Company. A person who
is not an Affiliate of the Company at any time during the 90 days preceding a
sale and who has beneficially owned shares for at least two years is entitled to
sell such shares under Rule 144(k) without regard to the volume limitations,
manner of sale provisions or notice or other requirements of Rule 144. In
addition, any employee, director or officer of, or consultant to, the Company
who purchased his shares pursuant to a written compensatory plan or contract may
be entitled to rely on the resale provisions of Rule 701, which permits
non-affiliates to sell their Rule 701 shares without having to comply with the
public information, holding period, volume limitation or notice provisions of
Rule 144, and permits affiliates to sell their Rule 701 shares without having to
comply with Rule 144's holding period restrictions.
The directors and executive officers of the Company and certain other
stockholders of the Company, who collectively hold 3,315,087 of the outstanding
shares of Common Stock, have agreed not to offer to sell, sell, contract to
sell, grant any option to sell, encumber, pledge or otherwise dispose of, or
exercise any demand rights with respect to, any Common Stock or securities
convertible into or exercisable or exchangeable for Common Stock for a period of
90 days, in the case of directors and executive officers, and 45 days, in the
case of such other stockholders, after the date of this Prospectus without the
prior written consent of PaineWebber Incorporated. Of the remaining 3,886,287
outstanding shares of Common Stock that are "restricted securities" not being
sold in this offering, 1,182,875 shares may be publicly resold pursuant to the
current public information, manner of sale and volume limitations of Rule 144
and 2,132,024 shares may be publicly resold without limitation pursuant to Rule
144(k). Certain stockholders of the Company are entitled to both demand and
incidental registration rights with respect to 4,403,388 shares of Common Stock
not being sold in this offering. On or after April 16, 1998, such holders,
except for holders of 1,692,436 shares who have agreed to the lockup arrangement
described in this paragraph, may choose to exercise their demand registration
rights, which could result in a large number of shares being sold in the public
market. AOL has the right to require the Company to file a shelf registration
statement to register for resale the 169,779 shares that AOL agreed to purchase;
to have such registration statement declared effective no later than April 16,
1998; and to use its best efforts to continuously maintain the effectiveness of
such registration statement until October 22, 1999. AOL has the right, secured
by a cash escrow arrangement, to require the Company to repurchase its shares
based on the then-current value of the Company's shares, if such resale
registration statement is not declared effective by April 16, 1998. In addition,
the holder of the AOL Warrant will have the right to require the Company to
register one-half of the shares of Common Stock for which the AOL Warrant is
exercisable beginning October 17, 1998 and the remaining half of the shares of
Common Stock for which the AOL Warrant is exercisable beginning October 17,
1999.
The Company has filed registration statements on Form S-8 under the
Securities Act to register an aggregate of (i) 2,080,632 of Common Stock
reserved for issuance pursuant to the exercise of stock options granted under
the Stock Option Plans, (ii) 500,000 of Common Stock reserved for issuance
pursuant to the exercise of stock options granted under the Directors' Plan and
(iii) 1,500,000 shares of Common Stock reserved for issuance pursuant to the
Purchase Plan. The stock registered under such registration statements will
thereafter be available for sale in the public market, subject to the resale
limitations of Rule 144 applicable to "affiliates" of the Company. See
"Management -- Stock Plans."
63
<PAGE> 64
UNDERWRITING
The Underwriters named below, acting through PaineWebber Incorporated,
Allen & Company Incorporated and Bear, Stearns & Co. Inc. (the
"Representatives"), have severally agreed, subject to the terms and conditions
set forth in the Underwriting Agreement by and among the Company, the Selling
Stockholders and the Representatives (the "Underwriting Agreement"), to purchase
from the Company and the Selling Stockholders, and the Company and the Selling
Stockholders have severally agreed to sell to the Underwriters, the number of
shares of Common Stock set forth opposite the names of such Underwriters below:
<TABLE>
<CAPTION>
NUMBER
UNDERWRITER OF SHARES
----------- ---------
<S> <C>
PaineWebber Incorporated.................................... 1,024,361
Allen & Company Incorporated................................ 1,024,361
Bear, Stearns & Co. Inc. ................................... 527,000
Hambrecht & Quist LLC....................................... 150,000
Boenning & Scattergood Inc. ................................ 80,000
Fahnestock & Co. Inc. ...................................... 80,000
Ladenburg Thalmann & Co. Inc. .............................. 80,000
Sanders Morris Mundy Inc. .................................. 80,000
Wheat, First Securities, Inc. .............................. 80,000
---------
Total............................................. 3,125,722
=========
</TABLE>
The Underwriting Agreement provides that the obligations of the
Underwriters to purchase all of the shares of Common Stock are subject to
certain conditions. The Underwriters are committed to purchase, and the Company
and the Selling Stockholders are obligated to sell, all of the shares of Common
Stock offered by this Prospectus, if any of the shares of Common Stock being
sold pursuant to the Underwriting Agreement are purchased.
The Company and the Selling Stockholders have been advised by the
Representatives that the Underwriters propose to offer the shares of Common
Stock to the public at the public offering price set forth on the cover page of
this Prospectus, and to certain securities dealers at such price less a
concession not in excess of $1.08 per share. The Underwriters may allow, and
such dealers may reallow, a discount not in excess of $0.10 per share. After the
public offering, the public offering price and the concessions and discounts may
be changed by the Representatives.
The Company has granted an option to the Underwriters, exercisable during
the 30-day period after the date of this Prospectus, to purchase up to 468,858
additional shares of Common Stock at the public offering price less the
underwriting discount and commissions set forth on the cover page of this
Prospectus. The Underwriters may exercise such option only to cover
over-allotments in the sale of the shares that the Underwriters have agreed to
purchase. To the extent that the Underwriters exercise such option, each of the
Underwriters will become obligated, subject to certain conditions, to purchase
approximately the same percentage of such additional shares as is approximately
the percentage of shares of Common Stock that it is obligated to purchase of the
total number of the shares under the Underwriting Agreement as shown in the
table set forth above.
The Company and the Selling Stockholders have agreed to indemnify the
Underwriters against certain liabilities, including liabilities under the
Securities Act or to contribute payments that the Underwriters may be required
to make in respect thereof.
64
<PAGE> 65
The Company, its directors and executive officers and certain stockholders
holding in the aggregate approximately 3,315,087 shares of Common Stock have
agreed not to offer, sell, contract to sell or grant any option to purchase or
otherwise dispose of any shares of Common Stock owned by them prior to the
expiration of 90 days, in the case of the Company, its directors and executive
officers, and 45 days, in the case of such other stockholders, from the date of
this Prospectus, except (i) for shares of Common Stock offered hereby; (ii) with
the prior written consent of PaineWebber Incorporated; and (iii) in the case of
the Company, for the issuance of shares of Common Stock upon the exercise of
options or the grant of options to purchase shares of Common Stock.
Robert C. Harris, Jr., a Senior Managing Director of Bear, Stearns & Co.
Inc., is a director and stockholder of the Company. See "Management" and
"Principal and Selling Stockholders."
In February 1996, Allen & Company Incorporated, and certain of its officers
and employees, purchased shares of preferred stock of the Company sold in a
private placement (which were converted into shares of Common Stock upon
consummation of the IPO), and in 1996 and 1997, prior to the IPO, Allen &
Company Incorporated acted as placement agent for the Company in connection with
certain private placements, for which Allen & Company Incorporated received
customary fees and warrants to purchase Common Stock.
In order to facilitate the offering of the Common Stock, the Underwriters
may engage in transactions that stabilize, maintain or otherwise affect the
price of the Common Stock. Specifically, the Underwriters may overallot in
connection with this offering, creating a short position in the Common Stock for
their own account. In addition, to cover overallotments or to stabilize the
price of the Common Stock, the Underwriters may bid for, and purchase, shares of
the Common Stock in the open market. The Underwriters may also reclaim selling
concessions allowed to an underwriter or a dealer for distributing the Common
Stock in transactions to cover their short positions, in stabilization
transactions or otherwise. Finally, the Underwriters may bid for, and purchase,
shares of the Common Stock in market making transactions and impose penalty
bids. These activities may stabilize or maintain the market price of the Common
Stock above market levels that may otherwise prevail. The Underwriters are not
required to engage in these activities, and may end any of these activities at
any time.
The Underwriters and dealers may engage in passive market making
transactions in the Common Stock in accordance with Rule 103 of Regulation M
promulgated by the Commission. In general, a passive market maker may not bid
for, or purchase, the Common Stock at a price that exceeds the highest
independent bid. In addition, the net daily purchases made by any passive market
maker generally may not exceed 30% of its average daily trading volume in the
Common Stock during a specified two-month prior period or 200 shares, whichever
is greater. A passive market maker must identify passive market making bids as
such on the Nasdaq electronic inter-dealer reporting system. Passive market
making may stabilize or maintain the market price of the Common Stock above
independent market levels. Underwriters and dealers are not required to engage
in passive market making and may end passive market making activities at any
time.
LEGAL MATTERS
Certain legal matters with respect to the validity of the Common Stock
offered hereby will be passed upon for the Company by its counsel, Dewey
Ballantine LLP, 1301 Avenue of the Americas, New York, New York 10019, and for
the Underwriters by O'Sullivan Graev & Karabell, LLP, 30 Rockefeller Plaza, New
York, New York 10112.
65
<PAGE> 66
EXPERTS
The audited consolidated financial statements of the Company as of December
31, 1996 and 1997, and for each of the years in the three-year period ended
December 31, 1997, included in this Prospectus and elsewhere in the Registration
Statement have been audited by Arthur Andersen LLP, independent public
accountants, as indicated in their report with respect thereto, and are included
herein in reliance upon the authority of said firm as experts in giving said
report.
The financial statements of N2K Inc., a New York corporation, as of
December 31, 1995 appearing in the Registration Statement have been audited by
Richard A. Eisner & Company, LLP, independent auditors, as set forth in their
report thereon appearing elsewhere in the Registration Statement and have been
included in reliance upon such report given upon the authority of such firm as
experts in auditing and accounting.
AVAILABLE INFORMATION
The Company is subject to the informational requirements of the Exchange
Act, and in accordance therewith files reports, proxy and information
statements, and other information with the Securities and Exchange Commission
(the "Commission"). Such reports, proxy and information statements, and other
information may be inspected and copied at the public reference facilities
maintained by the Commission at 450 Fifth Street, N.W., Washington, D.C.
20549-1004 and at the regional offices of the Commission located at 7 World
Trade Center, Suite 1300, New York, New York 10048 and Citicorp Center, 500 West
Madison Street, Suite 1400, Chicago, Illinois 60661-2511. Copies of such
materials may also be obtained from the Public Reference Section of the
Commission, 450 Fifth Street, N.W., Washington, D.C. 20549-1004 at prescribed
rates. The Commission maintains a web site at http://www.sec.gov that contains
reports, proxy and information statements, and other information regarding
registrants, like the Company, that file electronically with the Commission. The
Company's Common Stock is quoted on the Nasdaq National Market, and reports and
other information concerning the Company may be inspected at the National
Association of Securities Dealers, Inc. at 1735 K Street, N.W., Washington, D.C.
20006-1500.
The Company has filed with the Commission in Washington, D.C. a
Registration Statement on Form S-1 under the Securities Act with respect to the
Common Stock offered hereby. This Prospectus does not contain all of the
information set forth in the Registration Statement and the exhibits and
schedules filed therewith. For further information with respect to the Company
and the Common Stock offered hereby, reference is hereby made to such
Registration Statement and to the exhibits and schedules filed therewith.
Statements contained in this Prospectus regarding the contents of any agreement
or other document are not necessarily complete, and in each instance reference
is made to the copy of such agreement or document filed as an exhibit to the
Registration Statement, each such statement being qualified in all respects by
such reference. The Registration Statement, including the exhibits and schedules
thereto, may be inspected without charge at the offices of the Commission, or
obtained at prescribed rates from the public reference facilities maintained by
the Commission at the addresses set forth above.
66
<PAGE> 67
N2K INC. AND SUBSIDIARIES
<TABLE>
<S> <C>
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
CONSOLIDATED FINANCIAL STATEMENTS OF N2K INC. AND
SUBSIDIARIES
Report of Independent Public Accountants.................. F-2
Consolidated Balance Sheets............................... F-3
Consolidated Statements of Operations..................... F-4
Consolidated Statements of Stockholders' Equity........... F-5
Consolidated Statements of Cash Flows..................... F-6
Notes to Consolidated Financial Statements................ F-7
FINANCIAL STATEMENTS OF NEW YORK N2K
Independent Auditors' Report.............................. F-26
Balance Sheet............................................. F-27
Statement of Operations................................... F-28
Statement of Stockholders' Equity......................... F-29
Statement of Cash Flows................................... F-30
Notes to Financial Statements............................. F-31
</TABLE>
F-1
<PAGE> 68
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To N2K Inc.:
We have audited the accompanying consolidated balance sheets of N2K Inc. (a
Delaware corporation) and subsidiaries as of December 31, 1996 and 1997, and the
related consolidated statements of operations, stockholders' equity and cash
flows for each of the three years in the period ended December 31, 1997. These
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly,
in all material respects, the financial position of N2K Inc. and subsidiaries as
of December 31, 1996 and 1997 and the results of their operations and their cash
flows for each of the three years in the period ended December 31, 1997, in
conformity with generally accepted accounting principles.
ARTHUR ANDERSEN LLP
New York, New York
February 12, 1998
F-2
<PAGE> 69
N2K INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
DECEMBER 31,
----------------------------
1996 1997
------------ ------------
<S> <C> <C>
ASSETS
CURRENT ASSETS:
Cash and cash equivalents................................. $ 4,483,450 $ 36,831,748
Accounts receivable, net.................................. 63,549 239,882
Receivable for Common stock subject to put rights......... -- 2,999,995
Prepaid expenses.......................................... 703,657 16,786,535
Inventory................................................. 113,824 90,039
Advances and recoupable costs............................. 86,525 203,350
------------ ------------
Total current assets.............................. 5,451,005 57,151,549
------------ ------------
NET ASSETS OF DISCONTINUED OPERATIONS....................... 14,446 --
------------ ------------
PROPERTY AND EQUIPMENT:
Computer equipment........................................ 2,289,944 4,638,311
Office furniture and equipment............................ 491,942 1,147,102
Leasehold improvements.................................... 486,877 1,882,684
Property and equipment under capital leases............... 868,436 1,801,663
------------ ------------
4,137,199 9,469,760
Less -- Accumulated depreciation and amortization......... (1,002,435) (2,290,452)
------------ ------------
Net property and equipment........................ 3,134,764 7,179,308
------------ ------------
OTHER ASSETS:
Intangible assets, net.................................... 320,162 244,154
Restricted cash........................................... 167,000 167,000
Other..................................................... 299,093 138,206
------------ ------------
Total other assets................................ 786,255 549,360
------------ ------------
$ 9,386,470 $ 64,880,217
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Current portion of capital lease obligations.............. $ 182,868 $ 464,147
Accounts payable.......................................... 1,088,657 1,504,143
Accrued merchandise costs................................. 24,740 1,169,898
Accrued compensation...................................... 529,063 1,341,354
Accrued royalties......................................... -- 629,989
Other accrued liabilities................................. 1,571,012 2,599,457
------------ ------------
Total current liabilities......................... 3,396,340 7,708,988
------------ ------------
CAPITAL LEASE OBLIGATIONS................................... 235,153 653,558
------------ ------------
OTHER LONG-TERM LIABILITIES................................. 309,100 369,741
------------ ------------
COMMON STOCK SUBJECT TO PUT RIGHTS.......................... 537,498 2,999,995
------------ ------------
COMMITMENTS AND CONTINGENCIES (Note 11)
STOCKHOLDERS' EQUITY:
Preferred stock, $.001 par value, 40,000,000 shares
authorized, 15,397,088 shares and none issued and
outstanding............................................ 15,397 --
Common stock, $.001 par value, 100,000,000 shares
authorized, 2,923,216 and 12,118,100 shares issued and
outstanding............................................ 2,923 12,118
Additional paid-in capital................................ 31,694,385 109,197,798
Accumulated deficit....................................... (26,804,326) (56,061,981)
------------ ------------
Total stockholders' equity........................ 4,908,379 53,147,935
------------ ------------
$ 9,386,470 $ 64,880,217
============ ============
</TABLE>
The accompanying notes are an integral part of these statements.
F-3
<PAGE> 70
N2K INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
-----------------------------------------
1995 1996 1997
----------- ------------ ------------
<S> <C> <C> <C>
NET REVENUES.......................................... $ 96,505 $ 1,655,704 $ 11,262,788
COST OF REVENUES...................................... 85,176 1,493,764 9,393,539
----------- ------------ ------------
Gross profit................................ 11,329 161,940 1,869,249
OPERATING EXPENSES:
Operating and development........................... 1,034,617 7,954,616 14,851,666
Sales and marketing................................. 1,077,649 2,726,291 11,470,149
General and administrative.......................... 871,667 2,477,995 4,842,842
Charge for purchased research and development....... -- 5,242,523 --
----------- ------------ ------------
Operating loss.............................. (2,972,604) (18,239,485) (29,295,408)
INTEREST AND OTHER INCOME............................. 106,370 352,531 693,881
INTEREST EXPENSE...................................... (18,237) (52,281) (653,970)
----------- ------------ ------------
Loss from continuing operations............. (2,884,471) (17,939,235) (29,255,497)
INCOME (LOSS) FROM DISCONTINUED OPERATIONS............ 1,289,671 (968,674) (415,970)
GAIN ON DISPOSAL OF DISCONTINUED OPERATIONS........... -- -- 1,574,493
----------- ------------ ------------
LOSS BEFORE EXTRAORDINARY ITEM........................ (1,594,800) (18,907,909) (28,096,974)
EXTRAORDINARY ITEM.................................... -- -- (639,262)
----------- ------------ ------------
NET LOSS.............................................. $(1,594,800) $(18,907,909) $(28,736,236)
=========== ============ ============
BASIC AND DILUTED INCOME (LOSS) PER COMMON SHARE:
Loss from continuing operations..................... $ (1.84) $ (6.50) $ (5.99)
Income (loss) from discontinued operations.......... 0.82 (0.35) (0.08)
Gain on disposal of discontinued operations......... -- -- 0.32
Extraordinary item.................................. -- -- (0.13)
----------- ------------ ------------
Net loss per Common share................... $ (1.02) $ (6.85) $ (5.88)
=========== ============ ============
SHARES USED IN COMPUTING BASIC AND DILUTED NET LOSS
PER COMMON SHARE.................................... 1,566,955 2,760,948 4,885,556
=========== ============ ============
</TABLE>
The accompanying notes are an integral part of these statements.
F-4
<PAGE> 71
N2K INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
<TABLE>
<CAPTION>
ADDITIONAL
PREFERRED COMMON PAID-IN ACCUMULATED
STOCK STOCK CAPITAL DEFICIT TOTAL
--------- ------- ------------ ------------ ------------
<S> <C> <C> <C> <C> <C>
BALANCE, DECEMBER 31, 1994......... $ 4,057 $ 1,567 $ 8,539,697 $ (6,301,617) $ 2,243,704
Common stock options exercised... -- -- 80 -- 80
Net loss......................... -- -- -- (1,594,800) (1,594,800)
-------- ------- ------------ ------------ ------------
BALANCE, DECEMBER 31, 1995......... 4,057 1,567 8,539,777 (7,896,417) 648,984
Issuance of Common stock and
Series E Preferred stock in
connection with purchase of
New York N2K.................. 1,348 1,348 4,148,708 -- 4,151,404
Issuance of Series E Preferred
stock......................... 4,659 -- 3,722,701 -- 3,727,360
Issuance of Series F Preferred
stock, net.................... 5,333 -- 15,262,951 -- 15,268,284
Issuance of Common stock for
services rendered............. -- 6 14,244 -- 14,250
Common stock options exercised... -- 2 6,004 -- 6,006
Net loss......................... -- -- -- (18,907,909) (18,907,909)
-------- ------- ------------ ------------ ------------
BALANCE, DECEMBER 31, 1996......... 15,397 2,923 31,694,385 (26,804,326) 4,908,379
Issuance of Series G Preferred
stock, net.................... 2,480 -- 7,213,051 -- 7,215,531
Warrants issued in connection
with Management and Senior
Notes......................... -- -- 950,000 -- 950,000
Warrants issued in connection
with AOL Contract............. -- -- 775,000 -- 775,000
Issuance of Common stock in
initial public offering,
net........................... -- 3,830 65,320,929 -- 65,324,759
Conversion of Preferred stock to
Common stock.................. (17,877) 5,020 12,857 -- --
Management Note Conversion....... -- 95 1,811,637 -- 1,811,732
Rocktropolis Put Expiration...... -- 45 537,453 -- 537,498
Common stock purchase and
retirement.................... -- (41) -- (521,419) (521,460)
Issuance of Common stock for
services rendered............. -- 3 52,496 -- 52,499
Issuance of Common stock options
for services rendered......... -- -- 31,463 -- 31,463
Common stock options exercised... -- 243 798,527 -- 798,770
Net loss......................... -- -- -- (28,736,236) (28,736,236)
-------- ------- ------------ ------------ ------------
BALANCE, DECEMBER 31, 1997......... $ -- $12,118 $109,197,798 $(56,061,981) $ 53,147,935
======== ======= ============ ============ ============
</TABLE>
The accompanying notes are an integral part of these statements.
F-5
<PAGE> 72
N2K INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
-----------------------------------------
1995 1996 1997
----------- ------------ ------------
<S> <C> <C> <C>
OPERATING ACTIVITIES:
Net loss............................................ $(1,594,800) $(18,907,909) $(28,736,236)
Adjustments to reconcile net loss to net cash used
in operating activities --
Depreciation and amortization.................... 238,558 767,357 1,437,541
Amortization of marketing advances............... -- -- 2,769,741
Gain on disposal of discontinued operations...... -- -- (1,574,493)
Loss on disposal of property and equipment....... -- -- 79,620
Extraordinary loss from early extinguishment of
debt........................................... -- -- 639,262
Amortization of discount on Management and
Senior Notes................................... -- -- 310,738
Provision for doubtful accounts and returns...... -- 18,000 1,880,283
Charge for purchased research and development.... -- 5,242,523 --
Issuance of Common stock for services rendered... -- 14,250 52,499
Issuance of Common stock options for services
rendered....................................... -- -- 31,463
Decrease (increase) in --
Restricted cash................................ -- 500,000 --
Accounts receivable............................ 485,839 461,356 (1,022,882)
Receivable from Common stock subject to put
rights...................................... -- -- (2,999,995)
Prepaid expenses............................... (30,225) (610,365) (18,065,728)
Inventory...................................... -- (113,824) 23,785
Advances and recoupable costs.................. -- (86,525) (116,825)
Other assets................................... (229) (49,144) (45,945)
Increase (decrease) in --
Accounts payable............................... (30,951) 1,177,839 (61,680)
Accrued merchandise costs...................... 33,300 (8,560) 1,145,158
Accrued compensation........................... 44,335 484,819 625,084
Accrued royalties.............................. -- -- 629,989
Other accrued liabilities...................... 821 317,418 (733,858)
Other long-term liabilities.................... (20,671) 59,073 60,641
----------- ------------ ------------
Net cash used in operating activities....... (874,023) (10,733,692) (43,671,838)
----------- ------------ ------------
INVESTING ACTIVITIES:
Purchases of and deposits on property and
equipment........................................ (338,721) (2,933,196) (4,313,916)
Acquisition of New York N2K, net of cash acquired... -- (224,077) --
Purchase of Rocktropolis website.................... -- (671,744) --
Proceeds from disposal of discontinued operations... -- -- 3,000,000
----------- ------------ ------------
Net cash used in investing activities....... (338,721) (3,829,017) (1,313,916)
----------- ------------ ------------
FINANCING ACTIVITIES:
Net borrowings (repayments) under line of credit.... 400,000 (400,000) --
Proceeds from Management and Senior Notes........... -- -- 7,771,600
Repayment of Senior Notes........................... -- -- (6,021,600)
Payments on capital lease obligations............... (109,476) (103,115) (233,543)
Proceeds from issuance of Preferred stock, net...... -- 18,995,644 7,215,531
Proceeds from issuance of Common stock in
initial public offering, net..................... -- -- 65,324,759
Proceeds from AOL Purchase.......................... -- -- 2,999,995
Proceeds from exercise of Common stock options...... 80 6,006 277,310
----------- ------------ ------------
Net cash provided by financing activities... 290,604 18,498,535 77,334,052
----------- ------------ ------------
INCREASE (DECREASE) IN CASH AND
CASH EQUIVALENTS.................................... (922,140) 3,935,826 32,348,298
CASH AND CASH EQUIVALENTS,
BEGINNING OF YEAR................................... 1,469,764 547,624 4,483,450
----------- ------------ ------------
CASH AND CASH EQUIVALENTS, END OF YEAR................ $ 547,624 $ 4,483,450 $ 36,831,748
=========== ============ ============
</TABLE>
The accompanying notes are an integral part of these statements.
F-6
<PAGE> 73
N2K INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. THE COMPANY AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:
THE COMPANY:
Background
N2K Inc. (the Company or N2K), formerly Telebase Systems, Inc., was formed
as a result of the merger in February 1996, of N2K Inc., a New York corporation
(New York N2K) which was founded in 1995, and Telebase Systems, Inc. (Telebase),
which was founded in 1984 as a provider of on-line information services (see
Note 2). In 1994, recognizing increasing opportunities in the entertainment
market, Telebase expanded its strategy to include music entertainment. In April
1997, the Company discontinued its on-line information services business and in
August 1997, the Company sold substantially all of the net assets of this
business. The operations of the on-line information services business have been
accounted for as discontinued operations (see Note 3).
The Company is an on-line music entertainment company using the Internet as
a global platform for promoting, marketing and selling music and related
merchandise. The Company's strategy is to build loyal user communities around
genre-specific websites that provide music content and enable consumers to
purchase compact discs (CDs), cassettes and related merchandise. The Company
believes that as its user base continues to grow, it will be able to increase
revenues from sales of music, related merchandise, advertising and sponsorship
programs.
The Company has also established its own record label, N2K Encoded Music,
under the direction of Grammy Award-winning producer, Phil Ramone. N2K Encoded
Music uses the Company's websites, as well as record stores and other
traditional distribution channels, to promote, distribute and sell original and
licensed artist recordings. Since January 1997, the Company has released 13
recordings on the N2K Encoded Music label. The Company currently has agreements
with 12 artists for future recordings.
The Company has incurred significant losses and expects to continue to
incur significant losses on a quarterly and annual basis for the foreseeable
future. As of December 31, 1997, the Company had an accumulated deficit of
$56,061,981. The Company has incurred losses from continuing operations of
$17,939,235 and $29,255,497 for the years ended December 31, 1996 and 1997,
respectively. Since its inception, the Company has incurred costs to develop and
enhance its technology, to create, introduce and enhance its websites, to
establish marketing and distribution relationships and to build its
administrative organization. The Company currently intends to increase
substantially its operating expenses as a result of the Company's strategic
alliances, to fund increased sales and marketing, to enhance existing websites
and to implement strategic relationships important to the success of the
Company. To the extent that such expenses precede or are not subsequently
followed by increased revenues, the Company's business, results of operations
and financial condition will be materially adversely affected. There can be no
assurance that the Company will be able to generate sufficient revenues from the
sale of music recordings, related merchandise, advertising and sponsorship to
achieve or maintain profitability on a quarterly or annual basis in the future.
The Company expects negative cash flow from operations to continue for the
foreseeable future as it continues to develop and market its business.
In July 1997, the Company issued $1,750,000 aggregate principal amount of
promissory notes to Lawrence L. Rosen, Jonathan V. Diamond and Robert David
Grusin (the Management Notes), each of whom loaned the Company $583,333. The
Management Notes bore interest at 14% per annum and were due on the earlier of
(i) a change of control of the Company, as defined, and (ii) March 31, 1998. The
Management Notes, including interest, converted into an aggregate 95,354 shares
of Common stock upon the consummation of the initial public offering in October
1997 (the Management Note Conversion). In consideration for these loans, the
Company issued an aggregate of 48,609 warrants to purchase 48,609 shares of
Common stock, representing 16,203 warrants to each of Messrs. Rosen, Diamond and
Grusin. The warrants are exercisable at a price of $12 per share and expire in
July 2004. The Management Notes were recorded net
F-7
<PAGE> 74
N2K INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
of the value ($150,000) associated with these warrants. This discount was being
amortized over the term of the debt through March 31, 1998. When the Management
Notes were converted into Common stock, the Company recorded an extraordinary
charge to its consolidated statement of operations, which was equal to the
unamortized portion of the discount (approximately $102,000).
In August 1997, the Company issued $6,021,600 aggregate principal amount of
Senior Notes (the Senior Notes) to a group of five institutional investors
affiliated with an insurance company and one existing stockholder of the Company
in return for loans in that amount to the Company. The Senior Notes bore
interest at 14% per annum and were due on the earlier of (i) consummation of the
Company's initial public offering, (ii) a change of control of the Company, as
defined, and (iii) March 31, 1998. In consideration for these loans, the Company
issued an aggregate of 167,266 warrants to purchase 167,266 shares of Common
stock. The warrants are exercisable at a price of $12 per share and expire in
August 2004. The Senior Notes were recorded net of the value ($800,000)
associated with these warrants. This discount was being amortized over the term
of the debt through March 31, 1998. In connection with the early repayment of
the Senior Notes upon the consummation of the initial public offering, the
Company recorded an extraordinary charge to its consolidated statement of
operations which was equal to the unamortized portion of the discount
(approximately $537,000). In addition, the Company issued warrants to purchase
83,389 shares of Common stock at an exercise price of $12 per share as a
placement fee relating to this transaction.
In August 1997, the Company sold substantially all of the net assets of its
discontinued operations and received $3,000,000, which was paid in cash at
closing (see Note 3).
The Company and America Online, Inc. (AOL) formed a strategic alliance as
of September 1, 1997 under an interactive marketing agreement (the AOL
Contract), pursuant to which N2K is featured as the exclusive on-line music
retailer within the MusicSpace channel of AOL's on-line service. In addition,
pursuant to the terms of the AOL Contract, an N2K banner continuously appears in
a prominent place on the main screen of the MusicSpace channel and links to a
customized Music Boulevard website. N2K also receives an anchor tenant position
in the music retailing department of AOL's Shopping channel. Although a limited
number of other music retailers may appear in the Shopping channel, none will be
featured or promoted more prominently than N2K. The AOL Contract also provides
for an integrated package of placements, promotions and links through aol.com,
linking to the customized Music Boulevard website. N2K is also promoted on the
results pages for certain music-related searches conducted through the AOL
NetFind search engine on aol.com. N2K and AOL have also agreed to cooperate in
the sale of advertising on the websites governed by the terms of the AOL
Contract. Each party has the first right to sell any advertising or promotional
spaces which reside on their servers. In consideration of the marketing,
promotion, advertising and other services AOL provides under the AOL Contract,
N2K agreed to pay AOL a total of $18,000,000 over a three-year contract term, of
which an aggregate of $12,000,000 has been paid as of December 31, 1997
(included in prepaid expenses), with additional payments of $3,000,000 to be
made on each of November 1, 1998 and November 1, 1999. On November 1, 1997, the
Company amended the AOL Contract to provide for promotional and anchor tenant
buttons on aol.com's home and principal shopping pages with a guaranteed minimum
number of impressions over a term of one year in exchange for a fee of
$4,000,000 to be paid on November 1, 2000, and revenue sharing on sales and
advertising resulting from button-generated traffic to Music Boulevard. The
Company is amortizing the costs associated with the AOL Contract over the
contract terms of one to three years, primarily on a straight-line basis. For
the year ended December 31, 1997, the Company recorded amortization expense of
$2,098,876 related to the AOL Contract, which is included in sales and marketing
expenses on the accompanying consolidated statements of operations. The Company
will continually evaluate the realizability of the asset and if necessary, write
down the asset to its net realizable value. After the initial three year term,
the AOL Contract may be renewed at the option of AOL for additional one-year
terms.
F-8
<PAGE> 75
N2K INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
In connection with the AOL Contract, AOL and the Company entered into an
agreement, pursuant to which AOL agreed to purchase from the Company at the
initial public offering price per share (less underwriting discounts and
commissions) an aggregate amount of $3,000,000 or 169,779 shares (the AOL
Purchase). The Company has granted AOL certain shelf and other registration
rights with respect to the shares purchased by AOL in the AOL Purchase,
including the right to require the Company to register such shares for resale,
and to have such registration statement declared effective on or before 180 days
after the consummation of the AOL Purchase (April 16, 1998) and to maintain the
effectiveness of such registration statement for a period of two years from the
consummation of the AOL Purchase. In the event that the Company fails to cause
such registration statement to be declared effective within 183 days after the
consummation of the AOL Purchase, AOL will have the right to require the Company
to repurchase such shares for cash at a price equal to the greater of the
original purchase price therefor (which is being held by AOL in a segregated
account) and the then-current fair market value. The Company's repurchase
obligation is secured by an escrow in the form of cash and/or letter of credit
in an amount to be agreed upon by the Company and AOL, which amount shall not be
less than $3,000,000 nor more than $7,500,000. Accordingly, the value of these
shares is not included in Stockholders' equity. The Company plans to file a
registration statement soon after the consummation of this offering to register
such shares. However, at any time after April 16, 1998, AOL can require the
Company to repurchase such shares as discussed above, and, in such event, the
Company will honor the terms of its repurchase obligation to AOL and may use a
portion of the net proceeds of this offering to fund this obligation. If the
Company is required to repurchase such shares, the Common stock subject to put
rights on the accompanying consolidated balance sheets will be accreted to its
fair value based upon the price of the Company's Common stock at each reporting
date and will be recorded as a charge to the Company's statement of operations
at each reporting date. As of March 31, 1998, this accretion is approximately
$1,850,000. In addition, the Company granted AOL a warrant for the future
purchase of up to 184,736 additional shares of Common stock (the AOL Warrant) at
an exercise price equal to the initial public offering price per share. The AOL
Warrant is exercisable as to one-half of the total number of shares on the first
anniversary of the date of issuance and as to the balance of the shares on the
second anniversary of the date of issuance. The AOL Warrant expires in September
2004. The fair value of these warrants ($775,000) has been included in prepaid
expenses and is being amortized over the term of the AOL Contract, which is
three years.
On September 23, 1997, the Company entered into a sponsorship agreement
with Excite, Inc. (Excite) (the Excite Contract), pursuant to which N2K is the
exclusive retail music store sponsor of the excite.com website, provides certain
music-related content to the excite.com website, created a co-branded area of
Music Boulevard, the Company's website, and participates in joint promotions to
customers of this co-branded area. The Excite Contract provides for the Company
to pay Excite an initiation fee, an annual exclusivity fee and an annual
sponsorship fee for ongoing programming, links, placements, advertisements and
promotions. Under the terms of the Excite Contract, the Company also pays Excite
a specified share of gross margins realized by the Company on transactions,
advertising, sponsorship, promotions and other revenues generated during the
term of the Excite Contract on Music Boulevard as a result of users referred
from the excite.com website. In consideration of the sponsorship opportunity
afforded to the Company under the Excite Contract, N2K agreed to pay Excite a
guaranteed minimum total of $9,800,000 over a two-year contract term, of which
$3,300,000 has been paid as of December 31, 1997 (included in prepaid expenses),
with additional payments of $2,375,000 during 1998 and $4,125,000 during 1999.
The Company is amortizing the costs associated with the Excite Contract over the
initial contract term which expires on November 17, 1999. The amortization
method is primarily based upon the number of impressions received during the
contract term. For the year ended December 31, 1997, the Company recorded
amortization expense of $501,510 related to the Excite Contract, which is
included in sales and marketing expenses on the accompanying consolidated
statements of operations. The Company will continually evaluate the
realizability of this asset and, if necessary, write down the asset to its net
realizable value. Pursuant to the terms of the Excite Contract, Excite is
obligated to offer the Company the right of first refusal to negotiate with
Excite for renewal of the Excite Contract.
F-9
<PAGE> 76
N2K INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
On September 27, 1997, N2K entered into a website services agreement (the
Netscape Services Agreement) with Netscape Communications Corporation (Netscape)
pursuant to which the Company produced, developed and manages a retail website,
maintained on the Company's servers and linked to Netscape's website, modeled
after, but differentiated from, the Company's Music Boulevard website. Under
this Netscape Services Agreement, visitors to Netscape's website may readily
access the retail website, which is promoted by Netscape using content provided
by the Company, for the on-line purchase of music products and access to related
information. The Netscape Services Agreement provides for the Company to pay
Netscape $1,000,000 on December 18, 1998, 12 months after the date on which the
service was fully functional and accessible to end users, and a second payment
of $1,000,000 on June 18, 1999, 18 months after such date. The Company is
amortizing this cost, primarily as impressions are received over the two-year
contract term. In addition, over the two-year contract term, Netscape and the
Company will share net revenues from the sale of certain music products,
advertising services, subscriptions to content, fees paid by content providers
for the provision of pay-per-view access to end users and sponsorships. N2K has
entered into an additional agreement with Netscape. Under a trademark license
agreement (the Netscape License Agreement) effective as of September 28, 1997,
Netscape granted to the Company a license to use Netscape's trademark in
connection with the retail website that, in part, promotes Netscape's products
and services. In exchange for the rights granted to the Company under the
license, the Company has agreed to pay Netscape a one-time license fee of
$4,000,000, $3,000,000 of which was paid as of December 31, 1997 (included in
prepaid expenses), and the remainder of which is outstanding pending the outcome
of current negotiations. The Company is amortizing this cost over the two-year
contract term, primarily on a straight-line basis. The Company will continually
evaluate the realizability of these assets and, if necessary, write down the
assets to their net realizable value. For the year ended December 31, 1997, the
Company recorded amortization expense of $169,355 related to the Netscape
Services Agreement and the Netscape License Agreement which is included in sales
and marketing expenses on the accompanying consolidated statements of
operations. Pursuant to the terms of the Netscape License Agreement, Netscape is
obligated to offer the Company the right of first refusal to negotiate with
Netscape for renewal of the Netscape License Agreement.
On October 17, 1997, the Company completed its initial public offering of
3,330,221 shares of Common stock at a price of $19 per share. Additionally, on
October 22, 1997, the underwriter exercised their over-allotment option for the
purchase of 499,533 shares at a price of $19 per share. The Company received net
cash proceeds of approximately $65,300,000 from the initial public offering.
Additionally, on October 17, 1997, the following events occurred: (i) the
automatic conversion of all outstanding shares of the Company's Preferred stock;
$0.001 par value, into an aggregate of 4,986,778 shares of Common stock upon the
consummation of the initial public offering; (ii) the automatic expiration upon
the consummation of the initial public offering of the put rights associated
with 44,790 shares of Common stock issued in connection with purchase of the
rock website, Rocktropolis; (iii) the Management Note Conversion; (iv) the AOL
Purchase; and (v) the repayment of the Senior Notes.
Stock Split and Reorganization
On October 15, 1997, the Company effected a one-for-four reverse stock
split of each outstanding share of Common stock in N2K Inc., a Pennsylvania
corporation, prior to the reorganization of N2K Inc. as a Delaware corporation,
which occurred on October 16, 1997. All share, stock option and warrant data
have been restated to reflect the reverse stock split.
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:
Principles of Consolidation
The consolidated financial statements include the accounts of the Company
and its wholly owned subsidiaries. All significant intercompany accounts and
transactions have been eliminated.
F-10
<PAGE> 77
N2K INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Management's 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
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
Cash and Cash Equivalents
For purposes of the consolidated statements of cash flows, the Company
considers investment instruments with an original maturity of three months or
less to be cash equivalents. Cash equivalents are comprised of investments in
various mutual and money market funds, as well as short-term notes.
Supplemental Disclosures of Cash Flow Information
For the years ended December 31, 1995, 1996 and 1997, the Company paid
interest of $18,237, $52,281 and $277,528, respectively. Income taxes paid in
1995, 1996 and 1997 were immaterial. The Company incurred $99,454 and $933,227
of capital lease obligations during 1995 and 1997, respectively. There were no
capital lease obligations incurred during 1996.
The following table displays the noncash assets and liabilities that were
consolidated as a result of the New York N2K acquisition on February 13, 1996
(see Note 2):
<TABLE>
<S> <C>
Noncash assets (liabilities):
Accounts receivable....................................... $ 78,090
Prepaid expenses.......................................... 3,540
Property and equipment.................................... 557,455
Other assets.............................................. 36,612
Goodwill.................................................. 280,000
Charge for purchased research and development............. 4,133,281
Accounts payable and other accrued liabilities............ (405,118)
Capital lease obligations................................. (308,379)
-----------
Net noncash assets acquired............................ 4,375,481
Less -- Preferred stock issued......................... (1,078,286)
Common stock issued............................ (3,073,118)
-----------
Cash paid, net of cash acquired............................. $ 224,077
===========
</TABLE>
Additionally, the following table displays the noncash assets that were
acquired as a result of the Rocktropolis website acquisition on June 21, 1996
(see Note 2):
<TABLE>
<S> <C>
Noncash assets:
Charge for purchased research and development............. $1,109,242
Intangible assets......................................... 100,000
----------
Net noncash assets acquired............................ 1,209,242
Less -- Common stock issued............................ (537,498)
----------
Cash paid................................................... $ 671,744
==========
</TABLE>
Advances and Recoupable Costs
In accordance with Statement of Financial Accounting Standards (SFAS) No.
50, "Financial Reporting in the Record and Music Industry," advances to artists
and producers and other recoupable costs are capitalized as an asset when the
current popularity and past performance of the artist or producer provides a
sound basis for estimating the probable future recoupment of such advances from
earnings otherwise payable
F-11
<PAGE> 78
N2K INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
to the artist or producer. Any portion of such advances not deemed to be
recoupable from future royalties is reserved at the balance sheet date. All
other significant advances which do not meet the above criteria are expensed
when paid and included in operating and development expenses on the accompanying
consolidated statement of operations.
Property and Equipment
Property and equipment are stated at cost. Depreciation is calculated on a
straight-line basis over the estimated useful lives of the assets. Computer
equipment is depreciated primarily over an estimated useful life of 4 years and
office furniture and equipment is depreciated over an estimated useful life of 4
to 8 years. Leasehold improvements are amortized over the shorter of the
estimated useful life or the lease term. Improvements and betterments are
capitalized, and maintenance and repair costs are charged to expense as
incurred. Upon retirement or disposition, the applicable property amounts are
relieved from the accounts, and any gain or loss is recorded in the consolidated
statement of operations.
Intangible Assets
Intangible assets consist of acquired technology costs and the Rocktropolis
tradename and are being amortized over 5 years on a straight-line basis.
The Company evaluates the realizability of intangible assets based on
estimates of undiscounted future cash flows over the remaining useful life of
the asset. If the amount of such estimated undiscounted future cash flow is less
than the net book value of the asset, the asset is written down to its net
realizable value. As of December 31, 1997, no such write-down was required.
Revenue Recognition
Revenues from the sale of music CDs and cassettes sold via the Internet,
include shipping and handling charges, and are recognized at the time of
shipment. The Company records the estimated gross profit which will be lost due
to current period shipments being returned in future periods as a reduction of
revenues and cost of revenues in the period of shipment.
Beginning in January 1997, in connection with the Company's first record
release, revenues began to be derived from the sale of original and licensed
artist recordings. Revenues are recognized at the time of shipment. Provision is
made for the estimated effect of sales returns where right-of-return privileges
exist. Returns of product from customers are accepted in accordance with
standard industry practice. The full amount of the returns allowance (estimated
returns to be received net of distribution, royalty and inventory costs) is
shown, along with the allowance for doubtful accounts, as a reduction of
accounts receivable in the accompanying consolidated financial statements.
The Company has numerous agreements with other companies in the
entertainment business which provide for, among other things, the Company to pay
a percentage of revenues, as defined, derived from customers entering the
Company's website via the websites of these other companies. The Company records
these costs in cost of revenues at the time the related revenues are recorded.
Advertising revenues are derived from the sale of advertising on the
Company's websites. Advertising revenues are recognized in the period the
advertisement is displayed, provided that no significant Company obligations
remain and collection of the resulting receivable is probable. Company
obligations typically include guarantees of minimum number of "impressions", or
times that any advertisement is viewed by users on the Company's websites. To
the extent minimum guaranteed impressions are not met, the Company defers
recognition of the corresponding revenues until guaranteed impression levels are
achieved. Revenues from the sale of certain advertising on the Company's
websites are shared with third parties under the terms of certain agreements.
The Company records advertising revenues net of amounts allocable to third
parties under the terms of such agreements. To date, amounts allocable to third
parties have not been significant.
F-12
<PAGE> 79
N2K INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The Company recognizes advertising revenue as a result of barter
transactions. Such revenue is recognized based on the fair value received, which
generally consists of advertising displayed by other companies or merchandise.
Barter revenue and the corresponding expenses are recognized in the period the
advertising is displayed.
International net revenues were $25,570, $650,258 and $2,112,732 for the
years ended December 31, 1995, 1996 and 1997, respectively.
Operating and Development Expenses
Operating and development expenses consist of software engineering,
multimedia production, graphic design, certain nonrecoverable advances and
recoupable costs, artist relations, inventory management and computer operations
which support the Company's products. For the years ended December 31, 1995,
1996 and 1997, the Company incurred costs of $724,326, $3,051,174, and
$4,128,249, respectively, relating to research and development. These amounts
are included in operating and development expenses as shown in the accompanying
consolidated statements of operations.
Advertising Expenses
Promotional costs incurred in connection with the N2K Encoded Music label
are capitalized for unreleased projects and expensed when the related product is
released. All other advertising and promotional costs incurred by the Company
are expensed the first time the advertising takes place. Advertising and
promotion expense was $388,748, $1,759,515, and $8,724,941 for the years ended
December 31, 1995, 1996 and 1997, respectively, and is included in sales and
marketing expenses in the accompanying consolidated statements of operations.
Charge for Purchased Research and Development
In connection with the acquisition of New York N2K in February 1996 and the
rock website, Rocktropolis, in June 1996 (see Note 2), $5,242,523 of the
aggregate purchase price was allocated to incomplete research and development
projects. Accordingly, these costs were charged to expense as of the acquisition
dates. The development of these projects had not yet reached technological
feasibility and the technology had no alternative future use. The acquired
technology required substantial additional development by the Company.
Loss per Common Share
In February 1997, the Financial Accounting Standards Board issued SFAS No.
128, "Earnings per Share," which supersedes APB 15. SFAS No. 128 requires dual
presentation of basic and diluted earnings (loss) per share for complex capital
structures on the face of the statements of operations. According to SFAS No.
128, basic earnings (loss) per share, which replaces primary earnings (loss) per
share, is calculated by dividing net income available to Common stockholders by
the weighted average number of Common shares outstanding for the period. Diluted
earnings (loss) per share, which replaces fully diluted earnings (loss) per
share, reflects the potential dilution from the exercise or conversion of
securities into Common stock, such as stock options.
The Company adopted SFAS No. 128 during the period ended December 31, 1997,
as earlier application was not permitted. As required by SFAS No. 128, all
prior-period loss per common share data has been restated to conform with the
provisions of this statement.
F-13
<PAGE> 80
N2K INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The following is a summary of the numerators and denominators of the basic
and diluted net loss per Common share computations:
<TABLE>
<CAPTION>
1995 1996 1997
----------- ------------ ------------
<S> <C> <C> <C>
Loss (numerator).......................... $(1,594,800) $(18,907,909) $(28,736,236)
Shares (denominator)...................... 1,566,955 2,760,948 4,885,556
Per share amount.......................... $ (1.02) $ (6.85) $ (5.88)
</TABLE>
Diluted net loss per share is the same as basic net loss per share as no
additional shares for the potential dilution from the exercise or conversion of
securities into Common stock are included in the denominator as the result is
anti-dilutive due to the Company's losses. Options to purchase 2,059,366 shares
of Common stock at a weighted average exercise price of $9.45 per share,
warrants to purchase 599,554 shares of Common stock at a weighted average
exercise price of $14.16 per share and the AOL Purchase were outstanding as of
December 31, 1997, but were not included in the computation of diluted net loss
per Common share.
Major Supplier and Distribution Agreement
The Company had a contract with Valley Record Distributors (Valley), which
was re-negotiated in January 1998. Valley is currently the Company's primary
provider of order fulfillment for direct-to-consumer music products. The Company
has no fulfillment operation or facility of its own and, accordingly, is
dependent upon maintaining its existing relationship with Valley or establishing
a new fulfillment relationship with one of the few other fulfillment operations.
There can be no assurance that the Company will maintain its relationship with
Valley or that it will be able to find an alternative, comparable supplier
capable of providing fulfillment services on terms satisfactory to the Company
should its relationship with Valley terminate. An unanticipated termination of
the Company's relationship with Valley, particularly during the fourth quarter
of the calendar year in which a high percentage of recorded music sales are
made, could materially adversely affect the Company's results of operations for
the quarter in which such termination occurred even if the Company was able to
establish a relationship with an alternative fulfillment house. The
re-negotiated contract expires in February 2000. Valley may terminate its
existing agreement with the Company upon 30 days' written notice, in the event
that Valley decides to discontinue providing fulfillment services to all of
Valley's on-line service customers. To date, Valley has satisfied the Company's
requirements on a timely basis. However, to the extent that Valley does not have
sufficient capacity and is unable to satisfy on a timely basis increasing
requirements of the Company, such capacity constraint would have a material
adverse effect on the Company's business, results of operations and financial
condition. For the years ended December 31, 1995, 1996 and 1997, the Company
incurred costs related to this relationship of approximately $83,000, $1,439,000
and $5,941,000, respectively, which are included in cost of revenues on the
accompanying consolidated statements of operations. As of December 31, 1997,
relative to this relationship, Valley was due approximately $1,037,000 from the
Company, which is included in accrued merchandise costs on the accompanying
consolidated balance sheets.
On October 16, 1996, the Company and RED Distribution, Inc. (RED), a
subsidiary of Sony Music Entertainment, Inc., entered into a letter agreement
which provided that RED be the exclusive distribution agent in the United States
for the N2K Encoded Music label. The agreement has a three-year term and
provides for a distribution fee of between 16% to 20% of net revenues, as
defined. The agreement provides that the Company will deliver at least 12
previously unreleased, newly compiled or recorded studio albums during each year
of the term of the agreement and no less than 4 such albums during each six
months of each year of the term of the agreement. The distribution services
rendered by RED include billing and collecting from customers, bearing bad
debts, distributing promotional items, advertising, undertaking retail marketing
and inventory control activities and processing returns. The payment of the
distribution fees owed to RED by the Company is secured by all of the Company's
inventories in RED's possession awaiting distribution. The Company does not have
a distribution operation of its own for the N2K Encoded Music label and,
accordingly,
F-14
<PAGE> 81
N2K INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
is dependent upon maintaining its existing relationship with RED or establishing
a new distribution relationship with a comparable distributor. There can be no
assurance that the Company will maintain its relationship with RED beyond the
term of its existing agreement. The termination of such relationship would,
absent establishing a substitute relationship with another distributor, have a
material adverse effect on the Company's business, results of operations and
financial condition. As the Company's first recording was released in January
1997, there was no activity under this agreement prior to December 31, 1996. For
the year ended December 31, 1997, approximately $5,919,000 in gross product
revenues and approximately $3,170,000 in net product revenues were generated
through RED. Net amounts due from RED as of December 31, 1997, were
approximately $1,114,000, which are included in accounts receivable in the
accompanying consolidated balance sheets.
Reclassifications
The consolidated financial statements for prior years have been
reclassified to conform with the current year's presentation.
2. ACQUISITIONS:
Acquisition of New York N2K
On February 13, 1996, New York N2K merged with and into Telebase in a
transaction accounted for as a purchase. Telebase issued 1,347,857 shares of
Common stock valued at $3,073,118 and 1,347,860 shares of Series E Preferred
stock valued at $1,078,286 in exchange for all of the outstanding Common stock
of New York N2K. The fair value assigned to the Common stock was determined
based upon an independent appraisal. Telebase is the surviving corporation;
however, the corporate name of the surviving corporation was changed to N2K Inc.
Telebase was the acquirer in this purchase. The results of the acquired business
have been included in the consolidated financial statements from the date of
acquisition. The total purchase price of $4,375,481, including transaction
costs, was allocated to the assets acquired and liabilities assumed based on
their respective fair values. The Company recorded $4,133,281 of the purchase
price as a charge to the consolidated statements of operations on the
acquisition date as it was related to the fair value of incomplete research and
development projects. The remaining balance of the purchase price of $280,000
was allocated to acquired technology costs and is being amortized over 5 years
on a straight-line basis. If the acquisition of New York N2K had occurred on
January 1, 1995, the unaudited pro forma information, after giving effect to the
pro forma adjustments described below, would have been as follows:
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
---------------------------
1995 1996
----------- ------------
<S> <C> <C>
Unaudited pro forma revenues..................... $ 240,131 $ 1,724,331
=========== ============
Unaudited pro forma loss from continuing
operations..................................... $(4,129,250) $(14,189,842)
=========== ============
Unaudited pro forma net loss..................... $(2,839,579) $(15,158,516)
=========== ============
Unaudited pro forma basic and diluted net loss
per Common share............................... $ (1.81) $ (5.49)
=========== ============
</TABLE>
The unaudited pro forma information does not purport to be indicative of
the results that would have been attained if the operations had actually been
combined for the periods presented and is not necessarily indicative of the
operating results to be expected in the future.
The pro forma adjustments consist of compensation charges for certain
executive officers who did not receive any compensation from New York N2K prior
to the merger and the amortization of the acquired technology costs. The amount
of the compensation pro forma adjustment was $500,000 and $75,000 for the years
ended December 31, 1995 and 1996, respectively. The amount of the acquired
technology cost
F-15
<PAGE> 82
N2K INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
amortization pro forma adjustment was $46,667 and $7,000 for the years ended
December 31, 1995 and 1996, respectively. Additionally, the above unaudited pro
forma information excludes the one-time charge of $4,133,281 associated with the
write-off of purchased research and development costs in connection with the New
York N2K acquisition and includes the write-off of purchased research and
development costs associated with the purchase of the Rocktropolis website for
the year ended December 31, 1996. This one-time charge would have increased the
unaudited pro forma basic and diluted net loss per Common share for the year
ended December 31, 1996 by $1.50.
On February 13, 1996, the Company sold 3,750,000 shares of Series E
Preferred stock at $.80 per share and received gross proceeds of $3,000,000 (see
Note 7).
Acquisition of Rocktropolis Website
On June 21, 1996, the Company acquired the assets that relate to the rock
website known as Rocktropolis, from Rocktropolis Enterprises, LLC for $633,000
in cash and 44,790 shares of Common stock valued at $537,498. The total purchase
price of $1,209,242, including transaction costs, was allocated to the assets
acquired based on their respective fair values. The Company recorded $1,109,242
of the purchase price as a charge to the consolidated statements of operations
on the acquisition date as it was related to the fair value of incomplete
research and development projects. The remaining balance of the purchase price
was allocated to the Rocktropolis tradename and is being amortized on a
straight-line basis over 5 years.
The Common stock issued in connection with the acquisition of the
Rocktropolis website could be "put" back to the Company at a price of $12 per
share at any time beginning 366 days after the issuance date if there was not at
that time a public market for shares of the Company's Common stock. Accordingly,
the value of these shares ($537,498) was not included in Stockholders' equity in
the accompanying consolidated balance sheets prior to the consummation of the
initial public offering. The "put" rights expired upon the consummation of the
initial public offering.
3. DISCONTINUED OPERATIONS:
In April 1997, the Company's Board of Directors approved a formal plan of
disposal for its on-line information services business.
The on-line information services business was accounted for as discontinued
operations with a measurement date of April 4, 1997. The Company expected that
the sale of the on-line information services business would result in a gain on
the disposal of the segment's net assets which would be sufficient to offset the
losses of the segment from the measurement date to the disposal date. As a
result, no amounts were accrued in the accompanying consolidated financial
statements relating to the disposal of the segment. The net losses from
discontinued operations from the measurement date to the disposal date were
recorded as an adjustment to the net assets of the discontinued operations in
the accompanying consolidated balance sheets. The accompanying consolidated
financial statements reflect the operating results and balance sheet items of
the discontinued operations separately from continuing operations.
Effective August 1, 1997, the Company entered into an agreement for the
sale of all of the net assets of the on-line information services business,
except its accounts receivable and accounts payable. The total purchase price of
$6,000,000 consists of $3,000,000 which was paid in cash at closing, and up to
an additional $3,000,000 pursuant to an earn-out which, if and to the extent
earned, is payable at the purchaser's sole discretion on March 31, 1999 and
September 30, 1999, either in cash or that number of shares of its Common stock
having a market value equal to the amount to be paid. The earn-out is based upon
the revenues of the business which are generated from July 1, 1997 through
December 31, 1998. If revenues during the above period do not meet the specified
target, the earn-out is reduced. If revenues during the above period exceed the
specified target, the earn-out is increased, up to a maximum of $1,000,000. The
Company will record the
F-16
<PAGE> 83
N2K INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
earn-out as a gain on the sale of discontinued operations when realized. At
closing, the Company recorded a gain on the sale of discontinued operations of
$1,574,493. The gain was net of a provision for certain disposal costs including
accruals for future commitments relating to severance and doubtful accounts
relating to the on-line information services business' accounts receivable.
These costs are reflected in accrued discontinued operations disposal costs (see
Note 5). In connection with the sale, the Company entered into a services
agreement under which it will provide certain services and support personnel to
the purchaser through September 1999 for a fixed monthly fee.
Revenues and income (loss) from discontinued operations in the accompanying
consolidated statements of operations were:
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
---------------------------------------
1995 1996 1997
----------- ---------- ----------
<S> <C> <C> <C>
Revenues.............................. $10,976,711 $7,855,758 $2,411,057
=========== ========== ==========
Income (loss) before income taxes..... $ 1,289,971 $ (968,674) $ (415,970)
Income taxes.......................... 300 -- --
----------- ---------- ----------
Income (loss)......................... $ 1,289,671 $ (968,674) $ (415,970)
=========== ========== ==========
</TABLE>
The assets and liabilities of the on-line information services business
have been reclassified in the accompanying consolidated balance sheets to
separately identify them as net assets of discontinued operations. A summary of
these net assets of discontinued operations as of December 31, 1996 is as
follows:
<TABLE>
<S> <C>
Current assets, excluding accounts receivable............... $ 11,891
Accounts receivable......................................... 1,033,734
Property and equipment, net................................. 278,875
Other assets................................................ --
Current liabilities......................................... (1,310,054)
Long-term liabilities....................................... --
-----------
Net assets of discontinued operations....................... $ 14,446
===========
</TABLE>
4. PREPAID EXPENSES:
Prepaid expenses as of December 31, 1996 and 1997 consist of the following:
<TABLE>
<CAPTION>
DECEMBER 31,
-----------------------
1996 1997
-------- -----------
<S> <C> <C>
AOL marketing advances.............................. $ -- $12,775,000
Excite marketing advances........................... -- 3,300,000
Netscape marketing advances......................... -- 3,000,000
Other............................................... 703,657 481,276
-------- -----------
703,657 19,556,276
Less: Accumulated amortization of marketing
advances.......................................... -- (2,769,741)
-------- -----------
$703,657 $16,786,535
======== ===========
</TABLE>
F-17
<PAGE> 84
N2K INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
5. OTHER ACCRUED LIABILITIES:
Other accrued liabilities as of December 31, 1996 and 1997 consist of the
following:
<TABLE>
<CAPTION>
DECEMBER 31,
------------------------
1996 1997
---------- ----------
<S> <C> <C>
Office close-down................................... $ 500,722 $ 140,192
Accrued professional fees........................... 499,352 145,423
Accrued discontinued operations disposal costs (Note
3)................................................ -- 671,407
Other............................................... 570,938 1,642,435
---------- ----------
$1,571,012 $2,599,457
========== ==========
</TABLE>
During 1996, the Company recorded a provision related to the close-down of
an office. As of December 31, 1997, the Company has future obligations relating
to this close-down, which includes costs for lease payments (net of sublease
receipts) on the office facility as the Company is not utilizing the space and
employee severance. Actual results could differ from this estimate.
6. CREDIT AGREEMENTS:
The Company had a line of credit with a bank of $2,000,000 that originally
expired on December 31, 1997. On January 23, 1998, pursuant to a letter
agreement, the line of credit was extended to June 30, 1998. The Company is
obligated to pay a commitment fee equal to 0.5% on the average daily unused
portion of the commitment. The line of credit bears interest at the "bank's
prime rate," as defined, and is secured by a security interest in substantially
all of the Company's assets. Maximum borrowings are limited to certain
percentages of eligible accounts receivable (as defined). During 1995, 1996, and
1997 the maximum amount outstanding was $400,000, $600,000 and $850,000,
respectively. For the years ended December 31, 1995, 1996, and 1997, the
weighted average interest rate was 8.7%, 8.7% and 8.5%, respectively. In
addition, the line of credit requires the Company to meet certain financial
covenants. Interest expense for the years ended December 31, 1995, 1996 and 1997
was $7,360, $14,992 and $54,711, respectively.
7. PREFERRED STOCK:
At December 31, 1996, Preferred stock consisted of the following:
<TABLE>
<S> <C>
Preferred stock, $.001 par value, 40,000,000 shares
authorized and designated as follows --
Series A, 500,000 shares authorized, 488,838 shares issued
and outstanding........................................ $ 489
Series B, 625,000 shares authorized, issued and
outstanding............................................ 625
Series C, 2,857,143 shares authorized, 2,142,857 shares
issued and outstanding................................. 2,143
Series D, 1,000,000 shares authorized, 800,000 shares
issued and outstanding................................. 800
Series E, 6,007,060 shares authorized, issued and
outstanding............................................ 6,007
Series F, 5,333,333 shares authorized, issued and
outstanding............................................ 5,333
Series G, 15,000,000 shares authorized in 1997............ --
-------
$15,397
=======
</TABLE>
F-18
<PAGE> 85
N2K INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
In January 1988, the Company issued 488,838 shares of Series A Preferred
stock at $1.25 per share upon the conversion of certain liabilities. The Series
A Preferred shares were converted into 171,276 shares of Common stock upon the
consummation of the initial public offering.
In March 1988, the Company sold 625,000 shares of Series B Preferred stock
for $1,000,000. In August 1988, the Company sold 2,142,857 shares of Series C
Preferred stock for $3,000,000. In 1993, the Series C Preferred stockholder sold
all of its shares to various outside investors, as well as to certain officers
of the Company. In June 1997, certain officers converted 120,000 shares of their
Series C Preferred shares into 33,600 shares of Common stock. The Series B and
Series C Preferred shares were converted into 178,569 and 566,399 shares of
Common stock, respectively, upon the consummation of the initial public
offering.
In September 1994, the Company sold 800,000 shares of Series D Preferred
stock at $2 per share and received net proceeds of $1,559,084. The Series D
Preferred shares were converted into 615,381 shares of Common stock upon the
consummation of the initial public offering.
On February 13, 1996, the Company issued 1,347,860 shares of Series E
Preferred Stock in connection with the acquisition of New York N2K (see Note 2).
Also, on February 13, 1996, the Company sold 3,750,000 shares of Series E
Preferred stock for $.80 per share and received proceeds of $3,000,000. In April
and May 1996, the Company sold 909,200 shares of Series E Preferred stock at
$.80 per share and received proceeds of $727,360. The number of shares of Series
E Preferred stock sold to certain officers and directors of the Company at $.80
per share was 3,299,992. The Series E Preferred shares were converted into
1,501,755 shares of Common stock upon the consummation of the initial public
offering. In May and June 1996, the Company sold 5,333,333 shares of Series F
Preferred stock at $3 per share and received net proceeds of $15,268,284. The
Series F Preferred shares were converted into 1,333,321 shares of Common stock
upon the consummation of the initial public offering.
In April 1997, the Company sold 2,480,329 shares of Series G Preferred
stock at $3 per share, including 17,000 shares issued as a finder's fee, and
received gross proceeds of $7,389,987 and net proceeds of $7,215,531. The Series
G Preferred shares were converted into 620,077 shares of Common stock upon the
consummation of the initial public offering. The number of shares of Series G
Preferred stock sold to certain officers and directors of the Company at $3 per
share was 333,333. Additionally, the Company issued warrants to purchase 48,555
shares of Common stock at an exercise price of $12 per share as a placement fee
relating to this transaction.
8. STOCKHOLDERS' EQUITY:
Common Stock Options
Under the Company's 1987 Incentive Stock Option Plan, options to purchase
775,000 shares of Common stock could have been granted to certain officers,
directors and employees. The options expire ten years from the date of grant and
vest over four years. Expiration dates range from 1998 to 2005. As of December
31, 1997, there are 190,187 options outstanding and no additional grants will be
made under this plan.
Additionally, the Company has 59,132 nonqualified stock options outstanding
as of December 31, 1997, with expiration dates ranging from July 1998 to January
2005. Currently, these options are fully vested.
In February 1996, the Company established the 1996 Stock Option Plan, which
authorized options to purchase 1,650,000 shares of Common stock, as amended and
restated on June 20, 1996. Under the 1996 Stock Option Plan, options may be
granted to officers, directors and other key employees. The options expire ten
years from the date of grant and vest over four years, unless specifically
agreed to otherwise. The exercise price is fixed at the grant date and equals at
least 100% of the fair market value of the Common stock on the date of grant. As
of December 31, 1997, there are 1,440,998 options outstanding and 202,159
options available for grant under the 1996 Stock Option Plan.
F-19
<PAGE> 86
N2K INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
In December 1996, the Company granted 4,050 nonqualified stock options to
individuals who were neither employees or directors of the Company. The options
expire ten years from the date of grant and vested immediately upon grant. The
exercise price is equal to the fair market value of the Common stock on the date
of grant. These options were not granted under any of the Company's plans. In
July, 1997, the Company granted 324,999 stock options to Lawrence L. Rosen,
Jonathan V. Diamond and Robert David Grusin. The options expire seven years from
the date of grant and vest over four years. The exercise price is equal to the
fair market value of the Common stock on the date of grant. These options were
not granted under any of the Company's plans.
In April 1997, the Company's Board of Directors approved the issuance of
options to purchase 15,000 shares of Common stock, which were not pursuant to
any of the Company's option plans, to non-employees of the Company. These
options were granted at the time of the initial public offering and at an
exercise price equal to the price for shares sold in the initial public
offering. In accordance with SFAS No. 123, the Company recorded a charge for the
fair value of these options in the accompanying consolidated statement of
operations.
In April 1997, the Board of Directors adopted and the stockholders of the
Company approved, the 1997 Directors' Stock Option Plan (the Directors' Plan)
pursuant to which each member of the Board of Directors, who is not an employee
of the Company, who is elected or continues as a member of the Board of
Directors is entitled to receive annually, options to purchase 12,500 shares of
Common stock at an exercise price equal to fair market value; provided, however,
that no director may receive under the Directors' Plan, options to purchase an
aggregate of more than 125,000 shares of Common stock. Each option grant under
the Directors' Plan vests after the first anniversary of the date of grant and
expires three years thereafter. The maximum number of shares of Common stock
reserved for issuance under the Directors' Plan is 500,000 shares (subject to
adjustment for certain events such as stock splits and stock dividends). In
April 1997, the Board of Directors authorized the issuance of 25,000 options
under the Directors' Plan at an exercise price equal to the price for shares
sold in the initial public offering.
F-20
<PAGE> 87
N2K INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Information relative to all of the Company's stock option activity is as
follows:
<TABLE>
<CAPTION>
WEIGHTED
AVERAGE
EXERCISE
EXERCISE PRICE PRICE AGGREGATE
OPTIONS (PER SHARE) (PER SHARE) PROCEEDS
--------- --------------- ----------- -----------
<S> <C> <C> <C> <C>
Balance as of December 31, 1994...... 396,891 $ 2.50 - $ 5.00 $ 3.52 $ 1,398,884
Granted............................ 231,375 2.60 - .20 2.63 608,325
Exercised.......................... (25) 3.20 3.20 (80)
Terminated......................... (5,850) 3.20 3.20 (18,720)
--------- --------------- ------ -----------
Balance as of December 31, 1995...... 622,391 2.50 - 5.00 3.19 1,988,409
Granted............................ 1,020,169 3.20 - 12.00 4.83 4,922,483
Exercised.......................... (2,145) 2.60 - 3.20 2.80 (6,006)
Terminated......................... (102,363) 2.50 - 5.00 3.05 (311,994)
--------- --------------- ------ -----------
Balance as of December 31, 1996...... 1,538,052 2.50 - 12.00 4.29 6,592,892
Granted............................ 866,194 12.00 - 21.00 16.59 14,374,381
Exercised.......................... (242,417) 2.60 - 12.00 3.30 (798,770)
Terminated......................... (102,463) 2.60 - 21.00 6.89 (706,120)
--------- --------------- ------ -----------
Balance as of December 31, 1997...... 2,059,366 $ 2.50 - $21.00 $ 9.45 $19,462,383
========= =============== ====== ===========
Options exercisable as of December
31, 1997........................... 783,276 $ 8.08
========= ======
</TABLE>
The weighted average remaining contractual life of all options outstanding
at December 31, 1997 is 8.5 years.
The following table summarizes information relating to the all of the
Company's stock option activity based upon each exercise price.
<TABLE>
<CAPTION>
WEIGHTED
WEIGHTED AVERAGE
WEIGHTED AVERAGE EXERCISE
AVERAGE EXERCISE PRICE
RANGE OF OPTIONS REMAINING PRICE OF OPTIONS OF
EXERCISE OUTSTANDING AT CONTRACTUAL OUTSTANDING EXERCISABLE AT EXERCISABLE
PRICES DECEMBER 31, LIFE OPTIONS DECEMBER 31, OPTIONS
(PER SHARE) 1997 (YEARS) (PER SHARE) 1997 (PER SHARE)
- --------------- -------------- ----------- ----------- -------------- -----------
<S> <C> <C> <C> <C> <C>
$ 2.50 - $ 3.52 1,030,615 7.7 $3.28 347,565 $3.22
5.00 28,000 0.9 5.00 28,000 5.00
12.00 - 14.63 475,350 9.0 12.06 382,711 12.00
19.00 - 21.00 525,401 9.8 19.44 25,000 19.00
--------- -------
2,059,366 783,276
========= =======
</TABLE>
The Company accounts for all of its option plans under APB Opinion No. 25,
"Accounting for Stock Issued to Employees," under which no compensation cost has
been recognized. In 1995, the Financial Accounting Standards Board issued SFAS
No. 123, "Accounting for Stock-Based Compensation". SFAS No. 123 establishes a
fair value based method of accounting for stock-based compensation plans. This
statement also applies to transactions in which an entity issues its equity
instruments to acquire goods or services from non-employees. SFAS No. 123
requires that an employer's financial statements include certain disclosures
about stock-based employee compensation arrangements regardless of the method
used to account for the plan. Had the Company recognized compensation cost for
its stock option plans consistent with the provisions of SFAS No. 123, the
F-21
<PAGE> 88
N2K INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Company's net loss in 1995, 1996 and 1997 and the pro forma net loss per Common
share in 1995, 1996 and 1997 would have been increased to the following pro
forma amounts:
<TABLE>
<CAPTION>
1995 1996 1997
----------- ------------ ------------
<S> <C> <C> <C>
Net Loss:
As reported............................. $(1,594,800) $(18,907,909) $(28,736,236)
=========== ============ ============
Pro forma............................... $(2,218,800) $(21,681,909) $(32,061,236)
=========== ============ ============
Basic and Diluted Net Loss per Common
share:
As reported............................. $ (1.02) $ (6.85) $ (5.88)
=========== ============ ============
Pro forma............................... $ (1.42) $ (7.85) $ (6.56)
=========== ============ ============
</TABLE>
Since the SFAS No. 123 method of accounting has not been applied to options
granted prior to January 1, 1995, the pro forma compensation cost disclosed
above may not be representative of that to be expected in future years.
The weighted average fair value of the stock options granted during 1995,
1996 and 1997 was $9.93, $8.62 and $8.40, respectively. The fair value of each
option grant is estimated on the date of grant using the Black-Scholes option
pricing model with the following weighted average assumptions:
<TABLE>
<CAPTION>
1995 1996 1997
------- ------- -------
<S> <C> <C> <C>
Risk-free interest rate....................... 6.5% 5.5% 6.1%
Expected dividend yield....................... 0.0% 0.0% 0.0%
Expected life................................. 6 Years 6 Years 6 Years
Expected volatility........................... 0.0% 0.0% 33.1%
</TABLE>
Common Stock Warrants
In February 1996, the Company issued warrants to purchase 37,500 shares of
Common stock at an exercise price of $3.20 per share. In January 1998, these
warrants were exercised. In May and June 1996, the Company issued warrants to
purchase 66,999 shares of Common stock at an exercise price of $12 per share.
These warrants expire in 2003. In April 1997, the Company issued warrants to
purchase 48,555 shares of Common stock at an exercise price of $12 per share in
connection with the Series G Preferred stock financing. These warrants expire in
April 2004. Additionally, in July and August 1997, the Company issued warrants
to purchase an aggregate of 299,264 shares of Common stock at an exercise price
of $12 per share in connection with the issuance of the Management Notes and
Senior Notes (see Note 1). Additionally, in connection with the AOL agreements,
discussed in Note 1, the Company granted AOL a warrant for the future purchase
of up to 184,736 shares of Common stock at an exercise price equal to the
initial public offering price per share, which was $19.00 per share. The AOL
Warrant is exercisable as to one-half of the total number of shares on the first
anniversary of the date of issuance and as to the balance of the shares on the
second anniversary of the date of issuance. The AOL Warrant expires in September
2004.
Employee Stock Purchase Plan
In June 1996, the Company established the 1996 Employee Stock Purchase Plan
(the ESP Plan). The number of shares available to purchase under the ESP Plan is
1,500,000 shares of Common stock. As of December 31, 1997, 1,500,000 shares are
available for purchase under the ESP Plan. The employee's purchase price is the
lower of (a) 85% of the fair market value of a share of the Company's Common
stock on the first day of the Purchase period (as defined) and (b) 85% of the
fair market value of a share of the Company's Common stock on the last day of
the Purchase period (as defined).
F-22
<PAGE> 89
N2K INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
9. INCOME TAXES:
The Company accounts for income taxes in accordance with SFAS No. 109,
"Accounting for Income Taxes". SFAS No. 109 requires an asset-and-liability
approach in accounting for income taxes. Under this method, deferred income
taxes are computed based on the differences between financial reporting and
income tax reporting of assets and liabilities using enacted tax rates.
As of December 31, 1997, the Company had net operating loss carryforwards
for federal income tax purposes of approximately $40,225,000, which begin to
expire in 2001. Significant components of deferred income taxes consist of the
following:
<TABLE>
<CAPTION>
DECEMBER 31,
---------------------------
1996 1997
----------- ------------
<S> <C> <C>
Gross deferred tax assets:
Net operating loss carryforwards.......................... $ 8,534,000 $ 16,238,000
Depreciation and amortization............................. 13,000 --
Research and development expenses not currently
deductible............................................. -- 2,463,000
Accruals not currently deductible......................... 413,000 1,503,000
----------- ------------
8,960,000 20,204,000
----------- ------------
Gross deferred tax liabilities:
Depreciation and amortization............................. -- (183,000)
Other deferred tax liabilities............................ (17,000) (1,000)
----------- ------------
(17,000) (184,000)
----------- ------------
Less -- Valuation allowance................................. (8,943,000) (20,020,000)
----------- ------------
$ -- $ --
=========== ============
</TABLE>
The Company has recorded a valuation allowance for the net deferred tax
asset as the Company concluded that the net deferred tax asset did not meet the
recognition criteria under SFAS No. 109. The valuation allowance increased
$11,077,000 during 1997 due principally to net operating loss carryforwards and
research and development expenses which will be deductible in future years.
Based on changes in ownership of the Company, utilization of the net operating
loss carryforwards may be subject to annual limitations.
10. OTHER RELATED-PARTY TRANSACTIONS:
For the years ended December 31, 1995, 1996, and 1997, the Company incurred
fees of $30,000, $130,000, and $1,000, respectively, to a law firm in which
certain of its partners were Series A Preferred stockholders.
11. COMMITMENTS AND CONTINGENCIES:
The Company has entered into various operating and capital leases for
office space, computer equipment and office equipment. Assets acquired under
capital leases at a cost of $868,436 and $1,801,663 less accumulated
amortization of $477,535 and $709,777, are included in property and equipment in
the accompanying consolidated balance sheets as of December 31, 1996 and 1997,
respectively. Certain capital leases are secured by certificates of deposit
totaling $167,000, which are shown as restricted cash in other assets in the
accompanying consolidated balance sheets. Interest rates on these capital leases
range from 6.0%
F-23
<PAGE> 90
N2K INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
to 19.0%. Future minimum lease payments under operating and capital leases as of
December 31, 1997, are as follows:
<TABLE>
<CAPTION>
OPERATING CAPITAL
---------- ----------
<S> <C> <C>
1998................................................ $1,696,155 $ 538,343
1999................................................ 1,760,380 373,954
2000................................................ 1,740,692 280,683
2001................................................ 1,538,380 48,290
2002................................................ 912,985 8,048
---------- ----------
Total minimum lease payments........................ $7,648,592 1,249,318
----------
Less -- Amount representing interest................ (131,613)
----------
Present value of minimum capital lease payments..... $1,117,705
==========
</TABLE>
Rent expense under the operating leases for the years ended December 31,
1995, 1996 and 1997 was $100,870, $529,186 and $823,676, respectively.
The Company has entered into agreements with various content providers,
vendors and recording artists. The remaining terms of these agreements range
from one to five years. These agreements provide for the payment of royalties,
bounties and certain guaranteed amounts. Other than the payments to AOL, Excite
and Netscape, minimum guaranteed payments required under such agreements are
insignificant.
The Company has employment agreements with certain officers that provide
for, among other things, salary, bonus, severance and change in control
provisions.
The Company entered into an employment agreement with Phil Ramone (the
Ramone Employment Agreement) to provide for his service as President of N2K
Encoded Music effective as of October 15, 1996. The initial term of the Ramone
Employment Agreement is three years (the Initial Term), with an option for an
additional two-year period at the Company's discretion (the Option Period). The
Ramone Employment Agreement provides for a base salary of $450,000 for the first
year, increasing to $550,000 for the remainder of the Initial Term. If Mr.
Ramone's employment continues after the Initial Term, he will receive $650,000
for the first year of the Option Period, with the salary for the second year to
be negotiated in good faith upon commencement of the Option Period.
Notwithstanding the foregoing, in the event that the Company and Mr. Ramone are
unable to agree on the amount of Mr. Ramone's annual salary during the Option
Period after 30 days' good faith negotiations, then the Company's option will be
treated as if it had not been exercised. The Ramone Employment Agreement also
provides for (a) a one-time $100,000 bonus payable on October 1, 1997 in the
form of a loan from the Company, the principal of and the interest on which will
be forgiven (assuming no termination for cause) over a 12-month period beginning
on October 1, 1998 and (b) an annual performance bonus in the amount of (i)
$50,000 if the gross revenues of N2K Encoded Music are at least $8 million but
not in excess of $10 million during such fiscal year or (ii) $100,000 if such
gross revenues exceed $10 million during such fiscal year. As of February 12,
1998, the $100,000 one-time bonus has not yet been paid. The Ramone Employment
Agreement also provides that Mr. Ramone is entitled to 10% of the after-tax net
profit attributable to N2K Encoded Music's operations in any fiscal year,
including participation in the proceeds of a sale of N2K Encoded Music as if he
were a 5% (during the Initial Term) or a 7.5% (during the Option Period) equity
owner of N2K Encoded Music. Mr. Ramone was granted qualified and non-qualified
options under the terms of the Ramone Employment Agreement to purchase 73,677
shares of Common stock at $12.00 per share. Such options expire on October 15,
2002, but not later than one year from the date Mr. Ramone's employment with the
Company terminates. One quarter of Mr. Ramone's options vested at the beginning
of his employment on October 15, 1996, with the balance vesting ratably over a
three-year period. Should Mr. Ramone's employment with the Company be
terminated, the Company at its option may repurchase any or all shares of Common
stock issued to Mr. Ramone upon his exercise of any of his options
F-24
<PAGE> 91
N2K INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
held by him on the date of such termination at fair market value (or, if such
termination is for cause, at the price paid by Mr. Ramone for such shares). The
Company may elect to pay for these shares in three equal annual installments by
delivery of a promissory note with an interest rate of 8% per annum.
The Company was obligated to loan Mr. Ramone $100,000 at the signing of the
Ramone Employment Agreement on September 26, 1997. As of December 31, 1997, the
Company had loaned Mr. Ramone $50,000. Subsequent to December 31, 1997, the
remaining $50,000 was loaned to Mr. Ramone. The promissory note related to this
loan (the Ramone Note) is due on October 1, 2000 and is interest-free unless an
event of default (as defined therein) occurs, in which case the interest rate
shall become 15% until such default is cured. The terms of the Ramone Note give
the Company the right to deduct and withhold certain compensation owed by the
Company to Mr. Ramone under either of the Ramone Employment Agreement or the
Producer's Agreement (as defined below).
Simultaneously with the execution of the Ramone Employment Agreement, the
Company also entered into a Music Producer's Agreement (the Producer's
Agreement) with Mr. Ramone (through a personal corporation) providing for the
recording and production of master recordings of one or more of the Company's
recording artists. The term of the Producer's Agreement is coextensive with the
term of the Ramone Employment Agreement. Pursuant to the terms of the Producer's
Agreement, Mr. Ramone will receive a percentage of royalties based on agreed
upon formulas. No payments under the Producer's Agreement shall be made to Mr.
Ramone until such time that the Ramone Note has been repaid.
The Company is party to various claims arising in the ordinary course of
business. Although the ultimate outcome of these matters is presently not
determinable, management believes that the resolution of these matters will not
have a material adverse effect on the Company's financial position or results of
operations.
Due to the fact that material may be downloaded from websites and may be
subsequently distributed to others, there is potential that claims will be made
against the Company for defamation, negligence, copyright or trademark
infringement or other theories based on the nature and content of such material.
Although the Company carries general liability insurance, the Company's
insurance may not cover potential claims of this type or may not be adequate to
cover all costs incurred in defense of potential claims or to indemnify the
Company for all liability that may be imposed. Any costs or imposition of
liability that is not covered by insurance or in excess of insurance coverage
could have a material adverse effect on the Company's business, results of
operations and financial condition. The Company is currently not aware of any
such claims.
12. DEFINED CONTRIBUTION PLAN:
The Company maintains a Matched Savings Plan (the Plan) in accordance with
the provisions of Section 401(k) of the Internal Revenue Code. The Plan covers
substantially all full-time employees of the Company. Participants may
contribute up to 15% of their total compensation to the Plan, with the Company
matching 30% of the participant's contribution, limited to 6% of the
participant's total compensation. For the years ended December 31, 1995, 1996,
1997, the Company contributed $18,200, $53,100 and $111,786, respectively, to
the Plan.
F-25
<PAGE> 92
INDEPENDENT AUDITORS' REPORT
To the Board of Directors
N2K Inc.
New York, New York
We have audited the balance sheet of N2K Inc. (a New York corporation) as
of December 31, 1995, and the related statements of operations, stockholders'
equity and cash flows for the period beginning March 7, 1995 (date of inception)
through December 31, 1995. These financial statements are the responsibility of
the Company's management. Our responsibility is to express an opinion on these
financial statements based on our 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, the financial statements referred to above present fairly,
in all material respects, the financial position of N2K Inc. as of December 31,
1995 and the results of its operations and its cash flows for the period
beginning March 7, 1995 through December 31, 1995 in conformity with generally
accepted accounting principles.
As described in Note F, on February 13, 1996, the Company effected a
business combination in which it merged with a company formerly known as
Telebase Systems, Inc.
New York, New York
January 31, 1996
With respect to Note F
February 13, 1996
RICHARD A. EISNER & COMPANY, LLP
F-26
<PAGE> 93
N2K INC.
BALANCE SHEET
DECEMBER 31, 1995
<TABLE>
<S> <C>
ASSETS
Current assets:
Cash and cash equivalents................................. $245,423
Accounts receivable....................................... 57,281
Prepaid expenses.......................................... 2,057
--------
Total current assets.............................. 304,761
Property and equipment, net............................... 311,812
Goodwill.................................................. 4,467
Deposits.................................................. 101,621
--------
TOTAL............................................. $722,661
========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Current maturities of capital lease obligations........... $ 57,407
Accounts payable and accrued expenses..................... 207,144
--------
Total current liabilities......................... 264,551
Capital lease obligations................................. 136,184
Deferred rent payable..................................... 20,038
--------
Total liabilities................................. 420,773
--------
Commitments and contingencies
Stockholders' equity:
Common stock, $.01 par value, 2,000,000 authorized,
1,000,000 shares issued and outstanding............... 10,000
Additional paid-in capital............................. 990,000
Accumulated (deficit).................................. (698,112)
--------
Total stockholders' equity........................ 301,888
--------
TOTAL............................................. $722,661
========
</TABLE>
The accompanying notes to financial statements are an integral part hereof.
F-27
<PAGE> 94
N2K INC.
STATEMENT OF OPERATIONS
FOR THE PERIOD BEGINNING MARCH 7, 1995
(DATE OF INCEPTION) THROUGH DECEMBER 31, 1995
<TABLE>
<S> <C>
Revenues:
Consulting revenue........................................ $ 132,626
Network revenue........................................... 11,000
---------
Total revenue..................................... 143,626
---------
Expenses:
Selling, general and administrative expenses.............. 767,628
Purchased research and development........................ 56,262
Depreciation and amortization............................. 16,575
---------
Total expense..................................... 840,465
---------
Operating loss.............................................. (696,839)
Interest expense, net of interest income of $185............ (1,273)
---------
Net loss.................................................... $(698,112)
=========
</TABLE>
The accompanying notes to financial statements are an integral part hereof.
F-28
<PAGE> 95
N2K INC.
STATEMENT OF STOCKHOLDERS' EQUITY
FOR THE PERIOD BEGINNING MARCH 7, 1995
(DATE OF INCEPTION) THROUGH DECEMBER 31, 1995
<TABLE>
<CAPTION>
ADDITIONAL
COMMON PAID-IN ACCUMULATED
STOCK CAPITAL DEFICIT TOTAL
------- ---------- ----------- ----------
<S> <C> <C> <C> <C>
Sale of common stock................................ $10,000 $990,000 $1,000,000
Net loss............................................ $(698,112) (698,112)
------- -------- --------- ----------
Balance -- December 31, 1995........................ $10,000 $990,000 $(698,112) $ 301,888
======= ======== ========= ==========
</TABLE>
The accompanying notes to financial statements are an integral part hereof.
F-29
<PAGE> 96
N2K INC.
STATEMENT OF CASH FLOWS
FOR THE PERIOD BEGINNING MARCH 7, 1995
(DATE OF INCEPTION) THROUGH DECEMBER 31, 1995
<TABLE>
<S> <C>
Cash flows from operating activities:
Net loss.................................................. $ (698,112)
Adjustments to reconcile net loss to net cash used in
operating activities:
Depreciation and amortization.......................... 16,575
Changes in assets and liabilities:
Increase in:
Accounts receivable............................... (48,543)
Prepaid expenses.................................. (2,057)
Deposits.......................................... (101,621)
Accounts payable and accrued expenses............. 207,144
Deferred rent payable............................. 20,038
----------
Net cash used in operating activities........... (606,576)
----------
Cash flows from investing activities:
Assets acquired in purchase transaction................... (43,738)
Purchase of property and equipment........................ (101,612)
----------
Net cash used in investing activities........... (145,350)
----------
Cash flows from financing activities:
Principal payments on capital lease obligations........... (2,651)
Sale of common stock...................................... 1,000,000
----------
Net cash provided by financing activities....... 997,349
----------
Increase in cash and cash equivalents....................... 245,423
Cash and cash equivalents, beginning of period.............. --
----------
Cash and cash equivalents, end of period.................... $ 245,423
==========
Supplemental disclosures of cash flow information:
Cash paid during the period for interest.................. $ 1,458
Noncash investing and financing activity:
The Company entered into capital leases for equipment
valued at $196,242.
</TABLE>
The accompanying notes to financial statements are an integral part hereof.
F-30
<PAGE> 97
N2K INC.
NOTES TO FINANCIAL STATEMENTS
NOTE A -- ORGANIZATION AND ACQUISITION:
N2K Multimedia Company, Inc. (the "Company") was incorporated on March 7,
1995 for the purpose of developing interactive on-line web sites and technology,
with 200 shares of authorized common stock of which 100 shares were issued in
exchange for $100,000 paid in cash. On October 10, 1995 the authorized common
stock was increased to 2,000,000 shares of $.01 par value and the outstanding
shares were split 10,000 for 1. All references to shares in these financial
statements give retroactive effect to the stock split. On June 13, 1995 the
Company purchased substantially all the assets of N2K Inc. a company engaged
primarily in computer systems consulting and its name was changed to N2K Inc.
The purchase price was $100,000 which was allocated in accordance with fair
values as follows: Fixed Assets $30,000; Accounts Receivable $8,738; Research
and Development Costs $56,262, and Goodwill $5,000. Because computer systems
consulting is not the focus of the Company, the acquiree is not a predecessor
company.
After the acquisition the Company developed an on-line site called Jazz
Central Station that provides a comprehensive history of Jazz. The site was
launched on the Microsoft Network on August 24, 1995 and is in beta testing on
the World Wide Web.
NOTE B -- SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:
[1] Use of estimates:
These financial statements were prepared by management using generally
accepted accounting principles which require the use of estimates.
[2] Property and equipment:
Property and equipment are stated at cost. Depreciation is calculated on a
straight-line basis over estimated useful lives of the assets, primarily 5
years. Upon retirement or disposition, the applicable property amounts are
relieved from the accounts, and any gain or loss is recorded in the statement of
operations. When assets become fully depreciated, the applicable asset and
accumulated depreciation amounts are relieved.
[3] Goodwill:
Goodwill, which represents the excess purchase price of N2K Inc. over the
fair value of the identifiable assets acquired, is being amortized on a
straight-line basis over five years.
[4] Statement of Cash Flows:
Highly liquid investments with an original maturity of three months or less
are considered cash equivalents for purposes of the statement of cash flows.
[5] Capital Leases:
The Company capitalizes assets acquired under capital leases and records
the related capital lease obligations.
[6] Income Taxes:
The Company is an S corporation for Federal and State income tax purposes.
No provision for these taxes is required.
F-31
<PAGE> 98
N2K INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
NOTE C -- PROPERTY AND EQUIPMENT:
Property and equipment consists of the following:
<TABLE>
<S> <C>
Computer equipment........................................ $249,726
Furniture and fixtures.................................... 16,796
Leasehold improvements.................................... 61,332
--------
327,854
Less accumulated depreciation............................. (16,042)
--------
$311,812
========
</TABLE>
Included in property and equipment is property acquired under capital
leases with an aggregate cost of $196,242 and accumulated depreciation of
$9,569.
NOTE D -- EQUIPMENT LEASE FINANCING:
The Company has a line of credit to finance its acquisition of furniture,
office and computer equipment in the amount of $350,000. Under the terms of the
master agreement, acquired assets are financed pursuant to capital leases with a
three year term and interest rate of 8.75%. At December 31, 1995 $175,424 of the
line of credit was available. The Company is also obligated under two other
capital leases with interest rates of approximately 14% and aggregating $18,167
at December 31, 1995.
NOTE E -- COMMITMENTS, CONTINGENCIES AND RISKS:
The Company is obligated under operating and capital leases for office
space, computers and office equipment. Future annual minimum lease payments
under leases in effect at December 31, 1995 are as follows:
<TABLE>
<CAPTION>
OPERATING CAPITAL
--------- --------
<S> <C> <C>
1996................................................... $120,456 $ 72,233
1997................................................... 196,088 75,795
1998................................................... 195,356 68,132
1999................................................... 219,550 5,522
2000................................................... 213,155 -0-
--------
221,682
Less amount representing interest...................... 28,091
--------
Present value of capital lease obligations............. $193,591
========
</TABLE>
The Company maintains its accounts at one institution insured by the
Federal Deposit Insurance Corporation up to a maximum of $100,000.
The Company is committed to purchase furniture and equipment aggregating
approximately $125,000 which it expects to finance under the equipment lease
financing commitment described in Note D.
Two of the Company's consulting customers individually accounted for 59%
and 27% of the Company's consulting revenues for the period ended December 31,
1995 and 76% and 22% of the accounts receivable at December 31, 1995.
NOTE F -- SUBSEQUENT EVENT:
The Company merged with Telebase Systems, Inc. on February 13, 1996.
Pursuant to the merger the Company's shares were exchanged for common and
preferred shares of Telebase Systems, Inc. which changed its name to N2K Inc.
F-32
<PAGE> 99
[INSIDE BACK COVER--GRAPHIC INCORPORATING SCREENS FROM EACH OF THE MUSIC
BOULEVARD, ROCKTROPOLIS, JAZZ CENTRAL STATION, CLASSICAL INSITES, DAVID BOWIE
AND ROLLING STONES WEBSITES AND THE COVER ART FOR TWO OF THE N2K ENCODED MUSIC
CD RELEASES.]
<PAGE> 100
======================================================
NO PERSON HAS BEEN AUTHORIZED TO GIVE ANY INFORMATION OR TO MAKE ANY
REPRESENTATIONS IN CONNECTION WITH THIS OFFERING OTHER THAN THOSE CONTAINED IN
THIS PROSPECTUS AND, IF GIVEN OR MADE, SUCH OTHER INFORMATION AND
REPRESENTATIONS MUST NOT BE RELIED UPON AS HAVING BEEN AUTHORIZED BY THE COMPANY
OR THE UNDERWRITERS OR ANY OTHER PERSON. NEITHER THE DELIVERY OF THIS PROSPECTUS
NOR ANY SALE MADE HEREUNDER SHALL, UNDER ANY CIRCUMSTANCES, CREATE ANY
IMPLICATION THAT THERE HAS BEEN NO CHANGE IN THE AFFAIRS OF THE COMPANY SINCE
THE DATE HEREOF OR THAT THE INFORMATION CONTAINED HEREIN IS CORRECT AS OF ANY
TIME SUBSEQUENT TO ITS DATE. THIS PROSPECTUS DOES NOT CONSTITUTE AN OFFER TO
SELL OR A SOLICITATION OF AN OFFER TO BUY ANY SECURITIES OTHER THAN THE
REGISTERED SECURITIES TO WHICH IT RELATES. THIS PROSPECTUS DOES NOT CONSTITUTE
AN OFFER TO SELL OR A SOLICITATION OF AN OFFER TO BUY SUCH SECURITIES IN ANY
CIRCUMSTANCES IN WHICH SUCH OFFER OR SOLICITATION IS UNLAWFUL.
------------------------
TABLE OF CONTENTS
<TABLE>
<CAPTION>
PAGE
----
<S> <C>
Prospectus Summary.................... 3
Risk Factors.......................... 8
Price Range of Common Stock........... 16
Dividend Policy....................... 16
Use of Proceeds....................... 17
Capitalization........................ 18
Dilution.............................. 19
Selected Consolidated Financial
Data................................ 20
Management's Discussion and Analysis
of Financial Condition and Results
of Operations....................... 22
Business.............................. 30
Management............................ 46
Certain Transactions.................. 56
Principal and Selling Stockholders.... 58
Description of Capital Stock.......... 60
Shares Eligible for Future Sale....... 63
Underwriting.......................... 64
Legal Matters......................... 65
Experts............................... 66
Available Information................. 66
Index to Financial Statements......... F-1
</TABLE>
======================================================
======================================================
3,125,722 SHARES
[N2K INC. LOGO]
COMMON STOCK
------------------------
PROSPECTUS
------------------------
PAINEWEBBER INCORPORATED
ALLEN & COMPANY INCORPORATED
BEAR, STEARNS & CO. INC.
------------------------
APRIL 14, 1998
======================================================
