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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
Quarterly Report Pursuant to Section 13 or 15(d)
of the Securities Exchange Act of 1934.
FOR THE QUARTERLY PERIOD ENDED JUNE 28, 1998
Commission File Number 0-20684
AUREAL SEMICONDUCTOR INC.
(Exact name of registrant as specified in its charter)
DELAWARE 94-3117385
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification Number)
4245 TECHNOLOGY DRIVE
FREMONT, CA 94538
(Address of principal executive offices)
Telephone: (510) 252-4245
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes [X] No [ ]
Indicate by check mark whether the registrant has filed all documents required
to be filed by Section 12, 13 or 15 (d) of the Securities Exchange Act of 1934
subsequent to the distribution of securities under a plan confirmed by a court.
Yes [X] No [ ]
At July 28, 1998 42,246,789 shares of common stock, $0.001 par value, of the
registrant were outstanding.
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AUREAL SEMICONDUCTOR INC.
FORM 10-Q
Table of Contents
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Page
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PART I. FINANCIAL INFORMATION
Item 1. Financial Statements.......................................................................... 3
Item 2. Management's Discussion and Analysis of Financial Condition and Results of
Operations................................................................................... 11
PART II. OTHER INFORMATION
Item 1. Legal Proceedings............................................................................. 21
Item 4. Submission of Matters to a Vote of Security Holders........................................... 21
Item 6. Exhibits and Reports on Form 8-K.............................................................. 22
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PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
AUREAL SEMICONDUCTOR INC.
INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
The Interim Condensed Consolidated Financial Statements of Aureal
Semiconductor Inc. (the "Company") have been prepared by the Company, without
audit, pursuant to the rules and regulations of the Securities and Exchange
Commission. Certain information and footnote disclosures normally included in
financial statements prepared in accordance with generally accepted accounting
principals have been omitted pursuant to such rules and regulations. The
disclosures included in the Interim Condensed Consolidated Financial Statements
should be read in conjunction with the Company's audited financial statements at
December 28, 1997 and the notes thereto included in the Company's 1997 Annual
Report on Form 10-K.
The preparation of financial statements in conformity with generally
accepted accounting principles and pursuant to the rules and regulations of the
Securities and Exchange Commission 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.
The Interim Condensed Consolidated Financial Statements reflect, in the
opinion of management, all adjustments (which include only normal recurring
adjustments) necessary for a fair presentation of financial position, results of
operations and cash flows for such periods. The results of operations for the
fiscal quarter ended June 28, 1998 are not necessarily indicative of the results
that may be expected for any subsequent quarter or the entire fiscal year ending
January 2, 1999.
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AUREAL SEMICONDUCTOR INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(DOLLARS IN THOUSANDS)
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<CAPTION>
June 28, December 28,
1998 1997
--------- ---------
(Unaudited)
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ASSETS:
Current assets:
Cash and cash equivalents $ 116 $ 135
Restricted cash -- 109
Accounts receivable 3,453 21
Inventories 5,138 511
Deferred fair value of debt-related warrants 847 3,000
Prepaid expenses and other current assets 772 462
--------- ---------
Total current assets 10,326 4,238
Property and equipment:
Machinery and equipment 3,353 3,785
Furniture, fixtures and improvements 646 599
--------- ---------
3,999 4,384
Accumulated depreciation and amortization (2,169) (3,170)
--------- ---------
Net property and equipment 1,830 1,214
Long-term portion of fair value of debt-related warrants, other assets 1,405 898
--------- ---------
Total assets $ 13,561 $ 6,350
========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT):
Current liabilities:
Accounts payable $ 1,486 $ 1,523
Accrued compensation and benefits 1,375 1,115
Other accrued liabilities 987 1,365
Current portion of pre-petition claims 893 880
--------- ---------
Total current liabilities 4,741 4,883
Line of credit 385 21,975
Long-term portion of pre-petition claims and deferred obligations 2,199 3,641
--------- ---------
Total liabilities 7,325 30,499
--------- ---------
Stockholders' equity (deficit):
Preferred stock, $0.001 par value, Authorized Shares - 5,000,000:
Series A: Authorized shares - 500; Issued and outstanding
Shares - 500 in 1998 -- --
Series B: Authorized shares - 60,000; Issued and outstanding
Shares - 39,375 in 1998 -- --
Series C: Authorized shares - 1,500; Issued and outstanding
Shares - 600 in 1998 -- --
Additional paid-in capital 51,231 --
Common stock, $0.001 par value:
Authorized shares - 100,000,000; Issued and outstanding
shares - 42,196,687 in 1998 and 41,850,205 in 1997 42 42
Additional paid-in capital 116,559 114,352
Accumulated deficit (161,596) (138,543)
--------- ---------
Total stockholders' equity (deficit) 6,236 (24,149)
--------- ---------
Total liabilities and stockholders' equity (deficit) $ 13,561 $ 6,350
========= =========
</TABLE>
See accompanying notes.
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AUREAL SEMICONDUCTOR INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
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Quarter Ended Two Quarters Ended
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June 28, 1998 June 29, 1997 June 28, 1998 June 29, 1997
------------- ------------- ------------- -------------
(Unaudited) (Unaudited)
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Net sales $ 3,436 $ 695 $ 7,018 $ 1,122
Cost of sales 2,033 23 4,826 43
-------- -------- -------- --------
Gross Margin 1,403 672 2,192 1,079
Operating expenses:
Research and Development 2,916 1,561 5,534 2,999
Sales and Marketing 1,628 896 2,984 1,674
General and Administrative 816 597 1,676 1,181
Amortization of Reorganization Asset -- 625 -- 1,250
-------- -------- -------- --------
Total operating expenses 5,360 3,679 10,194 7,104
Operating loss (3,957) (3,007) (8,002) (6,025)
Amortization of debt-related warrants (577) -- (1,327) --
Interest expense (963) (643) (1,994) (1,165)
Other income (expense) 51 148 391 204
-------- -------- -------- --------
Loss from operations before income taxes (5,446) (3,502) (10,932) (6,986)
Provision for income taxes -- -- -- --
-------- -------- -------- --------
Net loss $ (5,446) $ (3,502) $(10,932) $ (6,986)
======== ======== ======== ========
Accretion / dividends related to preferred stock $(12,121) -- $(12,121) --
======== ======== ======== ========
Net Loss Attributable to Common Stockholders $(17,567) -- $(23,053) --
======== ======== ======== ========
Basic and diluted loss per share $ (0.42) $ (0.09) $ (0.55) $ (0.18)
======== ======== ======== ========
Shares used in calculating per share amounts 42,134 39,501 42,052 39,403
======== ======== ======== ========
</TABLE>
See accompanying notes.
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AUREAL SEMICONDUCTOR INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
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Two Quarters Ended
--------------------------------
June 28, June 29,
1998 1997
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(Unaudited)
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OPERATING ACTIVITIES
Net loss $(10,932) $ (6,986)
Adjustments to reconcile net loss to net cash
used in operating activities:
Depreciation and amortization 2,026 1,601
Changes in operating assets and liabilities:
Restricted cash 109 (103)
Accounts receivable (3,432) (114)
Inventories (4,845) (245)
Prepaid expenses and other current assets (549) 116
Other assets (465) --
Accounts payable (57) (187)
Accrued compensation and benefits, and
other accrued liabilities (315) (48)
-------- --------
Net cash used in operating activities (18,460) (5,966)
-------- --------
INVESTING ACTIVITIES
Acquisition of property and equipment (1,038) (179)
-------- --------
Net cash used in investing activities (1,038) (179)
-------- --------
FINANCING ACTIVITIES
Proceeds from Lines of Credit 18,984 6,770
Repayment on Lines of Credit (9,074) (500)
Principal payments on pre-petition claims (1,211) (458)
Proceeds from issuance of preferred and common
stock, net of issuance costs 10,780 331
-------- --------
Net cash provided by financing activities 19,479 6,143
-------- --------
Net (decrease) in cash and cash equivalents (19) (2)
Cash and cash equivalents at beginning of period 135 18
-------- --------
Cash and cash equivalents at end of period $ 116 $ 16
======== ========
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
Interest paid $ 2,439 $ 877
SUPPLEMENTAL DISCLOSURE OF NON-CASH FINANCING ACTIVITIES
Conversion of Line of Credit balance to Preferred stock $ 28,685 --
Accretion / dividends on Preferred Stock $ 12,121 --
Valuation of debt-related warrants issued $ 1,848 --
</TABLE>
See accompanying notes.
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AUREAL SEMICONDUCTOR INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
1. THE COMPANY AND RECENT FINANCIAL EVENTS
Aureal Semiconductor Inc., together with its subsidiaries Crystal River
Engineering, Inc. and Aureal Semiconductor Limited (combined, the "Company")
specialize in the design and marketing of audio semiconductor technologies for
use in both the PC and consumer electronics markets. Crystal River Engineering,
Inc. ("CRE"), founded in 1987 and acquired by Aureal in 1996, has been a pioneer
in the development of 3D audio technologies. Aureal Semiconductor Limited,
located in Hong Kong, was established in the first quarter of 1998 as a sales,
technical support and field engineering office. The Company's business involves
both the development and sale of audio processing semiconductor chips, as well
as the licensing of technology which is designed to define and develop advanced
audio standards in the marketplace. The Company's stock symbol on the OTC
Bulletin Board is AURL.
During March 1998, the Company completed the sale of $5 million of Aureal
Series A Preferred Stock.
On June 5, 1998 the Company completed three financing transactions, which
had the combined effect of increasing the Company's borrowing capacity and
providing additional equity for the Company. The transactions included the
following:
o The sale of $5 million of Aureal Series C Preferred Stock to DDJ Capital
Management, LLC. Approximately $3.66 million of the offering was used to
pay down the outstanding balance on the existing Line of Credit. The
remaining $1.34 million was utilized for working capital purposes.
o The remaining balance of $31.5 million on the existing Line of Credit was
exchanged for 39,375 shares of Aureal Series B Preferred Stock.
o A new $40 Million Revolving Credit Facility was established with Goldman
Sachs Credit Partners LP ("Goldman Sachs") and the Technology Finance
Division of Transamerica Business Credit Corporation ("Transamerica").
In addition to the above financing transactions, on June 26, 1998, the
Company completed the sale of $1 million of Aureal Series C Preferred Stock. The
proceeds of the offering were utilized to pay down outstanding borrowings under
the Credit Facility.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation
The Interim Condensed Consolidated Financial Statements of Aureal
Semiconductor Inc. have been prepared by the Company, without audit, pursuant to
the rules and regulations of the Securities and Exchange Commission. Certain
information and footnote disclosures normally included in the financial
statements prepared in accordance with generally accepted accounting principles
have been omitted pursuant to such rules and regulations. The disclosures
included in the Interim Condensed Consolidated Financial Statements should be
read in conjunction with the Company's audited financial statements at December
28, 1997 and the notes thereto included in the Company's 1997 Annual Report on
Form 10-K.
The Interim Condensed Consolidated Financial Statements reflect, in the
opinion of management, all adjustments (which include only normal recurring
adjustments) necessary for a fair presentation of financial position, results of
operations and cash flows for such periods. The results of operations for the
fiscal quarter and two quarters ended June 28, 1998 are not necessarily
indicative of the results that may be expected for any subsequent quarter or the
entire fiscal year ending January 2, 1999.
The preparation of financial statements in conformity with generally
accepted accounting principles and pursuant to the rules and regulations of the
Securities and Exchange Commission 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.
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Inventories
Inventories are stated at the lower-of-cost-or-market value on a
weighted-average costing method. The Company does not consider any inventory to
be raw material since the Company's point of purchase is for fabricated silicon
wafers or finished silicon dies. Net inventories at June 28, 1998 and December
28, 1997 consist of the following, in thousands:
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June 1998 December 1997
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Work in process $3,791 $ 243
Finished goods 1,347 268
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Total Inventories $5,138 $ 511
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Property and Equipment
Property and equipment are stated at cost and depreciated utilizing the
straight-line method over their estimated useful lives (one and one-half to five
years). Fixed assets with approximately $1.4 million in gross value and zero net
book value were retired during the first quarter of 1998 as they were determined
to no longer be in use.
Revenue Recognition
The Company's major sources of revenue consist of sales of proprietary
design, advanced audio semiconductor chips, and licensing of related audio
technologies. Revenue is recognized upon shipment for product sales. Software
licensing revenues are recognized upon shipment of licensed product if a
non-cancelable contract has been signed, the fees are fixed and determinable,
collection of the recognized fees is reasonably assured and there are no
remaining significant obligations.
Concentration of Financial Instrument and Credit Risks
Financial instruments, which potentially subject the Company to
concentration of market risk, consist primarily of the Company's line of credit.
This market risk on the line of credit relates to changes in the prime lending
rate, as the line of credit bears interest rates which fluctuate with changes in
the prime lending rate.
Credit risk for the Company consists primarily of trade receivables. Most
of the Company's trade receivables are the result of sales to foreign companies.
Concentration of credit risk is limited by the use of commercial letters of
credit for many of these international customers. Additionally, the Company has
established an allowance for doubtful accounts based on the credit risk of
specific customers.
Valuation of Warrants
In June 1998, the Company issued 1,350,000 warrants ("Credit Facility
Warrants") to purchase the Company's Common Stock to the lenders under the
Company's new Credit Facility (see Note 4). The fair value of the Credit
Facility Warrants was estimated to be $1.8 million. Amortization of the $1.8
million asset, as additional interest expense over the two-year life of the
Credit Facility commenced in June 1998 at the rate of $0.23 million per complete
fiscal quarter.
In 1997, the Company recorded the estimated fair value of warrants issued
to related parties in association with both the amendment of the line of credit
("Debt Warrants"), and the sale of common stock ("Equity Warrants"). The fair
value of the Debt Warrants and the Equity Warrants were estimated to be $5.0
million and $1.5 million, respectively. Amortization of the $5.0 million asset,
as additional interest expense over the life of the loan, commenced in August
1997 at the rate of $0.75 million per quarter. With the conversion of the loan
in June 1998, into preferred stock of the Company, the remaining balance of the
Debt Warrant valuation was eliminated as part of the net book value of the debt.
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Loss Per Share
SFAS No. 128 "Earnings per Share" requires that the calculation for basic
earnings per share ("EPS") exclude the dilutive effect of common stock
equivalents in the calculation for basic net income (loss) per share. Diluted
EPS under SFAS No. 128 is calculated using the weighted average number of common
shares and common stock equivalent shares outstanding during the period. Common
equivalent shares are computed using the treasury stock method for outstanding
warrants and stock options. Common equivalent shares are excluded from the
diluted EPS computation only if their effect is anti-dilutive. No common stock
equivalents were included in the calculations for any fiscal period presented,
as, due to the net loss position, any affect would be anti-dilutive.
SFAS No. 130 "Reporting Comprehensive Income" was adopted by the Company in
the first quarter of 1998. SFAS No. 130 requires companies to report a new,
additional measure of income, however the Company has no material items of other
comprehensive income in any period presented.
Amortization of Intangibles
At December 31, 1994, upon its emergence from Chapter 11 Bankruptcy
Protection, the reorganization value of the Company in excess of its net assets
generated a $44.1 million intangible value that was classified as a
reorganization asset in the consolidated balance sheet of the Company
("Reorganization Asset"). The value of the Reorganization Asset was reduced in
the second quarter of 1995 as the Company exited the retail products business.
The net remaining Reorganization Asset was amortized at the rate of $625,000 per
quarter through 1997, and was completely amortized as of December 28, 1997.
3. ELIMINATION / CONVERSION OF PREVIOUS LINE OF CREDIT WITH RELATED PARTIES
On June 5, 1998, the Company completed two transactions with the combined
effect of fully paying down the entire outstanding balance and eliminating the
Company's previous line of credit with related parties.
The sale of 500 shares of Aureal Series C Preferred Stock (the "Series C
Preferred") for $5.0 million was made to DDJ Capital Management, LLC. $3.66
million of the proceeds from the sale were used to pay down the outstanding
balance under the line of credit. The Series C Preferred Stock carries an 8%
accretion rate over its three-year term, and provides for conversion to Common
Stock of the Company or redemption at the option of the Company. It is
convertible at the lesser of a fixed value of $2.50 per Common share or a
discount from the then-current market price for the Company's Common Stock at
the date of conversion.
The remaining $31.5 million balance of the line of credit was exchanged for
39,375 shares of Aureal 8% Series B Preferred Stock (the "Series B Preferred"),
with a face value of $39,375,000, and the line of credit was terminated. The
lenders under the line of credit released their lien on all the assets of the
Company as part of the termination of the line of credit agreement. The Series B
Preferred Stock provides for conversion to Common Stock of the Company at the
rate of one share of Common Stock for every $2.50 face value of Series B
Preferred. The 8% annual dividend, payable quarterly may be paid in cash or in
additional shares of Series B Preferred, at the option of the Company. The
Company has the option to redeem the Series B Preferred at its face value at any
time during its five-year term.
4. NEW CREDIT FACILITY
In conjunction with the conversion and elimination of the previous line of
credit, on June 5, 1998, the Company entered into a new $40 million Revolving
Credit Facility with Goldman Sachs and Transamerica. Terms of the new Credit
Facility provide for up to $32.5 million availability for borrowings related to
specific Company accounts receivable, ("Tranche A"), with an additional $7.5
million of availability unrelated to specific collateral requirements ("Tranche
B"). Interest on borrowings under the two-year agreement is at the rates of
Prime plus three percent for Tranche A borrowings and Prime plus five percent
for Tranche B borrowings. The Company is subject to certain covenant
restrictions under the Credit Facility and has paid a $600,000 fee to the
lenders in connection with the initiation of the Credit Facility.
As of June 28, 1998 the Company was in compliance with all of the covenant
requirements.
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Also in conjunction with the establishment of the new Credit Facility, the
Company issued 1.35 million warrants to the lenders under the Credit Facility.
These warrants are exercisable at any time over their five-year life at the
exercise price of $2.156 per share of Common Stock.
5. PREFERRED STOCK
During the first half of 1998, the Company issued three series of preferred
stock. The net proceeds from all the preferred stock issuances were used to
reduce the Company's outstanding debt and for working capital purposes. In
March, the Company issued $5 million of Series A Preferred Stock (the "Series A
Preferred"). The Series A Preferred shares include conversion rights to Aureal
Common Stock at the lesser of a $2.50 fixed conversion rate or a variable
conversion pricing dependent upon the underlying price of the Common Stock at
the time of conversion. The Series A Preferred shares bear accretion at an 8%
annual rate over their three-year term.
On June 5, 1998, the Company sold $5 million of Series C Preferred to DDJ
Capital Management, LLC ("DDJ"). The terms of the Series C Preferred are
virtually identical to the Series A Preferred. On June 26, 1998, the Company
sold an additional $1 million of Series C Preferred to non-affiliates.
Also on June 5, 1998, the Company exchanged 39,375 shares of Series B
Preferred for the entire $31.5 million outstanding balance of the Company's
previous line of credit. The Series B Preferred bear a face value of $1,000 per
share and an 8% annual dividend rate. The dividends may be paid in cash or in
additional Series B Preferred shares, at the option of the Company. The $10.7
million difference between the fair market value of the Series B Preferred
shares and the net book value of the exchanged debt (less unamortized fees
associated therewith) was charged directly to accumulated deficit at the time of
the transaction.
Accretion related to the beneficial conversion features of the Series A
Preferred and the Series C Preferred, and the dividend/accretion rate of 8% on
all three series of preferred stock totaled $1.4 million in the second quarter
of 1998.
6. INCOME TAXES
The Company was not required to provide for income taxes in the first two
quarters of 1998 or 1997 due to its net operating losses. No tax benefit has
been recorded for the losses due to the uncertainty as to the realizability.
At December 28, 1997, the Company had available net operating loss
carryforwards ("NOL's") of approximately $285 million to reduce future taxable
income. The NOL's expire on various dates through 2012. In connection with the
adoption of fresh start accounting, any tax benefit resulting from the use of
the NOL's generated prior to the bankruptcy plan confirmation in 1994 will be
applied as a direct addition to stockholders' equity.
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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
THE FOLLOWING DISCUSSION SHOULD BE READ IN CONJUNCTION WITH THE UNAUDITED
CONDENSED CONSOLIDATED FINANCIAL STATEMENTS INCLUDED ELSEWHERE HEREIN AND THE
AUDITED CONSOLIDATED FINANCIAL STATEMENTS AND NOTES THERETO AND MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS FOR THE
YEAR ENDED DECEMBER 28, 1997, CONTAINED IN FORM 10-K FILED WITH THE SECURITIES
AND EXCHANGE COMMISSION.
FORWARD-LOOKING STATEMENTS IN THIS REPORT ARE MADE PURSUANT TO THE SAFE
HARBOR PROVISIONS OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995.
INVESTORS ARE CAUTIONED THAT SUCH FORWARD-LOOKING STATEMENTS INVOLVE RISKS AND
UNCERTAINTIES, INCLUDING, BUT NOT LIMITED TO, DEPENDENCE ON THE PC AND CONSUMER
ELECTRONICS INDUSTRIES AND ON PRODUCT LINES BASED ON NEW TECHNOLOGIES; FOUNDRY
CAPACITY, AVAILABILITY AND RELIABILITY; COMPETITION AND PRICING PRESSURES, AND
OTHER RISKS DETAILED BELOW AND FROM TIME TO TIME IN THE COMPANY'S FILINGS WITH
THE SECURITIES AND EXCHANGE COMMISSION.
OVERVIEW
The Company's objective is to be a leading supplier of high quality,
advanced audio solutions to both the PC and consumer electronics marketplaces.
The Company's operating strategy combines the development and sale of audio
processing semiconductor chips with the licensing of technology to strategic
partners in order to define and develop advanced audio standards in the
marketplace. This strategy encompasses the following primary elements:
o Create value in the Aureal and A3D logos - Aureal is working to establish
consumer association between the Aureal and A3D brand names and high
quality audio. This high quality branding strategy can be utilized on
multiple components of an entire audio solution in the PC arena.
o Offer low-cost PC audio acceleration - Aureal continues to develop and
offer high-feature audio accelerator chips at prices competitive with
lower-featured offerings from other manufacturers. In addition, the Company
is currently expanding its PC product offerings in response to the evolving
market for audio and audio communications components. Both audio cards and
audio communications combination cards are being developed for
distribution. This expansion of the Company's business model allows Aureal
to approach the PC market with a complete spectrum of audio components
targeted to provide solutions at various feature/price points in the
market.
o Provide integrated audio components to the consumer market - Aureal is
developing devices targeted to the consumer electronics marketplace which
provide lower system cost through integration of digital, analog and other
audio system functions.
On July 15, 1998, Diamond Multimedia Systems, Inc. ("Diamond") and the
Company jointly announced that they had entered into a strategic alliance to
develop and market next-generation audio solutions for the PC marketplace. Under
this agreement, Diamond will utilize Aureal's Vortex and A3D audio technologies
exclusively for products sold under Diamond's award-winning "Monster Sound" PCI
audio accelerator brand.
On June 15, 1998, the Company announced that Compaq Computer Corporation,
the world's leading personal computer company, would begin featuring Aureal's
A3D Interactive 3D audio technology on its new line of Presario desktop
computers. Compaq's marketing materials, including point-of-sale displays in
retail stores and website presentation have begun to actively support Aureal's
A3D technology.
In April 1998, the Company introduced A3D 2.0, a significant enhancement to
the existing version of A3D that was originally introduced in September 1996.
A3D 2.0, which is incorporated in a growing number of PC game titles, is
backward compatible with the original A3D technology. A3D is currently
incorporated into a number of major PCs (including computer lines from Dell
Computer Corporation and Compaq), as well as a number of PC add-in audio cards
under various brand names. The new A3D 2.0 includes Aureal Wavetracing
Technology (which enables real-time acoustic reflections, reverb and occlusion
rendering features), more 3D sources, a higher sample rate and larger
Head-Related Transfer Function (HRTF) filters. Together, all of these feature
enhancements provide for improved three-dimensional rendering of audio for
interactive applications.
Also during the first half of 1998, key design wins for the Vortex AU8820
and A3D were announced and chip sales in volume were commenced. The AU8820 is
currently implemented in sound cards utilized or marketed by Dell Computer
Corporation, Turtle Beach Systems, Aztech Systems Ltd. and TerraTec Electronic
GmbH. These customers, in addition to Compaq, are actively promoting Aureal's
A3D technology.
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Early 1998 marked the first shipments of audio semiconductor chips by
Aureal after two years of development work in the digital audio design area.
Many of the audio sound card applications utilizing the Vortex AU8820 chip are
based on Aureal's card reference design and have won widespread acclaim as well
as numerous awards from various PC publications. In addition, Aureal's A3D
Interactive audio technology has been widely recognized as the industry standard
for three-dimensional sound presentation. Aureal's Vortex AU8820 PCI-based
digital audio processor chip is a feature-rich audio solution designed for the
PC. In conjunction with Aureal's A3D three-dimensional audio technology, the
Company is offering an audio solution for the PC that takes advantage of the
benefits of PCI technology. The Company believes that the market for PCI audio
is expanding rapidly, and will be a significant market by year-end 1998.
Contributing to the move from ISA-based to PCI-based audio systems for PCs are
the requirements put forth by both Microsoft Corporation and Intel Corporation
relative to Windows qualifications.
With announced "design-wins" including Dell Computer Corp. (utilizing sound
cards incorporating the AU8820 chip) and Compaq Computer Corporation (A3D
implementation on the Presario line of desktop PCs), Aureal technology has begun
to appear in market-leading PCs. Aureal's A3D technology is also gaining
acceptance from PC game developers, and is currently supported by a number of
major game developers including Activision, Lucas Arts, Interplay, GT
Interactive, Broderbund, Electronic Arts, Sierra On-Line and Ubi Soft. Many of
these developers, as well as PC hardware manufacturers are working with Aureal
to support A3D and Aureal brand recognition through use of the Aureal and A3D
logos on packages and advertisements.
RESULTS OF OPERATIONS
Net Sales
Net sales for the second quarter of 1998 were $3.4 million, compared to
$3.6 million in the previous quarter and $0.7 million in the second quarter of
1997. Year-to-date revenues for 1998 of $7.0 million represent the sale of
several hundred thousand AU8820 chips, along with minor revenues from technology
licensing.
In addition, with the July 1998 announcement of the strategic alliance
between Aureal and Diamond, Aureal anticipates commencement of audio board sales
in the third quarter of the year. This will allow the Company to offer both chip
and board level products to various segments of the PC market. The Company
believes that this expansion of product categories will allow Aureal to better
address the needs of a broader cross section of the market over time.
Gross Margin
Gross margin rose from 22% in the first quarter of 1998 to 41% in the
second quarter as the AU8820 product moved from initial ramp-up into higher
volume production. Cost reductions associated with the higher production levels
and higher yield from silicon wafers both contributed to the margin improvement.
Gross margin percentages in the prior year were significantly higher,
although on limited revenues, as the majority of such revenues were technology
licensing based. The Company does not anticipate that license revenues will be a
significant portion of overall revenues in the future.
Gross margin percentages could vary and potentially be reduced on some
card-level products that the Company anticipates selling in future quarters.
12
<PAGE> 13
Research and Development
Expenditures for research and development continue to be the most
significant area of spending for the Company as it allocates significant
resources to create future audio products for both the PC and consumer
electronics markets. Spending in this area yields both short-term and long-term
product developments - as the Company looks to continue to bring new and
improved products to the audio forefront. Spending increased $0.3 million from
the first quarter to the second quarter of the year ($2.6 million to $2.9
million) as prototype runs of the Company's newest semiconductor product were
commenced during the second quarter. In addition, the Company has continued to
increase the staffing in the research and development area, both with employees
and some specific project contract work. Year-to-date expenditures in this area
increased from $3.0 million in 1997 to $5.5 million in 1998, and have generally
increased each quarter over the last two years as development efforts on both
software and hardware based technology have expanded.
The Company expects that the level of spending on research and development
will fluctuate, but is not expected to decline significantly in absolute dollars
in future periods.
Selling and Marketing
Selling and marketing expenses for the second quarter of 1998 were $1.6
million, an increase of $0.3 million over the previous quarter. This increase
over the first quarter of the year is primarily attributable to expenses
incurred to design and launch an advertising campaign designed to increase the
visibility of A3D to the end-user. This campaign includes media advertising in
various PC-related magazines. The substantial increase in year-to-date
expenditures ($3.0 million in 1998 versus $1.7 million in 1997) is primarily
attributable to costs, including selling commissions, related to the
commencement of AU8820 sales in 1998.
General and Administrative
General and administrative expenses for the second quarter were $0.8
million, flat with the level of expense in the first quarter. Quarterly and
year-to-date expenses ($1.7 million) rose from the prior year ($0.6 million and
$1.2 million, respectively) due primarily to increases in recruiting and
employment consulting expenses as the Company has added significant staff in the
first half of this year.
Amortization of Reorganization Asset
The Reorganization Asset originated pursuant to the Company's valuation
upon its exit from bankruptcy protection in December 1994, whereby the fair
value of the Company exceeded its net assets by $44.1 million. The
Reorganization Asset value was fully amortized at year-end 1997 (at the rate of
$625,000 per fiscal quarter, during 1997).
Interest Expense
Interest expense for the first half of both years consisted primarily of
interest on the line of credit at the rate of prime plus 5%. The expense in 1998
($2.0 million year-to-date, $1.0 million for the second quarter) increased over
the prior year ($1.2 million year-to-date, $0.6 million for the quarter) as the
balance under the line of credit grew over the period. During 1997 and 1998
to-date, the line of credit has been a major source of working capital for the
Company, and has expanded over that time. Proceeds from the sale of equity
capital over that time period have been utilized periodically to pay down the
balance of the debt.
With the pay down and elimination of the TCW line of credit in June 1998
through the exchange for Series B Preferred Stock of the Company, the interest
expense is expected to decline significantly. The new Credit Facility with
Goldman Sachs and Transamerica carries a lower interest rate than the prior line
to the extent borrowings are based on eligible accounts receivable borrowing
availability.
13
<PAGE> 14
Amortization of Debt-Related Warrants
In August 1997, in conjunction with the expansion and extension of the TCW
Line of Credit, the Company issued 3.15 million warrants to the lenders to
purchase the Company's Common Stock. Utilizing the Black-Scholes valuation
method, the estimated fair value of the warrants was determined to be $5.0
million. This value was amortized over the estimated life of the loan at the
rate of $0.75 million per quarter. When the loan was converted in June 1998, the
remaining unamortized deferred costs related to the warrants were netted against
the outstanding loan balance and eliminated as a reduction of the conversion
value of the Series B Preferred shares.
In connection with the new Credit Facility, the Company issued to the
lenders, in June 1998, 1.35 million warrants to purchase the Company's Common
Stock. The fair value of these warrants was estimated utilizing the
Black-Scholes valuation method as approximately $1.8 million, and is being
amortized over the two-year term of the Credit Facility.
Other Income
The Company recognized net other income of $51,000 and $340,000 in the
second and first quarters of 1998, respectively. This compares to $148,000 and
$56,000 in the corresponding quarters of 1997. The income recognized in all
quarters shown was primarily due to various receipts and credits resulting from
favorable resolutions to previously recorded liabilities.
Income Taxes
The Company was not required to provide income taxes in the first two
quarters of either 1998 or 1997 due to its net operating losses. No tax benefit
has been recorded for the net operating loss carryforwards due to the
uncertainty as to their realizability.
14
<PAGE> 15
LIQUIDITY AND CAPITAL RESOURCES
At June 28, 1998, the Company had working capital of $5.6 million and
stockholders' equity of $6.2 million. In quarterly financial statements since
1995, the Company has generally shown negative working capital amounts and
stockholders' deficit amounts. The stockholder equity of $6.2 million is largely
the result of the issuance of preferred stock in the first half of 1998, both
for cash and in exchange for the $31.5 million line of credit balance. These
transactions have resulted in significant Paid-in Capital increases, however the
Company continues to maintain a substantial accumulated deficit developed as
losses have been recorded over the last three years. The Company recognized a
net loss of $5.4 million in the second quarter of 1998 ($10.9 million
year-to-date) as well as direct charges to accumulated deficit of $12.1 million
in the second quarter related to dividends and accretion on preferred stock. Of
that amount, $10.7 million is a one-time charge related to the difference
between the conversion/redemption value of the Series B Preferred Stock ($39.4
million) and the net carrying value of the debt for which it was exchanged
($28.7 million). Other dividends and value accretion related to the Series A, B
and C Preferred Stock resulted in an additional charge of $1.4 million in the
second quarter.
Working capital used to support operating activities has totaled $18.5
million in the first half of 1998, averaging roughly $3.1 million per month.
This has resulted from the growth of accounts receivable and inventory over that
time, as well as increased operating losses. The Company believes that it will
move closer to generating cash flow from operations as revenues are expected to
grow in subsequent quarters. Such revenue growth is dependent upon the Company's
success in promoting both the Vortex semiconductor design and A3D audio
technology as valuable components to a PC's audio system. The acceptance of PCI
audio (the underlying data-bus technology utilized for both Vortex and A3D) as
the standard for the PC is also key to the Company's immediate growth plans. To
the extent such PCI acceptance and utilization does not materialize as rapidly
as expected, Aureal's growth could be significantly impacted.
The Company believes that the $40 million Credit Facility, of which $0.4
million was drawn as of June 28, 1998, will provide adequate financial resources
to sustain business for at least the next year. The Company may be required to
seek additional financing to expand its business. There can be no assurance that
the Company will be able to generate positive cash flows in the future or to
obtain financing on favorable terms, if at all.
Capital expenditures of $1.0 million during the first half of 1998
consisted primarily of hardware and software tools utilized in the Company's
research and development activities. Increased levels of capital expenditures
are anticipated during future quarters of 1998.
15
<PAGE> 16
RISK FACTORS
In evaluating the Company's business, certain factors, including those
discussed below and those included in documents previously filed with the
Securities and Exchange Commission, should be considered in addition to the
other information in this Form 10-Q.
History of Losses and Accumulated Deficit; Expectation of Future Losses
The Company emerged from Chapter 11 Reorganization in December 1994. Since
that time the Company has incurred losses, in the aggregate amount of $162
million, from (1) operating and eliminating its previous retail products
business in 1995, (2) during the research and development phases of its advanced
audio technologies business operations in 1996 and 1997, and (3) as it began to
sell advanced audio products in the first half of 1998. While the majority of
the Company's revenues in 1996 and 1997 were generated through technology
licensing transactions, the Company anticipates that the majority of its
revenues will come from the sale of audio products in 1998 and future years.
There can be no assurance that the Company will be able to sell significant
volumes of its products in the future, and the Company's ability to attain
profitability or generate positive cash flows is dependent thereon.
New Technologies and Products Developed with New Technologies
The Company's success depends on its ability to develop and market new
technologies aimed at advancing the level of audio quality in the PC and
consumer electronics devices. With respect to the PC market, audio technology is
shifting from utilization of the ISA bus to utilization of the more advanced
(higher bandwidth) PCI bus. This change enables advanced digital audio
functionality including positional 3D audio, streaming audio and higher quality
presentation. There can be no assurance that the shift from ISA-based audio to
PCI-based audio will occur in a timeframe for the Company to benefit from its
PCI-based products and technologies. As new technologies are developed, there
can be no assurance that markets will develop for them, or that markets will
develop on a timely basis for the Company to benefit therefrom.
The success of new products depends on a number of factors, including
timely completion of product development, market acceptance of the Company's and
its customer's new products and the Company's ability to offer new products at
competitive prices. Incorporating the Company's new products into its OEM
customers' new product designs requires the anticipation of market trends and
performance and functionality requirements of OEMs and the production of
products that can be available in a timely manner consistent with the OEMs'
development and production schedules. A failure in any of these areas could have
a material adverse effect on the Company's results of operations.
Each successive generation of microprocessors has provided increased
performance, which could in the future result in a microprocessor capable of
performing advanced audio functions to an extent that the need or preference for
the Company's products could be diminished or eliminated. Conversely, each new
generation of technology, including digital audio technology, generally requires
increased processing power. In this regard, Intel Corporation has created the
MMX functionality with its Pentium line of processors and is promoting the
processing power of MMX for data and signal intensive functions such as graphics
and audio processing. The Company believes that advanced audio processing, done
in conjunction with either video or graphics processing is best performed with a
separate accelerator chip in addition to the host processor. There can be no
assurance that the increased capabilities of microprocessors in the future will
not adversely affect demand for the Company's products.
Product Concentration and Expansion of Business Model
Substantially all of the Company's revenues are related to advanced audio
solutions for the PC and consumer electronics markets and the Company expects
this to continue for the foreseeable future. The Company is just embarking on an
expansion of its semiconductor business model to provide for an increased number
of audio related products including audio cards and audio communications
combination cards. This expansion may require additional working capital funds
to provide for incremental inventory as well as broader marketing programs. The
failure of this market to continue to grow, any reduction in demand as a result
of increased competition in this market, technological change, failure by the
Company to introduce new versions of products acceptable to the marketplace or
other similar factors would have a material adverse effect on the Company's
results of operations.
16
<PAGE> 17
Competition and Pricing Pressures
The markets in which the Company competes are intensely competitive and are
characterized by evolving industry standards resulting in relatively short
product life cycles, significant pricing and performance improvement pressures,
and frequent new product introductions. The Company expects competition to
increase in the future from existing competitors and from other companies that
may enter the markets with products that may be less costly or provide higher
performance or additional features. The Company is unable to predict the timing
and nature of any such competitive product offerings. In general, product prices
in the semiconductor industry have decreased over the life of a particular
product. The willingness of prospective customers to design the Company's
products into their products depends to a significant extent upon the ability of
the Company to price its products at levels that are cost-effective for such
customers. As the markets for the Company's products mature and competition
increases, the Company anticipates that prices for its products will generally
decline over time. If the Company is unable to reduce its costs sufficiently to
offset declines in product prices or is unable to introduce new, higher
performance products with higher product prices, the Company's results of
operations could be materially adversely affected.
The Company anticipates that it will compete for the development of new
technologies and for the sale of semiconductor products with a number of
companies who have more extensive resources including financial, manufacturing,
technical, marketing and distribution. In addition, some of those firms may have
greater intellectual property rights, broader product lines and longer-standing
relationships with customers than the Company. The Company's competitors may
also include a number of emerging companies.
Dependence on Credit Facility
Because it has not been profitable to date, the Company has funded its
losses through a combination of equity and debt financing. In June 1998, the
Company entered into a Credit Facility with Goldman Sachs and Transamerica,
which provides for an aggregate maximum borrowing line of $40 million. The
interest rate on this Credit Facility is generally the prime rate plus 3% to 5%.
Accordingly, while the Credit Facility provides for working capital, the high
cost of servicing any borrowings thereunder could negatively effect the
Company's liquidity. The can be no assurance that the Credit Facility will
provide sufficient funding to meet the Company's future needs. In the event the
Company is required to secure additional capital, there can be no assurance that
such capital will be available on acceptable terms or at all. The Company's
inability to secure such potential future financing, if necessary, would have a
material adverse effect on the Company's business, financial condition and
results of operations.
Factors Inhibiting Takeover
The Company is subject to the provisions of Section 203 of the Delaware
General Corporation Law, which imposes certain restrictions on the ability of a
third party to effect an unsolicited change in control of the Company. In
addition, the Company's Amended and Restated Certificate of Incorporation does
not provide for cumulative voting in the election of directors, and certain
provisions of the Company's Amended and Restated Certificate of Incorporation
and Bylaws, including the provision which divides the Board of Directors into
three separate classes, may have the effect of delaying or preventing changes in
control or management of the Company.
Trading in the Non-NASDAQ Over-the-Counter Market; Disclosure Relating to
Low Priced Stock
The Company's Common Stock trades only on the OTC Bulletin Board and the
trading volume has been generally light. The Company does not currently meet the
requirements of the NASDAQ National Market or other national stock exchanges.
There can be no assurance that the Company will, in the future, meet such
listing requirements or that it will be accepted for trading on any such
national exchange.
Because the Company's Common Stock trades on the Non-NASDAQ
Over-the-Counter market, an investor may find it more difficult to dispose of,
or to obtain accurate quotations as to the market value of, the Company's Common
Stock. In addition, because that Company's securities are not listed on NASDAQ,
trading in the Common Stock is also subject to certain rules promulgated under
the Securities Exchange Act of 1934, which require additional disclosure by
broker-dealers in connection with any trades involving a stock defined as a
penny stock (generally, a non-NASDAQ equity security that has a market price of
less than $5.00 per share, subject to certain exceptions). The additional
burdens imposed upon broker-dealers by such requirements may discourage
broker-dealers from effecting transactions in the Company's Common Stock, and
severely limit the market liquidity of the Company's Common Stock and the
ability of purchasers of the Company's Common Stock to resell such securities in
the secondary market.
17
<PAGE> 18
Risk of Additional Shares Sold in the Public Market
Because the holders of the Series A Preferred and Series C Preferred shares
may convert such shares into shares of the Company's Common Stock at variable
conversion prices, the exact number of shares of Common Stock which the Company
may issue upon conversion of Series A Preferred and Series C Preferred shares is
not presently known, and may fluctuate based on the market value of the
Company's Common Stock. Because of the variable conversion price feature of the
Series A Preferred and Series C Preferred shares, holders of such shares may
have incentive to take certain actions, including shorting the Company's Common
Stock, to decrease the market price of such Common Stock. Upon a decrease in the
market price of the Company's Common Stock, holders of the Series A Preferred
and Series C Preferred shares may elect to convert such shares at the variable
conversion price and thereby receive a greater number of shares of the Company's
Common Stock. Short selling is illegal if used to manipulate the price of a
company's securities for profit, and the Company has no knowledge that any
holders of Series A Preferred or Series C Preferred shares intends to take any
action which may cause the price of the Company's Common Stock to fall. However,
there can be no assurance that holders of the Company's Series A Preferred or
Series C Preferred shares will not short the Company's Common Stock or take such
other actions, the effect of which may be to drive down the market price of the
Company's Common Stock.
Concentration of Stock Ownership
Currently, three parties control approximately 75% of the outstanding
Common Stock, each of who control at least 10% individually. There can be no
assurance that the liquidity of the market for the Common Stock will be
maintained at or increase over its current levels, and the trading price for the
Common Stock may be influenced by the volume and liquidity of the market for the
Common Stock. Sales of a large percentage of the Company's total outstanding
Common Stock may have an adverse effect on its market price.
Dependence on Foundries
The Company is a "fabless" semiconductor firm, which depends on outside
manufacturing resources for production of all of its semiconductor products.
Currently the Company utilizes two foundries, one domestic and one foreign for
production of its existing products. Both of these foundries have indicated to
the Company that they have the manufacturing availability to provide for the
Company's planned production of each of its products for the next twelve months;
however the Company's production relationship with each foundry is based only
upon purchase orders and there is no assurance that either foundry will continue
to provide adequate manufacturing capacity to the Company for its current level
of production or any potential increases in production levels. In the event
either or both foundries cease to manufacture the Company's semiconductor
products, the Company would have to contract with alternative foundries. There
can be no assurance that the Company would be able to contract with alternative
foundries in a timely manner or at all. The failure to do so would have a
material adverse effect on the Company's business, financial condition and
results of operations.
The manufacture of semiconductor products is a highly complex and precise
process. Minute levels of contaminants in the manufacturing environment, defects
in the masks used to print circuits on silicon wafers, difficulties in the
fabrication process or other factors can cause a substantial percentage of
wafers to be rejected or a significant number of die on each wafer to be
non-functional. Many of these yield problems are difficult to diagnose, and
potentially time-consuming or expensive to remedy. There can be no assurance
that the Company's foundries will not experience irregularities or adverse yield
fluctuations in the manufacturing process of the Company's products in the
future, which could have a material adverse effect on the Company's business,
financial condition and results of operations.
Dependence on Key Personnel
The Company's success depends to a significant extent upon continued
services of key engineering, marketing, sales and management personnel. The
Company's employees may voluntarily terminate their employment with the Company
at any time. The Company recognizes the value of the contributions of each of
its employees and has developed compensation programs, including stock option
plans for the granting of options to all employees, designed to retain its
employees. Competition for such employees is intense and the loss of the
services of such employees could have a material adverse effect on the Company's
business, financial condition and results of operations.
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<PAGE> 19
Dependence on Proprietary Technology
The Company's ability to compete successfully will depend, in part, on its
ability to protect its proprietary technology. The Company relies on a
combination of patents, trade secret, copyright and trademark laws,
nondisclosure agreements and other contractual provisions and technical measures
to protect its proprietary rights. There can also be no assurance that such
measures will be adequate or safeguard the proprietary technology underlying the
Company's products, or that its agreements with employees, consultants and
others who participate in the development of its products will not be breached,
that the Company will have adequate remedies for any breach or that the
Company's proprietary information or trade secrets will not otherwise become
known. Moreover, notwithstanding the Company's efforts to protect its
intellectual property, there can be no assurance that competitors will not be
able to develop products which are equal or superior to the Company's products
without infringing any of the Company's intellectual property rights. In
addition, effective protection of intellectual property rights may be
unavailable or limited in certain countries. Accordingly, there can be no
assurance that the Company's means of protecting its intellectual property will
be adequate or that the Company's competitors will not independently develop
similar technologies or products.
Although the Company does not believe that its products infringe the
proprietary rights of any third parties, there can be no assurance that
infringement or invalidity claims (or claims for indemnification resulting from
infringement claims) will not be asserted against the Company or that any such
assertions will not materially adversely affect the Company's business,
financial condition or results of operations. Irrespective of the validity or
the successful assertion of such claims, the Company could incur significant
cost with respect to the defense thereof which could have a material adverse
effect on the Company's business, financial condition or results of operations.
In February 1998, the Company was served with a suit for patent infringement
filed by Creative Technology Ltd., a Singapore corporation ("Creative"), and its
subsidiary, E-MU Systems, Inc., a California corporation ("E-MU") in the U.S.
District Court, Northern District of California. The suit alleges that the
Company's Vortex AU8820 Digital Audio Processor infringes on a patent that
describes a specific implementation for an electronic musical instrument
designed by E-MU. Creative and E-MU seek, among other things, a preliminary and
permanent injunction against continuing acts of infringement by the Company and
an accounting of damages plus interest. The Company believes that the action is
without merit and has commenced vigorous defense of this action.
Shiva Holdings Limited ("Shiva") filed a cross-complaint against the
Company in December 1997 in the Superior Court of Santa Clara, California. The
cross-complaint alleges breach of contract; breach of implied covenant of good
faith and fair dealing, fraud and negligent misrepresentation in connection with
the Agreement for Purchase of Certain Assets entered into between Shiva and the
Company in February 1996. The Company had filed an action against Shiva for
breach of contract and specific performance in connection with the failure of
Shiva to perform under the February 1996 agreement between the companies. All
claims in these actions were settled in July 1998 with the termination of the
agreement without monetary exchange between the parties.
Litigation may be necessary to resolve the claims asserted by Creative,
E-MU and any other claims asserted in the future to defend against claims of
infringement or invalidity or to enforce and protect the Company's intellectual
property rights. There can be no assurance that the Company will prevail in any
such litigation, and any such litigation, whether or not determined in the
Company's favor or settled by the Company, would be costly and would divert the
efforts and attention of the Company's management and technical personnel from
normal business operations, which could have a material adverse effect on the
Company's business, financial condition and results of operations. Adverse
determinations in litigation could result in the loss of the Company's
proprietary rights, subject the Company to significant liabilities, require the
Company to seek licenses from third parties or prevent the Company from
licensing its technology, any of which could have a material adverse effect on
the Company's business, financial condition and results of operations.
19
<PAGE> 20
Year 2000 Compliance
The Company uses a number of computer software programs and operating
systems in its internal operations, including applications used in financial
systems and various administrative functions. To the extent that these software
applications contain source code that is unable to appropriately interpret the
upcoming calendar year 2000, some level of modification or even possibly
replacement of such applications could be necessary. Given the information known
at this time about the Company's systems, it is currently not anticipated that
such "Year 2000" costs will have a material impact on the Company. The Company
is not aware that any of its key suppliers or customers are not fully "Year
2000" compliant. If any of its key suppliers or customers are not yet fully
"Year 2000" compliant, there can be no assurance that such non-compliance would
not have a material adverse effect on the Company's business, financial
condition or results of operations.
20
<PAGE> 21
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
In February 1998, the Company was served with a suit for patent infringement
filed by Creative Technology Ltd., a Singapore corporation ("Creative"), and its
subsidiary, E-MU Systems, Inc., a California corporation ("E-MU") in the U.S.
District Court, Northern District of California. The suit alleges that the
Company's Vortex AU8820 Digital Audio Processor infringes on a patent that
describes a specific implementation for an electronic musical instrument
designed by E-MU. Creative and E-MU seek, among other things, a preliminary and
permanent injunction against continuing acts of infringement by the Company and
an accounting of damages plus interest. The Company believes that the action is
without merit and has commenced vigorous defense of this action.
Shiva Holdings Limited ("Shiva") filed a cross-complaint against the
Company in December 1997 in the Superior Court of Santa Clara, California. The
cross-complaint alleges breach of contract; breach of implied covenant of good
faith and fair dealing, fraud and negligent misrepresentation in connection with
the Agreement for Purchase of Certain Assets entered into between Shiva and the
Company in February 1996. The Company had filed an action against Shiva for
breach of contract and specific performance in connection with the failure of
Shiva to perform under the February 1996 agreement between the companies. All
claims in these actions were settled in July 1998 with the termination of the
agreement without monetary exchange between the parties.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
The Annual Meeting of Stockholders was held on May 20, 1998 at which the
stockholders voted on proposals as follows:
<TABLE>
<CAPTION>
Number of Shares
Voted For Withheld
--------- --------
<S> <C> <C>
Election of Directors:
L. William Krause 33,050,447 14,741
Thomas K. Smith, Jr 33,050,447 14,741
</TABLE>
<TABLE>
<CAPTION>
Voted For Voted Against Abstained
--------- ------------- ---------
<S> <C> <C> <C>
Ratify appointment of Arthur Andersen, LLP
as independent accountants of the Company
for the 1998 fiscal year 33,046,693 4,528 13,967
</TABLE>
21
<PAGE> 22
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibit index at page 23.
(b) Reports on Form 8-K:
On June 15, 1998, the Company filed a Form 8-K with the Securities and
Exchange Commission ("SEC") disclosing the completion of three
financing transactions. These included (1) the sale of $5 million of
Aureal Series C Preferred Stock, (2) the conversion and termination of
the Company's previous line of credit in exchange for 39,375 shares of
Aureal Series B Preferred Stock, and (3) the establishment of a new $40
million Revolving Credit Facility with Goldman Sachs and Transamerica.
In conjunction with the SEC's review of a Form S-2 filed to register
shares of Aureal Common Stock, the SEC requested that certain
amendments be made to wording in the above Form 8-K. An amended Form
8-K/A was filed in response to such request on July 2, 1998.
On March 16, 1998, the Company filed a Form 8-K disclosing the sale of
$5 million of Aureal Series A Preferred Stock. This Form 8-K was
amended via filing of Form 8-K/A's on June 3, 1998 and July 2, 1998,
again in response to SEC comments related to the review of the above
referenced Form S-2.
SIGNATURES
Pursuant to the requirements of the Securities and Exchange Act of 1934,
the registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
AUREAL SEMICONDUCTOR INC.
Date: July 31, 1998 By: /s/ Kenneth A. Kokinakis
---------------------------------
Kenneth A. Kokinakis
President and Chief Executive Officer
Date: July 31, 1998 By: /s/ David J. Domeier
---------------------------------
David J. Domeier
Vice President of Finance and
Chief Financial Officer
22
<PAGE> 23
EXHIBIT INDEX
<TABLE>
<CAPTION>
Exhibit No. Description of Document
----------- -----------------------
<S> <C>
2.1 Agreement and Plan of Reorganization among the Company, Aureal
Acquisition Corporation, a wholly-owned subsidiary of the Company
and Crystal River Engineering, Inc., dated as of May 7, 1996 (1)
2.2 Second Amended Joint Plan of Reorganization dated November 10,
1994 (4)
3.1 Second Amended and Restated Certificate of Incorporation of the
Company dated May 8, 1996 (2)
3.2 Restated Bylaws of Aureal Semiconductor Inc. (6)
4.1 Common Stock Purchase Agreement by and among the Company and
certain beneficial owners of 5% or more of the Company's Common
Stock, as amended (3)
4.2 Common Stock Purchase Agreement by and among the Company and
certain entities and individuals dated June 10, 1996 (5)
4.3 Common Stock Purchase Agreement by and among the Company and
certain entities and individuals dated August 6, 1997 (8)
4.4 Preferred Stock Regulation D Subscription Agreement (10)
4.5 Certificate of Designation of Series A Preferred Stock of Aureal
Semiconductor Inc. (10)
4.6 Preferred Stock Registration Rights Agreement (Common Stock
underlying Series A Preferred Stock) (10)
4.7 Aureal Semiconductor Inc. Regulation D Subscription Agreement for
Series C Preferred Stock (11)
4.8 Certificate of Designation of Series C Preferred Stock of Aureal
Semiconductor Inc. (11)
4.9 Registration Rights Agreement (Common Stock underlying Series C
Preferred Stock) (11)
4.10 Loan and Security Agreement (Goldman and TBCC Credit Facility)
(11)
4.11 Form of Warrant (Goldman and TBCC Warrants) (11)
4.12 8% Series B Convertible Preferred Stock Purchase Agreement (11)
4.13 Certificate of Designation of 8% Series B Convertible Preferred
Stock for Aureal Semiconductor Inc. (11)
4.14 Amendment Number 4 to Registration Rights Agreement (11)
10.1 Second Amended and Restated Loan Agreement between TCW Special
Credits and the Company dated August 6, 1997 increasing the loan
commitment from $20 million to $31.5 million (9)
10.2 1995 Stock Option Plan (3)
</TABLE>
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<TABLE>
<CAPTION>
Exhibit No. Description of Document
----------- -----------------------
<S> <C>
10.3 Form of incentive option agreement and non-statutory stock option
agreement used under 1995 Stock Option Plan (3)
10.4 1994 Stock Option Plan (4)
10.5 Form of incentive option agreement and non-statutory stock option
agreement used under 1994 Stock Option Plan (4)
10.6 Industrial Space Sublease with Chemical Waste Management, Inc.
dated September 13, 1995 (3)
10.7 Form of Indemnity Agreement for Directors and Officers (6)
10.8 1996 Outside Directors Stock Option Plan (7)
10.9* Manufacturing, Purchase and Distribution Agreement between Diamond
Multimedia Systems, Inc. and Aureal dated July 3, 1998
11.1 Computation of Earnings (Loss) Per Share (See Pages 5 and 9)
27.1 Financial Data Schedule (Edgar Only)
</TABLE>
* Confidential treatment has been requested for portions of this document.
(1) Incorporated by reference to the exhibits filed with Form 8-K dated May 22,
1996.
(2) Incorporated by reference to the exhibits filed with Form S-8 (Registration
number 333-09531) filed August 2, 1996.
(3) Incorporated by reference to the exhibits filed with Form 10-K for the year
ended December 31, 1995.
(4) Incorporated by reference to the exhibits filed with Form 10-K for the year
ended December 31, 1994.
(5) Incorporated by reference to the exhibits filed with Form S-3 (Registration
number 333-3870) filed June 26, 1996.
(6) Incorporated by reference to the exhibits filed with Form 10-Q for the
quarter ended September 29, 1996.
(7) Incorporated by reference to the exhibits filed with Form 10-K for the year
ended December 29, 1996.
(8) Incorporated by reference to the exhibits filed with Form S-3 (As
Post-Effective Amendment No. 1, Registration number 333-3870) filed
September 12, 1997.
(9) Incorporated by reference to the exhibits filed with Form 10-Q for the
quarter ended September 28, 1997.
(10) Incorporated by reference to the exhibits filed with Form 8-K dated March
16, 1998.
(11) Incorporated by reference to the exhibits filed with Form 8-K dated June
15, 1998.
24
<PAGE> 1
Exhibit 10.9
MANUFACTURING, PURCHASE AND DISTRIBUTION AGREEMENT
This Manufacturing, Purchase and Distribution Agreement (the
"Agreement") is entered into by and between Aureal Semiconductor Inc., a
Delaware corporation ("Aureal") with principal offices at 4245 Technology Drive,
Fremont, California 94538 and Diamond Multimedia Systems, Inc., a Delaware
corporation and its wholly owned subsidiaries ("Diamond"), with principal
offices at 2880 Junction Avenue, San Jose, California 95134-1922 and is
effective as of July 3, 1998 (the "Effective Date").
Recitals
A. Aureal possesses certain knowledge, expertise and know-how relating
to PCI Audio Chip design and manufacturing, audio sound card design and
three-dimensional audio technology. Aureal has implemented and embodied certain
of these audio technologies in its Vortex integrated circuit products which are
defined in Exhibit A (the "Aureal Chips").
B. Diamond and Aureal desire to enter into a partnership arrangement in
which Diamond will be the preferred provider of Add-In Sound Cards (defined
below) which incorporate the Aureal Chips for certain defined markets and Aureal
will be Diamond's preferred provider of audio products for all Diamond Add-In
Sound Card products and motherboard applications.
NOW, THEREFORE, in consideration of the mutual covenants and promises
contained herein, and other good and valuable consideration, the receipt and
sufficiency of which are hereby acknowledged, the parties agree as follows:
Agreement
1. Definitions.
1.1 "Add-In Sound Cards" means finished board level products
containing the Aureal Audio Products for Personal Computers.
1.2 "Aureal Audio Products" means audio only products
developed by Aureal to include audio integrated circuits, Add-In Sound Cards,
and other audio related components for the Personal Computer as listed on
Exhibit A.
1.3 "Commercial Distributor" means an entity that is licensed
to distribute computer hardware or software products in large volume shipments
to End-Users or other Resellers.
1.4 "Dealer" means an entity that has the right to distribute
pre-packaged computer hardware or software products directly to End Users
through retail channels.
1.5 "End-User" means an individual or entity that licenses or
purchases products for his, her or its own personal or business purposes, and
not for license or resale to others.
1.6 "Named OEMs" means OEM customers listed on Exhibit C.
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<PAGE> 2
1.7 "OEM" means an entity which manufactures computer
equipment or computer hardware for distribution with other third-party hardware
and software components as a complete system under its own brand name to End
Users and Resellers.
1.8 "Diamond Channel" means The Reseller, OEM's and
Commercial Distributor.
1.9 "Proprietary Rights" means copyrights, patent rights,
trade secret rights, trademark rights and other intellectual and proprietary
rights.
1.10 "Resellers" means Dealers, Retailers and System
Integrators.
1.11 "Retailer" means a customer who resells the Add-In Sound
Cards to customers who intend to use such products and do not have an intention
to resell them.
1.12 "Systems Integrator" means an entity which obtains or
licenses third-party hardware and software for distribution as a complete system
to End Users.
2. Manufacturing and Purchase.
2.1 Manufacturing. Aureal will design, manufacture and supply
Diamond with its Add-In Sound Card products. Diamond and Aureal will jointly
specify the Add-In Sound Cards for the relationship which Aureal shall
manufacture through its chosen subcontractor. The Diamond designed card can not
be sold to other customers without Diamond's consent. A card with similar
functionality but without Diamond-designed circuitry shall not be considered a
Diamond-designed card. Diamond retains the right to qualify such manufacturing
subcontractor pursuant to Diamond's standard qualification procedures. Diamond's
qualification of Aureal's manufacturing subcontractor shall not be unreasonably
withheld.
2.2 Aureal's Sale Obligation. Subject to the Phase Out Period
in Section 2.4 and the terms and conditions of this Agreement (including, but
not limited to, Section 3 "Minimum Purchase Commitments"), Aureal agrees that it
will provide Add-In Sound Cards to Diamond [****]. Additionally, nothing in this
Agreement shall prohibit Aureal from selling, either directly or through other
direct and indirect distribution channels, Aureal Chips in conjunction or in
connection with or for incorporation into any audio technology other than Add-In
Sound Cards.
2.3 Diamond Purchase Obligation. Subject to the Phase Out
Period in Section 2.4, Aureal will sell the Aureal Add-In Sound Cards to Diamond
pursuant to the terms and conditions set forth in Sections 2 and 5. Diamond will
exclusively use the Aureal Add-In Sound Cards for the Diamond Channels. Diamond
does not have a similar restriction on the Named OEM channels, however if
Diamond uses a non-Aureal chip in the Named OEM channels, Diamond can not use
the Monster brand name for such products. Aureal and Diamond will cooperate on
sales opportunities which require a different business model on a case by case
basis.
2.4 Phase Out Period.
[****] Confidential Treatment Requested
2
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2.4.1 Diamond. [****]
2.4.2 Aureal. [****]
2.5 Specifications of Aureal Products. From time to time,
Aureal and Diamond will mutually agree upon the specifications and functionality
of the Aureal Audio Products to be supplied by Aureal hereunder, and Aureal and
Diamond will work together to use commercially reasonable efforts to provide to
Diamond, Aureal Audio Products in accordance with such agreed upon
specifications and including such agreed upon functionality.
2.6 Prices.
2.6.1 Motherboard. [****]
2.6.2 Add-In Sound Card. Aureal will sell Add-In
Sound Cards to Diamond for the Diamond Channel pursuant to the pricing formulas
set out in Exhibit B.
3. Minimum Purchase Commitments. Aureal's obligation in Section 2.2
("Aureal's Sale Obligation") is subject to, among other things, [****]
("Diamond's Minimum Commitment"). The prices of such Add-In Sound Cards shall be
set forth in Exhibit B. These purchase orders shall be non-cancelable. If
Diamond fails to purchase such amounts, it shall submit payment for the balance
due for each of the quarters' remaining commitments, at the end of each quarter.
4. Warranties
4.1 Customer Response. Aureal shall deliver the Add-In Sound
Card product to Diamond based upon an agreed specification. Within 5 days after
receipt, Diamond shall accept the deliverable in writing or provide Aureal with
a written statement of defects for the Add In Sound Card. Aureal shall promptly
correct the defects and redeliver the Add-In Sound Card as soon as practicable.
4.2 Limited Software Warranty. Aureal warrants to Diamond that
the Software furnished with Aureal Audio Products will substantially conform
with Aureal's published specifications for such Software on the date of the
order for such Aureal Audio Products for a period of ninety (90) days after
delivery of the first copy of the first version of the software for the Aureal
Audio Products to Diamond. This warranty shall apply only if the Software is
properly used in accordance with the procedures described in the documentation
supplied by Aureal. Defects in the Software will be reported to Aureal in a form
and with supporting information reasonably requested by Aureal to enable Aureal
to document and reproduce the error at Aureal's facilities, and to diagnose and
correct the defect. THE FOREGOING IS DIAMOND'S SOLE AND EXCLUSIVE REMEDY FOR
BREACH OF WARRANTY BY AUREAL WITH RESPECT TO THE SOFTWARE.
4.3 Limited Hardware Warranty. For a period of one year after
delivery of a particular Aureal Audio Product to Diamond, Aureal warrants to
Diamond that such Hardware will substantially conform with the published
specifications for the Hardware on the date of the order if properly used in
accordance with procedures described in the documentation supplied by Aureal.
Diamond shall notify Aureal of any nonconformance during the warranty period,
and subject to Aureal's standard RMA
[****] Confidential Treatment Requested
3
<PAGE> 4
procedures, obtain a return material authorization ("RMA") for the nonconforming
Hardware from Aureal, and ship the nonconforming Hardware to Aureal's designated
repair facility, freight prepaid, within five (5) days of receipt of the RMA
with a statement which includes the RMA number, sufficient information to
identify the original purchase order and a brief statement explaining the
alleged nonconformity. Aureal's exclusive obligation with respect to
nonconforming Hardware shall be, at Aureal's option, to repair or replace such
Hardware, or to refund to Diamond the purchase price paid for the Hardware. THE
FOREGOING IS DIAMOND'S SOLE AND EXCLUSIVE REMEDY FOR BREACH OF WARRANTY BY
AUREAL WITH RESPECT TO THE HARDWARE.
4.4 Limitation on Warranty. The warranties set forth above
shall not apply to any Add-In Sound Card which has been modified, repaired or
altered, except by Aureal, or which has not been maintained in accordance with
any handling or operating instructions supplied by Aureal, or which has been
subjected to unusual physical or electrical stress, misuses, abuse, negligence
or accidents. The warranties herein are between Aureal and Diamond and do not
entitle Diamond's customers to any service directly by Aureal.
4.5 Disclaimer of Warranties. THE FOREGOING WARRANTIES ARE THE
SOLE WARRANTIES, EXPRESS OR IMPLIED, GIVEN BY AUREAL IN CONNECTION WITH THE
ADD-IN SOUND CARDS AND AUREAL DISCLAIMS ALL OTHER WARRANTIES, INCLUDING
WARRANTIES OF MERCHANTABILITY, FITNESS FOR A PARTICULAR PURPOSE AND
NONINFRINGEMENT OF THIRD PARTY RIGHTS. AUREAL DOES NOT WARRANT THAT THE SOFTWARE
WILL OPERATE CONTINUOUSLY OR BE ERROR-FREE.
4.6 Hardware and Software Design Defects. Diamond and Aureal
shall meet and confer on a regular basis to discuss product performance and
reliability issues. In the event that defects are identified by either party in
either the hardware or software portions of the products each problem will be
assigned a mutually agreed upon severity code. Severity code 1 problems shall be
those defects that cause interruption of the operation of the user's computer in
such a way that requires the computer to be rebooted to continue, corrupts data,
or results in the non-operation of major functionality of the product where such
non-operation cannot be restored by a user initiated workaround. Severity code 2
problems shall be those that are not code 1 problems, but are of greater than
cosmetic or nuisance level problems and include but are not limited to issues
that impair normal performance, or cause abnormal endings to operation of the
user's applications. Severity code 3 problems are those which are primarily
cosmetic in nature and do not impair the performance of the product or the users
normal operation of the product. Aureal will use its best efforts to correct
level 1 problems within 5 working days of such problems identification to a
level that allows the problem to be replicated. If a solution is not found
within 10 working days, Diamond shall be entitled to relief from its obligation
to accept future deliveries of affected products and relief from minimum
purchase quantities on a prorated basis after such 10 working day period until a
solution has been implemented to correct such code 1 problem. Aureal shall use
commercially reasonable efforts to correct severity code 2 problems within 10
working days of their identification to a level that allows reproduction of the
problem. For severity code 3 problems Aureal shall use commercially reasonable
efforts to correct such problems in the next regularly scheduled release of a
hardware or software update.
5. General Order, Delivery and Payment Terms.
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<PAGE> 5
5.1 Purchase Orders. The terms of this Agreement will govern
all purchase orders issued by one party ("Diamond") to the other party
("Aureal") hereunder (except for shipping addresses, quantities and delivery
dates specified therein) and all inconsistent terms and conditions on purchase
orders, acknowledgments or invoices issued to or by either party are superseded
and of no force or effect. All purchase orders are subject to acceptance by the
Aureal at its principal place of business and unless the Aureal rejects a
purchase order within five (5) days after receipt thereof, such purchase order
shall be deemed accepted.
5.2 Releases. Add-In Sound Cards shall be released for
shipment in accordance with the applicable release procedures regarding quality
control, inspection, permits and certifications, all as more particularly
described in Exhibit F ("Release Procedures") attached hereto. Aureal and
Diamond will jointly define the Release Procedures.
5.3 Rescheduling and Cancellation. No purchase orders
submitted by Diamond to Aureal hereunder may be canceled. Shipments of purchase
orders may be rescheduled at no charge, provided that (i) no purchase order is
rescheduled more than one time; (ii) shipment dates are not extended more than
ninety (90) days beyond that originally specified in the purchase order; and
(iii) quantities specified in purchase orders are not increased or decreased by
more than twenty-five percent (25%), provided however, that this Section shall
not apply to the quantities purchased under Section 3, Minimum Purchase
Commitments.
5.4 Shipping. Aureal will use commercially reasonable efforts
to ship Aureal Audio Products ordered by Diamond in the quantities and by the
dates specified in purchase orders but Aureal shall have no liability for
failing to so ship such products. In the event inventory is insufficient to meet
purchase orders, the Aureal will use commercially reasonable efforts to allocate
available inventory to all of its customers on a reasonably equitable basis. All
shipments by a Aureal will be shipped F.O.B. Aureal's shipping point.
5.5 Acceptance. Each Aureal Audio Product must conform in all
material respects to the applicable Specifications. Unless Diamond gives written
notice of rejection within thirty (30) days of shipment, the products shall be
deemed accepted. Should Diamond notify Aureal within said thirty (30) day period
that the product is non-conforming, then Diamond, upon receipt of authorization
from Aureal, shall promptly return the non-conforming product to Aureal in
accordance with Aureal's return material procedure, accompanied by a written
explanation of the reasons for the return. Aureal's exclusive obligation with
respect to non-conforming product shall be, at Aureal's option, to repair or
replace such product or to refund to Diamond the purchase price paid for the
product.
5.6 Payments. All invoices shall be paid for by the Diamond
within thirty (30) days after the date of the Aureal's invoice. Aureal will not
invoice the Diamond for Products until they have been shipped.
Payments shall be delivered to Aureal as follows:
Aureal Semiconductor Inc.
Attn: Accounts Receivable
4245 Technology Drive
Fremont, CA 95438
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<PAGE> 6
5.6.1 Revenue Sharing. Aureal and Diamond will meet
on a monthly basis to review and reconcile the revenue sharing model as set
forth in Exhibit B. Diamond and Aureal will appoint designated persons at their
respective companies to administer the revenue sharing program.
5.7 Taxes. The prices hereunder do not include state, federal
or local taxes, duties, penalties or interest and the Diamond is responsible for
the payment of all taxes imposed as a result of the transactions contemplated by
this Agreement, other than those based on the Aureal's net income.
5.8 Audit Rights. Both parties, at their own initial expense,
may audit or have a third party audit the records and supporting documentation
of the other party relating to the costs and other required information to
calculate the revenue sharing information set forth in Exhibit B. Audits will be
conducted not more than once per quarter during normal business hours. Each
party will provide the other with reasonable access to its premises during
normal business hours.
6. Ownership.
6.1 Aureal Rights. Notwithstanding anything else, as between
the parties, Aureal retains (i) all Proprietary Rights in and to the Aureal
Chips (including all technology and know-how incorporated therein or used in the
development thereof) and all copies, modifications, improvements and derivative
works thereof (by whomever produced), and all related documentation and
materials and (ii) all of its service marks, trademarks, trade names or any
other designations (and notwithstanding anything else herein, Diamond may not
use any name, mark or designation used by Aureal or its licensors except for use
in advertising or marketing the Aureal Audio Products as expressly provided in
Exhibit D).
6.2 Diamond Rights. Notwithstanding anything else, as between
the parties, Diamond retains all of its service marks, trademarks, trade names
or any other designations (and notwithstanding anything else herein, Aureal may
not use any name, mark or designation used by Diamond or its licensors except
for use in advertising or marketing the Aureal Chips and Add-In Sound Cards as
expressly provided herein).
7. Distribution of Add-In Sound Cards.
7.1 Distribution by Diamond. The parties agree that subject to
the terms and conditions of this Agreement, Diamond has the (i) non-exclusive
right to distribute Add-In Sound Cards to the Diamond Channel on a worldwide
basis as a product jointly branded with Aureal and (ii) non-exclusive right to
distribute Add-In Sound Cards to OEM's under its own brand name or in
conjunction with Aureal. [****]. Diamond will receive [****].
7.2 Distribution by Aureal. The parties agree that subject to
the terms and conditions of this Agreement, Aureal has [****]. Diamond and
Aureal agree to meet and discuss the direct marketing programs of both Diamond
and Aureal on or before December 31, 1998 to review the impact of such programs
on the retail and distribution channels and the impact on the minimum purchase
quantities and the minimum margin requirements for extension of this Agreement
for the purpose of revisiting those commitments in light of the volumes being
sold through direct marketing programs. Furthermore, in recognition of the sales
and marketing efforts Diamond will do to promote the Aureal brand under this
Agreement, [****].
[****] Confidential Treatment Requested
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<PAGE> 7
7.3 Diamond Option. Aureal is developing certain products
including a audio/modem combo card. Aureal shall give Diamond the right to
distribute such products through the Diamond channels provided the parties can
agree on reasonable minimum purchase requirements. Diamond shall have 15
business days from Aureal's written offer to include these products into this
agreement. If Diamond chooses not to add these products to this relationship,
Aureal is free to distribute them under the Aureal brand name or other brand
name in all markets and sales channels.
7.4 Named OEM Program. Aureal will provide a Diamond option to
OEM's for inclusion of a customized Diamond interfaces and brand name into
product on a licensed basis between Diamond and the Named OEM. Aureal will use
its best efforts to make Diamond aware of all such opportunities. Aureal will
notify a Diamond designated sales representative when Aureal intends to visit a
Named OEM for sales visits. Diamond will have the right to make a joint sales
call to the Named OEM. If the Named OEM does not want the Diamond option, Aureal
will proceed to sell the Named OEM a product directly from Aureal or through
Aureal's contract manufacturer. Diamond is not precluded from providing the
Named OEM with another audio chip solution. Diamond and Aureal will meet on a
regular basis to review various upcoming opportunities at the Named OEM's.
7.5 [****] Program. To the extent Aureal produces [****]
products and offers them to Diamond, Diamond agrees to include such products for
sale in the Diamond channel. Aureal and Diamond agree to meet promptly upon
inclusion of such products into the agreement to determine minimum purchase
commitments for the current period.
7.6 Branding.
7.6.1 The branding of Add-In Sound Cards distributed
under this Section 7.6 shall be in accordance with the procedures and
requirements set forth in Section 9 ("Labeling and Joint Marketing Obligations")
and Exhibit D ("Branding Procedure") attached hereto. In its distribution
efforts, will use the then-current names used by Aureal for the Aureal Chips
(but will not represent or imply that it is Aureal or is a part of Aureal), and
with respect to any jointly-branded product, neither party will represent or
imply that it is the other party or a part of the other party.
7.6.2 Each party ("Licensor") grants to the other party
("Licensee") a non-exclusive, non-transferable, limited license to use all
trademarks, service marks, trade names, logos or other words or symbols set
forth in Exhibit E ("Trademarks") (collectively, the "Marks") solely in
connection with the marketing and distribution of the Add-In Sound Cards sold by
Aureal to Diamond. The Marks of each Licensor are and will remain their
exclusive property. Licensee will not take any action that jeopardizes
Licensor's proprietary rights, or acquire any rights, in the Marks, except the
limited use rights specified herein. Licensee understands and agrees that use of
the Marks shall not create any right, title or interest in or to the use of the
Marks and that all such uses and goodwill associated with the Marks will be to
the benefit of Licensor. Except as otherwise agreed in writing, Licensee will
not register, directly or indirectly, any trademark, service mark, trade name,
copyright, company name or other proprietary or commercial right which is
identical or confusingly similar to the Marks or which are translations thereof
in any other language(s). Upon Licensor's request, Licensee will execute such
instruments and take such actions that may be appropriate to register, maintain
or renew the registration of the Marks in Licensor's
[****] Confidential Treatment Requested
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<PAGE> 8
name and/or protect Licensor's interest in the Marks. Licensee may use the Marks
solely in connection with Licensee's permitted activities under this Agreement,
provided Licensee clearly identifies Licensor's ownership of such Marks.
Licensor reserves the right to require Licensee to submit all advertising and
marketing material to Licensor for review and approval prior to release by
Licensee. Licensor may require Licensee to discontinue use of any advertising
and marketing materials that Licensor reasonably believes will have a
detrimental effect on Licensor's business. Licensee shall cooperate with
Licensor upon request to ensure that Licensee's use of the Marks conform to the
Licensor trademark policies and use guidelines as in effect from time to time.
7.7 Rights and Obligations of Customers. Where applicable and
reasonably possible, all distributions of Add-In Sound Cards must be subject to
a license agreement with terms (i) no less restrictive or materially less
protective of each party's rights in the Add-In Sound Cards than this Agreement
and (ii) disclaiming each party's warranties and limiting each party's liability
consistent with the terms of this Agreement. For each jurisdiction in which
Add-In Sound Cards are distributed, each party has the responsibility to use
commercially reasonable efforts (i) to use a license agreement that is
enforceable under and complies with the laws of such jurisdiction and (ii) to
use its diligent efforts to ensure that its Resellers, OEM's and End-Users
comply with the terms relating to each party's rights as contained in such
license agreements.
7.8 Sales Reports. Both parties will cooperate in preparing
and implementing training, sales and marketing presentations. Diamond agrees to
provide Aureal with periodic reports on or before the 5th day of each month
containing the following information:
a) Inventory report on Add-In Sound Cards
b) Two quarter rolling sales forecasts
c) Individual product sales and backlog data by
region and channel.
Aureal and Diamond Sales and Marketing representatives will meet on a monthly
basis to review sales and promotion opportunities throughout the Diamond
Channel.
8. Covenants.
8.1 Diamond Covenants. Diamond agrees:
8.1.1 that it will be responsible for the support and
maintenance of all Add-In Sound Cards distributed by them in accordance with
support and maintenance procedures to be negotiated in good faith and mutually
agreed upon by the parties;
8.1.2 to use its diligent efforts to successfully
market and distribute Add-In Sound Cards on a continuing basis and to comply
with good business practices and all laws and regulations relevant to this
Agreement or the subject matter hereof;
8.1.3 to use reasonable efforts to keep Aureal
informed as to any problems encountered with the Aureal Chips and any
resolutions arrived at for those problems, and to communicate promptly to Aureal
any and all modifications, design changes or improvements of the Aureal Chips
suggested by any customer, employee or agent. Diamond further agrees (i) that
Aureal shall have any and
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<PAGE> 9
all right, title and interest in and to any such suggested modifications, design
changes or improvements of the Aureal Chips, without the payment of any
additional consideration therefor either to Diamond, or its employees, agents or
customers and (ii) that it will cooperate with Aureal in connection with the
foregoing; and
8.1.4 to conduct its business in a manner which
favorably reflects upon Aureal.
8.2 Mutual Covenants. Each party agrees:
8.2.1 to comply with all export laws and restrictions
and regulations of the Department of Commerce or other United States or foreign
agency or authority, and not to export, or allow the export or re-export of any
Proprietary Information (as defined in Section 11.1 ("Obligation") below),
Aureal Chips or any direct product thereof in violation of any such
restrictions, laws or regulations, or to Afghanistan,] or any Group Q, S, W, Y
or Z country specified in the then current Supplement No. 1 to Section 770 of
the U.S. Export Administration Regulations (or any successor supplement or
regulations) and in the event Diamond requests that a Product be shipped to a
location requiring any licenses or permits in addition to those already
possessed by the Aureal, the Diamond shall obtain and bear all expenses relating
to such licenses or permits, or obtain exemptions therefrom, and shall, at the
Aureal's request, demonstrate compliance with all applicable laws and
regulations prior to delivery thereof by such Aureal;
8.2.2 to, in addition to and without in any way
limiting the obligations of each party hereunder, use all reasonable methods to
protect the other party's rights with respect to the Aureal Audio Products and
Proprietary Information (as applicable) as it uses to protect its own or any
third party's software, confidential information or rights;
8.2.3 that all advertising and marketing materials
relating to the Products and/or the other party shall be accurate in all
material respects; and
8.2.4 to designate one of its employees as the
contact person for the administration of this Agreement ("Contract
Representative") and to advise the other party of such employee's name, mailing
address and telephone number.
8.2.5 to use commercially reasonable efforts to
ensure that neither this Agreement (or any term hereof) nor the performance of
or exercise of rights under this Agreement, is restricted by, contrary to, in
conflict with, ineffective under any law or regulation known by a party to be
applicable to it. To the extent any such law or regulation requires registration
or approval of the Agreement or requires tax withholding by a party under the
Agreement or any termination payment or compulsory licensing with regard to the
Agreement, such party shall satisfy such obligations.
9. Labeling and Joint Marketing Obligations.
9.1 Proprietary Notices. Diamond shall not remove any
copyright notices or proprietary legends contained within the Aureal Chips and
Add-In Sound Cards. Further, Diamond shall include a copyright notice on all
Add-In Sound Cards containing Aureal Chips (and all packaging, specification
sheets and advertising for such products) that reflects the copyright ownership
of Diamond and Aureal as follows:
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<PAGE> 10
(C) 19__ Diamond and its licensors.
All rights reserved.
In addition, anytime software utilizing the Aureal Chips displays copyright
information to the End-user, a notice substantively similar to the following
shall be included therein:
Aureal 3D(TM) technology is provided by Aureal Semiconductor
Inc. (C) 1987-1998 Aureal Semiconductor Inc., All Rights
Reserved. A3D Interactive(TM) and logos are trademarks of
Aureal Semiconductor Inc.
9.2 Marking by Diamond. Subject to Section 7.6 ("Branding"),
Diamond hereby agrees to mark all products designed, made for or by, and sold by
Diamond, which incorporate the Aureal Audio Products (as well as all packaging,
specification sheets and advertising for such products) with the applicable
Aureal trademarks and copyright and/or patent notices, in a form reasonably
acceptable to Aureal or as detailed in Exhibit D.
9.3 Display of Logos. Diamond shall be required to prominently
display the Aureal 3D(TM) logo (or any other appropriate logo so designated by
Aureal upon prior approval from Diamond, which shall not be unreasonably
withheld), as provided by Aureal, on the front of the outside package and
booklet of all Add-In Sound Cards that incorporate the Aureal Chips. The size
and location (on the front of the box) of such display shall be noticeable and
readily apparent to the average consumer as detailed in Exhibit D. Diamond shall
make available to its system integrator customers the right to include the
Aureal 3D(TM) logo on their products as described in this section.
9.4 Advertising. Diamond agrees that all advertising,
marketing or promotional materials that Diamond transmits or distributes that
mention the 3-D audio technology or capabilities of products incorporating the
Aureal Chips, shall prominently display the A3D logo in all advertising and give
prominent credit to Aureal as the provider of the audio technology as detailed
in Exhibit D. Aureal shall have the opportunity to review and approve all
packaging, which approval shall not be unreasonably withheld. Aureal will have
input into the creative process for advertising and promotion and will jointly
be involved with Diamond on the administration of the promotion funds identified
in this agreement.
9.5 Additional Obligations. The parties will also perform the
obligations with respect to joint marketing of the Products as set forth in
Exhibit D ("Branding Procedure") attached hereto.
9.6 Marketing and Advertising Funds. Diamond will set aside a
marketing budget to be jointly administered between the companies in the amounts
set forth in Exhibit B. Diamond and Aureal representatives will meet to identify
and approve specific marketing and advertising programs in which to use the
agreed upon budget together with a specific budget for each such program. The
parties will mutually agree on which party, Diamond or Aureal, will administer
the specific programs in accordance with the budget requirements. The
representatives will meet on a weekly basis to review the programs.
9.7 Future Products. Aureal and Diamond will collaborate on
other prospective board design integration and chip feature implementations for
future products and also on [****] implementations.
10. Limitation of Liability. NOTWITHSTANDING ANYTHING ELSE IN THIS
AGREEMENT OR OTHERWISE, NEITHER PARTY WILL BE LIABLE WITH RESPECT TO ANY SUBJECT
MATTER OF
10
[****] Confidential Treatment Requested
<PAGE> 11
THIS AGREEMENT UNDER ANY CONTRACT, NEGLIGENCE, STRICT LIABILITY OR OTHER LEGAL
OR EQUITABLE THEORY (I) FOR ANY SPECIAL, INCIDENTAL, CONSEQUENTIAL OR INDIRECT
DAMAGES OR LOST DATA OR (II) FOR COST OF PROCUREMENT OF SUBSTITUTE GOODS,
TECHNOLOGY OR SERVICES. THIS LIMITATION SHALL APPLY EVEN IF A PARTY HAS BEEN
ADVISED OF THE POSSIBILITY OF SUCH DAMAGES.
11. Indemnities.
11.1 By Aureal. Aureal shall defend, indemnify and hold
Diamond and its officers, directors, agents and employees harmless from
liability resulting from infringement by the Aureal Audio Products of any
patent, copyright or trade secret provided that: (i) Aureal is promptly notified
of any and all threats, claims and proceedings related thereto; (ii) Aureal
shall have sole control of the defense and/or settlement thereof and Diamond
shall not settle or compromise any such claim without Aureal's prior written
consent; (iii) Diamond furnishes to Aureal, upon request, all information
available to Diamond related to the defense of such claim; and (iv) Diamond
provides Aureal with reasonable assistance at Aureal's expense. The foregoing
obligation of Aureal does not apply (i) to the extent that such infringement
results from Aureal Audio Products or portions or components thereof that are
(A) not supplied by Aureal; (B) modified after shipment by Diamond; (C) combined
with other products, processes, methods or materials, where such other products,
processes, methods or materials were required to sustain the infringement action
(ii) where Diamond continues the allegedly infringing activity after being
notified thereof or after being informed of modifications that would have
avoided the alleged infringement, or (iii) to the extent that Diamond's use of
the Aureal Audio Products is incident to an infringement not resulting primarily
from the Aureal Audio Products. Diamond shall indemnify Aureal and its officers,
directors, agents and employees from all damages, settlements, attorneys' fees
and expenses related to a claim of infringement or misappropriation excluded
from Aureal's indemnity obligation by this sentence.
11.2 By Diamond. Subject to Aureal's obligations under Section
11.1 ("By Aureal"), Diamond shall hold Aureal and its officers, directors,
agents and employees harmless from liability resulting from (i) infringement by
any Diamond product not attributable to the Aureal Audio Product and (ii)
Diamond's distribution of the such product, provided that: (i) Diamond is
promptly notified of any and all threats, claims and proceedings related
thereto; (ii) Diamond shall have sole control of the defense and/or settlement
thereof; (iii) Aureal furnishes to Diamond, upon request, information available
to Aureal for such defense; and (iv) Aureal provides Diamond with reasonable
assistance at Diamond's expense.
12. Confidentiality.
12.1 Obligation. Each party agrees that (i) all inventions,
algorithms, processes, technology, know-how and ideas and all other business,
technical and financial information it obtains from the other and (ii) the terms
and conditions of this Agreement shall constitute the confidential property of
the other party ("Proprietary Information"). Except as expressly allowed in this
Agreement, the receiving party will hold in confidence and not use or disclose
any Proprietary Information of the disclosing party and shall similarly bind its
employees in writing. The receiving party shall not be obligated under this
Section with respect to information the receiving party can document:
(a) is or has become readily publicly available through no
fault of the receiving party or its employees or agents; or
11
<PAGE> 12
(b) is received from a third party lawfully in possession of
such information and lawfully empowered to disclose such information and
provided the receiving party abides by all restrictions imposed by such third
party; or
(c) was rightfully in the possession of the receiving party
prior to its disclosure by the other party provided the receiving party abides
by all restrictions imposed on its possession of such information; or
(d) was independently developed by the receiving party without
use of the disclosing party's Proprietary Information.
(e) is required to be disclosed subject to Securities Exchange
Commission or other regulatory agency requirements.
12.2 Injunctive Relief. Each party agrees that any breach of
the confidentiality obligations contained in this Section 12 may cause
irreparable harm for which monetary damages will not be an adequate remedy, and
that each party shall, in addition to any other remedies available to it, be
entitled to seek all equitable remedies including injunctive relief to prevent
any such breach by the other party.
13. Term and Termination.
13.1 Term. This Agreement shall commence upon the Effective
Date and shall continue for a period of two (2) years unless terminated earlier
pursuant to Section 12.2 below. Thereafter, this Agreement shall renew for a
successive one (1) year period to include the following minimum purchase
commitment. [****].
13.2 Review Period. On or before December 31, 1998 both
parties will review the progress under this Agreement. Either party may decide
at that time to terminate the Agreement and will be no longer bound by its
terms. If the parties agree to continue, Aureal and Diamond will negotiate
minimum purchase commitments for each quarter in 1999. Provided however, that
the minimum purchase commitment will not be less than an aggregate of [****].
13.3 Termination for Breach. This Agreement may be terminated
by a party for cause immediately upon the occurrence of any of the following
events:
(1) if the other ceases to do business, or otherwise
terminates its business operations; or
(2) if the other materially breaches any material
provision of this Agreement and fails to fully cure such breach within thirty
(30) days (ten (10) days in the case of a failure to pay and immediately in the
case of a breach of Section 11 ("Confidentiality")) of written notice describing
the breach; or
(3) if the other ceases to fully support the audio PC
business on a commercial basis; or
[****] Confidential Treatment Requested
12
<PAGE> 13
(4) failure of Diamond to met the minimum purchase
commitment as set forth in Section 3, or as amended pursuant to Section 13.2 or
adjusted in accordance with Section 4.3.
(5) if the other shall seek protection under any
bankruptcy, receivership, trust deed, creditors arrangement, composition or
comparable proceeding, or if any such proceeding is instituted against the other
(and not dismissed within ninety (90) days).
13.4 Effect of Termination. In the event of any termination of
this Agreement, the parties shall return to each other or destroy all copies of
all Proprietary Information and shall provide to each other a certificate of an
authorized representative to the effect that such return or destruction has
occurred. If the Agreement is terminated due to Diamond's failure to meet
Section 3, Diamond shall immediately pay Aureal the balance due to reach the
then current quarterly requirement. Furthermore, all outstanding and unaccepted
purchase orders for Aureal Audio Products as of the effective termination date
will no longer be of any force or effect and purchase orders which have been
accepted shall be shipped by Aureal. Each party may continue to distribute
Add-In Sound Cards remaining in their respective inventory as of the effective
termination date pursuant to the terms of this Agreement.
13.5 Survival. Sections 4.5 ("Warranty Disclaimer"), 5
("General Order, Delivery and Payment Terms"), 6 ("Ownership"), or 10
("Limitation of Liability"), 11 ("Indemnities"), 12 ("Confidentiality"), 13
("Term and Termination") and 14 ("General") of this Agreement shall survive any
termination or expiration hereof. In particular, upon any termination or
expiration of this Agreement, each party shall retain all amounts received from
the other party prior to termination.
14. General.
14.1 Governing Law. This Agreement will be governed in all
respects by the laws of the United States of America and the State of
California, without regard to conflicts of laws provisions thereof and without
regard to the United Nations Convention on Contracts for the International Sale
of Goods. All disputes arising under this Agreement shall be brought in the
Superior Court of the State of California in Santa Clara County or the Federal
District Court located in San Jose as permitted by law. The Superior Court of
Santa Clara County and Federal District Court located in San Jose shall have
nonexclusive jurisdiction over disputes arising under or related to this
Agreement. Diamond and Aureal hereby submit to the personal jurisdiction of the
above courts.
14.2 No Agency. Aureal and Diamond are strictly independent
contractors and shall so represent themselves to all third parties. Neither
party has the right to bind the other in any manner whatsoever except as
expressly provided in this Agreement, and nothing in this Agreement will be
interpreted to make either party the agent, legal representative, employer or
franchiser of the other, or to make the parties partners or joint ventures.
14.3 Assignability. This Agreement shall not be assigned by
either party or by operation of law, without the prior written consent of the
other party. However, either party may assign this Agreement upon prior written
notice in connection with a merger, consolidation, reorganization or sale of all
or substantially all of such party's business, stock or assets that are related
to the performance of this Agreement. Any attempted assignment in contravention
of this Section will be null and void. This
13
<PAGE> 14
Agreement will be binding upon and inure to the benefit of the parties, their
successors and permitted assigns.
14.4 Waiver. The waiver of one breach or default under this
Agreement will not constitute a waiver of any subsequent breach or default. Any
provision of this Agreement held illegal or unenforceable, will be deemed
amended to conform to applicable laws and regulations, or if it cannot be so
amended without materially altering the intention of the parties, it will be
stricken and the remainder of this Agreement will continue in full force and
effect. WITHOUT LIMITING THE FOREGOING, THE PARTIES AGREE THAT IF ANY REMEDY
UNDER THIS AGREEMENT IS DETERMINED TO HAVE FAILED OF ITS ESSENTIAL PURPOSE, ALL
LIMITATIONS OF LIABILITY AND EXCLUSIONS OF DAMAGES SET FORTH IN THIS AGREEMENT
SHALL REMAIN IN FULL FORCE AND EFFECT.
14.5 Notices. All notices in connection with this Agreement
shall be deemed given upon actual receipt by the party being notified after
being deposited in the U.S. mail, postage prepaid, first class, certified or
registered, return receipt requested, or sent by overnight courier, charges
prepaid, in each case sent to a party's address as set forth in the opening
paragraph of this Agreement or to such other address designated by a party
hereto by notice in accordance with this Section.
14.6 Attorneys' Fees. The prevailing party in any action or to
enforce the terms of this Agreement shall be entitled to reimbursement by the
other party for all costs (including reasonable attorneys' fees) incurred in
connection with such proceeding, in addition to any other remedies to which it
may be entitled.
14.7 Integration. This Agreement and its attached Exhibits
constitutes the entire and exclusive agreement between the parties hereto with
respect to its subject matter and merges all other communications and
discussions, oral or written. Diamond acknowledges that it is not entering into
this Agreement on the basis of any representations not expressly contained in
the Agreement. No employee, agent or other representative of Aureal has any
authority to bind Aureal with regard to any statement, representation or
warranty unless the same is specifically set forth or incorporated by reference
in this Agreement. Other than as specified herein, this Agreement may only be
supplemented, modified or waived in writing signed by all parties.
14.8 Counterparts. This Agreement may be executed in
counterparts, each of which will be deemed an original, but all of which
together will constitute one in the same instrument.
14.9 Press Releases. On the Effective Date of this Agreement,
the parties will release mutually agreeable joint press releases announcing the
relationship established by this Agreement.
14.10 Section Headings. The Section headings in the Agreement
are inserted only as a matter of convenience and shall not be used in the
interpretation thereof.
14
<PAGE> 15
IN WITNESS WHEREOF, the parties have executed this Agreement as of the
date first written above.
DIAMOND MULTIMEDIA SYSTEMS, INC. AUREAL SEMICONDUCTOR INC.
By: /s/ William J. Schroeder By: /s/ Kenneth A. Kokinakis
-------------------------- ---------------------------------
(Signature) (Signature)
William J. Schroeder KENNETH A. KOKINAKIS
---------------------------- -------------------------------------
(Printed Name) (Printed Name)
President and CEO PRESIDENT AND CHIEF EXECUTIVE OFFICER
-------------------------- -------------------------------------
(Title) (Title)
15
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE
CONSOLIDATED FINANCIAL STATEMENTS FOR THE FISCAL QUARTER ENDED JUNE 28, 1998,
AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS.
</LEGEND>
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 3-MOS
<FISCAL-YEAR-END> JAN-03-1999
<PERIOD-START> DEC-29-1997
<PERIOD-END> JUN-28-1998
<CASH> 116
<SECURITIES> 0
<RECEIVABLES> 3,453
<ALLOWANCES> 0
<INVENTORY> 5,138
<CURRENT-ASSETS> 10,326
<PP&E> 3,999
<DEPRECIATION> 2,169
<TOTAL-ASSETS> 13,561
<CURRENT-LIABILITIES> 4,741
<BONDS> 0
0
0
<COMMON> 42
<OTHER-SE> 6,194
<TOTAL-LIABILITY-AND-EQUITY> 13,561
<SALES> 3,436
<TOTAL-REVENUES> 3,436
<CGS> 2,033
<TOTAL-COSTS> 2,033
<OTHER-EXPENSES> 5,360
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 1,540
<INCOME-PRETAX> (5,446)
<INCOME-TAX> 0
<INCOME-CONTINUING> (5,446)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (5,446)
<EPS-PRIMARY> (0.42)
<EPS-DILUTED> (0.42)
</TABLE>
