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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-K/A
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ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED JANUARY 3, 1999
COMMISSION FILE NUMBER 0-20684
AUREAL SEMICONDUCTOR INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
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DELAWARE 94-3117385
(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.)
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4245 TECHNOLOGY DRIVE
FREMONT, CALIFORNIA 94538
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)
(510) 252-4245
(REGISTRANT'S TELEPHONE NUMBER)
SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT: NONE
SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT:
COMMON STOCK, $0.001 PAR VALUE
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 last 90 days. Yes [X] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ ]
Indicate by check mark whether the registrant has filed all documents and
reports 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 [ ]
The aggregate market value of the voting stock held by non-affiliates of
the registrant as of March 22, 1999 was approximately $54 million based on the
closing bid price of Aureal's common stock as reported on the OTC Bulletin
Board. For purposes of this report only, Aureal assumes its affiliates to be its
officers, directors, entities associated with officers and directors, and
holders (or groups of associated holders) of ten percent or more of the common
stock of Aureal. As of March 22, 1999, Aureal had outstanding 65,453,386 shares
of common stock, par value $0.001.
DOCUMENTS INCORPORATED BY REFERENCE
Part III incorporates certain information by reference to the registrant's
definitive proxy statement relating to the annual meeting of stockholders
expected to be held on May 19, 1999.
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AUREAL SEMICONDUCTOR INC.
1998 FORM 10-K REPORT
TABLE OF CONTENTS
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PART I
Item 1. Business......................................... 1
Item 2. Properties....................................... 10
Item 3. Legal Proceedings................................ 10
Item 4. Submission of Matters to a Vote of Security
Holders.......................................... 10
PART II
Item 5. Market for the Registrant's Common Equity and
Related Stockholder Matters...................... 11
Item 6. Selected Financial Data.......................... 11
Item 7. Management's Discussion and Analysis of Financial
Condition and Results of Operations.............. 13
Item 8. Financial Statements and Supplementary Data...... 26
Item 9. Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure.............. 43
PART III
Item 10. Directors and Executive Officers of the
Registrant....................................... 43
Item 11. Executive Compensation........................... 43
Item 12. Security Ownership of Certain Beneficial Owners
and Management................................... 43
Item 13. Certain Relationships and Related Transactions... 43
PART IV
Item 14. Exhibits, Financial Statement Schedules, and
Reports on Form 8-K.............................. 43
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PART I
ITEM 1. BUSINESS.
THIS REPORT CONTAINS FORWARD-LOOKING STATEMENTS WITHIN THE MEANING OF
SECTION 27A OF THE SECURITIES ACT OF 1933 AND SECTION 21E OF THE SECURITIES
EXCHANGE ACT OF 1934. ANY FORWARD-LOOKING STATEMENTS MADE HEREIN ARE MADE
PURSUANT TO THE SAFE HARBOR PROVISIONS OF THE PRIVATE SECURITIES LITIGATION ACT
OF 1995. INVESTORS ARE CAUTIONED THAT ACTUAL RESULTS MAY DIFFER MATERIALLY FROM
THOSE PROJECTED IN ANY FORWARD-LOOKING STATEMENTS DUE TO A NUMBER OF FACTORS
INCLUDING, BUT NOT LIMITED TO, OUR DEPENDENCE ON THE PERSONAL COMPUTER AND
CONSUMER ELECTRONICS INDUSTRIES AND ON PRODUCT LINES BASED ON NEW TECHNOLOGIES;
FOUNDRY CAPACITY, AVAILABILITY AND RELIABILITY; COMPETITION AND PRICING
PRESSURES; OUR ABILITY TO SECURE ADDITIONAL FINANCING; AND OTHER RISKS DETAILED
BELOW AND FROM TIME TO TIME IN OUR FILINGS WITH THE SECURITIES AND EXCHANGE
COMMISSION. FOR A FURTHER DISCUSSION OF THE RISKS RELATING TO OUR BUSINESS, ALSO
SEE THE RISK FACTORS SECTION OF ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITIONS AND RESULTS OF OPERATIONS.
SUMMARY
Aureal is a market leader in interactive digital entertainment. Interactive
digital entertainment includes media forms such as computer games, interactive
movies, and 3D web-based entertainment where the audience takes a participatory
role, as opposed to traditional, passive entertainment forms such as books,
movies, and music. A key component of this market is the field "digital audio
imaging". Digital audio imaging is the process of creating a highly realistic
audio experience by closely simulating the real-world physics of audio
phenomenon.
We have been a driving force within this field with a series of audio
products for the personal computer (PC) and consumer electronics markets. These
products are based upon our core A3D technologies. A3D is the leading market
brand for digital audio imaging. We believe that digital audio imaging,
especially as provided by our products and technologies, will be a key factor in
improving the consumer experience in interactive digital entertainment
applications. These applications can be delivered through a variety of channels
and platforms. Currently, they are delivered primarily via multimedia software
on the PC. Increasingly, however, consumers are accessing these applications via
the internet and broadband networks using a PC or other device.
Our goal is to continue to enhance the consumer experience with these
entertainment applications by providing digital audio imaging products and
content to existing and future digital platforms. These products may take the
form of entertainment content, software, semiconductors, peripherals, or
multimedia components, and they will be able to leverage advanced digital audio
imaging within interactive entertainment applications. In our new products, we
will continue to leverage new hardware and software technology advancements from
industry leaders such as:
- Intel Corporation,
- Microsoft Corporation, and
- Motorola Inc.
We have seen success within the PC gaming market which has been one of the
largest markets for interactive digital content. We have been able to increase
the number of A3D-enabled games through continued evangelism of our technologies
to these game producers. This has led to a strong demand for add-in and
integrated audio products based on our Vortex audio processors which are
necessary to process and play the A3D-enabled game titles. By early 1999, after
a little more than a year of sales, we had shipped more than five million
A3D-enabled products to our customers.
We believe that the market for our digital audio imaging products is the
fastest growing portion of the PC audio market. We also believe that in the near
future, the market for interactive digital entertainment applications accessed
over the internet and delivered to PCs and other devices will begin to
proliferate. To service this market, we recently entered into a strategic
partnership with Flatland Online, Inc., a pioneer in internet 3D content
creation, to deliver digital audio imaging-enabled content creation tools to web
developers.
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By expanding our digital audio imaging-enabled content beyond the PC gaming
market onto the internet, we will increase our potential customer base for
current products and open up new avenues of potential product development. We
expect to see additional opportunities for content, software, add-in hardware,
and multimedia components for the PC and other internet-capable devices.
Over the past year, we have accomplished a number of significant milestones
within both the established PC gaming market and the emerging interactive
digital entertainment markets. These include:
- March 1999, we released our A3D 2.0 software development kit, which
enables the creation of interactive 3D audio content, to the general
development community. This kit had previously only been available to
selected game developers. The demand for CDs and internet downloads of
the kit reached into the thousands.
- Also in March 1999, we announced the formation of a partnership with
Flatland Online, Inc. As part of this partnership, we have integrated our
A3D 2.0 technology into Flatland's web tools and web browser extension
software providing the ability for web designers to include A3D directly
into their website.
- In February 1999, we received Computer Gaming World's prestigious Gaming
Hardware of the Year award for our Vortex2 audio processor. This event
was significant because it was the first time that the award was
presented to an audio hardware company, signifying a shift in industry
focus from graphics to audio. Also in February, we began web-based
distribution of our A3D Pro sound design software. This marked our first
foray into electronic commerce.
- In January 1999, we began direct sales to systems integrators. This
distribution channel accounts for at least one-fifth of worldwide
personal computer sales. We also announced an extension of our
relationship with Compaq Computer Corporation, in which Compaq agreed to
ship our Vortex sound card products in their new Presario 5600 desktop
computer products.
- In December 1998, we announced that Sony Electronics had begun shipping
new VAIO Digital Studio desktop computer products incorporating our
Vortex1 audio processors.
- In November 1998, we announced that Dell Computer Corporation had begun
shipments of new Dimension desktop computer products incorporating
Vortex2-based soundcards.
- In October 1998, we introduced a significant strategic alliance with
Motorola to deliver enhanced communications and audio solutions to the
personal computer market and also announced that Packard Bell (Europe)
had begun shipments of new Platinum and Pulsar desktop computer products
incorporating Vortex-based soundcards.
- In August 1998, we announced that Diamond Multimedia Systems' new MX300
soundcard would incorporate our Vortex2 audio processor. Since then, the
MX300 has won a significant number of industry awards.
- In July 1998, we announced a significant strategic relationship with
Diamond Multimedia Systems to co-develop and market next-generation PC
audio solutions.
- In June 1998, we announced that Compaq Computer Corporation had begun
shipments of new Presario desktop computer products incorporating A3D
audio technology.
- In April 1998, we introduced A3D 2.0, the next generation of our A3D
technology and began working with a number of top-tier game developers to
integrate A3D 2.0 into upcoming products.
- In February 1998, we announced that Dell Computer Corporation had begun
shipments of new Dimension desktop computer products incorporating
Vortex-based soundcards.
Our headquarters are located at 4245 Technology Drive, Fremont, CA 94538 in
a leased 36,000 square foot building. In January 1999, we leased an additional
8,000 square feet of office space in the vicinity of our Fremont headquarters to
meet the needs of continued expansion. We maintain additional office space in
Austin, Texas and Hong Kong.
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As of January 3, 1999, we employed 111 full-time, regular personnel. Of
this total, 74 were engaged in engineering functions, 26 were engaged in sales
and marketing roles, and 11 were engaged in administrative support. Competition
for qualified employees within our industry is intense. We consider our
relations with our employees to be good, and none of our employees are
represented by a labor union.
In March 1999, we reached, and our board of directors approved, an
agreement with our largest stockholders, those being certain funds and accounts
managed by Oaktree Capital Management, LLC, referred to as Oaktree, and by TCW
Special Credits, referred to as TCW, under which we will offer for sale $20
million of our common stock, at a price of $0.60 per share, under a subscription
rights offering. Stockholders of our common stock on the date of record will be
offered, on a pro-rata basis, the opportunity to purchase new shares of our
common stock. Oaktree and TCW, or any combination thereof, have agreed to
purchase any remaining unsubscribed shares of this offering, up to a maximum
amount of $20 million. In addition, we have also agreed to issue an additional
26.2 million shares of common stock to holders of our series B preferred stock
who convert those shares into common stock upon the closing of the rights
offering. These additional 26.2 million shares will not be registered but we
will grant standard demand and piggyback rights to the holders of those shares.
We understand that TCW and Oaktree, holders of all of our Series B preferred
stock, intend to convert their shares of Series B preferred stock into 20.5
million shares of common stock upon the closing of the rights offering. Oaktree
recently purchased the majority of the preferred stock previously held by DDJ.
These actions will effectively eliminate the majority of our preferred stock and
convert it to common stock. Subject to stockholder approval our board of
directors has also approved a one for fifteen reverse stock split, an increase
in the number of authorized shares reserved under our option plan and a change
in our name from Aureal Semiconductor Inc. to Aureal Inc.
INDUSTRY BACKGROUND
Over the past few years, the PC industry has seen revolutionary advances in
the area of 3D graphics technology fueled largely by rapid growth in PC gaming
and other forms of interactive digital entertainment. Only recently, however,
has the demand for improved audio technology increased. Makers of these
applications have been seeking means of differentiating their products within an
increasingly competitive marketplace, and many have turned to more realistic
audio as a means of accomplishing this.
Similarly, consumers of these products have come to expect advanced audio
features and are demanding better audio quality in the products they purchase.
We expect this trend to continue as even more applications for advanced PC audio
technologies emerge. We believe the drivers of PC audio technology will include,
in addition to gaming, DVD audio, MP3, multimedia products, and internet
communications and entertainment content.
The consumer electronics marketplace is also moving toward significant
advancements in audio technologies, especially with regard to home theater
applications. Motion picture sound quality has recently seen vast improvements
both in the recording and playback processes. In modern movie theaters, surround
sound presentations with multiple speakers immerse moviegoers with real-life
audio soundtracks, creating a more compelling entertainment experience. Bringing
these high-quality features into the home has been a long process, but with the
advent of new and more cost-effective technologies, the concept of the "home
theater" is becoming more widely accepted among mainstream entertainment
consumers.
Technology advances and cost decreases in home stereo, DVD, wide-screen and
digital television, and broadband entertainment television services is leading
consumers to invest in high-quality audio/visual components and systems. Over
time, television audio has evolved from single in-set speakers, to in-set stereo
speakers, to stereo audio connection with home audio equipment, to surround
sound home theater set-ups with four or more external speakers strategically
placed throughout the viewing environment. This shift in consumer awareness of
and demand for high-quality audio entertainment is providing us with new
opportunities for our technologies and products.
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AUREAL'S STRATEGY
Our objective is to become the leading provider of advanced digital audio
imaging solutions for interactive digital entertainment, regardless of the
delivery method or platform. We intend to leverage our experience and presence
in the PC gaming market to address the needs of new markets such as the internet
consumer electronics. We believe that our efforts within multiple interactive
digital entertainment markets are mutually complementary and that by leveraging
the successes within one of these markets, we will dramatically increase our
chances for success within the others. We are pursuing a focused strategy that
includes the following primary elements:
Strategic Branding: We believe that brand name recognition is an important
factor in consumer choices. Accordingly, we are building A3D and Vortex into
strong, recognizable brand identities across our products and technologies. By
trade-marking and strategically employing brand names including A3D and Vortex,
as well as the "Aureal" name itself, we are rapidly building a well-known
reputation for high-quality, innovative audio solutions.
To expand the public's recognition of our brand name, we are ensuring that
our customers include appropriate brand identification and positioning on the
Aureal based products they sell. We are aggressively evangelizing our
technologies to customers and trade and national press with the goal of ensuring
public recognition of our brands.
Product Diversification: By expanding our product lines to include
complementary areas of audio, from semiconductors and hardware peripheral
products to software and consumer electronics devices, we believe we will be
able to pursue numerous opportunities in the expanding markets for audio
products. We also believe that diversification of product offerings will enable
us to grow more rapidly and allow us to respond to emerging market needs in a
timely manner.
Strategic Partnerships: Through the development of strategic partnerships
with key industry influencers, we believe we will be able to strengthen our
position within the markets we serve. Relationships with certain key partners
will allow us to focus on our strengths while providing us with resources and
product offerings that will expand our reach into the world of PC and consumer
electronics audio. For example, in July 1998, we announced a strategic
partnership with Diamond Multimedia Systems, Inc. to develop and market
next-generation audio solutions for the PC marketplace. We produced, and Diamond
introduced to the retail marketplace, the award-wining Monster Sound MX300 and
Sonic Impact S90 products. This allowed us to expand rapidly into the retail
marketplace without the investment in infrastructure necessary to commit to a
retail brand strategy. In March of 1999, we announced a new strategic alliance
with Flatland to develop and expand 3D applications on the world wide web.
Channel Development: We believe strongly in growing and expanding
distribution and sales channels. In February 1999, we began sales of board-level
PC audio products into the systems integrator channel which represents more than
a fifth of worldwide PC sales. We believe that creating a strong presence within
such channels will lead to continued growth. We are committed to exploring the
potential in internet commerce for our current and future products. We also
believe it is beneficial to create a community of users who are linked to our
evolving products and technologies through the 3D web.
CURRENT PRODUCTS AND TECHNOLOGIES
We design and manufacture components and complete solutions for audio
applications, based on our patented advanced digital audio imaging technologies.
Currently, our efforts are centered on four areas of focus: technology products,
semiconductor products, board-level products, and advanced software products.
Technology: A3D is our foundation technology, comprised of algorithms for
advanced digital audio imaging. Our A3D technology is based on simulating
precise 3D positioning of audio sources within an aural environment.
Additionally, the technology provides a number of features for accurately
modeling the way sound travels and reacts to objects within that environment.
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Using A3D technology a content developer can simulate a number of sound
sources in a 3D environment, accurately positioned around the user, complete
with the environmental effects that could be expected within the real world. We
have produced a number of tools that allow content developers to easily
integrate A3D technology into their own products. In late 1998, we introduced a
breakthrough technology, A3D 2.0 featuring wavetracing. Aureal wavetracing is an
ambitious technology that translates the geometry of any scene into audio cues
as sound waves bounce off and pass through different materials realistically
informing the listener of his or her environment and immersing them in the
experience.
Semiconductor Products: Our flagship semiconductor products are the Vortex
audio processors. The Vortex family provides computational support for our A3D
digital audio imaging technology, and is designed to be integrated into a
PCI-based PC audio sub-system. By integrating a Vortex chip into a hardware
audio product, manufacturers are able to provide their customers with an
optimized platform for experiencing audio rendered by A3D-enabled software
applications. Members of the Vortex family include the Vortex AU8808, Vortex
AU8810, Vortex1 AU8820, and the Vortex2 AU8830.
Board-Level Products: In addition to providing audio semiconductors to our
customers, we have recently begun manufacturing and distributing complete audio
solutions, all featuring Vortex and A3D digital audio imaging technology. By
purchasing a board-level product from us, customers are ensured of a complete,
fully optimized platform for the rendering of A3D-enabled content. In addition
to the board-level products provided to Diamond Multimedia for sale in the
retail marketplace, we currently provide three board-level, Vortex-based audio
products to our system integration customers:
- Vortex1 PCI,
- Vortex2 PCI, and
- Vortex2 SuperQuad PCI.
Advanced Software: We directly market and distribute advanced software for
the creation of highly-optimized 3D audio content. A3D Pro, our primary software
product, enables professional sound designers to apply realistic 3D audio
positioning and effects to their content. By employing advanced audio processing
algorithms, A3D Pro can pre-render static 3D audio effects for optimal playback
on standard stereo audio hardware such as that found in PCs, home stereos,
televisions, and even movie theaters.
SALES AND MARKETING
Our products are sold worldwide through our direct sales force located at
our headquarters in Fremont, California, our subsidiary, Aureal Semiconductor
Limited, located in Hong Kong, and our representatives located throughout North
and South America, Europe and Asia. Our representatives are not subject to
minimum purchase requirements and can discontinue marketing any of our products
at any time.
Sales are generally made pursuant to standard purchase orders with product
deliveries scheduled upon our receipt of these purchase orders. In addition to
purchase orders, we may receive forecasts of future delivery requirements from
our customers. These purchase orders and forecasts generally allow our customers
to reschedule and cancel deliveries without significant penalties. For these
reasons, we believe that this information, while useful for scheduling
production, is not a reliable indicator of future revenues.
We are fully committed to maintaining close, integrated partnerships with
our customers through worldwide technical support. We employ our own in-house
technical staff for product development and technical support, and for providing
support through our representatives. We believe that nurturing these close,
supporting relationships with our customers is vital to ensuring customer
satisfaction, while at the same time, providing us with important insight into
future market and product direction.
We employ an extensive in-house technical marketing and engineering support
staff responsible for ensuring the widespread adoption of our technologies by
producers of PC software and other forms of content that may benefit from these
technologies. We believe that this is an important marketing function and that
it will drive consumer demand for digital audio imaging hardware based on our
products.
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Co-marketing and co-publicity programs with our distribution partners are
also a vital part of our marketing efforts. Where possible, we attempt to
leverage strategic relationships to drive consumer demand for our products and
technologies. With our partners and on our own, we carry out marketing and
publicity campaigns via a number of communications vehicles including
advertising, press releases, events and trade shows, direct mailings, direct
contact and the world wide web.
RESEARCH AND DEVELOPMENT
We expect to continue to invest heavily in research and development
efforts. Over the past few years, we have focused research and development on
leveraging our expertise in digital audio imaging technologies to develop
products for the PC and consumer electronics markets. Currently we are working
to expand our product offerings across the range of audio applications in the
markets we serve. We are also strongly committed to the continued development
and introduction of new technologies that may improve upon, complement and
expand our product line. Our strategic partnership with Flatland Online, Inc. is
an example of new areas into which our technology can be expanded.
We intend to continue to provide a comprehensive range of products to our
customers. These products range from advanced audio algorithms and software to
silicon and board-level audio solutions. We employ state-of-the-art equipment
and processes to develop our products, relying on workstation-based design
environments, advanced hardware and software simulation and modeling, and a
high-level design description language. Regular investments in new advanced
hardware and software tools is vital to the continuation of our effective
research and development efforts.
At January 3, 1999, we employed a total of 60 research and development
personnel, including those involved in semiconductor design, process
development, and software development. In addition, another 14 technical
personnel were engaged in product development and engineering support roles. We
also contract outside agencies to supplement our research and development staff
and enter into cooperative projects with other companies.
Our technology subsidiary Crystal River Engineering, Inc., has been working
to develop true 3D audio for almost 10 years. Patents on certain techniques
utilized in optimizing the technology have been granted to us. We have been
granted seventeen patents in the U.S., including two in September 1998 relating
to our A3D 3D audio processing technology. We expect to continue to actively
pursue additional patents for our digital audio imaging technologies.
COMPETITION
The markets for our products are characterized by evolving industry
standards and rapid technological change and product obsolescence. We expect
competition to increase in the future from existing and new competitors that may
enter our existing or future markets with products that may be less costly or
provide higher performance or additional features. Accordingly, our future
success is highly dependent upon the successful development and timely
deployment of new products at competitive performance levels and prices. The
success of new products depends on a number of factors, including timely
completion of product development, market acceptance of our new products, and
our ability to offer new products at competitive prices.
The market for PC audio technology supports a number of large and
entrenched competitors, including Creative Technology Ltd. and Yamaha of Japan.
There are also companies which compete with us in the area of chips only such
as:
- Analog Devices Inc.,
- Cirrus Logic Inc., and
- ESS Technology, Inc.
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In the area of 3D audio, a number of companies offer licensing arrangements
for 3D audio technologies, including:
- Qsound Labs Inc.,
- Spatializer Audio Laboratories Inc. and
- SRS Labs Inc.
In addition, Microsoft Corporation has incorporated 3D audio capabilities
in its DirectSound technology. Many of these current and potential competitors
have substantially greater financial, manufacturing, technical, marketing,
distribution, and other resources, greater intellectual property rights, broader
product lines, and longer-standing relationships with potential customers than
us. Certain of our competitors maintain their own semiconductor foundries and
may, therefore, have greater capacity, cost, and technical advantages than us.
We believe that our ability to compete successfully depends on a number of
factors, both within and outside of our control, including:
- price;
- quality and performance of our products and of our competitors' products;
- timing and success of new multimedia PC standards;
- development of technological innovations;
- our ability to obtain adequate foundry capacity and sources of raw
materials
- our efficiency of production;
- the rate at which our customers design our products into their own
products;
- the number and nature of our competitors within a given market;
- the assertion of intellectual property rights; and
- general market and economic conditions.
The markets for most of the applications of our products are characterized
by intense price competition. The willingness of prospective customers to design
our products into their own products or distribute our products within
distribution channels not covered by us depends to a significant extent upon our
ability to price our products at a level that is cost-effective for these
customers. As the markets for our products mature and competition increases, we
anticipate prices for our products will decline. If we are unable to reduce
costs sufficiently to offset declines in product prices or are unable to
introduce new, higher-performance products with competitive price points, our
operating results could be materially adversely affected. Although we believe
that we are competitive with respect to most of these factors, there can be no
assurance that we will remain competitive in the future.
Each successive generation of PC microprocessors has provided increased
performance, which could in the future result in a microprocessor capable of
performing increasingly complex and specialized functions, including those
performed by our own semiconductor components. For example, Intel Corporation
has developed MMX-based signal processing capability for use in conjunction with
its Pentium microprocessor product line, and is promoting the processing power
of the Pentium for data and signal intensive functions including graphics and
audio acceleration and other multimedia functions. Although our PC products are
designed to be complementary to, and take advantage of, MMX technology, there
can be no assurance that the increased capabilities of Intel's microprocessors
or competitive microprocessors will not materially adversely affect demand for
our products. Additionally, our A3D technologies provide support for and are
enabled by Microsoft's DirectSound technology. Any substantial future changes to
the DirectSound architecture may affect our ability, and our competitors',
abilities to support revised DirectSound features and functionality.
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MANAGEMENT
OFFICERS AND DIRECTORS OF AUREAL
As of January 3, 1999, our officers and directors were as follows:
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Kenneth A. Kokinakis...... 45 President, Chief Executive Officer and Director
David J. Domeier.......... 45 Vice President, Finance and Chief Financial Officer
Scott H. Foster........... 45 Chief Technical Officer
Michael L. Hunter......... 39 Vice President, Sales
S. Murty Cheruvu.......... 49 Vice President, Manufacturing Operations
Sanjay Iyer............... 42 Vice President, General Manager -- Technology Division
Brendan R. O'Flaherty..... 36 Vice President, General Manager -- Systems Division and
General Counsel
Toni W. Schneider......... 29 Vice President, Advanced Audio Products
Richard E. 51 Director
Christopher(1)..........
L. William Krause(1)...... 56 Director
D. Richard Masson(2)...... 40 Director
Thomas K. Smith, Jr.(2)... 34 Director
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(1) Member of the audit committee.
(2) Member of the compensation committee.
Mr. Kokinakis was appointed President and Chief Executive Officer effective
January 15, 1996 and a Director effective February 7, 1996. Prior to joining us,
Mr. Kokinakis served as the Managing Director and Chief Executive Officer of
Memec (Asia-Pacific), an electronic component distributor, since January 1991.
Prior to 1999, Mr. Kokinakis held various executive sales and marketing
positions at Xilinx, Inc. and Microchip Technology Inc.
Mr. Domeier has served as our Vice President, Finance and Chief Financial
Officer since March 1995. During the period of October 1995 to January 1996, Mr.
Domeier served as a member of the "Office of the President" for us. Prior to
joining us, Mr. Domeier was employed by Safeway Inc. from 1983 through 1994. His
most recent positions with Safeway Inc. were Senior Vice President, Re-
engineering in 1994 and Senior Vice President, Chief Financial and
Administrative Officer of the Northern California Division from 1992 through
1994.
Mr. Foster joined us as our Chief Technology Officer in May 1996 with the
merger of Crystal River Engineering, Inc., and Aureal. Mr. Foster founded
Crystal River in 1987 and served as its Chief Executive Officer until the
merger.
Mr. Hunter has served as our Vice President, Sales since March 1995 and
Vice President, OEM Sales since January 1995. Prior to joining us, Mr. Hunter
served as Vice President of Sales at SCM MicroSystems from October 1993 to
January 1995, as Vice President of Sales and Marketing at Criterion Computer
form July 1993 to October 1993, and as Senior Vice President of Sales and
Marketing at Orchid Technology from October 1988 to June 1993.
Mr. Cheruvu became Vice President, Manufacturing Operations in May 1997 and
has been with us since June 1995 when he joined us as the Director of
Semiconductor Project Operations. Prior to joining Aureal, he was Process
Manager with Cirrus Logic Inc. for five years and held engineering positions
with Samsung Semiconductor and National Semiconductor. He received his Ph.D. in
Materials Science from U.C. Berkeley.
Mr. Iyer was appointed Vice President -- General Manager, Technology
Division, in January 1999. Prior to that, Mr. Iyer served as Vice President, PC
Products from January 1998 to January 1999. From May 1996 to December 1997, he
served as Vice President of Marketing and from September 1995 to May
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<PAGE> 11
1996, as Vice President, Technology. Prior to then, Mr. Iyer served as the
Director of the Digital VLSI group from May 1994 to September 1995. Mr. Iyer
also served as our Director of Graphics Hardware from May 1993 to May 1994.
Prior to joining us, Mr. Iyer served as the Director of Graphics Hardware of
Pellucid, Inc. from 1991 to May 1993. Prior to joining Pellucid, Mr. Iyer served
as Hardware Manager of Silicon Graphics, Inc. from 1989 to 1991.
Mr. O'Flaherty became the Vice President and General Manager -- Systems
Division, and General Counsel in January 1999. In 1998 he served as Vice
President, Consumer Electronics and General Counsel. Prior to that he had served
as our Vice President, Business Development and General Counsel since May 1994.
During the period of October 1995 to January 1996, Mr. O'Flaherty served as a
member of Aureal's "Office of the President". Mr. O'Flaherty was a director of
Aureal from May 1994 to December 30, 1994. Mr. O'Flaherty joined us as corporate
counsel in November 1993. Prior to joining us, he was associated with the law
firm of Gray Cary Ware & Freidenrich from September 1989 to November 1993.
Mr. Schneider became our Vice President, Advanced Audio Products in January
1998. Mr. Schneider joined us in May 1996 through the merger of Aureal and CRE
and served as Vice President, Strategic Alliances from May 1996 through December
1997. From 1993 to October 1994, Mr. Schneider served at CRE in a number of
capacities including Vice President, Marketing. Prior to joining CRE, he held
various engineering positions at Autodesk's Cyberspace Group and VPL Research
while working toward a degree in computer science at Stanford University.
Mr. Masson has served as a director of Aureal since December 30, 1994. Mr.
Masson has been a principal of Oaktree since May 1995. Prior to the founding of
Oaktree, he was a partner of TCW Special Credits since 1991 and served as a
Managing Director and in various other capacities for Trust Company of the West
and TCW Asset Management Company ("TAMCO"), wholly-owned subsidiaries of The TCW
Group, Inc., since 1988. Mr. Masson also serves as a director of Winship
Properties.
Mr. Christopher has served as a director of Aureal since November 1996. Mr.
Christopher is Executive Vice President, Chief Operating Officer, and a director
of Triscend Co., a manufacturer of configurable micro controllers. From July
1992 through October 1998, Mr. Christopher was the Vice President of Worldwide
Sales for Chips and Technologies Inc., a supplier of advanced graphic
controllers and accelerators for notebook computers. Intel Corporation acquired
Chips and Technologies Inc. in February 1998. Prior to joining Chips and
Technologies Inc., Mr. Christopher spent twelve years at Fujitsu
Microelectronics where he became Senior Vice President and General Manager.
Mr. Krause has served as a director of Aureal since April 1995. Since
November 1998, Mr. Krause has been President of LWK Ventures, a private
investment company. Mr. Krause was President, Chief Executive Officer and a
director of Storm Technology Inc., a provider of computer peripherals and
software for digital imaging, from October 1991 until November 1998 when it
filed for protection under federal bankruptcy laws. Prior to that, Mr. Krause
spent ten years at 3Com Corporation, a manufacturer of networking systems, where
he served as President and Chief Executive Officer until he retired in September
1990. Mr. Krause continued as Chairman of the Board for 3Com Corporation until
1993. Mr. Krause currently serves as a director of Sybase, Inc. and Infoseek
Corporation.
Mr. Smith has served as a director of Aureal since December 1994. Mr. Smith
is a Senior Vice President of Trust Company of the West, a wholly owned
subsidiary of The TCW Group, Inc., which he joined in 1991 as an investment
analyst for TCW Special Credits. TCW Special Credits serves as general partner,
trustee and investment advisor to certain limited partnerships, trusts, and
accounts invested in the securities and debt obligations of financially
distressed companies. TAMCO is the managing general partner of TCW Special
Credits.
ITEM 2. PROPERTIES
The majority of our operations are currently located in approximately
36,000 square feet of leased office and warehouse space located in Fremont,
California. In January 1999, we leased an additional 8,000
9
<PAGE> 12
square very near this location. This additional space was secured to accommodate
the growth we are currently experiencing. Our rental expense for the original
facility was approximately $216,000 for the year ended January 3, 1999. See Note
6 of Notes to Consolidated Financial Statements. The lease on this facility will
expire in 1999. We anticipate locating new office space to accommodate the
entire Fremont workforce at the expiration of the current lease in 1999. To
date, we have not secured a lease on new facilities. If we fail to secure a new
lease prior to the expiration of our current lease, our business and operating
results may be materially, adversely affected. Additional amounts of office
space are also leased in Austin, Texas and in Hong Kong.
ITEM 3. LEGAL PROCEEDINGS
We have received, and may receive in the future, communications from third
parties asserting that our trademarks or products infringe patents, copyrights
or proprietary rights of third parties or seeking indemnification against such
infringement. The costs of any litigation alleging that we have infringed the
proprietary rights of a third party, or damages resulting from such a claim,
could be substantial and could materially adversely affect our business,
financial condition and results of operations.
In February 1998, we were 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"). The suit
alleges that a portion of our Vortex 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 us and an
accounting of damages plus interest. In response, we filed a motion for summary
judgement. In October of 1998, the court issued its first ruling in this case
denying the Creative motion for a preliminary injunction. The court also denied
our motion for a summary judgement. Further hearings were set for summer of 1999
with a trial set for September 1999. We believe that the actions brought by
Creative and E-MU are without merit and will continue to vigorously defend our
position.
In October 1998, Creative Labs, the U.S. based subsidiary of Creative,
filed a second lawsuit against us. This new lawsuit claims "false advertising"
and "unfair business practices". These complaints center primarily on a
comparison chart prepared by Aureal and published by third parties on the world
wide web. We believe that this action is without merit and have commenced a
vigorous defense of this action. We have filed a response denying these
allegations and filed counterclaims against Creative Labs.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
In a special meeting of our stockholders held on December 16, 1998 at our
offices, our stockholders were requested to vote on two proposals. Proposal
number one was to approve an amendment to our Amended and Restated Certificate
of Incorporation to increase the number of authorized shares of common stock
from 100,000,000 to 200,000,000. Proposal number two was to approve and ratify
an increase of 13,000,000 shares in the maximum number of shares issuable under
our 1995 Stock Option Plan, increasing the total number of shares that may be
issued under that plan from 12,000,000 to 25,000,000. The results of the votes
cast by our stockholders are shown in the table below:
<TABLE>
<CAPTION>
NON-VOTES AND
FOR AGAINST ABSTAIN BROKER NON-VOTES
----------------- ---------------- ------------- -----------------
<S> <C> <C> <C> <C>
Proposal 1................... 39,142,607 shares 716,448 shares 28,382 shares 21,406,811 shares
Proposal 2................... 32,498,016 shares 3,072,423 shares 30,583 shares 25,693,226 shares
</TABLE>
10
<PAGE> 13
PART II
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS
MARKET INFORMATION
Over the last two years our common stock has traded on the Over-The-Counter
Bulletin Board. As of March 22, 1999, there were approximately 325 stockholders
of record of our common stock. The following table sets forth the range of bid
price information for our common stock for the quarterly periods within the past
two fiscal years. These over-the-counter bid quotations may not necessarily
represent prices at which actual transactions took place.
<TABLE>
<CAPTION>
COMMON STOCK HIGH LOW
------------ ----- -----
<S> <C> <C>
FISCAL 1997
First Quarter............................................... $2.94 $1.75
Second Quarter.............................................. 2.69 1.88
Third Quarter............................................... 2.50 1.97
Fourth Quarter.............................................. 2.53 1.59
FISCAL 1998
First Quarter............................................... $3.50 $1.86
Second Quarter.............................................. 3.00 1.94
Third Quarter............................................... 2.25 0.56
Fourth Quarter.............................................. 0.91 0.41
</TABLE>
DIVIDENDS
We have not paid any cash dividends on our capital stock over the past two
years and currently anticipate that we will retain all available funds for use
in our business. We do not, therefore, anticipate paying any cash dividends in
the foreseeable future.
ITEM 6. SELECTED FINANCIAL DATA
The selected financial data set forth below have been audited by Arthur
Andersen LLP, independent public accountants and should be read in conjunction
with the consolidated financial statements and related notes thereto included in
Item 8 of this Annual Report.
We emerged from Chapter 11 bankruptcy proceedings on December 30, 1994 and
with Our Second Amended Plan of Reorganization, we became a new entity. We
adopted fresh start accounting effective December 31, 1994, and as a result, the
financial data for periods prior to that date are not considered comparable with
financial statements for periods subsequent to December 31, 1994.
In August 1995, we announced that we were divesting ourselves of our retail
multimedia components business to implement a business plan based upon
development and sale of software and semiconductor solutions to provide advanced
audio for the PC and consumer electronics markets. With this significant change
in business, revenues were reduced dramatically in the second half of 1995.
During the transition years of 1996 and 1997, we primarily focused on the
development of our new technology into product applications and thus revenue
levels were not significant. 1998 was the first year in which we shipped
products incorporating the new technology in significant volumes.
In May 1996, we acquired 100% ownership of Crystal River Engineering, Inc.,
a privately held firm specializing in 3D audio technology development. The
acquisition was recorded under the terms of purchase accounting. In conjunction
with this acquisition, in 1996, we recorded a write-off of $6.0 million due to
recognition that in-process research and development efforts associated with
Crystal River Engineering, Inc.'s 3D audio technology had not reached
technological feasibility with respect to our product line at the date of the
acquisition.
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<PAGE> 14
Given the significant changes to our business noted above, comparability of
the information included below between periods is not considered useful. In
addition, as we restructured our business in 1995 and began to develop new
technologies during 1996, 1997 and 1998, the information shown below should not
be utilized toward making any projections of our future revenues or
profitability.
<TABLE>
<CAPTION>
FISCAL YEAR
----------------------------------------------------------
1998 1997 1996 1995 1994
-------- -------- -------- --------- ---------
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<S> <C> <C> <C> <C> <C>
STATEMENT OF OPERATIONS DATA:
Net sales......................... $ 25,328 $ 1,640 $ 3,485 $ 47,747 $ 147,349
Loss from continuing operations... (18,506) (17,690) (17,020) (103,833) (157,956)
Loss before extraordinary item.... (18,506) (17,690) (17,020) (103,833) (166,457)
Extraordinary item, gain on
discharge of indebtedness....... -- -- -- -- 131,329
-------- -------- -------- --------- ---------
Net loss.......................... $(18,506) $(17,690) $(17,020) $(103,833) $ (35,128)
======== ======== ======== ========= =========
Accretion/dividends related to
preferred stock................. (15,518) -- -- -- --
Net loss attributable to common
shareholders.................... $(34,024) $(17,690) $(17,020) $(103,833) $ (35,128)
======== ======== ======== ========= =========
Basic and diluted earnings (loss)
per share:
Continuing operations........... $ (0.79) $ (0.44) $ (0.51) $ (5.19) $ (11.40)
Discontinued operations......... -- -- -- -- (0.61)
Extraordinary item.............. -- -- -- -- 9.48
-------- -------- -------- --------- ---------
$ (0.79) $ (0.44) $ (0.51) $ (5.19) $ (2.53)
======== ======== ======== ========= =========
Shares used in calculating per
share amounts................... 43,317 40,398 33,344 20,000 13,859
</TABLE>
<TABLE>
<CAPTION>
YEAR-END
----------------------------------------------------------
1998 1997 1996 1995 1994
-------- -------- -------- --------- ---------
(IN THOUSANDS)
<S> <C> <C> <C> <C> <C>
BALANCE SHEET DATA:
Working capital (deficiency)...... $ (3,586) $ (645) $ (3,500) $ (5,725) $ 37,506
Total assets............ 13,638 6,350 4,145 7,761 107,335
Long-term obligations and
redeemable preferred stock...... 889 25,616 15,848 24,289 12,393
Total liabilities....... 14,946 30,499 19,906 31,594 27,335
Stockholders' equity (deficit).... (1,308) (24,149) (15,761) (23,833) 80,000
</TABLE>
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<PAGE> 15
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
THE FOLLOWING DISCUSSION SHOULD BE READ IN CONJUNCTION WITH THE SELECTED
FINANCIAL DATA INCLUDED IN ITEM 6 AND THE CONSOLIDATED FINANCIAL STATEMENTS
INCLUDED IN ITEM 8 HEREIN.
THIS REPORT CONTAINS FORWARD-LOOKING STATEMENTS WITHIN THE MEANING OF
SECTION 27A OF THE SECURITIES ACT OF 1933 AND SECTION 21E OF THE SECURITIES
EXCHANGE ACT OF 1934. ANY FORWARD-LOOKING STATEMENTS MADE HEREIN ARE MADE
PURSUANT TO THE SAFE HARBOR PROVISIONS OF THE PRIVATE SECURITIES LITIGATION ACT
OF 1995. INVESTORS ARE CAUTIONED THAT ACTUAL RESULTS MAY DIFFER MATERIALLY FROM
THOSE PROJECTED IN ANY FORWARD-LOOKING STATEMENTS DUE TO A NUMBER OF FACTORS
INCLUDING, BUT NOT LIMITED, TO OUR DEPENDENCE ON THE PERSONAL COMPUTER AND
CONSUMER ELECTRONICS INDUSTRIES AND ON PRODUCT LINES BASED ON NEW TECHNOLOGIES;
FOUNDRY CAPACITY, AVAILABILITY AND RELIABILITY; COMPETITION AND PRICING
PRESSURES; OUR ABILITY TO SECURE ADDITIONAL FINANCING; AND OTHER RISKS DETAILED
BELOW AND FROM TIME TO TIME IN OUR FILINGS WITH THE SECURITIES AND EXCHANGE
COMMISSION
OVERVIEW
During the three-year period reported upon in this annual report,
significant changes took place in our business. These changes included:
- The introduction in 1998 of an expanded line of technology,
semiconductor, board-level and software products employing our
proprietary A3D technology in OEM, systems integrators and retail
channels
- The sale of $11 million of our preferred stock in March and June 1998
- The negotiation of $40 million credit facility and conversion of
pre-existing line of credit to preferred stock in June 1998
- A private placement of $3.8 million of our common stock in August 1997
- The acquisition of Crystal River Engineering, Inc. in May 1996
- A private placement of $22 million of our common stock from February
through June 1996
These changes, in conjunction with the business and financial reporting
changes necessitated by these changes, make it difficult to compare the
operating results of the three years reported. While we have included
comparative comments on these time periods, the composition of the business
differed greatly between 1998, 1997 and 1996. During the transition years of
1996 and 1997, we were primarily focused on the development of our new
technology into product applications, and thus, revenue levels were not
significant. In 1998, we commenced volume shipments of our products that
incorporate the new technology. No assumptions should be made as to future
operations based upon amounts or trends indicated by prior years.
Our objective is to be the provider of interactive entertainment solutions
for the PC and consumer electronics marketplaces. Our operating strategy
combines the development and sale of audio processing semiconductor chips and
cards with the licensing of technology to strategic partners in order to define
and develop advanced audio standards in the marketplace.
RESULTS OF OPERATIONS
Fiscal 1998 compared to fiscal 1997
Net sales
Net sales for the fiscal year 1998 were $25.3 million compared to $1.6
million in net sales in fiscal 1997. This 1480% increase in sales was the result
of the commercial success in the marketplace of our Vortex and Vortex2 products.
Annual revenues in 1998 included sales of AU8820 chips, 8820 sound cards, 8830
chips and sound cards and revenues from technology licensing. During the second
half of 1998, we
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<PAGE> 16
began sales of board-level audio solutions through a strategic alliance with a
major distributor of video and audio peripherals. This compares to revenues in
1997 mainly attributable to technology licensing.
Gross margin
Gross margin for 1998 was 30%. This was an expected decrease from the prior
year's 89% gross margin which was based on technology licensing and reflected
minimal direct costs of production. During 1998, we introduced numerous products
to the market place and we bore the initial testing and production start-up
costs of these products. While we anticipate the continuation of revenues from
technology licensing agreements, these revenues were not significant in 1998,
and we do not anticipate that they will be a significant percentage of our total
revenues in the future. We believe that our gross margins could vary depending
upon market demand for our various products.
Research and development
Expenditures for research and development continue to be significant as
resources are allocated 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 we continue to bring new and improved products
to the audio forefront. Research and development expenses increased from $7.4
million in 1997 to $11.8 million in 1998. We expect research and development to
continue to be a significant area of investment for us as we develop new
technologies and explore new audio frontiers. We expect that the level of
spending on research and development will fluctuate, but we do not expect it to
decline significantly in absolute dollars in the future.
Selling and marketing
During 1998, we designed and launched an advertising campaign to increase
the visibility of our A3D technology to the end-user. Expenditures for this
campaign as well as trade show, selling commissions and headcount increases
resulted in a 74% increase in selling expenses. While selling and marketing
expenses increased in absolute dollar terms from $3.7 million in 1997 to $6.4
million in 1998, they decreased substantially as a percentage of net sales. We
expect selling and marketing expenses will continue to increase in absolute
dollars in the future.
General and administrative
General and administrative expenses for the fiscal year 1998 increased 58%
to $3.8 million from $2.4 million in 1997. This increase was the result of
increased headcount, management and financial consulting fees and legal fees. We
expect that general and administrative expenses will increase in absolute dollar
terms over the next several periods due to headcount increases, the costs
associated with providing expanded infrastructure for our organization and
continuing legal fees.
Amortization of reorganization asset
The reorganization asset originated pursuant to our valuation upon exit
from bankruptcy protection in December 1994. At that time, our fair value
exceeded our net assets by $44.1 million. The reorganization asset value was
fully amortized at year-end 1997.
Interest expense
Interest expense for the fiscal years 1998 and 1997 was $2.6 million and
$2.8 million, respectively. These expenditures consisted primarily of interest
on our lines of credit at rates of prime plus 3% and 5%. During 1998 and 1997,
these lines of credit have been a major source of working capital for us.
Proceeds from the sales of equity capital during these time periods were used to
periodically pay down the balance of the debt.
14
<PAGE> 17
In June 1998, we paid down and eliminated a line of credit with TCW in
connection with the exchange for our series B preferred stock. This resulted in
the decline of interest expense during the third and fourth quarters of 1998.
Our current credit facility carries a lower interest rate than the prior line to
the extent borrowings are based on eligible accounts receivable borrowing
availability.
Amortization of debt-related warrants
In August 1997, in conjunction with the expansion and extension of our TCW
line of credit, we issued warrants to purchase 3.15 million shares of our common
stock to the lenders. Using 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 line of credit at the rate of $.75
million per quarter. When the line of credit was converted to preferred stock 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 our new credit facility with Transamerica and Goldman
Sachs, we issued warrants to purchase 1.35 million shares of our 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 this credit facility.
Other income
We recognized $0.4 million and $0.8 million of other income in 1998 and
1997, respectively. This income was primarily due to various receipts and
credits resulting from favorable resolutions to previously recorded liabilities.
Income taxes
We were not required to provide for income taxes in either 1998 or 1997 due
to our net operating losses. No tax benefit has been recorded for the net
operating loss carryforwards due to the uncertainty as to their realizability.
Fiscal 1997 compared to fiscal 1996
As noted above, 1997 and 1996 were periods where we focused primarily on
the development of our new technologies into product applications in both the PC
and consumer electronics markets. Revenues in both years were not significant,
as volume shipments of our semiconductor devices to customers did not occur
until 1998. Our primary goal in 1996 was to generate visibility for and
recognition of our technology in the marketplace. For 1997, our goal was to
transform that recognition into relationships in which customers designed our
semiconductor technology into their own products. Those objectives were achieved
as we secured design wins, licensing agreements, PC game developer commitments
and other working relationships with many firms in the PC and consumer
electronics industries.
Net sales
Revenues for 1997 totaled $1.6 million resulting primarily from technology
licensing transactions, with approximately 10% coming from semiconductor sales.
We entered into 3D audio licensing agreements for our trademarked A3D technology
with several companies. Due to the timing of license revenue recognition, 1997
revenues varied from quarter to quarter. 1996 revenues of $3.5 million reflected
sales and licensing fees associated with pre-existing audio technology,
primarily during the first half of the year. Included in the $3.5 million total
was $2.0 million associated with a one-time licensing transaction in January
1996. We did not receive significant revenue relating to this pre-existing
technology during 1997.
15
<PAGE> 18
Gross margin
Gross margin for the 1997 fiscal year was $1.5 million, or 89% of sales. We
expected future gross margins to decrease significantly as the sale of
semiconductor products replaced licensing transactions as the dominant source of
revenue. In 1996, we recorded gross margin of 91% of sales, or $3.2 million.
This margin reflected the large percentage of net sales represented by licensing
transactions. The vast majority of costs related to technology licensing
arrangements were recorded as research and development costs over the
development period of the technology. Relatively little expense was connected
directly with the recognized revenue and relatively high gross margin
percentages were produced.
Research and development
Costs for research and development in 1997 were $7.4 million, up $1.2
million or 19% over the prior year. The increase was due primarily to costs
associated with increased staff levels and reflected our continued emphasis on
new product and technology development. In addition to the costs identified as
research and development, certain employee and other costs related to creating
prototype products for customers to evaluate our semiconductor products, as well
as finalization of product specifics for individual customers (product
development) were reported as part of sales and marketing expenses in both years
presented.
Sales and marketing
Sales and marketing expenses were $3.7 million for 1997, compared to $2.2
million for the 1996 fiscal year. These increases included headcount additions
as well as costs associated with creating prototype products for customers to
evaluate our semiconductor products. Generally, in the case of products for sale
to original equipment manufacturers, commonly referred to as OEM's, significant
up-front costs are often incurred before the first order for product is ever
received. Expenses for people, travel, public relations, marketing and trade
shows are a result of the initial effort to introduce our technology during 1996
and to introduce semiconductor products during 1997. The aggregate effort and
resulting cost level of sales and marketing expenses was expected to grow in
future quarters.
General and administrative
General and administrative expenses remained fairly constant over these two
years. Expenses were $2.4 million in 1997, compared to $2.6 million in 1996. The
cost stability in this area reflected continued cost containment efforts.
Additional administrative staffing was not necessary, but was expected to change
as our business and sales volumes increased. In 1996, one significant area of
expenditure within this category was legal costs associated with preparing,
filing and prosecuting numerous patent applications.
Amortization of reorganization asset
We exited Chapter 11 bankruptcy protection on December 30, 1994. The
reorganization asset originated pursuant to our valuation upon exit from
bankruptcy protection whereby our fair value exceeded our net assets by $44.1
million. The reorganization asset initially was amortized over three years at
the rate of $3.7 million per fiscal quarter. During the second quarter of 1995
it was determined that a significant portion of the reorganization asset could
no longer be assured of recovery and a $30.5 million write-off was recorded (see
Restructuring charges below). The remaining reorganization asset value after the
write-off was amortized at the rate of $625,000 per fiscal quarter through 1997
and as of December 28, 1997 was completely amortized.
Restructuring charges
During 1995, we announced a plan to divest our worldwide retail operations
and provide a $61.6 million restructuring provision to reflect a write-down of
assets and record the incremental costs of exiting the business. This provision
was included as a component of operating expenses for the second and third
quarters of 1995 as the details of the process were determined. During 1995 and
1996, substantially
16
<PAGE> 19
all of the identified liabilities related to the restructuring were finalized.
As a result, a credit of $804,000 was recorded in the fourth quarter of 1996
reflecting a revision of the original estimated charges.
Interest expense
Interest expense of $2.8 million in 1997 and $2.2 million in 1996 consisted
primarily of interest on our working capital line of credit with TCW (at the
rate of prime plus 5%). In both years, the TCW credit facility was a primary
source of working capital.
Amortization of debt related warrants
Statement of financial accounting standards No. 123 requires accounting on
the basis of estimated fair value for the warrants issued in association with
the amendment to the line of credit ("Debt Warrants"), as described in Footnote
5. The fair value of the Debt Warrants was estimated to be $5.0 million. The
value of the Debt Warrants is included in both current and long-term assets in
the accompanying balance sheets. Amortization of the $5.0 million asset, as
additional interest expense over the life of the loan, began in August 1997 at
the rate of $0.75 million per quarter.
Interest income and other income and expenses
With cash balances at a minimum throughout 1997, interest income was not
significant.
Interest income of $156,000 in 1996 was generated primarily on funds
invested temporarily following our receipt of funds from private placements of
equity in the first quarter of the year. Terms of the funding transactions
placed certain limitations on our ability to use the offering proceeds to reduce
the outstanding balance of the TCW credit facility. The invested cash declined
during the second and third quarters as it was utilized for ongoing operations
costs as well as for the acquisition of Crystal River Engineering.
Other income for 1997 totaled $812,000, resulting primarily from the
favorable resolution of certain matters for which liabilities had been provided
in 1996. Also included was a value added tax refund and miscellaneous other
receipts. We recognized net other income of $563,000 in 1996 from a number of
sources, including receipt of prior year value added tax refunds and other
favorable resolutions to previously recorded liabilities, recovery of property
loss insurance proceeds and miscellaneous other receipts.
Income taxes
Due to our net operating losses in both 1997 and 1996, we were not required
to provide for income taxes in either year. No tax benefit has been recorded for
the losses due to the uncertainty as to its reliability.
LIQUIDITY AND CAPITAL RESOURCES
We have recorded operating losses for each of the last three years. Our
decision to terminate the prior retail PC upgrade kit business in mid-1995 and
concentrate all of our resources on development of audio technologies and
semiconductor solutions for the PC and consumer electronics markets led to a
period of product development without significant revenues.
As of January 3, 1999, we had a working capital deficit of $3.6 million and
stockholders' deficit of $1.3 million. The $20.5 million net cash used in
operations for 1998 was approximately $6.5 million more than was used in 1997,
due mainly to an increase in inventories and to the financing of accounts
receiveable we experienced as we moved into our first year of product sales. Net
cash used for investing in equipment and software tools was about $1.4 million
more than in 1997. Financing for these cash outlays was provided by the
negotiation of a new line of credit in 1998 and proceeds from the sale of
preferred stock. We expect to need additional cash to expand the business and to
finance additional inventory and accounts receiveable. It is extremely difficult
to estimate with any accuracy the cash flows, and the timing of these cash
flows, due to our lack of significant sales and customer payment history. We can
make no
17
<PAGE> 20
assurance that we will be able to generate positive cash flows in the future. At
January 3, 1999, we were out of compliance with the financial ratio covenants of
our line of credit. We have obtained a waiver of these covenants from our
lenders and our major stockholder, Oaktree, has expressed its commitment to
provide funds to support the cash flow demands of our current 1999 business
plan.
In March 1999, our board of directors approved, an agreement with our
largest stockholders, Oaktree and TCW, under which we will offer for sale $20
million of our common stock at a price of $0.60 per share under a subscription
rights offering. Stockholders of our common stock on the date of record will be
offered, on a pro-rata basis, the opportunity to purchase new shares of our
common stock. Oaktree and TCW, or any combination thereof, have agreed to
purchase any remaining unsubscribed shares of this offering, up to a maximum
amount of $20 million. We have also agreed to issue an additional 26.2 million
shares of common stock to holders of our series B preferred stock who convert
their shares into common stock upon the closing of the rights offering. These
additional 26.2 million shares will not be registered, but we will grant
standard demand and piggyback rights to the holders of those shares. We
understand that TCW and Oaktree, holders of all of our series B preferred stock,
intend to convert their shares of series B preferred stock into 20.5 million
shares of common stock upon the closing of the rights offering. Oaktree also
recently purchased the majority of the preferred stock position previously held
by DDJ. These actions will effectively eliminate the majority of our preferred
stock and convert it to common stock.
Our existing line of credit is a two year $40 million revolving credit
facility with Transamerica and Goldman Sachs entered into on June 5, 1998. Terms
of this credit facility provide for up to $32.5 million borrowing availability
related to specific accounts receivable, referred to as Tranche A, with an
additional $7.5 million of availability that is unrelated to specific collateral
requirements referred to as Tranche B. Interest on borrowings under the two-year
agreement is at the rates of Prime plus 3% on Tranch A borrowings and Prime plus
5% on Tranche B borrowings. We are subject to certain covenant restrictions
under the credit facility and have paid a $600,000 fee to the lenders in
connection with the initiation of the credit facility.
At January 3, 1999, our borrowings under this credit facility included $3.8
million of Tranche A borrowings at an interest rate of 10.75% and $0.5 million
of Tranche B borrowings at an interest rate of 12.75%. Our unused borrowing
availability under Tranch B was $7.0 million. At year-end 1998, our financial
ratios were out of compliance with financial covenant requirements for the
credit facility; however, at March 22, 1999 we had secured a waiver of
non-compliance for these specific covenant requirements.
Capital expenditures of $2.3 million in 1998 and $0.9 in 1997 consisted
primarily of hardware and software tools utilized in our research and
development activities. Capital expenditures are anticipated to increase
significantly during 1999, to an estimated level of between $3 million and $4
million for the year.
Disclosure regarding the year 2000
Year 2000 Readiness Disclosure:
Some computer, software, and other equipment include computer code in which
calendar year data is abbreviated to only two digits. As a result of this design
protocol, some of these systems could fail to operate or fail to produce correct
results if the year "00" is interpreted to mean 1900 instead of 2000. These
problems are widely expected to increase in frequency and severity as the year
2000 approaches and are commonly referred to as the "year 2000 problem."
Assessment:
The year 2000 problem affects some of the computers, software and other
equipment that we use, operate or maintain for our operations. We have developed
a year 2000 readiness plan to assess our exposure to the year 2000 problem,
implement solutions and develop necessary contingency plants. This plan has been
reported to our board of directors and progress is reported to them on a regular
basis. To
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<PAGE> 21
date we have obtained verification and validation from the majority of our
independent third party software and hardware suppliers of the year 2000
compliance of their products.
Internal infrastructure:
Of the systems we are currently using, the components of our mission
critical software are year 2000 compliant as are the majority of the software
packages we employ as engineering tools. Upon completion of the evaluation and
assessment of all of our software packages and hardware, we will commence the
process of modifying, upgrading and replacing any systems that have been
assessed as adversely affected. We expect to complete this process before the
occurrence of any material disruption of our business.
In addition to computers and software packages, there are office equipment
such as fax machines, telephone switches, security systems and other common
devices which may be affected by the year 2000 problem. Of these pieces of
equipment, we have identified our voice mail system as needing replacement or
upgrade and are anticipating that this will be completed by mid-1999.
Products and software programs:
We have tested our products for year 2000 problems. This testing was
completed during the first quarter of 1999. Our engineering staff performed
compliance testing on all A3D drivers, utilities and supporting software using
testing methods and measurements that specifically addressed potential risks to
seamless integration into the year 2000 environment. Our A3D product passed both
functional and usage tests without errors due to year 2000 non-compliance.
We estimate the cost of completing any required modifications, upgrades or
replacements of our internal systems to not be significant. All systems that we
have tested to date are year 2000 compliant, except for our voice mail system
which we expect to upgrade to be compliant by mid-1999. We believe that the
systems that we have not tested can be replaced or modified in the normal course
of business.
Suppliers:
We are checking the web sites of third-party suppliers of components used
in the manufacture of our products to determine if these suppliers are
certifying that the components they provide us are year 2000 compliant. To date,
we believe all critical components that we obtain from third party suppliers are
year 2000 compliant, except that Microsoft has not indicated that Windows 95 and
its office mail programs are year 2000 compliant. We expect that we will be able
to resolve any significant year 2000 problems with Microsoft and any other
third-party suppliers of components; however, there can be no assurance that
these suppliers will resolve any or all year 2000 problems before the occurrence
of a material disruption to the operation of our business. Any failure of these
third parties to timely resolve year 2000 problems with their systems could have
a material adverse effect on our business, operating results and financial
condition.
Most likely consequences of year 2000 problems:
We expect to identify and resolve all year 2000 problems before they
materially adversely affect our business operations; however, we believe that it
is not possible to determine with complete certainty that all year 2000 problems
affecting us have been identified or corrected. The number of devices that could
be affected and the interactions among these devices are simply too numerous. In
addition, no one can accurately predict how many year 2000 problem-related
failures will occur or the severity, duration, or financial consequences of
these perhaps inevitable failures. As a result, we believe that we could
experience a significant number of operational inconveniences and inefficiencies
for us, our contract manufacturers, and our customers that will divert
management's time and attention and financial and human resources from ordinary
business activities. We also believe that it is possible that there will be
business disputes alleging that we failed to comply with the delivery terms of
contracts.
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Contingency plans:
We will develop contingency plans to be implemented if our efforts to
correct identifiable year 2000 problems are not effective. Depending on the
systems identified as non-compliant, these plans could include: accelerated
replacement of affected equipment or software, short to medium-term use of
backup equipment and software; increased work hours for our personnel; and use
of contract personnel to correct on an accelerated schedule any year 2000
problems that arise or to provide manual workarounds for information systems.
Our implementation of any of these contingency plans could have a material
adverse effect on our business, operating results and financial condition.
Disclaimer:
The discussion of our efforts and expectations relating to year 2000
compliance are forward-looking statements. Our ability to achieve year 2000
compliance and the level of incremental costs associated therewith, could be
adversely affected by, among other things, the availability and cost of
programming and testing resources, third party suppliers' ability to modify
proprietary software, and unanticipated problems identified in the ongoing
compliance review.
RISK FACTORS
In addition to the other information in this prospectus or incorporated in
this prospectus by reference, you should consider carefully the following
factors in evaluating Aureal and our business before purchasing the common stock
offered by this prospectus:
WE ARE OFFERING OUR CURRENT STOCKHOLDERS SUBSCRIPTION RIGHTS FOR OUR COMMON
STOCK
We are offering holders of our common stock on the right to subscribe for
and purchase up to an aggregate 33,333,333 shares of our common stock at $0.60
per share. Every stockholder that exercises his subscription rights may also
elect to purchase shares that other stockholders have elected not to acquire. In
the event that all 33,333,333 shares are not subscribed for by our stockholders,
Oaktree and TCW, or any combination thereof, have agreed to purchase all
remaining shares. If holders of our common stock on the record date elect not to
subscribe to the rights offering, their percentage ownership of Aureal will be
immediately and substantially diluted by the rights offering. In addition,
holders who acquired our stock after the record date and hence are not able to
participate in the rights offering, will experience immediate and substantial
dilution of their percentage ownership of Aureal.
IF WE ANNOUNCE AND EFFECT A ONE-FOR-FIFTEEN REVERSE STOCK SPLIT, THE MARKET
PRICE OF OUR COMMON STOCK MAY DECLINE
Our stock price may decline because we have announced our intentions to
effect a one-for-fifteen reverse stock split. Many companies that have announced
and then effected reverse stock splits have seen their stock price fall, both
before and after the reverse split is effected. On March 18, 1999, a special
committee of disinterested directors approved a one-for-fifteen reverse split in
our common stock. While a reverse stock split does not in any way affect the
value of, or your investment in, Aureal, the markets may react negatively to it
which will cause our stock price to decline further. We cannot assure you that,
as a result of the reverse stock split, our stock price will not decline to a
price that is less than fifteen times the price of our stock prior to the
reverse stock split.
WE HAVE SUSTAINED LOSSES IN THE PAST AND WE EXPECT TO SUSTAIN LOSSES IN THE
FUTURE
We emerged from bankruptcy in December 1994. Since that time, we have
recorded an accumulated deficit of $173 million as of January 3, 1999, the end
of our fiscal 1998. This deficit is comprised of $157 million of incurred losses
and $16 million of accretion and dividends on our preferred stock. We generated
the majority of our revenues in 1997 and 1996 through technology licensing
transactions. The majority of our revenues in 1998 came from the sale of
advanced audio products. We expect that the
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majority of our future revenues will be derived from the sale of advanced audio
products. However, we will not be profitable unless we sell significant volumes
of our advanced audio products in the future.
A DIRECTOR OF AUREAL HAS VOTING CONTROL OVER A SUBSTANTIAL AMOUNT OF OUR STOCK
AND MAY, THEREFORE, INFLUENCE OUR AFFAIRS
As of March 22, 1999, Richard Masson, a director of Aureal, is deemed to
have voting control over approximately 59% of our common stock as a result of
his affiliations with Oaktree and TCW. As a result of the amount of our stock
deemed to be under the stockholder voting control of Mr. Masson, Mr. Masson may
directly and indirectly influence the affairs of Aureal requiring stockholders'
approval. Oaktree and TCW also own 100% of the outstanding shares of our series
B preferred stock, which, upon the closing of our rights offering, will convert
into approximately 20.5 million shares of our common stock. In addition, we have
agreed to issue an additional 26.2 million shares of our common stock to Oaktree
and TCW upon their conversion of our series B preferred stock on the closing of
the rights offering. In connection with the rights offering, Oaktree and TCW
have the right to subscribe for an aggregate of 19.7 million shares of our
common stock. Accordingly, Mr. Masson can be deemed to be, and after the rights
offering will be able to, control all matters requiring approval by our
stockholders, including the election of directors and the approval of mergers or
other business combinations.
INVESTORS MAY FIND IT DIFFICULT TO TRADE OUR COMMON STOCK ON THE
OVER-THE-COUNTER ELECTRONIC BULLETIN BOARD
Our common stock trades only on the Over-the-Counter Electronic Bulletin
Board. We currently do not meet the requirements for listing on the Nasdaq
National Market or any national stock exchange. However, we believe that our
common stock will qualify for listing on the Nasdaq National Market after we
effect a one-for-fifteen reverse stock split. Because our common stock trades on
the Bulletin Board, an investor may find it very difficult to sell or to obtain
accurate quotations as to the market value of our common stock. Furthermore,
because our common stock is not listed on the Nasdaq National Market, trading in
our common stock is also subject to certain rules promulgated by the SEC under
the Securities Exchange Act of 1934. These rules require additional disclosure
by broker-dealers in connection with any trades involving a stock defined as a
penny stock. Generally, a penny stock is any non-Nasdaq National Market listed
equity security that has a market price of less than $5.00 per share, subject to
certain exceptions. Our common stock meets the definition of a penny stock. The
additional burdens imposed upon broker-dealers by such requirements may
discourage broker-dealers from affecting transactions in our common stock and
may limit the ability of purchasers of our common stock to resell our common
stock in the secondary market.
WE EXPECT THE AVERAGE SELLING PRICE OF OUR PRODUCTS TO DECREASE WHICH MAY REDUCE
GROSS MARGINS AND REVENUES
Product prices in the audio technology industry generally decrease over the
life of a particular product. The willingness of prospective customers to design
our products into their products depends to a significant extent upon our
ability to price our products at levels that are cost-effective for these
customers. As the markets for our products mature and competition increases, we
anticipate that prices for our products will decline over time. If we are unable
to reduce our costs sufficiently to offset declines in our product prices, or if
we are unable to introduce new, higher performance products with higher product
prices, our gross margins and revenues will decline.
WE DEPEND ON A CREDIT FACILITY FROM TRANSAMERICA AND GOLDMAN SACHS TO FUND OUR
BUSINESS OPERATIONS
Because we have not been profitable to date, we have had to fund our losses
through a combination of equity and debt financings. In June 1998, we entered
into a credit facility with the Technology Finance Division of Transamerica
Business Credit Corporation and Goldman Sachs Credit Partners LP. This credit
facility provides for an aggregate maximum borrowing of $40 million. The
interest rate on the credit facility is generally the prime rate plus 3% to 5%.
Accordingly, while the credit facility provides us with
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needed working capital, the high cost of servicing any borrowing under it could
negatively affect our liquidity. In addition, the credit facility may not be
sufficient to meet our working capital requirements. In the event we must secure
capital in addition to the line of credit and the proceeds we receive from this
rights offering, there can be no assurance that such capital will be available
on acceptable terms or at all. Our inability to secure such potential future
financing, if necessary, would materially adversely affect our business,
financial condition and results of operations.
TO COMPETE EFFECTIVELY IN THE AUDIO TECHNOLOGY MARKET, WE NEED TO DEVELOP NEW
AUDIO TECHNOLOGIES THAT ARE WIDELY ACCEPTED BY OUR CUSTOMERS
Our success depends on our ability to develop and market new audio
technologies aimed at advancing the level of audio quality in personal computers
and consumer electronics devices. To be successful, we must timely develop new
products that we can sell at competitive prices to our customers who will design
them into their products. In order for our customers to design our advanced
audio products into their personal computers and consumer electronic products,
we must:
- anticipate market trends;
- anticipate the performance and functionality requirements of our current
and potential customers;
- develop and produce products that meet the timing and pricing
requirements of our current and potential customers; and
- produce products that can be available in a timely manner consistent with
our current and potential customers' development and production
schedules.
We are expanding our business model to provide for an increased number of
audio-related products, including audio cards and audio communications
combination cards. We may require additional working capital funds for this
expansion to provide for incremental inventory and broader marketing programs. A
number of factors may limit the success of our expansion, and each could
negatively impact our business and results of operations. These factors include:
- the failure of the market for advanced audio products to grow;
- reduced demand for our products as a result of increased competition in
this market;
- unforeseen technological change; and
- our potential failure to introduce new versions of products that our
customers and the market accept.
A failure to develop new audio technologies that will be accepted by our
customers could materially adversely affect our ability to generate revenues.
NEW GENERATIONS OF MICROPROCESSORS AND OTHER NEW TECHNOLOGIES MAY DECREASE
DEMAND FOR OUR PRODUCTS
We also face the risk that new generations of microprocessors that are
capable of performing the function of advanced audio products will greatly
reduce demand for our products. 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
diminishes or eliminates the need or preference for our products. In addition,
each new generation of technology, including digital audio technology, generally
requires increased processing power. The increased capabilities of
microprocessors in the future may lower demand for our products which will
materially adversely affect our business, financial condition and results of
operations.
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INTENSE COMPETITION IN THE MARKET FOR AUDIO PRODUCTS AND ADVANCED AUDIO
TECHNOLOGIES COULD PREVENT AUREAL FROM INCREASING REVENUE AND PREVENT AUREAL
FROM ACHIEVING PROFITABILITY
The markets for audio products and advanced audio technologies are
intensely competitive and are characterized by evolving industry standards that
result in:
- short product life cycles;
- significant pressure to improve price and performance; and
- frequent new product introductions.
We expect competition to increase from existing competitors and from other
companies that may enter the markets for advanced audio products with devices
that may be less costly or provide higher performance or additional features
than the products we currently offer. However, we are unable to predict the
timing and nature of any such competitive product offerings.
In addition, we anticipate that we 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. Furthermore, some of these competitors
have greater intellectual property rights, broader product lines and
longer-standing relationships with their customers than we do. In addition to
our established competitors, we may also face competition from a number of
emerging companies. To remain competitive, we believe we must, among other
things, invest significant resources in developing new products and enhancing
our current products and maintaining customer satisfaction. If we fail to do so,
our products will not compete favorably with those of our competitors and our
revenue could be materially adversely affected.
WE MAY NOT HAVE AN ADEQUATE SUPPLY OF OUR PRODUCTS BECAUSE WE DEPEND ON
FOUNDRIES TO PRODUCE OUR PRODUCTS AND OUR PRODUCTS ARE DIFFICULT TO MANUFACTURE
We do not manufacture our own products, and we depend on outside
manufacturing resources for production of all of our products. Currently, we
utilize one foreign semiconductor foundry for production of the majority of our
existing products. The foundry has indicated to us that it has the manufacturing
availability to provide for our planned levels of production of each of our
products for the next 12 months; however, our production relationship with the
foundry is based only upon purchase orders. Consequently, the foundry may not
continue to adequately provide manufacturing capacity to us for our current
level of production or any potential increases in our production levels. In the
event that the foundry ceases to manufacture our products, we would have to
contract with alternative foundries. However, we may not be able to timely
contract with alternative foundries or to contract with them at all. Such a
situation could materially adversely affect our ability to sell products to our
customers, which in turn would hurt our 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 wafers, difficulties in the fabrication
process and other factors can cause a substantial percentage of wafers to be
rejected or a significant number of die on each wafer not to function. Many of
these problems are difficult to diagnose and potentially time-consuming or
expensive to remedy. The foundries that we employ may, in the future, experience
irregularities or adverse yield fluctuations in the manufacturing processes of
our products. In such event, our business, financial condition and results of
operations may be materially adversely affected.
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OUR CHARTER DOCUMENTS AND DELAWARE LAW MAY INHIBIT A TAKEOVER OF AUREAL
Provisions in our amended and restated certificate of incorporation and
bylaws may have the effect of delaying or preventing a change of control or
changes in our management. These provisions include, among others:
- the division of the board of directors into three separate classes;
- the right of the board to elect the director to fill a space created by
the expansion of the board;
- the ability of the board to alter our bylaws; and
- the requirement that at least 10% of the outstanding shares are needed to
call a special meeting of stockholders.
Furthermore, because we are incorporated in Delaware, we are subject to the
provisions of section 203 of the Delaware General Corporation Law. These
provisions prohibit certain large stockholders, in particular those owning 15%
or more of the outstanding voting stock, from consummating a merger or
combination with a corporation unless (1) 66 2/3% of the shares of voting stock
not owned by this large stockholder approve the merger or combination or (2) the
board of directors approves the merger or combination or the transaction which
resulted in the large stockholder owning 15% or more of our outstanding voting
stock.
WE MAY NOT BE ABLE TO RETAIN OUR KEY ENGINEERING, MARKETING, SALES AND
MANAGEMENT PERSONNEL THAT WE NEED TO SUCCESSFULLY MANAGE OUR BUSINESS
Our success depends to a significant extent upon the continued services of
key engineering, marketing, sales and management personnel. Our employees may
voluntarily terminate their employment with us at any time. We recognize the
value of the contributions of each of our employees, and we have developed
compensation programs, including stock programs open to all employees, designed
to retain our employees. However, competition for these employees is intense,
particularly in Silicon Valley, and the loss of the services of any one of these
employees could materially adversely affect our business, financial condition
and results of operations.
OUR PRODUCTS EMPLOY PROPRIETARY TECHNOLOGY AND THIS TECHNOLOGY MAY INFRINGE ON
THE INTELLECTUAL PROPERTY RIGHTS OF THIRD PARTIES
Our ability to compete successfully will depend, in part, on our ability to
protect our proprietary technology. We rely on a combination of patents, trade
secrets, copyright and trademark laws, nondisclosure agreements and other
contractual provisions and technical measures to protect our proprietary rights.
Nevertheless, such measures may not be adequate or safeguard the proprietary
technology underlying our advanced audio products. In addition, employees,
consultants and others who participate in the development of our products may
breach their agreements with us regarding our intellectual property, and we may
not have adequate remedies for any such breach. We also realize that our
proprietary information and trade secrets may become known through other means
not currently foreseen by us. Moreover, notwithstanding our efforts to protect
our intellectual property, our competitors may be able to develop products that
are equal or superior to our products without infringing on any of our
intellectual property rights. In addition, we may not be able to effectively
protect our intellectual property rights in certain countries. Our failure to
protect our proprietary technology may materially adversely affect our financial
condition and results of operations.
Although we do not believe that our products infringe the proprietary
rights of any third parties, third parties may still assert infringement or
invalidity claims, or claims for indemnification resulting from infringement
claims, against us. The assertion of these claims could materially adversely
affect our business, financial condition and results of operations. In addition,
irrespective of the validity or the successful assertion of any claims, we could
incur significant costs in defending against these claims. In
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defending claims of alleged infringement, we could incur significant expenses
and waste resources that could have a material adverse affect on our business,
financial condition and results of operations.
WE ARE INVOLVED IN LAWSUITS WITH CREATIVE AND E-MU WHICH COULD NEGATIVELY IMPACT
OUR BUSINESS
In February 1998, Creative Technology Ltd. and its subsidiary, E-MU
Systems, Inc., served us with a lawsuit for patent infringement that Creative
and E-MU filed in the U.S. District Court, Northern District of California. The
lawsuit asserts that our original Vortex product 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 alleged continuing acts of infringement by us and
an accounting of damages plus interest. In response, we filed a motion for
summary judgment. In August 1998, E-MU and Creative filed a motion for a
preliminary injunction with respect to our original Vortex and updated Vortex2
products. In October 1998, the court denied Creative's motion for preliminary
injunction. In addition, our motion for summary judgment was also denied. We
believe that the actions that Creative and E-MU filed are without merit, and we
are vigorously defending against these actions. In December 1998, we filed a
lawsuit alleging patent infringement against Creative and E-MU. Aureal believes
that Creative and E-MU have infringed on two of their patents, Patent No.
5,596,644 entitled "Method and Apparatus for Efficient Presentation of
Hi-Quality 3-Dimensional Audio" and Patent No. 5,802,180 entitled "Method and
Apparatus for Efficient Presentation of 3-Dimensional Audio Including Ambient
Effects."
Additional litigation may be necessary to resolve the claims asserted by
Creative and E-MU and to resolve our claims against Creative and E-MU and any
other claims asserted in the future to defend against claims of infringement or
invalidity or to enforce and protect our intellectual property rights. We cannot
assure you that we will prevail in any litigation with either of them. Also, any
litigation, whether or not determined in our favor or settled by us, would be
costly and would divert the efforts and attention of our management and
technical personnel from normal business operations; this could materially
adversely affect our business, financial condition and results of operations.
Adverse determinations in litigation could result in the loss of our proprietary
rights, subject us to significant liabilities, require us to seek licenses from
third parties or prevent us from producing certain core products. Any of these
results could have a material adverse affect on our business, financial
condition and results of operations.
THE FAILURE OF OUR KEY SUPPLIERS AND CUSTOMERS TO BE YEAR 2000 COMPLIANT COULD
NEGATIVELY IMPACT OUR BUSINESS
We use a number of computer software programs and operating systems in our
internal operations, including applications used in financial business systems
and various administration 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 possible
replacement of such source code or applications could be necessary. Given the
current information, we currently do not anticipate that such year 2000 costs
will have a material impact upon us. We have requested and obtained information
regarding year 2000 compliance from suppliers and providers of all of our
mission critical software systems. Based on the information we currently have,
all mission critical systems appear to be year 2000 compliant. We are currently
contacting major vendors and customers to obtain year 2000 compliance
certificates. The failure of any of our key suppliers or customers to be year
2000 compliant could have a material adverse effect on our business, financial
condition and results of operations.
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ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To Aureal Semiconductor Inc.:
We have audited the accompanying consolidated balance sheets of Aureal
Semiconductor Inc. (a Delaware corporation) and subsidiaries as of January 3,
1999 and December 28, 1997, and the related consolidated statements of
operations, stockholders' equity (deficit) and cash flows for each of the three
fiscal years in the period ended January 3, 1999. These financial statements are
the responsibility of the Company's management. Our responsibility is to express
an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of Aureal
Semiconductor Inc. and subsidiaries as of January 3, 1999 and December 28, 1997,
the results of their operations and their cash flows for the each of the three
fiscal years in the period ended January 3, 1999, in conformity with generally
accepted accounting principles.
Our audits were made for the purpose of forming an opinion on the basic
financial statements taken as a whole. The schedule listed in Item 14.(a)(2) of
the financial statements is presented for purposes of complying with the
Securities and Exchange Commission's rules and is not part of the basic
financial statements. This schedule has been subjected to the auditing
procedures applied in the audit of the basic financial statements and, in our
opinion, fairly states in all material respects the financial data required to
be set forth therein in relation to the basic financial statements taken as a
whole.
ARTHUR ANDERSEN LLP
San Jose, California
March 31, 1999
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AUREAL SEMICONDUCTOR INC.
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
<TABLE>
<CAPTION>
YEAR-END
----------------------
1998 1997
--------- ---------
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents.............................. $ 87 $ 135
Restricted cash........................................ 6 109
Accounts receivable, net of allowance of $289 and $12,
respectively.......................................... 4,781 21
Inventories............................................ 3,916 511
Deferred fair value of debt related warrants........... 924 3,000
Prepaid loan fees and other assets..................... 757 462
--------- ---------
Total current assets.............................. 10,471 4,238
Property and equipment:
Machinery and equipment................................ 4,636 3,785
Furniture, fixtures and improvements................... 639 599
--------- ---------
5,275 4,384
Accumulated depreciation and amortization................. (2,795) (3,170)
--------- ---------
Net property and equipment........................ 2,480 1,214
Long-term portion of fair value of debt related warrants
and other assets....................................... 687 898
--------- ---------
Total assets...................................... $ 13,638 $ 6,350
========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
Current liabilities:
Line of credit......................................... $ 4,329 $ --
Accounts payable....................................... 5,966 1,523
Accrued compensation and benefits...................... 1,765 1,115
Other accrued liabilities.............................. 1,061 1,365
Current portion of pre-petition claims................. 936 880
--------- ---------
Total current liabilities......................... 14,057 4,883
Line of credit from TCW................................... -- 21,975
Long-term portion of pre-petition claims and deferred
obligations............................................ 889 3,641
--------- ---------
14,946 30,499
--------- ---------
Commitments (See Note 6)
Stockholders' equity (deficit):
Preferred stock, $.001 par value, Authorized
shares-5,000,000:
Series A: Authorized shares-500; 500 issued and 249
outstanding in 1998 (liquidation preference value of
$3,277)............................................. -- --
Series B: Authorized shares -- 60,000; 40,966 issued
and outstanding in 1998 (liquidation preference
value of $41,230)................................... -- --
Series C: Authorized shares -- 1,500; 600 issued and
outstanding in 1998 (liquidation preference value of
$7,774)............................................. -- --
Additional paid-in capital............................. 51,421 --
Common stock, $.001 par value:
Authorized shares -- 200,000,000; Issued and
outstanding shares -- 47,676,334 in 1998 and
41,850,205 in 1997.................................. 48 42
Additional paid-in capital............................. 119,790 114,352
Accumulated deficit.................................... (172,567) (138,543)
--------- ---------
Total stockholders' equity (deficit).............. (1,308) (24,149)
--------- ---------
Total liabilities and stockholders' deficit....... $ 13,638 $ 6,350
========= =========
</TABLE>
The accompanying notes are an integral part of these financial statements.
27
<PAGE> 30
AUREAL SEMICONDUCTOR INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<TABLE>
<CAPTION>
FISCAL YEAR
--------------------------------
1998 1997 1996
-------- -------- --------
<S> <C> <C> <C>
Net Sales.................................................. $ 25,328 $ 1,640 $ 3,485
Cost of Sales.............................................. 17,808 181 304
-------- -------- --------
Gross Margin............................................... 7,520 1,459 3,181
Operating expenses:
Research and development................................. 11,817 7,425 6,231
Sales and marketing...................................... 6,373 3,662 2,177
General and administrative............................... 3,820 2,379 2,564
Amortization of reorganization asset..................... -- 2,500 2,500
Restructuring charges.................................... -- -- (804)
Write-off of acquired research and development in
progress.............................................. -- -- 6,013
-------- -------- --------
Total operating expenses......................... 22,010 15,966 18,681
-------- -------- --------
Operating loss............................................. (14,490) (14,507) (15,500)
Interest expense......................................... (2,633) (2,757) (2,239)
Amortization of debt related warrants.................... (1,789) (1,250) --
Interest income.......................................... 20 12 156
Other income (expense)................................... 386 812 563
-------- -------- --------
Loss before income taxes................................... (18,506) (17,690) (17,020)
Provision (benefit) for income taxes....................... -- -- --
-------- -------- --------
Net loss................................................... $(18,506) $(17,690) $(17,020)
======== ======== ========
Accretion/dividends related to preferred stock............. $(15,518) -- --
======== ======== ========
Net loss attributable to common shareholders............... $(34,024) $(17,690) $(17,020)
======== ======== ========
Basic and diluted loss per share........................... $ (0.79) $ (0.44) $ (0.51)
======== ======== ========
Shares used in calculating per share amounts............... 43,317 40,398 33,344
======== ======== ========
</TABLE>
The accompanying notes are an integral part of these financial statements.
28
<PAGE> 31
AUREAL SEMICONDUCTOR INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
<TABLE>
<CAPTION>
FISCAL YEAR
--------------------------------
1998 1997 1996
-------- -------- --------
<S> <C> <C> <C>
OPERATING ACTIVITIES
Net loss................................................... $(18,506) $(17,690) $(17,020)
Adjustments to reconcile net loss to net cash used in
operating activities:
Depreciation and amortization............................ 3,273 4,451 3,262
Restructuring charges.................................... -- -- (804)
Write-off of acquired research and development in
process............................................... -- -- 6,013
Changes in operating assets and liabilities (net of
assets acquired and liabilities assumed in 1996):
Restricted cash....................................... 103 (109) 206
Accounts receivable................................... (5,049) 42 212
Inventories........................................... (3,867) (437) 178
Prepaid expenses and other current assets............. (824) (59) 722
Other assets.......................................... (155) (97) 236
Accounts payable...................................... 4,423 853 (283)
Accrued compensation and benefits, and other
liabilities......................................... 151 (890) (1,729)
-------- -------- --------
Net cash used in operating activities...................... (20,451) (13,936) (9,007)
INVESTING ACTIVITIES
Payment for acquisition of business, net of cash
acquired.............................................. -- -- (2,970)
Purchases of property and equipment...................... (2,320) (881) (590)
Proceeds from disposition of property and equipment...... -- 8 3
-------- -------- --------
Net cash used in investing activities...................... (2,320) (873) (3,557)
FINANCING ACTIVITIES
Proceeds from Lines of Credit............................ 40,736 15,540 6,153
Repayment of Lines of Credit............................. (26,882) (3,890) (15,128)
Principal payments on pre-petition claims................ (1,945) (1,020) (661)
Proceeds from issuance of preferred stock, net of
expenses.............................................. 10,415 3,820 21,957
Proceeds from issuance of common stock................... 399 476 239
-------- -------- --------
Net cash provided by financing activities.................. 22,723 14,926 12,560
-------- -------- --------
Net change in cash and cash equivalents.................... (48) 117 (4)
Cash and cash equivalents at beginning of period........... 135 18 22
-------- -------- --------
Cash and cash equivalents at end of period................. $ 87 $ 135 $ 18
======== ======== ========
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
Interest paid............................................ $ 3,325 $ 2,145 $ 2,685
SUPPLEMENTAL DISCLOSURE OF NON-CASH INVESTING AND FINANCING
ACTIVITIES
Valuation of debt related warrants issued................ $ 1,848 $ 5,000 $ --
Conversion of line of credit balance to preferred
stock................................................. 28,366
Accretion/dividends on preferred stock................... 4,828
Assumption of stock options in Crystal River Engineering
acquisition........................................... -- -- 2,838
</TABLE>
The accompanying notes are an integral part of these financial statements.
29
<PAGE> 32
AUREAL SEMICONDUCTOR INC.
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY (DEFICIT)
(IN THOUSANDS, EXCEPT SHARE AMOUNTS)
<TABLE>
<CAPTION>
CONVERTIBLE
PREFERRED STOCK COMMON STOCK
------------------- --------------------------------
ADDITIONAL ADDITIONAL STOCKHOLDER'S
PAID-IN PAID-IN ACCUMULATED EQUITY
SHARES CAPITAL SHARES AMOUNT CAPITAL DEFICIT (DEFICIT)
------ ---------- ---------- ------ ---------- ----------- -------------
<S> <C> <C> <C> <C> <C> <C> <C>
BALANCE AT DECEMBER 31, 1995... -- $ -- 20,000,000 $20 $ 79,980 $(103,833) $(23,833)
Issuance of common stock in
private placement
transactions................. 18,888,888 19 21,938 21,957
Issuance of common stock upon
exercise of stock options.... 301,907 239 239
Value of stock options in CRE
Acquisition.................... 2,838 2,838
Valuation of stock options and
warrants issued to non-employees... 58 58
Net Loss....................... -- -- -- (17,020) (17,020)
------ ------- ---------- --- -------- --------- --------
BALANCE AT DECEMBER 29, 1996... -- $ -- 39,190,795 $39 $105,053 $(120,853) $(15,761)
Issuance of common stock and
warrants in private placement
transactions................. 1,910,000 2 3,818 3,820
Issuance of common stock upon
exercise of stock options.... 749,410 1 475 476
Valuation of debt related
warrants..................... 5,000 5,000
Valuation of stock options
issued to non-employees...... 6 6
Net Loss....................... -- -- -- (17,690) (17,690)
------ ------- ---------- --- -------- --------- --------
BALANCE AT DECEMBER 28, 1997... -- $ -- 41,850,205 $42 $114,352 $(138,543) $(24,149)
Issuance of common stock and
warrants in private placement
transactions................. 70,000 185 185
Issuance of common stock upon
exercise of stock options.... 491,484 214 214
Issuance of series A preferred
stock, net................... 500 4,784 4,784
Issuance of series B preferred
stock, net................... 39,375 39,056 (10,690) 28,366
Issuance of series C preferred
stock, net................... 600 5,950 5,950
Conversion of preferred stock
to common stock.............. (251) (3,197) 5,264,645 6 3,191 --
Valuation of debt related
warrants..................... 1,848 1,848
Accretion/dividends related to
preferred stock.............. 1,591 4,828 (4,828) --
Net Loss....................... -- -- -- (18,506) (18,506)
------ ------- ---------- --- -------- --------- --------
BALANCE AT JANUARY 3, 1999..... 41,815 $51,421 47,676,334 $48 $119,790 $(172,567) $ (1,308)
====== ======= ========== === ======== ========= ========
</TABLE>
The accompanying notes are an integral part of these financial statements.
30
<PAGE> 33
AUREAL SEMICONDUCTOR INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. BUSINESS AND RECENT EVENTS
Aureal Semiconductor Inc., together with our subsidiary Crystal River
Engineering, Inc. 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 us in the
second quarter of 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. Our business involves the development and sale of audio processing
semiconductor chips, and the licensing of technology which is designed to define
and develop advanced audio standards in the marketplace. Our stock symbol on the
Over-the Counter bulletin board is AURL.
During March 1998, we completed the sale of $5 million of series A
preferred stock. On June 5, 1998, we completed three financing transactions
which had the combined effect of increasing our borrowing capacity and providing
additional equity. The transactions included the following:
- - The sale of $5 million of 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.
- - The remaining balance of $31.5 million on the existing line of credit was
exchanged for 39,375 shares of our series B preferred stock.
- - A new $40 million revolving credit facility was established with the
Technology Finance division of Transamerica Business Credit Corporation
("Transamerica") and Goldman Sachs Credit Partners LP ("Goldman Sachs").
In addition to the above financing transactions, on June 26, 1998, we
completed the sale of $1 million of our 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 consolidated financial statements include the accounts of Aureal and
our wholly-owned subsidiaries. All significant intercompany accounts are
eliminated in consolidation. The results of operations for the periods presented
are not necessarily indicative of results that may be expected in future
periods.
Our fiscal quarters include thirteen weeks, and the fiscal year ends on the
Sunday nearest the calendar year-end. For the years presented, the year ends
occurred on January 3, 1999, December 28, 1997 and December 29, 1996.
Use of estimates
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
disclosures of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
31
<PAGE> 34
AUREAL SEMICONDUCTOR INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
Cash equivalents and restricted cash
We consider all investments purchased with an original maturity of three
months or less to be cash equivalents. As of year end 1998, restricted cash
represented deposits for a flexible spending benefit plan for employees.
Inventories
Inventories are stated at the lower-of-cost-or-market value on a
weighted-average costing method. We do not consider any inventory to be raw
material, since our initial point of purchase is for fabricated silicon wafers.
Net inventories at fiscal year end for 1998 and 1997 consist of the following,
in thousands:
<TABLE>
<CAPTION>
1998 1997
------ ----
<S> <C> <C>
Work-in-process............................................. $2,460 $243
Finished goods.............................................. 1,456 268
------ ----
Total inventories........................................... $3,916 $511
====== ====
</TABLE>
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). Leasehold improvements are amortized utilizing the straight-line method
over their estimated useful lives or the term of the lease whichever is shorter.
Maintenance and repairs are expensed as incurred.
Revenue recognition
Our major sources of revenue consisted of sales of proprietary design,
advanced audio semiconductor chips and boards 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 probable, and there are no remaining
significant obligations.
Comprehensive income
In June 1997, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 130, "Reporting Comprehensive Income", which
we adopted in the first quarter of fiscal 1998. Statement of Financial
Accounting Standards No. 130 requires that we disclose all non-owner changes in
equity, such as cumulative foreign currency translation adjustments, certain
minimum pension liabilities and gains and losses on available-for-sale
securities. During the three fiscal years in the period ended January 3, 1999,
we had no elements of comprehensive income.
Concentration of financial instrument risks
Financial instruments which potentially subject us to concentration of
market risk consist primarily of our line of credit. Concentration of market
risk on the line of credit is related to changes in the prime lending rate, as
our line of credit bears interest rates which fluctuate with changes in the
prime lending rate. Our credit risk consists primarily of trade receivables.
Some of our trade receivables are the result of sales to foreign companies. We
have established an allowance for doubtful accounts based on the credit risks of
the business in general.
32
<PAGE> 35
AUREAL SEMICONDUCTOR INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
Valuation of warrants
In August 1997, in conjunction with the expansion and extension of the TCW
line of credit, we issued warrants to purchase 3.15 million shares of our common
stock to the lenders. 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 line of credit at the rate of
$.75 million per quarter. When the line of credit was converted in June of 1998
to shares of our series B preferred stock, the remaining unamortized deferred
costs related to the warrants, along with unamortized prepaid loan fees, 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, we issued warrants to purchase
1.35 million shares of our 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.
Loss per share
The Financial Accounting Standards Board has issued Statement of Financial
Accounting Standards No. 128, which is effective for financial statements for
periods ending after December 15, 1997. Statement of Financial Accounting
Standards No. 128 requires that the calculation for basic earnings per share
exclude the dilutive effect of common stock equivalents in the calculation for
basic net income (loss) per share. Diluted earnings per share under Statement of
Financial Accounting Standards No. 128, is calculated using the weighted average
number of common 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 earnings per share 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.
Accretion related to the beneficial conversion features of the series A
preferred and the series C preferred, the favorable conversion value on
conversion of debt to Series B preferred and the dividend/ accretion rate of 8%
on all three series of preferred stock totaled $15.5 million during fiscal year
1998. These charges were recorded directly to accumulated deficit and are
included as a component of net loss per share attributable to common
stockholders.
Amortization of Intangibles
We exited from Chapter 11 bankruptcy protection on December 31, 1994, and
on that date our reorganization value in excess of our net assets generated a
$44.1 million intangible value that was classified as a reorganization asset in
our consolidated balance sheet. The reorganization asset consisted primarily of
proprietary technology and other intangibles having an estimated useful life of
three years. Accordingly, the reorganization asset was amortized on a
straight-line basis over three years. The carrying value of the reorganization
asset was reviewed during the second quarter of 1995 in light of our revenue and
profitability levels and the related decision to divest our retail business.
This review suggested that the reorganization asset was impaired, as determined
based on our projected cash flows over the remaining amortization period. The
cash flow projections anticipated the cost and probable future savings from the
restructuring actions, the expected benefit from products and technologies then
in the latter stages of development, and availability of existing capital.
Consequently, the carrying value of the reorganization asset was reduced during
the second quarter of 1995 to $6.2 million in accordance with Statement of
Financial Accounting Standards No. 121, "Accounting for the Impairment of
Long-Lived Assets and for
33
<PAGE> 36
AUREAL SEMICONDUCTOR INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
Long-Lived Assets to be Disposed Of". Amortization of the reorganization asset
for 1997 and 1996 was $2.5 million and $2.5 million, respectively, and was
included as a component of operating expenses. The reorganization asset was
amortized at a rate of $625,000 per quarter through 1997 and as of December 28,
1997 was fully amortized.
Recently issued accounting standards
In June 1997, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 131, "Disclosures about Segments of an
Enterprise and Related Information", which established standards for reporting
information about operating segments in annual financial statements and interim
financial reports. It also established standards for related disclosures about
products and services, major customers and geographic areas. Generally,
financial information is required to be reported on the basis that it is used
internally for evaluating segment performance and deciding how to allocate
resources to segments. We adopted Statement of Financial Accounting Standards
131 in fiscal 1998. We are organized and operate as one business segment
designing, developing, manufacturing and marketing proprietary, advanced audio
solutions. As a result, the adoption of Statement of Financial Accounting
Standards 131 had no impact on our disclosures or financial statements.
3. ACQUISITION OF CRYSTAL RIVER ENGINEERING, INC.
During the second quarter of 1996, we acquired 100% ownership of Crystal
River Engineering Inc., a privately held firm specializing in the development of
3D audio technologies. The acquisition consideration included purchase of stock
for cash totaling approximately $2.9 million, the exchange of stock options
valued at $2.8 million and other cash considerations, both current and deferred,
totaling approximately $0.6 million. The acquisition was recorded using purchase
accounting. All operating results of Crystal River Engineering, Inc. subsequent
to the date of acquisition have been included in our consolidated financial
statements. The fair value of Crystal River Engineering Inc. assets and
liabilities at the date of acquisition were recorded in our consolidated
financial statements. As part of the allocation of fair values, we recorded a
non-recurring write-off of approximately $6.0 million in the second quarter due
to recognition that in-process research and development efforts associated with
Crystal River Engineering, Inc's. 3D audio technology had not reached
technological feasibility with respect to our product line at the date of
acquisition.
The unaudited pro-forma information assuming the acquisition had taken
place at the beginning of the 1996 fiscal year is shown below, in thousands
except per share amounts:
<TABLE>
<CAPTION>
FISCAL
1996
--------
<S> <C>
Revenues.................................................. $ 3,909
Costs and expenses........................................ 21,725
--------
Net loss.................................................. $(17,816)
========
Net loss per share........................................ $ (0.53)
========
</TABLE>
34
<PAGE> 37
AUREAL SEMICONDUCTOR INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
4. OTHER ACCRUED LIABILITIES
Other accrued liabilities as of year-end 1998 and 1997 consist of the
following, in thousands:
<TABLE>
<CAPTION>
1998 1997
------ ------
<S> <C> <C>
Interest payable........................................... $ 73 $ 687
Loan fees.................................................. 200 --
Professional fees related to bankruptcy filings............ -- 145
Legal...................................................... 500 260
Other...................................................... 288 273
------ ------
$1,061 $1,365
====== ======
</TABLE>
5. CREDIT FACILITY
On June 5, 1998, in conjunction with the elimination of the previous line
of credit, we entered into a two year $40 million revolving credit facility with
Transamerica and Goldman Sachs partially secured by our assets. Terms of the new
credit facility provide for up to $32.5 million borrowing availability related
to specific accounts receivable, referred to as Tranche A, with an additional
$7.5 million of availability unrelated to specific collateral requirements,
referred to as Tranche B. Interest on borrowings under the two-year agreement is
at the rates of prime plus 3% for Tranche A borrowings and prime plus 5% percent
for Tranche B borrowings. We are subject to certain covenant restrictions under
the credit facility and have paid a $600,000 fee to the lenders in connection
with the initiation of the credit facility.
Also in conjunction with the establishment of the new credit facility, we
issued warrants to purchase 1.35 million shares of our common stock 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.
At January 3, 1999, our borrowings under this credit facility included $3.8
million of Tranche A borrowings at an interest rate of 10.75% and $0.5 million
of Tranche B borrowings at an interest rate of 12.75%. Our unused borrowing
availability under Tranche B was $7.0 million. At year-end 1998, our financial
ratios were out of compliance with financial covenant requirements for the
credit facility; however, at March 22, 1999 we had secured a waiver of
non-compliance for these specific covenant requirements.
6. COMMITMENTS
Operating leases
We utilize facilities and certain equipment under non-cancelable operating
leases that expire at various dates through the year 2000. Under the terms of
the leases, we are generally responsible for taxes, insurance, and normal
maintenance costs. Aggregate future minimum annual payments under the operating
leases as of January 3, 1999 are as follows, in thousands:
<TABLE>
<CAPTION>
MINIMUM
COMMITMENT
----------
<S> <C>
1999..................................................... $213
2000 and thereafter...................................... 34
----
Total minimum lease payments............................. $247
====
</TABLE>
Rent expenses charged to operations totaled $0.2 million for each of the
fiscal years 1998, 1997 and 1996.
35
<PAGE> 38
AUREAL SEMICONDUCTOR INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
6. COMMITMENTS (CONTINUED)
Pre-petition claims
Pursuant to the plan of reorganization under which we exited Chapter 11
bankruptcy protection in 1994, we assumed certain lease claims and
administrative tax claims as unsecured debt obligations. These obligations are
payable in both monthly and quarterly installments through 2000 and bear
interest at 9.0% to 9.3%. Minimum future payment obligations as of January 3,
1999 are as follows, in thousands:
<TABLE>
<S> <C>
1999........................................................ $1,064
2000........................................................ 883
2001 and thereafter......................................... 22
------
Total future minimum payments............................... 1,969
Less amounts representing interest........................ (166)
------
Present value of future minimum payments.................... 1,803
Less current portion...................................... (936)
------
Long-term portion........................................... $ 867
======
</TABLE>
Litigation
We have received, and may receive in the future, communications from third
parties asserting that our trademarks or products infringe patents, copyrights
or proprietary rights of third parties or seeking indemnification against such
infringement. The costs of any litigation alleging that we have infringed the
proprietary rights of a third party, or damages resulting from such a claim,
could be substantial and could materially adversely affect our business,
financial condition and results of operations. We do not believe that any
currently known legal matters, including those mentioned below, will result in a
settlement which would adversely impact our financial position.
In February 1998, we were served with a suit for patent infringement filed
by Creative Technology Ltd., a Singapore corporation, commonly referred to as
Creative, and its subsidiary, E-MU Systems, Inc., a California corporation,
commonly referred to as E-MU. The suit alleges that a portion of our Vortex
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 us and an accounting of damages plus interest. In
response, we filed a motion for summary judgement. In October of 1998, the court
issued its first ruling in this case denying the Creative motion for a
preliminary injunction. The court also denied our motion for a summary
judgement. Further hearings were set for summer of 1999. We believe that the
actions brought by Creative and E-MU are without merit and will continue to
vigorously defend our position.
In October 1998, Creative Labs, the U.S. based subsidiary of Creative,
filed a second lawsuit against us. This new lawsuit claims "false advertising"
and "unfair business practices". These complaints center primarily on a
comparison chart prepared by Aureal and published by third parties on the world
wide web. We believe that this action is without merit and have commenced a
vigorous defense of this action. We have filed a response denying these
allegations and filed counterclaims against Creative Labs.
7. STOCKHOLDERS' EQUITY (DEFICIT)
Preferred stock
During the first half of 1998, we issued three series of preferred stock.
The net proceeds from all the preferred stock issuances were used to reduce our
outstanding debt and for working capital purposes. In
36
<PAGE> 39
AUREAL SEMICONDUCTOR INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
7. STOCKHOLDERS' EQUITY (DEFICIT) (CONTINUED)
March, we issued $5 million of series A preferred stock. The series A preferred
shares include rights to convert the preferred stock into shares of our 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 to a redemption value
at an 8% annual rate over their three-year term.
On June 5, 1998, we sold $5 million of series C preferred to DDJ Capital
Management, LLC. The terms of the series C preferred are virtually identical to
the series A preferred. On June 26, 1998, we sold an additional $1 million of
series C preferred to non-affiliates. The terms of the series C preferred stock
call for an 8% accretion rate over the three-year term and provide for
conversion to our common stock, or redemption, at our option. The series C
preferred shares include rights to convert the preferred stock into shares of
our 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.
Also on June 5, 1998, we exchanged 39,375 shares of series B preferred for
the entire $31.5 million outstanding balance of our line of credit with TCW. 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 our option. Dividends of 1,591 shares were issued during
fiscal 1998 and an additional accrual of $209,000 was accrued for dividends
payable at year end. We have the option for redeem the series B preferred stock
at its face value at any time during the five-year term. 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 associated unamortized fees, was
charged directly to accumulated deficit at the time of the transaction.
On December 14, 1998, we registered a total of 65,451,586 shares of common
stock to cover certain issued but unregistered shares of our common stock, the
conversion of the series A, B and C preferred stock and the exercise of the
warrants. Although this number covers more shares than the series A, B and C
preferred stock were able to convert into as of December 14, 1998, because of
the variable conversion price of the series A and C preferred stock, we may have
to register additional shares of common stock in the future. As of December 14,
1998, the holders of the series A, B and C preferred stock and the holders of
the warrants converted or could have converted their securities into 43,445,949
shares of common stock. Our series A and C preferred stockholders are not
entitled to voting privileges. For all three series of preferred stock, any
shares of stock remaining at the end of the term will be converted to common
stock at that time under the terms of each series offering.
The series A and C preferred shares each allowed for a beneficial
conversion price, relative to the market value of our common stock on the date
of issuance of the preferred shares, dependent upon the future fair market value
of our common stock in future periods. The value of this conversion feature
along with the dividend/accretion of 8% on all three series of preferred stock
is shown in the accompanying statement of stockholders' equity (deficit).
Additional details of the ownership position of the original preferred stock
offerings, as of March 22, 1999, are provided below, in thousands (unaudited):
<TABLE>
<CAPTION>
CLASS OF STOCK SERIES A SERIES B SERIES C
-------------- -------- -------- --------
<S> <C> <C> <C>
Original value issued................................... $5,000 $39,375 $6,000
Remaining stock value outstanding (at original issue
value)................................................ $ 35 $39,375 $1,540
Remaining stock value outstanding held by affiliates (at
original issue value)................................. $ -- $39,375 $1,000
% outstanding held by affiliates........................ 0% 100% 65%
</TABLE>
37
<PAGE> 40
AUREAL SEMICONDUCTOR INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
7. STOCKHOLDERS' EQUITY (DEFICIT) (CONTINUED)
Private placement of common stock
On August 6, 1997, we completed a private placement of equity capital, and
at the same time increased and extended our previous line of credit. The equity
transaction provided proceeds of approximately $3.8 million from the sale of 1.9
million common stock units at a price of $2.00 per unit. Each unit consisted of
one share of common stock and one-half of one warrant to purchase one share of
common stock at a price of $2.00 per share. The participants in this private
placement included the TCW Group, Inc., and DDJ Capital Management, LLC. Also
occurring on August 6, 1997, a total of 3,150,000 warrants for the purchase of
3,150,000 shares of common stock, at a purchase price of $2.00 per share, were
issued to the debt holders of the $31.5 million line of credit. All of the
warrants issued in conjunction with the sale of common stock units and the line
of credit extension terminate if not exercised prior to August 6, 2001. Net
proceeds from the sale of stock were used to pay down the line of credit.
During the first half of 1996, in three private transactions, we sold a
total of 18.9 million shares of common stock for $22 million. The proceeds from
the sale of this stock were used for working capital, to pay down the existing
TCW credit facility and to partially fund the acquisition of Crystal River
Engineering, Inc. All shares sold in these transactions, along with other shares
previously acquired by TCW have been registered for potential resale by the
holders into the public market via a Form S-3 registration statement declared
effective in June 1996 by the Securities and Exchange Commission.
Stock option plans
We have three stock option plans under which eligible individuals have been
granted options to purchase shares of common stock. In 1994, the board of
directors established and stockholders approved the 1994 Stock Option Plan
whereby 3,000,000 shares of common stock were reserved for issuance to employees
including consultants and directors who are employees. In August 1995, the board
of directors established the 1995 Stock Option Plan whereby 1,000,000 additional
shares were reserved for future issuance to employees including consultants and
directors who are not employees.
In February 1996, the board of directors, in anticipation of the above
noted private placement transactions, approved an increase of the share reserve
under the 1995 option plan such that an aggregate 20% of all outstanding shares
on a fully diluted basis would be available for issuance under the 1994 option
plan and the 1995 option plan, combined. The 1995 option plan was approved by
our stockholders at their May 1996 meeting. The 1995 option plan was amended at
a special meeting of our stockholders in December 1998. At this meeting the
maximum number of shares that may be issued under the plan was increased by
13,000,000 to a total of 25,000,000. Options granted under the 1994 and 1995
option plans are either incentive stock options or non-statutory stock options,
as designated by the plan administrator. In November 1996, the board of
directors established the 1996 Outside Directors Stock Option Plan whereby
200,000 shares of common stock were reserved for issuance to directors who are
not employees. The 1996 outside director option plan was formally approved at
the stockholders' meeting in May 1997.
The 1994 option plan provides that (i) the exercise price of an incentive
stock option will be no less than the fair market value of our common stock at
the date of grant, and (ii) the exercise price to an optionee who possesses more
than 10% of the total combined voting power of all classes of stock will be no
less than 110% of the fair market value, all as determined by the plan
administrator. Vesting under the 1994 option plan provides the holder the right
to exercise 20% of the shares 180 days after the date of grant, and the
remaining 80% at the rate of 1/42 per month over the succeeding 42 months. The
plan administrator has the authority to set exercise dates, no longer than ten
years from date of grant, or five years for an optionee who meets the 10%
criteria, payment terms and other provisions for each grant.
38
<PAGE> 41
AUREAL SEMICONDUCTOR INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
7. STOCKHOLDERS' EQUITY (DEFICIT) (CONTINUED)
The 1995 option plan provides that (i) the exercise price of an incentive
stock option will be no less than the fair market value of our common stock at
the date of grant, and (ii) the exercise price to an optionee who possesses more
than 10% of the total combined voting power of all classes of stock will be no
less than 110% of the fair market value, all as determined by the plan
administrator. Options under the 1995 option plan are generally exercisable
immediately, but are subject to repurchase based upon certain criteria
established by the plan administrator at the time the option is granted. The
plan administrator has the authority to set exercise dates, no longer than ten
years from date of grant, or five years for an optionee who meets the 10%
criteria, payment terms and other provisions for each grant. Vesting under the
1995 option plan provides the holder the right to exercise 25% of the shares one
year after the date of grant, and the remaining 75% at the rate of 2.08% per
month over the succeeding 36 months. Any outstanding options terminate 10 years
from the date of grant if not exercised previously.
The 1996 outside directors option plan provides that (i) automatic grants
of options for 30,000 shares are made to eligible directors upon appointment or
election to the board and incremental grants of options for 5,000 shares are
made annually thereafter, and (ii) the exercise prices of the options will be
the fair market value of the shares of stock on the date the options are
granted. Vesting under the 1996 directors option plan provides the holder the
right to exercise 25% of the shares one year after the date of grant, and the
remaining 75% at the rate of 2.08% per month over the succeeding 36 months. Any
outstanding options terminate 10 years from the date of grant if not exercised
previously.
Activity under the three option plans described above from 1996 through
1998 has been as follows:
<TABLE>
<CAPTION>
OPTIONS OUTSTANDING
--------------------------------------------------------------
OPTIONS WEIGHTED
AVAILABLE STOCK EXERCISE PRICE AVERAGE
FOR GRANT OPTIONS PER SHARE EXERCISE PRICE
---------- ---------- -------------- ----------------
<S> <C> <C> <C> <C>
BALANCE AT DECEMBER 31, 1995......... 998,553 3,001,447 $0.93 - $1.88 $1.43
Additional share reservation......... 8,567,067
Options granted...................... (4,278,750) 4,278,750 $0.88 - $2.48 $1.38
Options issued in CRE
Acquisition........................ (2,644,845) 2,644,845 $0.12 - $0.40 $0.28
Options exercised.................... (301,907) $0.12 - $1.88 $0.79
Options canceled..................... 410,448 (461,287) $0.36 - $1.88 $1.60
---------- ----------
BALANCE AT DECEMBER 29, 1996......... 3,052,473 9,161,848 $0.12 - $2.48 $1.09
Additional share reservation......... 475,566
Options granted...................... (3,002,000) 3,002,000 $1.75 - $2.80 $2.00
Options exercised.................... (749,410) $0.12 - $2.00 $0.74
Options canceled..................... 661,186 (661,186) $0.36 - $2.37 $1.46
---------- ----------
BALANCE AT DECEMBER 28, 1997......... 1,187,225 10,753,252 $0.12 - $2.80 $1.35
Additional share reservation......... 15,762,763
Options granted...................... (9,626,250) 9,626,250 $0.46 - $3.22 $1.04
Options exercised.................... (491,484) $0.12 - $1.81 $0.48
Options canceled..................... 7,430,663 (7,430,663) $0.36 - $3.22 $1.85
---------- ----------
BALANCE AT JANUARY 3, 1999........... 14,754,401 12,457,355 $0.12 - $2.48 $0.85
========== ==========
</TABLE>
In September 1998, outstanding options for approximately 6.3 million shares
granted under our various options plans were regranted at exercise prices equal
to the fair market value on the date of the
39
<PAGE> 42
AUREAL SEMICONDUCTOR INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
7. STOCKHOLDERS' EQUITY (DEFICIT) (CONTINUED)
regrant. The regrant did not effect the vested status of the options; however,
the options holders agreed to a six month "blackout" of their ability to
exercise the options after the date of the regrant.
As of January 3, 1999, 12,457,355 options were outstanding, and 12,378,060
options were exercisable at exercise prices ranging from $0.12 to $2.48 per
share. Of these shares, 9,876,071 were subject to our buyback provisions which
allow us to repurchase the shares at the option exercise price. The weighted
average remaining contractual life of the 12,457,355 options outstanding is 7.89
years.
In addition to the above stock option activity, warrants to purchase
5,645,000 shares were outstanding at January 3, 1999 at prices ranging from
$1.62 to $2.50. These warrants will expire by August 6, 2001 if not previously
exercised.
The Financial Accounting Standards Board Statement of Financial Accounting
Standards No. 123 "Accounting for Stock-Based Compensation" requires increased
disclosure of certain calculated value information related to stock options
granted to employees and specific accounting treatment for stock-based
compensation granted to non-employees. Statement of Financial Accounting
Standards No. 123 requires that a fair value be estimated using an option
valuation model, such as the Black-Scholes model We adopted Statement of
Financial Accounting Standards No. 123 effective for 1996, as required, although
under the terms of the statement, continue to account for stock-based
compensation for employees under criteria set forth in APB 25. Accordingly, no
compensation cost has been recognized related to employee stock option plan
activity. The amount recognized for 1998 related to stock options granted to
non-employee contractors was not material.
Statement of Financial Accounting Standards No. 123 requires disclosure of
calculated values for a fair value method of accounting for stock-based
compensation granted to employees if such accounting under Statement of
Financial Accounting Standards No. 123 is not implemented. It should be noted
that these valuation calculations are not necessarily indicative of the value of
the stock options at the time of grant or any specific time in the future, but
rather represent a calculation called for under the provisions of Statement of
Financial Accounting Standards No. 123. If we had elected to recognize
compensation cost, determined as the fair value of the options at grant date,
under the provisions of Statement of Financial Accounting Standards No. 123, our
net loss and loss per share would have been increased to the pro forma amounts
indicated below:
<TABLE>
<CAPTION>
1998 1997 1996
-------- -------- --------
<S> <C> <C> <C>
Net loss (in thousands)
As reported...................................... $(18,506) $(17,690) $(17,020)
======== ======== ========
Pro forma........................................ $(22,321) $(20,365) $(20,439)
======== ======== ========
Loss per share (basic and diluted)
As reported...................................... $ (0.79) $ (0.44) $ (0.51)
======== ======== ========
Pro forma........................................ $ (0.87) $ (0.50) $ (0.61)
======== ======== ========
</TABLE>
For purposes of this disclosure, the fair value of each option granted to
employees is estimated on the grant date using the Black-Scholes option pricing
model, with the following weighted average assumptions for all years presented:
<TABLE>
<S> <C>
Expected dividend yield........................... 0%
Expected stock price volatility................... 80%
Risk-free interest rate utilized.................. 6%
Expected option life.............................. 3.4 years
</TABLE>
40
<PAGE> 43
AUREAL SEMICONDUCTOR INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
7. STOCKHOLDERS' EQUITY (DEFICIT) (CONTINUED)
The weighted average grant date fair value of options granted during 1998,
1997 and 1996 were estimated as $1.04, $1.55 and $1.09, respectively, utilizing
the above assumptions and the estimation process called for under Statement of
Financial Accounting Standards No. 123.
8. EMPLOYEE BENEFIT PLAN
We maintain the Aureal Semiconductor Tax Deferred Savings Plan, commonly
referred to as the 401(k) Plan, to provide retirement benefits for eligible
employees. Under the terms of the 401(k) Plan, employees may elect to contribute
up to 15% of their gross compensation limited to a statutory maximum. We match
employee contributions at the rate of 50%. Our contributions for participants
vest over five years based upon the number of years employed. The matching
contribution expense was $327,000, $225,000, and $183,000 in 1998, 1997 and
1996, respectively.
9. INCOME TAXES
The benefit for income taxes reconciles to the amount calculated by
applying the federal statutory rate to loss from continuing operations before
provision for income taxes as follows:
<TABLE>
<CAPTION>
1998 1997 1996
------- ------- -------
(IN THOUSANDS)
<S> <C> <C> <C>
Federal tax benefit on loss from continuing
operations computed at statutory rate....... $(6,292) $(6,015) $(5,787)
Changes in prior year valuation allowance:
Increase in valuation allowance............. 6,872 5,379 2,396
Non-deductible reorganization expenses........ -- 850 2,894
Research credits and other.................... (580) (214) 497
------- ------- -------
$ -- $ -- $ --
======= ======= =======
</TABLE>
Deferred tax assets are comprised of the following:
<TABLE>
<CAPTION>
1998 1997
--------- --------
(IN THOUSANDS)
<S> <C> <C>
Federal net operating loss carryforward............... $ 104,635 $ 96,967
Temporary differences................................. (526) 559
Tax credit carryforwards.............................. 2,761 2,472
--------- --------
106,870 99,998
========= ========
Valuation allowance................................... (106,870) (99,998)
--------- --------
$ -- $ --
========= ========
</TABLE>
Temporary differences represent differences in the recognition of assets
and liabilities for tax and financial reporting purposes, primarily receivable
and inventory allowances and obligations for restructuring and bankruptcy
proceedings attributable to our former retail operations.
At January 3, 1999, we had available net operating loss carryforwards
("NOL's") of approximately $308 million to reduce future taxable income. The
NOL's expire on various dates through 2013. In connection with the adoption of
fresh start accounting in 1994, any tax benefit resulting from the use of these
NOL's or future tax deductible amounts will be reported as a direct addition to
stockholders' equity.
41
<PAGE> 44
AUREAL SEMICONDUCTOR INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
10. INDUSTRY SEGMENTS AND MAJOR CUSTOMERS
1998 was our first year of significant product sales subsequent to our 1995
restructuring. Aureal operates in a single segment which includes three product
revenue groups. During 1998, we generated $18 million in revenues from the sale
of chips, $6.6 million from the sale of board-level products and $0.7 million
from licensing agreements. Almost all of our revenues related to newly developed
technologies. Three new customers accounted for approximately 26%, 25% and 22%,
respectively, of total 1998 revenues. Approximately 44% of our total product and
licensing revenues in 1998 came from foreign customers. Of total revenues in
1998, 26% were from customers in Singapore.
During 1997, the majority of our revenues resulted from licensing or
contract transactions. Essentially all of the revenues related to newly
developed technologies, and not to our legacy technologies. Three customers
accounted for approximately 15%, 15% and 14% respectively of total 1997
revenues. None of the three customers purchased semiconductor chips from us in
1997. Approximately 28% of 1997 revenues came from sales or licensing
transactions with foreign customers.
Pursuant to our restructuring in mid-1995, revenues after that time through
1996, consisted primarily of audio technology licensing fees related to our
legacy technologies, as we focused on the development of a number of new audio
semiconductor products. During 1996, two customers accounted for approximately
$2.5 million, $2.0 million and $500,000, respectively, or 72% of net sales,
through license payments for these legacy audio technologies. Neither of the
companies accounted for significant revenues in 1997 or 1998. We discontinued
operations in our foreign locations during 1995, however, approximately 10% of
our 1996 revenues came from sales to foreign customers.
11. SUBSEQUENT EVENT -- RECAPITALIZATION
In March 1999, we reached, and our board of directors approved, an
agreement with our largest shareholders, Oaktree and TCW, under which we will
offer for sale $20 million of our common stock under a subscription rights
offering. Stockholders of our common stock on the date of record will be
offered, on a pro-rata basis, the opportunity to purchase new shares of our
common stock. Oaktree and TCW, or any combination thereof, have agreed to
purchase any remaining unsubscribed shares of this offering, up to a maximum
amount of $20 million. Oaktree and TCW have provided Transamerica and Goldman
Sachs with certain guarantees to extend their participation under the existing
loan agreement until the earlier of the completion of a minimum of $25 million
renewed loan agreement or the completion of the rights offering. In addition, we
have also agreed to issue an additional 26.2 million shares of common stock to
holders of our series B preferred stock who convert those shares into common
stock upon the closing of the rights offering. These additional 26.2 million
shares will not be registered but we will grant standard demand and piggyback
rights to the holders of those shares. We understand that TCW and Oaktree,
holders of all of our series B preferred stock, intend to convert their shares
of series B preferred stock into 20.5 million shares of common stock upon the
closing of the rights offering. Oaktree recently purchased the majority of the
preferred stock position previously held by DDJ. These actions will effectively
eliminate the majority of our preferred stock and convert it to common stock.
At our 1999 annual meeting of stockholders, we are seeking stockholder
approval for a one-for-fifteen stock split. At this time, we will also be
seeking stockholder approval for an increase in the number of shares for the
option plan. These actions have not been reflected in the accompanying
consolidated financial statements.
42
<PAGE> 45
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
We reported no changes in independent accountants, nor disagreements with
accountants on accounting and financial disclosure issues during 1998.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
For information required under this item with respect to our directors, see
"Information concerning the board of directors" and "Section 16 (a) beneficial
ownership reporting compliance" in our definitive proxy statement relating to
the annual meeting of stockholders expected to be held on May 19, 1999 which
sections are hereby incorporated by reference.
For information required under this item with respect to executive officers
of ours see "Management" under Item 1.
ITEM 11. EXECUTIVE COMPENSATION
For information required under this item with respect to executive
compensation, see "Executive compensation" in our definitive proxy statement
relating to the annual meeting of stockholders expected to be held on May 19,
1999, which sections are hereby incorporated by reference.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
For information required under this item with respect to beneficial
ownership of our voting securities by each director and all executive officers
and directors as a group, and by any person known to beneficially own more than
5% of any class of voting security of we, see "Security ownership by certain
beneficial owners and management" in our definitive proxy statement relating to
the annual meeting of stockholders expected to be held on May 19, 1999 which
sections are hereby incorporated by reference.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
For information required under this item with respect to certain
relationships and related transactions, see "Board compensation" and "Certain
relationships and related transactions" in our definitive proxy statement
relating to the annual meeting of stockholders expected to be held on May 19,
1999, which sections are hereby incorporated by reference.
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a)(1) Financial Statements:
The following financial statements of Aureal Semiconductor Inc. and related
notes, together with the report thereon of Arthur Andersen LLP, our independent
public accountants, are set forth herein as indicated below.
<TABLE>
<CAPTION>
PAGE
----
<S> <C>
Report of Independent Public Accountants.................... 26
Audited Consolidated Financial Statements:
Consolidated Balance Sheets............................... 27
Consolidated Statements of Operations..................... 28
Consolidated Statements of Cash Flows..................... 29
Consolidated Statement of Stockholders' Equity
(Deficit).............................................. 30
Notes to Consolidated Financial Statements.................. 31
</TABLE>
43
<PAGE> 46
(a)(2) Financial Statement Schedules:
Included in Part IV of this Annual Report is the following schedule:
Schedule II Valuation and Qualifying Accounts
Schedules not listed above have been omitted because the information
required to be set forth therein is not applicable or is shown in the Financial
Statements or notes thereto.
(a)(3) Exhibits:
<TABLE>
<CAPTION>
EXHIBIT NO. DESCRIPTION OF DOCUMENT
----------- -----------------------
<C> <S>
2.1 Agreement and Plan of Reorganization among Aureal, Aureal
Acquisition Corporation, a wholly-owned subsidiary of Aureal
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
Aureal dated May 8, 1996(2)
3.2 Restated Bylaws of Aureal Semiconductor Inc.(6)
4.1 Common Stock Purchase Agreement by and among Aureal and
certain beneficial owners of 5% or more of Aureal's Common
Stock, as amended(3)
4.2 Common Stock Purchase Agreement by and among Aureal and
certain entities and individuals dated June 10, 1996(5)
4.3 Common Stock Purchase Agreement by and among Aureal 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)
4.15 Form of Subscription Agreement(14)
4.16 Form of Instructions to Stockholders(14)
4.17 Form of Letter to Common Stockholders (Record)(14)
4.18 Form of Letter to Banks and Brokers(14)
4.19 Form of Letter to Common Stockholders (Beneficial)(14)
4.20 Form of Registration Rights Agreement among Oaktree, TCW and
the Company(14)
10.1 Second Amended and Restated Loan Agreement between TCW
Special Credits and Aureal dated August 6, 1997 increasing
the loan commitment from $20 million to $31.5 million(9)
10.2 1995 Stock Option Plan(3)
</TABLE>
44
<PAGE> 47
<TABLE>
<CAPTION>
EXHIBIT NO. DESCRIPTION OF DOCUMENT
----------- -----------------------
<C> <S>
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(13)
10.10 Form of the Standby Commitment Agreement among Oaktree, TCW
and the Company(14)
23.1 Consent of Arthur Andersen LLP
27.1* Financial Data Schedule (Edgar Only)
</TABLE>
- ---------------
* Previously filed.
(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
(12) Incorporated by reference to the exhibits filed with Form 8-K dated July 8,
1998
(13) Incorporated by reference to the exhibits filed with Form 10-Q for the
quarter ended June 28, 1998
(14) Incorporated by reference to exhibits filed with Form S-3 (Registration
number 333-75631) filed April 2, 1999.
(b) Reports on Form 8-K:
We filed no reports on Form 8-K during the fourth quarter ended January 3,
1999.
45
<PAGE> 48
AUREAL SEMICONDUCTOR INC.
SCHEDULE II VALUATION AND QUALIFYING ACCOUNTS
(IN THOUSANDS)
<TABLE>
<CAPTION>
ADDITIONS
BALANCE AT CHARGED TO BALANCE AT
BEGINNING COSTS AND END OF
OF PERIOD EXPENSES DEDUCTIONS PERIOD
---------- ---------- ---------- ----------
<S> <C> <C> <C> <C>
YEAR ENDED DECEMBER 29, 1996:
Accounts receivable allowances...................... $2,585 $ -- $2,562 $ 23
YEAR ENDED DECEMBER 28, 1997:
Accounts receivable allowances...................... $ 23 $ -- $ 11 12
YEAR ENDED JANUARY 3, 1999:
Accounts receivable allowances...................... $ 12 $277 $ -- $289
</TABLE>
46
<PAGE> 49
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, Aureal Semiconductor Inc. has duly caused this Report on
Form 10-K/A to be signed on its behalf by the undersigned, thereunto duly
authorized, on April 16, 1999.
AUREAL SEMICONDUCTOR INC.
/s/ KENNETH A. KOKINAKIS
--------------------------------------
Kenneth A. Kokinakis, President and
Chief Executive Officer
Pursuant to the requirements of the Securities and Exchange Act of 1934,
this Annual Report on Form 10-K/A has been signed below by the following persons
on behalf of Aureal and in the capacities and on the dates indicated.
<TABLE>
<CAPTION>
SIGNATURE TITLE DATE
--------- ----- ----
<C> <S> <C>
/s/ KENNETH A. KOKINAKIS President, Chief Executive April 16, 1999
- ----------------------------------------------------- Officer and Director
Kenneth A. Kokinakis
/s/ DAVID J. DOMEIER Vice President, Finance and April 16, 1999
- ----------------------------------------------------- Chief Financial Officer
David J. Domeier (Principle Accounting Officer)
/s/ RICHARD E. CHRISTOPHER* Director April 16, 1999
- -----------------------------------------------------
Richard E. Christopher
Director
- -----------------------------------------------------
L. William Krause
/s/ D. RICHARD MASSON* Director April 16, 1999
- -----------------------------------------------------
D. Richard Masson
/s/ THOMAS K. SMITH, JR.* Director April 16, 1999
- -----------------------------------------------------
Thomas K. Smith, Jr.
*By: /s/ DAVID J. DOMEIER
------------------------------------------------
David J. Domeier, Attorney-in-fact
</TABLE>
47
<PAGE> 50
INDEX TO EXHIBITS
<TABLE>
<CAPTION>
EXHIBIT NO. DESCRIPTION OF DOCUMENT
----------- -----------------------
<C> <S>
2.1 Agreement and Plan of Reorganization among Aureal, Aureal
Acquisition Corporation, a wholly-owned subsidiary of Aureal
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
Aureal dated May 8, 1996(2)
3.2 Restated Bylaws of Aureal Semiconductor Inc.(6)
4.1 Common Stock Purchase Agreement by and among Aureal and
certain beneficial owners of 5% or more of Aureal's Common
Stock, as amended(3)
4.2 Common Stock Purchase Agreement by and among Aureal and
certain entities and individuals dated June 10, 1996(5)
4.3 Common Stock Purchase Agreement by and among Aureal 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)
4.15 Form of Subscription Agreement(14)
4.16 Form of Instructions to Stockholders(14)
4.17 Form of Letter to Common Stockholders (Record)(14)
4.18 Form of Letter to Banks and Brokers(14)
4.19 Form of Letter to Common Stockholders (Beneficial)(14)
4.20 Form of Registration Rights Agreement among Oaktree, TCW and
the Company(14)
10.1 Second Amended and Restated Loan Agreement between TCW
Special Credits and Aureal dated August 6, 1997 increasing
the loan commitment from $20 million to $31.5 million(9)
10.2 1995 Stock Option Plan(3)
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)
</TABLE>
48
<PAGE> 51
<TABLE>
<CAPTION>
EXHIBIT NO. DESCRIPTION OF DOCUMENT
----------- -----------------------
<C> <S>
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(13)
10.10 Form of the Standby Commitment Agreement among Oaktree, TCW
and the Company(14)
23.1 Consent of Arthur Andersen LLP
27.1* Financial Data Schedule (Edgar Only)
</TABLE>
- ---------------
* Previously filed.
(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
(12) Incorporated by reference to the exhibits filed with Form 8-K dated July 8,
1998
(13) Incorporated by reference to the exhibits filed with Form 10-Q for the
quarter ended June 28, 1998
(14) Incorporated by reference to exhibits filed with Form S-3 (Registration
number 333-75631) filed April 2, 1999.
49
<PAGE> 1
EXHIBIT 23.1
CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS
As independent public accountants, we hereby consent to the incorporation
of our report dated March 31, 1999 with respect to the consolidated financial
statements and schedule included in this Form 10-K, into the Company's
previously filed Registration Statements on Form S-8 (File No. 333-90798, File
No. 333-36086, File No. 333-55008 and File No. 333-55006), on Form S-3 (File No.
333-39939), and on Form S-2 (File No. 333-66867).
ARTHUR ANDERSEN LLP
San Jose, California
April 15, 1999
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE
CONSOLIDATED FINANCIAL STATMENTS FOR THE FISCAL YEAR ENDED JANUARY 3, 1999 AND
IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS.
</LEGEND>
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> JAN-03-1999
<PERIOD-START> DEC-29-1997
<PERIOD-END> JAN-03-1999
<CASH> 87
<SECURITIES> 0
<RECEIVABLES> 4,781
<ALLOWANCES> 289
<INVENTORY> 3,916
<CURRENT-ASSETS> 10,471
<PP&E> 5,275
<DEPRECIATION> 2,795
<TOTAL-ASSETS> 13,638
<CURRENT-LIABILITIES> 14,057
<BONDS> 0
0
0
<COMMON> 48
<OTHER-SE> (1,356)
<TOTAL-LIABILITY-AND-EQUITY> 13,638
<SALES> 25,328
<TOTAL-REVENUES> 25,328
<CGS> 17,808
<TOTAL-COSTS> 17,808
<OTHER-EXPENSES> 22,018
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 4,422
<INCOME-PRETAX> (18,506)
<INCOME-TAX> 0
<INCOME-CONTINUING> (18,506)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (18,506)
<EPS-PRIMARY> (0.79)
<EPS-DILUTED> (0.79)
</TABLE>
