SONIC SOLUTIONS/CA/
10-Q, 2000-02-14
COMPUTER INTEGRATED SYSTEMS DESIGN
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<PAGE>

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


                                   Form 10-Q
(Mark one)

[x]  Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange
     Act of 1934
     For the quarterly period ended December 31, 1999 or


[  ]  Transition Report Pursuant to Section 13 or 15(d) of the Securities
      Exchange Act of 1934
      For the transition period from __________ to ___________

Commission File Number:  72870



                                SONIC SOLUTIONS
             (Exact name of registrant as specified in its charter)


California                                               93-0925818
(State or other jurisdiction of                          (I.R.S.Employer
incorporation or organization)                           Identification No.)

101 Rowland Way, Suite 110  Novato, CA                               94945
(Address of principal executive offices)                             (Zip Code)

Registrant's telephone number, including area code:           (415) 893-8000
Securities registered pursuant to Section 12(b) of the Act:   None
Securities registered pursuant to Section 12(g) of the Act:   Common Stock,
                                                              no par value
                                                              (Title of class)

Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.

                            Yes   x             No ___
                                -----


The number of outstanding shares of the registrant's Common Stock on February
11, 2000, was 11,259,720.

                                       1
<PAGE>

                                SONIC SOLUTIONS

                                   FORM 10-Q

                For the quarterly period ended December 31, 1999



                               Table of Contents

                                                                       Page

PART I.    FINANCIAL INFORMATION

ITEM 1.    Condensed Balance Sheets as of March 31, 1999
           and December 31, 1999....................................     3

           Condensed Statements of  Operations for the
           three and nine months ended December 31, 1998 and 1999....    4

           Condensed Statements of Cash Flows for the
           nine months ended December 31, 1998 and 1999..............    5

           Notes to Condensed Financial Statements...................    6

ITEM 2.    Management's Discussion and Analysis of
           Financial Condition and Results of Operations.............    9


PART II.      OTHER INFORMATION

ITEM 6.       Exhibits and Reports on Form 8-K.......................   14

              Signatures.............................................   15

                                       2
<PAGE>

                          PART I - FINANCIAL INFORMATION

ITEM 1.   CONDENSED FINANCIAL STATEMENTS
                                Sonic Solutions
                            Condensed Balance Sheets
                      (in thousands, except share amounts)

<TABLE>
<CAPTION>
                                                                                                    1999
                                                                                          ------------------------
ASSETS                                                                                    March 31    December 31
- - ------                                                                                    ---------   ------------
                                                                                                      (unaudited)
<S>                                                                                       <C>         <C>
Current Assets:
   Cash and cash equivalents...........................................................   $  2,414          2,018
   Accounts receivable, net of allowance for returns and doubtful
     accounts of $599 and $1,249 at March 31, 1999 and December 31,
     1999, respectively................................................................      5,403          5,280
   Inventory...........................................................................        807          1,218
   Prepaid expenses and other current assets...........................................        287            533
                                                                                          --------        -------

   Total current assets................................................................      8,911          9,049
Fixed assets, net......................................................................      2,313          1,693
Purchased and internally developed software costs, net.................................      2,385          2,005
Other assets...........................................................................        156            185
                                                                                          --------        -------

   Total assets........................................................................   $ 13,765         12,932
                                                                                          ========         =======

                      LIABILITIES AND SHAREHOLDERS' EQUITY
                      -------------------------------------
Current Liabilities:
   Accounts payable and accrued liabilities............................................   $  4,359          4,615
   Bank note payable...................................................................        500            922
   Deferred revenue and deposits.......................................................      1,318          1,330
   Subordinated debt, current portion..................................................      1,419            526
   Current portion of obligations under capital leases.................................        148             99
                                                                                          --------        -------

   Total current liabilities...........................................................      7,744          7,492
Subordinated debt, net of current portion..............................................          -            175
Obligations under capital leases, net of current portion...............................         89             27
                                                                                          --------        -------
   Total liabilities...................................................................      7,833          7,694
                                                                                          --------        -------
Commitments and contingencies
Shareholders' Equity:
Convertible preferred stock, no par value, 10,000,000 shares authorized; 294,038
and 155,544 shares issued and outstanding at March 31, 1999
     and December 31, 1999, respectively...............................................        956            506
Common stock, no par value, 30,000,000 shares authorized; 9,468,123
     and 11,259,720 shares issued and outstanding at March 31, 1999
     and December 31, 1999, respectively...............................................     18,121         22,481
Accumulated deficit....................................................................    (13,145)       (17,749)
                                                                                          --------        -------

   Total shareholders' equity..........................................................      5,932          5,238
                                                                                          --------        -------
   Total liabilities and shareholders' equity..........................................   $ 13,765         12,932
                                                                                          ========        =======
</TABLE>

           See accompanying notes to condensed financial statements.

                                       3
<PAGE>

                                Sonic Solutions

                      Condensed Statements of Operations
               (in thousands, except share amounts - unaudited)


<TABLE>
<CAPTION>
                                                                        Three Months Ended     Nine Months Ended
                                                                       --------------------   -------------------
                                                                           December 31,          December 31,
                                                                       --------------------   -------------------
                                                                         1998        1999       1998       1999
                                                                       ---------   --------   ---------   -------
<S>                                                                    <C>         <C>        <C>         <C>
Net revenue.........................................................    $ 5,795      5,156     $15,404    15,558
Cost of revenue.....................................................      2,277      2,160       6,796     6,869
                                                                        -------    -------     -------   -------

    Gross profit....................................................      3,518      2,996       8,608     8,689
                                                                        -------    -------     -------   -------

Operating expenses:
    Marketing and sales.............................................      1,837      2,335       5,345     6,679
    Research and development........................................      1,269      1,458       3,798     4,749
    General and administrative......................................        376      1,030       1,151     1,762
                                                                        -------    -------     -------   -------

    Total operating expenses........................................      3,482      4,823      10,294    13,190
                                                                        -------    -------     -------   -------

    Operating income (loss).........................................         36     (1,827)     (1,686)   (4,701)

Other expense, net..................................................        (79)      (106)       (249)     (200)
                                                                        -------    -------     -------   -------

    Loss before income taxes........................................        (43)    (1,933)     (1,935)   (4,701)

Provision (benefit) for income taxes................................          -          -           -       (97)
                                                                        -------    -------     -------   -------

    Net loss........................................................        (43)    (1,933)     (1,935)   (4,604)
                                                                        =======    =======     =======   =======
    Basic and diluted loss per share applicable to
    common shareholders..............................................    ($0.01)     (0.19)     ($0.23)    (0.47)
                                                                        =======    =======     =======   =======
    Weighted average shares used in computing per
    share amounts....................................................     9,127     10,799       8,720    10,061
                                                                        =======    =======     =======   =======
</TABLE>

          See accompanying notes to condensed financial statements.


                                       4
<PAGE>

                                Sonic Solutions
                       Condensed Statements of Cash Flows
                          (in thousands -- unaudited)

<TABLE>
<CAPTION>

                                                                                               Nine Months Ended
                                                                                               -----------------
                                                                                                  December 31,
                                                                                                  ------------
                                                                                              1998          1999
                                                                                             ------         ------
Cash flows from operating activities:
<S>                                                                                          <C>            <C>
Net loss.............................................................................        ($1,935)       (4,604)
Adjustments to reconcile net loss to net cash used in
  operating activities:
  Depreciation and amortization......................................................          1,940         2,224
  Provision for returns and doubtful accounts, net of write-offs.....................            (50)          650
  Changes in operating assets and liabilities:
     Accounts receivable.............................................................         (1,194)         (527)
     Inventory.......................................................................           (328)         (411)
     Prepaid expenses and other current assets.......................................            218          (246)
     Other assets....................................................................            (31)          (29)
     Accounts payable and accrued liabilities........................................            778           256
     Deferred revenue and deposits...................................................            234            12
                                                                                              ------         ------
     Net cash used in operating activities...........................................           (368)       (2,675)
                                                                                                -------      ------
Cash flows from investing activities:
  Purchase of fixed assets...........................................................           (485)         (606)
  Additions to purchased and internally developed software...........................           (523)         (618)
                                                                                                -------       -----
     Net cash used in investing activities...........................................          1,008)       (1,224)
                                                                                                -------     -------
Cash flows from financing activities:
  Proceeds from exercise of common stock options.....................................             35            33
  Borrowings on line of credit.......................................................            420           422
  Repayments on line of credit.......................................................           (420)            -
  Proceeds associated with equity line financing.....................................          2,358         3,180
  Redemption of warrants.............................................................            (83)            0
  Payment of dividends...............................................................            (45)          (41)
  Repayments of subordinated debt....................................................           (185)          (20)
  Principal payments on capital leases...............................................           (102)         (111)
                                                                                               -------      ------
     Net cash provided by financing activities.......................................          1,978         3,503
                                                                                               -------      ------
Net increase (decrease) in cash and cash equivalents.................................            602          (396)
Cash and cash equivalents, beginning of period.......................................          2,479         2,414
                                                                                              -------        ------
Cash and cash equivalents, end of period.............................................         $3,081         2,018
                                                                                              =======        ======
Supplemental disclosure of cash flow information:
  Interest paid during period........................................................         $   56            93
                                                                                              -------        ------
  Income taxes paid during period....................................................          $   9
                                                                                              -------        ------
         Noncash financing and investing activities:
  Conversion of preferred stock to common stock......................................            408           950

                                                                                              -------        ------
         Issuance of preferred stock for subordinated debt...........................              -           500
         Issuance of warrants for subordinated debt                                                -           235
</TABLE>

          See accompanying notes to condensed financial statements.

                                       5
<PAGE>

                                Sonic Solutions
                    Notes to Condensed Financial Statements
                                  (unaudited)


(1)     Basis of Presentation

  The accompanying unaudited condensed financial statements have been prepared
in accordance with generally accepted accounting principles for interim
financial information and with the instructions to Form 10-Q and Article 10 of
Regulation S-X.  Accordingly, they do not include all of the information and
footnotes required by generally accepted accounting principles for complete
financial statements.  However, in the opinion of management, the condensed
financial statements include all adjustments (consisting of only normal,
recurring adjustments) necessary for their fair presentation.  The interim
results are not necessarily indicative of results expected for a full year.
These unaudited condensed financial statements should be read in conjunction
with the financial statements and related notes included in the Company's Form
10-K for the year ended March 31, 1999, filed with the Securities and Exchange
Commission.

(2)  Basic and diluted loss per share

  SFAS No. 128 "Earnings Per Share" requires the presentation of basic net
income per share, and for companies with complex capital structures, diluted net
income per share.

  The following table sets forth the computations of shares and net loss per
share, applicable to common shareholders used in the calculation of basic and
diluted net loss per share for the three and nine months ended December 31, 1998
and 1999 (in thousands, except per share data):

<TABLE>
<CAPTION>
                                                                 Three Months Ended               Nine Months Ended
                                                            -----------------------------   -----------------------------
                                                                    December 31,                    December 31,
                                                            -----------------------------   -----------------------------
                                                                1998            1999            1998            1999
                                                            -------------   -------------   -------------   -------------
<S>                                                         <C>             <C>             <C>             <C>

Net loss.................................................      ($43)           (1,933)        ($1,935)         (4,604)
Beneficial conversion feature given to preferred
 shareholders............................................         0               110               0             110
Dividends paid to preferred shareholders.................        15                13              45              41
                                                               ------          -------        --------         -------

Net loss applicable to common shareholders...............       (58)           (2,056)         (1,980)         (4,755)
                                                               ======          =======         =======          ======


Weighted average number of common shares outstanding.....     9,127            10,799           8,720          10,061
                                                              ======           ======           =====         =======


Basic and diluted net loss per share applicable to
 common shareholders.....................................    ($0.01)            (0.19)         ($0.23)          (0.47)
                                                             =======            ======         =======         =======

</TABLE>

      As of December 31, 1998 and 1999, potentially dilutive shares totaling
 935,775 and 1,311,514, respectively, for convertible preferred stock and
 options with exercise prices less than the average market price that could
 dilute basic earnings per share in the future, were not included in earnings
 per share as their effect was anti-dilutive for those periods.

                                       6
<PAGE>

(3)  Inventory

     The components of inventory consist of (in thousands):
                                                  March 31,     December 31,
                                                  ---------     ------------
                                                   1999            1999
                                                   -----           -----
Finished goods.................................    $ 315            394
Work-in-process................................      187            122
Raw materials..................................      305            702
                                                   -----          -----
                                                   $ 807          1,218
                                                   =====          =====


(4)  Income Taxes

  We account for income taxes under the asset and liability method of
accounting.  Under the asset and liability method, deferred tax assets and
liabilities are recognized based on the future tax consequences attributable to
differences between the financial statement carrying amount of existing assets
and liabilities and their respective tax bases.

(5)  Debt Restructuring

     In October, 1999, we renegotiated our financing arrangement with Hambrecht
& Quist Guaranty Finance. The agreement we reached involved the restructuring of
$1,500,000 debt into 153,846 shares of Series C Convertible Preferred Stock and
$1,000,000 of debt. The interest rate on the restructured debt is 7.25% and the
debt and interest is payable in monthly installments beginning on November 1,
1999 and continuing through April 30, 2001. In connection with this agreement,
we issued warrants to purchase 120,000 common shares at an exercise price of
$2.50. These warrants expire on April 30, 2006. The incremental conversion
feature and the warrants were recorded at their relative fair values. We also
changed the conversion rate of our Series C Convertible Preferred Stock so that
each share of Series C Convertible Preferred Stock is convertible into 1.625
shares of Common Stock. We recorded $345,000 of deferred financing costs
attributable to this finance restructuring with Hambrecht & Quist Guaranty. This
amount is being amortized using the effective interest rate method to interest
expense over the term of the financing facility (18 months). The value of the
warrants was estimated using the Black-Scholes option pricing model and the
following assumptions: volatility of .50, dividend yield rate of 6% (for the
preferred stock), risk free interest rate of 6% and expected life equal to the
contractual terms. The fair value of the preferred stock was valued using the
intrinsic value of the beneficial conversion feature. In accordance with EITF
98-S the relative fair value of the warrants and the beneficial conversion
feature have been charged to common stock. We have filed a Form S-3 Registration
Statement under the Securities Act of 1933 to register the shares of the common
stock which underlie the Series C Convertible Preferred Stock and the 120,000
shares of our common stock which underlie the warrants issued to Hambrecht &
Quist Guaranty Finance. During the nine months ended December 31, 1999, 292,340
shares of the Preferred Stock were converted into common stock.

(6)  Segment Reporting

  In 1997, the Financial Accounting Standards Board issued SFAS No. 131,
"Disclosures about Segments of an Enterprise and Related Information," which was
adopted by us in 1998.  SFAS No. 131 requires companies to report financial and
descriptive information about its reportable operating segments, including
segment profit or loss, certain specific revenue and expense items and segment
assets, as well as information about the revenues derived from our products and
services, the countries in which we earn revenue and hold assets, and major
customers.

  We operate in the audio and video media market and derive substantially all
our revenue from the sales of two workstation products.  We organize our
operations based on designing, developing, manufacturing, selling and supporting
these products.  Our chief operating decision maker is the Chief Executive
Officer (CEO) and the CEO allocates resources based on financial information,
including gross margins and operating losses, reported in a manner consistent
with the accompanying financial statements.  Sales, gross profit, and operating
losses are not allocated or specific to individual products or departments
within the organization.  Accordingly, we have a single reportable segment.  As
such, we are required to disclose the following geographic information:

<TABLE>
<CAPTION>
                                                           Three Months Ended             Nine Months Ended
                                                           ------------------             -----------------
                                                              December 31,                   December 31,
                                                              ------------                   ------------
                                                          1998            1999           1998           1999
                                                      -------------   ------------   ------------   -------------
<S>                                                   <C>             <C>            <C>            <C>

        North America...................               $3,276             2,850        $ 8,062           8,254
        Export:
            Europe.....................                 1,396             1,491          3,923           4,188
            Pacific Rim................                   963               803          3,212           2,916
            Other international........                   160                12            207             200
                                                       ------             -----        -------          ------

                                                       $5,795             5,156        $15,404          15,558
                       Total net revenue               ======             =====        =======          ======
</TABLE>

                                       7
<PAGE>

     We sell our products to customers categorized geographically by each
customer's country of domicile.  We do not have any material investment in long-
lived assets located in foreign countries for any of the periods presented.

     Our accounting system does not capture meaningful revenue information by
product line.  Accordingly, such information has not been disclosed.


(7)  Recently Issued Accounting Pronouncements

     In June 1998, the Financial Accounting Standards Board issued SFAS No. 133,
as amended by SFAS No. 137, "Accounting for Derivative instruments and hedging
activities". We are required to adopt SFAS No. 133 in the first quarter of
fiscal year 2002. We do not anticipate that SFAS No. 133 will have a material
impact on our financial statements.

     In December 1998, the AICPA issued Statement of Position (SOP) 98-9,
"Modification of SOP 97-2 Software Revenue Recognition with Respect to Certain
Transactions". This amendment clarified the specification of what was considered
vendor specific objective evidence of fair value for the various elements in a
multiple element arrangement. We adopted SOP 98-9 during our first quarter ended
June 30, 1999 and the amendment did not have a material impact on our operating
results, financial position, or cash flow for the three and nine months ended
December 31, 1999.

                                       8
<PAGE>

ITEM 2.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
         CONDITION AND RESULTS OF OPERATIONS

OVERVIEW; CERTAIN FACTORS THAT MAKE FUTURE RESULTS DIFFICULT TO PREDICT; CERTAIN
ITEMS TO REMEMBER WHEN READING OUR FINANCIAL STATEMENTS

     Our quarterly operating results vary significantly depending on the timing
of new product introductions and enhancements by ourselves and by our
competitors.  Our results also depend on the volume and timing of orders which
are difficult to forecast.  Because our customers generally order on an as-
needed basis, and we normally ship products within one week after receipt of an
order, we don't have an order backlog which can assist us in forecasting
results.  For all these reasons, our results of operations for any quarter are a
poor indicator of the results to be expected in any future quarter.

     A large portion of our quarterly revenue is usually generated in the last
few weeks of the quarter.  Since our ongoing operating expenses are relatively
fixed, and we plan our expenditures based primarily on sales forecasts, if
revenue generated in the last few weeks of a quarter do not meet our forecast,
operating results can be very negatively affected.

     We capitalize our software development costs in accordance with Statement
of Financial Accounting Standard No. 86.  Such capitalized costs are amortized
to cost of revenue over the estimated economic life of the product, which is
generally three years.

     In September, 1999, we began shipments of two new products; both are
included in our DVD product line. The two new products are DVDit! and DVD
Fusion. DVDit! is a simplified DVD-Video authoring application which provides
DVD authoring capabilities to consumer, "prosumer," and some professional users.
DVD Fusion, which is part of our DVD Creator professional DVD-Video product
line, provides video producers and editors a comprehensive set of tools for
encoding, authoring and proofing DVD-Video titles derived from projects created
on non-linear video editing systems such as those provided by Avid Technology
and Media 100.

Because DVDit! is aimed at a broader market than our traditional professional
products we are building a distribution capability for it.  There are three
elements to this effort.

         .  We are adding dealers and distributors for DVDit!, some of which
            already carry some of our professional products, but many of which
            do not. In the near term we are targeting dealers and distributors
            specializing in digital video applications. In the longer term we
            plan to target dealers and distributors who participate in the
            broader personal computer marketplace.

        .  We are entering into "bundling" arrangements with various other
           companies in which copies of DVDit! are included or "bundled" with
           shipments of those companies' products. These companies (we refer to
           them as "OEM Partners") are motivated to include our software as a
           value added offering for their customers. We are motivated to enter
           into bundling arrangements because it generates revenue for us as
           well as creates a large installed base of customers to whom we can
           sell upgraded or enhanced versions of our products. To facilitate
           such bundling arrangement we have designed different limited-feature
           versions of DVDit!. Currently we are shipping two such versions -
           DVDit!-LE ("Limited Edition") and DVDit!-SE ("Standard Edition") -
           and have announced the future availability of another version -
           DVDit!-PE ("Professional Edition").

        .  We have initiated a web-based retail store for our DVDit! products.
           Our web store is intended both to meet retail demand for our DVDit!
           products as well as to service upgrade orders for our products, in
           particular, the upgrade orders which derive from our bundle shipments
           by our OEM Partners.

     Building distribution for DVDit! will be a time-consuming and expensive
process.  Since this is a new kind of product for us, there is significant risk
that our efforts, or at least some of them, will not be successful.

                                       9
<PAGE>

Results of Operations

  The following table sets forth certain items from the Company's statements of
operations as a percentage of net revenue for the three and nine months ended
December 31, 1998 and 1999:

<TABLE>
<CAPTION>

                                 Three Months Ended                          Nine Months Ended
                                 ------------------                          -----------------
                                     December 31,                              December 31,
                                     ------------                              ------------
                               1998                 1999                 1998                 1999
                               ------               ------               -------              -------
<S>                            <C>                  <C>                  <C>                  <C>
 Net revenue.....               100.0%               100.0%               100.0%               100.0%
 Cost of revenue.                39.3                 41.9                 44.1                 44.2
                                -----                -----               ------                -----
 Gross profit....                60.7                 58.1                 55.9                 55.8
 Operating
  expenses:
   Marketing and                 31.7                 45.3                 34.7                 42.9
   sales.........
   Research and                  21.9                 28.3                 24.7                 30.5
   development...
   General and                    6.4                 20.0                  7.5                 11.4
   administrative               -----                -----               ------                -----
 Total operating                 60.0                 93.6                 66.9                 84.8
  expenses.......               -----                -----               ------                -----
 Operating                        0.7                (35.5)               (11.0)               (29.0)
  income (loss)..
 Other expense...                (1.4)                (2.0)                (1.6)                (1.3)
 Provision                          -                    -                    -                 (0.6)
  (benefit) for                 -----                -----               ------                -----
  income taxes...
 Net loss........               (0.7)%               (37.5)%             (12.6)%               (29.7)%
                                =====                =====               ======                =====
</TABLE>



Comparison of three and nine months ended December 31

  NET REVENUE. Our net revenue decreased from $5,795,000 for the quarter ended
December 31, 1998 to $5,156,000 for the quarter ended December 31, 1999,
representing a decrease of 11%. For the nine months ended December 31, 1999, net
revenue increased from $15,404,000 to $15,558,000 compared to the same period in
the prior fiscal year. The decrease in net revenue for the three months ended
December 31, 1999 is primarily due to the decrease in sales of our audio
products which was partially offset by sales of our DVD systems, including our
two newer products -- DVDit! and DVD Fusion. The increase in net revenue for the
nine months ended December 31, 1999 is primarily due to increased sales of our
DVD systems (including DVDit! and DVD Fusion).

  International sales accounted for 43.5% and 44.7% of our net revenue for the
quarters ended December 31, 1998 and 1999, respectively.  International sales
accounted for 47.7% and 46.9% of net revenue for the nine months ended December
31, 1998, and 1999, respectively.  See Note 5 of Notes to Condensed Financial
Statements.  International sales have historically represented between 43% and
52% of our quarterly sales, and we expect that they will continue to represent a
significant percentage of future revenue.

  COST OF REVENUE. Our cost of revenue, as a percentage of net revenue,
increased from 39.3% for the quarter ended December 31, 1998 to 41.9% for the
quarter ended December 31, 1999. For the nine months ended December 31, 1999,
our cost of revenue, as a percentage of net revenue, was approximately constant
at 44.1% when compared to 44.2% in the same period in the prior fiscal year.
Cost of revenue can vary based upon the mix of products sold during the quarter.

     MARKETING AND SALES.  Our marketing and sales expenses increased from
$1,837,000 for the quarter ended December 31, 1998 to $2,335,000 for the quarter
ended December 31, 1999 and increased from $5,345,000 for the nine months ended
December 31, 1998 to $6,679,000 for the nine months ended December 31, 1999.
Marketing and sales represented 31.7%, 45.3%, 34.7% and 42.9% of net revenue for
the quarters ended December 31, 1998 and 1999 and the nine months ended December
31, 1998 and 1999,

                                       10
<PAGE>

respectively. Our marketing and sales headcount increased from thirty-six at
December 31, 1998 to thirty-nine at December 31, 1999. Our marketing and sales
expenses increased primarily due to increases in salary expenses as a result of
the increase in headcount, and increases in advertising and marketing costs
related to our DVD product lines. Included in our marketing and sales expenses
are dealer and employee commission expenses, which as a percentage of net
revenue decreased from 5.5% for the quarter ended December 31, 1998 to 4.4% for
the quarter ended December 31, 1999.

  RESEARCH AND DEVELOPMENT.  Our research and development expenses increased
from $1,269,000 for the quarter ended December 31, 1998 to $1,458,000 for the
quarter ended December 31, 1999 and increased from $3,798,000 for the nine
months ended December 31, 1998 to $4,749,000 for the nine months ended December
31, 1999.  Our research and development expenses represented 21.9%, 28.3%, 24.7%
and 30.5% for the quarter and nine months ended December 31, 1998 and 1999,
respectively.  We capitalize our software development costs in accordance with
Statement of Financial Accounting Standards No. 86.  (This means that a portion
of the costs we incur for software development are not recorded as an expense in
the period.  Instead they are recorded as an asset on our balance sheet.  The
amount recorded on our balance sheet is then amortized over the estimated life
of the products.)   Our research and development expenses increased primarily
due to increases in salary expenses as a result of the increase in headcount.
Headcount increased from twenty-nine at December 31, 1998 to thirty-three at
December 31, 1999.   Our research and development expenses also increased due to
consulting expenses associated with introductions of new products, including our
DVDit! product.  Consulting expenses can fluctuate significantly from period
to period depending upon the status of hardware and software development
projects and our schedule of new product introductions.

  GENERAL AND ADMINISTRATIVE. Our general and administrative expense increased
from $376,000 for the quarter ended December 31, 1998 to $1,030,000 for the
quarter ended December 31, 1999 and from $1,151,000 for the nine months ended
December 31, 1998 to $1,762,000 for the nine months ended December 31, 1999. Our
general and administrative expenses represented 6.4%, 20.0%, 7.5% and 11.4% of
net revenue for the quarter ended December 31, 1998 and 1999 and the nine months
ended December 31, 1998 and 1999, respectively. Included in general and
administrative expense for the quarter ended December 31, 1999 is a charge to
bad debt expense of $600,000 which represents an additional reserve for sales to
audio professionals and distributors who are experiencing liquidity difficulties
due to a decline in their business. We anticipate that general and
administrative expenses (exclusive of the bad debt expense) will increase in the
future as costs increase and our operations expand.

  OTHER EXPENSE, NET. The "Other Expense" item on our statement of operations
includes primarily the net amount of interest or other financing charges we have
incurred due to borrowings reduced by the interest we earn on cash balances and
short term investments. For the quarter and nine months ended December 31, 1999
and 1998, we incurred interest and other financing charges related to financing
agreements we had with entities associated with Hambrecht & Quist, as well as
borrowings under our bank credit line.

  PROVISION FOR INCOME TAXES. In accordance with Statement of Financial
Accounting Standards No. 109, no provision was made for income taxes for the
quarter ended December 31, 1998 and 1999, respectively. For the nine months
ended December 31, 1999 a benefit was recorded (during the quarter ended June
30, 1999) to reflect the refund due us following the conclusion of an Internal
Revenue Service audit. During the fiscal year ended March 31, 1996, we exhausted
our ability to carryback tax losses.

  LIQUIDITY AND CAPITAL RESOURCES.   In December, 1996 we entered into a Loan
and Security Agreement with Silicon Valley Bank.  This Agreement, which we
sometimes refer to as our "bank credit line", has been modified or renewed at
various times since December 1996.  The current bank credit line (renewed in
September, 1999) provides for up to $2,500,000 in available borrowings based
upon our eligible accounts receivable balances. This bank credit line provides
for a variety of covenants, including among other things, that we maintain
certain financial ratios.  The bank credit line is collateralized by a security
interest in substantially all of our assets.  Interest on borrowings under this
agreement is payable

                                       11
<PAGE>

monthly at a rate of one and one quarter percent in excess of the prime rate. On
December 31, 1999 $922,000 was outstanding under this agreement. The Company was
in compliance with its debt covenants under this agreement at December 31, 1999.

     In December, 1996, we also obtained a $5,100,000 financing facility with
entities associated with Hambrecht & Quist.  This facility included subordinated
debt as well as equipment lease financing.  We received $3,000,000 of
subordinated debt from Hambrecht & Quist Transition Capital, LLC and $1,100,000
of subordinated debt from Hambrecht & Quist Guaranty Finance, LLC pursuant to
the above facility.  The remaining $1,000,000 of the facility was used to fund a
master lease line for financing of future capital asset purchases.  The facility
with the Hambrecht & Quist entities is secured by an interest in our fixed
assets and substantially all of our other assets but is subordinate to our bank
credit line.  In connection with this financing facility we issued warrants to
purchase 260,200 common shares to entities associated with Hambrecht & Quist.
The Hambrecht & Quist entities were entitled to exercise the warrants with
respect to 130,100 shares at an exercise price of $10.00 at any time on or
before December 24, 2004, and with respect to 130,100 shares at an exercise
price of $7.00 at any time on or after December 24, 1997 and before December 24,
2004.  In December, 1997, all of the $7.00 warrants were exercised on a "net"
basis, and the warrant holder received 40,266 shares of common stock.  We
recorded $549,000 of deferred interest attributable to the value of the
warrants, which was amortized using the effective interest rate method to
interest expense over the term of the financing facility.  The value of the
warrants was estimated using the Black-Scholes option pricing model and the
following assumptions:  volatility of .75, risk free interest rate of 6.3% and
expected life equal to the contractual terms.

     In March, 1998, we renegotiated our financing arrangement with Hambrecht &
Quist Guaranty Finance.  The agreement we reached involved the restructuring of
$3,000,000 debt into $1,500,000 of convertible preferred stock and $1,500,000 of
debt.  The interest rate on such restructured debt was 7.25% payable monthly and
the note was due in October 1999.  We filed a Form S-3 Registration Statement
under the Securities Act of 1933 to register the 461,538 shares of our common
stock which underlie the Series C Convertible Preferred Stock issued to
Hambrecht & Quist Guaranty Finance.  In connection with the agreement, the
exercise price of 90,000 of the $10.00 warrants issued in connection with the
original arrangement reached in December 1996 was changed to $3.25.  We
accounted for this transaction by revaluing the new warrant, using comparable
assumptions as the original warrant grant and the resultant value of $90,000 is
being amortized to interest expense over the new loan period.  In June, 1998,
90,000 of the $3.25 warrants were exercised on a "net exercise" basis, and
warrant holder received 29,691 shares of common stock.  During the 1999 fiscal
year 167,500 shares of the Preferred Stock were converted into common stock.

                                       12
<PAGE>

     In December, 1997, we secured a $7,000,000 equity-based line of credit by
entering into a stock purchase agreement with Kingsbridge Capital Ltd.
("Kingsbridge").  Under this arrangement, we had the right to draw up to a total
of $7,000,000 in cash in exchange for common stock.  Pricing of the common stock
issued was based on the market price of Sonic Solutions' common stock at the
time of a draw subject to a 14% discount and a 4% commission payable in common
stock.  The availability of the credit line, and the amounts and timing of draws
under the line were subject to a number of conditions.  In January, 1998, we
filed a Form S-3 Registration Statement under the Securities Act of 1933 to
register the resale of shares issued under this credit line.  During the fiscal
year ended March 31, 1998, we drew $1,450,000 from this credit line for which we
issued 606,130 shares of common stock to Kingsbridge and 12,000 shares to
Trinity Capital Advisors.  During the fiscal year ended March 31, 1999, we drew
an additional $2,358,000 from this credit line for which we issued 903,870
shares of common stock.

     On May 20, 1999, we secured a new equity-based line of credit by entering
into a new stock purchase agreement with Kingsbridge.  Under the new
arrangement, we may draw up to $12,000,000 in cash in exchange for common stock;
provided, however, that in any event we can not sell more than a total of
1,800,000 shares to Kingsbridge under this arrangement, unless we obtain
shareholder approval. Pricing of the common stock issued under this arrangement
is based on the market price of our common stock at the time of a draw,
discounted by 10% or 12% depending upon the price of our common stock. The
availability of the credit line, and the amounts and timing of draws under the
line were subject to a number of conditions.  On May 27, 1999, we filed a
Registration Statement on Form S-1 to register for resale the shares we may
issue to Kingsbridge under this credit line and on August 12, 1999 the Statement
became effective.  During the quarter ended December 31, 1999, we drew
$1,500,000 from this new credit line for which we issued 482,962 shares of
common stock.

     Our operating activities have used cash of $368,000 and $2,675,000 for the
nine months ended December 31, 1998 and 1999, respectively.  Cash was used
primarily to fund the operating loss and to support the increase in accounts
receivables for the nine months ended December 31, 1998. Cash was used primarily
to fund the operating loss, to support the increase in accounts receivables, and
to support the increase in inventory, for the nine months ended December 31,
1999.

     We believe that existing cash, cash equivalents and short term investments,
cash generated from operations, and cash available from the new equity-based
line of credit will be sufficient to meet the Company's cash and investment
requirements at least through the middle of fiscal 2001.

     As of December 31, 1999, the Company had cash and cash equivalents of
$2,018,000 and net working capital of $1,557,000.

     IMPACT OF YEAR 2000 ISSUE. We have not experienced any major system
failures or disruptions of operations as a result of the Year 2000 issue.  In
addition, we did not incur significant incremental costs to become Year 2000
compliant.

  FORWARD LOOKING STATEMENTS. Certain statements in this Report, including
statements contained under the caption "Management's Discussion and Analysis of
Financial Condition and Results of Operations", constitute "forward-looking
statements" within the meaning of the Private Securities Litigation Reform Act
of 1995.  Such forward looking statements involve known and unknown risks,
uncertainties and other factors which may cause the actual results, performance
or achievements of Sonic Solutions to be materially different from any future
results, performance or achievements express or implied by such forward-looking
statements.  Such factors include, but are not limited to the following: general
economic and business conditions; charges and costs related to acquisitions; and
the ability of Sonic Solutions to develop and market products for the markets in
which it operates, to successfully integrate its acquired products and services,
to adjust to changes in technology, customer preferences, enhanced competition
and new competitors in the markets in which it operates.

                                       13
<PAGE>

                           PART II - OTHER INFORMATION



ITEM 6.  EXHIBITS AND REPORTS ON FORM 8-K

     (a)  Exhibits
          27.1  Financial Data Schedule

     (b)  Reports on Form 8-K
          None.

                                       14
<PAGE>

                                   SIGNATURES


Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant, Sonic Solutions, has duly caused this report to be signed on its
behalf by the undersigned thereunto duly authorized, in the City of Novato,
State of California, on the 14th day of February, 2000.



   SONIC SOLUTIONS

Signature                                                         Date
- - --------                                                          -----
/s/ Robert J. Doris                                        February 14, 2000
- - -------------------
Robert J. Doris
President and Director (Principal
Executive Officer)

/s/ A. Clay Leighton                                       February 14, 2000
- - --------------------
A. Clay Leighton
Senior Vice President of Worldwide
Operations and Finance and Chief
Financial Officer (Principal Financial
Accounting Officer)


                                       15

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<PAGE>

<ARTICLE> 5
<MULTIPLIER> 1,000

<S>                             <C>
<PERIOD-TYPE>                   9-MOS
<FISCAL-YEAR-END>                          MAR-31-2000
<PERIOD-START>                             APR-01-1999
<PERIOD-END>                               DEC-31-1999
<CASH>                                           2,018
<SECURITIES>                                         0
<RECEIVABLES>                                    6,529
<ALLOWANCES>                                     1,249
<INVENTORY>                                      1,218
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<PP&E>                                           8,521
<DEPRECIATION>                                   6,828
<TOTAL-ASSETS>                                  12,932
<CURRENT-LIABILITIES>                            7,492
<BONDS>                                              0
                                0
                                        506
<COMMON>                                        22,479
<OTHER-SE>                                           0
<TOTAL-LIABILITY-AND-EQUITY>                    12,932
<SALES>                                         15,558
<TOTAL-REVENUES>                                15,558
<CGS>                                            6,869
<TOTAL-COSTS>                                   13,190
<OTHER-EXPENSES>                                     0
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<INTEREST-EXPENSE>                                 200
<INCOME-PRETAX>                                (4,701)
<INCOME-TAX>                                      (97)
<INCOME-CONTINUING>                            (4,604)
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<CHANGES>                                            0
<NET-INCOME>                                   (4,604)
<EPS-BASIC>                                     (0.47)
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