<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 SEPTEMBER 30, 1998
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 0-24936
7TH LEVEL, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 75-2480669
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
1201 RICHARDSON DRIVE
SUITE 277
RICHARDSON, TEXAS 75080
(Address of principal executive offices) (Zip Code)
REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (972) 498-8100
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 and
(2) has been subject to such filing requirements for the past 90 days.
Yes X No
--- ---
Indicate the number of shares outstanding of each of the issuer's classes
of common stock, as of the latest practicable date.
COMMON STOCK, $0.01 PAR VALUE 17,586,192
(Title of Each Class) Number of Shares Outstanding at
November 6, 1998
<PAGE>
7TH LEVEL, INC.
Form 10-Q
For the Quarterly Period Ended September 30, 1998
Index
PART I FINANCIAL INFORMATION Page No.
--------
Item 1 Condensed Consolidated Balance Sheets at September 30, 1998
and December 31, 1997 3
Condensed Consolidated Statements of Operations for the Three
and Nine Months Ended September 30, 1998 and 1997 4
Condensed Consolidated Statements of Cash Flows for the Nine
Months Ended September 30, 1998 and 1997 5
Notes to Condensed Consolidated Financial Statements 6
Item 2 Management's Discussion and Analysis of Financial Condition
and Results of Operations 8
PART II OTHER INFORMATION
Item 1 Legal Proceedings 15
Item 2 Changes in Securities 15
Item 6 Exhibits and Reports on Form 8-K 16
SIGNATURE 17
<PAGE>
Part I - FINANCIAL INFORMATION
Item 1. Condensed Consolidated Financial Statements
7TH LEVEL, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited)
<TABLE>
<CAPTION>
September 30, 1998 December 31, 1997
------------------ -----------------
ASSETS
<S> <C> <C>
Cash and cash equivalents $ 7,292,750 $ 2,465,079
Accounts receivable, net 49,876 1,112,026
Inventories -- 18,477
Other current assets 122,686 752,847
------------ ------------
Total current assets 7,465,312 4,348,429
Fixed assets, net 3,249,156 4,960,560
Intangible assets, net 8,577 13,132
Other assets 114,674 532,605
------------ ------------
Total assets $ 10,837,719 $ 9,854,726
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
Accounts payable $ 256,896 $ 1,111,732
Accrued expenses and other current liabilities 3,881,757 5,352,874
Current portion of notes payable 485,135 79,318
------------ ------------
Total current liabilities 4,623,788 6,543,924
Notes payable -- 377,027
Notes payable to related parties -- 108,108
Other 203,395 366,212
------------ ------------
Total liabilities 4,827,183 7,395,271
Commitments and contingencies
Stockholders' equity:
Series B convertible preferred stock
($10,173,151 liquidation value) 5,479,138 --
Common stock 175,862 137,837
Additional capital 93,482,588 70,642,628
Accumulated deficit (93,127,052) (68,333,578)
Cumulative other comprehensive income -- 12,568
------------ ------------
Total stockholders' equity 6,010,536 2,459,455
------------ ------------
Total liabilities and stockholders' equity $ 10,837,719 $ 9,854,726
============ ============
</TABLE>
See accompanying notes.
3
<PAGE>
7TH LEVEL, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
<TABLE>
<CAPTION>
Three Months Ended Three Months Ended Nine Months Ended Nine Months Ended
September 30, 1998 September 30, 1997 September 30, 1998 September 30, 1997
------------------ ------------------ ------------------ ------------------
<S> <C> <C> <C> <C>
Net revenues $ 251,345 $ 3,271,245 $ 785,486 $ 8,432,817
Cost of revenues 40,867 558,691 164,210 4,261,839
------------ ------------ ------------ ------------
Gross profit 210,478 2,712,554 621,276 4,170,978
------------ ------------ ------------ ------------
Operating expenses:
Research and product development 1,028,766 4,370,096 3,197,739 12,991,379
Sales and marketing 231,317 1,808,237 773,627 5,532,830
General and administrative 999,192 1,289,558 4,824,743 4,228,984
Amortization of intangible assets 1,518 453,529 4,554 507,848
------------ ------------ ------------ ------------
Total operating expenses 2,260,793 7,921,420 8,800,663 23,261,041
------------ ------------ ------------ ------------
Operating loss (2,050,315) (5,208,866) (8,179,387) (19,090,063)
Interest and other, net (220,198) 30,433 (1,643,225) 311,226
------------ ------------ ------------ ------------
Net loss $ (2,270,513) $ (5,178,433) $ (9,822,612) $(18,778,837)
Dividends on preferred stock 173,151 -- 173,151 --
Beneficial conversion feature in association
with preferred stock 14,970,862 -- 14,970,862 --
------------ ------------ ------------ ------------
Net loss available to common shareholders $(17,414,526) $ (5,178,433) $(24,966,625) $(18,778,837)
============ ============ ============ ============
Basic and diluted loss per common share $ (1.00) $ (0.38) $ (1.62) $ (1.38)
============ ============ ============ ============
Basis and diluted weighted average
shares outstanding 17,462,159 13,679,239 15,439,185 13,635,203
============ ============ ============ ============
</TABLE>
See accompanying notes.
4
<PAGE>
7TH LEVEL, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
<TABLE>
<CAPTION>
Nine Months Ended Nine Months Ended
September 30, 1998 September 30, 1997
------------------ ------------------
<S> <C> <C>
Cash flows from operating activities:
Net loss $ (9,822,612) $(18,778,837)
Adjustments to reconcile net loss to net cash used in
operating activities:
Non-cash compensation and interest 3,096,237 --
Depreciation and amortization 1,449,787 3,097,171
(Gain) loss on sale of assets 166,745 (94,802)
Gain on early retirement of debt -- (10,142)
Change in operating assets and liabilities (213,694) 4,553,338
------------ ------------
Net cash used in operating activities (5,323,537) (11,233,272)
------------ ------------
Cash flows from investing activities:
Capital expenditures (43,968) (437,464)
Proceeds from sale of assets 49,529 5,594,010
Sale of short-term investments -- 3,791,162
------------ ------------
Net cash provided by investing activities 5,561 8,947,708
------------ ------------
Cash flows from financing activities:
Issuance of Common Stock under stock option
and stock purchase plans 674,598 254,288
Issuance of Common Stock 7,650 400
Net proceeds from issuance of preferred stock 5,268,876 --
Net proceeds from debt issuance 4,310,900 --
Proceeds from exercise of warrants 28,000 --
Repayment of long-term obligations (144,377) (5,750,000)
------------ ------------
Net cash provided by (used in ) financing activities 10,145,647 (5,495,312)
------------ ------------
Effect of exchange rate changes on cash -- (29,013)
------------ ------------
Net increase (decrease) in cash 4,827,671 (7,809,889)
Cash and cash equivalents, beginning of period 2,465,079 10,798,372
------------ ------------
Cash and cash equivalents, end of period $ 7,292,750 $ 2,988,483
============ ============
</TABLE>
See accompanying notes.
5
<PAGE>
7TH LEVEL, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
1. Basis of Presentation
The condensed consolidated financial statements of 7th Level, Inc.
(the "Company") are unaudited and reflect all adjustments, consisting of normal
recurring adjustments, which are, in the opinion of management, necessary for a
fair presentation of the results for the interim periods. These condensed
consolidated financial statements should be read in conjunction with the
financial statements and notes thereto included in the Company's Annual Report
on Form 10-K for the year ended December 31, 1997 and the Company's Quarterly
Reports on Form 10-Q for the quarterly periods ended March 31, 1998 and June 30,
1998. The results of operations for the three and nine months ended September
30, 1998 are not necessarily indicative of the results for the entire year
ending December 31, 1998.
2. Loss per Common Share
The Company adopted the provisions of Statement of Financial
Accounting Standards No. 128 ("SFAS 128"), Earnings per Share, in the fourth
quarter of 1997, which requires companies to present basic earnings per share
and diluted earnings per share. Basic loss per share is computed by dividing
loss attributable to common stockholders by the weighted average number of
common shares outstanding during the period. Diluted loss per share reflects
the potential dilution that could occur if securities or other contracts to
issue common stock were exercised or converted into common stock. There is no
difference between basic and diluted loss per share in the accompanying
financial statements as the potential issuances of common stock had an
antidilutive effect. Options outstanding to purchase 3,267,807 and 2,589,200
shares of common stock during the three- and nine-month periods ended September
30, 1998 and 1997, respectively, and warrants outstanding to purchase 1,278,195
and 350,000 shares of common stock during the three- and nine-month periods
ended September 30, 1998 and 1997, respectively and 10,000 shares of Series B
Convertible Preferred Stock convertible into 5,000,000 shares of common stock
during the three- and nine-month periods ended September 30, 1998 and notes
payable convertible into 137,562 shares of common stock during the three- and
nine-month periods ended September 30, 1998 and 1997 have not been included in
the computation of dilutive loss per share because to do so would be
antidilutive.
3. Private Placement
In May 1998, the Company sold, pursuant to a private placement,
Secured Promissory Notes ("Notes") in the aggregate principal amount of
$4,500,000 and warrants for 675,000 shares of common stock, par value $0.01 per
share ("Common Stock"), of the Company at an exercise price of $0.01 per share.
The Company allocated approximately $1,200,000 of the proceeds from the Notes to
the warrants based on the relative fair values of the Notes and the warrants.
Accordingly, the Company amortized the related debt discount to interest expense
over the period from May 6, 1998 (date of issuance) to July 13, 1998 (date of
exchange see below). All of such warrants were exercised in June 1998. On July
9, 1998, the Company obtained stockholder approval for, among other things, an
increase in its authorized Common Stock (the "Certificate of Amendment") at its
1998 Annual Meeting of Stockholders. The Certificate of Amendment was filed on
July 10, 1998. On July 13, 1998, the holders of the Notes exchanged the Notes
for 4,500 shares of the Company's Series B Convertible Preferred Stock, $0.01
par value per share ("Series B Convertible Preferred Stock") and warrants to
purchase 1,125,000 shares of Common Stock at an exercise price of $0.01 per
share. The Company allocated $3,000,000 to Series B Convertible Preferred Stock
and $1,500,000 to warrants in accounting for the exchange.
In May 1998, the Company also sold, pursuant to a private placement,
shares of Series A Preferred Stock in the aggregate amount of $5,500,000 and
warrants for 1,375,000 shares of Common Stock at an exercise price of $0.01 per
share. The Company allocated approximately $2,500,000 of the proceeds from the
Series A Preferred Stock to the warrants based on the relative fair values of
the Series A Preferred Stock and the warrants. All of such warrants were
exercised in June 1998. On July 13, 1998, after the Certificate of Amendment was
approved by the Company's stockholders and was filed with the
6
<PAGE>
Secretary of State of the State of Delaware, the exchange of 5,500 shares of
Series A Preferred Stock for 5,500 shares of Series B Convertible Preferred
Stock was effected.
The Certificate of Designations, Preferences and Rights of Series B
Convertible Preferred Stock (the "Certificate of Designations") provides that on
the original issue date of the Series B Convertible Preferred Stock, the holders
of the Series B Convertible Preferred Stock will have the right to nominate two
members of the Board of Directors of the Company. The Series B Convertible
Preferred Stock ranks senior and prior to the Common Stock and to all other
classes or series of stock issued by the Company. Dividends accrue on the
shares of Series B Convertible Preferred Stock at the rate of 8% per annum;
provided, however, that in the event the Company fails to redeem the Series B
Convertible Preferred Stock on or before April 30, 2005 (the "Anniversary
Redemption Date"), pursuant to the Certificate of Designations, the dividend
rate on the Series B Convertible Preferred Stock shall increase 2% per annum on
each anniversary of the Anniversary Redemption Date. Annual dividends are
cumulative and are payable quarterly in arrears when and as declared by the
Company's Board of Directors. These shares have a liquidation preference of
$1,000 per share. The Series B Convertible Preferred Stock is convertible
immediately into Common Stock, initially at a conversion price of $2.00 per
share, subject to adjustment. The shares of Series B Convertible Preferred
Stock may be redeemed, at the option of the Company, at $1,000 per share on or
after the Anniversary Redemption Date. Upon a change of control, the Company
may offer to redeem such shares at $2,000 per share or the Company may issue to
each holder of Series B Convertible Preferred Stock warrants exercisable for
250,000 shares of Common Stock for each 1,000 shares of Series B Convertible
Preferred Stock owned by such holder at an exercise price of $0.01 per share.
The Company also has optional redemption rights at any time after i) completion
of an underwritten public offering by the Company with gross proceeds to the
Company of at least $20,000,000 and a price per share of Common Stock of at
least $4.00 per share, subject to adjustment, or ii) after the Company's Common
Stock shall have traded at an average price in excess of $4.00 per share,
subject to adjustment, for 20 consecutive trading days and the aggregate market
value of the Common Stock held by non-Affiliates of the Company is at least
$35,000,000. The holders of Series B Convertible Preferred Stock also are
entitled to certain preemptive rights, co-sale rights and registration rights.
For the three and nine months ended September 30, 1998, the Company was required
to increase the loss attributable to common stockholders, as a result of the
beneficial conversion feature which arose due to the increase in the market
price of the Company's Common Stock from the date the Company received
commitments with respect to the $10,000,000 financing (April 20, 1998) to the
date of issuance of the Series B Convertible Preferred Stock (July 13, 1998).
The beneficial conversion feature is based upon the difference between the
market price of the 5,000,000 shares of Common Stock into which the Series B
Convertible Preferred Stock is convertible and the carrying value of the Series
B Convertible Preferred Stock on the date of authorized issuance, or
approximately $15,000,000. The one-time occurrence was accounted for similar to
a non-cash dividend and had no effect on the Company's net loss or aggregate
stockholders' equity.
4. Contingencies
In connection with the Company's exit from the multimedia CD-ROM
content development and publishing business, including international office
closures, the Company is party to certain controversies. It is the opinion of
management that adequate provision for losses has been made and the ultimate
resolution of these issues is not expected to have a materially adverse effect
on the Company's financial position, results of operations or cash flows.
7
<PAGE>
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
The following information should be read in conjunction with the
financial statements and the notes thereto and in conjunction with Management's
Discussion and Analysis of Financial Condition and Results of Operations in the
Company's Annual Report on Form 10-K for the year ended December 31, 1997 and
the Company's Quarterly Reports on Form 10-Q for the quarterly periods ended
March 31, 1998 and June 30, 1998. This analysis is provided pursuant to
applicable Securities and Exchange Commission regulations and is not intended to
serve as a basis for projections of future events.
OVERVIEW
The Company continues to leverage its core animation software
technology on the Internet, other narrow and broadband networks and standalone
PC's. The Company has developed a software technology, Agent 7, which can be
used to produce, lip synch and play back animated characters on Web pages and
from within all major PC software packages, such as Microsoft PowerPoint, Word
and Excel. Agent 7 1.0, which was first released for sale on the Company's
website on August 7, 1998, is the first commercial application of 7th Level's
core technology, which has been named Media Control 7, or "Mc7". Mc7 can be used
to control, manipulate and publish multiple sources of media streaming over the
Internet and other networks or multiple sources resident on standalone PCs. 7th
Level plans to release additional applications this year and next, based on
Mc7/(1)/.
The Company is emerging from the development phase of its new Internet
technology. The Company released the first application of its new Internet
technology, Agent 7, in August 1998. Sales of this application are dependent to
a substantial extent on the download of its player, Mc7, which enables Internet
users to view the interactive animation published by Agent 7. The Company to
date is largely dependent upon its strategic marketing and distribution partners
to proliferate independent downloads of Mc7, and, based upon agreements and
forecasts by such key partners, had anticipated substantial download activity in
the summer of 1998. For reasons independent of the Company, anticipated download
activity has been delayed, resulting in delay of the Company's proposed
marketing program for Agent 7 and concomitant delay in sales activity. The
Company has been advised by one if its key marketing partners, RealNetworks,
that it expects to release a final version of its new player accompanied by a
substantial marketing program designed to promote download of its updated player
known as Realplayer G2 in the near future. G2 will support an auto-install
feature of Mc7 which the Company believes will result in commencement of
substantially more downloads of its player/1/. In addition, with the release and
promotion of G2, RealNetworks will release for sale a special version of Agent 7
designed for use with RealNetworks' G2 player and has advised the Company that
it intends to support the release of Agent 7 G2 with a substantial marketing
campaign/1/. The Company intends to tailor its own marketing of Agent 7 to the
timing and success of the G2 program. The Company has also been negotiating
licenses of its Agent 7 technology to other companies who would integrate the
technology in their own vertical applications such as web based training
applications. The Company believes that use of its technology by others in this
fashion will enhance licensees' offerings and therefore represent an attractive
royalty revenue source for the Company in the future/(1)/.
Realizing that the delay in independent Mc7 downloads could delay a
substantial portion of anticipated sales of Agent 7, the Company accelerated
completion of development of two applications that are not dependent on advance
player download for broad based adoption, namely desktop applications known as
Present 7 and voice activated e-mail known as Mail 7. The first of these
applications, Present 7, is expected to be completed and ready for marketing
around year end, and Mail 7 is expected to be completed in the first quarter of
1999/(1)/. The Company has begun discussions with potential marketing and
distribution partners for these applications. The Company has also completed an
alpha version of its interactive character animation technology for use in
instant messaging such as ICQ and expects to have a beta version ready in the
second quarter of 1999/1/. Instant messaging applications have enjoyed a great
deal of growth and attention in the Internet space over the course of the last
year, and in the opinion of management, represents a substantial opportunity for
the Company's technology.
The Company has begun to realize the benefits of previous actions
reflecting a dramatically lower cost structure primarily due to staff reductions
and associated overhead requirements. Further, the Company believes actions
taken in the early fourth quarter of 1998, specifically a reduction in the
production personnel in the Glendale, California office and a subleasing of a
portion of the Glendale facility, will reduce expenses by over $1 million on an
annualized basis/(1)/.
8
<PAGE>
RESULTS OF OPERATIONS
Three Month Periods Ended September 30, 1998 and September 30, 1997
In the three months ended September 30, 1998, 7th Level net revenues
decreased to $251,345, which is significantly lower than the $3,271,245 achieved
in the three months ended September 30, 1997. Approximately $37,000 of revenues
from custom character work and Agent 7 was recognized in the three months ended
September 30, 1998 which amounted to 15% of total revenues. The remaining 85%
of revenues were royalties from licenses for the Company's CD-ROM game
technology. The Company's minimal revenues in the 1998 period represent the
transition from the previous business model and the new strategy as discussed
above. Included in net revenues for the three months ended September 30, 1997
was $1.8 million for the sale of Dominion, one of the Company's CD ROM game
titles. Excluding the sale of Dominion in the third quarter of 1997,
approximately 51% of remaining net revenues related to product sales and 49% was
from licensing, OEM and development contracts.
Cost of revenues for the quarter ended September 30, 1998 was $40,867
or 16% of net revenue, including processing of e-commerce sales, royalty
payments and development costs. For the quarter ended September 30, 1997, cost
of revenues was $558,691 or 17% of net revenues. The Company expects
fluctuations in gross margin in the future as the Company's new business
strategy is implemented and as changes occur in the composition of the revenues
and the associated cost of revenues./(1)/
Research and product development expenses were $1,028,766 and
$4,370,096 for the three months ended September 30, 1998 and 1997, respectively.
Research and product development costs decreased 76% in the 1998 period due to
reductions in headcount and related expenditures in line with the new business
strategy. Results from the 1997 period included spending for five CD-ROM titles
in active production.
Sales and marketing expenses were $231,317 and $1,808,237 for the
quarter ended September 30, 1998 and 1997, respectively. Sales and marketing
expenses included $107,526 and $446,321 of expenses for advertising, marketing
and public relations and $123,791 and $1,361,916 of expenses related to internal
staffing for the three months ended September 30, 1998 and 1997, respectively.
Following its departure from the CD-ROM games business, the Company has effected
various cost saving measures including staff reductions and lower advertising
expenditures which resulted in the significant decrease in sales and marketing
expenses between the two periods. The Company expects increases in sales and
marketing expenses in the future as the Company launches the new mc7
applications./(1)/
General and administrative expenses, including amortization of
intangible assets, for the three months ended September 30, 1998 were $1,000,710
compared with $1,743,087 for the three months ended September 30, 1997. General
and administrative expenses for the quarter ended September 30, 1997 included
approximately $453,500 amortization for the write off of the goodwill associated
with the San Francisco based Lanpro entities acquired in December 1995.
Excluding the write off, general and administrative expenses decreased
approximately 22% between the two periods.
The Company's interest income was more than offset by interest expense
in the three months ended September 30, 1998. Net interest expense was $220,198
recognized in the three months ended September 30, 1998 compared to $30,433 net
interest income for the three months ended September 30, 1997. Included in the
amount for 1998 was approximately $317,000 expense related to amortization of
debt issuance costs and accretion of debt discount following the financing
transaction (see "Liquidity and Capital Resources").
9
<PAGE>
Nine Month Periods Ended September 30, 1998 and September 30, 1997
For the nine months ended September 30, 1998, net revenues totaled
$785,486 compared to $8,432,817 for the nine months ended September 30, 1997. As
previously disclosed and as described above, the Company has transitioned from
the CD-ROM games business and is leveraging the underlying software technologies
in the new business strategy. The 91% decrease in net revenues reflects the
shift in business strategy as the first of the new products on the mc7 platform
was formally released late in the third quarter of 1998 and accordingly, no
significant revenues have been realized.
Cost of revenues during the nine months ended September 30, 1998 was
$164,210 or 21% of net revenue. For the nine months ended September 30, 1997
cost of revenues was $4,261,839 or 51% of net revenue. The Company expects
fluctuations in gross margin in the future as the Company's new business
strategy is implemented.(1) The gross margin in the first nine months of 1997
was negatively impacted by changes in the revenue mix, through the inclusion of
substantial returns and price protection adjustments and development revenue,
which has a higher cost of revenue than product sales or OEM licensing revenue.
Research and product development expenses were $3,197,739 for the nine
months ended September 30, 1998 compared to $12,991,379 for the nine months
ended September 30, 1997. Research and product development expenses decreased
75% over the same period of the prior year due to reductions in headcount and
related expenditures in line with the new business strategy.
Sales and marketing expenses were $773,627 or 98% of revenues, for the
nine months ended September 30, 1998, compared to $5,532,830, or 66% of
revenues, for the nine months ended September 30, 1997. Internal staffing
expenses decreased approximately 84% as a result of personnel reductions and
closure of the Company's international sales and marketing offices. Costs for
advertising, marketing and public relations decreased by 88% in the first nine
months of 1998 compared to the first nine months of 1997 as only one product was
released during the 1998 period, the formal launch of which was in early fourth
quarter and therefore marketing activities were negligible in the first nine
months of 1998.
General and administrative expenses were $4,829,297, including
amortization of intangible assets, for the nine months ended September 30, 1998,
compared with $4,736,832 for the nine months ended September 30, 1997. One time
charges were recognized in the first nine months of 1998 totaling $1,824,000
which included approximately (i)$1,380,000 in non-cash compensation related to
stock granted to the Company's Chairman and Vice Chairman, (ii) $44,000 in
charges for certain stock options and stock warrants granted to consultants and
(iii) $400,000 related to professional fees associated with the terminated
merger with Pulse. Approximately $853,500 of the amount in the 1997 period was
for non-recurring items, including approximately $453,500 for the write off of
goodwill associated with the San Francisco based Lanpro entities acquired in
December 1995 and approximately $400,000 was associated with expenses related to
employee resignations in the first quarter of 1997. Excluding these non-
recurring expenses, general and administrative expenses decreased approximately
23% between the two periods.
Net interest expense was $1,643,225 for the nine months ended
September 30, 1998 compared to $311,226 net interest income for the nine months
ended September 30, 1997. Included in the amount for 1998 was approximately
$1,657,000 expense related to amortization of debt issuance costs and accretion
of debt discount following the financing transaction (see "Liquidity and Capital
Resources"). The change is also because of lower cash balances available for
investment along with higher average debt outstanding. Included in the amount
for 1997 was approximately $95,000 for the gain recognized from the sale of an
office building, net of the interest capitalized as a cost of financing the
acquisition of land and office building construction.
10
<PAGE>
LIQUIDITY AND CAPITAL RESOURCES
Cash and cash equivalents increased $4,827,671 during the first nine
months of the year to $7,292,750 at September 30, 1998. The increase is the
result of the $10,000,000 private placement funded in May 1998, offset by
operating activities during the first nine months of 1998. Net cash used in
operating activities was $5,323,537 which included a net loss of $9,822,612 for
the nine months ended September 30, 1998, offset by non cash items such as
charges for stock grants and amortization of debt issuance costs and accretion
of debt discount described above, as well as the non-cash depreciation and
amortization expenses. Approximately $710,000 of cash was provided in the nine
months ended September 30, 1998 from the issuance of Common Stock due to
exercises of stock options, stock purchase agreements and stock warrants. The
Company sold surplus equipment resulting in a loss on disposition of
approximately $167,000, and has significantly curtailed capital expenditures,
with disbursements of approximately $44,000, in the first nine months of 1998
compared to approximately $437,000 in the same period of 1997. Capital
expenditures for the remainder of 1998 are anticipated to be minimal/(1)/,
however, the Company continues to use cash and operate at a loss.
In May 1998, the Company sold, pursuant to a private placement, Notes
in the aggregate principal amount of $4,500,000 and warrants for 675,000 shares
of Common Stock at an exercise price of $0.01 per share. The Company allocated
approximately $1,200,000 of the proceeds from the Notes to the warrants based on
the relative fair values of the Notes and the warrants. Accordingly, the Company
amortized the related debt discount to interest expense over the period from May
6, 1998 (date of issuance) to July 13, 1998 (date of exchange see below). All of
such warrants were exercised in June 1998. On July 9, 1998, the Company obtained
stockholder approval for, among other things, an increase in its authorized
Common Stock and the Certificate of Amendment was filed on July 10, 1998. On
July 13, 1998, the holders of the Notes exchanged the Notes for 4,500 shares of
the Company's Series B Convertible Preferred Stock, $0.01 par value per share
("Series B Convertible Preferred Stock") and warrants to purchase 1,125,000
shares of Common Stock at an exercise price of $0.01 per share.
In May 1998, the Company also sold, pursuant to a private placement,
shares of Series A Preferred Stock in the aggregate amount of $5,500,000 and
warrants for 1,375,000 shares of Common Stock at an exercise price of $0.01 per
share. The Company allocated approximately $2,500,000 of the proceeds from the
Series A Preferred Stock to the warrants based on the relative fair values of
the Series A Preferred Stock and the warrants. All of such warrants were
exercised in June 1998. On July 13, 1998, after the Certificate of Amendment was
approved by the Company's stockholders and was filed with the Secretary of State
of the State of Delaware, the exchange of 5,500 shares of Series A Preferred
Stock for 5,500 shares of Series B Convertible Preferred Stock was effected.
The Certificate of Designations, Preferences and Rights of Series B
Convertible Preferred Stock (the "Certificate of Designations") provides that on
the original issue date of the Series B Convertible Preferred Stock, the holders
of the Series B Convertible Preferred Stock will have the right to nominate two
members of the Board of Directors of the Company. The Series B Convertible
Preferred Stock ranks senior and prior to the Common Stock and to all other
classes or series of stock issued by the Company. Dividends accrue on the
shares of Series B Convertible Preferred Stock at the rate of 8% per annum;
provided, however, that in the event the Company fails to redeem the Series B
Convertible Preferred Stock on or before April 30, 2005, (the "Anniversary
Redemption Date") pursuant to the Certificate of Designations, the dividend rate
on the Series B Convertible Preferred Stock shall increase 2% per annum on each
anniversary of the Anniversary Redemption Date. Annual dividends are cumulative
and are payable quarterly in arrears when and as declared by the Company's Board
of Directors. These shares have a liquidation preference of $1,000 per share.
The Series B Convertible Preferred Stock is convertible immediately into Common
Stock, initially at a conversion price of $2.00 per share, subject to
adjustment. The shares of Series B Convertible Preferred Stock may be redeemed,
at the option of the Company, at $1,000 per share on or after the Anniversary
Redemption Date. Upon a change of control, the Company may offer to redeem such
shares at $2,000 per share or the Company may issue to each holder of Series B
Convertible Preferred Stock warrants exercisable for 250,000 shares of Common
Stock for each 1,000
11
<PAGE>
shares of Series B Convertible Preferred Stock owned by such holder at an
exercise price of $0.01 per share. The Company also has optional redemption
rights at any time after i) completion of an underwritten public offering by the
Company with gross proceeds to the Company of at least $20,000,000 and a price
per share of Common Stock of at least $4.00 per share, subject to adjustment, or
ii) after the Company's Common Stock shall have traded at an average price in
excess of $4.00 per share, subject to adjustment, for 20 consecutive trading
days and the aggregate market value of the Common Stock held by non-Affiliates
of the Company is at least $35,000,000. The holders of Series B Convertible
Preferred Stock are also entitled to certain preemptive rights, co-sale rights
and registration rights.
For the quarter ended September 30, 1998, the Company was required to
increase the loss attributable to common shareholders, as a result of the
increase in the market price of the Company's Common Stock from the date the
Company received commitments with respect to the $10,000,000 financing (April
20, 1998) to the date of issuance of the Series B Convertible Preferred Stock
(July 13, 1998). The beneficial conversion feature, which increases the loss
attributable to common shareholders, is based upon the difference between the
market price of the 5,000,000 shares of Common Stock into which the Series B
Convertible Preferred Stock is convertible and the carrying value of the Series
B Convertible Preferred Stock on the date of authorized issuance, or
approximately $15,000,000. The one-time occurrence was accounted for similar to
a non-cash dividend and had no effect on the Company's net loss or aggregate
stockholders' equity. In the view of the Company's accountants, based on the
SEC's current position and the recent discussions of the Financial Accounting
Standards Board's Emerging Issues Task Force Topic D-60 (Accounting for the
Issuance of Convertible Preferred Stock and Debt Securities with a Nondetachable
Conversion Feature), the Series B Convertible Preferred Stock conversion feature
is required to be recognized and measured on July 13, 1998, notwithstanding the
fact that the price of the Company's stock was lower than the conversion price
at the time the financing was committed. The underlying conversion rate was
provided for when the terms of the financing were agreed to and at a price above
the then current market price of the Company's Common Stock, i.e., "out-of-the-
money". Subsequent to reaching agreement on the financing transaction, the
market price of the Company's Common Stock increased such that the conversion
rate (fixed at the time of the financing commitment) was "in the money" at the
time the securities were issued. Management does not believe that the required
accounting treatment reflects the favorable impact of the financing on the
Company's financial condition.
In the normal course of business, the Company evaluates potential
acquisitions, joint ventures and strategic alliances that may complement the
Company's business. While the Company has no present commitments or agreements
with respect to any material business combinations, the Company may in the
future consummate transactions which may require the Company to issue additional
capital and such issuances may be significant.
To date, the Company continues to use cash and operate at a loss. The
Company's ability to achieve positive cash flow depends upon a variety of
factors, including the timely introduction and market success of its products,
the costs of developing, producing and marketing such products, adoption of the
Internet as a medium of commerce and communications and various other factors,
some of which may be beyond the Company's control. If the Company requires
additional capital, it would seek such funding through additional public or
private financing, although there can be no assurance that the Company will be
able to obtain such financing/(1)/.
YEAR 2000
In the past, a number of computer software programs were written using
two digits rather than four to determine the applicable year. As a result, date-
sensitive computer software may recognize a date using "00" as the year 1900
rather than the year 2000. This could result in major system failures or
12
<PAGE>
miscalculations, and is generally referred to as the "Year 2000" problem. A
review of the Company's information systems has been completed and a plan is
currently in process to modify or replace those systems that are not Year 2000
compliant. Management believes that all Company systems are compliant, or will
be compliant by December 31, 1998. Additional validation of the Company's
systems will be conducted through testing throughout 1999.
In addition to the assessment of in house systems, the Company plans
to assess the readiness of its significant vendors for the Year 2000 issue.
Contingency plans will be developed in the event that business-critical vendors
do not provide the Company with satisfactory evidence of their readiness to
handle Year 2000 issues.
The Company does not believe the costs related to the Year 2000
compliance project will be material to its financial position or results of
operation. However, the cost of the project and the date on which the Company
plans to complete the Year 2000 modifications are based on management's best
estimates. Unanticipated failures by critical vendors as well as failure by the
Company to satisfactorily execute its own compliance could have a material
adverse effect on costs and timing of the program. As a result, there can be no
assurance that these forward-looking estimates will be achieved and the actual
cost and vendor compliance could differ materially from those plans, resulting
in material financial risk.
13
<PAGE>
RECENTLY ISSUED ACCOUNTING PRINCIPLES
In June 1997, Statement of Financial Accounting Standards No. 131,
Disclosures about Segments of an Enterprise and Related Information ("SFAS No.
131") was issued. This statement establishes standards for reporting information
about operating segments in annual and interim financial statements, although
this statement need not be applied to interim financial statement in the initial
year of its application. This statement is effective for fiscal years beginning
after December 15, 1997. The adoption of SFAS No. 131 is not expected to have a
material impact on the Company's financial statements and related disclosures.
In April, 1998, Statement of Position (SOP) 98-5, Reporting on the
Costs of Start-up Activities was issued. This SOP provides guidance on the
financial reporting of start-up and organization costs and requires that these
costs be expensed as incurred. The provisions of SOP 98-5 are effective for
financial statements for fiscal years beginning after December 15, 1998.
Adoption of SOP 98-5 is not expected to have a material impact on the Company's
financial statements. The Company will adopt the provisions of this SOP on
January 1, 1999.
- - --------------------------------------------------------------------------------
/(1)/ Certain statements contained herein including those
indicated by (1) are forward looking statements that involve
risks and uncertainties. Accordingly, no assurance can be given
that the actual events and results will not be materially
different than the anticipated results described in the forward
looking statement. There are a number of important factors that
could cause actual results to differ materially from those
expressed in any forward looking statements made by the Company.
These factors include among others, the Company's ability to
complete new products at planned costs and on planned schedules,
the Company's ability to attract and retain strategic partners,
the Company's ability to leverage intangible assets in its
technology, the success of the Company's cost reduction strategy
and the Company's ability to maintain a sufficient level of
financing for its new business strategy. Additional factors which
are beyond the Company's control and could influence results
include market acceptance of the Company's products and adoption
of the Internet as a medium of commerce and communications. See
the discussion of the Company's business and a description of the
various factors that could materially affect the ability of the
Company to achieve the anticipated results described in the
forward looking statement which is included in Item 1 of the
Company's Report on Form 10-K for the year ended December 31,
1997.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Not applicable
14
<PAGE>
7TH LEVEL, INC.
Part II. Other Information
Item 1. Legal Proceedings
Technology Edutainment Network Laboratory Co., Ltd. v. 7th Level,
Inc., United States District Court for the Central District of
California, Case No. 98-3923 AAH (JGx). On May 19, 1998, plaintiff
Technology Endutainment Network Laboratory Co., Ltd. ("TEN") filed a
suit against the Company for alleged breach of contract and related
claims concerning a contract for development of CD-ROM software,
seeking $246,000 in alleged damages (the "Action"), and secured an
order for the issuance of a writ of attachment in the amount of
$144,000 which was not issued. On June 29, 1998, TEN instituted
arbitration proceedings before the American Arbitration Association on
the same claims it brought in the Action (the "Arbitration"). The
Company filed defenses and a counterclaim against TEN in the
Arbitration, seeking $366,000. On September 16, 1998, the Company and
TEN entered into a confidential settlement agreement fully and finally
resolving these matters between them and resulting in dismissal with
prejudice of both the Action and the Arbitration.
Thomas Randolph and Kay Randolph v. 7th Level, Inc., San
Francisco Superior Court, Case No. 998675. On October 20, 1998,
plaintiffs Thomas Randolph and Kay Randolph filed suit against the
Company for alleged wrongful termination (of Thomas Randolph) and
alleged breach of contract and covenant of good faith and fair dealing
arising out of Thomas Randolph's position as the Company's former head
of its 7th Level Asia Pacific subsidiary. The complaint seeks
unspecified compensatory and punitive damages. The Company believes
the plaintiffs' claims are without merit and intends to vigorously
defend itself and expects to file cross-claims against plaintiffs.
Item 2. Changes in Securities
On July 9, 1998, the Certificate of Amendment including the
increase in the number of authorized shares of Common Stock was
approved by stockholders and on July 10, 1998, the Certificate of
Amendment was filed with the Secretary of State of the State of
Delaware. On July 13, 1998, the holders of the Notes exchanged the
Notes for 4,500 shares of the Company's Series B Convertible Preferred
Stock and warrants to purchase 1,125,000 shares of Common Stock at an
exercise price of $0.01 per share. Also on July 13, 1998, the
automatic exchange of 5,500 shares of Series A Preferred Stock for
5,500 shares of Series B Convertible Preferred Stock was effected.
The information concerning the Notes, the Series A Preferred
Stock, the Series B Convertible Preferred Stock and the warrants
issued with respect to the Notes and the Series A Preferred Stock set
forth in Part 1, Item 2, "Management's Discussion and Analysis of
Financial Condition and Results of Operations" in the second and third
paragraphs under "Liquidity and Capital Resources" on pages ten and
eleven of this Report is incorporated herein by reference.
15
<PAGE>
The Company believes the sale of the Notes and the warrants
issued in connection therewith qualifies as a transaction by an issuer
not involving a public offering within the meaning of Section 4(2) of
the Securities Act of 1933, as amended (the "Securities Act"), based
on the manner of offering (a negotiated sale to two "accredited
investors" (as defined in Rule 501 of Regulation D under the
Securities Act) without general solicitation) and the purchasers'
financial status, investment experience and investment intent, as
represented to the Company.
The Company believes the sale of the Series A Preferred Stock and
the warrants issued in connection therewith qualifies as a transaction
by an issuer not involving a public offering within the meaning of
Section 4(2) of the Securities Act based on the manner of offering (a
negotiated sale to "accredited investors" (as defined in Rule 501 of
Regulation D under the Securities Act) and to two non-accredited
investors without general solicitation) and the purchasers' financial
status, investment experience and investment intent, as represented to
the Company.
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
27 - Financial data schedule
(b) Reports on Form 8-K
Registrant filed a Current Report on Form 8-K, dated July 9,
1998, in respect to the proposals approved at the annual meeting of
stockholders, the filing of the Certificate of Amendment, the
automatic conversion of Series A Preferred Stock to Series B
Convertible Preferred Stock and the exchange of the Notes for Series B
Convertible Preferred Stock. (Item 5).
16
<PAGE>
7TH LEVEL, INC.
Signature
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
7TH LEVEL, INC.
Date: November 16, 1998 By: /s/ DONALD SCHUPAK
-----------------------------------
Donald Schupak
Chairman of the Board and Director
(Principal Financial Officer)
17
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