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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
(Mark One)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 1997
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 of incorporation) (I.R.S. Employer Identification No.)
1110 EAST COLLINS BOULEVARD
SUITE 122
RICHARDSON, TEXAS 75081
(Address of principal executive offices) (Zip Code)
REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (972) 498-8100
Securities Registered Pursuant to Section 12(b) of the Act: None
Securities Registered Pursuant to Section 12(g) of the Act:
Common Stock, $0.01 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 [_]
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [X]
The approximate aggregate market value of the voting stock held by non-
affiliates of the registrant as of February 18, 1998 was approximately
$20,486,618. As of February 18, 1998, there were 13,783,736 outstanding shares
of the registrant's common stock.
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Table of Contents
Page
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PART I
Item 1. Business 3
Item 2. Properties 9
Item 3. Legal Proceedings 9
Item 4. Submission of Matters to a Vote of Security Holders 9
PART II
Item 5. Market for Registrant's Common Equity and Related
Stockholder Matters 10
Item 6. Selected Financial Data 11
Item 7. Management's Discussion and Analysis of Financial
Condition and Results of Operations 12
Item 8. Financial Statements and Supplementary Data 18
Item 9. Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure 36
PART III
Item 10. Directors and Executive Officers of the Registrant 36
Item 11. Executive Compensation 38
Item 12. Security Ownership of Certain Beneficial Owners and
Management 42
Item 13. Certain Relationships and Related Transactions 43
PART IV
Item 14. Exhibits, Financial Statement Schedules, and
Reports on Form 8-K 44
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PART I
ITEM 1. BUSINESS
General
7th Level, Inc. (the "Company") began as a developer and publisher of
interactive multimedia entertainment and edutainment products and a creator of
proprietary multimedia development tools and technologies. The Company
integrated its computer-based production techniques with the creativity,
production talent and storytelling skills of Hollywood in the development of
numerous award winning interactive software products. The Company's integrated
production process was designed to produce feature-film quality animation as
well as 3D, video and audio content primarily for CD-ROM but also for other
media platforms on a cost-effective and timely basis. The Company has been
developing a proprietary tool suite, known as Studio 7/TM/, which includes
TopGun/TM/, a Windows-based next-generation authoring and playback engine,
Annie(R), a digital inking and painting software system customized for automatic
script generation, several plug-ins that connect to other technologies and an
automated asset and production management system.
Business Strategy
The Company was founded in 1993 with the goal of becoming a leading
developer and publisher of interactive entertainment and educational products as
well as the creator of state of the art tools and technologies. While the
Company succeeded in garnering great respect in the industry and numerous awards
for its achievements, it was unable to generate a profit from the publishing
business or to commercialize its tools. In February 1997, the Company announced
the termination of its educational efforts and its decision to concentrate on
the development and publishing of games. Due to numerous difficulties including
schedule and budget over-runs, the Company's first hard core game release proved
to be unprofitable.
In March 1997, the Company underwent a change in management. New
management began immediately to evaluate the Company's existing business and
concluded that the Company required a change in business direction. In August
1997, new management announced its strategy to quickly transform the Company
from being a self-funded content developer and publisher to being a leading edge
supplier of custom and packaged new media and electronic commerce solutions for
a broad array of applications and platforms, including online, CD-ROM and video.
The new strategy called for focusing the Company's resources on developing the
services and solutions side of its business and for the commercialization of the
Company's tools and technologies, all of which would require some further
investment and development. The Company retained a financial advisor to provide
consulting services and assist the Company in evaluating its business
opportunities, resources and requirements.
The Company streamlined its operation by divesting itself of its games
development groups and concentrated on building strategic relationships with
major corporations, brand and content owners, developers and marketers in order
to leverage its systems, its expertise and its technology to provide content and
technology solutions to these partners. The Company then moved aggressively to
identify a viable and complementary partner with the appropriate technology
assets and management expertise necessary to implement the new strategy. The
Company also has been pursuing opportunities to benefit from the utilization of
its technology and integrated studio capacity in conjunction with other content
owners, developers and marketers, and is seeking to leverage its assets and
technology through key strategic relationships/(1)/. There can be no assurance
that the Company's new strategy will be successful. In addition, the
profitability of the Company in the near future will be adversely affected since
the Company will incur additional expenses to implement its new strategy,
particularly expenses in completing the development and integration of its tool
suite and investments in expanding its integrated custom solutions business.
The Company's ability to derive revenues from new media solutions will
depend in part upon a
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growing industry and the infrastructure for providing Internet access and
carrying Internet traffic/(1)/. The Internet may not prove to be a viable
commercial marketplace because of inadequate development of the necessary
infrastructure, such as a reliable network backbone or timely development of
complementary products, such as high speed modems. Because global commerce and
online exchange of information on the Internet and other similar open wide area
networks are new and evolving, it is difficult to predict with any assurance
whether the Internet will prove to be and remain a viable commercial
marketplace. Moreover, critical issues concerning the commercial use of the
Internet (including security, reliability, cost, ease of use and access, and
quality of service) remain unresolved and may impact the growth of Internet use.
There can be no assurance that the Internet will become a viable commercial
marketplace. If the necessary infrastructure or complementary products are not
developed, or if the Internet does not become a viable commercial marketplace,
the Company's business, operating results and financial condition could be
materially adversely affected.
The digital media, Internet and on-line services market and the personal
computer industry in general are characterized by rapidly changing technology,
resulting in short product life cycles and rapid price declines. The Company's
success is dependent upon, among other things, the ability of the Company to
achieve and maintain technological and quality leadership by anticipating and
developing new technologies and to remain competitive in terms of price and
performance and evolving industry standards and practices/(1)/. If the Company
were unable, due to resource constraints or technological or other reasons, to
develop new technologies in a timely manner, this inability could have a
material adverse effect on the Company's results of operations.
The Company's new strategy involves entry into two new markets. The
Company is devoting substantial resources to the development of the integrated
custom solutions business and intends to offer a full range of services from
consultation and design for new media and electronic commerce to fully
integrated and scalable 2D and 3D content and technology creation, rapid
authoring and flexible playback and comprehensive production and development
management/(1)/. While the Company believes that its experience in development
and production for third parties will translate well to the integrated custom
solutions business, there can be no assurance that the Company will be able to
develop this new business or as to the timing or extent of such development.
The Company also intends to enter the market for packaged development tools
through the development of a commercial version of its existing Studio 7/TM/
technology integrated with Pulse's 3D capabilities/(1)/. There can be no
assurance that the Company can integrate the suite of tools successfully or that
if completed, the tools can achieve commercial success given that this market is
characterized by an existing installed base of competitors' tools. Furthermore,
the Company's entry into the above-described new markets will require the
Company to change its product distribution from an indirect model through retail
distribution to a model involving direct sales to certain large multimedia and
other technology companies and indirect sales through strategic partnerships,
resellers and retail distribution. The Company has had relatively little
experience in certain of these distribution methods and there can be no
assurance that the Company will be successful in selling its products through
these new channels.
Agreement to Merge
On November 17, 1997, the Company announced it had signed a letter
agreement to merge (the "Merger") with Pulse Entertainment, Inc. ("Pulse"). The
Merger is subject to a number of conditions including, but not limited to,
approval by a majority of the shareholders of both companies, delivery of a
fairness opinion and the raising of $15,000,000 in private securities (the
"Financing") to support the Company's completion of its tools and provide
working capital to market those tools and to staff up for the solutions
business. The Company has retained Donaldson, Lufkin & Jenrette Securities
Corporation ("DLJ") to provide a fairness opinion with respect to the
consideration to be paid in the Merger. The Merger will be accounted for as a
reverse acquisition for accounting and financial reporting purposes with the
Company being designated as the acquiree and Pulse as the acquiror. On February
25, 1998, the definitive Agreement and Plan of Merger (the "Merger Agreement")
was signed by the Company and Pulse. Representatives of the boards of directors
of the Company and Pulse have met and agreed to consider reevaluating certain
terms of the Merger and/or whether or not the Merger should go forward. There
can be no assurance that the Merger will be successfully concluded.
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Principal Services
The Company's strategy is to become a leading supplier of custom solutions
and services, and tools and technologies/(1)/. Consequently, the Company has
sold or licensed its game properties during the second half of 1997 to allow it
to focus its technical, production and marketing resources on expanding its
custom solutions business and on completing its Studio 7/TM/ suite of tools.
Integrated Custom Solutions
The Company intends to offer customers a full range of services from
consultation and design for their new media and electronic commerce needs, to
fully integrated and scalable 2D content and technology creation, rapid
authoring and flexible playback and comprehensive production and development
management/(1)/. The Company's strategy and business plan is to provide custom
new media solutions for corporations, entertainment, media and content
companies, advertising agencies, systems integrators and communications
providers/(1)/. While the senior management of the Company is experienced in
advertising and promotional media and marketing, the Company also intends to
accelerate its penetration into this new market by partnering with other larger
organizations to leverage their marketing and sales capabilities.
The Company believes its core competency in the integrated solutions
business is in interactive design and integration and implementation of both
content development and technology with a focus on intelligent delivery and
retrieval of data and compelling presentation. The Company's suite of tools,
Studio 7/TM/, features a proprietary, next-generation authoring and high-speed
playback technology and a fully integrated production process. The Company has
built a state of the art, scalable digital production studio that features fully
integrated content creation, asset management, digital ink and paint, animation,
video and audio creation and processing, and automated production management.
The studio is located in the media center between Glendale and Burbank,
California, where the talent pool allows for a swift ramp-up of qualified
personnel for large scale productions.
Currently, the Company is providing custom content and technology solutions
to Bandai Digital Entertainment and Microsoft Corporation ("Microsoft"), among
others. In these relationships, the Company is engaged to design and create a
solution on a fee-plus-royalty or license basis. Management has extensive
experience in consultation, design and implementation, and the Company intends
to expand the consultation side of its business in the future.
Packaged Solutions: Tools and Technology
With the convergence of content to digital media and a trend toward
networks and interactivity, the Company believes the demand for tools to create,
manipulate, author and deliver content will grow rapidly/(1)/. Digital content
creators from large corporations to small web developers and even consumers
require network-oriented tools that help them create highly visual, interactive
content quickly and cost effectively. The Company's tools have been built from
their inception with these uses in mind. The tools are designed to be used by
non-engineers and content makers to create presentations, intelligent
characters, games, and full multimedia experiences and to deliver all of the
above across a wide array of platforms including networks, CD-ROM and
video/(1)/.
In combination with Pulse, the Company expects to initially market a suite
of smaller tools and plug-ins for use in different forms of digital content
creation across a variety of media, including a web character building tool that
allows users to download a character and synchronize it with streaming
audio/(1)/. With the full integration of the Company's Studio 7/TM/ and Pulse's
3D capabilities, the Company will then be able to offer a comprehensive tool
suite featuring scalable architecture, a next generation 3D and 2D authoring
tool, an on-line interactive 3D plug-in, as well as simple plug-ins for existing
technologies and
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post production tools/(1)/. The Company intends to market these tools to a broad
array of users including web developers, corporate creative services
departments, design professionals, game developers and post-production
houses/(1)/.
The Company expects the market for both custom integrated solutions and the
market for tools and technology to grow rapidly/(1)/. At the same time, the
Company expects its integrated solutions business to identify and define the
next generation of tools and technology which can be brought to market with
minimal additional development costs/(1)/. However, while the market is
expected to grow rapidly and the Company believes it offers leading edge
technology and know-how, there can be no assurance that the Company will be able
to secure an adequate volume of solutions business on terms favorable to the
Company, or that the Company can complete the integration of its suite of tools
successfully or that if completed, the tools can be sold in sufficient
quantities to be profitable. The Company expects that 1998 results will reflect
a significant operating loss as the Company completes the development and
integration of its tool suite and invests in expanding its integrated custom
solutions business/(1)/.
Competition
The Company's new strategy is to offer a complement of design, production
and technology capabilities for the production and delivery of interactive
digital content, delivered on-line to the Internet or intranets. The Company's
competitors in the integrated solutions business include companies with a
background in the field of marketing, as well as those with a focus on
production and technology. Competitors include companies such as CKS Partners,
Poppe Tyson Interactive (Neterra), a division of Poppe Tyson Group, Inc.,
Pittard Sullivan New Media, and USWeb Corp., as well as a large number of "web
shops." These companies and others may utilize advanced technology and may have
long standing client relationships and an understanding of a client's business
that are important competitive advantages. The barriers to entry in this
emerging business are also low and the Company expects to compete with companies
providing a variety of services ranging from strategy consulting, to analysis
and design, to technology development to implementation, integration and
maintenance. The Company expects that the size and anticipated growth rate of
the market and the lack of full range service vendors and rapidly evolving
technology and standards will attract new competitors, as well as attract major
investments from computer hardware vendors, telecom companies, Internet service
providers and major software vendors.
In the multimedia tools market, the Company faces competition from
established suppliers with integrated and fully developed offerings such as
Macromedia Inc. ("Macromedia"), Kinetix, a division of Autodesk, Inc., Silicon
Graphics Inc. ("SGI") and Microsoft with principal products that have achieved
market acceptance.. In addition, the high growth of the web network or Internet
has also seen the creation of a large number of new companies with leading edge
technology, including a number of new companies with key individuals from
Macromedia, Apple Computer, Inc., SGI and other strong technology companies.
Competition will also be influenced by the timing of competitive product
releases and the similarity of such products to those of the Company/(1)/. In
addition, the Company believes that potential new competitors, including large
software companies, media companies and film studios are increasing their focus
on the interactive entertainment market/(1)/. There can be no assurance that
the Company will be able to compete successfully with current or future
competitors or that competitive pressures faced by the Company will not
materially and adversely affect its business, operating results and financial
condition.
Sales and Marketing
In support of the Company's original strategy to develop and publish
interactive entertainment products, the Company's initial marketing efforts
entailed indirect retail techniques such as advertising, in store promotions,
direct funding to resellers for specific marketing plans, Internet product
demonstrations and samples, direct mail campaigns and attendance at consumer
trade shows. In addition, the Company invested in a marketing approach which
included hosting an interactive Internet Web site, PythonOnline, an Internet-
based entertainment site with several Studio 7 enabled games. However, the
Company's new
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strategy involves entry into two new markets. The Company's entry
into these new markets will require the Company to change its product
distribution from an indirect model through retail distribution to a model
involving direct sales to certain large multimedia and other technology
companies and indirect sales through strategic partnerships resellers and retail
distribution/(1)/. The Company has had relatively little experience in certain
of these distribution methods and there can be no assurance that the Company
will be successful in selling its products through these new channels.
In the custom integrated solutions business, the Company plans to directly
market and license a full range of custom solutions from consultation and design
for new media and electronic commerce to fully integrated and scalable content
and technology creation, primarily to corporate customers/(1)/. Business
development professionals will work to identify and close opportunities across a
wide range of markets and applications, including computer based training and
advertising and in-house corporate production studios/(1)/. While the Company
believes that its experience in development and production for third parties
will translate well to the integrated customs solutions business, there can be
no assurance that the Company will be able to develop this new business or as to
the timing or extent of such development.
The Company also intends to enter the market for packaged development tools
through the development of a commercial version of its existing Studio 7/TM/
technology integrated with Pulse's 3D capabilities/(1)/. The Company's packaged
solutions are planned to be marketed indirectly through VARs, and directly
through licensing, retail and custom solutions/(1)/. The Company plans to
partner with leading software vendors to integrate and extend their products
with customized technology from the Company while leveraging their existing
sales channels/(1)/. There can be no assurance that the Company can integrate
the suite of tools successfully or that if completed, the tools can achieve
commercial success given that this market is characterized by an existing
installed base of competitors' tools.
Manufacturing and Distribution Risks; Product Returns
The production of the Company's tools products consists of pressing CD-ROM
disks, assembling purchased product components, printing product packaging and
user manuals and packaging finished products, all of which are performed for the
Company by third party vendors in accordance with the Company's specifications
and forecasts. While these services are available from multiple parties and at
multiple sites, there can be no assurance that an interruption in the
manufacture of the Company's products could be remedied without undue delay and
without materially and adversely affecting the Company's results of operations.
The Company plans to sell product indirectly through VAR's and through
licensing, retail and custom solutions/(1)/. These distribution channels have
been characterized by rapid change, including consolidations and financial
difficulties of certain distributors and the emergence of new channels for
distribution including on-line. In addition, there are an increasing number of
companies competing for access to these channels.
Employees
The Company has reduced the number of its employees from 253 at the end of
1996 to approximately 30 in February 1998, all of whom are employed in either
the Richardson, Texas or the Glendale, California location. None of the
Company's employees is represented by a labor union or is subject to a
collective bargaining agreement. The Company has never experienced a work
stoppage and believes that its relationships with its employees are
satisfactory.
The Company's business is labor intensive and its future success depends to
a significant degree on the continued service of its key personnel (and upon
consummation of the Merger, the continued service of Pulse's key personnel) and
on its ability to attract, motivate and retain highly qualified employees who
can provide the technology, marketing, creative and professional skills required
to provide customer solutions. The Company's key employees may voluntarily
terminate their employment with the Company at any time. Competition for such
employees is intense and the process of locating key management and technical
personnel with the combination of skills and attributes required to execute the
Company's strategy is often lengthy. Accordingly, the loss of the services of
key personnel or the inability to recruit
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new employees with the appropriate skills could have a material adverse effect
upon the Company's results of operations and on its research and development
efforts.
- --------------------------------------------
/(1)/ This statement is a forward looking statement that involves risks and
uncertainties. Such statements reflect the current views of management of
the Company, are based on many assumptions, including, but not limited
to, that no significant changes will occur in the operating environment
of the Company, and are subject to risks, uncertainties and other factors
which could cause these statements to differ materially from what
actually occurs. The Company may execute new agreements, terminate
existing agreements or enter into new financing arrangements that may
affect the accuracy of these statements. None of these events can be
predicted with certainty, and, accordingly, are not taken into
consideration in the making of the forward-looking statements. Readers
are cautioned to carefully consider such factors. There is no assurance
that the assumptions used are necessarily the most likely to occur. The
Company assumes no obligation to update any forward-looking statement to
reflect actual results, changes in assumptions or changes in other
factors affecting such statement.
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ITEM 2. PROPERTIES
The Company's headquarters are based in Richardson, Texas. It
currently leases an approximately 23,500 square foot office facility pursuant to
a lease expiring in July 31, 1999, with a Company option to renew. The Company
also leases a 38,000 square foot production facility and studio in Glendale,
California under a seven-year lease, expiring in 2002.
ITEM 3. LEGAL PROCEEDINGS
The Company is involved in certain claims and lawsuits which are generally
incidental to its business. The Company is vigorously contesting all such
matters and believes that their ultimate resolution will not have a material
adverse effect on the Company's financial position, results of operations or
cash flows.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
There were no matters submitted to a vote of security holders during the
fourth quarter of fiscal 1997.
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PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED
STOCKHOLDER MATTERS
The Company's common stock is quoted on the NASDAQ National Market System
under the symbol "SEVL". At February 25, 1998, the number of record holders of
the Company's common stock exceeded 800. The following table sets forth the
range of high and low bid quotations for the Company's common stock as reported
by the NASDAQ National Market System during the periods as indicated.
QUARTER ENDED HIGH LOW
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March 31, 1996 $15.00 $9.25
June 30, 1996 14.25 8.25
September 30, 1996 13.00 5.88
December 31, 1996 6.50 3.38
March 31, 1997 5.00 2.88
June 30, 1997 4.00 1.50
September 30, 1997 3.94 1.63
December 31, 1997 3.44 1.38
The Company has not paid cash dividends on its common stock and presently
intends to continue a policy of retaining any earnings for reinvestment in its
business.
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ITEM 6. SELECTED FINANCIAL DATA
The following table sets forth selected financial data for the Company as
of the dates and for the periods indicated. The data should be read in
conjunction with "Management's Discussion and Analysis of Financial Condition
and Results of Operations" and the financial statements and related notes
thereto included elsewhere in this Report.
<TABLE>
<CAPTION>
7TH LEVEL SOLE COMPANY
PROPRIETORSHIP ---------------------------------------------------------------------------
PERIOD FROM PERIOD FROM
JAN. 1, 1993 APR. 28, 1993 YEAR YEAR YEAR
(INCEPTION) (INCEPTION) ENDED ENDED ENDED
THROUGH THROUGH YEAR ENDED DEC. 31, DEC. 31, DEC. 31,
DEC. 31, 1993 DEC. 31, 1993 DECEMBER 31, 1994 1995 1996 1997
----------------- ----------------- --------------------- --------- --------- ---------
ACTUAL ACTUAL ACTUAL COMBINED(1) ACTUAL ACTUAL ACTUAL
----------------- ----------------- -------- ----------- --------- --------- ---------
STATEMENT OF OPERATIONS DATA: (in thousands, except per share amounts)
<S> <C> <C> <C> <C> <C> <C> <C>
Net revenues (2)................ $ - $ - $ 4,103 $ 4,708 $ 12,161 $ 20,549 $ 10,499
Income (loss) from
operations.................... (2,149) 20 (6,260) (6,064) (15,581) (25,508) (23,790)
Net income (loss)............... (2,151) 15 (6,453) (6,301) (14,603) (24,253) (22,458)
Basic and diluted loss per
common share................. - - (0.85) - (1.33) (1.80) (1.64)
Basic and diluted weighted
average shares outstanding... - - 7,888 - 10,961 13,442 13,697
</TABLE>
<TABLE>
<CAPTION>
7TH LEVEL SOLE COMPANY
PROPRIETORSHIP --------------------------------------------------------------------------
DEC. 31, 1993 DEC. 31, 1993 DEC. 31, 1994 DEC. 31, 1995 DEC. 31, 1996 DEC. 31, 1997
-------------- ------------- ------------- ------------- ------------- -------------
(in thousands)
<S> <C> <C> <C> <C> <C> <C>
BALANCE SHEET DATA:
Total assets...................... $2,374 $30 $26,403 $54,562 $38,933 $9,855
Long-term debt (including
current portion)............... 1,463 - 5,738 859 6,790 946
Stockholders' equity.............. 660 25 19,184 48,265 24,652 2,459
</TABLE>
_________________
(1) Gives effect to the results from 7th Level, Inc. and the 7th Level Sole
Proprietorship on a combined basis.
(2) Net of allowance for product returns, stock balancing rights and
allowances.
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ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
The following information should be read in conjunction with the
consolidated financial statements and the notes thereto. 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
In August 1997, the Company announced a new strategy to leverage its
existing core technology and to transition from being a self-funded content
developer and publisher to position itself as a supplier of custom solutions and
services, tools and technology. The Company has moved aggressively to implement
the new strategy and is pursuing opportunities to benefit from the utilization
of its technology and integrated studio capacity in conjunction with other
content owners, developers and marketers, and is seeking to leverage its assets
and technology through key strategic relationships. The Company closed
satellite offices in Munich, San Francisco and Tokyo in the third quarter of
1997, dismantling its international distribution and localization business and
sold the majority of its assets related to the game publishing business in the
U.S. The Company sold one interactive software title in the final stages of
development, Dominion, in September 1997 under an agreement which also included
a license of its TopGun development technology to the purchaser. In November
1997, the Company entered a master distribution agreement with Take-Two
Interactive Software, Inc. ("Take-Two") to distribute its catalog of Monty
Python titles, including Meaning of Life which was completed in early November.
In addition, in December 1997, the Company announced the sale of its PyroTechnix
Inc. ("PyroTechnix") subsidiary, which included the sale of its other major
title in production, Return to Krondor, and a license to its TopGun technology.
The Company continues to use cash and operate at a significant loss, (See
"Liquidity and Capital Resources") however, the Company has significantly
reduced expenses. Staffing decreased from 253 employees at the end of 1996 to
approximately 30 in February 1998. The Company believes actions taken in the
second half of 1997 and early 1998 will reduce expenses by over $20 million on
an annual basis, to less than one third the rate experienced in the first half
of 1997/(2)/ Management continues to review, evaluate and revise the Company's
operations and priorities.
In November 1997 the Company signed a letter agreement to merge with Pulse.
Under terms of the agreement, the Company must raise $15 million in private debt
or equity financing as a requirement of the Merger. In February 1998 the Merger
Agreement was signed by the Company and Pulse. There can be no assurance
that the Merger will be successfully concluded./(2)/ See Business - Agreement
to Merge.
RESULTS OF OPERATIONS
Comparison of Years Ended December 31, 1997 and December 31, 1996
The Company's strategy change in 1997 impacted all of its operations. Net
revenues decreased 49% to $10,499,021 for the year ended December 31, 1997
compared to $20,548,725 for the year ended December 31, 1996. In 1997, product
sales constituted approximately 40% of net revenue and the remaining 60% was
from other sources, including the sale of a title in the final stages of
development, Dominion, for $1,800,000, non-refundable advance royalties of
$1,480,000 for Python titles, and approximately $1,200,000 from Microsoft for
development and initial royalties on the Barney Actimates titles. In contrast,
approximately 50% of 1996 net revenues came from product sales and the remaining
50% was from licensing, OEM (Original Equipment Manufacturer) and development
contracts. Sales to customers outside of the United States in 1997 were similar
to 1996 and approximated 23% of net revenue.
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Cost of revenues for the year ended December 31, 1997 was $4,541,960 or 43%
of net revenue, including product development, manufacturing, and royalty and
licensing costs of $1,641,749, $1,181,787 and $1,718,424, respectively. For the
year ended December 31, 1996, cost of revenues was $8,298,647 or 40% of net
revenues. Although the total cost of revenues as a percentage of net revenues
was comparable between years, the 1997 revenues from the sale of Dominion and
advance royalties for Python referred to above had a very low cost associated
therewith which was offset by a much higher relative cost of revenues associated
with the development contracts. The Company expects fluctuations in gross
margin in the future as changes occur in the composition of the revenues and the
associated cost of revenues./(2)/
Research and product development expenses were $17,436,042 and $21,402,287
for the years ended December 31, 1997 and 1996, respectively. Research and
product development costs decreased in 1997 as the Company reduced headcount and
related expenditures. Approximately $700,000 related to the closing of the
international localization studios is included in the 1997 amount. Research and
production development expenses decreased 22% in 1997, excluding the one-time
closing expenses, compared to 1996. Research and product development expenses
for 1997 included $6,356,696 of production expenses, $5,873,907 for software
research and development and $5,205,440 for expenses of the companies acquired
in 1995 and 1996 (as described in note 4) to provide expertise in the
development of 3D technology and graphics design and to provide the capabilities
needed to expand into the Asia Pacific market. In addition to the closure of
international localization studios, the Company has significantly reduced head
count in production and engineering in connection with the change in the
strategic direction of the Company. Because a large portion of the 1997
staffing cuts were implemented late in the year, the impact of these changes is
expected to primarily benefit future periods./(2)/
Sales and marketing expenses were $6,118,011 and $11,409,102 for the years
ended December 31, 1997 and 1996, respectively. Included in the 1997 amount is
approximately $965,000 related to the closing of the Company's international
sales offices. Sales and marketing expenses for 1997 included $2,425,056 of
expenses for advertising, marketing and public relations and $3,692,955 of
expenses related to internal staffing. For 1996, expenses of $6,327,266 for
advertising, marketing and public relations and $5,081,836 related to internal
staffing were incurred. Excluding costs for closing the Company's international
sales offices, sales and marketing expenses decreased approximately $6,250,000
or 55% in 1997 compared to 1996. As a percentage of net revenues, sales and
marketing expenses related to internal staffing increased to 35% in 1997 from
25% in 1996. However, the advertising, marketing and public relations expenses
decreased to 23% from 31% as a percentage of net revenues in 1997 compared to
1996. The Company has effected various cost savings measures including staff
reductions related to sales and marketing and significantly lower advertising
expenditures following departure from the games business.
General and administrative expenses for the year ended December 31, 1997
were $5,683,859 compared with $4,827,618 for the year ended December 31, 1996.
Approximately $400,000 of the increase of $856,241 is associated with expenses
related to employee resignations in the first quarter of 1997. Additionally,
the Company incurred higher legal and professional fees in 1997 which also
contributed to the increase in general and administrative fees compared to 1996.
Amortization of intangible assets was $509,444 for the year ended December
31, 1997 compared to $119,428 for the year ended December 31, 1996, and
primarily represents amortization of intangible assets acquired in the Lanpro
Acquisition (see note 4.) These assets were acquired on December 29, 1995 and
were being amortized over periods up to seven years; however, the assets were
written off when the Company closed its offices in San Francisco and Tokyo.
Interest income was $340,434 for the year ended December 31, 1997 compared
with $1,332,578 in the year ended December 31, 1996. This change was due to
lower average cash balances which were available for investment during 1997.
Interest expense was $121,321 and $76,511 for the years ended December 31, 1997
and 1996, respectively. Approximately $188,000 of interest expense was
capitalized as a cost of financing the acquisition of a tract of land and office
building construction during 1996.
13
<PAGE>
Other income was $1,113,505 for the year ended December 31, 1997 compared
with other expense of $445 for the year ended December 31, 1996. In November
1997, the Company sold its PyroTechnix subsidiary which included the sale of the
Return to Krondor game title and a license to its TopGun technology and
recognized a gain of approximately $1,033,000 which resulted in the significant
increase over the 1996 amount. For the year ended December 31, 1997, the
PyroTechnix subsidiary recognized revenues of approximately $320,000, cost of
revenues of approximately $317,000 and operating expenses of approximately
$1,527,000.
Comparison of Years Ended December 31, 1996 and December 31, 1995
In 1996, 7th Level continued its growth in revenues with the introduction
of new titles combined with development and licensing projects with third
parties and sales of existing titles. Net revenues increased 69% to $20,548,725
for the year ended December 31, 1996 compared to $12,161,205 for the year ended
December 31, 1995. In 1996, approximately 50% of revenues came from product
sales and the remaining 50% was from licensing, OEM and development contracts.
In contrast, product sales in 1995 constituted 74% of revenues and the remaining
26% was from licensing and OEM agreements. The Company's most popular products
include the two Monty Python titles and the Disney GameBreak! titles. During
1995, the Company had only one educational title. The various educational
titles did not contribute significantly to revenue in 1996 as the new titles
rounding out the series were introduced late in the year and competing products
were well established in the market. Sales to customers outside of the United
States in 1996 increased from 18% to approximately 23% of net revenue.
Cost of revenues for the year ended December 31, 1996 was $8,298,647 or 40%
of net revenue, including product development, manufacturing, and royalty and
licensing costs of $2,672,528, $2,503,460 and $3,122,659, respectively. For the
year ended December 31, 1995, cost of revenues was $2,250,673 or 19% of net
revenues. The significant increase in cost of revenues in 1996 as a percentage
of net revenues is due to several factors, including the lower margins
associated with development revenue and higher royalty rates. The Company's
royalty agreements generally provide for stepped increases in royalty rates
based on quantities sold, and accordingly, such rates have reached higher
royalty tiers on certain of the more popular releases such as the Python titles.
Additionally, ACE VENTURA, which is a product of a joint venture between the
Company and Morgan Creek has a low gross margin as the Company pays a high
effective royalty rate to Morgan Creek. During 1995 cost of revenues was lower
because relatively more revenues were generated from non-royalty bearing titles
featuring internally-created characters. The Company expects fluctuations in
gross margin in the future as changes occur in the composition of the revenues
and the associated cost of revenues./(2)/
Research and product development expenses were $21,402,287 and $11,224,981
for the years ended December 31, 1996 and 1995, respectively. Research and
product development costs increased significantly during 1996 as the Company
more than doubled its capacity from 1995, which involved internal expansion as
well as growth from acquisitions. Results from 1995 included a $2,282,497
write off of in-process research and development expenses from the acquisitions
of Distant Thunder and the Lanpro entities. Research and product development
expenses for 1996 included $11,049,053 of production expenses, $6,118,089 for
software research and development and $4,235,145 for expenses of the companies
acquired in 1995 and 1996 (as described in note 4) to provide expertise in the
development of 3D technology and graphics design and to provide the capabilities
needed to expand into the Asia Pacific market. Although the Company
significantly reduced head count in production during the second half of 1996,
such staff reductions followed a heavy production mode in various studio
departments such as animation. The staffing cuts were effected in the latter
months of the year and severance related amounts were included as expenses;
therefore, the impact of these changes is expected to benefit future periods.
The Company is focused on optimization of its production processes and
technology and anticipates these measures will allow more efficient title
development even with reduced staff resources./ (2)/
Sales and marketing expenses were $11,409,102 and $6,697,846 for the years
ended December 31, 1996 and 1995, respectively. Sales and marketing expenses
for 1996 included $6,327,266 of expenses for advertising, marketing and public
relations and $5,081,836 of expenses related to internal staffing. For 1995,
expenses of $3,961,969 for advertising, marketing and public relations and
$2,735,877 related to
14
<PAGE>
internal staffing were incurred. As a percentage of net revenues, sales and
marketing expenses related to internal staffing increased to 25% in 1996 from
22% in 1995. However, the advertising, marketing and public relations expenses
decreased slightly to 31% from 33% as a percentage of net revenues in 1996
compared to 1995. The Company has focused its efforts to review and implement
only marketing activities with the highest returns.
General and administrative expenses for the year ended December 31, 1996
were $4,827,618 compared with $3,024,232 for the year ended December 31, 1995.
The increase of $1,803,386 is associated with the expansion of the Company's
operational and administrative support infrastructure. As a percentage of net
revenues, general and administrative expenses have decreased slightly in 1996 to
23% from 25% in 1995.
Amortization of intangible assets was $119,428 for the year ended December
31, 1996, and primarily represents amortization of intangible assets acquired in
the Lanpro Acquisition (see note 4.) These assets were acquired on December 29,
1995 and are being amortized over periods up to seven years. Amortization of
intangible assets for the year ended December 31, 1995 was $2,261,507 and
primarily related to intangible assets acquired in the MetroCel asset
acquisition in March of 1994 which were fully amortized by December 31, 1995.
Net interest income was $1,255,622 for the year ended December 31, 1996
compared with $977,891 in the year ended December 31, 1995. This change was due
to higher average cash balances which were generated by a public stock offering
in late 1995. Also, approximately $188,000 of interest expense was capitalized
as a cost of financing the acquisition of a tract of land and office building
construction during 1996.
LIQUIDITY AND CAPITAL RESOURCES
The Company has incurred significant losses since inception, including
operating losses of approximately $23.8 million, $25.5 million and $15.6 million
for the years ended December 31, 1997, 1996 and 1995, respectively. As a result,
as of December 31, 1997, the Company does not have sufficient resources to meet
its anticipated operating requirements during 1998 without obtaining additional
financing.
As noted in previous quarterly reports, in March 1997 there was a
substantial change in the Company's management. Since that time, management has
been re-examining the Company's business and assets, and is aggressively moving
to establish a strategy to benefit the Company and its stockholders. The
Company retained a financial advisor to provide consulting services and assist
the Company in evaluating its business opportunities, resources and
requirements. In the fourth quarter of 1997, the Company's cash and short term
investments balance decreased $1,223,845 from $3,688,924 at September 30, 1997
to $2,465,079 at December 31, 1997 after the benefit of approximately $2,300,000
proceeds from the sale of the PyroTechnix subsidiary and advance royalties on
the Python titles as described above. The Company believes that actions taken
throughout the second half of 1997 to reduce operating expenses and cash usage,
including the sale of PyroTechnix, have reduced operating expenses by over $20
million on an annual basis to less than $1 million per month as of December 31,
1997./(2)/
The Company's immediate priority is to identify funding for the Company's
new business strategy. In connection therewith, the Company is seeking to obtain
approximately $15 million of financing through the private placement of equity
or debt securities. The Company believes that current assets alone will be
insufficient to satisfy the Company's capital requirements in the short
term./(2)/ Accordingly, the Company is seeking to secure financing which is the
subject of ongoing discussions. There can be no assurance that the private
placement financing or other financing will be consummated on terms acceptable
to the Company, or at all./(2)/
15
<PAGE>
During 1997 cash and short term investments decreased $12,818,763 to
$2,465,079 at December 31, 1997. The decrease is the result of the net loss of
$22,457,677 sustained during 1997 offset by proceeds from sales of assets and
the positive impact from the management of cash receipts and payments as well as
the non-cash depreciation and amortization expenses. During 1997, the Company
sold its office building, which was under construction, for approximately $5.6
million and used the proceeds to pay down the outstanding balance of a similar
amount under a bank line of credit.
The Company has taken steps to significantly reduce its cash usage and
operating expenses. However, the Company continues to use cash and operate at a
loss. As articulated above, the Company's main focus in addressing its liquidity
needs is the pursuit of financing. Although the Company believes that it will be
able to obtain such financing, there can be no assurance to that effect, and the
precise amount or composition of financing is uncertain and the terms thereof
may be onerous./(2)/
RECENTLY ISSUED ACCOUNTING PRINCIPLES
In June 1997, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards "SFAS") No. 130, "Reporting Comprehensive Income"
("SFAS 130"). SFAS 130 is effective for fiscal years beginning after December
15, 1997. This statement establishes standards for reporting and display of
comprehensive income and its components. The effective adoption of SFAS 130 is
not expected to have a material impact on the Company's financial statements and
related disclosures.
In June 1997, the Financial Accounting Standards Board issued SFAS No. 131,
"Disclosure about Segments of an Enterprise and Related Information" ("SFAS
131"). SFAS 131 is effective for fiscal years beginning after December 31,
1997. This statement establishes standards for the way that public companies
report information about segments in annual and interim financial statements.
The effective adoption of SFAS 131 is not expected to have a material impact on
the Company's financial statements and related disclosures.
The Accounting Standards Executive Committee of the American Institute of
Certified Public Accountants has issued Statement of Position 97-2, "Software
Revenue Recognition," ("SOP 97-2"), which will become effective for transactions
entered into in fiscal years beginning after December 15, 1997. The effect of
SOP 97-2, if implemented currently, would not result in significant changes to
the Company's historical financial statements.
Year 2000 Impact
During the fiscal year ended December 31, 1997, the Company began a process
to identify and address issues surrounding the Year 2000 and its impact on the
Company's computer operations. The issue surrounding the Year 2000 is whether
the Company's computer systems will properly recognize data sensitive
information when the year changes to 2000, or "00." Systems that do not
properly recognize such information could generate erroneous data or cause a
system to fail. As the Company has not completed their initial assessment of
the impact the Year 2000 may have on their computer operations, management can
not estimate the costs associated with ensuring the Company's systems are Year
2000 compliant. However, there can be no assurance that the Company's systems
nor the computer systems of other companies with whom the Company conducts
business will be Year 2000 compliant prior to December 31, 1999. If such
modifications and conversions are not completed timely, the Year 2000 problem
may have a material impact on the operations of the Company.
- -----------------------------------------------
/(2)/ This statement is a forward looking statement that involves risks and
uncertainties. Accordingly, no assurance can be given that the actual
events and results will not be materially
16
<PAGE>
different than the anticipated results described in the forward looking
statement. 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 this report.
17
<PAGE>
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Index to Financial Statements and Financial Statement Schedule
Financial Statements:
19 Independent Auditors' Report
20 Consolidated Balance Sheets as of December 31, 1997 and 1996
21 Consolidated Statements of Operations for the years ended December 31,
1997, 1996 and 1995
22 Consolidated Statements of Stockholders' Equity for the years ended
December 31, 1997, 1996 and 1995
23 Consolidated Statements of Cash Flows for the years ended December 31,
1997, 1996 and 1995
24 Notes to Consolidated Financial Statements
Financial Statement Schedule:
S-1 Schedule II - Valuation and Qualifying Accounts for the years ended
December 31, 1997, 1996 and 1995
All other schedules are omitted because they are not applicable or the
required information is shown in the financial statements or notes thereto.
18
<PAGE>
INDEPENDENT AUDITORS' REPORT
The Board of Directors and Stockholders
7th Level, Inc.:
We have audited the accompanying consolidated balance sheets of 7th Level,
Inc. as of December 31, 1997 and 1996, and the related consolidated statements
of operations, stockholders' equity, and cash flows for each of the years in the
three year period ended December 31, 1997. In connection with our audits of the
consolidated financial statements, we also have audited the financial statement
schedule as listed in the accompanying index. These consolidated financial
statements and financial statement schedule are the responsibility of the
Company's management. Our responsibility is to express an opinion on these
consolidated financial statements and financial statement schedule based on our
audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of 7th Level, Inc. as
of December 31, 1997 and 1996 and the results of their operations and their cash
flows for each of the years in the three year period ended December 31, 1997, in
conformity with generally accepted accounting principles. Also, in our opinion,
the related financial statement schedule, when considered in relation to the
basic financial statements taken as a whole, presents fairly, in all material
respects, the information set forth therein.
The accompanying consolidated financial statements have been prepared assuming
that the Company will continue as a going concern. As discussed in note 3 to
the consolidated financial statements, the Company has suffered recurring losses
since inception and does not currently have sufficient resources to meet its
anticipated operating requirements during 1998, which conditions raise
substantial doubt about the Company's ability to continue as a going concern.
Management's plans in regard to these matters are also described in note 3. The
consolidated financial statements and financial statement schedule do not
include any adjustments that might result from the outcome of these
uncertainties.
KPMG Peat Marwick LLP
Dallas, Texas
January 30, 1998
19
<PAGE>
7TH LEVEL, INC.
CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
December 31, 1997 December 31, 1996
----------------- -----------------
<S> <C> <C>
ASSETS
Cash and cash equivalents $2,465,079 $10,798,372
Short-term investments - 4,485,470
Accounts receivable, net of allowances of $1,126,524
and $1,565,291 1,112,026 6,130,903
Inventories 18,477 571,545
Building for sale - 5,117,222
Other current assets 752,847 1,776,446
--------------- ---------------
Total current assets 4,348,429 28,879,958
Fixed assets, net 4,960,560 7,839,278
Intangible assets, net 13,132 1,130,095
Other assets 532,605 1,083,603
--------------- ---------------
Total assets $9,854,726 $38,932,934
=============== ===============
LIABILITIES AND STOCKHOLDERS' EQUITY
Accounts payable $1,111,732 $2,190,290
Accrued expenses 4,549,868 4,594,153
Current portion of notes payable 79,318 5,633,675
Other current liabilities 803,006 710,442
--------------- ---------------
Total current liabilities 6,543,924 13,128,560
Notes payable 377,027 94,626
Notes payable to related parties 108,108 581,098
Other 366,212 476,263
--------------- ---------------
Total liabilities 7,395,271 14,280,547
Commitments and contingencies
Stockholders' equity:
Preferred Stock, par value $0.01 per share,
100,000 shares authorized; none issued
or outstanding - -
Common Stock, par value $0.01 per share,
20,000,000 shares authorized; 13,783,736 and
13,579,522 shares issued and outstanding 137,837 135,795
Additional capital 70,642,628 70,347,110
Accumulated deficit (68,333,578) (45,875,900)
Cumulative translation adjustment 12,568 51,193
Unrealized loss on investments - (5,811)
--------------- ---------------
Total stockholders' equity 2,459,455 24,652,387
--------------- ---------------
Total liabilities and stockholders' equity $9,854,726 $38,932,934
=============== ===============
</TABLE>
See accompanying notes.
20
<PAGE>
7TH LEVEL, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
<TABLE>
<CAPTION>
Year Ended Year Ended Year Ended
December 31, 1997 December 31, 1996 December 31, 1995
----------------- ----------------- -----------------
<S> <C> <C> <C>
Net revenues $ 10,499,021 $ 20,548,725 $ 12,161,205
Cost of revenues 4,541,960 8,298,647 2,250,673
---------------- --------------- -----------------
Gross profit 5,957,061 12,250,078 9,910,532
---------------- --------------- -----------------
Operating expenses:
Research and product development 17,436,042 21,402,287 11,224,981
Purchased in-process research and
development - - 2,282,497
Sales and marketing 6,118,011 11,409,102 6,697,846
General and administrative 5,683,859 4,827,618 3,024,232
Amortization of intangible assets 509,444 119,428 2,261,507
---------------- --------------- -----------------
Total operating expenses 29,747,356 37,758,435 25,491,063
---------------- --------------- -----------------
Operating loss (23,790,295) (25,508,357) (15,580,531)
Interest expense (121,321) (76,511) (295,402)
Interest income 340,434 1,332,578 1,277,975
Other income (expense) 1,113,504 (445) (4,682)
---------------- --------------- -----------------
Net loss $ (22,457,678) $ (24,252,735) $ (14,602,640)
================ =============== =================
Basic and diluted loss per common share $ (1.64) $ (1.80) $ (1.33)
================ =============== =================
Weighted average basic and diluted
shares outstanding 13,696,730 13,442,101 10,961,306
================ =============== =================
</TABLE>
See accompanying notes.
21
<PAGE>
7TH LEVEL, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
<TABLE>
<CAPTION>
Common Stock Cumulative Unrealized Total
----------------------- Additional Accumulated Translation Gain(loss) on Stockholders'
Shares Amount Capital Deficit Adjustment Investments Equity
------------ ---------- ------------- -------------- ----------- ------------- ------------
<S> <C> <C> <C> <C> <C> <C> <C>
Balance at December 31, 1994 10,152,255 $ 101,523 $ 25,519,586 $ (6,437,603) $ - $ - $ 19,183,506
Proceeds from secondary offering 2,500,000 25,000 40,714,639 - - - 40,739,639
Common stock issued under
stock option plan and
stock purchase plan 149,542 1,495 397,649 - - - 399,144
Common stock issued for
acquisitions 276,667 2,767 2,536,188 - - - 2,538,955
Foreign currency translation
adjustment - - - - (14,923) - (14,923)
Unrealized gain on investments - - - - - 21,791 21,791
Net loss - - - (14,602,640) - - (14,602,640)
------------ ---------- ------------- -------------- ----------- ------------ --------------
Balance at December 31, 1995 13,078,464 130,785 69,168,061 (21,040,243) (14,923) 21,791 48,265,471
Common stock issued under
stock option plan and
stock purchase plan 184,719 1,847 764,989 - - - 766,836
Common stock issued for
acquisitions 280,732 2,807 331,318 (582,922) - - (248,797)
Common stock issued for
conversion of debt 22,607 226 79,497 - - - 79,723
Common stock issued on
exercise of warrants 13,000 130 3,245 - - - 3,375
Foreign currency translation
adjustment - - - - 66,116 - 66,116
Unrealized loss on investments - - - - - (27,602) (27,602)
Net loss - - - (24,252,735) - - (24,252,735)
------------ ---------- ------------- -------------- ----------- ------------ --------------
Balance at December 31, 1996 13,579,522 135,795 70,347,110 (45,875,900) 51,193 (5,811) 24,652,387
Common stock issued under
stock option plan and
stock purchase plan 198,580 1,986 326,634 - - - 328,620
Common stock issued on
exercise of warrants 5,634 56 1,404 - - - 1,460
Common stock issued for
consulting services 40,000 400 74,600 - - - 75,000
Cancellation of unearned
common stock issued as - - - - - -
contingent purchase
consideration (40,000) (400) (107,120) - - - (107,520)
Foreign currency translation
adjustment - - - - (38,625) - (38,625)
Unrealized loss on investments - - - - - 5,811 5,811
Net loss - - - (22,457,678) - - (22,457,678)
------------ ---------- ------------- -------------- ----------- ------------ --------------
Balance at December 31, 1997 13,783,736 $ 137,837 $ 70,642,628 $ (68,333,578) $ 12,568 $ - $ 2,459,455
============ ========== ============= ============== =========== ============ ==============
</TABLE>
See accompanying notes.
22
<PAGE>
7TH LEVEL, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
Year Ended Year Ended Year Ended
December 31, 1997 December 31, 1996 December 31, 1995
----------------- ----------------- -----------------
<S> <C> <C> <C>
Cash flows from operating activities:
Net loss $ (22,457,678) $ (24,252,735) $ (14,602,640)
Adjustments to reconcile net loss to net cash
used in operating activities:
Depreciation and amortization 4,180,144 2,564,609 2,982,360
Purchased in-process research and development - - 2,282,497
Gain on sale of assets (1,115,800) - -
Gain on early retirement of debt (10,142) - -
Other 75,000 - -
Changes in assets and liabilities, net of acquisitions:
Accounts receivable 5,149,670 650,585 (4,709,370)
Inventories 551,846 (181,297) (317,809)
Other current assets 865,059 (592,837) (903,213)
Other assets 533,438 (366,529) (130,012)
Accounts payable (1,059,444) 883,866 885,240
Other current liabilities (65,720) 1,554,554 1,790,124
---------------- --------------- ---------------
Net cash used in operating activities (13,353,627) (19,739,784) (12,722,823)
---------------- --------------- ---------------
Cash flows from investing activities:
Proceeds from sale of assets 6,593,010 - -
Purchase of short-term investments - (7,965,007) (9,657,445)
Proceeds from sales of short-term investments 4,491,367 13,158,205 1,057,155
Equity investment - (400,000) -
Acquisitions, net of cash acquired (paid) - (771,966) 248,856
Capital expenditures (436,409) (9,643,055) (4,722,581)
Purchase of intangible assets - - (531,965)
---------------- --------------- ---------------
Net cash provided by (used in) investing activities 10,647,968 (5,621,823) (13,605,980)
---------------- --------------- ---------------
Cash flows from financing activities:
Net proceeds from public offerings - - 40,739,639
Proceeds from bank line of credit - 6,000,000 -
Repayment of bank line of credit (5,625,000) (375,000) -
Repayment of notes payable to related parties (125,000) - (4,146,500)
Repayment of notes payable to third parties - - (848,500)
Principal payments under capital lease obligations (232,746) (163,365) (71,311)
Issuance of common stock under stock option and
stock purchase plan 330,080 766,836 399,144
Other - 3,375 198,000
---------------- --------------- ---------------
Net cash (used in) provided by financing activities (5,652,666) 6,231,846 36,270,472
---------------- --------------- ---------------
Effect of exchange rate changes on cash 25,032 (12,084) (3,064)
---------------- --------------- ---------------
Net increase (decrease) in cash and cash
equivalents (8,333,293) (19,141,845) 9,938,605
Cash and cash equivalents, beginning of period 10,798,372 29,940,217 20,001,612
---------------- --------------- ---------------
Cash and cash equivalents, end of period $ 2,465,079 $ 10,798,372 $ 29,940,217
================ =============== ===============
Supplemental disclosure of cash flow information--cash
paid for interest $ 204,915 $ 352,562 $ 248,700
================ =============== ===============
</TABLE>
See accompanying notes.
23
<PAGE>
7TH LEVEL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. Incorporation and Nature of Business
7th Level, Inc. (the "Company") was incorporated under the laws of the
State of Delaware on April 28, 1993. The Company has been engaged in the
business of developing entertainment and educational software. In August 1997,
the Company announced a strategy to transform the Company from a self-funded
content developer and publisher to a supplier of custom and packaged new media
and electronic commerce solutions for a broad array of applications and
platforms, including on-line, CD-ROM and video. In November 1997, the Company
announced the execution of a letter agreement with respect to a proposed merger
between the Company and Pulse Entertainment, Inc. (the "Merger"). (See note
12).
2. Summary of Significant Accounting Policies
Principles of Consolidation
The accompanying consolidated financial statements include the accounts of
the Company and its wholly owned subsidiaries. All significant intercompany
transactions and accounts have been eliminated. At December 31, 1997, the
Company's wholly owned subsidiaries included Distant Thunder Entertainment, Inc.
("Distant Thunder"), 7th Level Ltd., 7th Level Deutschland GmbH, and 7th
Level Asia Pacific, Inc.
Use of Estimates
The preparation of consolidated financial statements in conformity with
generally accepted accounting principles requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
Revenue Recognition
The Company generates revenue primarily from interactive software product
sales, licensing agreements and product development agreements. Software
product sales are recognized as revenue upon shipment of the products to
customers, provided that there are no significant vendor obligations and
collection of the related receivable is probable. The Company accounts for
insignificant vendor obligations and post-contract support at the time of
product delivery by accruing such estimated costs or recognizing them ratably as
the obligations are fulfilled. Provision for estimated returns including
distributors' stock balancing rights and allowances is recorded at the time of
sale.
Revenues from development contracts are recognized as the services are
performed under the terms of the respective contracts. The Company had deferred
revenues of approximately $385,000 and $200,000 included in other current
liabilities associated with development and licensing contracts at December 31,
1997 and 1996, respectively.
Revenues from products licensed to original equipment manufacturers
("OEMs") consisting of one-time license fees and contracts for minimum advances
against future unit licenses are recognized when the criteria for revenue
recognition under Statement of Position 91-1, "Software Revenue Recognition,"
are satisfied. These criteria include, but are not limited to, delivery of the
software master, the Company's lack of other significant obligations to the
customer and a determination that collectibility of the amount due is probable.
Additional royalty use or unit copy royalty fees are recognized when they are
earned pursuant to the license agreements and upon notification of shipment from
the OEMs.
24
<PAGE>
7TH LEVEL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Research and Product Development Expenditures
Financial accounting standards provide for the capitalization of certain
software development costs once technological feasibility has been established.
In addition, the Company evaluates the recoverability of any capitalized costs
as provided by generally accepted accounting principles. No such costs have
been capitalized to date as the impact on the consolidated financial statements
for all periods presented would be immaterial.
Fair Value of Financial Instruments
The carrying values of cash, cash equivalents, accounts receivable and
accounts payable approximate fair value due to their short maturities. See note
7 for fair value of 7% Convertible Notes Payable.
Advertising Costs
Advertising costs, included in sales and marketing expenses, are charged to
expense when the advertising takes place. Advertising costs were $1,542,175,
$4,816,231 and $2,745,349 for the years ended December 31, 1997, 1996 and 1995,
respectively.
Cash and Cash Equivalents
The Company considers all highly liquid securities with original maturities
of three months or less to be cash equivalents. Cash and cash equivalents
consist of money market funds, commercial paper, U.S. Treasury securities and
other debt securities. The Company had cash equivalents of approximately
$2,300,000 and $9,104,000 at December 31, 1997 and 1996, respectively.
Short-term Investments
In accordance with Statement of Financial Accounting Standards No. 115,
"Accounting for Certain Investments in Debt and Equity Securities," the
appropriate classification of securities is determined at the time of purchase
and reevaluated as of each balance sheet date. The Company has no short-term
investments at December 31, 1997 although certain debt securities were held as
available-for-sale during the year ended December 31, 1997 with unrealized gains
reported as a net amount in a separate component of stockholders' equity until
realized.
Other Current Assets
Other current assets includes prepaid insurance, prepaid royalties, value
added tax refund receivables, interest receivable, advances to employees, and
other miscellaneous prepaid expenses.
Inventories
Inventories, which are comprised of software product components and
finished goods, are carried at the lower of cost, determined on a first-in,
first-out basis, or market.
25
<PAGE>
7TH LEVEL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Fixed Assets
Fixed assets are recorded at cost and are depreciated over three to five
years depending upon the estimated useful life of the asset. Leasehold
improvements and assets under capital leases are amortized over the shorter of
the estimated useful life of the asset or the term of the lease.
Intangible Assets
At December 31, 1996 intangible assets consisted of various patents,
copyrights, and trademarks, technological know-how, assembled workforce and
goodwill acquired in acquisitions. Accumulated amortization of intangible
assets was $4,006,261 and $4,101,147 at December 31, 1997 and 1996,
respectively. The Company assesses the recoverability of intangible assets by
determining whether the amortization of the intangible assets over their
remaining lives can be recovered through projected undiscounted future cash
flows. During 1997, in connection with the sale of a 3D game and the closure of
its Asia Pacific localization and sales offices, the Company wrote off the
remaining intangible assets and the related accumulated amortization acquired in
certain prior business combinations (see note 4.)
Other Assets
At December 31, 1997 other assets consisted of restricted cash placed in
escrow for the Merger, restricted cash which collateralized a letter of credit
and other miscellaneous balances.
Foreign Currency Translation
For the Company's subsidiaries outside the United States, the functional
currency is the local currency of the country in which the subsidiary is
domiciled. Accordingly, assets and liabilities of the subsidiaries outside of
the United States are translated into US dollars at year end exchange rates.
Income and expense items are translated at average rates of exchange prevailing
during the year. The adjustments resulting from translating the financial
statements of these subsidiaries are reflected as cumulative translation
adjustments and included in stockholders' equity. Foreign currency transaction
gains and losses are recognized when they occur. Such amounts are not material
in any of the periods presented.
Royalties
Royalties are accrued based on net revenues, pursuant to contractual
agreements with talent for various products published by the Company. Royalty
expense is included in the cost of revenues.
Loss per Share
In February 1997, the Financial Accounting Standards Board issued Statement
of Financial Accounting Standards No. 128, "Earnings Per Share" ("SFAS No.
128"). SFAS No. 128 revised the previous calculation methods and presentations
of earnings per share and requires that all prior-period earnings (loss) per
share data be restated. The Company adopted SFAS No. 128 in the fourth quarter
of 1997 as required by this Statement. In accordance with SFAS No. 128, the
Company has presented basic loss per share, computed on the basis of the
weighted average number of common shares outstanding during the year, and
diluted loss per share, computed on the basis of the weighted average number of
common shares and all dilutive potential common shares outstanding during the
year. All prior period loss per share amounts have been restated in accordance
with this Statement.
26
<PAGE>
7TH LEVEL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Income Taxes
The Company accounts for income taxes in accordance with Statement of
Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("SFAS No.
109"). SFAS No. 109 requires recognition of deferred tax assets and liabilities
for the future tax consequences of temporary differences between the financial
statement carrying amounts and the tax bases of assets and liabilities.
The Company had operating losses for financial statement and income tax
purposes in 1997, 1996 and 1995. Deferred tax assets relating to the operating
loss have been fully offset by a valuation allowance. Accordingly, no income
tax benefit has been recorded. As of December 31, 1997, the Company has net
operating loss carryforwards of approximately $60,300,000 which expire between
2015 and 2018.
Reclassifications
Certain prior year balances have been reclassified to conform to the
current year presentation.
New Accounting Standard
The Accounting Standards Executive Committee of the American Institute of
Certified Public Accountants has issued Statement of Position 97-2, "Software
Revenue Recognition," ("SOP 97-2"), which will become effective for transactions
entered into in fiscal years beginning after December 15, 1997. The effect of
SOP 97-2, if implemented currently, would not result in significant changes to
the Company's historical financial statements.
3. Liquidity
The Company has incurred significant losses since inception, including
operating losses of approximately $23.8 million, $25.5 million and $15.6 million
for the years ended December 31, 1997, 1996 and 1995, respectively. As a
result, as of December 31, 1997, the Company does not have sufficient resources
to meet its anticipated operating requirements during 1998 without obtaining
additional financing. While these uncertainties raise substantial doubt about
the Company's ability to continue as a going concern, the accompanying
consolidated financial statements have been prepared assuming the Company will
continue as a going concern and do not include any adjustments that might result
from the outcome of these uncertainties.
In August 1997 the Company announced a new strategy, by leveraging its
existing core technology, to transition from being a self-funded content
developer and publisher to position itself as a supplier of custom solutions and
services, tools and technologies. As part of that shift in strategy, the
Company divested itself of its games development groups and new titles under
development. The Company sold its Dominion title in the final stages of
development for $1.8 million, which also included a license of its TopGun
development technology to the purchaser. Additionally, the Company entered into
a master distribution agreement with a third party to distribute Meaning of
Life, its third Monty Python title, which was completed in November 1997. The
Company recognized approximately $1.5 million in non-refundable advance
royalties under this distribution agreement. Further, the Company sold its
PyroTechnix subsidiary, which included the sale of the Return to Krondor game
title and a license to its TopGun technology (see note 4).
The Company also closed its international localization and sales offices,
including those in San Francisco, Tokyo and Munich during 1997. Research and
product development and sales and marketing
27
<PAGE>
7TH LEVEL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
expenses include approximately $700,000 and $965,000, respectively, related to
the closing of the international localization and sales offices.
In November 1997 the Company signed a letter agreement to merge with Pulse
Entertainment, Inc. ("Pulse") (see notes 12 and 14). Under terms of the
agreement, the Company must raise at least $15 million in private debt or equity
financing as a contingency of the merger. In addition, the Company is currently
pursuing bridge financing to meet its operating requirements and obligations
prior to the consummation of the Merger. Management believes that it will be
able to secure sufficient bridge financing and the required $15 million private
financing in order to consummate the Merger during 1998. There can be no
assurance that the Merger will be successfully concluded.
4. Business Combinations
PyroTechnix Acquisition
On March 1, 1996, the Company acquired all of the outstanding capital stock
of PyroTechnix, Inc. ("PyroTechnix") for 300,000 shares of the Company's common
stock including 280,732 shares exchanged at the time of the acquisition and
19,268 shares issuable upon exercise of outstanding warrants. The acquisition
was accounted for as a pooling of interests. The related acquisition costs were
charged to expense during the quarter ended March 31, 1996. PyroTechnix is a
software development company which specializes in realtime 3D rendering
technology. The operating results for PyroTechnix were not material to the
combined results of the two companies for all periods prior to the acquisition
and therefore results for those periods have not been restated. The operating
results of PyroTechnix have been included in the consolidated financial
statements from the date of the acquisition.
The Company sold its PyroTechnix subsidiary in November 1997 and recognized
a gain of approximately $1,033,000 which is included as non-operating income in
the accompanying statement of operations for the year ended December 31, 1997.
Included in the consolidated statements of operations are losses from operations
of PyroTechnix of approximately $1,524,000 and $307,000, respectively, for the
years ended December 31, 1997 and 1996.
Lanpro Acquisition
On December 29, 1995, the Company acquired all of the outstanding capital
stock of two affiliated companies, Lanpro Corporation and Lanpro Localization
Center, Inc. (collectively, the "Lanpro entities") in exchange for short-term
payables and 90,000 shares of common stock valued at $15 per share. The short-
term payables amounted to $778,289 and are included in other current liabilities
at December 31, 1995. The Lanpro entities are in the business of software
localization and technology transfers focusing on the Asia Pacific market. The
acquisition was accounted for as a purchase. The purchase price was allocated
based on estimated fair values at the date of the acquisition and included
intangible assets of approximately $450,000. The intangible assets relate to
technological know-how, assembled work force and goodwill. A portion of the
purchase price was allocated to in-process research and development, the
technological feasibility of which had not yet been established at the time of
the acquisition and such costs had no separate future economic value; therefore,
this amount was written off at the date of the acquisition and is included as a
one-time charge in the Company's 1995 results of operations. In connection with
the acquisition, assets were acquired and liabilities were assumed as follows:
Fair value of assets acquired $ 1,377,414
Purchased in-process research
and development 782,497
Issuance of common stock (1,260,000)
Issuance of short term payable (778,289)
-----------
Liabilities assumed $ 121,622
===========
28
<PAGE>
7TH LEVEL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The Company closed its offices in San Francisco and Tokyo in the third
quarter of 1997. Amortization for the 1997 period includes a write off of
approximately $450,000 for the intangible assets associated with the Lanpro
entities.
Distant Thunder Acquisition
On February 23, 1995, the Company acquired all of the outstanding stock of
Distant Thunder in exchange for $100,000 in cash and 186,667 shares of the
Company's common stock, valued at the closing price on the date of the
acquisition of $7 per share. Distant Thunder is a game developer specializing
in 3D games. The acquisition was accounted for as a purchase and resulted in a
one-time charge to the Company's operations of $1,500,000, as the purchase price
associated with in-process research and development of Distant Thunder was
written off at the date of the acquisition. The results of operations of
Distant Thunder have been included in the consolidated financial statements from
the date of acquisition. In connection with the acquisition, assets were
acquired and liabilities were assumed as follows:
Purchased in-process research and
development $ 1,500,000
Fair value of assets acquired 108,424
Issuance of common stock (1,306,669)
Cash paid (100,000)
-----------
Liabilities assumed $ 201,755
===========
On March 17, 1995 the Company paid Merit Studios, Inc. $500,000 for the
distribution rights to two CD-ROM titles being developed by Distant Thunder.
The product rights were being amortized as intangible assets over the life of
the 3D titles and the remaining asset balance of approximately $160,000 was
fully expensed as a cost of revenue, when the 3D game, Dominion, was sold as an
unfinished title in September 1997.
5. Fixed Assets
Fixed assets, at cost, as of December 31, 1997 and 1996 consisted of the
following:
<TABLE>
<CAPTION>
1997 1996
---- ----
<S> <C> <C>
Equipment $ 6,960,778 $ 7,854,063
Leasehold improvements 2,903,346 2,952,676
Furniture and fixtures 410,360 499,821
----------- -----------
10,274,484 11,306,560
Less accumulated depreciation and
amortization 5,313,924 3,467,282
----------- -----------
$ 4,960,560 $ 7,839,278
=========== ===========
</TABLE>
The Company leases certain office equipment under capital lease agreements.
At December 31, 1997 and 1996, respectively, the carrying value of capital
assets was $388,906 and $492,956, net of accumulated amortization of $208,664
and $186,696.
In April 1997 the Company sold its office building, which was under
construction, for $5.6 million, and as a result, recognized a gain of
approximately $95,000. The Company used the proceeds to pay down the
outstanding balance under the bank line of credit.
6. Accrued Liabilities
29
<PAGE>
7TH LEVEL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Accrued liabilities consist of the following at December 31, 1997 and 1996:
<TABLE>
<CAPTION>
1997 1996
---- ----
<S> <C> <C>
Accrued office closing costs $1,064,702 $ 548,688
Accrued royalties 859,475 1,085,312
Accrued channel marketing 344,441 600,238
Legal and corporate company expense 361,374 298,881
Accrued compensation 565,377 850,701
Accrued interest and taxes 169,353 140,703
Other accrued liabilities 1,185,146 1,069,630
---------- ----------
$4,549,868 $4,594,153
========== ==========
</TABLE>
7. Debt
As of December 31, 1997 and 1996 the Company's debt was as follows:
<TABLE>
<CAPTION>
1997 1996
---- ----
<S> <C> <C>
7% Convertible Note Payable, dated February 11,
1994; annual interest payments; notes are
convertible, in whole but not in part, at the
option of the holder at approximately 283 shares of
common stock for each $1,000 principal amount
outstanding. Remaining principal balance due
February 11, 1999. Related parties balance is
$108,108. $485,135 $ 620,277
Bank line of credit - 5,625,000
Other debt 79,318 64,122
-------- ----------
Total $564,453 $6,309,399
Less current portion 79,318 5,633,675
-------- ----------
Notes payable $485,135 $ 675,724
======== ==========
</TABLE>
In April 1997 the Company repaid the principal balance plus accrued
interest on the line of credit with the net proceeds from the sale of an office
building.
The fair value of the 7% Convertible Note Payable, based on a discounted
cash flow analysis, is approximately $483,663 at December 31, 1997. This
estimate is subjective in nature and involves uncertainties and matters of
significant judgment and therefore cannot be determined with precision. Changes
in assumptions could significantly affect this estimate. Interest expense to
related parties on the above debt was $7,568 and $40,677 for the years ended
December 31, 1997 and 1996 respectively.
30
<PAGE>
7TH LEVEL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
8. Stockholders' Equity
Common Stock
On October 12, 1995 the Company issued 2,500,000 shares of common stock at
$17.50 per share in a secondary public offering. The net proceeds to the
Company, after deducting underwriters' discounts and commissions and expenses of
the offering, were approximately $40.73 million.
Preferred Stock
There are 100,000 shares of preferred stock, par value of $0.01 per share,
authorized and none outstanding as of December 31, 1997. The board of directors
is authorized to provide for the issuance of the shares of preferred stock in
one or more series and to establish the number of shares included in any such
series and to fix the designation, powers, preferences and rights of the shares
of any such series.
Stock Compensation Plans
The Company has granted options to certain employees to purchase common
stock under an incentive stock option plan. The option price represents
estimated fair value at the date of grant. Under the 7th Level, Inc. Amended
and Restated Incentive Stock Option Plan (the "Incentive Stock Option Plan"),
the Company may grant options to its employees for up to 3,200,000 shares of
common stock.
Pursuant to the Option Share Repurchase Agreement, the Company had the
right to purchase up to 948,000 shares of common stock from certain stockholders
at $0.003 per share in the event certain outstanding options (exercisable for an
identical number of shares) are exercised, and the Company intends to satisfy
its obligations to issue shares of common stock upon any exercise of such
associated options by delivering to the exercising optionee(s) shares of
treasury stock acquired from the existing stockholders, thereby resulting in no
change in the number of outstanding shares of common stock due to the exercise
of such options. At December 31, 1997, 504,000 options associated with the
Option Share Repurchase Agreement had been exercised at a weighted average
exercise price of $0.124 per share (and an identical number of shares of common
stock had been purchased by the Company pursuant to the Option Share Repurchase
Agreement).
At December 31, 1997, 436,500 options subject to the Option Share
Repurchase Agreement with an exercise price of $0.003 per share had been
canceled. Notwithstanding the cancellation of certain options, the stockholders
party to the Option Share Repurchase Agreement agreed that 112,500 shares of
common stock underlying such canceled options would remain subject to the
agreement. Accordingly, of the 120,000 shares remaining under the Option Share
Repurchase Agreement, 51,000 shares have corresponding options granted.
Transactions in stock options under the Incentive Stock Option Plan are
summarized as follows:
<TABLE>
<CAPTION>
Option Share
Repurchase Weighted Average Weighted Average
Agreement Exercise Price Stock Options Exercise Price
-------------------------------- ---------------------------------
<S> <C> <C> <C> <C>
Balance at December 31, 1994 437,250 $0.397 697,400 $ 2.45
Granted - - 1,095,000 11.14
Exercised (140,250) 0.105 (120,150) 1.37
Canceled (75,000) 0.003 (187,000) 5.08
-------------------------------- ---------------------------------
Balance at December 31, 1995 222,000 $0.715 1,485,250 $ 8.61
</TABLE>
31
<PAGE>
7TH LEVEL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
<TABLE>
<S> <C> <C> <C> <C>
Granted - - 2,662,750 7.27
Exercised (85,250) 0.450 (102,800) 2.14
Canceled (15,000) 0.003 (1,832,374) 11.08
-------------------------------- ---------------------------------
Balance at December 31, 1996 121,750 $0.990 2,212,826 $ 5.26
Granted - - 267,500 3.12
Exercised (69,250) 0.083 ( 95,625) 1.11
Canceled (1,500) 0.003 (1,343,436) 5.36
-------------------------------- ---------------------------------
Balance at December 31, 1997 51,000 $2.244 1,041,265 $ 4.96
================================ =================================
</TABLE>
The Company has granted to directors options to purchase common stock under
a non-employee directors' stock option plan with vesting over four years. Under
the 7th Level Inc. Amended and Restated 1994 Non-Employee Directors' Stock
Option Plan, the Company may grant options to its non-employee directors for up
to 125,000 shares of common stock. At December 31, 1997, options to purchase
65,000 shares, at a weighted average exercise price of approximately $6.34 per
share, were outstanding, 20,000 of which are exercisable. The option price
represents estimated fair value at the date of grant.
Additionally, during 1997 the Company granted options to purchase 737,500
shares of common stock to two of the non employee directors and certain other
consultants outside the Company stock option plans currently in place. At
December 31, 1997, options to purchase 737,500 shares at a weighted average
exercise price of $3.76 per share were outstanding, of which 541,458 shares were
vested.
The following table summarizes information about stock options outstanding
at December 31, 1997:
<TABLE>
<CAPTION>
Total options outstanding Total options exercisable
--------------------------------------------------- -------------------------------
Weighted average Weighted Weighted
Range of Number remaining average Number average
exercise prices outstanding contractual life exercise price exercisable exercise price
- ----------------------------------------------------------------------------- -------------------------------
<S> <C> <C> <C> <C> <C>
$ .003 - 2.44 354,429 7.78 years $2.19 297,304 $2.31
3.00 - 5.50 1,414,086 8.69 years 4.76 763,110 4.49
6.00 - 16.75 126,250 8.13 years 7.60 66,500 7.97
--------- ---------
1,894,765 1,126,914
========= =========
</TABLE>
Options vest over varying periods ranging from three to four years. During
1996, 1,217,250 outstanding options were repriced at current market value and
such options are included in both the granted and canceled options reported in
the above schedule.
The Company's Employee Stock Purchase Plan allows eligible employees to
authorize the Company to withhold from 1% to 10% of gross earnings to purchase
shares of the Company's common stock. Shares are purchased by participants at
the lower of 85% of fair market value at either the beginning or purchase date
of each 24 month offering period. Purchase dates are every six months. As of
December 31, 1997, 300,000 shares were authorized for purchase pursuant to the
plan and 217,108 shares had been issued.
The Company applies APB Opinion No. 25 and related Interpretations in
accounting for its stock based compensation plans described above. Accordingly,
no compensation cost has been recognized for its stock option and stock purchase
plans. Had compensation costs for the Company's stock-based
32
<PAGE>
7TH LEVEL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
compensation plans been determined consistent with SFAS No. 123, the Company's
net loss and net loss per share would have been increased to the pro forma
amounts indicated below:
<TABLE>
<CAPTION>
1997 1996 1995
------------------- ------------------- -------------------
<S> <C> <C> <C> <C>
Net loss As Reported $(22,457,678) $(24,252,735) $(14,602,640)
Pro forma (25,466,761) (29,004,105) (15,892,221)
Basic and diluted loss per
common share As Reported $ (1.64) $ (1.80) $ (1.33)
Pro forma (1.86) (2.16) (1.45)
</TABLE>
The fair value of each option grant and employee purchase rights are
estimated on the date of grant using the Black-Scholes option-pricing model with
the following weighted-average assumptions: no dividend yield; expected
volatility of 67 to 83 percent; risk free interest rates of 6 to 6 and one-half
percent; and variable expected lives of zero, two and one-half and five years,
depending on the characteristics of the individual grants. The pro forma
amounts are based upon assumptions that the Company's management believes are
reasonable; however, the Company has a relatively short history on which to base
these estimates. The assumptions used in option pricing models significantly
affect the estimated value of stock benefits and, accordingly, the pro forma
amounts do not purport to represent the Company's results of operations for any
future period.
Warrants
In connection with a $2,000,000 bridge loan agreement entered into in 1994
between the Company and certain existing stockholders prior to the initial
public offering, the Company issued warrants to purchase 350,000 shares of
common stock at $7.50 per share. The warrants expire October 11, 1999. All
350,000 warrants were outstanding at December 31, 1997.
In 1995, in connection with the development of a computer software title
based on the Ace Ventura character owned by Morgan Creek Interactive, Inc.
("Morgan Creek"), warrants were granted to Morgan Creek to purchase 75,000
shares of common stock at $20 per share and 100,000 shares of common stock at
$24 per share. These warrants were canceled in 1997 as part of a settlement
agreement with Morgan Creek.
In connection with the acquisition of PyroTechnix, the Company assumed the
liability for outstanding warrants of PyroTechnix. There were warrants for
5,000 shares of PyroTechnix common stock which was converted at a rate of
3.85356 shares of 7th Level common stock for one share of PyroTechnix common
stock. The warrants carried an exercise price of $0.26 per share. As of
December 31, 1997, 19,268 shares of 7th Level common stock had been issued to
cover the exercise of all of these warrants.
9. Leases
The Company leases office facilities in California and Texas and certain
office equipment under operating leases which expire at various dates through
2002. Rental expense for operating leases amounted to $911,385, $904,948 and
$531,551 for 1997, 1996 and 1995, respectively.
33
<PAGE>
7TH LEVEL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Minimum payments under leases expiring subsequent to December 31, 1997 are
as follows:
Capital Operating
Year Leases Leases
---- ------ ------
1998 $204,502 $ 455,013
1999 176,490 365,051
2000 47,412 235,622
2001 3,328 246,068
2002 - 184,551
-------- ----------
Total 431,732 $1,486,305
==========
Less amount representing interest (48,071)
--------
Present value of minimum
lease payments $383,661
========
10. Major Customers and Concentration of Credit Risk
Financial instruments which potentially subject the Company to
concentrations of credit risk consist primarily of short-term investments and
accounts receivable. The Company has investment policies that limit investment
to short term investment grade securities. Accounts receivable are principally
from distributors and retailers of the Company's products as well as the
Company's development and licensing customers. The Company performs ongoing
credit evaluations of its customers' financial condition and maintains reserves
for potential credit losses.
The Company has one significant customer which accounted for 17% of net
revenues during 1997 and four other customers had 16%, 18%, 22% and 26% of the
accounts receivable balance at December 31, 1997. Transactions with one
significant customer accounted for 14% of net revenues for 1996 and 29% of
accounts receivable as of December 31, 1996. Sales to customers located outside
the United States represent approximately 20% and 23% of the Company's total
sales for the years ended December 31, 1997 and 1996, respectively.
11. Employee Benefit Plan
The Company sponsors a 401(k) plan for its employees whereby employees that
qualify for participation under the plan can contribute up to 15% of their
salary, on a before tax basis, subject to a maximum contribution limit as
determined by the Internal Revenue Service. The Company matched participant
contributions 50% up to a maximum of 6% of a participant's salary. For the
years ended December 31, 1997, 1996 and 1995, the Company made contributions to
the plan of approximately $220,000, $280,000 and $91,000, respectively.
12. Pulse Merger
On November 17, 1997, the Company announced it had signed a letter
agreement to merge with Pulse. The Merger is subject to a number of conditions
including, but not limited to, approval by a majority of the stockholders of
both companies, delivery of a fairness opinion and the raising of $15,000,000 in
private securities to support the Company's completion of its tools and provide
working capital to market those tools and to staff up for the solutions
business. The Merger will be accounted for as a reverse acquisition for
accounting and financial reporting purposes with the Company being designated as
the acquiree and Pulse as the acquiror. There can be no assurance that the
Merger will be successfully concluded.
34
<PAGE>
7TH LEVEL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
13. Contingencies
In connection with the international office closures, the Company is party
to certain controversies relating to repatriation of certain of the Company's
assets. Although the Company does not currently possess sufficient information
to ascertain the values which may ultimately be recovered, it is the opinion of
management that adequate provision for losses has been made and the ultimate
resolution of these issues will not have a materially adverse effect on the
financial position of the Company.
The Company is involved in other claims and lawsuits which are generally
incidental to its business. The Company is vigorously contesting all such
matters and believes that their ultimate resolution will not have a material
adverse effect on the Company's financial position, results of operations or
cash flows.
14. Event Subsequent to Date of Independent Auditors' Report (unaudited)
Subsequent to January 30, 1998, representatives of the boards of directors
of the Company and Pulse have met and agreed to consider reevaluating certain
terms of the Merger discussed in notes 3 and 12 and/or whether or not the Merger
should go forward.
35
<PAGE>
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING
AND FINANCIAL DISCLOSURES
None.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The Board of Directors consists of two persons who are employees of the
Company and three persons who are outside directors and there are currently two
vacant positions. The executive officers and directors of the Company, and
their ages as of February 18, 1998, are:
NAME AGE POSITION
- ----------------------------------- --- --------------------------------------
Donald Schupak..................... 54 Chairman of the Board and Director
Robert Alan Ezrin.................. 48 President, Chief Executive Officer and
Director
W. Scott Page...................... 46 Executive Vice President of Production
and Director
Merv Adelson....................... 68 Director
James A. Cannavino................. 53 Director
David W. Craig *................... 53 Chief Financial Officer
* Effective February 28, 1998, Mr. Craig has resigned as CFO of the Company.
Directors of the Company are elected to serve one-year terms and until
their successors have been elected and qualified. Executive officers serve at
the discretion of the Board of Directors.
PRINCIPAL OCCUPATIONS OF DIRECTORS AND EXECUTIVE OFFICERS
Set forth below are descriptions of the principal occupations and business
experience of the Company's executive officers and directors.
Donald Schupak currently serves as Chairman of the Board and Director. He
has been a member of the Board of Directors since January 1997 and has been
Chairman since March 1997. Mr. Schupak is the Chief Executive Officer of
Schupak Group, an organization that provides strategic planning, management
consulting and corporate services to corporations worldwide. Mr. Schupak has
been with Schupak Group since 1990. On March 27, 1997, he became the Chairman
of the Board for Danskin, Inc. He served as Chairman and Chief Executive
Officer at Horn & Hardart Company from 1988 to 1990. Mr. Schupak is also a
member of the Advisory Board of the Maxwell School of Citizenship and Public
Affairs at Syracuse University.
Robert Alan Ezrin currently serves as President, Chief Executive Officer
and Director. Mr. Ezrin is a founder of the Company and has served as President
and Director since November 1995 and has served as Chief Executive Officer since
March 1997. Mr. Ezrin served as Vice President, Co-Chairman of the Board and
Director of the Company since its inception in April 1993 until November 1995.
Mr. Ezrin served as Executive Vice President of
36
<PAGE>
Production from April 1994 to November 1995. From 1984 through 1994, Mr. Ezrin
was a Producer with Lozem Productions, Inc. Mr. Ezrin has more than 25 years of
experience in the international entertainment business, producing music, video
and television projects for numerous internationally known stars such as Pink
Floyd, Rod Stewart, KISS, Peter Gabriel and Roger Daltry. Mr. Ezrin is Chairman
of the Board of Directors of Metropolitan Los Angeles Communities in Schools.
W. Scott Page is a founder of the Company and has been a Vice President and
Director of the Company since its inception in April 1993 and has served as
Executive Vice President of Production since November 1995. Mr. Page served as
Executive Vice President of Creative from March 1994 until November 1995. Prior
to joining the Company, from November 1988 through April 1993, Mr. Page was
President of The Walt Tucker Group, a post-production studio that he founded
which specialized in long and short form music videos and graphics
merchandising. Mr. Page also was a tenor saxophonist and guitarist for the
musical rock groups Pink Floyd, Supertramp and others.
Merv Adelson has served as a Director of the Company since February 1994.
Since 1989, Mr. Adelson has been the owner of East-West Capital Associates,
Inc., a merchant banking and venture capital company, and currently serves as
its Chairman of the Board and Chief Executive Officer. Mr. Adelson co-founded
the predecessor of Lorimar Telepictures in 1969, which was sold to Warner Bros.
in 1989. Mr. Adelson is also a director of Time Warner, Inc.
James A. Cannavino has served as a Director of the Company since January
1997. Since April 1, 1998, Mr. Cannavino is Chairman and Chief Executive Officer
of CyberSafe Corporation, a company that makes corporate network security
products, and Chairman of Softworks, a systems software tools company. Mr.
Cannavino was a private investor from July 1997 to March 1998. Mr. Cannavino
served as the President, Chief Executive Officer and Director of Perot Systems
Corporation ("Perot Systems") from September 1996 to July 1997 and he served as
President, Chief Operating Officer and Director of Perot Systems from September
1995 to September 1996. Mr. Cannavino has more than 30 years of experience in
the computer and information technology industries. Prior to joining Perot
Systems in September 1995, he was a private investor from April 1995 to
September 1995. Previously, Mr. Cannavino was at IBM Corporation, where he was
Senior Vice President of Strategy and Development from 1993 to April 1995, and
prior to this, he served as Senior Vice President and General Manager of the
Personal Systems Group at IBM from 1991 to 1993.
David W. Craig joined the Company as Chief Financial Officer in March 1996.
Prior to joining the Company, Mr. Craig was with Convex Computer Corporation, a
supercomputer firm which he joined in 1984, where he most recently served as
Vice President, Finance and Chief Financial Officer. Prior to joining Convex,
Mr. Craig was employed in a variety of financial management positions at Texas
Instruments.
ITEM 11. EXECUTIVE COMPENSATION
COMPENSATION OF DIRECTORS
The Company's directors who are officers of the Company receive no
compensation for their services as directors. The Company's outside directors
earn $10,000 per annum, plus $2,000 per annum for each committee membership, and
they are reimbursed for their out-of-pocket expenses incurred in attending board
meetings. Additionally, pursuant to the Non-Employee Directors' Stock Option
Plan, upon first being elected to the Board of Directors each outside director
is granted an option to purchase 20,000 shares of common stock. In addition, an
option to purchase 5,000 shares is granted to each outside director on the date
of each annual meeting. The exercise prices are equal to the fair market value
of such underlying shares on the date of grant; however, Merv Adelson, an
outside director first elected prior to adoption of the Non-Employee Directors'
Stock Option Plan, was granted an option to purchase 10,000 shares of common
stock exercisable at a price equal to the fair market value, as determined by
the Board of Directors, of the underlying shares on the date he was actually
elected. The initial options granted under the Non-Employee Directors' Stock
Option Plan vest over a four-year period in 25% increments beginning on the
first anniversary of date of grant. Each annual 5,000 share option grant is
fully vested as of the date of the grant. As of February 18 1998, the Non-
Employee Directors' Plan has 125,000 shares of common stock authorized to be
issued and options to purchase 65,000 of such shares of common stock are
outstanding.
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<PAGE>
In addition to the above mentioned grants Donald Schupak and James A.
Cannavino have each been granted additional options for 75,000 shares of common
stock outside of the Non-Employee Directors' Stock Option Plan (collectively
"the Additional Options"). These grants were issued on January 16, 1997, the
date they were elected to the Board of Directors, and are fully vested as of
that date.
At the appropriate time, as determined by the Company's Board of Directors,
the Company shall register for issuance under the Securities Act of 1933, as
amended (the "Act"), the shares of common stock acquired upon exercise of the
Additional Options, and to keep such registration effective thereafter
throughout the period the Additional Options are exercisable. In the absence of
such effective registration or an available exemption from registration under
the Act, issuance of shares of common stock acquirable upon exercise of the
Additional Options will be delayed until registration of such shares is
effective or an exemption from registration under the Act is available. In the
event exemption from registration under the Act is available upon exercise of
the Additional Options, the holder, if requested by the Company to do so, will
execute and deliver to the Company in writing an agreement containing such
provisions as the Company may require to assure compliance with applicable
securities laws.
Mr. Schupak is taking an active role in the executive management of the
Company and has assumed responsibility for formulation of a strategic plan for
the Company. For this service Mr. Schupak was granted additional options for
560,000 shares of common stock outside of the Non-Employee Directors' Stock
Option Plan. The grant was issued on May 9, 1997, at prices and vesting as
follows:
186,666 shares at $2.44 per share vesting on May 9, 1997;
186,667 shares at $3.38 per share vesting on September 10, 1997; and
186,667 shares at $5.00 per share vesting on March 10, 1998.
In March 1997, the Company and The Schupak Group entered into an agreement
whereby the Company pays $12,000 per month to the Schupak Group for the services
of Donald Schupak and other employees of the Schupak Group. Additionally, Mr.
Schupak is entitled to the reimbursement of reasonable travel and other expenses
incidental to the performance of his duties.
COMPENSATION OF EXECUTIVE OFFICERS
SUMMARY COMPENSATION TABLE. The following table summarizes the
compensation paid during 1997, 1996 and 1995 to the two individuals who served
as the Company's Chief Executive Officer during 1997, each person serving as an
executive officer on December 31, 1997 and two individuals who were among the
highest paid employees for the year ended December 31, 1997 but were not
executive officers on December 31, 1997 (collectively, the "Named Executive
Officers").
<TABLE>
<CAPTION>
LONG-TERM
COMPENSATION:
ANNUAL COMPENSATION SECURITIES
NAME AND PRINCIPAL FISCAL ------------------- UNDERLYING
POSITION YEAR SALARY BONUS OPTIONS (1) OTHER (2)
-------- ---- ------ ----- ----------- ---------
<S> <C> <C> <C> <C> <C>
George D. Grayson (3)............... 1997 $117,312 $ - - $ 3,102
Former Chief Executive 1996 251,083 - 100,000 12,432
Officer and Chairman of the 1995 43,576 100,000 20,000 (4) 1,000
Board
Robert Alan Ezrin................... 1997 275,000 - - 17,331
President and Director 1996 263,083 - 50,000 17,378
1995 250,500 50,000 10,000 (4) 15,405
</TABLE>
38
<PAGE>
<TABLE>
<S> <C> <C> <C> <C> <C>
W. Scott Page....................... 1997 193,750 - - 17,334
Executive Vice President 1996 187,667 - - 17,227
of Production and Director 1995 152,583 - - 15,260
David W. Craig...................... 1997 180,900 - - 5,496
Chief Financial Officer 1996 135,388 - 70,000 3,180
1995 - - - -
David R. Henkel (3)................. 1997 257,642 - - 15,797
Former Chief Operating 1996 251,083 - 25,000 32,796 (5)
Officer and Director 1995 237,500 50,000 10,000 (4) 55,623 (5)
Daniel Kuenster (3)................. 1997 189,592 5,000 - 6,500
Vice President of Animation 1996 182,533 10,000 30,000 52,500 (5)
1995 156,260 20,000 - 37,125 (5)
</TABLE>
____________________
(1) Represents the number of options (each to acquire one share of common
stock) granted pursuant to the 7th Level, Inc. Amended and Restated
Incentive Stock Option Plan (the "Incentive Stock Option Plan").
(2) Includes auto allowance, Company match contributions to the Company's
401(k) Plan and dollar value of life insurance premiums paid by the
Company.
(3) Messrs. George D. Grayson and David R. Henkel resigned March 10, 1997.
Messr. Daniel Kuenster resigned on December 31, 1997.
(4) This table does not reflect options granted in 1995 to purchase 100,000
50,000 and 25,000 shares at exercise prices of $16.75, $16.00 and $16.00
per share that were held by George D. Grayson, Robert Alan Ezrin and David
R. Henkel, respectively, because such options were canceled and new grants
were made in 1996 as shown.
(5) Includes the dollar value difference between the price paid and the fair
market value of common stock upon exercise of options granted under the
Incentive Stock Option Plan.
OPTION GRANTS IN 1997. There were no stock options granted to Named
Executive Officers during 1997.
39
<PAGE>
OPTION EXERCISES AND FISCAL YEAR END VALUES. The following table provides
information about exercised stock options held by the Named Executive Officers.
During 1997, only one of the Named Executive Officers exercised stock options
granted by the Company.
<TABLE>
<CAPTION>
NUMBER OF
SHARES SECURITIES UNDERLYING VALUE OF UNEXERCISED
ACQUIRED UNEXERCISED OPTIONS IN-THE-MONEY OPTIONS
ON VALUE AT DECEMBER 31, 1997 AT DECEMBER 31, 1997(1)
NAME EXERCISE REALIZED EXERCISABLE UNEXERCISABLE EXERCISABLE UNEXERCISABLE
- ----------------------------- -------- -------- ----------- ------------- ------------ --------------
<S> <C> <C> <C> <C> <C> <C>
George D. Grayson (2) - - - - - -
Robert Alan Ezrin - - 17,500 42,500 - (3) - (3)
W. Scott Page - - - - - -
David W. Craig - - 17,500 52,500 - (3) - (3)
David R. Henkel (2) 45,000 $183,075 (4) 11,250 - - (3) -
Daniel Kuenster (2) - - 52,000 - - (3) -
</TABLE>
____________________
(1) Value based on the December 31, 1997 closing price of the Company's common
stock on the NASDAQ National Market System of $1.69 per share.
(2) Messers. George D. Grayson and David R. Henkel resigned March 10, 1997.
Messr. Daniel Kuenster resigned on December 31, 1997.
(3) Underlying options that are not in-the-money are not valued in this table.
(4) Value based on the January 28, 1997 and March 11, 1997 (dates of exercise)
closing prices of the Company's common stock on the NASDAQ National Market
System of $4.00 and $4.63 per share.
EMPLOYMENT CONTRACTS
The Company had employment agreements with George D. Grayson (the "Grayson
Agreement") and David R. Henkel (the "Henkel Agreement").
The Grayson Agreement provided that Mr. Grayson was entitled to cash
compensation of at least $25,000 per annum plus a bonus pursuant to any bonus
plan of the Company. The Grayson Agreement was terminable by the Company upon
Mr. Grayson's death or incapacity or with the vote of five of six disinterested
directors. Upon any termination of Mr. Grayson upon a vote of the Board of
Directors, Mr. Grayson would be entitled to receive accrued salary, bonus and
other benefits and the Company would repurchase from Mr. Grayson any shares of
common stock which Mr. Grayson desired to sell within twelve months of his
termination (such twelve month period to be extended if Mr. Grayson was delayed
or prohibited by state or federal securities laws from selling such stock). The
Grayson Agreement was terminable by Mr. Grayson upon ninety days notice. The
Grayson agreement had an original term of five years commencing April 28, 1993
and automatically renewed for successive five year periods unless earlier
terminated in accordance therewith.
On March 10, 1997, Mr. Grayson resigned from his positions as officer,
director and employee of the Company. In connection with such resignation, the
Company agreed to continue paying Mr. Grayson's salary at the then current
annual level of $250,000 for a ninety day period. Additionally, the Company
agreed to an early debt repayment to Mr. Grayson for debt issued February 11,
1994 as a 7% Subordinated Convertible Note. The Company agreed to pay $125,000
to Mr. Grayson as full repayment of $135,142 principal and accrued interest of
approximately $1,000.
The Henkel Agreement provided that Mr. Henkel was entitled to receive cash
compensation of $250,000 per year. Mr. Henkel was also entitled to participate
in any cash bonus plan for key executive officers of the Company adopted
beginning in 1995. The Henkel Agreement provided that if the Company terminated
his employment for any reason other than gross negligence, he would be paid a
severance equal to six months of his current salary (excluding bonuses).
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<PAGE>
On March 10, 1997, Mr. Henkel resigned from his positions as an officer and
director of the Company. Mr. Henkel and the Company agreed that Mr. Henkel would
provide additional consulting services to the Company through November, 1997 for
which Mr. Henkel was paid at the rate of $20,833 per month.
INCENTIVE STOCK OPTION PLAN
General
Pursuant to the Incentive Stock Option Plan, the Company may grant
incentive stock options ("Incentive Stock Options" or "ISOs") as defined in
section 422 of the Internal Revenue Code of 1986, as amended (the "Code"), and
options that are not intended to be ISOs ("Non-Qualified Stock Option" or
"NQSO"). The Incentive Stock Option Plan covers an aggregate of 3,200,000 shares
of common stock, subject to adjustment in the event of stock dividends, stock
splits and certain other events. With the exception of 90,000 options which vest
over three years, all options granted pursuant to the Incentive Stock Option
Plan vest over four years.
Administration
The Compensation Committee of the Board of Directors of the Company (the
"Compensation Committee") administers the Incentive Stock Option Plan and, as
such, selects employees to receive options, determines the type and size of
options, determines when options will be granted, and determines the terms of
each option.
Option Share Repurchase Agreement
In February 1994, the Company entered into an Option Share Repurchase
Agreement (the "Repurchase Agreement") with George D. Grayson, Robert A. Ezrin
and W. Scott Page (collectively, the "Contracting Stockholders"). Pursuant to
the Repurchase Agreement, upon the exercise of certain outstanding options
granted under the Incentive Stock Option Plan, the Company has the right to
repurchase the same number of shares of common stock from the Contracting
Stockholders at $0.003 per share. In the aggregate, 1,060,500 options and
corresponding shares of common stock held by the Contracting Stockholders are or
have been subject to the Repurchase Agreement (as amended). At December 31,
1997, 991,500 options associated with the Option Share Repurchase Agreement had
been granted, of which 504,000 had been exercised and 436,500 had been canceled.
The Company has satisfied, and intends to continue to satisfy, its obligation to
issue shares of common stock upon any exercise of an option associated with the
Repurchase Agreement by delivering to the exercising optionee(s) shares of
treasury stock acquired from the Contracting Stockholders, thereby resulting in
no change in the number of outstanding shares of common stock due to the
exercise of such options.
Benefits Awarded
As of February 15, 1998, 831,675 shares of common stock had been issued
upon exercise of options granted under the Incentive Stock Option Plan, and
options to purchase an additional 975,953 shares were outstanding under such
plan. Future awards, if any, that will be made to eligible participants in the
Incentive Plan are subject to the discretion of the Compensation Committee and,
therefore, are not determinable at this time.
Federal Income Taxes
As a general rule, no federal income tax is imposed on an optionee upon the
grant of a Non-Qualified Stock Option and the Company is not entitled to a tax
deduction by reason of such a grant. Instead, an optionee is taxed upon the
exercise of the option, at ordinary income rates, on the excess, if any, of the
fair market value of the shares acquired (determined as of the date of exercise)
over the exercise price. Upon a subsequent disposition of any shares received
upon exercise of a NQSO, the excess of the amount realized on the disposition
over the basis of the shares (exercise price plus any compensation income
recognized) should qualify as long-term or short-term capital gain, depending on
whether the shares were held for more than one year prior to disposition. The
Company will generally by entitled to a tax deduction for the same taxable year
and in the same amount as any compensation included in the optionee's income.
As a general rule, no federal income tax is imposed on an optionee upon the
grant or exercise of an Incentive Stock Option and the Company is not entitled
to a tax deduction by reason of such a grant or exercise. However, the excess of
the fair market value of the purchased shares over the exercise price is an item
of tax preference to the
41
<PAGE>
optionee in the year of exercise for purposes of determining alternative minimum
tax. Instead, under Section 422 of the Code, when shares acquired through the
exercise of an ISO are sold or exchanged in a taxable disposition, any amount
received by the optionee in excess of the exercise price will be treated as
long-term capital gain, and any loss realized will be treated as a long-term
capital loss.
To obtain this favorable tax treatment for ISOs under the Code, an optionee
must not dispose of shares received from the exercise of an ISO within two years
of the grant date and within one year from the date of exercise of the ISO. In
addition, the date of exercise of an ISO must be during or within three months
following the optionee's continuous employment relationship with the Company,
unless the employment terminates due to disability or death. If the optionee's
employment terminates as a result of disability or death, the period for
exercise can extend up to twelve months following the disability and even longer
following death. The terms of options granted under the Incentive Stock Option
Plan are at the discretion of the Compensation Committee and may not comply with
these requirements for favorable treatment under Section 422 of the Code.
If the requirements of the preceding paragraph are not satisfied, the
disposition of the shares acquired through the exercise of an ISO will be
treated as a "disqualifying disposition." Upon a disqualifying disposition, the
excess of the value of the shares on the date of exercise over the exercise
price will be treated as ordinary income. Any gain realized in excess of such
ordinary income will be long-term or short-term capital gain, depending on the
holding period of the shares. If the shares acquired through the exercise of
such option are sold for an amount less than the exercise price, such loss will
be treated as a long-term or short-term capital loss, depending on the holding
period. In the event of a disqualifying disposition, the Company will be allowed
a deduction in an amount equal to the amount that the optionee is required to
treat as ordinary income in the Company's taxable year that ends with or within
the taxable year in which the optionee is required to recognize such ordinary
income.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The following table sets forth the beneficial ownership of the Company's
common stock as of February 18, 1998 by (a) each director, (b) the Named
Executive Officers, (c) all persons known to the Company to be the beneficial
owners of more than five percent of the Company's common stock and (d) all
directors and executive officers as a group:
APPROXIMATE
NAME OF PERSON NUMBER OF PERCENTAGE OF
OR IDENTITY OF GROUP SHARES CLASS
- ------------------------------------------ --------- -------------
Robert Alan Ezrin (1) 1,729,965 12.4%
1110 East Collins Blvd., Suite 122
Richardson, TX 75081
Entec Associates (2)...................... 1,166,658 8.3%
P. O. Box 491459
Los Angeles, California 90049
Donald Schupak (3)........................ 700,092 4.9%
W. Scott Page (4)......................... 585,984 4.3%
Merv Adelson (5).......................... 558,018 4.0%
George D. Grayson (6)..................... 106,558 *
James A. Cannavino (7).................... 80,000 *
David W. Craig (8)........................ 35,000 *
David R. Henkel (9)....................... 16,500 *
All current directors and executive
officers as a group..................... 3,654,059 24.5%
____________________
(1) Includes all shares beneficially owned by Entec Associates ("Entec") with
respect to which Mr. Ezrin has sole voting power pursuant to a
stockholders' voting agreement and irrevocable proxy. Shares shown as
beneficially owned include 39,997 shares which may be purchased by the
Company pursuant to the Option Share Repurchase Agreement at $0.003 per
share upon the exercise of certain options granted or to be granted under
the Company's Incentive Stock Option Plan and 20,000 shares of common stock
issuable on the exercise of vested stock options with an exercise price of
$6.05 per share.
42
<PAGE>
(2) Michael R. Milken is a general partner of Entec, and the Company believes
that Mr. Milken has sole investment power with respect to, and may be
deemed a beneficial owner of, the shares held by Entec. All shares of
common stock beneficially owned by Entec are subject to a stockholders'
voting agreement and irrevocable proxy pursuant to which Robert Alan Ezrin
has sole voting power with respect to the shares of common stock
beneficially owned by Entec. Shares shown as beneficially owned include
166,391 shares issuable upon the exercise of warrants at an exercise price
of $7.50 per share and 95,757 shares issuable upon conversion of 7%
Subordinated Convertible Notes.
(3) Shares shown as beneficially owned as of February 18, 1998 include shares
issuable on the exercise of vested stock options with exercise prices as
follows: 186,666 shares as of $2.44, 186,667 shares at $3.38 per share,
186,667 shares at $5.00 per share and 80,000 shares at $4.00 per share.
(4) Shares shown as beneficially owned include 39,999 shares which may be
purchased by the Company pursuant to an Option Share Repurchase Agreement
at $0.003 per share upon the exercise of certain options granted or to be
granted under the Company's Incentive Stock Option Plan.
(5) Shares shown as beneficially owned also include 53,242 shares issuable upon
the exercise of warrants which are exercisable at $7.50 per share, 30,641
shares issuable on conversion of 7% Subordinated Convertible Notes and
20,000 shares issuable on the exercise of vested options with an exercise
price of $12.75 per share held by Mr. Adelson.
(6) Shares shown as beneficially owned include 40,004 shares which may be
purchased by the Company pursuant to an Option Share Repurchase Agreement
at $0.003 per share upon the exercise of certain options granted or to be
granted under the Company's Incentive Stock Option Plan. Shares shown as
beneficially owned also include 66,554 shares issuable upon the exercise of
warrants at an exercise price of $7.50 per share.
(7) Shares shown as benficially owned include 80,000 shares issuable on the
exercise of vested stock options with an exercise price of $4.00 per share.
(8) Shares shown as beneficially owned include 35,000 shares issuable upon the
exercise of vested stock options with an exercise price of $5.50 per share.
(9) Shares shown as beneficially owned include 5,250 shares of common stock
issuable upon the exercise of warrants at an exercise price per share of
$7.50, and 11,250 shares of common stock issuable on the exercise of vested
stock options with exercise price of $5.50 per share.
* Represents beneficial ownership of less than 1% of the common stock.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
In March 1997, the Company and The Schupak Group entered into an agreement
whereby the Company pays $12,000 per month to the Schupak Group for the services
of Donald Schupak and other employees of the Schupak Group. Additionally, Mr.
Schupak is entitled to the reimbursement of reasonable travel and other expenses
incidental to the performance of his duties.
The Company has agreed to issue 635,000 shares of common stock to Mr.
Schupak upon consummation of the Merger in exchange for the surrender of options
issued to Mr. Schupak to purchase 635,000 shares of common stock.
See Item 11. Executive Compensation - Employment Contracts.
43
<PAGE>
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a)(1)-- The financial statements filed as part of this Report at
Item 8 are listed in the Index to Financial Statements and
Financial Statement Schedule on page 18 of this Report.
(a)(2)-- The financial statement schedule filed as part of this
Report at Item 8 is listed in the Index to Financial
Statements and Financial Statement Schedule on page 18 of
this Report.
(a)(3)-- The following documents are filed or incorporated by
reference as exhibits to this Report:
**3(i)-- Restated Certificate of Incorporation of 7th Level, Inc.
(the "Company").
*3(ii)-- Bylaws of the Company as adopted by the Board of Directors
of the Company as of May 14, 1993; as amended by Amendment
No. 1 thereto dated February 11, 1994.
**4.1-- Form of Bridge Loan Warrant.
*10.1-- Stock Purchase Agreement entered into as of the 11th day of
February, 1994 by and among the Company and the Purchasers
listed on Exhibit A thereto.
*10.2-- Stockholders' Agreement entered into as of the 11th day of
February, 1994 by and among the Company and George D.
Grayson, Robert A. Ezrin, the George D. and Kathy Grayson
Irrevocable Trust, David R. Henkel, Onyx Partners, Inc., W.
Scott Page, James E. Shepherd, Robert A. Tercek, Entec
Associates, Mezzonen S.A., Merv Adelson, Andrew Adelson,
Tarragona Fund, Inc., and Zenga Investments, Ltd. (the
"Investors").
*10.3-- Letter Agreement dated May 28, 1993 from Onyx Partners,
Inc. ("Onyx") to the Company.
*10.4-- Option Share Repurchase Agreement entered into as of the
11th day of February, 1994, by and among the Company,
George D. Grayson, Robert A. Ezrin and W. Scott Page.
**10.5-- Amended and Restated Incentive Stock Option Plan of 7th
Level, Inc.
**10.6-- Employee Stock Purchase Plan of 7th Level, Inc.
*10.7-- Assignment and Assumption Agreement entered into as of the
11th day of February, 1994 by and among the Company and 7th
Level, a sole proprietorship.
*10.8-- Employment Agreement entered into as of April 28, 1993 by
and among the Company and George D. Grayson.
*10.9-- Letter Agreement dated as of January 20, 1994 from the
Company to David R. Henkel.
*10.10-- Asset Purchase Agreement entered into as of the 24th day of
March, 1994, by and among the Company and MetroLight.
*10.11-- Software License Agreement entered into as of the 24th day
of March, 1994, by and among the Company and MetroLight.
*10.12-- Assumption Agreement entered into as of the 24th day of
March, 1994, by and among the Company and MetroLight.
*10.13-- Registration Rights Agreement entered into as of the 24th
day of March, 1994, by and among the Company and
MetroLight.
*10.14-- Letter Agreement dated as of November 11, 1993 from Python
(Monty) Pictures, Ltd. to the Company.
*10.15-- Letter Agreement dated as of June 8, 1993 relating to the
services of Howie Mandel and accepted and agreed to on
September 2, 1993 by the Company and Alevy Productions,
Inc.
44
<PAGE>
**10.16-- Distribution Agreement entered into as of January 11, 1994
by and between the Company and Ingram Micro Inc. (Portions
have been omitted and filed separately with the Commission
in accordance with Rule 406 of the Securities Act of 1933,
as amended, and the Registrant's request for confidential
treatment.)
*10.17-- Letter Agreement dated May 3, 1994 from the Company to
Charles Fleischer.
**10.18-- Form of Exchange Agreement dated September __, 1994 among
the Company and the Investors.
**10.19-- Letter Agreement dated August 30, 1994 from Python (Monty)
Pictures Ltd. to the Company.
***10.20-- Letter Agreement dated September 16, 1994 from
International Business Machines Corporation to the Company.
**10.21-- Letter Agreement dated May 25, 1994 from the Company to
Bill Plympton.
**10.22-- Letter Agreement dated August 15, 1994 from Quincy Jones--
David Salzman Entertainment to the Company.
**10.23-- Letter Agreement dated July 29, 1994 from Imperial Bank to
the Company.
**10.24-- Letter Agreement dated September 6, 1994 from the Company
to Imperial Bank.
**10.25-- Form of Bridge Loan Agreement dated as of July 13, 1994
among the Company and each Lender which is a signatory
thereto.
****10.26-- Amended and Restated 1994 Non-Employee Directors' Stock
Option Plan of the Company.
***10.27-- Form of 7% Convertible Note Due February 11, 1999.
***10.28-- Loan Modification Agreement effective the 21st day of July,
1994 between the Company and George D. Grayson.
*****10.29-- Agreement made as of the 28th day of September, 1994, by
and between Entec Associates ("Entec") and the Company,
including exhibits thereto.
*****10.30-- Lock-Up Agreement made and entered into the 26th day of
September, 1994 by and among Entec and the Company.
*******10.31-- Registration Rights Agreement entered into as of the 23rd
day of February, 1995 by and among the Company and Todd
Porter, Jeremiah O'Flaherty, Gregory Harvey, Stephen
Kennedy, Harry Wenzel and Robert Legg.
******10.32-- 7th Level, Inc. 7% Subordinated Notes Due 1996.
********10.33-- Letter Agreement dated June 27, 1995 from Disney
Interactive, Inc. ("Disney") to the Company.
*********10.34-- Letter agreement dated August 31, 1995 by and between
Morgan Creek Interactive, Inc. and the Company (portions of
which have been omitted and filed separately with the
Commission in accordance with Rule 406 of the Securities
Act of 1933, as amended, and the Company's request for
confidential treatment.
**********10.35-- Imperial Bank - Credit Terms and Conditions; $6,000,000
Note; $5,000,000 Note; General Security Agreement;
Mortgage, Assignment and Grant of Security Interest with
Respect to Trademarks; and Mortgage, Assignment and Grant
of Security Interest with Respect to Copyrights and Other
Collateral, all dated September 6, 1996.
23.1-- Consent of KPMG Peat Marwick LLP.
***********99.1-- Press release concerning the merger of 7th Level, Inc.
with Pulse Entertainment, Inc.
45
<PAGE>
(b)-- Registrant filed a Current Report on Form 8-K , dated
December 9, 1997 in respect to the agreement to merge with
Pulse Entertainment,
Inc.
__________________________________
* Filed as an Exhibit to the Company's Registration Statement on
Form S-1 (File No. 33-79092) filed with the Commission on May 18,
1994, and incorporated by reference herein.
** Filed as an Exhibit to Amendment No. 1 to the Company's
Registration Statement on Form S-1 (File No. 33-79092) filed with
the Commission on September 19, 1994, and incorporated by
reference herein.
*** Filed as an Exhibit to Amendment No. 2 to the Company's
Registration Statement on Form S-1 (File No. 33-79092) filed with
the Commission on September 28, 1994, and incorporated by
reference herein.
**** Filed as an Exhibit to Amendment No. 3 to the Company's
Registration Statement on Form S-1 (File No. 33-79092) filed with
the Commission on October 14, 1994, and incorporated by reference
herein.
***** Filed as an Exhibit to Amendment No. 4 to the Company's
Registration Statement on Form S-1 (File No. 33-79092) filed with
the Commission on October 19, 1994, and incorporated by reference
herein.
****** Filed as an Exhibit to the Company's Quarterly Report on Form 10-
Q for the quarter ended September 30, 1994.
******* Filed as an Exhibit to the Company's Annual Report on Form 10-K
for the year ended December 31, 1994.
******** Filed as an Exhibit to the Company's Quarterly Report on Form 10-
Q for the quarter ended June 30, 1995.
********* Filed as an Exhibit to Amendment No. 1 to the Company's
Registration Statement on Form S-1 (File No. 33-96522) filed with
the Commission on September 12, 1995 and incorporated by
reference herein.
********** Filed as an Exhibit to the Company's Quarterly Report on Form 10-
Q for the quarter ended September 30, 1996
*********** Filed as an Exhibit to the Company's Current Report on Form 8-K
(File No. 000-24936) filed with the Commission on December 9,
1997 and incorporated by reference herein.
46
<PAGE>
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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, in the City of
Richardson and State of Texas, on April 14, 1998.
7TH LEVEL, INC.
By: /s/ ROBERT ALAN EZRIN
-----------------------------------------
Robert Alan Ezrin
President, Chief Exective
Officer and Director
Pursuant to the requirements of the Securities and Exchange Act of 1934,
this report has been signed below by the following persons on behalf of the
Registrant in the capacities and on the dates indicated.
Signature Title
/s/ MERV ADELSON Director April 15, 1998
- -----------------------------
(Merv Adelson)
/s/ JAMES A CANNAVINO Director April 14, 1998
- -----------------------------
(James A. Cannavino)
/s/ ROBERT ALAN EZRIN President, Chief Executive April 14, 1998
- ----------------------------- Officer, and Director
(Robert Alan Ezrin)
/s/ W. SCOTT PAGE Executive Vice President of April 14, 1998
- ----------------------------- Production and Director
(W. Scott Page)
/s/ DONALD SCHUPAK Chairman of the Board and April 14, 1998
- ----------------------------- Director
(Donald Schupak)
47
<PAGE>
7TH LEVEL, INC.
SCHEDULE II -- VALUATION AND QUALIFYING ACCOUNTS
Balance at Balance at
Beginning End of
Description of Period Additions Deductions Period
- ---------------------------------- ---------- ---------- ---------- ----------
Allowance for sales returns,
doubtful accounts and
price concessions
Year ended December 31, 1997: $1,565,291 $3,062,581 $3,501,348 $1,126,524
Year ended December 31, 1996: 1,209,866 5,194,196 4,830,716 1,565,291
Year ended December 31, 1995: 616,629 1,604,804 1,011,547 1,209,866
Reserve for Inventory Obsolescence
Year ended December 31, 1997: $ 302,951 $ 415,131 $ -0- $ 718,082
Year ended December 31, 1996: 102,000 295,821 94,870 302,951
Year ended December 31, 1995: -0- 102,000 -0- 102,000
S-1
<PAGE>
INDEX TO EXHIBITS
SEQUENTIAL
EXHIBIT PAGE
NUMBER DOCUMENT DESCRIPTION NUMBER
- --------- ------------------------------------------------------ ----------
**3(i)-- Restated Certificate of Incorporation of 7th Level,
Inc. (the "Company").
*3(ii)-- Bylaws of the Company as adopted by the Board of
Directors of the Company as of May 14, 1993; as
amended by Amendment No. 1 thereto dated February 11,
1994.
**4.1-- Form of Bridge Loan Warrant.
*10.1-- Stock Purchase Agreement entered into as of the 11th
day of February, 1994 by and among the Company and
the Purchasers listed on Exhibit A thereto.
*10.2-- Stockholders' Agreement entered into as of the 11th
day of February, 1994 by and among the Company and
George D. Grayson, Robert A. Ezrin, the George D.
and Kathy Grayson Irrevocable Trust, David R. Henkel,
Onyx Partners, Inc., W. Scott Page, James E. Shepherd,
Robert A. Tercek, Entec Associates, Mezzonen S.A.,
Merv Adelson, Andrew Adelson, Tarragona Fund, Inc.,
and Zenga Investments, Ltd. (the "Investors").
*10.3-- Letter Agreement dated May 28, 1993 from Onyx Partners,
Inc. ("Onyx") to the Company.
*10.4-- Option Share Repurchase Agreement entered into as of
the 11th day of February, 1994, by and among the
Company, George D. Grayson, Robert A. Ezrin and W.
Scott Page.
**10.5-- Amended and Restated Incentive Stock Option Plan of
7th Level, Inc.
**10.6-- Employee Stock Purchase Plan of 7th Level, Inc.
*10.7-- Assignment and Assumption Agreement entered into as
of the 11th day of February, 1994 by and among the
Company and 7th Level, a sole proprietorship.
*10.8-- Employment Agreement entered into as of April 28,
1993 by and among the Company and George D. Grayson.
*10.9-- Letter Agreement dated as of January 20, 1994 from
the Company to David R. Henkel.
*10.10-- Asset Purchase Agreement entered into as of the 24th
day of March, 1994, by and among the Company and
MetroLight.
*10.11-- Software License Agreement entered into as of the
24th day of March, 1994, by and among the Company and
MetroLight.
*10.12-- Assumption Agreement entered into as of the 24th day
of March, 1994, by and among the Company and MetroLight.
*10.13-- Registration Rights Agreement entered into as of the
24th day of March, 1994, by and among the Company and
MetroLight.
<PAGE>
SEQUENTIAL
EXHIBIT PAGE
NUMBER DOCUMENT DESCRIPTION NUMBER
- --------- ------------------------------------------------------ ----------
*10.14-- Letter Agreement dated as of November 11, 1993 from
Python (Monty) Pictures, Ltd. to the Company.
*10.15-- Letter Agreement dated as of June 8, 1993 relating to
the services of Howie Mandel and accepted and agreed
to on September 2, 1993 by the Company and Alevy
Productions, Inc.
**10.16-- Distribution Agreement entered into as of January 11,
1994 by and between the Company and Ingram Micro, Inc.
(Portions have been omitted and filed separately with
the Commission in accordance with Rule 406 of the
Securities Act of 1933, as amended, and the Registrant's
request for confidential treatment.)
*10.17-- Letter Agreement dated May 3, 1994 from the Company to
Charles Fleischer.
**10.18-- Form of Exchange Agreement dated September __, 1994
among the Company and the Investors.
**10.19-- Letter Agreement dated August 30, 1994 from Python
(Monty) Pictures Ltd. to the Company.
***10.20-- Letter Agreement dated September 16, 1994 from
International Business Machines Corporation to the
Company.
**10.21-- Letter Agreement dated May 25, 1994 from the Company
to Bill Plympton.
**10.22-- Letter Agreement dated August 15, 1994 from Quincy
Jones--David Salzman Entertainment to the Company.
**10.23-- Letter Agreement dated July 29, 1994 from Imperial
Bank to the Company.
**10.24-- Letter Agreement dated September 6, 1994 from the
Company to Imperial Bank.
**10.25-- Form of Bridge Loan Agreement dated as of July 13,
1994 among the Company and each Lender which is a
signatory thereto.
****10.26-- Amended and Restated 1994 Non-Employee Directors'
Stock Option Plan of the Company.
***10.27-- Form of 7% Convertible Note Due February 11, 1999.
***10.28-- Loan Modification Agreement effective the 21st day
of July, 1994 between the Company and George D.
Grayson.
*****10.29-- Agreement made as of the 28th day of September,
1994, by and between Entec Associates ("Entec") and
the Company, including exhibits thereto.
*****10.30-- Lock-Up Agreement made and entered into the 26th day
of September, 1994 by and among Entec and the Company.
<PAGE>
SEQUENTIAL
EXHIBIT PAGE
NUMBER DOCUMENT DESCRIPTION NUMBER
- --------------- -------------------------------------------------- ----------
*******10.31-- Registration Rights Agreement entered into as of
the 23rd day of February, 1995 by and among the
Company and Todd Porter, Jeremiah O'Flaherty,
Gregory Harvey, Stephen Kennedy, Harry Wenzel and
Robert Legg.
******10.32-- 7th Level, Inc. 7% Subordinated Notes Due 1996.
********10.33-- Letter Agreement dated June 27, 1995 from Disney
Interactive, Inc. ("Disney") to the Company.
*********10.34-- Letter agreement dated August 31, 1995 by and
between Morgan Creek Interactive, Inc. and the
Company (portions of which have been omitted and
filed separately with the Commission in accordance
with Rule 406 of the Securities Act of 1933, as
amended, and the Company's request for confidential
treatment.
**********10.35-- Imperial Bank - Credit Terms and Conditions;
$6,000,000 Note; $5,000,000 Note; General Security
Agreement; Mortgage, Assignment and Grant of
Security Interest with Respect to Trademarks; and
Mortgage, Assignment and Grant of Security Interest
with Respect to Copyrights and Other Collateral, all
dated September 6, 1996.
23.1-- Consent of KPMG Peat Marwick LLP.
***********99.1-- Press release concerning the merger of 7th Level,
Inc. with Pulse Entertainment, Inc.
__________________________________
* Filed as an Exhibit to the Company's Registration Statement on
Form S-1 (File No. 33-79092) filed with the Commission on May 18,
1994, and incorporated by reference herein.
** Filed as an Exhibit to Amendment No. 1 to the Company's
Registration Statement on Form S-1 (File No. 33-79092) filed with
the Commission on September 19, 1994, and incorporated by
reference herein.
*** Filed as an Exhibit to Amendment No. 2 to the Company's
Registration Statement on Form S-1 (File No. 33-79092) filed with
the Commission on September 28, 1994, and incorporated by
reference herein.
**** Filed as an Exhibit to Amendment No. 3 to the Company's
Registration Statement on Form S-1 (File No. 33-79092) filed with
the Commission on October 14, 1994, and incorporated by reference
herein.
***** Filed as an Exhibit to Amendment No. 4 to the Company's
Registration Statement on Form S-1 (File No. 33-79092) filed with
the Commission on October 19, 1994, and incorporated by reference
herein.
****** Filed as an Exhibit to the Company's Quarterly Report on Form 10-
Q for the quarter ended September 30, 1994.
<PAGE>
******* Filed as an Exhibit to the Company's Annual Report on Form 10-K
for the year ended December 31, 1994.
******** Filed as an Exhibit to the Company's Quarterly Report on Form 10-
Q for the quarter ended June 30, 1995.
********* Filed as an Exhibit to Amendment No. 1 to the Company's
Registration Statement on Form S-1 (File No. 33-96522) filed with
the Commission on September 12, 1995 and incorporated by
reference herein.
********** Filed as an Exhibit to the Company's Quarterly Report on Form 10-
Q for the quarter ended September 30, 1996.
*********** Filed as an Exhibit to the Company's Current Report on Form 8-K
(File No. 000-24936) filed with the Commission on December 9,
1997 and incorporated by reference herein.
<PAGE>
EXHIBIT 23.1
CONSENT OF INDEPENDENT AUDITORS
The Board of Directors
7th Level, Inc.:
We consent to incorporation by reference in the Registration Statements (Nos.
333-10335, 333-10339 and 333-10341) on Form S-8 of 7th Level, Inc. of our report
dated January 30, 1998, related to the consolidated balance sheets of 7th Level,
Inc. and subsidiaries as of December 31, 1997 and 1996, and the related
consolidated statements of operations, stockholders' equity, and cash flows and
related schedule for each of the years in the three year period ended December
31, 1997, which report appears in the December 31, 1997 annual report on
Form 10-K of 7th Level, Inc.
Our report dated January 30, 1998 contains an explanatory paragraph that states
that the Company has suffered recurring losses since inception and does not
currently have sufficient resources to meet its anticipated operating
requirements during 1998, which conditions raise substantial doubt about the
Company's ability to continue as a going concern. The consolidated financial
statements and financial statement schedule do not include any adjustments that
might result from the outcome of that uncertainty.
KPMG Peat Marwick LLP
Dallas, Texas
April 14, 1998
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<S> <C> <C>
<PERIOD-TYPE> YEAR YEAR
<FISCAL-YEAR-END> DEC-31-1997 DEC-31-1996
<PERIOD-START> JAN-01-1997 JAN-01-1996
<PERIOD-END> DEC-31-1997 DEC-31-1996
<CASH> 2,465,079 10,798,372
<SECURITIES> 0 4,485,470
<RECEIVABLES> 2,238,550 7,696,134
<ALLOWANCES> 1,126,524 1,565,291
<INVENTORY> 18,477 571,545
<CURRENT-ASSETS> 4,348,429 28,879,958
<PP&E> 10,274,484 11,306,560
<DEPRECIATION> 5,313,924 3,467,282
<TOTAL-ASSETS> 9,854,726 38,932,934
<CURRENT-LIABILITIES> 6,543,924 13,128,560
<BONDS> 0 0
0 0
0 0
<COMMON> 137,837 135,795
<OTHER-SE> 2,321,618 24,516,592
<TOTAL-LIABILITY-AND-EQUITY> 9,854,726 38,932,934
<SALES> 0 0
<TOTAL-REVENUES> 10,499,021 20,548,725
<CGS> 4,541,960 8,298,647
<TOTAL-COSTS> 29,747,359 37,758,435
<OTHER-EXPENSES> 0 0
<LOSS-PROVISION> 0 0
<INTEREST-EXPENSE> (1,332,617) (1,255,622)
<INCOME-PRETAX> (22,457,678) (24,252,735)
<INCOME-TAX> 0 0
<INCOME-CONTINUING> 0 0
<DISCONTINUED> 0 0
<EXTRAORDINARY> 0 0
<CHANGES> 0 0
<NET-INCOME> (22,457,678) (24,252,735)
<EPS-PRIMARY> (1.64) (1.80)
<EPS-DILUTED> 0 0
</TABLE>
