<PAGE>
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
_______________
FORM 10-Q
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED JUNE 30, 1998
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM TO
------ ------
Commission file number 0-24936
7TH LEVEL, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 75-2480669
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
1201 RICHARDSON DRIVE
SUITE 277
RICHARDSON, TEXAS 75080
(Address of principal executive offices) (Zip Code)
REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (972) 498-8100
Registrant (1) has filed all reports required to be filed by Section 13 or
15(d) of the Securities Exchange Act of 1934 during the preceding 12 months and
(2) has been subject to such filing requirements for the past 90 days.
Yes X No
---- ----
Indicate the number of shares outstanding of each of the issuer's classes
of common stock, as of the latest practicable date.
COMMON STOCK, $0.01 PAR VALUE 17,585,192
(Title of Each Class) Number of Shares Outstanding at
July 28, 1998
<PAGE>
7TH LEVEL, INC.
Form 10-Q
For the Quarterly Period Ended June 30, 1998
Index
<TABLE>
<CAPTION>
PART I FINANCIAL INFORMATION Page No.
----------------
<S> <C> <C>
Item 1 Condensed Consolidated Balance Sheets at June 30, 1998 and
December 31, 1997 3
Condensed Consolidated Statements of Operations for the
Three and Six Months Ended June 30, 1998 and 1997 4
Condensed Consolidated Statements of Cash Flows for the Six
Months Ended June 30, 1998 and 1997 5
Notes to Condensed Consolidated Financial Statements 6
Item 2 Management's Discussion and Analysis of Financial Condition
and Results of Operations 8
PART II OTHER INFORMATION
Item 1 Legal Proceedings 14
Item 2 Changes in Securities 14
Item 4 Submission of Matters to a Vote of Security Holders 16
Item 6 Exhibits and Reports on Form 8-K 16
SIGNATURE 17
</TABLE>
<PAGE>
Part I - FINANCIAL INFORMATION
Item 1. Condensed Consolidated Financial Statements
7TH LEVEL, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited)
<TABLE>
<CAPTION>
June 30, 1998 December 31, 1997
------------- -----------------
ASSETS
<S> <C> <C>
Cash and cash equivalents $ 9,052,907 $ 2,465,079
Accounts receivable, net 90,703 1,112,026
Inventories - 18,477
Other current assets 599,435 752,847
--------------- ---------------
Total current assets 9,743,045 4,348,429
Fixed assets, net 3,745,699 4,960,560
Intangible assets, net 10,095 13,132
Other assets 315,997 532,605
=============== ===============
Total assets $ 13,814,836 $ 9,854,726
=============== ===============
LIABILITIES AND STOCKHOLDERS' EQUITY
Accounts payable $ 499,708 $ 1,111,732
Accrued expenses and other current liabilities 4,502,044 5,352,874
Current portion of notes payable 564,453 79,318
--------------- ---------------
Total current liabilities 5,566,204 6,543,924
Notes payable 4,266,431 377,027
Notes payable to related parties - 108,108
Other 256,268 366,212
--------------- ---------------
Total liabilities 10,088,904 7,395,271
Commitments and contingencies
Stockholders' equity:
Series A preferred stock ($5,500,000 liquidation value) 2,479,138 -
Common stock 168,156 137,837
Additional capital 76,964,315 70,642,628
Accumulated deficit (75,885,677) (68,333,578)
Cumulative other comprehensive income - 12,568
--------------- ---------------
Total stockholders' equity 3,725,932 2,459,455
=============== ===============
Total liabilities and stockholders' equity $ 13,814,836 $ 9,854,726
=============== ===============
</TABLE>
See accompanying notes.
3
<PAGE>
7TH LEVEL, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
<TABLE>
<CAPTION>
Three Months Ended Three Months Ended Six Months Ended Six Months Ended
June 30, 1998 June 30, 1997 June 30, 1998 June 30, 1997
------------- ------------- ------------- -------------
<S> <C> <C> <C> <C>
Net revenues $ 72,388 $ 963,736 $ 534,141 $ 5,161,572
Cost of revenues 38,423 1,037,013 123,343 3,703,148
------------- ------------- ------------- -------------
Gross profit (loss) 33,965 (73,277) 410,798 1,458,424
------------- ------------- ------------- -------------
Operating expenses:
Research and product development 1,002,757 4,033,503 2,168,973 8,621,283
Sales and marketing 191,365 1,821,248 542,310 3,724,593
General and administrative 2,584,269 1,392,811 3,828,587 2,993,745
------------- ------------- ------------- -------------
Total operating expenses 3,778,391 7,247,562 6,539,870 15,339,621
------------- ------------- ------------- -------------
Operating loss (3,744,426) (7,320,839) (6,129,072) (13,881,197)
Interest and other, net (1,266,198) 181,681 (1,423,027) 280,793
------------- ------------- ------------- -------------
Net loss $ (5,010,624) $ (7,139,158) $ (7,552,099) $ (13,600,404)
============= ============= ============= =============
Basic and diluted loss per common share $ (0.33) $ (0.52) $ (0.52) $ (1.00)
============= ============= ============= =============
Weighted average basic and diluted
shares outstanding 15,022,132 13,628,742 14,406,355 13,612,820
============= ============= ============= =============
</TABLE>
See accompanying notes.
4
<PAGE>
7TH LEVEL, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
<TABLE>
<CAPTION>
Six Months Ended Six Months Ended
June 30, 1998 June 30, 1997
------------- -------------
<S> <C> <C>
Cash flows from operating activities:
Net loss $(7,552,099) $ (13,600,404)
Adjustments to reconcile net loss to net cash used in
operating activities:
Non-cash compensation and interest 2,767,749 -
Depreciation and amortization 1,039,401 1,791,983
(Gain) loss on sale of assets 161,207 (94,802)
Gain on early retirement of debt - (10,142)
Change in operating assets and liabilities 6,941 ,991,113
------------- -------------
Net cash used in operating activities (3,576,801) (7,922,252)
------------- -------------
Cash flows from investing activities:
Capital expenditures (22,240) (427,910)
Proceeds from sale of assets 39,528 5,594,010
Sale of short-term investments - 2,992,458
------------- -------------
Net cash provided by investing activities 17,288 8,158,558
------------- -------------
Cash flows from financing activities:
Issuance of Common Stock under stock option
and stock purchase plans 638,774 216,167
Net proceeds from issuance of preferred stock 5,268,876 -
Net proceeds from debt issuance 4,616,796 -
Proceeds from exercise of warrants 20,500 -
Issuance of Common Stock 7,650 -
Repayment of long-term obligations (99,359) (5,750,000)
------------- -------------
Net cash provided by (used in ) financing activities 10,453,237 (5,533,833)
------------- -------------
Effect of exchange rate changes on cash - (17,357)
------------- -------------
Net increase (decrease) in cash 6,893,724 (5,314,884)
Cash and cash equivalents, beginning of period 2,465,079 10,798,372
------------- -------------
Cash and cash equivalents, end of period $ 9,358,803 $ 5,483,488
============= =============
</TABLE>
See accompanying notes.
5
<PAGE>
7TH LEVEL, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
1. Basis of Presentation
The condensed consolidated financial statements of 7th Level, Inc.
(the "Company") are unaudited and reflect all adjustments, consisting of normal
recurring adjustments, which are, in the opinion of management, necessary for a
fair presentation of the results for the interim periods. These condensed
consolidated financial statements should be read in conjunction with the
financial statements and notes thereto included in the Company's Annual Report
on Form 10-K for the year ended December 31, 1997 [and the Company's Quarterly
Report on Form 10-Q for the quarterly period ended March 31, 1998]. The results
of operations for the three and six months June 30, 1998 are not necessarily
indicative of the results for the entire year ending December 31, 1998.
2. Loss per Common Share
The Company adopted the provisions of Statement of Financial
Accounting Standards No. 128 ("SFAS 128"), Earnings per Share, in the fourth
quarter of 1997, which required companies to present basic earnings per share
and diluted earnings per share. Basic loss per share is computed by dividing
loss attributable to common stockholders by the weighted average number of
common shares outstanding during the period. Diluted loss per share reflects
the potential dilution that could occur if securities or other contracts to
issue common stock were exercised or converted into common stock. There is no
difference between basic and diluted loss per share in the accompanying
financial statements as the potential issuances of common stock had an
antidilutive effect.
3. Private Placement
In May 1998, the Company sold, pursuant to a private placement,
Secured Promissory Notes ("Notes") in the aggregate principal amount of
$4,500,000 and warrants for 675,000 shares of common stock, par value $0.01 per
share ("Common Stock"), of the Company at an exercise price of $0.01 per share.
The Company allocated approximately $1,200,000 of the proceeds from the Notes to
the warrants based on the relative fair values of the Notes and the warrants.
Accordingly, the Company is amortizing the related debt discount to interest
expense over the period from May 6, 1998 (date of issuance) to July 13, 1998
(date of exchange see below). All of such warrants were exercised in June
1998. On July 9, 1998, the Company obtained stockholder approval for, among
other things, an increase in its authorized Common Stock (the "Certificate of
Amendment") at its 1998 Annual Meeting of Stockholders. The Certificate of
Amendment was filed on July 10, 1998. On July 13, 1998, the holders of the
Notes exchanged the Notes for 4,500 shares of the Company's Series B Convertible
Preferred Stock, $0.01 par value per share ("Series B Convertible Preferred
Stock") and warrants to purchase 1,125,000 shares of Common Stock at an exercise
price of $0.01 per share.
In May 1998, the Company also sold, pursuant to a private placement,
shares of Series A Preferred Stock in the aggregate amount of $5,500,000 and
warrants exercisable at any time or from time to time commencing from June 1,
1998 until March 30, 2005, unless there is a change in control of the Company,
at which time the warrants may be exercised immediately, for 1,375,000 shares of
Common Stock at an exercise price of $0.01 per share. The Company allocated
approximately $2,500,000 of the proceeds from the Series A Preferred Stock to
the warrants based on the relative fair values of the Series A Preferred Stock
and the warrants. All of such warrants were exercised in June 1998. On July 13,
1998, after the Certificate of Amendment was approved by the Company's
stockholders and was filed with the
6
<PAGE>
Secretary of State of the State of Delaware, the exchange of 5,500 shares of
Series A Preferred Stock for 5,500 shares of Series B Convertible Preferred
Stock was effected.
The Certificate of Designations, Preferences and Rights of Series B
Convertible Preferred Stock ("the Certificate of Designations") provides that on
the original issue date of the Series B Convertible Preferred Stock, the holders
of the Series B Convertible Preferred Stock will have the right to nominate two
members of the Board of Directors of the Company. The Series B Convertible
Preferred Stock ranks senior and prior to the Common Stock and to all other
classes or series of stock issued by the Company. Dividends accrue on the
shares of Series B Convertible Preferred Stock at the rate of 8% per annum;
provided, however, that in the event the Company fails to redeem the Series B
Convertible Preferred Stock on or before April 30, 2005, (the "Anniversary
Redemption Date") pursuant to the Certificate of Designations, the dividend rate
on the Series B Convertible Preferred Stock shall increase 2% per annum on each
anniversary of the Anniversary Redemption Date. Annual dividends are cumulative
and are payable quarterly in arrears when and as declared by the Company's Board
of Directors. These shares have a liquidation preference of $1,000 per share.
The Series B Convertible Preferred Stock is convertible immediately into Common
Stock, initially at a conversion price of $2.00 per share, subject to
adjustment. The shares of Series B Convertible Preferred Stock may be redeemed,
at the option of the Company, at $1,000 per share on or after the Anniversary
Redemption Date. Upon a change of control, the Company may offer to redeem such
shares at $2,000 per share or the Company may issue to each holder of Series B
Convertible Preferred Stock warrants exercisable for 250,000 shares of Common
Stock for each 1,000 shares of Series B Convertible Preferred Stock, at an
exercise price of $0.01 per share. The Company also has optional redemption
rights at any time after i) completion of an underwritten public offering by the
Company with gross proceeds to the Company of at least $20,000,000 and a price
per share of Common Stock , initially in excess of $4.00 per share or ii) after
the Company's Common Stock shall have traded at an average price generally in
excess of $4.00 per share for 20 consecutive trading days and the aggregate
market value of the Common Stock held by non-Affiliates of the Company is at
least $35,000,000. The holders of Series B Convertible Preferred Stock also are
entitled to certain preemptive rights, co-sale rights and registration rights.
7
<PAGE>
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
The following information should be read in conjunction with the
financial statements and the notes thereto and in conjunction with Management's
Discussion and Analysis of Financial Condition and Results of Operations in the
Company's Annual Report on Form 10-K for the year ended December 31, 1997 [and
the Company's Quarterly Report on Form 10-Q for the quarterly period ended March
31, 1998]. This analysis is provided pursuant to applicable Securities and
Exchange Commission regulations and is not intended to serve as a basis for
projections of future events.
OVERVIEW
The Company continues to leverage its core animation software
technology on the Internet, other narrow and broadband networks and standalone
PC's. The Company has developed a software technology, Agent 7, which can be
used to produce, lip synch and play back animated characters on Web pages and
from within all major PC software packages, such as Microsoft PowerPoint, Word
and Excel. Agent 7 1.0, which was first released for sale on the Company's
website on August 7, 1998, is the first commercial application of 7th Level's
core technology, which has been named Media Control 7, or "mc7". mc7 can be used
to control, manipulate, and publish multiple sources of media streaming over the
Internet and other networks or multiple sources resident on standalone PCs. 7th
Level plans to release additional applications this year and next, based on
mc7(1).
On May 6, 1998, the Company closed a $10 million private placement to
finance the rollout of the Company's new line of Internet software products.
(See "Liquidity and Capital Resources.") Additionally, the Company announced
several new strategic distribution agreements and a new management team to lead
the Company's entry into the market for Internet applications, tools and
technology. Richard S. Merrick, the Company's Senior Vice President of
Technology and Chief Strategist, was named Chief Executive Officer; Curt W.
Marvis, Senior Vice President of Business Development, was named President; and
Timothy J. Cahill, formerly Vice President and General Manager of Pulse
Entertainment, Inc., was named Chief Operating Officer and Executive Vice
President. Robert Alan Ezrin, a founder of the Company, relinquished his
position as interim Chief Executive Officer and President to become Vice
Chairman of the Board of Directors.
The Company is emerging from the development phase of its new Internet
technology and accordingly, the Company believes that significant revenues from
its new mc7 technology will not be realized until at least the second half of
1998.(1) However, the Company has begun to realize the benefits of previous
actions reflecting a dramatically lower cost structure primarily due to staff
reductions.
RESULTS OF OPERATIONS
Three Month Periods Ended June 30, 1998 and June 30, 1997
In the three months ended June 30, 1998, 7th Level net revenues
decreased to $72,388, which is significantly lower than the $963,736 achieved in
the three months ended June 30, 1997. Approximately $25,000 of revenues from
custom character work was recognized in the three months ended June 30, 1998
which amounted to 35% of total revenues. The remaining 65% of revenues was from
sales of CD-ROM products and licenses. The Company's minimal revenues in the
1998 period represent the transition from the previous business model and the
new strategy as discussed above. Gross revenues for the second quarter of 1997
were reduced approximately $800,000 for returns allowances and price reductions
on CD-ROM inventory already in the channel. The Company continued pricing
actions into the second quarter of 1997 to stimulate sales through the
distribution channel. The Company's returns allowance was higher in the 1997
period than previously experienced, as many of the titles in the back catalog
were not achieving sales expectations at the retail level and risked losing
shelf space. In the second three months of 1997, approximately 45% of net
revenues related to product sales and the remaining 55% was from licensing, OEM
and development contracts.
8
<PAGE>
Cost of revenues for the quarter ended June 30, 1998 was $38,423 or
53% of net revenue, including manufacturing cost of $7,288 and royalty and
licensing costs of $31,135. For the quarter ended June 30, 1997, cost of
revenues was $1,037,013 or 108% of net revenues. The significant cost of
revenues in the 1997 period as a percentage of net revenues is due to numerous
factors including the returns and price protection adjustments noted above as
well as asset valuation reductions, primarily inventory and prepaid royalties,
along with lower margins associated with development revenue. The Company
expects fluctuations in gross margin in the future as the Company's new business
strategy is implemented and as changes occur in the composition of the revenues
and the associated cost of revenues.(1)
Research and product development expenses were $1,002,757 and
$4,033,503 for the three months ended June 30, 1998 and 1997, respectively.
Research and product development costs decreased 75% in the 1998 period due to
reductions in headcount and related expenditures in line with the new business
strategy. Results from the 1997 period included spending for five CD-ROM titles
in active production.
Sales and marketing expenses were $191,365 and $1,821,248 for the
quarter ended June 30, 1998 and 1997, respectively. Sales and marketing expenses
included $94,257 and $782,061 of expenses for advertising, marketing and public
relations and $97,108 and $1,039,187 of expenses related to internal staffing
for the three months ended June 30, 1998 and 1997, respectively. Following its
departure from the CD-ROM games business, the Company has effected various cost
saving measures including staff reductions and lower advertising expenditures
which resulted in the significant decrease in sales and marketing expenses
between the two periods.
General and administrative expenses for the three months ended June
30, 1998 were $2,584,269 compared with $1,392,811 for the three months ended
June 30, 1997. General and administrative expenses for the quarter ended June
30, 1998 included approximately $1,380,000 in non-cash compensation related to
stock granted to the Company's Chairman and Vice Chairman and approximately
$44,000 in charges for certain stock options and stock warrants granted to
consultants. Excluding the one-time expenses, general and administrative
expenses decreased approximately 17% between the two periods.
The Company's interest income was more than offset by interest expense
in the three months ended June 30, 1998. Net interest expense was $1,266,198
recognized in the three months ended June 30, 1998 compared to $181,681 net
interest income for the three months ended June 30, 1997. Included in the amount
for 1998 was approximately $1,340,000 related to amortization of debt issuance
costs and accretion of debt discount following the financing transaction (see
"Liquidity and Capital Resources"). Included in the amount for 1997 was
approximately $95,000 for the gain recognized from the sale of an office
building, net of the interest capitalized as a cost of financing the acquisition
of land and office building construction.
Six Month Periods Ended June 30, 1998 and June 30, 1997
For the six months ended June 30, 1998, net revenues totaled $534,141
compared to $5,161,572 for the six months ended June 30, 1997. As previously
disclosed, the Company has transitioned from the CD-ROM games business and is
leveraging the underlying software technologies in the new business strategy.
The 90% decrease in net revenues reflects the shift in business strategy as the
new products on the mc7 platform have not yet been launched and accordingly, no
revenues have been realized.
Cost of revenues during the six months ended June 30, 1998 was
$123,343 or 23% of net revenue. For the six months ended June 30, 1997 cost of
revenues was $3,703,148 or 72% of net revenue. The Company expects fluctuations
in gross margin in the future as the Company's new business strategy is
implemented.(1 The gross margin in the first half of 1997 was negatively
impacted by changes in the revenue mix, through the inclusion of substantial
returns and price protection adjustments and development revenue, which has a
higher cost of revenue than product sales or OEM licensing revenue.
9
<PAGE>
Research and product development expenses were $2,168,973 for the six
months ended June 30, 1998 compared to $8,621,283 for the six months ended June
30, 1997. Research and product development expenses decreased 75% over the same
period of the prior year due to reductions in headcount and related expenditures
in line with the new business strategy.
Sales and marketing expenses were $542,310 or 102% of revenues, for
the six months ended June 30, 1998, compared to $3,724,593, or 72% of revenues,
for the six months ended June 30, 1997. Internal staffing expenses decreased
approximately 80% as a result of personnel reductions and closure of the
Company's international sales and marketing offices. Costs for advertising,
marketing and public relations decreased by 91% in the first half of 1998
compared to the first half of 1997 as no products were launched in the first
half of 1998 and marketing activities were negligible.
General and administrative expenses were $3,828,587 for the six months
ended June 30, 1998, compared with $2,993,745 for the six months ended June 30,
1997. One time charges were recognized in the first half of 1998 totaling
$1,824,000 which included approximately (i)$1,380,000 in non-cash compensation
related to stock granted to the Company's Chairman and Vice Chairman, (ii)
$44,000 in charges for certain stock options and stock warrants granted to
consultants and (iii) $400,000 related to professional fees associated with the
terminated merger with Pulse. Approximately $400,000 of the amount in the 1997
period was associated with expenses related to employee resignations in the
first quarter of 1997. Excluding the one-time expenses, general and
administrative expenses decreased approximately 23% between the two periods.
Net interest expense was $1,423,027 for the six months ended June 30,
1998 compared to $280,793 net interest income for the six months ended June 30,
1997. Included in the amount for 1998 was approximately $1,340,000 expense
related to amortization of debt issuance costs and accretion of debt discount
following the financing transaction (see "Liquidity and Capital Resources"). The
decrease is also because of lower cash balances available for investment along
with higher average debt outstanding. Included in the amount for 1997 was
approximately $95,000 for the gain recognized from the sale of an office
building, net of the interest capitalized as a cost of financing the acquisition
of land and office building construction.
LIQUIDITY AND CAPITAL RESOURCES
Cash and short term investments increased $6,587,828 during the first
half of the year to $9,052,907 at June 30, 1998. The increase is the result of
the $10,000,000 private placement funded in May 1998, offset by operating
activities during the first six months of 1998. Net cash used in operating
activities was $3,729,749 which included a net loss of $7,552,099 for the six
months ended June 30, 1998, offset by non cash items such as charges for stock
grants and amortization of debt issuance costs and accretion of debt discount
described above, as well as the non-cash depreciation and amortization expenses.
Approximately $660,000 cash was provided in the six months ended June 30, 1998
from the issuance of Common Stock due to exercises of stock options, stock
purchase agreements and stock warrants. The Company sold surplus equipment
resulting in a loss on disposition of $161,207, and has significantly curtailed
capital expenditures, with disbursements of $22,240, in the first six months of
1998 compared to $427,910 in the same period of 1997. Capital expenditures for
the second half of 1998 are anticipated to be minimal (1), however, the Company
continues to use cash and operate at a loss.
In May 1998, the Company sold, pursuant to a private placement, Notes
in the aggregate principal amount of $4,500,000 and warrants for 675,000 shares
of Common Stock at an exercise price of $0.01 per share. The Company allocated
approximately $1,200,000 of the proceeds from the Notes to the warrants based on
the relative fair values of the Notes and the warrants. Accordingly, the Company
is amortizing the related debt discount to interest expense over the period from
May 6, 1998 (date of issuance) to July 13, 1998 (date of exchange see below).
All of such warrants were exercised in June 1998. On July 9, 1998, the Company
obtained stockholder approval for, among other things, an increase in its
authorized
10
<PAGE>
Common Stock and the Certificate of Amendment was filed on July 10, 1998. On
July 13, 1998, the holders of the Notes exchanged the Notes for 4,500 shares of
the Company's Series B Convertible Preferred Stock, $0.01 par value per share
("Series B Convertible Preferred Stock") and warrants to purchase 1,125,000
shares of Common Stock at an exercise price of $0.01 per share.
In May 1998, the Company also sold, pursuant to a private placement,
shares of Series A Preferred Stock in the aggregate amount of $5,500,000 and
warrants exercisable at any time or from time to time commencing from June 1,
1998 until March 30, 2005, unless there is a change in control of the Company,
at which time the warrants may be exercised immediately, for 1,375,000 shares of
Common Stock at an exercise price of $0.01 per share. The Company allocated
approximately $2,500,000 of the proceeds from the Series A Preferred Stock to
the warrants based on the relative fair values of the Series A Preferred Stock
and the warrants. All of such warrants were exercised in June 1998. On July 13,
1998, after the Certificate of Amendment was approved by the Company's
stockholders and was filed with the Secretary of State of the State of Delaware,
the exchange of 5,500 shares of Series A Preferred Stock for 5,500 shares of
Series B Convertible Preferred Stock was effected.
The Certificate of Designations, Preferences and Rights of Series B
Convertible Preferred Stock ("the Certificate of Designations") provides that on
the original issue date of the Series B Convertible Preferred Stock, the holders
of the Series B Convertible Preferred Stock will have the right to nominate two
members of the Board of Directors of the Company. The Series B Convertible
Preferred Stock ranks senior and prior to the Common Stock and to all other
classes or series of stock issued by the Company. Dividends accrue on the
shares of Series B Convertible Preferred Stock at the rate of 8% per annum;
provided, however, that in the event the Company fails to redeem the Series B
Convertible Preferred Stock on or before April 30, 2005, (the "Anniversary
Redemption Date") pursuant to the Certificate of Designations, the dividend rate
on the Series B Convertible Preferred Stock shall increase 2% per annum on each
anniversary of the Anniversary Redemption Date. Annual dividends are cumulative
and are payable quarterly in arrears when and as declared by the Company's Board
of Directors. These shares have a liquidation preference of $1,000 per share.
The Series B Convertible Preferred Stock is convertible immediately into Common
Stock, initially at a conversion price of $2.00 per share, subject to
adjustment. The shares of Series B Convertible Preferred Stock may be redeemed,
at the option of the Company, at $1,000 per share on or after the Anniversary
Redemption Date. Upon a change of control, the Company may offer to redeem such
shares at $2,000 per share or the Company may issue to each holder of Series B
Convertible Preferred Stock warrants exercisable for 250,000 shares of Common
Stock for each 1,000 shares of Series B Convertible Preferred Stock, at an
exercise price of $0.01 per share. The Company also has optional redemption
rights at any time after i) completion of an underwritten public offering by the
Company with gross proceeds to the Company of at least $20,000,000 and a price
per share of Common Stock , initially in excess of $4.00 per share or ii) after
the Company's Common Stock shall have traded at an average price generally in
excess of $4.00 per share for 20 consecutive trading days and the aggregate
market value of the Common Stock held by non-Affiliates of the Company is at
least $35,000,000. The holders of Series B Convertible Preferred Stock are also
entitled to certain preemptive rights, co-sale rights and registration rights.
Subsequent to accepting commitments for the $10,000,000 financing,
the Company was advised that it will be required to decrease the income
(increase the loss) attributable to common shareholders for the quarter ending
September 30, 1998, as a result of the increase in the market price of the
Company's Common Stock from the date the Company entered into agreements with
respect to the financing to the date of issuance of the Series B Convertible
Preferred Stock (July 13, 1998). The reduction in income (increase in loss)
attributable to common shareholders is based upon the difference between the
market price of 5,000,000 shares of Common Stock into which the Series B
Convertible Preferred Stock is convertible and the carrying value of the Series
B Convertible Preferred Stock on the assumed date of conversion, or
approximately $15,000,000. The one-time occurrence would be accounted for
similar to a non-cash dividend and would not affect the Company's net income
(loss) nor aggregate stockholders' equity. In the view of the Company's
accountants, based on the SEC's current position and the recent discussions of
the Financial Accounting Standards Board's Emerging Issues Task Force Topic
D-60 (Accounting for the Issuance of Convertible Preferred Stock and Debt
Securities with a Nondetachable Conversion Feature), the Series B Convertible
Preferred Stock conversion feature should be recognized and measured on July 13,
1998. The underlying conversion rate was provided for when the terms of the
financing were agreed to and at a price above the then current market price of
the Company's Common Stock, i.e., "out-of-the-money". Subsequent to reaching
agreement on the financing transaction, the market price of the Company's Common
Stock increased such that the conversion rate (fixed at the time of the
financing commitment) was "in the money" at the time the securities were issued.
11
<PAGE>
To date, the Company continues to use cash and operate at a loss. The
Company's ability to achieve positive cash flow depends upon a variety of
factors, including the timely introduction and market success of its products,
the costs of developing, producing and marketing such products, adoption of the
Internet as a medium of commerce and communications and various other factors,
some of which may be beyond the Company's control. If the Company requires
additional capital, it would seek such funding through additional public or
private financing, although there can be no assurance that the Company will be
able to obtain such financing(1).
The Company received a letter from Nasdaq setting forth conditions for
continued listing. The Company satisfied all of Nasdaq's conditions. The
Company subsequently received a memo entitled, "Update to Hearings Memorandum
from Nasdaq" regarding certain stock and option issuances to directors and
officers. The Company believes it is in compliance with all of Nasdaq's
requirements and has so indicated in its response to Nasdaq.
12
<PAGE>
RECENTLY ISSUED ACCOUNTING PRINCIPLES
In June 1997, Statement of Financial Accounting Standards No. 131,
Disclosures about Segments of an Enterprise and Related Information ("SFAS No.
131") was issued. This statement establishes standards for reporting
information about operating segments in annual and interim financial statements,
although this statement need not be applied to interim financial statement in
the initial year of its application. This statement is effective for fiscal
years beginning after December 15, 1997. The adoption of SFAS No. 131 is not
expected to have a material impact on the Company's financial statements and
related disclosures.
In April, 1998, Statement of Position (SOP) 98-5, Reporting on the
Costs of Start-up Activities was issued. This SOP provides guidance on the
financial reporting of start-up and organization costs and requires that these
costs be expensed as incurred. The provisions of SOP 98-5 are effective for
financial statements for fiscal years beginning after December 15, 1998,
although early adoption is allowed. Adoption of SOP 98-5 is not expected to
have a material impact on the Company's financial statements. The Company will
adopt the provisions of this SOP on January 1, 1999.
_______________________________________________________________________________
(1) Certain statements contained herein including those indicated by (1)
are forward looking statements that involve risks and uncertainties.
Accordingly, no assurance can be given that the actual events and
results will not be materially different than the anticipated results
described in the forward looking statement. There are a number of
important factors that could cause actual results to differ materially
from those expressed in any forward looking statements made by the
Company. These factors include among others, the Company's ability to
complete new products at planned costs and on planned schedules, the
Company's ability to attract and retain strategic partners, the
Company's ability to leverage intangible assets in its technology, the
success of the Company's cost reduction strategy and the Company's
ability to maintain a sufficient level of financing for its new
business strategy. Additional factors which are beyond the Company's
control and could influence results include market acceptance of the
Company's products and adoption of the Internet as a medium of
commerce and communications. See the discussion of the Company's
business and a description of the various factors that could
materially affect the ability of the Company to achieve the
anticipated results described in the forward looking statement which
is included in Item 1 of the Company's Report on Form 10-K for the
year ended December 31, 1997.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Not applicable
13
<PAGE>
7TH LEVEL, INC.
Part II. Other Information
Item 1. Legal Proceedings
Technology Edutainment Network Laboratory Co., Ltd. v. 7th Level,
Inc., United States District Court for the Central District of
California, Case No. 98-3923 ADH (JGx). On May 19, 1998, plaintiff
Technology Endutainment Network Laboratory Co., Ltd. ("TEN") filed a
suit against the Company for alleged breach of contract and related
claims concerning a contract for development of CD-ROM software,
seeking $246,000 in alleged damages (the "Action"). On June 26, 1998,
the Court partially granted TEN's application for a writ of attachment
in the amount of $144,000. The writ of attachment has not yet been
issued, and the Company intends to file an undertaking with the Court,
or take other steps to secure against the attachment order so that no
property is attached. On June 29, 1998, TEN instituted arbitration
proceedings before the American Arbitration Association ("AAA") on the
same claims it brought in the Action. On July 13, 1998, the Court
issued an order staying the Action pending arbitration of the issues
contained in the Action before the AAA. The Company intends
vigorously to defend itself against TEN's claims in the arbitration
and is considering filing a counterclaim against TEN concerning its
alleged non-performance under the software development contract. The
matter is still in its early stages and no arbitration proceedings
have taken place.
Item 2. Changes in Securities
In April 1998, the Board of Directors approved the grant of
options under a broad based plan to purchase approximately 2,967
shares of Series C Preferred Stock, ("Series C Preferred Stock") or
upon the filing of a Certificate of Amendment (the "Amendment")
increasing the Company's authorized Common Stock, which occurred on
July 10, 1998, approximately 2,967,000 shares of Common Stock to
Directors, management, employees and consultants.
In May 1998, the Board of Directors approved the potential grant
of an option to purchase 350 shares of Series C Preferred Stock or,
upon the filing of the Amendment, which occurred on July 10, 1998,
350,000 shares of Common Stock to the new Chief Executive Officer
conditioned upon a successful secondary offering and the attainment of
a $15 per share stock price average for 60 days by the Company.
In May 1998, the Board of Directors approved the grant of a
warrant to purchase 200 shares of Series C Preferred Stock or, upon
the filing of the Amendment, which occurred on July 10, 1998, 200,000
shares of Common Stock to East West Capital Associates, Inc. in
connection with a consulting agreement, of which 50 shares of Series C
Preferred Stock will be issued at $2.00 per one one-thousandth of a
share, 50 shares at $3.00 per one one-thousandth of a share, 50 shares
at $4.00 per one one-thousandth of a share and 50 shares at $5.00 per
one one-thousandth of a share, or 50,000 shares of Common Stock will
be issued at $2.00 per share, 50,000 shares at $3.00 per share, 50,000
shares at $4.00 per share and 50,000 shares at $5.00 per share.
14
<PAGE>
In May 1998, the Board of Directors approved the grant of a
warrant to purchase 800 shares of Series C Preferred Stock or, upon
the filing of the Amendment, which occurred on July 10, 1998, 800,000
shares of Common Stock to Donaldson, Lufkin and Jenrette Securities
Corporation in connection with an engagement letter executed in
November 1997, with respect to the Company's private placement of debt
or equity securities, of which 200 shares of Series C Preferred Stock
will be issued at $2.00 per one one-thousandth of a share, 200 shares
at $3.00 per one one-thousandth of a share, 200 shares at $4.00 per
one one-thousandth of a share and 200 shares at $5.00 per one one-
thousandth of a share, or 200,000 shares of Common Stock will be
issued at $2.00 per share, 200,000 shares at $3.00 per share, 200,000
shares at $4.00 per share and 200,000 shares at $5.00 per share.
In April, 1998, as part of the broad based plan, the Board of
Directors granted 655,000 and 110,000 shares of Common Stock to Donald
Schupak and Robert Ezrin, respectively, in exchange for the payment of
$0.01 per share and the surrender of options issued to Messrs. Schupak
and Ezrin to purchase 655,000 and 60,000 shares of Common Stock,
respectively. In addition, Messrs. Schupak and Ezrin waived cash
bonuses which they were entitled to upon completion of the Company's
$10,000,000 financing.
The information concerning the Notes, the Series A Preferred
Stock, the Series B Convertible Preferred Stock and the warrants
issued with respect to the Notes and the Series A Preferred Stock set
forth in Part 1, Item 2, "Management's Discussion and Analysis of
Financial Condition and Results of Operations" in the second and third
paragraphs under "Liquidity and Capital Resources" on pages ten and
eleven of this Report is incorporated herein by reference.
The Company believes the sale of the Notes and the warrants
issued in connection therewith qualifies as a transaction by an issuer
not involving a public offering within the meaning of Section 4(2) of
the Securities Act of 1933, as amended (the "Securities Act"), based
on the manner of offering (a negotiated sale to two "accredited
investors" (as defined in Rule 501 of Regulation D under the
Securities Act) without general solicitation) and the purchasers'
financial status, investment experience and investment intent, as
represented to the Company.
The Company believes the sale of the Series A Preferred Stock and
the warrants issued in connection therewith qualifies as a transaction
by an issuer not involving a public offering within the meaning of
Section 4(2) of the Securities Act based on the manner of offering (a
negotiated sale to "accredited investors" (as defined in Rule 501 of
Regulation D under the Securities Act) and to two non-accredited
investors without general solicitation) and the purchasers' financial
status, investment experience and investment intent, as represented to
the Company.
15
<PAGE>
Item 4. Submission of Matters to a Vote of Security Holders
The Company's Annual Meeting of Stockholders was held on July 9, 1998.
The results of the voting were as follows:
Proposal 1: Election of Directors of the Company
<TABLE>
<CAPTION>
Votes Votes Votes
----- ----- -----
Nominee For Against Abstaining
------- --- ------- ----------
<S> <C> <C> <C>
Donald Schupak 16,388,144 7,855 129,878
Robert Alan Ezrin 16,380,052 16,214 129,878
Merv Adelson 16,383,416 12,850 129,878
James A. Cannavino 16,389,116 7,150 129,878
Richard S. Merrick 16,389,666 6,600 129,878
</TABLE>
Proposal 2: Approval of an amendment to the Restated Certificate of
Incorporation of the Corporation (the "Certificate of Incorporation")
to increase the number of authorized shares of Common Stock from
20,000,000 to 100,000,000.
Votes For: 15,986,641
Votes Against: 469,448
Votes Abstaining: 70,055
Proposal 3: Approval of an amendment to the Certificate of
Incorporation to amend the terms of the Corporation's blank check
preferred stock to provide that the Board of Directors of the
Corporation may designate shares of preferred stock with voting rights
other than one vote per share.
Votes For: 9,402,803
Votes Against: 474,057
Votes Abstaining: 184,098
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
10.43 - Employment Agreement, dated as of April 20, 1998 by and
between the Company and Richard S. Merrick
27 - Financial data schedule
(b) Reports on Form 8-K
Registrant filed a Current Report on Form 8-K, dated July 9,
1998, in respect to the proposals approved at the annual stock holder
meeting, the filing of the Certificate of Amendment, the automatic
conversion of Series A Preferred Stock to Series B Convertible
Preferred Stock and the exchange of the Notes for Series B Convertible
Preferred Stock. (Item 5).
Registrant filed a Current Report on Form 8-K, dated April 23,
1998, in respect to the press release of registrant dated April 22,
1998 announcing 7th Level & Pulse Cancel Merger Plans; 7th Level
Announces Commitments and Terms for $4.5 Million Bridge Loan and $10
Million Private Placement. (Item 5.)
16
<PAGE>
7TH LEVEL, INC.
Signature
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
7/TH/ LEVEL, INC.
Date: August 12, 1998 By: /s/ DONALD SCHUPAK
----------------------------------
Donald Schupak
Chairman of the Board and Director
(Principal Financial Officer)
17
<PAGE>
EXHIBIT 10.43
EMPLOYMENT AGREEMENT
EMPLOYMENT AGREEMENT dated as of April 20, 1998 (this "Agreement"), by and
between 7TH LEVEL, INC., a Delaware corporation (the "Company"), and RICHARD S.
MERRICK ("Executive").
RECITALS
--------
WHEREAS, the Company desires to employ Executive as Chief Executive Officer
of the Company on the terms and conditions hereinafter set forth and Executive
desires to accept such employment.
NOW, THEREFORE, in consideration of the premises and mutual covenants
contained herein, and for other good and valuable consideration, the receipt and
adequacy of which is hereby acknowledged, the parties agree as follows:
1. Employment.
1.1 Subject to the terms and conditions of this Agreement, the
Company agrees to employ Executive during the Term (as herein defined).
Executive shall be employed as Chief Executive Officer of the Company and as
such shall report to the Chairman of the Board of Directors of the Company and
the Board of Directors of the Company. As Chief Executive Officer of the
Company, Executive shall perform such duties and responsibilities as are
customarily performed by the chief executive officer of a company the size and
nature of the Company, and such other managerial duties and responsibilities
with the Company which are appropriate for his position at the Company as, from
time to time, may be assigned to him by the Chairman of the Board of Directors
of the Company or the Board of Directors of the Company.
1.2 Subject to the terms and conditions of this Agreement, Executive
hereby accepts employment hereunder and agrees to devote his full working time
and efforts to the performance of services, duties and responsibilities in
connection therewith. Nothing in this Agreement shall preclude Executive, so
long as, such activities are not prohibited under Section 9.2 hereof and, in the
reasonable determination of the Board of Directors of the Company (the "Board"),
such activities do not materially interfere with his duties and responsibilities
hereunder, from engaging in charitable and community affairs or from managing
any passive investment made by him in real estate or other property (provided
that no such investment may exceed 2% of the equity securities of any entity,
without the prior approval of the Board).
1.3 So long as the Executive shall serve as Chief Executive Officer
of the Company, the Company shall cause Executive to be nominated for election
to the Board of Directors of the Company.
<PAGE>
2. Term of Employment. The term of this Agreement shall commence as of
the date of execution hereof and continue for a period of two (2) years (the
"Term"); subject to earlier termination in accordance with the terms and
conditions contained in Section 6 hereof. The Term shall be extended
automatically for successive one year periods unless terminated by written
notice not less than ninety (90) days prior to the end of the Term or any
successive one year extension by either of the parties hereto.
3. Place of Employment. During the Term, Executive shall perform his
services primarily at the principal place of business of the Company which is
presently located in 1110 East Collins Boulevard, Suite 122, Richardson, Texas
75081. Executive acknowledges and agrees that in connection with his employment,
he may be required to travel on behalf of the Company.
4. Compensation.
4.1 Salary. The Company shall pay Executive a base salary ("Base
Salary") at the rate of One Hundred Sixty Thousand Dollars ($160,000); provided,
however, that the Base Salary shall be increased to Two Hundred Twenty Five
Thousand Dollars ($225,000) commencing on the first anniversary of the beginning
of the Term. The Base Salary shall be payable in accordance with the ordinary
payroll practices of the Company for its executive officers but in no event less
frequently than semi-monthly. The Base Salary shall be reviewed annually by the
Board of Directors and subsequent to the initial Term hereunder may be adjusted
by the Board of Directors in its sole discretion, but may not be less than the
Base Salary in effect at that time. As used in this Agreement, the term "Base
Salary" shall include Executive's base salary as it may be adjusted from time to
time.
4.2 Bonus. Executive shall be eligible to participate in any Company
wide bonus plan (or other such cash incentive plan) that may be adopted by the
Company from time to time. It is acknowledged by the parties that no such plan
currently exists at the Company but that Executive shall participate in any
bonus plan that is adopted in the future.
4.3 Stock Options. As an inducement to Executive to enter into this
Agreement, the Company has on April 20, 1998 (the "Grant Date") granted to
Executive options (the "Options") to purchase 700,000 shares of common stock,
par value $.01 per share, of the Company ("Common Stock") (or to the extent
there is not enough authorized Common Stock available, shares of Preferred Stock
approved by the Board of Directors of the Company) exercisable at a price equal
to $2.00 per share of Common Stock. Pursuant to the terms of the grant, vesting
of such Options shall occur as follows, provided the Executive is still then
employed by the Company:
100,000 Options shall vest immediately;
200,000 Options shall vest on the first anniversary of the
Grant Date;
200,000 Options shall vest on the second anniversary of the
Grant Date;
200,000 Options shall vest on the third anniversary of the
Grant Date.
2
<PAGE>
The Company shall deliver a written and duly executed option
agreement consistent with the foregoing terms as promptly as practicable
following the execution of this Agreement.
The Company shall, as soon as practicable, register the Common
Stock underlying all such Options under the Securities Act of 1933, as amended
on a Registration Statement on Form S-8. Vested Options shall be exercisable by
Executive as long as he is employed by the Company and for ninety (90) days
after termination of employment and shall terminate on the tenth anniversary of
the Grant Date; provided, however, that Executive agrees not to exercise any
Options until the earlier of (a) six months from the date hereof and (b) the
effective filing with the Secretary of State of the State of Delaware of an
amendment to the Company's Certificate of Incorporation which authorizes a
sufficient number of shares of Common Stock.
In the event the Company completes a secondary stock offering
through a nationally recognized investment bank and thereafter the closing price
of the Common Stock averages fifteen ($15.00) per share for any sixty (60) day
period, Options relating to all 700,000 shares shall immediately vest and, in
addition, Executive shall be granted options to purchase an additional 350,000
shares of Common Stock on the last day of such sixty (60) day period. Such
additional options shall have an exercise price equal to the fair market value
of the Common Stock on the date of grant and shall vest in equal installments
over the three (3) years following the grant.
5. Employee Benefits.
5.1 Employee Benefit Programs, Plans and Practices. The Company
shall provide Executive, during the Term, with coverage under all employee
benefit programs, plans and practices which the Company makes available from
time to time to its senior executives, with at least the same opportunity to
participate as the other senior executives of the Company.
5.2 Expenses. Executive is authorized to incur reasonable expenses
in carrying out his duties and responsibilities under this Agreement, (in
accordance with the policies and procedures established from time to time by the
Company for its senior executive officers) including, without limitation,
reasonable entertainment and travel expenses. The Company will promptly
reimburse Executive in full for all such out-of-pocket expenses upon
presentation by Executive from time to time of a proper account of such
expenditures in accordance with the policies and procedures established by the
Board and applicable to executive officers of the Company.
5.3 Indemnification. Executive shall be entitled, at all times, to
the benefit of the maximum indemnification and advancement of expenses available
from time to time under the Company's Articles of Incorporation and By-laws,
and, if not set forth therein, to the maximum extent available under the laws of
the Company's state of incorporation.
3
<PAGE>
6. Termination of Employment.
6.1 Good Reason. Executive shall be entitled to terminate his
employment for "Good Reason." For purposes of this Agreement, "Good Reason"
shall mean (without Executive's express prior written consent as a shareholder,
director or otherwise) (i) failure by the Company to pay any compensation when
due hereunder or (ii) a material reduction by the Company of Executive's duties
in managing the Company's business or the assignment of duties to Executive by
the Board of Directors of the Company inconsistent with Executive's position
(except in connection with termination of Executive's employment for Cause, as a
result of Disability, as a result of Executive's death or by Executive other
than for Good Reason). If Executive desires to terminate his employment with the
Company, he shall first give written notice of the facts and circumstances
providing Good Reason to the Company, and shall allow the Company no less than
ten (10) days to remedy, cure or rectify the situation giving rise to Good
Reason.
6.2 Disability. If Executive shall fail during the Term, because of
illness, physical or mental disability or other incapacity, for a period of 90
days in any 365 consecutive days, to render the services provided for by this
Agreement or be adjudged an incompetent ("Disability") (provided that the date
on which the Disability will be deemed to occur shall be such 90th day or the
date on which Executive is adjudged an incompetent, as the case may be), the
Company may terminate Executive's employment on not less than two (2) weeks
written notice thereof, setting forth the facts and circumstances claimed to
provide a basis for termination of Executive's employment under this Section
6.2.
6.3 Death. Executive's employment hereunder will terminate
automatically if he should die.
6.4 Other Termination. The Company shall have the right to terminate
the employment of Executive with or without Cause (as hereinafter defined). The
term "Cause," as used herein, shall mean (i) Executive's willful refusal and
failure to perform his duties hereunder or under any lawful directive of the
Board of Directors of the Company, (ii) Executive's willful misconduct or gross
neglect in the performance of his duties hereunder, (iii) the material breach of
this Agreement by Executive, (iv) the indictment, conviction, plea of guilty or
nolo contendere of Executive in respect of any felony or for any misdemeanor
constituting theft or embezzlement from the Company, (v) other fraudulent action
against the Company, (vi) an act of personal dishonesty by Executive, (vii)
breach of fiduciary duty by Executive or (viii) the willful violation of any
law, rule or regulation (other than traffic violations or similar offenses) or
any cease and desist order. Termination by the Company for Cause may be effected
by written notice of the Company to Executive; provided, however, that if the
Company determines to terminate the Executive's employment pursuant to clause
(i), (ii) or (iii) hereof, the Company shall give the Executive written notice
of the facts and circumstances providing Cause and shall allow Executive no less
than ten (10) days in the case of a proposed termination pursuant to clause (i),
(ii) or (iii) above to remedy, cure or rectify the situation giving rise to
Cause; provided, however, that the Company shall not be required to give more
than one such notice pursuant to this Section 6.4.
4
<PAGE>
7. Change of Control.
7.1 Effect of Change of Control. In the event of a Change of
Control, Executive shall become immediately and fully vested in all Options held
by Executive. For purposes of this Agreement, a "Change of Control" shall mean
that (i) any "person" (as such term is defined within the meaning of Rule
13(d)(3) of the Securities Exchange Act of 1934, as amended (the "1934 Act")),
other than any person who as of the date hereof beneficially owns (as defined in
Rule 13(d)(3) of the 1934 Act) directly or indirectly 5% or more of the
Company's outstanding Common Stock or as of the date hereof is on, or has
designated a member of, the Board of Directors of the Company, or is a purchaser
in the Bridge Financing or the permanent financing contemplated as of the date
hereof, becomes a beneficial owner directly or indirectly of securities of the
Company representing in excess of fifty percent (50%) of the Company's then
outstanding securities having the right to vote for the election of directors or
(ii) the Company shall have consummated the sale of all or substantially all of
the assets of the Company.
8. Compensation Upon Termination.
8.1 Termination for Good Reason; Termination by Company Without
Cause. (i) If Executive terminates his employment pursuant to Section 6.1, or
(ii) if Executive's employment is terminated by the Company without Cause, or
(iii) if the Company, pursuant to Section 2 hereof, delivers written notice of
its determination not to extend the Term of this Agreement for any successive
one year period, Executive shall be entitled to (1) receive, in a lump sum, the
greater of (A) an amount equal to one year's Base Salary or (B) an amount equal
to the Base Salary for the remainder of the Term and (2) Options whose vesting
was to occur in the then current one year vesting period shall be accelerated
pro rata for the period up to the termination of executive's employment (for
example, if Executive's employment should terminate as described in this Section
8.1 eighteen months from the Grant Date, Executive would be vested in an
aggregate of 400,000 Options). Such payment shall be made within five (5) days
of the termination of employment hereunder.
8.2 Termination by Executive other than for Good Reason; Termination
by Company for Cause. If Executive's employment is terminated by the Company for
Cause or by Executive other than pursuant to Section 7.1, Executive shall be
entitled to receive only Executive's Base Salary and benefits as set forth in
Section 4 to which Executive is entitled up to and including the effective date
of Executive's termination of employment hereunder. After such termination of
employment, the obligations of the Company under this Agreement to make any
further payments or to provide any benefits provided for herein, to Executive
shall cease and terminate.
5
<PAGE>
9. Nondisclosure; Non-Competition.
9.1 Nondisclosure.
(a) Executive acknowledges and agrees that, during his
employment by the Company hereunder, he will come to have confidential knowledge
and information with respect to the Company, its affiliates and its or their
Customers (as defined below). Executive agrees that he will not at any time
divulge, furnish or make accessible to anyone (other than in the regular course
of his performance of services for the benefit of the Company, its successors or
assigns) any such confidential knowledge or information of the Company, its
successors or assigns or any of its affiliates or Customers. Notwithstanding the
foregoing, confidential information described in the preceding sentences shall
not include any information which (i) is or becomes known generally to the
public (other than as a result of unauthorized disclosure by Executive), (ii)
was available to Executive on a non-confidential basis prior to its disclosure
to Executive by the Company or its Customers or (iii) is required to be
disclosed pursuant to the valid order of a governmental agency or a judicial
court of competent jurisdiction, in which case Executive shall give prompt
written notice to the Company of such requirement so that the Company may take
such action as it deems appropriate.
(b) Executive agrees that any and all information including, but
not limited to, confidential information as described above, which is disclosed
to Executive or known or developed by Executive as a consequence of or through
this Agreement (all of the foregoing being hereinafter called "Proprietary
Property") that is created, developed or discovered by and/or for the Company or
its Customers (including Proprietary Property created, developed or discovered
by Executive in the course of the performance by Executive of his services
hereunder), or is acquired by the Company from others, including, but not
limited to, Customers, and that comes into Executive's knowledge or possession
during and in the course of this Agreement, shall be received by Executive as an
agent of the Company and not in any way for his own benefit, and that Executive
shall have no rights, and shall acquire no rights, therein unless and until the
Company or its Customers shall expressly and in writing waive the rights that
they have therein and thereto. Executive further agrees (a) that any and all
Proprietary Property that is created, written, developed, furnished or produced
by Executive or suggested by Executive to the Company, during the term of this
Agreement in any capacity, shall be the exclusive property of the Company, and
that Executive shall have no right, title or interest, of any kind therein or
thereto or in and to any results or proceeds therefrom, and (b) that at any
time, whether during or after the term of this Agreement, Executive will (1)
upon the request and at the expense of the Company (i) obtain patents or
copyrights on, or (ii) permit the Company or its Customers to patent or
copyright, any such material, whichever of (i) or (ii) is appropriate, and/or
(2) at the request of the Company, execute any and all assignments, instruments
of transfer, or other documents, that the Company deems necessary or appropriate
to transfer to the Company or its Customers all rights in or to such material or
to evidence the Company's or its Customers' ownership of such rights; provided,
however, that Proprietary Property shall not include intellectual property
developed by Executive which is not related to the Business (as defined below);
provided, further, Executive shall not apply for patents or copyrights of any
such
6
<PAGE>
intellectual property during the term hereof. The Company or its Customers, as
applicable, shall compensate Executive for all expenses in connection with
developing Proprietary Property and will compensate Executive for services,
outside of the normal course of the time commitment of Executive hereunder, in
connection with developing Proprietary Property. Executive shall not, without
limitation as to time or place, use any Proprietary Property except with respect
to the Company's businesses, during or after the term of this Agreement, nor
disclose the same to any other person, firm or company, except for disclosure
with respect to the Company's businesses.
9.2 Non-Compete and Non-Solicitation.
(a) Prohibition on Competition. Executive agrees that during the
term of Executive's employment by the Company and for the greater of either (i)
twelve (12) months thereafter or (ii) the period which is equivalent to the time
period for which the amount of the Base Salary provided by the Company to the
Executive hereunder as severance equals (the "Non-Competition Period"),
Executive will not: directly or indirectly, either alone or with others, as
principal, manager, agent, consultant, officer, director, partner, investor,
lender, lessor, sublessor, guarantor or employee, or in any other capacity,
carry on, be engaged in, be employed by, or have any interest or otherwise be
connected or affiliated or associated with any corporation, partnership, limited
liability company or partnership, proprietorship, firm, association or other
entity which is engaged in any manner in, or otherwise competes with, the
Business. For purposes hereof, "Business" shall mean animation preparation and
production software as presently conducted or proposed to be conducted and any
other business actually engaged in during the term hereof, directly or
indirectly, by the Company or its subsidiaries.
(b) Non-Solicitation of Employees. During the Non-competition
Period, Executive will not:
(i) solicit or request any employee of or consultant to the
Company or its affiliates to (i) leave the employ or cease consulting
for the Company or its affiliates or (ii) join the employ of or begin
consulting for any individual or entity that competes with the
Business;
(ii) solicit or request any individual or entity that competes
with the Business to employ any employee of or consultant to the
Company or its affiliates; or
(iii) employ, assist in employing or otherwise associate with any
employee, officer or agent of or consultant to the Company or its
affiliates in any business or venture which may compete with the
Business.
7
<PAGE>
(c) Non-Solicitation of Customers. During the Non-competition
Period, Executive will not, directly or indirectly, through brokers or
otherwise, solicit or attempt to solicit, or sell services or attempt to sell
services relating to the Business of the Company to, any Customer; for purposes
hereof, "Customer" shall mean (A) all customers of the Company (i) during the
term of this Agreement, (ii) as of the date hereof and (iii) within the two (2)
year period preceding the date hereof and (B) all potential customers of the
Company who are being actively solicited by the Company at the time of the
termination of Executive's employment.
9.3 Acknowledgment of Reasonableness of Terms; Specific Performance.
Executive and the Company agree that the covenants of non-competition and non-
solicitation are reasonable covenants under the circumstances, and further agree
that if, in the opinion of any court of competent jurisdiction such covenants
are not reasonable in any respect, such court shall have the right, power and
authority to excise or modify such provision or provisions of these covenants as
to the court shall appear not reasonable and to enforce the remainder of these
covenants as so amended. Executive agrees that any breach of the covenants
contained herein would irreparably injure the Company. Accordingly, Executive
hereby agrees that, in such event, the Company shall be entitled, without the
necessity of proving damages or posting bond, and notwithstanding any election
by the Company to claim damages, to obtain a temporary and/or permanent
injunction to restrain any such breach or threatened breach or to obtain
specific performance of any such provisions, all without prejudice to any and
all other remedies which the Company may have at law or in equity.
10. Mitigation of Damages. Executive shall not be required to
mitigate the amount of any payment provided for under this Agreement by seeking
other employment or otherwise, and, after his termination of employment
hereunder, any payments made by the Company hereunder shall not be reduced by
any amount Executive receives from any other such employment.
11. Notices. Any notice, request, demand or other communication
required or permitted hereunder shall be in writing and shall be deemed to have
been duly given when delivered by hand, electronic transmission (with a copy
following by hand or by overnight courier), by registered or certified mail,
postage prepaid, return receipt requested or by overnight courier addressed to
the other party. All notices shall be addressed as follows, or to such other
address or addresses as may be substituted by notice in writing:
To the Company:
7th Level, Inc.
1110 East Collins Boulevard
Suite 122
Richardson, TX 75081
Attention: Chairman of the Board
Fax No.: (972) 437-2717
8
<PAGE>
with a copy to:
Shereff, Friedman, Hoffman & Goodman, LLP
919 Third Avenue
New York, NY 10022
Attention: Martin Nussbaum, Esq.
Fax No.: (212) 758-9526
To Executive:
Richard S. Merrick
370 Oakwood Trail
McKinney, TX 75069
with a copy to:
Scott Carpenter
777 E. 15th, Suite 203
Plano, TX 75074
Communications delivered by hand or by overnight courier shall be deemed
received on the date of delivery; communications sent by electronic means shall
be deemed received one (1) business day after the sending thereof, and
communications sent by registered or certified mail shall be deemed received
three (3) business days after the sending thereof.
12. Severability; Legal Fees. If any provision of this Agreement shall be
declared to be invalid or unenforceable, in whole or in part, such invalidity or
unenforceability shall not affect the remaining provisions hereof which shall
remain in full force and effect. Each party shall bear the costs of any legal
fees and other fees and expenses which may be incurred in respect of enforcing
its respective rights under this Agreement.
13. Assignment. This contract shall be binding upon and inure to the
benefit of the heirs and representatives of Executive and the assigns and
successors of the Company. Neither this Agreement nor any rights hereunder shall
be assignable or otherwise subject to hypothecation by Executive (except by will
or by operation of the laws of intestate succession) or by the Company, except
that the Company may assign this Agreement to any successor (whether by merger,
acquisition of stock, purchase or otherwise) to all or substantially all of the
assets or business of the Company, if such successor expressly agrees in writing
to assume the obligations of the Company hereunder.
9
<PAGE>
14. Amendment; Waiver. This Agreement may only be amended by written
agreement signed by the parties hereto. A waiver by the Company or Executive of
a breach of any provision of this Agreement by the other party shall not operate
or be construed as a waiver of any subsequent breach by the other party.
15. Survivorship. The respective rights and obligations of the parties
hereunder shall survive any termination of this Agreement to the extent
necessary to the intended preservation of such rights and obligations. The
provisions of this Section 15 are in addition to the survivorship provisions of
any other section of this Agreement.
16. Governing Law. This Agreement shall be construed, interpreted and
governed in accordance with the laws of the State of Delaware, without reference
to rules relating to conflicts of law.
17. Entire Agreement. This Agreement and the Stock Option Agreement dated
as of April 20, 1998, by and between the Company and the Executive contain the
entire understanding among Executive and the Company and supersede in all
respects any prior or other agreement or understanding between the Company and
Executive as to the matters set forth herein and therein. Except for the
obligations specifically set forth herein and therein, the Company does not owe
any obligations to Executive and Executive does not owe any obligations to the
Company with respect to the matters set forth herein.
18. Arbitration. Any dispute arising under, out of, in connection with, or
in relation to this Agreement, or any claimed breach hereof, shall be determined
and settled by arbitration in Dallas County under the auspices of and pursuant
to the rules then obtaining of the American Arbitration Association; provided,
however, that any such dispute shall be determined by a panel of three (3)
arbitrators selected in accordance with this Section 18. Each of the Company and
Executive shall select one member of the panel and such two members shall select
the third member of the panel. Any award rendered upon any such arbitration
shall be final and conclusive and a judgment thereon may be entered in any court
of competent jurisdiction.
19. Withholding. The Company shall withhold from any payments due to
Executive hereunder, all taxes, FICA or other amounts required to be withheld
pursuant to any applicable law.
20. Headings. The section headings contained in this Agreement are for the
convenience of reference only and shall not affect the construction of any
provision of this Agreement.
21. Counterparts. This Agreement may be executed in two or more
counterparts, each of which will be deemed an original but all of which together
shall constitute one and the same instrument.
10
<PAGE>
IN WITNESS WHEREOF, the parties hereto have caused this Agreement to be
signed as of the date and year first above written.
7TH LEVEL, INC.
June 8, 1998 By: /s/ Donald Schupak
------------------------------------------
Name: Donald Schupak
Title: Chairman of the Board
/s/ Richard S. Merrick
---------------------------------------------
Richard S. Merrick
11
<PAGE>
ACKNOWLEDGEMENT OF SURRENDER
----------------------------
In consideration of the payment by 7th Level, Inc. (the "Company") of
$1.00 and for other good and valuable consideration, the receipt and adequacy of
which are hereby acknowledged, the undersigned hereby surrenders the right to
receive options to purchase 42,500 shares of Common Stock (the "Surrendered
Options") which were granted to the undersigned by the Board of Directors of the
Company on August 8, 1997. The undersigned acknowledges that the Company and the
undersigned did not execute an option agreement regarding the Surrendered
Options and the Company shall have no obligation, liability or any other duty in
connection with the Surrendered Options.
Dated: As of April 20, 1998
/s/ RICHARD S. MERRICK
--------------------------------
Richard S. Merrick
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<S> <C> <C>
<PERIOD-TYPE> 6-MOS 6-MOS
<FISCAL-YEAR-END> DEC-31-1998 DEC-31-1997
<PERIOD-START> JAN-01-1998 JAN-01-1997
<PERIOD-END> JUN-30-1998 JUN-30-1997
<CASH> 9,052,907 2,465,079
<SECURITIES> 0 0
<RECEIVABLES> 90,703 1,112,026
<ALLOWANCES> 0 0
<INVENTORY> 0 18,477
<CURRENT-ASSETS> 9,743,045 4,348,429
<PP&E> 3,745,699 4,960,560
<DEPRECIATION> 0 0
<TOTAL-ASSETS> 13,814,836 9,854,726
<CURRENT-LIABILITIES> 5,566,204 6,543,924
<BONDS> 0 0
0 0
2,479,138 0
<COMMON> 168,156 137,837
<OTHER-SE> 1,078,638 2,321,618
<TOTAL-LIABILITY-AND-EQUITY> 13,814,836 9,854,726
<SALES> 534,141 5,161,572
<TOTAL-REVENUES> 0 0
<CGS> 123,343 3,703,148
<TOTAL-COSTS> 6,539,870 15,339,621
<OTHER-EXPENSES> 0 0
<LOSS-PROVISION> 0 0
<INTEREST-EXPENSE> 1,423,027 (280,793)
<INCOME-PRETAX> 0 0
<INCOME-TAX> 0 0
<INCOME-CONTINUING> 0 0
<DISCONTINUED> 0 0
<EXTRAORDINARY> 0 0
<CHANGES> 0 0
<NET-INCOME> (7,552,099) (13,600,404)
<EPS-PRIMARY> (.52) (1.00)
<EPS-DILUTED> (.52) (1.00)
</TABLE>
