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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K/A
(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, 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 of incorporation) (I.R.S. Employer Identification No.)
925 WESTCHESTER AVENUE
WHITE PLAINS, NEW YORK 10604
(Address of principal executive offices) (Zip Code)
REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (914) 682-4300
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
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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
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The approximate aggregate market value of the common stock held by
non-affiliates of the registrant as of March 15, 1999 was approximately
$180,635,373 or $6.875 per share. As of March 15, 1999, there were 30,639,435
outstanding shares of the registrant's common stock.
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Table of Contents
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PART I
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Item 1. Business 3
Item 2. Properties 14
Item 3. Legal Proceedings 14
Item 4. Submission of Matters to a Vote of Security Holders 14
PART II
Item 5. Market for Registrant's Common Equity and Related
Stockholder Matters 15
Item 6. Selected Financial Data 16
Item 7. Management's Discussion and Analysis of Financial
Condition and Results of Operations 17
Item 8. Financial Statements and Supplementary Data 23
Item 9. Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure 42
PART III
Item 10. Directors and Executive Officers of the Registrant 45
Item 11. Executive Compensation 47
Item 12. Security Ownership of Certain Beneficial Owners and
Management 53
Item 13. Certain Relationships and Related Transactions 56
PART IV
Item 14. Exhibits, Financial Statement Schedules, and
Reports on Form 8-K 58
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PART I
ITEM 1. BUSINESS
General
7th Level, Inc. was founded in 1993 with the goal of becoming a leading
developer and publisher of interactive entertainment and educational products as
well as a creator of state of the art tools and technologies. In 1998, our
research and development activities were focused primarily on developing and
enhancing our Agent7(TM) technology. Agent7 is a technology that evolved from
our existing technology assets and enables animated characters to automatically
speak and gesture based on speaker-independent voice recognition and
text-to-speech synthesis. Agent7 characters can deliver virtually any kind of
information and provide interactivity to assist and instruct the average
Internet user.
We recognized that a large market for this technology would likely develop for
learning, education and enhanced communications. To establish a business plan
that could serve both as a revenue source and a showcase of our technology, we
searched for a viable and complementary partner with the appropriate technology
and content assets, distribution channel and management expertise.
Street Technologies, Inc. Acquisition
In February 1999, we acquired all of the outstanding stock of Street
Technologies, Inc., a privately held company, and began doing business as
7thStreet.com, Inc. We began marketing and developing training solutions
delivered over intranets and the Internet.
Street was founded in 1995 with the mission of providing engaging, interactive,
training and learning content delivered over computer networks including the
Internet. To accomplish this mission, Street acquired StreamMaker(TM), a
streaming technology, and hired its inventors. Streaming technology enables the
transmission and playback of continuous "streams" of multimedia content, such as
audio, video, graphics and animation without download. Street became an
aggregator of multimedia tutorials and training courses on a variety of
subjects. Street marketed and distributed these multimedia tutorials over the
Internet and corporate intranets through Street's internally developed
electronic commerce and administration systems.
In conjunction with our acquisition of Street, we appointed Stephen P. Gott,
Street's founder, Chairman of the Board, President and Chief Executive Officer,
as our President and Chief Executive Officer. Mr. Gott, a former Chief
Technology and Operations Officer at Lehman Brothers, was also appointed to our
Board of Directors. In addition, Richard S. Merrick, our Chief Executive
Officer, Curt W. Marvis our President, and Timothy J. Cahill, our Chief
Operating Officer, resigned from their respective positions. Mr. Merrick, who
still is a member of our Board of Directors, is currently facilitating the
transition of our operations to our new headquarters in White Plains, New York.
Marc E. Landy was appointed our Chief Financial Officer, which was the same
position he held with Street.
Business Strategy and Strategic Direction
Our goal is to become the world's leading provider of Internet and network
delivered learning, education and enhanced communications. Our mission is to
provide our customers, including consumers, corporations, government agencies
and educational organizations, with a complete solution for learning, education
and enhanced communications. To accomplish our goal, we have initiated the
following:
o Content Acquisition - We license or purchase effective and engaging content
by building and maintaining relationships with a variety of high quality
publishers and content providers covering a wide range of subjects.
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o Content Integration - We integrate our technologies with the content to
provide our customers and users with enhanced content. We refer to this
enhanced content as "7thStreet Enabled(TM)".
o Marketing and Distribution - Our marketing efforts consist of direct sales
through our own sales force, indirect sales through our authorized
resellers and e-commerce sales on the Internet. We distribute 7thStreet
Enabled content over computer networks and the Internet to provide easy
access to our customers.
o Research and Development - We are integrating Agent7 with StreamMaker to
enhance the sophistication of our products and services. When integrated
with our tutorials, Agent7 characters can synchronously speak the voiceover
dialog and gesture to specific items on the screen. We believe this will
result in increased user comprehension and retention of information. We are
constantly adding new features and functions to our technologies.
Name Change
Our Board of Directors has approved the change of the name of our Company from
7th Level, Inc. to 7thStreet.com, Inc. Our name change will be effective if
approved by our stockholders.
Marketplace
For many years, organizations have fulfilled their requirements for education
and training primarily through instructor-led training, computer based training
and CD-ROM multimedia training. Each of these models has limitations.
Instructor-led training typically requires employees to attend classes at
off-site locations. Computer based training generally consists of text and
graphics that are downloaded over computer networks to a user's PC or accessed
through client server applications. Computer based training is limiting because
there is no audio and the entire training program must be downloaded before a
user can begin. In addition, there are significant costs from computer network
congestion and a high degree of internal technical support. CD-ROM's are
limiting because of the difficulty and expense in locating, managing and storing
the wide array of content on the CD-ROMs.
Our products and services overcome these limitations by streaming, rather than
downloading, the tutorials. Our content is enriched with graphics, audio and
animation. The highly compressed streams that contain the tutorials alleviate
computer network congestion. Our solutions include instant delivery over
computer networks, including the Internet, interactive multimedia tutorials,
individual assessment, a comprehensive administrative system and an intelligent
agent icon for communications. The outsourced hosting service we provide to our
customers is fundamental to our solutions. Our customers and we benefit from
this service because it greatly minimizes the technical support ordinarily
required for the delivery and internal maintenance of client server and other
web based applications installed on a customer's computer network. In addition,
we are enhancing our solutions with an Agent7 based guide that offers immediate
answers to user questions.
We have created or licensed over 200 tutorial titles. The subject matter of the
tutorials includes the following:
o Desktop applications including Windows 98 and Microsoft Office 97;
o Courses to prepare for Microsoft Certification;
o Programming courses including Visual Basic and HTML; and
o Business skills including time management and interviewing skills.
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Products and Services
CONSUMER - TUTORIALS.COM
We market interactive multimedia tutorials to consumers on the Internet through
our TUTORIALS.COM web site. Users of TUTORIALS.COM can choose from a variety of
titles covering a wide range of subjects including desktop application software,
computer programming and English as a second language. This online library is
targeted to both the mass consumer audience who frequently use the Internet as
well as the large and growing segment of work at home professionals and students
who demand instantaneous results. Our goal is to be universal so that
TUTORIALS.COM is linked to numerous web sites and web searches for "tutorials"
will always link to TUTORIALS.COM. We own the domain name "TUTORIALS.COM" and
are penetrating this market through the following channels:
o Vertical Portal - We have and are continuing to enter into revenue sharing
arrangements with widely recognized, branded web sites or portals.
TUTORIALS.COM is an educational content provider benefiting from that
site's local traffic. To date, an anchor tenant contract with AOL
represents our most widely recognized relationship.
o PC Manufacturers - We have and are continuing to enter into revenue sharing
arrangements with PC manufacturers. Under these arrangements, an icon on
the desktop links directly to TUTORIALS.COM. We have entered into a
contract with Gateway 2000, Inc. which is our first step toward this
objective.
o Affiliates Program - We have and are continuing to extend our market
presence through our Affiliates Program, which enables associated web sites
to make our products available to their audiences. We have entered into an
agreement with GeoCities, in which we are among the first 16 merchants to
be exposed to its 3.5 million web site owners. Within the first two weeks
over 8,000 web sites applied to join our Affiliates Program. We have also
entered into an agreement with Linkshare, which specializes in building
affiliate programs and provides us with access to over 65,000 web sites.
o Destination Site - We are marketing TUTORIALS.COM as a destination web site
through a comprehensive marketing strategy designed to strengthen the
TUTORIALS.COM brand name, increase customer traffic to the TUTORIALS.COM
web site, build customer loyalty, encourage repeat purchases and develop
incremental revenue opportunities.
CORPORATIONS AND OTHER ORGANIZATIONS - LEARNING UNIVERSITY, STREAMMAKER AND
AGENT7
Our solutions for corporations and other organizations consist primarily of the
following products and services:
o Learning University(TM)
o StreamMaker(TM), custom tutorial creation and conversion
o Agent7(TM) and custom character creation
LEARNING UNIVERSITY. - Learning University(TM) 2.8, the current version of LU,
is an interactive education and learning web site that we maintain for our
customers. LU includes tutorials, administration, reporting and e-commerce
capabilities. LU provides a cost effective, value added service that we believe
is superior to that which an organization can deliver on its own. Our customers
can offer training to their employees, across a computer network, corporate
intranet or the Internet. LU allows each customer and its employees to tailor
training to their individual needs. LU enables users to practice and test skills
as they learn, utilizing simulation technologies that allow users to practice
many of the concepts introduced. After the completion of each course, users can
print a completion certificate indicating that they have successfully met all of
the requirements of the course. Users of LU can choose from a variety of titles
covering a wide range of subjects, including desktop application software,
computer programming and business skills.
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STREAMMAKER - StreamMaker(TM) 4.3, the current version of our authoring tool,
utilizes patent pending technology to produce fully synchronized, interactive,
CD-ROM quality multimedia streams that can be delivered through computer network
connections, including a 28.8 modem connection, without download. The benefits
of StreamMaker include:
o A proprietary method for graphics compression
o A patent pending technology which ensures that the elements of a multimedia
production, including, audio, graphics, animation, video and text, are
synchronized
o The ability to develop interactive streams
o A design which facilitates integration with other technologies
To date, we have licensed StreamMaker to several companies including IBM and
Intuit.
CUSTOM TUTORIAL CREATION AND CONVERSION - We use StreamMaker to stream or create
"7thStreet-Enabled" tutorials for our customers' web based applications or
proprietary software. We are currently marketing these services to companies
that have active web sites. Our services are intended to help our customers
educate their customers on the use of, navigation of, content of, and products
on their web sites. We also use StreamMaker to convert existing content so that
it can be streamed. In certain cases we may recommend authorized consultants to
our customers to create original or convert existing content for them.
AGENT7 AND CUSTOM CHARACTER CREATION - Agent7(TM) version 1.2 is our intelligent
agent authoring tool that streams data to enable animated characters to
automatically speak and gesture based on speaker-independent voice recognition
and text-to-speech synthesis. The benefits of Agent7 include:
o The ability to reuse animation gestures with different dialogs. This saves
production costs and allows the modification of gestures and dialogs in
only minutes instead of days or weeks.
o The quality and impact of the animation experience exceeds the typical
quality experienced at normal Internet modem speeds by streaming animation
data, then assembling it on the PC.
o No special programming skills are necessary.
o Users can program interactivity to link the characters to web pages and
applications.
We currently have a library of approximately one hundred 2D and 3D animated
characters covering a broad array of styles from serious to humorous. We also
can create custom characters that represent a company's mascot or logo. Agent7
characters can deliver virtually any kind of information and provide
interactivity to assist and instruct the average Internet user. Agent7
characters can be delivered over the Internet in a variety of ways including
embedded into web pages and delivered in e-mails.
Our plan is to license Agent7 on a monthly service fee basis to customers for
the following applications:
o As navigational web guides, Agent7 characters can provide information about
what's new, where to find topical information and automatically take a user
to an area of interest.
o In a help desk application, Agent7 characters can respond to questions with
spoken answers and built-in links to relevant web pages.
o Agent7 characters can be used as "intelligent" icons that are placed on the
PC desktop to deliver learning tips and offer direct links to tutorials.
The Total Solution
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We believe that there is a significant market opportunity for our flexible,
engaging and cost-effective education and training solutions. We believe that
the combination of our off the shelf and custom products and services will
attract customers who desire the convenience of one stop shopping. In addition,
we believe that once customers have purchased our products and services we will
have significant opportunities to sell additional products and services.
Product Distribution - Corporations and Other Organizations
We market our products through direct and indirect sales channels.
Direct sales channel - On March 1, 1999 we began to market our products and
services directly to Fortune 1000 companies and government agencies. We market a
total learning solution through our combined offering of LU, technologies and
custom services. We generally license our tutorials through one year agreements.
In 1999, we plan to increase our current direct sales force from four sales
professionals to at least 17 sales professionals located in key cities
throughout the United States.
Indirect sales channel - We have entered and continue to enter into Reseller
Agreements with value added resellers. These resellers sell LU to corporations,
school systems and governmental agencies either under their own branded web
sites or with co-branded web sites. The resellers generally license the
tutorials through one-year agreements. Our success is not contingent upon any
single reseller.
Suppliers
We currently have relationships with approximately ten content providers. We
believe that we have assembled a critical mass of titles for market acceptance.
However we intend to broaden the scope of the subject matter and increase the
number of content providers. Some of the new subjects may include home
improvement, foreign languages and K-12 courseware.
E-Commerce and Infrastructure Technology
We have implemented web site management tools, search engines, transaction
processing and fulfillment services using a combination of our own proprietary
technologies and commercially available, licensed technologies. Our current
strategy is to create and enhance our proprietary technologies and to license or
acquire commercially developed technologies for other applications where
available and appropriate.
Our systems administrators and network managers monitor and operate our web
sites, network operations and transaction processing systems. The continued
uninterrupted operation of our web sites and transaction processing systems is
essential to our business. We use the services of an Internet service provider
to obtain connectivity to the Internet.
Competition
INTERNET AND WEB BASED TRAINING
The Internet and web based training market is new, rapidly evolving and
intensely competitive. Our current and potential competitors include:
o Other web based training companies including ZD, Inc.
o Traditional computer based training companies including CBT Systems and
NETg
o Instructor led training companies
o CD-ROM companies and video companies
o Publishers of instructional books
o Companies that provide help desk services
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Currently, computer based training is more common than web based training and
may continue to be widely accepted. Furthermore, the web based training market
requires its customers to have Internet access. The computer based training
industry has several dominant, more financially secure players including CBT
Systems and NETg, both of which have entered the web based training market.
MULTIMEDIA STREAMING TECHNOLOGY
The two major providers of streaming technology are Microsoft and RealNetworks.
We believe that StreamMaker is different than other streaming technologies
because we engineered it specifically for use in training and distance learning
applications. However, both Microsoft and RealNetworks have substantial
resources. In addition Macromedia has strong CD-ROM authoring technologies which
it has been evolving into Internet capable technologies.
AGENT TECHNOLOGY
The digital animation and "intelligent agent" products and services industry is
intensely competitive, rapidly changing and significantly affected by new
product introductions and other market activities of industry participants. We
are aware of numerous competitors that provide products and services similar to
those offered by us including the following:
o Animated character software vendors, including Microsoft, Macromedia,
Extempo, ToggleThis, 3D Planet, Atomic 3D, Pulse and Parable
o Recommendation and agent software vendors, including Net Perceptions,
Autonomy and Aptex
o Q&A natural language response systems vendors, including Teknimedia, Big
Science, Inference and c-serv
In addition, with the rapid expansion of the Internet, it is likely that
additional competitors will enter the digital animation and "intelligent agent"
market. Increased competition may result in the development of products which
are superior to ours, or are perceived by the market to be superior, which could
cause price reductions, reduced gross margins and loss of market share for us.
Intellectual Property and Licenses
Our success and ability to compete effectively will depend, in part, on our
ability to protect our intellectual property. We rely primarily on a combination
of statutory and common law copyright, trademark and trade secret laws, customer
licensing agreements, employee and third-party nondisclosure agreements and
other methods to protect our proprietary rights. We have applied for several
patents that are necessary for the operation of our business. We may not be
issued these patents based on our applications or future applications, and even
if these patents are issued they may not be sufficiently broad to protect our
rights.
We have limited mechanisms to prevent or inhibit unauthorized use, but we
generally require the execution of a license agreement that restricts copying
and use of our products. If unauthorized copying or misuse of our products were
to occur to any substantial degree, then our business would be materially
adversely affected. It may be possible for a third-party to copy or otherwise
obtain and use our tutorials or technologies without authorization, or to
develop similar tutorials or technologies independently.
We use employee and third-party confidentiality and non-disclosure agreements to
protect our trade secrets and unpatented know-how. We require our employees to
assign to us all rights in any proprietary information or technology made or
contributed by the employee during his or her employment with us. In addition,
we regularly enter into non-disclosure agreements with third parties including
consultants, potential strategic partners and customers. Unfortunately, these
agreements cannot guarantee the confidentiality of our trade secrets or
unpatented know-how, nor can they prevent third parties from independently
developing substantially equivalent proprietary information or copying,
developing, or otherwise obtaining and using our proprietary information without
authorization.
We may resort to litigation to enforce our intellectual property rights, to
determine the validity and scope
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of the proprietary rights of others, or to defend ourselves against claims of
infringement or invalidity by others. While we are not currently engaged in any
intellectual property litigation or proceedings, we may be in the future. An
adverse outcome in a litigation or similar proceeding could subject us to
significant liabilities to third parties, require disputed rights to be licensed
from others, or require us to cease marketing or using certain products or
services. The cost of addressing any intellectual property litigation, both in
legal fees and the diversion of management resources, regardless of whether the
claim is valid, could be significant.
Third parties may claim that our current or future products infringe on their
proprietary rights. We may be increasingly subject to these claims as the number
of products and competitors in the education and training industry grows and the
functionality of products in the marketplace overlaps. Any of these claims, with
or without merit, could result in costly litigation or might require us to enter
into royalty or licensing agreements. These royalty or license agreements, if
required, may not be available on terms acceptable to us, if at all.
Employees
As of March 15, 1999 we had a total of 62 full-time employees, of whom 16 were
engaged in sales and marketing, 37 in product development, production and
customer support, and 9 in management, administration and finance. Substantially
all of the employees work in our offices in Richardson, Texas; Golden, Colorado
or White Plains, New York. None of our employees are subject to a collective
bargaining agreement and we have not experienced any work stoppages. We believe
that our relationship with our employees is good.
We may not be able to retain our key executives and engineers. As an
organization that is currently integrating the business plans and technologies
of two companies, we heavily rely on the two principal executive officers of the
two companies as well as the inventors of our two main technology platforms. We
expect to continue to hire additional product development, sales and marketing,
production and accounting staff. We may not be successful in attracting,
retaining or motivating key personnel. Our inability to hire and retain
qualified personnel or the loss of the services of key personnel could have a
material adverse effect upon our business.
ADDITIONAL FACTORS THAT MAY AFFECT OUR FUTURE RESULTS
You should carefully consider the following risk factors and other information
included in this Form 10-K. The risks and uncertainties described below are not
the only ones we face. Additional risks and uncertainties not presently known to
us or that we currently deem immaterial also may impair our business operations.
If any of the following risks materialize, our business could be materially
adversely affected.
We have a limited operating history.
As an early-stage Internet company, we have an evolving and unpredictable
business model. In addition, we face intense competition and must effectively
manage our growth and respond quickly to rapid changes in customer demands and
industry standards. We may not succeed in addressing these challenges and risks.
We have an accumulated deficit and anticipate further losses.
We have incurred significant losses since we began doing business. As of
December 31, 1998, we had an accumulated deficit of approximately $85 million.
To succeed we must invest in marketing, promoting and developing our products,
technologies and operating infrastructure. In addition, the expenses associated
with our recent acquisition of Street will adversely affect our operating
results.
The successful combination of 7th Level and 7thStreet.com, including the
successful integration of Agent7 and StreamMaker, will require substantial
effort.
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The diversion of the attention of management and difficulties encountered in the
transition process could have an adverse impact on our ability to realize the
full benefits of the merger. The successful combination of the two companies
will also require coordination of our sales and marketing efforts. In addition,
the process of combining the two organizations could cause the interruption of,
or loss of momentum in, our activities.
Due to our limited operating history and the unpredictability of our industry,
we cannot accurately forecast our revenues.
We base our current and future expense levels on our investment plans and
estimates of future revenues. Our expenses are to a large extent fixed. We may
not be able to adjust our spending quickly if our revenues fall short of our
expectations. Further, we may make pricing, purchasing, service, marketing,
acquisition or financing decisions that could adversely affect our business
results.
Our quarterly operating results will fluctuate for many reasons, including:
o Our ability to retain existing customers, attract new customers and satisfy
our customers' demand
o Our ability to acquire content and manage our content relationships
o Changes in gross margins of our current and future products, services and
markets
o Introduction of our new web sites, services and products or those of our
competitors
o Changes in usage of the Internet and online services and consumer
acceptance of the Internet and electronic commerce
o Timing of upgrades and developments in our systems and infrastructure
o The level of traffic on our web sites
o The effects of acquisitions and other business combinations, and related
integration
o Technical difficulties, system downtime or Internet brownouts
You should not rely on period-to-period comparisons of our financial results to
forecast our future performance. Our future operating results may fall below the
expectations of securities analysts or investors, which would likely cause the
trading price of our common stock to decline.
We face rapid technological change and frequent new product introductions.
The markets for our products and services are characterized by rapid
technological change, frequent new product introductions and evolving industry
standards. We believe that our future success depends upon our ability to
develop and market products and services that incorporate and apply new
technologies, and our ability to enhance and expand our existing product lines
and services. We will need to spend significant amounts of capital to develop,
market and enhance our products and services to meet and take advantage of
technological changes. We may not be:
o Able to develop or market new products or services successfully
o Successful in commercially developing new products and services
o Able to respond effectively to technological changes, new industry
standards, or new products or services offered by our competitors
o Able to raise sufficient capital when required to implement our strategies
Our future success will depend upon, among other factors, the extent to which
companies continue to adopt web based training programs, the proliferation of
multimedia PCs inside corporations and the acceptance of the Internet as a
viable distribution medium. If our solutions do not become widespread or we do
not achieve market acceptance, or are unable to anticipate technological change
or evolving industry standards and successfully introduce new products our
business, results of operations, and financial condition could be adversely
affected.
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We depend upon strategic alliances or relationships.
We depend upon third parties for several critical elements of our business
including technology, content development and distribution activities.
Technology - Technology critical to our products and solutions including speech
recognition and the speech synthesis engine are licensed from third parties. We
have improved these technologies and applied them in unique ways with our other
proprietary techniques. If the licensors were to terminate our license
agreements we may have to make substantial expenditures to develop or license
replacement technology. This could adversely affect the performance of our
business.
Content Development - Some of our licensed content is available from a limited
number of resources. Currently, seventy-five percent (75%) of our tutorials are
licensed from two sources; Viagrafix and NIIT. Although to date we have been
able to license adequate tutorials, our inability in the future to obtain
content from third parties, or to develop our own content could result in delays
in product introductions or shipments. We depend on the quality and reliability
of the tutorials licensed and timely delivery of these tutorials by our sources.
Although we have agreements specifying the terms of the licenses, these
agreements may not be enforceable. We believe that we can arrange alternate
sources for some or all of these tutorials, but the inability of any of these
content providers to provide these tutorials to us on a timely basis could
affect the performance of our business.
Distribution Activities - We currently have relationships with online services
and Internet content providers including AOL, GeoCites and Linkshare.
Additionally, we have relationships with authorized resellers. Under our
agreement with AOL, its members will have direct access to TUTORIALS.COM.
GeoCities and Linkshare market our Affiliates Program to their customers. These
distribution agreements typically are not exclusive and may be terminated upon
certain conditions.
We face a risk of system failure.
Our operations depend to a significant extent on our ability to maintain our
computer and telecommunications systems. Currently, we are using one major
Internet service provider. We must also protect our systems against damage from
fire, natural disaster, power loss, telecommunications failure or similar
events. Our business depends in significant part on our operations center in
Golden, Colorado. Although we have arranged for off-site back-up for our network
control, this measure does not eliminate the risk to our operations from a
natural disaster or system failure. In addition, growth of our customer base may
strain the capacity of our computer operations center and telecommunications
systems and/or lead to degradations in performance or system failure. Any damage
to or loss of our computer and telecommunications networks including our
operations center could adversely affect the performance of our business.
A large portion of our revenues comes from a small number of customers.
At present, a relatively small group of our customers are responsible for a
significant percentage of our revenue. For example, for the year ended December
31, 1998, royalties and production fees from our largest customer accounted for
34 % of net revenue. Although we believe that our current relationships with our
customers are generally good, the loss of one or more of our major customers
could affect the performance of our business.
The market price of our common stock is volatile.
The trading price of our common stock can fluctuate significantly. For example,
during the 52-week period ended March 26, 1999, the market price of our stock
ranged from $1.25 to $12.625. The market price of our common stock may fluctuate
in response to certain events and factors. For example, On March 5, 1999, we
announced an agreement with AOL to offer training to AOL members through
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Tutorials.com. As a result of the announcement, on the following Monday March 8,
1999, the stock price ranged from $5.00 to $8.884 with a trading volume of
38,259,000 shares.
The Internet is an evolving commercial venue. We consider building and
maintaining key marketing and technology relationships an important factor in
our success. In addition these relationships are likely to impact the trading
price of our common stock.
A drop in the market price of our common stock may adversely affect our business
and financing opportunities. In addition, the stock market in general and the
market prices for Internet-related companies in particular have experienced
volatility that often has been unrelated to the operating performance of these
companies.
Certain events could result in a dilution of your ownership of our common stock.
As of February 28, 1999, we had 30,547,560 shares of common stock outstanding
and 5,509,490 common stock equivalents including convertible preferred stock,
warrants and stock options. The exercise prices and conversion prices, as the
case may be, of the common stock equivalents range from $.01 and $11.50 per
share. These securities also provide for antidilution protection upon the
occurrence of stock splits, redemptions, mergers and other similar transactions.
If one or more of these events occurs the number of shares of our common stock
that may be acquired upon conversion or exercise would increase. If converted or
exercised these securities will result in a dilution to your percentage
ownership of our common stock.
Under the terms of a subscription agreement, Fletcher International Limited
purchased 1,666,667 shares of our common stock for $5,000,000, or $3.00 per
share, and rights to purchase an additional 100,000 and 650,000 shares of common
stock for $.01 and $4.50, respectively. The subscription agreement provides that
at our election and as long as the market price of our common stock is greater
than $3.00 per share, Fletcher is obligated to purchase up to an additional
$5,000,000 of common stock at market prices when we elect to exercise our right.
Fletcher's obligation to purchase additional shares is contingent upon the
effectiveness of a registration statement to resell Fletcher's shares. In
addition, Fletcher may receive additional shares of common stock if our common
stock does not meet certain price targets or if we do not have an effective
registration statement for the resale of Fletcher's shares. Any additional
issuances to Fletcher would further dilute your percentage ownership of our
common stock.
Under the terms of the Agreement and Plan of Merger, we issued 4,948,182 shares
of our common stock and 21,644 shares of our Series D Preferred Stock to the
Street stockholders. The Street stockholders' shares of Series D Preferred Stock
will automatically convert into 7,214,666 shares of our common stock if approved
by our common stockholders. The conversion of Series D Preferred Stock would
further dilute your percentage ownership of our common stock.
12
<PAGE>
FORWARD-LOOKING STATEMENTS IN THIS FORM 10-K MAY NOT PROVE TO BE ACCURATE
This Form 10-K contains or incorporates forward-looking statements including
statements regarding, among other items, our business strategy, growth strategy,
and anticipated trends in our business. We may make additional written or oral
forward-looking statements from time to time in filings with the SEC or
otherwise. When we use the words "believe," "expect," "anticipate," "project"
and similar expressions, this should alert you that this is a forward-looking
statement. Forward-looking statements speak only as of the date the statement is
made.
These forward-looking statements are based largely on our expectations. They are
subject to a number of risks and uncertainties, some of which cannot be
predicted or quantified and are beyond our control. Future events and actual
results could differ materially from those set forth in, contemplated by, or
underlying the forward-looking statements. Statements in this Form 10-K or made
in documents incorporated into this Form 10-K, describe factors that could
contribute to or cause differences between our expectations and actual results.
We have described many of these factors in this Form 10-K. Because of these
risks and uncertainties, the forward-looking information contained in this Form
10-K may not in fact occur or prove to be accurate. All subsequent written and
oral forward-looking statements attributable to us or persons acting on our
behalf are expressly qualified in their entirety by this section.
13
<PAGE>
ITEM 2. PROPERTIES
The Company leases the following facilities:
<TABLE>
<CAPTION>
Expiration Renewal
Location Use Sq. Feet Date Option Notes
-------- --- -------- ---- ------ -----
<S> <C> <C> <C> <C> <C>
White Plains, New York Headquarters Office 3,965 6/14/99 None 1
Golden, Colorado Research & Development and
Production 5,900 3/06/00 None
Richardson, Texas Research & Development 6,170 3/31/02 None 2
Richardson, Texas Sub-Leased 23,500 7/31/99 None 3
Glendale, California Office 37,680 9/30/02 None 4
</TABLE>
(1) The Company is currently negotiating a new lease for an office in the same
vicinity.
(2) This was the Company's headquarters until February 19, 1999. The Company
plans to sublet most of this facility as soon as a suitable sublessee can be
found and the necessary approvals are obtained from the landlord.
(3) This was the Company's headquarters until August 1998. Since that time the
entire facility has been subleased.
(4) This facility was the Company's production studio until early 1998.
Beginning December 1, 1998 the Company subleased 75% of this facility to a third
party for approximately 100% of the rent it pays to the landlord. The sublease
expires on September 30, 2002. The Company plans to use the balance of the space
for meetings with potential and existing West Coast customers.
ITEM 3. LEGAL PROCEEDINGS
The Company is involved in certain claims and lawsuits that 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 1998.
14
<PAGE>
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Our common stock is quoted on the NASDAQ National Market System under the symbol
"SEVL". At March 15, 1999, we had more than 450 record holders of our common
stock as reported by our transfer agent. The following table sets forth the
range of high and low bid quotations for our common stock as reported by the
NASDAQ National Market System during the periods as indicated.
<TABLE>
<CAPTION>
QUARTER ENDED HIGH LOW
------------- ---- ---
<S> <C> <C>
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
March 31, 1998 2.13 1.25
June 30, 1998 12.63 1.38
September 30, 1998 5.45 1.75
December 31, 1998 5.00 1.94
</TABLE>
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.
On December 15, 1998, we sold the following securities to Fletcher International
Limited for $5 million:
o 1,666,667 shares of our common stock
o An option to purchase 650,000 shares of our common stock for $4.50 per
share exercisable until December 15, 2003
o An option to purchase 100,000 shares of our common stock for $.01 per
share exercisable until December 15, 2003
We believe that the sale of our securities to Fletcher was a transaction by an
issuer not involving a public offering within the meaning of Section 4(2) of the
Securities Act. We did not offer our securities by a general solicitation. The
only purchaser of our securities was Fletcher which represented to us that it
was an "accredited investor" as defined in Rule 501 of the Securities Act.
15
<PAGE>
ITEM 6. SELECTED FINANCIAL DATA
The following table sets forth selected financial data for 7th Level 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>
YEAR ENDED DECEMBER 31,
-----------------------------------------------------------------------------------
1994 1995 1996 1997 1998
ACTUAL COMBINED(1) ACTUAL ACTUAL ACTUAL ACTUAL
------ ----------- ------ ------ ------ ------
(in thousands, except per share amounts)
<S> <C> <C> <C> <C> <C> <C>
STATEMENT OF OPERATIONS
Data:
Net revenues (2) ............ $ 4,103 $ 4,708 $ 12,161 $ 20,549 $ 10,499 $ 1,571
Loss from
operations ................ (6,260) (6,064) (15,581) (25,508) (23,790) (8,282)
Net loss .................... (6,453) (6,301) (14,603) (24,253) (22,458) (10,958)
Dividends on Preferred Stock -- -- -- -- -- 338
Beneficial conversion
feature in association with
Preferred Stock ........... -- -- -- -- -- 5,479
Net loss available to Common
Shareholders ............. (6,453) (6,301) (14,603) (24,253) (22,458) (16,775)
Basic and diluted loss per
Common Share ............. (0.85) (1.33) (1.80) (1.64) (1.03)
Basic and diluted weighted
average shares outstanding 7,888 -- 10,961 13,442 13,697 16,355
</TABLE>
<TABLE>
<CAPTION>
AS OF DECEMBER 31,
------------------------------------------------------------
1994 1995 1996 1997 1998
---- ---- ---- ---- ----
(in thousands)
<S> <C> <C> <C> <C> <C>
BALANCE SHEET DATA:
Total assets ............ $26,403 $54,562 $38,933 $ 9,855 $13,016
Long-term debt (including
Current portion) ...... 5,738 859 6,790 946 194
Stockholders' equity .... 19,184 48,265 24,652 2,459 9,783
</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.
16
<PAGE>
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
7th Level, Inc. was founded in 1993 with the goal of becoming a leading
developer and publisher of interactive entertainment and educational products as
well as a creator of state of the art tools and technologies. In 1998, our
research and development activities were focused primarily on developing and
enhancing our Agent7(TM) technology. We recognized that appropriate applications
of this technology were in the delivery of learning, education and enhanced
communications. To strengthen our position in the marketplace, we searched for a
viable and complementary partner with the appropriate technology assets,
distribution channel and management expertise.
In February 1999, we acquired all of the outstanding stock of Street
Technologies, Inc, a privately held company, and changed the name of Street to
7thStreet.com, Inc. 7thStreet markets and develops technology based training
solutions delivered over intranets and the Internet. Our Board of Directors has
approved the change of the name of our company from 7th Level, Inc. to
7thStreet.com, Inc. and the renaming of the new subsidiary. Our name change will
be effective if approved by our stockholders.
We continued to use cash and operate at a loss during 1998, (See "Liquidity and
Capital Resources") however, we were able to significantly reduce expenses. We
continue to review, evaluate and revise the Company's operations and priorities.
RESULTS OF OPERATIONS
COMPARISON OF YEARS ENDED DECEMBER 31, 1998 AND DECEMBER 31, 1997
The Company's strategy change in 1997 continued to impact all of its operations
in 1998. As previously disclosed and as described above, the Company has
transitioned from the CD-ROM games business and is leveraging the underlying
software technologies in the new business strategy. Net revenues decreased 85%
to $1,571,398 for the year ended December 31, 1998 compared to $10,499,021 for
the year ended December 31, 1997. The 85% decrease in net revenues reflects the
shift in business strategy as the first of the new products on the Agent7
platform was formally released late in the third quarter of 1998 and
accordingly, no significant revenues have been realized. In 1998, product sales
related to Agent7 were approximately 12% of net revenues. The remaining 88% was
from various sources including royalty streams from our discontinued CD-ROM game
business and reversals of prior period returns and price protection allowances
in excess of actual returns and price protections. In contrast, during 1997, all
of our revenue was associated with the CD-ROM game business. In 1997, product
sales constituted approximately 40% of net revenue. 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. Sales to customers outside of
the United States were 25% and 20% of net revenue in 1998 and 1997,
respectively.
For the year ended December 31, 1998, cost of revenues was $233,454 or 15% of
net revenues. During 1998 cost of revenues consisted primarily of royalties and
development. Cost of revenues for the year ended December 31, 1997 was
$4,541,960 or 43% of net revenue, including product development, manufacturing,
and royalties and licensing. The total cost of revenues as a percentage of net
revenues fluctuated from year to year as a result of significant differences in
the make up of the revenue. We expect fluctuations in gross margin in the future
as changes occur in the composition of the revenues and the associated cost of
revenues.
17
<PAGE>
Research and product development expenses were $3,629,786 and $17,436,042 for
the years ended December 31, 1998 and 1997, respectively. Research and product
development costs decreased in 1998 as the Company continued to reduce headcount
and related expenditures. Approximately $700,000 related to the closing of the
international localization studios is included in the 1997 amount. During 1998
we completed this process and reversed $250,000 in over accruals. Research and
production development expenses decreased 79% in 1998, excluding the one-time
closing expenses recorded in 1997. In 1998, research and product development
expenses included $2,189,934 for production expenses and $1,439,852 for software
research and development expenses. 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 and closed or sold during 1997. Because a large portion of the
1997 staffing cuts, in connection with the change in the strategic direction of
the Company, were implemented late in the year and continued into 1998 the
benefit was not fully realized until 1998.
Sales and marketing expenses were $555,593 and $6,118,011 for the years ended
December 31, 1998 and 1997, respectively. Sales and marketing expenses for 1998
included $142,158 of expenses for advertising, marketing and public relations
and $413,435 of expenses related to internal staffing. Included in the 1997
amount is approximately $965,000 related to the closing of our international
sales offices. The 1997 expenses included $2,425,056 of expenses for
advertising, marketing and public relations and $3,692,955 of expenses related
to internal staffing. Excluding costs for closing our international sales
offices, sales and marketing expenses decreased approximately $4,597,000 or 89%
in 1998 compared to 1997. As a percentage of net revenues, sales and marketing
expenses related to internal staffing decreased to 26% in 1998 from 35% in 1997.
Likewise, the advertising, marketing and public relations expenses decreased to
9% from 24% as a percentage of net revenues in 1998 compared to 1997.
General and administrative expenses for the year ended December 31, 1998 were
$5,428,783 compared with $5,683,859 for the year ended December 31, 1997.
Approximately $1,379,000 of the 1998 total is attributable to stock grants to
two of the company's directors. Additionally, the Company incurred higher legal
and professional fees in 1998 that also contributed to the general and
administrative fees continuing to remain almost unchanged compared to the 1997
amounts.
Amortization of intangible assets was $6,072 for the year ended December 31,
1998 compared to $509,444 for the year ended December 31,1997. Of the 1997
amount, approximately $450,000 represents the early write off of the
amortization of intangible assets acquired in the 1995 acquisition of Lanpro
Corporation and Lanpro Localization Center, Inc. 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 we closed our offices in San Francisco
and Tokyo.
Interest income was $333,346 for the year ended December 31, 1998 compared to
$340,434 for the year ended December 31, 1997. Interest expense was $1,731,403
and $121,321 for the years ended December 31, 1998 and 1997, respectively.
Approximately $1,657,000 related to amortization of debt issuance costs and
accretion of debt discount was included in the amount for 1998. (See Note 4 to
the Consolidated Financial Statements).
Other expenses were $1,277,352 for the year ended December 31, 1998 compared to
other income of $1,113,504 for the year ended December 31, 1997. During 1998, we
disposed of assets at a net loss of approximately $1,500,000 that was offset by
reversals of accrued royalty expense in excess of actual liabilities in the
amount of $237,500. In November 1997, we sold our PyroTechnix subsidiary which
included the sale of the RETURN TO KRONDOR game title and a license for our
TopGun technology and recognized a gain of approximately $1,033,000 which
resulted in the significant other income amount. For the year ended December 31,
1997, our PyroTechnix subsidiary recognized revenues of approximately $320,000,
cost of revenues of approximately $317,000 and operating expenses of
approximately $1,527,000.
18
<PAGE>
COMPARISON OF YEARS ENDED DECEMBER 31, 1997 AND DECEMBER 31, 1996
Our strategy change in 1997 impacted all of our 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. 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.
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.
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 we 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 the Financial Statements) 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.
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 our 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 our 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.
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, we
incurred higher legal and professional fees in 1997 which contributed to the
increase in general and administrative expenses 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 to the Financial Statements.) 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 we closed our offices in San Francisco and Tokyo.
19
<PAGE>
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 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.
Other income was $1,113,504 for the year ended December 31, 1997 compared with
other expense of $445 for the year ended December 31, 1996. In November 1997, we
sold our PyroTechnix subsidiary which included the sale of the RETURN TO KRONDOR
game title and a license to our 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, our PyroTechnix subsidiary
recognized revenues of approximately $320,000, cost of revenues of approximately
$317,000 and operating expenses of approximately $1,527,000.
LIQUIDITY AND CAPITAL RESOURCES
We have incurred significant losses since inception including operating losses
of approximately $8.3 million, $23.8 million and $25.5 million for the years
ended December 31, 1998, 1997 and 1996, respectively. The Independent Auditors'
Report related to our December 31, 1997 consolidated financial statements
contained an explanitory paragraph that reflected their concern about our
ability to meet our anticipated operating requirements during 1998 without
obtaining additional financing. During 1998, we obtained additional financing as
more fully described below. The Report of Independent Public Accountants related
to our December 31, 1998 consolidated financial statements was issued without
qualification.
During 1998, we raised over $14.3 million dollars, net of offering expenses, in
connection with private placements to fund operations. Furthermore, at our
election, we have the right to sell up to $5,000,000 in Common Stock under an
existing agreement under certain conditions.
Cash and cash equivalents increased $8,750,623 during the year to $11,215,702 at
December 31, 1998. The increase is the result of the $10,000,000 private
placement funded in May 1998 and a $5,000,000 private placement funded in
December 1998, offset by operating activities during 1998. Net cash used in
operating activities was $6,302,646, which included a net loss of $10,957,698
for the year ended December 31, 1998, offset by non cash items such as charges
for stock grants, amortization of debt issuance costs, accretion of debt
discount, as well as depreciation and amortization expenses. Approximately
$900,000 of cash was provided in 1998 from the issuance of Common Stock
associated with exercises of stock options, stock purchase agreements and stock
warrants. We also sold surplus equipment resulting in a loss on disposition of
approximately $1.5 million, and significantly curtailed capital expenditures,
with disbursements of approximately $44,000, in 1998 compared to approximately
$437,000 in the 1997.
In May 1998, we sold, pursuant to a private placement, Senior Secured Promissory
Notes ("Notes") in the aggregate principal amount of $4,500,000 and warrants to
purchase 675,000 shares of Common Stock at an exercise price of $0.01 per share.
We 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, we amortized the related debt discount to interest expense over the
period from May 6, 1998 (date of issuance) to July 13, 1998 (date of exchange).
On July 13, 1998, the holders of the Notes exchanged the Notes for 4,500 shares
of our 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. As of March 15, 1999, all
of the Series B Convertible Preferred Stock has been converted and all of the
warrants have been exercised.
In May 1998, we also sold, pursuant to a private placement, shares of Series A
Preferred Stock in the aggregate amount of $5,500,000 and warrants for 1,375,000
shares of Common Stock at an exercise price of $0.01 per share. We 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
20
<PAGE>
of such warrants were exercised in June 1998. On July 13, 1998, the exchange of
5,500 shares of Series A Preferred Stock for 5,500 shares of Series B
Convertible Preferred Stock was effected. As of March 15, 1999, all of the
Series B Convertible Preferred Stock has been converted and all of the warrants
have been exercised.
In December 1998, we sold, pursuant to a subscription agreement, 1,666,667
shares of common stock for $5,000,000, or $3.00 per share, and rights to
purchase an additional 100,000 and 650,000 shares of common stock for $.01 and
$4.50, respectively, to Fletcher International Limited. At our sole option, as
long as the market price of our common stock is greater than $3.00 per share and
we have an effective registration shatement for the resale of Fletecher's
shares, Fletcher is obligated to purchase up to an additional $5,000,000 of
common stock at market prices. In addition, Fletcher may receive additional
shares of common stock if our common stock does not meet certain price targets
or if we do not register the resale of Fletcher's shares by certain dates.
To date, we continue to use cash and operate at a loss. Our ability to achieve
positive cash flow depends upon a variety of factors, including the timely
introduction and market success of our 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 our control. If we require additional capital, we would seek such funding
through additional public or private financing, although there can be no
assurance that we will be able to obtain such financing.
We are in the process of reviewing our current operations with a view towards
reducing redundancies created by our recent merger and creating an operating
environment conducive to the pursuit of our new business strategy. As a
consequence of this review, which is expected to be completed by the end of
first quarter 1999, we expect to record write-downs and other charges in 1999
beginning with our first quarter financial statements. Based upon the
determinations made to date in connection with the implementation of our plan,
we will record charges of approximately $2 million in our first quarter
financial statements.
RECENTLY ISSUED ACCOUNTING PRINCIPLES
In June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive Income"
("SFAS No. 130"). SFAS No. 130 requires disclosure of all components of
comprehensive income on an annual and interim basis. Comprehensive income is
defined as the change in equity of a business enterprise during a period from
transactions and other events and circumstances from nonowner sources. SFAS No.
130 is effective for fiscal years beginning after December 15, 1997. The
adoption had no impact on the Company's consolidated financial position, results
of operations or cash flows.
In June 1997, the FASB issued SFAS No. 131, "Disclosures About Segments of an
Enterprise and Related Information" ("SFAS No. 131"). SFAS No. 131 requires
certain financial and supplementary information to be disclosed on an annual and
interim basis for each reportable segment of an enterprise. SFAS No.131 is
effective for fiscal years beginning after December 15, 1997. Comparative
information for earlier years presented is to be restated. The adoption had no
impact on the Company's consolidated financial position, results of operations
or cash flows.
In March 1998, the American Institute of Certified Public Accountants issued
Statement of Position ("SOP") 98-1, "Accounting for the Costs of Computer
Software Developed or Obtained for Internal Use". SOP 98-1 requires computer
software costs associated with internal use software to be charged to operations
as incurred until certain capitalization criteria are met. SOP 98-1 is effective
beginning January 1, 1999. The Company does not expect adoption of this
statement to have a material impact on its consolidated financial position,
results of operations or cash flows.
YEAR 2000 IMPACT
Many currently installed computer systems may be coded to accept only two-digit
entries in the date code field and cannot distinguish 21st century dates from
20th century dates. As a result, many software and
21
<PAGE>
computer systems may need to be upgraded or replaced. We are in the process of
assessing the Year 2000 issue and expect to complete the program in the second
quarter of 1999. To date we have not incurred material costs. We do not believe
that the cost of additional actions will have a material effect on our
consolidated financial position, results of operations or cash flows. Our
current systems and products may contain undetected errors or defects with Year
2000 date functions that may result in material costs. In addition, we utilize
third-party equipment, software and content, including non-information
technology systems that may not be Year 2000 compliant. We are in the process of
completing our activities relative to assessing whether our internally developed
software, third-party systems and non-information technology systems are
adequately addressing the Year 2000 issue. Failure of third-party equipment,
software or content to operate properly with regard to the Year 2000 issue could
require unanticipated expenses, which could have a material adverse effect on
our business. We are assessing whether our suppliers are adequately addressing
their Year 2000 compliance issues. We have initiated formal communications with
our significant suppliers and service providers to determine the extent to which
their systems or services may be vulnerable if they fail to address and correct
their own Year 2000 issues. We cannot guarantee that the systems of suppliers or
other companies on which we rely will be Year 2000 compliant. We are in the
process of developing a contingency plan that will address situations that may
result should Year 2000 compliance for critical operations not be fully achieved
in 1999.
22
<PAGE>
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Index to Financial Statements and Financial Statement Schedule
Financial Statements:
24 Report of Independent Public Accountants
25 Independent Auditors' Report
26 Consolidated Balance Sheets as of December 31, 1998 and 1997
27 Consolidated Statements of Operations for the years ended
December 31, 1998, 1997 and 1996
28 Consolidated Statements of Stockholders' Equity for the years
ended December 31, 1998, 1997 and 1996
29 Consolidated Statements of Cash Flows for the years ended
December 31, 1998, 1997 and 1996
30 Notes to Consolidated Financial Statements
Financial Statement Schedule:
S-1 Schedule II - Valuation and Qualifying Accounts for the years
ended December 31, 1998, 1997 and 1996
All other schedules are omitted because they are not applicable or the required
information is shown in the financial statements or notes thereto.
23
<PAGE>
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To the Board of Directors and Stockholders of
7th Level, Inc.:
We have audited the accompanying consolidated balance sheet of 7th Level, Inc.,
(a Delaware corporation) as of December 31, 1998, and the related consolidated
statement of operations, stockholders' equity, and cash flows for the year then
ended. These consolidated financial statements are the responsibility of the
Company's management. Our responsibility is to express an opinion on these
financial statements based on our audit.
We conducted our audit 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 audit provides 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, 1998, and the results of its operations and its cash flows for
the year then ended in conformity with generally accepted accounting principles.
Our audit was made for the purpose of forming an opinion on the basic
consolidated financial statements taken as a whole. The schedule listed in the
index of consolidated financial statements is presented for purposes of
complying with the Securities and Exchange Commissions rules and is not part of
the basic consolidated financial statements. This schedule has been subjected to
the auditing procedures applied in the audit of the basic consolidated financial
statements and, in our opinion, fairly states in all material respects the
financial data required to be set forth therein in relation to the basic
consolidated financial statements taken as a whole.
New York, New York
March 17, 1999
Arthur Andersen LLP
24
<PAGE>
INDEPENDENT AUDITORS' REPORT
The Board of Directors and Stockholders
7th Level, Inc.:
We have audited the accompanying consolidated balance sheet of 7th Level, Inc.
as of December 31, 1997, and the related consolidated statements of operations,
stockholders' equity, and cash flows for each of the years in the two year
period ended December 31, 1997. In connection with our audits of the
consolidated financial statements, we also have audited the financial statement
schedule for the years ended December 31, 1997 and 1996 as listed in the
accompanying index for such years. 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 the results of their operations and their cash flows
for each of the years in the two year period ended December 31, 1997, in
conformity with generally accepted accounting principles. Also, in our opinion,
the related financial statement schedule for the years ended December 31, 1997
and 1996, 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 LLP
Dallas, Texas
January 30, 1998
25
<PAGE>
7TH LEVEL, INC.
CONSOLIDATED BALANCE SHEETS
AS OF DECEMBER 31, 1998 AND 1997
<TABLE>
<CAPTION>
1998 1997
------------ ------------
<S> <C> <C>
ASSETS
Cash and cash equivalents $ 11,215,702 $ 2,465,079
Accounts receivable, net of allowances of $963
and $1,126,524 42,317 1,112,026
Inventories -- 18,477
Other current assets 286,238 752,847
------------ ------------
Total current assets 11,544,257 4,348,429
Fixed assets, net 1,399,652 4,960,560
Intangible assets, net 7,059 13,132
Other assets 65,421 532,605
------------ ------------
Total assets $ 13,016,389 $ 9,854,726
------------ ------------
------------ ------------
LIABILITIES AND STOCKHOLDERS' EQUITY
Accounts payable $ 197,962 $ 1,111,732
Accrued expenses 2,172,692 4,549,868
Current portion of notes payable 485,135 79,318
Current portion of capital lease obligations 148,493 172,439
Other current liabilities 183,114 630,567
------------ ------------
Total current liabilities 3,187,396 6,543,924
Notes payable -- 377,027
Notes payable to related parties -- 108,108
Other 45,916 366,212
------------ ------------
Total liabilities 3,233,312 7,395,271
Commitments and contingencies (Note 11)
Stockholders' equity:
Series B Convertible Preferred Stock, par value $0.01 per share,
100,000 shares authorized; 1,395 and 0 shares issued and
outstanding, in 1998 and 1997,
respectively ($1,395,000 liquidation value) 628,800 --
Common Stock, par value $0.01 per share,
100,000,000 shares authorized; 23,763,622 and
13,783,736 shares issued and outstanding in
1998 and 1997, respectively 237,636 137,837
Additional capital 93,965,769 70,642,628
Accumulated deficit (85,049,128) (68,333,578)
Cumulative translation adjustment -- 12,568
------------ ------------
Total stockholders' equity 9,783,077 2,459,455
------------ ------------
Total liabilities and stockholders' equity $ 13,016,389 $ 9,854,726
------------ ------------
------------ ------------
</TABLE>
The accompanying notes are an integral part of these
consolidated financial statements.
26
<PAGE>
7TH LEVEL, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
FOR THE YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
<TABLE>
<CAPTION>
1998 1997 1996
------------ ------------ ------------
<S> <C> <C> <C>
Net revenues $ 1,571,398 $ 10,499,021 $ 20,548,725
Cost of revenues 233,454 4,541,960 8,298,647
------------ ------------ ------------
Gross profit 1,337,944 5,957,061 12,250,078
------------ ------------ ------------
Operating expenses:
Research and product development 3,629,786 17,436,042 21,402,287
Sales and marketing 555,593 6,118,011 11,409,102
General and administrative 5,428,783 5,683,859 4,827,618
Amortization of intangible assets 6,072 509,444 119,428
------------ ------------ ------------
Total operating expenses 9,620,234 29,747,356 37,758,435
------------ ------------ ------------
Operating loss (8,282,290) (23,790,295) (25,508,357)
Interest expense (1,731,403) (121,321) (76,511)
Interest income 333,346 340,434 1,332,578
Other (expense) income (1,277,352) 1,113,504 (445)
------------ ------------ ------------
Net loss $(10,957,699) $(22,457,678) $(24,252,735)
Dividends on Preferred Stock 337,807 -- --
Beneficial conversion feature in association
with Preferred Stock (Note 3) 5,479,138 -- --
------------ ------------ ------------
Net loss available to Common Shareholders $(16,774,644) $(22,457,678) $(24,252,735)
------------ ------------ ------------
------------ ------------ ------------
Basic and diluted loss per Common Share $ (1.03) $ (1.64) $ (1.80)
------------ ------------ ------------
------------ ------------ ------------
Weighted average basic and diluted
shares outstanding 16,355,158 13,696,730 13,442,101
------------ ------------ ------------
------------ ------------ ------------
</TABLE>
The accompanying notes are an integral part of these
consolidated financial statements.
27
<PAGE>
7TH LEVEL, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
FOR THE YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
<TABLE>
<CAPTION>
Common Stock Convertible Convertible
---------------------------- Preferred Preferred Additional
Shares Amount Series A Series B Capital
------------ ------------ ------------ ------------ ------------
<S> <C> <C> <C> <C> <C>
Balance at December 31, 1995 13,078,464 $ 130,785 $ -- $ -- $ 69,168,061
Common Stock issued under
Stock Option Plan and
Stock Purchase Plan 184,719 1,847 -- -- 764,989
Common Stock issued for
acquisitions 280,732 2,807 -- -- 331,318
Common Stock issued for
conversion of debt 22,607 226 -- -- 79,497
Common stock issued on
exercise of warrants 13,000 130 -- -- 3,245
Foreign currency translation
adjustment -- -- -- -- --
Unrealized loss on investments -- -- -- -- --
Net loss -- -- -- -- --
------------ ------------ ------------ ------------ ------------
Balance at December 31, 1996 13,579,522 $ 135,795 $ -- $ -- $ 70,347,110
Common Stock issued under
Stock Option Plan and
Stock Purchase Plan 198,580 1,986 -- -- 326,634
Common stock issued on
exercise of warrants 5,634 56 -- -- 1,404
Common stock issued for
consulting services 40,000 400 -- -- 74,600
Cancellation of unearned
Common Stock issued as
contingent purchase
consideration (40,000) (400) -- -- (107,120)
Foreign currency translation
adjustment -- -- -- -- --
Unrealized gain on investments -- -- -- -- --
Net loss -- -- -- -- --
------------ ------------ ------------ ------------ ------------
Balance at December 31, 1997 13,783,736 $ 137,837 $ -- $ -- $ 70,642,628
Issuance of Series A Preferred Stock
(net of issuance costs of $3,020,862) -- -- 2,479,138 -- 2,789,738
Issuance costs in connection with Notes -- -- -- -- 1,467,452
Beneficial Conversion Feature -- -- -- -- 5,479,138
Conversion of Series A Preferred Stock
to Series B Preferred Stock -- -- (2,479,138) 2,479,138 --
Conversion of Notes to Series B Preferred Stock -- -- -- 3,000,000 1,500,000
Common Stock issued on conversion of
Series B Preferred Stock 4,302,500 43,025 -- (4,850,338) 4,807,313
Common Stock dividends 106,692 1,067 -- -- 277,602
Common Stock issued in private placement 1,666,667 16,667 -- -- 4,683,333
Warrants issued to Non-employees -- -- -- -- 31,451
Common Stock issued upon exercise of warrants 2,813,584 28,136 -- -- (136)
Common Stock Granted to Officers 765,000 7,650 -- -- 1,379,295
Common Stock issued under
Stock Option Plan and
Stock Purchase Plan 325,443 3,254 -- -- 867,221
Compensation expense on options issued
to non-employees -- -- -- -- 40,734
Foreign currency translation adjustment -- -- -- -- --
Net loss -- -- -- -- --
------------ ------------ ------------ ------------ ------------
Balance at December 31, 1998 23,763,622 $ 237,636 $ -- $ 628,800 $ 93,965,769
------------ ------------ ------------ ------------ ------------
------------ ------------ ------------ ------------ ------------
</TABLE>
<TABLE>
<CAPTION>
Cumulative Unrealized Total
Translation Gain (loss) on Accumulated Stockholders'
Adjustment Investments Deficit Equity
------------ ------------ ------------ ------------
<S> <C> <C> <C> <C>
Balance at December 31, 1995 $ (14,923) $ 21,791 $(21,040,243) $ 48,265,471
Common Stock issued under
Stock Option Plan and
Stock Purchase Plan -- -- -- 766,836
Common Stock issued for
acquisitions -- -- (582,922) (248,797)
Common Stock issued for
conversion of debt -- -- -- 79,723
Common stock issued on
exercise of warrants -- -- -- 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 $ 51,193 $ (5,811) $(45,875,900) $ 24,652,387
Common Stock issued under
Stock Option Plan and
Stock Purchase Plan -- -- -- 328,620
Common stock issued on
exercise of warrants -- -- -- 1,460
Common stock issued for
consulting services -- -- -- 75,000
Cancellation of unearned
Common Stock issued as
contingent purchase
consideration -- -- -- (107,520)
Foreign currency translation
adjustment (38,625) -- -- (38,625)
Unrealized gain on investments -- 5,811 -- 5,811
Net loss -- -- (22,457,678) (22,457,678)
------------ ------------ ------------ ------------
Balance at December 31, 1997 $ 12,568 $ -- $(68,333,578) $ 2,459,455
Issuance of Series A Preferred Stock
(net of issuance costs of $3,020,862) -- -- -- 5,268,876
Issuance costs in connection with Notes -- -- -- 1,467,452
Beneficial Conversion Feature -- -- (5,479,138) --
Conversion of Series A Preferred Stock
to Series B Preferred Stock -- -- -- --
Conversion of Notes to Series B Preferred Stock -- -- -- 4,500,000
Common Stock issued on conversion of
Series B Preferred Stock -- -- -- --
Common Stock dividends -- -- (278,713) (44)
Common Stock issued in private placement -- -- -- 4,700,000
Warrants issued to Non-employees -- -- -- 31,451
Common Stock issued upon exercise of warrants -- -- -- 28,000
Common Stock Granted to Officers -- -- -- 1,386,945
Common Stock issued under
Stock Option Plan and
Stock Purchase Plan -- -- -- 870,475
Compensation expense on options issued
to non-employees -- -- -- 40,734
Foreign currency translation adjustment (12,568) -- -- (12,568)
Net loss -- -- (10,957,699) (10,957,699)
------------ ------------ ------------ ------------
Balance at December 31, 1998 $ -- $ -- $(85,049,128) $ 9,783,077
------------ ------------ ------------ ------------
------------ ------------ ------------ ------------
</TABLE>
The accompanying notes are an integral part of these
consolidated financial statements.
28
<PAGE>
7TH LEVEL, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
<TABLE>
<CAPTION>
1998 1997 1996
------------ ------------ ------------
<S> <C> <C> <C>
Cash flows from operating activities:
Net loss $(10,957,698) $(22,457,678) $(24,252,735)
Adjustments to reconcile net loss to net cash
used in operating activities:
Non-cash compensation and interest 3,108,032 -- --
Depreciation and amortization 1,806,365 4,180,144 2,564,609
Loss (gain) on sale of assets 1,518,504 (1,115,800) --
Gain on early retirement of debt -- (10,142) --
Other 187,865 75,000 --
Changes in assets and liabilities, net of acquisitions:
Accounts receivable 1,069,709 5,149,670 650,585
Inventories 18,477 551,846 (181,297)
Other current assets 466,611 865,059 (592,837)
Other assets 467,184 533,438 (366,529)
Accounts payable (913,771) (1,059,444) 883,866
Other current liabilities (3,073,924) (65,720) 1,554,554
------------ ------------ ------------
Net cash used in operating activities (6,302,646) (13,353,627) (19,739,784)
------------ ------------ ------------
Cash flows from investing activities:
Proceeds from sale of assets 98,214 6,593,010 --
Purchase of short-term investments -- -- (7,965,007)
Proceeds from sales of short-term investments -- 4,491,367 13,158,205
Equity investment -- -- (400,000)
Acquisitions, net of cash acquired (paid) -- -- (771,966)
Capital expenditures (43,968) (436,409) (9,643,055)
------------ ------------ ------------
Net cash provided by (used in) investing activities 54,246 10,647,968 (5,621,823)
------------ ------------ ------------
Cash flows from financing activities:
Net proceeds from private placement of Common Stock 4,700,000 -- --
Net proceeds from issuance of Preferred Stock 5,268,876 -- --
Net proceeds from debt issuance 4,310,900 -- --
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) --
Principal payments under capital lease obligations (186,877) (232,746) (163,365)
Issuance of Common Stock under Stock Option and
Stock Purchase Plan 870,474 330,080 766,836
Other 35,650 -- 3,375
------------ ------------ ------------
Net cash provided by (used in) financing activities 14,999,023 (5,652,666) 6,231,846
------------ ------------ ------------
Effect of exchange rate changes on cash and
cash equivalents -- 25,032 (12,084)
------------ ------------ ------------
Net increase (decrease) in cash and cash
equivalents 8,750,623 (8,333,293) (19,141,845)
Cash and cash equivalents, beginning of period 2,465,079 10,798,372 29,940,217
------------ ------------ ------------
Cash and cash equivalents, end of period $ 11,215,702 $ 2,465,079 $ 10,798,372
------------ ------------ ------------
------------ ------------ ------------
Supplemental disclosure of cash flow information--
Cash paid for interest $ 74,853 $ 204,915 $ 352,562
------------ ------------ ------------
------------ ------------ ------------
</TABLE>
The accompanying notes are an integral part of these
consolidated financial statements.
29
<PAGE>
7TH LEVEL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1998
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 April 1998, the Company
announced a strategy to become a leading developer of Internet media preparation
tools and technologies. In February 1999, 7th Level Merger Corporation, a
wholly-owned subsidiary of the Company, merged with Street Technologies, Inc.
(the "Merger"). (See Note 12)
The Company has incurred significant losses since inception including operating
losses of approximately $8.3 million, $23.8 million and $25.5 million for the
years ended December 31, 1998, 1997 and 1996, respectively.
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 also closed its international localization and sales offices including
those in San Francisco, Tokyo and Munich and sold its PyroTechnix, Inc.
subsidiary during 1997. In fourth quarter 1998 the production facilities located
in Glendale, California were closed. Research and product development and sales
and marketing expenses include approximately, $700,000 and $965,000,
respectively, related to the closing of the international localization and sales
offices. In the year ended December 31, 1998, the Company was able to reverse
into income certain reserves established in 1997 as it was able to settle
certain liabilities and commitments for approximately $523,000 less than
anticipated.
During fiscal 1998, the Company raised over $14.3 million, net of offering
expenses, in connection with private placements (See Note 3) to fund operations.
Furthermore, at the Company's election, as defined, the Company has the right to
sell shares of Common Stock under a Subscription Agreement in exchange for an
additional $5,000,000, as defined (See Note 3).
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.
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.
The Company's estimates and future results could be affected adversely by a
number of uncertainties related to its new software products. Such factors
include, but are not limited to market acceptance; ability to obtain sales
volumes and adequate prices; the Company's sustained commitment of resources to
further develop and market the technology; and the technological competitive
advantage of these new products.
REVENUE RECOGNITION
The Company recognizes revenue in accordance with the provisions of Statement of
Position No. 97-2, "Software 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
30
<PAGE>
7TH LEVEL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1998
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 $3,000 and $385,000 included in other current liabilities
associated with development and licensing contracts at December 31, 1998 and
1997, 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 No. 97-2 are met, as discussed above. 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.
RESEARCH AND PRODUCT DEVELOPMENT EXPENDITURES
The Statement of Financial Accounting Standards ("SFAS") No. 86 "Accounting for
the Costs of Computer Software to be Sold, Leased or Otherwise Marketed",
provides 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. To date, no such costs have been capitalized 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.
ADVERTISING COSTS
Advertising costs, included in sales and marketing expenses, are charged as an
expense when they are incurred. Advertising costs were $178,300, $1,542,175 and
$4,816,231 for the years ended December 31, 1998, 1997 and 1996, respectively.
CASH AND CASH EQUIVALENTS
The Company considers all highly liquid investments 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 $11,200,000 and
$2,300,000 at December 31, 1998 and 1997, respectively.
OTHER CURRENT ASSETS
Other current assets include prepaid insurance, prepaid royalties, interest
receivable, other receivables, 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.
31
<PAGE>
7TH LEVEL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1998
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, 1998 intangible assets consisted of various patents, copyrights,
and trademarks, technological know-how, assembled workforce and goodwill
acquired in acquisitions. Intangible assets are being amortized on a straight
line basis over estimated useful lives of three to seven years. The Company
assesses the recoverability of intangible assets in accordance with SFAS No. 121
"Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to
Be Disposed Of," 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. Combined, these
totaled approximately $610,000.
OTHER ASSETS
At December 31, 1997 other assets consisted primarily of restricted cash placed
in escrow for a planned merger that was not completed and 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. The Company applies SFAS No. 52 "Accounting for the Translation of
Foreign Currency Transactions and Foreign Currency Financial Statements".
Accordingly, assets and liabilities of the subsidiaries outside of the United
States are translated into U.S. 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. During 1998 the Company closed down its foreign operations
and accordingly the adjustment was removed from the separate component of equity
and reported as a part of the loss on cessation of these operations.
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 1997, the Financial Accounting Standards Board ("FASB") issued SFAS No. 128,
"Earnings Per Share" ("SFAS No. 128"). This statement established standards for
computing and presenting earnings per share. This statement is effective for
periods ending after December 15, 1997. In February 1998, the Securities and
Exchange Commission ("SEC") issued Staff Accounting Bulletin ("SAB") No. 98.
This bulletin revised the SEC's guidance for calculating earnings per share with
respect to equity security issuances before an initial public offering ("IPO")
and is effective for fiscal years ending after December 15, 1997. The prior
years' earnings per share have been retroactively restated to reflect the
adoption of SFAS No. 128 and SAB No. 98.
32
<PAGE>
7TH LEVEL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1998
Basic earnings per share was determined by dividing net loss by the weighted
average common shares outstanding during the period. Diluted earnings per share
was determined by dividing net loss by diluted weighted average shares
outstanding. Diluted weighted average shares reflects the dilutive effect, if
any, of common equivalent shares and nominal issuances. Common equivalent shares
include common stock options and warrants to the extent their effect is
dilutive, based on the treasury stock method. Nominal issuances arise when a
company issues common stock, options or warrants to purchase common stock or
other potentially dilutive instruments for nominal consideration, as defined by
SAB No. 98, in the periods preceding an IPO. During the period preceding the
Company's IPO, the Company did not have any nominal issuances.
The calculations of basic and dilutive weighted average shares outstanding are
as follows:
<TABLE>
<CAPTION>
Year Ended December 31,
-----------------------
1998 1997 1996
---------- ---------- ----------
<S> <C> <C> <C>
Basic weighted average Common
shares outstanding 16,355,158 13,696,730 13,442,101
Weighted average Common equivalent
shares -- -- --
---------- ---------- ----------
Diluted weighted average shares
outstanding 16,355,158 13,696,730 13,442,101
---------- ---------- ----------
---------- ---------- ----------
</TABLE>
Diluted weighted average shares outstanding do not include 3,903,679 and
1,405,109 common equivalent shares at December 31, 1998 and 1997, respectively,
as their effect would be anti-dilutive.
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.
At December 31, 1998 and 1997, the Company had operating loss carryforwards
available to offset future federal taxable income of approximately $70 million
and $60 million, respectively. Deferred tax assets relating to the operating
losses have been fully offset by a valuation allowance. Accordingly, no income
tax benefit has been recorded. These operating loss carryforwards expire at
various dates through 2018 and under Section 382 of the Internal Revenue Code
may be limited due to ownership changes.
RECLASSIFICATIONS
Certain prior year balances have been reclassified to conform to the current
year presentation.
NEW ACCOUNTING PRONOUNCEMENTS
In June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive Income"
("SFAS No. 130"). SFAS No. 130 requires disclosure of all components of
comprehensive income on an annual and interim basis. Comprehensive income is
defined as the change in equity of a business enterprise during a period from
transactions and other events and circumstances from nonowner sources. SFAS No.
130 is effective for fiscal years beginning after December 15, 1997. The
adoption had no impact on the Company's consolidated financial position, results
of operations or cash flows.
In June 1997, the FASB issued SFAS No. 131, "Disclosures About Segments of an
Enterprise and Related Information" ("SFAS No. 131"). SFAS No. 131 requires
certain financial and supplementary information to be disclosed on an annual and
interim basis for each reportable segment of an enterprise. SFAS No.131 is
effective for
33
<PAGE>
7TH LEVEL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1998
fiscal years beginning after December 15, 1997. Comparative information for
earlier years presented is to be restated. The adoption had no impact on the
Company's consolidated financial position, results of operations or cash flows.
In March 1998, the American Institute of Certified Public Accountants issued
Statement of Position ("SOP") 98-1, "Accounting for the Costs of Computer
Software Developed or Obtained for Internal Use". SOP 98-1 requires computer
software costs associated with internal use software to be charged to operations
as incurred until certain capitalization criteria are met. SOP 98-1 is effective
beginning January 1, 1999. The Company does not expect adoption of this
statement to have a material impact on its consolidated financial position,
results of operations or cash flows.
3. BUSINESS COMBINATIONS AND PRIVATE PLACEMENTS
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. The acquisition was accounted for as a pooling of interests. 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 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 consolidated 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.
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 at an exercise price of $0.01 per
share. The Company allocated approximately $1,200,000 of the proceeds from the
Notes to the warrants based on the relative fair values of the Notes and the
warrants. Accordingly, the Company amortized the related debt discount to
interest expense over the period from May 6, 1998 (date of issuance) to July 13,
1998 (date of exchange - see below). All of such warrants were exercised in June
1998. On July 9, 1998, the Company obtained stockholder approval for, among
other things, an increase in its authorized Common Stock (the "Certificate of
Amendment") at its 1998 Annual Meeting of Stockholders. The Certificate of
Amendment was filed on July 10, 1998. On July 13, 1998, the holders of the Notes
exchanged the Notes for 4,500 shares of the Company's Series B Convertible
Preferred Stock, $0.01 par value per share and warrants to purchase 1,125,000
shares of Common Stock at an exercise price of $0.01 per share. The Company
allocated $3,000,000 to Series B Convertible Preferred Stock and $1,500,000 to
warrants in accounting for the exchange.
In May 1998, the Company also sold, pursuant to a private placement, shares of
Series A Preferred Stock in the aggregate amount of $5,500,000 and warrants for
1,375,000 shares of Common Stock at an exercise price of $0.01 per share. The
Company allocated approximately $2,500,000 of the proceeds from the Series A
Preferred Stock to the warrants based on the relative fair values of the Series
A Preferred Stock and the warrants. All of such warrants were exercised in June
1998. On July 13, 1998, after the Certificate of Amendment was approved by the
Company's stockholders and was filed with the 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
34
<PAGE>
7TH LEVEL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1998
the Company. The Series B Convertible Preferred Stock ranks senior and prior to
the Common Stock and to all other classes or series of stock issued by the
Company. Dividends accrue on the shares of Series B Convertible Preferred Stock
at the rate of 8% per annum; provided, however, that in the event the Company
fails to redeem the Series B Convertible Preferred Stock on or before April 30,
2005 (the "Anniversary Redemption Date"), pursuant to the Certificate of
Designations, the dividend rate on the Series B Convertible Preferred Stock
shall increase 2% per annum on each anniversary of the Anniversary Redemption
Date. Annual dividends are cumulative and are payable quarterly in arrears when
and as declared by the Company's Board of Directors. These shares have a
liquidation preference of $1,000 per share. The Series B Convertible Preferred
Stock is convertible immediately into Common Stock, initially at a conversion
price of $2.00 per share, subject to adjustment. The shares of Series B
Convertible Preferred Stock may be redeemed, at the option of the Company, at
$1,000 per share on or after the Anniversary Redemption Date. Upon a change of
control, the Company may offer to redeem such shares at $2,000 per share or the
Company may issue to each holder of Series B Convertible Preferred Stock
warrants exercisable for 250,000 shares of Common Stock for each 1,000 shares of
Series B Convertible Preferred Stock owned by such holder at an exercise price
of $0.01 per share. The Company also has optional redemption rights at any time
after i) completion of an underwritten public offering by the Company with gross
proceeds to the Company of at least $20,000,000 and a price per share of Common
Stock of at least $4.00 per share, subject to adjustment, or ii) after the
Company's Common Stock shall have traded at an average price in excess of $4.00
per share, subject to adjustment, for 20 consecutive trading days and the
aggregate market value of the Common Stock held by non-Affiliates of the Company
is at least $35,000,000. The holders of Series B Convertible Preferred Stock
also are entitled to certain preemptive rights, co-sale rights and registration
rights.
For the year ended December 31, 1998, the Company was required to increase the
loss attributable to common stockholders, as a result of the beneficial
conversion feature which arose due to the increase in the market price of the
Company's Common Stock from the date the Company received commitments with
respect to the $10,000,000 financing (April 20, 1998) to the date of issuance of
the Series B Convertible Preferred Stock (July 13, 1998). The beneficial
conversion feature is based upon the difference between the market price of the
5,000,000 shares of Common Stock into which the Series B Convertible Preferred
Stock is convertible and the carrying value of the Series B Convertible
Preferred Stock on the date of authorized issuance, but is limited (as discussed
above) to the proceeds received with respect to each security issued. As the
Company allocated $3,000,000 of proceeds to the Series B Convertible Preferred
Stock, and approximately $2,500,000 of proceeds to the Series A Preferred Stock,
the amount of the beneficial conversion feature is approximately $5,500,000. The
one-time occurrence was accounted for similar to a non-cash dividend and had no
effect on the Company's net loss or aggregate stockholders' equity.
In December 1998, the Company sold, pursuant to a subscription agreement,
1,666,667 shares of Common Stock for $5,000,000, or $3.00 per share, and rights
to purchase an additional 100,000 and 650,000 shares of Common Stock for $.01
and $4.50, respectively, to Fletcher International Limited ("Fletcher"). The
Subscription Agreement provides that, at the Company's election, and as long as
the market price of the Company's Common Stock is greater than $3.00 per share
and the Company has an effective registration statement for the resale of
Fletcher's shares, Fletcher is obligated to purchase up to an additional
$5,000,000 of Common Stock at market prices when the Company elects to exercise
its right to sell shares to Fletcher. In addition, Fletcher may receive
additional shares of Common Stock if the Company's Common Stock does not meet
certain price targets or if the Company does not register the resale of
Fletcher's shares by certain dates, as defined.
35
<PAGE>
7TH LEVEL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1998
4. FIXED ASSETS, NET
Fixed assets, at cost, as of December 31, 1998 and 1997 consisted of the
following:
<TABLE>
<CAPTION>
1998 1997
----------- -----------
<S> <C> <C>
Equipment $ 3,877,804 $ 6,960,778
Leasehold improvements 335,000 2,903,346
Furniture and fixtures 243,393 410,360
------------ ------------
4,456,197 10,274,484
Less: accumulated depreciation and
amortization (3,056,545) (5,313,924)
------------ ------------
$ 1,399,652 $ 4,960,560
------------ ------------
------------ ------------
</TABLE>
The Company leases certain office equipment under capital lease agreements. At
December 31, 1998 and 1997, respectively, the carrying value of capital assets
was $193,360 and $388,906, net of accumulated amortization of $317,308 and
$208,664.
During 1998 the Company disposed of approximately $1.8 million of net capital
assets as a result of a reduction in capacity and recognized a loss in the
December 31, 1998 consolidated financial statements related to this disposition
of these assets of approximately $1.5 million.
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.
5. ACCRUED EXPENSES
Accrued liabilities consist of the following at December 31, 1998 and 1997:
<TABLE>
<CAPTION>
T
1998 1997
---------- ----------
<S> <C> <C>
Accrued office closing costs $ 264,646 $1,064,702
Accrued royalties 346,597 859,475
Accrued discounts and allowances 677,850 806,953
Accrued legal and corporate expenses 295,000 361,374
Accrued compensation 120,310 565,377
Accrued interest and taxes 31,075 169,353
Other 437,214 722,634
---------- ----------
$2,172,692 $4,549,868
---------- ----------
---------- ----------
</TABLE>
36
<PAGE>
7TH LEVEL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1998
6. DEBT
As of December 31, 1998 and 1997 the Company's debt was as follows:
<TABLE>
<CAPTION>
1998 1997
-------- --------
<S> <C> <C>
7% Convertible Notes 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 and satisfied
(See Note 12 b). Included in this
amount is $108,108 due to related parties $485,135 $485,135
Other -- 79,318
-------- --------
Total $485,135 $564,453
Less current portion 485,135 79,318
-------- --------
Long term payables $ -- $485,135
-------- --------
-------- --------
</TABLE>
Interest expense to related parties on the above debt was $7,568 for each of the
years ended December 31, 1998 and 1997.
7. STOCKHOLDERS' EQUITY
COMMON STOCK
On July 9, 1998 the shareholders of the Company authorized an increase in the
number of shares of Common Stock from 20,000,000 to 100,000,000, par value $0.01
per share (the "Common Stock").
PREFERRED STOCK
There are 100,000 shares of Preferred Stock, par value of $0.01 per share,
authorized and 1,395 shares were outstanding as of December 31, 1998. 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.
In May 1998, the Company sold, pursuant to a private placement, 5,500 shares of
Series A Preferred Stock. On July 13, 1998 the Notes were exchanged for 4,500
shares of the Series B Convertible Preferred Stock (See Note 3). In a separate
transaction the Series A Preferred Stock was exchanged for 5,500 shares of
Series B Convertible Preferred Stock. During the fourth quarter of 1998, 8,605
shares of the Series B Convertible Preferred Stock were converted into 4,302,500
shares of Common Stock.
STOCK COMPENSATION PLANS
The Company has granted options to certain employees, directors and outside
consultants to purchase Common Stock outside of any defined plans and 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. As of December
37
<PAGE>
7TH LEVEL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1998
31, 1998 the Incentive Stock Option Plan had 228,275 option shares outstanding
and 1,790,435 shares available to grant. Of the 228,275 shares outstanding
45,500 shares are subject to the Option Share Repurchase Agreement with certain
stockholders and no new shares will be issued upon the exercise of grants.
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. The Company may invoke this right in the event certain
outstanding options (exercisable for an identical number of shares) are
exercised. 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, thereby resulting in no change
in the number of outstanding shares of Common Stock. At December 31, 1998,
545,500 options associated with the Option Share Repurchase Agreement had been
exercised at a weighted average exercise price of $0.163 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, 1998, 469,500 options subject to the Option Share Repurchase
Agreement with a weighted average exercise price of $0.253 per share had been
canceled. Notwithstanding the cancellation of certain options, the stockholders
who are 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. During 1998, 69,000 shares were assigned to outstanding options.
Accordingly, all the 45,500 shares remaining under the Option Share Repurchase
Agreement have corresponding option grants.
Transactions in stock options under the Incentive Stock Option Plan are
summarized as follows:
<TABLE>
<CAPTION>
Option Share Weighted Average Weighted
Repurchase Exercise Average
Agreement Price Stock Options Exercise Price
----------------------------------------------------------------
<S> <C> <C> <C> <C>
Balance at December 31, 1995 222,000 $ 0.715 1,485,250 $ 8.61
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
Granted -- -- 516,825 1.72
Exercised (41,500) 0.634 (308,115) 2.65
Reassigned 69,000 1.250 (69,000) 1.25
Canceled (33,000) 3.561 (998,200) 4.90
---------------------------- -------------------------------
Balance at December 31, 1998 45,500 $ 1.250 182,775 $ 1.44
---------------------------- -------------------------------
---------------------------- -------------------------------
</TABLE>
38
<PAGE>
7TH LEVEL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1998
Transactions in stock options to employees, directors and consultants outside
either of the formal plans mentioned above are summarized as follows:
<TABLE>
<CAPTION>
Weighted Average
Exercise
Stock Options Price
-------------------------
<S> <C> <C>
Balance at December 31, 1996 -- $--
Granted 737,500 3.76
Exercised -- --
Canceled -- --
-------------------------
Balance at December 31, 1997 737,500 $3.76
Granted 3,056,500 1.98
Exercised (11,000) 1.32
Canceled (956,000) 3.26
-------------------------
-------------------------
Balance at December 31, 1998 2,827,000 $2.02
-------------------------
-------------------------
</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 "Directors' Plan"), the Company may grant options to its
non-employee directors for up to 125,000 shares of Common Stock. In 1998, 65,000
shares outstanding under the Directors' Plan were cancelled in exchange for new
options granted outside this plan. All of the 125,000 shares authorized under
the Directors' Plan were deregistered. At December 31, 1998, no options were
outstanding.
In May 1998, the Company exchanged with two board members their options to
purchase 715,000 shares of Common Stock for 765,000 shares of Common Stock for
$0.01 per share. The Company recognized a compensation charge of $1,377,000
related to this stock issuance.
Subsequent to year end, three members of the Board of Directors exercised
options to purchase 960,000 shares of Common Stock for the aggregate amount of
approximately $1.9 million. In connection with these exercises, the Company
received promissory notes from these individuals in the approximate amount of
$1.7 million.
The following table summarizes information about Incentive Stock Option Plan and
non-plan stock options outstanding at December 31, 1998:
<TABLE>
<CAPTION>
Total options outstanding Total options exercisable
------------------------------------------------ -----------------------------
Weighted
average Weighted Weighted
Range of exercise Number remaining average Number average
prices outstanding contractual exercise price exercisable exercise price
life
--------------------- -------------- ---------------- ---------------- ------------- ---------------
<S> <C> <C> <C> <C> <C>
$ .003 - 1.99 214,750 8.72 years $ 1.25 190,125 $ 1.25
2.00 - 4.99 2,830,525 9.25 years 2.01 490,775 2.00
5.00 - 11.50 10,000 7.38 years 11.50 5,000 11.50
--------- -------
3,055,275 685,900
--------- -------
--------- -------
</TABLE>
Options vest over varying time periods ranging from zero to four years. During
1998 and 1996 respectively, 527,500 and 1,217,250 outstanding options were
repriced at the then current market value. 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
39
<PAGE>
7TH LEVEL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1998
offering period. Purchase dates are every six months. As of December 31, 1998,
300,000 shares were authorized for purchase pursuant to the plan and 223,436
shares had been issued.
The Company adopted SFAS No. 123, "Accounting for Stock Based Compensation",
during 1996 and elected to continue to apply the intrinsic value method provided
under Accounting Principles Board ("APB") Opinion No. 25 and related
interpretations in accounting for its stock based compensation plans described
above. If compensation costs for the Company's stock-based compensation plans
had been determined under the fair value method the Company's net loss available
to common shareholders per share would have been increased to the pro forma
amounts indicated below:
<TABLE>
<CAPTION>
1998 1997 1996
---- ---- ----
<S> <C> <C> <C> <C>
Net loss As Reported $ (16,774,644) $ (22,457,678) $ (24,252,735)
Pro forma (19,523,711) (25,466,761) (29,004,105)
Basic and diluted loss per
Common share As Reported $ (1.03) $ (1.64) $ (1.80)
Pro forma (1.19) (1.86) (2.16)
</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 211 percent; risk free interest rates of 5.2 to 6.5 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. At
December 31, 1998, 278,195 of these warrants were outstanding.
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 and as of December 31, 1997, 19,268 shares of
the Company's Common Stock had been issued to cover the exercise of all of these
warrants.
In May 1998, in connection with the private placements (See Note 3), the Company
issued warrants to purchase 675,000 and 1,375,000 shares of Common Stock at an
exercise price of $0.01 per share. The Company allocated approximately
$1,200,000 and $2,500,000, respectively, of the total proceeds of $10,000,000 to
these warrants. All of the warrants were exercised in June 1998. In connection
with the exchange of the Notes issued in the above mentioned private placement
the Company issued additional warrants to purchase 1,125,000 shares of Common
Stock at an exercise price of $0.01 per share. During 1998, 750,000 shares of
Common Stock were issued upon the exercise of the warrants and warrants for
375,000 shares remained outstanding at December 31, 1998. Subsequent to year end
all of these warrants were exercised.
In December 1998, as part of the stock subscription agreement between the
Company and Fletcher, the Company issued rights to purchase an additional
100,000 and 650,000 shares of Common Stock for $.01 and $4.50, respectively (See
Note 3). As of December 31, 1998, all of these rights remain outstanding.
40
<PAGE>
7TH LEVEL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1998
8. LEASES
The Company leases office facilities in California and Texas and certain office
equipment under operating leases that expire at various dates through 2002.
Rental expense for operating leases amounted to $461,638, $911,385 and $904,948
for 1998, 1997 and 1996, respectively.
Minimum payments under leases expiring subsequent to December 31, 1998 are as
follows:
<TABLE>
<CAPTION>
Capital Operating
Year Leases Leases
---- ------ ------
<S> <C> <C>
1999 $ 161,218 $ 449,888
2000 47,412 320,459
2001 3,328 330,905
2002 -- 205,760
---------- ----------
Total $ 211,958 $1,307,012
----------
Less amount representing interest (17,549)
-------
Present value of minimum
lease payments $ 194,409
----------
</TABLE>
9. MAJOR CUSTOMERS AND CONCENTRATION OF CREDIT RISK
SFAS No. 105, "Disclosure of Information About Financial Instruments with
Off-Balance-Sheet Risk and Financial Instruments with Concentrations of Credit
Risk", requires disclosure of any significant off balance sheet and credit risk
concentration. The Company has no significant off-balance-sheet concentration of
credit risk such as foreign currency exchange contracts or other hedging
arrangements. Financial instruments that subject the Company to credit risk
consist of cash and cash equivalents and accounts receivable. The Company places
its temporary cash in financial institutions. For the years ended December 31,
1998 and 1997, two and five customers represented approximately 47% and 50% of
the Company's total net revenues, respectively. Sales to customers located
outside the United States represent approximately 25% and 20% of the Company's
total sales for the years ended December 31, 1998 and 1997, respectively.
10. 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, 1998, 1997 and 1996, the Company made contributions to the
plan of approximately $48,000, $220,000 and $280,000, respectively.
11. COMMITMENTS AND CONTINGENCIES
The Company is involved in other claims and lawsuits that 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 consolidated financial position, results of
operations or cash flows.
12. SUBSEQUENT EVENTS
A. STREET TECHNOLOGIES, INC. ACQUISITION
In February 1999, the Company acquired Street Technologies, Inc., a company that
uses streaming technology to market and sale its extensive catalog of online
training course products. Effective as of the date of the merger,
41
<PAGE>
7TH LEVEL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1998
Street Technologies, Inc. changed its name to 7thStreet.com, Inc. To consummate
the transaction, the Company issued 4,948,182 shares of Common Stock and 21,644
shares of Series D 8% Preferred Stock (the "Series D Stock") with an aggregate
liquidation preference of $21,643,970. Upon the receipt of Common Stockholders
approval to convert, the Series D Stock will convert into Common Stock at $3.00
per share. The Series D 8% Preferred Stockholders are entitled to participate
with the Common Stockholders in dividends and distributions and to vote on most
matters on an "as converted" basis with the Common stockholders and as a
separate class, except for the vote on whether to convert the Series D Stock.
The total value of the transaction is approximately $36 million and will be
accounted for using the purchase method of accounting.
B. CONVERSION OF 7% CONVERTIBLE NOTES PAYABLE
The 7% Convertible Notes Payable were due and payable on February 11, 1999 (See
Note 6). To induce the holders to convert the note into Common Stock the Company
on February 10, 1999, offered the holders the right to convert at a price equal
to 85% of the then current market rate of the stock. During February 1999, the
Company issued 186,982 shares of Common Stock in exchange for $458,108 of
current notes payable. Accordingly, the Company recognized interest expense in
the amount of $114,618. As of March 17, 1999 the remaining balance of $27,027
has not been paid to the one remaining holder.
42
<PAGE>
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURES
As of January 15, 1999, we replaced our principal accountant KPMG LLP with
Arthur Andersen LLP. Our decision to change accountants was recommended by our
Board of Directors.
KPMG LLP's report on our consolidated financial statements as of December 31,
1997 and 1996 and for each of the years in the three-year period ended December
31, 1997 contained a separate paragraph stating 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. 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."
On April 20, 1998, we received commitments for an aggregate $10 million
financing which was comprised of $4.5 million principal amount of senior secured
promissory notes and $5.5 million liquidation preference of non-convertible
preferred stock. The terms of the financing provided that upon stockholder
approval the non-convertible preferred stock would be automatically exchanged
into convertible preferred stock and the holders of the senior secured
promissory notes would have the option of exchanging their notes into
convertible preferred stock. On July 13, 1998, an aggregate of $10 million
liquidation preference of our Series B Convertible Preferred Stock was issued to
the holders of the senior secured promissory notes and non-convertible preferred
stock. Between April 20, 1998 and July 13, 1998, the market price of our common
stock increased such that the conversion price of the Series B Convertible
Preferred Stock was greater than the market price of our common stock on April
20, 1998 but less than the market price of our common stock on July 13, 1998.
Due to the beneficial conversion feature of the Series B Convertible Preferred
Stock, we were required to increase the loss attributable to common stockholders
for the quarter ended September 30, 1998. The one-time occurrence was accounted
for similar to a non-cash dividend and had no effect on our net loss or
aggregate stockholders' equity.
KPMG LLP informed us about the accounting treatment of the beneficial conversion
feature. Management then requested KPMG LLP to look into alternative accounting
treatments. Management believes that its inquiries and discussions regarding
this matter did not constitute a disagreement. However, KPMG LLP has informed us
that in view of all the circumstances surrounding the discussions about this
issue this matter constitutes a disagreement as contemplated by Item 4 of Form
8-K and Item 304(a)(1) of Regulation S-K. Upon KPMG LLP informing us that in
KPMG's opinion there was no alternative accounting treatment, we followed the
advice of KPMG LLP and accounted for the Series B Convertible Preferred Stock as
described above to the satisfaction of KPMG LLP.
We have authorized KPMG LLP to respond fully to the inquiries of Arthur Andersen
LLP concerning the subject matter of the beneficial conversion feature.
The following is the response submitted to the SEC by KPMG LLP:
"We were previously principal accountants for 7th Level, Inc. and under the date
of January 30, 1998, we reported on the consolidated financial statements of 7th
Level, Inc. and subsidiaries as of December 31, 1997 and 1996 and for each of
the years in the three-year period ended December 31, 1997. On January 15, 1999,
our appointment as principal accountants was terminated. We have read 7th Level,
Inc.'s statements included under Item 4 of its Form 8-K dated January 15, 1999,
and agree with such statements, except that we are not in a position to agree or
disagree with 7th Level, Inc.'s statement that the change in principal
accountants was recommended by the Company's Board of Directors."
After the change in accountants took place it came to the Company's attention
that at the November 18, 1998 meeting of the Emerging Issues Task Force, the
staff of the Securities Exchange Commission ("SEC") issued a statement regarding
how issuers should account for convertible securities. The minutes dealt with,
among other things, the observation, by the Task Force, that in certain
circumstances, the intrinsic value of the beneficial conversion feature may be
greater than the proceeds received from the sale of the convertible instrument.
In those situations, the Task Force reached a tentative conclusion that the
amount of the discount assigned to the beneficial
43
<PAGE>
conversion feature should be limited to the amount of proceeds received.
As a result of the foregoing, the Company has restated the financial statements
contained in the Quarterly Report on Form 10-Q for the three and nine month
periods ended September 30, 1998. The Company has reduced the beneficial
conversion feature originally recorded in the amount of approximately
$15,000,000 to approximately $5,500,000. The impact of such restatement on the
Company's Condensed Consolidated Statement of Operations and Balance Sheet is as
follows:
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30, 1998 September 30, 1998
As Originally As Originally
As Restated Reported As Restated Reported
------------- -------------- -------------- --------------
<S> <C> <C> <C> <C>
Net Loss available to common stockholders ($ 7,922,802) ($ 17,414,526) ($ 15,474,901) ($ 24,966,625)
Loss per Common Share ($ .45) ($ 1.00) ($ 1.00) ($ 1.62)
</TABLE>
<TABLE>
<CAPTION>
September 30, 1998
As Restated As Originally
Reported
------------ ------------
<S> <C> <C>
Additional Capital $83,990,864 $93,482,588
Accumulated Deficit ($83,635,328) ($93,127,052)
</TABLE>
44
<PAGE>
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The following table sets forth the names, ages and all positions and offices
with the Corporation held by the Corporation's present executive officers.
<TABLE>
<CAPTION>
NAME AGE POSITION
- ------------------------------------------- --- -------------------------------------------
<S> <C> <C>
Donald Schupak............................. 56 Director and Chairman of the Board of
Directors
Robert Alan Ezrin.......................... 50 Director and Vice Chairman of the Board of
Directors
Stephen P. Gott............................ 49 President, Chief Executive Officer and
Director
Marc E. Landy.............................. 38 Vice President and Chief Financial Officer
</TABLE>
Executive officers are appointed by the Board of Directors and serve at the
discretion of the Board.
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 President and Chief Executive
Officer of the Schupak Group, Inc., an organization that provides strategic
planning, management consulting and corporate services to corporations
worldwide. Mr. Schupak has been with the Schupak Group, Inc. since 1990. Mr.
Schupak is also Chairman of the Board for Danskin, Inc. He previously 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 Vice Chairman of the Board and
Director. Mr. Ezrin is a founder of the Corporation and has served as a Director
since its inception in April 1993 and has served as Vice Chairman of the Board
since April 1998. Mr. Ezrin served as President from November 1995 until April
1998 and Chief Executive Officer from March 1997 until April 1998. Mr. Ezrin
served as Co-Chairman of the Board of the Corporation from its inception in
April 1993 until November 1995. Mr. Ezrin served as Executive Vice President of
Production from April 1994 to November 1995 and served as Vice President from
April 1993 to April 1994. 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.
STEPHEN P. GOTT has served as President, Chief Executive Officer and
Director of the Corporation since February 1999. From November 1994 to February
1999, Mr. Gott served as the President, Chief Executive Officer and Chairman of
the Board of Street Technologies, Inc. which the Corporation acquired in
February 1999. From June 1986 to November 1994, Mr. Gott served as the Chief
Technology and Operations Officer at Lehman Brothers. Mr. Gott is a Director for
Viagrafix, Inc.
MARC E. LANDY currently serves as Vice President and Chief Financial Officer
of the Corporation. From November 1996 to February 1999, Mr. Landy served as the
Vice President and Chief Financial Officer of Street Technologies, Inc. which
the Corporation acquired in February 1999. From April 1993
45
<PAGE>
to November 1996, Mr. Landy served in several management capacities including
Controller and Director of Consulting for Flexi International. Mr. Landy is CPA
and from 1990 to 1992 he was a Senior Audit Manager at Ernst and Young.
DIRECTORS
The names of the director nominees of 7(th) Level, Inc. (the "Company"), all
of whom are currently 7(th) Level directors, and certain information about those
director nominees who are not executive officers named above (including their
term of service), are set forth below:
<TABLE>
<CAPTION>
DIRECTOR OF THE
NAME OF DIRECTOR AGE CORPORATION SINCE
- -------------------------------------------------------------------- --- -----------------
<S> <C> <C>
Donald Schupak...................................................... 56 1997 to present
Stephen P. Gott..................................................... 49 1999 to present
Merv Adelson........................................................ 69 1994 to present
James A. Cannavino.................................................. 55 1997 to present
Robert Alan Ezrin................................................... 50 1993 to present
Richard S. Merrick.................................................. 43 1998 to present
</TABLE>
MERV ADELSON has served as a Director of the Corporation since February
1994. Since 1989, Mr. Adelson has been the trustee of the sole shareholder of
East West Capital Associates, Inc. ("Capital"), 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. and Faroudja.
JAMES A. CANNAVINO has served as a Director of the Corporation 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 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 Corporation from 1991 to 1993.
RICHARD S. MERRICK currently serves as Chief Technology Officer and
Director. He has been a member of the Board of Directors since June 1998. Mr.
Merrick served as Chief Executive Officer from April 1998 to February 1999. Mr.
Merrick served as Senior Vice President of Technology and Chief Strategist of
the Corporation from January 1998 until April 1998. From November 1995 to
January 1998, Mr. Merrick served as Vice President of Technology. From May 1993
to November 1995, Mr. Merrick served as Vice President of Research and
Development.
COMPLIANCE WITH THE EXCHANGE ACT
The Corporation's executive officers and directors are required under the
Securities Exchange Act of 1934, as amended, to file reports of ownership and
changes in ownership with the Securities and Exchange Commission. Copies of
those reports must also be furnished to the Corporation. Based solely on the
Corporation's review of the copies of such reports it has received, the
Corporation believes that all its executive officers and directors and greater
than ten percent beneficial owners complied with all filing requirements
applicable to them.
46
<PAGE>
ITEM 11. DIRECTOR AND EXECUTIVE COMPENSATION
COMPENSATION OF DIRECTORS
None of Messrs. Gott (Director), Merrick (Director), or Schupak (Director)
receives any compensation for his services as director. The Corporation'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 of Directors meetings.
As discussed in the "Compensation Committee Report on Executive
Compensation," on April 20, 1998, due to employee turnover, employee morale and
the challenges and opportunities facing the Corporation, the Board of Directors
determined to reprice options of a significant number of its employees,
consultants and directors as well as grant additional options. As part of such
repricing, options for 75,000 shares of Common Stock held by James A. Cannavino
were repriced to an exercise price equal to $2.00 per share. On the date of the
repricing of such options, the closing price of the Common Stock on the Nasdaq
National Market was $1.8125.
In April 1998, the Board of Directors adopted a broad based plan that, due
to the limited number of authorized shares of Common Stock available, was for
options exercisable for approximately 2,967 shares of Series C Preferred Stock,
par value $.01 per share ("Series C Preferred Stock"). On July 9, 1998 the
Certificate of Incorporation was amended to increase the number of authorized
shares of Common Stock from 20,000,000 to 100,000,000, and the options
exercisable under such plan became exercisable for approximately 2,967,000
shares of Common Stock. All of the options granted on such date are exercisable
at an exercise price equal to $2.00 per share. On the date of the grant of such
options, the closing price of the Common Stock on the Nasdaq National Market was
$1.8125. Messrs. Schupak, Ezrin and Merrick received options exercisable for
600, 125 and 700 shares of Series C Preferred Stock, respectively, or 600,000,
125,000 and 700,000 shares of Common Stock, respectively. Mr. Adelson received
options exercisable for 55 shares of Series C Preferred Stock (or 55,000 shares
of Common Stock) in exchange for the surrender of options exercisable for 25,000
shares of Common Stock. Mr. Cannavino received options exercisable for 140
shares of Series C Preferred Stock (or 140,000 shares of Common Stock) in
exchange for the surrender of options exercisable for 20,000 shares of Common
Stock.
As part of the broad based plan, each director of the Corporation (i.e.,
Messrs. Schupak, Ezrin, Adelson, Cannavino and Merrick) received options
exercisable into 30 shares of Series C Preferred Stock (or 30,000 shares of
Common Stock) which are included in the option grants described above. In
addition, Messrs. Schupak and Ezrin surrendered their options exercisable into
655,000 and 60,000 shares, respectively, in exchange for the issuance of 655,000
and 110,000 shares of Common Stock. Mr. Schupak also waived his right to be
considered for a cash bonus for 1997. In April 1998, the Corporation terminated
the Non-Employee Directors' Stock Option Plan.
In March 1997, the Corporation and the Schupak Group, Inc. entered into an
agreement whereby the Corporation pays $12,000 per month to Schupak West, Inc.,
an affiliate of the Schupak Group, Inc. for the consulting services of Donald
Schupak and other employees of the Schupak Group, Inc. Additionally, Mr. Schupak
is entitled to the reimbursement of reasonable travel and other expenses
incidental to the performance of his consulting duties. Mr. Schupak also serves
as Chairman of the Board and a director of the Corporation, but receives no
additional compensation for his services as a director. Mr. Schupak is entitled
to have the Board of Directors consider a bonus at the end of each fiscal year.
In February 1999, the Corporation paid to Mr. Ezrin $40,000 and issued to
him an option to purchase 20,000 shares of Common Stock exercisable at a price
equal to $3.00 per share as full payment for the Corporation's obligations
regarding Mr. Ezrin's severance entitlement as the former President and Chief
Executive Officer of the Corporation. Such options vested immediately.
In February 1999, in connection with the acquisition of Street Technologies,
Inc. ("Street") and as an inducement to Mr. Schupak to act as Chairman of the
Board of the combined company,
47
<PAGE>
Mr. Schupak was granted an option to purchase 500,000 shares of Common Stock
exercisable at a price equal to $3.25 per share; the inclusion of 250,000 shares
of Common Stock under the Amended and Restated Incentive Stock Option Plan of
the Corporation is subject to stockholder approval of an amendment to such plan.
EMPLOYMENT CONTRACTS AND TERMINATION AND CHANGE-IN-CONTROL ARRANGEMENTS
The Corporation entered into an Employment Agreement, as of February 16,
1999, employing Stephen P. Gott as Chief Executive Officer of the Corporation
for a two year term, subject to earlier termination for death, disability,
resignation or removal. Mr. Gott's annual base salary is $200,000 and he is
entitled to receive an annual performance bonus of not less than $50,000. Mr.
Gott will be eligible to participate in any Corporation-wide bonus plan that may
be adopted by the Corporation. In addition, Mr. Gott was granted options to
purchase 1,000,000 shares of Common Stock exercisable at a price equal to $3.25
per share. The options vest ratably over three years on the anniversaries of
February 16, 1999. In the event of a "change of control" (as defined in the
employment agreement), the stock options shall immediately vest. If Mr. Gott
resigns his employment for "good reason" (as defined in the employment
agreement), if the Corporation terminates his employment without "cause" (as
defined in the employment agreement), or if the Corporation elects not to extend
the term of Mr. Gott's employment, Mr. Gott will be entitled to (1) receive, in
a lump sum, an amount equal to one year's base salary and performance bonus and
(2) vesting of all stock options. Mr. Gott's employment agreement also contains
confidentiality, non-competition and indemnification provisions.
The Corporation entered into an Employment Agreement, as of April 20, 1998,
employing Richard S. Merrick as Chief Executive Officer of the Corporation from
June 10, 1998 for a two year term, subject to earlier termination for death,
disability, resignation or removal. Mr. Merrick was succeeded as Chief Executive
Officer by Mr. Gott on February 16, 1999. Mr. Merrick is currently Chief
Technology Officer and a Director. Mr. Merrick's annual base salary is $160,000;
provided, that such base salary will increase to $225,000 per annum commencing
on the first anniversary of the beginning of the term of employment. Mr. Merrick
will be eligible to participate in any Corporation-wide bonus plan that may be
adopted by the Corporation. In addition, Mr. Merrick was granted options to
purchase 700 shares of Series C Preferred Stock (or 700,000 shares of Common
Stock) exercisable at a price equal to $2.00 per one one-thousandth of a share
of Series C Preferred Stock or per share of Common Stock, as the case may be.
The options vest 100 shares of Series C Preferred Stock upon the earlier to
occur of October 20, 1998 or the filing of the proposed amendment to the
Certificate of Incorporation increasing the number of authorized shares of
Common Stock which shall become vested as to 100,000 shares of Common Stock upon
the filing of such amendment, and the balance ratably over three years on the
anniversaries of April 20, 1998. The options are subject to accelerated vesting
in the event that (a) the Corporation completes a secondary stock offering
through a nationally recognized investment banking firm and (b) thereafter, the
closing price of Common Stock averages $15.00 per share over any sixty day
period (the "Acceleration Condition"). The Corporation is also obligated to
issue to Mr. Merrick options to purchase 350,000 shares of Common Stock on the
date the Acceleration Condition is achieved, at an exercise price equal to the
fair market value on the date of grant. In the event of a "change of control"
(as defined in the employment agreement), the stock options shall immediately
vest. If Mr. Merrick resigns his employment for "good reason" (as defined in the
employment agreement), if the Corporation terminates his employment without
"cause" (as defined in the employment agreement), or if the Corporation elects
not to extend the term of Mr. Merrick's employment, Mr. Merrick will 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) vesting of all stock options whose vesting was to occur in the year
of termination shall be accelerated pro rata for the period up to the
termination of employment. Mr. Merrick's employment agreement also contains
confidentiality, non-competition and indemnification provisions.
48
<PAGE>
The Corporation entered into an Employment Agreement, as of February 15,
1999, employing James W. Bell as a senior software engineer of the Corporation
for a one year term, subject to earlier termination for death, disability,
resignation or removal. Mr. Bell's annual base salary is $120,000. Mr. Bell was
granted options to purchase 50,000 shares of Common Stock exercisable at a price
equal to $3.25 per share. The options vest ratably over three years on the
anniversaries of February 16, 1999. The Corporation also agreed to accelerate a
portion of Mr. Bell's Unvested April 20, 1998 Options (as defined in the
employment agreement). In addition, if employed at the time, Mr. Bell will be
entitled (1) on each of the three anniversaries of February 16, 1999 to purchase
an additional 10,000 shares of Common Stock at a price equal to the closing
market price on the respective day of such grants and (2) on the one year
anniversary of February 16, 1999, provided that Mr. Bell has not sold all of the
shares of Common Stock acquired as a result of vesting, an option equal to 50%
of the number of Vested Options (as defined in the employment agreement) still
owned at a price equal to the closing market price. Vesting as to all of the
stock options described in the previous sentence shall occur as to one-third
(1/3) of such options on each of the three anniversaries of the grant date of
the respective options. If Mr. Bell resigns his employment for "good reason" (as
defined in the employment agreement) or if the Corporation terminates his
employment without "cause" (as defined in the employment agreement), Mr. Bell
will be entitled to (1) receive an amount equal to three month's base salary and
(2) vesting of all remaining unvested stock options granted on April 20, 1998.
Mr. Bell's employment agreement also contains confidentiality, non-competition
and lock-up provisions.
The Corporation entered into a Separation Agreement and Release, as of
February 16, 1999, terminating its employment relationship with Curt W. Marvis,
the Corporation's former President. Mr. Marvis received six months and two weeks
severance pay based on Mr. Marvis' base annual salary. In addition, the
Corporation accelerated the vesting of a pro rata portion of Mr. Marvis'
Unvested April 20, 1998 Options (as defined in the separation agreement and
release) and further accelerated an additional fifty percent of the remaining
Unvested April 20, 1998 Options. The options vested on Mr. Marvis' Termination
Date (as defined in the separation agreement and release). The remaining
Unvested April 20, 1998 Options are null and void. Mr. Marvis generally released
the Corporation from liability and assigned all copyrights, inventions and
improvements made during his employment to the Corporation. Mr. Marvis'
separation agreement and release was conditioned upon the closing of the merger
between the Corporation and Street and contained confidentiality,
non-competition and lock-up provisions.
The Corporation entered into a Separation Agreement and Release, as of
February 16, 1999, terminating its employment relationship with Jeffrey B.
Croson, the Corporation's former Senior Vice President Sales and Marketing. The
Corporation accelerated the vesting of a pro rata portion of Mr. Croson's
Unvested April 20, 1998 Options (as defined in the separation agreement and
release) and further accelerated an additional fifty percent of the remaining
Unvested April 20, 1998 Options. The options vested on February 16, 1999 and Mr.
Croson has twelve months after the Unrestricted Sale Date (as defined in the
separation agreement and release) to exercise the accelerated options. The
remaining Unvested April 20, 1998 Options are null and void. Options granted to
Mr. Croson on March 26, 1998 will vest in accordance with their original terms,
except that Mr. Croson's time period within which to exercise such options shall
commence on the Unrestricted Sale Date. Mr. Croson generally released the
Corporation from liability and assigned all copyrights, inventions and
improvements made during his employment to the Corporation. Mr. Croson's
separation agreement and release was conditioned upon the closing of the merger
between the Corporation and Street and contained confidentiality,
non-competition and lock-up provisions.
EXECUTIVE COMPENSATION
The following table summarizes the compensation paid during 1998, 1997 and
1996 to the two individuals who served as the Corporation's Chief Executive
Officer during 1998, each person serving as an executive officer on December 31,
1998 who earned more than $100,000 in salary and bonus in fiscal 1998 and two
individuals who were among the highest paid employees for the year ended
December 31, 1998 but were not executive officers on December 31, 1998
(collectively, the "Named Executives").
49
<PAGE>
SUMMARY COMPENSATION TABLE
<TABLE>
<CAPTION>
LONG-TERM
ANNUAL COMPENSATION:
COMPENSATION SECURITIES
FISCAL --------------------- UNDERLYING
NAME AND PRINCIPAL POSITION YEAR SALARY BONUS OPTIONS (1) OTHER (2)
- ------------------------------------------------------ ----------- ---------- --------- -------------- ----------
<S> <C> <C> <C> <C> <C>
Robert Alan Ezrin (3)................................. 1998 $ 192,840 $ -- 125,000 $ 206,963
Former President and Chief 1997 275,000 -- -- 17,331
Executive Officer and current 1996 263,083 -- 60,000(4) 17,378
Vice Chairman and Director
Richard S. Merrick (5)................................ 1998 145,167 20,000 700,000 3,004
Former Chief Executive Officer 1997 115,500 -- 42,500(6) 2,230
and current Chief Technology 1996 110,458 -- -- 2,322
Officer and Director
Curt W. Marvis (7).................................... 1998 151,667 -- 345,000 3,327
Former President 1997 30,833 -- -- --
1996 -- -- -- --
Jeffrey B. Croson (8)................................. 1998 115,000 32,000 125,000 2,672
Former Senior Vice President 1997 105,000 64,730 -- 3,854
Sales and Marketing 1996 100,417 78,922 30,000 4,816
James W. Bell......................................... 1998 123,333 -- 76,000 198
Vice President Research and 1997 123,292 20,000 30,000 1,925
Development 1996 100,833 -- 35,000 3,391
</TABLE>
- ------------------------
(1) Represents the number of options (each to acquire one share of Common Stock)
granted pursuant to the Incentive Stock Option Plan.
(2) Includes auto allowance, Corporation match contributions to the
Corporation's 401(k) Plan and dollar value of life insurance premiums paid
by the Corporation.
(3) Mr. Ezrin resigned as President and Chief Executive Officer on April 20,
1998.
(4) Stock Options exchanged with the Corporation for shares of Common Stock
issued in 1998.
(5) Mr. Merrick was succeeded as Chief Executive Officer on February 16, 1999.
(6) Stock Options canceled in 1998.
(7) Mr. Marvis was succeeded as President on February 16, 1999.
(8) Mr. Croson resigned on January 12, 1999.
50
<PAGE>
STOCK OPTION GRANTS AND EXERCISES
The following stock options were granted to Named Executives during 1998:
<TABLE>
<CAPTION>
POTENTIAL REALIZED VALUE
AT ASSUMED ANNUAL
% OF TOTAL RATES OF STOCK PRICE
NUMBER OF OPTIONS APPRECIATION
SECURITIES GRANTED TO FOR OPTION TERM (1)
UNDERLYING EMPLOYEES EXERCISE EXPIRATION ---------------------------
NAME OPTIONS IN 1998 PRICE DATE 5% 10%
- ------------------------------------------- ----------- --------------- ----------- ----------- ------------ -------------
<S> <C> <C> <C> <C> <C> <C>
Robert Alan Ezrin.......................... 125,000 5.6% $ 2.00 4/20/2008 $ 157,224 $ 398,436
Richard S. Merrick......................... 700,000 31.4% 2.00 4/20/2008 880,452 2,231,239
Curt W. Marvis............................. 345,000 15.5% 2.00 4/20/2008 433,937 1,099,682
Jeffrey B. Croson.......................... 125,000 5.6% 2.00 4/20/2008 157,224 398,436
James W. Bell.............................. 76,000 3.4% 2.00 4/20/2008 95,592 242,249
</TABLE>
- ------------------------
(1) Calculated on the assumption that the market value of the underlying stock
increases at the stated values compounded annually for the ten-year term of
the option.
51
<PAGE>
OPTION EXERCISES AND FISCAL YEAR-END VALUES
The following table provides information about exercised stock options held
by the Named Executives. During 1998, only two of the Named Executives exercised
stock options granted by the Corporation.
<TABLE>
<CAPTION>
NUMBER OF
SECURITIES UNDERLYING VALUE OF UNEXERCISED
UNEXERCISED OPTIONS IN-THE-MONEY OPTIONS
AT DECEMBER 31, 1998 AT DECEMBER 31, 1998(1)
SHARES VALUE -------------------------- --------------------------
NAME EXERCISED REALIZED EXERCISABLE UNEXERCISABLE EXERCISABLE UNEXERCISABLE
- ------------------------------ ----------- --------- ----------- ------------- ----------- -------------
<S> <C> <C> <C> <C> <C> <C>
Robert Alan Ezrin............. -- $ -- 30,000 95,000 $ 19,680 $ 62,320
Richard S. Merrick............ 17,500 26,198(2) 100,000 600,000 65,600 393,600
Curt W. Marvis................ -- -- 45,000 300,000 29,520 196,800
Jeffrey B. Croson............. -- -- 47,500 112,500 51,785 79,425
James W. Bell................. 20,000 66,452(3) 59,250 72,250 68,306 59,584
</TABLE>
- ------------------------
(1) Value based on the December 31, 1998 closing price of the Common Stock on
the Nasdaq National Market of $2.66 per share.
(2) Value based on the March 9, 1998 (date of exercise) closing price of the
Common Stock on the Nasdaq National Market of $1.50 per share.
(3) Value based on exercises of 5,000 shares on June 25, 1998, 5,000 shares on
July 9, 1998, 5,000 shares on July 17, 1998 and 5,000 shares on July 29,
1998 with closing prices of the Common Stock of $4.125, $4.25, $4.50 and
$5.25 per share, respectively.
Mr. Ezrin, Vice Chairman of the Board, resigned as President and Interim
Chief Executive Officer on April 20, 1998. Mr. Merrick, Chief Technology Officer
and a Director, was succeeded as Chief Executive Officer on February 16, 1999.
Mr. Marvis, was succeeded as President on February 16, 1999. Mr. Croson resigned
on January 12, 1999.
Underlying options that are not in-the-money are not valued in this table.
TEN-YEAR OPTION REPRICINGS
In the second quarter of 1998, following a restructuring plan that reduced
the number of employees, the Company repriced stock options of all remaining
employees, including the Named Executive Officers, to an amount which slightly
exceeded the then current market price. The Board of Directors and the
Compensation Committee took this action to maintain morale across the Company,
to help maintain momentum in the projects under development and to retain key
contributors in all areas of the Company, including the Named Executive
Officers. There was no separate analysis of the impact of the repricing on the
overall compensation of the executive officers or any other employee.
52
<PAGE>
The following stock options granted to Named Executives were repriced during
1998:
<TABLE>
<CAPTION>
LENGTH OF
NUMBER OF EXERCISE ORIGINAL OPTION
SECURITIES MARKET PRICE PRICE TERM
UNDERLYING OF STOCK AT AT THE TIME NEW REMAINING AT
NAME AND PRINCIPAL DATE OF OPTIONS TIME OF OF EXERCISE DATE OF
POSITION REPRICING REPRICED REPRICING REPRICING PRICE REPRICING
- --------------------------------- --------- ----------- ------------- ------------ ----------- ---------------
<S> <C> <C> <C> <C> <C> <C>
Robert Alan Ezrin................ 10/22/96 10,000(1) $ 5.375 $ 8.250 $ 6.050 8.49 years
Former Chief Executive 10/22/96 19,696(1) 5.375 18.150 6.050 9.08 years
Officer and currently a 10/22/96 30,304(1) 5.375 16.000 6.050 9.08 years
Director
Jeffrey B. Croson................ 10/22/96 5,000 5.375 7.500 5.500 8.49 years
Former Senior Vice 10/22/96 10,000 5.375 12.500 5.500 9.63 years
President, Sales 3/26/98 5,000 1.250 5.500 1.250 8.58 years
and Marketing 3/26/98 10,000 1.250 5.500 1.250 8.58 years
3/26/98 20,000 1.250 5.500 1.250 8.58 years
James W. Bell.................... 10/22/96 9,000 5.375 7.500 5.500 8.49 years
Vice President of 10/22/96 15,000 5.375 13.000 5.500 9.45 years
Research and 3/26/98 9,000 1.250 5.500 1.250 8.58 years
Development 3/26/98 15,000 1.250 5.500 1.250 8.58 years
3/26/98 20,000 1.250 5.500 1.250 8.58 years
3/26/98 15,000 1.250 2.440 1.250 9.12 years
3/26/98 15,000 1.250 4.000 1.250 9.12 years
</TABLE>
- ------------------------
(1) Options exchanged for grant of Common Stock in 1998.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The following table sets forth certain information as of March 31, 1999
(except as otherwise noted) with respect to the beneficial ownership of the
Voting Stock by (i) each person known by the Corporation to be the beneficial
owner of more than 5% of the outstanding shares of Common Stock or Series D
Stock, (ii) each director of the Corporation, (iii) each named officer of the
Corporation listed in the Summary Compensation Table and (iv) all officers and
directors of the Corporation as a group. Unless otherwise noted, the Corporation
believes that all persons named in the table have sole voting and investment
power with respect to all shares of Voting Stock beneficially owned by them.
53
<PAGE>
<TABLE>
<CAPTION>
NUMBER OF
NUMBER OF APPROXIMATE SHARES OF APPROXIMATE
NAME OF PERSON SHARES OF PERCENTAGE OF SERIES D PERCENTAGE
OR IDENTITY OF GROUP COMMON STOCK CLASS PREFERRED STOCK OF CLASS
- --------------------------------------- ----------------- --------------- ------------------- ---------------------
<S> <C> <C> <C> <C>
Charterhouse Equity Partners II, LP 535
Madison Avenue New York, New York
10022................................ 4,267,965 11.14% -- --
Fletcher International Limited (1) c/o
Fletcher Asset Management 22 E.
67(th) Street New York, New York
10021................................ 2,534,524 6.47% -- --
Stephen P. Gott (2).................... 6,547,632 17.09% 17,969 83.0%
Safa Alai (3).......................... 563,331 1.47% 1,546 7.1%
Scott Near (4)......................... 563,331 1.47% 1,546 7.1%
Merv Adelson (5)....................... 1,557,250 4.05% -- --
Donald Schupak......................... 1,315,092 3.43% -- --
Richard S. Merrick (6)................. 405,000 1.05% -- --
James A. Cannavino..................... 215,000 * -- --
Robert Alan Ezrin (7).................. 777,391 2.03% -- --
Curt W. Marvis (8)..................... 260,000 * -- --
Jeffrey B. Croson (9).................. 112,775 * -- --
James W. Bell (10)..................... 70,598 * -- --
All current directors and
Executive officers as a group (6
persons) (11) (12)................... 10,817,365 27.89% 17,969 83.0%
</TABLE>
- ------------------------
(1) Shares shown as beneficially owned include (i) 17,857 shares of Common Stock
issuable at the option of Fletcher International Limited ("Fletcher"), in
either $125,000 cash or 17,857 shares of Common Stock beginning on March 16,
1999, (ii) 650,000 shares of Common Stock issuable on the exercise of
warrants at an exercise price of $4.50 per share and (iii) 200,000 shares of
Common Stock issuable on the exercise of warrants at an exercise price of
$0.01 per share. We have been informed by Fletcher that Alphonse Fletcher,
Jr. will exercise the voting and investment authority over the Voting Stock
owned by Fletcher.
(2) Shares shown as beneficially owned include 5,989,786 shares of Common Stock
issuable on the conversion of Series D Stock.
(3) Shares shown as beneficially owned include 515,344 shares of Common Stock
issuable on the conversion of Series D Stock.
(4) Shares shown as beneficially owned include 513,344 shares of Common Stock
issuable on the conversion of Series D Stock.
(5) Includes all shares beneficially owned by East West Capital Associates, Inc.
which is owned by The Mervyn Adelson Trust U/T/A dated September 29, 1992,
of which Mr. Adelson is the trustee. Shares shown as beneficially owned by
Mr. Adelson also include 53,242 shares issuable upon the
54
<PAGE>
exercise of vested warrants, which are exercisable at $7.50 per share.
Shares shown as beneficially owned include (i) 55,000 shares of Common
Stock issuable upon the exercise of vested stock options with an
exercise price of $2.00 per share for Common Stock and (ii) 66,666 vested
shares of a warrant for 200,000 shares of Common Stock issuable upon
exercise, which vests ratably each month over a 36-month period
commencing May 6, 1998. Of the 200,000 shares of Common Stock 50,000
shares are issuable at an exercise price of $2.00 per share, 50,000
shares are issuable at an exercise price of $3.00 per share, 50,000
shares are issuable at an exercise price of $4.00 per share and 50,000
shares are issuable at an exercise price of $5.00 per share.
(6) Shares shown as beneficially owned include 300,000 shares of Common
Stock issuable upon the exercise of options with an exercise price of
$2.00 per share.
(7) Shares shown as beneficially owned include 8,915 shares which may be
purchased by the Corporation 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 Incentive Stock Option Plan.
(8) Shares shown as beneficially owned include 246,500 shares of Common
Stock issuable on the exercise of option at an exercise price of
$2.00 per share.
(9) Shares shown as beneficially owned include 112,775 shares of Common
Stock issuable on the exercise of options with exercise prices from
$1.25 to $2.00 per share.
(10) Shares shown as beneficially owned include 70,598 shares of Common
Stock issuable on the exercise of options with exercise prices from
$1.25 to $2.00 per share.
(11) Shares shown as beneficially owned include (i) 355,000 shares issuable
upon exercise of vested stock options with an exercise price of $2.00
per share,(ii) 119,907 shares issuable upon exercise of vested warrants
at exercise prices from $2.00 to $7.50 per share, (iii) 5,989,786 shares
of common stock issuable on conversion of Series D Preferred Stock.
(12) Does not include Marc E. Landy the current Chief Financial Officer
because he was not an Officer of the Corporation as of December 31,
1998.
* Represents beneficial ownership of less than 1% of the Common Stock.
55
<PAGE>
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
On May 6, 1998, the Corporation completed a private placement of Senior
Secured Promissory Notes (the "Senior Notes") in the aggregate principal amount
of $4,500,000 and warrants exercisable for 675,000 shares of Common Stock, at an
exercise price of $.01 per share. In connection with such private placement,
East West Capital Associates, Inc. ("Capital") purchased Senior Notes in the
aggregate principal amount of $1,500,000 and warrants exercisable for 225,000
shares of Common Stock, at an exercise price of $.01 per share. Merv Adelson, a
director of the Corporation, is the trustee of the sole shareholder of Capital
and currently serves as its Chairman of the Board and Chief Executive Officer.
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 a
Certificate of Amendment to the Certificate of Incorporation increasing the
Corporation's authorized Common Stock, 200,000 shares of Common Stock, to
Capital in connection with a consulting agreement. The exercise price of such
warrant is as follows: 50 shares of Series C Preferred Stock 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 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.
In February 1999, Donald Schupak, the Chairman of the Board of the
Corporation, exercised options to purchase an aggregate of 600,000 shares of
Common Stock for an aggregate exercise price of $1,200,000. Mr. Schupak paid the
Corporation $6,000 which represented the par value of the shares of Common Stock
purchased. Mr. Schupak borrowed the remaining $1,194,000 which accrues interest
at 6% payable quarterly or, at the option of Mr. Schupak, accrues at the rate of
7% payable upon maturity of the loan in February 2004. As collateral for the
loan, Mr. Schupak pledged the 600,000 shares of Common Stock purchased plus an
additional 213,000 shares of Common Stock. If the market value of the pledged
shares of Common Stock is equal to more than 200% of the principal amount of the
loan, then Mr. Schupak may request that the Corporation release a number of
shares which have a market value in excess of such amount. If the market value
of the pledged shares of Common Stock is equal to less than 125% of the
principal amount of the loan, then Mr. Schupak must pledge additional shares of
Common Stock to bring the market value of the pledged shares to such amount.
In March 1999, Robert Alan Ezrin, the Vice Chairman of the Board of the
Corporation, exercised options to purchase an aggregate of 145,000 shares of
Common Stock for an aggregate exercise price of $310,000. Mr. Ezrin paid the
Corporation $103,333 and borrowed the remaining $206,667. The loan accrues
interest at 6% payable quarterly or, at the option of Mr. Ezrin, accrues at the
rate of 7% payable upon maturity of the loan in March 2004. As collateral for
the loan, Mr. Ezrin pledged the 145,000 shares of Common Stock purchased plus an
additional 1,964 shares of Common Stock. If the market value of the pledged
shares of Common Stock is equal to more than 200% of the principal amount of the
loan, then Mr. Ezrin may request that the Corporation release a number of shares
which have a market value in excess of such amount. If the market value of the
pledged shares of Common Stock is equal to less than 125% of the principal
amount of the loan, then Mr. Ezrin must pledge additional shares of Common Stock
to bring the market value of the pledged shares to such amount.
In March 1999, James A. Cannavino, a Director of the Corporation, exercised
options to purchase an aggregate of 215,000 shares of Common Stock for an
aggregate of $430,000. Mr. Cannavino paid the Corporation $143,333 and borrowed
the remaining $286,667. The loan accrues at 6% payable quarterly or, at the
option of Mr. Cannavino, accrues at the rate of 7% payable upon maturity of the
loan in March 2004. As collateral for the loan, Mr. Cannavino pledged the
215,000 shares of Common Stock purchased. If the market value of the pledged
shares of Common Stock is equal to more than 200% of the principal amount of the
loan, then Mr. Cannavino may request that the Corporation release a
56
<PAGE>
number of shares which have a market value in excess of such amount. If the
market value of the pledged shares of Common Stock is equal to less than 125% of
the principal amount of the loan, then Mr. Cannavino must pledge additional
shares of Common Stock to bring the market value of the pledged shares to such
amount.
On February 19, 1999, the Corporation acquired all of the outstanding common
stock and preferred stock of Street. Pursuant to the Agreement and Plan of
Merger, the Corporation issued 4,954,214 shares of Common Stock and 21,644
shares of Series D Stock to the stockholders of Street. Stephen Gott, the
President, Chief Executive Officer and a Director of the Corporation, received
557,846 shares of Common Stock and 17,969 shares of Series D Stock which will be
converted into 5,989,786 shares of Common Stock if the Corporation's
stockholders approve the issuance. Each of Scott Near, the Senior Vice
President--Development of the Corporation, and Safa Alai, the Vice President of
Engineering of the Corporation, received 47,987 shares of Common Stock and 1,546
shares of Series D Stock which will be converted into 515,344 shares of Common
Stock if the Corporation's Stockholders approve the issuance.
On February 10, 1999, the Board of Directors approved, by unanimous written
consent, the reduction of the conversion price of the 7% Convertible
Subordinated Notes (the "7% Convertible Notes") due February 11, 1999. The Board
of Directors reduced the conversion price of the 7% Convertible Notes from $3.53
to $2.45 (80% of the closing market price of the Common Stock on February 10,
1999) to induce the holders of the 7% Convertible Notes to convert in lieu of
receiving cash from the Corporation. Merv Adelson, a Director of the
Corporation, owned an aggregate principal amount of $108,108 of the 7%
Convertible Notes which he converted into 44,125 shares of Common Stock instead
of 30,654 shares of Common Stock due to the reduction of the conversion price.
57
<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 23 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 23 of this Report.
(a)(3) -- The following documents are filed or incorporated
by reference as exhibits to this Report:
*****************2.1 -- Agreement and Plan of Merger dated as of February
16, 1999, by and among 7th Level, Inc., 7th Level
Merger Corporation, Street Technologies, Inc. and
the stock holders of Street Technologies, Inc.
named therein.
**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.
************4.2 -- Form of Warrant
************4.3 -- Certificate of Designation of Series A Preferred
Stock
************4.4 -- Certificate of Designation of Series C Preferred
Stock
(1) 4.5 -- Certificate of Designation of Series D Preferred
Stock
*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.
58
<PAGE>
*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.
**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.
59
<PAGE>
******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.
************10.36 -- Securities Purchase Agreement dated as of May 6,
1998, by and among the Company, Alpine Associates,
a New Jersey Limited Partnership ("Alpine") and
East West Capital Associates, Inc. ("Capital")
************10.37 -- Security Agreement dated as of May 6, 1998, by and
among the Company, Capital, Alpine and Alpine, as
collateral agent for itself and Capital.
************10.38 -- Senior Secured Promissory Note in the aggregate
principal amount of $3,000,000 issued to Alpine.
************10.39 -- Senior Secured Promissory Note in the aggregate
principal amount of $1,500,000 issued to Capital.
************10.40 -- Securities Purchase Agreement dated as of May 6,
1998, between the Company and the Purchasers
parties thereto.
************10.41 -- Registration Rights Agreement dated May 6, 1998 by
and among the Company and the Purchasers parties
thereto
************10.42 -- Specimen of Preferred Stock certificate.
*************10.43 -- Employment Agreement dated as of April 20, 1998 by
and between the Company and Richard S. Merrick.
**************10.44 -- Subscription Agreement dated as of December 14,
1998, by and between 7th Level, Inc. and Fletcher
International Limited.
(1) 10.45 -- Employment Agreement dated as of February 16, 1999
by and between the Company and Stephen Gott.
23.1 -- Consent of KPMG LLP.
23.2 -- Consent of Arthur Andersen LLP
***********99.1 -- Press release concerning the merger of 7th Level,
Inc. with Pulse Entertainment, Inc.
***************99.2 -- Press release of 7th Level, Inc. dated April 22,
1998 concerning cancellation of proposed merger
with Pulse Entertainment, Inc. and commitments and
terms for $4.5 million bridge loan and $10 million
private placement.
****************99.3 -- Unaudited Pro Forma Condensed Balance Sheet of 7th
Level, Inc. as of May 31, 1998.
(b) -- Registrant filed a Current Report on Form 8-K ,
dated December 14, 1998, in respect to the
Subscription Agreement with Fletcher International
Limited under which Fletcher invested $5 million
of equity into Registrant and has agreed to an
equity line of credit for an additional $5
million.
60
<PAGE>
- ----------
* 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 Report on Form 8-K
(File No. 000-24936) filed with the Commission on December
9, 1997 and incorporated by reference herein.
************ Filed as an Exhibit to the Company's Quarterly Report on
Form 10-Q for the quarter ended March 31, 1998.
************* Filed as an Exhibit to the Company's Quarterly Report on
Form 10-Q for the quarter ended June 30, 1998
************** Filed as an Exhibit to the Company's Report on Form 8-K
(File No. 000-24936) filed with the Commission on April 23,
1998 and incorporated by reference herein
*************** Filed as an Exhibit to the Company's Report on Form 8-K
(File No. 000-24936) filed with the Commission on July 9,
1998 and incorporated by reference herein.
**************** Filed as an Exhibit to the Company's Report on Form 8-K
(File No. 000-24936) filed with the Commission on December
14, 1998 and incorporated by reference herein.
***************** Filed as and Exhibit to the Company's Current Report on Form
8-K (File No. 000-24936) filed with the Commission on
February 25, 1999 and incorporated by reference herein.
(1) Filed as an Exhibit to the Company's Annual Report on
Form 10-K for the year ended December 31, 1998.
61
<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 White
Plains and State of New York, on April 30, 1999.
7TH LEVEL, INC.
By: /s/ MARC E. LANDY
------------------
Marc E. Landy
Chief Financial Officer
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 30, 1999
-----------------------
(Merv Adelson)
/s/ JAMES A. CANNAVINO Director April 30, 1999
-----------------------
(James A. Cannavino)
/s/ ROBERT ALAN EZRIN Vice Chairman of the Board April 30, 1999
----------------------- and Director
(Robert Alan Ezrin)
/s/ STEPHEN P. GOTT President, Chief Executive April 30, 1999
----------------------- Officer and Director
(Stephen P. Gott) (Principal Executive
Officer)
/s/ MARC E. LANDY Chief Financial Officer April 30, 1999
----------------------- and Vice President
(Marc E. Landy) (Principal Financial
Officer)
/s/ RICHARD S. MERRICK Director April 30, 1999
----------------------
(Richard S. Merrick)
/s/ DONALD SCHUPAK Chairman of the Board and April 30, 1999
----------------------- Director
(Donald Schupak)
62
<PAGE>
7TH LEVEL, INC.
SCHEDULE II -- VALUATION AND QUALIFYING ACCOUNTS
<TABLE>
<CAPTION>
Balance at Balance at
Beginning End of
Description of Period Additions Deductions Period
----------- --------- --------- ---------- ------
<S> <C> <C> <C> <C>
Allowance for sales returns, doubtful accounts and
price concessions
Year ended December 31, 1998: $1,126,524 $ 4,007 $1,129,568 $ 963
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
Reserve for Inventory Obsolescence
Year ended December 31, 1998: $ 718,082 $ 0 $ 718,082 $ 0
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
</TABLE>
S-1
<PAGE>
INDEX TO EXHIBITS
Exhibit
Number Document Description
------ --------------------
**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.
*****************2.1-- Agreement and Plan of Merger, dated as of
February 16, 1999, by and among 7th Level,
Inc., 7th Level Merger Corporation, Steet
Technologies, Inc. and the stock holders of
Street Technologies, Inc. named therein.
**4.1-- Form of Bridge Loan Warrant.
************4.2-- Form of Warrant
************4.3-- Certificate of Designation of Series A
Preferred Stock
************4.4-- Certificate of Designation of Series C
Preferred Stock
(1) 4.5-- Certificate of Designation of Series D
Preferred Stock
*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.
<PAGE>
Exhibit
Number Document Description
------ --------------------
*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.
**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
<PAGE>
Exhibit
Number Document Description
------ --------------------
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.
************10.36-- Securities Purchase Agreement dated as of May
6, 1998, by and among the Company, Alpine
Associates, a New Jersey Limited Partnership
("Alpine") and East West Capital Associates,
Inc. ("Capital")
************10.37-- Security Agreement dated as of May 6, 1998, by
and among the Company, Capital, Alpine and
Alpine, as collateral agent for itself and
Capital.
************10.38-- Senior Secured Promissory Note in the
aggregate principal amount of $3,000,000
issued to Alpine.
************10.39-- Senior Secured Promissory Note in the
aggregate principal amount of $1,500,000
issued to Capital.
************10.40-- Securities Purchase Agreement dated as of May
6, 1998, between the Company and the
Purchasers parties thereto.
************10.41-- Registration Rights Agreement dated May 6,
1998 by and among the Company and the
Purchasers parties thereto
************10.42-- Specimen of Preferred Stock certificate.
*************10.43-- Employment Agreement dated as of April 20,
1998 by and between the Company and Richard S.
Merrick.
**************10.44-- Subscription Agreement dated as of December
14, 1998, by and between 7th
<PAGE>
Exhibit
Number Document Description
------ --------------------
Level, Inc. and Fletcher International
Limited.
(1) 10.45-- Employment Agreement dated as of February 16,
1999 by and between the Company and Stephen
Gott.
23.1-- Consent of KPMG LLP.
23.2-- Consent of Arthur Andersen LLP
***********99.1-- Press release concerning the merger of 7th
Level, Inc. with Pulse Entertainment, Inc.
***************99.2-- Press release of 7th Level, Inc. dated April
22, 1998 concerning cancelation of proposed
merger with Pulse Entertainment, Inc. and
commitments and terms for $4.5 million bridge
loan and $10 million private placement.
****************99.3-- Unaudited Pro Forma Condensed Balance Sheet of
7th Level, Inc. as of May 31, 1998.
- ----------------------------------
* 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
<PAGE>
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 Report on Form
8-K (File No. 000-24936) filed with the Commission on
December 9, 1997 and incorporated by reference herein.
************ Filed as an Exhibit to the Company's Quarterly Report
on Form 10-Q for the quarter ended March 31, 1998.
************* Filed as an Exhibit to the Company's Quarterly Report
on Form 10-Q for the quarter ended June 30, 1998
************** Filed as an Exhibit to the Company's Report on Form
8-K (File No. 000-24936) filed with the Commission on
April 23, 1998 and incorporated by reference herein
*************** Filed as an Exhibit to the Company's Report on Form
8-K (File No. 000-24936) filed with the Commission on
July 9, 1998 and incorporated by reference herein.
**************** Filed as an Exhibit to the Company's Report on Form
8-K (File No. 000-24936) filed with the Commission on
December 14, 1998 and incorporated by reference
herein.
***************** Filed as an Exhibit to the Company's Current Report on
Form 8-K (File No. 000-24936) filed with the
Commission on February 25, 1999 and incorporated by
reference herein.
(1) Filed as an Exhibit to the Company's Annual Report on
From 10-K for the year ended December 31, 1998.
<PAGE>
Exhibit 23.1
INDEPENDENT AUDITORS' CONSENT
The Board of Directors
7th Level, Inc.:
We consent to incorporation by reference in Registration Statements on Form S-8
(Nos. 333-10335, 333-10339, 333-65525, 033-87944 and 333-10341) and on Form S-3
(No. 333-64365) of 7th Level, Inc. of our report dated January 30, 1998, related
to the consolidated balance sheet of 7th Level, Inc. and subsidiaries as of
December 31, 1997, and the related consolidated statements of operations,
stockholders' equity, and cash flows and related schedule for each of the years
in the two year period ended December 31, 1997, which report appears in the
December 31, 1998 annual report on Form 10-K/A 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 LLP
Dallas, Texas
April 30, 1999
<PAGE>
Exhibit 23.2
CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS
The Board of Directors
7th Level, Inc.:
As independent public accountants, we hereby consent to the incorporation of our
report dated March 17, 1999, included in this Form 10-K/A, into the Company's
previously filed Registration Statements Filed No. 333-65525, No. 333-10335,
No. 033-87944, No. 333-10341 and No. 333-10339 filed on Forms S-8 and
No. 333-64365 filed on Form S-3.
Arthur Andersen LLP
New York, New York
April 30, 1999
