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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-KSB
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF
THE SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED APRIL 30, 1996
COMMISSION FILE NUMBER 0-24346
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VIDEO UPDATE, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 41-1461110
(State or other jurisdiction (I.R.S. employer
of incorporation or identification No.)
organization)
3100 WORLD TRADE CENTER 55101
30 EAST SEVENTH STREET (Zip Code)
ST. PAUL, MINNESOTA 55427
(Address of principal
executive offices)
(612) 222-0006
(Registrant's telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act:
TITLE OF EACH CLASS
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Class A Common Stock
Class A Warrant
Class B Warrant
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
Yes _X_ No ___
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-B is not contained herein, and will not be contained, to the
best of the registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-KSB or any
amendment to this Form 10-KSB. _X_
The aggregate market value of the voting stock held by non-affiliates of the
registrant on April 30, 1996 was $89,072,221. As of June 14, 1996, 10,962,735
shares (excluding 55,000 unregistered shares related to one of the Company's
1996 acquisitions pending resolution of a dispute with the sellers) of Class A
Common Stock, $.01 par value per share, and 2,000,000 shares of Class B Common
Stock, $.01 par value per share, of the registrant were outstanding.
The registrant's revenues for the fiscal year ended April 30, 1996 were
$50,504,000.
DOCUMENTS INCORPORATED BY REFERENCE
Definitive Proxy Statement for the Annual Meeting of Stockholders for the
fiscal year ended April 30, 1996, and to be filed pursuant to Regulation 14A, is
incorporated by reference in Part III of this Form 10-KSB.
Transitional Small Business Disclosure Format (check one):
Yes ___ No _X_
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PART I
ITEM 1. DESCRIPTION OF BUSINESS.
GENERAL
The Company owns and operates 204 video specialty stores under the name
"Video Update" located in Alaska, Arizona, Illinois, Indiana, Minnesota,
Missouri, Nevada, Pennsylvania, Washington and Canada and franchises 25
additional video specialty stores predominantly in the United States. As of
April 30, 1996, all of the Company's stores in the United States, and 26 or
approximately 39% of the Company's Canadian stores, are superstores which are
defined as retail video stores that carry more than 7,500 rental units. The
Company believes that, as of the end of its most recent fiscal year, it is the
fourth largest video specialty retailer in the United States and the third
largest video specialty retailer in Canada based on the number of stores it
operates and franchises. Video Update stores in the United States and Canada
offer on average approximately 11,000 and 7,700 rental units, respectively,
including multiple copies of new and popular releases and video games, in a
visually appealing and customer friendly layout.
The Company franchised its first store in January 1983 and opened its first
Company-owned store in September 1989. By July 1994, when the Company completed
its initial public offering, the Company had grown to 15 Company-owned stores
and 30 franchised stores and had developed a cost-effective superstore format
that distinguished the Company from other video retailers by providing it with
the flexibility to expand into desirable sites in both small and large markets
without compromising profitability, or decreasing the number of viable markets
into which it could expand. During fiscal 1996, the Company grew rapidly in size
from 33 to 204 Company-owned stores. During this period, the Company acquired
136 video stores in 12 transactions and opened 35 new video superstores. Same
store sales during fiscal 1996 increased by approximately 16%. As a result of
these acquisitions, new superstore openings and increases in same store sales,
the Company's revenues and net income increased from approximately $9,051,000
and $154,000 in fiscal 1995, to approximately $50,504,000 and $1,628,000 in
fiscal 1996, respectively.
THE HOME VIDEO INDUSTRY
The home video retail industry has experienced significant growth over the
last several years. According to Paul Kagan's THE STATE OF HOME VIDEO industry
report, gross revenues for the home video industry in the United States have
grown from approximately $2.9 billion for rentals and approximately $656 million
for sales in 1985 to approximately $9.9 billion for rentals and approximately $5
billion for sales in 1995 and are projected to reach approximately $12.7 billion
and approximately $9.1 billion, respectively, by the year 2005. Paul Kagan's
research also shows that in 1995 over 80% of American households owning
televisions also owned a VCR.
According to Paul Kagan, total United States consumer spending on filmed
entertainment has increased from approximately $4.6 billion in 1980 to
approximately $31 billion in 1994. According to MEDIA GROUP RESEARCH, a video
industry analyst, the home video market was the largest single source of revenue
to movie studios, accounting for approximately 54% of movie studios' total
revenues. Of the many movies produced by major studios and released in the
United States each year, relatively few are profitable for the studios based on
box office revenue alone. In addition to purchasing box office hits, video
specialty stores typically purchase movies on video that were not as successful
at the box office because customers will often rent a video that they might not
view at a theater. The Company believes that the consumer is more likely to view
movies that were not box office hits on a rented video than on any other medium
because video specialty stores provide an inviting opportunity to browse and
make an impulse choice among a very broad selection of movie titles at a
relatively low price. These purchases by the video stores provide the major
movie studios with a reliable source of revenue for the majority of their
movies.
The Company believes that the home video industry is highly fragmented.
According to Paul Kagan, in 1994 an estimated 27,400 video specialty stores
operated in the United States, including approximately 6,100 superstores.
According to VIDEO STORE MAGAZINE, only nine multiple store businesses operated
in excess of 100 stores in 1995. The Company also believes that there has been a
recent trend toward consolidation in the retail video industry driven by the
recognition by store operators of the competitive advantages that larger
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organizations enjoy in terms of access to working capital, marketing
efficiencies and other economies of scale and the enhanced ability to obtain
quality retail locations. The Company believes that attractive acquisition
opportunities will continue to arise as the industry consolidates.
Although the domestic video retail industry includes both rentals and sales,
the consumer market for videos has primarily been a rental market. Movie studios
determine the suggested retail prices of videos and through that pricing
influence the relative levels of video rentals and sales. Videos released at a
relatively high price, generally $60 or more, are generally purchased by video
retailers and made available for rental. Videos released at a relatively low
price, typically between $15 and $25, are generally purchased by video retailers
for both sale and rental and may be purchased by consumers at a variety of
retail locations. The Company believes that movie studios attempt to maximize
total revenue from video releases by maintaining retail prices at a relatively
high level during the first four months to one year after a new video release,
during which time sales are made primarily to video retailers for rental, and
then releasing the video at a lower price to promote sales to consumers. From
time to time, however, certain movies that are believed to have mass appeal or
family appeal, such as BATMAN FOREVER, POCAHONTAS and CASPER, are initially
released for sale at a relatively low price. Video retailers purchase a large
portion of these titles at the same low price, which titles thereafter become
low cost rentals for such retailers. These lower priced releases are more
attractive rentals to the retailer because of the relatively few number of
rentals required to recover their cost and provide a favorable economic return
to the retailer.
Historically, new technologies have led to the creation of additional
distribution channels for movie studios. Movie studios seek to maximize their
revenues by releasing movies in sequential release date "windows" to various
movie distribution channels. These distribution channels currently include, in
release date order, movie theaters, video specialty stores, pay-per-view, basic
cable television, and foreign, network and syndicated television. The Company
believes that this method of sequential release has allowed movie studios to
increase their total revenue with relatively little adverse effect on the
revenue derived from previously established channels and that movie studios will
continue the practice of sequential release as new distribution channels become
available. According to Paul Kagan, many movie studios have recently agreed to
extend the length of the exclusive window on many new release videos for video
specialty stores from the current practice of 30 days to between 60 and 90 days.
OPERATING STRATEGY
The Company's management has substantial experience in the video retailing
industry. The Company's senior management operations team has worked together
for more than ten years. Through the management team, the Company has developed
a cost-effective superstore format that distinguishes the Company from other
video retailers by providing it with the flexibility to expand into desirable
sites in both small and large markets without compromising profitability or
decreasing the number of viable markets into which it can expand. Management's
depth of experience in and knowledge of the industry are reflected in the
Company's operating strategy, the key elements of which include the following:
PROVIDE EXTENSIVE SELECTION OF VIDEOCASSETTES. At April 30, 1996, all of
the Company's stores in the United States and 26, or approximately 39%, of the
Company's Canadian stores are superstores. Superstores are video rental stores
that have more than 7,500 rental units. The Company believes that an extensive
selection of videocassettes is a key determinant that consumers consider in
choosing to visit and patronize a particular video store. The Company tailors
the videocassettes available for rent in a given store according to the market
served by the store. Additionally, catalog videocassettes (those in release for
more than one year) are displayed in a library style (spine-out method) allowing
for significantly more videocassettes to be made available for rent. As a
result, the Company believes that it is able to provide an extensive selection,
yet retain greater flexibility than many of its competitors in terms of store
size in which it can operate. Video Update stores in the United States and
Canada offer on average approximately 11,000 and 7,700 rental units,
respectively.
EFFECTIVELY MANAGE INVENTORIES. The Company maintains an integrated POS
system that provides it with immediate access to and feedback on records related
to, among other things, videocassette rentals, individual title performance,
category rental performance, shrinkage and overdue rentals. The Company
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endeavors to convert the POS systems of acquired stores to that of the Company's
as quickly as is practicable. The Company utilizes its POS system to manage its
inventory turns, purchase new inventory, and balance customer demand and rental
trends, all of which the Company believes maximizes each store's profitability.
AGGRESSIVE MARKETING. The Company utilizes an aggressive marketing program
designed to attract new customers and increase the frequency of rentals by
current customers. The Company focuses its marketing on individual stores and
the local markets in which they operate. Direct mailings, including postcards
and flyers, are utilized regularly. Additionally, the Company promotes
extensively with couponing and cross promotions. The Company's popular
"Two-for-Tuesday" rental promotion is used throughout its system and has been
effective in building customer loyalty and increasing revenue on a day of the
week that historically has not been a significant rental volume day.
GEOGRAPHIC CONCENTRATION. The Company intends to continue developing new
super stores and acquiring existing chains of stores in regions where the
Company has existing operations. The Company also intends to expand into
additional metropolitan areas where it determines that sufficient quality
locations and/or acquisition opportunities are available. The Company believes
that this geographic concentration will allow the Company to more easily monitor
store operations through its regional management offices and to achieve
operating efficiencies in inventory management, marketing, distribution,
training and store supervision. Because the Company operates multiple stores, it
is able to receive relatively large aggregate cooperative advertising credits
from its distributors. The Company receives cooperative advertising credits for
each store it operates, and by operating multiple stores in a single geographic
market, the Company can more effectively use cooperative advertising credits to
maximize the impact of its advertising.
CONSISTENCY OF IMAGE AND OPERATIONS. The Company strives to create a
national presence and name recognition. To achieve this objective and to most
efficiently and effectively operate its stores, the Company attempts to maintain
consistency among its Company-owned and franchised stores. This consistency of
operations includes signage, store layout, marketing, management information
systems and customer service. The Company attempts to fully integrate acquired
stores into its overall format as quickly as is practicable. Such integration
typically involves the prompt installation of the management information systems
and interior signage, supplementing the existing base stock of titles,
processing acquired videocassettes, training existing management and sales
personnel, and completing limited build-out of the facilities. Substantially all
of the Company's acquired stores to date have completed these integration items.
Subject to permit requirements and other such regulatory controls, the Company
installs exterior signage as soon as practicable. To expedite the integration of
acquired businesses, the Company has developed a uniform approach that
management believes minimizes the time necessary to fully assimilate an acquired
store's operations into those of the Company.
GROWTH STRATEGY
The Company's objective is to become a national presence in the video rental
industry. The key elements of the Company's growth strategy are the following:
TARGETED ACQUISITIONS. The Company believes that acquiring chains of stores
is often the most cost-effective means of entering a new market, particularly
when the stores are in desirable locations. The Company also believes that the
rental video industry has experienced a recent trend toward consolidation driven
by the recognition by store operators of the competitive advantages that larger
organizations enjoy in terms of access to working capital, marketing
efficiencies and other economies of scale and the enhanced ability to obtain
quality retail locations. This trend has created an opportunity for the Company
to grow further through acquisitions. The Company believes that it will continue
to be presented with attractive acquisition opportunities.
During fiscal 1996, the Company grew rapidly in size from 33 to 204
Company-owned stores. Approximately 80% of such growth was accomplished through
acquisitions with the balance resulting from new superstore openings.
Altogether, the Company acquired 136 video stores in 12 transactions during
fiscal 1996.
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The following table summarizes the 12 acquisitions made by the Company
during fiscal 1996:
<TABLE>
<CAPTION>
DATE OF NUMBER OF STORES LOCATION OF
ACQUIRED BUSINESSES ACQUISITION ACQUIRED STORE(S)
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<S> <C> <C> <C>
Video Powerstore, Inc. June 1995 22 Arizona/Nevada
Tops N Video June 1995 3 Arizona
Steve Nielsen Corp. July 1995 1 Minnesota
AV Video, Inc. August 1995 14 Washington
Wilderness Video Group Ltd. August 1995 55 Canada
Indy Video, Inc. September 1995 10 Indiana
94 Video West, Inc. October 1995 12 Canada
Mega Movies, Inc. October 1995 2 Alaska
Talerico Enterprises, Inc. October 1995 6 Arizona
B&R Investment, Inc. October 1995 1 Minnesota
Videoland, Inc. November 1995 7 Indiana
Bedard Entertainment, Inc. January 1996 3 Minnesota
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Total 136
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</TABLE>
NEW SUPERSTORE DEVELOPMENT. During fiscal 1996, the Company opened 35 new
video superstores. The Company intends to open superstores in its existing
markets and selected new markets where attractive opportunities are available.
Although no assurance can be given, the Company believes that the selection of
locations for its superstores has been and will continue to be critical to the
success of its operations. Important criteria for selection of a new superstore
location include density of local residential population, traffic count on roads
immediately adjacent to the superstore location, visibility of the superstore to
passing motorists, easy accessibility and ample parking. The Company estimates
that each new superstore currently requires 12 months of operations in order to
ramp-up to its expected level of mature operations.
FRANCHISE OPERATIONS. The Company intends to increase its franchise
marketing and to expand its franchise operations. Franchised superstores operate
under substantially the same hours and methods of operation as Company-owned
stores. The Company currently intends to franchise stores primarily in areas
where the Company does not expect to pursue new superstore development or
acquisitions.
STORE OPERATIONS AND LOCATIONS
Each Video Update store operates under substantially the same plan of
operation. Company-owned stores are open 365 days a year with daily hours
generally from 10:00 a.m. to 11:00 p.m. Sunday through Thursday and from 10:00
a.m. to 12 midnight Friday and Saturday. The Company's stores use a self-service
system, whereby customers select products from the shelves and proceed to the
checkout counter. Video Update stores in the United States and Canada average
approximately 5,700 and 3,500 square feet in size, respectively. Superstores
developed in fiscal 1996 averaged approximately 6,700 square feet in size and
are representative of the Company's superstore prototype going forward.
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The Company seeks to locate its stores in geographic areas that will enable
it to achieve operating efficiencies in inventory management, advertising,
marketing, distribution, training and store supervision. The following table
sets forth the locations of existing Company-owned and franchised stores as of
April 30, 1996:
<TABLE>
<CAPTION>
NUMBER OF COMPANY- OWNED NUMBER OF FRANCHISED TOTAL OF
STATE OR PROVINCE STORES STORES STORES
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<S> <C> <C> <C>
Alaska...................................... 2 - 2
Arizona..................................... 31 - 31
Illinois.................................... 8 - 8
Indiana..................................... 19 - 19
Minnesota................................... 42 9 51
Missouri.................................... 3 - 3
Nevada...................................... 3 - 3
New Hampshire............................... - 4 4
Pennsylvania................................ 5 1 6
South Carolina.............................. - 1 1
Virginia.................................... - 8 8
Washington.................................. 24 - 24
Wisconsin................................... - 1 1
Alberta..................................... 21 - 21
British Columbia............................ 45 1 46
Saskatchewan................................ 1 - 1
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Total................................... 204 25 229
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</TABLE>
MANAGEMENT INFORMATION SYSTEMS
The Company believes the accurate and efficient management of purchasing,
inventory and sales records has been important to the Company's success. The
Company maintains information, updated daily, regarding revenue, current and
historical sales and rental activity, demographics of store membership and
videocassette rental patterns. This information can be organized by store, by
region or for all operations.
The Company maintains a national POS system and a corporate information
system. All rental and sales transactions are recorded by the POS system when
scanned at the time of customer checkout. Nightly, the POS system transmits each
store's data from operations into the corporate information system. The systems
track all rental and sales products from the videocassette distribution center
to each store using scanned bar code information. The systems also maintain
detailed rental history of each customer and title. This information produces
the reports used by the Company, including those used in making purchasing
decisions on new releases. All of the Company's stores, including all of the
acquired stores, use the Company's POS system.
PRODUCTS
VIDEOCASSETTE RENTAL. The Company's primary source of revenue is the rental
of videocassettes. Video rental prices per night generally range from $2.49 to
$3.49 for new releases to $1.99 for catalog titles. Videocassettes are available
for one-night, two-night or multiple night rental. The Company's stores
generally carry approximately 11,000 and 7,700 videos for rent in its US and
Canadian stores, respectively, representing approximately 7,900 and 5,500
titles, respectively. Movie titles are classified into at least 23 categories,
such as "Action," "Drama," "Family," and "Children" and are displayed
alphabetically within those categories. The Company determines its rental prices
for titles and duration of rentals based on the length of time the title has
been available on videocassette. The Company believes that its rental prices are
competitive to those of other video stores, and its videocassettes are available
for one-day and multiple-day rentals.
VIDEO GAMES. In addition to videocassette rentals, stores also rent video
games for use with Sony Playstation-TM-, Nintendo-TM- and Sega Genesis-TM- video
game machines.
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ADDITIONAL PRODUCTS. The Company recently began renting audio books, which
are now available in a majority of its stores. The selection of audio books
includes fiction and non-fiction classics, and educational materials and books.
For the convenience of its customers, the Company also sells blank
videocassettes and video cleaning equipment and rents videocassette and video
game players. In addition, the Company sells previously viewed videocassettes
and new and used video games.
FRANCHISE OPERATIONS
To maximize its ability to expand rapidly in the home video business, the
Company has employed a strategy of developing Video Update superstores through a
combination of Company-owned and franchised stores. The balance between Company
and franchise development in a given market is determined by evaluating a number
of different criteria, including the availability of acquisition or store
development opportunities and resources.
The standard Company franchise agreement generally requires the franchisee
to pay the Company a continuing monthly royalty fee equal to five percent of the
franchisee's gross monthly revenue, as calculated under the terms of the
franchise agreement. The franchisee is also generally obligated to pay a
continuing monthly royalty fee of one percent of gross monthly revenues derived
specifically from the sale of certain video products. The monthly royalty fees
are calculated and due from the date that the franchised superstore opens for
business. In addition to the royalty payments, franchisees generally also are
required to pay a monthly advertising fee equal to one percent of the
franchisee's gross monthly revenue for the preceding month.
Under the Company's current franchising program, the Company will grant to a
franchise owner the right to develop one or a specified number of Video Update
superstores at an approved location or future locations (within specific
geographic areas) pursuant to the terms of a franchise agreement. The
exclusivity accorded to a franchisee is individually negotiated but generally
does not extend beyond a radius of one mile from the franchised location. Prior
to the actual store opening, the Company provides advice to the franchisee on
promotions, store displays and inventory control as well as a five day
comprehensive training course.
The Company monitors franchisees' compliance with ongoing obligations on the
basis of monthly revenue reports and ordered inventory reports. The franchise
agreement generally also grants the Company the right to audit the franchisee's
books, business records, sales reports, financial statements, and tax returns at
any time. The franchise agreement allows the Company to terminate the franchise
under certain conditions, including without limitation, failure to comply with
the Company's operating guidelines, failure to obtain and maintain the necessary
retail licenses and permits, operation of a competitive venture, and
understatement of gross monthly revenues for any two operating periods by more
than two percent. To date, the Company has experienced no material problems
relating to the understatement of revenues by franchisees.
MARKETING AND ADVERTISING
The Company primarily relies on direct mail advertising to promote its
business and increase the familiarity of potential customers with the Company.
The Company's direct mail typically consists of pricing-related promotions such
as two-for-one coupons or a free rental coupon for new customers. The Company's
general practice of opening several Company-owned or franchised stores within a
geographic region enables it to maximize the effectiveness of its advertising
expenditures. The cost of these activities is generally funded by cooperative
movie advertising promotions made available by studios or suppliers to promote
certain videocassettes. The Company also benefits from the advertising and
marketing of studios and theaters in connection with their efforts to promote
films and increase box office revenues.
The Company relies on referrals from current franchisees and advertising in
franchise-oriented publications in marketing its franchises.
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SUPPLIERS
The Company acquires its inventory of videocassettes and video games and
accessories from several videocassette suppliers, including local divisions of
Sight and Sound Distributors of St. Louis, Missouri ("Sight and Sound"), Baker &
Taylor, Inc. of Chicago, Illinois, Ingram Entertainment Incorporated of
Nashville, Tennessee, and Midwest Multimedia & Games of Chicago, Illinois.
The videocassette inventory in each Company-owned and franchised store
consists of catalog titles and new release titles. To develop its inventory of
titles for store openings, the Company transfers videocassettes from existing
stores and purchases videocassettes from suppliers.
The Company currently purchases new release rental videocassettes at an
average cost of approximately $40 to $45. Since September 1989, the Company has
acquired most of its new release inventory from Sight and Sound, and during each
of fiscal 1995 and 1996 the Company purchased approximately 75%, of its new
release titles from that supplier. The Company believes that, if its
relationship with Sight and Sound were terminated, the Company could obtain
videocassettes from other suppliers at prices and on terms comparable to those
available from Sight and Sound.
Suppliers generally provide the Company with a comprehensive monthly listing
of all new video releases. In addition, movie studios generally provide the
Company with several copies of a new release video for preview by the Company.
The Company's movie selection committee uses listings of new releases, video
previews, knowledge of the popularity of past video releases and the Company's
computerized information on the past performance of titles rented by the Company
to select the titles and number of copies of each title to be acquired for
rental in each of its stores. The Company is permitted to return unopened or
defective videocassettes to its suppliers in certain circumstances. The Company
purchases video game software from a variety of distributors, based on price and
availability.
INVENTORY
New release videocassettes are ordered by the Company and delivered directly
to stores where they are offered for rental or sale on the studio release date
for the title. Previously viewed inventory for existing and new stores is
received, processed and stored in the Company's approximately 34,000 square foot
central distribution facility located in St. Paul, Minnesota. New release and
previously viewed videocassettes and games are processed for rental according to
uniform Company-wide standards. Each videocassette is removed from its original
carton and placed in a standard Video Update rental case with a magnetic
security device. Bar codes are then affixed to each videocassette and video
game. For previously viewed videocassettes, the artwork from the original carton
is cut out and inserted into clear pockets on the standard Video Update rental
case for shelf display. For new release videocassettes, the original carton is
displayed separately in front of the standard Video Update rental case
containing the videocassette.
COMPETITION
The video rental industry is highly competitive. The Company competes with
other video retail stores, including Blockbuster and other superstores, and with
supermarkets, pharmacies, convenience stores, bookstores, mass merchants, mail
order operations, vending machines and other retailers, as well as with
noncommercial sources such as libraries. In addition to competing with other
video retailers, the Company competes with other leisure-time activities,
especially entertainment activities such as movie theaters, sporting events,
network television and cable television.
The Company also competes with other distribution channels for studio
movies, including pay-per-view television on basic cable service, which
currently offer only a limited number of channels and monthly movie selections.
Recently developed digital compression technology combined with fiber optics and
other technology will eventually permit cable companies, direct broadcast
satellite companies and other telecommunications companies to transmit a much
greater number of movies to homes at scheduled intervals throughout the day.
Ultimately, these technologies could lead to the availability of movies to the
consumer on demand. Certain cable and other telecommunications companies have
tested and are continuing to test movie on demand services in some markets.
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Certain of the Company's larger, better capitalized competitors may seek to
acquire some of the same video specialty stores that the Company seeks to
acquire. Such competition for acquisitions would likely increase acquisition
prices and related costs and result in fewer attractive acquisition
opportunities, which could have a material adverse effect on the Company's
growth.
The Company's franchise operations compete with numerous franchise
operations in many industries that have significantly greater financial and
human resources and more experience in selling franchises than does the Company.
Potential franchisees may believe that these franchisers offer greater
opportunities for success than the Company.
TRADEMARKS
The Company has a federal registration for its trademark "Video
Update-Registered Trademark-" and a logo that includes its trademark. The
Company considers its service marks and trademarks to be important to its
business and intends to actively protect them.
GOVERNMENT REGULATION
The Company is subject to various federal, state and local laws, including
the Federal Videotape Privacy Protection Act and similar state laws that govern
the disclosure and destruction of video rental records. The Company also must
comply with various regulations affecting its business, including state and
local licensing, zoning, land use, construction and environmental regulations.
The Company has not made, nor does it anticipate making, any material
capital expenditures in order to comply with environmental regulations. No
assurance can be given, however, that new environmental regulations will not be
adopted that will require the Company to make material capital expenditures for
compliance.
The Company also is subject to the Federal Trade Commission's Trade
Regulation Rule entitled "Disclosure Requirements and Prohibitions Concerning
Franchising and Business Opportunity Ventures" (the "FTC Franchise Rule") and
state laws and regulations that govern the offer and sale of franchises. To
offer and sell franchises, the Company is required by the FTC Franchise Rule to
furnish each prospective franchisee a current franchise offering circular prior
to the sale of a franchise. In addition, a number of states require a franchisor
to comply with registration or filing requirements prior to offering a franchise
in the state and to provide a prospective franchisee with a current franchise
offering circular complying with the state's laws, prior to the sale of the
franchise. Although no assurance can be given, the Company intends to maintain a
franchise offering circular that complies with all applicable federal and state
franchise sales laws. However, if the Company is unable to comply with the
franchise sales laws and regulations of any state that regulates the offer and
sales of franchises, the Company will be unable to offer and sell franchises in
such state.
The Company is required to update its franchise offering circular to reflect
material changes, under applicable law, regarding its franchise offering and to
comply with changes in disclosure requirements. The occurrence of any such
material changes may, from time to time, require the Company to stop offering
and selling franchises until its franchise offering circular is updated. No
assurance can be given that the Company's franchising program will not be
adversely affected by its failure to register or file in certain states
consistent with its expansion plans, or because compliance with applicable law
necessitates that the Company cease offering and selling franchises in certain
states until its franchise offering circular is updated, or because of its
inability to comply with existing or future franchise laws.
The Company also is subject to a number of state laws and regulations that
regulate certain substantive aspects of the franchisor-franchisee relationship,
including those governing the termination or nonrenewal of a franchise agreement
(such as requirements that "good cause" exist as a basis for such termination
and that a franchisee be given advance notice of, and a right to cure, a default
prior to termination), requirements that the franchisor deal with its
franchisees in good faith, prohibitions against interference with the right of
free association among franchisees and those regulating discrimination among
franchisees in charges, royalties or fees.
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Compliance with federal and state franchise laws is costly and time
consuming, and no assurance can be given that the Company will not encounter
difficulties or delays in this area or that it will not require significant
capital for franchising activities.
EMPLOYEES
As of June 15, 1996, Video Update employed 2,047 persons, including 1,827 in
Company-owned stores and 220 in the Company's corporate, administrative and
warehousing operations. Of the employees, approximately 350 were full-time and
1,697 were part-time. The typical required staffing for a Video Update store is
8 to 12 employees, including a store manager. Store managers are supervised by
district managers who in turn are supervised by regional managers. Regional
managers report directly to the Company's Vice President of Store Operations or
Chief Operations Officer. The Company believes that its employee relations are
satisfactory.
The Company has an incentive bonus plan under which store managers are
eligible for monthly bonuses. The performance of each manager is evaluated on a
variety of criteria, including store revenue, payroll, cash overages and
shortages and inventory control.
ITEM 2. FACILITIES
The Company leases substantially all of the sites (including buildings and
improvements) where its Company-owned video stores are located. The occupancy
expense for these sites for the years ended April 30, 1995 and 1996 was
approximately $1,426,000 and $10,304,000, respectively. These leases generally
have a term of three to ten years and provide options to renew for periods
ranging from three to five additional years. The Company is generally
responsible for real estate taxes, insurance and utilities under all leases. See
Note 7 of Notes to Consolidated Financial Statements. The Company expects that
most future video superstores will also occupy leased premises. The Company owns
three locations for Company-owned superstores, one of which is subject to a
mortgage. See "Management's Discussion and Analysis of Financial Condition and
Results of Operations -- Liquidity and Capital Resources."
The Company's franchisees enter into leases individually for their
respective superstore locations. These leases are on terms substantially similar
to the terms for Company-owned superstore leases. Generally, the Company does
not guarantee and is not a party to such leases.
The Company's corporate headquarters are located at 3100 World Trade Center,
30 East Seventh Street, St. Paul, Minnesota 55101 and consists of approximately
14,500 square feet of office space. The Company's central distribution facility
is located at a different location in St. Paul, Minnesota and consists of
approximately 34,000 square feet. The Company's headquarters and distribution
facilities are leased pursuant to agreements that expire on October 31, 2001 and
August 31, 2001, respectively. In addition, the Company maintains other
locations for the offices of district and regional managers and for limited
storage purposes. The Company expects that suitable additional space will be
available in the Twin Cities area, when needed, on commercially reasonable
terms.
ITEM 3. LITIGATION
In connection with the acquisition of the assets of Talerico Enterprises,
Inc. ("TEI") in October 1995, the Company has advised TEI of what it believes to
be various breaches of representations and warranties made by TEI in its asset
purchase agreement with the Company. Accordingly, the Company has withheld a
portion of the purchase price, including 55,000 shares of Class A Common Stock.
In December 1995, TEI filed an action against the Company in Arizona state court
for breach of contract. The Company intends to vigorously defend this action,
and it has asserted counterclaims in the action. Although no assurance can be
given as to the outcome of such litigation, the Company does not believe that
the resolution of such action will materially adversely impact the Company's
operations.
The Company has been notified of a potential claim by the owner/landlord of
a retail location previously occupied by the Company in Kent, Washington for
breach of a lease contract and back rent. The landlord has advised the Company
that it may seek in excess of $50,000 in damages. The Company intends to
vigorously
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defend this action. Although no assurance can be given as to the outcome of such
litigation, the Company does not believe that the resolution of the matter will
materially adversely impact the Company's financial position or results of
operations.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
The Company submitted no matters to a vote of security holders during the
fourth quarter of the fiscal year ended April 30, 1996.
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.
From May 1, 1995 until May 7, 1995, the Company's Class A Common Stock was
traded on the NASDAQ Small Cap Market. From May 8, 1995 to date, the Company's
Class A Common Stock has traded on the NASDAQ National Market System under the
symbol "VUPDA." The Company's Class A Common Stock began trading on NASDAQ on
July 20, 1994. On April 30, 1996, the last bid price for the Class A Common
Stock as reported by NASDAQ was $8.125 per share.
For the period indicated, the following table sets forth the range of high
and low bid prices for the Class A Common Stock as reported on the NASDAQ
National Market System.
CLASS A COMMON STOCK
<TABLE>
<CAPTION>
HIGH LOW
---------- -----
<S> <C> <C>
Quarter ended July 31, 1995 (1)............................................... $ 117/8 $ 41/4
Quarter ended October 31, 1995................................................ 13 71/4
Quarter ended January 31, 1996................................................ 10 6
Quarter ended April 30, 1996.................................................. 83/8 51/2
</TABLE>
- - ------------------------
(1) The Company began trading on the Nasdaq National Market on May 8, 1995.
As of April 30, 1996, there were 79 stockholders of record of the Company's
Class A Common Stock.
During the fiscal year ended April 30, 1996, the Company did not pay any
dividends on its Common Stock and management does not anticipate the payment of
any dividends to its stockholders in the foreseeable future. The Company
currently intends to reinvest earnings, if any, in the development and expansion
of its business. The declaration of dividends in the future will be at the
discretion of the Board of Directors and will depend upon the earnings, capital
requirements and financial position of the Company, general economic conditions
and other pertinent factors, including covenants relating to bank indebtedness.
ITEM 6. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS.
The following discussion of the financial condition and results of
operations should be read in conjunction with the Company's audited consolidated
financial statements and notes thereto appearing elsewhere herein.
OVERVIEW
The Company franchised its first store in January 1983 and opened its first
Company-owned store in September 1989. By July 1994, when the Company completed
its initial public offering, the Company had grown to 15 Company-owned stores
and 30 franchised stores. Subsequently, the Company substantially accelerated
its growth and now operates 150 acquired and 54 developed stores in 9 states and
in Canada, and has 25 franchised stores predominantly in the United States. All
of the Company's stores located in the United States are superstores.
Superstores are video specialty stores that carry more than 7,500 rental units.
During fiscal 1996, the Company has acquired, in 12 transactions, 136 video
retail stores. The acquired assets and liabilities related to all of these
acquisitions are recorded in the Company's balance sheet at their estimated fair
market value at the date of the acquisition. As a result of these acquisitions,
the Company anticipates that its results of operations will be reduced by the
amortization of goodwill of approximately
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<PAGE>
$24,072,000 and amortization of non-compete agreements of approximately
$280,000, with anticipated quarterly non-cash charges of approximately $301,000
and $31,000, for goodwill and non-competition amortization costs, respectively.
The Company anticipates that future acquisitions could involve the recording of
additional significant amounts of goodwill and deferred charges on its balance
sheet.
The Company generates revenues primarily from the rental of videocassettes
and video games, from service fees from its franchisees, and from the sale of
products. As reflected in the chart below, rental revenues at Video Update
stores have accounted for the substantial majority of the Company's revenues.
The Company expects that this trend will continue.
<TABLE>
<CAPTION>
FISCAL YEAR ENDED APRIL 30,
-------------------------------
1994 1995 1996
--------- --------- ---------
(IN THOUSANDS)
<S> <C> <C> <C>
Rental revenue............................................... $ 4,180 $ 8,364 $ 46,592
Service fees................................................. 472 421 491
Product sales................................................ 337 266 3,421
--------- --------- ---------
$ 4,989 $ 9,051 $ 50,504
--------- --------- ---------
--------- --------- ---------
</TABLE>
Effective February 1, 1996, videocassettes that are considered base stock
(including copies one through three of new releases) are amortized over 36
months on a straight-line basis to a salvage value of $6.00 per videocassette.
New release videocassettes are amortized as follows: the fourth through ninth
copies of each title per store are amortized on a straight-line basis during
their first six months to a net book value of $6.00 and then on a straight-line
basis over 30 months with no salvage value; and the tenth and any succeeding
copies of each title per store are amortized on a straight-line basis during
their first six months to a net book value of $6.00 and then on a straight-line
basis over three months with no salvage value. The changes, which represent in
part a change in accounting principle and a change in accounting estimate, have
been reflected in the accompanying financial statements in total as a change in
an estimate in the fourth quarter of fiscal 1996.
Prior to February 1, 1996, base stock videocassettes were amortized over 36
months on a straight-line basis with no salvage value. Prior to May 1, 1995, new
release videocassettes were amortized as follows: copies one through three of
each title per store were amortized as base stock; the fourth through ninth
copies of each title per store were amortized 40% in the first year and 30% in
each of the second and third years; and the tenth and any succeeding copies of
each title per store were amortized over nine months on a straight-line basis.
The new method of amortization was adopted because the Company believes
accelerating expense recognition for new release videocassettes (copies four and
greater) during the first six months more closely matches the typically higher
revenue generated following a title's release, and believes that $6.00
represents a reasonable salvage value for base stock videocassettes after 36
months.
The effect of the change for recognizing salvage value of base stock and the
effect of the application of the new method of amortizing videocassette copies
in excess of the base stock to May 1, 1995, had the impact, in total, of
increasing amortization expense by $2,773,000 and decreasing income from
continuing operations and net income by $1,604,000, or $.15 per share, for
fiscal 1996, after the effect of income taxes of $1,169,000, all of which has
been recorded in the fourth quarter.
12
<PAGE>
OPERATING RESULTS
The table below sets forth the percentage of revenues represented by certain
items included in the Company's statement of operations for the periods
indicated.
<TABLE>
<CAPTION>
FISCAL YEAR ENDED APRIL 30,
----------------------------------------
1994 1995 1996
------------ ------------ ------------
<S> <C> <C> <C>
Revenues:
Rental revenue..................................................... 83.8% 92.4% 92.2%
Service fees....................................................... 9.5 4.7 1.0
Product sales...................................................... 6.7 2.9 6.8
----- ----- -----
Total revenues................................................. 100.0 100.0 100.0
Costs and expenses:
Store operating expenses........................................... 60.1 66.1 78.6
Selling, general and administrative................................ 23.6 24.6 10.6
Cost of product sales.............................................. 3.7 1.5 3.7
Amortization of goodwill........................................... - 0.9 2.1
----- ----- -----
Total cost and expenses........................................ 87.4 93.1 95.0
----- ----- -----
Operating income..................................................... 12.6 6.9 5.0
Other income (expense):
Interest expense................................................... (2.9) (2.1) (0.5)
Amortization of debt costs......................................... - (1.7) -
Other income....................................................... 0.3 1.7 1.1
----- ----- -----
Total other income (expense)................................... (2.6) (2.1) 0.6
----- ----- -----
Income from continuing operations before income taxes................ 10.0 4.8 5.6
Income tax expense................................................... 4.0 2.4 2.4
----- ----- -----
Income from continuing operations.................................... 6.0 2.4 3.2
Discontinued operations:
Loss from discontinued operations,
net of applicable income tax benefit.............................. - (0.3) -
Loss on disposal of discontinued operations,
net of applicable income tax benefit.............................. - (0.4) -
----- ----- -----
Net loss from discontinued operations................................ - (0.7) -
----- ----- -----
Net income........................................................... 6.0% 1.7% 3.2%
----- ----- -----
----- ----- -----
</TABLE>
FISCAL 1996 COMPARED TO FISCAL 1995.
RENTAL REVENUE. Rental revenue was approximately $46,592,000 and
$8,364,000, or 92.2% and 92.4% of total revenues for fiscal 1996 and 1995,
respectively. The increase in rental revenue of $38,228,000 was derived from
video stores acquired during the period which accounted for approximately
$28,998,000 or 75.9% of the increase, from the opening of 35 new Company-owned
stores which accounted for approximately $4,735,000 or 12.4% of the increase,
and from a 16% increase in same store revenues.
SERVICE FEES. Service fees were approximately $491,000 and $421,000, or
1.0% and 4.7% of total revenues for fiscal 1996 and 1995, respectively.
Continuing service fees and royalties from franchisees accounted for 95% and
100% of total service fees, respectively. The decrease in service fees as a
percentage of total revenues was due to a significant increase in the number of
Company-owned stores without a corresponding increase in the number of franchise
stores.
PRODUCT SALES. Product sales were approximately $3,421,000 and $266,000, or
6.8% and 2.9% of total revenues for fiscal 1996 and 1995, respectively. The
increase in product sales of $3,155,000 was a result of product sales by the
video stores acquired during the period which accounted for approximately
$2,505,000 or 79.4% of the increase, the opening of 35 Company-owned video
stores, and sales of inventory and fixtures
13
<PAGE>
to franchisees. The increase in product sales as a percentage of total revenues
was a result of higher product sales as a percentage of total revenues by video
stores acquired during the period and increased sales of inventory and fixtures
to franchisees.
STORE OPERATING EXPENSES. Store operating expenses consist primarily of
compensation and related expenses, occupancy expenses, and depreciation and
amortization expenses. Operating expenses were approximately $39,685,000 and
$5,986,000, or 78.6% and 66.1% of total revenues for fiscal 1996 and 1995,
respectively. The increase in store operating expenses of $33,699,000, was
primarily the result of video stores acquired during the period, the opening of
35 Company-owned video stores, a change in accounting method for amortizing
videocassettes, and the expansion and relocation of video stores during fiscal
1996. The increase in store operating expenses as a percentage of total revenues
was primarily due to a change in accounting method for amortizing
videocassettes, additional regional expenses related to developing new markets,
higher initial expenses related to new store openings, and video stores acquired
during the period.
Compensation and related expenses were approximately $12,601,000 and
$1,922,000, or 25.0% and 21.2% of total revenues for fiscal 1996 and 1995,
respectively. The increase of $10,679,000 was primarily due to video stores
acquired during the period which accounted for approximately $7,254,000 or 67.9%
of the increase and the opening of 35 Company-owned video stores. The increase
as a percentage of total revenues was primarily due to additional regional
management expenses related to developing new markets, higher initial payroll
costs associated with video stores acquired and higher initial payroll costs
associated with the opening of new Company-owned video stores.
Occupancy expenses were approximately $10,304,000 and $1,426,000, or 20.4%
and 15.8% of total revenues for fiscal 1996 and 1995, respectively. The increase
of $8,878,000, was primarily due to video stores acquired during the period,
which accounted for $6,429,000 or 72.4% of the increase, the expansion of
several stores in fiscal 1996 and the opening of 35 Company-owned stores. The
increase as a percentage of total revenues was primarily due to higher costs
associated with the video stores acquired during the period and higher costs as
a percentage of total revenues associated with the opening of new video stores
prior to revenue reaching maturity during the first year of operations.
Depreciation and amortization expenses were approximately $13,894,000 and
$1,879,000, or 27.5% and 20.8% of total revenues for fiscal 1996 and 1995,
respectively. Depreciation and amortization expense reflects the depreciation of
store equipment and fixtures and the amortization of videocassettes. The
increase of $12,015,000 was primarily attributable to the addition of new
release videocassette inventory for new, existing, and acquired stores and a
change in policy for amortization of videocassettes. Depreciation and
amortization expense would have been approximately $11,121,000 or 22% of total
revenues, had the accounting change in amortization of videocassettes not been
made. The effect of the change for recognizing salvage value of base stock and
the effect of the application of the new method of amortizing videocassette
copies in excess of the base stock to May 1, 1995, had the impact, in total, of
increasing amortization expense by $2,773,000 and decreasing income from
continuing operations and net income by $1,604,000 or $.15 per share, for fiscal
1996, after the effect of income taxes $1,169,000, all of which has been
recorded in the fourth quarter.
SELLING, GENERAL AND ADMINISTRATIVE. Selling, general and administrative
expenses were approximately $5,362,000 and $2,223,000, or 10.6% and 24.6% of
total revenues for fiscal 1996 and 1995, respectively. The increase of
approximately $3,139,000 was primarily due to adding management personnel and
administrative staff to support the Company's growth and related expenditures.
The decrease as a percentage of total revenues was due to the increases in total
revenues without a proportional increase in corporate overhead.
COST OF PRODUCT SALES. Cost of product sales was approximately $1,880,000
and $136,000, or 3.7% and 1.5% of total revenues for fiscal 1996 and 1995,
respectively. The cost of product sales as a percentage of total product sales
revenue was approximately 55.0% and 51.1% for fiscal 1996 and 1995,
respectively. The increase in the cost of product sales as a percentage of total
product sales was primarily the result of a different mix of products sold in
video stores acquired during the period and the sale of inventory and fixtures
to franchisees.
14
<PAGE>
AMORTIZATION OF GOODWILL. Amortization of goodwill was approximately
$1,072,000 and $83,000, or 2.1% and 0.9% of total revenues for fiscal 1996 and
1995, respectively. The increase was primarily attributable to the amortization
of certain intangible assets resulting from the video stores acquired during the
period.
INTEREST EXPENSE. Interest expense was approximately $232,000 and $194,000,
or 0.5% and 2.1% of total revenues for fiscal 1996 and 1995, respectively. The
increase of $38,000 was primarily attributable to interest on debt incurred or
assumed from the video stores acquired during the period and interest on
borrowings under the Company's bank line of credit.
OTHER INCOME. Other income was approximately $548,000 and $155,000, or 1.1%
and 1.7% of total revenues for fiscal 1996 and 1995, respectively. The increase
of $393,000 was primarily due to interest earned on approximately $7,200,000 of
net proceeds from the April 7, 1995 public offering, interest earned on
approximately $28,414,000 of net proceeds from the exercise of the Class A
Warrants prior to their use for acquisitions and interest earned on notes
receivable from related parties.
FISCAL 1995 COMPARED TO FISCAL 1994.
RENTAL REVENUE. Rental revenue was approximately $8,364,000 and $4,180,000
for fiscal 1995 and 1994, respectively. The increase in rental revenue of
$4,184,000 was the result of revenues derived from video stores acquired during
the period which accounted for approximately $2,702,000, or 64.6% of the
increase, with the balance of the increase resulting from (i) the increase in
same store revenues of 21%, and (ii) the opening of four new Company-owned
superstores.
SERVICE FEES. Service fees were approximately $421,000 and $472,000 for
fiscal 1995 and 1994, respectively, of which continuing service fees and
royalties accounted for 100% and 86%, respectively, of service fee revenues for
these periods.
PRODUCT SALES. Product sales were approximately $266,000 and $337,000 for
fiscal 1995 and 1994, respectively. The decrease in product sales of $71,000,
reflects the sale of less initial catalog videocassette inventory to
franchisees. The decrease was offset in part by an increase in product sales by
video stores acquired during the period, and the opening of four Company-owned
video stores.
STORE OPERATING EXPENSES. Store operating expenses were approximately
$5,986,000 and $2,997,000 for fiscal 1995 and 1994, respectively. The increase
in store operating expenses of $2,989,000, resulted primarily from expenses of
the video stores acquired during the period, the opening of four Company-owned
video superstores, the expansion and relocation of several video superstores
during fiscal 1995, and an increase in the starting hourly wage of store
employees. Store operating expenses as a percentage of rental revenue of
$8,364,000 and $4,180,000 for fiscal 1995 and 1994, were approximately 71.6% and
71.7% respectively.
Compensation and related expenses were approximately $1,922,000 and $892,000
for fiscal 1995 and 1994, respectively. The increase of $1,030,000, was due to
(i) expenses related to video stores acquired during the period which accounted
for $636,000 of the increase, (ii) higher initial costs associated with opening
and relocating Company-owned superstores, (iii) same store expense increases,
(iv) an increase in the starting hourly wages of store employees, and (v) the
hiring of additional store managers due to expansion.
Occupancy expenses were approximately $1,426,000 and $630,000 for fiscal
1995 and 1994, respectively. The increase of $796,000, reflected the expansion
of several stores in fiscal 1995, the opening of four Company-owned video
superstores during fiscal 1995, and the video stores acquired during the period.
Depreciation and amortization expenses were approximately $1,879,000 and
$1,083,000 for fiscal 1995 and 1994, respectively. The increase of $796,000, was
primarily attributable to the additional new release videocassette inventory for
new, existing and acquired stores as part of the Company's marketing plan. In
fiscal 1995, the Company had a change in accounting estimate pertaining to the
amortization method for rental videocassettes, which had the effect of
increasing net income by approximately $251,000.
Other operating expenses, consisting of the balance of the change in
operating expenses (i.e. advertising expenses) changed proportionally with sales
increases.
15
<PAGE>
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. Selling, general and
administrative expenses were approximately $2,223,000 and $1,179,000 for fiscal
1995 and 1994, respectively. The increase of approximately $1,044,000, was
primarily due to the addition of management personnel and additional
administrative staff to support the Company's planned growth and related
expenditures.
COST OF PRODUCT SALES. Cost of product sales were approximately $136,000
and $186,000 for fiscal 1995 and 1994, respectively. The cost of product sales
as a percentage of total product sales revenue was approximately 51.1% and 55.2%
for fiscal 1995 and 1994, respectively. The percentage decrease was primarily
the result of the mix of products sold.
AMORTIZATION OF GOODWILL. Amortization of goodwill was approximately
$83,000 for fiscal 1995 with no corresponding amount for fiscal 1994. The
increase was primarily attributable to the amortization of certain intangible
assets resulting from the acquisitions during the period.
INTEREST EXPENSE. Interest expense was approximately $194,000 and $143,000
for fiscal 1995 and 1994, respectively. The increase of $51,000, was due to the
approximately $620,000 of notes ("Subordinated Notes") issued in the Company's
subordinated note offering in February 1994 and the $1,000,000 of notes ("Bridge
Notes") issued in the Company's bridge financing in May 1994. The Subordinated
Notes and Bridge Notes were paid in full when the Company completed its initial
public offering in July 1994.
AMORTIZATION OF DEBT COSTS. Amortization of debt costs was approximately
$157,000 for fiscal 1995 with no corresponding expense for fiscal 1994. These
debt costs related to the issuance of the Subordinated Notes and the Bridge
Notes, both of which were paid in full in July 1994.
OTHER INCOME. Other income was approximately $155,000 and $17,000 for
fiscal 1995 and 1994, respectively. The increase of $138,000 resulted from a
gain on the sale of securities and an increase in the rent received from a
Company-owned building.
The net loss from discontinued operations and disposal of discontinued
operations was approximately $59,000 (net of tax) for fiscal 1995. The net loss
from discontinued operations and disposal of discontinued operations resulted
from the closing of the Company's Gamesters-Registered Trademark-, a video game
specialty store.
LIQUIDITY AND CAPITAL RESOURCES
The Company has funded its operations through cash from operations, the
proceeds of prior equity and debt offerings, borrowings under bank facilities,
trade credit and equipment leases. The Company's principal capital requirements
are for the acquisition of existing stores, the opening of new superstores, and
the purchase of videocassette rental inventory.
At April 30, 1996, the Company had cash and cash equivalents of
approximately $676,000. The Company uses an unclassified balance sheet in its
financial statements, and as a result, does not classify its assets or
liabilities as current or noncurrent. If the Company were to use a classified
balance sheet, a portion of videocassette rental inventories would be classified
as noncurrent because they are not assets that are reasonably expected to be
completely realized in cash or sold in one year. The acquisition cost of these
inventories, however, would be reflected in current liabilities. The Company
believes that classification of videocassette rental inventories as noncurrent
assets would be misleading because it would not indicate the level of assets
expected to be converted into cash in the next year as a result of rentals or
sales of these videocassettes.
For the year ended April 30, 1996, net cash provided by operating activities
was approximately $19,083,000. Net cash used in investment activities was
approximately $53,683,000, consisting primarily of approximately $17,391,000 for
businesses acquired during the period, approximately $12,301,000 for new and
remodeled stores, and approximately $22,739,000 for the purchase of
videocassette inventory for existing and new stores, and for the conversion of
stores acquired during the period. Net cash generated from financing activities
was approximately $29,703,000, resulting primarily from the exercise of the
Class A Warrants.
16
<PAGE>
In April 1996, the Company entered into a one-year revolving credit facility
with Bank of America Illinois (the "Line of Credit") under which the Company may
borrow up to $10,000,000, with amounts borrowed thereunder bearing interest at
variable rates based on the federal funds rate, prime rate or the interbank
Eurodollar rate. The Line of Credit is convertible into a two-year term loan if
it is not renewed. As of April 30, 1996, approximately $4,100,000 was
outstanding under the Line of Credit, bearing interest at 8.25%. During the term
of the Line of Credit and thereafter to the extent any amounts are outstanding
under the Line of Credit, the Company is subject to various restrictive
covenants, including limitations on further indebtedness, other than trade
credit and capital or operating leases, and requirements that the Company obtain
the written consent of Bank of America (the "Bank") for certain acquisitions of
new businesses or their assets (excluding new superstore openings) or entering
into business combinations, including mergers, syndicates or joint ventures. In
particular, the Bank's prior consent is required for any merger, acquisition or
purchase in which the consideration paid by the Company exceeds (a) 5% of the
Company's consolidated stockholder's equity ("Net Worth") immediately prior to
any one acquisition and (b) 10% of the Company's Net Worth as of its most recent
fiscal year end in the aggregate as to all such acquisitions. The Line of Credit
also restricts the amount and terms of debt that may be issued to sellers of
acquired businesses and requires that the Company maintain certain cash flow
ratios as well as certain ratios of total liabilities to tangible net worth.
During fiscal 1996, the Company acquired, in 12 transactions, 136 video
retail stores. The cost of conversion of acquired stores to the Company's
superstore design varies and, unless remodeled, has ranged from approximately
$12,000 to $86,000 per store, which costs are primarily related to the
installation of the Company's POS system, interior and exterior signage, and the
addition of inventory.
In connection with six of the Company's recent acquisitions in which the
Company has issued an aggregate of 635,613 shares of Class A Common Stock to
sellers, the Company may be obligated to make Deficiency Payments to such
sellers equal to the difference between the Guaranteed Price for each share
issued, and the actual market or sales price of such shares as of a specified
date. Based upon the closing sale price of the Class A Common Stock of $8.125 on
April 30, 1996, the aggregate Deficiency Payments that the Company may be liable
for is approximately $1,180,000 (all of which, except for payments that may be
due with respect to 40,000 shares, may be paid in shares of Class A Common
Stock, at the Company's option).
The Company has amended recourse notes receivables (the "Recourse Notes")
from the Company's Chief Executive Officer and from the President for
approximately $2,055,000 and $1,142,000, respectively, including accrued
interest thereon. The Recourse Notes, which provide for full recourse against
the respective officer's personal assets and Company stockholdings, are payable
in ten equal annual installments, the last of which is due in May 2005, and
accrue interest at 6.9% per annum. The Recourse Notes were issued by the
executives upon their exercise in August 1995 of 420,000 options granted to them
under the Stock Option Plan issued in May 1995 at an exercise price of $4.3125,
the fair market value of the stock on the date the options were granted. The
Recourse Notes represent the total exercise price of such options plus amounts
advanced by the Company to such executives to satisfy the then anticipated tax
liabilities.
In addition, as of April 30, 1996, the Company has a note receivable from
the President of the Company for $29,000 which accrues interest at 8% and is due
November 1996. The note represents advances from the Company to the President
from January 1994 to April 1994, together with accrued interest.
The Company generally does not offer lines of credit or guarantees for the
obligations of its franchisees, although on occasion, the Company has made short
term loans to current franchisees. The Company intends to evaluate the
possibility of providing loans or limited guarantees for certain franchisee
obligations, which in the aggregate are not expected to be material to the
Company's financial condition.
Substantially all Company-owned stores are in leased premises, except for
three stores that are located on premises owned by the Company. The Company
expects that most future stores will occupy leased premises.
17
<PAGE>
INFLATION
To date, inflation has not had a material effect on the Company's business.
The Company anticipates that its business will be affected by general economic
trends. Although the Company has not operated during a period of high inflation,
it believes that it would generally be able to pass increased costs resulting
from inflation on to customers.
ITEM 7. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
The following financial statements are filed as part of this report.
<TABLE>
<CAPTION>
PAGE
-----
<S> <C>
Report of Independent Auditors......................................................... F-2
Consolidated Balance Sheets as of April 30, 1995 and 1996.............................. F-3
Consolidated Statements of Income for the years ended April 30, 1994, 1995 and 1996.... F-4
Consolidated Statement of Stockholders' Equity for the years ended April 30, 1994, 1995
and 1996.............................................................................. F-5
Consolidated Statements of Cash Flows for the years ended April 30, 1994, 1995 and
1996.................................................................................. F-6
Notes to Consolidated Financial Statements............................................. F-7
</TABLE>
ITEM 8. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE.
In July 1993, the Company, in contemplation of its initial public offering,
changed its independent auditors, Johnson, West & Co., PLC ("Johnson, West &
Co.") and engaged the services of Ernst & Young LLP as its principal independent
accountants. The decision to engage the services of Ernst & Young LLP was
approved by the Company's Board of Directors.
During the two most recent fiscal years and the subsequent interim period
preceding such change, the reports prepared by Johnson, West & Co. on the
Company's financial statements contained no adverse opinions or disclaimers of
opinion, or modifications as to uncertainty, audit scope, or accounting
principles.
Further, during the two most recent fiscal years and the subsequent interim
period preceding such change, no disagreements existed between the Company and
Johnson, West & Co. on any matter of accounting principles or practices,
financial statement disclosure, or auditing scope or procedure, which
disagreement(s), if not resolved to the satisfaction of Johnson, West & Co.
would have caused it to make a reference to the subject matter of the
disagreements in connection with its reports.
None of the "reportable events" described in Item 304(a)(1)(iv) of
Regulation S-B occurred with respect to the Registrant within the two most
recent fiscal years and the subsequent interim period preceding such change.
PART III
ITEM 9. DIRECTORS, EXECUTIVE OFFICERS AND CONTROL PERSONS; COMPLIANCE WITH
SECTION 16(A) OF THE EXCHANGE ACT.
The Company intends to file a Definitive Proxy Statement within 120 days of
the completion of the Company's fiscal year ended April 30, 1996. The
information required by this item is incorporated by reference from the Proxy
Statement.
ITEM 10. EXECUTIVE COMPENSATION.
The information required by this Item is incorporated by reference from the
Proxy Statement.
ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
The information required by this Item is incorporated by reference from the
Proxy Statement.
ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
The information required by this Item is incorporated by reference from the
Proxy Statement.
18
<PAGE>
ITEM 13. EXHIBITS AND REPORTS ON FORM 8-K.
a. Exhibits.
1. The following exhibits are filed herewith:
<TABLE>
<CAPTION>
EXHIBIT
NO. TITLE
- - ------- ----------------------------------------------------------------------
<C> <S>
3 Restated Certificate of Incorporation.
10a Amended Recourse Promissory Note from Daniel A. Potter to the Company,
dated June 26, 1996.
10b Amended Recourse Promissory Note from John M. Bedard to the Company,
dated June 26, 1996.
18 Letter on Change in Accounting Principles.
21 List of Subsidiaries.
23 Consent of Ernst & Young LLP.
27 Financial Data Schedule.
</TABLE>
2. The following exhibits were filed as part of the Company's Current
Report on Form 8-K, filed with the Commission on April 16, 1996, and are
incorporated herein by reference:
<TABLE>
<CAPTION>
EXHIBIT
NO. TITLE
- - ------- ----------------------------------------------------------------------
<C> <S>
10a Credit Agreement by and between the Company and the Bank of America
Illinois, dated as of April 15, 1996.
10b Security Agreement by and among the Company, Tinseltown Video, Inc.
and Bank of America Illinois, dated as of April 15, 1996.
</TABLE>
3. The following exhibits were filed as part of the Company's Current
Report on Form 8-K, filed with the Commission on March 14, 1996, and are
incorporated herein by reference:
<TABLE>
<CAPTION>
EXHIBIT
NO. TITLE
- - ------- ----------------------------------------------------------------------
<C> <S>
3 Bylaws, as amended.
10a Restated Employment Agreement between the Company and Daniel A.
Potter, effective as of February 1, 1996.
10b Restated Employment Agreement between the Company and John M. Bedard,
effective as of February 1, 1996.
</TABLE>
4. The following exhibit was filed as part of the Company's Current Report
on Form 8-K/A, filed with the Commission on January 26, 1996, and is
incorporated herein by reference:
<TABLE>
<CAPTION>
EXHIBIT
NO. TITLE
- - ------- ----------------------------------------------------------------------
<C> <S>
2 Purchase Agreement by and between the Company, Videoland, Inc. and the
Stockholder of Videoland, Inc., dated as of November 14, 1995.
</TABLE>
5. The following exhibits were filed as part of the Company's Current
Report on Form 8-K, filed with the Commission on October 13, 1995, and are
incorporated herein by reference:
<TABLE>
<CAPTION>
EXHIBIT
NO. TITLE
- - ------- ----------------------------------------------------------------------
<C> <S>
2a Purchase Agreement by and among the Company, 94 Video West, Inc. and
Michael Bennett and Paul Levens, dated as of October 2, 1995.
2b Purchase Agreement by and between the Company, Talerico Enterprises,
Inc. ("TEI") and the stockholder of TEI, dated as of October 5, 1995.
</TABLE>
19
<PAGE>
6. The following exhibit was filed as part of the Company's Current Report
on Form 8-K, filed with the Commission on September 27, 1995, and is
incorporated herein by reference:
<TABLE>
<CAPTION>
EXHIBIT
NO. TITLE
- - ------- ----------------------------------------------------------------------
<C> <S>
2 Purchase Agreement by and between the Company and the Stockholders of
Indy Video, Inc., dated as of September 26, 1995.
</TABLE>
7. The following exhibits were filed as part of the Company's Current
Report on Form 8-K, filed with the Commission on August 30, 1995, and are
incorporated herein by reference:
<TABLE>
<CAPTION>
EXHIBIT
NO. TITLE
- - ------- ----------------------------------------------------------------------
<C> <S>
2a Stock Purchase and Sale Agreement by and among the Company, Wilderness
Video Group Ltd., Richard Walton, the Walton Family Trust, Alexsay
Holdings Ltd., Barclays Bank of Canada, Allstate Life Insurance
Company of Canada, and Ontario Municipal Employees Retirement Board,
dated as of August 22, 1995.
2b Stock Purchase and Sale Agreement by and between the Company and Glenn
Forth, dated August 23, 1995.
2c Stock Purchase and Sale Agreement by and between the Company and Sieg
Badke, dated August 23, 1995.
2d Stock Purchase and Sale Agreement by and among the Company, 443972
B.C. Ltd., Dale Mounzer and Jim Collen, dated August 22, 1995.
</TABLE>
8. The following exhibit was filed as part of the Company's Current Report
on Form 8-K, filed with the Commission on July 26, 1995, and is incorporated
herein by reference:
<TABLE>
<CAPTION>
EXHIBIT
NO. TITLE
- - ------- ----------------------------------------------------------------------
<C> <S>
2 Purchase Agreement by and between the Company and the Stockholders of
AV Video, dated as of July 14, 1995.
</TABLE>
9. The following exhibit was filed as part of the Company's Current Report
on Form 8-K, filed with the Commission on June 29, 1995, and is incorporated
herein by reference:
<TABLE>
<CAPTION>
EXHIBIT
NO. TITLE
- - ------- ----------------------------------------------------------------------
<C> <S>
2 Purchase Agreement by and between the Company and the Proprietors of
Video Powerstore, dated as of June 2, 1995.
</TABLE>
10. The following exhibits were filed as part of the Company's Pre-Effective
Amendment No. 1 to its Form SB-2 Registration Statement (No. 33-89018)
originally filed with the Commission on March 31, 1995, and are incorporated
herein by reference:
<TABLE>
<CAPTION>
EXHIBIT
NO. TITLE
- - ------- ----------------------------------------------------------------------
<C> <S>
4a Form of Unit Purchase Option.
10a Form of Merger and Acquisition Agreement between the Company and D.H.
Blair Investment Banking Corp.
10b Form of Amendment to Warrant Agreement dated July 20, 1994 between the
Company, American Stock Transfer & Trust Company and D.H. Blair
Investment Banking Corp.
</TABLE>
20
<PAGE>
11. The following exhibit was filed as part of the Company's Quarterly
Report on Form 10-QSB for the quarter ended January 31, 1995, filed with the
Commission on March 17, 1995, and is incorporated herein by reference:
<TABLE>
<CAPTION>
EXHIBIT
NO. TITLE
- - ------- ----------------------------------------------------------------------
<C> <S>
2a Second Amendment to the Agreement and Plan of Merger by and among the
Company, Schmidt & Schmidt Limited ("SSL"), and the Stockholders of
SSL, dated February 28, 1995.
</TABLE>
12. The following exhibit was filed as part of the Company's Current Report
on Form 8-K, filed with the Commission on February 16, 1995, and is incorporated
herein by reference:
<TABLE>
<CAPTION>
EXHIBIT
NO. TITLE
- - ------- ----------------------------------------------------------------------
<C> <S>
10a Stock Exchange Agreement by and between the Company and certain
stockholders of Tinseltown Video, Inc.
</TABLE>
13. The following exhibit was filed as part of the Company's Form SB-2
Registration Statement (No. 33-89018) filed with the Commission on January 31,
1995, and is incorporated herein by reference:
<TABLE>
<CAPTION>
EXHIBIT
NO. TITLE
- - ------- ----------------------------------------------------------------------
<C> <S>
10a Formula Stock Option Plan.
</TABLE>
14. The following exhibit was filed as part of the Company's Quarterly
Report on Form 10-QSB for the quarter ended October 31, 1994, filed with the
Commission on December 15, 1994, and is incorporated herein by reference:
<TABLE>
<CAPTION>
EXHIBIT
NO. TITLE
- - ------- ----------------------------------------------------------------------
<C> <S>
2b Agreement and Plan of Merger by and among the Company, Jarzig
Enterprises, Inc., and the Stockholders of Jarzig Enterprises, Inc.,
dated October 25, 1994.
</TABLE>
15. The following exhibits were filed as part of the Company's Current
Report on Form 8-K, filed with the Commission on October 3, 1994, and are
incorporated herein by reference:
<TABLE>
<CAPTION>
EXHIBIT
NO. TITLE
- - ------- ----------------------------------------------------------------------
<C> <S>
2a Agreement and Plan of Merger by and among the Company, Schmidt &
Schmidt Limited, and the Stockholders of Schmidt & Schmidt Limited,
dated September 16, 1994.
2b Agreement and Plan of Merger by and among the Company, Halgrimson
Enterprises, Inc., and the Stockholders of Halgrimson Enterprises,
Inc., dated September 16, 1994.
</TABLE>
16. The following exhibit was filed as part of the Company's Quarterly
Report on Form 10-QSB for the quarter ended July 31, 1994, filed with the
Commission on September 10, 1994, and is incorporated herein by reference:
<TABLE>
<CAPTION>
EXHIBIT
NO. TITLE
- - ------- ----------------------------------------------------------------------
<C> <S>
2 Agreement and Plan of Merger by and among the Company, Koonrod, Inc.
and the Stockholders of Koonrod, Inc., dated September 2, 1994.
</TABLE>
21
<PAGE>
17. The following exhibits were filed as part of the Company's Form SB-2
Registration Statement (No. 33-79292-C) declared effective by the Commission on
July 20, 1994, and are incorporated herein by reference:
<TABLE>
<CAPTION>
EXHIBIT
NO. TITLE
- - ------- ----------------------------------------------------------------------
<C> <S>
4a Specimen Class A Common Stock Certificate.
4b Specimen Class B Common Stock Certificate.
4c Form of Warrant Agreement, including Form of Class A and Class B
Warrant Certificates.
4d Form of Unit Purchase Option of D.H. Blair Investment Banking Corp.
4e Form of Escrow Agreement between certain Stockholders of the Company,
the Company and American Stock Transfer & Trust Company.
10c Form of Uniform Franchise Offering Circular & Franchise Agreement.
10d Form of Franchise Agreement between the Company and Franchisees.
10f Form of Consulting Agreement between the Company and D.H. Blair
Investment Banking Corp.
10z Form of Escrow Agreement between the Company and United States Trust
Company of New York.
10aa Form of Agency Agreement between the Company and D.H. Blair Investment
Banking Corp.
10bb 1994 Stock Option Plan.
</TABLE>
b. Reports on Form 8-K.
On March 14, 1996, the Company filed a Current Report on Form 8-K dated
March 13, 1996 to report an amendment to the Company's Bylaws, and the execution
of Restated Employment Agreements with the Company's Chief Executive Officer and
the Company's President.
On April 16, 1996, the Company filed a Current Report on Form 8-K dated
April 15, 1996 to report that the Company entered into Credit and Security
Agreements with the Bank of America Illinois.
22
<PAGE>
SIGNATURES
In accordance with Section 13 or 15(d) of the Securities Exchange Act of
1934, as amended, the registrant caused this report to be signed on its behalf
by the undersigned, thereunto duly authorized.
VIDEO UPDATE, INC.
Date: July 10, 1996 By: /s/ DANIEL A. POTTER
------------------------------------
Daniel A. Potter
CHAIRMAN AND CHIEF EXECUTIVE OFFICER
In accordance with the Securities Exchange Act of 1934, as amended, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the date indicated.
<TABLE>
<CAPTION>
NAME CAPACITY DATE
- - ------------------------------------------------ ---------------------------------------------- ---------------
<C> <S> <C>
/s/ DANIEL A. POTTER
-------------------------------------- Chairman and Chief Executive Officer July 10, 1996
Daniel A. Potter (Principal executive officer)
/s/ JOHN M. BEDARD
-------------------------------------- President and Director July 10, 1996
John M. Bedard
/s/ DANIEL C. HOWARD
-------------------------------------- Chief Operations Officer and Director July 10, 1996
Daniel C. Howard
/s/ CHRISTOPHER J. GONDECK
-------------------------------------- Chief Financial Officer (Principal financial July 10, 1996
Christopher J. Gondeck and accounting officer)
/s/ ROBERT E. YAGER
-------------------------------------- Vice President of Store Operations and July 10, 1996
Robert E. Yager Director
/s/ JANA WEBSTER VAUGHN
-------------------------------------- Director July 10, 1996
Jana Webster Vaughn
/s/ PAUL KELNBERGER
-------------------------------------- Director July 10, 1996
Paul Kelnberger
</TABLE>
23
<PAGE>
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
<TABLE>
<CAPTION>
PAGE
----
<S> <C>
Report of Independent Auditors............................................ F-2
Consolidated Balance Sheets as of April 30, 1995 and 1996............... F-3
Consolidated Statements of Income for the years ended April 30, 1994,
1995 and 1996.......................................................... F-4
Consolidated Statement of Stockholders' Equity for the years ended
April 30, 1994, 1995 and 1996.......................................... F-5
Consolidated Statements of Cash Flows for the years ended April 30,
1994, 1995 and 1996.................................................... F-6
Notes to Consolidated Financial Statements.............................. F-7
</TABLE>
F-1
<PAGE>
REPORT OF INDEPENDENT AUDITORS
Board of Directors
Video Update, Inc.
We have audited the accompanying consolidated balance sheets of Video
Update, Inc. and subsidiaries as of April 30, 1995 and 1996, and the related
consolidated statements of income, stockholders' equity and cash flows for each
of the three years in the period ended April 30, 1996. These financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements 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, these financial statements present fairly, in all material
respects, the consolidated financial position of Video Update, Inc. and
subsidiaries at April 30, 1995 and 1996, and the consolidated results of its
operations and its cash flows for each of the three years in the period ended
April 30, 1996 in conformity with generally accepted accounting principles.
As discussed in Note 2 to the consolidated financial statements, in 1996 the
Company changed its method of accounting for the amortization of its
videocassette rental inventory.
/s/ Ernst & Young LLP
Minneapolis, Minnesota
June 12, 1996
F-2
<PAGE>
VIDEO UPDATE, INC.
CONSOLIDATED BALANCE SHEETS
ASSETS
<TABLE>
<CAPTION>
APRIL 30, APRIL 30,
1995 1996
------------ ------------
(IN THOUSANDS)
<S> <C> <C>
Cash and cash equivalents......................... $ 5,573 $ 676
Accounts receivable............................... 91 558
Notes receivable from related parties............. 30 1,555
Inventory......................................... 1,239 4,545
Videocassette rental inventory -- net............. 4,821 25,701
Property and equipment -- net..................... 4,594 18,988
Prepaid expenses.................................. 135 682
Goodwill -- net................................... 2,912 25,973
Other assets...................................... 55 840
------------ ------------
Total assets...................................... $ 19,450 $ 79,518
------------ ------------
------------ ------------
LIABILITIES AND STOCKHOLDERS' EQUITY
Notes payable..................................... $ 1,278 $ 4,859
Accounts payable.................................. 1,194 8,692
Accrued compensation.............................. 255 1,334
Accrued expenses.................................. 735 977
Accrued rent expense.............................. 157 228
Income taxes payable.............................. - 593
Deferred income taxes............................. 566 841
Other liabilities................................. 94 494
Commitments and contingencies.....................
Stockholders' equity:
Preferred Stock, par value $.01 per share:
Authorized shares -- 5,000,000
Issued shares -- None......................... - -
Class A Common Stock, par value $.01 per share:
Authorized shares -- 50,000,000...............
Issued and outstanding shares -- 4,138,366 at
April 30, 1995
and 11,017,735 at April 30, 1996............. 41 110
Class B Common Stock, par value $.01 per share:
Authorized, issued and outstanding shares --
2,000,000 at
April 30, 1995 and 1996...................... 20 20
Additional paid-in capital...................... 14,552 61,029
Retained earnings............................... 558 2,186
Foreign currency translation.................... - (34)
------------ ------------
15,171 63,311
Notes receivable from officers for the exercise
of options..................................... - (1,811)
------------ ------------
Total stockholders' equity........................ 15,171 61,500
------------ ------------
Total liabilities and stockholders' equity........ $ 19,450 $ 79,518
------------ ------------
------------ ------------
</TABLE>
See accompanying notes
F-3
<PAGE>
VIDEO UPDATE, INC.
CONSOLIDATED STATEMENTS OF INCOME
<TABLE>
<CAPTION>
FISCAL YEAR ENDED APRIL 30,
-------------------------------
1994 1995 1996
--------- --------- ---------
(IN THOUSANDS,
EXCEPT PER SHARE AMOUNTS)
<S> <C> <C> <C>
Revenues:
Rental revenue................................................................. $ 4,180 $ 8,364 $ 46,592
Service fees................................................................... 472 421 491
Product sales.................................................................. 337 266 3,421
--------- --------- ---------
4,989 9,051 50,504
Costs and expenses:
Store operating expenses....................................................... 2,997 5,986 39,685
Selling, general and administrative............................................ 1,179 2,223 5,362
Cost of product sales.......................................................... 186 136 1,880
Amortization of goodwill....................................................... - 83 1,072
--------- --------- ---------
4,362 8,428 47,999
--------- --------- ---------
Operating income................................................................. 627 623 2,505
Interest expense................................................................. (143) (194) (232)
Amortization of debt costs....................................................... - (157) -
Other income..................................................................... 17 155 548
--------- --------- ---------
(126) (196) 316
--------- --------- ---------
Income from continuing operations before income taxes............................ 501 427 2,821
Income tax expense............................................................... 200 214 1,193
--------- --------- ---------
Income from continuing operations................................................ 301 213 1,628
Discontinued operations:
Loss from discontinued operations, net of applicable income tax benefit........ - (24) -
Loss on disposal of discontinued operations, net of applicable income tax
benefit....................................................................... - (35) -
--------- --------- ---------
Net loss from discontinued operations............................................ - (59) -
--------- --------- ---------
Net income....................................................................... $ 301 $ 154 $ 1,628
--------- --------- ---------
--------- --------- ---------
Primary income (loss) per share:
Income from continuing operations.............................................. $ .33 $ .10 $ .15
Discontinued operations........................................................ - (.03) -
--------- --------- ---------
Net income..................................................................... $ .33 $ .07 $ .15
--------- --------- ---------
--------- --------- ---------
Fully diluted income (loss) per share:
Income from continuing operations.............................................. $ .33 $ .10 $ .14
Discontinued operations........................................................ - (.03) -
--------- --------- ---------
Net income..................................................................... $ .33 $ .07 $ .14
--------- --------- ---------
--------- --------- ---------
</TABLE>
See accompanying notes
F-4
<PAGE>
VIDEO UPDATE, INC.
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
(IN THOUSANDS, EXCEPT SHARES)
<TABLE>
<CAPTION>
CLASS A CLASS B ADDITIONAL
COMON STOCK COMMON STOCK PAID-IN RETAINED
------------------------ ------------------------ CAPITAL EARNINGS
NUMBER OF NUMBER OF ----------- -----------
SHARES AMOUNT SHARES AMOUNT AMOUNT AMOUNT
----------- ----------- ----------- ----------- ----------- -----------
<S> <C> <C> <C> <C> <C> <C>
Balance at April 30, 1993................. - $ - 455,520 $ 5 $ 461 $ 103
Issuance of additional shares and
transfer to adjust common stock to
authorized par value as a result of
2.1953-for-1 stock split............... - - 544,480 5 (5) -
Issuance of additional shares and
transfer to adjust common stock to
authorized par value as a result of
2-for-1 stock split.................... - - 1,000,000 10 (10) -
Warrants issued in connection with
subordinated equity notes.............. - - - - 5 -
Net income.............................. - - - - - 301
----------- ----- ----------- --- ----------- -----------
Balance at April 30, 1994................. - - 2,000,000 20 451 404
Issuance of shares in connection with
the Initial Public Offering net of
registration expenses.................. 1,351,250 13 - - 5,280 -
Issuance of shares in connection with
the Company's acquisitions............. 481,616 5 - - 2,643 -
Issuance of shares in connection with
the Subsequent Public Offering net of
registration expenses.................. 2,305,500 23 - - 6,178 -
Net income.............................. - - - - - 154
----------- ----- ----------- --- ----------- -----------
Balance at April 30, 1995................. 4,138,366 41 2,000,000 20 14,552 558
Issuance of shares in connection with
the overallotment option related to the
Subsequent Public Offering............. 345,970 3 - - 989 -
Issuance of shares in connection with
the Company's acquisitions............. 1,603,444 17 - - 14,746 -
Issuance of shares in connection with
the redemption of the Class A
Warrants............................... 4,502,105 45 - - 28,369 -
Issuance of shares related to employee
stock options exercised................ 427,850 4 - - 1,842 -
Notes issued by officers for the
exercise of stock options.............. - - - - - -
Tax benefit resulting from the exercise
of non-qualified stock options......... - - - - 531 -
Foreign currency translation............ - - - - - -
Net income.............................. - - - - - 1,628
----------- ----- ----------- --- ----------- -----------
Balance at April 30, 1996................. 11,017,735 $ 110 2,000,000 $ 20 $ 61,029 $ 2,186
----------- ----- ----------- --- ----------- -----------
----------- ----- ----------- --- ----------- -----------
<CAPTION>
FOREIGN OFFICERS'
CURRENCY NOTES
TRANSLATION RECEIVABLE
--------------- -----------
AMOUNT AMOUNT TOTAL
--------------- ----------- ---------
<S> <C> <C> <C>
Balance at April 30, 1993................. $ - $ - $ 569
Issuance of additional shares and
transfer to adjust common stock to
authorized par value as a result of
2.1953-for-1 stock split............... - - -
Issuance of additional shares and
transfer to adjust common stock to
authorized par value as a result of
2-for-1 stock split.................... - - -
Warrants issued in connection with
subordinated equity notes.............. - - 5
Net income.............................. - - 301
--- ----------- ---------
Balance at April 30, 1994................. - - 875
Issuance of shares in connection with
the Initial Public Offering net of
registration expenses.................. - - 5,293
Issuance of shares in connection with
the Company's acquisitions............. - - 2,648
Issuance of shares in connection with
the Subsequent Public Offering net of
registration expenses.................. - - 6,201
Net income.............................. - - 154
--- ----------- ---------
Balance at April 30, 1995................. - - 15,171
Issuance of shares in connection with
the overallotment option related to the
Subsequent Public Offering............. - - 992
Issuance of shares in connection with
the Company's acquisitions............. - - 14,763
Issuance of shares in connection with
the redemption of the Class A
Warrants............................... - - 28,414
Issuance of shares related to employee
stock options exercised................ - - 1,846
Notes issued by officers for the
exercise of stock options.............. - (1,811) (1,811)
Tax benefit resulting from the exercise
of non-qualified stock options......... - - 531
Foreign currency translation............ (34) - (34)
Net income.............................. - - 1,628
--- ----------- ---------
Balance at April 30, 1996................. $ (34) $ (1,811) $ 61,500
--- ----------- ---------
--- ----------- ---------
</TABLE>
See accompanying notes
F-5
<PAGE>
VIDEO UPDATE, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
FISCAL YEAR ENDED APRIL 30,
--------------------------------
1994 1995 1996
--------- --------- ----------
(IN THOUSANDS)
<S> <C> <C> <C>
OPERATING ACTIVITIES
Net income...................................................................... $ 301 $ 154 $ 1,628
Adjustments to reconcile net income to net cash provided by operating
activities:
Depreciation and amortization................................................. 1,149 2,212 15,241
Deferred rent and other liabilities........................................... - 129 472
Deferred income taxes......................................................... - 406 31
Provision for discontinued operations......................................... - 35 -
Changes in operating assets and liabilities, net of acquisitions of
businesses:
Accounts receivable......................................................... (39) 24 (385)
Notes receivable............................................................ (14) 1 (272)
Inventory................................................................... (124) (946) (2,563)
Other assets................................................................ (141) 8 (801)
Accounts payable............................................................ 143 92 5,921
Income taxes payable........................................................ - (240) 1,130
Other liabilities........................................................... - 317 (1,319)
--------- --------- ----------
Net cash provided by operating activities....................................... 1,275 2,192 19,083
INVESTING ACTIVITIES
Purchase of videocassette rental inventory...................................... (1,606) (3,752) (22,739)
Purchase of property and equipment.............................................. (400) (2,901) (12,301)
Investment in businesses, net of cash acquired.................................. - (708) (17,391)
Notes receivable from officers.................................................. - - (1,252)
--------- --------- ----------
Net cash used in investing activities........................................... (2,006) (7,361) (53,683)
FINANCING ACTIVITIES
Proceeds from bank line of credit............................................... - - 4,100
Proceeds from notes payable..................................................... 900 2,171 -
Payments on notes payable....................................................... (164) (2,829) (3,838)
Payments of loan costs.......................................................... (24) (145) -
Proceeds from exercise of employee options...................................... - - 35
Proceeds from exercise of Class A warrants...................................... - - 28,414
Proceeds from issuance of common stock.......................................... - 11,494 992
--------- --------- ----------
Net cash provided by financing activities....................................... 712 10,691 29,703
--------- --------- ----------
Increase (decrease) in cash and cash equivalents................................ (19) 5,522 (4,897)
Cash and cash equivalents at beginning of year.................................. 70 51 5,573
--------- --------- ----------
Cash and cash equivalents at end of year........................................ $ 51 $ 5,573 $ 676
--------- --------- ----------
--------- --------- ----------
</TABLE>
See accompanying notes
F-6
<PAGE>
VIDEO UPDATE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
APRIL 30, 1996
1. SIGNIFICANT ACCOUNTING POLICIES
NATURE OF BUSINESS
Video Update, Inc. and subsidiaries (the "Company") own and operate retail
video stores and sell and support retail video franchises. Company-owned stores
are located in the United States and Canada with franchises located principally
in the United States.
CONSOLIDATION
The accompanying financial statements present the consolidated financial
position, results of operations and cash flows of the Company. All intercompany
accounts and transactions have been eliminated.
USE OF ESTIMATES
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the amounts reported in the consolidated financial
statements and accompanying notes. The most significant estimates and
assumptions relate to the amortization methods and useful lives of videocassette
rental inventory and goodwill. These estimates and assumptions could change and
actual results could differ from these estimates.
BASIS OF PRESENTATION
The Company utilizes an unclassified balance sheet presentation. This format
was followed based on the premise that the videocassette rental inventory
represents assets used by the Company to generate current operating income, and
management believes that to classify all of these costs as noncurrent would be
misleading to the readers of the financial statements because it would not
indicate the level of assets expected to be converted into cash in the next year
as a result of the rentals of the videocassettes.
SERVICE FEES
The Company receives continuing monthly royalty and other fee revenue from
its franchisees based on a percentage of the franchisees' gross monthly revenue.
Royalty fee and other fee revenues will continue for the initial terms of the
franchise agreements, after which the revenues will be based upon renewed
franchise agreements. Origination franchise fees collected are deferred and not
recorded as revenue in the statement of income until the franchisee has executed
a lease or a letter of intent for a franchised store location.
CASH EQUIVALENTS
The Company considers all highly liquid investments with a remaining
maturity of three months or less when purchased to be cash equivalents.
INVENTORY
Inventory is stated at the lower of cost or market. Inventory consists of
videocassettes held as base stock for the opening of new stores, videocassettes
held for sale and supplies available for sale to franchisees.
F-7
<PAGE>
VIDEO UPDATE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
APRIL 30, 1996
1. SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
VIDEOCASSETTE RENTAL INVENTORY
Videocassette rental inventory is stated at cost, and is amortized over the
estimated economic life as follows:
<TABLE>
<CAPTION>
NUMBER OF COPIES
OF TITLE PER STORE AMORTIZATION POLICY
- - ------------------- ------------------------------------------------------------
<S> <C>
One through three Straight-line over 36 months to a salvage value of $6.00 per
videocassette.
Four through nine Straight-line over 6 months to a book value of $6.00 and
then straight-line over 30 months.
Ten and over Straight-line over 6 months to a book value of $6.00 and
then straight-line over 3 months.
</TABLE>
PROPERTY AND EQUIPMENT
Furniture and equipment are recorded at cost and depreciated using the
straight-line method over the estimated economic life of the asset of five to
ten years. Leasehold improvements are recorded at cost and depreciated using the
straight-line method over the lesser of the estimated economic life of ten years
or the lease term.
GOODWILL
Goodwill, consisting principally of excess cost over net assets from the
acquisitions of businesses, is net of accumulated amortization of $83,000 and
$1,155,000 at April 30, 1995 and 1996, respectively, and is being amortized on a
straight-line basis over twenty years. If facts and circumstances suggest that
the goodwill will not be recoverable, as determined based on the undiscounted
cash flows of the assets acquired over the remaining amortization period, the
Company's carrying value of goodwill will be reduced by the estimated shortfalls
of cash flows.
INCOME TAXES
The Company accounts for income taxes utilizing the liability method.
Deferred income taxes are recorded to reflect the tax consequences of
differences between the tax and financial reporting bases of assets and
liabilities.
STOCK-BASED COMPENSATION
The Company plans to implement the disclosure provisions of Statement of
Financial Accounting Standards Number 123 (SFAS 123), "Accounting for
Stock-Based Compensation", in fiscal 1997. SFAS 123 was issued by the Financial
Accounting Standards Board in October 1995, and allows companies to choose
whether to account for stock-based compensation under the current method as
prescribed in Accounting Principles Board Opinion Number 25 (APB 25) or use the
fair value method described in SFAS 123. The Company plans to continue to follow
the accounting measurement provisions of APB 25. Therefore, management believes
the impact of implementing the disclosure provisions of SFAS 123 will not have a
significant effect on the Company's financial position or results of operations.
RECENTLY ISSUED ACCOUNTING STANDARD
In March 1995, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards Number 121 (SFAS 121) "Accounting for the
Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of."
SFAS 121 prescribes the accounting treatment for long-lived assets, identifiable
intangibles and goodwill related to those assets when there are indications that
the carrying
F-8
<PAGE>
VIDEO UPDATE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
APRIL 30, 1996
1. SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
values of those assets may not be recoverable. Management believes that the
adoption of SFAS 121 in fiscal 1997 will not have a material adverse effect on
the Company's results of operations or its financial condition taken as a whole.
FAIR VALUE OF FINANCIAL INSTRUMENTS
At April 30, 1995 and 1996, the carrying value of financial instruments such
as cash and cash equivalents, accounts payable and notes payable approximated
their fair values.
NET INCOME PER COMMON SHARE
Net income per share is computed by dividing net income for the year by the
weighted average number of shares of common stock and common stock equivalents,
if dilutive, outstanding during the year. The weighted average number of shares
used in the net income per share calculation was reduced by the common shares
placed in escrow in connection with the Company's initial public offering.
<TABLE>
<CAPTION>
FISCAL YEAR ENDED APRIL
30,
-------------------------
1994 1995 1996
------- ------- -------
(IN THOUSANDS, EXCEPT PER
SHARE AMOUNTS)
<S> <C> <C> <C>
PRIMARY NET INCOME PER SHARE
Net income............................................................ $ 301 $ 154 $ 1,628
------- ------- -------
------- ------- -------
Weighted average shares outstanding:
Class A common shares outstanding at year end....................... - 4,138 11,018
Class B common shares outstanding at year end....................... 2,000 2,000 2,000
Less: Class B common shares placed in escrow in connection with the
initial public offering............................................ (1,300) (1,300) (1,300)
Effect of using weighted average common shares outstanding.......... 204 (2,612) (2,046)
Effect of shares issuable under stock options and warrants based on
the treasury stock method.......................................... - - 991
------- ------- -------
Shares used in computing net income per share..................... 904 2,226 10,663
------- ------- -------
------- ------- -------
Net income per common and common equivalent share, primary............ $ .33 $ .07 $ .15
------- ------- -------
------- ------- -------
FULLY DILUTED NET INCOME PER SHARE
Net income............................................................ $ 301 $ 154 $ 1,628
------- ------- -------
------- ------- -------
Weighted average shares outstanding:
Class A common shares outstanding at year end....................... - 4,138 11,018
Class B common shares outstanding at year end....................... 2,000 2,000 2,000
Less: Class B common shares placed in escrow in connection with the
initial public offering............................................ (1,300) (1,300) (1,300)
Effect of using weighted average common shares outstanding.......... 204 (2,612) (2,046)
Effect of shares issuable under stock options and warrants based on
the treasury stock method.......................................... - - 1,557
------- ------- -------
Shares used in computing net income per share..................... 904 2,226 11,229
------- ------- -------
------- ------- -------
Net income per common and common equivalent share, fully diluted...... $ .33 $ .07 $ .14
------- ------- -------
------- ------- -------
</TABLE>
RECLASSIFICATION
Certain prior year items have been reclassified to conform with the fiscal
1996 presentation.
F-9
<PAGE>
VIDEO UPDATE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
APRIL 30, 1996
2. CHANGE IN AMORTIZATION METHOD FOR VIDEOCASSETTE RENTAL INVENTORY
Effective February 1, 1996, videocassettes that are considered base stock
(including copies one through three of new releases) are amortized over 36
months on a straight-line basis to a salvage value of $6.00 per videocassette.
New release videocassettes are amortized as follows: the fourth through ninth
copies of each title per store are amortized on a straight-line basis during
their first six months to a net book value of $6.00 and then on a straight-line
basis over 30 months with no salvage value; and the tenth and any succeeding
copies of each title per store are amortized on a straight-line basis during
their first six months to a net book value of $6.00 and then on a straight-line
basis over three months with no salvage value. The changes, which represent in
part a change in accounting principle and a change in accounting estimate, have
been reflected in the accompanying financial statements in total as a change in
an estimate in the fourth quarter of fiscal 1996.
Prior to February 1, 1996, base stock videocassettes were amortized over 36
months on a straight-line basis with no salvage value. Prior to May 1, 1995, new
release videocassettes were amortized as follows: copies one through three of
each title per store were amortized as base stock; the fourth through ninth
copies of each title per store were amortized 40% in the first year and 30% in
each of the second and third years; and the tenth and any succeeding copies of
each title per store were amortized over nine months on a straight-line basis.
The new method of amortization was adopted because the Company believes
accelerating expense recognition for new release videocassettes (copies four and
greater) during the first six months more closely matches the typically higher
revenue generated following a title's release, and believes that $6.00
represents a reasonable salvage value for base stock videocassettes after 36
months.
The effect of the change for recognizing salvage value of base stock and the
effect of the application of the new method of amortizing videocassette copies
in excess of the base stock to May 1, 1995, had the impact, in total, of
increasing amortization expense by $2,773,000 and decreasing income from
continuing operations and net income by $1,604,000, or $.15 per share, for
fiscal 1996, after the effect of income taxes of $1,169,000, all of which has
been recorded in the fourth quarter.
3. VIDEOCASSETTE RENTAL INVENTORY -- NET
<TABLE>
<CAPTION>
APRIL 30, APRIL 30,
1995 1996
--------- ----------
(IN THOUSANDS)
<S> <C> <C>
Videocassette rental inventory........................................ $ 8,387 $ 41,759
Accumulated amortization.............................................. (3,566) (16,058)
--------- ----------
$ 4,821 $ 25,701
--------- ----------
--------- ----------
</TABLE>
Amortization expense for videocassette rental inventory, which is included
in store operating expenses, was $975,000, $1,643,000 and $12,532,000 for the
years ended April 30, 1994, 1995 and 1996, respectively.
F-10
<PAGE>
VIDEO UPDATE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
APRIL 30, 1996
4. PROPERTY AND EQUIPMENT -- NET
<TABLE>
<CAPTION>
APRIL 30, APRIL 30,
1995 1996
----------- ---------
(IN THOUSANDS)
<S> <C> <C>
Land................................................................... $ 458 $ 473
Buildings.............................................................. 1,085 1,300
Furniture and equipment................................................ 3,074 12,218
Leasehold improvements................................................. 651 7,332
Accumulated depreciation............................................... (674) (2,335)
----------- ---------
$ 4,594 $ 18,988
----------- ---------
----------- ---------
</TABLE>
Depreciation expense was $134,000, $299,000 and $1,607,000 for the years
ended April 30, 1994, 1995 and 1996, respectively.
5. NOTES PAYABLE
The notes payable balance consists of the following:
<TABLE>
<CAPTION>
APRIL 30, APRIL 30,
1995 1996
--------- ----------
(IN THOUSANDS)
<S> <C> <C>
Revolving credit facility with a bank; quarterly payments of interest at the
prime rate (8.25% at April 30, 1996) maturing in April 1997 and secured by all
assets of the Company.......................................................... $ - $ 4,100
Note payable, interest at the United States government treasury securities rate
plus 4.5% (10.26% at April 30, 1996). The note is secured by a mortgage and
specific assets of the Company................................................. 567 548
Note payable in monthly installments of $14,329 which includes interest at 7.5%
until December 1996............................................................ - 111
Other notes payable with monthly installments ranging from $1,305 to $2,105 with
interest rates of 9.25% to 11%................................................. 136 100
Note payable to a bank, monthly installments of $15,036, which included interest
at the bank's base rate plus 3% (12.00% at April 30, 1995). The note was paid
in full in April 1996.......................................................... 423 -
Contract for deed payable, monthly installments of $2,296 which included
interest at 12%. The contract for deed was paid in full in 1996................ 152 -
--------- ----------
$ 1,278 $ 4,859
--------- ----------
--------- ----------
</TABLE>
In April 1996, the Company entered into a one-year revolving credit facility
("Line of Credit") under which the Company may borrow up to $10,000,000
($4,100,000 outstanding at April 30, 1996), with amounts borrowed thereunder
bearing interest at variable rates based on the federal funds rate, prime rate
or the interbank Eurodollar rate. The Line of Credit is convertible into a
two-year term loan if it is not renewed. During the term of the Line of Credit
and thereafter to the extent any amounts are outstanding under the Line of
Credit, the Company is subject to various restrictive covenants. The Line of
Credit also requires that the Company maintain certain cash flow ratios as well
as certain ratios of total liabilities to tangible net worth.
F-11
<PAGE>
VIDEO UPDATE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
APRIL 30, 1996
5. NOTES PAYABLE (CONTINUED)
The weighted-average interest rate on borrowings outstanding was 10.0% and
8.25% at April 30, 1995 and 1996, respectively.
The aggregate maturities of the notes payable at April 30, 1996 are as
follows:
<TABLE>
<CAPTION>
(IN THOUSANDS)
<S> <C>
1997...................................................... $ 4,331
1998...................................................... 22
1999...................................................... 24
2000...................................................... 26
2001...................................................... 34
2002 and thereafter....................................... 422
------
$ 4,859
------
------
</TABLE>
6. RELATED PARTY TRANSACTIONS
Family members of stockholders own a majority interest at April 30, 1994,
1995 and 1996 in two, one and one franchise stores, respectively. The amount of
service fees earned from these franchisees was $30,000, $18,000 and $20,000 for
the years ended April 30, 1994, 1995 and 1996, respectively. The amount due from
the franchisees at April 30, 1995 and 1996 amounted to $2,000, for each year.
In 1994, the Company entered into an Agreement and Plan of Merger with
Koonrod, Inc. ("KRI") and the stockholders of KRI. Under the Agreement, the
Company acquired all of the outstanding stock of KRI in exchange for $75,000
cash and 105,000 shares of the Company's Class A Common Stock which were valued
at approximately $496,000, and KRI was merged into the Company. The two
stockholders of KRI who owned all of the outstanding stock of KRI are the father
and brother-in-law of the Company's Chief Executive Officer ("CEO").
In 1995, the Company entered into a Purchase Agreement with Bedard
Entertainment, Inc. ("BEI"), and the stockholders of BEI. Under the Purchase
Agreement, the Company acquired substantially all of the assets of BEI in
exchange for 15,000 shares of Class A Common Stock and the assumption of
indebtedness of BEI in the amount of approximately $275,000. The two
stockholders of BEI who owned all of the outstanding stock of BEI are the
brother and sister-in-law of the Company's President.
During the years ended April 30, 1994, 1995 and 1996, the Company incurred
approximately $19,000, $48,000, and $245,000, respectively, in expenses from
Johnson, West & Co., PLC ("Johnson, West & Co.") for accounting and tax
services. A director of the Company is a member of Johnson, West & Co.
In fiscal 1996, the Company advanced to its CEO and its President under
notes receivable, as amended, $1,164,000 and $647,000, respectively, to enable
them to exercise options to purchase a total of 420,000 shares of the Company's
Class A Common Stock at an exercise price of $4.3125, the fair market value of
the stock on the date the options were granted, with such amounts reflected as a
reduction of stockholders' equity at April 30, 1996. Additionally, the Company
advanced these officers under similar arrangements an additional $1,252,000 to
satisfy the then anticipated tax liabilities. The notes receivable as amended
are full recourse loans payable in ten equal installments due in August of each
of the first nine years with the final payment due in May of 2005 and accrues
interest at 6.9%. At April 30, 1996 the total due the Company under the notes
including interest was approximately $3,197,000.
As of April 30, 1995 and 1996, the Company has a note receivable from the
President for $26,000 and $29,000, respectively, which bears interest at 8% and
is due November 1996.
F-12
<PAGE>
VIDEO UPDATE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
APRIL 30, 1996
7. LEASE AGREEMENTS
The Company leases office and retail space under operating leases with terms
of 6 to 144 months. These leases generally have a term of three to ten years and
provide options to renew for periods ranging from three to five additional
years. Under the leasing agreements, the Company is generally responsible for
the real estate taxes, insurance, and other expenses related to the property.
The leases expire at varying dates through 2008. The Company also leases
vehicles and computer equipment.
At April 30, 1996, minimum annual rental commitments under non-cancelable
operating leases are as follows:
<TABLE>
<CAPTION>
(IN THOUSANDS)
<S> <C>
1997...................................................... $ 11,074
1998...................................................... 10,338
1999...................................................... 8,972
2000...................................................... 6,569
2001...................................................... 4,737
2002 and thereafter....................................... 13,739
-------
Total minimum lease payments.............................. $ 55,429
-------
-------
</TABLE>
Rent expense, principally retail and office space, under operating leases
amounted to $630,000, $1,292,000 and $7,675,000 for the years ended April 30,
1994, 1995 and 1996, respectively.
8. INCOME TAXES
Income from continuing operations before income taxes in fiscal 1996 of
$2,821,000 is comprised of $2,412,000 in the United States and $409,000 in
Canada. There were no operations outside of the United States in prior years.
Income tax expense is as follows:
<TABLE>
<CAPTION>
FISCAL YEAR ENDED APRIL 30,
-------------------------------------
1994 1995 1996
----------- ----------- -----------
(IN THOUSANDS)
<S> <C> <C> <C>
Current:
Federal................................................... $ 92 $ (28) $ 833
State..................................................... 33 - 164
International............................................. - - 165
----- ----- -----------
125 (28) 1,162
Deferred:
Federal................................................... 57 164 39
State..................................................... 18 41 (53)
International............................................. - - 45
----- ----- -----------
75 205 31
----- ----- -----------
Total income tax expense.................................... 200 177 1,193
Income tax benefit related to
discontinued operations.................................... - 37 -
----- ----- -----------
Income tax expense related to continuing operations......... $ 200 $ 214 $ 1,193
----- ----- -----------
----- ----- -----------
</TABLE>
F-13
<PAGE>
VIDEO UPDATE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
APRIL 30, 1996
8. INCOME TAXES (CONTINUED)
Components of the net deferred tax liability, resulting from differences in
book and income tax accounting methods, are as follows:
<TABLE>
<CAPTION>
APRIL APRIL
30, 30,
1995 1996
-------- --------
(IN THOUSANDS)
<S> <C> <C>
Deferred income tax liabilities:
Tax over book depreciation and amortization............... $ 420 $ 780
Tax over book merger basis adjustment..................... 248 337
-------- --------
668 1,117
Deferred income tax assets:
Book over tax rent expense................................ (102) (276)
-------- --------
Net deferred income tax liabilities....................... $ 566 $ 841
-------- --------
-------- --------
</TABLE>
The reconciliation of the federal statutory rate (34%) to the Company's
effective income tax rate is as follows:
<TABLE>
<CAPTION>
FISCAL YEAR ENDED APRIL 30,
----------------------------------------
1994 1995 1996
------------ ------------ ------------
<S> <C> <C> <C>
Federal tax at statutory rate............................... 34.0% 34.0% 34.0%
State tax, net of federal benefit........................... 6.7 10.8 2.6
International............................................... - - 2.0
Goodwill.................................................... - 7.0 2.0
Other....................................................... (.8) 1.7 1.7
--- --- ---
39.9% 53.5% 42.3%
--- --- ---
--- --- ---
</TABLE>
9. SUPPLEMENTAL CASH FLOW INFORMATION
<TABLE>
<CAPTION>
FISCAL YEAR ENDED APRIL 30,
-------------------------------------
1994 1995 1996
----------- ----------- -----------
(IN THOUSANDS)
<S> <C> <C> <C>
Interest paid............................................... $ 93 $ 213 $ 226
Income taxes paid........................................... $ 120 $ 41 $ 29
</TABLE>
10. STOCKHOLDERS' EQUITY
In July and August 1994, the Company completed its initial public offering
("IPO") of 1,351,250 Units, each Unit consisting of one share of Class A Common
Stock, one Class A Warrant and one Class B Warrant, including 176,350 Units
subject to the underwriter's over-allotment. Proceeds to the Company, net of
registration expenses, were approximately $5,300,000.
In February 1995, the Company increased the number of authorized shares of
Class A Common Stock from 18,000,000 shares to 50,000,000 shares.
In April and May 1995, the Company completed a subsequent public offering of
2,305,500 Units and 345,970 Units for the underwriter's overallotment, each
consisting of one share of Class A Common Stock, one Class A Warrant and one
Class B Warrant. Proceeds to the Company, net of registration expenses, were
approximately $7,200,000.
The number of outstanding shares of Class A Common Stock at April 30, 1996
includes 55,000 unregistered shares related to one of the Company's 1996
acquisitions pending resolution of a dispute with the sellers.
F-14
<PAGE>
VIDEO UPDATE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
APRIL 30, 1996
10. STOCKHOLDERS' EQUITY (CONTINUED)
CLASS A COMMON STOCK -- CLASS B COMMON STOCK
The rights of the holders of the Class A Common Stock and the Class B Common
Stock are essentially identical and, except as expressly required by law, are
treated as a single class of stock in all respects, except that the holders of
the Class A Common Stock are entitled to one vote per share, and the holders of
the Class B Common Stock are entitled to five votes per share, and each share of
Class B Common Stock is convertible into one share of Class A Common Stock at
any time and automatically converts into one share of Class A Common Stock in
the event of any sale or transfer, and upon the death of the original holder.
In connection with the Company's IPO, all of the holders of the Company's
Class B Common Stock have placed, on a pro rata basis, an aggregate of 1,300,000
shares (the "Escrow Shares") into escrow. The Escrow Shares will be released to
the stockholders on a pro rata basis, in the event specified levels of pretax
income of the Company for the years ending April 30, 1995 to April 30, 1998 are
achieved, or the market price of the Company's Class A Common Stock attains
specified targets during a 36 month period commencing from the effective date of
the registration statement relating to the Company's IPO. Any shares remaining
in escrow on July 31, 1998 will be forfeited, which shares will then be
contributed to the Company's capital.
In the event that the foregoing earnings or market price levels are attained
and the Escrow Shares released, the Securities and Exchange Commission has
adopted the position that the release of Escrow Shares to officers, directors,
employees and consultants of the Company will be compensatory and, accordingly,
a non-cash compensation expense would be recorded with an increase to paid-in
capital for financial reporting purposes. As such, stockholder's equity in total
would not change. The expense would equal the fair market value of the Escrow
Shares on the date of release and could result in a material charge to earnings.
WARRANTS -- CLASS A AND B
Each of the units sold in connection with the Company's public offerings
consisted of one share of Class A Common Stock of the Company, one Class A
Warrant and one Class B Warrant. The components of the units were separately
transferable immediately. When issued, each Class A Warrant, upon its exercise,
entitled the holder to purchase one share of the Company's Class A Common Stock
and one Class B Warrant. The Class A Warrant exercise price was $6.50 per share
subject to certain adjustments. In August 1995, the Company called for
redemption all of its outstanding Class A Warrants. The redemption date set
forth in the Notice of Redemption was September 7, 1995. Approximately 4,502,000
Class A Warrants were exercised resulting in net proceeds to the Company of
approximately $28,414,000. At April 30, 1996, the Company has Class B Warrants
outstanding enabling the holders the ability to purchase approximately 8,005,000
shares of Class A Common Stock at $8.75 per share. Such warrants expire in July
1999. In addition, there are 500,000 Class B Warrants outstanding that were
issued by the Company in a 1994 bridge financing. These warrants provide the
holders the ability to purchase the underlying Class A Common Stock of the
Company at $8.75 per share and expire July 1999.
BLAIR OPTIONS
At April 30, 1996 the Company has 117,500 shares of Class A Common Stock
reserved for issuance upon exercise of the Unit Purchase Option (the "Initial
Option") at an aggregate exercise price of $734,375, issued to D.H. Blair
Investment Banking Corp. ("Blair") in connection with its services as
underwriter of the Company's initial public offering; 230,550 shares of Class A
Common Stock reserved for issuance upon exercise of the Unit Purchase Option
(the "Subsequent Option") at an aggregate exercise price of $1,033,500, issued
to Blair or its' affiliates in connection with its services as underwriter of
the Company's subsequent public offering (collectively, the Initial Option and
the Subsequent Option are referred to as the
F-15
<PAGE>
VIDEO UPDATE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
APRIL 30, 1996
10. STOCKHOLDERS' EQUITY (CONTINUED)
"Blair Options"); 348,050 shares of Class A Common Stock reserved for issuance
upon exercise of the redeemable Class A Warrants (the "Class A Warrants")
underlying the Blair Options, at an exercise price of $6.50 per share; 696,100
shares of Class A Common Stock issuable upon exercise of the Class B Warrants
underlying the Blair Options, at an exercise price of $8.75 per share.
11. STOCK OPTION PLANS
In April 1994, the Company established an incentive stock option plan (the
"1994 Stock Plan") whereby 150,000 shares of Class A Common Stock were reserved.
The options can be either incentive stock options or non-qualified options, as
defined by Section 422 of the Internal Revenue Code ("Section 422") to be
granted to eligible individuals. The exercise price for the incentive stock
options granted under the 1994 Stock Plan may not be less than the fair market
value of the Class A Common Stock on the date the option is granted.
In May 1995, the Company established an additional stock option plan (the
"1995 Plan") whereby 850,000 shares were reserved for grant to eligible
individuals to purchase Class A Common Stock of the Company. Options under the
1995 Plan may be incentive stock options or non-qualified options. The exercise
price for the incentive stock options granted under the 1995 Plan may not be
less than fair market value of the Class A Common Stock on the date the option
is granted. In August 1995, 420,000 options were exercised by the CEO and
President of the Company.
The remaining options granted to employees under the stock plans vest over a
three year period from the date of issue, or vest according to income and share
price targets set forth in the escrow share agreement of the Class B Common
shares.
In September 1994, the Board of Directors approved the Formula Stock Option
Plan (the "Formula Plan") whereby 50,000 shares of Class A Common Stock have
been reserved. The Formula Plan provides for the granting of options to
non-management directors of the Company. As of April 30, 1996 options to
purchase 6,000 shares of Class A Common Stock were granted. The exercise price
for the incentive stock options granted under the plan may not be less than the
fair market value of the Class A Common Stock on the date the option is granted.
To date, none of these options have been exercised.
Option activity is summarized as follows:
<TABLE>
<CAPTION>
1994 AND
SHARES 1995 PLAN FORMULA EXERCISE
AVAILABLE OPTIONS PLAN OPTIONS PRICE
FOR GRANT OUTSTANDING OUTSTANDING EXERCISABLE PER SHARE
---------- ----------- --------------- ----------- --------------
<S> <C> <C> <C> <C> <C>
Balance at April 30, 1994................... 150,000 - - - -
Establishment of the Formula Plan......... 50,000 - - - -
Granted................................... (169,200) 166,200 3,000 - $4.50 - 6.75
Became exercisable........................ - - - 61,170 4.50 - 5.50
Canceled.................................. 30,900 (30,900) - (10,815) 5.00
---------- ----------- ----- -----------
Balance at April 30, 1995................... 61,700 135,300 3,000 50,355 4.50 - 6.75
Establishment of the 1995 Plan............ 850,000 - - - -
Granted................................... (830,000) 827,000 3,000 - 4.31 - 10.25
Became exercisable........................ - - - 576,000 4.31 - 7.63
Exercised................................. - (427,850) - (427,850) 4.31 - 4.50
Canceled.................................. 6,000 (6,000) - (2,000) 7.63
---------- ----------- ----- -----------
Balance at April 30, 1996................... 87,700 528,450 6,000 196,505 $4.31 - 10.25
---------- ----------- ----- -----------
---------- ----------- ----- -----------
</TABLE>
F-16
<PAGE>
VIDEO UPDATE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
APRIL 30, 1996
12. ACQUISITIONS
During fiscal years 1995 and 1996, the Company acquired, in 19 transactions,
nine video retail stores previously operated by Video Update franchisees, and
141 video retail stores operated by unaffiliated third party operators (the
"Acquisitions"). The purchase method of accounting has been used to account for
each of the Acquisitions and are included in the Company's consolidated
financial statements from the date of acquisition.
During fiscal year 1995, the Company acquired, in seven transactions, nine
video retail stores previously operated by Video Update franchisees and five
retail stores operated by unaffiliated third party operators. The aggregate
purchase price of these acquisitions totaling approximately $3,510,000, included
$862,000 in cash, and 481,616 shares of Class A Common Stock valued at
$2,648,000. The excess of the cost over the estimated fair value of the assets
acquired of $2,775,000 is being amortized over 20 years on a straight-line
basis.
During fiscal 1996, the Company acquired, in 12 transactions, 136 retail
stores. The aggregate purchase price of these acquisitions totaling
approximately $40,114,000, included $17,391,000 in cash, $3,319,000 in
promissory notes, $4,641,000 in assumed indebtedness and transaction costs, and
1,603,444 shares of Class A Common Stock valued at $14,763,000 and an option to
purchase 20,000 shares of Class A Common Stock at a price equal to the fair
market value at the date of issuance. The excess of the cost over the estimated
fair value of the assets acquired of $24,352,000 (goodwill and deferred charges)
is being amortized over 20 years on a straight-line basis.
In connection with six acquisitions in which the Company has issued an
aggregate of 635,613 shares of Class A Common Stock, the Company may be
obligated to make deficiency payments to such sellers equal to the difference
between the guaranteed price of $7.00 to $12.00 for each share issued, and the
actual market price of such shares as of specified dates between July and
October 1996. As of April 30, 1996 the deficiency payments are estimated to be
approximately equal to $1,180,000. In two of these acquisitions, the Company has
the option of satisfying approximately $1,105,000 of this liability at April 30,
1996 through the issuance of approximately 136,000 additional shares of Class A
Common Stock (based on the April 30, 1996 stock price).
The following unaudited pro forma information presents the consolidated
results of operations of the Company as if the Acquisitions had been completed
at the beginning of the year in which the acquisition occurred and the
immediately preceding year. In the opinion of the Company's management, all
adjustments necessary to present fairly such pro forma summary have been made
based on the terms and structure of the transactions.
<TABLE>
<CAPTION>
FISCAL YEAR ENDED APRIL 30,
-------------------------------
1994 1995 1996
--------- --------- ---------
(IN THOUSANDS, EXCEPT PER SHARE
DATA)
<S> <C> <C> <C>
Revenues................................................ $ 8,650 $ 50,177 $ 62,949
Income from continuing operations....................... $ 520 $ 4,196 $ 3,037
Primary income per share................................ $ .35 $ .46 $ .26
Fully diluted income per share.......................... $ .35 $ .46 $ .25
</TABLE>
This unaudited pro forma financial summary does not necessarily indicate the
actual results had the Acquisitions occurred at the beginning of the respective
periods, nor do they purport to indicate the results of future operations of the
Company.
F-17
<PAGE>
VIDEO UPDATE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
APRIL 30, 1996
13. GEOGRAPHIC BUSINESS OPERATIONS
The Company owns and operates retail video stores in the United States and
in Canada. A summary of the Company's operations by geographic area is presented
for 1996. There were no operations outside of the United States in prior years.
All intercompany revenues and expenses have been eliminated.
<TABLE>
<CAPTION>
OPERATING TOTAL
REVENUES INCOME ASSETS
--------- ----------- ---------
(IN THOUSANDS)
<S> <C> <C> <C>
United States............................................ $ 40,372 $ 2,107 $ 70,582
Canada................................................... 10,132 398 8,936
--------- ----------- ---------
$ 50,504 $ 2,505 $ 79,518
--------- ----------- ---------
--------- ----------- ---------
</TABLE>
14. DISCONTINUED OPERATIONS
Effective October 31, 1994, the Company adopted a plan to dispose of
Gamesters, a video game specialty store. Accordingly, Gamesters was reported as
a discontinued operation at October 31, 1994, and the financial statements have
been reclassified to report separately the operating results of the business.
The provision for losses on the disposal of Gamesters was $35,000 net of
taxes of $25,000, consisting of an estimated loss on disposal of the business of
$12,000 and a provision of $48,000 for anticipated losses until disposal. In
addition, the summary operating results of the discontinued operation for the
year ended April 30, 1995 were as follows:
<TABLE>
<S> <C>
Product sales..................................................... $ 31,000
Cost and expenses................................................. 67,000
---------
(Loss) before income taxes........................................ (36,000)
Income tax benefit................................................ 12,000
---------
Net (loss)........................................................ $ (24,000)
---------
---------
</TABLE>
15. SUBSEQUENT EVENTS
The Company and the Selling Stockholders (the Company's CEO and President)
expect to file a registration statement with the Securities and Exchange
Commission in July 1996 to offer for sale approximately 5,500,000 shares of its
Class A Common Stock in an underwritten public offering. Included as a part of
the shares to be sold are 420,000 shares of common stock currently held by the
Company's CEO and President as a result of their exercise of options in August
1995. The proceeds to be received by the officers from the sale of their shares
will first be used to pay in full the notes receivable and interest therein
totaling $3,197,000 discussed in Note 6. Additionally, net proceeds will be used
to retire outstanding notes payable of $4,100,000 as of April 30, 1996. The
effect on supplemental net income and net income per share as a result of the
use of proceeds to reduce outstanding debt is not material.
In June 1996, the Board of Directors approved an additional stock option
plan (the "1996 Plan"). The 1996 Plan provides for the granting of up to 820,000
options to eligible individuals to purchase shares of Class A Common Stock of
the Company. Options under the 1996 Plan may be incentive stock options or
non-qualified options.
F-18
<PAGE>
EXHIBIT INDEX
<TABLE>
<CAPTION>
SEQUENTIALLY
EXHIBIT NUMBERED PAGE
NO. TITLE NUMBER
- - -------- ------------------------------------------------------------ --------------
<C> <S> <C>
3 Restated Certificate of Incorporation.......................
10a Amended Recourse Promissory Note from Daniel A. Potter to
the Company, dated June 26, 1996...........................
10b Amended Recourse Promissory Note from John M. Bedard to the
Company, dated June 26, 1996...............................
18 Letter on Change in Accounting Principles...................
21 List of Subsidiaries........................................
23 Consent of Ernst & Young LLP................................
27 Financial Data Schedule.....................................
</TABLE>
<PAGE>
RESTATED CERTIFICATE OF INCORPORATION
VIDEO UPDATE, INC.
[originally incorporated under the same name on March 30, 1994]
1. The name of the corporation is Video Update, Inc.
2. The address of its registered office in the State of Delaware is 1209
Orange Street, in the City of Wilmington, County of New Castle. The name of its
registered agent at such address is The Corporation Trust Company.
3. The nature of the business or purposes to be conducted or promoted is:
To engage in any lawful act or activity for which corporations may be
organized under the General Corporation Law of Delaware.
4. The total number of shares of stock which the Corporation shall have the
authority to issue is Fifty-Seven Million (57,000,000) shares, Fifty Million
(50,000,000) of which shall be Class A Common Stock, $.01 par value per share,
Two Million (2,000,000) of which shall be Class B Common Stock, $.01 par value
per share, and Five Million (5,000,000) of which shall be Preferred Stock, $.01
par value per share, amounting in the aggregate to Five Hundred Seventy Thousand
and 00/100 Dollars ($570,000.00).
Additional designations and powers, preferences and rights and
qualifications, limitations or restrictions thereof of the shares of Preferred
Stock shall be determined by the Board of Directors from time to time.
Holders of Class A Common Stock shall have the right to cast one vote for
each share held of record and holders of Class B Common Stock have the right to
cast five votes for each share held of record on all matters submitted to a vote
of the holders of Common Stock. The Class A Common Stock and Class B Common
Stock shall vote together as a single class on all matters on which stockholders
may vote, including the election of directors, except when class voting is
required by applicable law.
Shares of Class B Common Stock are automatically converted into an
equivalent number of fully paid and non-assessable shares of Class A Common
Stock: (i) upon the death of the original record holder thereof or (ii) upon the
sale or transfer of such shares of Class B Common Stock by the original record
holder thereof. Each share of Class B Common Stock also is convertible at any
time at the option of the holder into one share of Class A Common Stock; once
such shares are converted into Class A Common Stock, they are retired and
unavailable for future reissuance as Class B Common Stock.
Holders of the Class A Common Stock and Class B Common Stock shall have
equal ratable rights to dividends from funds legally available therefor, when,
as and if declared by the Board of Directors and are entitled to share ratably,
as a single class, in all of the assets of the Company available for
distribution to holders of shares of Class A Common Stock and Class B Common
Stock upon the liquidation, dissolution or winding up of the affairs of the
Company
<PAGE>
5. The Corporation is to have perpetual existence.
6. In furtherance and not in limitation of the powers conferred by statute,
the Board of Directors is expressly authorized:
To make, alter or repeal the bylaws of the Corporation.
To authorize and cause to be executed mortgages and liens upon the real and
personal property of the Corporation.
To set apart out of any of the funds of the Corporation available for
dividends a reserve or reserves for any proper purpose and to abolish any such
reserve in the manner in which it was created.
By a majority of the whole Board, to designate one or more committees, each
committee to consist of one or more of the Directors of the Corporation. The
Board may designate one or more directors as alternate members of any committee,
who may replace any absent or disqualified member at any meeting of the
committee. The bylaws may provide that in the absence or disqualification of a
member of a committee, the member or members thereof present at any meeting and
not disqualified from voting, whether or not he or they constitute a quorum, may
unanimously appoint another member of the Board of Directors to act at the
meeting in the place of any such agent or disqualified member. Any such
committee, to the extent provided in the resolution of the Board of Directors,
or in the bylaws of the corporation, shall have and may exercise all the powers
and authority of the Board of Directors in the management of the business and
affairs of the Corporation, and may authorize the seal of the Corporation to be
affixed to all papers which may require it; but no such committee shall have the
power or authority in reference to amending the certificate of incorporation,
adopting an agreement of merger or consolidation, recommending to the
stockholders the sale, lease, or exchange of all or substantially all of the
corporation's property and assets, recommending to the stockholders a
dissolution of the corporation or a revocation of a dissolution, or amending the
bylaws of the corporation; and, unless the resolution or bylaws expressly so
provide, no such committee shall have the power or authority to declare a
dividend or to authorize the issuance of stock.
When and as authorized by the stockholders in accordance with statute, to
sell, lease or exchange all or substantially all of the property and assets of
the corporation, including its goodwill and its corporate franchises, upon such
terms and conditions and for such consideration, which may consist in whole or
in part of money or property, including shares of stock in, and/or other
securities of, any other corporation or corporation, as its board of directors
shall deem expedient and for the best interests of the corporation.
7. To the maximum extent permitted by Section 102(b)(7) of the General
Corporation Law of Delaware, a director of this Corporation shall not be
personally liable to the Corporation or its stockholders for monetary damages
for breach of fiduciary duty as a director, except for liability (i) for any
breach of the director's duty of loyalty to the Corporation or its stockholders,
(ii) for acts or omissions not in good faith or which involve intentional
misconduct or a knowing violation of law, (iii) under Section 174 of the
Delaware General Corporation Law, or (iv) for any transaction from which the
director derived an improper personal benefit.
<PAGE>
8. Whenever a compromise or arrangement is proposed between this
corporation and its creditors or any class of them and/or between this
corporation and its stockholders or any class of them, any court or equitable
jurisdiction within the State of Delaware may, on the application in a summary
way of this corporation or of any creditor or stockholder thereof, or on the
application of any receiver or receivers appointed for this corporation under
the provisions of Section 291 of Title 8 of the Delaware Code or on the
application of trustees in dissolution or of any receiver or receivers appointed
for this corporation under the provisions of Section 279 of Title 8 of the
Delaware Code, order a meeting of the creditors or class of creditors, and/or of
the stockholders or class of stockholders of this corporation, as the case may
be, to be summoned in such manner as the said court directors. If a majority in
number representing three-fourths in value of the creditors or class of
creditors, and/or of the stockholders or class of stockholders of this
corporation, as the case may be, agree to any compromise or arrangement to any
reorganization of this corporation as consequences of such compromise or
arrangement, the said compromise or arrangement and the said reorganization
shall, if sanctioned by the court to which the said application has been made,
be binding on all the creditors or class of creditors, and/or on all the
stockholders or class of stockholders of this corporation, as the case may be,
and also on this corporation.
9. Meetings of the stockholders may be held within or without the
State of Delaware, as the bylaws may provide. The books of the corporation
may be kept (subject to any provision contained in the statutes) outside the
State of Delaware at such place or places as may be designated from time to
time by the Board of Directors or in the bylaws of the corporation.
Elections of directors need not be by written ballot unless the bylaws of the
corporation shall so provide.
10. The corporation reserves the right to amend, alter, change, or repeal
any provision contained in this certificate of incorporation, in the manner now
or hereafter prescribed by statute, and all rights conferred upon stockholders
herein are granted subject to this reservation; except that any such amendment
shall be made by the holders of at least two-thirds of the outstanding shares of
Common Stock of the Corporation.
IN WITNESS WHEREOF, this Restated Certificate of Incorporation, which only
restates and integrates and does not further amend the certificate of Video
Update, Inc., as heretofore amended or supplemented, there being no discrepancy
between those provisions and the provisions of the Restated Certificate of
Incorporation, has been duly adopted in accordance with Section 245 of the
Delaware General Corporation Law, has been executed by its authorized officer
this 2nd day of July, 1996.
VIDEO UPDATE, INC.
By: /s/ Daniel A. Potter
--------------------------------
Daniel A. Potter
Chairman and Chief Executive Officer
<PAGE>
RECOURSE PROMISSORY NOTE
$1,094,126.70 June 26, 1996
FOR VALUE RECEIVED, the undersigned (the "Maker"), promises to pay to the
order of Video Update, Inc., ("Video Update") a Delaware corporation with its
principal place of business at 3100 World Trade Center, 30 East Seventh Street,
St. Paul, Minnesota 55101("Payee") on or before August 23, 2005 (the "Payment
Date"), the principal sum of One Million Ninety-Four Thousand One Hundred
Twenty-Six Dollars and Seventy Cents ($1,094,126.70) together with interest at
the rate of 6.9% simple interest per annum, which amount shall be paid in ten
annual installments in accordance with SCHEDULE 1 annexed hereto. This Recourse
Note (the "Note") amends, restates and supersedes in their entirety the
Promissory Notes of the Maker to Video Update, dated August 23, 1995, and shall
be given full force and effect as if executed on such date.
1. PAYMENTS OF PRINCIPAL AND INTEREST. Subject to the provisions
contained and referred to herein, the Maker shall pay the principal and all
accrued interest in accordance with SCHEDULE 1 on or before the Payment Date.
2. RECOURSE. As recourse for this Note, the Payee shall have full
recourse against the Maker's personal assets, including without limitation, any
securities of Video Update held by the Maker and purchased by means of this Note
as referenced on SCHEDULE 2 attached hereto (the "Shares"). The Maker hereby
pledges the Shares to the Payee as security for the Maker's obligations under
this Note, provided that Payee may sell the Shares (including in connection with
any underwritten public offering of Video Update's securities) so long as the
proceeds of such sales are used immediately to satisfy the Maker's obligations
hereunder.
3. ALLOCATION OF PAYMENTS. All payments shall be first allocated to
payment of interest and then to payment of principal.
4. DEFAULT IN PAYMENT. For the purposes of this Note, a default shall, at
the option of Video Update, be deemed to exist if the Maker shall fail to make
payment on the Payment Date described herein for more than thirty (30) days
after written notice from Video Update. In the event of any default described
above, Video Update may, at its option, demand payment of any amount then due
and payable under the terms of this Note from the Maker as follows: Upon the
occurrence and continuation past the cure periods specified hereof of any
default, Video Update, at its option, upon written notice to the Maker, may
declare the unpaid principal hereof and accrued interest thereon to be
immediately due and payable without presentment, demand, protest or further
notice, all of which are hereby expressly waived, and enforce its rights as a
secured party. No course of dealing or conduct and no delay on the part of the
Payee in exercising any right hereunder shall operate as a waiver thereof and no
consent or waiver in any instance shall operate as waiver in any other
instance. To be effective, any waiver must be in writing and signed by Video
Update.
<PAGE>
5. PREPAYMENT. The Maker may prepay all or part of this Note at any time
without further interest or penalty.
6. SUCCESSORS AND ASSIGNS. This Note shall inure to the benefit of the
successors and assigns of Video Update and be binding upon the Maker and his
heirs, executors, administrators, successors and assigns, provided that Payee
may not assign or transfer this Note without the prior written consent of the
Maker.
7. CONSTRUCTION. This Note shall be governed by and construed in
accordance with, the laws of the State of Minnesota (without regard to the
conflict of law principles thereof).
8. WAIVERS. No waiver of any right hereunder by any party shall operate
as a waiver of any other right, or of the same right with respect to any
subsequent occasion for its exercise, or of any right to damages. No waiver by
any party of any breach of the Maker's obligations hereunder shall be held to
constitute a waiver of any other breach or a continuation of the same breach.
All remedies provided by this Note are in addition to all other remedies
provided by law. This Agreement may not be amended except in a writing signed
by the parties hereto.
9. UNENFORCEABILITY. If any provision of this Note shall be declared
void or unenforceable by any judicial or administrative authority, the validity
of any other provisions and of the entire Note shall not be affected thereby.
10. COUNTERPARTS. This Note may be executed in two or more
counterparts, each of which shall be deemed an original, but all of which
together shall constitute one and the same instrument.
11. ENTIRE AGREEMENT. This Note represents the complete agreement of the
parties with respect to the transactions contemplated hereby and supersedes all
prior agreements and understandings, including but not limited to all previous
promissory notes issued by the Maker to the Payee.
Signed as of the date first written above.
/s/ Daniel A. Potter
---------------------------------------------
Daniel A. Potter, MAKER
Agreed and Acknowledged
/s/ John M. Bedard
- - --------------------------------
Video Update, Inc., PAYEE
<PAGE>
RECOURSE PROMISSORY NOTE
$1,969,428.06 June 26, 1996
FOR VALUE RECEIVED, the undersigned (the "Maker"), promises to pay to the
order of Video Update, Inc., ("Video Update") a Delaware corporation with its
principal place of business at 3100 World Trade Center, 30 East Seventh Street,
St. Paul, Minnesota 55101("Payee") on or before August 23, 2005 (the "Payment
Date"), the principal sum of One Million Nine Hundred Sixty-Nine Thousand Four
Hundred Twenty-Eight Dollars and Six Cents ($1,969,428.06) together with
interest at the rate of 6.9% simple interest per annum, which amount shall be
paid in ten annual installments in accordance with SCHEDULE 1 annexed hereto.
This Recourse Note (the "Note") amends, restates and supersedes in their
entirety the Promissory Notes of the Maker to Video Update, dated August 23,
1995, and shall be given full force and effect as if executed on such date.
1. PAYMENTS OF PRINCIPAL AND INTEREST. Subject to the provisions
contained and referred to herein, the Maker shall pay the principal and all
accrued interest in accordance with SCHEDULE 1 on or before the Payment Date.
2. RECOURSE. As recourse for this Note, the Payee shall have full
recourse against the Maker's personal assets, including without limitation, any
securities of Video Update held by the Maker and purchased by means of this Note
as referenced on SCHEDULE 2 attached hereto (the "Shares"). The Maker hereby
pledges the Shares to the Payee as security for the Maker's obligations under
this Note, provided that Payee may sell the Shares (including in connection with
any underwritten public offering of Video Update's securities) so long as the
proceeds of such sales are used immediately to satisfy the Maker's obligations
hereunder.
3. ALLOCATION OF PAYMENTS. All payments shall be first allocated to
payment of interest and then to payment of principal.
4. DEFAULT IN PAYMENT. For the purposes of this Note, a default shall, at
the option of Video Update, be deemed to exist if the Maker shall fail to make
payment on the Payment Date described herein for more than thirty (30) days
after written notice from Video Update. In the event of any default described
above, Video Update may, at its option, demand payment of any amount then due
and payable under the terms of this Note from the Maker as follows: Upon the
occurrence and continuation past the cure periods specified hereof of any
default, Video Update, at its option, upon written notice to the Maker, may
declare the unpaid principal hereof and accrued interest thereon to be
immediately due and payable without presentment, demand, protest or further
notice, all of which are hereby expressly waived, and enforce its rights as a
secured party. No course of dealing or conduct and no delay on the part of the
Payee in exercising any right hereunder shall operate as a waiver thereof and no
consent or waiver in any instance shall operate as waiver in any other
instance. To be effective, any waiver must be in writing and signed by Video
Update.
5. PREPAYMENT. The Maker may prepay all or part of this Note at any time
without further interest or penalty.
<PAGE>
6. SUCCESSORS AND ASSIGNS. This Note shall inure to the benefit of the
successors and assigns of Video Update and be binding upon the Maker and his
heirs, executors, administrators, successors and assigns, provided that Payee
may not assign or transfer this Note without the prior written consent of the
Maker.
7. CONSTRUCTION. This Note shall be governed by and construed in
accordance with, the laws of the State of Minnesota (without regard to the
conflict of law principles thereof).
8. WAIVERS. No waiver of any right hereunder by any party shall operate
as a waiver of any other right, or of the same right with respect to any
subsequent occasion for its exercise, or of any right to damages. No waiver by
any party of any breach of the Maker's obligations hereunder shall be held to
constitute a waiver of any other breach or a continuation of the same breach.
All remedies provided by this Note are in addition to all other remedies
provided by law. This Agreement may not be amended except in a writing signed
by the parties hereto.
9. UNENFORCEABILITY. If any provision of this Note shall be declared
void or unenforceable by any judicial or administrative authority, the validity
of any other provisions and of the entire Note shall not be affected thereby.
10. COUNTERPARTS. This Note may be executed in two or more counterparts,
each of which shall be deemed an original, but all of which together shall
constitute one and the same instrument.
11. ENTIRE AGREEMENT. This Note represents the complete agreement of the
parties with respect to the transactions contemplated hereby and supersedes all
prior agreements and understandings, including but not limited to all previous
promissory notes issued by the Maker to the Payee.
Signed as of the date first written above.
/s/ John Bedard
---------------------------------------------
John Bedard, MAKER
Agreed and Acknowledged
/s/ Daniel A. Potter
- - -------------------------------
Video Update, Inc., PAYEE
<PAGE>
[Ernst & Young Letterhead]
Board of Directors
Video Update, Inc.
3100 World Trade Center
30 East Seventh Street
St. Paul, Minnesota 55101
Dear Directors:
Note 2 of the notes to the consolidated financial statements as of and for the
year ended April 30, 1996 of Video Update, Inc. included in its Form 10-KSB
for the year ended April 30, 1996 describes a change in the method of
accounting of videocassette rental inventory which has been reflected as a
change in an estimate. The change pertains to the 4 through 9 and over 9
categories of copies of title per store. The former policy amortized copies 4
through 9 over a three year period at a rate of 40% of the cost in year one
and 30% in each of year two and three and amortized copies 10 and over on a
straight-line basis over nine months. The new policy amortizes copies 4
through 9 straight-line over six months down to a value of $6.00 with the
$6.00 then amortizing straight-line over thirty months and amortizes copies
10 and over on a straight-line over six months down to a value of $6.00 with
the $6.00 then amortizing straight-line over three months. You have advised
us that you believe that the change is to a preferable method in your
circumstance because it results in an accelerated amortization recognition
for new release videocassettes during the first six months which creates an
improved matching with the higher revenues that generally are realized
following a title's release. Additionally, you have advised us that the
change is similar to amortization methods recently adopted by the other large
video specialty store operators in the video rental industry.
There are no authoritative criteria for determining a "preferable"
amortization method of videocassette rental inventory based on the particular
circumstances; however, we conclude that the change in the method of
accounting for videocassette rental inventory amortization is to an
acceptable alternative method which, based on your judgment to make this
change for the reasons cited above, is preferable in your circumstances.
Very truly yours,
Minneapolis, Minnesota
June 12, 1996
<PAGE>
Exhibit 21
Subsidiaries of the Small Business Issuer
1. Tinseltown Video, Inc., a Washington corporation.
2. Video Update Canada Inc., an Ontario corporation (formerly Wilderness
Video Group Ltd., a British Columbia corporation).
3. 24 Hour Entertainment Group Ltd., a British Columbia corporation.
4. 24 Hour Entertainment Leasing Ltd., a British Columbia corporation.
5. Alexsay Holdings Ltd., a British Columbia corporation.
6. 1149463 Ontario Limited, an Ontario corporation.
7. 1173239 Ontario Limited, an Ontario corporation.
<PAGE>
Exhibit 23
Consent of Independent Auditors
We consent to the incorporation by reference in the Registration Statements
on Form S-8 (No. 33-96024) pertaining to the 1994 Stock Option Plan, the 1994
Formula Stock Option Plan and the 1995 Stock Option Plan of Video Update,
Inc., and Form S-3 (No. 33-94980 and No. 333-486) of Video Update, Inc. for
the registration of 15,071,896 shares of Class A Common Stock, 500,000
Redeemable Class A Warrants and 500 Redeemable Class B Warrants, and the
registration of 903,181 shares of Class A Common Stock, respectively, of our
report dated June 12, 1996, with respect to the consolidated financial
statements of Video Update, Inc. included in the Annual Report (Form 10-KSB)
for the year ended April 30, 1996.
/s/ Ernst & Young
Minneapolis, Minnesota
July 10, 1996
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE
CONSOLIDATED FINANCIAL STATEMENTS FOR THE FISCAL YEAR ENDED APRIL 30, 1996 AND
IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS.
</LEGEND>
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> APR-30-1996
<PERIOD-START> MAY-01-1995
<PERIOD-END> APR-30-1996
<CASH> 676
<SECURITIES> 0
<RECEIVABLES> 558
<ALLOWANCES> 0
<INVENTORY> 30,246
<CURRENT-ASSETS> 0<F1>
<PP&E> 21,324
<DEPRECIATION> 2,336
<TOTAL-ASSETS> 79,518
<CURRENT-LIABILITIES> 16,135<F1>
<BONDS> 548
0
0
<COMMON> 0
<OTHER-SE> 0
<TOTAL-LIABILITY-AND-EQUITY> 79,518
<SALES> 3,421
<TOTAL-REVENUES> 50,504
<CGS> 1,880
<TOTAL-COSTS> 47,999
<OTHER-EXPENSES> (548)
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 232
<INCOME-PRETAX> 2,821
<INCOME-TAX> 1,193
<INCOME-CONTINUING> 1,628
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 1,628
<EPS-PRIMARY> .15
<EPS-DILUTED> .14
<FN>
<F1>The Company utilizes an unclassified balance sheet presentation. This format
was followed based on the premise that the videocassette rental inventory
represents assets used by the Company to generate current operating income, and
management believes that to classify all of these costs as noncurrent would be
misleading to the readers of the financial statements because it would not
indicate the level of assets expected to be converted into cash in the next
year as a result of the rentals of the videocassettes.
</FN>
</TABLE>
