<PAGE>
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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
(Mark One)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934.
FOR THE FISCAL YEAR ENDED DECEMBER 31, 1998
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934.
FOR THE TRANSITION PERIOD FROM ______ TO ______
Commission File Number 0-26516
EUPHONIX, INC.
(Exact name of registrant as specified in its charter)
California 77-0189481
---------- ----------
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
220 Portage Avenue, Palo Alto, CA 94306
----------------------------------------
(Address of principal executives, zip code)
(650) 855-0400
--------------
(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:
Common Stock, $.001 Par Value
(Title of class)
Indicate by check mark whether the registrant has filed (1) 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 regis-
trant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. YES [X] NO___
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of Registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ ]
The aggregate market value of the voting stock held by non-affiliates
of the Registrant, based upon the closing sale price of the Common Stock on
March 15, 1999, as reported on the Nasdaq National Market, was approximately
$8,568,432. Shares of Common Stock held by each executive officer and director
and by each person who owns 5% or more of the outstanding Common Stock have
been excluded in that such persons may under certain circumstances be deemed to
be affiliates. This determination of affiliate status is not necessarily a
conclusive determination for other purposes.
The number of shares of the Registrant's Common Stock as of March 15, 1999
was 7,956,521.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the following documents are incorporated by reference into the
part of this Form 10-K as indicated. None.
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<PAGE>
TABLE OF CONTENTS
Page
----
PART 1
Item 1. Business........................................................ 3
Item 2. Properties...................................................... 22
Item 3. Legal Proceedings............................................... 22
Item 4. Submission of Matters to a Vote of Security Holders............. 22
PART II
Item 5. Market for the Registrant's Common Equity and Related Stockhold-
er Matters...................................................... 23
Item 6. Selected Financial Data......................................... 24
Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations........................................... 24
Item 7A. Quantitative and Qualitative Disclosures about Market Risk...... 31
Item 8. Financial Statements and Supplementary Data..................... 32
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure............................................ 52
PART III
Item 10. Directors and Executive Officers of the Registrant.............. 53
Item 11. Executive Compensation.......................................... 55
Item 12. Security Ownership of Certain Beneficial Owners and Management.. 58
Item 13. Certain Relationships and Related Transactions.................. 60
PART IV
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K. 62
SIGNATURES................................................................ 66
2
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PART I
The Business section and other parts of this Report contain forward-looking
statements that involve risks and uncertainties. The Company's actual results
may differ significantly from the results discussed in the forward-looking
statements. Factors that might cause such a difference include, but are not
limited to, those discussed in the section entitled "Management's Discussion and
Analysis of Financial Condition and Results of Operations -- Factors Affecting
Future Operating Results."
Item 1. Business.
Euphonix, Inc.'s core business is the development, manufacture and marketing
of digitally controlled audio mixing consoles and multi-track recorders for use
in the production of audio content for the music, post production (film and
television), broadcast, live sound reinforcement (live concerts and theater) and
multimedia segments of the professional audio market. The Company is an indus-
try leader in providing software-driven functionality that serves to automate
and streamline tedious and repetitive tasks during the audio production process,
while providing high quality audio and extended functionality relative to the
current audio industry standards. Euphonix's high performance audio systems play
a major role in the production of popular music, motion picture and television
projects. Award winning artists and producers such as Steve Miller, Kenny G,
David Foster, George Duke, Teddy Riley and Glen Ballard have benefited from the
power and versatility of the Company's CS series of mixing console in their
studios. Feature films, such as this year's The Thin Red Line, Prince of Egypt
and The Horse Whisperer have been scored on Euphonix consoles. The Company's
CS3000 consoles have also been used to mix and score a number of hit television
programs such as Friends, Touched By an Angel and The Tonight Show with Jay
Leno.
It is Euphonix's business strategy to produce hardware products and services
for mixing, editing and recording audio for high end professional use. These
products will have the capability to be used in an integrated manner, sharing
common commands and functions to further automate the audio production process.
During the past fiscal year, the Company introduced a number of new pro-
ducts. In April, Euphonix launched the CS3100B mixing console and a new rack-
mountable Tower II at the National Association of Broadcasters (NAB) Trade Show
in Las Vegas. These products were specifically designed to serve the demanding
needs of Broadcast customers. During the year the Company phased out the CS2000
mixing console. In June, the Company released MixView 3.2 which provided im-
proved automated surround sound panning and EQ linking. The Company believes
MixView 3.2 positions the CS3000 console as one of the leading surround sound
recording and mixing consoles available. In September, Euphonix debuted its R-1
Multi-track Recorder System at the Audio Engineering Society (AES) Trade Show in
San Francisco. It is the professional audio industry's first product to offer a
user-friendly transition from analog or 16-bit digital tape-based recording to
24-bit disk-based recording. The product received "Best in Show" awards at the
San Francisco AES, Paris SATIS and Tokyo InterBEE Trade Shows. The Company be-
lieves this innovative product will establish new benchmarks in price/perfor-
mance, sound quality and ease of use. See "--Products."*
The Company was incorporated in California in July 1988. The Company's prin-
cipal executive offices are located at 220 Portage Avenue, Palo Alto, California
94306, and its telephone number is (650) 855-0400.
<F1>
* This paragraph contains forward-looking statements reflecting current expec-
tations. There can be no assurance that the Company's actual future perfor-
mance will meet the Company's current expectations. Investors are strongly
encouraged to review the section entitled "Factors Affecting Future Operat-
ing Results" commencing on page 30 for a discussion of factors that could
affect future performance.
3
<PAGE>
Industry Overview
Audio content for the entertainment industry is produced by professionals in
four primary applications: music (CD's, tapes, music for film and television),
post production (sound for film, video, DVD and television), broadcast (sound
for broadcast television), and live sound reinforcement (sound for live concerts
and theater). An emerging market requiring audio production for multimedia con-
sumer products, such as interactive CD-ROM, DVD-ROM and games, is forming and,
the Company believes, may grow in the future.*
Mixing consoles serve as the central component of most professional audio
production studios, and are used by all applications of the professional audio
market throughout the production process, which includes recording, editing and
mixing. A mixing console electronically blends, routes and enhances sound from
musical instruments, voices, sound effects and pre-recorded material. Mixing
consoles used in each market during the different stages of production share a
high degree of common functionality. Professional mixing consoles are used to
process, combine, and reduce a large number of individual audio inputs (typical-
ly 20-100) to produce a smaller number of outputs (typically 2-8) for the audio
engineer to hear or record. Mixing consoles provide at least one fader (sliding
potentiometer) to control the individual volume of each input. In addition, con-
soles provide processing for each input that may require anywhere from 1-40 var-
iable controls (knobs) and 1-100 switching controls (buttons). Such controls
include those for adjusting the tonal qualities of an individual channel to en-
hance nuances and filter out noise or correct other problems ("EQ"), enhancing,
inducing or correcting volume fluctuations on individual channels ("Dynamics"),
adding special effects to an individual channel such as reverberation, delay or
pitch shifting ("Aux Sends") and locating each individual channel on the sound
field of the final output ("Panning"). Mixing consoles used for professional ap-
plications often require up to 100 faders, 4,000 knobs, and 10,000 buttons. The
Company expects that as the complexity of audio production increases in all mar-
ket segments, due to industry demand for higher quality and more captivating
sound, the need for more and larger-scale mixing consoles will increase.*
In order to prepare for a recording, editing or mixing session, the controls
on a mixing console must be configured in such a way as to duplicate the setup
from an earlier session or such controls must be reset for a new session. It is
common for the duplication process to take anywhere from 10 to 30 minutes on
traditional consoles because each control must be manually set by the operator.
During the mixing phase of a production, it is also common for the console oper-
ator to perform many adjustments to controls so that the characteristics of each
input (including voices, sound effects and musical instruments) may change over
time. When the operator is required to perform multiple changes over time, or
to update changes that have already been performed, it becomes highly advanta-
geous to provide computer automation in order to capture and replay the opera-
tor's performance. However, while high-end consoles have been available with
computer automated faders as an optional retrofit, the thousands of other con-
trols on the mixing console (high-end and otherwise) traditionally have been
operated manually.
In addition, traditional mixing consoles have required large surfaces in or-
der to accommodate the multitude of faders, knobs and buttons. Moreover, all
audio electronics necessary for operation of the console have typically been lo-
cated under the large control surface because the faders, knobs and switches are
mechanically coupled to the audio processing hardware. It is not uncommon to
find large mixing consoles that are over 12 feet long and weigh over 1,000
pounds. Operators often have difficulty operating these traditional systems be-
cause of their size, and frequently more than one operator is required to oper-
ate the system. The size and weight of these traditional-architecture mixing
<F1>
* This paragraph contains forward-looking statements reflecting current
expectations. There can be no assurance that the Company's actual perfor-
mance will meet the Company's current expectations. Investors are strongly
encouraged to review the section entitled "Factors Affecting Future Oper-
ating Results" commencing on page 30 for a discussion of factors that could
affect future performance.
4
<PAGE>
consoles and their lack of modularity and upgradeability have placed restric-
tions on the installation, location and portability of the hardware required to
record, edit and mix audio. Moreover, these traditional systems have typically
been purchased with a fixed size and feature set and often require total re-
placement to expand the customer's capabilities.
To date the predominant mode of audio processing and transmission to and
from a mixing console has been analog due to its simplicity, cost-effectiveness,
high sound quality and the extensive analog infrastructure which currently ex-
ists in the professional audio market. Digital control/digital processing mixing
consoles have been available in the marketplace for a number of years, although
the Company believes that their rate of acceptance in the marketplace has been
restricted due to the sound quality (relative to analog systems) and disadvant-
ages generally associated with digital processing (higher complexity, higher
cost, audible processing delays, and the relative lack of digital audio infra-
structure products including cabling, patching, and interconnecting devices).
Euphonix Solution
Euphonix has developed a digitally controlled analog mixing console that the
Company believes represents an industry breakthrough in sound quality, automa-
tion of controls and processing functions, together with lower cost, upgradeable
features and smaller size. The Company believes that its system provides audio
performance and processing features that are equal to or better than traditional
architectures at a substantial reduction in price. With its unique HyperSurround
capabilities found in MixView 3.2, a user can create audio mixes in every format
of surround sound in use today. The Euphonix system provides the benefits of
digital control to the professional audio industry with the sound quality, sim-
plicity and cost-effectiveness of analog signal processing and transmission,
without requiring the industry to abandon its existing investment in analog
transmission and processing infrastructure. The Company has also provided new
features to mixing consoles that enable operators to perform functions that to
date have been difficult to perform, as well as a dynamic hardware and software
upgrade path for all of its systems that allows users to utilize new features
and functions as they are released. Moreover, because the Euphonix system is
modular and scaleable, it allows customers to configure the systems to meet
their professional needs and financial resources, and to upgrade their systems
as their needs change. In addition, the Euphonix architecture is capable of pro-
viding digital control of audio processing regardless of whether the transmis-
sion method is analog or digital. As a result, as the audio production industry
increasingly adopts digital processing in the future, the Company believes that
its system will be upgradeable to incorporate such technology with further pro-
duct development.*
Strategy
The Company's goal is to become the leading provider of sound production
tools for the entertainment industry through developing innovative, high value,
user oriented products. The Company's strategy includes the following key
elements:
Develop a family of products
The Company's goal is to leverage its reputation and substantial investment
in digital control technology, digital signal processing and distributed com-
puter processing to develop a family of digital product offerings to support
recording, editing and mixing functions. The Company plans to focus on the needs
of the high-end professional music recording, short and long form post produc-
tion and on-air broadcast studios. In the long term, the Company intends to
develop, internally or through acquisitions or licensing, a range of compatible
<F1>
* This paragraph contains forward-looking statements reflecting current
expectations. There can be no assurance that the Company's actual perfor-
mance will meet the Company's current expectations. Investors are strongly
encouraged to review the section entitled "Factors Affecting Future Operat-
ing Results" commencing on page 30 for a discussion of factors that could
affect future performance.
5
<PAGE>
audio production products that will enable the Euphonix system to become the
control center for automating and streamlining significant portions of the audio
production process.*
Capitalize on Leading Edge Technology
Since its inception in 1988, the Company has dedicated itself to bringing
cost-effective digital and software technology to professional audio mixing. In
1991, the Company brought to market the first digitally controlled audio mixing
console with performance the Company believes rivaled high-end products from
other manufacturers at a significantly lower price. The Company's product archi-
tecture and technology have been designed to enable the professional user to ex-
press more easily creative talents while reducing labor and time-intensive oper-
ations, at a more favorable price-performance ratio than existing mixing sys-
tems.
Provide Complete Scaleable Solutions
The Company offers modular systems that provide customers a range of func-
tionality and flexibility, allowing them to configure the Company's systems to
meet their professional needs and financial resources. A key focus of the Com-
pany's product development efforts is to maintain compatibility of its new pro-
ducts and features with its current products, enabling customers to make an ini-
tial investment in a Euphonix system, and then upgrade their system as their
needs and finances permit.
Leverage Brand Name Recognition
The Company seeks to enhance its reputation for technical innovation, high
quality and superior price-performance. To date, as a result of the Company's
product architecture, customer satisfaction, excellent price-performance and
significant industry visibility, the Company believes it has generated brand
name recognition and loyalty, which will benefit the Company as it seeks to in-
crease its share of its target market.*
Increase Penetration into Other Market Segments
The Company seeks to leverage its success in the music market to continue to
expand into complementary market applications of the professional audio market,
including post production, broadcast, live sound reinforcement and multimedia.
The Company believes that the key features of the Euphonix system, including its
time-based automation, SnapShot Recall, flexible architecture and compact de-
sign, are well-suited to meet the needs of such complementary market segments.
The Company is increasing marketing efforts to aggressively target these market
segments.
Build Global Presence
The Company's sales strategy is to build a worldwide presence in order to
fully address its target markets and to serve customers that operate on an in-
ternational basis. The Company's sales outside the United States as a percen-
tage of its net revenues were approximately 43%, 41% and 53%, in fiscal years
1998, 1997 and 1996, respectively. In addition to its New York, Los Angeles,
Nashville and Palo Alto offices in the United States, the Company has offices in
London and Tokyo and a network of sales representatives outside of the United
States.
<F1>
* This paragraph contains forward-looking statements reflecting current expec-
tations. There can be no assurance that the Company's actual future perfor-
mance will meet the Company's current expectations. Investors are strongly
encouraged to review the section entitled "Factors Affecting Future Operat-
ing Results" commencing on page 30 for a discussion of factors that could
affect future performance.
6
<PAGE>
Products
The Company's products include its base CS3000 system mixing consoles, its
R-1 Multi-track Recorder product introduced in 1999, system options and system
packages configured for specific market applications, as described below. The
Company phased out the CS2000 system mixing console, selling only six in 1998;
and also phased out Spectral products.
CS3000D
CS3000D Base Systems
The Euphonix CS3000 (the "System") has been designed for operational speed,
high sound quality and flexible configuration control and processing. System op-
tions may be factory installed or added in the field, allowing customers to
tailor the product to their exact requirements and then to subsequently modify
and upgrade their Systems as their needs change. The Company offers specific
features developed for individual market applications to all customers in order
to ensure compatibility between Systems and to provide customers with the abil-
ity to change applications across market applications. The System can use the
same version of software for various applications. The base System may currently
be specified with hardware variations to accommodate differences in application
of the product by the music ("D" & "M" Systems), post production ("P" & "F"
Systems), and broadcast ("B" Systems) market applications.
The key features and advantages of the System include:
Centralized Control Panel. Mixing consoles for professional applications
often require up to 100 faders, 4,000 knobs and 10,000 buttons. The System
uses a proprietary central control panel which eliminates a significant por-
tion of these knobs and buttons by assigning multiple tasks to individual
controls. The operator can therefore control a large amount of processing
without moving away from the "sweet spot" (the optimal listening position).
Centralized Graphical User Interface. The System incorporates a built-in,
flat screen interactive color graphics monitor allowing the operator to vis-
ualize, set up and meter the effects that control settings have on the audio
as it is being processed. A graphical representation of the assignable rotary
controls for channel control, EQ, Dynamics and Aux Sends are centrally lo-
cated for easy viewing capability.
Machine Control Interface. The TT007 optional hardware module allows the
systems to become the central hub for all machine control within a studio.
(Also available as a stand alone machine control interface.) Virtually any
machine, in any location, may be controlled with the touch of a button direc-
tly from mix position. Additionally, entire multi-machine configurations may
be set into motion from almost any machine location within the system.
Fast Reconfiguration and Recall. Utilizing the Company's "SnapShotTM Re-
call," a user can reconfigure the Euphonix mixing console in less than one
video frame (1/30th of a second) at the push of a button. This feature enab-
les the user to save and recall console setups at any time and to move quick-
ly between sessions or multiple projects, thereby saving significant labor
time and enhancing creative potential.
Hyper-SurroundTM. Utilizing the Company's surround sound mixing feature
within MixView 3.2 a user can create audio mixes in every format of surround
sound in use today. This feature provides direct multi-format surround pan
controls for every channel of the console. The new version of MixView 3.2
7
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provides improved automated surround sound panning and EQ linking. Surround
mixes can be user configured with as few as 4 channels up to as many as 32.
With Hyper-SurroundTM, programs may be simultaneously mixed in stereo and
surround, saving time and costs associated with repetitive audio mixing ses-
sions. Designed to easily add to an existing system, broadcasters can add
surround capability when required.
Modularity. The modular architecture of the Company's products enables
the customer to upgrade its existing System and to implement product enhance-
ments. Furthermore, the Company believes that the modularity of its products
enables the Company to be more efficient in manufacturing and servicing its
products, as well as in designing and developing incremental improvements to
its products.
Compact Design. The console's compact design allows for easier access by
users to the controls, eliminating the potential need for multiple operators.
In addition, the compact design is attractive for studios with space and
other environmental constraints, as well as for mobile applications, such as
live concerts and sports events.
CS3000 Options
The modular form of the Euphonix CS3000 System provides customers with a
range of functionality and flexibility that allows them to configure their Sys-
tem to meet their professional needs and financial resources and to upgrade
their Systems as their needs change. Euphonix offers two primary options to in-
crease the amount of audio processing provided by the overall System -- the
Audio Cube and the Dynamics processors. The Company plans to continue develop-
ing a range of options to allow the Systems to meet the changing needs in its
market applications.*
Audio Cube. The Audio Cube is a hardware option that provides additional
output capability to the base System. The flexible nature of the System
software allows the customer to determine the feature set provided by the
Audio Cube. Music applications typically require the Audio Cube to expand
the base system's Aux Send capability (allowing more special effects). Post
production applications require the Audio Cube to be configured as a panning
and stemming device (allowing users to separate music, effects and dialog
mixes with 4 or 6 channel surround sound outputs). Broadcast customers can
use the Audio Cube to provide remote "mix minus" feeds to reporters and com-
mentators through telecom or satellite links. The Audio Cube is both modular
and scaleable so that it may be specified or upgraded according to the number
of channels required (4-48) and the number of outputs desired for each chan-
nel (4-48).
Dynamic Processors. This option adds Dynamics to the base System in sec-
tions of 8 channels at a time, up to 120 additional channels. Traditional
high-end consoles have been marketed with Dynamics built into every channel
as a standard feature. This practice has served to increase the price of a
standard console and forces the customer to pay for a feature that is typi-
cally not used on every channel at the same time. By providing Dynamics as a
modular option, Euphonix has helped to provide customers with a basic high-
end System at a lower price.
<F1>
* This paragraph contains forward-looking statements reflecting current
expectations. There can be no assurance that the Company's actual perfor-
mance will meet the Company's current expectations. Investors are strongly
encouraged to review the section entitled "Factors Affecting Future Operat-
ing Results" commencing on page 30 for a discussion of factors that could
affect future performance.
8
<PAGE>
CS3000 Packages
The Company also offers System packages configured for particular market
segments, including the following:
CS3000M Systems. The Company created the "M" (Music) System package to
provide commercial music customers the ability to offer a consistent feature
set to their clients when moving projects between different Euphonix equipped
studios. The Audio Cube and Dynamics options are included in this configura-
tion.
CS3000P Systems. The Company created the "P" (Post Production) System
package to provide the TV audio post production customer a totally automated
mixing System which is easily locked to video sources.
CS3000F Systems. The Company has designed the "F" (Film) System package to
provide multiple operator functionality as required for film dubbing applica-
tions. The "F" System is designed as one, two or three "P" Systems which can
be physically joined together to allow for usage by one, two or three opera-
tors.
CS3100B Systems. The Company added the "3100B" (Broadcast) System package
to provide broadcast customers the ability to increase the quality of on-air
and taped programming audio. With Euphonix digital control technology, broad-
cast facilities can meet the demands of multiple studios from a single audio
control room. In remote broadcasting, the compact lightweight digital control
surface provides increased control in less space. Broadcast specific options
such as the MX464 add GPI (programmable relay closures), listenback, multiple
studio monitoring, and an input routing matrix to the base system. Redundant
power supplies are available to meet the demands of live on-air broadcasting.
R-1 Multitrack Recorder
The Company debuted the R-1 Multi-track Recorder (the "R-1") at the AES show
in San Francisco during September 1998. The R-1 shipments began in the first
quarter of 1999. It is the professional audio industry's first product to offer
a user-friendly transition from analog or 16-bit digital tape recording to 24-
bit disk recording. The R-1 provides the users of over 50,000 professional
multi-track tape recorders with a replacement product that significantly im-
proves sound quality, reliability, and operational efficiency while maintaining
a user-interface that has remained an industry standard since the early 1970's.
Key features include:
Improved Sound Quality results from 24-bit domain conversion, transmission,
and storage combined with 40-bit floating point Digital Signal Processing.
Almost 100% of the installed tape recorders are either analog or 16-bit
digital, providing significantly less audio resolution than the R-1.
Operational Feel and Efficiency surpasses tape recorders where possible yet
emulates tape recorders where tradition dictates, to provide recording en-
gineers with a zero learning curve transition to disk recording.
Solid Reliability is an essential attribute for equipment that is required
to capture performances that may only happen once in a lifetime. The R-1
has been designed for equal or better fault tolerance and endurance when
compared with tape recorders.
9
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Non-Degrading Storage has long been a desire for the audio industry. Ex-
tremely low wear and long shelf life are well known attributes of hard-disk
technology. Tape technology suffers from constant media and component wear
that occurs every time audio is recorded and played back. Tape has a signi-
ficantly shorter shelf life than disk storage products.
Random Access to audio anywhere in a recording reduces waiting time for re-
cording artists and engineers. The R-1 provides instant locating and loop-
ing capabilities. Tape is rewound and fast-forwarded hundreds of times in a
typical recording session while recording engineers and artists wait.
Cut and Paste Editing is provided on the R-1 to permit sound manipulation
not possible on tape recorders. Basic editing functions are provided so re-
cording engineers do not have to spend time and money transferring to edit-
ing equipment in order to implement a basic adjustment or correction to a
recorded track.
Non-Destructive Recording is possible on the R-1. When enabled, this fea-
ture allows more than one take of a recording to be kept for every track.
In comparison, tape technology requires the destruction of a previous re-
cording every time an existing track is used to record a new take. The R-1
reduces the risk of accidentally erasing or recording over a once in a
lifetime performance.
Modular, Scalable, and Open Architecture provides the ability to expand or
re-purpose systems over time in much the same way computer owners can in-
crease the size, performance, or feature sets of their PC's as new techno-
logy and product offerings permit.
Proposed Products
In 1998, the Company stated that its new products with planned initial ship-
ments in 1999, would integrate the recording and mixing functions of sound pro-
duction as well as digital audio processing and networking systems. The Company
anticipates that these new products will help strengthen its position in the
mixing and recorder markets and its entrance into the editing market. The Com-
pany expects that its software for these products will utilize technology not
widely used by the audio industry, but successfully employed by the computer in-
dustry, to allow a high degree of connectivity and integration among multiple
users. The Company's planned products are also being designed to enable up-
grading from the Company's present product line to allow hybrid digital and ana-
log processing, a feature that Euphonix believes will mirror customer's require-
ments for sound quality as well as provide minimal conversion from one format to
another. It is intended that these new digital products will also have file
compatibility between editing and mixing functions, as well as high speed digi-
tal routing for simple networking of multiple systems. *
Technology
The Company's proprietary technology is central to its product offering and
its business strategy. The key elements of its technology are described below.
<F1>
* This paragraph contains forward-looking statements reflecting current
expectations. There can be no assurance that the Company's actual future
performance will meet the Company's current expectations. Investors are
strongly encouraged to review the section entitled "Factors Affecting
Future Operating Results" commencing on page 30 for a discussion of
factors that could affect future performance.
10
<PAGE>
Hard Disk Recording and Editing
The Company utilizes technology to record and edit sound using off-the-shelf
computer hard disks. Much of this technology was gained through the acquisition
of Spectral Inc. in 1996. However, Spectral's unamortized capitalized technology
was charged to expense in the fourth quarter of 1996, due to new products being
planned and developed which will address the high end digital audio workstation
(DAW) and recorder markets being developed that do not include Spectral's exist-
ing technology.
Audio Format Conversion
The Company has developed proprietary technology to convert audio between
the various signal transmission formats that are used in Broadcast, Post Produc-
tion, and Music Studios. Euphonix has focused development on the primary formats
that are endorsed by the Audio Engineering Society including: Analog, AES/EBU
digital, and MADI (Multi-channel Audio Digital Interface). Sample Rate Conver-
sion technology is employed to convert digital audio between formats that are
operating at different sampling frequencies such as 44.1kHz for CD-Audio, 48kHz
for professional audio production and 96kHz for emerging standards such as DVD-
Audio.
Digital Control of Analog Audio Processing
The Company utilizes an architecture that physically separates the mixing
control surface from the audio processing hardware. The Company has replaced
manual (mechanically coupled) control methods with digital control technology so
that the audio processing hardware may be controlled remotely over a digital
link by the separated control surface. Because of this separation, it is possi-
ble to insert a computer in the link between the controller and the processing
circuit so that audio may be manipulated either by the operator or the computer.
A high degree of computer automation can then be provided with the appropriate
software. The elimination of bulky and expensive mechanical controls, the abil-
ity to share digital controls for different functions and the relocation of the
audio processing hardware to a separate enclosure has allowed a substantial re-
duction in size, weight, heat generation and cost of the console surface.
Traditionally, the predominant mode of audio processing and transmission has
been analog due to its simplicity, cost-effectiveness, high sound quality and
the extensive analog infrastructure which currently exists in the professional
audio market. Euphonix is a market leader in providing digital control in con-
junction with analog processing and transmission. Euphonix believes that its hy-
brid digital control/analog processing technology has allowed the acceptance of
digital control because it is compatible with potential customers' existing
studio design and peripheral equipment. The Euphonix architecture is capable of
providing digital control of audio processing regardless of whether the trans-
mission method is analog or digital. As a result, as the audio production in-
dustry increasingly adopts digital audio processing in the future, the Company
believes that its system will be upgradeable to incorporate such technology with
further product development.*
<F1>
* This paragraph contains forward-looking statements reflecting current
expectations. There can be no assurance that the Company's actual future
performance will meet the Company's current expectations. Investors are
strongly encouraged to review the section entitled "Factors Affecting
Future Operating Results" commencing on page 30 for a discussion of fac-
tors that could affect future performance.
11
<PAGE>
Scaleable, Distributed Computer Processing
The computer power required to instantly reconfigure and automate a mixing
console is proportional to the console's size (number of controls per channel
times the number of channels). Two approaches may be taken in order to provide
adequate computer power to reset and automate a large-scale mixing console. The
first is to use a large, fast and powerful central computer that has sufficient
capacity to manipulate all of the console's controls in the required period of
time for the largest possible console. The second is to distribute the process-
ing load over multiple processors that have sufficient capacity to handle their
share of the processing load. Euphonix has chosen the distributed processing
method because it has the added benefit to being scaleable. The Euphonix system
may be configured in and upgraded to a range of sizes. Euphonix customers bene-
fit because they only pay for computer power that is proportional to the size of
their systems, yet more computer power can be added as their systems are up-
graded. Because of the lighter demand placed on each individual microprocessor
in a distributed system, the use of low-cost components is possible to further
leverage price performance. Another benefit of the Company's distributed pro-
cessing architecture is its systemwide SnapShotTMRecall performance within one
video frame (1/30 of a second) which the Company believes is superior to compe-
titive commercial offerings.
Multi-Processor Communications and Real-time Operating Systems
Euphonix has developed real-time operating system technologies for inter-
facing the multiple microprocessors required to support its large distributed
processing system. A typical large Euphonix console will contain as many as 125
independent microprocessors of different varieties and functions all working to-
gether as one system. In addition, the Euphonix system provides interfaces to
microprocessors in third-party peripheral studio equipment. This seamless net-
working of internal processors (Euphonix components) and external equipment
(third-party digital audio workstations, tape machines and MIDI devices) pro-
vides a powerful foundation to encourage new product development by both Euph-
onix and third-party manufacturers.
Digital Signal Processing
The Company's products employ state-of-the-art digital signal processing
techniques in their digital control subsystems. The Company intends to continue
to develop digital signal processing technology in order to improve fidelity,
simplify interfaces and reduce costs involved with digital audio transmission
and processing.
Advanced User Interface Methods for Audio Processing
Euphonix's digitally controlled system gives the user real-time feedback of
the system's performance, thereby enabling the user to evaluate and improve the
audio mix more effectively and efficiently. Euphonix has developed several user
interface methods for the professional audio market that are designed to simp-
lify and improve the user's understanding of how the mixing console is affecting
the sound. The Company's interface techniques are designed to allow the oper-
ator to harness the power of digital control in a user-friendly manner. For ex-
ample, graphical user interfaces are used extensively to show views of settings
and parameters, enabling a "what you see is what you hear" display. Such graph-
ical comparisons and various archival, marking and retrieval methods allow for
greater operator efficiency.
12
<PAGE>
Customers
The Euphonix product line has been adopted by many professional audio facil-
ities worldwide, with more than 408 Euphonix consoles currently installed. The
following table sets forth a partial list of Euphonix customers:
<TABLE>
<S>
<C> <C> <C>
- ------------------------------------------------------------------------------
CUSTOMER | LOCATION | SAMPLE PROJECT/OTHER
- ------------------------------------------------------------------------------
Music
- -------------------------------------------------------------------------------
A&M Recording | Los Angeles |Leading record label in USA
- -------------------------------------------------------------------------------
Black City | South Africa |High profile commercial music studio
- ------------------------------------------------------------------------------
Hitokuti-zaka | Japan |Elite commercial music studio
- -------------------------------------------------------------------------------
Chung King | New York |One of the premier New York
| |commercial music facilities,
- -------------------------------------------------------------------------------
Frank Camelli | London |Independent song writer, musician
| |purchased for his home studio.
- -------------------------------------------------------------------------------
Kenny G | Los Angeles |Internationally known musician
| |purchased a CS3000 for his home
| |studio.
- -------------------------------------------------------------------------------
Steve Miller | Idaho |Internationally known musician
| |purchased a CS3000 for his home
| |studio.
- -------------------------------------------------------------------------------
Bulldog Studios | Nashville |High profile commercial music
| |facility.
- -------------------------------------------------------------------------------
Teddy Riley | Virginia |Internatioanally known R&B song
Future Records | |writer, composer has purchased 3
| |large CS3000's to record and mix.
- -------------------------------------------------------------------------------
King Records | Japan |High profile commercial music
| |facility.
- -------------------------------------------------------------------------------
Babyface | Los Angeles |Two time Grammy Award Winner for
Brandons Way | |"Producer of the Year", in 1998 and
| |1997. Various projects. Purchased
| |his 5th console.
- -------------------------------------------------------------------------------
Jed Leiber | Los Angeles |Commercial music facility
- -------------------------------------------------------------------------------
Ocean VU | Florida |High profile commercial music
| |facility catering the booming Latin
| |America music scene.
- -------------------------------------------------------------------------------
Basil Poledouris | Los Angeles |Film score for Starship Troopers,
| |Switchback, Breakdown, Robocop,
| |and The Hunt For Red October
- -------------------------------------------------------------------------------
Bruce Springsteen | Los Angeles |1997 Grammy Award The Ghost of
| |Tom Joad
- -------------------------------------------------------------------------------
Carter Burwell | New York |Film scores for Rob Roy, The Big
| |Lebowski, The Jackal, The Locusts,
| |Conspiracy Theory, Picture Perfect
| |and Girl's Night Out
- -------------------------------------------------------------------------------
13
<PAGE>
- -------------------------------------------------------------------------------
CUSTOMER | LOCATION | SAMPLE PROJECT/OTHER
- -------------------------------------------------------------------------------
Music
- -------------------------------------------------------------------------------
Curb Records | Nashville |Second largest Country Music record
| |label in the USA, 1998 Grammy Best
| |Country Song Butterfly Kisses 1997
| |Grammy Best New Artist LeAnne
| |Rimes, Best Country Album The
| |Road To Ensenada, Best Female
| |Country Vocal Performance Blue
| |(LeAnn Rimes)
- -------------------------------------------------------------------------------
David Newman | Los Angeles |1998 Academy Award Nominee for
| |Anastasia
- -------------------------------------------------------------------------------
Dennis De Young | Illinois |Solo Albums Desert Moon, Back to
| |the World and Boomchild
- -------------------------------------------------------------------------------
Hans Zimmer/ | Los Angeles |1998 Academy Award Nonimee for
Media Ventures | |As Good As It Gets, Film scores for
| |The Rock, Crimson Tide, The Peace-
| |maker, and Prince of Egypt 1997
| |Academy Award Winner The Lion King
- -------------------------------------------------------------------------------
Herbie Hancock | Los Angeles |1998 Grammy for instrumental
| |composition Aung San Suu Kyi
- -------------------------------------------------------------------------------
James Newton Howard | Los Angeles |1998 Academy Award Nominee for My
| |Best Friend's Wedding, Film scores
| |for Devil's Advocate, The Postman,
| |Dante's Peak, Liar Liar, and
| |Father's Day
- -------------------------------------------------------------------------------
Snuffy Walden | Los Angeles |1997 BMI Film & TV Music Award for
Productions | |The Drew Carey Show, and Ellen
- -------------------------------------------------------------------------------
Maruni | Japan |Various Japanese album projects
- -------------------------------------------------------------------------------
Sony Music | New York |Mariah Carey's TV special Fantasy
- -------------------------------------------------------------------------------
Post Production
- -------------------------------------------------------------------------------
Thomas Newman | Los Angeles |Dual 1996 Academy Award Nominee
| |for The Shawshank Redemption and
| |Little Women
| |Film scores for Oscar and Lucinda
| |and The Horse Whisperer
- -------------------------------------------------------------------------------
Buzz | Nashville |TV commercials for Pizza Hut &
| |Budweiser
- -------------------------------------------------------------------------------
Cinar | Montreal |Film mixing for children's cartoons
- -------------------------------------------------------------------------------
CRC | Chicago |Chicago Recording Company
| |purchased 2nd post production
| |console.
- -------------------------------------------------------------------------------
Sound Services | Los Angeles |High profile Post Production
Incorporated | |facility
- -------------------------------------------------------------------------------
AVEX | Japan |High profile Post Production
| |facility
- -------------------------------------------------------------------------------
Crawford Post | Atlanta |TV and Film post projects
- -------------------------------------------------------------------------------
KSS | Japan |Various Japanese TV projects
- -------------------------------------------------------------------------------
Soundtrack | New York/Boston |Various TV commercials
- -------------------------------------------------------------------------------
14
<PAGE>
- -------------------------------------------------------------------------------
CUSTOMER | LOCATION | SAMPLE PROJECT/OTHER
- -------------------------------------------------------------------------------
Post Production (Cont)
- -------------------------------------------------------------------------------
SPG Studios | Los Angeles |Audio Post for NEC, Space Systems
| |Loral, Conan and various projects
- -------------------------------------------------------------------------------
National Sound | New York |TV series Spin City
- -------------------------------------------------------------------------------
Omnibus | Japan |Various TV/Film post projects
- -------------------------------------------------------------------------------
Warner Hollywood | Los Angeles |Audio Post (Foley) on various Films
- -------------------------------------------------------------------------------
Mark Isham | Los Angeles |Movie - TV series Michael Hayes,
| |Nothing Sacred, The Defenders and
| |Kiss The Girls
- -------------------------------------------------------------------------------
Ramses 2 | France |Film mixing on various projects
- -------------------------------------------------------------------------------
Waves Sound Recorders | Los Angeles |Various TV commercials
- -------------------------------------------------------------------------------
Westwind Media | Los Angeles |Own 4 CS3000's for work on movies
| |of the Week and TV series Brooklyn
| |South Movie Buffalo Soldiers and
| |Casper, The Friendly Ghost.
- -------------------------------------------------------------------------------
Saban Entertainment | Burbank |TV series X-Men & Power Rangers
- -------------------------------------------------------------------------------
Broadcast
- -------------------------------------------------------------------------------
CBS Sports | USA |Various live sporting events includ-
| |ing exclusive coverage of the 1998
| |Olympic games at the Nagano Sports
| |Park and Habuka ski jumps, with a
| |second unit at the men's and women's
| |downhill ski course. (2 consoles)
- -------------------------------------------------------------------------------
China Television | People's Republic|Various TV productions
| of China |
- -------------------------------------------------------------------------------
KSDN | Los Angeles |On-Air Broadcaster in San Diego
- -------------------------------------------------------------------------------
WTXF | Philadelphia |On-Air Broadcaster
- -------------------------------------------------------------------------------
CBS | Los Angeles |On-Air Broadcaster
- -------------------------------------------------------------------------------
KNVX | Phoenix |On-Air Broadcaster
- -------------------------------------------------------------------------------
NBC | Los Angeles |TV show Tonight Show with Jay
| |Leno
- -------------------------------------------------------------------------------
NBC | Los Angeles |New console for the Evening News
- -------------------------------------------------------------------------------
NHK | Japan |1998 Winter Olympics in Nagano
| |employing 5 consoles
- -------------------------------------------------------------------------------
NRK | Norway |Music recording for radio
- -------------------------------------------------------------------------------
Network 7 | Australia |1998 Nagano Olympic broadcast
| |audio for the Australian market
- -------------------------------------------------------------------------------
Paramount Television | Los Angeles |TV show Entertainment Tonight and
| |Soul Train, 3 consoles.
- -------------------------------------------------------------------------------
Sight & Sound | Pennsylvania |Post production facility
Entertainment | |
- -------------------------------------------------------------------------------
Keith Street Media | Florida |Post production facility
- -------------------------------------------------------------------------------
SudWest Funk | Germany |Music recording for radio
- -------------------------------------------------------------------------------
15
<PAGE>
- -------------------------------------------------------------------------------
CUSTOMER | LOCATION | SAMPLE PROJECT/OTHER
- -------------------------------------------------------------------------------
Broadcast (Cont)
- -------------------------------------------------------------------------------
Swiss-Italian Tele- | Switzerland |Console installed in OB-Van used to
vision, TSI | |mix and broadcast local live events,
| |such as jazz, rock, pop and classi-
| |cal concerts; outside comedy and
| |game shows.
- -------------------------------------------------------------------------------
Live Sound Reinforcement
- -------------------------------------------------------------------------------
Lyon Opera House | France |Live sound reinforcement
- -------------------------------------------------------------------------------
San Francisco Opera | San Francisco |Live sound reinforcement
- -------------------------------------------------------------------------------
The Gothenburg Opera | Sweden |Live sound reinforcement
House | |
- -------------------------------------------------------------------------------
West Point Academy | West Point |Live sound reinforcement & recording
- -------------------------------------------------------------------------------
Multimedia
- -------------------------------------------------------------------------------
Electronic Arts | Canada |Sound for multimedia games
- -------------------------------------------------------------------------------
7th Level | Los Angeles |Sound for multimedia games
- -------------------------------------------------------------------------------
Square | Tokyo |Sound for multimedia games
- -------------------------------------------------------------------------------
Other
- -------------------------------------------------------------------------------
Cal Arts | Los Angeles |Sound recording education
- -------------------------------------------------------------------------------
China Music Conservatory| People's Republic|Music and recording education
| of China |
- -------------------------------------------------------------------------------
Cheiron Studios | Sweden |Music and sound recording
- -------------------------------------------------------------------------------
University of Arkansas | Little Rock |Sound recording education
- -------------------------------------------------------------------------------
University of Las Vegas | Las Vegas |Sound recording education
- -------------------------------------------------------------------------------
Westwood One | Los Angeles |Mobile recording
- -------------------------------------------------------------------------------
</TABLE>
Marketing
The Company's marketing strategy has been to create awareness of its pro-
ducts and to differentiate its products from its competitors' products in terms
of performance and cost-effectiveness. The Company participates in trade shows,
direct-mail advertising and selective advertisements in industry publications.
The Company believes that its high quality products, technical innovation, sup-
port and service result in significant industry awareness of its products, and
numerous word of mouth referrals for its products. The Company differentiates
its products through one-on-one sessions with the key decision makers of its
current and prospective customers during which the Company's trained engineers
and distributors perform product demonstrations.
Historically, the Company has focused its marketing efforts primarily on the
music market application. In this market, most of the Company's sales were to
individual recording artists, composers, producers and independent record com-
panies who purchase the Company's systems for their own professional or personal
use. While the Company believes that there is continued substantial opportunity
for growth of the Company's sales in the music application of the market, the
Company's strategy is to continue to expand into the complementary and adjacent
market applications, including post production, broadcast, live sound reinforce-
ment and multimedia. The past year proved to be a successful year in selling to
the on-air broadcasters with significant broadcasters taking delivery of CS3100B
broadcast consoles. The CS3000's flexible architecture, high performance and
high quality at an affordable price has made it the choice of many high profile
16
<PAGE>
end users in these segments. To address these adjacent market segments, during
1998 the Company produced market specific product literature, broadened its base
of publications in which it advertises, attended trade shows and communicated
through direct mail communications. *
Sales and Distribution
Euphonix sells its consoles through its direct sales organization in the
United States, the United Kingdom and Japan, and manages a network of interna-
tional sales representatives for sales in other countries. The Company conducts
its direct sales activity in the United States from its sales offices in Los An-
geles, New York and Nashville.
The Company's international distributors typically cover an exclusive geo-
graphic region. Distributors generally order and purchase systems from the Com-
pany based on orders they receive for Euphonix systems. Certain of the Company's
distributors provide direct customer support and installation, while the other
distributors receive customer support and installation from the Company's inter-
national sales offices. There were no customers who accounted for 10.0% or more
of the Company's net revenues in fiscal 1998, 1997 or 1996.
A key element of the Company's strategy is to continue to build a worldwide
presence through its international sales presence and its network of sales re-
presentatives in order to address fully its target markets and to serve cus-
tomers that operate on an international basis. The Company believes that reve-
nues from customers outside the United States will no longer continue to account
for a substantial portion of its revenues, due to weak economic conditions in
many International countries. The Company will continue to maintain sales ef-
forts of the Company's console in international markets through its interna-
tional sales presence and its network of international distributors.
Customer Service and Support
Providing excellent customer service and support is a key element of the
Company's strategy to maintain and build its reputation for high quality and en-
hance brand name loyalty. The Company provides service, support and training to
its customers and sales representatives through a wide range of support serv-
ices, including on-site and telephone support and training in the use of the
Company's consoles.
The Company's customer service organization provides the following services:
Systems Installation and Training. The Company's systems installation per-
sonnel assist customers in the configuration, installation and testing of Euph-
onix systems at the customer's site. The systems can usually be installed in
less than one day, which the Company believes to be considerably less time than
required for other manufacturers' large format consoles. The Company provides
demonstration equipment for use by customers as well as prospective purchasers
at each of the Company's sales offices. The Company may also provide on-site
training following installation of its system, as well as advanced operations
documentation regarding the Euphonix system.
Technical Support. The Company's technical support personnel provide tele-
phone assistance to customers and sales representatives. These personnel assist
customers in the use of their systems, and diagnose and solve technical hardware
and application problems with the aid of self-diagnostic programs within the
Euphonix system. The Company provides a one-year warranty on the Euphonix sys-
<F1>
*
This paragraph contains forward-looking statements reflecting current expec-
tations. There can be no assurance that the Company's actual performance
will meet the Company's current expectations. Investors are strongly en-
couraged to review the section entitled "Factors Affecting Future Operating
Results" commencing on page 30 for a discussion of factors that could affect
future performance.
17
<PAGE>
tem covering defects in materials and workmanship. Such policy provides that
the Company may, at its option, repair, replace or refund the full purchase
price of any defective products sold to the customers. Technical support per-
sonnel maintain a supply of similar or spare modules to deliver to customers if
necessary for repair, and in more complicated situations will dispatch an on-
site technician to assist the customer. The Company also offers an on-line 24-
hour computer bulletin board to maintain communications with its customers.
Research and Development
The Company's research and development strategy is to develop high-quality
enhancements to its products, focusing on modularity and upgradeability of such
products, as well as new products for its target market segments. The Company's
research and development and engineering staff consists of highly trained soft-
ware, electronic and mechanical engineers and technicians with technical back-
grounds in computer software design, digital signal processing, analog audio
processing and high speed audio communications.
The Company's research and development expenses for the years ended December
31, 1998, 1997, and 1996 were $4.6 million, $3.7 million, and $2.8 million, res-
pectively.
Proprietary Rights
The Company generally relies on a combination of trade secrets, copyright
law and trademark law, contracts and technical measures to establish and protect
its proprietary rights in its products and technologies. However, the Company
believes that such measures provide only limited protection of its proprietary
information, and there is no assurance that such measures will be adequate to
prevent misappropriation. The Company currently has two United States register-
ed trademarks, three issued United States patents and several applications for
United States patents pending with respect to certain elements of its hardware
and software. The Company has no foreign patents nor has it filed any applica-
tions for any foreign patents.
The Company believes that, due to the rapid proliferation of new technolo-
gies in the audio, video and general software industries, intellectual property
protection of the Company's proprietary technology will be less influential on
the Company's ability to compete in its target markets than the ability of the
Company's research and development personnel to design products that continue to
address evolving customer requirements, the ability of the Company to enter new
markets and the ability of Euphonix to service its customers. *
Manufacturing and Suppliers
The Company focuses its manufacturing efforts on producing high quality pro-
ducts in a cost-effective manner. The Company's manufacturing operations for
mixing consoles, located in Palo Alto, consist primarily of materials and pro-
curement management, testing and final assembly of products, quality assurance
and shipping. The Company subcontracts other functions, including the production
of printed circuit boards, specialized metal finishing and other subassemblies,
which currently are not cost-effective for the Company to perform. The Company's
systems undergo complete testing and quality inspection at the board level and
final assembly stages of production.
The Company and its manufacturing vendors are dependent upon single or limi-
ted source suppliers, such as Analog Devices, Inc. and Maxim Integrated Pro-
ducts, Inc., for numerous components and parts used in the Company's products.
Currently, the Company uses many sole or limited source suppliers, certain of
<F1>
*
This paragraph contains forward-looking statements reflecting current expec-
tations. There can be no assurance that the Company's actual performance
will meet the Company's current expectations. Investors are strongly encour-
aged to review the section entitled "Factors Affecting Future Operating
Results" commencing on page 30 for a discussion of factors that could affect
future performance.
18
<PAGE>
which are critical to the Company's continued uninterrupted production because
they supply key components, such as integrated circuits, included in the Com-
pany's base system. Major delays or terminations in supplies of such components
could significantly adversely affect the Company's timely shipment of its pro-
ducts, which in turn would adversely affect the Company's business and results
of operations. There can be no assurance that these suppliers will continue to
be able and willing to meet the Company's requirements for any sole-sourced com-
ponents. The Company generally purchases these single or limited source compon-
ents pursuant to purchase orders and has no guaranteed supply arrangements with
such suppliers. In addition, the availability of many components to the Com-
pany's subcontractors is dependent in part on the Company's ability to provide
its subcontractors, and in turn the subcontractor's ability to provide their
suppliers, with accurate forecasts of their future requirements. The process of
qualifying suppliers or designing out certain parts could be lengthy, and no
assurance can be given that any additional sources or product redesign would be
available to the Company or implemented on a timely basis. In the past, the
Company has experienced interruptions in the supply of certain key components
from suppliers which delayed product shipments and there can be no assurance
that the Company will not experience significant shortages for these components
in the future. The Company does not maintain an extensive inventory of such com-
ponents and any extended interruption or reduction in the future supply or in-
creases in prices of any key components currently obtained from a single limited
source supplier could have a material adverse effect on the Company's business
and results of operations for any given period. *
Competition
The markets for the Company's mixing products are intensely competitive and
characterized by significant price competition. The markets for mixing consoles
can be classified based on price, as follows: (1) low-end range products with
prices up to $30,000; (2) mid-range products with prices from $30,000 to
$100,000; and (3) high end range products with prices over $100,000. Prices for
mixing consoles generally vary based on the number of channels and the process-
ing power per channel, which directly affects the quality of the sound output
of the particular mixing consoles. The Company's products compete primarily
with other mixing consoles in the high end price range of the Company's targeted
market segments, although they may also compete with lower priced products with
fewer features. Competing companies in the high-end price range include, among
others, Solid State Logic, Ltd. (a wholly-owned subsidiary of Carlton Communica-
tions Ltd.), AMS Neve, GLW a.k.a. Harrison, Amek Technology Group, plc, Sony
Corporation, Calrec Ltd., Soundtracs, D&R, Trident, Cantus, Fairlight, Studer,
and Otari Corporation. In addition, the Company believes that, as technology in
the professional audio industry advances, prices for mixing consoles and other
audio equipment, including the Company's products, will decrease, and as a re-
sult the Company's products may increasingly compete against lower priced pro-
ducts, as well as products in the high-end price range. There are numerous com-
panies, in addition to those listed above, that compete in the low-end and mid-
range of the professional audio market. Many of the Company's competitors are
larger and have greater financial, technical, manufacturing and marketing re-
sources, broader product offerings, more extensive distribution networks and
larger installed bases than the Company. A number of the Company's competitors
currently offer all digital mixing consoles, as well as analog control/analog
processing mixing consoles, at least two competitors (Harrison & Calrec) cur-
rently offer a hybrid digital control/analog processing mixing console, and all
such competitors are likely to have additional products under development. The
Company believes that companies with large installed bases, in particular, may
have a competitive advantage since many potential customers in the Company's
targeted markets are often reluctant to commit significant resources to replace
their current products and to retrain operators to use new products despite
technological advantages of such new alternative products. Certain of the
<F1>
*
This paragraph contains forward-looking statements reflecting current expec-
tations. There can be no assurance that the Company's actual future perfor-
mance will meet the Company's current expectations. Investors are strongly
encouraged to review the section entitled "Factors Affecting Future Operat-
ing Results" commencing on page 30 for a discussion of factors that could
affect future performance.
19
<PAGE>
Company's competitors also offer customers leasing or refinancing packages in
connection with the purchase of their mixing consoles, which financing alterna-
tives the Company does not generally offer. Furthermore, the Company competes
with resellers of used mixing consoles and equipment who are able to sell high-
end price range products at generally lower prices.*
The introduction of the R-1 brings on new competitive issues for the Com-
pany. The R-1 allows the Company to sell to largely the same customer base that
purchases the Company's large format consoles. Many of the traditional console
manufacturers sell traditional tape based multi-track tape machines. The primary
competing companies in the traditional tape based multi-track recorder market
segment include, among others, Studer, Otari and Sony. The R-1 is targeted as a
direct replacement of traditional tape based products. Additionally, the R-1
will face competition from a number of disk based competitors, that while tech-
nically similar, are less focused on the direct replacement of a multi-track re-
corder and more focused on editing of the audio than pure recording. These com-
petitors include Digidesign, Fairlight and Augan. Otari has been shipping the
Radar and the Radar II disk based multi-track recorder replacement and has
helped establish a market for disk based multi-track recorders.
The Company believes that its ability to compete depends on elements both
within and outside its control, including the success and timing of new product
development and introduction by the Company and its competitors, product perfor-
mance and price, distribution, availability of lease or other financing alterna-
tives, resale of used systems and customer support. There can be no assurance
that the Company will be able to compete successfully with respect to these fac-
tors. In addition, there can be no assurance that the Company will successfully
differentiate its products from the products of its competitors or that the mar-
ketplace will consider the Company's products to be superior to competing pro-
ducts. Moreover, the Company's competitors may introduce additional products
that are competitive with those of the Company, and there can be no assurance
that the Company's products would compete effectively with such products. Al-
though the Company believes that its audio mixing console has certain technolog-
ical advantages over its competitors, maintaining such advantages will require
continued investment by the Company in research and development, sales and mar-
keting and customer service and support. There can be no assurance that the Com-
pany will have sufficient resources to be able to maintain such competitive ad-
vantages. *
Backlog
An order is booked into backlog when a deposit or a purchase order is re-
ceived from the customer. The Company's products are typically delivered to cus-
tomers two to three months after receipt of an order. However, because shipment
of the product is dependent upon other customer requirements or changing situa-
tions, the product may not be delivered for more than a year after the receipt
of the order. All orders are subject to cancellation or rescheduling by the cus-
tomer. The Company does not believe that its backlog at any particular point in
time is indicative of future sales levels.
<F1>
*
This paragraph contains forward-looking statements reflecting current expec-
tations. There can be no assurance that the Company's actual future perfor-
mance will meet the Company's current expectations. Investors are strongly
encouraged to review the section entitled "Factors Affecting Future Operat-
ing Results" commencing on page 30 for a discussion of factors that could
affect future performance.
20
<PAGE>
Employees
As of December 31, 1998, the Company had 141 full-time employees and consul-
tants. The Company currently intends to hire additional personnel during the
next 12 months. None of the Company's employees are represented by a labor union
and the Company has never experienced a work stoppage, slowdown or strike. The
Company considers its employee relations to be good.
Acquisition
On February 7, 1996, the Company acquired Spectral, Incorporated, a Washing-
ton-based company that develops and markets PC-based digital audio workstations.
The purchase price of the acquisition was approximately $2.3 million, which con-
sisted of the purchase of Spectral's stock for $1.5 million and debt reduction
of $778,000.
21
<PAGE>
Item 2. Properties.
The Company leases approximately a 40,000 square-feet space at its headquar-
ters located on Portage Avenue in Palo Alto, California, under leases expiring
in September 2004. Activities at this facility include engineering, manufactur-
ing, management information systems, customer service, distribution and general
administration. Euphonix also leases space for its sales and service offices in
Los Angeles, New York, Nashville and London, and its subsidiary in Seattle. In
addition, the Company rents an office for its subsidiary in Japan on a month to
month basis.
Item 3. Legal Proceedings.
The Company is not currently involved in any material legal proceedings.
Item 4. Submission of Matters to a Vote of Security Holders.
Not applicable.
22
<PAGE>
PART II
Item 5. Market for the Registrant's Common Equity and Related Stockholder
Matters.
The Company effected the initial public offering of its Common Stock on
August 22, 1995, at a price to the public of $8.00 per share. The following
table sets forth, for the periods indicated, the high and low closing prices
for the Company's common stock:
<TABLE>
<CAPTION>
<S>
Fiscal 1997 High Low
- ----------- ---- ---
<C> <C>
First quarter...................$ 4.63 $ 2.69
Second quarter.................. 4.00 2.50
Third quarter................... 3.00 1.75
Fourth quarter.................. 2.06 0.97
Fiscal 1998
- -----------
First quarter................... 1.88 1.06
Second quarter.................. 1.94 1.38
Third quarter................... 1.38 0.94
Fourth quarter.................. 1.50 1.00
</TABLE>
As of March 15, 1999, there were approximately 83 holders of record of the
Company's Common Stock. The Company's Common Stock is listed for quotation in
the Nasdaq National Market under the Symbol "EUPH".
The Company has not paid any cash dividends on its Common Stock and current-
ly intends to retain any future earnings for use in its business. Accordingly,
the Company does not anticipate that any cash dividends will be declared or paid
on the Common Stock in the foreseeable future. *
<F1>
*
This paragraph contains forward-looking statements reflecting current expec-
tations. There can be no assurance that the Company's actual performance
will meet the Company's current expectations. Investors are strongly encour-
aged to review the section entitled "Factors Affecting Future Operating
Results" commencing on page 30 for a discussion of factors that could affect
future performance.
23
<PAGE>
Item 6. Selected Financial Data.
The following selected financial data for the five-year period ended Decem-
ber 31, 1998, should be read in conjunction with the Company's Financial State-
ments and notes thereto and "Management's Discussion and Analysis of Financial
Condition and Results of Operation" included in Item 7 of this report.
<TABLE>
<CAPTION>
<S>
Year Ended December 31,
-------------------------------------------------------
<C> 1998 1997 1996 1995 1994
---- ---- ---- ---- ----
(In thousands, except per share data)
Statement of Operations Data:
Net revenues.........$ 15,614 $ 18,093 $ 18,237 $ 14,681 $ 8,133
Gross margin......... 7,014 8,860 9,396 7,482 4,246
Operating income (loss) (5,306) (2,304) (1,836) 1,436 416
Net income (loss)....$ (5,240) $ (1,933) $ (1,398) $ 1,346 $ 472
Net income (loss) per
share:
Basic (1) ..........$ (0.82) $ (0.35) $ (0.25) $ 0.50
Diluted (1).........$ (0.82) $ (0.35) $ (0.25) $ 0.28
Shares used in computing
net income (loss) per
share:
Basic............... 6,404 5,576 5,515 2,702
Diluted............. 6,404 5,576 5,515 4,827
------------------------------------------------------
December 31,
------------------------------------------------------
1998 1997 1996 1995 1994
---- ---- ---- ---- ----
(In thousands)
Balance Sheet Data:
Working capital $5,925 $9,095 $11,035 $12,937 $2,588
Total assets 11,231 13,208 15,466 18,279 4,999
Long-term obligations(2) 2 32 66 ---- ----
Redeemable convertible
preferred stock ---- ---- ---- ---- 2,185
Shareholders' equity 7,375 10,487 12,338 13,602 964
</TABLE>
(1) Prior to 1995, statements of operations data omit net income per share as it
was not presented in the initial public offering registration statement.
(2) Represents long-term portion of capital lease obligations.
Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations.
Overview
The Company develops, manufactures and markets digitally controlled audio
mixing consoles for the use in the production of audio content for the music,
post production (film and television), broadcast, live sound reinforcement (live
concerts and theater) and multimedia segments of the professional audio market.
As of December 31, 1998, the Company has shipped over 408 of its mixing consoles
worldwide.
The price of the Company's mixing consoles generally ranges from $100,000 to
$400,000, and is often the most expensive piece of equipment in the studio. The
Company performs ongoing credit evaluations of its customers' financial condi-
tion and prior to shipping the product, generally requires a $5,000 deposit and
a firm purchase order. From time to time and depending on the financial condi-
24
<PAGE>
tion of the customer, the Company may require payment of a substantial portion
of the purchase price, an irrevocable letter of credit, or a purchase order from
a third-party lessor. The Company usually relies on new orders in the same quar-
ter to achieve its net revenues. The Company generally recognizes revenue upon
shipment, unless customers make installation and acceptance terms a condition of
the sale, or if the third party financing arrangements have not been finalized.
In these instances, revenue is deferred upon shipment and not recognized until
installation and acceptance, or financing arrangements have been completed.
Annual Results of Operations
The following table sets forth certain operating data as a percentage of net
revenues for the periods indicated:
<TABLE>
<CAPTION>
<S>
Year Ended December 31,
-----------------------
<C> 1998 1997 1996
---- ---- ----
Net revenues............................100.0% 100.0% 100.0%
Cost of revenues........................ 55.1 51.0 48.5
----- ----- -----
Gross margin.......................... 44.9 49.0 51.5
Operating expenses:
Research and development............... 29.4 20.4 15.5
Sales and marketing.................... 34.9 30.0 25.0
General and administrative............. 14.6 11.3 10.7
Non-recurring charges.................. --- --- 10.3
----- ----- -----
Total operating expenses............. 78.9 61.7 61.5
----- ----- -----
Operating loss......................... (34.0) (12.7) (10.0)
Interest income, net................... .4 .8 2.6
----- ----- -----
Loss before income taxes............... (33.6) (11.9) (7.4)
Provision (benefit) for income taxes... --- (1.2) 0.3
----- ----- -----
Net loss............................... (33.6)% (10.7)% (7.7)%
----- ----- -----
</TABLE>
Net Revenues
Net revenues decreased to $15.6 million in 1998 down from $18.1 million in
1997 and $18.2 million in 1996, representing a decrease of 13.7% in 1998 from
1997 and a decrease of 0.8% in 1997 from 1996. The decrease in net revenues from
1997 to 1998 and from 1996 to 1997 is primarily due to a weakness in sales in
Europe and in the Pacific Rim. The decline in Asian sales in 1998 was a direct
result of the weakness in the Asian economy. The decline in European sales in
1997 was the direct result of employee turnover within the international sales
department and the loss of sales representatives, which limited the Company's
ability to maintain existing market share and penetrate new markets abroad.
Sales of the Company's products in the United States were $8.9 million,
$10.7 million, and $8.7 million, comprising approximately 56.9%, 59.1%, and
47.3% of the Company's net revenues for 1998, 1997, and 1996, respectively. Ex-
port sales were $6.7 million, $7.4 million, and $9.5 million, comprising approx-
imately 43.1%, 40.9%, and 52.7% of the Company's net revenues for 1998, 1997,
and 1996, respectively. Export sales in absolute dollars were down in 1998 com-
pared to 1997 as a result of the weakness in the Asian economy. Export sales in
absolute dollars as well as a percent of net revenues, were down in 1997 com-
pared to 1996 due to inadequate resources to support the sales and distribution
efforts in Europe.
25
<PAGE>
Gross Margin
The Company's gross margin decreased to $7.0 million in 1998 from $8.9 mil-
lion in 1997, and down from $9.4 million in 1996, representing a decrease of
20.8% from 1997 to 1998 and 5.7% from 1996 to 1997. Gross margin as a percent of
net revenue was 44.9% in 1998 down from 49.0% in 1997 and 51.5% in 1996. The
decrease in the margin from 1997 to 1998 was primarily due to selling off older/
used inventory at lower margins, a $238,000 charge for excess and obsolete in-
ventories, and to manufacturing overhead investments associated with the new R-1
Recorder and other product development activities. The decrease in the margin in
1997 from 1996 was primarily attributable to higher material procurement costs
for the CS3000 mixing consoles, which was introduced in April 1997.
Research and Development
Research and development expenses increased to $4.6 million in 1998 up from
$3.7 million in 1997 and $2.8 million in 1996, representing an increase in re-
search and development expenses of 24.6% in 1998 as compared to 1997, and an in-
crease of 30.0% in 1997 as compared to 1996. Research and development expenses
as a percentage of net revenues increased to 29.4% in 1998, up from 20.4% in
1997, and up from 15.5% in 1996. The increase in research and development ex-
penses in absolute dollars and as a percentage of net revenues from 1997 to 1998
was primarily due to substantial investment in the development of next genera-
tion products. The increase in research and development expenses in absolute
dollars and as a percentage of net revenues from 1996 to 1997 was primarily due
to additional personnel as well as increased development efforts for the next
generation of products. The increase in research and development expenses
in absolute dollars and as a percentage of net revenues from 1996 to 1997 was
primarily due to additional personnel as well as increased development efforts
for next generation products.
Sales and Marketing
Sales and marketing expenses increased to $5.5 million in 1998 up from $5.4
million in 1997 and $4.6 million in 1996, representing an increase in sales and
marketing expenses of 0.1% in 1998 as compared with 1997 and 19.3% in 1997 as
compared with 1996. Sales and marketing expenses also increased as a percentage
of net revenues to 34.9% in 1998 from 30.0% in 1997 and from 25.0% in 1996. In
late 1998, the Company increased it's expenditures for advertising, trade shows
and product demonstrations to support the introduction of the R-1 Multitrack
Recorder in 1999. This increase during 1998 was partially offset by allocating a
management fee for support services of the Company's subsidiary in Japan to gen-
eral and administrative expenses. The increase during 1998 was partially offset
by allocating a management fee for support services of the Company's subsidiary
in Japan to general and administrative expenses. The increase in sales and mar-
keting expenses in absolute dollars and as a percentage of net revenues in 1997,
was primarily attributable to additional personnel to strengthen its interna-
tional sales operations, and increased investments in new and existing market
segments. The Company increased it's expenditures for advertising, trade shows
and product demonstrations to support the introduction of the CS3000 in 1997.
General and Administrative
General and administrative expenses were $2.3 million in 1998 up from $2.0
million in 1997 and 1996, representing an increase in general and administrative
expenses of 12.0% in 1998 from 1997, and representing no additional increase in
1997 from 1996. General and administrative expenses as a percent of net revenues
increased to 14.6% in 1998 from 11.3% in 1997 and from 10.7% in 1996, respec-
tively. The increase in general and administrative expenses in absolute dollars
and as a percentage of net revenues in 1998 and the increase in general and ad-
ministrative expenses as a percentage of net revenues in 1997 is due to in-
creases in the allowance for doubtful accounts reserve to cover inherent risk of
carrying higher receivable balances and selling to new customers. The increase
in 1998 is also due to the allocation of a management fee for support services
of the Company's subsidiary in Japan from sales and marketing expenses and in-
creased costs of being a public company.
26
<PAGE>
In-process Technology & Write off of Intangibles and Goodwill
In connection with the acquisition of Spectral, Euphonix recorded a charge
in 1996 for in-process technology that had not yet reached technological feasi-
bility and did not have alternative future uses. This one-time charge amounted
to $1.4 million during the first quarter of 1996. In the fourth quarter of 1996
the unamortized capitalized technology and goodwill was charged to expense due
to new products being planned and developed which would address the high end
digital audio workstation (DAW) and recorder markets that did not include Spec-
tral's existing technology. In addition Spectral's existing technology had no
alternative future uses.
Provision / (benefit) for Income Taxes
For fiscal 1998, the Company did not recognize the tax benefit of its opera-
ting losses. Management believes the resulting deferred tax assets are not rea-
lizable on a more likely than not basis. The Company's effective tax rate was a
benefit of 10.3% in 1997 and a provision of 9.3% in 1996, excluding the effects
of a one time in-process technology and goodwill write-off in 1996 for which no
tax benefit was available.
Liquidity and Capital Resources
The Company has funded its operations primarily through cash flows from
operations, the private sale of equity securities, and the initial public offer-
ing of Common Stock completed in September 1995. In March 1998, the Company re-
ceived proceeds of $1,950,000 from existing investors in exchange for the is-
suance of 1,040,000 shares of $0.001 par value common stock at $1.875 per share,
the closing price of the Company's common stock on the NASDAQ on the date the
common stock purchase agreement was executed. In January 1999, the Company
received proceeds of $1,303,676 from existing investors in exchange for the is-
suance of 1,320,446 shares of $0.001 par value common stock at $0.987 per share.
For the year ended December 31, 1998, cash, cash equivalents and short-term in-
vestments decreased by $1.4 million to approximately $2.2 million. Also during
this period, working capital decreased by $3.2 million to approximately $5.9
million.
The Company's operating activities used cash of approximately $2.6 million
in 1998 and $2.8 million in 1997 and 1996, respectively. Cash used in operating
activities for 1998 was comprised primarily of a net loss, a decrease in cus-
tomer deposits, an increase in inventory, and an increase in prepaid expenses,
other current assets and other assets, offset partially by higher depreciation
and amortization expense and a decrease in income tax receivable and a decrease
in accounts receivable. Cash used in operating activities for 1997 was comprised
primarily of a net loss, a decrease in customer deposits, an increase in inven-
tory, an increase in accounts receivable, and an increase in income taxes re-
ceivable, offset partially by higher depreciation and amortization expense and a
decrease in prepaid expenses, other current assets and other assets.
On February 7, 1996 the Company used cash to acquire Spectral, Incorporated,
a Washington based company, that develops and markets PC-based digital audio
workstations. The cost of the acquisition was approximately $2.3 million which
included the purchase of Spectral's stock for $1.5 million and debt reduction
of $778,000.
For the year ended December 31, 1998, the Company incurred a net loss of ap-
proximately $5.2 million and had used approximately $2.6 million of cash for
operating activities. The Company expects to continue to incur operating losses
through at least December 1999 or until the Company is able to attain revenues
from sales of its new products sufficient to support its operations. At December
31, 1998, the Company had $2.2 million of cash and short-term investments on
hand and received an additional $1.3 million of equity financing from existing
27
<PAGE>
investors in January 1999. Management believes that cash and investments of
$2.2 million combined with the equity financing received in January 1999 will
be sufficient to support its operations through at least August 1999. The Com-
pany is currently in the process of obtaining an additional $2.0 million of debt
or equity financing from existing investors and others sufficient to support its
operations through at least December 31, 1999. In addition, the Company may re-
duce certain operating expenditures during the second half of 1999. Management
believes that cash and investments of $2.2 million combined with: 1) the $1.3
million of equity financing received in January 1999, 2) the $2.0 million of
additional debt or equity financing currently under negotiation, and 3) the pos-
sible reduction in operating expenses during the second half of 1999 will be
sufficient to support its operations through at least December 1999. There can
be no assurance that the additional debt or equity financing to be received will
be available on acceptable terms, if at all. In addition, the Company may need
to delay or significantly reduce other operating expenditures, which would have
a material adverse effect on its business, results of operations and business
prospects.
Year 2000 Risks
The Year 2000 issue is the result of computer programs being written using
two digits rather than four to define the applicable year. Any of the Company's
computer programs or hardware that have date-sensitive software or embedded
chips may recognize a date using "00" as the year 1900 rather than the year
2000.
Based on recent assessments, the Company determined that it would not be
required to upgrade, modify, and/or replace portions of its software and certain
hardware so that those systems will properly utilize dates beyond December 31,
1999. The Company presently believes that the Year 2000 issue is resolved with-
out modifications or replacements of existing software and certain hardware.
The Company's plan in resolving the Year 2000 issue involved the following
four phases: inventory, assessment, remediation, and testing/implementation.
Both information technology ("IT") and non-information technology technology
("Non-IT") systems were addressed. The Company has completed its assessment of
IT and Non-IT systems that could have been significantly affected by the Year
2000. The completed assessment indicated that all of the Company's significant
IT systems would not be affected, particularly the order entry, general ledger,
billing, and inventory systems. None of the Company's Non-IT systems would be
affected.
Based on a review of its product lines, the Company has determined that most
of the products it has sold and will continue to sell do not require remediation
to be Year 2000 compliant. Based on the results of product review and testing
completed, the Company believes its programming software for its audio consoles
and R-1 Multi-track Recorders to be compliant as defined by the British Stan-
dards Institute DISC PC-2000-1 definition. Accordingly, the Company does not be-
lieve that the Year 2000 presents a material exposure as it relates to the
Company's products.
The Company has queried all of its significant suppliers and subcontractors
systems with the Company ("suppliers"). To date, the Company is not aware of any
supplier with a Year 2000 issue that would materially impact the Company's re-
sults of operations, liquidity, or capital resources. However, the Company has
no means of ensuring that its suppliers will be Year 2000 ready. The inability
of suppliers to complete their Year 2000 resolution process in a timely fashion
could materially and adversely impact the Company. The effect of noncompliance
by suppliers is not determinable.
To date, the Company has incurred costs of less than $5,000 on the Year 2000
project, and estimates that there will be no material future costs.
As noted above, the Company has completed all necessary phases of the Year
2000 program. The Company believes that it is more likely to experience Year
2000 problems with the systems of key suppliers rather than with the Company's
internal systems or products. The Company's Year 2000 program includes efforts
to assess the Year 2000 compliance of its key suppliers.
28
<PAGE>
The Company currently has no contingency plans in place in the event it does
not complete all phases of the Year 2000 program. The Company intends to develop
a contingency plan to deal with Year 2000 issues that may materially adversely
affect its business processes. The Company intends to have a contingency plan in
place no later than September 30, 1999.
Impact of Recently Issued Accounting Pronouncements
In June 1998, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 133, "Accounting for Derivative Instruments
and Hedging Activities" ("SFAS 133"), which is required to be adopted in years
beginning after June 15, 1999. The adoption of SFAS 133 is not expected to
materially impact the Company's results of operations, financial position or
cash flows.
The American Institute of Certified Public Accountants issued Statement of
Position 98-1, "Accounting For the Costs of Computer Software Developed or Ob-
tained for Internal Use" ("SOP 98-1"), on March 4, 1998. SOP 98-1 provides
guidelines for accounting for costs of computer software developed for internal
use. SOP 98-1 is effective for financial statements for fiscal years beginning
after December 15, 1998. The adoption of SOP 98-1 is not expected to materially
impact the Company's results of operations, financial position or cash flow.
Factors Affecting Future Operating Results
The Company has derived virtually all of its revenues from sales of its dig-
itally controlled audio mixing console system, which system is based upon its
hardware platform. The Company believes that sales of this system, along with
enhancements thereof, and the R-1 recorder will continue to constitute virtually
all of the Company's revenues for the foreseeable future. Accordingly, any fac-
tor adversely affecting the Company's base system, whether technical, competi-
tive or otherwise, could have a material adverse effect on the Company's busi-
ness and results of operations.
The Company has expended and will continue to expend substantial funds to
launch its new System 5 and R-1 Recorder products in the first half of fiscal
1999. The Company's ability to fund operations through December 31, 1999 is
dependent upon achievement of its operating plan and attainment of additional
equity financing. The Company believes that additional debt or equity financing
will be available from existing investors and others. However, there can be no
assurance as to the terms and conditions of any such financing and no certainty
that funds would be available when needed. The inability to obtain additional
financing, when needed, would be likely to curtail the Company's sales and mar-
keting and product development efforts and would be likely to have a material
adverse effect on the Company. To the extent that any future financing involves
the sale of the Company's equity securities, the Company's then existing share-
holders could be substantially diluted.
A limited number of the Company's system sales typically account for a sub-
stantial percentage of the Company's quarterly revenue because of the relatively
high average sales price of such systems. Moreover, the Company's expense levels
are based in part on its expectations of future revenue. Therefore, if revenue
is below expectations, the Company's operating results are likely to be adverse-
ly affected. In addition, the timing of revenue is influenced by a number of
other factors, including the timing of individual orders and shipments, industry
trade shows, seasonal customer buying patterns, changes in product development
and sales and marketing expenditures, custom financing arrangements, production
limitations and international sales activity. Because the Company's operating
expenses are based on anticipated revenue levels and a high percentage of the
Company's expenses are relatively fixed in the short term, variations in the
timing of recognition of revenue could cause significant fluctuations in operat-
ing results from quarter to quarter and may result in unanticipated quarterly
earnings shortfalls or losses.
29
<PAGE>
The markets for the Company's system are characterized by changing technolo-
gies and new product introductions. The Company's future success will depend in
part upon its continued ability to enhance its base system with features includ-
ing new software and hardware add-ons and to develop or acquire and introduce
new products and features which meet new market demands and changing customer
requirements on a timely basis. The Company is currently designing and develop-
ing new products, primarily in the areas of recording, editing and mixing func-
tions of sound production as well as digital audio processing and networking
systems. In addition, there can be no assurance that products or technologies
developed by others will not render the Company's products or technologies non-
competitive or obsolete. See "Business".
To date, the Company's primary market success has been in the music segment
of the professional audio market. In order for the Company to grow, the Company
believes that it must continue to gain market share in the music market segment,
as well as in its other targeted market segments. There can be no assurance that
the Company will be able to compete favorably in any market segments. The Com-
pany's inability to compete favorably could have a material adverse effect on
its business and results of operations. The markets for the Company's products
are intensely competitive and characterized by significant price competition.
The Company believes that its ability to compete depends on elements both within
and outside its control, including the success and timing of new product de-
velopment (including development on a timely basis of a hybrid digital product,
of which there can be no assurance) and introduction by the Company and its com-
petitors, product performance and price, distribution, availability of lease or
other financing alternatives, resale of used systems and customer support. See
"Business--Competition".
Currently, the Company uses many sole or limited source suppliers, certain
of which are critical to the integrated circuits included in the Company's base
system. Major delays or terminations in supplies of such components could have a
significant adverse effect on the Company's timely shipment of its products,
which in turn would adversely affect the Company's business and results of oper-
ations. The Company also relies on single vendors to manufacture major subassem-
blies for its products. Any extended interruption in the future supply or in-
crease in the cost of subassemblies manufactured by its primary or other third
party vendors could have a material adverse effect on the Company's business and
results of operations. See "Business--Manufacturing and Suppliers".
In addition, as different electrical, radiation or other standards applic-
able to the Company's products are adopted in countries, including the United
States, or groups of countries in which the Company sells its products, the
failure of the Company to modify its products, if necessary, to comply with such
standards would likely have an adverse effect on the Company's business and re-
sults of operations. See "Business--Sales and Distribution".
The Company generally relies on a combination of trade secret, copyright law
and trademark law, contracts and technical measures to establish and protect its
proprietary rights in its products and technologies. However, the Company be-
lieves that such measures provide only limited protection of its proprietary in-
formation, and there is no assurance that such measures will be adequate to pre-
vent misappropriation. In addition, significant and protracted litigation may be
necessary to protect the Company's intellectual property rights, to determine
the scope of the proprietary rights of others or to defend against claims of in-
fringement. There can be no assurance that third-party claims alleging infringe-
ment will not be asserted against the Company in the future. Any such claims
could have a material adverse effect on the Company's business and results of
operations. See "Business--Proprietary Rights".
The Company's success depends, in part, on its ability to retain key manage-
ment and technical employees and its continued ability to attract and retain
highly skilled personnel. In addition, the Company's ability to manage any
growth will require it to continue to improve and expand its management, oper-
ational and financial systems and controls. If the Company's management is un-
able to manage growth effectively, its business and results of operations will
be adversely affected.
30
<PAGE>
The Company acquired Spectral in February 1996. Sale of Spectral products
for 1998, 1997 and 1996 were significantly below plan and below 1995 sales
levels. Spectral's pre-tax operating loss for 1998 decreased from 1997 and 1996
due primarily to transferring the general and administrative, and sales func-
tions to Palo Alto. In 1996, Spectral engineering, marketing and sales activi-
ties were integrated into the respective Euphonix organizations. In 1997, the
Company further integrated Spectral activities by the transfer of their manufac-
turing to Euphonix headquarters in Palo Alto, California. In 1998, the Company
sold Spectral's technology to Telos, Inc.
As a result of these and other factors, the Company has experienced signifi-
cant quarterly fluctuations in operating results and anticipates that these
fluctuations will continue in future periods. There can be no assurance that the
Company will be successful in maintaining or improving its profitability or
avoiding losses in any future period. Further, it is likely that in some future
period the Company's net revenues or operating results will be below the expec-
tations of public market securities analysts and investors. In such event, the
price of the Company's Common Stock would likely be materially adversely affect-
ed. See "Factors Affecting Future Operating Results."
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
As of December 31, 1998, the Company's investment portfolio consists of
money market funds and certificates of deposits. The Company does not invest for
speculative or trading purposes. The Company's primary objective with its in-
vestment portfolio is to invest available cash while preserving principal and
meeting liquidity needs. In accordance with the Company's investment policy,
the Company places investments with high credit quality institutions and limits
the amount of credit exposure to any one issuer. These securities, which approx-
imate $601,000 at December 31, 1998, and have an average interest rate of ap-
proximately 5%, are subject to interest rate risks. Interest income for the year
ended December 31, 1998 was approximately $66,000. A decrease in interest rates
could result in lower interest income earned from its money market and other
cash deposit investments. However, based on the investment portfolio contents,
the Company believes that if a significant change in interest rates were to oc-
cur, it would not have a material effect on the Company's results of operations,
financial condition, or cash flows, although there can be no assurance of this.
Sales through the Company's Japanese subsidiary are denominated in Japanese
Yen. The Company's receivables denominated in Yen are subject to foreign ex-
change risk. The Company does not enter into hedging arrangements to mitigate
the foreign currency risk with respect to such arrangements. An adverse change
in the foreign exchange rate would have an effect on the price the Company ult-
imately sells its consoles for in Japan and could result in foreign currency
transaction losses. An adverse change of 10% in the Yen exchange rate would
result in a decline in income before taxes of approximately $ 172,200.
31
<PAGE>
Item 8. Financial Statements and Supplementary Data
Index to Financial Statements
Page
----
Report of Ernst & Young LLP, Independent Auditors ..................... 33
Consolidated Balance Sheets as of December 31, 1998 and 1997 .......... 34
Consolidated Statements of Operations for the years ended December 31,
1998, 1997, and 1996 ................................................. 35
Consolidated Statements of Shareholders' Equity for the years ended
December 31, 1998, 1997 and 1996...................................... 36
Consolidated Statements of Cash Flows for the years ended December 31,
1998, 1997 and 1996................................................... 37
Notes to Consolidated Financial Statements............................. 38
32
<PAGE>
REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
The Board of Directors and Shareholders
Euphonix, Inc.
We have audited the accompanying consolidated balance sheets of Euphonix, Inc.
as of December 31, 1998 and 1997, and the related consolidated statements of
operations, shareholders' equity, and cash flows for each of the three years in
the period ended December 31, 1998. Our audit also included the financial state-
ment schedule listed in the Index at Item 14(a). These financial statements and
schedule are the responsibility of the Company's management. Our responsibility
is to express an opinion on these financial statements and schedule based on our
audits.
We conducted our audits in accordance with generally accepted auditing stan-
dards. Those standards require that we plan and perform the audit to obtain rea-
sonable 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 man-
agement, as well as evaluating the overall financial statement presentation. We
believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the consolidated financial position of Euph-
onix, Inc. at December 31, 1998 and 1997, and the consolidated results of its
operations and its cash flows for each of the three years in the period ended
December 31, 1998, in conformity with generally accepted accounting principles.
Also, in our opinion, the related financial statement schedule, when considered
in relation to the basic financial statements taken as a whole, presents fairly
in all material respects the information set forth therein.
ERNST & YOUNG LLP
Palo Alto, California
March 4, 1999
33
<PAGE>
EUPHONIX, INC.
CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
<S> December 31,
---------------------------------
ASSETS <C> 1998 1997
---- ----
CURRENT ASSETS:
Cash and cash equivalents.................. $ 1,637,332 $ 1,880,093
Short-term investments..................... 601,146 1,710,223
Accounts receivable (net of allowance for
doubtful accounts: 1998, $403,282; 1997,
$222,793.................................. 1,543,335 1,911,095
Inventories................................ 5,558,637 5,309,818
Income tax receivable...................... ----- 544,000
Prepaid expenses and other current assets.. 237,512 306,308
------------- ------------
Total current assets............. 9,577,962 11,661,537
Property and equipment, net................. 1,360,186 1,425,709
Deposits and other assets................... 292,716 120,829
------------- ------------
Total assets....................... $ 11,230,864 $ 13,208,075
============= ============
LIABILITIES AND SHAREHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable........................... $ 1,636,358 $ 924,721
Accrued payroll and related liabilities,
including deferred salary................. 548,926 387,337
Accrued warranty........................... 439,397 347,850
Accrued commissions........................ 126,094 155,708
Income taxes payable....................... ----- -----
Sales tax payable.......................... 187,687 48,949
Deferred revenues.......................... 185,344 ----
Other accrued liabilities.................. 401,118 412,665
Customer deposits.......................... 97,914 237,866
Short term portion capital leases ......... 29,691 51,565
------------- ------------
Total current liabilities.......... 3,652,529 2,566,661
Long term portion capital leases ........... 2,282 31,973
Deferred rent .............................. 1,055 3,170
Deferred tax liabilities.................... 200,000 119,000
COMMITMENTS
SHAREHOLDERS' EQUITY:
Preferred stock, $0.001 par value: 2,000,000
authorized shares, none issued and outstand-
ing....................................... ---- ----
Common stock, $0.001 par value: 20,000,000
authorized shares, 6,635,408 and 5,589,824
shares issued and outstanding in 1998 and
1997, respectively ....................... 6,636 5,590
Additional paid-in capital ................ 15,672,808 13,722,855
Accumulated Other Comprehensive Income/(Loss) 74,975 (11,515)
Accumulated deficit........................ (8,329,921) (3,090,159)
Deferred compensation ..................... (49,500) (139,500)
------------- -------------
Total shareholders' equity......... 7,374,998 10,487,271
------------- -------------
Total liabilities and shareholders' equity $ 11,230,864 $ 13,208,075
============= =============
</TABLE>
See accompanying notes.
34
<PAGE>
EUPHONIX, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
<TABLE>
<CAPTION>
<S> Years Ended December 31,
-------------------------------------------
<C> 1998 1997 1996
---- ---- ----
Net revenues..................... $ 15,613,827 $ 18,093,403 $ 18,237,149
Cost of revenues................. 8,599,527 9,233,651 8,841,122
------------- ------------- -------------
Gross margin..................... 7,014,300 8,859,752 9,396,027
Costs and expenses:
Research and development....... 4,587,212 3,682,884 2,831,861
Sales and marketing............ 5,450,269 5,442,966 4,563,542
General and administrative..... 2,282,839 2,037,408 1,951,450
Non-recurring charges.......... --- --- 1,884,866
------------- ------------- -------------
12,320,320 11,163,258 11,231,719
------------- ------------- -------------
Operating loss................... (5,306,020) (2,303,506) (1,835,692)
Interest income and other, net... 66,258 148,560 487,723
------------- ------------- -------------
Loss before income taxes ........ (5,239,762) (2,154,946) (1,347,969)
Provision (benefit) for income taxes --- (222,000) 49,943
------------- ------------- -------------
Net loss......................... $ (5,239,762) $ (1,932,946) $ (1,397,912)
============= ============= =============
Net loss per share:
Basic and diluted.............. $ (0.82) $ (0.35) $ (0.25)
============= ============= =============
Number of shares used in computing
per share amounts (in thousands)
Basic and diluted.............. 6,404 5,576 5,515
============= ============= =============
</TABLE>
See accompanying notes.
35
<PAGE>
EUPHONIX, INC.
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
<TABLE>
<CAPTION>
<S> Accumulated
Additional Other
<C> Common Stock Paid-In Comprehensive
Shares Amount Capital Income(Loss)
------ ------ ---------- -------------
Balance at December 31, 1995 5,410,284 $ 5,410 $ 13,675,329 $ ---
Comprehensive loss
Net loss.................. --- --- ---
Other comprehensive loss,
net of tax:
Change in unrealized gain
(loss) on investments.... --- --- ---
Comprehensive loss.........
Exercise of stock options. 155,004 156 43,740 ---
Amortization of deferred
compensation............. --- --- --- ---
---------- ------- ------------ --------------
Balance at December 31, 1996 5,565,288 5,566 13,719,069 ---
Comprehensive loss
Net loss.................. --- --- --- ---
Other comprehensive loss,
net of tax:
Foreign currency transla-
tion adjustment.......... --- --- --- (11,515)
Comprehensive loss.........
Exercise of stock options. 24,536 24 3,786 ---
Amortization of deferred
compensation............. --- --- --- ---
----------- ------ ------------ --------------
Balance at December 31, 1997 5,589,824 5,590 13,722,855 (11,515)
Comprehensive loss
Net loss.................. --- --- --- ---
Other comprehensive gain,
net of tax:
Foreign currency transla-
tion adjustment.......... --- --- --- 86,490
Comprehensive loss.........
Sale of common stock...... 1,040,000 1,040 1,948,958 ---
Exercise of stock options. 5,584 6 995 ---
Amortization of deferred
compensation............. --- --- --- ---
---------- ------ ------------ -------------
6,635,408 $6,636 $ 15,672,808 $ 74,975
========== ====== ============ =============
(Cont.)
Accumulated Deferred
Deficit Compensation Total
------------- ------------ --------------
Balance at December 31, 1995.... $ 240,699 $ (319,500) $ 13,601,938
Comprehensive loss
Net loss...................... (1,397,912) --- (1,397,912)
Other comprehensive loss, net
of tax:
Change in unrealized gain on
(loss) on investments....... --- --- ---
-------------
Comprehensive loss............. (1,397,912)
Exercise of stock options..... --- --- 43,896
Amortization of deferred com-
pensation.................... --- 90,000 90,000
-------------- ------------ -------------
Balance at December 31, 1996.... (1,157,213) (229,500) 12,337,922
Comprehensive loss
Net loss...................... (1,932,946) --- (1,932,946)
Other comprehensive loss, net
of tax:
Foreign currency translation
adjustment................. --- --- (11,515)
------------
Comprehensive loss............. (1,944,461)
Exercise of stock options..... --- --- 3,810
Amortization of deferred com-
pensation.................... --- 90,000 90,000
-------------- ------------ ------------
Balance at December 31, 1997.... (3,090,159) (139,500) 10,487,271
Comprehensive loss
Net loss...................... (5,239,762) --- (5,239,762)
Other comprehensive gain, net
of tax:
Foreign currency translation
adjustment................. --- --- 86,490
------------
Comprehensive loss............. (5,153,272)
Sale of common stock.......... --- --- 1,949,998
Exercise of stock options..... --- --- 1,001
Amortization of deferred com-
pensation.................... --- 90,000 90,000
-------------- ----------- ------------
$ (8,329,921) $ (49,500) $ 7,374,998
============== =========== ============
</TABLE>
See accompanying notes.
36
<PAGE>
EUPHONIX, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
<S>
Years Ended December 31,
---------------------------------------
<C> 1998 1997 1996
---- ---- ----
Operating activities
Net loss............................. $(5,239,762) $(1,932,946) $(1,397,912)
Adjustments to reconcile net (loss)
income to net cash provided by (used
in) operating activities:
Depreciation and amortization....... 561,519 407,797 306,964
Loss on disposal of fixed assets.... 160,853 9,520 ---
Amortization of technology and goodwill --- --- 180,783
Amortization of organization expense 23,882 6,999 8,554
Amortization of patents and trademarks 9,110 7,638 7,015
Deferred compensation amortization.... 90,000 90,000 90,000
Non-recurring charges................. --- --- 1,884,866
Deferred income taxes................. 81,000 322,000 (183,000)
Changes in operating assets and liabil-
ities:
Prepaid expenses, other current assets
and other assets.................... (49,593) 167,336 (324,884)
Income tax receivable................. 544,000 (544,000) ---
Accounts receivable................... 367,760 (284,339) 176,236
Inventory............................. (248,819) (635,736) (1,033,785)
Accounts payable, accrued liabilities,
and deferred rent................... 1,245,579 (178,854) (487,575)
Customer deposits..................... (139,952) (247,094) (2,023,500)
------------- ------------ ------------
Total adjustments...................... 2,645,339 (878,733) (1,398,326)
------------- ------------ ------------
Net cash provided by (used in) oper-
ating activities...................... (2,594,423) (2,811,679) (2,796,238)
Investing activities
Purchase of Spectral, Inc. net of cash
acquired.............................. --- --- (2,283,327)
Proceeds from sales of available-for-
sale securities....................... 1,109,077 4,925,938 6,355,774
Purchases of available-for-sale securities --- (1,044,889) ---
Purchase of property and equipment, net
or retirements........................ (656,849) (573,984) (716,300)
------------- ------------ -----------
Net cash provided by (used in) investing
activities............................ 452,228 3,307,065 3,356,147
Financing activities
Principle payments under capital lease
obligations........................... (51,565) (47,198) (36,237)
Proceeds from short-term borrowings.... --- 500,000 287,000
Repayment of short-term borrowings..... --- (500,000) (287,000)
Proceeds from sale of common stock..... 1,950,999 3,810 43,896
------------- ------------ -----------
Net cash provided by (used in) financ-
ing activities........................ 1,899,434 (43,388) 7,659
------------- ------------ -----------
Net increase (decrease) in cash and
cash equivalents...................... (242,761) 451,998 67,568
Cash and cash equivalents at beginning
of year............................... 1,880,093 1,428,095 860,527
------------- ------------ -----------
Cash and cash equivalents at end of
year.................................. $ 1,637,332 $ 1,880,093 $ 1,428,095
------------- ------------ -----------
Supplemental disclosures of cash flow
information
Cash paid for income taxes............. $ --- $ --- $ 894,000
Supplemental schedules of noncash
investing and financing activities
Equipment acquired under capital leases $ --- $ 21,109 $ ---
Translation Adjustment gain/(loss)..... $ 86,490 $ (11,515) $ ---
</TABLE>
See accompanying notes.
37
<PAGE>
EUPHONIX, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. Business Activities and Summary of Significant Accounting Policies
Business Activities
Euphonix, Inc. (the "Company") was incorporated on July 6, 1988. The Com-
pany's core business is the development, manufacture and marketing of digitally
controlled audio mixing consoles and accessories for use in the production of
audio content for music, post production for film and television, broadcast,
live sound reinforcement and multimedia world-wide markets. On February 7, 1996,
Euphonix acquired 100% of the stock of Spectral Incorporated. Spectral, a wholly
owned subsidiary, develops and markets PC-based digital audio workstations. In
January 1997, Euphonix began operations at its wholly owned subsidiary Euphonix
Japan, in Tokyo. Euphonix Japan markets digitally controlled audio mixing con-
soles in the Japanese market.
For the year ended December 31, 1998, the Company incurred a net loss of ap-
proximately $5.2 million and used approximately $2.6 million of cash for operat-
- -ing activities. The Company expects to continue to incur operating losses
through at least December 1999 or until the Company is able to attain revenues
from sales of its new products sufficient to support its operations. At December
31, 1998, the Company had $2.2 million of cash and short-term investments on
hand and received an additional $1.3 million of equity financing from existing
investors in January 1999. Management believes that cash and investments of
$2.2 million combined with the equity financing received in January 1999 will
be sufficient to support its operations through at least August 1999. The Com-
pany is currently in the process of obtaining an additional $2.0 million of debt
or equity financing from existing investors and others sufficient to support its
operations through at least December 31, 1999. In addition, the Company may re-
duce certain operating expenditures during the second half of 1999. Management
believes that cash and investments of $2.2 million combined with: 1) the $1.3
million of equity financing received in January 1999, 2) the $2.0 million of
additional debt or equity financing currently under negotiation, and 3) the pos-
sible reduction in operating expenses during the second half of 1999 will be
sufficient to support its operations through at least December 1999. There can
be no assurance that the additional debt or equity financing to be received will
be available on acceptable terms, if at all. In addition, the Company may need
to delay or significantly reduce other operating expenditures, which would have
a material adverse effect on its business, results of operations and business
prospects.
Principles of Consolidation
The consolidated financial statements include the accounts of the Company
and its wholly-owned subsidiaries. All significant intercompany accounts and
transactions have been eliminated in consolidation.
Foreign Currency Translation
The functional currency for the Company's Japanese subsidiary is the U.S.
dollar. Assets and liabilities of the Japanese subsidiary are denominated in
Japanese Yen. Translation adjustments, resulting from the process of translating
the Japanese subsidiary financial statements into U.S. dollars have been in-
cluded and disclosed as a separate component of shareholders' equity.
Foreign Currency Risk
Assets and liabilities that are not denominated in the functional currency
are remeasured into U.S. dollars at the month end exchange rate, and the result-
ing gains or losses are included in net income as foreign exchange gains and
losses. The Company does not enter into hedging arrangements to mitigate the
foreign currency risk with respect to foreign currency denominated assets and
liabilities. An adverse change in the foreign exchange rate could result in for-
eign currency transaction losses that could materially affect the Company's
38
<PAGE>
EUPHONIX, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
operations, financial position and cash flows. Foreign exchange gains and los-
ses were $ 14,374 and $ 6,084 for the years ended December 31, 1998 and 1997,
respectively. There were no foreign exchange gains or losses in 1996.
Use of Estimates
The preparation of the financial statements in conformity with generally ac-
cepted accounting principles requires management to make estimates and assump-
tions that affect the amounts reported in the financial statements and accom-
panying notes. Actual results could differ from those estimates.
Cash, Cash Equivalents, and Short-Term Investments
Cash equivalents consist of short-term financial instruments that are read-
ily convertible into cash with original maturities of less then ninety days from
the date of acquisition. The carrying amount reported in the balance sheets for
cash and cash equivalents approximates fair value. The fair values for short-
term investments are based on quoted market prices.
The Company accounts for its investments in accordance with the provisions
of Statement of Financial Accounting Standards No. 115, "Accounting for Certain
Investments in Debt and Equity Securities." At December 31, 1998 and 1997, the
Company has classified its short term investments, which are substantially money
market funds, that invest in government obligations and corporate securities, as
available-for-sale, and has included them in short-term investments. Available-
for-sale securities are carried at fair value with unrealized gains and losses,
reported in a separate component of shareholders' equity. Unrealized holding
gains and losses at December 31, 1998 and 1997 were not material. Amortization
is included in investment income. Realized gains and losses and declines in
value judged to be other-than-temporary on available-for-sale securities are
included in interest income. The cost of securities sold is based on the speci-
fic identification method. Interest and dividends on securities classified as
available-for-sale are included in interest income.
At December 31, 1998 and 1997, estimated fair value approximated cost.
Realized gains for the years ended December 31, 1998, 1997 and 1996 were
$8,000, $5,000 and $28,000 respectively.
Inventories
Inventories are stated at the lower of cost (first-in, first-out) or market
(net realizable value). Inventories consist of the following:
<TABLE>
<CAPTION>
<S>
December 31,
--------------------------------
<C> 1998 1997
---- ----
Raw materials......... $ 2,112,349 $ 1,213,574
Work-in-process....... 1,390,931 1,281,064
Finished goods........ 2,055,357 2,815,180
------------ ------------
$ 5,558,637 $ 5,309,818
============ ============
</TABLE>
39
<PAGE>
EUPHONIX, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Property and Equipment, net
Property and equipment, net, consists of the following:
<TABLE>
<CAPTION>
<S>
December 31,
---------------------------------
<C> 1998 1997
---- ----
Furniture and fixtures................ $ 225,397 $ 253,514
Computer equipment and purchased software 1,848,466 1,839,949
Leasehold improvements................ 321,009 283,647
Demo equipment........................ 332,996 282,421
----------- -----------
2,727,868 2,659,531
Accumulated depreciation and amortization (1,367,682) (1,233,822)
----------- ------------
Property and equipment, net............ $ 1,360,186 $ 1,425,709
=========== ============
</TABLE>
Depreciation expense was $535,841, $358,748, and $258,781 for the three years
ended December 31, 1998, 1997 and 1996.
Revenue Recognition
The Company generally recognizes revenue upon shipment, unless customers
make installation and acceptance terms a condition of the sale, or if third par-
ty financing arrangements have not been finalized. In these instances, revenue
is deferred upon shipment and not recognized until installation and acceptance,
or financing arrangements have been completed. At December 31, 1998, there was
approximately $185,000 of deferred revenue.
Warranty Accrual
The Company provides a one-year parts and labor warranty on its products.
The Company accrues for estimated warranty costs upon shipment.
Comprehensive Income
As of January 1, 1998, the Company adopted SFAS No. 130, "Reporting Compre-
hensive Income" ("SFAS 130"). SFAS 130 establishes new rules for the reporting
and display of comprehensive income and its components; however, the adoption of
the Statement had no impact on the Company's net loss or stockholders' equity.
SFAS 130 requires unrealized gains or losses on the Company's available-for-sale
securities and foreign currency translation adjustments, which prior to adoption
were reported separately in stockholders' equity, to be included in other com-
prehensive income. Prior year financial statements have been reclassified to
conform to the requirements of SFAS 130.
40
<PAGE>
EUPHONIX, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Advertising Costs
The Company expenses advertising costs as incurred. Advertising expense was
approximately $503,976, $435,000 and $293,000 in 1998, 1997 and 1996, respec-
tively.
Stock-Based Compensation
The Company accounts for stock-based awards to employees using the intrinsic
value method in accordance with Accounting Principles Board Opinion No. 25, "Ac-
counting for Stock Issued to Employees" ("APB 25"). Accordingly, no compensation
expense is recognized when the exercise price for fixed cost stock option plans
equals the fair value of underlying common stock on the grant date. The Company
provides additional pro forma disclosures as required under Statement of Finan-
cial Accounting Standards No. 123, "Accounting for Stock Based Compensation"
("SFAS 123").
Earnings Per Share
The Company adopted the provisions of Statement of Financial Accounting
Standards No. 128, "Earnings Per Share" ("SFAS 128"), beginning with the finan-
cial statements for the year ended December 31, 1997, and all share and per
share data for prior periods have been adjusted retroactively to comply with
SFAS 128.
Impact of Recently Issued Accounting Pronouncements
In June 1998, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 133, "Accounting for Derivative Instruments
and Hedging Activities" ("SFAS 133"), which is required to be adopted in years
beginning after June 15, 1999. The adoption of SFAS 133 is not expected to
materially impact the Company's results of operations, financial position or
cash flows.
The American Institute of Certified Public Accountants issued Statement of
Position 98-1, "Accounting For the Costs of Computer Software Developed or Ob-
tained For Internal Use" ("SOP 98-1"), on March 4, 1998. SOP 98-1 provides
guidelines for accounting for costs of computer software developed for internal
use. SOP 98-1 is effective for financial statements for fiscal years beginning
after December 15, 1998. The adoption of SOP 98-1 is not expected to materially
impact the Company's results of operations, financial position or cash flow.
Concentration of Credit Risk
Financial instruments that potentially subject the Company to concentrations
of credit risk consist principally of cash investments and trade receivables.
The Company's investments consist of certificates of deposits and money market
funds, which invest in government obligations and corporate securities. The
Company is exposed to credit risks in the event of default by the financial in-
stitutions or issuers of investments to the extent of amounts recorded on the
balance sheet. The Company manufactures and sells its products to end-users,
sales representatives, distributors and leasing companies in the music, post
production (film and television), and broadcast industries. The Company performs
ongoing credit evaluations of its customers' financial condition and prior to
shipping the product, generally requires a $5,000 deposit and a firm purchase
order. From time to time and depending on the financial condition of the cus-
tomer, the Company may require payment of a substantial portion of the purchase
price, an irrevocable letter of credit, or a purchase order from a third-party
lessor. The Company is exposed to credit risks in the event of insolvency by its
41
<PAGE>
customers to the extent of amounts recorded on the balance sheet. The Company
maintains reserves for potential credit losses, and such losses have been within
management's expectations.
2. Commitments
The Company leases facilities for its headquarters in Palo Alto, California,
its subsidiary in Woodinville, Washington, and its sales offices in Los Angeles,
Nashville, New York, London and Tokyo. These operating lease agreements expire
beginning August 1999 through August 2004, and all leases contain renewal op-
tions. Certain leases contain provisions for rental adjustments and require the
Company to pay property taxes, insurance, and normal maintenance costs. In Sep-
tember 1998, the Company sub-leased portions of its facilities in Palo Alto,
California and New York.
The aggregate future minimum lease payments under operating leases are as fol-
lows:
<TABLE>
<CAPTION>
<S> Facilities Subleases Net
<C>---------- --------- ---
Commitments
-----------
1999........ $ 839,677 $ 302,410 $ 537,267
2000........ 964,822 286,195 678,627
2001........ 930,787 71,549 859,238
2002........ 957,732 ---- 957,732
2003........ 951,622 ---- 951,622
Thereafter 698,301 ---- 698,301
---------- --------- -----------
Total $5,342,941 $ 660,154 $ 4,682,787
========== ========= ===========
</TABLE>
Total rent expense was approximately $744,021, $651,870 and $410,000 in
1998, 1997 and 1996, respectively. Rental income was $80,080 for fiscal 1998.
3. Obligations Under Capital Leases
In conjunction with the acquisition of Spectral in 1996, the Company assumed
certain capital lease obligations of its wholly owned subsidiary. Obligations
under capital leases represent the present value of future payments under the
equipment lease agreements.
<TABLE>
<CAPTION>
<S> December 31, December 31,
<C> 1998 1997
------------ ------------
Property, plant and equipment under capital leases $ 223,715 $ 223,715
Accumulated amortization ......................... (209,988) (165,570)
------------ ------------
Net property, plant and equipment under capital
leases........................................... $ 13,727 $ 58,145
------------ ------------
</TABLE>
Amortization expense related to assets acquired under capital leases was
$25,678, $49,049 and $48,183 for the years ended December 31, 1998, December 31,
1997, and December 31, 1996, respectively.
42
<PAGE>
EUPHONIX, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Future minimum payments under capital leases consist of the following at Decem-
ber 31, 1998:
<TABLE>
<CAPTION>
<S>
Fiscal year ending December 31: <C>
1999 ......................... $ 32,268
2000 ......................... 2,362
----------
Total minimum lease payments ..... 34,630
Amount representing interest ..... 2,657
----------
Present value of net minimum lease
payments ........................ 31,973
Less current portion ............. 29,691
----------
Long-term portion ................ $ 2,282
==========
</TABLE>
4. Shareholders' Equity
Preferred Stock
The Company is authorized to issue 2,000,000 shares of undesignated prefer-
red stock. Preferred stock may be issued from time to time in one or more
series. The Board of Directors is authorized to determine the rights, preferen-
ces, privileges, and restrictions granted to and imposed upon any wholly unis-
sued series of preferred stock and to fix the number of shares of any series of
preferred stock and the designation of any such series without any vote or ac-
tion by the Company's shareholders.
Common Stock
In March 1998, the Company received proceeds of $1,950,000 from existing in-
vestors in exchange for the issuance of 1,040,000 shares of $0.001 par value
common stock at $1.875 per share, the closing price of the Company's common
stock on the NASDAQ on the date the common stock purchase agreement was exe-
cuted.
1990 Stock Plan
The 1990 Stock Plan (the "1990 Plan") provides for the grant of incentive
stock options to employees of the Company and nonstatutory stock options and
stock purchase rights to employees of the Company. The Company has authorized
2,042,281 shares of common stock for issuance under the 1990 Plan. At December
31, 1998, no stock option shares were available for grant under the Plan. Op-
tions issued under the 1990 Plan are exercisable upon vesting, which is general-
ly four to five years.
1995 Performance Based Stock Option Plan
The 1995 Performance Based Stock Option Plan (the "1995 Plan") provides for
the grant of incentive stock options and nonstatutory options to employees of
the Company. A total of 50,000 shares of common stock has been reserved for is-
suance under the 1995 Plan. At December 31, 1998, 14,750 stock option shares
were available to grant under the Plan. Prior to 1997, options granted under
the 1995 Plan during 1995 vest at the rate of one-third of the shares one year
following the vesting commencement date, with one thirty-sixth of the shares
vesting each month thereafter. All options granted under the 1995 Plan during
1997 shall vest on December 11, 2000; provided, however, that if any time prior
to December 11, 2000 the optionee meets the performance targets set for such
43
<PAGE>
EUPHONIX, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
optionee by the Board of Directors for fiscal year 1998, 1999 or 2000, then all
of the shares subject to the option shall vest upon the date such targets are
met.
1995 New Director Option Plan
The 1995 New Director Option Plan (the "Directors' Plan") authorizes the
Company to issue nonstatutory stock options to purchase up to 50,000 shares of
the Company's common stock at an exercise price equal to the fair market value
of the common stock on the grant date. At December 31, 1998, 26,000 stock option
shares were available to grant under the Plan. The Directors' Plan provides that
each person who is an outside director on the effective date of the Directors'
Plan and each outside director who subsequently becomes a member of the Board
of Directors shall be automatically granted an option to purchase 10,000 shares.
Additionally, each outside director shall be automatically granted an option to
purchase 2,000 shares on the date of each annual shareholders' meeting provided
he is an outside director as of the date of such meeting and is reelected to the
Board of Directors at such meeting. Options under the plan vest one-fourth each
anniversary from date of grant.
1997 Nonstatutory Stock Option Plan
The 1997 Nonstatutory Stock Plan (the "1997 Plan") authorizes the Company to
issue nonstatutory stock options to employees of the Company. A total of 750,000
shares of common stock have been reserved for issuance under the 1997 Plan. At
December 31, 1998, 251,250 stock option shares were available to grant under the
Plan. To date, all options granted under the 1997 Plan shall vest on December
11, 2000; provided, however, that if any time prior to December 11, 2000 the op-
tionee meets the performance targets set for such optionee by the Board of
Directors for fiscal year 1998, 1999, or 2000, then all of the shares subject to
the option shall vest upon the date such targets are met.
Re-pricing of Stock Options
On October 27, 1996, the Company was authorized to exchange stock options
granted under these plans and having an exercise price greater than $5.375 for
options with an exercise price of $5.375 (the fair market value of the Company's
stock on October 27, 1996). A total of 382,732 stock option shares were re-
priced.
44
<PAGE>
EUPHONIX, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
A summary of the Company's stock option activity for all of its stock option
plans, is as follows:
<TABLE>
<CAPTION>
<S> Weighted
Number of Average
Shares Exercise
Outstanding Price
-------------------------------------------------------------
<C>
Balance at December 31, 1995 437,470 $1.49
Granted ................... 540,750 5.37
Exercised ................. (155,004) 0.33
Canceled .................. (168,874) 4.54
------------ ----------
Balance at December 31, 1996 654,342 4.08
Granted ................... 730,950 1.59
Exercised ................. (24,536) 0.16
Canceled .................. (194,468) 3.06
------------ ----------
Balance at December 31, 1997 1,166,288 2.77
Granted ................... 653,797 1.27
Exercised ................. (5,584) 0.18
Canceled .................. (48,550) 2.13
------------ ----------
Balance at December 31, 1998 1,765,951 $2.25
------------ ----------
</TABLE>
The following table summarizes information about stock options outstanding at
December 31, 1998:
<TABLE>
<CAPTION>
<S>
Options Outstanding Options Exercisable
----------------------------------------------------------
Weighted
Average Weighted Weighted
<C>Range of Number of Remaining Average Number of Average
Exercise Shares Contractual Exercise Options Exercise
Prices Outstanding Life Price Exercisable Price
-----------------------------------------------------------
$0.10-$0.15 12,983 3.1 years $0.14 12,983 $0.14
$0.16-$1.25 556,692 9.0 1.03 95,577 0.95
$1.26-$2.00 763,500 9.2 1.65 125,471 1.99
$2.01-$4.00 76,247 6.8 2.99 57,712 3.00
$4.01-$5.38 360,529 7.1 5.37 236,078 5.37
--------- -----------
Total 1,765,951 $2.25 527,821 $3.38
--------- -----------
</TABLE>
There were 244,189 and 153,427 outstanding options that were exercisable at
December 31, 1997 and 1996, respectively.
Pro forma information regarding net loss and net loss per share is required
by FAS 123, which also requires that the information be determined as if the
Company has accounted for its employee stock options granted subsequent to
45
<PAGE>
EUPHONIX, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
to December 31, 1994 under the fair value method. The fair value for options
granted prior to the initial public offering was estimated at the date of grant
using the minimum value method. The fair value for options granted subsequent
to the initial public offering was estimated at the date of grant using the
Black-Scholes option pricing model. The minimum value method differs from the
Black-Scholes option pricing model because it does not consider the effect of
expected volatility. The following weighted average assumptions were used for
1998, 1997, and 1996, respectively: risk-free interest rates of 5.59%, 6.27%,
and 6.17; a dividend yield of 0%; volatility factors of the expected market
price of the Company's common stock of 90% in 1998, 80.0% in 1997 and 65.0% in
1996; and a weighted average expected life of the option of 6 years.
The Black-Scholes option valuation model was developed for use in estimating
the fair value of traded options which have no vesting restrictions and are ful-
ly transferable. In addition, option valuation models require the input of high-
ly subjective assumptions including the expected stock price volatility. Because
the Company's employee stock options have characteristics significantly differ-
ent from those of traded options, and because changes in the subjective input
assumptions can materially affect the fair value estimate, in management's opin-
ion, the existing models do not necessarily provide a reliable single measure of
the fair value of its employee stock options.
For purposes of pro forma disclosures, the estimated fair value of the op-
tions is amortized to expense over the options' vesting period. The Company's
pro forma information follows:
<TABLE>
<CAPTION>
<S> Year Ended December 31,
-----------------------
<C> 1998 1997 1996
---- ---- ----
(in thousands, except per share amounts)
Pro forma net loss................ $ (6,220) $ (2,501) $ (1,932)
Pro forma loss per share:
Basic and diluted.............. $ (0.97) $ (0.45) $ (0.35)
</TABLE>
The weighted-average grant-date fair value of options granted during the
years ended December 31, 1998, 1997, and 1996 were $0.94, $1.18, and $3.36, res-
pectively. The effects on pro forma disclosures of applying FAS 123 are not
likely to be representative of the effects on pro forma disclosures in future
years.
Deferred Compensation
For certain options granted, the Company recognized $372,000 as deferred
compensation for the excess of the deemed value at the grant date for accounting
purposes of the common stock issuable upon exercise of such options over the ag-
gregate exercise price of such options. The deemed value for accounting purposes
represents fair value at the date of grant. Deferred compensation is amortized
ratably over the vesting period of the options into expense. For the years ended
December 31, 1998, 1997, and 1996 $90,000 per year was charged to operations.
46
<PAGE>
EUPHONIX, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
5. Income Taxes
The Company did not record a benefit for income taxes for the year ended
December 31, 1998 due to uncertainties surrounding the realizability of such
deferred tax assets. The provision (benefit) for income taxes for the years
ended December 31, 1997 and 1996 consists of the following:
<TABLE>
<CAPTION>
<S> 1997 1996
---- ----
Federal: <C>
Current........... $(222,000) $ 226,943
Deferred.......... ---- (183,000)
---------- -----------
(222,000) 43,943
---------- -----------
State:
Current........... ---- 7,000
Deferred.......... ---- (1,000)
---------- -----------
---- 6,000
---------- -----------
Total............... $(222,000) $ 49,943
========== ===========
</TABLE>
No provision (benefit) for income taxes was recorded for the year ended
December 31, 1998. A reconciliation of the provision (benefit) for income taxes
at the federal statutory rate to the provision (benefit) for income taxes at the
effective tax rate for the years ended December 31, 1997 and 1996 is as follows:
<TABLE>
<CAPTION>
<S> Years Ended December 31,
------------------------
<C> 1997 1996
---- ----
Income taxes computed at the federal statutory rate.. $ (754,000) $(458,000)
In process R&D charge ............................... --- 492,000
Valuation reserve movement .......................... 519,000 (31,000)
State taxes, net of federal benefit.................. --- 4,000
Other individually immaterial items.................. 13,000 42,943
----------- ----------
(Benefit) provision for income taxes................. $ (222,000) $ 49,943
----------- ----------
</TABLE>
47
<PAGE>
EUPHONIX, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Significant components of the Company's deferred tax assets are as follows:
<TABLE>
<CAPTION>
<S> December 31,
----------------------------
<C> 1998 1997
---- ----
Deferred tax assets:
Net operating loss carryforwards..... $ 2,200,000 $ 82,000
Research and development credit carryforwards. 500,000 77,000
Accruals and reserves currently not deductible
for tax..................................... 500,000 430,000
Capitalized research and development costs.... 400,000 112,000
------------ ----------
Total deferred tax assets...................... 3,600,000 701,000
Deferred tax liabilities:
Depreciation.................................. (200,000) (119,000)
------------- -----------
3,400,000 582,000
Valuation allowance for net deferred tax assets (3,400,000) (582,000)
------------- -----------
Net deferred tax assets $ ---- $ ----
============= ===========
</TABLE>
As of December 31, 1998, the Company had fully offset deferred tax assets by
a valuation allowance. Management believes that such net deferred tax assets are
not realizable on a more likely than not basis. The net valuation allowance in-
creased by $519,000 during the year ended December 31, 1997.
As of December 31, 1998, the Company had federal net operating loss carry-
forwards of approximately $6,500,000. The Company also had federal research and
development tax credit carryforwards of approximately $400,000. The net operat-
ing loss and credit carryforwards will expire at various dates beginning on 2005
through 2018, if not utilized.
Utilization of the net operating losses and credits may be subject to a sub-
stantial annual limitation due to the "change in ownership" provisions of the
Internal Revenue Code of 1986 and similar state provisions. The annual limita-
tion may result in the expiration of net operating losses and credits before
utilization.
6. Segment Disclosures
The Company operates in a single industry segment, designing, developing,
manufacturing and marketing of digitally controlled audio mixing consoles for
use in the production of audio content for the music, post production (film and
television) and broadcast industries. Net revenue from the sale of digitally
controlled audio mixing consoles accounted for 82%, 78% and 88% of consolidated
revenues for the years ended December 31, 1998, 1997 and 1996, respectively.
These revenues were generated primarily from the CS3000 (which accounted for
93%, 45% and 0% of mixing console revenue for the years ended December 31, 1998,
1997 and 1996), and the CS2000 (which accounted for 7%, 55% and 100% of mixing
console revenue for the years ended December 31, 1998, 1997 and 1996). The Com-
pany also derives revenues from the sale of PC-based digital audio workstations,
which accounted for 4%, 7% and 6% of consolidated revenues for the years ended
December 31, 1998, 1997 and 1996, respectively. The remainder of the Company's
revenues for the years ended December 31, 1998, 1997 and 1996 were derived from
the sale of accessories to the consoles.
48
<PAGE>
EUPHONIX, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
The Company markets its products in the United States and in foreign count-
ries through its sales personnel, sales representatives and distributors. The
Company's geographic information is as follows:
<TABLE>
<CAPTION>
<S>
Revenues:
---------
<C> 1998 1997 1996
$ % $ % $ %
United States 8,902,526 57.0 11,009,354 60.9 8,632,168 47.3
Export:
Europe 1,025,396 6.6 2,020,765 11.2 4,075,502 22.3
Japan 3,360,685 21.5 1,816,508 10.0 1,289,568 7.1
Other international 2,325,220 14.9 3,246,162 17.9 4,239,908 23.3
Long-lived assets:
1998 1997
$ $
United States 1,286,316 1,385,373
Europe 70,987 50,348
Japan 37,048 47,271
</TABLE>
7. Concentration of Other Risks
Products
The Company has derived substantially all of its revenues to date from sales
of its digitally controlled audio mixing console system. The Company expects
that its ability to maintain or expand its current levels of revenues and pro-
fits, if any, in the future will depend upon, among other things, its success in
enhancing its base system with features including new software and hardware add-
ons and developing and marketing new products and features which meet new market
demands and changing customer requirements on a timely basis.
Markets
The markets for the Company's products are characterized by rapidly changing
technologies, significant price competition and frequent new product introduc-
tions. The Company believes that it must continue to gain market share in the
music market. If, in the future, there should be a downturn in the music market,
the Company's business could be materially and adversely affected.
Inventories
The Company makes inventory provisions for potentially excess and obsolete
inventory based on backlog and forecasted demand. Actual demand will inevitably
differ from such anticipated demand, and such differences may have a material
effect on the financial statements.
49
<PAGE>
EUPHONIX, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Customers
The Company markets and sells its products primarily to a broad base of cus-
tomers comprised of end-users and sales representatives. No one end-user or dis-
tributor constituted 10% or more of net revenues in 1998, 1997, and 1996.
Export Sales
If in the future, there should be a downturn in the music, post production
(film and television) or broadcast industries, or in the economic conditions
abroad, the Company's business could be materially and adversely affected. A
substantial decline in export sales has occurred in Europe and Japan over the
last three years. With the exception of sales to customers through the Japanese
subsidiary, sales in all foreign countries are denominated in U.S. dollars.
Sales through the Japanese subsidiary are denominated in Yen.
Materials
Currently, the Company uses many sole or limited source suppliers, certain
of which are critical to integrated circuits included in the Company's base sys-
tem. If there were to be major delays or terminations in supplies of such com-
ponents, the Company could experience a delay in the shipment of its products,
which could have a materially adverse affect on its financial statements. The
Company generally purchases these single or limited source components pursuant
to purchase orders and has no guaranteed supply arrangements with such sup-
pliers.
8. Benefit Plans
Defined Contribution Plan
The Company has an employee 401(k) salary deferral plan (the "Plan") that
allows voluntary contributions by all full-time U.S. employees. Eligible em-
ployees may contribute from 1% to 20% of their respective compensation. The Com-
pany does not contribute to the Plan.
9. Acquistion
On February 7, 1996 the Company acquired Spectral, Incorporated, who de-
velops and markets PC-based digital audio workstations. The cost of the acquisi-
tion was approximately $2.3 million, which included the purchase of Spectral's
stock for $1.5 million and debt reduction of $778,000. In 1995, Spectral's net
revenues and net loss were approximately $2.3 million and $435,000, respec-
tively.
Legal, accounting and appraisal costs related to the transaction were ap-
proximately $50,000. The acquisition was accounted for as a purchase in accord-
ance with Accounting Principles Board Opinion No. 16. The excess of the total
acquisition cost over the fair value of assets acquired was approximately
$758,000 and was allocated, based on values determined by an independent ap-
praisal, to existing technology which had reached technological feasibility and
in process research and development.
50
<PAGE>
EUPHONIX, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
To determine the value of the technology in the development stage, the Com-
pany considered, among other factors, the stage of development of each project,
the time and resources needed to complete each project, expected income and as-
sociated risks. Associated risks including the inherent difficulties and uncer-
tainties in completing the project and thereby achieving technological feasibil-
ity, and risks related to the viability of and potential changes to future tar-
get markets. This analysis resulted in a value of approximately $1,446,000 being
assigned to technology in the development stage that had not yet reached tech-
nological feasibility and did not have alternative future uses. Therefore, in
accordance with generally accepted accounting principles, the $1,446,000 of
technology in the development stage was expensed.
To determine the value of the existing technology, the expected future cash
flows of each existing technology product were discounted taking into account
risks related to the characteristics and applications of each product, existing
and future markets, and assessments of the life cycle stage of each product.
Based on this analysis the existing technology, which had reached technological
feasibility, was assigned a value of approximately $435,000, and capitalized.
The unamortized capitalized technology and goodwill was charged to expense in
the fourth quarter of 1996, due to new products being planned and developed
which will address the high end digital audio workstation (DAW) and recorder
markets being developed that do not include Spectral's existing technology. In
addition Spectral's existing technology has no alternative uses.
In process research and development valued at approximately $1,446,000 as of
the acquisition date was charged to expense in the first quarter 1996, and
$439,000, net of $116,000 of taxes was charged to expense in the fourth quarter,
but are excluded from the pro forma net income for the year ended December 31,
1996 and 1995 as such amounts represent non-recurring charges.
10. Subsequent Event
Sale of Common Stock
In January 1999, the Company received proceeds of $1,303,676 from existing
investors in exchange for the issuance of 1,320,446 shares of $0.001 par value
common stock at $0.987 per share, 90% of the average closing bid price per share
on the NASDAQ, for the ten days immediately preceding January 26, 1999. The
authorized capital stock of the Company as of the date of this agreement is
20,000,000 shares of common stock and 2,000,000 shares of preferred stock, par
value $0.001.
51
<PAGE>
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure.
Not applicable.
52
<PAGE>
PART III
--------
Item 10. Directors and Executive Officers of the Registrant.
Directors and Executive Officers
The directors and executive officers of the Company and their ages as of
December 31, 1998 are as follows:
<TABLE>
<CAPTION>
<S>
<C> Name Age Position
- ---------------------------- ----- ----------------------------------------
Milton M.T. Chang, Ph.D. 55 Director
James Dobbie 68 Chairman of the Board
Thomas C. Fristoe 38 Vice President of World Wide Sales and
Marketing Communications
Paul L. Hammel 53 Senior Vice President of Operations
B. Yeshwant Kamath 50 Director
Robert F. Kuhling, Jr. 50 Director
Barry L. Margerum 47 President, Chief Executive Officer and
Director
Steven H. Milne 40 Vice President of Engineering
Scott W. Silfvast 36 Senior Vice President of Product
Marketing and Director
</TABLE>
Milton M.T. Chang, Ph.D. has served on the Board of Directors since the
Company's inception in July 1988. Since April 1996, Dr. Chang has served as
Chairman of the Board of New Focus, Inc., a privately held manufacturer of optic
components which he co-founded, and from May 1990 to April 1996, Dr Chang served
as its President. From 1988 to May 1990, Dr. Chang was self-employed as a con-
sultant. Dr. Chang also serves on the board of directors of Iridex Corporation
and serves as a director for a number of privately held companies.
James Dobbie has served as Chairman of the Board of the Company since March
1991 and served as Chief Executive Officer from March 1991 until June 1997. From
1988 to February 1991, Mr. Dobbie was a self-employed consultant and consulted
for the Company from November 1990 to February 1991. From 1984 to 1987, Mr.
Dobbie was Chairman of the Board of Akashic Memories, a privately held supplier
of high density computer disks. From 1980 to 1983, Mr. Dobbie was President of
Avantek, an electronic component company.
Thomas C. Fristoe joined the Company as Vice President, Worldwide Sales in
June 1997. In December 1997, Mr. Fristoe was promoted to Vice President of
Worldwide Sales and Marketing Communications. From March 1996 to June 1997, Mr.
Fristoe was VP, Sales and Marketing for Specular International, a software pub-
lisher of 3D design, automation and internet design tools. From December 1993
to 1996, Mr. Fristoe was Vice President of Sales for FWB. From 1991 to November
1993, Mr. Fristoe was National Sales Manager for Digital F/X.
Paul L. Hammel joined the Company in February 1998 as Senior Vice President
of Operations. From 1994 to 1998, he was employed at Plantronics, Inc. as Vice
President Customer Services and President of Walker Equipment Division of Plan-
tronics, Inc. From 1989 to 1994, Mr. Hammel was Vice President of Operations and
Customer Services for GO Corporation.
53
<PAGE>
B. Yeshwant Kamath has served as a director of the Company since October
1996. Since November 1997 Dr. Kamath has served as President of Videonics, Inc.
Prior to that he served as Division President of the KUB division of Videonics,
Inc. KUB Systems, a company that manufactures video special effects equipment
was founded by Dr. Kamath in February 1992 and acquired by Videonics, Inc. in
May 1996. Previously, Dr. Kamath was a founder of Abekas Video Systems, Inc.,
a subsidiary of Carlton Communications PLC, where he was President from 1982 to
August 1990. Dr. Kamath is also a director of Elantec Semiconductor, Inc. and
Videonics, Inc.
Robert F. Kuhling Jr. has served as a director of the Company since October
1990. Since 1987, Mr. Kuhling has been a general partner of several venture
capital partnerships managed by ONSET Ventures Services Corp., a venture capital
firm. Mr. Kuhling also serves on the board of directors of Conceptus, Inc. and
serves as a director for a number of privately held companies.
Barry L. Margerum was appointed Chief Executive Officer and President of the
Company in June 1997 and has served as a director of the Company since August
1997. From 1994 to June 1997, he served as Vice President of Marketing and then
as President and General Manager of the CMS Division of Plantronics, Inc. From
1989 to 1994, Mr. Margerum was President and Chief Executive Officer of MITEM
Corporation, a provider of middleware technology for enterprise distributed sys-
tems. From 1980 to 1988, Mr. Margerum held a variety of executive sales and mar-
keting executive positions for GriD Systems Corporation, a pioneer in the field
of lap-top computers. Prior to that, Mr. Margerum was employed by Apple Com-
puter, Inc., Epsilon Data Management and International Business Machines Corp-
oration.
Steven H. Milne joined the Company in April 1996 as Vice President of Engi-
neering. From 1992 to 1996, he was employed at Taligent, Inc., most recently as
Director, Media Software Development. Taligent, Inc. is a software joint venture
owned by International Business Machines Corporation, Hewlett-Packard Company,
and Apple Computer, Inc. From 1986 to 1992, Mr. Milne was an engineer and man-
ager working on audio for Apple Computer, Inc. Prior to that, Mr. Milne was
employed by Sydis, Inc. and Wang Laboratories, working on voice recording pro-
ducts.
Scott W. Silfvast founded the Company in July 1988. He has been a director
of the Company since its inception, has served as Senior Vice President since
June 1997 and served as President from March 1990 until May 1997. Mr. Silfvast
also served as Chairmain of the Board from July 1988 until February 1991. From
1983 to July 1988, he was an engineer for SRS, a measurement instrumentation
company.
Section 16(a) Beneficial Ownership Reporting Compliance
Under the securities laws of the United States, the Company's directors,
executive officers, and any persons holding more than ten percent of the Com-
pany's Common Stock ("Reporting Persons") are required to report, to the Securi-
ties and Exchange Commission (the "SEC") and to the exchange upon which the Com-
mon Stock is traded, their initial ownership of the Company's stock and any sub-
sequent changes in that ownership. Specific due dates for these reports have
been established, and the Company is required to disclose in this Form 10K any
failure to file these reports on a timely basis.
54
<PAGE>
Based solely on its review of the copies of such reports received by it or
written representations from certain reporting persons that no Forms 3, 4 or 5
were required, the Company believes that as of December 31, 1998, all reporting
persons complied with all applicable filing requirements, except that the Forms
4 required to be filed by Steven H. Milne for December 1997 and December 1998,
by B. Yeshwant Kamath for June 1997 and June 1998, and by Thomas C. Fristoe,
Paul L. Hammel and Scott W. Silfvast for December 1998 were filed late.
Item 11. Executive Compensation.
Summary Compensation Table
The following table sets forth information concerning the compensation paid
by the Company during the fiscal years ended December 31, 1998 ("Fiscal 1998"),
1997 and 1996, to the Company's Chief Executive Officer and each of the four
other most highly compensated executive officers serving as executive officers
at the end of the last fiscal year (collectively, the "Named Officers").
<TABLE>
<CAPTION>
<S> Long-Term
Compensation
Annual Compensation Awards
------------------- ------------
Securities
<C> Underlying All Other
Name and Principal Position Year Salary($) Bonus($)(1) Options(#) Compen-
sation($)
- --------------------------- ---- --------- ----------- ---------- ---------
Barry L. Margerum.......... 1998 180,000 54,000(2)(3) 147,297 4,195(4)
President and Chief Execu- 1997 105,000 36,750 250,000 3,540
tive Officer 1996 --- --- --- ---
Thomas C. Fristoe.......... 1998 124,992 78,313(3)(5) 9,000 0
Vice President of World Wide 1997 84,814 35,000 70,000 14,484
Sales and Marketing Commun- 1996 --- --- --- ---
ications
Scott W. Silfvast.......... 1998 150,000 27,000(3)(6) 25,000 0
Senior Vice President of 1997 148,125 22,500 50,000 0
Product Marketing 1996 132,284 12,500 0 0
Steven H. Milne............ 1998 128,100 22,720 25,000 0
Vice President of Engineer- 1997 128,100 19,200 20,000 0
ing 1996 90,901 20,000 60,000 ---
Paul L. Hammel............. 1998 133,558 29,563(3)(7) 100,000 0
Senior Vice President of 1997 --- --- --- ---
Operations 1996 --- --- --- ---
</TABLE>
- --------------------
(1) Includes bonus amounts earned in a fiscal year and paid in the subsequent
fiscal year.
(2) $27,000 of the bonus will be paid in cash and $27,000 of the bonus was paid
in 26,181 stock purchase rights under the Company's 1999 Stock Plan (the
"Plan") at a per share purchase price of $.001. The number of stock purchase
rights is equal to $27,000 divided by $1.03125, which is equal to the fair
market value of the Company's Common Stock on the April 12, 1999 date of
grant of such rights (the "April 12 FMV").
(3) Following shareholder approval of the Plan, the officer shall be paid an
additional, as yet undetermined, cash amount, such that the officer shall
be "grossed up" for taxes so that the net effect to such officer, with res-
pect to that portion of the bonus paid in stock purchase rights, is as if
federal and state income taxes did not apply to such portion of his bonus.
In the event shareholder approval of the Plan is not obtained at the next
scheduled meeting of shareholders, the stock purchase rights referenced in
note (2) above and in notes (5), (6) and (7) below shall be cancelled and
that portion of the bonus designated to be paid in stock purchase rights
shall instead be paid in cash.
(4) Represents life insurance and health insurance premiums.
(5) $60,813 of the bonus will be paid in cash and $17,500 of the bonus was paid
in 16,969 stock purchase rights under the Plan at a per share purchase price
of $.001. The number of stock purchase rights is equal to $17,500 divided by
the April 12 FMV.
(6) $13,500 of the bonus will be paid in cash and $13,500 of the bonus was paid
in 13,090 stock purchase rights under the Plan at a per share purchase price
of $.001. The number of stock purchase rights is equal to $13,500 divided by
the April 12 FMV.
(7) All of the bonus was paid in 28,667 stock purchase rights under the Plan at
a per share purchase price of $.001. The number of stock purchase rights is
equal to $29,563 divided by the April 12 FMV.
55
<PAGE>
Option Grants in Last Fiscal Year
The following table sets forth, as to the Named Officers, certain informa-
tion relating to stock options granted during Fiscal 1998.
<TABLE>
<CAPTION>
<S> Potential Realizable
Value at Assumed
Annual Rates of Stock
Price Appreciation
<C> Individual Grants for Option Term(4)
---------------------------------------- ---------------------
Number of
Securities % of Total
Underlying Options
Options Granted to Exercise or
Granted Employees in Base Price Expiration
Name (#) Fiscal Year(1) ($/Sh)(2) Date(3) 5%($) 10%($)
- ----------------- --------- -------------- ----------- ---------- ----- -------
Barry L. Margerum 147,297 2.4% 0.9375 09/01/08 86,845 220,081
Thomas C. Fristoe 9,000 0.1% 1.2812 12/16/08 7,252 18,377
Scott W. Silfvast 25,000 0.4% 1.2812 12/16/08 20,144 51,048
Steven H. Milne 25,000 0.4% 1.2812 12/16/08 20,144 51,048
Paul L. Hammel 100,000 1.6% 1.5625 02/12/08 98,265 249,022
Paul L. Hammel 10,000 0.2% 1.2812 12/16/08 8,057 20,419
</TABLE>
- ---------------
(1) The total number of shares subject to options granted to employees during
Fiscal 1998 was 625,797.
(2) The exercise price is equal to the closing price of the Company's Common
Stock on the market date immediately preceding the date of grant.
(3) Options may terminate before their expiration date if the optionee's status
as an employee or consultant is terminated or upon optionee's death.
(4) The Potential Realizable Value is calculated based on the fair market value
on the date of grant, which is equal to the exercise price of options grant-
ed in Fiscal 1998, assuming that the stock appreciates in value from the
date of grant until the end of the option term at the annual rate specified
(5% and 10%). Potential Realizable Value is net of the option exercise
price. The assumed rates of appreciation are specified in rules of the SEC,
and do not represent the Company's estimate or projection of future stock
price. Actual gains, if any, resulting from stock option exercises and Com-
mon Stock holdings are dependent on the future performance of the Common
Stock, overall stock market conditions, as well as the option holders' con-
tinued employment through the exercise/vesting period. There can be no as-
surance that the amounts reflected in this table will be achieved.
Aggregated Option Exercises in Fiscal 1998 and Fiscal 1998 Year-End Option
Values
The following table sets forth for each Named Officer certain information
concerning the number of shares subject to both exercisable and unexercisable
stock options as of December 31, 1998. Also reported are values for "in-the-
money" options that represent the positive spread between the respective exer-
cise prices of outstanding stock options and the fair market value of the Com-
pany's Common Stock as of December 31, 1998. No options were exercised by the
Named Officers during Fiscal 1998.
56
<PAGE>
<TABLE>
<CAPTION>
<S> Number of Securities Value of Unexercised
Underlying Unexercised In-the-Money Options at
Options at Fiscal Year End(#) Fiscal Year End($)(1)
----------------------------- ------------------------
Name <C> Exercisable Unexercisable Exercisable Unexercisable
- ----------------- ----------- ------------- ----------- -------------
Barry L. Margerum 106,034 291,263 1,151 12,658
Thomas C. Fristoe 22,499 56,501 0 0
Scott W. Silfvast 32,499 72,501 0 0
Steven H. Milne 34,499 70,501 0 0
Paul L. Hammel 0 110,000 0 0
</TABLE>
- ---------------
(1) Market value of underlying securities based on the closing price of $1.03125
of the Company's Common Stock on December 31, 1998, minus the exercise
price.
Compensation Committee Interlocks and Insider Participation
The Company's Compensation Committee was formed in April 1992 to review and
approve the compensation and benefits for the Company's key executive officers,
administer the Company's stock option plans and make recommendations to the
board of directors regarding such matters. The committee is currently composed
of Milton M.T. Chang, Ph.D. and Robert F. Kuhling, Jr., neither of whom is an
officer of the Company. No interlocking relationship exists between any member
of the Company's Board of Directors or Compensation Committee and any member of
the board of directors or compensation committee of any other company, nor has
any such interlocking relationship existed in the past.
Compensation of Directors
Non-employee directors of the Company currently do not receive compensation
for each Board meeting attended. Reimbursement of expenses is allowed. Officers
of the Company do not receive additional compensation for attendance at Board
of Directors meetings or committee meetings. In addition, all non-employee
directors elected for the first time after July 20, 1995 are eligible to parti-
cipate in the Company's 1995 New Director Option Plan (the "Director Plan"). The
Director Plan provides for the automatic grant of a nonstatutory stock option to
purchase 10,000 shares of Common Stock of the Company to each non-employee
director of the Company's on the date which such person first becomes a director
and an additional grant of a nonstatutory stock option to purchase 2,000 shares
of Common Stock of the Company on the date of each annual meeting of the share-
holders. All options granted under the Director Plan are subject to a four-year
vesting schedule.
Employment Arrangements
In March 1997, the Company and Barry L. Margerum entered into an employment
offer letter pursuant to which Mr. Margerum agreed to serve as Chief Executive
Officer and a director of the Company at an annual salary of $180,000, with a
target annual bonus of 40% of salary based upon mutually agreed upon milestones.
One-half of Mr. Margerum's targeted bonus amount is guaranteed at the end of his
first year of employment. The company agreed to recommend to the Board of Direc-
tors that Mr. Margerum be granted a 250,000 share stock option at a per share
57
<PAGE>
exercise price equal to the fair market value of the Company's stock on the date
of grant and vesting over four years. Pursuant to an amendment to such option
effected in September 1998, Mr. Margerum's option shall become fully vested and
exercisable upon the earlier of (i) six months following a change of control of
the Company or (ii) the date following a change of control that Mr. Margerum's
employment is terminated without cause and, to the extent vested, shall be exer-
cisable until the first to occur of (a) three years following termination of
employment or (b) August 5, 2007. In the event the Company terminates Mr. Mar-
gerum's employment, he will be entitled to a severance arrangement of six months
salary, a bonus amount equal to 20% of annual salary, six months vesting accel-
eration of his stock option and continuation of Company benefits for six months.
The Company also agreed to obtain $500,000 in life insurance for Mr. Margerum.
In addition, the Company agreed to cover 75% of commuting cost with a driver or
local apartment rental of up to $1,000 per month; however, in September 1998,
the Company's Board of Directors determined that Mr. Margerum would receive a
car allowance of $500 per month in lieu thereof. Mr. Margerum is also eligible
to participate in the Company's employee benefit plans.
In May 1997, the Company and Thomas C. Fristoe entered into an employment
offer letter pursuant to which Mr. Fristoe agreed to serve as Vice President of
Sales of the Company at an annual salary of $120,000. In addition, upon Mr.
Fristoe obtaining aggregate net order amounts of $14 million from end users and
distributors between his hire date and December 31, 1997, the Company agreed to
pay Mr. Fristoe a bonus amount of $65,000 (the "Quota Bonus"), to be increased
by $10,000 for each additional $1 million in net orders obtained. Payment of
$30,000 of the Quota Bonus was guaranteed. The Company agreed to recommend to
the Board of Directors that Mr. Fristoe be granted a 60,000 share stock option
at a per share exercise price equal to the fair market value of the Company's
stock on the date of grant. Such option vests at the rate of twenty-five percent
(25%) of the shares on the first anniversary of the date of grant with the
remaining shares vesting ratably thereafter over three years. The Company also
agreed to pay relocation related expenses of up to $15,000. In the event Mr.
Fristoe's employment is terminated by the Company within the first two years of
employment, other than for cause, the Company will continue to pay Mr. Fristoe's
salary until the first to occur of (i) the date six months following his termi-
nation date or (ii) the date Mr. Fristoe becomes employed by, or commences
serving as a consultant to, another company. Mr. Fristoe is also eligible to
participate in the Company's employee benefit plans.
Item 12. Security Ownership of Certain Beneficial Owners and Management.
The table below indicates the number of shares of the Company's Common Stock
beneficially owned as of March 31, 1999 by: (i) each person or entity known by
the Company to be the beneficial owner of more than 5% of the Company's out-
standing stock, (ii) each of the Company's directors, (iii) each of the Named
Officers, and (iv) all directors and executive officers as a group. Except as
otherwise indicated, each person has sole investment and voting powers with res-
pect to the shares shown as beneficially owned. Ownership information is based
upon information furnished by the respective individuals.
58
<PAGE>
<TABLE>
<CAPTION>
<S> Number of Shares
Beneficially Owned(1)
---------------------
Directors, Executive Officers and 5% Shareholders <C> Number Percent
- ------------------------------------------------- ------ -------
Robert F. Kuhling, Jr. (2)............................. 1,744,922 21.9%
c/o ONSET Enterprise Associates
2490 Sand Hill Road
Menlo Park, CA 94025
ONSET Enterprise Associates............................ 1,744,335 21.9%
2490 Sand Hill Road
Menlo Park, CA 94025
Dieter Meier........................................... 1,000,000 12.6%
c/o Soundproof, Inc.
5180 Linwood Drive
Los Angeles, CA 90027
Pegasus Capital II, L.P................................ 527,925 6.6%
181 Elm Street
New Canaan, CT 06840
Milton M.T. Chang, Ph.D................................ 368,800 4.6%
Scott W. Silfvast (3).................................. 331,909 4.2%
James Dobbie (3)....................................... 192,730 2.4%
Barry L. Margerum (3).................................. 144,350 1.8%
Steven H. Milne (3).................................... 40,540 *
Thomas C. Fristoe (3).................................. 28,749 *
B. Yeshwant Kamath (3)................................. 5,500 *
All executive officers and directors as a group (9 persons)
(3)................................................... 2,888,749 34.8%
</TABLE>
- ---------------------------
* Less than one percent.
(1) Based on 7,956,521 shares of Common Stock outstanding as of March 31, 1999.
(2) Includes 1,744,335 shares held by ONSET Enterprise Associates ("ONSET").
Mr. Kuhling is a general partner of OEA Management, L.P. ("OEA"), which is
the general partner of ONSET, and, together with the other general partners
of OEA, shares voting and investment power with respect to such shares. Mr.
Kuhling disclaims beneficial ownership of the shares held by ONSET except
to his proportionate partnership interest therein. Also includes 587 shares
held by a trust for the benefit of Mr. Kuhling and his spouse.
(3) Includes 38,228, 47,375, 144,350, 40,540, 28,749, 5,500 and 335,991 shares
which Messrs. Silfvast, Dobbie, Margerum, Milne, Fristoe, Kamath and all
59
<PAGE>
present directors and executive officers as a group, respectively, have the
right to acquire within 60 days of March 31, 1999 upon the exercise of
stock options.
Item 13. Certain Relationships and Related Transactions.
1998 Private Placement of Common Stock. On March 16, 1998, the Company
entered into a Common Stock Purchase Agreement (the "1998 Purchase Agreement")
with, among others, ONSET, the Company's largest shareholder, and Milton M.T.
Chang and Scott W. Silfvast, directors of the Company. Under the 1998 Purchase
Agreement, a total of 1,039,999 shares of Common Stock were sold in a private
placement transaction at a per share purchase price of $1.875, which price is
equal to the closing price of the Company's Common Stock on March 16, 1998.
800,000 shares were purchased by ONSET for $1,500,000, 80,000 shares were pur-
chased by Mr. Chang for $150,000 and 53,333 shares were purchased by Mr. Silf-
vast for $100,000. Until March 16, 2000, holders of an aggregate of greater than
50% of the shares purchased under the 1998 Purchase Agreement may request the
Company register such shares pursuant to a "shelf" registration on Form S-1
under the Securities Act of 1933, as amended.
1999 Private Placement of Common Stock. On January 26, 1999, the Company
entered into a Common Stock Purchase Agreement (the "1999 Purchase Agreement")
with, Dieter Meier and Stephen D. Jackson. Under the 1999 Purchase Agreement, a
total of 1,320,446 shares of Common Stock were sold in a private placement
transaction at a per share purchase price of $0.9873, which price was equal to
90% of the average bid price per share for the ten days immediately preceding
January 26, 1999. 1,000,000 shares were purchased by Dieter Meier for $987,300
and 320,446 shares were purchased by Stephen D. Jackson for $316,376. Under cer-
tain circumstances, such persons have the right, to request on one occasion that
the Company register such shares, or to include such shares in a registration
effected by the Company, with the number of shares included in each such regis-
tration subject to underwriter cutbacks. Under certain circumstances, such per-
sons have the right to designate one nominee for election to the Company's Board
of Directors.
1999 Note Financing. In April 1999, the Company executed a Secured Promis-
sory Note (the "Note") with certain persons under which the Company may draw up
to $2 million through July 31, 1999. Under the Note, ONSET, Milton M.T. Chang,
Dieter Meier, Stephen D. Jackson and Pegasus Capital II, L.P. have commitments
to advance $1,000,000, $400,000, $350,000, $150,000 and $100,000, respectively,
pursuant to the terms thereof. Interest on the Note accrues at the rate of 7.75%
per annum and such interest, together with the outstanding principal amount, is
due in April 2001. The Company may not prepay the Note. Subject to obtaining the
necessary approvals, the Note is convertible into Common Stock of the Company
pursuant to the terms thereof. Under certain circumstances (but not sooner than
January 1, 2000), the Note may become immediately due and payable. The Note is
secured by the assets of the Company.
Option Grants to Executive Officers. In Fiscal 1998, stock options under the
Company's 1990 Stock Plan (the "1990 Plan") and 1997 Nonstatutory Stock Option
60
<PAGE>
Plan (the "1997 Plan") were granted to the following executive officers as of
the grant dates and for the number of shares of Common Stock and at the exercise
prices set forth below opposite their names:
<TABLE>
<CAPTION>
<S> Per Share
Officer <C> Date of Grant Plan No. of Shares Exercise Price
- ----------------- ------------- ---- ------------- --------------
Thomas C. Fristoe 12/16/98 1997 9,000 $1.2812
Paul L. Hammel 02/12/98 1990 100,000 1.5625
Paul L. Hammel 12/16/98 1997 10,000 1.2812
Barry L. Margerum 09/01/98 1990 46,797 0.9375
Barry L. Margerum 09/01/98 1997 100,500 0.9375
Steven H. Milne 12/16/98 1997 25,000 1.2812
Scott W. Silfvast 12/16/98 1997 25,000 1.2812
</TABLE>
The per share exercise price of each of the above options is equal to the
closing price of the Company's Common Stock on the market date immediately pre-
ceding the date of grant. The 100,000 share option granted to Mr. Hammel vests
as to 25% of the shares on February 12, 1999, with the balance of the shares
vesting ratably over three years. The options granted to Messrs. Fristoe, Ham-
mel, Milne and Silfvast on December 16, 1998 vest as to 25% of the shares on
December 16, 1999, with the balance of the shares vesting ratably over three
years.
The two options granted to Mr. Margerum vest ratably over four years; how-
ever, such options shall become fully vested and exercisable upon the earlier of
(i) six month following a change of control of the Company or (ii) the date
following a change of control that Mr. Margerum's employment is terminated with-
out cause and, to the extent vested, shall be exercisable until the first to
occur of (a) three years following termination of employment or (b) September 1,
2008.
Bonus Payments to Executive Officers. See "Item 11-Executive Compensation-
Summary Compensation Table" regarding bonuses paid to executive officers in
recognition of services rendered to the Company in Fiscal 1998.
61
<PAGE>
PART IV
-------
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 10-K.
(a) 1. List of Financial Statement Schedules
The following financial statements of Euphonix, Inc., are included
in Item 8:
Consolidated Balance Sheets as of December 31, 1998 and 1997
Consolidated Statements of Operations for each of the three years
in the period ended December 31, 1998
Consolidated Statements of Shareholders' Equity for each of the
three years in the period ended December 31, 1998
Consolidated Statements of Cash Flows for each of the three years
in the period ended December 31, 1998
Notes to Consolidated Financial Statements
2. Supplemental Schedule
The following financial statement schedule of Euphonix, Inc. is
filed as part of this annual report, and should be read in conjunc-
tion with the financial statements of Euphonix, Inc.:
Schedule II Valuation and qualifying accounts
Schedules not listed above have been omitted because the information re-
quired to be set forth therein is not applicable or is shown in the financial
statements or notes thereto.
62
<PAGE>
SCHEDULE II
VALUATION AND QUALIFYING ACCOUNTS
<TABLE>
<CAPTION>
<S>
Charged
Balance at to costs Balance
<C> Beginning and at End of
Descriptions of Period Expenses Deduction(1) Period
------------ ---------- -------- ------------ ---------
Year Ended December 31, 1996
Allowance for Doubtful Accounts $ 84,820 $ 34,919 $ ---- $ 119,739
Accrued Warranty............... $ 171,398 $ 348,018 $ 136,701 $ 382,715
Year Ended December 31, 1997
Allowance for Doubtful Accounts $ 119,739 $ 103,054 $ ---- $ 222,793
Accrued Warranty............... $ 382,715 $ 224,763 $ 259,628 $ 347,850
Year Ended December 31, 1998
Allowance for Doubtful Accounts $ 222,793 $ 180,489 $ 85,600 $ 403,282
Accrued Warranty............... $ 347,850 $ 256,572 $ 165,025 $ 439,397
</TABLE>
________________
(1) Charges for uncollectible accounts, net of recoveries
63
<PAGE>
3. Exhibits.
--------
Exhibit
Number Description of Document
- ------ -----------------------
3.1(1) Amended and Restated Articles of Incorporation of the Registrant.
3.2(1) Bylaws of the Registrant.
10.1(1) Form of indemnification Agreement between the Registrant and each of its
directors and officers.
10.2(3) 1990 Stock Plan and forms of stock option agreement and restricted stock
purchase agreement thereunder.
10.3(1) 1995 Performance Based Stock Option Plan and form of stock option agree-
ment thereunder.
10.4(1) 1995 New Director Option Plan and form of stock option agreement there-
under.
10.5(4) 1997 Nonstatutory Stock Option Plan and form of stock option agreement
thereunder.
10.6(1) Modification Agreement dated November 6, 1991, among the Registrant and
certain shareholders of the Registrant.
10.7(1) Credit Agreement dated September 30, 1994 between the Registrant and
Bank of the West, as amended.
10.8(1) Lease Agreement dated December 31, 1990, as amended May 14, 1993, by and
between the Registrant and El Camino Center.
10.9(2) Agreement and Plan of Reorganization dated January 15, 1996 by and
among the registran , Spectral, Incorporated, Euphonix Acquisition Cor-
poration and certain shareholders of Spectral, Incorporated.
10.10(5)Common Stock Purchase Agreement dated March 16, 1998 between the Reg-
istrant and the purchasers thereunder.
10.11(5 Common Stock Purchase Agreement dated January 26, 1999 between the
Registrant, Dieter Meier and Stephen D. Jackson.
10.12(5)Registration Rights Agreement January 26, 1999 between the Registrant
and the purchasers thereunder.
64
<PAGE>
10.13 Secured Promissory Note dated April 23, 1999 between the Registrant and
the investors thereunder.
23.1 Consent of Ernst & Young LLP, Independent Auditors
24.1 Power of Attorney
27.1 Financial Data Schedule
- ---------------------------
(1) Incorporated by reference to the exhibit filed with the Registrant's Reg-
istration Statement on Form SB-2 (File No. 33-94898-LA), effective August 21,
1995.
(2) Incorporated by reference to the exhibit filed with the Registrant's cur-
rent report on Form 8-K dated February 7, 1996.
(3) Incorporated by reference to the exhibit filed with the Registrant's Regis-
tration Statement on Form S-8 (File No. 333-17545) effective December 10, 1996.
(4) Incorporated by reference to the exhibit filed with the Registrant's Regis-
stration Statement on Form S-8 (File No. 333-68425) effective December 4, 1998.
(5) To be filed by amendment.
(b) Reports on Form 8-K.
None.
(C) Exhibits.
See (a) above.
(d) Financial Statement Schedules.
See (a) above.
65
<PAGE>
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Ex-
change Act of 1934, the Registrant has duly caused this Report on Form 10-K to
be signed on its behalf by the undersigned, thereunto duly authorized, in the
City of Palo Alto, State of California, on the 26th day of April, 1999.
EUPHONIX, INC.
By /s/ BARRY MARGERUM
--------------------------
Barry Margerum
Chief Executive Officer, President and Director
POWER OF ATTORNEY
KNOW ALL PERSON BY THESE PRESENTS, that each person whose signature appears
below hereby constitutes and appoints James Dobbie and Barry Margerum, and each
of them acting individually, as his attorney-in-fact, each with full power of
substitution, for him in any and all capacities, to sign any and all amendments
to thes Report on Form 10-K, and to file the same, with exhibits thereto and
other documents in connection therewith, with the Securities and Exchange Com-
mission, hereby ratifying and confirming our signatures as they may be signed
by our said attorney to any and all amendments to said Report.
Pursuant to the requirements of the Securities Exchange Act of 1934, this
Registration Statement has been signed by the following persons in the capaci-
ties and on the date indicated:
Signature Title Date
--------- ----- ----
/s/ JAMES DOBBIE Chairman April 26, 1999
- -----------------------
James Dobbie
/s/ BARRY L. MARGERUM Chief Executive Officer, April 26, 1999
- ----------------------- President, Director
Barry L. Margerum (Principal Executive and
Financial Officer)
/s/ SCOTT W. SILFVAST Director, Senior Vice President April 26, 1999
- -----------------------
Scott W. Silfvast
/s/ MILTON M.T. CHANG Director April 26, 1999
- -----------------------
Milton M.T. Chang, Ph.D.
/s/ ROBERT F. KUHLING, JR. Director April 26, 1999
- --------------------------
Robert F. Kuhling, Jr.
/s/ B. YESHWANT KAMATH Director April 26, 1999
- -----------------------
B. Yeshwant Kamath
/s/ HARRIET N. DIETZ Controller (Principal April 26, 1999
- ----------------------- Accounting Officer)
Harriet N. Dietz
66
<PAGE>
10.13 Secured Promissory Note dated April 23, 1999 between the Registrant and
the investors thereunder.
THE SECURITY EVIDENCED BY THIS NOTE AND THE SECURITIES ISSUABLE UPON CONVERSION
OF THIS NOTE HAVE NOT BEEN REGISTERED UNDER THE SECURITIES ACT OF 1933, AS
AMENDED, AND MAY NOT BE SOLD, TRANSFERRED OR ASSIGNED UNLESS THERE IS AN EFFEC-
TIVE REGISTRATION STATEMENT UNDER SUCH ACT COVERING SUCH SECURITIES, THE SALE,
TRANSFER OR ASSIGNMENT IS MADE IN ACCORDANCE WITH RULE 144 UNDER THE ACT, OR THE
COMPANY RECEIVES AN OPINION OF COUNSEL FOR THE HOLDER OF THESE SECURITIES
REASONABLY SATISFACTORY TO THE COMPANY, STATING THAT SUCH SALE, TRANSFER OR
ASSIGNMENT IS EXEMPT FROM THE REGISTRATION AND PROSPECTUS DELIVERY REQUIREMENTS
OF SUCH ACT.
SECURED PROMISSORY NOTE
-----------------------
Two Million Dollars
($2,000,000.00) April 23, 1999
FOR VALUE RECEIVED, the undersigned, Euphonix, Inc., a California corpora-
tion ("Borrower"), hereby promises to pay to Onset Enterprise Associates, Milton
M.T. Chang, Dieter Meier, Stephen D. Jackson and Pegasus Capital II, L.P. (indi-
vidually an "Investor" and collectively, the "Investors" or "Lender"), the prin-
cipal sum of Two Million Dollars ($2,000,000) or so much of such principal sum
as may from time to time have been advanced by each investor and be outstanding,
together with accrued interest, as provided herein, with the maximum principal
sum hereof (or lesser amount, to the extent that less than the full amount of
such principal sum is advanced and outstanding) allocable among the Investors as
follows:
<TABLE>
<CAPTION>
<S>
Name of Investor <C> Maximum Principal Amount
---------------- ------------------------
Onset Enterprise Associates $ 1,000,000
Milton M.T. Chang $ 400,000
Dieter Meier $ 350,000
Stephen D. Jackson $ 150,000
Pegasus Capital II, L.P. $ 100,000
----------------
Total $ 2,000,000
</TABLE>
A. Principal
---------
1. Advances. From the date hereof until 5:00 p.m. Pacific Standard Time on
July 31, 1999, Borrower may from time to time request advances from Lender (in-
dividually an "Advance" and collectively the "Advances") by giving written
notice to the Investors in accordance with terms hereof, which notice shall in-
dicate the amount of the Advance requested. Subject to the satisfaction or
waiver of the conditions set forth in Section A.3 below, and provided that the
67
<PAGE>
requested Advance would not cause an Event of Default (as Defined in Section E
below) to occur, Lender shall make the Advance to Borrower within three (3) bus-
iness days of receipt of Borrower's notice for each Advance. Lender shall not be
obligated to make an Advance to the extent that such Advance, when aggregated
with all prior Advances, would exceed Two Million Dollars ($2,000,000).
2. Commitments. Each Investor shall advance to Borrower its pro rata por-
tion of each Advance based on its proportionate share of the principal sum here-
of set forth above besides its name. Each Investor shall be severally but not
jointly liable to make its pro rata portion of the Advances hereunder. Failure
by any Investor to fund its pro rata portion of any Advance shall not relieve
any other Investor from its obligation to fund its pro rata portion thereof.
3. Conditions to Advances. Borrower's right to request, and Lender's obli-
gation to make, each Advance shall be subject, in each case, to the satisfaction
of the following conditions, any or all of which may be waived by Lender, in its
sole and exclusive discretion, to the extent permitted by law:
(a) The representations and warranties contained in Section D.2 shall be
true and correct in all material respects on and as of the date of such request
for an Advance and on the effective date of each Advance as though made at and
as of each such date, and no Event of Default shall have occurred and be con-
tinuing, or would result from such Advance.
(b) There shall be no law, order, rule or regulation of any governmen-
tal authority in effect which has the effect of prohibiting, making unlawful or
hindering any of the transactions contemplated by this Note.
4. Use of Proceeds. The proceeds of Advances shall be used for general cor-
porate purposes, including for working capital.
B. Interest. Interest shall accrue with respect to Advances on the principal
sum hereunder at the per annum rate of seven and three quarters percent (7.75%).
Interest payable hereunder shall be calculated on the basis of a three hundred
sixty (360) day year for actual days elapsed. Interest shall be due and payable
(or convert as set forth in Section C below) upon payment or conversion of the
outstanding principal sum of this Note pursuant to Section C below.
C. Payment or Conversion
1. Scheduled Payment. Subject to other provisions of this Note, the out-
standing principal sum of this Note, together with the accrued interest thereon,
shall be due and payable on April 23, 2001.
2. No Prepayment. Borrower shall not have the right at any time to time to
prepay, in whole or in part, the outstanding principal sum of this Note and/or
any accrued interest thereon.
68
<PAGE>
3. Form of Payment. Unless converted pursuant to the terms set forth below,
the outstanding principal sum and accrued interest thereon are to be paid in
lawful money of the United States of America in federal or other immediately
available funds.
4. Immediate Payment. Notwithstanding anything herein to the contrary, in
the event that all necessary shareholder, regulatory and other approvals or con-
sents for the convertibility of this Note as set forth below are not obtained by
July 31, 1999, (i) the outstanding principal sum from all Advances as of the
date thereof and all future Advances from the date thereof and (ii) accrued in-
terest thereon, shall be repaid in full upon demand by the Investors represent-
ing two-thirds (2/3) of the then outstanding principal sum of this Note; pro-
vided, however, no such demand may be made until January 1, 2000; and provided,
further, that the Investors must provide at least one (1) month prior written
notice to the Borrower prior to such demand. To the extent the approvals or con-
sents contemplated herein are obtained after July 31, 1999, this Note shall not
be subject to repayment upon demand as set forth herein but rather in accordance
with the scheduled payment as set forth in Section C.1 above. In addition, such
demand may not be made if shareholder approval for the convertibility of this
Note is not obtained as a result of the Investors failing to vote or consent for
such convertibility.
5. Conversion.
(a) To the extent permissible under applicable law and the rules of the
Nasdaq Stock Market and subject to obtaining all necessary shareholder, regula-
tory and other approvals or consents and further subject to Section C.5 (c)
hereof, the then outstanding principal sum of this Note, together with the ac-
crued interest thereon, shall be convertible at the option of the Lender into
shares of common stock of the Borrower (the "Common Stock"). The number of
shares of Common Stock to be issued upon such conversion(s) shall be equal to
the quotient obtained by dividing the (i) then outstanding principal sum of this
Note plus accrued interest thereon by (ii) the average closing price per share
of Common Stock during the ten (10) consecutive trading days immediately preced-
ing the date hereof as reported on the Nasdaq Stock Market.
(b) No fractional share of Common Stock will be issued upon such conver-
sion(s) of this Note. In lieu of any fractional share to which the Lender would
otherwise be entitled, the Borrower will pay to the Lender in cash the amount of
the unconverted principal and interest balance of this Note that would otherwise
be converted into such fractional share. At its expense, the Borrower, will as
soon as practicable thereafter, issue and deliver to each Investor, at its prin-
cipal office, or other address notified by each Investor to the Borrower from
time to time, a certificate or certificates for the number of shares (represent-
ing its pro rata portion) to which the Investor is entitled upon such conver-
sion(s). Upon such conversion(s) of this Note, the Borrower will be forever re-
leased from all of its obligations and liabilities under this Note, to the ex-
tent of the conversion. Such conversions may be exercised individually by each
Investor but notwithstanding anything herein to the contrary, each such conver-
sion must be for the full amount of the outstanding principal and accrued in-
terest thereon payable to the Investor exercising its rights under Section 5
hereunder at the time of such exercise.
69
<PAGE>
(c) Notwithstanding anything herein to the contray, Section C.5(a) of
this Note shall not apply and this Note shall not be convertible into shares of
Common Stock as contemplated herein upon the occurence of the following: the
consummation of any transaction or series of transactions (collectively, the
"Transaction"), including without limitation, the sale, transfer or disposition
of all or substantially all of the Borrower's assets or the merger of the Bor-
rower with or into, or consolidation with, any other corporate entity, whereby
the holders of the Borrower's voting securities prior to the Transaction do not
hold more than 50% of the voting securities of the surviving entity following
the consummation of the Transaction. Notice of any such Transaction shall be
provided to the Investors fourteen (14) calendar days prior to the consummation
of any such Transaction.
D. Security Interest
1. Grant of Security Interest. Upon the first Advance hereunder, Borrower
grants to Lender a security interest in the Collateral, as defined herein, to
secure the payment of all of the outstanding indebtedness hereunder (the "Se-
cured Obligations").
2. Representations and Warranties Regarding Collateral. On and as of the
date of each Advance under this Note, Borrower shall represent and warrant to
Lender, that as of each such date and to the Borrower's knowledge, Borrower is
the true and lawful owner of the Collateral, having good and marketable title
thereto, free and clear of any and all Liens other than the Lien and security
interest granted to Lender hereunder and Permitted Liens. Borrower shall not
create or assume or permit to exist any such Lien on or against any of the Col-
lateral except as created or permitted by this Note and Permitted Liens, and
Borrower shall promptly notify Lender of any such other Lien against the Colla-
teral and shall defend the Collateral against, and take all such action as may
be reasonably necessary to remove or discharge, any such Lien. To the Borrower's
knowledge, (i) no part of the Intellectual Property Collateral has been judged
invalid or unenforceable, in whole or in part, and (ii) no claim has been made
that any part of the Intellectual Property Collateral violates the rights of any
third party.
3. Perfection of Security Interest. Borrower agrees to take all actions re-
quested by Lender and reasonably necessary to perfect, to continue the perfec-
tion of, and to otherwise give notice of, the Lien granted hereunder, including,
but not limited to, execution of financing statements.
4. Subordination. Notwithstanding anything herein to the contrary, the Len-
der shall permit and subordinate its security interest granted hereunder to any
security interest granted to establish receivable lines of credit with commer-
cial banks or other institutional lenders. The Lender covenants to take all
reasonably necessary action to subordinate its security interest granted here-
under under the circumstances set forth above.
E. Events of Default.
1. Definition of Event of Default. The occurrence of any one or more of the
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<PAGE>
following events shall constitute an "Event of Default" hereunder:
(a) Borrower's failure to perform, keep or observe any obligation under
this Note or any of the covenants contained in the Note which failure is not
cured within 30 days from the notice of the occurrence thereof delivered by
Lender to Borrower; or
(b) Borrower's institution of proceedings against it, or Borrower's
filing of a petition or answer or consent seeking reorganization or release, un-
der the federal Bankruptcy Code, or any other applicable federal or state law
relating to creditor rights and remedies, or Borrower's consent to the filing of
any such petition or the appointment of a receiver, liquidator, assignee, trus-
tee or other similar official of Borrower or of any substantial part of its pro-
perty, or Borrower's making of an assignment for the benefit of creditors, or
the taking of corporate action in furtherance of such action.
2. Rights and Remedies on Event of Default.
(a) During the continuance of an Event of Default, Lender shall have the
right, itself or through any of its agents, with notice to Borrower (as provided
below), as to any or all of the Collateral, by any available judicial procedure,
or without judicial process (provided, however, that is is in compliance with
the UCC), to declare all obligations evidenced by this Note immediately due and
payable, cease advancing money or extending credit to or for the benefit of Bor-
rower under this Note, and to exercise any and all rights afforded to a secured
party under the UCC or other applicable law. Without limiting the generality of
the foregoing, Lender shall have the right to sell or otherwise dispose of all
or any part of the Collateral, either at public or private sale, in lots or in
bulk, for cash or for credit, with or without warranties or representations, and
upon such terms and conditions, all as Lender, in its reasonable discretion, may
deem advisable, and it shall have the right to purchase at any such sale. Bor-
rower agrees that a notice sent at least fifteen (15) days before the time of
any intended public sale or of the time after which any private sale or other
disposition of the Collateral is to be made shall be reasonable notice of such
sale or other disposition. The proceeds of any such sale, or other Collateral
disposition shall be applied, first to the expenses of retaking, holding,
storing, processing and preparing for sale, selling, and the like, and to
Lender's reasonable attorneys' fees and legal expenses, and then to the Secured
Obligations and to the payment of any other amounts required by applicable law,
after which Lender shall account to Borrower for any surplus proceeds. If, upon
the sale or other disposition of the Collateral, the proceeds thereof are insuf-
ficient to pay all amounts to which Lender is legally entitled, Borrower shall
be liable for the deficiency, together with interest thereon, and the reasonable
fees of any attorneys Lender employs to collect such deficiency; provided, how-
ever that the foregoing shall not be deemed to require Lender to resort to or
initiate proceedings against the Collateral prior to the collection of any such
deficiency from Borrower.
(b) Borrower appoints Lender, and any officer, employee or agent of
Lender, with full power of substitution, as Borrower's true and lawful attorney-
in-fact, effective as of the date hereof, with power, in its own name or in the
name of Borrower, during the continuance of an Event of Default, to endorse any
notes, checks, drafts, money orders, or other instruments of payment in respect
71
<PAGE>
of the Collateral that may come into Lender's possession, to sign and endorse
any drafts against debtors, assignments, verifications and notices in connection
with accounts, and other documents relating to Collateral; to pay or discharge
taxes or Liens at any time levied or placed on or threatened against the Colla-
teral; to demand, collect, issue receipt for, comprise, settle and sue for mon-
ies due in respect of the Collateral; to notify persons and entities obligated
with respect to the Collateral to make payments directly to Lender; and, gener-
ally, to do, at Lender's option and at Borrower's expense, at any time, or from
time to time, all acts and things which Lender deems necessary to protect, pre-
serve and realize upon the Collateral and Lender's security interest therein to
effect the intent of this Note, all as fully and effectually as Borrower might
or could do; and Borrower hereby ratifies all that said attorney shall lawfully
do or cause to be done by virtue hereof. This power of attorney shall be irrevo-
cable as long as any of the Secured Obligations are outstanding.
(c) All of Lender's rights and remedies with respect to the Collateral,
whether established hereby or by any other agreements, instruments or documents
or by law shall be cumulative and may be exercised singly or concurrently.
F. Restrictions on Transfer and Compliance with Securities Act.
1. Certificates. Certificates representing any of the shares of Common
Stock acquired pursuant to the provisions of this Note shall have endorsed
thereon the following legends, as appropriate.
(a) Such shares of Common Stock will not be registered under the Securi-
ties Act of 1933, as amended (the "Securities Act"), nor qualified (if neces-
sary) under applicable state securities laws and consequently will have the fol-
lowing legend:
"THE SECURITIES EVIDENCED BY THIS CERTIFICATE HAVE NOT BEEN REGISTERED UNDER
THE SECURITIES ACT OF 1933, AS AMENDED, AND MAY NOT BE SOLD, TRANSFERRED, AS-
SIGNED OR HYPOTHECATED UNLESS THERE IS AN EFFECTIVE REGISTRATION STATEMENT UNDER
SUCH ACT COVERING SUCH SECURITIES, THE SALE IS MADE IN ACCORDANCE WITH RULE 144
UNDER THE ACT, OR THE COMPANY RECEIVES AN OPINION OF COUNSEL FOR THE HOLDER OF
THESE SECURITIES REASONABLY SATISFACTORY TO THE COMPANY, STATING THAT SUCH SALE,
TRANSFER, ASSIGNMENT OR HYPOTHECATION IS EXEMPT FROM THE REGISTRATION AND PROS-
PECTUS DELIVERY REQUIREMENTS OF SUCH ACT."
(b) Any legend required to be placed thereon by any applicable state
securities laws.
(c) Each Investor, by acceptance hereof, agrees that this Note and the
shares of Common Stock to be issued upon conversion pursuant to the terms hereof
are being acquired solely for its own account and not as a nominee for any other
72
<PAGE>
party and not with a view toward the resale or distribution thereof and that it
will not offer, sell or otherwise dispose of this Note or any shares of Common
Stock to be issued upon conversion pursuant to the terms hereof except under
circumstances which will not result in a violation of the Securities Act or of
applicable state securities laws.
(d) Each Investor, by acceptance hereof, represents that it is (i) an
accredited investor within the meaning of Rule 501 under the Securities Act and
has such knowledge and experience in financial and business matters that it is
capable of evaluating the merits and risks of the purchase of the Note; (ii)
aware of the Company's business affairs and financial condition; and (iii) aware
that the Note has not been registered under the Securities Act of 1933, as
amended, in reliance upon a specific exemption therefrom.
G. Covenant. Upon receipt of the necessary approvals for the convertibility
feature of this Note set forth in Section C.5 above, the Borrower hereby
covenants to amend its existing agreements regarding registration rights with
each of the Investors to provide for the registration of the shares of Common
Stock into which the Note is then convertible pursuant to the existing terms of
such agreements (or in the case of Pegasus Capital II, L.P. to enter into such
an agreement substantially similar to that existing with Dieter Meier and
Stephen D. Jackson). The Investors shall cooperate to amend such existing agree-
ments to include such shares of Common Stock (or in the case of Pegasus Capital
II, L.P., to enter into such an agreement substantially similar to that existing
with Dieter Meier and Stephen D. Jackson).
H. Other Provisions
1. Definitions. As used herein, the following terms shall have the follow-
ing meanings:
"Collateral" means the property described on Exhibit A attached hereto.
"Copyrights" means any and all copyright rights, copyright applications,
copyright registrations and like protections in each work or authorship and
derivative work thereof, whether published or unpublished and whether or not the
same also constitutes a trade secret, now or hereafter existing, created, ac-
quired or held.
"Intellectual Property Collateral" means:
(a) Copyrights, Trademarks and Patents;
(b) Any and all trade secrets, and any and all intellectual property
rights in computer software and computer software products now or hereafter
existing, created, acquired or held;
(c) Any and all design rights which may be available to Borrower now or
hereafter existing, created, acquired or held;
73
<PAGE>
(d) Any and all claims for damages by way of past, present and future
infringement of any of the rights included above, with the right, but not the
obligation, to sue for and collect such damages for said use or infringement of
the intellectual property rights identified above;
(e) All licenses or other rights to use any of the Copyrights, Patents
or Trademarks, and all license fees and royalties arising from such use to the
extent permitted by such license or rights;
(f) All amendments, renewals and extensions of any of the Copyrights,
Trademarks or Patents; and
(g) All proceeds and products of the foregoing, including without limit-
ation all payments under insurance or any indemnity or warranty payable in res-
pect of any of the foregoing.
"Lien" means any lien (statutory or other), mortgage, pledge, hypotheca-
tion, assignment, deposit arrangement, security interest, charge, claim or other
encumbrance of any kind (including any conditional sale or other title retention
agreement, any lease in the nature thereof, and any agreement to give any secur-
ity interest) and any agreement to give or refrain from giving a lien, mortgage,
pledge, hypothecation, assignment, deposit arrangement, security interest,
charge, claim or other encumbrance of any kind.
"Patents" means all patents, patent applications and like protections
including without limitation improvements, divisions, continuations, renewals,
reissues, extensions and continuations in part of the same.
"Permitted Liens" means: (i) Liens imposed by law, such as carriers',
warehousemen's materialmen's and mechanics' liens, or Liens arising out of
judgements or awards against Borrower with respect to which Borrower at the time
shall currently be prosecuting an appeal or proceedings for review; (ii) Liens
for taxes not yet subject to penalties for nonpayment and Liens for taxes the
payment of which is being contested in good faith and by appropriate proceedings
and for which, to the extent required by generally accepted accounted principles
then in effect, proper and adequate book reserves relating thereto are estab-
lished by Borrower; (iii) purchase money security interests and liens in con-
nection with capital leases incurred in the ordinary course of business (to the
extent such liens are only on the leased property) or existing on after acquired
property at the time of its acquisition by the Borrower; (iv) liens existing on
property as of the date of this Note; (v) liens securing the performance of
bids, trade contracts, leases, surety bonds and the like; (vi) leases and sub-
licenses granted to others in the ordinary course of business; (vii) liens con-
sisting of rights of set-off or bankers liens of a customary nature; (viii)
liens in connection with the establishment of receivable lines of credit with
commercial banks or other institutional lenders; and (ix) liens consisting of
agreements to refrain from giving or creating Liens (other than the Lien and
security interest granted to Lender hereunder) in connection with joint venture
agreements, strategic alliances and the like.
74
<PAGE>
"Trademarks" means any trademark and servicemark rights, whether regis-
tered or not, applications to register and registrations of the same and like
protections, and the entire goodwill of the business of Borrower connected with
and symbolized by such trademarks.
"UCC" means the Uniform Commercial Code in effect from time to time in
the relevant jurisdiction.
2. Governing law; Venue. This Note shall be governed by the laws of the
State of California, without giving effect to conflicts of law principles. Bor-
rower and Lender agree that all actions or proceedings arising in connection
with this Note shall be tried and litigated only in the state and federal courts
located in the City and County of San Francisco, State of California or, at Len-
der's option, any court in which Lender determines it is necessary or appro-
priate to initiate legal or equitable proceedings in order to exercise, pre-
serve, protect or defend any of its rights and remedies under this Note or
otherwise or to exercise, preserve, protect or defend its Lien, and the priority
thereof, against the Collateral, and which has subject matter jurisdiction over
the matter in controversy. Borrower waives any right it may have to assert the
doctrine of forum non conveniens or to object to such venue, and consents to any
court ordered relief Borrower waives personal service of process and agrees that
a summons and complaint commencing an action or proceeding in any such court
shall be promptly served and shall confer personal jurisdiction if served by
registered or certified mail to Borrower. The choice of forum set forth herein
shall not be deemed to preclude the enforcement of any judgement obtained in
such forum, or the taking of any action under this Note to enforce the same, in
any appropriate jurisdiction.
3. Notices. Any notice or communication required or desired to be served,
given or delivered hereunder shall be in the form and manner specified below,
and shall be addressed to the party to be notified as follows:
If to Investors: Onset Enterprise Associates
2490 Sand Hill Road
Menlo Park, California 94025
Attention: Rob Kuhling
Fax: (650) 529-0777
Milton M.T. Chang
2630 Walsh Avenue
Santa Clara, California 95051
fax: (650) 941-7267
Dieter Meier
c/o Soundproof, Inc.
5180 Linwood Drive
Los Angeles, California 90027
Fax: 011-411-212-0883
75
<PAGE>
Stephen D. Jackson
1307 East Pine
Lodi, California 95240
Fax: (209) 369-6240
Pegasus Capital II, L.P.
181 Elm Street
New Canaan, CT 06840
Attention: Mark Lanier
Fax: (203) 966-4788
If to Borrower: Euphonix, Inc.
220 Portage Avenue
Palo Alto, California 94306
Attention: Barry Margerum
Fax: (650) 846-1131
with a copy to: Wilson Sonsini Goodrich & Rosati
Professional Corporation
650 Page Mill Road
Palo Alto, California 94304-1050
Attn: John Roos, Esq.
Fax: (650) 493-6811
or to such other address as each party designates to the other by notice in the
manner herein prescribed. Notice shall be deemed given hereunder if (i) deliver-
ed personally or otherwise actually received, (ii) sent by overnight delivery
service, (iii) mailed by first-class United States mail, postage prepaid, regis-
tered or certified, with return receipt requested, or (iv) sent via telecopy
machine with a duplicate signed copy sent on the same day as provided in clause
(ii) above. Notice mailed as provided in clause (iii) above shall be effective
upon the expiration of three (3) business days after its deposit in the United
States mail, and notice telecopied as provided in clause (iv) above shall be
effective upon receipt of such telecopy if the duplicate signed copy is sent un-
der clause (iv) above. Notice given in any other manner described in this sec-
tion shall be effective upon receipt by the addressee thereof, provided, how-
ever, that if any notice is tendered to an addressee and delivery thereof is
refused by such addressee, such notice shall be effective upon such tender un-
less expressly set forth in such notice.
5. Lender's Rights; Borrower Waivers. Lender's acceptance of partial or
delinquent payment from Borrower hereunder, or Lender's failure to exercise any
right hereunder, shall not consitute a waiver of any obligation of Borrower
hereunder, or any right of Lender hereunder, and shall not affect in any way
the right to require full performance at any time thereafter. Except as other-
wise expressly provided herein, Borrower waives presentment, diligence, demand
of payment, notice, protest and all other demands and notices in connection with
the delivery, acceptance, performance, default or enforcement of this Note. In
76
<PAGE>
any action on this Note, Lender need not produce or file the original of this
Note, but need only file a photocopy of this Note certified by Lender to be a
true and correct copy of this Note in all material respects.
6. Severability. Whenever possible each provision of this Note shall be in-
terpreted in such manner as to be effective and valid under applicable law, but
if any provision is prohibited by or invalid under applicable law, it shall be
ineffective to the extent of such prohibition or invalidity, without invalidat-
ing the remainder of the provision or the remaining provisions of this Note.
7. Amendment Provisions. This Note may not be amended or modified, nor may
any of its terms be waived, except by written instruments signed by Borrower and
Lender.
8. Binding Effect. This Note shall be binding upon, and shall inure to the
benefit of, Borrower and the holder hereof and their respective successors and
assigns; provided, however, that Borrower's rights and obligations shall not be
be assigned or delegated without Lender's prior written consent, given in its
sole discretion, and any purported assignment or delegation without such consent
shall be void ab initio.
9. Time of Essence. Time is of the essence of each and every provision of
this Note.
10. Headings. Section headings used in this Note have been set forth herein
for convenience of reference only. Unless the contrary is compelled by the con-
text, everything contained in each section hereof applies equally to this entire
Note.
77
<PAGE>
IN WITNESS WHEREOF, the Borrower and each of the Investors has caused this
Note to be duly executed on the date first written above.
EUPHONIX, INC.
By: /s/ BARRY MARGERUM
-------------------
Name: Barry Margerum
Title: Chief Executive Officer
"INVESTORS":
-----------------------
By:
--------------------
Name:
Title:
78
<PAGE>
EXHIBIT "A"
COLLATERAL DESCRIPTION ATTACHMENT
TO SECURED PROMISSORY NOTE
All personal property of Borrower (herein referred to as "Borrower" or Deb-
tor") whether presently existing or hereafter created, written, produced or ac-
quired, including, but not limited to:
(1) all accounts receivable, accounts, chattel paper, contract rights
(including, without limitation, royalty agreements, license agreements and dis-
tribution agreements), documents, instruments, money, deposit accounts and gen-
eral intangibles, including, without limitation, returns, repossessions, books
and records relating thereto, and equipment containing said books and records,
all investment property, including securities and securities entitlements;
(2) all software, computer source codes and other computer programs
(collectively, the "Software Products"), and all common law and statutory copy-
rights and copyright registrations, applications for registration, now existing
or hereafter arising, United States of America and foreign, obtained or to be
obtained on or in connection with the Software Products, or any parts thereof or
or any underlying or component elements of the Software Products together with
the right to copyright and all rights to renew or extend such copyrights and the
right (but not the obligation) of Lender (herein referred to as "Lender" or
"Secured Party") to sue in its own name and/or the name of the Debtor for past,
present and future infringements of copyright;
(3) all goods, including, without limitation, equipment and inventory
(including, without limitation, all export inventory);
(4) all guarantees and other security therefor;
(5) all trademarks, service marks, trade names and service names and
the goodwill associated therewith;
(6)(a) all patents and patent applications filed in the United States
Patent and Trademark Office or any similar office of any foreign jurisdiction,
and interest under patent license agreements, including, without limitation, the
inventions and improvements described and claimed therein, (b) licenses pertain-
ing to any patent whether Debtor is licensor or licensee, (c) all income, royal-
ties, damages, payments, accounts and accounts receivable now or hereafter due
and/or payable under and with respect thereto, including, without limitation,
damages and payments for past, present or future infringements thereof, (d) the
right (but not the obligation) to sue for past, present and future infringements
thereof, (e) all rights corresponding thereto throughout the world in all juris-
dictions in which such patents have been issued or applied for, and (f) the re-
issues, divisions, continuations, renewals, extensions and continuations-in-
part with any of the foregoing (all of the foregoing patents and applications
and interests under patent license agreements, together with the items described
in clauses (a) through (f) in this paragraph are sometimes herein individually
79
<PAGE>
and collectively referred to as the "Patents"); and
(7) all products and proceeds, including, without limitation, insurance
proceeds, of any of the foregoing. Notwithstanding the foregoing, the grant of a
security interest as provided herein shall not extend to, and the term "Colla-
teral" shall not include, any contractual, license or lease rights or interests
in which Borrower is the grantee, licensee or lessee thereunder to the extent
that Borrower, whether by law or by the terms of such contract, license or
lease, is not permitted to assign or grant a security in interest in its rights
thereunder without the consent of the other party thereto.
80
<PAGE>
EXHIBIT 23
CONSENT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
We consent to the incorporation by reference in the Registration Statement (Form
S-8 No. 333-17545) pertaining to the 1990 Stock Plan, the Registration Statement
(Form S-8 No. 333-98130) pertaining to the 1990 Stock Plan, 1995 Performance
Based Stock Option Plan and 1995 New Director Option Plan, and the Registration
Statement (Form S-8 No. 333-68425) pertaining to the 1997 Nonstatutory Stock
Option Plan of our report dated March 4, 1999, with respect to the consolidated
financial statements and schedule of Euphonix, Inc. included in its Annual Re-
port (Form 10-K) for the year ended December 31, 1998, filed with the Securities
and Exchange Commission.
Palo Alto, California
April 23, 1999
81
<PAGE>
WARNING: THE EDGAR SYSTEM ENCOUNTERED ERROR(S) WHILE PROCESSING THIS SCHEDULE.
<TABLE> <S> <C>
<S> <C>
<PAGE>
<ARTICLE> 5
<S> <C>
<PERIOD-TYPE> 12-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-END> DEC-31-1998
<CASH> 1,637,332
<SECURITIES> 601,146
<RECEIVABLES> 1,543,335
<ALLOWANCES> 0
<INVENTORY> 5,558,637
<CURRENT-ASSETS> 9,577,962
<PP&E> 1,360,186
<DEPRECIATION> 0
<TOTAL-ASSETS> 11,230,864
<CURRENT-LIABILITIES> 3,652,529
<BONDS> 0
<COMMON> 6,636
0
0
<OTHER-SE> 7,368,362
<TOTAL-LIABILITY-AND-EQUITY> 11,230,864
<SALES> 15,613,827
<TOTAL-REVENUES> 15,613,827
<CGS> 8,599,527
<TOTAL-COSTS> 12,320,320
<OTHER-EXPENSES> 0
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 0
<INCOME-PRETAX> (5,239,762)
<INCOME-TAX> 0
<INCOME-CONTINUING> (5,239,762)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (5,239,762)
<EPS-BASIC> (0.82)
<EPS-DILUTED> (0.82)
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