UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549


Form 10-K

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934
   
For the Fiscal Year Ended December 31, 20022003
Commission File Number 0-23137

RealNetworks, Inc.

(Exact Name of Registrant as Specified in Its Charter)
   
Washington
 91-1628146
(State of incorporation) (I.R.S. Employer Identification Number)
 
2601 Elliott Avenue, Suite 1000
Seattle, Washington
(Address of principal executive offices)
 98121
(Zip Code)

(Registrant’s telephone number, including area code)

(206) 674-2700

Securities registered pursuant to Section 12(b) of the Act:

None

Securities registered pursuant to Section 12(g) of the Act:

(Title of Class)

Common Stock, Par Value $0.001 per share

     Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.     Yes þ          No o

     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 the 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.     þ

     Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2).     Yes þ          No o

     The aggregate market value of the Common Stock held by non-affiliates of the registrant was approximately $357,339,374$599,978,654 on June 28, 2002,30, 2003, based on the closing price of the Common Stock on that date, as reported on the Nasdaq National Market.(1)

     The number of shares of the registrant’s Common Stock outstanding as of March 20, 200310, 2004 was 157,782,779.168,746,492.

DOCUMENTS INCORPORATED BY REFERENCE

     Portions of the registrant’s Proxy Statement relating to the registrant’s 20032004 Annual Meeting of Shareholders to be held on or about May 20, 2003June 4, 2004 are incorporated by reference into Part III of this Report.


(1) Excludes shares held of record on that date by directors, executive officers and 10% shareholders of the registrant. Exclusion of such shares should not be construed to indicate that any such person directly or indirectly possesses the power to direct or cause the direction of the management of the policies of the registrant.




TABLE OF CONTENTS

TABLE OF CONTENTS
PART I.
Item 1. Business
Item 2. Properties
Item 3. Legal Proceedings
Item 4. Submission of Matters to a Vote of Security Holders
PART II.
Item 5. Market for Registrant’s Common Equity and Related Shareholder Matters
Item 6. Selected Consolidated Financial Data
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
Item 8. Financial Statements and Supplementary Data
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
PART III.
Item 10. Directors and Executive Officers of the Registrant
Item 11. Executive Compensation
Item 12. Security Ownership of Certain Beneficial Owners and Management
Item 13. Certain Relationships and Related Transactions
Item 14. Controls and Procedures
PART IV.
Item 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K
SIGNATURES
EXHIBIT 21.1
EXHIBIT 23.1
EXHIBIT 99.1
EXHIBIT 99.2


TABLE OF CONTENTS

       
Page

PART I
 Business  1 
 Properties10
Legal Proceedings  11 
 Legal Proceedings11
Item 4.Submission of Matters to a Vote of Security Holders  11 
Executive Officers of the Registrant  11 
PART II
 Market for Registrant’s Common Equity and Related Shareholder Matters  1312 
 Selected Consolidated Financial Data  14 
 Management’s Discussion and Analysis of Financial Condition and Results of Operations  16 
 Quantitative and Qualitative Disclosures About Market Risk  5549 
 Financial Statements and Supplementary Data  5751 
 Changes in and Disagreements with Accountants on Accounting and Financial Disclosure  8583
Controls and Procedures83 
PART III
 Directors and Executive Officers of the Registrant  8583 
 Executive Compensation  8583 
 Security Ownership of Certain Beneficial Owners and Management  8583 
 Certain Relationships and Related Transactions  8684 
 ControlsPrincipal Accountant Fees and ProceduresServices  8684 
PART IV
 Exhibits, Financial Statement Schedules, and Reports on Form 8-K  8684 
Exhibit Index  8785 
EXHIBIT 10.10
EXHIBIT 14.1
EXHIBIT 21.1
EXHIBIT 23.1
EXHIBIT 23.2
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32.1
EXHIBIT 32.2


PART I.

     This Annual Report on Form 10-K and the documents incorporated herein by reference contain forward-looking statements that have been made pursuant to the provisions of the Private Securities Litigation Reform Act of 1995. These forward-looking statements are based on current expectations, estimates and projections about RealNetworks’ industry, management’s beliefs, and certain assumptions made by management. Words such as “anticipates,” “expects,” “intends,” “plans,” “believes,” “seeks,” “estimates” and similar expressions are intended to identify forward-looking statements. These statements are not guarantees of future performance and actual actions or results may differ materially. These statements are subject to certain risks, uncertainties and assumptions that are difficult to predict, including those noted in the documents incorporated herein by reference. Particular attention should also be paid to the cautionary language in the section of Item 1 entitled “Intellectual Property,” in Item 3 entitled “Legal Proceedings” and in the sections entitled “Factors That May Affect Our Business, Future Operating Results and Financial Condition” and “Special Note Regarding Forward-Looking Statements.” RealNetworks undertakes no obligation to update publicly any forward-looking statements as a result of new information, future events or otherwise, unless required by law. Readers should, however, carefully review the risk factors included in other reports or documents filed by RealNetworks from time to time with the Securities and Exchange Commission, particularly the Quarterly Reports on Form 10-Q and any Current Reports on Form 8-K.

Item 1.     Business

Overview

     RealNetworks, Inc. is athe leading global providercreator of network-delivered digital media services and the technology that enables digital media creation, distributionsoftware. Consumers use our services and consumption. Our company is at the center of the intersection between technologysoftware to find, play, purchase and digital content.

     Our strategy is to drive the creation of a market for subscription-based digital audiomanage free and video content online, and we are positioned to benefit from this market in three primary ways: (1) as an electronic retailer ofpremium digital content, to consumers; (2) as a business-to-business services provider to third parties who wish to distribute their content to consumers over digital networks;including music, video and (3) as a supplier of the underlying technology used by content owners andgames. Broadcasters, network operators, media companies and enterprises use our products and services to create and distributedeliver digital content.media to PCs, mobile phones and consumer electronics devices.

     We have helpedbeen a pioneer in the development of technology for the transmission of digital media over the Internet, and we have used our technology to create a large ecosystembase of consumers, network operators and content owners who use our products and services to create, send and receive both free and paid content. We believe that we canOur strategy is to continue to grow and leverage this ecosystembase of users to successfully compete indrive the creation of a market for premium digital audio and video content online and related technology.generate profitable revenue from this market in two primary ways:

     (1) as a creator, packager and seller of software and digital content to consumers; and
     (2) as a supplier of the underlying technology and business to business services to content owners, enterprises and network operators to create and distribute digital content.

     Consumers use our RealOne Playermedia player software to play, create and manage their digital media, rip and burn CDs, tune in to Internet radio and play streaming and on-demand audio and video. Since our inception, there have been more than 300 million unique registered users worldwideIn January 2004, we released the most recent version of our RealOne Playermedia player software, RealPlayer 10, which offers support for every major media format and its predecessor,includes an integrated digital music download store, the RealPlayer. RealOne PlayerRealPlayer Music Store, along with an integrated radio tuner and premium radio subscription services. RealPlayer users can also subscribe to one of our RealOne SuperPass subscription services,service, which offeroffers subscribers a package of premium software and services and access to premium content. We offer a variety of subscription service offerings to consumers under our RealOne brand,content, including RealOne SuperPass, which provides consumers access to online sports, news, music and entertainment programming from brand-name media companies,companies. We also market and RealOne RadioPass,distribute Rhapsody, an online music subscription service, which offers consumers unlimited, on-demand streaming access to over 550,000 songs, and RealArcade, a subscription radio service. In addition,software platform through which we distribute downloadable games through subscriptions and a subscription to one of our RealOne services includes a premium version of our RealOne Player software, offering playback of over 50 media types, advanced CD burning and other features designed to enhance the user experience for digital media. RealOne Player users can also subscribe to one of the subscription products we offer that feature the content of our content partners, including CNN, Major League Baseball Advanced Media and NASCAR.com. At December 31, 2002, our subscription offerings had over 900,000 paying subscribers. We believe this represents one of the largest paid media subscription businesses on the Internet.la carte sales.

     Our ecosystem also includes contentContent owners and network operators who use our products to create and distribute free and paid digital content, as well asand other technology companies who license our technology in order to integrate digital media into their products. While the primary application of these products today is for Internet-connected PCs, we believe mobile devices will become an increasingly important part of our business, and we believe we are establishing a leading position in the mobile market for media delivery and player products and services.

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The technology platform that we use for our products and that we license to other companies consists of the Real 10 Platform (Real 10) and the Helix Platform (Helix). Real 10 is called Helix. Theour proprietary technology for digital audio/ video compression, transport and playback and includes RealAudio 10, RealVideo 10, RealProducer 10 and RealPlayer 10. Helix platform is capableincludes a suite of commercial rights management and server software products for protecting and delivering digital media in any majormultiple formats to media format over any Internet protocol-enabled network to any media-enabled device. Helix

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supports all of the major server and device operating systems, and it enables content providers to deliver high quality digital audio and video content to consumers with high levels of scalability, reliability and flexibility. We have made the core Helix technology available in source code to a community of developers — the “Helix Community” — to help increase the speed, creativity and innovation in development on our platform. More than 10,000 people have registered to join the Helix Community. At the same time, we have also entered into agreements with leading manufacturers of chips, servers, personal computers, and wireless and personal music devices,players, as well as other consumer electronic devices,a suite of software source code that third parties can use to build multi-format digital media products. This source code is licensed via the Helix Community, which many leading technology companies have joined in order to incorporate our open source streaming and downloadable media technology in their products. We believe that this will enable even more rapid adoption of Helix technologies.

     The size of our worldwide user base provides us with an ability to pool consumer demand on a very large scale. Accordingly, we have developed a variety of products and services to connect content providers, broadcasters and advertisers with that user base, including our RealOne subscription services. Our strategy is to continue to leverage our Internet media technology and our worldwide user base to create industry-leading products, services and businesses atgenerate revenues from the intersection of digital technology and digital media.

Consumer Media Products and Services

RealOne Player.The RealOne Player is the successor to our RealPlayer and RealJukebox products and enables consumers to play a wide varietysale of digital media includingproducts and services.

History

     RealNetworks has consistently been a pioneer in bringing new digital media technologies and services to market since it was founded in 1994. In 1995, we released RealAudio, the first version of our RealPlayer products. In 1996, we began selling RealPlayer Plus, a premium version of our RealPlayer product and in 1997 we released our RealSystem streaming media solution, which included our RealAudio and downloaded content, CDs, MP3sRealVideo technology. In 1999, we released our RealJukebox and Internet radio stations,RealJukebox Plus products, a personal music management system and currently supports over 50we launched our first for-pay media formats. Thesubscription service, RealPlayer GoldPass, in 2000. In 2001, we launched our RealOne Player blends features ofsubscription service, which incorporated our RealPlayer and RealJukebox products together with premium digital content to create a multi-dimensional media experience for consumers. We also introduced RealArcade, an end-to-end platform for the digital distribution of PC games. In 2002, we announced Helix, an open, comprehensive Internet media delivery platform and community to help enable creation of digital media products and applications for any format, operating system or device. In 2003, we acquired Listen.Com, Inc. (“Listen”) and its Rhapsody music subscription service to strengthen our digital music offerings and in January 2004, we acquired GameHouse, Inc. (“GameHouse”), a singledeveloper and distributor of downloadable games.

Consumer Products and Services

Multimedia Products and Services

RealPlayer.RealPlayer 10 is the latest version of our media player productsoftware. RealPlayer 10 includes major new features and consumer services that make it easier for consumers to discover, purchase and manage digital music, and find video and audio programming on the Web. RealPlayer 10 offers consumers support for every major media format and the ability to play music from all of the major online music stores, support for over 50 portable music devices, access to free content in the new RealGuide, and an integrated music download service for North American consumers, the RealPlayer Music Store. The RealPlayer also includes a media and Internet browser,browsing functionality, a content discovery window and a video-playback window. The RealOne Playerwindow and enables users to listen to and view content from Web sites as well as acquire, record, store, organize and playmanage their personal music collections from a PC. The RealOne Player includes functions such as play, stop, fast-forward, rewind, volume adjustment, customizable navigational tools and services for personalized access to multimedia content and TurboPlay, a new technology enabling near-instant playback of audio and video content for broadband PC users. Consumers can acquire music for playback from a number of different sources, including free promotional music downloads, purchased Internet music downloads and music purchased through links to online music retailers. Consumers can also record CDs onto their hard disks at high speeds using their choice of several recording formats. The RealOne Player supports playback for a wide variety of digital formats, including RealAudio, RealVideo, MP3, MPEG-4, Windows Media and QuickTime and enables users to make their music collection portable by transferring their music to portable digital playback devices and other portable storage solutions manufactured by our partners. Support for some formats may require the installation of third-party components. The RealOne Player also includes information services that provide access to CD information from an online music database, including track name, artist, album and genre and offers users digital music management capability, including a “Now Playing” list that provides a flexible means of creating audio and video playlists from content in the user’s media library or on the Internet.

     The RealOne PlayerRealPlayer is available to consumers as a free download from our Web site and also through bundling with third-party products. We also sell our premium RealOne PlayerRealPlayer Plus product, in a number of countries, which contains additional features beyond those found in the free version, including theater mode for video, high-fidelity audio quality withadvanced CD burning, a 10-band graphic equalizer, picture qualityadvanced video controls, such as contrast, brightness and tint,analog recording, and a higher MP3 encoding rate. We have developed localized versions of the RealOne Player product for use in seven foreign languages.

     In December 2002, we released the gold version of RealOne Player for Mac OS X. The RealOne Mobile Player, introduced in June 2001, enables consumers to access streaming or downloaded content via wireless LANs and next generation mobile networks.

     RealOne Subscription Services.SuperPass.In December 2001, we launched our RealOne subscription service platform and in March 2002, we introduced RealOne SuperPass is our core premium media subscription service that offers consumers a broad range of programming,premium content, including content currently provided by ABCNEWS.com, CNN, E! Networks, FOXSports.com, iFILM, MLB Advanced Media, NASCAR.com and the NBA, SI.com, The Wall Street Journal Online and The Weather Channel. Members of ouras well as commercial free Internet radio stations. Subscribers to RealOne subscription services are able to take advantage ofSuperPass also receive the enhanced features of the RealOne PlayerRealPlayer Plus. RealOne SuperPass provides a single source for

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consumers to access popular news, sports, music and entertainment online, while allowing

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content providers the ability to offer exclusive access to content and to potentially profit from multiple revenue opportunities.

     We also offer other subscription-based products under our RealOne brand, including RealOne RadioPass, a radio-based subscription service and RealOne MusicPass, a service that offers high-quality, reliable downloads and streams of content from major and independent record labels. RealOne RadioPass subscribers receive access to over 50 ad-free, high bit-rate digital music stations in addition to 3,200 worldwide commercial stations. RealOne RadioPass is available as a stand-alone subscription product and we also make certain features of RadioPass available to subscribers to our RealOne SuperPass service. RealOne MusicPass is based on an online music distribution platform developed by MusicNet, Inc., a joint venture we formed in 2001 with several leading media companies to create a platform for online music subscription services. RealOne MusicPass also integrates with the RealOne Player to permit members to combine music from MusicNet with their existing collections, compile personalized playlists of downloaded or streaming tracks, listen to favorites and discover new music.

Stand-alone Subscription Services.We also offer a variety of subscription products that feature the content of our content partners, including offerings from CNN, Major League Baseball Advanced MediaNASCAR.com and NASCAR.com.UEFA Champions League. These offerings are generally made available on a stand-alone basis or as an addition to a RealOne SuperPass subscription. In certain cases, these products or certain features of these products are included with a RealOne SuperPass subscription.

Music

     Games; RealOne Arcade.Rhapsody.RealOne Arcade In August 2003, we completed our acquisition of Listen, and its digital music subscription service, Rhapsody. Rhapsody is the centerpiece of our comprehensive set of music offerings, which also include RadioPass, our Internet radio subscription service, and the RealPlayer Music Store. We are now offering Rhapsody as our primary music subscription service offering through our Web sites. We also distribute Rhapsody through third party distribution channels, such as broadband service providers, music retailers and home network hardware providers.

     Subscribers to Rhapsody receive legal, unlimited, on-demand streaming access to over 550,000 songs in exchange for a monthly subscription fee. Rhapsody subscribers can build playlists and create customized radio stations of their favorite artists and similar artists. Rhapsody subscribers can also burn most of the songs available on the service onto CDs for $0.79 a song. We believe the Rhapsody music service is the leading online music subscription service based on the number of subscribers.

RadioPass. Our RadioPass subscription service provides subscribers with access to over 70 pre-programmed, ad-free, high fidelity digital music radio stations in addition to simulcasts of 3,200 worldwide broadcast stations in exchange for a monthly subscription fee. Subscribers to RadioPass also receive our RealPlayer Plus software product.

RealPlayer Music Store. The free version of RealPlayer 10 contains an all-in-oneintegrated music download store, the RealPlayer Music Store. The RealPlayer Music Store has over 400,000 songs available for purchase by North American consumers for $0.99 per song and $9.95 for most albums. Consumers can also securely transfer purchased songs to leading portable devices manufactured by Palm and Creative Labs.

Games

RealArcade. RealArcade was launched in October of 2001 and is a leading Internet game download service offeringtargeted at both male and female adult gamers. RealArcade features over 200 high quality downloadable games across all popular game genres and makes it easy for consumers the ability to find, acquire,discover, manage and play PC-baseddownloadable PC games. The RealOne ArcadeAll games are made available with a time limited free trial and can be purchased on a transaction basis or as part of a subscription.

RealArcade GamePass. RealArcade GamePass is a premium subscription service isof RealArcade. It was launched in July of 2002 and provides consumers with a free game each month as well as discounts on additional games purchases in exchange for a monthly subscription fee.

GameHouse. On January 30, 2004, we acquired GameHouse, a leading developer, publisher and distributor of downloadable PC games. GameHouse develops and publishes downloadable, casual PC games, including the leading titles SuperCollapse II, Puzzle Inlay, Magic Inlay, TextTwist and BounceOut. GameHouse games are available for free downloadon GameHouse’s Web site (www.gamehouse.com), and makesthrough a wide variety of games available for preview, free trialsdistribution channels including MSN, Yahoo!, Shockwave and purchase. In July 2002, we launched GamePass, a monthly subscription game offering for RealOne Arcade. GamePass subscribers receive a credit each month to acquire a game from theour RealArcade service. In addition, they receive discounts on other game purchases that they make through the service.

Advertising and Third Party Distribution

     Third Party Accessories.We make third party software products available for trialmarket and for sale from the Accessories linkssell advertising on our Web sites and client software. Our primary Web presence consists of our Real.com Web site.site and our new RealGuide service that provides consumers with personalized access to popular audio and video content on the Web. The Real.com site showcases our premium software and

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subscription service offerings, including RealOne SuperPass, RealRhapsody, RadioPass and RealArcade. The RealGuide is accessible from our Real.com Web site and also as an embedded application in the RealPlayer and offers visitors the ability to search for and locate multimedia content on the Internet and in our subscription services. We have developed 14 localized foreign editions of the RealGuide for users outside of the United States and Canada. Our products and services offer broad reach to advertisers as well as contextually relevant and geographically segmented targeting opportunities to Internet advertisers. Additionally, we sell and distribute third-party software products directly to end users via our Web sites and by bundling third party products with the distribution of our own products.

System SoftwareBusiness Products and Services

Servers and Tools

     Helix Products.We develop and make available a variety of software products forthat enable media content creators, Web site owners and network operators to create, secure and distribute digital media content to PCs and non-PC devices. These software products are marketed under the brand Helix.Real and Helix brands.

     Helix Producer,Real Tools — RealProducer, RealAudio and RealVideo.Helix ProducerRealProducer is a multimedia creation and publishing tool that content owners use to convert audio and video content into our RealAudio and RealVideo formats. A basic version of the Helix ProducerRealProducer is available to content creators as a free download from our Web site. We also make an advanced or Plus version of the Helix ProducerRealProducer available for purchase from our Web site by professionals and consumers who require more sophisticated media creation features and capabilities.

RealAudio and RealVideo use a variety of compression/decompression algorithms (or codecs) to translate time-based, data-intensive content such as audio, video or animation data into discrete data packets. The compression process enables the data to be streamed to a player even in narrowband bandwidths or congested network environments by reducing the amount of data to be streamed. In 2002, we introduced RealAudio Surround, which enables multi-channel surround sound and works with receivers already in consumers’ homes, and RealVideo 9, which offers a 30% improvement in quality over RealVideo 8.

     Helix DRM.Introduced in January 2003, Helix DRM is a set of products for the secure licensing, delivery and rights management of digital media. It is the successor to our RealSystem Media Commerce Suite digital rights management solution. Helix DRM is the first major digital rights management system to support both of the leading Internet media formatsRealAudio and RealVideo as well as standards-based formats like MP3 and MPEG-4.AAC. Helix DRM is designed to provide end-to-end security throughout the media’s product lifecycle, from packaging to distribution to enjoyment by the audience. It provides a choice of media delivery methods, including streaming, download, peer-to-peer distribution and physical media. Media Commerce Suite and

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Helix DRM are used by content owners and distributors such as MovieLink, MusicNet and Sony Pictures Digital Entertainment.

     Helix Universal Server and Helix Universal Gateway.Server.The Helix Universal Server allows broadcasters and content providers to broadcast live orand on-demand audio, video and other multimedia programming to large numbers of simultaneous users. It supports all major Internet media formats which enables network operators, including ISPs,Internet Service Providers (“ISPs”), content delivery networks, mobile service providers and enterprises to consolidate their media delivery infrastructure with one system architecture. Features of the Helix Universal Server include an integrated content networking system designed to provide live and on-demand content reliability across distributed networks, the scalability to reach 10,000 simultaneous users on a single server, and server fail-over capabilities that automatically route client requests to back-up servers in the event of service failures or unplanned outages. We provide a specialized version of the server to the mobile industry to accommodate the media formats and network requirements of mobile networks and mobile devices.

     Helix UniversalProxy and Gateway.Helix Proxy and Gateway the successor to RealSystem Proxy, is aproducts are middle-of-the-network technology,technologies, placed between an origina Helix Universal Server and our playerRealPlayer products in order to increase the scalability, reliability and flexibility of specialized networks, such as enterprise and ISP networks, and minimize incoming bandwidth requirements through intelligent management of live and on-demand content requested by users in these networks. We license our server and gateway products based on units deployed, features and streaming capacity. We offer a variety of server product configurations to meet the varying needs and requirements of broadcasters, enterprises and content providers.

     Helix Software Development Kits.RealNetworks makesWe create software development kits (known as SDKs) available for free download and licensing to software developers. SDKs allow developers to create new software products that are compatible with and complementary to the RealOne Playerour RealPlayer, Real Tools and the Helix products. The Helix SDK, the architecture upon which the RealOne PlayerRealPlayer and the Helix Universal Server, Proxy and Gateway are built, describes

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programming interfaces and processes by which a developer may build applications for the Helix Platform (described below). The Helix ProducerRealProducer SDK similarly describes interfaces and processes, and includes object code, to enable developers to create applications that convert audio, video and events and image map data into RealNetworksour file formats. The RealOneRealPlayer Digital Distribution SDK provides third-party device manufacturers an application programming interface to transfer music data from the RealOne PlayerRealPlayer music database to portable devices, such as MP3 players and removable storage peripherals.

     Helix Community and Helix Platform.In July 2002, we announced the creation of theThe Helix Community is a collaborative developer network that enables software developers and technology companies to license, enhance, and build products from the core source code of our producer, server and player products. This enables creation of products that support not only our RealAudio and RealVideo formats, butand also standards-based formats such as MP3 and third party proprietary formats.formats, protocols and standards. The source code products made available via the Helix Community are called Helix DNA Products. The Helix DNA Producer, Helix DNA Server and Helix DNA Client together form the Helix DNA Platform.

     Our Helix strategy is designed to address and leverage the needs and interests both of commercial products companies and of the “open source” community that has made products like the Linux operating system and Apache successful in the market.web server platform successful. As part of this strategy, the Helix Community offers the source code of the Helix DNA Platform under two source code licenses, the RealNetworks Community Source License (RCSL)(“RCSL”) and the RealNetworks Public Source License (RPSL)(“RPSL”). The RCSL is structured to ensure that products built under the RCSL remain compatible with the Helix interfaces while allowing Helix Community members to create their own proprietary, value-added extensions. In most cases, the RCSL is a royalty-bearing license that will deliverdelivers royalty revenue to us when third parties sell products that include the Helix DNA technology. The royalty-free RPSL is structured to provide developers greater flexibility in their use of the source code with the requirement that any products they build using Helix are also open source. The RPSL is an Open Source Initiative-certified open source license.

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     We believe that opening the Helix DNA ProductPlatform source code to a community of other developers will deliverdelivers several important commercial benefits to us, including:

 • Increasing the number of third party products that include support for our protocols, formats and digital rights management system, thus increasing the strength of our ecosystem in each of its core constituencies;system;
 
 • Increasing the number of non-PC consumer devices to which we can deliver our premium media subscription services;
 
 • Generating royalty revenue;
 
 • Expanding the capabilities of our platform; and
 
 • Reinforcing in the minds of our partners and commercial customers that our platform is open, durable, and standards-compliant.

Mobile Products

     InWe have created enhanced versions of our Helix and Real products for use in wireless applications. These modified products include the first six months followingHelix Universal Server — Mobile, the Helix Universal Gateway — Mobile, the Helix Mobile Producer and the Mobile RealPlayer. Helix Universal Server Mobile is a streaming media software system designed to deliver media experiences to mobile handsets over wireless networks. Helix Universal Server — Mobile enables business customers to deliver live and on-demand programming in all major media formats as well as other standards-based formats to RealPlayers and 3GPP compatible mobile clients over 2.5G and 3G networks as well as over the public Internet.

     We license our announcementserver software and products to a variety of mobile network operators on a worldwide basis, including Vodafone and Sprint. The majority of wireless carriers are located internationally and as a result, to date, the majority of our mobile system software sales have been made to international wireless carriers. We have also entered into agreements with mobile handset manufacturers to preinstall our mobile player software on mobile handsets. We have agreements with some of the Helix Community, more than 10,000 people registeredleading handset manufacturers,

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including Nokia and Motorola, the two leading handset manufacturers. These agreements typically require the handset manufacturers to joinpay per unit fees to us for each handset shipped with a version of our mobile media player software, although the community,agreements do not typically require the manufacturers to ship our software and several new development projects were commenced thatto date we believe could add significant valuehave not received substantial per unit royalties from these arrangements.

     Our mobile media software player, the RealPlayer Mobile, enables consumers to access streaming or downloaded content via 2.5G and 3G mobile networks. Users can also access mobile content by synchronizing content to their device using the RealPlayer on the PC and the appropriate device plug-in. RealPlayer Mobile is available for a variety of platforms, including Symbian OS, Palm OS 5, Openwave, Linux, and PocketPC for PDAs and is also available on select handsets, including the Nokia 9200 and 9500 Series Communicators and Nokia Series 60 phones. To date, the majority of these services have been provided in the U.S.

We also make mobile content subscription services available to wireless carriers for sale to end-users. These services offer content similar to our platform.RealOne SuperPass service on PCs, including news, sports, and entertainment content from a variety of content providers. To date, the majority of these services have been provided in the U.S. via AT&T Wireless and Sprint PCS to consumers using handsets that incorporate the RealPlayer Mobile or other Java-based or BREW-based media players.

Managed Application Services

     Media Hosting and Delivery.Real Broadcast Network is ourWe offer a range of outsourced managed broadcast service through which we provide hostingapplication services for Internet delivered media on behalf of broadcasters, enterprises and content providers. Through Real Broadcast Network, we provide full turnkeyrights holders. These services including thecan include hardware, facilities, software, personnel, network connectivity, and bandwidth necessarysatellite/ telephony signal acquisition to enable businesses to deliver both live scheduled and on-demand programming services over the Internet. Real Broadcast Network’s distributed architectureOur services offerings include media acquisition, live event management, media hosting and management, secure media delivery, subscription management, payment processing, software delivery and management, promotion and merchandising and end-user customer support. We offer turnkey options for outsourcing both promotional public content services (e.g. public company earnings announcements) as well as conditional access content services for both premium consumer services (e.g. subscription and pay-per-view) and private business services. We have built out a substantial proprietary infrastructure with proprietary software and operational capabilities to enable large scale end-user services in a reliable and cost efficient manner. This same infrastructure and operational environment is designed to improve Internet broadcasts by routing consumers to the nearest broadcast hub on the Internet. Real Broadcast Network offers a wide range of proprietary customer applicationsalso used by radio stations, TV stations, cable networks, enterprises and financial services companies. We also use Real Broadcast Network to deliver our own consumer subscription and advertising-supported services.

Advertising

Professional Technical Services and Support

     We market and sell advertising on our Web sites and client software. Our primary Web presence consists of two Web sites, Real.com and RealOne.com. The Real.com and RealOne.com sites showcase our premium software and subscription service offerings, including RealOne SuperPass, RealOne RadioPass, RealOne MusicPass and RealArcade. Also accessible from our sites, RealOne Guide offers visitors the ability to search for and locate multimedia content on the Internet and in our RealOne subscription service. We have developed eleven localized foreign editions of the RealOne Guide for users outside of the United States and Canada. Our RealOne products and services offer broad reach to advertisers as well as contextually relevant and demographically segmented targeting opportunities to Internet advertisers. RealOne, as an advertising platform, combines the broadcast capabilities of televisionIn connection with the direct response attributeslicensing of the Internetour business software products, we also provide professional technical services and specialized technical support to deliver an interactive advertisingcertain customers. The nature of these services vary from customer-to-customer and marketing experiencefrom period-to-period. In general, these services are designed to the end user.customize and integrate our technology with our customers existing systems and technology.

Research and Development

     We devote a substantial portion of our resources to developing new products, enhancing existing products, expanding and improving our fundamental streaming technology and strengthening our technological expertise. During the years ended December 31, 2003, 2002 2001 and 2000,2001, we expended approximately 26%23%, 30%26% and 24%30%, respectively, of our total net revenues on research and development activities. As of December 31, 2002, RealNetworks had 304 full-time employees, or approximately 44% of our work force, engaged in research and development activities.

Sales, Marketing and Distribution

     We believe that any individual, company, government or other organization that desiressell our products and services to customers who want to send, support, manage or receive multimedia content delivered over the Internet is a potential customer.network. To reach as many of these potential customers as possible, we sell and distribute our business products and services through several distribution channels,

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both directly (over the Internet and through a sales force) and indirectly (through original equipment manufacturers (“OEMs”), value added resellers (“VARs”) and other distributors). As of December 31, 2002, we had 283 full-time employees, or approximately 41% of our work force, engaged in sales, marketing and distribution activities.

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     Electronic Commerce.Substantially allMany of the products,business and consumer subscription services and system software products we sell can be purchased and delivered directly from our Web sites. Our Web sites provide us with a low-cost, globally accessible sales channel that is available 24 hours per day, seven days per week.

     Direct Sales Force.Our direct sales force primarily markets and sells our software systemsbusiness products and services to enterprise, infrastructure, mobile, broadband and media customers. We also have an advertising sales force that markets and sells advertising on our Web sites and client software. We have subsidiaries and offices in several other countries whichthat market and sell our products outside the United States and we use a third party advertising representation firm to sell international advertising inventory.

     OEMs and VARs.We have entered into various distribution relationships with third parties pursuant to which our products and technologies are incorporated into, bundled with or offered with third-party products for delivery by the third party directly or indirectly to end users. For example, we have entered into distribution agreements with PC manufacturers to pre-install our RealOne PlayerRealPlayer software on computers that are intended for sale to non-corporate end users.

     Sales Through Other Distributors.We sell our software systemsbusiness products and services to other distributors, including hardware server companies, content aggregators, ISPs and other hosting providers that redistribute or provide end users access to our streaming technology from their Web sites and systems. We have agreements with many popular software and hardware companies and Web sites to distribute our products as a click-through or to bundle our player products into their applications and software.

     Marketing Programs.Our marketing programs are aimed at increasing brand awareness of our products and services, stimulating market demand and educating potential customers about the economic opportunities in delivering multimedia content over the Internet. We have a number of marketing initiatives, including:

 • ShowcasingAdvertising and marketing our various products and solutions in trade shows, conferences and seminars;services to our end users;
 
 • Providing product-specific information through our Web sites;Advertising products and services in print, electronic and other online media;
 
 • Promoting and co-promoting special events with our partners in fields such as broadcasting, music and professional sports;
 
 • Advertising productsDirect mail and services in print, electronice-mail offers to qualified potential and other online media;existing customers;
• Providing product-specific information through our Web sites; and
 
 • AdvertisingShowcasing our various products and marketing our RealOne services to our end users.solutions in trade shows, conferences and seminars.

History

     We were incorporated in February 1994 and were in the development stage until July 1995, when we released the commercial version of RealAudio Version 1.0, the first version of our RealPlayer products. In August 1996, we began selling RealPlayer Plus, a premium version of our RealPlayer product. Since its initial release, RealPlayer has been available for download free of charge from our Web sites. In December 1997, we released the commercial version of RealSystem Version 5.0, a streaming media solution that included RealAudio and RealVideo technology. In September 1999, we released the commercial versions of RealJukebox and RealJukebox Plus, a personal music management system. In August 2000, we released the gold versions of RealPlayer 8 and RealJukebox 2, and launched RealPlayer GoldPass, a for-pay media subscription service available to RealPlayer Plus customers. In March 2001, we introduced RealArcade, an end-to-end platform for the digital distribution of PC games benefiting both developers and consumers. In June 2001, we launched RealSystem Media Commerce Suite, a platform for Internet media commerce that is intended to provide a universal platform for secure distribution of digital movies, music, and other content. In December 2001, we launched our RealOne subscription service which incorporates our RealPlayer and RealJukebox products together with a new media browser and content to create a multi-dimensional media

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experience for consumers. In June 2002, we launched RealOne Europe, a European edition of our RealOne subscription service. In July 2002, we announced Helix, an open, comprehensive Internet media delivery platform and community to enable creation of digital media products and applications for any format, operating system or device. In September 2002, we launched RealOne Player Version 2.0.

Customers

     Our customers include consumers and businesses located throughout the world. Sales to customers outside the United States, primarily in Asia and Europe, were approximately 28%27%, 29%28% and 27%29% of total net revenues in the years ended December 31, 2003, 2002 2001 and 2000,2001, respectively.

Customer Support

     OurCustomer support is integral to the provision of our consumer products and services and important to the success of our system software customers.

Consumer Products and Services Customer Support

     Consumers who use our consumer software products and services, including games, music, news, sports and entertainment services, can get assistance via the Web, e-mail or telephone. Telephone support is limited to those customers have a choice ofwho purchase our products. We contract with third-party outsource support options depending on the level of service desired and the nature of the products acquired. We provide customer support through our customer support department and through third-party contractors. Customers can access a technical support hotline to receive answers to inquiries or initiate e-mail inquiries and we provide an online database of technical information for customer self-service. We also offer RealNetworks Platinum Services which provides 24-hour, seven days per week support and dedicated on-site support to our major systems customers. As of December 31, 2002, we employed 16 full-time technical and customer support representatives, approximately 2% of our work force, to respond to customer requests for support. We also rely on third-party vendors to provide the primary staffing for thefirst-tier customer support function globally.

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Business Products and Services Customer Support

     We provide various support services options for our business customers using our systems, tools and middleware software products as well as our managed application services. We also provide support services to software developers using our products and technologies. Support service options include hotline telephone support, online support services and on-site support personnel covering technical and business-related support topics. We provide a range of support response levels and availability commitments to different customer segments based on the nature of products they purchase from us as well as the desired turnaround times and overall involvement in problem solving that the customer requests from us. We also offer outsourced end-user support services as an option for certain business customers in conjunction with our consumer business.managed application services offerings.

Competition

     The market for software and services for media delivery over the Internet is relatively new, constantly changing and intensely competitive. As media delivery evolves into a central component of the Internet experience, more companies are entering the market for, and expending increasing resources to develop, media delivery software and services. We expect that competition will continue to intensify.we face intense competition. Many of our current and potential competitors have longer operating histories, greater name recognition, more employees and significantly greater financial, technical, marketing, public relations and distribution resources than we do. In addition, new competitors with potentially unique or more desirable products or

Consumer Products and Services

     Our multimedia content services are entering the market all the time. The competitive environment may require us to make changes in(including our products, pricing, licensing, services or marketing to maintain and extend our current brand, technology and services businesses.

Subscription Services.OurRealOne SuperPass subscription servicesservice) are a relatively new business modelmodels for delivering media over the Internet and represent a new and rapidly evolving business modelmodels for us. We believe that our subscription services and other music offerings compete with both traditional and online entertainment service providers although, to date, we have not faced significant direct competition with our subscription service offerings.providers. We anticipate increasing competition for online subscriptionmedia service revenues from a wide range of companies, including AOL Time Warner, Microsoft and Yahoo!, which has recently launched a service to compete with our subscription services, as well as other Internet portals and broadband service providers. Many of these providers have significantly more resources than we have, including access to content, and some of our competitors may be able to leverage their experience in providing subscription or similar services to customers in other businesses to the sale of digital media subscriptions.content. In order to increase our subscription service revenues,compete successfully in these markets, we must continue to obtain premium digital content in order to maintain and increase subscriptions and overall customer satisfaction. To date, a limited amount of premium digital content has been made available for delivery over the Internet that can only be accessed through a for-pay service and not for free.

     In conjunction with We compete in the releasemultimedia content market primarily on the basis of the RealOne Playerquality and quantity of the content available in our RealOne subscription services, we also releasedthe quality and usability of our RealOne MusicPass service, a for-paymedia player products, the reach of our media formats, as well as the perceived value of our products and services to consumers.

     Our Rhapsody music subscription service based upon the platform of MusicNet. Our music subscription services willand our RealPlayer Music Store face competition from traditional offline music distribution competitors and from other online digital music services, including pressplay, MusicMatchApple’s iTunes music store, Walmart.com’s music store, Roxio’s Napster music subscription service, and a wide variety of other competitors who are now offering digital music for sale over the Web. We expect that Microsoft will also begin offering premium music services in conjunction with its Windows Media Player which is bundled with the Windows operating system. Our Rhapsody service competes primarily on the basis of the quality and quantity of the music catalog that is available to subscribers, the overall user experience, the perceived value of that experience to the consumer and the Rhapsodyeffectiveness of our distribution network. As the market for purchasing music service provided by Listen.com. Competingonline grows, we expect that competition for subscribers and purchasers will become increasingly intense. Apple and Roxio have spent substantial amounts to market and promote their respective services may be ableand we expect those investments to obtain more or bettercontinue as companies attempt to win new consumers for their services. In addition, we believe that Apple’s sale of low margin digital music content than MusicNet, or may be abledownloads is being used to license such content on more favorable terms than MusicNet. RealOnedrive sales of Apple’s higher margin hardware products. Accordingly, we believe that Apple will continue to spend significantly to market and promote the sale of downloadable music to further this business model.

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MusicPass     Our music offerings also facesface substantial competition from “free” peer-to-peer services. Although several of these “free” services have been found to be illegally violating copyright laws, enforcement efforts to date have not effectively shut down these services and there can be no assurance that thesesome recent decisions call into question whether peer-to-peer services will ever be shut down.violate copyright laws. The ongoing presence of these “free” services even if they are subsequently found to be illegal, substantially impairs the marketability of legitimate services such as RealOne MusicPass.
Rhapsody and the RealPlayer Music Store.

     There are two distinct components of our games business: our distribution platform — RealArcade, and our content studio — GameHouse. These two businesses have very different competitive landscapes. RealAr-

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cade competes with high volume distribution channels for downloadable games including Yahoo Games, MSN Gamezone, Pogo.com and Shockwave. We compete in this market primarily on the basis of the quality and convenience of our RealArcade service, the nature and quality of our distribution arrangements and the quality and breadth of our game catalog. Our GameHouse studio unit competes with other developers and publishers of downloadable games. In this business we compete based on our ability to develop and publish high quality games that resonate with our audience, our effectiveness at building our brands and our ability to secure distribution relationships for our titles.
Media Technologies.Business Products and Services

We believe that the primary competitive factors in the media delivery market include:

 • the quality, reliability, price and licensing terms of the overall media delivery solution;
 
 • ubiquitous and easy consumer accessibility to media playback capability;
• access to distribution channels necessary to achieve broad distribution and use of products;
• the availability of valuable, compatible and marketable content for delivery over the Internet;
 
 • the ability to license or develop, support and distribute secure formats and digital rights management systems for digital media delivery, particularly music and video, which includes the ability to convince consumer electronics makers to adopt our technology and the willingness of content providers to use our digital rights management technology;
 
 • the ability to license and support popular and emerging media formats for digital media delivery in a market where competitors may control the intellectual property rights for these formats;
 
 • the size of the active audience for streaming and digital media and its appeal to content providers and advertisers;
• scalability of streaming media and media delivery technology and cost per user;
 
 • the ability to obtain any necessary patent rights underlying important streaming media and digital distribution technologies that gain market acceptance; and
 
 • compatibility with new and existing media formats, and with the user’s existing network components and software systems;
• the build-out and deployment of broadband infrastructures and technologies; and
• challenges caused by bandwidth constraints and other limitations of digital delivery infrastructure.systems.

     Microsoft is a principal competitor in the development and distribution of digital media and media distribution technology. Microsoft currently competes with us in the market for digital media servers, players, encoders, digital rights management, codecs and other technology and services related to digital distribution of media. Microsoft’s commitment to and presence in the media delivery industry has increased and we expect that Microsoft will continue to increase competitive pressure in the overall market for digital media and media distribution.

     Microsoft distributes its competing streaming media server, player, tools and digital rights management products by bundling them with its Windows operating systems, including Windows NT and Windows XP, at no additional cost or otherwise making them available free of charge. Microsoft’s practices have caused, and may continue to cause, pricing pressure on our revenue generating products and services and affect usage of our competing products and formats. We believe that Microsoft has used and may continue to use its monopoly position in the computer industry and its financial resources to secure preferential or exclusive distribution, use and bundling contracts for its media delivery technologies and products with third parties, such as ISPs, content delivery networks, content providers, entertainment and media companies, VARs and OEMs, including third parties with whom we have relationships. Microsoft has also invested significant money in, has provided substantial financial incentives to, or offered or conditioned placement on or through the Windows operating system, the Internet Explorer Web browser and Microsoft’s MSN service to certain of our current and potential customers and content suppliers. Such arrangements, together with Microsoft’s aggressive marketing of its Windows operating systems, server products and digital media products, may reduce our share of the streaming media and digital distribution markets. While courts have ruled that several of Microsoft’s practices violated relevant laws related to illegal maintenance of monopoly power, court remedies to date have had only

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a minor impact. There can be no assurance that there will be future court remedies against Microsoft’s illegal actions, or if there are any such future remedies, there can be no assurance that these remedies will be effective in curtailing these activities

Microsoft’s Windows Media Player competes with our media player products. We expect that by leveraging its monopoly position in operating systems and tying streaming or digital media into its operating systems and its Web browser, Microsoft will distribute substantially more copies of the Windows Media Player in the future than it has in the past and may be able to attract more users and content providers to use its streaming or digital media products. In addition, Microsoft does not document or expose all of the interfaces that would allow our products to take full advantage of the features and functionality of Windows XP that it makes available to the Windows Media Player. Microsoft’s Windows Media Player

     We also competes with the personal music management features of the RealOne Player. The Windows Media Player supports the Windows Media format, but not RealNetworks’ media formats. Microsoft also licenses various Windows Media Technology applications for authoring, delivering and playing digital media intended to compete with our system software products, and supports and promotes other third party products competitive to our products. In addition, Microsoft provides servers that support Windows Media Technologies at no additional cost to customers who purchase its Windows servers, whereas we offer versions of our competitive servers for sale. Microsoft bundles its Windows Media Server product with its server operating systems. In some cases, Microsoft has conditioned use of the Windows Media Digital Rights Management and security technologies supported by Windows XP to support for Windows Media formats and use of Windows Media Player and servers. We compete with Microsoft and Sony Corporation in the market for digital rights management technologies. Sony’s recent acquisition of digital rights management patents from Intertrust in conjunction with Philips Electronics indicates that Sony may increase its focus on competing with us in the market for digital rights management technology.

     Microsoft also competes with us in attempting to acquire from broadcasters and other owners high quality or popular content to promote and deliver such content in Microsoft’s formats, in some cases on an exclusive or preferential basis. This may harm both our systems software businesses and our player businesses. Our player products may be disadvantaged if they cannot play content in Windows Media formats or content that is secured by the Windows Media Digital Rights Management technology, or if content providers do not also make their content available in RealNetworks’ media formats using digital rights management systems supported by us. In some cases, we believe Microsoft uses its financial resources and monopoly leverage to obtain rights to such content, and to provide incentives to content providers to prepare their content in Microsoft’s formats. Microsoft’s commitment to and presence in the media delivery industry has increased and we believe that Microsoft will continue to increase competitive pressure in the overall market for streaming media and media distribution.

     In addition to Microsoft, we face competition from other companies that develop and market streaming media products. For example, Apple Computer offers the QuickTime streaming media technology, including a free media player and a free streaming media server, and licenses for free source code to the server under the conditions of Apple’s end user license agreement. Apple also offers competitive music management software and hardware. Apple has also enlisted the open source code community to assist its development of competitive products. Other than Microsoft and Apple, we have other competitors in the streaming media systems business,

     While some of which have greater resources than us.

     We do not believe that completeindustry standards have emergedbeen specified with respect to non-PC wireless and cable-based systems, though participantsthese standards have not had a significant market impact in those industries generally express support for the evolutionterms of industry-wide standards which may disfavor proprietary solutions.mobile media consumer usage. Likewise, no single company has yet gained a dominant position in the mobile device market. However, certain third party products and services in these marketsthis market support our technology, and certain products and services support our competitors’ technologies, especially Microsoft, which can use its monopoly position in the operating system

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business and other financial resources to gain access to these markets, potentially to our exclusion. In addition, our brand and capabilities are not as well known in thesethis market sectorssector, which has created and may continue to create opportunities for smaller competitors to effectively compete with us, especially in the market for mobile devices outside the United States.

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Media Hosting and Delivery.Our media hosting and delivery service, the Real Broadcast Network, competes with a variety of companies that provide streaming media hosting and broadcast services. Some of these competitors have cost or other advantages over our services and offer other services which Real Broadcast Network does not offer, such as Web page hosting or broadcast hosting in media formats not supported by Real Broadcast Network. Some of our media hosting competitors are also customers on whom we rely to help drive product download traffic to our Web sites through their broadcast events. We also sell servers and tools to competitors that compete with Real Broadcast Network.

Web Site Destinations, Content and Advertising.Our Web sites compete for user traffic and Internet advertising revenues with a wide variety of Web sites, Internet portals and ISPs. In particular, aggregators of audio, video and other media, such as Yahoo! Broadcast Services and Microsoft’s Windows Media Guide, compete with us.

Intellectual Property

     As of December 31, 2002,2003, we had 4556 registered U.S. trademarks or service marks, and had applications pending for several more U.S. trademarks. We also have several unregistered trademarks. In addition, we have several foreign trademark registrations and pending applications. Many of our marks begin with the word “Real” (such as RealOne,RealPlayer, RealAudio and RealVideo). We are aware of other companies that use “Real” in their marks alone or in combination with other words, and we do not expect to be able to prevent all third-party uses of the word “Real” for all goods and services.

     As of December 31, 2002,2003, we had 2024 U.S. patents and numerous patent applications on file relating to various aspects of our technology. We are continuously preparing additional patent applications on other current and anticipated features of our technology.

     To protect our proprietary rights, we rely on a combination of patent, trademark, copyright and trade secret laws, confidentiality agreements with our employees and third parties, and protective contractual provisions. These efforts to protect our intellectual property rights may not be effective in preventing misappropriation of our technology, or may not prevent the development and design by others of products or technologies similar to or competitive with those we develop.

Employees

     At December 31, 2002,2003, we had 689740 full-time employees and seven4 part-time employees, 602583 of whom were based at our executive offices in Seattle, Washington, 6372 of whom were based at RealNetworks’our offices in Australia, Brazil, Canada, France, Germany, Hong Kong, Japan, China, Mexico, Singapore South Korea and the United Kingdom, and 3189 of whom were based at other locations. None of our employees are subject to a collective bargaining agreement, and we believe that our relations with our employees are good.

Position on Charitable Responsibility

     In periods where we achieve profitability, (excluding the effects of goodwill and other acquisition charges), we intend to donate 5% of our annual pre-tax net income to charitable organizations, which will reduce our net income for those periods. The non-profit RealNetworks Foundation manages our charitable giving efforts. We attempt to encourage employee giving by using a portion of our intended contribution to match charitable donations made by employees.

Available Information

     Our corporate Internet address iswww.realnetworks.com. We make available free of charge onwww.realnetworks.comour annual, quarterly and current reports as soon as reasonably practicable after we electronically file such material with, or furnish it to, the SEC. However, the information found on our Web site is not part of this or any other report.

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Item 2.Properties

     We lease our corporate headquartersthree separate principal properties in the United States, two of which are located in Seattle, Washington.Washington and one which is located in San Francisco, California. The lease for our corporate headquarters, located in Seattle, commenced on April 1, 1999 and expires on March 31, 2011, with an option to renew for either a three- orthree-or a ten-year period. As of December 31, 2002,At this location we lease approximately 280,000 square feet at an average monthly rent of approximately $566,000. In addition,$472,000. At a second location in Seattle, we lease approximately 133,000 square feet of additional office space in a second location in Seattle, Washington at an average monthly rent of approximately $381,000 under a lease which commenced on October 1, 2000 and which expires on September 30, 2010. In 2001, we re-evaluated our facilities requirements and as a result, decided to attempt to sublet all of this office space for the remainder of

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the term of our lease. Our lease in San Francisco commenced on August 4, 2003 in connection with our acquisition of Listen.Com and expires on November 30, 2004. This lease is for approximately 28,750 square feet of office space at an average monthly rent of approximately $37,000. We also lease other office space in the United States and various other countries.
 
Item 3.Legal Proceedings

     See “Notes to Consolidated Financial Statements — Commitments and Contingencies” (Note 12)14C) for information regarding legal proceedings.

 
Item 4.Submission of Matters to a Vote of Security Holders

     No matters were submitted to a vote of RealNetworks’ shareholders during the fourth quarter of its fiscal year ended December 31, 2002.2003.

Executive Officers of the Registrant

     The executive officers of RealNetworks as of March 15, 20038, 2004 were as follows:

       
NameAgePosition



Robert Glaser  4142  Chairman of the Board and Chief Executive Officer
Lawrence Jacobson  4445  President
Phillip BarrettMartin Plaehn  4946  SeniorExecutive Vice President — Products and Services
Merrill BrownRichard Wolpert  5041Chief Strategy Officer
Roy Goodman46  Senior Vice President, — RealOne ServicesChief Financial Officer and Treasurer
Kelly Jo MacArthur  3839  Senior Vice President and Chief of Staff
Martin PlaehnDan Sheeran  4537  Senior Vice President — Software ProductsMarketing
Carla Stratfold  4344  Senior Vice President — North American Sales
Brian V. TurnerRobert Kimball  4340  Senior Vice President, FinanceLegal and Operations, Chief Financial OfficerBusiness Affairs, General Counsel and TreasurerCorporate Secretary

     ROBERT GLASER has served as Chairman of the Board and Chief Executive Officer of RealNetworks since its inception in February 1994, and as Treasurer from February 1994 to April 2000. He also serves as RealNetworks’ Policy Ombudsman, with the exclusive authority to adopt or change the editorial policies of RealNetworks as reflected on its Web sites or in other communications or media in which RealNetworks has a significant editorial or media voice. Mr. Glaser holds a B.A. and an M.A. in Economics and a B.S. in Computer Science from Yale University.

     LAWRENCE JACOBSON has served as President of RealNetworks since February 2003. From February 2001 to February 2003, Mr. Jacobson served as President and Chief Operating Officer of RealNetworks. From January 2000 to January 2001, Mr. Jacobson served as President and Chief Operating Officer of Ticketmaster Corporation, the leading ticketing services company. From 1990 to January 2000, Mr. Jacobson was employed at News Corporation, a global media and distribution company, where he held various positions within its subsidiaries, most recently serving as President of the FOX Television Network. Mr. Jacobson holds a B.A. in Economics from Harvard College and an M.B.A. from Harvard Business School.

     MARTIN PLAEHN has served as Executive Vice President, Products and Services of RealNetworks since June 2003. Mr. Plaehn served as Senior Vice President, Software Products from February 2003 to June 2003, and from September 1999 to February 2003, Mr. Plaehn served as Senior Vice President, Media Systems of RealNetworks. From April 1996 to August 1999, Mr. Plaehn served as President of Viewpoint Digital and as its Chairman and CEO until its acquisition by Computer Associates in October 1998. Mr. Plaehn holds a B.A. from the University of California San Diego and is a graduate of UCSD’s Executive Program for Scientists and Engineers.

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     PHILLIP BARRETTRICHARD WOLPERT has served as Chief Strategy Officer of RealNetworks since June 2003. From September 2000 to June 2003, Mr. Wolpert served as the Strategic Advisor of RealNetworks. From 1998 to September 2000, Mr. Wolpert served as the partner in charge of Internet and technology ventures for The Yucaipa Companies, a private investment firm. From 1996 to 1998, Mr. Wolpert served as President of Disney Online, a business unit of the Walt Disney Internet Group, where he was responsible for the company’s business and creative strategy. Mr. Wolpert holds a B.S. degree from UCLA.

     ROY GOODMAN has served as Senior Vice President, Chief Financial Officer and Treasurer of RealNetworks since FebruarySeptember 2003. From JulyApril 2000 to FebruaryJanuary 2003, Mr. BarrettGoodman served as Senior Vice President-Consumer ProductsChief Financial Officer of RealNetworks.Juniper Financial Corporation, a company engaged in the issuance of credit cards. From July 19981980 to JulyMay 2000, Mr. Barrett servedGoodman was employed by Heilig-Meyers, a publicly traded home-furnishings retailer, serving as Senior Vice President — Media Technologies of RealNetworks,Chief Financial Officer from January 1997 to July 1998, he served as Senior Vice President — Media Systems of RealNetworks, and2000. Mr. Goodman holds a B.S. in Finance from November 1994 to January 1997 he served as Vice President — Software Development of RealNetworks. From March 1986 to October 1994, Mr. Barrett was a Development Group Manager at Microsoft, where he led development efforts for Windows 386, Windows 3.0 and Windows 3.1. Mr. Barrett holds an A.B. in Mathematics from Rutgers UniversityVirginia Tech and an M.S. in Computer SciencesMBA from the University of Wisconsin, Madison.

     MERRILL BROWN has served as Senior Vice President-RealOne Services since August 2002. From August 1996 to June 2002, Mr. Brown was employed by MSNBC.com, an online news service, most recently serving as Senior Vice President and Editor-in-Chief. From 1994 to 1996, Mr. Brown served as a media and communications consultant to several media ventures, including Time Inc., NBC and U.S. West. From 1990 to 1994, Mr. Brown held the position of Senior Vice President, Corporate and Program Development for Court TV. Mr. Brown has also served as Editor-in-Chief at Channels Magazine and as a business writer and correspondent for The Washington Post. Mr. Brown holds a B.A. in Political Science from Washington University, St. Louis.Richmond.

     KELLY JO MACARTHUR has served as Senior Vice President and Chief of Staff of RealNetworks since January 2003. Ms. MacArthur held the positions of Senior Vice President, Legal and Business Affairs, General Counsel and Corporate Secretary of RealNetworks from April 2000 to January 2003, and Vice President and General Counsel of RealNetworks from October 1996 to April 2000. From 1995 to 1996, Ms. MacArthur served as General Counsel and Director of Business Affairs for Compton’s NewMedia, Inc. From 1989 to 1994, Ms. MacArthur was an attorney with the firm of Sidley & Austin in Chicago. Ms. MacArthur graduatedsumma cum laudefrom the University of Illinois at Champaign-Urbana and holds a J.D. from Harvard Law School.

     MARTIN PLAEHNDAN SHEERAN has served as Senior Vice President-Software ProductsPresident, Marketing of RealNetworks since FebruaryJune 2003. From SeptemberAugust 2001 to June 2003, Mr. Sheeran served as Vice President, Media Systems Marketing of RealNetworks. From 1999 to February 2003,August 2001, Mr. PlaehnSheeran served as Senior Vice President — Media Systems of RealNetworks.Worldwide Sales and Marketing of nCUBE, a provider of on-demand media systems and digital advertising systems for cable operators and telecommunications network providers. From April 19961994 to August 1999, Mr. PlaehnSheeran served as President of Viewpoint Digital and as its Chairman and CEO until its acquisition by Computer Associates in October 1998. From 1990 to 1996, Mr. Plaehn served as ExecutiveSenior Vice President, Product Management at SkyConnect, a provider of Business and Product Development and was a member ofdigital video management solutions for the Board of Directors of Wavefront Technologies Inc., which was acquired by Silicon Graphics in 1995.cable television industry. Mr. Plaehn started his career as a software developer at General Atomic Company in 1978, ISSCO Graphics in 1980, and Template Graphics Software from 1982 to 1990. Mr. PlaehnSheeran holds a B.AB.S. in the School of Foreign Service,cum laude, from theGeorgetown University, of California San Diego and is a graduate of UCSD’s Executive Program for Scientists and Engineers.an M.B.A. from Northwestern University.

     CARLA STRATFOLD has served as Senior Vice President-NorthPresident, North American Sales of RealNetworks since May 2001. From December 1998 to March 2000, Ms. Stratfold served as Vice President of Business Development of BackWeb Technologies Ltd., a provider of Internet communication infrastructure software. From 1988 to November 1998, Ms. Stratfold was employed by Oracle Corporation, a leading supplier of software for information management, where she held various positions, most recently serving as Vice President of Product Sales and Marketing. Ms. Stratfold holds a B.S. in Political Science from Washington State University.

     BRIAN V. TURNERROBERT KIMBALL has served as Senior Vice President, FinanceLegal and Operations, Chief Financial OfficerBusiness Affairs, General Counsel and TreasurerCorporate Secretary of RealNetworks since October 2001. From December 2000 to October 2001,January 2003. Mr. Turner served as President, Chief Operating Officer and Secretary, andKimball held the positions of Associate General Counsel of RealNetworks from AprilMarch 1999 to December 2000, as SeniorApril 2001, and Vice President, Legal and Business Affairs of Operations, Chief Financial Officer and Secretary of BSQUARE Corporation, a company engagedRealNetworks from May 2001 to January 2003. Before joining RealNetworks in the development, marketing and support of a variety of software products and services for the development and deployment of intelligent computing devices. From September 1995 to April 1999, Mr. Turner served as theKimball was Senior Vice PresidentAttorney and Manager of Operations and Chief Financial Officer of RadiSys Corporation, a manufacturer and designer of computers. Between July 1982 and September 1995,Business Relations for IBM Global Services. Mr. Turner was employed by PricewaterhouseCoopers LLP, an accounting firm, most recently as a director in

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Corporate Finance. Mr. Turner holdsKimball has a B.A. degree in international political science and a B.B.A. in accountingwith distinction from the University of Washington.
Michigan and a J.D.,magna cum laude, from the University of Michigan Law School.

PART II.

Item 5.Market for Registrant’s Common Equity and Related Shareholder Matters

     RealNetworks’ common stock has been traded on the Nasdaq National Market under the symbol “RNWK” since the Company’s initial public offering in November 1997. There is no assurance that any quantity of the common stock could be sold at or near reported trading prices.

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     The following table sets forth for the periods indicated the high and low sale prices for our common stock, as adjusted for stock splits.stock. These quotations represent prices between dealers and do not include retail markups, markdowns or commissions and may not necessarily represent actual transactions.

Year Ended December 31, 20022003

          
HighLowHighLow




First Quarter $8.95 $5.11  $4.67 $3.02 
Second Quarter 9.28 3.39  9.29 4.15 
Third Quarter 5.03 3.32  7.74 5.05 
Fourth Quarter 4.90 2.68  8.00 4.73 

Year Ended December 31, 20012002

            
HighLowHighLow




First Quarter $12.375 $5.000  $8.95 $5.11 
Second Quarter 15.670 6.125  9.28 3.39 
Third Quarter 12.470 3.260  5.03 3.32 
Fourth Quarter 7.710 4.560  4.90 2.68 

     We have not paid any cash dividends and do not intend to pay any cash dividends in the foreseeable future.

     As of March 20, 2003,10, 2004, there were approximately 756801 holders of record of our common stock. Most shares of our common stock are held by brokers and other institutions on behalf of shareholders.

     The information required by this item regarding equity compensation plans is incorporated by reference to the information set forth in Item 12 of this Form 10-K.

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Item 6.Selected Consolidated Financial Data

     The following selected consolidated financial data should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the Consolidated Financial Statements and Notes to Consolidated Financial Statements included elsewhere in this report.

                                 
Years Ended December 31,Years Ended December 31,


2002200120001999199820032002200120001999










(In thousands, except per share data)(In thousands, except per share data)
Consolidated Statement of Operations Data:
Consolidated Statement of Operations Data:
 
Consolidated Statement of Operations Data:
 
Net revenues:Net revenues: Net revenues: 
Software license fees $72,753 108,586 148,091 90,627 48,487 Software license fees $61,970 72,753 108,586 148,091 90,627 
Service revenues 103,161 64,740 52,505 26,466 14,742 Service revenues 134,058 103,161 64,740 52,505 26,466 
Advertising 6,765 15,579 40,942 14,149 3,148 Advertising 6,349 6,765 15,579 40,942 14,149 
 
 
 
 
 
   
 
 
 
 
 
 Total net revenues 182,679 188,905 241,538 131,242 66,377  Total net revenues 202,377 182,679 188,905 241,538 131,242 
 
 
 
 
 
   
 
 
 
 
 
Cost of revenues:Cost of revenues: Cost of revenues: 
Software license fees 6,865 7,969 14,341 13,006 8,308 Software license fees 9,917 6,865 7,969 14,341 13,006 
Service revenues 41,259 23,895 14,718 6,579 2,631 Service revenues 56,690 41,259 23,895 14,718 6,579 
Advertising 2,145 6,324 9,629 2,906 1,727 Advertising 1,736 2,145 6,324 9,629 2,906 
 
 
 
 
 
   
 
 
 
 
 
 Total cost of revenues 50,269 38,188 38,688 22,491 12,666  Total cost of revenues 68,343 50,269 38,188 38,688 22,491 
 
 
 
 
 
   
 
 
 
 
 
 Gross profit 132,410 150,717 202,850 108,751 53,711  Gross profit 134,034 132,410 150,717 202,850 108,751 
 
 
 
 
 
   
 
 
 
 
 
Operating expenses:Operating expenses: Operating expenses: 
Research and development 48,186 55,904 57,819 38,415 22,480 Research and development 46,763 48,186 55,904 57,819 38,415 
Sales and marketing 73,928 73,129 101,197 53,465 33,460 Sales and marketing 77,335 73,928 73,129 101,197 53,465 
General and administrative 19,820 20,554 27,807 16,380 11,540 General and administrative 21,007 19,820 20,554 27,807 16,380 
Loss on excess office facilities 17,207 22,208    Antitrust litigation 1,574     
Personnel reduction and related charges 3,595 3,613    Loss on excess office facilities 7,098 17,207 22,208   
Goodwill amortization, acquisitions charges, and stock-based compensation (A) 1,328 40,633 142,053 3,531 10,319 Personnel reduction and related charges  3,595 3,613   
 
 
 
 
 
 Goodwill amortization, acquisitions charges, and stock-based compensation(A) 1,120 1,328 40,633 142,053 3,531 
 Total operating expenses 164,064 216,041 328,876 111,791 77,799   
 
 
 
 
 
 
 
 
 
 
  Total operating expenses 154,897 164,064 216,041 328,876 111,791 
 Operating loss (31,654) (65,324) (126,026) (3,040) (24,088)  
 
 
 
 
 
 
 
 
 
 
  Operating loss (20,863) (31,654) (65,324) (126,026) (3,040)
 
 
 
 
 
 
Other income (expense), netOther income (expense), net (727) (13,497) 18,871 9,966 4,135 Other income (expense), net (444) (727) (13,497) 18,871 9,966 
 
 
 
 
 
   
 
 
 
 
 
Net income (loss) before income taxesNet income (loss) before income taxes (32,381) (78,821) (107,155) 6,926 (19,953)Net income (loss) before income taxes (21,307) (32,381) (78,821) (107,155) 6,926 
Income tax provision (benefit) 5,972 (4,058) 2,966   Income tax (provision) benefit (144) (5,972) 4,058 (2,966)  
 
 
 
 
 
   
 
 
 
 
 
 Net income (loss) $(38,353) (74,763) (110,121) 6,926 (19,953) Net income (loss) $(21,451) (38,353) (74,763) (110,121) 6,926 
 
 
 
 
 
   
 
 
 
 
 
Basic net income (loss) per shareBasic net income (loss) per share $(0.24) (0.47) (0.72) 0.05 (0.15)Basic net income (loss) per share $(0.13) (0.24) (0.47) (0.72) 0.05 
Diluted net income (loss) per shareDiluted net income (loss) per share $(0.24) (0.47) (0.72) 0.04 (0.15)Diluted net income (loss) per share $(0.13) (0.24) (0.47) (0.72) 0.04 
Shares used to compute basic net income (loss) per shareShares used to compute basic net income (loss) per share 159,365 160,532 153,870 142,016 130,156 Shares used to compute basic net income (loss) per share 160,309 159,365 160,532 153,870 142,016 
Shares used to compute diluted net income (loss) per shareShares used to compute diluted net income (loss) per share 159,365 160,532 153,870 166,576 130,156 Shares used to compute diluted net income (loss) per share 160,309 159,365 160,532 153,870 166,576 

14


                            
December 31,December 31,


2002200120001999199820032002200120001999










(In thousands)(In thousands)
Consolidated balance sheet data:
  
Cash, cash equivalents and short-term investments $309,071 344,509 364,710 344,627 89,801  $373,593 309,071 344,509 364,710 344,627 
Working capital 248,400 285,279 305,322 273,827 57,746  310,679 248,400 285,279 305,322 273,827 
Total assets 462,101 567,860 578,408 411,124 128,774  580,939 462,101 567,860 578,408 411,124 
Shareholders’ equity 349,765 464,879 480,812 330,559 81,304  366,486 349,765 464,879 480,812 330,559 


(A) For the yearyears ended December 31, 2003 and 2002, this amount includes only stock-based compensation. As of January 1, 2002, the Company adopted new accounting standard SFAS 142, which requires that goodwill no longer be amortized but instead tested at least annually for impairment.

15


 
Item 7.Management’s Discussion and Analysis of Financial Condition and Results of Operations

     The discussion in this report contains forward-looking statements that involve risks and uncertainties. RealNetworks’ actual results could differ materially from those discussed below. Factors that could cause or contribute to such differences include, but are not limited to, those identified below, and those discussed in the section titled “Factors that May Affect Our Business, Future Operating Results and Financial Condition,” included elsewhere in this Report. You should also carefully review the risk factors set forth in other reports or documents that RealNetworks files from time to time with the Securities and Exchange Commission, particularly Quarterly Reports on Form 10-Q and any Current Reports on Form 8-K. You should also read the following discussion and analysis in conjunction with our consolidated financial statements and related notes included in this report.

Overview

     RealNetworks, Inc. is athe leading global providercreator of network-delivered digital media services and the technology that enables digital media creation, distributionsoftware. Consumers use our services and consumption. Our company is at the center of the intersection between technologysoftware to find, play, purchase and digital content.

     Our strategy is to drive the creation of a market for subscription-based digital audiomanage free and video content online, and we believe we are positioned to benefit from this market in three primary ways: (1) as an electronic retailer ofpremium digital content, to consumers; (2) as a business-to-business services provider to third parties who wish to distribute their content to consumers via digital networks;including music, video and (3) as a supplier of the underlying technology needed by content owners andgames. Broadcasters, network operators, media companies and enterprises use our products and services to create and distributedeliver digital content. Since our inceptionmedia to PCs, mobile phones and consumer electronics devices.

     We have been a pioneer in the development of technology for the transmission of digital media over the Internet, and we have helpedused this technology leadership to create a large ecosystembase of consumers, network operators and content owners who use our products and services to create, send and receive both free and paid content. Our strategy is to continue to grow and leverage this base of users to drive the creation of a market for premium digital audio and video content online and generate profitable revenue from this market in two primary ways:

     (1) as a creator, packager and seller of software and digital content to consumers; and
     (2) as a supplier of the underlying technology and business to business services to content owners and network operators to create and distribute digital content.

     Over the last three years, our core business has evolved to address changing dynamics in our industry. We initially developed our business as a leading provider of software technology for the delivery and playback of digital media content over digital networks, and became a leader in that market. We have recently leveraged our technology leadership position and large technology user base to define and develop new markets and businesses predicated on digital media technology. These new businesses principally involve paid digital media content. We have aggressively pursued development of these new businesses, through both internal initiatives and strategic acquisitions of businesses and technologies. As these new businesses have developed, the focus of our core business, including our promotional efforts, has shifted toward these markets and has resulted in significant increases in the number of subscribers to our service offerings. This shift in focus and number of subscribers is reflected in our results of operations in the following primary ways:

• A significant increase in service revenues, including primarily consumer subscription services;
• A significant increase in revenues in our video, music and games businesses; and
• A higher percentage of our total revenues relating to the above areas of our business.

     Despite the growth of our consumer subscription businesses, our overall results have been substantially affected over the last three years by weaker demand for our business software products and services. The weak demand for our business products during this period has been caused primarily by Microsoft’s continuing practice of bundling its competing Windows Media Player and server software for free with its Windows NT operating system products, which we believe is an illegal practice, and also by general macroeconomic conditions. These factors resulted in cutbacks in capital and information technology spending by our

16


customers and potential customers. Some or all of these factors have principally impacted our operating results in the following ways:

• A decline in demand for our business products and services resulting in declines in related revenues;
• Personnel reduction and related charges in 2002 and 2001; and
• Losses on excess office facilities in 2003, 2002 and 2001.

     We report revenues and cost of revenues in three categories:

 • Software license fees, which primarily includeinclude: revenues from sales of premium versions of our RealPlayer Plus and RealJukeboxrelated products; sales of third-party products and content such as game downloads and music copying or “burning;” and sales of our media delivery system software, including RealServer and Helix system software and related authoring and publishing tools, both directly to customers and indirectly through original equipment manufacturer (OEM) channels, and sales of third-party products, including games. The English language version of our RealPlayer Plus and RealJukebox Plus products, which have previously contributed to software license fees, are now combined in our RealOne subscription offering, the revenue from which is included in service revenues.channels;
 
 • Service revenues, which primarily includeinclude: revenues from digital media subscription services such as RealOne SuperPass, MusicPass, RadioPass, Rhapsody, GamePass and GamePass,stand-alone and add-on subscriptions; revenues from support and maintenance services that we sell to customers who purchase our RealPlayer Plus, RealJukebox Plus, and media delivery system software including RealServer and Helix system software, and related authoring and publishing tools,products; revenues from broadcast hosting services we provide through our Real Broadcast Network andservices; revenues from consulting services we offer to our customers.customers; and revenues from distribution of third party software; and
 
 • Advertising revenues which are derived from sales of advertising on our Web sites and consumer software and within the media streams that we host on behalf of our corporate customers.

16     In August 2003, we acquired all of the outstanding securities of Listen. Listen operates an on-demand streamed music subscription service for which it charges monthly subscription fees. It also provides its subscribers with the ability to burn compact discs for which it charges a per-track fee. The results of Listen’s operations are included in our consolidated financial statements since the date of acquisition and impact the comparability of the 2003 financial information when compared to 2002.

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     The following table sets forth certain financial data for the periods indicated as a percentage of total net revenues:

                    
Years Ended December 31,Years Ended December 31,


200220012000200320022001






Net revenues:Net revenues: Net revenues: 
Software license fees 39.8% 57.5 61.3 Software license fees 30.6% 39.8 57.5 
Service revenues 56.5 34.3 21.7 Service revenues 66.3 56.5 34.3 
Advertising 3.7 8.2 17.0 Advertising 3.1 3.7 8.2 
 
 
 
   
 
 
 
 Total net revenues 100.0 100.0 100.0  Total net revenues 100.0 100.0 100.0 
Cost of revenues:Cost of revenues: Cost of revenues: 
Software license fees 3.7 4.2 5.9 Software license fees 4.9 3.7 4.2 
Service revenues 22.6 12.7 6.1 Service revenues 28.0 22.6 12.7 
Advertising 1.2 3.3 4.0 Advertising 0.9 1.2 3.3 
 
 
 
   
 
 
 
 Total cost of revenues 27.5 20.2 16.0  Total cost of revenues 33.8 27.5 20.2 
 
 
 
   
 
 
 
 Gross profit 72.5 79.8 84.0  Gross profit 66.2 72.5 79.8 
 
 
 
   
 
 
 
Operating expenses:Operating expenses: Operating expenses: 
Research and development 26.4 29.6 23.9 Research and development 23.1 26.4 29.6 
Sales and marketing 40.5 38.7 41.9 Sales and marketing 38.2 40.5 38.7 
General and administrative 10.8 10.9 11.5 General and administrative 10.4 10.8 10.9 
Loss on excess office facilities 9.4 11.8  Antitrust litigation 0.8   
Personnel reduction and related charges 2.0 1.9  Loss on excess office facilities 3.4 9.4 11.8 
Goodwill amortization, acquisitions charges, and stock based compensation 0.7 21.5 58.9 Personnel reduction and related charges  2.0 1.9 
 
 
 
 Goodwill amortization, acquisition charges, and stock-based compensation 0.6 0.7 21.5 
 Total operating expenses 89.8 114.4 136.2   
 
 
 
 
 
 
  Total operating expenses 76.5 89.8 114.4 
 Operating loss (17.3) (34.6) (52.2)  
 
 
 
Other income (expense), net (0.4) (7.1) 7.8 
 Operating loss (10.3) (17.3) (34.6)
Other expense, netOther expense, net (0.2) (0.4) (7.1)
 
 
 
   
 
 
 
Net loss before income taxesNet loss before income taxes (17.7) (41.7) (44.4)Net loss before income taxes (10.5) (17.7) (41.7)
 
 
 
   
 
 
 
Income tax provision (benefit) 3.3 (2.1) 1.2 
Income tax (provision) benefitIncome tax (provision) benefit (0.1) (3.3) 2.1 
 
 
 
   
 
 
 
Net lossNet loss (21.0)% (39.6) (45.6)Net loss (10.6)% (21.0) (39.6)
 
 
 
   
 
 
 

Critical Accounting Policies and Estimates

     The preparation of our financial statements requires us to make estimates and assumptions that affect the reported amount of assets and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reported period. Our critical accounting policies and estimates are as follows:

 • Revenue recognitionrecognition;
 
 • Estimating sales returns and the allowance for doubtful accountsaccounts;
 
 • Estimating losses on excess office facilitiesfacilities;
 
 • Determining whether declines in the fair value of investments are other-than-temporary and estimating fair market value of investments in privately held companiescompanies;

18


 • Valuation of goodwillgoodwill; and
 
 • Valuation of deferred income tax assetsassets.

     Revenue Recognition.As described below, significant management judgments and estimates must be made and used in connection with the revenue recognized in any accounting period. Material differences may

17


result in the amount and timing of our revenue for any period if our management made different judgments or utilized different estimates.

     WeFor software related products and services, we recognize revenue pursuant to the requirements of Statement of Position No. 97-2, “Software Revenue Recognition” (SOP 97-2), as amended by Statement of Position No. 98-9, “Software Revenue Recognition with Respect to Certain Arrangements.” Under SOP 97-2, revenue attributable to an element in a customer arrangement is recognized when persuasive evidence of an arrangement exists and delivery has occurred, provided the fee is fixed or determinable, collectibility is probable and the arrangement does not require significant customization of the software. Some of our software arrangements include consulting implementation services sold separately under consulting engagement contracts. Consulting revenues from these arrangements are generally accounted for separately from new software license revenues because the arrangements qualify as service transactions as defined in SOP 97-2. Revenues for consulting services are generally recognized as the services are performed.

     In addition, for transactions not falling under the scope of SOP 97-2, our revenue recognition policies are in accordance with Securities and Exchange Commission (SEC) Staff Accounting Bulletin (SAB) 104, “Revenue Recognition,” which was issued on December 17, 2003 and supersedes SAB 101, Revenue Recognition in Financial Statements. The adoption of SAB 104 did not materially affect our revenue recognition policies, or our results of operations, financial position or cash flows.

     For all sales, except those completed via credit card transactions through the Internet, we use either a binding purchase order or signed agreement, depending on the nature of the transaction, as evidence of an arrangement. For sales made via the Internet, we use the customer’s authorization to charge their credit card as evidence of an arrangement. Sales through our distributors are evidenced by a master agreement governing the relationship together with binding purchase orders on a transaction by transaction basis.

     For software license fees in single element arrangements and multiple element arrangements whichthat do not include customization or consulting services, delivery typically occurs when the product is made available to the customer for download or when products are shipped to customers.the customer. For service and advertising revenues, delivery typically occurs as the services are being performed.

     At the time of each transaction, we assess whether the fee associated with our revenue transactionstransaction is fixed and determinable and whether or not collection is probable. We assess whether the fee is fixed and determinable based on the payment terms associated with the transaction. If a significant portion of a fee is due after our normal payment terms, is based upon a variable matrix such as a minimum level of distribution or is subject to refund, we account forconsider the fee asto not beingbe fixed and determinable. In these cases, we defer revenue and recognize it when it becomes due and payable.

     We assess the probability of collection based on a number of factors, including past transaction history with the customer and the current financial condition of the customer. We do not request collateral from our customers but often require payments before or at the time products and services are delivered. If we determine that collection of a fee is not probable, we defer revenue until the time collection becomes probable, which is generally upon receipt of cash.

     For multiple element arrangements, when company-specific objective evidence of fair value exists for all of the undelivered elements of the arrangement, but does not exist for one or more of the delivered elements in the arrangement, we recognize revenue under the residual method. Under the residual method, at the outset of the arrangement with a customer, we defer revenue for the fair value of the arrangement’s undelivered elements such as consulting services and product support and upgrades, and recognize the revenue for the remainder of the arrangement fee attributable to the elements initially delivered, such as software licenses, when the criteria in SOP 97-2 have been met. Company-specific objective evidence is established for support

19


and upgrades of standard products for which no installation or customization is required based upon the amounts we charge when support and upgrades are sold separately. Company-specific objective evidence is established for consulting and installation services based on the hourly rates we charge for our employees when they are performing these services, provided we have the ability to accurately estimate the hours required to complete a project based upon our experience with similar projects. For multiple element arrangements involving installation or customization, company-specific objective evidence is established for support and upgradesupgrade arrangements if our customers have an optional annual renewal rate specified in the arrangement and the rate is substantive.

     If specific objective evidence does not exist for an undelivered element in a software arrangement, which may include distribution or other term-based arrangements in which the license fee includes support during the arrangement term, revenue is recognized over the term of the support period commencing upon delivery of our technology to the customer.

     Revenue from software license agreements with OEMs is recognized when the OEM delivers its product incorporating our software to the end user. In the case of prepayments received from an OEM, we typically

18


recognize revenue based on the actual products sold by the OEM. If we provide ongoing support to the OEM in the form of future upgrades, enhancements or other services over the term of the contract, all of the revenue under the arrangement is generally recognized ratably over the term of the contract.

     Service revenues include payments under support and upgrade contracts, RealOne mediaand Rhapsody subscription services, consulting services and streaming media content hosting. Support and upgrade revenues are recognized ratably over the term of the contract, which typically is twelve months. Media subscription service revenues are recognized ratably over the period that services are provided. Other service revenues are recognized as the services are performed.

     Fees generated from advertising are recognized as advertising is delivered over the termsterm of the contracts.contract. We may guarantee a minimum number of advertising impressions, click-throughs or other criteria on our Web sites or products for a specified period. To the extent these guarantees are not met, we defer recognition of the corresponding revenues until guaranteed delivery levels are achieved.

     Sales Returns and the Allowance for Doubtful Accounts.The preparation of our financial statements requires us to make estimates and assumptions that affect the reported amount of assets and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reported period. Specifically, we We must make estimates of potential future product returns related to current period product revenue. We analyze historical returns, current economic trends, and changes in customer demand and acceptance of our products when evaluating the adequacy of the sales returns and other allowances. Similarly, we must make estimates of the uncollectibility of our accounts receivables. We specifically analyze the age of accounts receivable and analyze historical bad debts, customer credit-worthiness and current economic trends when evaluating the adequacy of the allowance for doubtful accounts. Significant judgments and estimates must be made and used in connection with establishing allowances for sales returns and the allowance for doubtful accounts in any accounting period. Material differences may result in the amount and timing of our revenue for any period if we madewere to make different judgments or utilizedutilize different estimates. Similarly, we must make estimates of the uncollectibility of our accounts receivables. We specifically analyze the age of accounts receivable and analyze historical bad debts, customer credit-worthiness and current economic trends when evaluating the adequacy of the allowance for doubtful accounts.

     Accrued Loss On Excess Office Facilities.We have made significant estimates in determining the appropriate amount of accrued loss on excess office facilities. If we made different estimates, our loss on excess office facilities would be significantly different from that recorded, which could have a material impact on our operating results. We have revised our original estimate twicethree times in the last two years, increasing the accrual for loss on excess office facilities both times.each time. These first two revisions were in both cases the result of changes in the market for commercial real estate where we operate. The third revision, which took place in 2003, was the Seattle, Washington area.result of adding an additional tenant at a sublease rate lower than the rate used in previous estimates. If the market for such space declines further in future periods, we may have to revise our estimates, which may result in additional losses on excess office facilities. The significant factors we considered in making our estimateestimates are discussed in the section entitled “Loss on Excess Office Facilities.”

     Impairment of Investments.As part of the process of preparing our consolidated financial statements we periodically evaluate whether any declines in the fair value of our investments are other-than-temporary. Significant judgments and estimates must be made to assess whether an other-than-temporary decline in fair

20


value of investments has occurred and to estimate the fair value of investments in privately held companies. See “Other income (expense), net”Expense, Net” in the following pages for a discussion of the factors we considered in evaluating whether declines in fair value of our investments were other-than-temporary and the factors we considered in estimating the fair value of investments in private companies.

     Valuation of Goodwill.We assess the impairment of goodwill on an annual basis or whenever events or changes in circumstances indicate that the fair value of the reporting unit to which goodwill relates is less than the carrying value. Factors we consider important which could trigger an impairment review include the following:

 • poor economic performance relative to historical or projected future operating resultsresults;
 
 • significant negative industry, economic or company specific trendstrends;
 
 • changes in the manner of our use of the assets or the plans for our businessbusiness; and
 
 • loss of key personnelpersonnel.

19


     If we were to determine that the fair value of a reporting unit was less than its carrying value, including goodwill, based upon the annual test or the existence of one or more of the above indicators of impairment, we would measure impairment based on a comparison of the implied fair value of reporting unit goodwill with the carrying amount of goodwill. The implied fair value of goodwill is determined by allocating the fair value of a reporting unit to its assets (recognized and unrecognized) and liabilities in a manner similar to a purchase price allocation. The residual fair value after this allocation is the implied fair value of reporting unit goodwill. To the extent the carrying amount of reporting unit goodwill is greater than the implied fair value of reporting unit goodwill, we would record an impairment charge for the difference. Judgment is required in determining what our reporting units are for the purpose of assessing fair value compared to carrying value.

     There waswere no impairment chargecharges for goodwill in 2002.2003, 2002 or 2001.

     Valuation of Deferred Income Tax Assets.In accordance with generally accepted accounting principles, we must periodically assess the likelihood that our deferred tax assets will be recovered from future taxable income, and to the extent that recovery is not likely, a valuation allowance must be established. The establishment of a valuation allowance and increases to such an allowance result in either increases to income tax expense or reduction of income tax benefits in the statement of operations. Factors we consider in making such an assessment include, but are not limited to, past performance and our expectation of future taxable income, macro-economic conditions and issues facing our industry, existing contracts, backlog, our ability to project future results and any appreciation of our investments and other assets.

     As of December 31, 2001, we had recorded net deferred tax assets of $5.6 million. Due to the net losses incurred during the year ended December 31, 2002, difficult economic conditions facing our industry and our customers and declines in the fair value of our investments, we determined that it was appropriate to increase our valuation allowance to reduce our net deferred tax assets as of December 31, 2002 to zero. Those conditions have not changed materially during 2003 and, therefore our gross deferred tax assets at December 31, 2003 of $235 million are reduced to zero by a full valuation allowance.

Revenues

                            
2002Change2001Change20002003Change2002Change2001










(Dollars in thousands)(Dollars in thousands)
Software license feesSoftware license fees $72,753 (33)% $108,586 (27)% $148,091 Software license fees $61,970 (15)% $72,753 (33)% $108,586 
Service revenuesService revenues 103,161 59 64,740 23 52,505 Service revenues 134,058 30 103,161 59 64,740 
AdvertisingAdvertising 6,765 (57) 15,579 (62) 40,942 Advertising 6,349 (6) 6,765 (57) 15,579 
 
 
 
   
 
 
 
Total net revenues $182,679 (3)% $188,905 (22)% $241,538 Total net revenues $202,377 11% $182,679 (3)% $188,905 
 
 
 
   
 
 
 

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200320022001



(as a percentage of
total net revenues)
Software license fees  31%  40   58 
Service revenues  66   56   34 
Advertising  3   4   8 
   
   
   
 
 Total net revenues  100%  100   100 
   
   
   
 

     Software License Fees.Software license fees were $72.8 million in 2002, a decrease of 33% from $108.6 million in 2001. This decrease is due in part to focusing our consumer promotional activities to feature our digital media subscription services. In June 2002, we also launched a European edition of our RealOne subscription service. Both of these factors have resulted in a shift of revenue from software license fees to service revenues. Additionally, the English language version of our RealOne Player Plus and RealJukebox Plus products, which have previously contributed significantly to software license fees, are now combined in our RealOne subscription offering, the revenue from which is included in service revenues. While we continue to sell a successor software product, RealOne Player Plus, on a stand-alone basis, we promote our RealOne subscription offerings (which include the RealOne PlayerPlus) as our primary offerings in a substantial majority of our marketing channels.

     We also believe that theThe decrease in software license fees in 2003 was due primarily to continued cutbackslower revenue from certain of our business software products, including revenue from our OEM partners and decreased sales of our premium consumer license products. The decrease in capital and information technology spendingrevenues in 2003 was partially offset by revenues from increased sales of our customers and potential customers caused by macroeconomic conditions and that these macroeconomic conditions resulted in decreased system software sales. In particular, customersto mobile and potential customers inwireless infrastructure companies as well as revenues from the systems software and telecommunication industries have become increasingly cautious in their buying decisions dueon-line sale of individual songs resulting from the inclusion of the operations of Listen since the date of acquisition. See “Overview” for a description of the general factors we believe contributed to economic trends specific to those industries. In addition, Microsoft has continued to bundle its competing Windows Media Player and server software for free with its operating system products, causing certain potential customers to adopt Microsoft’s media delivery products.the decreased sales. We believe the macroeconomic environment and competition from Microsoft, including Microsoft’s conduct described below in “Factors that may Affect our Business, Future Operating Results and Financial Condition,”those factors have negatively impacted sales to and the ratecustomers in a variety of adoption of our systems software products by,

20


consumers,market segments, including customers in the corporate enterprise, broadcast hosting, Internet content provider, non-PC device manufacturer, systems software, telecommunication and original equipment manufacturer market segments.markets. No assurance can be given when, or if, we will experience increased demand for our business software products from customers in these markets will beginmarkets.

     The decrease in software license fees in 2002 was caused in part by the general factors described above in “Overview,” as well as the fact that the English language version of our RealPlayer Plus and RealJukebox Plus products, which had previously contributed to increase capital spending levels.

     Softwaresoftware license fees, were $108.6 millioncombined in 2001,our RealOne subscription offerings starting in 2002, the revenue from which is included in service revenues. While we continued to sell a decrease of 27% from $148.1 millionsuccessor software product, on a stand-alone basis, we promoted our subscription offerings (which included the RealPlayer Plus at no extra charge) as our primary offerings in 2000. We believe the decrease was due in part to continuing cutbacks in capital and information technology spending by our customers and potential customers as a result of global economic conditions. We further believe the decrease was due to a significant reduction in equity funding of new and Internet-related businesses in 2001. We believe that this reduced funding impacted, either directly or indirectly, Internet-related and other technology-centric businesses, which thereby directly impacted both our customers and potential customers. The reduced availability of funding contributed to certainmajority of our customers and potential customers ceasing operations and others experiencing difficult financial situations. We believe that this environment also resultedmarketing channels.

Service Revenues.The increase in customers and potential customers delaying or foregoing purchases and has caused sales cycles for some customers to take longer than in the past. These factors negatively impacted ourservice revenues in 2001. Additionally, we have focused our consumer promotional activities2003 was primarily attributable to featuregrowth in subscribers to our digital media subscription services, which has resultedpartially offset by decreases in a shiftother service offerings including support and upgrades. The increases in subscribers were primarily due to the inclusion of the operations of Listen since the date of acquisition as well as growth in our other subscription offerings including RadioPass, GamePass, and stand-alone subscriptions such as sports and entertainment content due to the evolution of our revenues from software license fees to service revenues. Thesecore business as described in “Overview.” Our subscription services have characteristics of longer-term, recurring revenue, unlike our software product offerings that typically generate one-time, non-recurring revenue, exclusiveaccounted for approximately $107.1 million and $75.5 million of service revenues in 2003 and 2002, respectively. The reasons for increases in subscription revenues are described in more detail in “Revenue By Product Type — Consumer Subscription Services” below. We believe the decreased revenues in our other service offerings, including support arrangements. Additionally, software license fees for 2000 included $5.2 million relatedand upgrades, are due primarily to a three-year license agreement we entered into with Microsoft which expiredthe factors described above in the quarter ended June 30, 2000. There was no such Microsoft-related revenue in 2001.“Overview.”

Service Revenues. Service revenues were $103.2 million in 2002, an increase of 59% from $64.7 million in 2001.     The increase in service revenues in 2002 was primarily attributable to growth in subscribers to our digital media subscription services, partially offset by decreases in other service offerings including content hosting revenues. Also,revenues due to the factors described above in “Overview.” In addition, in June 2002, we launched the European edition of our RealOne subscription service. Our subscription services accounted for approximately $75.5 million and $28.2 million of service revenues in 2002 and 2001, respectively. Reasons for the increase

Advertising.The decrease in subscription services revenues are described in more detail in “Revenues By Product Type — Consumer Subscription Services” below. We believe the decreasedadvertising revenues in 2003 was due in part to our other service offerings, including content hosting, are due primarily to competitionremoval of paid advertising from Microsoftcertain Web pages and the macro-economic and industry-specific conditions described above in “Software License Fees.”

     Service revenues were $64.7 million in 2001, an increaseincreased use of 23% from $52.5 million in 2000. The increase during 2001 was primarily attributableour advertising space to the continued growth ofpromote our digital media subscription services. Revenue related to digital media subscription services was $28.2 million in 2001 compared to $2.0 million in 2000. This increase was partially offset by decreases in other service offerings, including content hosting services and support and maintenance services. We believe the decrease in these other service offerings was due to the economic and market conditions described in the above section entitled “Software License Fees.”

     Advertising.Advertising revenues were $6.8 million in 2002, a decrease of 57% from $15.6 million in 2001. We believe theThe decrease in advertising revenues in 2002 was due in part to the continued depressed environment for Internet advertising, which resulted in lower volumes and lower average advertising rates. We also believe the focusThe removal of our promotional and marketing efforts to more prominently feature our digital media subscription offerings contributed to the decrease in advertising revenues, as we removed paid advertising from certain of our Web pages and usedthe increased use of our advertising space to promote our digital media subscription services. Advertising revenues were $15.6 million in 2001, a decrease of 62% from $40.9 million in 2000. The decrease was primarily dueservices also contributed to a decline in the demand for Internet advertising, and advertising in general. This reduced demand resulted in lower average advertising rates. Additionally, certain longer-term promotional and advertising contracts were not renewed and some of our advertising customers and potential customers ceased operations.decrease.

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Revenues by Product Type

                        
2002Change2001Change20002003Change2002Change2001










(Dollars in thousands)(Dollars in thousands)
Consumer software and related servicesConsumer software and related services $31,276 (33)% $47,005 (41)% $79,290 Consumer software and related services $30,207 (3)% $31,276 (33)% $47,005 
Consumer subscription servicesConsumer subscription services 75,497 167 28,231 1,322 1,986 Consumer subscription services 107,093 42 75,497 167 28,231 
Systems 69,141 (30) 98,090 (18) 119,320 
AdvertisingAdvertising 6,765 (57) 15,579 (62) 40,942 Advertising 6,349 (6) 6,765 (57) 15,579 
 
 
 
   
 
 
 
Total net revenues $182,679 (3)% $188,905 (22)% $241,538 Total consumer products and services revenues 143,649 27 113,538 25 90,815 
Business products and servicesBusiness products and services 58,728 (15) 69,141 (30) 98,090 
 
 
 
   
 
 
 
Total net revenues $202,377 11% $182,679 (3)% $188,905 
 
 
 
 
              
200320022001



(as a percentage of
total net revenues)
Consumer software and related services  15%  17   25 
Consumer subscription services  53   41   15 
Advertising  3   4   8 
   
   
   
 
 Total consumer products and services revenues  71   62   48 
Business products and services  29   38   52 
   
   
   
 
 Total net revenues  100%  100   100 
   
   
   
 

     Consumer Software and Related Services.Consumer software and related services revenues are derived fromrevenue consists of sales of our RealOne Player Plus, RealJukeboxRealPlayer Plus and other related products, revenuesrevenue from support and maintenance services that we sell to customers who purchase these products, sales and salesdistribution of third-party software products including games.and content such as game downloads and music burning. These products and services are sold primarily through the Internet, and we charge customers’ credit cards at the time of sale. Consumer software and related services revenues were $31.3 milliondecreased in 2003 and 2002 a decrease of 33% from $47.0 million in 2001. Consumer software and related services revenues were $47.0 million in 2001, a decrease of 41% from $79.3 million in 2000. The decreases wereprimarily due in part to a change in focus of our consumer promotional activities to feature our digital media subscription services over our traditional consumer products, as well as competition from Microsoftthe general factors described in “Revenues — Software License Fees”“Overview” above.

     Additionally, as discussed in “Revenues — Software License Fees” above, the English language editions of our RealOne PlayerRealPlayer Plus and RealJukebox Plus products, which havehad previously contributed significantly to consumer software and related services revenues, are nowwere combined in our RealOne subscription offering during 2002, the revenue from which is included in consumer subscription services. In June 2002, we also launched a European edition of our RealOne subscription service which also contributed to the shift from consumer software and related services revenue to consumer subscription services revenue.

     Consumer Subscription Services.Consumer subscription services revenues consistrevenue consists of our digital media subscription services, including RealOne SuperPass, RadioPass, MusicPass, GoldPassRhapsody, GamePass and stand-alone and add-on subscriptions. These services are sold primarily through the Internet, and we charge the customers’ credit cards at the time of sale. Billing periods for our consumer subscription services occur monthly, quarterly or annually, depending on the service purchased. ConsumerThe increases in consumer subscription services revenues were $75.5 million in 2002, an increase of 167% from $28.2 million in 2001. Consumer subscription services revenues were $28.2 million in 2001, an increase of 1,322% from $2.0 million in 2000. The increasesduring 2003 were primarily attributable to the increased focus of our promotional activities on our digital media subscription services,general factors described above in “Overview” and specifically, due to the introduction ofgrowth in new subscription services and the related increase in paying subscribers. We also believe that the continuedsubscribers as well as an increase in exclusive and premium content available to our digital media subscribers has resulted in a broader reach among consumers, thereby leading to greater consumer adoption rates and higher revenues. For example, newly available on our subscription services in 2002 is contentrevenues from partners such as ABCNEWS.com, NASCAR, CBS, CNN, E! Networks, FOXSports.com and others.the inclusion of the operations of Listen since the date of acquisition. Additionally, in June 2002 we launched a European edition of our RealOne subscription service with premium content from brand name European partners such as BBC and Champions League Soccer from UEFA, Big Brother 3, CNN Europe and MTV Europe. We believe the launch of our European edition of our RealOne subscription service will continue a shift from consumer software and related services revenue to consumer subscription services revenue in the European market. Additionally, GoldPass, our first consumer subscription offering, was launched in the third quarter of 2000, and therefore our GoldPass-related revenues in 2000 do not represent a full year of revenue for comparison purposes. Our subscription services offerings represent a relatively new business model for Internet media delivery and a new business model for us and, to date, we have not faced significant direct competition with these offerings. We cannot predict with accuracy how these subscription offerings will perform in the future, at what rate subscription revenues will grow, if at all, or the nature or potential impact of anticipated competition. We believe that the increase in consumerUEFA. Consumer subscription services revenues on a percentage basis over the preceding year waswere substantially lower in 20022003 than in 20012002 primarily because in 2002 we arewere in the early phases of developing our subscription business and, therefore, the base of revenues was smaller in 20002001 than in 2001.2002. See “2002“2003 Quarterly Revenue” for a discussion of recent quarterly period trends in subscription services revenues.

22


Advertising.See “Revenues — Advertising” above for analysis.

     Systems.Business Products and Services. Systems revenues areBusiness products and services revenue is derived from salesthe licensing of our media delivery system software, including RealServer and Helix system software and related authoring and publishing tools,

23


digital rights management technology, support and maintenance services that we sell to customers who purchase these products, broadcast hosting services we provide through our Real Broadcast Network and consulting services we offer to our customers. These products and services are primarily soldlicensed to corporate customers. We do not require collateral from our customers, but we often require payment before or at the time products and services are delivered. Many of our customers are given standard commercial credit terms, and for these customers we do not require payment before products and services are delivered. Systems revenues were $69.1 million in 2002, a decrease of 30% from $98.1 million in 2001. Systems revenues were $98.1 million in 2001, a decrease of 18% from $119.3 million in 2000. See “Revenues — Software License Fees” above for analysis of the principal reasons for the decreases in these revenues in 2003 and 2002.

Consumer Products and Services Revenues

A further analysis of our consumer products and services revenues is as follows:

                      
2003Change2002Change2001





Video, consumer software and other $116,394   11% $104,784   22% $86,150 
Music  15,093   1,472   960       
Games  12,162   56   7,794   67   4,665 
   
       
       
 
 Total consumer products and services revenue $143,649   27% $113,538   25% $90,815 
   
       
       
 

Video, Consumer Software and Other.Video, consumer software and other revenue includes primarily revenues from our RealOne and stand alone subscription services, RealPlayer Plus and related products, revenue from support services that we sell to customers who purchase these products, and sales and distribution of third-party software products and all advertising other than that related directly to games. See “Revenues — Consumer Subscription Services” and “Revenues — Consumer Software and Related Services” above for analysis.

     Advertising.Music.AdvertisingMusic revenue primarily includes revenues were $6.8 millionfrom our RadioPass and Rhapsody subscription services and sales of music content. The increase is due to the introduction and subsequent growth of our RadioPass service in the fourth quarter of 2002 a decreaseand the inclusion and subsequent growth of 57%the operations of Listen during the third quarter of 2003. We believe the growth is due to the increased focus of our marketing efforts on our music offerings and the broader acceptance of paid on-line music services.

Games.Games revenue primarily includes revenues from $15.6 milliongame downloads through our RealArcade service and from our GamePass subscription service and related advertising. The increases are due to the introduction and subsequent growth of our GamePass subscription service in 2001. Advertising revenues were $15.6 million in 2001, a decreasethe fourth quarter of 62% from $40.9 million in 2000. See “Revenues — Advertising” above for analysis.2002. We believe the growth is due to increased focus of our marketing efforts on our games business and the addition of new game titles to our RealArcade and GamePass offerings.

Geographic Revenues

                          
2002Change2001Change20002003Change2002Change2001










(Dollars in thousands)(Dollars in thousands)
United StatesUnited States $132,009 (2)% $134,190 (24)% $177,484 United States $147,613 12% $132,009 (2)% $134,190 
EuropeEurope 27,019 (3) 27,809 (19) 34,499 Europe 32,106 19 27,019 (3) 27,809 
AsiaAsia 19,685 3 19,197 (7) 20,710 Asia 19,811 1 19,685 3 19,197 
Rest of the worldRest of the world 3,966 (49) 7,709 (13) 8,845 Rest of the world 2,847 (28) 3,966 (49) 7,709 
 
 
 
   
 
 
 
Total $182,679 (3)% $188,905 (22)% $241,538 Total $202,377 11% $182,679 (3)% $188,905 
 
 
 
   
 
 
 

     International revenues represented 27% of total net revenues in 2003, 28% of total net revenues in 2002, and 29% of total net revenues in 2001, and 27%2001. Revenues generated in Europe were 16% of total net revenues in 2000. Revenues generated in Europe were2003 and 15% of total net revenues in 2002 and 2001, and 14%revenues generated in Asia were 10% of total net revenues in 2000, and revenues generated in Asia were2003, 11% of total net revenues in 2002, and 10% of total net revenues in 2001, and 9% of total net revenues in 2000.2001. International revenues decreased as a percentage of total net revenues in 2003 and 2002 primarily due to the increased U.S.-based

24


subscriptions services revenue combined with a decline in revenues generated in Latin America as a result of adverse financial conditions in that region. International revenues increased as a percentage of total net revenues in 2001 primarily due to U.S.-based revenues decreasing at a faster rate than the decrease in international revenues. At December 31, 2002,2003, accounts receivable due from international customers represented approximately 21%37% of trade accounts receivable. The functional currency of our foreign subsidiaries is the local currency of the country in which the subsidiary operates. We currently manage a portion of our foreign currency exposures through the use of foreign currency exchange forward contracts and therefore are still subject to some risk of changes in exchange rates. Our foreign currency exchange risk management program reduces, but does not eliminate, the impact of currency exchange rate movements. We currently do not hedge the majority of our foreign currency exposures and therefore are subject to the risk of changes in exchange rates. The costs of bothgross margins on domestic and international revenues are substantially the same.

Deferred Revenues

     Deferred revenue is comprised of the unrecognized revenue related to support contracts, prepayments under OEM arrangements, unearned subscription services revenue and other prepayments for which the earnings process has not been completed. Revenue from contracts with customers developing content delivery networks is generally recognized over the term of the arrangement commencing upon the customer’s deployment of our technology in their network. Because many of the agreements relatedDeferred revenue at December 31, 2003 was $35.7 million compared to the content delivery networks have been with companies that have had limited operating histories, we have historically required prepayments from such customers to mitigate our credit risk. Cash prepayments associated with these contracts are recorded as deferred revenue and amounted to $24.0 million and $27.2$44.2 million at December 31, 2002 and 2001, respectively.2002. The decrease in deferred revenue related to these contracts during

23


the year ended December 31, 2002 2003 is primarily due to prepayments received under contracts occurring at a slower rate than recognition of revenue on existing contracts. We believe the decreaseThe slower rate of prepayment receipts has been largely due to the decrease in new systemsbusiness products and services contracts in recent periods, which represent a significant portion of deferred revenue. We believe the decrease in new systemsbusiness products and services contracts results primarily from the conditions described in “Revenues“Revenue — Software License Fees” above.

Cost of Revenues

                                
2002Change2001Change20002003Change2002Change2001










(Dollars in thousands)(Dollars in thousands)
Software license feesSoftware license fees $6,865 (14)% $7,969 (44)% $14,341 Software license fees $9,917 44% $6,865 (14)% $7,969 
Service revenuesService revenues 41,259 73 23,895 62 14,718 Service revenues 56,690 37 41,259 73 23,895 
AdvertisingAdvertising 2,145 (66) 6,324 (34) 9,629 Advertising 1,736 (19) 2,145 (66) 6,324 
 
 
 
   
 
 
 
Total cost of revenues $50,269 32 % $38,188 (1)% $38,688 Total cost of revenues $68,343 36% $50,269 32% $38,188 
 
 
 
   
 
 
 
As a percentage of total net revenuesAs a percentage of total net revenues 28% 20% 16%As a percentage of total net revenues 34% 28% 20%

     Cost of Software License Fees.Cost of software license fees includes royalties paid on sales of games, music and other third-party products, amounts paid for licensed technology, costs of product media, duplication, manuals, packaging materials, amounts paid for licensed technology,and fees paid to third-party vendors for order fulfillment and royalties paid on sales of games and other third-party products.fulfillment. Cost of software license fees was $6.9 millionin 2003 increased by 44% from 2002 and increased as a percentage of software license fees to 16% from 9% in 2002. The increases in costs both in dollars and as a percentage of software license fees for 2003 were primarily due to the licensing costs associated with music burns revenue resulting from the inclusion of the operations of Listen since the date of acquisition, as well as costs of revenue related to custom development work and an increase in royalties resulting from a shift in product mix towards products with higher royalties.

     Cost of software license fees decreased 14% in 2002 a decrease of 14% from $8.0 million incompared to 2001 and increased as a percentage of software license fees to 9% from 7% in 2001. The decrease in costs for 2002 was primarily due to lower sales volumes. The lower sales volumes reduced royalty and other product fulfillment costs such as shipping and packaging costs. The increase in cost of software license fees as a percentage of software license fees revenue was due to a lower percentageamount of software license fee revenue arising from systemsbusiness software licenses, which typically have higher margins than other components of software license fees. Cost of software license fees was $8.0 million in 2001, a decrease of 44% from $14.3 million in 2000, and decreased as a percentage of software license fees to 7% from 10% in 2000. The decrease in costs was due primarily to lower sales volumes and the expiration of certain royalty agreements. The decrease in percentage terms was due primarily to the expiration of certain royalty agreements and a reduction in per unit fulfillment costs as a result of more efficient packaging.

     Cost of Service Revenues.Cost of service revenues includes the cost of content, and delivery of the content, included in our digital media subscription service offerings, cost of in-house and contract personnel providing support and consulting services, and expenses incurred in providing our streaming media hosting and delivery services. Cost of service revenues increased 37% in 2003 from 2002 and increased as a percentage of service

25


revenues to 42% in 2003 from 40% in 2002. The increase in costs was $41.3 millionprimarily due to increasing costs associated with content included in our digital media subscription services. The costs of content are expensed over the periods the content is available to our subscription services customers. The content costs increased due to an increase in paying subscribers and the costs of adding new content to our services as well as the increase in costs associated with revenues from the operations of Listen since the date of acquisition. The increase in cost of service revenue as a percentage of service revenue was due to higher fixed content costs for certain contracts as well as the impact of including the costs of service revenues related to Listen which tend to be higher as a percentage of service revenues than those of our other offerings.

     Cost of service revenues increased 73% in 2002 an increase of 73% from $23.9 million in 2001 and increased as a percentage of service revenues to 40% in 2002 from 37% in 2001. The increase in costs was primarily due to costs associated with content included in our digital media subscription services, which have fixed and variable components, as well as increased customer service and technical support costs associated with the growth of our subscription services. The costs of content are expensed over the periods the content is available to our subscription services customers. The increase in percentage terms is due to shifts in product mix towards our digital media subscription services, which are characterized by relatively higher costs of revenues than our other service offerings.

     Cost of service revenues was $23.9 million in 2001, an increase of 62% from $14.7 million in 2000, and increased as a percentage of service revenues to 37% from 28% in 2000. The increase in costs was primarily due to costs associated with content included in our digital media subscription services, introduced in August 2000, as well as increased customer service and technical support costs associated with our subscription services.

     Our digital media subscription services, including the services of Listen, are a relatively new and growing portion of our business and, to date, have been characterized by relatively higher costs of revenuesrevenue than our other products and services, primarily due to the cost of licensing media content to provide these services. As a result, if this portion of our business continues to grow as a percentage of revenues, we anticipate thatrevenue, our cost of service revenuesrevenue may

24


grow at an increased rate relative to net revenuesrevenue and thereby maywill lead to reductions in our gross marginsmargin percentages in the future.
In addition, we anticipate that our cost of service revenue as a percentage of service revenue will fluctuate on a quarter-to-quarter basis due to seasonal characteristics of certain popular subscription content as we periodically enter into new agreements for subscription content. We are currently evaluating a relationship with a content provider whose content as of the first quarter of 2004 is not being used in our primary video subscription services. Those negotiations could result in a one-time charge of up to $6 million; if this happens, our future content costs would be reduced accordingly.

     Cost of Advertising.Cost of advertising includes the cost of personnel associated with maintenance of programming services, content creation and maintenance and advertising delivery services. Cost of advertising was $2.1 milliondecreased 19% in 2003 from 2002, and decreased as a percentage of advertising revenues to 27% in 2003 from 32% in 2002. Cost of advertising decreased 66% in 2002 a decrease of 66% from $6.3 million in 2001, and decreased as a percentage of advertising revenues to 32% in 2002 from 41% in 2001. The decreasedecreases in costs waswere primarily due to lower sales volumes and shifting programming personnel to other areas of our business. The decreasedecreases in percentage terms waswere due to costs decreasing at a faster rate than the decrease in advertising revenues. Cost of advertising was $6.3 million in 2001, a decrease of 34% from $9.6 million in 2000, but increased as a percentage of advertising revenues to 41% from 24% in 2000. The decrease in costs was primarily due to lower sales volumes, the expiration of certain advertising contracts and shifting programming personnel to other areas of our business. The increase in percentage terms was due to fixed expenses decreasing at a lower rate than the decrease in advertising revenues.

Operating Expenses

Research and Development

                              
2002Change2001Change20002003Change2002Change2001










(Dollars in thousands)(Dollars in thousands)
Research and development $48,186 (14)% $55,904 (3)% $57,819  $46,763 (3)% $48,186 (14)% $55,904 
As a percentage of total net revenues 26% 30% 24% 23% 26% 30%

     Research and development expenses consist primarily of salaries and related personnel costs, consulting fees associated with product development and costs of technology acquired from third parties to incorporate into products currently under development. To date, all research and development costs have been expensed as incurred because technological feasibility for software products is generally not established until substantially all development is complete. Research and development expenses, excluding non-cash stock-based compensation, were $48.2 milliondecreased in 2003 primarily due to a reduction in personnel and related costs in the third quarter of 2002 aas part of an overall plan to control costs, partially offset by an increase in expenses for contract labor and the inclusion of the operations of Listen since the date of acquisition. The decrease of 14% from $55.9 million in 2001, and decreased as a percentage of total net revenuesrevenue was the result of expenses decreasing due to 26% from 30%cost controls while net revenue increased.

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Research and development expenses, excluding non-cash stock-based compensation, decreased in 2001. The decrease in expenses was2002 primarily due to a reduction in personnel and contract labor in Augustthe third quarters of 2002 and July 2001 and increased efficiencies as part of an overall plan to control costs. These reductions were partially offset by expenses related to the development of new technology and products. New product developments in 2002 included RealOne Player version 2.0 andproducts, including our Helix products. The decrease in percentage terms was primarily a result of expenses decreasing at a faster rate than the decrease in total net revenues. Research and development expenses, excluding non-cash stock-based compensation, were $55.9 million in 2001, a decrease of 3% from $57.8 million in 2000, but increased as a percentage of total net revenues to 30% from 24% in 2000. The decrease in expenses was primarily due to a reduction in personnel and contract labor in July 2001 and increased efficiencies as part of an overall plan to control costs. These reductions were partially offset by expenses related to the development of new technology and products. New product developments in 2001 included RealArcade, the RealSystem Media Commerce Suite and our RealOne Player and subscription services. The increase in percentage terms was primarily a result of expenses decreasing at a lower rate than the decrease in total net revenues.

     Sales and Marketing

Sales and Marketing
                                 
2002Change2001Change20002003Change2002Change2001










(Dollars in thousands)(Dollars in thousands)
Sales and marketing $73,928 1% $73,129 (28)% $101,197  $77,335 5% $73,928 1% $73,129 
As a percentage of total net revenues 40% 39% 42% 38% 40% 39%

     Sales and marketing expenses consist primarily of salaries and related personnel costs, sales commissions, credit card fees, subscriber acquisition costs, consulting fees, trade show expenses, advertising costs and costs of marketing collateral. The increase in sales and marketing expenses in 2003 was primarily due to the inclusion of the operations of Listen since the acquisition date as well as increased payments made to third parties for referrals of new customers. The decrease in percentage terms was a result of sales and marketing expenses increasing at a lower rate than total net revenues.

Sales and marketing expenses excluding non-cash stock-based compensation, were $73.9 million in 2002 an increase of 1% from $73.1 million in 2001, and increased as a percentage of total net revenues to 40% from 39% in 2001. The increase in expenses was primarily due to increases of $1.5 million in

25


credit card fees and $1.5 million in subscriber acquisition costs, both related to our digital media subscription services, partially offset by decreases in sales and marketing expenses related to system softwarebusiness products and services sales. Credit card fees increased due to the increase in consumer subscription services revenues, the cash from which is collected via customer credit cards. Subscriber acquisition costs increased due to an increase in the number of content partners that referreferred new subscribers to us via their Web sites and a corresponding increase in related payments to such partners. The increase in percentage terms was a result of sales and marketing expenses increasing while total net revenues decreased. Sales and marketing expenses, excluding non-cash stock-based compensation, were $73.1 million in 2001, a decrease of 28% from $101.2 million in 2000, and decreased as a percentage of total net revenues to 39% from 42% in 2000. The decrease in expenses was primarily due to reductions in personnel and contract labor, increased efficiencies as part of an overall plan to control costs, decreases in advertising and marketing expenses and decreased advertising, promotions and expenses related to our overall corporate branding and marketing. These reductions were partially offset by costs associated with opening offices in Korea and Singapore. The decrease in percentage terms was a result of cost saving measures that reduced sales and marketing expenses more rapidly than the rate of decline in total net revenues.

General and Administrative

                               
2002Change2001Change20002003Change2002Change2001










(Dollars in thousands)(Dollars in thousands)
General and administrative $19,820 (4)% $20,554 (26)% $27,807  $21,007 6% $19,820 (4)% $20,554 
As a percentage of total net revenues 11% 11% 12% 10% 11% 11%

     General and administrative expenses consist primarily of salaries, related personnel costs, and fees for professional and temporary services.services and other general corporate and contractor costs. General and administrative expenses, were $19.8 millionexcluding non-cash compensation, increased in 2002, a2003 primarily due to increased payroll and contractor costs, increased litigation defense costs and the inclusion of the operations of Listen since the acquisition date. The decrease of 4% from $20.6 million in 2001, and remained flat as a percentage of total net revenues in 2003 was a result of general and administrative expenses increasing at 11% for botha lower rate than total net revenues.

General and administrative expenses in 2002 and 2001. The decrease in expenses wasdecreased primarily due to reductions in personnel and related personnel costs. General and administrative expenses were $20.6

Antitrust Litigation

Antitrust litigation of $1.6 million in 2001,2003 consists of costs, primarily legal fees and professional services, incurred in our antitrust action against Microsoft. See “Notes to Consolidated Financial Statements — Commitments and Contingencies” (Note 14 C) for a decreasedescription of 26% from $27.8 million in 2000, and decreased as a percentage of total net revenues to 11% from 12% in 2000. The decreases in both absolute dollars and as a percentage of total net revenues were primarily due to a reduction in personnel and decreased litigation defense costs.

this action.

Loss on Excess Office Facilities

     In October 2000, we entered into a 10-year lease agreement for additional office space located near our corporate headquarters in Seattle, Washington. During 2001, we re-evaluated our facilities requirements and,

27


as a result, decided to permanently sublet all of this office space. The market for office space in Seattle hashad significantly declined from the date we entered into this lease. As a result, we recorded losses of $17.2 million and $22.2 million in 2002 andduring the year ended December 31, 2001. For the year ended December 31, 2001, respectively. Thesethese losses represented approximately $32.4$15.2 million of rent and operating expenses over the remaining life of the lease, net of expected sublease income of $38.1 million, and approximately $7.0 million for the write-down of leasehold improvements to their estimated fair value. Our estimates were based upon many factors including projections of sublease rates and the time period required to locate tenants. During the year ended December 31, 2002, the Seattle real estate market continued to display significant weakness, which iswas reflected in both increasing vacancy rates and declining rental rates. Based on discussions with prospective tenants, we concluded that the excess office facilities were not likely to be sublet at rates used in the original loss estimates in 2001.estimates. As a result, we recorded additional losses in 2002. Our estimates are based upon many factors including projections of sublease rates and$17.2 million during the time period required to locate tenants. As ofyear ended December 31, 2002, $25.9 million has been accrued for2002. During 2003, we secured an additional tenant at a sublease rate lower than the rate used in previous loss on excess office facilities, which is netestimates. As a result, we adjusted our estimates to reflect the lower lease rate and recorded an additional loss of $7.1 million. The estimated total loss in 2003 included an estimate of future sublease income of $21.9$14.7 million of which $8.0 million was committed under sublease contracts at the time of the estimate. The accrued loss of $29.1 million at December 31, 2003 is shown net of expected future sublease income of $14.0 million. We regularly evaluate the market for office space in Seattle.the cities where we have operations. If the market for such space declines further in future periods, we may have to revise our estimates further, which may result in additional losses on excess office facilities.
 
Personnel Reduction, Restructuring and Related Charges

     In August 2002, we implemented a restructuring plan to reduce costs, which included reducing our staffing levels by approximately 10%, closing selected offices, and canceling our annual user conference. We

26


recorded a charge of approximately $3.6 million in 2002 to reflect costs associated with implementing this restructuring. These costs were primarily related to severance payments but also included other miscellaneous costs such as professional fees, outplacement services for terminated employees, office closures and tradeshow deposit forfeitures, all of which were incurred as of December 31, 2002. We expect the remaining accrued costs of $919,000 to be paid in 2003. In July 2001, we reduced our staffing levels by approximately 15%. We recorded a charge of approximately $3.6 million in 2001 to reflect costs associated with implementing the staff reduction.
As of December 31, 2003, $506,000 is accrued related to the 2002 plan, primarily related to estimated future payments associated with closed offices.
 
Goodwill Amortization, Acquisition Charges and Stock-Based Compensation

     Goodwill amortization, acquisition charges and stock-based compensation were $1.1 million and $1.3 million $40.6in 2003 and 2002, respectively, consisting entirely of stock-based compensation.

     Goodwill amortization, acquisition charges and stock-based compensation in 2001 included a stock based compensation benefit of $9.5 million offset by goodwill amortization expense of $49.4 million and $142.1 millionacquisition charges of $0.8 million. The benefit related to stock-based compensation for 2001 was primarily due to the voluntary resignation of certain former employees in 2002, 2001 and 2000, respectively.resulting in a reversal of previously recognized stock compensation expense. We adopted Statement of Financial Accounting Standards (SFAS) No. 142, “Goodwill and Other Intangible Assets” (SFAS 142) effective January 1, 2002. SFAS 142 requires that goodwill and intangible assets with indefinite useful lives no longer be amortized, but instead be tested for impairment at least annually in accordance with the provisions of SFAS 142. During 2002, we completed our transitional goodwill impairment test as required under SFAS 142. Based upon our analysis, we determined that no goodwill impairment had occurred as of January 1, 2002, upon adoption of SFAS 142. In addition, we completed our annual impairment testtests during the fourth quarterquarters of 2002 and 2003 and again determined that goodwill was not impaired. Goodwill amortization was $49.4 million and $42.4in 2001.

     On August 4, 2003, we acquired all of the outstanding securities of Listen in exchange for approximately $18.8 million in 2001cash payments, including a $1.5 million payment made in January 2004 based on the achievement of a specified milestone, and 2000, respectively.an aggregate of 3.8 million shares and options to acquire 0.4 million shares of our common stock valued at $19.4 million. The value assigned to the stock portion of the purchase price is $4.72 per share based on the average closing price of our common stock for the five days beginning two

     Stock-based compensation was $1.3 million, a benefit28


days prior to and ending two days after April 21, 2003 (the date of $(9.5) millionthe Agreement and $96.6Plan of Merger and Reorganization). Options issued were valued based on the Black-Scholes options pricing model. In addition, as of the acquisition date, we had invested $7.3 million in 2002, 2001 and 2000, respectively. Goodwill amortization expense andListen in the form of convertible promissory notes that became a part of the purchase consideration. The cash balance at Listen on the acquisition charges were $0, $50.2 million and $45.4 milliondate was $4.9 million. As part of the acquisition, a management incentive plan was established whereby certain employees of Listen could be entitled over a two-year period to receive payments in 2002, 2001 and 2000, respectively. While the changes among periods are due partiallycash or stock having a value of up to the timing of acquisitions and the implementation of SFAS 142, particularly with respect to goodwill, the benefit related to stock-based compensation for 2001 was primarily due to the voluntary resignation of certain former employees in 2001 resulting in a reversal of previously recognized stock compensation expense.$3.0 million.

     In April 2002, we acquired, for cash and common stock valued at approximately $5.1 million, a privately held company engaged in the business of developing Internet media software and technology. The purchase price included amounts payable to certain former shareholders of the acquired company who are eligible to receive additional cash and common stock valued at approximately $3.1 million over a thirty-month period provided that they remain employed by RealNetworksus during such period. These costs will be recognized as compensation costexpense over the related employment period. The acquisition was accounted for as a purchase transaction and, accordingly, our results include the results for the acquired company since the transaction date. Goodwill of $2.3 million and acquired technology of $0.9 million were recorded as a result of the acquisition. We had previously made an equity investment in the acquired company and our investment balance at the time of acquisition was included in the purchase price allocation. Pro forma results are not presented, as they are not material to our overall financial statements. For the year ended December 31, 2002, we recognized stock-based compensation expense of $0.8 million related to this acquisition.

Other Income (Expense),Expense, Net

                                
2002Change2001Change20002003Change2002Change2001










(Dollars in thousands)(Dollars in thousands)
Interest income $7,483 (58)% $17,653 (19)% $21,804 
Interest income, netInterest income, net $4,251 (43)% $7,483 (58)% $17,653 
Equity in net loss of MusicNetEquity in net loss of MusicNet (6,324) 60 (3,946) n/a  Equity in net loss of MusicNet (5,378) (15) (6,324) 60 (3,946)
Impairment of equity investmentsImpairment of equity investments (5,103) (80) (25,342) n/a  Impairment of equity investments (424) (92) (5,103) (80) (25,342)
Other income (expense)Other income (expense) 3,217 (273) (1,862) (37) (2,933)Other income (expense) 1,107 (66) 3,217 (273) (1,862)
 
 
 
   
 
 
 
Other income (expense), net $(727) (95)% $(13,497) (172)% $18,871 Other expense, net $(444) (39)% $(727) (95)% $(13,497)
 
 
 
   
 
 
 

     Other income (expense),expense, net consists primarily of interest earnings on our cash, cash equivalents and short-term investments, equity in net loss of MusicNet, Inc. (“MusicNet”) and impairment of certain equity investments. Other income (expense),expense, net decreased to $(0.7) million in 2002 from $(13.5) million in 2001, a decrease of 95%.

27


This decrease was2003 primarily due to the inclusion of lower losses for impairment of certain equity investments and lower equity in net losses of MusicNet, offset by decreased interest income due to lower effective interest rates on investment balances.

     Other expense, net decreased in 2002 primarily due to the inclusion of lower losses for impairment of certain equity investments, partially offset by higher net losses of MusicNet, lower effective interest rates and lower investment balances. Lower cash balances in 2002 compared to 2001 were primarily the result of cash used to repurchase our common stock. Other income (expense), net decreased from $18.9 million

     Our investment in 2000 to $(13.5) million in 2001,MusicNet, a decrease of 172%. The decrease for 2001 was due to lower effective interest rates and lower investment balances, the inclusion of equity in net losses of MusicNet and the inclusion of the impairment of certain equity investments.

     MusicNet is ajoint venture formed with several media companies to create a platform for online music subscription services.services, is accounted for under the equity method of accounting. As a result, we record in our statement of operations our equity share in MusicNet’s net loss which was $5.4 million for the year ended December 31, 2003. MusicNet, which previously was a subsidiary of ours, issued additional shares of capital stock in April and July 2001 thereby reducing our ownership interest to approximately 36.8% in 2001. We account for our interest inIn 2003 and 2002, MusicNet using the equity method of accounting. As a result,raised additional capital from its investors to fund its business. In connection with this fund raising, we record in our statement of operations our equity share in MusicNet’s net income (loss). In July and November 2002, we and the other investors in MusicNet contributed additional capital to MusicNet to fund its business.in the amount of $3.0 million and $6.6 million, respectively. We received convertible notes, convertible into additional shares of MusicNet capital stock, in exchange for our additional investments. We anticipate that MusicNet will continue to incur losses in the foreseeable future and will require additional fundingfunding. Because of this, in the future, our investment may be diluted or we could be required to supportrecord an impairment charge to reduce the developmentcarrying value of its business model.this investment. Based on the nature

29


and terms of the convertible notes, in the yearyears ended December 31, 2003 and 2002, for purposes of calculating our equity in net loss of MusicNet, the convertible notes were treated on an “as if” converted basis. As a result, the losses recorded by us in the quartersyear ended September 30 and December 31, 2003 and 2002 represent approximately 36.9% and 37.8% of MusicNet’s loss. As of December 31, 2002,2003, our ownership interest in outstanding shares of capital stock of MusicNet was approximately 28.6%25.5% and the carrying value of our investment was $8.9$6.5 million.

     Our Chief Executive Officer, Robert Glaser, was the Chairman and a member of the Board of Directors of MusicNet from April 2001 until March 2003 and also served as the temporary acting Chief Executive Officer of MusicNet from April 2001 until October 2001. Mr. Glaser received no cash or equity remuneration for his services as Chairman and Director, nor did he receive any such remuneration for his services as the acting Chief Executive Officer. In 2003, we recognized approximately $1.1 million of revenue related to license and services agreements with MusicNet. In 2002, we recognized approximately $1.4 million of revenue related to agreements with MusicNet and were reimbursed $217,000 in 2002$0.2 million for certain administrative services provided to MusicNet on a transitional basis which has beenwas accounted for as a reduction of related expenses. In 2001, we received $4.2 million in cash from MusicNet pursuant to the terms of a license agreement with MusicNet and recognized $0.4 million of revenue related to this agreement. In addition, we were reimbursed $2.1 million in 2001 for certain administrative services provided to MusicNet on a transitional basis which has beenwas accounted for as reduction of related expenses.

     We have made minority equity investments for business and strategic purposes through the purchase of voting capital stock of companies. Our investments in publicly traded companies are accounted for as available-for-sale, carried at current market value and are classified as long-term as they are strategic in nature. We periodically evaluate whether any declines in fair value of our investments are other-than-temporary. This evaluation consists of a review of qualitative and quantitative factors. For investments with publicly quoted market prices, these factors include the time period and extent that theby which its accounting basis exceeds its quoted market price is less than its accounting basis.price. We consider additional factors to determine whether declines in fair value are other-than-temporary, such as the investee’s financial condition, results of operations and operating trends. The evaluation also considers publicly available information regarding the investee companies. For investments in private companies with no quoted market price, we consider similar qualitative and quantitative factors and also consider the implied value from any recent rounds of financing completed by the investee. Based upon an evaluation of the facts and circumstances during 2003, we determined that other-than-temporary declines in fair value had occurred in two of our publicly traded investments resulting in impairment charges of $0.4 million to reflect changes in the fair value of these investments in the results of operations. Based upon an evaluation of the facts and circumstances during 2002, we determined that other-than-temporary declines in fair value had occurred in two of our privately-held investments and three of our publicly traded investments. As a result,investments resulting in impairment charges of $5.1 million were recorded in 2002 to reflect changes in the fair value of these investments in the results of operations.million. During 2001, certain of these investments were written down to fair value based upon our analysis that the declines in fair value were other-than-temporary, resulting in impairment charges of $25.3 million in 2001.

     As of December 31, 2002,2003, we owned marketable equity securities of a Japanese company, representingdigital media company. We own approximately 14% of the outstanding shares which areand this investment is accounted for as an available-for-sale securities.security. The market value of these shares has significantly increased from theour original cost of approximately $1 million, resulting in a carrying value at December 31,

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2002 2003 of $17.3$25.1 million. The increase over our cost basis, net of tax effects, is reflected as a component of accumulated other comprehensive income (loss). During the years ended December 31, 2002, we sold a portionportions of our holdings recognizing a gain of $2.4 million which was reclassified from accumulated other comprehensive income (loss) to other income (expense), net.net loss. There were no similar gains or losses in 20012003 or 2000. Excluding the effect of this sale, the2001. The fair value of our investment declinedincreased by $54.6$7.8 million during the year ended December 31, 2002.2003. This increase is reflected as a component of other comprehensive loss. The market for this investee’scompany’s shares is relatively limited, the share price is volatile and ourthe investment is strategic in nature. Accordingly, there can be no assurance that a gain of this magnitude can be realized through the disposition of these shares.

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Income Taxes

     During the year ended December 31, 2002,2003, we recognized income tax expense of $6.0 million primarily$144,000 related to increasing our valuation allowance for net deferredcurrent foreign income taxes in the amount of $274,000 offset by current state and local income tax assets. In addition, we did not recognize a deferred tax benefit for losses incurred in 2002.

benefits of $130,000. We must assess the likelihood that our deferred tax assets will be recovered from future taxable income. In making this assessment, all available evidence must be considered including the current economic climate, our expectations of future taxable income and our ability to project such income and the appreciation of our investments and other assets. At December 31, 2003 we recorded a valuation allowance sufficient to net deferred tax assets to zero. We did not recognize a deferred tax benefit for losses incurred in 2003.

     During the year ended December 31, 2002, we recognized income tax expense of $6.0 million. Because of unfavorable economic conditions and uncertainty, significant net losses, and significant declines in the value of our investments, we determined that it was appropriate to increase our valuation allowance for net deferred tax assets in 2002, which resulted in a $5.6 million charge for deferred income tax expense. In addition, we did not recognize a deferred tax benefit for losses incurred in 2002.

     For the year ended December 31, 2001, we recorded an income tax benefit due primarily to the future tax benefit to be received on the loss on excess office facilities when the losses were to become deductible for income tax purposes. During the same periods, weWe also recorded impairment losses for other-than-temporary declines in fair value of investments. We did not record a related income tax benefit for these losses, which can only be utilized to offset future capital gains, as we did not have any significant sources of capital gain income as of December 31, 2001.

20022003 Quarterly Revenue

     The following table summarizes unaudited revenue for each quarter of 20022003 (in thousands):

                                     
Quarter endedQuarter ended


March 31June 30September 30December 31TotalTotalDecember 31September 30June 30March 31










(Dollars in thousands)(Dollars in thousands)
Consumer software and related servicesConsumer software and related services $9,455 7,225 6,820 7,776 31,276 Consumer software and related services $30,207 9,255 6,889 6,166 7,897 
Consumer subscription servicesConsumer subscription services 13,622 17,800 21,398 22,677 75,497 Consumer subscription services 107,093 30,075 27,909 25,470 23,639 
Systems 22,624 17,147 15,538 13,832 69,141 
Business products and servicesBusiness products and services 58,728 12,842 15,432 16,474 13,980 
AdvertisingAdvertising 1,591 1,586 1,662 1,926 6,765 Advertising 6,349 1,884 1,579 1,536 1,350 
 
 
 
 
 
   
 
 
 
 
 
Total net revenues $47,292 43,758 45,418 46,211 182,679 Total net revenues $202,377 54,056 51,809 49,646 46,866 
 
 
 
 
 
   
 
 
 
 
 

Consumer Software and Related Services. During the first threetwo quarters of 2002,2003, consumer software and related services revenue declined due to the reasons mentioned above in “Revenues — Consumer Software and Related Services.” ConsumerThe sequential increases in consumer software and related services revenue increased in the third and fourth quarter duequarters relate primarily to the launchinclusion of seven local language versionsmusic burn revenues since the date of our RealOne premium playerthe acquisition of Listen and increased revenue from distribution of third-party software.

Consumer Subscription Services. During all four quarters of 2002,2003, consumer subscription services revenue increased due to the reasons mentioneddescribed above in “Revenues — Consumer Subscription Services.” We believe

Business Products and Services. Business Products and Services revenue fluctuates on a quarter by quarter basis due to the decreasefact that transactions in growth ratethis category tend to be larger in dollar amount and fewer in number. A small number of transactions can have a significant impact on quarterly revenue. Specifically, in the fourthsecond quarter, was primarily caused by limited availability of live sports programming offerings in our subscription serviceswe recognized revenue previously deferred after a bankruptcy court ruling held that we were no longer required to provide future support or other obligations to a customer. In addition, the ruling included a payment from this customer in the fourththird quarter.

     During all four Also in the second and third quarters, sales of 2002,our systems software to mobile and wireless infrastructure companies favorably impacted revenue. With the exception of the impact of large transactions in the second and third quarters, business products and services revenue decreaseddeclined during the year due to the reasons mentioned above in “Revenues — Systems.Business Products and Services.

2931


     Advertising.During all four quarters of 2002,2003, the changessequential increases in advertising were primarily due to new arrangements with certain existing customers. In general, advertising revenue will fluctuate by quarter depending on the timing of selling and delivering advertising contracts.

Impact of Recently Issued Accounting Standards

     We adopted SFAS 142 effectiveIn January 1, 2002. Goodwill and intangible assets acquired in a purchase business combination and determined to have an indefinite useful life are not amortized, but instead tested for impairment at least annually in accordance with the provisions of SFAS 142. SFAS 142 also requires that intangible assets with definite useful lives be amortized over their respective estimated useful lives to their estimated residual values, and reviewed for impairment in accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (SFAS 144).

     In connection with SFAS 142’s transitional goodwill impairment evaluation, the Statement required that we perform an assessment of whether there was an indication that goodwill is impaired as of the date of adoption. To accomplish this, we were required to identify our reporting units and determine the carrying value of each reporting unit by assigning the assets and liabilities, including the existing goodwill and intangible assets, to those reporting units as of January 1, 2002. We were required to determine the fair value of each reporting unit and compare it to the carrying amount of the reporting unit within six months of January 1, 2002. To the extent the carrying amount of a reporting unit exceeded the fair value of the reporting unit, we would be required to perform the second step of the transitional impairment test, which would require that we compare the implied fair value of the reporting unit goodwill with the carrying amount of the reporting unit goodwill. As of January 1, 2002, the second step was not required as the implied fair value of our reporting units exceeded their respective carrying amounts. In December 2002, we performed a similar test to that described above, in connection with our annual impairment test required under SFAS 142 and, again, the implied fair value of our reporting units exceeded their respective carrying amounts and we were not required to recognize an impairment loss.

     Prior to the adoption of SFAS 142, goodwill was amortized on a straight-line basis over the expected periods to be benefited, generally three to five years, and assessed for recoverability by determining whether the amortization of the goodwill balance over its remaining life could be recovered through future operating cash flows of the acquired operation.

     In June 2001, the Financial Accounting Standards Board (FASB) issued SFAS No. 143, “Accounting for Asset Retirement Obligations” (SFAS 143). SFAS 143 requires that we record the fair value of an asset retirement obligation as a liability in the period in which it incurs a legal obligation associated with the retirement of tangible long-lived assets that result from the acquisition, construction, development and/or normal use of assets. We also record a corresponding asset that is depreciated over the life of the asset. Subsequent to the initial measurement of the asset retirement obligation, the obligation will be adjusted at the end of each period to reflect the passage of time and changes in the estimated future cash flows underlying the obligation. We will adopt SFAS 143 on January 1, 2003. The adoption of SFAS 143 is not expected to have a material effect on our financial statements.

     In October 2001, the FASB issued SFAS 144, which was effective for us beginning in 2002. SFAS 144 supersedes certain provisions of APB Opinion No. 30 “Reporting the Results of Operations — Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions” and supersedes SFAS 121. We adopted SFAS 144 as of January 1, 2002. The adoption of SFAS 144 did not affect our consolidated financial position or results of operations.

     In June 2002, the FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities” (SFAS 146), which is effective for fiscal years beginning after December 31, 2002, with early application encouraged. SFAS 146 supersedes Emerging Issues Task Force (EITF) Issue No. 94-3, “Liabilities Recognized for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).” We do not expect the adoption of SFAS 146 to have a material effect on our consolidated financial position or results of operations.

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     In November 2002, the EITF reached a consensus on Issue No. 00-21, “Revenue Arrangements With Multiple Deliverables” (EITF 00-21). EITF 00-21 addresses certain aspects of the accounting by a vendor for arrangements under which the vendor will perform multiple revenue generating activities. EITF 00-21 will be effective for periods beginning after June 15, 2003. We do not expect the adoption of EITF 00-21 to have a material effect on our financial position or results of operations.

     In November 2002,2003, the FASB issued Interpretation No. 45 “Guarantor’s Accounting and Disclosure Requirements46, Consolidation of Variable Interest Entities (FIN 46). In general, a variable interest entity is a corporation, partnership, trust or any other legal structure used for Guarantees, Including Indirect Guarantees of Indebtednessbusiness purposes that either (a) does not have equity investors with voting rights or (b) has equity investors that do not provide sufficient financial resources for the entity to Others, an interpretation of FASB Statements No. 5, 57 and 107 and a rescission of FASB Interpretation No. 34.” This Interpretation elaborates on the disclosuressupport its activities. FIN 46 requires certain variable interest entities to be madeconsolidated by a guarantor in its interim and annual financial statements about its obligations under guarantees issued. The Interpretation also clarifies that a guarantor is required to recognize, at inceptionthe primary beneficiary of the entity if the investors do not have the characteristics of a guarantee, a liabilitycontrolling financial interest or do not have sufficient equity at risk for the fair valueentity to finance its activities without additional subordinated financial support from other parties. The consolidation requirements of the obligation undertaken. The initial recognition and measurement provisions of the Interpretation are applicableFIN 46 apply immediately to guarantees issued or modifiedvariable interest entities created after DecemberJanuary 31, 2002 and are not expected to have a material effect on our financial statements. The disclosure requirements are effective for financial statements of interim and annual periods ending after December 15, 2002.

2003. In December 2002,2003, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure, an amendment of SFAS No. 123” (SFAS 148). This Statement amends SFAS No. 123, “Accounting for Stock-Based Compensation” (SFAS 123),FIN 46R with respect to provide alternative methods of transition for a voluntary changevariable interest entities created before January 31, 2003, which among other things, revised the implementation date to the fair value method of accounting for stock-based employee compensation. In addition, this Statement amends the disclosure requirements of SFAS 123 to require prominent disclosures in both annual andfirst fiscal year or interim financial statements. Certain of the disclosure modifications are required for fiscal yearsperiod ending after DecemberMarch 15, 2002 and2004, with the exception of Special Purpose Entities (“SPE”). We are included incurrently evaluating the notes topotential impact the adoption of this Interpretation will have on our consolidated financial statements.

Liquidity and Capital Resources

     Net cash used in operating activities was $8.8 million in 2003 and $0.8 million in 2002. Net cash provided by operating activities was $14.9 million in 2001. Net cash used in operating activities in 2003 was the result of a net loss of $21.5 million as well as net changes in certain assets and $56.0liabilities of $8.1 million, due primarily to the timing of cash receipts or payments at the beginning and end of the year and the recognition of deferred revenue, offset by depreciation and amortization of $12.4 million, equity in 2001net losses of equity method investments of $5.4 million and 2000, respectively.an increase in the accrued loss on excess office facilities of $3 million. Net cash used in operating activities in 2002 was the result of a net loss of $38.4 million as well as net changes in certain assets and liabilities of $4.7 million, due primarily to the timing of cash receipts or payments at the beginning and end of the year and the recognition of deferred revenue, and gains on sales of investments of $2.3 million, offset by an increase in accrued loss on excess office facilities of $13.5 million, non-cash depreciation and amortization expense of $11.8$13.1 million, equity in net losses of equity method investments of $6.8 million, deferred income taxes of $5.6 million and impairment of equity investments of $5.1 million. Net cash provided by operating activities in 2001 resulted primarily from a net loss of $74.8 million a decreaseas well as net changes in certain assets and liabilities of $5.5 million, due primarily to the timing of cash receipts or payments at the beginning and end of the year and the recognition of deferred revenue and deferred income tax benefit of $4.7 million, a decrease in accrued and other liabilities of $5.7 million and an increase in prepaid expenses and other current assets of $3.9$7.9 million, offset by a $25.3 million charge for impairment of equity investments, a $19.4 million fromcharge for the loss on excess office facilities, depreciation and amortization of equipment, leasehold improvements and other intangible assets of $12.1 million $41.2 million forand goodwill amortization and stock-based compensation and a decrease in accounts receivable of $3.1$41.2 million.

     Net cash provided by operatingused in investing activities was $22.4 million in 2000 resulted primarily from a net loss of $110.1 million and increases in accounts receivable of $1.3 million and prepaid expenses and other current assets of $3.5 million, offset by an increase in deferred revenue of $3.7 million, an increase in accrued and other liabilities of $9.3 million, $142.1 million for goodwill amortization and stock-based compensation and depreciation and amortization of $9.3 million.

2003. Net cash provided by investing activities was $41.3 million in 2002. Net cash used in investing activities was $54.6 million in 2001. Net cash used in investing activities in 2003 was primarily due to the payment of acquisition costs and $89.9 million in 2001purchases of long-term investments and 2000, respectively.equipment and leasehold improvements, offset by net sales and maturities of short-term investments. Net cash provided by investing activities in 2002 was primarily related to net sales and maturities of short-term investments, partially offset by purchases of equipment and leasehold improvements and purchases of equity securities held as long-term investments. Net cash used in investing activities in 2001 and 2000 was primarily related to net increases inpurchases of short-term investments, purchases of equity securities held as long-term investments, and purchases of equipment and leasehold improvements.

     Net cash provided by financing activities was $107.1 million in 2003. Net cash used in financing activities was $23.0 million and $3.4 million in 2002 and 2001, respectively. Net cash provided by financing activities in 2003 was $21.7 millionrelated to the proceeds from our convertible debt offering in 2000.June 2003 (see “Notes to Consolidated Financial Statements — Convertible Debt” (Note 10) for a description of this offering) and net proceeds

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from sales of common stock and exercise of stock options and warrants. Net cash used in financing activities in 2002 and 2001 was primarily related to repurchases of our common stock, partially offset by exercisesnet proceeds from sales of

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employee common stock options. Net cash provided by financing activitiesand exercise of $21.7 million in 2000 was primarily from exercises of employee stock options.options and warrants.

     In September 2001, we announced a share repurchase program. Our Board of Directors authorized the repurchase of up to an aggregate of $50 million of our outstanding common stock. Any purchases of common stock under our share repurchase program will be made from time-to-time, in the open market, through block trades or otherwise. Depending on market conditions and other factors, these purchases may be commenced or suspended at any time without prior notice. There were no repurchases in 2003. As of December 31, 2002,2003, we had repurchased approximately 9.1 million shares at an average cost of $4.64 per share. We currently intend to continue our stock repurchase program depending on market conditions and other factors until we reach the $50 million limit authorized by our Board of Directors, which will be a further use of cash.

     We currently have no planned significant capital expenditures for 2004 other than those in the ordinary course of business. In the future, we may seek to raise additional funds through public or private equity financing, or through other sources such as credit facilities. The sale of additional equity securities could result in dilution to our shareholders. In addition, in the future, we may enter into cash or stock acquisition transactions or other strategic transactions that could reduce cash available to fund our operations or result in dilution to shareholders.

     At December 31, 2002,2003, we had $326.4$373.6 million in cash, cash equivalents, short-term investments and restricted cash equivalents. Our principal commitments include office leases and contractual payments due to content and other service providers. We believe that our current cash, cash equivalents and short-term investments will be sufficient to meet our anticipated cash needs for working capital and capital expenditures for at least the next 12 months.

     On January 30, 2004, we acquired all of the outstanding securities of GameHouse in exchange for approximately $9.1 million in cash payments, including an estimated future payment of $0.1 million to cover certain tax obligations of the selling shareholders, and 3.0 million shares and options to acquire 0.3 million shares of RealNetworks common stock valued at $20.9 million. The value assigned to the stock portion of the purchase price is $6.40 per share based on the average closing price of our common stock for the five days beginning two days prior to and ending two days after January 26, 2004 (the date of the Agreement and Plan of Merger). Options issued were valued based on the Black-Scholes options pricing model. Included in the purchase price is $0.4 million in estimated acquisition-related expenditures consisting primarily of professional fees. Certain former GameHouse shareholders are eligible to receive $5.5 million over a four year period, payable in cash or, at our discretion, in our common stock valued in that amount provided they remain employed by us during such period. In addition, we could pay a total of $1.0 million over a four-year period to certain GameHouse employees in the form of a management incentive plan. Such amounts are not included in the aggregate purchase price and, to the extent earned, will be recorded as compensation expense over the related employment periods.

     We do not hold derivative financial instruments or equity securities in our short-term investment portfolio. Our cash equivalents and short-term investments consist of high quality securities, as specified in our investment policy guidelines. The policy limits the amount of credit exposure to any one non-U.S. Government or non-U.S. Agency issue or issuer to a maximum of 5% of the total portfolio. These securities are subject to interest rate risk and will decrease in value if interest rates increase. Because we have historically had the ability to hold our fixed income investments until maturity, we would not expect our operating results or cash flows to be significantly affected by a sudden change in market interest rates in our securities portfolio.

     We conduct our operations in ten primary functional currencies: the United States dollar, the Japanese yen, the British pound, the Euro, the Mexican peso, the Brazilian real, the Australian dollar, the Hong Kong dollar, the Singapore dollar and the Korean won. Historically, neither fluctuations in foreign exchange rates nor changes in foreign economic conditions have had a significant impact on our financial condition or results of operations. We currently do not hedge the majority of our foreign currency exposures and are therefore subject to the risk of exchange rate fluctuations. We invoice our international customers primarily in U.S. dollars, except in Japan, Germany, France, the United Kingdom and Australia, where we invoice our

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customers primarily in yen, euros (for Germany and France), pounds and Australian dollars, respectively. We are exposed to foreign exchange rate fluctuations as the financial results of foreign subsidiaries are translated into U.S. dollars in consolidation. Our exposure to foreign exchange rate fluctuations also arises from intercompany payables and receivables to and from our foreign subsidiaries. Foreign exchange rate fluctuations did not have a material impact on our financial results in 2003, 2002 2001 and 2000.2001.

     We currently intendOur only significant off-balance sheet arrangements relate to continue our stock repurchase program into 2003 until we reach the $50 million limit authorized by our Board of Directors, which will be a further use of cash. We currently have no planned significant capital expendituresoperating lease obligations for 2003office facility leases and other than thosecontractual obligations related primarily to minimum contractual payments due to content and other service providers. Future annual minimum rental lease payments and other contractual obligations are included in the ordinary course of business. In the future, we may seek to raise additional funds through public or private equity financing, or through other sources such as credit facilities. The sale of additional equity securities could result in dilution to our shareholders.commitment schedule below.

     At December 31, 2002,2003, we had commitments to make the following payments:

                                   
Less than1-34-5After 5Less than1-34-5After 5
Contractual ObligationsContractual ObligationsTotal1 YearYearsYearsYearsContractual ObligationsTotal1 YearYearsYearsYears













(In thousands)(In thousands)
Office leasesOffice leases $99,133 11,428 23,361 24,580 39,764 Office leases $91,126 12,520 24,372 25,121 29,113 
 Up to Up to 
Convertible debtConvertible debt 100,000 100,000 
Other contractual obligationsOther contractual obligations 55,913 29,612 26,301   Other contractual obligations 51,495 23,722 18,363 4,750 4,660 
 
 
 
 
 
   
 
 
 
 
 
Total contractual cash obligations $155,046 41,040 49,662 24,580 39,764   Up to Up to 
 
 
 
 
 
 Total contractual cash obligations $242,621 36,242 42,735 129,871 33,773 
 
 
 
 
 
 

     Other contractual obligations primarily relate to minimum contractual payments due to content and other service providers.

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Factors That May Affect Our Business, Future Operating Results and Financial Condition

     You should carefully consider the risks described below together with all of the other information included in this annual reportAnnual Report on Form 10-K. The risks and uncertainties described below are not the only ones facing our company. If any of the following risks actually occurs, our business, financial condition or operating results could be harmed. In such case, the trading price of our common stock could decline, and investors in our common stock could lose all or part of their investment.

We Have a Relatively Limited Operating History, Which Makes it Difficult to Evaluate Our Business

     We were incorporated in February 1994 and have a relatively limited operating history particularlywith our paid media content businesses, which makes it difficult to evaluate our business.

     We have a relatively limited history operating our paid media content businesses, including our subscription businesses, which in recent periods have become an increasingly important part of our consumer subscription businesses. Webusiness and now represent a majority of our revenues. As a result, we have limited financial results from these businesses on which you can assess our future success.prospects. Our prospects must be considered in light of the risks, expenses and difficulties frequently encountered by growing companies in new and rapidly evolving markets,businesses, such as the markets for online consumer subscription services and digitalpaid media softwarecontent businesses in which we operate.

     To address Our paid content business revenue and subscriber/user base have grown relatively rapidly in the risks and uncertainties faced by our business,early phases of the development of these businesses. If these businesses continue to grow, the growth rates we must meet many challenges including:

• establishing and maintaining broad market acceptance of our products and services and converting that acceptance into direct and indirect sources of revenues;
• establishing and maintaining our brand name;
• timely and successfully developing new products, product features and services and increasing the functionality and features of existing products and services;
• developing subscription services products that result in high degrees of consumer satisfaction and high levels of consumer usage;
• successfully respondinghave experienced to date are unlikely to competition from Microsoft and others, including competition from emerging technologies and solutions; and
• developing and maintaining strategic relationships to enhance the distribution, features and utility of our products and services.

     Our business strategy may be unsuccessful and we may be unable to address the risks we face in a cost-effective manner, if at all. If we are unable to successfully address these risks our business will be harmed.sustainable.

We Havehave a Historyhistory of Losseslosses, and we cannot be sure that we will be able to return to profitability in the future.

     We have incurred significant losses since our inception. As of December 31, 2002,2003, we had an accumulated deficit of approximately $258.1$280 million. We have had a net losslosses for each year subsequent to the yearsyear ended December 31, 2002, 2001 and 2000,1999, and we may not generate sufficient revenuesrevenue to be profitable on a quarterly or annual basis in the future. We devote significant resources to developing, enhancing, selling, marketing and marketingobtaining content for our products and services. As a result, we will need to generate significant revenuesrevenue to be profitable in the future.

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Our Operating Results Are Likelyoperating results are difficult to Fluctuate Significantly, Which May Cause Our Stock Pricepredict and may fluctuate, which may contribute to Fluctuatefluctuations in our stock price.

     As a result of our relatively brief operating history and the rapidly changing and uncertain nature of the markets in which we compete, our quarterly and annual revenuesrevenue and operating results are likely tomay fluctuate from period-to-period, and period-to-period comparisons may not be meaningful. These fluctuations are caused by a number of factors, many of which are beyond our control. Our futureIn past periods, our operating results have been affected by personnel reductions and related charges, charges relating to losses on excess office facilities, and impairment charges for certain of our equity investments. Our operating results may be adversely affected by similar or other charges or events in future periods, which could fall belowcause the expectations of public market analysts or investors, which would likely significantly reduce the markettrading price of our common stock. Fluctuations in our operating results will likely increase the volatilitystock to decline.

     Certain of our stock price.

     Ourexpense decisions (for example, research and development and sales and marketing efforts, our media content licensing efforts and other business expenditures generally,generally) are partially based on predictions regarding certain developments for media deliveryour business and digital media

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distribution and on the consumption of online consumer subscription services.markets in which we compete. To the extent that these predictions prove inaccurate, our revenuesrevenue may not be sufficient to offset these expenditures, and our operating results may be harmed.

Our Revenues May Be Harmed If General Economic Conditions Do Not Improvesuit against Microsoft for antitrust violations may not be successful and could harm our financial results.

     In recent periods, general adverse economic conditions have caused many customers and prospective customers of our media delivery system software to experience financial difficulties. As a result, some of these companies have ceased or consolidated operations, some are continuing to experience financial difficulty, sales cycles for many of our customers and potential customers have become longer and less predictable thanOn December 18, 2003, we filed suit against Microsoft Corporation in the pastU.S. District Court for the Northern District of California, alleging that Microsoft violated U.S. and California antitrust laws. In our lawsuit, we allege that Microsoft has illegally used its monopoly power to restrict competition, limit consumer choice and attempt to monopolize the field of digital media. We expect that the litigation, if it is not resolved before trial, will carry on for several years. It is not possible to predict accurately how much the litigation will cost, or its duration. The costs of the litigation could have an adverse impact on our operating results in some cases, certain customers have adopted the media delivery products of our primary competitor because it bundles its competing media delivery products with its operating system for no additional charge. In particular, customers and potential customers in the systems software and telecommunication industries have become increasingly cautious in their buying decisions due to the economic trends specific to those industries. The macroeconomic environment, including Microsoft’s bundling practices, has also impacted sales to, and the rate of adoption of our systems software products by consumers, customers in the corporate enterprise, broadcast hosting, Internet content provider, non-PC device manufacturer, systems software, telecommunication and original equipment manufacturer market segments. No assurance can be given when, or if, customers in these markets will increase capital spending levels. In the event that a substantial numberexcess of our current or potential customers experience financial difficulties in the future, the rate of adoption ofexpectations. The litigation may also distract our products may be slowed, our ability to increase or maintain sales to such customers will be adversely affected and our ability to generate revenuesmanagement team from these companies will also be adversely impacted. Further, if U.S. or global economic conditions worsen, our business, operating results, and financial condition could be harmed. Our system software revenues are dependent on the health of the economy and the growth of our customers.

     Our consumer subscription services are a new business model for us and we believe these services represent a discretionary spending item for many consumers. Accordingly, the development of these services could be negatively impacted by a general decline in consumer spending levels or other changes in consumer habits caused by macroeconomic conditions, which would harm our business and our business prospects.

Our Restructuring Efforts May Not Be Effective

     In July 2001 and August 2002, we took steps to better align our resources with the levels required to operate efficiently in the prevailing market. Through these steps, we reduced our headcount and are attempting to sublease certain of our excess facility capacity. While we believe that these steps will help us achieve greater operating efficiency, we have no prior history with such measures and cannot predict whether they will be effective. These measures could adversely impact the employees that we wish to retain, our customers and/or our vendors,operational matters, which could harm our abilitybusiness results. We may not prevail in our claims against Microsoft, in which case our costs of litigation will not be recovered. Even if we do prevail, the litigation may not be successful in causing Microsoft to operatealter its anticompetitive behavior. Furthermore, Microsoft’s defense strategy may include the assertion of counterclaims against us, as intended and which would harm our business.

There Are a Number of Risks Associated With Our Recently Announced Helix Initiative

     We recently announced the introduction of Helix, a combination of technology and a new licensing model designed to create an open, comprehensive platform and community to enable the creation of digital media products and applications for multiple formats, operating systems and devices. Under the new licensing model, Helix community members can access, use and modify certain RealNetworks source code. This enables a large group of developers to extend the Helix technology to other platforms, fix software bugs and create their own applications using the Helix platform.

     Because these initiatives and products were introduced so recently, there are a number of risks associated with them, including risks associated with open source and community source technology licensing, development and business models and the risks typically associated with the introduction of new products and technologies. There can be no assurance that the industry will adopt the Helix Platform or the Helix Community, or that third parties will develop and introduce technologies or products based on them. Further,

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there can be no assurance that new or existing customers will license the Helix Universal Server. While we have invested substantial resourceswell as leveraging its power in the development of these initiatives and products, there can be no assurance that they will be accepted by the market, that we will derive substantial revenue from such initiatives and products or that the introduction of Helix and the Helix Universal Server will notcommercial marketplace to adversely affect our sales.
current and potential business relationships, either of which may have an adverse affect on our business results.

Our Subscription Services May Not Be Successfulonline paid content businesses have generally lower margins than our traditional software license business.

     In August 2000, we introduced our RealPlayer GoldPass subscription service, which provided customers access to a combination of premium software, services and content in exchange for a monthly fee. In December 2001, we launched our RealOne subscription service which is provided through our RealOne Player Plus full-featured digital media player. Members of oneCosts of our RealOne subscription services gain access to premium subscriptiononline paid content and are able to take advantage of certain enhanced features of the RealOne Player. These subscription services are a relatively new business model for delivering media over the Internet and represent a new business model for us. It is too early to predict whether consumers will accept in significant numbers our subscription services or whether the services will otherwise be financially viable. To date, costs of our subscription services as a percentage of the revenue generated by those businesses are higher than the ratio of costs to revenues in our historical software licensing business. This includes our music subscriptions and sales, video subscription services revenues are significantly higher than such costs represented in our business historically, and wegames licensing. We expect this trend will continue to negatively impact our overall gross margins as we grow our consumer subscription business and it becomesonline paid content businesses as a larger portionpercentage of our overall revenues. Our subscription services compete with both traditional and online entertainment service providers although, to date, we have not faced significant direct competition with our subscription service offerings. We anticipate increasing competition for online subscription servicebusiness. If paid content revenues fromgrow as a wide range of companies, including AOL Time Warner, Microsoft and Yahoo!, which has recently announced its intention to compete with our subscription services. Manypercentage of our competitors have significantly more resources than us, including accessoverall revenues, our margins may further decrease which may affect the rate at which we achieve profitability.

Our digital content subscription businesses depend on our continuing ability to license compelling content and some of our competitors may be able to leverage their experience in providing subscription or similar services to customers in other businesses to the sale of digital media subscriptions.on commercially reasonable terms.

     We must continue to obtain premiumcompelling digital media content in order to maintain and increase subscriptions and subscription service revenuesrevenue and overall customer satisfaction. It is too early to predict whether our subscription business will require highly popular content to increase or maintain subscriptions, and, if so, whether we will be able to obtain such content on a consistent basis, or on commercially acceptable terms.satisfaction for these products. To date, with the exception of music, a limited amount of premium digital content has been made available for delivery over the Internet that can only be accessed through a for-pay service and not for free. In some cases, we have had to pay substantial fees to obtain content. If we are unable to obtain premium digital content that consumers desire on commercially reasonable terms, or at all, or if we do not successfully market our subscription services to our end users and other potential subscribers, our business couldwill be harmed. We have limited experience determining what content will be successful with current and prospective customers. In addition, if the adoption of broadband services is slower than anticipated it may impact the desirabilitycertain of our services as users encounter low-quality content over slower connections. In the future, increased competition for subscription services may make it more difficult to secure content licenses under reasonable terms.

If We Do Not Continue To Add Subscribers To Our Subscription Services Or If We Experience Excessive Rates of Subscriber Churn, Our Revenueslicensing agreements have high fixed costs associated with them, and Business Will Be Harmed

     Our subscription serviceswe have become an increasingly important source of our total revenues. We believe the subscription business represents a major growth opportunity for us and also creates substantial risks. Subscribers may cancel their subscriptions to our subscription services for many reasons, including a perception that they do not use the subscription services sufficiently, a lack of attractive or exclusive content, the service is of a poor value and customer service issues are not satisfactorily resolved. In order to increase our subscriber numbers and subscription revenues, we must continue to add new subscribers each quarter while minimizing the rate of loss of existing subscribers. If our marketing and promotional activities fail to add significant numbers of new subscribers or if too many of our subscribers cancel their memberships because they are dissatisfied with the service or otherwise, our revenues and business will suffer. In addition, if the costs of such marketing and promotional activities increase in order to add new subscribers, our margins and operating results will suffer. Our subscription revenues and subscription base have grown on a percentage basisdecided

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not to renew certain of these agreements. Failure to renew these contracts has resulted, and may in the early phasesfuture result, in the loss of subscribers to our subscription offerings and a corresponding loss of revenue.

Our subscription levels may vary due to the seasonal or periodic nature of some popular content and as we experiment with different types of content offerings.

     Some of the development ofmost popular content we have offered in our premium subscription content services has been content that is seasonal or periodic in nature. Additionally, as we develop our subscription business. If our subscription revenues and subscriber base continuecontent business, we are experimenting with different types of content to grow, the percentage growth rates we have experienced to date are unlikely to be sustainable.

     Many of our subscribers subscribe to our stand-alone premium subscription service products, some of which are seasonal in nature, such as our Major League Baseball Advanced Media and NASCAR.com offerings.determine what consumers prefer. We have limited experience with these types of offerings and cannot predict how the seasonal or periodic nature of these offerings will impact our subscriber growth rates, future subscriber retention levels or our quarterly financial results. No assurance can be givenWe anticipate that these stand-alone subscriberssubscriber levels for our various subscription service offerings will remain subscribersfluctuate due to seasonally available popular content and as we experiment with new types of content offerings.

The success of our subscription services atbusinesses depends upon our ability to add new subscribers and minimize subscriber churn.

     Our subscription services are an increasingly important source of our total revenue. If we do not continue to add new subscribers each quarter while minimizing the endrate of any seasonloss of existing subscribers, our operating results will be adversely impacted. Because Internet subscription content businesses are a relatively new media delivery model and a new business for us, we cannot predict with accuracy our long-term ability to retain subscribers or add new subscribers. Subscribers may cancel their subscriptions to our services for many reasons, including a perception that they do not use the services sufficiently or that they will renew their subscriptions for following seasons.the service does not provide enough value, a lack of attractive or exclusive content generally or as compared to competitive service offerings (including Internet piracy), or because customer service issues are not satisfactorily resolved. In addition, no assurance can be giventhe costs of marketing and promotional activities necessary to add new subscribers, and the costs of obtaining content that the grosscustomers desire, may adversely impact our margins associated with these offerings will be consistent with our historical gross margins or our gross margins for our other subscription products, such as RealOne SuperPass.and operating results.

Our Online Music Services Initiatives May Not Be Successfulonline music services depend upon our licensing agreements with the major music label companies.

     In 2001, we announced the formation of a joint venture called MusicNet with several leading media companies to create a technology platform forOur online music subscription services. We also entered into an agreement with MusicNet to license the MusicNet platform and service for sale to our own customers. In December 2001, we began offering the RealOne MusicPass subscription service, a for-pay music subscription service based on the MusicNet platform. The business models, technologies and market for online music subscription services are new and unproven. Consumers may not accept certain features of our current RealOne MusicPass subscription offering, including the inability to copy or “burn” RealOne Music content onto CD’s, the expiration of a subscriber’s rights to access RealOne MusicPass content at the end of each month of the subscription, and the availability of a limited selection of content from certain major record labels. To date, consumer adoption and usage of our RealOne MusicPass offering has not been significant. If RealOne MusicPass is unable to improve the features of its music service offering, it may not achieve market acceptance and our financial results and business prospects could be harmed. In addition, we record in our statement of operations our equity share in MusicNet’s net income (loss) which was a loss of $6.3 million for the year ended December 31, 2002. We anticipate that MusicNet will continue to incur losses in the foreseeable future and will need additional funding to support the development of its business model. No assurance can be made that MusicNet will ever contribute net income to our statement of operations or that losses recorded from MusicNet will not increase in the future. Our ability to provide music services is dependentofferings depend on music licenses from the major music labels. The current license agreements are for relatively short terms (many of these licenses are due to expire and will need to be renewed in 2004), and we cannot be sure that the music labels will renew the licenses on commercially viable terms, or at all. Due to the increasing importance of our music services to our overall revenues, the failure of the major music labels to license their music catalogsrenew these licenses under terms that are acceptable to consumersus will harm our ability to offer music subscription services.

     Oursuccessful music subscription services and would harm our operating results.

Music publishing royalty rates for streaming are not yet established; a determination of high royalty rates could negatively impact our operating results.

     Royalty rates associated with streaming musical compositions in the U.S. have not yet been established with respect to public performances and, if required, reproductions. Public performance licenses are negotiated individually, and we have not yet agreed to rates with all of the performing rights societies for all of our music streaming activities. We may be required to pay a rate that is higher than we expect, or the issue may be submitted to a “Rate Court” for judicial determination. We have a license agreement with the Harry Fox Agency, an agency that represents music publishers, to reproduce musical compositions as required in the creation and delivery of on-demand streams, but this license agreement does not include a rate. The license agreement anticipates industry-wide agreement on rate, or, if no industry-wide agreement can be reached, determination by a copyright arbitration royalty panel (“CARP”), an administrative judicial proceeding supervised by the United States Copyright Office. If the rates agreed to or determined by a CARP are higher than we expect, this expense could negatively impact our operating results. The publishing rates associated with our international music streaming services are also not yet determined, and may be higher than we anticipate.

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Our products and services must compete with the products and services of strong or dominant competitors.

     Our software and services must compete with strong existing competitors, and new competitors may enter with competitive new products, services and technologies. These market conditions have in the past resulted in, and could likely continue to result in, in the following consequences, any of which could adversely affect our business, our operating results and the trading price of our stock:

• reduced prices, revenues and margins;
• increased expenses in responding to competitors;
• loss of current and potential customers, market share and market power;
• lengthened sales cycles;
• degradation of our stature in the market and reputation;
• changes in our business and distribution and marketing strategies;
• changes to our products, services, technology, licenses and business practices, and other disruption of our operations;
• strained relationships with partners; and
• premature release of products and product enhancements.

Many of our current and potential competitors have longer operating histories, greater name recognition, more employees and significantly greater resources than we do. Our competitors across the breadth of our product line include a number of large and powerful companies, such as Microsoft, Apple Computer, Yahoo!, the AOL division of Time Warner and others. Some of our competitors have in the past and may in the future enter into collaborative arrangements with each other that enable them to better compete with our business.

Microsoft is one of our strongest competitors, and employs highly aggressive tactics against us.

     Microsoft is one of our principal competitors in the development and distribution of digital media and media distribution technology. Microsoft’s market power in related markets such as personal computer operating systems, office software suites and web browser software give it unique advantages in the digital media markets. We expect that Microsoft will continue to increase pressure in the digital media markets in the future. Microsoft’s dominant position in certain parts of the computer and software markets, and its aggressive activities have had, and in the future will likely continue to have, adverse effects on our business and operating results.

We believe that Microsoft has employed, and will likely continue to employ highly aggressive tactics against us such as leveraging Microsoft’s market dominating position in operating systems and servers to distribute and promote its digital media products. We also believe that Microsoft limits exposure to third parties (including us) of the interfaces to its operating systems, which limits the ability of our products to take full advantage of the features and functionality of Microsoft’s operating systems and limiting our ability to compete effectively with Microsoft. The effects of Microsoft’s activities include loss of customers and market share, unnatural pressure on the pricing of our products and continuing costs of developing and revising business strategies in response to these activities.

Our consumer businesses face substantial competitive challenges that may prevent us from being successful in those businesses.

Multimedia products and services. Our multimedia content services (including our RealOne SuperPass subscription) face competition from existing competitive alternatives and other emerging services and technologies. We face competition in these markets from traditional media outlets such as television, radio, CDs, DVDs, videocassettes and others. We also face competition from emerging Internet media sources and established companies entering into the Internet media content market, including Time Warner’s AOL subsidiary, Microsoft, Apple, Yahoo! and broadband Internet service providers. We expect that, as the market

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for Internet content matures, more competitors will enter these new markets, making competition even more intense. Competing services may be able to obtain better or more favorable access to compelling media content than us, and may also develop better offerings than us.

Music.Our music service offerings face competition from traditional offline music distribution competitors and fromform other newonline digital music services. Some of these competing services have been the subject of substantial marketing efforts and have received significant media attention, including Apple’s iTunes music service, WalMart.com’s music store and Roxio’s Napster online music subscription service. We expect that Microsoft will also begin offering premium music services including pressplay, a joint venture formed between two leading media companies, the Rhapsodyin conjunction with its Windows Media Player. Our current music service distributed by Listen.com, Inc. and other online efforts of the leading media companies. Competing services, like pressplay and Rhapsody,offerings may not be able to obtain more or better music content or may be able to license such content on more favorable terms than MusicNet, which could harm the ability of MusicNet and our music subscription services to compete effectively in the marketplace.this highly competitive market. Our music subscription services also face significant competition from “free” peer-to-peer services such as KaZaA and Morpheus, thatwhich allow consumers to directly access an expansive array of free content without securing licenses from content providers. Although several of these “free” services have been found to be illegally violating copyright laws, enforcement efforts to date have not effectively shut down these services, and there can be no assurance that these services will ever be shut down. The ongoing presence of these “free” services, even if they are subsequently found to be illegal, substantially impairs the marketability of legitimate services such as RealOne MusicPass. MusicNet also is a licenseelike ours.

Games.Our RealArcade service competes with other online distributors of our technologydownloadable games. Some of these distributors have high volume distribution channels and has used our digital music architecturegreater financial resources than us, including Yahoo Games, MSN Gamezone, Pogo.com and Shockwave. We expect competition to build its technology platform. If MusicNet is not successfulintensify in this market from these and other online music subscription services do not license our technology, our businesscompetitors and business prospects could be harmed.

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     The Antitrust Division of the U.S. Department of Justice and certain European antitrust regulatory authorities have recently commenced investigations into music licensing and other business practices related to online music businesses, including the business of MusicNet. If the business of MusicNet is harmed or materially modified as a result of these investigations, our financial results and business prospects could be harmed.

We May Be Unable to Successfully Compete With Microsoft and Other Companies in the Media Delivery Market

     The market for software and services for media delivery over the Internet is relatively new, constantly changing and intensely and increasingly competitive. As media delivery evolves into a central component of the Internet experience, more companies are entering the market for, and expending increasing resources to develop, media delivery software and services. We expect that competition will continue to intensify. Increased competition could hurt our business and the trading price of our stock. Increased competition may also result in price reductions, reduced margins, loss of customers, and a change in our business and marketing strategies, any of which could harm our business.

     Many of our current and potential competitors have longer operating histories, greater name recognition, more employees and significantly greater financial, technical, marketing, public relations and distribution resources than we do. In addition, new competitors with potentially unique or more desirable products or services are entering the market all the time. The competitive environment may require us to make changes in our products, pricing, licensing, services or marketing to maintain and extend our current brand and technology franchise. Price concessions or the emergence of other pricing, licensing and distribution strategies or technology solutions of competitors may diminish our revenues, impact our margins or lead to a reduction in our market share, any of which will harm our business. Other changes we have to make in response to competition could cause us to expend significant financial and other resources, disrupt our operations, strain relationships with partners, or release products and enhancements before they are thoroughly tested, any of which could harm our operating results and stock price.

     Microsoft is a principal competitor in the development and distribution of digital media and media distribution technology. Microsoft currently competes with us in the market for digital media servers, players, encoders, digital rights management, codecs and other technology and services related to digital distribution of media. Microsoft’s commitment to and presence in the media delivery industry has increased and we expect that Microsoft will continue to increase competitive pressure in the overall market for digital media and media distribution.

     Microsoft distributes its competing streaming media server, player, tools and digital rights management products by bundling them with its Windows operating systems and servers at no additional cost or otherwise making them available free of charge. Microsoft’s practices have caused, and may continue to cause, pricing pressure on our revenue generating products and services and affect usage of our competing products and formats. Microsoft’s practices have led in some cases, and could continue to lead to, longer sales cycles, decreased sales, loss of existing and potential customers and reduced market share. In addition, we believe that Microsoft has used and may continue to use its monopoly position in the computer industry and its financial resources to secure preferential or exclusive distribution, use and bundling contracts for its media delivery technologies and products with third parties, such as ISPs, content delivery networks, content providers, entertainment and media companies, VARs and OEMs, including third parties with whom we have relationships. Microsoft has also invested significant money in, has provided substantial financial incentives to, or offered or conditioned placement on or through the Windows operating system, the Internet Explorer Web browser and Microsoft’s MSN service to certain of our current and potential customers and content suppliers, and we expect this trend to continue, which may cause those customers to stop using or reduce their use of our products and services and which may cause those content suppliers to withhold desirable media content from us or end users of our products and services. Such arrangements, together with Microsoft’s aggressive marketing of its Windows operating systems, server products and digital media products, may reduce our share of the streaming media and digital distribution markets. While courts have ruled that several of Microsoft’s practices violated relevant laws related to illegal maintenance of monopoly power, court remedies to date have

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had only a minor impact. Thereassurance can be no assurancemade that therewe will be future court remedies against Microsoft’s illegal actions, or if there are any such future remedies, there can be no assurance that these remedies will be effective in curtailing these activities.

     Microsoft’s Windows Media Player competes with our media player products. Certain versions of the Windows Media Player are available for download from Microsoft’s Web site for free, and the Windows Media Player is integrated into Microsoft’s Windows XP operating system and the Windows 98, Windows 2000 and Windows ME operating systems, the Internet Explorer Web browser, and Microsoft’s MSN service. Windows XP, a significant focus of which is digital media delivery, gives very prominent and persistent placement to Microsoft’s Windows Media Player, Windows Media Guide, music services, and other media delivery services in the operating system and on the end user’s desktop. In some cases, the Windows Media Player may override default playback settings set by end users or by our software. New versions of Internet Explorer and MSN Explorer also prominently feature and promote Windows Media. We expect that by leveraging its monopoly position in operating systems and tying streaming or digital media into its operating systems and its Web browser, Microsoft will distribute substantially more copies of the Windows Media Player in the future than it has in the past and may be able to attract more userscontinue to grow our games distribution business or that we will be able to remain competitive in the downloadable games category in the future. We recently competed the acquisition of GameHouse, a developer of downloadable PC games and content providers to use its streaming or digital media products. In addition, Microsoft does not document or expose all of the interfaces that would allow our products to take full advantage of the features and functionality of Windows XP that it makes available to the Windows Media Player. In light of Microsoft’s efforts and dominant position in operating systems, our market position may be difficult to sustain. The ubiquitous distribution of Windows Media Player with Microsoft’s Windows operating systems may make it less likely that Internet content providers would use our technology.

     Microsoft’s Windows Media Playernow also competes with the personal music management features of the RealOne Player. Microsoft has made strategic investments in other digital distribution technologies that compete with RealJukebox and with the RealOne Player. The Windows Media Player supports the Windows Media format, but not our media formats. Microsoft also licenses various Windows Media Technology applications, a platform for authoring, delivering and playing digital media intended to compete with our system software products, and supports and promotes other third party products competitive to our products. In addition, Microsoft provides servers that support Windows Media Technologies at no additional cost to customers who purchase its Windows servers, whereas we offer versions of our competitive servers for sale. Microsoft bundles its Windows Media Server product with its server operating systems. In some cases, Microsoft has conditioned use of the Windows Media Digital Rights Management and security technologies supported by Windows XP to support for Windows Media formats and use of Windows Media Player and servers. We compete with Microsoft and Sony Corporation in the market for digital rights management technologies. Sony’s recent acquisition of digital rights management patents from Intertrust in conjunction with Philips Electronics indicates that Sony may increase its focus on competing with us in the market for digital rights management technology. We expect Microsoft, Sony and other competitors to devote significantly greater resources to product development in the music management and digital media categories in the future.

     Microsoft also competes with us to attract broadcasters and owners of high quality or popular content to promote and deliver such content in Microsoft’s formats, in some cases on an exclusive or preferential basis. While we have rights to play back certain content in Microsoft formats through our player products under a limited set of conditions, we may not secure necessary rights from Microsoft to enable our products to play back all such content or content in Microsoft’s newest formats, or such rights may not be available to us on commercially reasonable terms. Our player products may be disadvantaged if they cannot play content in Windows Media formats or content that is secured by the Windows Media Digital Rights Management technology, or if such content providers do not also make their content available in our media formats using digital rights management systems supported by us. In some cases, we believe Microsoft uses its financial resources and monopoly leverage to obtain rights to such content, and to provide incentives to content providers to prepare their content in Microsoft’s formats. If content providers use Microsoft’s digital media technology rather than ours, it may harm our ability to sell subscription services, players and Helix technology. Microsoft’s commitment to and presence in the media delivery industry has increased and we believe that

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Microsoft will continue to increase competitive pressure in the overall market for streaming media and media distribution.

     Microsoft has aggressively marketed and licensed its Windows Media technology to consumer electronics companies, a number of which have built support for Windows Media in their products. If Microsoft is successful in spreading Windows Media technology to non-PC devices — in part through leveraging their operating system monopoly — and we are not, it could harm our business.

     In addition to Microsoft, we face competition from other companies that develop and market streaming media products. For example, Apple Computer offers the QuickTime streaming media technology, including a free media player and a free streaming media server, and licenses for free source code to the server under the conditions of Apple’s end user license agreement. Apple also offers competitive music management software and hardware. Apple has recently begun to devote significant resources to developing and marketing digital media products and we expect they will continue to do so to enable them to compete vigorously with us in the marketplace. Apple has also enlisted the open source code development community to assist its development of competitive products. Companies such as AOL Time Warner and Yahoo! and many smaller competitors also offer various products that compete with our player products and content subscription services. In connection with the deployment of our system software in AOL’s Internet service, we also licensed our technology to AOL for use with its own Internet service media player application. Such licensing may impact the number of end users of our player products if AOL users only use AOL applications. As more companies enter the market with products that compete with our servers, players and tools, the competitive landscape could change rapidly to our disadvantage. If our player products and formats do not continue to achieve a high level of consumer adoption and usage, our revenues and business could be harmed.

We May Be Unable To Successfully Compete In Other Parts of Our Business

Media Hosting and Delivery.Our media hosting and delivery service, the Real Broadcast Network, competes with a variety of companies that provide streaming media hosting and broadcast services. These companies include Akamai, Yahoo! Broadcast Services and other emerging broadcast networks. Somedevelopers of these competitors have cost or other advantages over our services and offer other services that the Real Broadcast Network does not offer, such as creating corporate intranet portals or hosting in media formats not supported by the Real Broadcast Network. We may not establish or sustain our competitive position in this market segment. In recent periods, many of the customers of the Real Broadcast Network have either gone out of business or reduced their usage of our media hosting services. Some of our media hosting competitors are also customers on whom we rely to help drive product download traffic to our Web sites through their broadcast events. We also sell servers and tools to companies that compete with the Real Broadcast Network. If our relationship with these companies becomes more competitive, such companies may reduce their level of usage and purchases of our products or services.games.

We may not be successful in the market for downloadable media and personal music management systems.

     Web Site Destinations, Content and Advertising.Our Web sites and the Real.com Network compete for user traffic and Internet advertising revenues with a wide variety of Web sites, Internet portals and ISPs. In particular, aggregators of audio, video and other media, such as Yahoo! Broadcast Services and Microsoft’s Windows Media Guide, compete with us and generate substantially more traffic than we do.

     We cannot be certain that advertisers will place advertising with us or that revenues derived from such advertising will be meaningful. Internet advertising revenues across the industry have decreased substantially in recent periods and our advertising revenues have substantially declined during that time. We cannot predict when, or if, advertising revenues will stabilize and it is unlikely that they will return to previous levels. If we lose advertising customers, fail to attract new customers, are forced to reduce advertising rates or otherwise modify our rate structure to retain or attract customers, our business could be harmed. Our business could also be harmed if we lose Web site traffic or if the usage of our player products fails to produce a sufficient amount of advertising inventory.

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We May Not Be Successful In the Market For Downloadable Media and Personal Music Management Systems

The market for products that enable the downloading of media and that provide a personal music management system is relatively new and still evolving. We may be unable to develop a revenue model or sufficient demand to take advantage of this market opportunity. We cannot predict whether consumers will adopt RealJukebox or the RealOne Playerour products as their primary application to play, record, download and manage their digital music. There are a number of competitive products on the market that offer certainmusic, especially in light of the music management features currently offered by RealJukebox and by the RealOne Player. These products include WinAmp Player, MusicMatch Jukebox, Apple QuickTime Player, Sonique Player, AOL client andfact that Microsoft bundles its competing Windows Media Player. Given the size and importance of the general market for music distribution, competitors will likely release additional products that directly competePlayer with RealJukebox and the RealOne Player, which could harm our business. Our competitors may develop new features and technology not available in RealJukebox or the RealOne Player, including advanced codecs and digital rights management technology, which could harm our business.

     RealJukebox and the RealOne Player also face competition from the emergence of widespread peer-to-peer file sharing services and programs such as KazaA and Morpheus, and a variety of other similar services that allow computer users to connect with each other and to copy many types of program files, including music and other media, from one another’s hard drives. These services allow consumers to directly access an expansive array of content without relying on content providers to make the content available for streaming or digital download, and without relying on products such as our RealJukebox or RealOne Player to be able to play, record and store such content.its Windows operating system. Our inability to achieve widespread acceptance for our digital music architecture or widespread distribution of our player products or to create newcould hold back the development of revenue streams from the newthese market segments, including digital music content, and therefore could harm the prospects for our business.

Our paid content businesses depend upon effective digital rights management solutions.

     We must also provideOur paid content businesses depend upon effective digital rights management solutions that allow control of accessibility to online digital content. These solutions are important to the economics of these businesses and other security mechanisms in orderalso to address concerns of content providers, and weproviders. We cannot be certain that we can develop, license or acquire such solutions, or that content licensors or consumers will accept them. In addition, consumers may be unwilling to accept the use of digital rights management technologies that limit their use of content, especially with large amounts of free content readily available. In connection with the continued development of our products, particularly with respect to the adaptation of our products on non-PC devices, weWe may need to license other digital rights management solutions to support our products. No assurance can be given that such solutions will be available to us or, if they will be available to us at reasonable rates or uponon reasonable terms which could harm the development of our products and our business.

Our Industry Is Experiencing Consolidation That May Intensify Competition

     The Internet and media distribution industriesor at all. If digital rights management solutions are undergoing substantial change which has resulted in increasing consolidation and a proliferation of strategic transactions. Many companies in these industries have been going out of businessnot effective, or are being acquired by competitors. As a result, we are increasingly competing with larger competitors that have substantially greater resources than we do. We expect this consolidation and strategic partnering to continue. Acquisitions or strategic relationships could harm us in a number of ways. For example:

• competitors could acquire or enter into relationships with companies with which we have strategic relationships and discontinue our relationship, resulting in the loss of distribution opportunities for our products and services or the loss of certain enhancements or value-added features to our products and services;
• competitors could obtain exclusive access to desirable multimedia content and prevent that content from being available in our formats, thus decreasing the use of our products and services to distribute and experience the content that audiences most desire, and hurting our ability to attract advertisers to our Web sites and product offerings;

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• suppliers of important or emerging technologies could be acquired by a competitor or other company which could prevent us from being able to utilize such technologies in our offerings, and disadvantage our offerings relative to those of competitors;
• a competitor could be acquired by a party with significant resources and experience that could increase the ability of the competitor to compete with our products and services; and
• other companies with related interests could combine to form new, formidable competition, which could preclude us from obtaining access to certain markets or content, or which could dramatically change the market for our products and services.

     Any of these events could put us at a competitive disadvantage which could cause us to lose customers, revenue and market share. They could also force us to expend greater resources to meet new or additional competitive threats, which could also harm our operating results.

We Rely On Content Provided By Third Parties To Increase Market Acceptance of Our Products and Services

     If third parties doperceived as not develop or offer compellingeffective, content to be delivered over the Internet, or grant necessary licenses to us or our customers to distribute or perform such content, our business will be harmed and our products and servicesproviders may not achieve or sustain broad market acceptance. We rely on third-party content providers, such as radio and television stations, record labels, media companies, Web sites and other companies,be willing to develop and offerinclude content in our formats that can be delivered using our server products and played back using our player products. We also rely entirely on third-party content for the programming and content offerings that comprise our RealOne and stand-alone subscription services. In some cases, we pay substantial fees to obtain content for these services. In order to provide a compelling subscription service, we must be able to offer unique and in some cases exclusive content and programming to our customers. We face competition in the market for subscription content services, from companies such as AOL Time Warner, Microsoft and Yahoo!, who may have greater access to content or the ability to pay substantially higher fees to content providers. We cannot guarantee that third-party content providers will continue to rely on our technology or offer compelling content in our formats, nor can we guarantee that we will be able to secure licenses to their content or that such licenses will be available at commercially reasonable rates, to encourage and sustain broad market acceptance of our products and services. The failure to do sowhich would harm our business and operating results.

     Digital rights management technologies are frequently the subject of hostile attack by third parties seeking to break the system. If our digital rights management technology is compromised or otherwise malfunctions, we could be subject to lawsuits seeking compensation for any harm caused and our business prospects.could be harmed if content providers lose confidence in our ability to protect their content.

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We may not be able to successfully operate our software game development business because it is a new business for us, and certain distribution partners for our game development business compete with other products and services we offer.

We recently competed the acquisition of GameHouse, a developer of downloadable PC games. Game development is a new business for us, and we may not be able to successfully develop and market software games in the future. In addition, certain competitors of our RealArcade service also distribute and promote games developed by GameHouse. No assurance can be made that these distributors will continue to distribute and promote games in the same manner as a result of our acquisition of GameHouse.

Our systems software business has been negatively impacted by economic conditions and the efforts of our competitors, and this business may not return to previous levels.

The aggressive competitive efforts of Microsoft, including the provision of free software and other incentives to induce customers to use its competing technology, have negatively impacted systems software sales to customers in a variety of business market segments in recent periods. We cannot predict when, or if, we will experience increased demand for our systems software products from customers in these markets.

Our Helix open source initiative is subject to risks associated with open source technology.

There are a number of risks associated with our Helix open source initiative, including risks associated with open source and community source technology licensing, development and business models and the risks typically associated with the introduction of new products and technologies. The industry may not adopt the Helix DNA Platform or the Helix Community, and third parties may not develop or introduce technologies or products based on them. While we have a numberinvested substantial resources in the development of short-term agreements with third parties to provide contentthese initiatives and products, the market may not accept them, we may not derive substantial revenue from their Web sites inthese initiatives and products and the introduction of our formats, most third parties are not obligated to develop or offer content usingHelix open source software may adversely affect our technology.sales. In addition, some third parties have entered into and may inour open source approach means that we no longer exercise control over many aspects of the future enter into agreements withdevelopment of the technology that comprises our competitors, principally Microsoft, to develop or offer all or a substantial portion of their content in our competitors’ formats and using their digital rights management technology. This may prevent such content from being playable through our products. Microsoft has substantially more resources than us that may enable it to secure preferential and even exclusive relationships with content providers, including preferential placement on or through the Windows Operating System, Internet Explorer or MSN. There could be less demand for and use of our products if Microsoft or another competitor were to secure preferential or exclusive relationships with the leading content providers, Web sites or broadcasters.Helix initiative.

If we do not timely and successfully develop, market and implement new products and services, our business and operating results will suffer.

     Our success also depends on the availability of third-party content, especially music, that current users of our RealJukebox and RealOne Player can lawfully and easily access, record and play back. Our products may not achieve or sustain market acceptance if third parties are unwilling to offer their content for free download, streaming or purchase by users of our player products. Current concerns regarding the secure distribution of music over the Internet, and the difficulties and high costs associated with obtaining necessary or desirable licensing rights, are contributing to the delay or unavailability of music content for distribution.

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We May Not Successfully Develop New Products and Services

     Our growth depends on our ability to continue to develop leading edge media delivery and digital distribution products and services.     Our business and operating results would be harmed if we fail to timely and successfully develop, market and deliver products and services that achieve widespread market acceptance or thatif the products and services we develop fail to generate significant revenuesrevenue or gross profits to offset our development and operating costs. We may not timely and successfully identify, develop and market new product and service opportunities. If we introduce new products and services, they may not attain broad market acceptance or contribute meaningfully to our revenues or profitability. Competitive or technological developments may require us to make substantial unanticipated investments in new products and technologies, and we may not have sufficient resources to make these investments. If we are unable to be a technological leader in our market our business is likely to be harmed. In addition, with the recent introduction of our Helix initiative, we no longer exercise control over many aspects of the development of the open source technology that comprises our Helix initiative and accordingly, there can be no assurance that the industry will adopt the Helix Platform or the Helix Community, or that third parties will develop and introduce technologies or products based on them.

     Because the markets for our products and services are changing rapidly, we must develop new offerings quickly. We have experienced development delays and cost overruns in our development efforts in the past and we may encounter such problems in the future. Delays and cost overruns could affect our ability to respond to technological changes, evolving industry standards, competitive developments or customer requirements. OurAlso, our products also may contain undetected errors that could cause increased development costs, loss of revenues,revenue, adverse publicity, reduced market acceptance of our products or services or lawsuits by customers.

Our business is dependent in part on third party vendors whom we do not control.

     RealJukeboxCertain of our products and services are dependent in part on the RealOne Playerlicensing and incorporation of technology from third party vendors. The markets in which we compete are new and rapidly evolving and, in some cases, significant technology innovation occurs at very early-stage companies. In some cases, we rely on the technology of these types of vendors in order to make our products and services more competitive. If the technology of these vendors fails to perform as expected or if key vendors do not continue to support their technology, because the vendor has gone out of business or willotherwise, then we may incur substantial costs in replacing the products and services, or we may fall behind in our development schedule while we search for a

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replacement. These costs or the potential delay in the development of our products and services could harm our business and our prospects.
We enter into strategic transactions that may not yield direct financial benefits.

Because of the evolving and dynamic nature of the markets in which we compete, from time to time we enter into strategic transactions that have uncertain financial impact on our business and operations. We often enter into these types of transactions with infrastructure providers and other large companies to broaden the reach of our technology, media formats and products. While we believe that these types of transactions are important for our overall business, they may not yield the desired benefits to our business or result in meaningful direct revenues.

If our products are not able to support the most popular digital media formats, our business will be substantially impaired.

The success of our products and services depends upon our products’ support for a variety of audiomedia formats including RealAudio, MP3, Windows Media Audio, Apple QuickTime and MPEG-4. Support for some formats, including Windows Media Audio and Apple QuickTime, requires the user to have additional third party software installed. However, technicalwireless data formats. Technical formats and consumer preferences evolve very rapidly,change over time, and we may be unable to adequately address consumer preferences or fulfill the market demand for new and evolving formats. Changing formats may give our competitors an opportunity to the extent it exists.gain market share if they can respond to or anticipate market demand for formats before we do. We also may not be unableable to license technologies, like codecs, that obtain widespread consumer and developer use, which would harm consumer and developer acceptance of our products and services. In addition, our codecs and formats may not continue to be in demand or as desirable as other third party codecs and formats, including codecs and formats created by Microsoft or industry standard codecs and formats created by MPEG, become more readily available.

We Depend On Key Personnel Who May Not Continue To Work For Us

Our mobile products will not be successful if consumers do not use mobile devices to access digital media.

     In order for our investments in the development of mobile products to be successful, consumers must adopt and use mobile devices for consumption of digital media. To date, consumers have not widely adopted these products for use in accessing and consuming digital media and if the rate of adoption of these products to consume digital media does not increase, our business could be harmed.

We depend on key personnel who may not continue to work for us.

Our success substantially depends on the continued employment of certain executive officers and key employees, particularly Robert Glaser, our founder, Chairman of the Board and Chief Executive Officer. The loss of the services of Mr. Glaser or other key executive officers or employees could harm our business. If any of these individuals were to leave, RealNetworks, we could face high costs and substantial difficulty in hiring qualified successors and could experience a loss in productivity while any such successor obtains the necessary training and experience. A number of our key employees have reached or will soon reach the five-year anniversary of their RealNetworks hiring date and, as a result, will have become or will shortly become fully vested in their initial stock option grants. While most personnel are typically granted additional five-year stock options subsequent to their hire date to provide additional incentive to remain at RealNetworks, the initial option grant is typically the largest and an employee may be more likely to leave our employ upon completion of the vesting period for the initial option grant. We do not maintain “key person” life insurance policies. If we do not succeed in retaining and motivating existing personnel, our business could be harmed.

Our Failure To Attract, Train or Retain Highly Qualified Personnel Could Harm Our Business

Our failure to attract, train or retain highly qualified personnel could harm our business.

     Our success also depends on our ability to attract, train or retain qualified personnel in all areas, especially those with management and product development skills. In particular, we must hire additionaland retain experienced management personnel to help us continue to grow and manage our business, and skilled software engineers to further our research and development efforts. At times, we have experienced difficulties in hiring personnel with the proper training or experience, particularly in technical and media areas. Competition for qualified

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personnel is intense, particularly in high-technology centers such as the Pacific Northwest, where our corporate headquarters are located. If we do not succeed in attracting new personnel or in retaining and motivating our current personnel, our business could be harmed.

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Our industry is experiencing consolidation that may cause us to lose key relationships and intensify competition.

     In making employment decisions, particularly in theThe Internet and high-technologymedia distribution industries are undergoing substantial change which has resulted in increasing consolidation and formation of strategic relationships. We expect this consolidation and strategic partnering to continue. Acquisitions or other consolidating transactions could harm us in a number of ways, including:

• we could lose strategic relationships if our strategic partners are acquired by or enter into relationships with a competitor (which could caused us to lose access to distribution, content, technology and other resources);
• we could lose customers if competitors or users of competing technologies consolidate with our current or potential customers; and
• our current competitors could become stronger, or new competitors could form, from consolidations.

Any of these events could put us at a competitive disadvantage, which could cause us to lose customers, revenue and market share. Consolidation could also force us to expend greater resources to meet new or additional competitive threats, which could also harm our current employees and prospective job candidates often consider the value of stock options they hold or that they may receive in connection with their employment. As a result of recent volatility in our stock price, we may be disadvantaged in competing with companies that have not experienced similar volatility or that have not yet sold their stock publicly.

Potential Acquisitions Involve Risks We May Not Adequately Addressoperating results.

Potential acquisitions involve risks that could harm our business and impair our ability to realize potential benefits from acquisitions.

     As part of our business strategy, we have acquired technologies and businesses in the past, and expect that we will to continue to do so in the future. The failure to adequately address the financial, legal and operational risks raised by acquisitions of technology and businesses could harm our business. Acquisition or business combination transactions are accompanied by a numberand prevent us from realizing the benefits of significant risks.the acquisitions. Financial risks related to acquisitions may harm our financial position, reported operating results or stock price, and include:

 • potentially dilutive issuances ofpotential equity securities;
• dilution, use of cash resources;
• theresources and incurrence of debt and contingent liabilities;liabilities in funding acquisitions;
 
 • large write-offs and difficulties in assessment of the relative percentages of in-process research and development expense that can be immediately written off as compared to the amount which must be amortized over the appropriate life of the asset; and
 
 • amortization expenses related to other intangible assets.

     Acquisitions also involve operational risks that could harm our existing operations or prevent realization of anticipated benefits from an acquisition. These operational risks include:

 • difficulties and expenses in assimilating the operations, products, technology, information systems or personnel of the acquired company;
 
 • diversion of management’s attention from other business concerns and the potential disruption of our ongoing business;
 
 • the difficulty of incorporating acquired technology or content and rights into our products and services and unanticipated expenses related to such incorporation;
• impairment of relationships with our employees, affiliates, advertisers and content providers;
• inability to maintain uniform standards, controls, proceduresproviders of our business and policies;the acquired business;
 
 • the assumption of known and unknown liabilities of the acquired company;company, including intellectual property claims; and
 
 • entrance into markets in which we have no direct prior experience; and
• subsequent loss of key employees of the acquired company.experience.

We May Not Be Successful In Making Strategic Investmentsrecently acquired Listen, and the operations associated with Listen will remain in San Francisco. This will be our first experience operating and integrating a substantial acquired business in a remote location. The geographic separation could increase the operational risks described above. We also recently acquired GameHouse. The acquisition of GameHouse is our first attempt to operate and manage a content creation

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business. We may not be successful in operating this type of business, which could harm our business and our prospects.
Our strategic investments may not be successful and we may have to recognize expenses in our income statement in connection with these investments.

     We have made, and in the future we may continue to make, strategic investments in other companies.companies, including joint ventures. These investments have been made,often involve immature and future investments will likely be made, in immatureunproven businesses with unproven track records and technologies. Such investments havetechnologies, and involve a high degree of risk, with the possibility that we mayrisk. We could lose the totalentire amount of our investment. We also may be required to record on our financial statements significant charges from reductions in the value of our strategic investments, and, potentially from the net losses of the companies in which we invest. We have taken these charges in the past. These charges could adversely impact our reported operating results. No assurance can be made that the strategic benefits will be realized from any strategic investment.

We have a substantial investment in MusicNet, a joint venture formed with several leading media companies to create a technology platform for online digital music subscription sales. We relay on financial statements provided by MusicNet in determining the amount of our equity share of MusicNet’s net loss for each of our reporting periods. We do not be able to identify suitable investment candidates,control MusicNet and even if we do not participate in the preparation of its financial statements. If the financial statements supplied to us by MusicNet are inaccurate, we may be forced to adjust or restate our operating results. If MusicNet does not provide its financial statements to us in a timely manner, we may not be able to make those investments on acceptable terms. In addition, even if we make investments, we may not gain strategic benefits from those investments.

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The Growth of Our Business Depends On the Increased Use of the Internet For Communications, Electronic Commercetimely satisfy our Securities and Advertising

     The growth of our business depends on the continued growth of the Internet as a medium for media consumption, communications, electronic commerce and advertising. Our businessExchange Commission reporting obligations. We anticipate that MusicNet will be harmed if Internet usage does not continue to grow, particularly as a source of media informationincur losses in the foreseeable future and entertainment and as a vehicle for commerce in goods and services.will need additional funding.

Changes in network infrastructure, transmission methods and protocols, and broadband technologies pose risks to our business.

     Our success also depends on the efforts of third parties to develop the infrastructure and complementary products and services necessary to maintain and expanddepend upon the Internet as a viable commercial medium. We believe that other Internet-related issues, such as security, privacy, reliability, cost, speed, ease of use andmeans by which users access quality of service and necessary increases in bandwidth availability, remain largely unresolved and may affect the amount and type of business that is conductedmedia content over the Internet and may impact our ability to sellwireless networks. If popular technologies, transmission methods and protocols used for accessing digital media content change, and we do not timely and successfully adapt our products and services to these new technologies, transmission methods and ultimately impactprotocols, our business results and prospects.

     If Internet usage grows, the Internet infrastructure may notreputation could be able to support the demands placed on it by such growth, specifically the demands of delivering high-quality media content. As a result, its performance and reliability may decline. In addition, Web sites have experienced interruptions in service as a result of outages, system attacks and other delays occurring throughout the Internet network infrastructure. If these outages, attacks or delays occur frequently or on a broad scale in the future, Internet usage, as well as the usagedamaged, use of our technologies and products services and Web sites, could grow more slowly or decline.

Rate of Adoption of Broadband Technologies Poses Risks To Our Business

     We believe that increased Internet use and especially the increased use of media over the Internet may depend on the availability of greater bandwidth or data transmission speeds (also known as broadband transmission). If broadband technologies do not become widely available or widely adopted, our products and services, particularly our subscription services, may not achieve broad market acceptancewould decrease, and our business and prospects couldoperating results would be harmed. To date, we believe that broadband technologies have been adopted at a slower rate than expected, which we believe has slowed the level of use of media over the Internet and may harm our business and prospects if the rate of adoption does not increase.

Changes In Network Infrastructure, Transmission Methods and Broadband Technologies Pose Risks To Our Business

     If broadband access becomes widely available, we believe it presents both a substantial opportunity and a significant business challenge for us.Communicating Internet access through cable television set-top boxes, cable lines, digital subscriber lines or wireless connections could dramatically reduce the demand for our products and services by utilizing alternate technology that more efficiently or conveniently transmits data and media. This could harm our business as currently conducted.

Also, our products and services adapted to new technologies and transmission methods and protocols may not achieve market acceptance or generate sufficient revenuesrevenue to offset our costs of developing products and services compatible with broadband transmission formats and infrastructure.

Development of new technologies, products and services for anew transmission infrastructure could increase our vulnerability to competitors by enabling the emergence of new competitors, such as traditional broadcast and cable television companies, which have significant control over access to content, substantial resources and established relationships with media providers. Our current competitors may also develop relationships with, or ownership interests in, companies that have significant access to or control over the broadband transmission infrastructure involves a number of additional risks, including:

or content.

• changes in content delivery methods and protocols;
• the emergence of new competitors, such as traditional broadcast and cable television companies, which have significant control over accessWe need to content, substantial resources and establisheddevelop relationships with manufacturers of non-PC media providers;
• the development byand communication devices to grow our current competitors, particularly Microsoft and AOL Time Warner, of relationships with, or ownership interests in, companies that have significant access to or control over the broadband transmission infrastructure or content; and
• the need to establish new relationships with non-PC based providers of broadband access, such as providers of television set-top boxes and cable television, some of which may compete with us.business.

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More Individuals Are Utilizing Non-PC Devices To     Access the Internet and We May Not Be Successful In Developing Versions of Our Products and Services That Will Gain Widespread Adoption By Users of Such Devices

     In the coming years, the number of individuals who accessto the Internet through devices other than a personal computer, such as personal digital assistants, cellular telephones, television set-top devices, game consoles and Internet appliances, has increased dramatically and is expected to increase dramatically.continue to increase. Manufacturers of these types of products are increasingly investing in media-related applications, but development of these devices is still in an experimental stage and business models are new and unproven. If we are unable to attract and retain a substantial number of alternative device manufacturers todo not license and incorporate our technology into their devices, we may fail to capture a sufficient share of an

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increasingly important portion of the market for digital media delivery. Further, aA failure to develop revenue-generating relationships with a sufficient number of device manufacturers could harm our business prospects.

We do not believe that complete standards have emerged with respect to non-PC wirelessinvested significant resources in adapting our technologies and cable-based systems, though participants in those industries generally express support for the evolution of industry-wide standards which may disfavor proprietary solutions. Likewise, no single company has yet gained a dominant position in the mobile device market. However, certain third party products and services in these markets support our technology, and certain products and services support our competitors’ technologies, especially Microsoft, which can use its monopoly position in the operating system business and other financial resources to gain access to these markets, potentially to our exclusion. In addition, our brandnew technologies, networks and capabilitiesdevices (wireless networks in particular), and we will not recoup these investments if they are not as well known in these market sectors which haswidely adopted for accessing data and may continue to create opportunities for smaller competitors to effectively compete with us, especially in the market for mobile devices outside the United States. Other companies’ products and services, including industry-standard technologies like MPEG-4 and 3GPP, or other new standards may emerge or become dominant in any of these areas, and differing standards may emerge among different global markets, which could reduce demand for our technology and products or render them obsolete.multimedia content. In addition, our ability to reach customers in these markets is often controlled by large network operators and our success in these markets is dependent on securingour ability to secure relationships with these key operators.

Emerging new standards for non-PC devices could harm our business if our products and technologies are not compatible with the new standards.

     We do not believe that complete standards have also recently announced our Helix initiative, which is aimed, in part, at stimulating the development of Internet media technology onemerged with respect to non-PC devices.wireless and cable-based systems. If the open-source features of Helixwe do not successfully stimulate the development of technology on non-PC devices usingmake our platform,products and technologies compatible with emerging standards, we may miss market opportunities and our business and prospectsresults will suffer. If other companies’ products and services, including industry-standard technologies or other new standards emerge or become dominant in any of these areas, or differing standards emerge among different global markets, demand for our technology and products could be harmed.reduced or they could become obsolete.

If we are not successful in maintaining, managing and adding to our strategic relationships, our business and operating results will be adversely affected.

We Could Lose Strategic Relationships That Are Essential To Our Business

rely on many strategic relationships with third parties in connection with our business, including relationships providing for the distribution of our products, licensing of technology and licensing of content for our paid content services. The loss of certain current strategic relationships, or key licensing arrangements, the inability to find other strategic partners, our failure to effectively manage these relationships or the failure of our existing relationships to achieve meaningful positive results for us could harm our business. We rely in partmay not be able to replace these relationships with others on strategicacceptable terms, or at all, or find alternative sources for resources that these relationships to help us:

provide.

• increase adoption ofOur business and operating results will suffer if our systems or networks fail, become unavailable or perform poorly so that current or potential users do not have adequate access to our products, through distribution arrangements;
• increase the amountservices and availability of compelling media content on the Internet to help boost demand for our products and services, including our RealOne subscription services;
• acquire desirable or necessary technology components and intellectual property rights;
• establish and maintain our brands;
• expand the range of commercial activities based on our technology; and
• increase the performance and utility of our products and services.websites.

     We would be unable to accomplish many of these goals without the assistance of third parties. For example, we may become more reliant on strategic partnersOur ability to provide multimedia contentour products and technology,services to provide alternative distribution channels, to provide more secureour customers and easy-to-use electronic commerce solutionsoperate our business depends on the continued operation of our information systems and to build out the necessary infrastructure for media delivery. We may not be successful in forming

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networks. A significant or managing strategic relationships and, in particular, we may meet resistance in forging such relationships if our potential strategic partners desire to minimize their dependency on any one technology provider.

Our Business Will Suffer If Our Systems Fail or Become Unavailable

     Arepeated reduction in the performance, reliability or availability of our Web sitesinformation systems and network infrastructure maycould harm our ability to distributeconduct our productsbusiness, and services to our users, as well asharm our reputation and ability to attract and retain users, customers, advertisers and content providers. Our revenues depend in large part on the number of users that download our products from our Web sites, access the content services on our Web sites and use our subscription services. Our systems and operations are susceptible to, and could be damaged or interrupted by, outages caused by fire, flood, power loss, telecommunications failure, Internet breakdown, earthquake and similar events. Our systems are also subject to human error, security breaches, power losses, computer viruses, break-ins, “denial of service” attacks, sabotage, intentional acts of vandalism and tampering designed to disrupt our computer systems, Web sites and network communications, and our systems could be subject to greater vulnerability in periods of high employee turnover, such as after our recent staff reductions. A sudden and significant increase in traffic on our Web sites could strain the capacity of the software, hardware and telecommunications systems that we deploy or use. This could lead to slower response times or system failures.

     Our operations also depend on receipt of timely feeds from our content providers, and any failure or delay in the transmission or receipt of such feeds could disrupt our operations. We also depend on Web browsers, ISPs and online service providers to provide Internet users access to our Web sites. Many of these providers have experienced significant outages in the past, and could experience outages, delays and other difficulties due to system failures unrelated to our systems. In addition, certain ISPs have temporarily interrupted our Web site operations and ability to communicate with certain customers in response to the heavy volume of email transmissions we generate and send to our large user base. These types of interruptions could continue or increase in the future.

     Our electronic commerce and digital distribution activities are managed by complex software and computer systems. We must continually develop and update these systems over time as our business and business needs grow and change, and these systems may not adequately reflect the current needs of our business. We may encounter delays in developing these systems, and the systems may contain undetected errors that could cause system failures, authentication or payment processing problems, or security issues. We have on occasion experienced system errors and failures that cause interruption in availability of products or content or an increase in response time,time. Problems with our systems and any such errors or failuresnetworks could result in a lossfrom our failure to adequately maintain and enhance these systems and networks, natural disasters and similar events, power failures, intentional actions to disrupt our systems and networks and many other causes. The vulnerability of potential or existing business services customers, users, subscribers, advertisers or content providers. If we suffer sustained or repeated interruptions, our products, services and Web sites could be less attractive to such entities or individuals and our business could be harmed.

     Real Broadcast Network’s business is dependent on providing customers with efficient and reliable services to enable such customers to broadcast content to large audiences on a live or on-demand basis. Real Broadcast Network’s operations are also dependent in part upon transmission capacity provided by third-party telecommunications network providers. Any failure of such network providers to provide the capacity we require may result in a reduction in, or interruption of, service to our customers. If we do not have access to third-party transmission capacity, we could lose customers and if we are unable to obtain such capacity on terms commercially acceptable to us, our business and operating results could suffer.

     Our computer and communications infrastructure is enhanced because it is located at a single leased facility in Seattle, Washington, an area that is at heightened risk of earthquake, flood, and volcanic events. We do not currently have fully redundant systems or a formal disaster recovery plan, and we may not have adequate business interruption insurance to compensate us for losses that may occur from a system outage. Despite

We rely on the continued reliable operation of third parties’ systems and networks and, if these systems and networks fail to operate or operate poorly, our business and operating results will be harmed.

     Our operations are in part dependent upon the continued reliable operation of the information systems and networks of third parties. If these third parties do not provide reliable operation, our efforts,ability to service our network infrastructurecustomers will be impaired and systemsour business, reputation and operating results could be subject to service interruptions or damage and any resulting interruption of services could harm our business, operating results and reputation.harmed.

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Our Network Is Subject To Security Risks That Could Harm Our Business and Reputation and Expose Us To Litigation Or Liability

Our network is subject to security risks that could harm our business and reputation and expose us to litigation or liability.

     Online commerce and communications depend on the ability to transmit confidential information and licensed intellectual property securely over private and public networks. Any compromise of our ability to transmit such information and data securely, and any costs associated with preventing or eliminating such problems, could harm our business. Online transmissions are subject to a number of security risks, including:

• our own or licensed encryption and authentication technology, and access and security procedures, may be compromised, breached or otherwise be insufficient to ensure the security of customer information or intellectual property;
• we could experience unauthorized access, computer viruses, system interference or destruction, “denial of service” attacks and other disruptive problems, whether intentional or accidental, that may inhibit or prevent access to our Web sites or use of our products and services; and
• someone could circumvent our security measures and misappropriate our, our partners’ or our customers’ proprietary information or content or interrupt operations.

     The occurrence of any of these or similar events could damage our business, hurt our ability to distribute products and services and collect revenue, threaten the proprietary or confidential nature of our technology, harm our reputation, and expose us to litigation or liability. We also may be required to expend significant capital or other resources to protect against the threat of security breaches or hacker attacks or to alleviate problems caused by such breaches or attacks.

Our International Operations Involve Operational Any successful attack or breach of our security could hurt consumer demand for our products and Financial Risksservices, expose us to consumer class action lawsuits and harm our business.

Our international operations expose our business to additional operational and financial risks.

     We operate subsidiaries in tenseveral foreign countries, and market and sell products in a number of other countries. We have also entered into joint ventures internationally. For the year ended December 31, 2002, approximately 28%A significant portion of our revenues wererevenue is derived from international operations. Our foreign operations involve risks inherent in doing business on an international level, including difficulties in managing operations due to distance, language and cultural differences, different or conflicting laws and regulations and exchange rate fluctuations. Any of these factors could harm our future international operations, and consequently our business, operating results and financial condition. Our foreign currency exchange risk management program reduces, but does not eliminate, the impact of currency exchange rate movements.

The growth of our business is dependent in part on successfully implementing our international expansion strategy.

     A key part of our strategy is to develop localized products and services in international markets through joint ventures, subsidiaries and branch offices. If we do not successfully implement this strategy, we may not recoup our international investments, successfully take advantage of international opportunities and we may lose worldwide market share. To date, we have only limited experience in developing localized versions of our products and services and marketing and operating our products and services internationally, and we often rely on the efforts and abilities of our foreign business partners, who we do not control, in such activities. We believe that in light of the potential size of the customer base and the audience for content, and the substantial anticipated competition, we need to continue to expand into international markets in order to effectively obtain and maintain market share. International markets we have selected may not develop at a rate that supports our level of investment. In particular, international markets typically have been slower in adoption of the Internet as an advertising and commerce medium, which is reflected in our international revenue results.

     In addition to uncertainty about our ability to continue to generate revenues from our foreign operations and expand our international presence, there are certain risks inherent in doing business on an international level, including difficulties in managing operations due to distance, language and cultural differences, different or conflicting laws and regulations and exchange rate fluctuations.

     Any of these factors could harm our future international operations, and consequently our business, operating results and financial condition. We currently manage a portion of our foreign currency exposures. Our foreign currency exchange risk management program reduces, but does not eliminate, the impact of currency exchange rate movements.

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We May Be Unable To Adequately Protect Our Proprietary Rights and May Be Subject To Intellectual Property Infringement Claims, Which Are Costly To Defend and Could Limit Our Ability To Use Certain Technologies In the Future

We may be unable to adequately protect our proprietary rights.

     Our inability to protect our proprietary rights, and the costs of doing so, could harm our business. Our success and ability to compete partly dependdepends on the superiority, uniqueness or value of our technology, including both internally developed technology and technology licensed from third parties. To protect our proprietary rights, we rely on a combination of patent, trademark, copyright and trade secret laws, confidentiality agreements with our employees and third parties, and protective contractual provisions. TheseDespite these efforts, to protect our intellectual property rightsany of the following occurrences may not be effective in preventing misappropriation of our technology. These efforts also may not prevent the development and design by others of products or technologies similar to or competitive with, or superior to those we develop. Any of these results could reduce the value of our intellectual property.property:

• Our applications for patents and trademarks relating to our business may not be granted and, if granted, may be challenged or invalidated.
• Issued patents and trademarks may not provide us with any competitive advantages.
• Our efforts to protect our intellectual property rights may not be effective in preventing misappropriation of our technology.
• Our efforts may not prevent the development and design by others of products or technologies similar to or competitive with, or superior to those we develop.

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• Another party may obtain a blocking patent so we would need to either obtain a license or design around the patent. We may not be able to obtain such a license on acceptable terms, if at all, or design around the patent.

We may be forced to litigate to defend our intellectual property rights, or to defend against claims by third parties against us relating to intellectual property rights.

     As of December 31, 2002, we had 45 registered U.S. trademarks or service marks, and had applications pending for several more U.S. trademarks. We also have several unregistered trademarks. In addition, RealNetworks has several foreign trademark registrations and pending applications. Many of our marks begin with the word “Real” (such as RealOne, RealAudio and RealVideo). We are aware of other companies that use “Real” in their marks alone or in combination with other words, and we do not expect to be able to prevent all third-party uses of the word “Real” for all goods and services.

     As of December 31, 2002, we had 20 U.S. patents and numerous patent applications on file relating to various aspects of our technology. We intend to increase our investment in filing additional patent applications on other features of our technology. Patents with respect to our technology may not be granted and, if granted, may be challenged or invalidated. Issued patents may not provide us with any competitive advantages and may be challenged by third parties.

     Many of our current and potential competitors dedicate substantially greater resources to protection and enforcement of their intellectual property rights, especially patents. Many parties are actively developing streaming media and digital distribution-related technologies, e-commerce and other Web-related technologies, as well as a variety of online business methods and models. We believe that these parties will continue to take steps to protect these technologies, including, but not limited to seeking patent protection. As a result, disputesDisputes regarding the ownership of these technologies and rights associated with streaming media, digital distribution and online businesses are common and likely to arise in the future and may be very costly. In addition to existing patents and intellectual property rights, we anticipate that additional third-party patents related to our products and services will be issued in the future. If a blocking patent has been issued or is issued in the future, we would need to either obtain a license or design around the patent. We may not be able to obtain such a license on acceptable terms, if at all, or design around the patent, which could harm our business.

     Companies in the technology and content-related industries have frequently resorted to litigation regarding intellectual property rights. We may be forced to litigate to enforce or defend our intellectual property rights, to protect our trade secrets or to determine the validity and scope of other parties’ proprietary rights. Any such litigation could be very costly and could distract our management from focusing on operating our business. In addition, we believe these industries are experiencing an increased level of litigation to determine the applicability of current laws to, and impact of new technologies on, the use and distribution of content over the Internet and through new devices, especially in the music industry, and as we develop products and services that provide or enable the provision of content in such ways, our litigation risk may increase. The existence and/or outcome of any such litigation could harm our business.

     From time to time we receive claims and inquiries from third parties alleging that our internally developed technology or technology we license from third parties may infringe the third parties’ proprietary rights, especially patents. Third parties have also asserted and most likely will continue to assert claims against us alleging infringement of copyrights, trademark rights, trade secret rights or other proprietary rights, or alleging unfair competition or violations of privacy rights. We are now investigating a number of such pending claims. In July 2002, a lawsuit was filed against RealNetworksclaims, some of which are described in federal court in Boston, alleging that RealNetworks willfully infringes certain patents relating to “the downloadingPart II of data from a server computer

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to a client computer.” The plaintiff seeks to enjoin RealNetworks fromthis report under the alleged infringing activity and to recover treble damages from the alleged infringement. RealNetworks has filed a counterclaim against the plaintiff seeking a declaratory judgment that the patents at issue are invalid and unenforceable due to plaintiff’s inequitable conduct, as well as its reasonable attorneys fees and costs. We could be required to spend significant amounts of time and money to defend ourselves against such claims. If any of these claims were to prevail, we could be forced to pay damages, comply with injunctions, or stop distributing our products and services while we re-engineer them or seek licenses to necessary technology, which might not be available on reasonable terms. We could also be subject to claims for indemnification resulting from infringement claims made against our customers and strategic partners, which could increase our defense costs and potential damages. Any of these events could require us to change our business practices and harm our business.heading “Legal Proceedings.”
Interpretation of existing laws that did not originally contemplate the Internet could harm our business and operating results.

     In August 1998, Venson M. Shaw and Steven M. Shaw filed a lawsuit against us and co-defendant Broadcast.com in the United States District Court for the Northern District of Texas — Dallas Division. The plaintiffs allege that we, individually and in combination with Broadcast.com, infringe on a certain patent owned by the plaintiffs. The plaintiffs filed a similar claim, based on the same patent, as a separate lawsuit against Microsoft and Broadcast.com, which was consolidated with the lawsuit against us. We have settled the lawsuit on our behalf as of January 10, 2003, and we have settled any indemnity obligation owing from us to Broadcast.com. The claims against us have been dismissed with prejudice. The terms of the settlement are confidential, but will not have a material adverse affect on our financial position or results of operations.

We Are Subject To Risks Associated With Governmental Regulation and Legal Uncertainties

     Few existing laws or regulations specifically apply to the Internet, other than laws and regulations generally applicable to businesses. Certain U.S. export controls and import controls of other countries, including controls on the use of encryption technologies, may apply to our products. Many laws and regulations, however, are pending and may be adopted in the United States, individual states and local jurisdictions and other countries with respect to the Internet. These laws may relate to many areas that impact our business, including content issues (such as obscenity, indecency and defamation), copyright and other intellectual property rights, digital rights management, encryption, caching of content by server products, personal privacy, taxation, e-mail, sweepstakes, promotions, network and information security and the convergence of traditional communication services with Internet communications, including the future availability of broadband transmission capability and wireless networks. These types of regulations are likely to differ between countries and other political and geographic divisions. Other countries and political organizations are likely to impose or favor more and different regulation than that which has been proposed in the United States, thus furthering the complexity of regulation. In addition, state and local governments may impose regulations in addition to, inconsistent with, or stricter than federal regulations. The adoption of such laws or regulations, and uncertainties associated with their validity, interpretation, applicability and enforcement, may affect the available distribution channels for and costs associated with our products and services, and may affect the growth of the Internet. Such laws or regulations may harm our business. Our products and services may also become subject to investigation and regulation of foreign data protection and e-commerce authorities, including those in the European Union. Such activities could result in additional product and distribution costs for us in order to comply with such regulation.

     We do not know for certainThere is uncertainty regarding how existing laws governing issues such as property ownership, copyright and other intellectual property issues digital rights management, taxation, gambling, security, illegal or obscene content, retransmission of media, and personal privacy and data protection apply to the Internet. The vast majorityMany of suchthese laws were adopted before the advent of the Internet and related technologies and do not address the unique issues associated with the Internet and related technologies. MostIn many cases, the relationship of thethese laws that relate to the Internet havehas not yet been interpreted. In additionNew interpretations of existing laws may increase our costs, require us to potential legislation from local, statechange business practices and federal governments, labor guild agreements and other laws and regulations that impose fees, royalties or unanticipated payments regarding the distribution of media over the Internet may directly or indirectly affectotherwise harm our business. While we and our customers may be directly affected by such agreements, we are not a party to such agreements and have little ability to influence the degree such agreements favor or disfavor Internet

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distribution or our business models. Changes to or the interpretation of these laws and the entry into such industry agreements could:

• limitIt is not yet clear how laws designed to protect children that use the growth of the Internet;
• create uncertaintyInternet may be interpreted, and such laws may apply to our business in the marketplaceways that could reduce demand for our products and services;
• increase our cost of doing business;
• expose us to increased litigation risk, substantial defense costs and significant liabilities associated with content available on our Web sites or distributed or accessed through our products or services, with our provision of products and services, and with the features or performance of our products and Web sites;
• lead to increased product development costs or otherwisemay harm our business; or
• decrease the rate of growth of our user base and limit our ability to effectively communicate with and market to our user base.business.

     The Digital Millennium Copyright Act (DMCA) includes statutory licenses for the performance of sound recordings and for the making of recordings to facilitate transmissions. Under these statutory licenses, we and our broadcast customers may be required to pay licensing fees for digital sound recordings we deliver in original and archived programming and through retransmissions of radio broadcasts. The DMCA does not specify the rate and terms of the licenses, which are determined by arbitration proceedings, known as CARP proceedings, supervised by the United States Copyright Office. Past CARP proceedings have resulted in proposed rates for statutory webcasting that were significantly in excess of rates requested by webcasters. CARP proceedings relating to music subscription and non-subscription services offering music programming that qualify for various licenses under U.S. copyright law are pending. We cannot predict the outcome of these CARP proceedings and may elect instead to directly license music content for our subscription and/or non-subscription services, either alone or in concert with other affected companies. Such licenses may only apply to music performed in the United States, and the availability of corresponding licenses for international performances is unclear. Therefore, our ability to find rights holders and negotiate appropriate licenses is uncertain. Many of our systems software and Real Broadcast Network customers may be affected by these rates, which may negatively impact our revenues. There are three other CARPs in process for 2002-2003 which will set rates for subscription music services and services that deliver digital downloads of music, and the outcome of these CARPs will also likely affect our business in ways that we cannot predict. Depending on the rates and terms adopted for the statutory licenses, our business could be harmed both by increasing our own cost of doing business, as well as by increasing the cost of doing business for our customers. We anticipate future CARPs relating to music subscription delivery services, which may also adversely affect the online distribution of music and, in particular, our RealOne Music subscription service.

The Child Online Protection Act and the Child Online Privacy Protection Act impose civil and criminal penalties on persons distributing material harmful to minors (e.g., obscene material) over the Internet to persons under the age of 17, or collecting personal information from children under the age of 13. We do not knowingly distribute harmful materials to minors or collect personal information from children under the age of 13. The manner in which these Acts may be interpreted and enforced cannot be fully determined, and future legislation similar to these Acts could subject us to potential liability if we were deemed to be non-compliant with such rules and regulations, which in turn could harm our business.

We may be subject to market risk and legal liability in connection with the data collection capabilities of our products and services.

     There are a large number of legislative proposals before the United States Congress and various state legislatures regarding intellectual property, digital rights management, copy protection requirements, privacy, email marketing and security issues related to our business. It is not possible to predict whether or when such legislation may be adopted, and certain proposals, if adopted, could materially and adversely affect our business through a decrease in user registration and revenue, and influence how and whether we can communicate with our customers.

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We May Be Subject To Market Risk and Legal Liability In Connection With the Data Collection Capabilities of Our Products and Services

Many of our products are interactive Internet applications that by their very nature require communication between a client and server to operate. To provide better consumer experiences and to operate effectively, our products send information to servers at RealNetworks.our servers. Many of the services we provide also require that a user provide certain information to us. We post an extensive privacy policy concerning the collection, use and disclosure of user data involved in interactions between our client and server products. Any failure by us to comply with our posted privacy policy and existing or new legislation regarding privacy issues could impact the market for our products and services, subject us to litigation and harm our business.

     Between November 1999 and March 2000, fourteen lawsuits were filed against us in federal and/or state courts in California, Illinois, Pennsylvania, Texas and Washington. The plaintiffs have voluntarily dismissed all of the state court cases with the exception of the case pending in California. The remaining actions, which seek to certify classes of plaintiffs, allege breach of contract, invasion of privacy, deceptive trade practices, negligence, fraud and violation of certain federal and state laws in connection with various communications features of our RealPlayer and RealJukebox products. Plaintiffs are seeking both damages and injunctive relief. We have filed answers denying the claims and have filed suit in Washington State Court to compel the state court plaintiffs to arbitrate the claims as required by our End User License Agreements. The Washington State Court has granted our motion to compel arbitration. However, the California trial court has entered an order stating that it is not bound by the Washington court’s decision. That order is currently under review by the California Court of Appeal. On February 10, 2000, the federal Judicial Panel on Multidistrict Litigation transferred all pending federal cases to the federal district court for the Northern District of Illinois. On the same day, that court granted RealNetworks’ motion to stay the court proceedings because the claims are subject to arbitration under our End User License Agreement. RealNetworks and the California state court plaintiffs have agreed on tentative terms to settle the California litigation. The proposed settlement must be approved by the California court before taking effect and it has not yet been approved. Under the agreed terms, the settlement would not have a material effect on the Company’s financial condition or results of operations. Although no assurance can be given as to the outcome of these lawsuits, we believe that the allegations in these actions are without merit, and intend to vigorously defend ourselves. If the plaintiffs prevail in their claims, we could be required to pay damages or other penalties, in addition to complying with injunctive relief, which could harm our business and our operating results.

We May Be Subject To Legal Liability For the Provision of Third-Party Products, Services or Content

We may be subject to legal liability for the provision of third-party products, services or content.

     We periodically enter into arrangements to offer third-party products, services, content or contentadvertising under the RealNetworks brand or via distribution on our Web sites, in products or service offerings. We may

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be subject to claims concerning these products, services, content or contentadvertising by virtue of our involvement in marketing, branding, broadcasting or providing access to them, even if we do not ourselves host, operate, provide, or provide access to these products, services or content. While ourthem. Our agreements with these parties often provide that we will be indemnified against such liabilities, such indemnification may not be adequate.adequately protect us from these potential liabilities. It is also possible that, if any information provided directly by us contains errors or is otherwise negligently provided to users, third parties could make claims against us, including, for example, claims for intellectual property infringement. Investigating and defending any of these types of claims is expensive, even if the claims do not result in liability. If any of these claims do result in liability, we could be required to pay damages or other penalties, which could harm our business and our operating results.

Our Directors and Executive Officers Beneficially Own Approximately 37.3% of Our Stock; Their Interests Could Conflict With Yours; Significant Sales of Stock Held By Them Could Have a Negative Effect On Our Stock Price; Shareholders May Be Unable To Exercise Control

Our directors and executive officers beneficially own approximately one third of our stock, which gives them significant control over certain major decisions on which our shareholders may vote, may discourage an acquisition of us, and any significant sales of stock by our officers and directors could have a negative effect on our stock price.

     As of December 31, 2002, ourOur executive officers, directors and affiliated persons beneficially owned approximately 37.3%more than one third of our common stock. Robert Glaser, our Chief Executive Officer and Chairman of the

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Board, beneficially owns approximately 33.9%the majority of our commonthat stock. As a result, our executive officers, directors and affiliated persons will have significant influence to:

 • elect or defeat the election of our directors;
 
 • amend or prevent amendment of our articles of incorporation or bylaws;
 
 • effect or prevent a merger, sale of assets or other corporate transaction; and
 
 • control the outcome of any other matter submitted to the shareholders for vote.

     Management’s stock ownership may discourage a potential acquirer from making a tender offer or otherwise attempting to obtain control of RealNetworks, which in turn could reduce our stock price or prevent our shareholders from realizing a premium over our stock price.

Provisions of Our Charter Documents, Shareholder Rights Plan and Washington Law Could Discourage Our Acquisition By a Third Party

Provisions of our charter documents, Shareholder Rights Plan, and Washington law could discourage our acquisition by a third party.

     Our articles of incorporation provide for a strategic transaction committee of the board of directors. Without the prior approval of this committee, and subject to certain limited exceptions, the board of directors does not have the authority to:

 • adopt a plan of merger;
 
 • authorize the sale, lease, exchange or mortgage of:

(A) of assets representing more than 50% of the book value of our assets prior to the transaction;transaction or

(B) any other asset or assets on which our long-term business strategy is substantially dependent;

 • authorize our voluntary dissolution; or
 
 • take any action that has the effect of any of the above.

     RealNetworks also entered into an agreement providing Mr. Glaser with certain contractual rights relating to the enforcement of our charter documents and Mr. Glaser’s roles and authority within RealNetworks.

     We have adopted a shareholder rights plan that provides that shares of our common stock have associated preferred stock purchase rights. The exercise of these rights would make the acquisition of RealNetworks by a third party more expensive to that party and has the effect of discouraging third parties from acquiring RealNetworks without the approval of our board of directors, which has the power to redeem these rights and prevent their exercise.

     Washington law imposes restrictions on some transactions between a corporation and certain significant shareholders. The foregoing provisions of our charter documents, shareholder rights plan, our agreement with

46


Mr. Glaser, the notes and Washington law, as well as those relating to a classified board of directors and the availability of “blank check” preferred stock, could have the effect of making it more difficult or more expensive for a third party to acquire, or of discouraging a third party from attempting to acquire, control of us. These provisions may therefore have the effect of limiting the price that investors might be willing to pay in the future for our common stock.

Our Stock Price Has Been and May Continue To Be Volatile

Our stock price has been volatile in the past and may continue to be volatile.

     The trading price of our common stock has been and is likely to continue to be highly volatile. For example, during the 52-week period ended December 31, 2002,2003, the price of our common stock ranged from $2.68$3.02 to $9.28$9.29 per share. Our stock price could be subject to wide fluctuations in response to factors such as:

 • actual or anticipated variations in quarterly operating results;
 
 • announcements of technological innovations, new products or services by us or our competitors;

52


 • changes in financial estimates or recommendations by securities analysts;
 
 • the addition or loss of strategic relationships or relationships with our key customers;
 
 • conditions or trends in the Internet, streaming media, media delivery andor online commerce markets;
 
 • changes in the market valuations of other Internet, online service or software companies;
 
 • announcements by us or our competitors of significant acquisitions, strategic partnerships, joint ventures or capital commitments or of significant new product developments or changes in business strategy;
 
 • legal, regulatory or political developments;
 
 • additions or departures of key personnel;
 
 • sales of our common stock; and
 
 • general market conditions.

     In addition, the stock market in general, and the Nasdaq National Market and the market for Internet and technology companies in particular, have experienced extreme price and volume fluctuations that have often been unrelated or disproportionate to the operating performance of these companies. These broad market and industry factors have in the past and may in the future reduce our stock price, regardless of our operating performance.

We May Be Subject To Assessment of Sales and Other Taxes For the Sale of Our Products, License of Technology or Provision of Services

Financial forecasting of our operating results will be difficult because of the changing nature of our products and business, and our actual results may differ from forecasts.

     We may haveAs a result of the dynamic and changing nature of our products and business, and of the markets in which we compete, it is difficult to pay past salesaccurately forecast our revenues, gross margin, operating expenses, number of subscribers and other financial and operating data. Our inability or other taxes that we have not collectedthe inability of the financial community to accurately forecast our operating results could result in our reported net income (losses) in a given quarter to differ from expectations, which could cause a decline in the trading price of our customers.common stock.

We may be subject to assessment of sales and other taxes for the sale of our products, license of technology or provision of services.

     We do not currently collect sales or other taxes on the sale of our products, license of technology or provision of services in states and countries other than those in which we have offices or employees. Our business would be harmed if one or more states or any foreign country were able to require us to collect sales or other taxes from past sales of products, licenses of technology or provision of services, particularly because we would be unable to go back to customers to collect sales taxes for past sales and maywould likely have to pay such taxes out of our own funds.

     In October 1998, the Internet Tax Freedom Act (“ITFA”) was signed into law. Among other things, the ITFA imposed a three-year moratorium on discriminatory taxes on electronic commerce which expired October 20, 2001. In November 2001, the moratorium was extended another two years until November 2003. Nonetheless, foreign countries or, following the moratorium, one or more states, may seek to impose sales or other tax obligations on companies that engage in such activities within their jurisdictions. The European Union introduced legislation effective47


     Effective July 1, 2003, requiring all non-European Union vendors to collectwe began collecting Value Added Tax, (“VAT”).or VAT, is imposed on sales of all electronically“electronically supplied software and servicesservices” provided to European Union residents, including software products, games, data, publications, music, video and fee-based broadcasting services. It is our intention to comply with the European Union VAT legislation upon its effective date. In order to comply with the VAT legislation, we must modify our existing customer transaction processing system to meet the requirements imposed by the legislation. While we anticipate that our systems will be able to accommodate the requirements of the legislation, thereThere can be no assurance that the European Union will not make further modifications to the legislation,VAT collection scheme, the effects of which could require significant enhancements to our systems and increase the cost of selling our products and services into the European Union. Additionally, we have not determined the impact VAT will have on the pricing and demand for our products and services, the effects of which may adversely impact our revenue and profit. We anticipate theThe collection and remittance of VAT will subjectsubjects us to additional currency fluctuation risks.

We DonateThe Internet Tax Freedom Act, or ITFA, expired November 2003 and Congress is currently considering an extension. Among other things, the ITFA imposed a Portionmoratorium on discriminatory taxes on electronic commerce. The imposition by state and local governments of Net Income to Charityvarious taxes upon Internet commerce could create administrative burdens for us and could decrease our future sales.

We donate a portion of net income to charity.

     In periods where we achieve profitability (excluding the effects of goodwill and other acquisition charges), we intend to donate 5% of our annual pre-tax net income to charitable organizations, which will

53


reduce our net income for those periods. The non-profit RealNetworks Foundation manages our charitable giving efforts.

Special Note Regarding Forward-Looking Statements

     We have made forward-looking statements in this document, all of which are subject to risks and uncertainties. When we use words such as “anticipate,” “expect,” “intend,” “plan,” “believe,” “seek” and “estimate” or similar words, we are making forward-looking statements. Forward-looking statements include information concerning our possible or assumed future business success or financial results. Such forward-looking statements include, but are not limited to, statements as to our expectations regarding:

 • the future development and growth of, and opportunities for, the Internetpremium digital audio and the online media delivery market;
• the features and functionality of our future products, services and technologies;video content online;
 
 • the future adoption of our currentdevelopment and future products, services and technologies;
• future revenue opportunities;
• the future growth of digital media delivery to mobile devices, and our customer base;position in that market;
 
 • our ability to successfully developleverage our digital media delivery technology and introduce futureuser base to generate revenue from the sale of digital media products and services;
 
 • the future expense levels (including costsuccess of, revenues, research and development, sales and marketing and general and administrative);
• future sales and marketing efforts;
• future capital needs and capital expenditures;anticipated benefits from, our open source technology initiatives;
 
 • the effecteffectiveness of past and future acquisitions;our marketing programs;
 
 • future charges for impairmentcompetition from existing and new competitors in each of long-lived assetsour markets, and goodwill;our ability to compete with such competitors;
 
 • anticipated future prepayment requirementscompetitive activities of Microsoft, and the anticipated results of those activities;
• potential future growth of service revenues, and the rate of that growth;
• anticipated fluctuation in our customers’ contractspaid content subscriber base and the associated effect on deferred revenues;
 
 • future rates of growth of our costs of service revenues and future reductionsits impact on our gross margins;
• anticipated fluctuations in gross margins;our revenues and cost of service revenues;
• anticipated effects of potential content acquisition transactions;
 
 • the impact of our interest in MusicNet on our operating results;
 
 • whether we will pay federal income taxes in the near future;
• potential effects of interest rates on our operating results;future activities under our stock repurchase program;
 
 • future competition from existingcapital needs and new competitors and our ability to compete with such competitors;capital expenditures;
 
 • the anticipated benefitsfuture impact of allowing access tointerest rates on our source code by operating results and cash flows;

48


• the open source community;impact of current litigation in which we are involved;
 
 • whetheranticipated consolidation and strategic partnering activities in our products and services will be accepted in international markets;
• our future charitable donations;
 
 • the future effectiveness of our intellectual property rights;rights and potential future litigation involving us regarding intellectual property matters; and
 
 • the impactpotential future charges relating to personnel reductions, excess facilities, impairment of current litigationassets and reduction in which we are involved.value of investments.

     You should note that an investment in our common stock involves certain risks and uncertainties that could affect our future business success or financial results. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors, including those set forth in “Factors That May Affect Our Business, Future Operating Results and Financial Condition” and elsewhere in this Annual Report on Form 10-K.

54


     We believe that it is important to communicate our expectations to our investors. However, there may be events in the future that we are not able to predict accurately or over which we have no control. Before you invest in our common stock, you should be aware that the occurrence of the events described in the “Factors That May Affect Our Business, Future Operating Results and Financial Condition” and elsewhere in this Annual Report on Form 10-K could materially and adversely affect our business, financial condition and operating results. We undertake no obligation to publicly update any forward-looking statements for any reason, even if new information becomes available or other events occur in the future.

 
Item 7A.Quantitative and Qualitative Disclosures About Market Risk

     The following discussion about our market risk involves forward-looking statements. Actual results could differ materially from those projected in the forward-looking statements.

     Interest Rate Risk. Our exposure to interest rate risk from changes in market interest rates relates primarily to our short-term investment portfolio. We do not hold derivative financial instruments or equity investments in our short-term investment portfolio. Our short-term investments consist of high quality securities as specified in our investment policy guidelines. Investments in both fixed and floating rate instruments carry a degree of interest rate risk. The fair value of fixed rate securities may be adversely impacted due to a rise in interest rates, while floating rate securities may produce less income than expected if interest rates fall. Additionally, in a falling rate environment there may be a degree of reinvestment risk since as securities mature the proceeds are reinvested at a lower rate, generating less interest income. Due in part to these factors, our future interest income may be adversely impacted due to changes in interest rates. In addition, we may incur losses in principal if we are forced to sell securities which have declined in market value due to changes in interest rates. Because we have historically had the ability to hold our short-term investments until maturity and the substantial majority matures within one year of purchase, we would not expect our operating results or cash flows to be significantly impacted by a sudden change in market interest rates. There have been no material changes in our investment methodology regarding our cash equivalents and short-term investments during the year ended December 31, 2002.2003.

     The table below presents the amounts related to weighted average interest rates and contractual maturities of our short-term investment portfolio at December 31, 20022003 (dollars in thousands):

                                           
WeightedExpected Maturity DatesExpected Maturity
Average
AmortizedEstimatedWeightedDates
December 31, 2002Interest Rate200320042005CostFair Value
Average
AmortizedEstimated
December 31, 2003December 31, 2003Interest Rate20042005CostFair Value














Short-term investments:Short-term investments: Short-term investments: 
Corporate notes 4.32% $42,479 7,445 1,000 50,924 51,040 Corporate notes and bonds 7.20% $502  502 502 
Commercial paper 2.29 20,711   20,711 20,711 U.S. Government agency securities 2.87 145,134 29,850 174,984 175,063 
U.S. Government agency securities 3.74 88,091 24,137 3,000 115,228 115,541   
 
 
 
 
 
 
 
 
 
  Total short-term investments 2.88% $145,636 29,850 175,486 175,565 
 Total short-term investments 3.71% $151,281 31,582 4,000 186,863 187,292   
 
 
 
 
 
 
 
 
 
 

     Investment Risk. As of December 31, 2002,2003, we had investments in voting capital stock of both public and privately-held technology companies for business and strategic purposes. Some of these securities do not

49


have a quoted market price. Our investments in publicly traded companies are carried at current market value and are classified as long-term as they are strategic in nature. We periodically evaluate whether any declines in fair value of our investments are other-than-temporary. This evaluation consists of a review of qualitative and quantitative factors. Based upon an evaluation of the facts and circumstances during 2002,2003, we determined that an other-than-temporary impairment had occurred on fivetwo of our investments. Impairment charges have been recorded to reflect these investments at fair value. Impairment charges of $5.1$0.4 million were recognized in 2002.2003. Equity price fluctuations of plus or minus 10% of prices at December 31, 20022003 would have had an approximate $1.8$2.5 million impact on the value of our investments in publicly traded companies at December 31, 2002,2003, related primarily to our investment in a publicly traded Japanese company.

55


     Foreign Currency Risk.We conduct business internationally in several currencies. As such, we are exposed to adverse movements in foreign currency exchange rates.

     Our exposure to foreign exchange rate fluctuations arise in part from: (1) translation of the financial results of foreign subsidiaries into U.S. dollars in consolidation, (2) the re-measurement of non-functional currency assets, liabilities and intercompany balances into U.S. dollars for financial reporting purposes, and (3) non-U.S. dollar denominated sales to foreign customers.

     A portion of these risks is managed through the use of financial derivatives, but fluctuations could impact our results of operations and financial position.

     Generally, our practice is to manage foreign currency risk for the majority of material short-term intercompany balances through the use of foreign currency forward contracts. These contracts require us to exchange currencies at rates agreed upon at the contract’s inception. Because the impact of movements in currency exchange rates on forward contracts offsets the related impact on the short-term intercompany balances, these financial instruments help alleviate the risk that might otherwise result from certain changes in currency exchange rates. We do not designate our foreign exchange forward contracts related to short-term intercompany accounts as hedges and, accordingly, we adjust these instruments to fair value through results of operations. However, we may periodically hedge a portion of our foreign exchange exposures associated with material firmly committed transactions, long-term investments, highly predictable anticipated exposures and net investments in foreign subsidiaries.

     Our foreign currency risk management program reduces, but does not entirely eliminate, the impact of currency exchange rate movements.

     Historically, neither fluctuations in foreign exchange rates nor changes in foreign economic conditions have had a significant impact on our financial condition or results of operations. Foreign exchange rate fluctuations did not have a material impact on our financial results for the years ended December 31, 2003, 2002 2001 and 2000.2001.

     At December 31, 2002,2003, we had the following foreign currency contracts outstanding (in thousands):

                        
ContractContract
Contract AmountAmountContract AmountAmount
(Local Currency)(US Dollars)Fair Value(Local Currency)(US Dollars)Fair Value






British Pounds (“GBP”) (contracts to receive GBP/pay US$) (GBP)1,000 $1,590 $12  (GBP)1,100 $1,926 $34 
Euro (“EUR”) (contracts to receive EUR/pay US$) (EUR)240 $247 $5 
Euro (“EUR”) (contracts to pay EUR/receive US$) (EUR)2,150 $2,648 $(48)
Japanese Yen (“YEN”) (contracts to pay YEN/receive US$) (YEN)293,200 $2,410 $(70) (YEN)295,200 $2,749 $(2)

     All derivatives, whether designated in hedging relationships or not, are recorded on the balance sheet at fair value.

5650


Item 8.     Financial Statements and Supplementary Data

REALNETWORKS, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

                    
December 31,December 31,


2002200120032002




(In thousands, except per(In thousands, except per
share data)share data)
ASSETSASSETSASSETS
Current assets:Current assets: Current assets: 
Cash, cash equivalents and short-term investments $309,071 344,509 Cash, cash equivalents and short-term investments $373,593 309,071 
Trade accounts receivable, net of allowances for doubtful accounts and sales returns of $2,501 in 2002 and $1,823 in 2001 6,560 5,854 Trade accounts receivable, net of allowances for doubtful accounts and sales returns of $2,858 in 2003 and $2,501 in 2002 10,618 6,560 
Prepaid expenses and other current assets 7,278 7,244 Prepaid expenses and other current assets 8,879 7,278 
Deferred income taxes  5,225   
 
 
 
 
  Total current assets 393,090 322,909 
 Total current assets 322,909 362,832   
 
 
 
 
 
Equipment and leasehold improvements, at cost:Equipment and leasehold improvements, at cost: Equipment and leasehold improvements, at cost: 
Equipment and software 27,536 31,298 Equipment and software 37,110 27,536 
Leasehold improvements 25,227 24,965 Leasehold improvements 26,085 25,227 
 
 
   
 
 
 Total equipment and leasehold improvements 52,763 56,263  Total equipment and leasehold improvements 63,195 52,763 
Less accumulated depreciation and amortization 22,718 20,721 Less accumulated depreciation and amortization 33,258 22,718 
 
 
   
 
 
 Net equipment and leasehold improvements 30,045 35,542  Net equipment and leasehold improvements 29,937 30,045 
 
 
   
 
 
Restricted cash equivalentsRestricted cash equivalents 17,300 17,300 Restricted cash equivalents 19,953 17,300 
Notes receivable from related partiesNotes receivable from related parties 771  
Equity investmentsEquity investments 29,196 92,940 Equity investments 34,577 29,196 
Other assetsOther assets 1,726 1,070 Other assets 4,069 1,726 
Deferred income taxes  360 
Goodwill, net of accumulated amortization of $96,432 in 2002 and 2001 60,077 57,816 
Other intangible assets, net of accumulated amortization of $102 in 2002 and $0 in 2001 848  
Goodwill, net of accumulated amortization of $96,432 in 2003 and 2002Goodwill, net of accumulated amortization of $96,432 in 2003 and 2002 97,477 60,077 
Other intangible assets, net of accumulated amortization of $615 in 2003 and $102 in 2002Other intangible assets, net of accumulated amortization of $615 in 2003 and $102 in 2002 1,065 848 
 
 
   
 
 
 Total assets $462,101 567,860  Total assets $580,939 462,101 
 
 
   
 
 
LIABILITIES AND SHAREHOLDERS’ EQUITYLIABILITIES AND SHAREHOLDERS’ EQUITYLIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities:Current liabilities: Current liabilities: 
Accounts payable $7,830 9,950 Accounts payable $6,865 7,830 
Accrued and other liabilities 31,083 30,853 Accrued and other liabilities 39,400 31,083 
Deferred revenue, excluding non-current portion 31,771 31,462 Deferred revenue, excluding non-current portion 31,186 31,771 
Accrued loss on excess office facilities, excluding non-current portion 3,825 5,288 Accrued loss on excess office facilities, excluding non-current portion 4,960 3,825 
 
 
   
 
 
 Total current liabilities 74,509 77,553  Total current liabilities 82,411 74,509 
 
 
   
 
 
Deferred revenue, excluding current portionDeferred revenue, excluding current portion 12,446 15,380 Deferred revenue, excluding current portion 4,561 12,446 
Accrued loss on excess office facilities, excluding current portionAccrued loss on excess office facilities, excluding current portion 22,110 7,149 Accrued loss on excess office facilities, excluding current portion 24,099 22,110 
Deferred rentDeferred rent 3,271 2,899 Deferred rent 3,382 3,271 
Convertible debtConvertible debt 100,000  
Commitments and contingenciesCommitments and contingencies Commitments and contingencies 
Shareholders’ equity:Shareholders’ equity: Shareholders’ equity: 
Preferred stock, $0.001 par value, no shares issued and outstanding Preferred stock, $0.001 par value, no shares issued and outstanding
Series A: authorized 200 shares
   
 Series A: authorized 200 shares    Undesignated series: authorized 59,800 shares   
 Undesignated series: authorized 59,800 shares   Common stock, $0.001 par value 
Common stock, $0.001 par value  Authorized 1,000,000 shares; issued and outstanding 164,197 shares in 2003 and 157,681 shares in 2002 164 158 
 Authorized 1,000,000 shares; issued and outstanding 157,681 shares in 2002 and 159,844 shares in 2001 158 160 Additional paid-in capital 639,369 609,833 
Additional paid-in capital 609,833 628,919 Notes receivable from shareholders (58)  
Deferred stock compensation (1,070) (914)Deferred stock compensation (620) (1,070)
Accumulated other comprehensive income (loss) (1,054) 56,463 Accumulated other comprehensive income (loss) 7,184 (1,054)
Accumulated deficit (258,102) (219,749)Accumulated deficit (279,553) (258,102)
 
 
   
 
 
 Total shareholders’ equity 349,765 464,879  Total shareholders’ equity 366,486 349,765 
 
 
   
 
 
 Total liabilities and shareholders’ equity $462,101 567,860  Total liabilities and shareholders’ equity $580,939 462,101 
 
 
   
 
 

See accompanying notes to consolidated financial statementsstatements.

5751


REALNETWORKS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS

                            
Years Ended December 31,Years Ended December 31,


200220012000200320022001






(In thousands, except per share data)(In thousands, except per share data)
Net revenues:Net revenues: Net revenues: 
Software license fees $72,753 108,586 148,091 Software license fees $61,970 72,753 108,586 
Service revenues 103,161 64,740 52,505 Service revenues 134,058 103,161 64,740 
Advertising 6,765 15,579 40,942 Advertising 6,349 6,765 15,579 
 
 
 
   
 
 
 
 Total net revenues 182,679 188,905 241,538  Total net revenues 202,377 182,679 188,905 
 
 
 
   
 
 
 
Cost of revenues:Cost of revenues: Cost of revenues: 
Software license fees 6,865 7,969 14,341 Software license fees 9,917 6,865 7,969 
Service revenues 41,259 23,895 14,718 Service revenues 56,690 41,259 23,895 
Advertising 2,145 6,324 9,629 Advertising 1,736 2,145 6,324 
 
 
 
   
 
 
 
 Total cost of revenues 50,269 38,188 38,688  Total cost of revenues 68,343 50,269 38,188 
 
 
 
   
 
 
 
 Gross profit 132,410 150,717 202,850  Gross profit 134,034 132,410 150,717 
 
 
 
   
 
 
 
Operating expenses:Operating expenses: Operating expenses: 
Research and development (excluding non-cash stock-based compensation of $1,328 for 2002, $(9,498) for 2001 and $92,161 for 2000, included below) 48,186 55,904 57,819 Research and development (excluding non-cash stock-based compensation, included below, of $967 for 2003, $1,328 for 2002 and $(9,498) for 2001) 46,763 48,186 55,904 
Sales and marketing (excluding non-cash stock-based compensation of $0 for 2002, $(42) for 2001 and $4,454 for 2000, included below) 73,928 73,129 101,197 Sales and marketing (excluding non-cash stock-based compensation, included below, of $(42) for 2001) 77,335 73,928 73,129 
General and administrative 19,820 20,554 27,807 General and administrative (excluding non-cash stock-based compensation, included below, of $153 for 2003) 21,007 19,820 20,554 
Loss on excess office facilities 17,207 22,208  Antitrust litigation 1,574   
Personnel reduction and related charges 3,595 3,613  Loss on excess office facilities 7,098 17,207 22,208 
Goodwill amortization, acquisition charges, and stock-based compensation 1,328 40,633 142,053 Personnel reduction and related charges  3,595 3,613 
 
 
 
 Goodwill amortization, acquisition charges, and stock-based compensation 1,120 1,328 40,633 
 Total operating expenses 164,064 216,041 328,876   
 
 
 
 
 
 
  Total operating expenses 154,897 164,064 216,041 
 Operating loss (31,654) (65,324) (126,026)  
 
 
 
 
 
 
  Operating loss (20,863) (31,654) (65,324)
 
 
 
 
Other income (expense):Other income (expense): Other income (expense): 
Interest income, net 7,483 17,653 21,804 Interest income, net 4,251 7,483 17,653 
Equity in net loss of MusicNet (6,324) (3,946)  Equity in net loss of MusicNet (5,378) (6,324) (3,946)
Impairment of equity investments (5,103) (25,342)  Impairment of equity investments (424) (5,103) (25,342)
Other income (expense) 3,217 (1,862) (2,933)Other income (expense) 1,107 3,217 (1,862)
 
 
 
   
 
 
 
 Other income (expense), net (727) (13,497) 18,871  Other expense, net (444) (727) (13,497)
 
 
 
   
 
 
 
Net loss before income taxesNet loss before income taxes (32,381) (78,821) (107,155)Net loss before income taxes (21,307) (32,381) (78,821)
 Income tax provision (benefit) 5,972 (4,058) 2,966  Income tax (provision) benefit (144) (5,972) 4,058 
 
 
 
   
 
 
 
Net lossNet loss $(38,353) (74,763) (110,121)Net loss $(21,451) (38,353) (74,763)
 
 
 
   
 
 
 
Basic and diluted net loss per shareBasic and diluted net loss per share $(0.24) (0.47) (0.72)Basic and diluted net loss per share $(0.13) (0.24) (0.47)
Shares used to compute basic and diluted net loss per shareShares used to compute basic and diluted net loss per share 159,365 160,532 153,870 Shares used to compute basic and diluted net loss per share 160,309 159,365 160,532 
Comprehensive loss:Comprehensive loss: Comprehensive loss: 
Net loss $(38,353) (74,763) (110,121)Net loss $(21,451) (38,353) (74,763)
Unrealized gain (loss) on investments: Unrealized gain (loss) on investments: 
 Unrealized holding gains (losses), net of tax (55,900) 53,516 (12,338) Unrealized holding gains (losses), net of tax 8,035 (55,900) 53,516 
 Adjustments for losses (gains) reclassified to net loss (1,705) 16,519   Adjustments for (gains) losses reclassified to net loss (56) (1,705) 16,519 
Foreign currency translation adjustments 88 (188) (143)Foreign currency translation gains (losses) 259 88 (188)
 
 
 
   
 
 
 
 Comprehensive loss $(95,870) (4,916) (122,602) Comprehensive loss $(13,213) (95,870) (4,916)
 
 
 
   
 
 
 

See accompanying notes to consolidated financial statementsstatements.

5852


REALNETWORKS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

                         
Years Ended December 31,Years Ended December 31,


200220012000200320022001






(In thousands)(In thousands)
Cash flows from operating activities:Cash flows from operating activities: Cash flows from operating activities: 
Net loss $(38,353) (74,763) (110,121)Net loss $(21,451) (38,353) (74,763)
Adjustments to reconcile net loss to net cash provided by (used in) operating activities: Adjustments to reconcile net loss to net cash provided by (used in) operating activities: 
 Amortization of goodwill and stock-based compensation 1,328 41,162 142,053  Amortization of goodwill and stock-based compensation 1,120 1,328 41,162 
 Depreciation and amortization of equipment and leasehold improvements 11,760 12,111 9,287  Depreciation and amortization of equipment, leasehold improvements and other intangible assets 11,250 11,760 12,111 
 Impairment of equity investments 5,103 25,342   Impairment of equity investments 424 5,103 25,342 
 Equity in net losses of equity method investments 6,790 4,568 1,859  Equity in net losses of equity method investments 5,378 6,790 4,568 
 Loss (gain) on sale of equity investments (2,348) 151 1,246  Loss (gain) on sale of equity investments (824) (2,348) 151 
 Accrued loss on excess office facilities 13,498 19,396   Accrued loss on excess office facilities 3,009 13,498 19,396 
 Income tax benefit related to stock options  2,981 16,230  Income tax benefit related to stock options   2,981 
 Deferred income taxes 5,585 (7,921) (14,142) Deferred income taxes  5,585 (7,921)
 Other 567 800 34  Other 381 567 800 
 Changes in certain assets and liabilities:  Changes in certain assets and liabilities: 
 Trade accounts receivable (914) 3,101 (1,297) Trade accounts receivable (4,267) (914) 3,101 
 Prepaid expenses and other current assets (27) (3,884) (3,511) Prepaid expenses and other current assets 164 (27) (3,884)
 Accounts payable (2,532) 2,153 1,389  Accounts payable (1,024) (2,532) 2,153 
 Accrued and other liabilities 965 (5,678) 9,252  Accrued and other liabilities 5,700 965 (5,678)
 Deferred revenue (2,210) (4,661) 3,699  Deferred revenue (8,649) (2,210) (4,661)
 
 
 
   
 
 
 
 Net cash provided by (used in) operating activities (788) 14,858 55,978  Net cash provided by (used in) operating activities (8,789) (788) 14,858 
 
 
 
   
 
 
 
Cash flows from investing activities:Cash flows from investing activities: Cash flows from investing activities: 
Purchases of equipment and leasehold improvements (6,264) (12,227) (23,993)Purchases of equipment and leasehold improvements (9,065) (6,264) (12,227)
Purchases of short-term investments (524,817) (737,205) (854,816)Purchases of short-term investments (311,367) (524,817) (737,205)
Sales and maturities of short-term investments 578,012 713,538 822,750 Sales and maturities of short-term investments 322,742 578,012 713,538 
Purchase of long-term equity investments (6,550) (18,480) (29,299)Additions to and purchases of long-term equity investments (3,266) (6,550) (18,480)
Change in other assets  189 4,058 Change in other assets   189 
Decrease (increase) in restricted cash equivalents  1,500 (5,100)Proceeds from repayments of notes receivable 85   
Proceeds from sale of long-term equity investments 3,312   Decrease (increase) in restricted cash equivalents (2,488)  1,500 
Payment of acquisition costs, net of cash acquired (2,422) (1,949) (3,526)Proceeds from sale of long-term equity investments 1,237 3,312  
 
 
 
 Payment of acquisition costs, net of cash acquired (20,257) (2,422) (1,949)
 Net cash provided by (used in) investing activities 41,271 (54,634) (89,926)  
 
 
 
 
 
 
  Net cash provided by (used in) investing activities (22,379) 41,271 (54,634)
 
 
 
 
Cash flows from financing activities:Cash flows from financing activities: Cash flows from financing activities: 
Net proceeds from sales of preferred and common stock and exercise of stock options and warrants 7,741 8,003 21,427 Proceeds from sale of convertible debt, net of offering costs of $3,037 96,963   
Repurchase of common stock (30,728) (11,446)  Net proceeds from sales of common stock and exercise of stock options and warrants 10,166 7,741 8,003 
Collection of shareholder loan receivable   310 Repurchase of common stock  (30,728) (11,446)
 
 
 
   
 
 
 
 Net cash provided by (used in) financing activities (22,987) (3,443) 21,737  Net cash provided by (used in) financing activities 107,129 (22,987) (3,443)
 
 
 
   
 
 
 
Effect of exchange rate changes on cashEffect of exchange rate changes on cash 101 (484) (859)Effect of exchange rate changes on cash 288 101 (484)
 
 
 
   
 
 
 
 Net increase (decrease) in cash and cash equivalents 17,597 (43,703) (13,070) Net increase (decrease) in cash and cash equivalents 76,249 17,597 (43,703)
Cash and cash equivalents at beginning of yearCash and cash equivalents at beginning of year 104,182 147,885 160,955 Cash and cash equivalents at beginning of year 121,779 104,182 147,885 
 
 
 
   
 
 
 
Cash and cash equivalents at end of yearCash and cash equivalents at end of year $121,779 104,182 147,885 Cash and cash equivalents at end of year $198,028 121,779 104,182 
 
 
 
   
 
 
 
Supplemental disclosure of cash flow information:Supplemental disclosure of cash flow information: Supplemental disclosure of cash flow information: 
Cash paid during the year for interest $  62 Cash paid during the year for income taxes $683 352 567 
Cash paid during the year for income taxes 352 567 227 
Supplemental disclosure of noncash financing and investing activities:Supplemental disclosure of noncash financing and investing activities: Supplemental disclosure of noncash financing and investing activities: 
Common stock issued in business combinations, net of deferred compensation 1,004  138,239 Common stock and options to purchase common stock issued in business combinations, net of deferred compensation $19,376 1,004  
Payable for repurchase of common stock 216 1,344  Accrued acquisition costs and contingent consideration $1,649   
Payable for repurchase of common stock $ 216 1,344 

See accompanying notes to consolidated financial statementsstatements.

5953


REALNETWORKS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

                                        
AccumulatedNotesAccumulated
Common StockAdditionalDeferredOtherTotalCommon StockAdditionalReceivableDeferredOtherTotal

Paid-inStockComprehensiveAccumulatedShareholders’
Paid-inFromStockComprehensiveAccumulatedShareholders’
SharesAmountCapitalCompensationIncome (loss)DeficitEquitySharesAmountCapitalShareholdersCompensationIncome (loss)DeficitEquity















(In thousands)(In thousands)
Balances at December 31, 1999
 149,648 $150 366,177  (903) (34,865) 330,559 
Balances at December 31, 2000
 159,214 $159 692,245  (53,222) (13,384) (144,986) $480,812 
Common stock issued: 
Exercise of options and Employee Stock Purchase Plan 5,174 5 21,422    21,427 Exercise of options and Employee Stock Purchase Plan 3,579 4 7,999     8,003 
Business combinations 4,428 4 288,072 (149,837)   138,239 
Payment of services 1  34    34 
Amortization of deferred stock compensation    96,615   96,615 
Repayment of shareholder loan   310    310 
Escrow shares returned (37)       
Tax benefit related to stock options   16,230    16,230 
Unrealized loss on investments, net of tax     (12,338)  (12,338)
Translation adjustment     (143)  (143)
Net loss      (110,121) (110,121)
 
 
 
 
 
 
 
 
Balances at December 31, 2000
 159,214 159 692,245 (53,222) (13,384) (144,986) 480,812 
Exercise of options and Employee Stock Purchase Plan 3,579 4 7,999    8,003 
Amortization of deferred stock  
compensation net of reversals and forfeitures of deferred stock compensation (525) (1) (61,856) 52,308   (9,549)
Amortization of deferred stock compensation net of reversals and forfeitures of deferred stock compensationAmortization of deferred stock compensation net of reversals and forfeitures of deferred stock compensation (525) (1) (61,856)  52,308   (9,549)
Repurchase of common stockRepurchase of common stock (2,424) (2) (12,788)    (12,790)Repurchase of common stock (2,424) (2) (12,788)     (12,790)
Tax benefit related to stock optionsTax benefit related to stock options   2,981    2,981 Tax benefit related to stock options   2,981     2,981 
Unrealized gain on investments, net of taxUnrealized gain on investments, net of tax     53,516  53,516 Unrealized gain on investments, net of tax      53,516  53,516 
Adjustments for losses (gains) reclassified to net loss     16,519  16,519 
Adjustments for losses reclassified to net lossAdjustments for losses reclassified to net loss      16,519  16,519 
Translation adjustmentTranslation adjustment     (188)  (188)Translation adjustment      (188)  (188)
OtherOther   338    338 Other   338     338 
Net lossNet loss      (74,763) (74,763)Net loss       (74,763) (74,763)
 
 
 
 
 
 
 
   
 
 
 
 
 
 
 
 
Balances at December 31, 2001
 159,844 160 628,919 (914) 56,463 (219,749) 464,879 
Balances at December 31, 2001
 159,844 160 628,919  (914) 56,463 (219,749) 464,879 
Common stock issued: 
Common stock issued for:Common stock issued for: 
Exercise of options and Employee Stock Purchase Plan 4,175 4 7,737    7,741 Exercise of options and Employee Stock Purchase Plan 4,175 4 7,737     7,741 
Business combinations 374  2,488 (1,484)   1,004 Business combination 374  2,488  (1,484)   1,004 
Amortization of deferred stock compensationAmortization of deferred stock compensation    1,328   1,328 Amortization of deferred stock compensation     1,328   1,328 
Repurchase of common stockRepurchase of common stock (6,712) (6) (29,594)    (29,600)Repurchase of common stock (6,712) (6) (29,594)     (29,600)
Unrealized loss on investments, net of taxUnrealized loss on investments, net of tax     (55,900)  (55,900)Unrealized loss on investments, net of tax      (55,900)  (55,900)
Adjustments for losses (gains) reclassified to net loss     (1,705)  (1,705)
Adjustments for gains reclassified to net lossAdjustments for gains reclassified to net loss      (1,705)  (1,705)
Translation adjustmentTranslation adjustment     88  88 Translation adjustment      88  88 
OtherOther   283    283 Other   283     283 
Net lossNet loss      (38,353) (38,353)Net loss       (38,353) (38,353)
 
 
 
 
 
 
 
   
 
 
 
 
 
 
 
 
Balances at December 31, 2002
 157,681 $158 609,833 (1,070) (1,054) (258,102) 349,765 
Balances at December 31, 2002
 157,681 158 609,833  (1,070) (1,054) (258,102) 349,765 
Common stock issued for:Common stock issued for: 
 
 
 
 
 
 
 
 Exercise of options and Employee Stock Purchase Plan 2,715 2 10,164     10,166 
Business combination 3,801 4 19,372  (670)   18,706 
Notes receivable acquired in business combinationNotes receivable acquired in business combination    (83)    (83)
Amortization of deferred stock compensationAmortization of deferred stock compensation     1,120   1,120 
Repayment of notes receivable from shareholdersRepayment of notes receivable from shareholders    25    25 
Unrealized gain on investments, net of taxUnrealized gain on investments, net of tax      8,035  8,035 
Adjustments for gains reclassified to net lossAdjustments for gains reclassified to net loss      (56)  (56)
Translation adjustmentTranslation adjustment      259  259 
Net lossNet loss       (21,451) (21,451)
 
 
 
 
 
 
 
 
 
Balances at December 31, 2003
 164,197 $164 639,369 (58) (620) 7,184 (279,553) $366,486 
 
 
 
 
 
 
 
 
 

See accompanying notes to consolidated financial statementsstatements.

6054


REALNETWORKS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Years ended December 31, 2003, 2002 2001 and 20002001

Note 1. Description of Business and Summary of Significant Accounting Policies

     A.     Description of Business.RealNetworks, Inc. and subsidiaries (RealNetworks or Company) is a leading global provider of network-delivered digital media content and services and the technology that enables digital media creation, distribution and consumption. The Company develops and markets software products and services designed to enable users of personal computers and other consumer electronic devices to send and receive audio, video and other multimedia services using the Internet and other digital networks.

     Inherent in the Company’s business are various risks and uncertainties, including its limited operating history and the limited history of premium subscription services on the Internet. The Company’s success maywill depend in part upon the emergence of the Internet and corporate intranets as a communications medium,on the acceptance of the Company’s technology and services by the marketplace and the Company’s ability to generate license, service and advertising revenues from the use of its technology on the Internet.

     B.     Basis of Presentation.The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation.

     C.     Cash, Cash Equivalents, Short-Term Investments and Marketable Equity Securities.The Company considers all short-term investments with a remaining contractual maturity at date of purchase of three months or less to be cash equivalents.

     The Company has classified all marketable debt and equity securities for which there is a determinable fair market value and there are no restrictions on the Company’s ability to sell within the next 12 months as available-for-sale. Available-for-sale securities are carried at fair value, with unrealized gains and losses reported as a separate component of shareholders’ equity, net of applicable income taxes. Realized gains and losses and declines in value judged to be other-than-temporary on available-for-sale securities are included in other income (expense). The cost basis for determining realized gains and losses on available-for-sale securities is determined on the specific identification method.

     D.     Other Investments.The cost method is used to account for equity investments in companies in which the Company holds less than a 20 percent voting interest, does not exercise significant influence and the related securities do not have a quoted market price.

     The Company has investments that are accounted for under the equity method of accounting. Under the equity method of accounting, the Company’s share of the investee’s earnings or loss is included in the Company’s consolidated operating results. In certain cases where the Company has loaned the investee funds, the Company may record more than its relative share of the investee’s losses.

     E.     Fair Value of Financial Instruments.At December 31, 2002,2003, the Company had the following financial instruments: cash and cash equivalents, investments, accounts receivable, accounts payable, accrued liabilities and accrued liabilities.convertible debt. The carrying value of cash and cash equivalents, investments, accounts receivable, accounts payable and accrued liabilities approximates their fair value based on the liquidity of these financial instruments or based on their short-term nature. The fair value of convertible debt that has a carrying value of $100 million was approximately $89.1 million on December 31, 2003.

     F.     Revenue Recognition.The Company recognizes revenue in connection with its software products pursuant to the requirements of Statement of Position No. 97-2, “Software Revenue Recognition” (SOP 97-2), as amended by Statement of Position No. 98-9, “Software Revenue Recognition with Respect to Certain Arrangements.” Some of the Company’s software arrangements include consulting implementation services sold separately under consulting engagement contracts. Consulting revenues from these arrangements are generally accounted for separately from new software license revenues because the arrangements qualify as service transactions as defined in SOP 97-2. Revenues for consulting services are generally recognized as the services are performed.

     Under55


REALNETWORKS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

     For transactions not falling under the scope of SOP 97-2, the Company’s revenue recognition policies are in accordance with Securities and Exchange Commission (“SEC”) Staff Accounting Bulletin (“SAB”) 104, “Revenue Recognition,” which was issued on December 17, 2003 and supercedes SAB 101, “Revenue Recognition.” The adoption of SAB 104 did not materially affect the Company’s revenue recognition policies, its results of operations, financial position or cash flows.

     Revenue attributable to an element in a customer arrangement is recognized when persuasive evidence of an arrangement exists and delivery has occurred, provided the fee is fixed or determinable, collectibility is probable and the arrangement does not require significant customization of the software. If at the outset of the customer arrangement, the Company determines that the arrangement fee is

61


REALNETWORKS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

not fixed or determinable or that collectibility is not probable, the Company defers the revenue and recognizes the revenue when the arrangement fee becomes due and payable or as cash is received when collectibility concerns exist.

     For multiple element arrangements when Company-specific objective evidence of fair value exists for all of the undelivered elements of the arrangement, but does not exist for one or more of the delivered elements in the arrangement, the Company recognizes revenue under the residual method. Under the residual method, at the outset of the arrangement with a customer, the Company defers revenue for the fair value of its undelivered elements such as consulting services and product support and upgrades, and recognizes the revenue for the remainder of the arrangement fee attributable to the elements initially delivered, such as software licenses, when the criteria in SOP 97-2 have been met. If specific objective evidence does not exist for an undelivered element in a software arrangement, which may include distribution or other term-based arrangements in which the license fee includes support during the arrangement term, revenue is recognized over the term of the support period commencing upon delivery of the Company’s technology to the customer. For software license fees in single element arrangements such as consumer software sales and music copying or “burning,” revenue recognition typically occurs when the product is made available to the customer for download or when products are shipped to the customer, or in the case of music burns, when the burn occurs.

     Revenue from software license agreements with original equipment manufacturers (OEM) is recognized when the OEM delivers its product incorporating the Company’s software to the end user. In the case of prepayments received from an OEM, the Company generally recognizes revenue based on the actual products sold by the OEM. If the Company provides ongoing support to the OEM in the form of future upgrades, enhancements or other services over the term of the contract, revenue is generally recognized ratably over the term of the contract.

     Service revenues include payments under support and upgrade contracts, RealOne media subscription services, and fees from consulting services and streaming media content hosting. Support and upgrade revenues are recognized ratably over the term of the contract, which typically is twelve months. Media subscription service revenues are recognized ratably over the period that services are provided, which is generally one to twelve months. Other service revenues are recognized when the services are performed.

     Fees generated from advertising appearing on the Company’s Web sites, and from advertising included in the Company’s products, such as fees for distribution of RealChannels, LiveStations, and e-commerce and other links in the RealPlayer RealJukebox and GoldPass/ RealOne products, are recognized as revenue over the terms of the contracts. The Company may guarantee a minimum number of advertising impressions, click-throughs or other criteria on the Company’s Web sites or products for a specified period. To the extent these guarantees are not met, the Company defers recognition of the corresponding revenues until guaranteed delivery levels are achieved.

     G.     Research and Development.Costs incurred in research and development are expensed as incurred. Software development costs are required to be capitalized when a product’s technological feasibility has been established through the date the product is available for general release to customers. The Company has not capitalized any software development costs as technological feasibility is generally not established until a working model is completed at which time substantially all development is complete.

56


REALNETWORKS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

     H.     Stock-Based Compensation.The Company has elected to apply the disclosure-only provisions of Statement of Financial Accounting Standards (SFAS) No. 123, “Accounting for Stock-Based Compensation” (SFAS 123). Accordingly, the Company accounts for stock-based compensation transactions with employees using the intrinsic value method prescribed in Accounting Principles Board Opinion No. 25, “Accounting for Stock Options Issued to Employees,” (APB 25) and related interpretations. Compensation cost for employee stock options is measured as the excess, if any, of the fair value of the Company’s common stock at the date of grant over the stock option exercise price. Compensation cost for awards to non-employees is based on the fair value of the awards in accordance with SFAS 123 and related interpretations.

62


REALNETWORKS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

     The Company recognizes compensation cost related to fixed employee awards on an accelerated basis over the applicable vesting period using the methodology described in Financial Accounting Standards Board (FASB) Interpretation No. 28, “Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans.”

     At December 31, 2002,2003, the Company has five stock-based employee compensation plans, which are described more fully in Note 9.11. The Company accounts for those plans under the recognition and measurement principles of APB 25 and related interpretations. The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS 123 to stock-based employee compensation.

                          
Years Ended December 31,Years Ended December 31,


200220012000200320022001






(in thousands)(in thousands)
Net loss, as reportedNet loss, as reported $(38,353) (74,763) (110,121)Net loss, as reported $(21,451) (38,353) (74,763)
Plus: Stock-based employee compensation expense (benefit) included in reported net income, net of related tax effects 1,328 (9,540) 96,615 
Stock-based employee compensation expense (benefit) included in reported net income, net of related tax effectsStock-based employee compensation expense (benefit) included in reported net income, net of related tax effects 1,120 1,328 (9,540)
Less: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effectsLess: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects 77,781 97,752 319,127 Less: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects (33,899) (77,781) (97,752)
 
 
 
   
 
 
 
Pro forma net lossPro forma net loss $(114,806) (182,055) (332,633)Pro forma net loss $(54,230) (114,806) (182,055)
 
 
 
   
 
 
 
Earnings per share: 
Net loss per share:Net loss per share: 
Basic and diluted — as reported $(0.24) (0.47) (0.72)Basic and diluted — as reported $(0.13) (0.24) (0.47)
Basic and diluted — pro forma (0.72) (1.13) (2.16)Basic and diluted — pro forma (0.34) (0.72) (1.13)

     I.     Advertising Expenses.The Company expenses the cost of advertising and promoting its products as incurred. Such costs are included in sales and marketing expense and totaled $6.2 million in 2003, $3.8 million in 2002 and $2.2 million in 2001 and $8.9 million in 2000.2001.

     J.     Depreciation and Amortization.Depreciation and amortization of equipment and leasehold improvements are computed using the straight-line method over the lesser of the estimated useful lives of the assets, generally three years, or the lease term. Goodwill represents the excess of the purchase price over the fair value of identifiable tangible and intangible assets acquired and liabilities assumed in business combinations accounted for under the purchase method. The Company adopted the provisions of SFAS No. 142, “Goodwill and Other Intangible Assets” (SFAS 142) as of January 1, 2002. Goodwill and intangible assets acquired in a purchase business combination and determined to have an indefinite useful life are not amortized, but instead tested for impairment at least annually in accordance with the provisions of SFAS 142. SFAS 142 also requires that intangible assets with definite useful lives be amortized over their respective estimated useful lives to their estimated residual values, and reviewed for impairment in accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (SFAS 144).

57


REALNETWORKS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

     The provisions of SFAS No. 141, “Business Combinations” (SFAS 141) were adopted effective July 1, 2001. Goodwill and intangible assets acquired in business combinations completed before July 1, 2001 have been amortized through December 31, 2001.

     In connection with SFAS 142’s transitional goodwill impairment evaluation, the Statement required the Company to perform an assessment of whether there was an indication that goodwill was impaired as of the date of adoption. To accomplish this, the Company was required to identify its reporting units and determine the carrying value of each reporting unit by assigning the assets and liabilities, including the existing goodwill and intangible assets, to those reporting units as of January 1, 2002. The Company was required to

63


REALNETWORKS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

determine the fair value of each reporting unit and compare it to the carrying amount of the reporting unit within six months of January 1, 2002.unit. To the extent the carrying amount of a reporting unit exceeded the fair value of the reporting unit, the Company would be required to perform the second step of the transitional impairment test which would require the Company to compare the implied fair value of the reporting unit goodwill with the carrying amount of the reporting unit goodwill. As of January 1, 2002, the second step was not required as the implied fair value of the Company’s reporting units exceeded their respective carrying amounts. In Decemberthe fourth quarters of 2003 and 2002, the Company performed a similar test to that described above, in connection with its annual impairment test required under SFAS 142 and, again, the implied fair value of the reporting units exceeded their respective carrying amounts and the Company was not required to recognize an impairment loss.

     Prior to the adoption of SFAS 142, goodwill was amortized on a straight-line basis over the expected periods to be benefited, generally 3 to 5 years, and assessed for recoverability by determining whether the amortization of the goodwill balance over its remaining life could be recovered through future operating cash flows of the acquired operation.

     K.     Income Taxes.The Company computes income taxes using the asset and liability method, under which deferred income taxes are provided for the temporary differences between the financial reporting basis and the tax basis of the Company’s assets and liabilities and operating loss and tax credit carryforwards. A valuation allowance is established when necessary to reduce deferred tax assets to the amount expected to be realized. Deferred tax assets and liabilities and operating loss and tax credit carryforwards are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences and operating loss and tax credit carryforwards are expected to be recovered or settled.

     L.     Trade Accounts Receivable.Trade accounts receivable are recorded at the invoiced amount and do not bear interest. The allowance for doubtful accounts is the Company’s best estimate of the amount of probable credit losses in the Company’s existing accounts receivable. The Company determines the allowance based on analysis of historical bad debts, customer concentrations, customer credit-worthiness and current economic trends. The Company reviews its allowance for doubtful accounts quarterly. Past due balances over 90 days and specified other balances are reviewed individually for collectibility. All other balances are reviewed on an aggregate basis. Account balances are written off against the allowance after all means of collection have been exhausted and the potential for recovery is considered remote. The Company does not have any off-balance sheet credit exposure related to its customers. As of December 31, 2003, one international customer accounts for 20% of total accounts receivable. No one customer accounted for more than 10% of total accounts receivable at December 31, 2002 or 2001.

     M.     Derivative Financial Instruments.The Company conducts business internationally in several currencies. As such, it is exposed to adverse movements in foreign currency exchange rates. A portion of these risks is managed through the use of financial derivatives, but fluctuations could impact the Company’s results of operations and financial position. The Company’s foreign currency risk management program reduces, but does not entirely eliminate, the impact of currency exchange rate movements.

     Generally, the Company’s practice is to manage foreign currency risk for the majority of material short-term intercompany balances through the use of foreign currency forward contracts. These contracts require

58


REALNETWORKS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

the Company to exchange currencies at rates agreed upon at the contract’s inception. Because the impact of movements in currency exchange rates on forward contracts offsets the related impact on the short-term intercompany balances, these financial instruments help alleviate the risk that might otherwise result from certain changes in currency exchange rates. The Company does not designate its foreign exchange forward contracts related to short-term intercompany accounts as hedges and, accordingly, the Company adjusts these instruments to fair value through results of operations. However, the Company may periodically hedge a portion of its foreign exchange exposures associated with material firmly committed transactions and long-term investments.

64


REALNETWORKS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

     All derivatives, whether designated in hedging relationships or not, are recorded on the balance sheet at fair value. If the derivative is designated a hedge, then depending on the nature of the hedge, changes in fair value will either be recorded immediately in results of operations, or be recognized in other comprehensive income until the hedged item is recognized in results of operations.

     The following foreign currency contracts were outstanding and recorded at fair value (in thousands):

             
Contract AmountContract Amount
December 31, 2002(Local Currency)(US Dollars)Fair Value




British Pounds (“GBP”) (contracts to receive GBP/pay US$)  (GBP) 1,000  $1,590  $12 
Euro (“EUR”) (contracts to receive EUR/pay US$)  (EUR) 240  $247  $5 
Japanese Yen (“YEN”) (contracts to pay YEN/receive US$)  (YEN) 293,200  $2,410  $(70)
                  
Contract AmountContract Amount
December 31, 2003(Local Currency)(US Dollars)Fair Value




British Pounds (“GBP”)                
 (contracts to receive GBP/pay US$)  (GBP)   1,100  $1,926  $34 
Euro (“EUR”)                
 (contracts to pay EUR/receive US$)  (EUR)   2,150  $2,648  $(48)
Japanese Yen (“YEN”)                
 (contracts to pay YEN/receive US$)  (YEN)   295,200  $2,749  $(2)
             
Contract AmountContract Amount
December 31, 2001(Local Currency)(US Dollars)Fair Value




British Pounds (“GBP”) (contracts to pay GBP/receive US$)  (GBP) 304  $436  $(6)
Japanese Yen (“YEN”) (contracts to pay YEN/receive US$)  (YEN) 312,743  $2,564  $184 
                  
Contract AmountContract Amount
December 31, 2002(Local Currency)(US Dollars)Fair Value




British Pounds (“GBP”)                
 (contracts to receive GBP/pay US$)  (GBP)   1,000  $1,590  $12 
Euro (“EUR”)                
 (contracts to receive EUR/pay US$)  (EUR)   240  $247  $5 
Japanese Yen (“YEN”)                
 (contracts to pay YEN/receive US$)  (YEN)   293,200  $2,410  $(70)

     No derivative instruments were outstanding at December 31, 2002, which were designated as hedges for accounting purposes.purposes were outstanding at December 31, 2003 and 2002.

     N.     Net Income (Loss)Loss Per Share.Basic net income (loss)loss per share is computed by dividing net income (loss)loss by the weighted average number of common shares outstanding during the period. Diluted net income (loss)loss per share is computed by dividing net income (loss)loss by the weighted average number of common and dilutive common equivalent shares outstanding during the period. As the Company had a net loss in 2003, 2002 2001 and 2000,2001, basic and diluted net loss per share are the same for those periods. The share count used to compute basic and diluted net loss per share is calculated as follows (in thousands):

                  
Years Ended December 31,Years Ended December 31,


200220012000200320022001






Weighted average shares outstanding 159,739 160,715 153,956  160,580 159,739 160,715 
Less restricted shares 374 183 86  271 374 183 
 
 
 
  
 
 
 
Shares used to compute basic net loss per share 159,365 160,532 153,870 
Shares used to compute basic and diluted net loss per share 160,309 159,365 160,532 
 
 
 
  
 
 
 

     In addition to the restricted shares above,Potentially dilutive securities outstanding were not included in the computation of diluted net income (loss)loss per common share excludes the following optionsbecause to acquire shares of common stockdo so would have been anti-dilutive. Potentially dilutive securities for the years indicated because their effect would be anti-dilutive (in thousands, except per share data):

             
Years Ended December 31,

200220012000



Common stock options  34,587   36,903   41,614 
Weighted average exercise price per share $7.23   7.71   25.69 
year

O.     Comprehensive Income (Loss).The Company’s comprehensive income (loss) for 2002, 2001 and 2000 consisted of net loss, unrealized gains (losses) on marketable securities and the gross amount of foreign currency translation adjustments. The tax effect of the foreign currency translation adjustments and unrealized gains (losses) on investments has been taken into account if applicable.

6559


REALNETWORKS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

ended December 31, 2003 included options to purchase approximately 36.6 million common shares with a weighted average exercise price of $7.05 per share and approximately 10.8 million contingently issuable common shares related to convertible debt described in Note 10. Potentially dilutive securities for the years ended December 31, 2002 and 2001 include options to purchase approximately 34.6 million common shares with a weighted average exercise price of $7.23 per share and approximately 36.9 million common shares with a weighted average exercise price of $7.71 per share, respectively.

O.     Comprehensive Income (Loss). The Company’s comprehensive loss for 2003, 2002 and 2001 consisted of net loss, unrealized gains (losses) on marketable securities and the gross amount of foreign currency translation gains (losses). The tax effect of the foreign currency translation gains (losses) and unrealized gains (losses) on investments has been taken into account if applicable.

     The components of accumulated other comprehensive income (loss) are as follows (in thousands):

              
December 31,December 31,


2002200120032002




Unrealized gains (losses) on investments, including taxes of $16,479 in 2002 and 2001 $(578) 57,027 
Unrealized gains (losses) on investments, including taxes of $16,916 in 2003 and 2002 $7,401 (578)
Foreign currency translation adjustments (476) (564) (217) (476)
 
 
  
 
 
 $(1,054) 56,463  $7,184 (1,054)
 
 
  
 
 

     P.     Foreign Currency.The Company considers the functional currency of its foreign subsidiaries to be the local currency of the country in which the subsidiary operates. Assets and liabilities of foreign operations are translated into U.S. dollars using rates of exchange in effect at the end of the reporting period. Income and expense accounts are translated into U.S. dollars using average rates of exchange. The net gain or loss resulting from translation is shown as translation adjustment and included in accumulated other comprehensive income (loss) in shareholders’ equity. Gains and losses from foreign currency transactions are included in the consolidated statements of operations. There were no significant gains or losses on foreign currency transactions in 2003, 2002 2001 and 2000.2001.

     Q.     Use of Estimates.The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

     R. Impairment of Long-Lived Assets.SFAS 144 provides a single accounting model for long-lived assets to be disposed of. SFAS 144 also changes the criteria for classifying an asset as held for sale, and broadens the scope of businesses to be disposed of that qualify for reporting as discontinued operations and changes the timing of recognizing losses on such operations. The Company adopted SFAS 144 on January 1, 2002. The adoption of SFAS 144 did not affect the Company’s consolidated financial statements.

     In accordance with SFAS 144, the Company reviews its long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets held and used is measured by a comparison of the carrying amount of an asset to estimated undiscounted future cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds their estimated future cash flows. Assets to be disposed of are separately presented on the balance sheet and reported at the lower of their carrying amount or fair value less costs to sell, and are no longer depreciated.

60


REALNETWORKS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

     Goodwill and intangible assets not subject to amortization are tested annually for impairment, and are tested for impairment more frequently if events and circumstances indicate that the asset might be impaired. Factors we consider important which could trigger an impairment review include the following:

• poor economic performance relative to historical or projected future operating results
• significant negative industry, economic or company specific trends
• changes in the manner of our use of the assets or the plans for our business
• loss of key personnel

     An impairment loss is recognized to the extent that the carrying amount exceeds the asset’s fair value.

     Prior to the adoption of SFAS 144, the Company accounted for long-lived assets in accordance with SFAS No. 121, “Accounting for Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of” (SFAS 121).

     S.     Reclassifications.Certain reclassifications have been made to the 20012002 and 20002001 consolidated financial statements to conform to the 20022003 presentation.

     T.     New Accounting Pronouncements.The Company adopted SFAS 142, effective In January 1, 2002. The impact of adopting SFAS 142 is discussed in Note 3.

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REALNETWORKS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

     In June 2001, the FASB issued SFAS No. 143, “Accounting for Asset Retirement Obligations” (SFAS 143). SFAS 143 requires the Company to record the fair value of an asset retirement obligation as a liability in the period in which it incurs a legal obligation associated with the retirement of tangible long-lived assets that result from the acquisition, construction, development, and/or normal use of assets. The Company also records a corresponding asset that is depreciated over the life of the asset. Subsequent to the initial measurement of the asset retirement obligation, the obligation will be adjusted at the end of each period to reflect the passage of time and changes in the estimated future cash flows underlying the obligation. The Company is required to adopt SFAS 143 on January 1, 2003. The adoption of SFAS 143 is not expected to have a material effect on the Company’s financial statements.

     In October 2001, the FASB issued SFAS 144, which became effective for fiscal years beginning after December 15, 2001. SFAS 144 supersedes certain provisions of APB Opinion No. 30 “Reporting the Results of Operations-Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions” and supersedes SFAS 121. The Company adopted SFAS 144 as of January 1, 2002. The adoption of SFAS 144 did not affect the Company’s consolidated financial position or results of operations.

     In June 2002, the FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities” (SFAS 146), which is effective for fiscal years beginning after December 31, 2002, with early application encouraged. SFAS 146 supersedes Emerging Issues Task Force (EITF) Issue No. 94-3, “Liabilities Recognized for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).” The Company does not expect the adoption of SFAS 146 to have a material effect on its consolidated financial position or results of operations.

     In November 2002, the EITF reached a consensus on Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables” (EITF 00-21). EITF 00-21 addresses certain aspects of the accounting by a vendor for arrangements under which the vendor will perform multiple revenue generating activities. EITF 00-21 will be effective for periods beginning after June 15, 2003. The Company does not expect the adoption of EITF 00-21 to have a material impact on its financial position or results of operations.

     In November 2002,2003, the FASB issued Interpretation No. 45 “Guarantor’s Accounting and Disclosure Requirements46, “Consolidation of Variable Interest Entities” (“FIN 46”). In general, a variable interest entity is a corporation, partnership, trust or any other legal structure used for Guarantees, Including Indirect Guaranteesbusiness purposes that either (a) does not have equity investors with voting rights or (b) has equity investors that do not provide sufficient financial resources for the entity to support its activities. FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary of Indebtednessthe entity if the investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to Others, an interpretationfinance its activities without additional subordinated financial support from other parties. The consolidation requirements of FASB Statements No. 5, 57, and 107 and a rescission of FASB Interpretation No. 34” (FIN 45). The disclosure requirements are effective for financial statements of interim and annual periods endingFIN 46 apply immediately to variable interest entities created after December 15, 2002, and are discussed in Note 13.

January 31, 2003. In December 2002,2003, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure, an amendment of FASB No. 123” (SFAS 148). This Statement amends SFAS 123,FIN 46R with respect to provide alternative methods of transition for a voluntary changevariable interest entities created before January 31, 2003, which among other things, revised the implementation date to the fair value method of accounting for stock-based employee compensation. In addition, this Statement amends the disclosure requirements of SFAS 123 to require prominent disclosures in both annual andfirst fiscal year or interim financial statements. Certain of the disclosure modifications are required for fiscal yearsperiod ending after DecemberMarch 15, 2002 and are included in2004, with the notes to theseexception of Special Purpose Entities (“SPE”). The Company is currently evaluating the potential impact the adoption of this interpretation will have on its consolidated financial statements.

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REALNETWORKS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Note 2. Cash and Cash Equivalents and Short-Term Investments

     The Company considers all short-term investments as available-for-sale. Accordingly, these investments are carried at fair value which is based on quoted market prices. The Company had net unrealized gains on short-term investments of approximately $429,000$79,000 and $269,000$429,000 at December 31, 20022003 and 2001,2002, respectively. All short-term investments have remaining contractual maturities of threetwo years or less.

61


REALNETWORKS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

     The Company’s cash, cash equivalents and short-term investments consist of the following (in thousands):

                                
GrossGrossGrossGross
AmortizedUnrealizedUnrealizedEstimatedAmortizedUnrealizedUnrealizedEstimated
December 31, 2002CostGainsLossesFair Value
December 31, 2003December 31, 2003CostGainsLossesFair Value











Cash and cash equivalents:Cash and cash equivalents: Cash and cash equivalents: 
Cash $8,583   8,583 
Cash equivalents 2,281   2,281 Cash $1,105   $1,105 
Money market mutual funds 110,915 110,915 Money market mutual funds 196,923 196,923 
 
 
 
 
   
 
 
 
 
 Total cash and cash equivalents 121,779   121,779  Total cash and cash equivalents 198,028   198,028 
 
 
 
 
   
 
 
 
 
Short-term investments:Short-term investments: Short-term investments: 
Corporate notes & bonds 50,924 129 (13) 51,040 Corporate notes & bonds 502   502 
Commercial paper & CD’s 20,711   20,711 U.S. Government agency securities 174,984 92 (13) 175,063 
U.S. Government agency securities 115,228 313  115,541   
 
 
 
 
 
 
 
 
  Total short-term investments 175,486 92 (13) 175,565 
 Total short-term investments 186,863 442 (13) 187,292   
 
 
 
 
 
 
 
 
  Total cash, cash equivalents and short-term investments $373,514 92 (13) $373,593 
 Total cash, cash equivalents and short-term investments $308,642 442 (13) 309,071   
 
 
 
 
 
 
 
 
 
Restricted cash equivalentsRestricted cash equivalents $17,300   17,300 Restricted cash equivalents $19,953   $19,953 
 
 
 
 
   
 
 
 
 
                                
GrossGrossGrossGross
AmortizedUnrealizedUnrealizedEstimatedAmortizedUnrealizedUnrealizedEstimated
December 31, 2001CostGainsLossesFair Value
December 31, 2002December 31, 2002CostGainsLossesFair Value











Cash and cash equivalents:Cash and cash equivalents: Cash and cash equivalents: 
Cash $8,583   $8,583 
Cash $82,438   82,438 Cash equivalents 2,281   2,281 
Commercial paper 21,744   21,744 Money market mutual funds 110,915 110,915 
 
 
 
 
   
 
 
 
 
 Total cash and cash equivalents 104,182   104,182  Total cash and cash equivalents 121,779   121,779 
 
 
 
 
   
 
 
 
 
Short-term investments:Short-term investments: Short-term investments: 
Corporate notes & bonds 65,234 341 (91) 65,484 Corporate notes & bonds 50,924 129 (13) 51,040 
Commercial paper & CD’s 37,066   37,066 Commercial paper & CDs 20,711   20,711 
U.S. Government agency securities 137,758 156 (137) 137,777 U.S. Government agency securities 115,228 313  115,541 
 
 
 
 
   
 
 
 
 
 Total short-term investments 240,058 497 (228) 240,327  Total short-term investments 186,863 442 (13) 187,292 
 
 
 
 
   
 
 
 
 
 Total cash, cash equivalents and short-term investments $344,240 497 (228) 344,509  Total cash, cash equivalents and short-term investments $308,642 442 (13) $309,071 
 
 
 
 
   
 
 
 
 
Restricted cash equivalentsRestricted cash equivalents $17,300   17,300 Restricted cash equivalents $17,300   $17,300 
 
 
 
 
   
 
 
 
 

     RestrictedAt December 31, 2003, restricted cash equivalents represent (a) cash equivalents pledged as collateral against a $10.0 million letter of credit in connection with a lease agreement for the Company’s corporate headquarters, and (b) cash

68


REALNETWORKS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

equivalents pledged as collateral against a $7.3 million letter of credit with a bank which represents collateral on the lease of a building located near the Company’s corporate headquarters.headquarters, (c) cash equivalents of $2.5 million pledged as collateral against minimum payments in connection with a contract for services, and (d) $153,000 pledged as collateral in connection with credit agreements with certain financial institutions.

     Realized gains or losses on sales of available-for-sale securities for 2003, 2002 2001 and 20002001 were not significant.

62


REALNETWORKS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

     The contractual maturities of available-for-sale debt securities at December 31, 20022003 are as follows (in thousands):

          
December 31, 2002Amortized CostEstimated Fair Value



Within one year $151,281   151,635 
Between one year and three years  35,582   35,657 
   
   
 
 Short-term investments $186,863   187,292 
   
   
 
          
Estimated
Amortized CostFair Value


Within one year $145,636   145,676 
Between one year and two years  29,850   29,889 
   
   
 
 Short-term investments $175,486   175,565 
   
   
 

Note 3. Notes Receivable from Related Parties and Shareholders

     Notes receivable from related parties consist of cash advances made in 2000 by Listen.com, Inc. (Listen), a company acquired by RealNetworks in 2003 (see Note 4), to certain former officers of Listen. The notes bear interest at rates ranging from 6.13% to 6.60% and are due between February 2005 and September 2005.

     Notes receivable from shareholders consist of full recourse notes issued as consideration for the exercise of Listen stock options by certain former employees of Listen in 1999. The notes bear interest at rates ranging from 5.28% to 6.23% and are due seven years from the date of issuance.

Note 4. Business Combinations: Goodwill & Intangible Assets

          A.     Business CombinationsCombination in 2003.

     On August 4, 2003, the Company acquired all of the outstanding securities of Listen in exchange for approximately $18.8 million in cash payments, including a $1.5 million payment made in January 2004 based on the achievement of a specified milestone, and 3.8 million shares and 0.4 million options to acquire shares of RealNetworks common stock valued at $19.4 million. The value assigned to the stock portion of the purchase price was $4.72 per share based on the average closing price of RealNetworks’ common stock for the five days beginning two days prior to and ending two days after April 21, 2003 (the date of the Agreement and Plan of Merger and Reorganization). Options issued were valued based on the Black-Scholes options pricing model. Included in the purchase price is $735,000 in acquisition-related expenditures consisting primarily of professional fees. In addition, as of the acquisition date, RealNetworks had invested $7.3 million in Listen in the form of convertible promissory notes that became a part of the purchase consideration. The cash balance at Listen on the acquisition date was $4.9 million. As part of the acquisition, a management incentive plan was established whereby certain employees of Listen could be entitled over a two-year period to receive payments in cash or stock having a value of up to $3 million.

     Listen operates an on-demand and premium, commercial-free radio music subscription service for which it charges monthly subscription fees. It also provides its subscribers with the ability to copy or “burn” music to compact discs for which it charges a per-track fee. The Company believes that combining the services of Listen with the Company’s digital music assets and distribution network will enable the Company to create a compelling digital music experience. The results of Listen’s operations are included in the Company’s consolidated financial statements since the date of acquisition.

A summary of the purchase price for the acquisition is as follows (in thousands):

      
Cash $18,754 
Fair value of RealNetworks common stock and options issued  19,376 
Convertible notes receivable converted upon acquisition  7,300 
Direct acquisition costs  735 
   
 
 Total $46,165 
   
 

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REALNETWORKS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

     The total purchase consideration has been allocated to the assets and liabilities acquired, including identifiable intangible assets, based on their respective estimated fair values as summarized below. The respective fair values were determined by an independent appraisal at the acquisition date. Goodwill in the amount of $37.4 million is not deductible for tax purposes.

A summary of the allocation of the purchase price follows (in thousands):

      
Current assets $6,738 
Property and equipment  1,435 
Other assets  988 
Tradenames  132 
Patents  252 
Subscriber and Distribution Agreements  346 
Goodwill  37,400 
Current liabilities  (1,879)
Shareholder notes receivable  83 
Deferred stock compensation  670 
   
 
 Net assets acquired $46,165 
   
 

     Tradenames and patents have a weighted average estimated useful life of one year and subscriber and distribution agreements have a weighted average estimated useful life of four years.

The following table presents unaudited pro forma results of operations for the years ended December 31, 2003 and 2002 as if the acquisition of Listen had occurred on January 1, 2003 and January 1, 2002, respectively. The unaudited pro forma information is not necessarily indicative of the combined results that would have occurred had the acquisitions taken place at the beginning of the periods presented, nor is it necessarily indicative of results that may occur in the future.

         
Year Ended
December 31,

20032002


Revenues $205,054   183,352 
Net loss  29,604   57,463 
Loss per share  0.18   0.35 

          B.     Business Combination in 2002.

     In April 2002, the Company acquired, for cash and common stock valued at approximately $5.1 million, a privately held company engaged in the business of developing Internet media software and technology. The acquisition was accounted for as a purchase transaction and, accordingly, RealNetworks’ results include the results for the acquired company since the transaction date. Goodwill of $2.3 million and acquired technology of $0.9 million were recorded as a result of the acquisition. The Company had previously made an equity investment in the acquired company and its investment balance at the time of the acquisition was included in the purchase price allocation. Pro forma results are not presented, as they are not material to the Company’s overall financial statements. Certain former shareholders of the acquired company are eligible to receive additional cash and common stock valued at approximately $3.1 million over a thirty-month period provided that they remain employed by RealNetworks during such period. These costs will be recognized as compensation cost over the related employment period. As of the year ended December 31, 2002, the Company recognized stock-based compensation expense of $0.8 million related to this acquisition.

          B.     Business Combinations in 2000.

     In December 2000, the Company acquired all of the outstanding securities of Aegisoft Corp. (Aegisoft), a developer of secure digital media software, for approximately 1,212,000 shares (including options to purchase shares) of its common stock. Approximately 274,000 of those shares are subject to repurchase by the Company at a nominal price in certain circumstances. The acquisition was accounted for under the purchase method of accounting and, accordingly, the results of Aegisoft’s operations are included in the Company’s consolidated financial statements since the date of acquisition. The Company incurred approximately $1.3 million in acquisition-related expenditures, including $0.6 million of relocation payments for Aegisoft employees which were dependent upon the related individuals remaining employed by the Company, and are expensed over the applicable employment term, and $0.7 million in professional fees and other costs. As of December 31, 2002, all of these costs have been paid.

     In July 2000, the Company acquired a privately held company using the purchase method of accounting for total consideration of $5.6 million including common shares valued at $3.5 million which are subject to repurchase by the Company under certain circumstances. Goodwill of $2.1 million was recorded and represents the excess of the purchase price over the fair value of identifiable tangible and intangible assets acquired and liabilities assumed.

     In January 2000, the Company acquired all of the outstanding securities of NetZip, Inc. (NetZip), a developer and provider of Internet download management and utility software for approximately 3,418,000

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REALNETWORKS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

shares (including options to purchase shares) of its common stock. Approximately 1,820,000 of those shares issued to certain former NetZip stockholders were subject to repurchase by the Company at a nominal price in the event the individuals did not remain employed by RealNetworks. The acquisition was accounted for under the purchase method of accounting and, accordingly, the results of NetZip’s operations are included in the Company’s consolidated financial statements since the date of acquisition. The Company incurred approximately $5.0 million in acquisition-related expenditures, including $3.2 million of relocation payments and stay bonuses for NetZip employees which were dependent upon the related individuals remaining employed by the Company, and were expensed over the related employment term, and $1.8 million in professional fees and other costs. As of December 31, 2002, all of these costs have been paid.

Summaries of the purchase price for Aegisoft and NetZip are as follows (in thousands):

          
AegisoftNetZip


Stock and stock options $10,303   125,913 
Direct acquisition costs  725   1,771 
Accrued liabilities assumed  89   809 
Other liabilities assumed     281 
   
   
 
 Total purchase price  11,117   128,774 
Stock based compensation not included in purchase price  2,327   143,973 
   
   
 
 Total acquisition cost and value of common stock to be issued under compensation agreements $13,444   272,747 
   
   
 

The purchase price was allocated as follows (in thousands):

          
AegisoftNetZip


Cash $   73 
Other current assets acquired  33   440 
Equipment  51   324 
Non-current assets acquired  26   15 
Goodwill  11,007   127,922 
   
   
 
 Total $11,117   128,774 
   
   
 

     No elements of in-process research and development were identified as part of the acquisitions.

     In April 2001, the Company repurchased approximately 738,000 shares of its common stock from former NetZip stockholders for a nominal amount. These shares were restricted pursuant to restricted stock agreements entered into with each such stockholder. The restricted stock agreements provided that such common stock was subject to forfeiture over a period of 30 months beginning in January 2000 if such stockholders did not remain employed with the Company. The Company also released certain shares from the restrictions in the restricted stock agreement, making them no longer subject to repurchase. The net effect of this repurchase was that the Company recorded a reversal of previously recorded stock-based compensation expense of $(25.4) million. As a result, in 2001 the Company recorded a benefit related to the reversal of stock-based compensation expense of $(10.0) million. No future stock compensation expense related to the NetZip acquisition will be recognized.

7064


REALNETWORKS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

     C.     Goodwill Amortization, Acquisition Charges and Stock-Based Compensation.Goodwill amortization, acquisition charges and stock-based compensation for these and other acquisitions are as follows (in thousands):

                   
Years Ended December 31,Years Ended December 31,


200220012000200320022001






Stock-based compensationStock-based compensation $1,328 16,789 96,615 Stock-based compensation $1,120 1,328 16,789 
Reversal of previously recorded stock-based compensationReversal of previously recorded stock-based compensation  (26,329)  Reversal of previously recorded stock-based compensation   (26,329)
Goodwill amortization and acquisition chargesGoodwill amortization and acquisition charges  50,173 45,438 Goodwill amortization and acquisition charges   50,173 
 
 
 
   
 
 
 
Total $1,328 40,633 142,053 Total $1,120 1,328 40,633 
 
 
 
   
 
 
 

     In July 2001, the FASB issued SFAS 141 and SFAS 142. SFAS 141 requires that the purchase method of accounting be used for all business combinations initiated after June 30, 2001 as well as all purchase method business combinations completed after June 30, 2001. SFAS 141 also specifies certain criteria that intangible assets acquired in a purchase method business combination must meet in order to be recognized and reported apart from goodwill. SFAS 142 requires that goodwill and intangible assets with indefinite useful lives no longer be amortized, but instead be tested for impairment at least annually in accordance with the provisions of SFAS 142. SFAS 142 also requires that intangible assets with definite useful lives be amortized over their respective estimated useful lives to their estimated residual values, and reviewed for impairment in accordance with SFAS 121, which was superseded by SFAS 144.

     The provisions of SFAS 141 were adopted effective July 1, 2001. Goodwill and intangible assets acquired in business combinations completed before July 1, 2001 have been amortized through December 31, 2001.

     As of January 1, 2002, the Company had no recorded intangible assets apart from goodwill of $57.8 million, net of accumulated amortization. During the quarter ended March 31, 2002, the Company completed its transitional goodwill impairment test. Based upon the Company’s analysis, there was no impairment of goodwill upon adoption of SFAS 142 on January 1, 2002. During the quarterquarters ended December 31, 2003 and 2002, the Company conducted its annual impairment testing. Based upon the Company’s annual analysis, there was no impairment of goodwill during 2003 or 2002. As of December 31, 2002, goodwill net2003, other intangible assets acquired in business combinations consisted of accumulated amortization was $60.1 million and acquired technology, tradenames, patents, and subscriber and distribution agreements. Amortization expense related to these assets was $0.8 million, which$513,000 and $102,000 in 2003 and 2002, respectively and is being amortized at approximately $0.3 million per year.scheduled to be $627,000, $301,000, $86,000, and $51,000 in 2004, 2005, 2006, and 2007 respectively.

     Net loss and net loss per share for 2001 and 2000 adjusted to exclude goodwill amortization expense are as follows (in thousands, except per share data):

         
Years Ended
December 31,

20012000


     
Net loss:Net loss: Net loss: 
Reported net loss $(74,763) (110,121)Reported net loss $(74,763)
Goodwill amortization 49,391 42,413 Goodwill amortization 49,391 
 
 
   
 
Adjusted net loss $(25,372) (67,708)Adjusted net loss $(25,372)
 
 
   
 
Basic and diluted net loss per share:Basic and diluted net loss per share: Basic and diluted net loss per share: 
Reported basic and diluted net loss per share $(0.47) (0.72)Reported basic and diluted net loss per share $(0.47)
Goodwill amortization 0.31 0.28 Goodwill amortization 0.31 
 
 
   
 
Adjusted basic and diluted net loss per share $(0.16) (0.44)Adjusted basic and diluted net loss per share $(0.16)
 
 
   
 
Shares used to compute basic and diluted net loss per shareShares used to compute basic and diluted net loss per share 160,532 153,870 Shares used to compute basic and diluted net loss per share 160,532 

7165


REALNETWORKS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Note 5.Note 4.     Other Investments

     RealNetworks has made minority equity investments for business and strategic purposes through the purchase of voting capital stock of companies. The Company’s investments in publicly traded companies are available for sale, carried at current market value and are classified as long-term as they are strategic in nature. The Company periodically evaluates whether declines in fair value, if any, of its investments are other-than-temporary. This evaluation consists of a review of qualitative and quantitative factors. For investments with publicly quoted market prices, these factors include the time period and extent forby which theits accounting basis exceeds its quoted market price is less than its accounting basis.price. The Company also considers other factors to determine whether declines in fair value are other-than-temporary, such as the investee’s financial condition, results of operations and operating trends. The evaluation also considers publicly available information regarding the investee companies. For investments in private companies with no quoted market price, the Company considers similar qualitative and quantitative factors and also considers the implied value from any recent rounds of financing completed by the investee. Based upon an evaluation of the facts and circumstances during 2003, the Company determined that other-than-temporary declines in fair value had occurred in two of its publicly traded investments resulting in impairment charges of $0.4 million to reflect changes in the fair value of these investments in the results of operations. Based upon an evaluation of the facts and circumstances during 2002, the Company determined that an other-than-temporary impairment existed for fivedeclines in fair value had occurred in two of its investments. Impairment charges have been recorded to reflect theseprivately-held investments at fair value. Impairmentand three of its publicly traded investments resulting in impairment charges of $5.1 million,million. During 2001, certain of these investments were written down to fair value resulting in impairment charges of $25.3 million and $0 were recognized in 2002, 2001 and 2000, respectively. million.

The effects of these impairments on cost and carrying value are incorporated into the values below. A summary of the investments is as follows (in thousands):

                 
December 31,December 31,


2002200120032002




Privately held investmentsPrivately held investments Privately held investments 
Cost $40,895 34,341 Cost $39,571 40,895 
Carrying value 11,514 16,753 Carrying value 9,292 11,514 
Publicly traded investmentsPublicly traded investments Publicly traded investments 
Cost 1,379 2,529 Cost 1,046 1,754 
Carrying value 17,682 76,187 Carrying value 25,285 17,682 

     Privately held investments include investments accounted for using the cost and equity methods.

     As of December 31, 2002,2003, the Company owned marketable equity securities of a Japanese company. The Company owns approximately 14% of the outstanding shares and this investment is accounted for as an available-for-sale security. The market value of these shares has significantly increased from the Company’s original cost of approximately $1.0 million, resulting in a carrying value at December 31, 20022003 of $17.3$25.1 million. The increase over the Company’s cost basis, net of tax effects, is reflected as a component of accumulated other comprehensive income (loss). During the year ended December 31, 2002, the Company sold a portionportions of its holdings recognizing a gain of $2.4 million which was reclassified from accumulated other comprehensive income (loss) to net loss. There were no similar gains or losses in 20012003 or 2000. Excluding the effect of this sale, the2001. The fair value of the Company’s investment declinedincreased by $54.6$7.8 million during the year ended December 31, 2002.2003. This declineincrease is reflected as a component of other comprehensive loss. The market for this company’s shares is relatively limited, the share price is volatile and the investment is strategic in nature. Accordingly, there can be no assurance that a gain of this magnitude can be realized through the disposition of these shares.

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REALNETWORKS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Note 6.Note 5.     Investment in MusicNet

     In 2001, the Company announced the formation of MusicNet, Inc. (MusicNet), a joint venture with several media companies to create a platform for online music subscription services. MusicNet, which previously was a subsidiary of the Company, issued additional shares of capital stock in April and July 2001 reducing the Company’s ownership interest. The Company’s investment in MusicNet is accounted for under the equity method of accounting. As a result, the Company records in its statement of operations its equity

72


REALNETWORKS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

share of MusicNet’s net income (loss)loss, which was a loss of $6.3$5.4 million for the year ended December 31, 2002.2003. In July2003 and November 2002, MusicNet raised additional capital from its investors to fund its business. In connection with this fund raising, the Company and the other investors in MusicNet contributed additional capital to MusicNet to fund its business.in the amount of $3.0 million and $6.6 million, respectively. The Company received convertible notes, convertible into additional shares of MusicNet capital stock, in exchange for its additional investments. The Company anticipates that MusicNet will continue to incur losses in the foreseeable future and will require additional funding to support the development of its business model.funding. Based on the nature and terms of the convertible notes, for the yearyears ended December 31, 2003 and 2002, for purposes of calculating the Company’s equity in net loss of MusicNet, the convertible notes were treated on an “as if” converted basis. As a result, the losses recorded by the Company for the yearyears ended December 31, 2003 and 2002, represent approximately 36.9% and 37.8% of MusicNet’s loss. As of December 31, 2002,2003, the Company’s ownership interest in outstanding shares of capital stock of MusicNet was approximately 28.6%25.5% and the carrying value for its investment was $8.9$6.5 million. In 2003, the Company recognized approximately $1.1 million of revenue related to agreements with MusicNet. In 2002, the Company recognized approximately $1.4 million of revenue related to agreements with MusicNet and was reimbursed $217,000$0.2 million for certain administrative services provided to MusicNet on a transitional basis, which has been accounted for as a reduction of related expenses. In 2001, the Company received $4.2 million in cash from MusicNet pursuant to the terms of a license agreement and recognized $0.4 million of revenue related to this agreement. In addition, the Company was reimbursed $2.1 million in 2001 for certain administrative services provided to MusicNet on a transitional basis which has been accounted for as reduction of related expenses.

     The following unaudited summary financial data does not contemplate the elimination of intercompany transactions. As of and for the years ended December 31, 2003 and 2002 and for the year ended December 31, 2002,2001, unaudited financial information for MusicNet is as follows (in thousands):

        
December 31

200320022001
    


Total assets $17,792  $11,154 17,792 20,615 
Total liabilities 10,863  14,654 10,863 3,042 
Net loss (19,778) 14,877 19,778 13,325 

Note 7.Note 6.     Accrued and Other Liabilities

     The following table summarizes the Company’s accrued and other liabilities (in thousands):

              
December 31,December 31,


2002200120032002




Employee compensation, commissions and benefits $5,582 7,227  $6,429 5,582 
Royalties and costs of sales and fulfillment 14,221 11,578  18,528 14,221 
Sales and marketing expenses 2,871 2,439  1,663 2,871 
Other 8,409 9,609  12,780 8,409 
 
 
  
 
 
Total $31,083 30,853  $39,400 31,083 
 
 
  
 
 

67


REALNETWORKS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Note 8.Note 7.     Loss on Excess Office Facilities

     In October 2000, the Company entered into a 10-year lease agreement for additional office space located near its corporate headquarters in Seattle, Washington. During 2001, the Company re-evaluated its facilities requirements and, as a result, decided to permanently sublet all of this office space. The market for office space in Seattle has significantly declined from the date the Company entered into this lease. As a result, the Company recorded losses of $22.2 million during the year ended December 31, 2001. For the year ended December 31, 2001, these losses represented approximately $15.2 million of rent and operating expenses over the remaining life of the lease, net of expected sublease income of $38.1 million, and approximately $7.0 million for the write-down of leasehold improvements to their estimated fair value. The Company’s

73


REALNETWORKS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

estimates were based upon many factors including projections of sublease rates and the time period required to locate tenants. During the year ended December 31, 2002, the Seattle real estate market continued to display significant weakness, which is reflected in both increasing vacancy rates and declining rental rates. Based on discussions with prospective tenants, the Company concluded that the excess office facilities are not likely to be sublet at rates used in the original loss estimates. As a result, the Company recorded additional losses of $17.2 million during the year ended December 31, 2002. During 2003, the Company secured an additional tenant at a sublease rate lower than the rate used in previous loss estimates. As a result, the Company adjusted its estimates to reflect the lower lease rate and recorded an additional loss of $7.1 million. The most recent estimated total loss in 2003 estimated future sublease income of $14.7 million of which $8.0 million was committed under sublease contracts as of the time of the estimate. Also, during 2003, the Company recorded an accrual for estimated future losses on excess office facilities located in San Francisco as part of its allocation of the Listen.com purchase price. In all years, losses on excess office facilities were calculated using undiscounted values. The Company regularly evaluates the market for office space in Seattle.the cities where it operates. If the market for such space declines further in future periods, the Company may have to revise its estimates, which may result in additional losses on excess office facilities.

     A summary of activity for the accrued loss on excess office facilities is as follows (in thousands):

          
Loss on excess office facilities initially recordedLoss on excess office facilities initially recorded $22,208 Loss on excess office facilities initially recorded $22,208 
Less amounts paid in 2001, net of sublease income (2,812)Less amounts paid in 2001, net of sublease income (2,812)
Less write-down of leasehold improvements (6,959)Less write-down of leasehold improvements (6,959)
 
   
 
Accrued loss at December 31, 2001Accrued loss at December 31, 2001 12,437 Accrued loss at December 31, 2001 12,437 
Revisions to estimates in 2002 17,207 Revisions to estimates in 2002 17,207 
Less amounts paid in 2002, net of sublease income (3,709)Less amounts paid in 2002, net of sublease income (3,709)
 
   
 
Accrued loss at December 31, 2002Accrued loss at December 31, 2002 $25,935 Accrued loss at December 31, 2002 25,935 
 
 Revisions to estimates in 2003 7,098 
Accrued loss related to Listen 115 
Less amounts paid in 2003, net of sublease income (4,089)
 
 
Accrued loss at December 31, 2003Accrued loss at December 31, 2003 $29,059 
 
 

     The accrued loss of $25.9$29.1 million at December 31, 20022003 is shown net of expected sublease income of $21.9$14.0 million. The expected sublease income is $2.2$1.3 million in 20032004 and $3.0$1.4 million in 2004.

2005.

Note 9.Note 8.     Personnel Reduction, Restructuring and Related Charges

     In July 2001, the Company reduced its staffing levels by approximately 15%, or 150 employees. The Company recorded a charge of approximately $3.6 million during the year ended December 31, 2001 to reflect costs associated with implementing the staff reduction. In August 2002, the Company implemented a restructuring plan to reduce costs, which included reducing its staffing levels by approximately 10%, or 84

68


REALNETWORKS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

employees, closing selected offices, and canceling its annual user conference. The Company recorded a charge of approximately $3.6 million during the year ended December 31, 2002 to reflect costs associated with implementing this plan. These costs were primarily related to severance payments, but also included other miscellaneous costs such as professional fees, outplacement services for terminated employees, office closures, and tradeshow deposit forfeitures, all of which were incurred as of December 31, 2002.

A summary of activity for the personnel reduction, restructuring, and related accrual in 2003, 2002 and 2001 is as follows (in thousands):

                      
ProfessionalOfficeTradeshow
SeveranceServicesClosuresDepositsTotal





Accrual related to July 2001 staff reduction charges $2,892   923   78      3,893 
 Less change in estimate     (280)        (280)
 Less amounts paid  (2,750)  (521)  (37)     (3,308)
   
   
   
   
   
 
Accrued amount at December 31, 2001, related to previous staff reduction charges  142   122   41      305 
   
   
   
   
   
 
 August 2002 restructuring plan  1,721   395   966   513   3,595 
 Less amounts paid  (1,702)  (304)  (462)  (513)  (2,981)
   
   
   
   
   
 
Accrued loss at December 31, 2002  161   213   545      919 
 Change in estimate     (213)  213       
 Less amounts paid  (161)     (252)     (413)
   
   
   
   
   
 
Accrued loss at December 31, 2003 $      506      506 
   
   
   
   
   
 

     The accrued loss of $506,000 at December 31, 2003, is included in accrued and other liabilities on the Company’s consolidated balance sheet.

Note 10.     Convertible Debt

     During 2003, the Company expects paymentsissued $100 million aggregate principal amount of zero coupon convertible subordinated notes due July 1, 2010, pursuant to Rule 144A under the Securities Act of 1933, as amended. The notes are subordinated to any Company senior debt, and are also effectively subordinated in right of payment to all indebtedness and other liabilities of its subsidiaries. The notes are convertible into shares of the Company’s common stock based on an initial effective conversion price of approximately $9.30 if (1) the closing sale price of the Company’s common stock exceeds $10.23, subject to certain restrictions, (2) the notes are called for restructuringredemption, (3) the Company makes a significant distribution to its shareholders or becomes a party to a transaction that would result in a change in control, or (4) the trading price of the notes falls below 95% of the value of common stock that the notes are convertible into, subject to certain restrictions; one of which allows the Company, at its discretion, to issue cash or common stock or a combination thereof upon conversion. On or after July 1, 2008, the Company has the option to redeem all or a portion of the notes that have not been previously purchased, repurchased or converted, in exchange for cash at 100% of the principal amount of the notes. The purchaser may require the Company to purchase all or a portion of its notes in cash on July 1, 2008 at 100% of the principal amount of the notes. As a result of this issuance, the Company has received proceeds of $97.0 million, net of estimated offering costs. The offering costs are included in other assets and are being amortized over a 5-year period. Interest expense from the amortization of offering costs in the amount of $0.3 million is recorded in interest income, net for the year ended December 31, 2003. The net proceeds of the issuance are intended to be completed in 2003.used for general corporate purposes, acquisitions, other strategic transactions including joint ventures, and working capital requirements.

7469


REALNETWORKS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

A summary of activity for the 2002 and 2001 personnel reduction, restructuring, and related charges is as follows (in thousands):

                      
ProfessionalOfficeTradeshow
SeveranceServicesClosuresDepositsTotal





Accrual related to July 2001 staff reduction charges $2,892   923   78      3,893 
 Less change in estimate     (280)        (280)
 Less amounts paid  (2,750)  (521)  (37)     (3,308)
   
   
   
   
   
 
Accrued amount at December 31, 2001, related to previous staff reduction charges  142   122   41      305 
   
   
   
   
   
 
 August 2002 restructuring plan  1,721   395   966   513   3,595 
 Less amounts paid  (1,702)  (304)  (462)  (513)  (2,981)
   
   
   
   
   
 
Accrued loss at December 31, 2002 $161   213   545      919 
   
   
   
   
   
 

     The accrued loss of $919,000 at December 31, 2002, is included in Accrued and other liabilities on the Company’s consolidated balance sheet.

Note 9.11.     Shareholders’ Equity

     A.     Preferred Stock.Each share of Series A preferred stock entitles the holder to one thousand votes and dividends equal to one thousand times the aggregate per share amount of dividends declared on the common stock. There are no shares of Series A preferred stock outstanding.

     Undesignated preferred stock will have rights and preferences that are determinable by the Board of Directors when determination of a new series of preferred stock has been established.

     B.     Shareholder Rights Plan.On October 16, 1998, the Company’s board of directors declared a dividend of one preferred share purchase right (Right) in connection with its adoption of a Shareholder Rights Plan dated December 4, 1998, for each outstanding share of the Company’s common stock on December 14, 1998 (Record Date). Each share of common stock issued after the Record Date will be issued with an attached Right. The Rights will not immediately be exercisable and detachable from the common stock. The Rights will become exercisable and detachable only following the acquisition by a person or a group of 15 percent or more of the outstanding common stock or ten days following the announcement of a tender or exchange offer for 15 percent or more of the outstanding common stock (Distribution Date). After the Distribution Date, each Right will entitle the holder to purchase for $37.50 (Exercise Price), a fraction of a share of the Company’s Series A preferred stock with economic terms similar to that of one share of the Company’s common stock. Upon a person or a group acquiring 15 percent or more of the outstanding common stock, each Right will allow the holder (other than the acquiror) to purchase common stock or securities of the Company having a then current market value of two times the Exercise Price of the Right. In the event that following the acquisition of 15 percent of the common stock by an acquiror, the Company is acquired in a merger or other business combination or 50 percent or more of the Company’s assets or earning power are sold, each Right will entitle the holder to purchase for the Exercise Price, common stock or securities of the acquiror having a then current market value of two times the Exercise Price. In certain circumstances, the Rights may be redeemed by the Company at a redemption price of $0.0025 per Right. If not earlier exchanged or redeemed, the Rights will expire on December 4, 2008.

75


REALNETWORKS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

     C.     Stock Option Plan.The Company has five stock option plans (Plans) to compensate employees for past and future services and hashad reserved 79,350,000 shares of common stock for option grants under the Plans. Generally, options vest based on continuous employment, over a five-year period. The options expire twenty years from the date of grant and are exercisable at the fair market value of the common stock at the grant date.

70


REALNETWORKS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

     A summary of stock option related activity is as follows (in thousands, except per share data):

                                  
Options OutstandingOptions Outstanding
Shares
AvailableNumber ofWeighted Average
for GrantSharesExercise Price



Balance at December 31, 1999 5,750 38,256 $18.07 
Plan amendment 19,000   
Weighted
Options granted (14,939) 14,939 40.09 SharesWeightedAverage Fair
Options exercised  (5,084) 3.87 AvailableNumber ofAverageValue-
Options canceled 6,497 (6,497) 31.89 for GrantSharesExercise PriceGrants
 
 
 



Balance at December 31, 2000Balance at December 31, 2000 16,308 41,614 25.69 Balance at December 31, 2000 16,308 41,614 $25.69  
Options granted (23,222) 23,222 7.30 Options granted (23,222) 23,222 7.30 4.29 
Options exercised  (3,230) 1.83 Options exercised  (3,230) 1.83  
Options canceled 24,703 (24,703) 38.37 Options canceled 24,703 (24,703) 38.37  
 
 
   
 
 
Balance at December 31, 2001Balance at December 31, 2001 17,789 36,903 7.71 Balance at December 31, 2001 17,789 36,903 7.71  
New plan 750   New plan 750    
Options granted (7,476) 7,476 4.42 Options granted (7,476) 7,476 4.42 3.01 
Options exercised  (3,657) 1.71 Options exercised  (3,657) 1.71  
Options canceled 6,135 (6,135) 10.04 Options canceled 6,135 (6,135) 10.04  
 
 
   
 
 
Balance at December 31, 2002Balance at December 31, 2002 17,198 34,587 $7.23 Balance at December 31, 2002 17,198 34,587 7.23  
 
 
 Options granted at or above common stock price (9,122) 9,122 5.70 3.27 
Options granted below common stock price (377) 377 1.81 4.03 
Options exercised  (2,352) 3.72  
Options canceled 5,090 (5,090) 7.01  
 
 
 
Balance at December 31, 2003Balance at December 31, 2003 12,789 36,644 $7.05  
 
 
 

The fair value of options granted was determined using the Black-Scholes model. The following weighted average assumptions were used to perform the calculations:

             
Years Ended December 31,

200320022001



Expected dividend yield  0%  0%  0%
Risk-free interest rate  2.13%  2.89%  3.98%
Expected life (years)  4.2   5.3   4.3 
Volatility  80%  95%  98%

     In February 2001, the Company offered a voluntary stock option cancellation and regrant program to its employees. The plan allowed employees, at their election, to cancel a portion or all of their unexercised stock options effective February 22, 2001, provided that, should an employee participate, any option granted to that employee within the six-month period preceding February 22, 2001 would be automatically cancelled. In exchange, the employee would be granted on August 31, 2001, provided they were still employed by the Company at that time, new options to purchase a number of shares equal to the number of shares underlying the cancelled options. The Company granted these new options on August 31, 2001, with an exercise price of $7.22, the fair market price of the Company’s common stock as quoted on the Nasdaq National Market at the close of business on that day, and the vesting periods for the new options remained consistent with the original option grants. Members of the Company’s Board of Directors, including the Chairman and CEO as well as the CFO and General Counsel, were not eligible for this program, and participation by other named executive officers was limited. In connection with the program, options to purchase approximately 18,485,000 shares of the Company’s common stock were cancelled, and new options to purchase approximately 14,663,000 shares of the Company’s common stock were granted.

7671


REALNETWORKS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

     Details regarding options cancelled during 2001 under the program are as follows (in thousands, except per share data):

                         
Weighted Average
SharesExercise Price


Exercise PricesVestedUnvestedTotalVestedUnvestedTotal







$ 7.03 - $14.88  6   1,629   1,635  $13.75   14.65   14.64 
$15.78 - $30.56  518   4,530   5,048   29.35   28.60   28.68 
$30.81 - $46.00  950   3,758   4,708   40.68   40.18   40.28 
$46.19 - $88.88  271   6,823   7,094   50.14   65.88   65.28 
   
   
   
             
   1,745   16,740   18,485  $38.69   45.04   44.44 
   
   
   
             

     The following table summarizes information about stock options outstanding at December 31, 20022003 (in thousands, except per share data):

                     
Options OutstandingOptions Exercisable


Weighted
AverageWeightedWeighted
RemainingAverageAverage
Number ofContractualExerciseNumber ofExercise
Exercise PricesSharesLife (Years)PriceSharesPrice






$ 0.02 - $ 3.61  3,892   13.89  $1.05   3,650  $0.89 
$ 3.74 - $ 3.76  4,948   19.43   3.76   644   3.76 
$ 3.81 - $ 7.21  5,399   18.15   5.73   1,507   5.70 
$ 7.22 - $ 7.22  13,048   18.64   7.22   6,870   7.22 
$ 7.25 - $11.77  5,020   17.09   8.95   2,299   8.94 
$12.00 - $46.19  2,280   16.67   25.06   1,446   26.69 
   
           
     
   34,587   17.79  $7.23   16,416  $7.50 
   
           
     
                     
Options OutstandingOptions Exercisable


Weighted
AverageWeightedWeighted
RemainingAverageAverage
Number ofContractualExerciseNumber ofExercise
Exercise PricesSharesLife (Years)PriceSharesPrice






$ 0.02 - $ 3.69  3,486   12.71  $1.23   3,061  $0.93 
$ 3.70 - $ 3.76  3,749   18.52   3.76   1,065   3.76 
$ 3.81 - $ 5.94  5,204   18.21   5.00   1,683   5.26 
$ 6.01 - $ 6.12  4,456   19.52   6.11   459   6.11 
$ 6.13 - $ 6.96  1,665   18.17   6.59   374   6.66 
$ 6.97 - $ 7.22  11,596   17.64   7.21   8,345   7.22 
$ 7.25 - $11.00  4,319   15.93   8.85   2,762   8.95 
$11.16 - $46.19  2,169   15.78   24.77   1,721   25.89 
   
           
     
   36,644   17.28  $7.05   19,470  $7.73 
   
           
     

     The per shareAs of December 31, 2002 there were 16,416,000 exercisable options outstanding with a weighted average fair valueexercise price of stock$7.50. At December 31, 2001 there were 11,113,000 exercisable options granted during 2002, 2001 and 2000 was $3.01, $4.29 and $28.78, respectively, on the date of grant. The fair value was determined using the Black-Scholes model. The followingoutstanding with a weighted average assumptions were used to perform the calculations:

             
Years Ended December 31,

200220012000



Expected dividend yield  0%   0%   0% 
Risk-free interest rate  2.89%   3.98%   6.17% 
Expected life (years)  5.3   4.3   3.9 
Volatility  95%   98%   100% 
exercise price of $9.73.

     D.     Employee Stock Purchase Plan.Effective January 1998, the Company adopted an Employee Stock Purchase Plan (ESPP), and has reserved 4,000,000 shares of common stock for issuance under the ESPP. Under the ESPP, an eligible employee may purchase shares of common stock, based on certain limitations, at a price equal to the lesser of 85 percent of the fair market value of the common stock at the beginning or end of the respective semi-annual offering periods. There were approximately 363,000, 441,000 349,000 and 90,000349,000 shares purchased under the ESPP during 2003, 2002 2001 and 2000,2001, respectively. The weighted average fair value of the employee stock purchase rights was $2.22, $2.10 and $3.00 in 2003, 2002 and 2001, respectively. The following weighted average assumptions were used to perform the calculation:

             
Years Ended December 31,

200320022001



Expected dividend yield  0%   0%   0% 
Risk-free interest rate  1.13%   2.00%   3.46% 
Expected life (years)  0.5   0.5   0.5 
Volatility  70%   95%   98% 

7772


REALNETWORKS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

employee stock purchase rights was $2.10, $3.00 and $9.59 in 2002, 2001 and 2000, respectively. The following assumptions were used to perform the calculation:

             
Years Ended December 31,

200220012000



Expected dividend yield  0%   0%   0% 
Risk-free interest rate  2.00%   3.46%   6.08% 
Expected life (years)  0.5   0.5   0.5 
Volatility  95%   98%   100% 

     E.     Repurchase of Common Stock.The Company’s Board of Directors has authorized the repurchase of up to $50 million of the Company’s outstanding common stock. Any purchases of common stock under the share repurchase program will be made from time-to-time, in the open market, through block trades or otherwise. Depending on market conditions and other factors, these purchases may be commenced or suspended at any time or from time-to-time without prior notice. As of December 31, 2002,2003, the Company had repurchased approximately 9.1 million shares at an average cost of $4.64 per share, orfor a total cost of $42.4 million. No shares were repurchased in 2003.

Note 10.12.     Income Taxes

     The components of loss before income taxes are as follows (in thousands):

                      
Years Ended December 31,Years Ended December 31,


200220012000200320022001






U.S. operations $(33,645) (80,500) (109,209) $(22,318) (33,645) (80,500)
Foreign operations 1,264 1,679 2,054  1,011 1,264 1,679 
 
 
 
  
 
 
 
 $(32,381) (78,821) (107,155) $(21,307) (32,381) (78,821)
 
 
 
  
 
 
 

     The components of income tax expense (benefit) are as follows (in thousands):

                     
Years Ended December 31,Years Ended December 31,


200220012000200320022001






Current:Current: Current: 
U.S. Federal $   U.S. Federal $   
State and local  323 211 State and local (130)  323 
Foreign 387 559 667 Foreign 274 387 559 
 
 
 
   
 
 
 
 Total current 387 882 878  Total current 144 387 882 
Deferred:Deferred: Deferred: 
U.S. Federal 5,585 (7,921) (14,142)U.S. Federal  5,585 (7,921)
Charge in lieu of taxes attributable to employee stock option plansCharge in lieu of taxes attributable to employee stock option plans  2,981 16,230 Charge in lieu of taxes attributable to employee stock option plans   2,981 
 
 
 
   
 
 
 
 $5,972 (4,058) 2,966   $144 5,972 (4,058)
 
 
 
   
 
 
 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

     Income tax expense (benefit) differs from “expected” income tax expense (benefit) (computed by applying the U.S. Federal income tax rate of 35 percent in 2003, 2002 2001 and 2000)2001) as follows (in thousands):

                      
Years Ended December 31,Years Ended December 31,


200220012000200320022001






US federal taxes (benefit) at statutory rate $(11,333) (27,587) (37,504)
US federal tax benefit at statutory rate $(7,457) (11,333) (27,587)
State taxes, net of federal benefit  210 137  (85)  210 
Amortization of nondeductible goodwill  17,572 14,844    17,572 
Nondeductable stock compensation 465 (3,339) 33,815 
Nondeductible stock compensation 392 465 (3,339)
Change in valuation allowance for deferred tax assets 17,553 9,331 (8,097) 9,747 17,553 9,331 
Research and development credit and other (713) (245) (229) (2,453) (713) (245)
 
 
 
  
 
 
 
 $5,972 (4,058) 2,966  $144 5,972 (4,058)
 
 
 
  
 
 
 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

     The tax effects of temporary differences and operating loss carryforwards that give rise to significant portions of net deferred tax assets are comprised of the following (in thousands):

                  
December 31,December 31,


2002200120032002




Deferred tax assetsDeferred tax assets Deferred tax assets 
Net operating loss carryforwards $160,292 154,641 Net operating loss carryforwards $183,288 160,292 
Research and development credit carry forwards 18,412 16,513 Research and development credit carry forwards 20,409 18,412 
Accrual for loss on excess office facilities, not currently taken for tax purposes 9,077 6,693 Accrual for loss on excess office facilities, not currently taken for tax purposes 10,142 9,077 
Deferred revenue 7,888 9,587 Deferred revenue 5,681 7,888 
Net unrealized losses on investments 4,815  Tax benefit of MusicNet loss 5,415 3,532 
Other 9,565 7,433 Net unrealized losses on investments 2,240 4,815 
 
 
 Other 7,677 7,554 
 
 
 
Gross deferred tax assetsGross deferred tax assets 210,049 194,867 Gross deferred tax assets 234,852 211,570 
Less valuation allowance (210,049) (172,803)Less valuation allowance (232,977) (210,049)
 
 
   
 
 
  22,064   1,875 1,521 
Deferred Tax Liabilities 
Deferred tax liabilitiesDeferred tax liabilities 
Net unrealized gains on equity securities  (16,479)Prepaid expenses (1,875) (1,521)
 
 
   
 
 
Net deferred tax assetsNet deferred tax assets $ 5,585 Net deferred tax assets $  
 
 
   
 
 

     The Company’s net operating losses total $458.0$524 million at December 31, 2002.2003. Substantially all net operating loss carryforwards pertain to the exercise of employee stock options. The Company has provided a valuation allowance on these deferred tax assets which will be reduced in the period in which the Company realizes a benefit on its tax returns from a reduction of income taxes payable. If realized, the tax benefit of these losses will be accounted for as a credit to shareholders’ equity rather than a reduction to the income tax provision. The net operating loss and research and development credit carryforwards begin to expire in 2013, if not utilized. Since the Company’s utilization of deferred tax assets depends on future profits, which are not assured, a valuation allowance equal to the net deferred tax assets has been provided.

     The valuation allowance for deferred tax assets increased by $22.9 million, $37.2 million and $7.1 million for 2003, 2002 and $68.1 million for 2002, 2001, and 2000, respectively.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Note 11.13.     Segment Information

     The Company operates in one business segment, media delivery, for which the Company receives revenues from its customers. The Company’s Chief Operating Decision Maker is considered to be the Company’s Operating Committee (COC)CEO Staff (CEOS), which is comprised of the Company’s Chief Executive Officer, President, and Executive and Senior Vice Presidents.Presidents, General Counsel, and the Company’s Chief Strategy Officer. The COCCEOS reviews financial information presented on a consolidated basis accompanied by disaggregated information about products and services and geographical regions for purposes of making decisions and assessing financial performance. The COCCEOS does not review discrete financial information regarding profitability of the Company’s different products or services and, therefore, the Company does not havehas only one operating segmentssegment as defined by Statement of Financial Accounting Standards No. 131, “Disclosure About Segments of an Enterprise and Related Information.”

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

     The Company’s customers consist primarily of end users located in the United States and various foreign countries. Revenues by geographic region are as follows (in thousands):

                      
Years Ended December 31,Years Ended December 31,


200220012000200320022001






United StatesUnited States $132,009 134,190 177,484 United States $147,613 132,009 134,190 
EuropeEurope 27,019 27,809 34,499 Europe 32,106 27,019 27,809 
AsiaAsia 19,685 19,197 20,710 Asia 19,811 19,685 19,197 
Rest of the worldRest of the world 3,966 7,709 8,845 Rest of the world 2,847 3,966 7,709 
 
 
 
   
 
 
 
Total net revenues $182,679 188,905 241,538 Total net revenues $202,377 182,679 188,905 
 
 
 
   
 
 
 

     The Company’s product types are defined as follows:

 • Consumer software and related services revenues are derived from sales of the Company’s RealOne Player Plus, RealJukeboxRealPlayer Plus and other related products, revenues from support and maintenance services that the Company sells to customers who purchase these products and sales of third-party software products including games.and content such as games and music, and revenue from distributing third party software. These products and services are sold primarily through the Internet, and the Company charges customers’ credit cards at the time of sale.
 
 • Consumer subscription services revenues consist of digital media subscription services, including RealOne SuperPass, RealOne RadioPass, MusicPass, GoldPassRhapsody and stand-alone and add-on subscriptions. These services are sold primarily through the Internet, and the Company charges the customer’s credit cards at the time of sale. Billing periods for consumer subscriptions services occur monthly, quarterly or annually, depending on the service purchased.
 
 • SystemsAdvertising revenues, which are derived from sales of advertising on the Company’s Web sites and consumer software and within the media streams that the Company hosts on behalf of its corporate customers.
• Business products and services revenues are derived from sales of media delivery system software, including RealServers and Helix system software for both wired and wireless systems, related authoring and publishing tools, digital rights management technology, support and maintenance services that we sellthe Company sells to customers who purchase these products, broadcast hosting services provided through the Real Broadcast Network and consulting services offered to the Company’s customers. These products and services are primarily sold to corporate customers.
• Advertising revenues, which are derived from sales of advertising on the Company’s Web sites and consumer software and within the media streams that the Company hosts on behalf of its corporate customers.

80Revenue from external customers by product type are as follows (in thousands):

               
Years Ended December 31,

200320022001



Consumer software and related services $30,207   31,276   47,005 
Consumer subscription services  107,093   75,497   28,231 
Advertising  6,349   6,765   15,579 
   
   
   
 
 Total consumer products and services revenues  143,649   113,538   90,815 
Business products and services  58,728   69,141   98,090 
   
   
   
 
  Total net revenues $202,377   182,679   188,905 
   
   
   
 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

     Revenue from external customers by product type is as followsConsumer products and services revenues are comprised of the following (in thousands):

              
Years Ended December 31,

200220012000



Consumer software and related services $31,276   47,005   79,290 
Consumer subscription services  75,497   28,231   1,986 
Systems  69,141   98,090   119,320 
Advertising  6,765   15,579   40,942 
   
   
   
 
 Total net revenues $182,679   188,905   241,538 
   
   
   
 
              
Years Ended December 31,

200320022001



Video, consumer software and other $116,394   104,784   86,150 
Music  15,093   960    
Games  12,162   7,794   4,665 
   
   
   
 
 Total consumer products and services revenue $143,649   113,538   90,815 
   
   
   
 

     Long-lived assets, consisting of equipment and leasehold improvements, goodwill, and other intangible assets, by geographic location are as follows (in thousands):

                 
December 31,December 31,


2002200120032002




United StatesUnited States $90,234 92,551 United States $127,694 90,234 
EuropeEurope 218 180 Europe 230 218 
Asia/ Rest of the world 518 627 
Asia/Rest of the worldAsia/Rest of the world 555 518 
 
 
   
 
 
Total $90,970 93,358 Total $128,479 90,970 
 
 
   
 
 

     At December 31, 2003, net assets in Europe and Asia and the rest of the world were $3.0 million and $0.5 million, respectively.

Note 12.14.     Commitments and Contingencies

     A.Commitments.The Company has commitments for future payments related to office facilities leases and other contractual obligations. The Company leases its office facilities under terms of operating lease agreements expiring through April 2011. The Company also has other contractual obligations expiring over varying time periods into the future. Future minimum payments are as follows (in thousands):

                      
OtherOther
OfficeContractualOfficeContractual
LeasesObligationsTotalLeasesObligationsTotal






2003 $11,428 29,612 41,040 
20042004 11,501 26,301 37,802 2004 $12,520 23,722 $36,242 
20052005 11,860  11,860 2005 12,068 12,757 24,825 
20062006 12,231  12,231 2006 12,304 5,606 17,910 
20072007 12,349  12,349 2007 12,421 2,420 14,841 
20082008 12,700 2,330 15,030 
ThereafterThereafter 39,764  39,764 Thereafter 29,113 4,660 33,773 
 
 
 
   
 
 
 
Total minimum payments $99,133 55,913 155,046 Total minimum payments $91,126 51,495 $142,621 
Less future minimum payments under subleasesLess future minimum payments under subleases 2,208  2,208 Less future minimum payments under subleases (8,022)  (8,022)
 
 
 
   
 
 
 
Net $96,925 55,913 152,838 Net $83,104 51,495 $134,599 
 
 
 
   
 
 
 

     Of the total net office lease commitments, $29.1 million is recorded in accrued loss on excess office facilities at December 31, 2003. Other contractual obligations primarily relate to minimum contractual payments due to content and other service providers.

     Rent expense was $6.4 million in 2003, $6.8 million in 2002, and $6.7 million in 2001 and $4.8 million in 2000.2001.

     B.     401(k) Retirement Savings Plan.The Company has a salary deferral plan (401(k) Plan) that covers substantially all employees. The Company, at its discretion, may make contributions to the 401(k)

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REALNETWORKS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Plan, although it has not made any contributions to date. Employees can contribute a portion of their salary up to the maximum allowed by the federal tax guidelines. The Company has no other post-employment or post-retirement benefit plans.

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REALNETWORKS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

     C.     Litigation.LitigationIn August 1998, Venson M. Shaw and Steven M. Shaw filed

     On March 9, 2004, the Company sued MLB Advanced Media, L.P. (“MLBAM”) in the U.S. District Court for the Western District of Washington, asserting a lawsuit againstclaim for breach of contract relating to an agreement between the Company and co-defendant Broadcast.comMLBAM which requires MLBAM to provide certain streaming media content in the United StatesCompany’s formats. The Company is seeking injunctive relief requiring MLBAM to perform its obligations under that agreement. The Company is also seeking monetary damages and reasonable attorneys fees.

     On December 18, 2003, the Company filed suit against Microsoft Corporation in the U.S. District Court for the Northern District of Texas — Dallas Division.California, pursuant to U.S. and California antitrust laws. The plaintiffs allegeCompany alleged that Microsoft has illegally used its monopoly power to restrict competition, limit consumer choice and attempt to monopolize the field of digital media. Microsoft has filed an answer denying the claims and raising a variety of defenses. The Company believes it has a strong case and intends to vigorously pursue the litigation. If successful, the Company may be entitled to both monetary and injunctive relief from Microsoft. The Company expects that the Company, individually and in combination with Broadcast.com, infringeslitigation will carry on a certain patent owned by the plaintiffs. The plaintiffs filed a similar claim, based on the same patent, as a separate lawsuit against Microsoft and Broadcast.com, which was consolidated with the lawsuit against the Company. The Company has settled the lawsuit on behalf of itself as of January 10, 2003, and has settled any indemnity obligation owing from the Company to Broadcast.com. The claims against the Company have been dismissed with prejudice. The settlement did not have a material adverse effect on the Company’s financial position or results of operations.for several years before it can be resolved through trial.

     Between November 1999 and March 2000, fourteen lawsuits wereIn September 2003, a lawsuit was filed against the Company in federal and/or state courtscourt in California, Illinois, Pennsylvania, WashingtonMarshall, Texas, alleging that the Company infringes certain patents relating to the transmittal of information recorded on information storage “means” from a central server to subscribers via a high data rate digital telecommunications network. The plaintiff seeks to enjoin the Company from the alleged infringing activity and Texas. The plaintiffs have voluntarily dismissed all ofto recover damages from the state court cases with the exception of the case pending in California. The remaining actions, which seek to certify classes of plaintiffs, allege breach of contract, invasion of privacy, deceptive trade practices, negligence, fraud and violation of certain federal and state laws in connection with various communications features of the Company’s RealPlayer and RealJukebox products. Plaintiffs are seeking both damages and injunctive relief.alleged infringement. The Company has answered the complaint and filed answers denyinga counterclaim against plaintiff challenging the claimsvalidity of its patents at issue and hasasserting inequitable conduct. The Company disputes the allegations in this action and intends to vigorously defend itself against these claims.

     In June 2003, a lawsuit was filed suitagainst the Company and Listen in Washington State Court to compel the state court plaintiffs to arbitrate the claims as required by the Company’s End User License Agreements. The Washington State Court has granted the Company’s motion to compel arbitration. On February 10, 2000, the federal Judicial Panel on Multidistrict Litigation transferred all pending federal cases to the federal district court for the Northern District of Illinois. On the same day,Illinois, alleging that court granted RealNetworks’ motion to stay the court proceedings because the claims are subject to arbitration under RealNetworks’ End User License Agreement. RealNetworks and the California state court plaintiffs have agreed on tentative terms to settle the California litigation. The proposed settlement must be approved by the California court before taking effect and it has not yet been approved. Under the agreed terms, the settlement would not have a material effect oncertain features of the Company’s financial condition or results of operations. Although no assurance can be given asand Listen’s products and services willfully infringe certain patents relating to allowing users “to search for streaming media files, to create custom playlists, and to listen to the outcome of these lawsuits,streaming media file sequentially and continuously.” The plaintiff seeks to enjoin the Company believes thatfrom the alleged infringing activity and to recover treble damages from the alleged infringement. The Company has filed its answer and a counterclaim against plaintiff challenging the validity of the patents at issue. The Company disputes the allegations in these actions are without merit,this action and intends to vigorously defend itself.

     In March 2003, William Cirignani filed a putative consumer class action against the Company in Washington state court, alleging causes of action based on the Washington Consumer Protection Act and unjust enrichment. The plaintiff alleges that consumers who attempted to download or purchase certain of the Company’s products and services were fraudulently and deceptively enrolled in, and prevented from canceling, the Company’s subscription services. The plaintiff seeks compensatory damages, equitable relief in the form of an order prohibiting the alleged false and deceptive practices, treble damages and other relief. The Company believesdisputes the ultimate outcome will not have a material adverse effect on its financial position or results of operations. If the plaintiffs prevailallegations in their claims, the Company could be requiredthis action and intends to pay damages or other penalties in addition to complying with injunctive relief, which could harm the Company’s business and its operating results.vigorously defend itself against these claims.

     In July 2002, a lawsuit was filed against the Company in federal court in Boston, Massachusetts, alleging that RealNetworksthe Company willfully infringes certain patents relating to “the downloading of data from a server computer to a client computer.” The plaintiff seeks to enjoin the Company from the alleged infringing activity and to recover treble damages from the alleged infringement. The Company has filed a counterclaimcounterclaims against the plaintiff seeking a declaratory judgment that the patents at issue are invalid and unenforceable due to plaintiff’s inequitable conduct, as well as its recovery of damages for plaintiff’s infringement of a Company

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REALNETWORKS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

patent, and reasonable attorneys fees and costs. Although no assurance can be given as to the outcome of this lawsuit, theThe Company believes thatdisputes the allegations in this action are without merit and intends to vigorously defend itself. The Company believes the ultimate outcome will not have a material adverse effect on its financial position or results of operations. If the plaintiffs prevail in their claims, the Company could be required to pay damages or other penalties in addition to complying with injunctive relief, which could harm the Company’s business and its operating results.

     From time to time RealNetworksthe Company is, and expects to continue to be, subject to legal proceedings and claims in the ordinary course of its business, including employment claims, contract-related claims and claims of alleged infringement of third-party patents, trademarks and other intellectual property rights. These claims, including those described above, even if not meritorious, could force the Company to spend significant financial and managerial resources. The Company currently has a number of such claims threatened against it relating to intellectual property infringement or employment, though it believes these claims are without merit. The Company is not aware of

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REALNETWORKS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

any legal proceedings or claims that the Company believes will have, individually or taken together, a material adverse effect on the Company’s business, prospects, financial condition or results of operations. However, the Company may incur substantial expenses in defending against third party claims. In the event of a determination adverse to the Company, the Company may incur substantial monetary liability, and/or be required to change its business practices. Either of these could have a material adverse effect on the Company’s financial position and results of operations.

Note 13.15.     Guarantees

     In November 2002, the FASB issued Interpretation No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees and Indebtedness of Others (“FIN 45.45”) an interpretation of FASB Statements No. 5, 57, and 107 and rescission of FASB interpretation No. 34. FIN 45 provides expanded accounting guidance surrounding liability recognition and disclosure requirements related to guarantees, as defined by this Interpretation. WeThe Company adopted FIN 45 during the quarter ended December 31, 2002. In the ordinary course of business, we arethe Company is not subject to potential obligations under guarantees that fall within the scope of FIN 45 except for standard indemnification and warranty provisions that are contained within many of ourthe Company’s customer license and service agreements, and give rise only to the disclosure requirements prescribed by FIN 45.

     Indemnification and warranty provisions contained within ourthe Company’s customer license and service agreements are generally consistent with those prevalent in ourthe Company’s industry. The duration of ourthe Company’s product warranties generally does not exceed 90 days following delivery of ourthe Company’s products. We haveThe Company has not incurred significant obligations under customer indemnification or warranty provisions historically and dodoes not expect to incur significant obligations in the future. Accordingly, we dothe Company does not maintain accruals for potential customer indemnification or warranty-related obligations.

Note 14.16.     Subsequent Events

     On January 30, 2004, the Company acquired all of the outstanding securities of GameHouse, Inc. (GameHouse) in exchange for approximately $9.1 million in cash payments, including an estimated future payment of $0.1 million to cover certain tax obligations of the selling shareholders, and 3.0 million shares and options to acquire 0.3 million shares of RealNetworks common stock valued at approximately $20.7 million. The value assigned to the stock portion of the purchase price is $6.40 per share based on the average closing price of RealNetworks’ common stock for the five days beginning two days prior to and ending two days after January 26, 2004 (the date of the Agreement and Plan of Merger). Options issued were valued based on the Black-Scholes options pricing model. Included in the purchase price is $0.4 million in estimated acquisition-related expenditures consisting primarily of professional fees. Certain former GameHouse shareholders are eligible to receive $5.5 million over a four year period, payable in cash or, at the Company’s discretion, in RealNetworks common stock valued in that amount provided they remain employed by RealNetworks during such period. In addition, the Company may be obligated to pay a total of $1.0 million over a four-year period to certain GameHouse employees in the form of a management incentive plan. Such amounts are not included in the aggregate purchase price and, to the extent earned, will be recorded as compensation expense over the related employment periods.

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REALNETWORKS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

     GameHouse is a developer, publisher and distributor of downloadable PC games. The acquisition is designed to strengthen RealNetworks’ position in the downloadable PC games market by combining the assets of GameHouse with RealNetworks’ downloadable games distribution platform. The results of GameHouse’s operations will be included in RealNetworks’ consolidated financial statements starting from the date of acquisition.

A summary of the preliminary purchase price to be allocated for the acquisition is as follows (in thousands):

      
Cash $9,131 
Fair value of RealNetworks common stock and options issued  20,901 
Estimated direct acquisition costs  350 
   
 
 Total $30,382 
   
 

     The aggregate purchase consideration has been allocated to the assets and liabilities acquired, including identifiable intangible assets, based on their respective estimated fair values as summarized below. The respective estimated fair values were determined by a preliminary independent appraisal as of the acquisition date and resulted in excess purchase consideration over the net tangible and identifiable intangible assets acquired of $21.9 million. The allocation of the purchase price may be subject to change based on the finalization of the closing balance sheet.

A summary of the allocation of the purchase price follows (in thousands):

      
Current assets $1,315 
Property and equipment  82 
Technology/ Games  5,200 
Tradename  1,600 
Customer list  400 
Goodwill  21,894 
Current liabilities  (331)
Deferred stock compensation  222 
   
 
 Net assets acquired $30,382 
   
 

     Technology/ Games have a weighted average estimated useful life of two years. Tradename and customer list have a weighted average estimated useful life of four years.

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REALNETWORKS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Note 17.     Quarterly Information (Unaudited)

     The following table summarizes the unaudited statement of operations for each quarter of 20022003 and 20012002 (in thousands, except per share data):

                                 
TotalDec. 31Sept. 30June 30Mar. 31TotalDec. 31Sept. 30June 30Mar. 31










2003
 
Net revenues $202,377 54,056 51,809 49,646 46,866 
Gross profit 134,034 33,276 32,950 34,726 33,082 
Operating loss (20,863) (5,304) (4,082) (9,551) (1,926)
Net loss (21,451) (5,327) (3,654) (9,632) (2,838)
Basic and diluted net loss per share (0.13) (0.03) (0.02) (0.06) (0.02)
2002
  
Net revenues $182,679 46,211 45,418 43,758 47,292  $182,679 46,211 45,418 43,758 47,292 
Gross profit 132,410 32,836 31,751 32,743 35,080  132,410 32,836 31,751 32,743 35,080 
Operating income (loss) (31,654) (2,592) (25,080) (4,942) 960  (31,654) (2,592) (25,080) (4,942) 960 
Net income (loss) (38,353) (2,457) (35,389) (1,555) 1,048  (38,353) (2,457) (35,389) (1,555) 1,048 
Basic net income (loss) per share (0.24) (0.02) (0.22) (0.01) 0.01 
Diluted net income (loss) per share (0.24) (0.02) (0.22) (0.01) 0.01 
2001
 
Net revenues $188,905 45,438 45,228 47,860 50,379 
Gross profit 150,717 35,197 36,061 38,008 41,451 
Operating loss (65,324) (11,546) (21,457) (3,986) (28,335)
Net loss (74,763) (11,820) (19,380) (19,190) (24,373)
Basic and diluted net loss per share (0.47) (0.07) (0.12) (0.12) (0.15)
Basic and diluted net income (loss) per share (0.24) (0.02) (0.22) (0.01) 0.01 

     Due to use of rounding convention for quarterly reporting, sum of quarters may not equal annual totals.

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REALNETWORKS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

The following table summarizes unaudited revenue from external customers by business group for each quarter of 2003, 2002 and 2001 (in thousands):

                       
TotalDec. 31Sept. 30June 30Mar. 31





2003
                    
Video, consumer software and other $116,394   29,347   28,572   28,830   29,645 
Music  15,093   7,937   4,655   1,670   831 
Games  12,162   3,930   3,150   2,672   2,410 
   
   
   
   
   
 
 Total consumer products and services revenues  143,649   41,214   36,377   33,172   32,886 
Business products and services  58,728   12,842   15,432   16,474   13,980 
   
   
   
   
   
 
  Total net revenues $202,377   54,056   51,809   49,646   46,866 
   
   
   
   
   
 
2002
                    
Video, consumer software and other $104,784   29,965   28,005   24,516   22,298 
Music  960   416   210   200   134 
Games  7,794   1,998   1,665   1,895   2,236 
   
   
   
   
   
 
 Total consumer products and services revenues  113,538   32,379   29,880   26,611   24,668 
Business products and services  69,141   13,832   15,538   17,147   22,624 
   
   
   
   
   
 
  Total net revenues $182,679   46,211   45,418   43,758   47,292 
   
   
   
   
   
 
2001
                    
Video, consumer software and other $86,150   22,205   20,163   20,581   23,201 
Music               
Games  4,665   1,942   1,246   843   634 
   
   
   
   
   
 
 Total consumer products and services revenues  90,815   24,147   21,409   21,424   23,835 
Business products and services  98,090   21,291   23,819   26,436   26,544 
   
   
   
   
   
 
  Total net revenues $188,905   45,438   45,228   47,860   50,379 
   
   
   
   
   
 

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INDEPENDENT AUDITORS’ REPORT

The Board of Directors and Shareholders

RealNetworks, Inc.:

     We have audited the accompanying consolidated balance sheets of RealNetworks, Inc. and subsidiaries as of December 31, 20022003 and 2001,2002, and the related consolidated statements of operations and comprehensive loss, shareholders’ equity and cash flows for each of the years in the three-year period ended December 31, 2002.2003. In connection with our audits of the consolidated financial statements, we also have audited the financial statement schedule listed in the index at Item 15 (a)(2). These consolidated financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedule based on our audits.

     We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

     In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of RealNetworks, Inc. and subsidiaries as of December 31, 20022003 and 2001,2002, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2002,2003, in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.

     As discussed in Note 1 to the consolidated financial statements, the Company changed its method of accounting for goodwill and other intangible assets as of January 1, 2002.

/s/ KPMG LLP

Seattle, Washington

January 17, 200330, 2004

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Item 9.Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

     Not applicable.

Item 9A.Controls and Procedures

(a) Evaluation of Disclosure Controls and Procedures. Based on their evaluation as of the end of the period covered by this Annual Report on Form 10-K, the Company’s principal executive officer and principal financial officer have concluded that the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”)) are effective to ensure that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms.

(b) Changes in Internal Controls. There were no significant changes in the Company’s internal control over financial reporting identified in management’s evaluation during the fourth quarter of fiscal 2003 that have materially affected or are reasonably likely to materially affect the Company’s internal control over financial reporting.

PART III.

 
Item 10.Directors and Executive Officers of the Registrant

     The information required by this Item is contained in part in the sections captioned “Board of Directors-Nominees for Director,” “Board of Directors-Continuing Directors-Not Standing for Election This Year,” “Board of Directors-Contractual Arrangements” and “Voting Securities and Principal Holders-Section 16(a) Beneficial Ownership Reporting Compliance” in the Proxy Statement for RealNetworks’ Annual Meeting of Shareholders scheduled to be held on or around May 20, 2003,June 4, 2004, and such information is incorporated herein by reference.

     The remaining information required by this Item is set forth in Part I of this report under the caption “Executive Officers of the Registrant.”

 
Item 11.Executive Compensation

     The information required by this Item is incorporated by reference to the information contained in the section captioned “Compensation and Benefits” of the Proxy Statement for RealNetworks’ Annual Meeting of Shareholders scheduled to be held on or around May 20, 2003.June 4, 2004.

 
Item 12.Security Ownership of Certain Beneficial Owners and Management

     The information required by this Item is incorporated by reference to the information contained in the sections captioned “Voting Securities and Principal Holders” of the Proxy Statement for RealNetworks’ Annual Meeting of Shareholders scheduled to be held on or around May 20, 2003.June 4, 2004.

Equity Compensation Plans

     As of December 31, 20022003 we had five equity compensation plans. These plans include the RealNetworks, Inc. 1995 Stock Option Plan (the “1995 Plan), the RealNetworks, Inc. 1996 Stock Option Plan, as amended and restated (the “1996 Plan”), the RealNetworks, Inc. 2000 Stock Option Plan, as amended and restated (the “2000 Plan”), the RealNetworks, Inc. 2002 Director Plan (the “2002 Plan”) and the Vivo Software, Inc. 1993 Equity Incentive Plan (the “Vivo Plan”). The 1995 Plan, the 1996 Plan and the 2002 Plan have been approved by our shareholders. The 2000 Plan has not been approved by our shareholders. The Vivo plan was

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approved by the shareholders of Vivo Software, Inc. prior to its acquisition by RealNetworks in March 1998. The following table aggregates the data from our five plans:
                         
Number of SecuritiesNumber of Securities
Remaining AvailableRemaining Available
Number of Securitiesfor Future IssuanceNumber of Securitiesfor Future Issuance
to be Issued UponWeight-averageUnder Equityto be Issued UponWeight-averageUnder Equity
Exercise ofExercise Price ofCompensation PlansExercise ofExercise Price ofCompensation Plans
Outstanding Options,Outstanding Options,(excluding securitiesOutstanding Options,Outstanding Options,(excluding securities
Warrants and RightsWarrants and Rightsreflected in column (a))Warrants and RightsWarrants and Rightsreflected in column (a))
Plan Category(a)(b)(c)Plan Category(a)(b)(c)








Equity compensation plans approved by security holders 34,452,049 $7.23 16,582,613 Equity compensation plans approved by security holders 34,794,250 $6.93 10,758,662 
Equity compensation plans not approved by security holders 135,000 $5.676 615,000 Equity compensation plans not approved by security holders 1,849,844 $9.36 2,030,169 
Total
 34,587,049 $7.2250 17,197,613 
 
 
 
Total 36,644,094 $7.05 12,788,831 
 
 
 

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Item 13.Certain Relationships and Related Transactions

     The information required by this Item is incorporated by reference to the information contained in the section captioned “Voting Securities and Principal Holders-Certain Transactions” of the Proxy Statement for RealNetworks’ Annual Meeting of Shareholders scheduled to be held on or around May 20, 2003.June 4, 2004.

 
Item 14.ControlsPrincipal Accountant Fees and ProceduresServices

     (a) Evaluation of Disclosure Controls and Procedures.Based on their evaluation as of a date within 90 days of the filing date of this Annual Report on Form 10-K, the Company’s principal executive officer and principal financial officer have concluded that the Company’s disclosure controls and procedures (as defined in Rules 13a-14(c) and 15d-14(c)The information set forth under the Securities Exchange Act of 1934 (the “Exchange Act”)) are effective to ensure that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act is recorded, processed, summarizedcaption “Principal Accountant Fees and reported within the time periods specified in Securities and Exchange Commission rules and forms.

(b) Changes in Internal Controls.There were no significant changesServices” appearing in the Company’s internal controlsdefinitive Proxy Statement for the Annual Meeting of Shareholders to be held on or in other factors that could significantly affect these controls subsequent to the date of their evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.around June 4, 2004.

PART IV.

 
Item 15.Exhibits, Financial Statement Schedules, and Reports on Form 8-K

     (a)(1) Index to Consolidated Financial Statements

      The following consolidated financial statements of RealNetworks, Inc. and subsidiaries are filed as part of this report:

          Consolidated Balance Sheets — December 31, 20022003 and 20012002

            Consolidated Statements of Operations and Comprehensive Loss — Years Ended December 31, 2003, 2002 2001 and 20002001

            Consolidated Statements of Cash Flows — Years Ended December 31, 2003, 2002 2001 and 20002001

            Consolidated Statements of Shareholders’ Equity — Years Ended December 31, 2003, 2002 2001 and 20002001

            Notes to Consolidated Financial Statements

            Independent Auditors’ Report

     (a)(2) Financial Statement Schedules

            Independent Auditors’ Report

Schedule II: Valuation and Qualifying Accounts

            Schedule: Financial Statements of a 50-percent-or-less-owned person

     The following financial statements of MusicNet, Inc. are filed as a schedule to this report:

          Independent Auditors’ Report

          Balance Sheets — December 31, 2003 and 2002

84


            Statements of Operations — Years Ended December 31, 2003, 2002 and 2001

            Statements of Convertible Preferred Stock and Stockholders’ Deficit — Years Ended December 31, 2003, 2002 and 2001

            Statements of Cash Flows — Years Ended December 31, 2003, 2002 and 2001

            Notes to Financial Statements

      Schedules not listed above have been omitted because the information required to be set forth therein is not applicable or is included in the Consolidated Financial Statements or notes thereto.

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     (b) Reports on Form 8-K

      NoneOn October 29, 2003, RealNetworks, Inc. furnished a report on Form 8-K relating to its announcement on October 29, 2003 of the results for its third quarter ended September 30, 2003.
     On December 18, 2003, RealNetworks filed a report on Form 8-K in connection with its announcement on December 18, 2003 of the filing of an antitrust lawsuit against Microsoft Corporation.

     (c) ExhibitsExhibit Index

      The following exhibits are incorporated herein by reference or are filed with this report as indicated below:

     
Exhibit No. 2:  PlanofAcquisition,Plan of Acquisition, Reorganization,Arrangement,Liquidation orSuccessionor Succession
 2.1  Agreement and Plan of Merger and Reorganization by and among RealNetworks, Inc., Varsity Acquisition Corp., NetZip, Inc., certain shareholders of NetZip, Inc. and Mellon Investor Services LLC (formerly ChaseMellon Shareholder Services L.L.C.) dated as of January 25, 2000 (incorporated by reference from Exhibit 2.1 to the Current Report on Form 8-K filed with the Securities and Exchange Commission on January 26, 2000)
 2.2  Agreement and Plan of Merger and Reorganization by and among RealNetworks, Inc., McKinley Acquisition Corp., Aegisoft Corp., certain shareholders of Aegisoft Corp. and Mellon Investor Services LLC dated as of December 29, 2000 (incorporated by reference from Exhibit 2.1 to the Current Report on Form 8-K filed with Securities and Exchange Commission on January 12, 2001)
2.3Agreement and Plan of Merger and Reorganization by and among RealNetworks, Inc., Symphony Acquisition Corp. I, Symphony Acquisition Corp. II, Listen.Com, Inc., Mellon Investor Services LLC, as Escrow Agent and Robert Reid, as Shareholder Representative dated as of April 21, 2003 (incorporated by reference from Exhibit 2.1 to RealNetworks, Inc.’s Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2003 filed with the Securities and Exchange Commission on August 14, 2003)
Exhibit No. 3:  ArticlesofIncorporationandBylawsArticles of Incorporation and Bylaws
 3.1  Amended and Restated Articles of Incorporation (incorporated by reference from Exhibit 3.1 to RealNetworks’ Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2000 filed with the Securities and Exchange Commission on August 11, 2000)
 3.2  Amended and Restated Bylaws (incorporated by reference from Exhibit 3.2 to RealNetworks’ Quarterly Report on Form 10-Q for the quarterly period ended September 30, 29981998 filed with the Securities and Exchange Commission on November 13, 1998)
3.3Amendment No. 1 dated April  22, 2003 to Amended and Restated Bylaws of RealNetworks, Inc. Adopted July 16, 1998 (incorporated by reference from Exhibit 3.1 to RealNetworks’ Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2003 filed with the Securities and Exchange Commission on August 14, 2003)

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Exhibit No. 4:  InstrumentsDefiningtheRightsofSecurityHoldersInstruments Defining the Rights of Security Holders
 4.1  Shareholder Rights Plan dated as of December 4, 1998 between RealNetworks, Inc. and Mellon Investor Services LLC (formerly ChaseMellon Shareholder Services, L.L.C.) (incorporated by reference from Exhibit 1 to RealNetworks’ Registration Statement on Form 8-A12G filed with the Securities and Exchange Commission on December 14, 1998)
 4.2  Amendment No. 1 dated as of January 21, 2000 to Shareholder Rights Plan between between RealNetworks, Inc. and Mellon Investor Services LLC (formerly ChaseMellon Shareholder Services, L.L.C.) (incorporated by reference from Exhibit 1 to RealNetworks’ Registration Statement on Form 8-A12G/A filed with the Securities and Exchange Commission on February 7, 2000)
 4.3  Amendment No. 2 dated as of May 30, 2000 to Shareholder Rights Plan between RealNetworks, Inc. and Mellon Investor Services LLC (formerly ChaseMellon Shareholder Services, L.L.C.)(incorporated (incorporated by reference from Exhibit 1 to RealNetworks’ Registration Statement on Form 8-A12G/A filed with the Securities and Exchange Commission on June 8, 2000)
 4.4  Third Amended and Restated Investors’ Rights Agreement dated March 24, 1998 by and among RealNetworks, Inc. and certain shareholders of RealNetworks (incorporated by reference from Exhibit 10.16 to RealNetworks’ Annual Report on Form 10-K for the year ended December 31, 1997 filed with the Securities and Exchange Commission on March 30, 1998)
4.5Indenture dated as of June 17, 2003 between RealNetworks, Inc. and U.S. Bank National Association, including the form of Zero Coupon Subordinated Note due 2010 included in Section 2.2 thereof (incorporated by reference from Exhibit 4.1 to RealNetworks’ Amendment No. 1 to Registration Statement on Form S-3 filed with the Securities and Exchange Commission on November 18, 2003)
4.6Registration Rights Agreement dated as of June 17, 2003, between RealNetworks, Inc. and Goldman, Sachs & Co. (incorporated by reference from Exhibit 4.3 to RealNetworks’ Registration Statement on Form S-3 filed with the Securities and Exchange Commission on September 12, 2003)
Exhibit No. 10:  MaterialContractsMaterial Contracts
Executive Compensation Plans and Agreements
 10.1  RealNetworks, Inc. 1995 Stock Option Plan (incorporated by reference from Exhibit 99.1 to RealNetworks’ Registration Statement on Form S-8 filed with the Securities and Exchange Commission on September 14, 1998)

87


 10.2  RealNetworks, Inc. 1996 Stock Option Plan, as amended and restated on June 1, 2001 (incorporated by reference from Exhibit 10.1 to RealNetworks’ Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2001 filed with the Securities and Exchange Commission on August 13, 2001)
 10.3  RealNetworks, Inc. 2000 Stock Option Plan, as amended and restated on June 1, 2001 (incorporated by reference from Exhibit 10.2 to RealNetworks’ Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2001 filed with the Securities and Exchange Commission on August 13, 2001)
 10.4  RealNetworks, Inc. 2002 Director Stock Option Plan (incorporated by reference from Exhibit 10.2 to RealNetworks’ Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2002 filed with the Securities and Exchange Commission on July 25, 2002)
 10.5  Vivo Software, Inc. 1993 Equity Incentive Plan, as amended (incorporated by reference from Exhibit 99.1 to RealNetworks’ Registration Statement on Form S-8 filed with the Securities and Exchange Commission on May 20, 1998)

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 10.6  Form of Stock Option Agreement under the RealNetworks, Inc. 1996 Stock Option Plan, as amended and restated (incorporated by reference from Exhibit 10.1 to RealNetworks’ Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2002 filed with the Securities and Exchange Commission on November 14, 2002)
 10.7  Form of Stock Option Agreement under the RealNetworks, Inc. 2000 Stock Option Plan, as amended and restated (incorporated by reference from Exhibit 10.2 to RealNetworks’ Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2002 filed with the Securities and Exchange Commission on November 14, 2002)
 10.8  Forms of Stock Option Agreement under the RealNetworks, Inc. 2002 Director Stock Option Plan (incorporated by reference from Exhibit 10.3 to RealNetworks’ Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2002 filed with the Securities and Exchange Commission on November 14, 2002)
 10.9  RealNetworks, Inc. 1998 Employee Stock Purchase Plan, as amended and restated on April 9, 2002 (incorporated by reference from Exhibit 10.1 to RealNetworks’ Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2002 filed with the Securities and Exchange Commission on July 25, 2002)
 10.10  RealNetworks, Inc. Director Compensation Stock Plan.
10.11Offer Letter dated February 1, 2002 between RealNetworks, Inc. and Lawrence Jacobson (incorporated by reference from Exhibit 10.11 to RealNetworks’ Annual Report on Form 10-K for the year ended December 31, 2002 filed with the Securities and Exchange Commission on April 2, 2001)
Other Material Contracts
 10.1110.12  Lease dated January 21, 1998 between RealNetworks, Inc. as Lessee and 2601 Elliott, LLC (incorporated by reference from Exhibit 10.1 to RealNetworks’ Quarterly Report on Form 10-Q for the quarterly period ended March 31, 1998 filed with the Securities and Exchange Commission on May 14, 1998)
 10.1210.13  Form of Director and Officer Indemnification Agreement (incorporated by reference from Exhibit 10.14 to RealNetworks’ Registration Statement on Form S-1 filed with the Securities and Exchange Commission on September 26, 1997 (File No. 333-36553))
 10.1310.14  Voting Agreement dated September 25, 1997 by and among RealNetworks, Robert Glaser, Accel IV L.P., Mitchell Kapor and Bruce Jacobsen (incorporated by reference from Exhibit 10.17 to RealNetworks’ Registration Statement on Form S-1 filed with the Securities and Exchange Commission on September 26, 1997 (File No. 333-36553))
 10.1410.15  Agreement dated September 26, 1997 by and between RealNetworks and Robert Glaser (incorporated by reference from Exhibit 10.18 to RealNetworks’ Registration Statement on Form S-1 filed with the Securities and Exchange Commission on September 26, 1997 (File No. 333-36553))
Exhibit No. 14:  Code of Ethics
14.1RealNetworks, Inc. Code of Business Conduct and Ethics
Exhibit No. 21:  Subsidiaries of the Registrant
21.1Subsidiaries of RealNetworks, Inc.
Exhibit No. 23:  Consents of Experts and Counsel
23.1Consent of KPMG LLP
23.2Consent of KPMG LLP

8887


     
Exhibit No. 21: SubsidiariesoftheRegistrant
21.1Subsidiaries24:  Power of RealNetworks, Inc.
Exhibit No. 23: ConsentsofExpertsandCounsel
23.1Consent of KPMG LLP
Exhibit No. 24: PowerofAttorneyAttorney
 24.1  Power of Attorney (included on signature page)
Exhibit No. 99: AdditionalExhibits31:  Rule 13a-14(a)/15d-14(a) Certifications
 99.131.1Certification of Robert Glaser, Chairman and Chief Executive Officer of RealNetworks, Inc., Pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2Certification of Roy B. Goodman, Senior Vice President, Chief Financial Officer and Treasurer of RealNetworks, Inc., Pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
Exhibit No. 32:  Section 1350 Certifications
32.1  Certification of Robert Glaser, Chairman and Chief Executive Officer of RealNetworks, Inc., Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
 99.232.2  Certification of Brian V. Turner,Roy B. Goodman, Senior Vice President, Finance and Operations, Chief Financial Officer and Treasurer of RealNetworks, Inc., Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

8988


SIGNATURES

     Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Seattle, State of Washington, on March 28, 2003.12, 2004.

 REALNETWORKS, INC

 By: /s/ ROBERT GLASER
 
 Robert Glaser
 Chief Executive Officer

POWER OF ATTORNEY

     Each person whose signature appears below hereby constitutes and appoints Robert Glaser and Brian V. Turner,Roy B. Goodman, and each of them severally, his or her true and lawful attorneys-in-fact and agents, with full power to act without the other and with full power of substitution and resubstitution, to execute in his or her name and on his or her behalf, individually and in each capacity stated below, any and all amendments and supplements to this Report, and any and all other instruments necessary or incidental in connection herewith, and to file the same with the Commission.

     Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities indicated below on March 28, 2003.12, 2004.

   
SignatureTitle


 
/s/ ROBERT GLASER

Robert Glaser
 Chairman of the Board and Chief Executive Officer
(Principal Executive Officer)
 
/s/ BRIAN V. TURNERROY B. GOODMAN

Brian V. TurnerRoy B. Goodman
 Senior Vice President, Finance and Operations,
Chief Financial Officer and Treasurer
(Principal Financial and Accounting Officer)
/s/ ERIC A. BENHAMOU

Eric A. Benhamou
Director
 
/s/ EDWARD BLEIER

Edward Bleier
 Director
 
/s/ JAMES W. BREYER

James W. Breyer
 Director
 
/s/ JEREMY JAECH

Jeremy Jaech
 Director
 
/s/ JONATHAN D. KLEIN

Jonathan D. Klein
 Director
 
/s/ KALPANA RAINA

Kalpana Raina
 Director

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CERTIFICATION

     I, Robert Glaser, certify that:

1.I have reviewed this annual report on Form 10-K of RealNetworks, Inc.;
2.Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report;
3.Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report;
4.The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:

a)designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared;
b)evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the “Evaluation Date”); and
c)presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

5.The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent functions):

a)all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and
b)any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and

6.The registrant’s other certifying officer and I have indicated in this annual report whether there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.

Date: March 28, 2003

/s/ ROBERT GLASER

Robert Glaser
Chairman and Chief Executive Officer
(Principal Executive Officer)

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CERTIFICATION

     I, Brian V. Turner, certify that:

     1. I have reviewed this annual report on Form 10-K of RealNetworks, Inc.;
     2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report;
     3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report;
     4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:

     a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared;
     b) evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the “Evaluation Date”); and
     c) presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

     5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent functions):

     a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and
     b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and

     6. The registrant’s other certifying officer and I have indicated in this annual report whether there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.

Date: March 28, 2003

/s/ BRIAN V. TURNER

Brian V. Turner
Senior Vice President, Finance and Operations,
Chief Financial Officer and Treasurer
(Principal Financial Officer)

92


INDEPENDENT AUDITORS’ REPORT

The Board of Directors and Shareholders

RealNetworks, Inc.:

     Under date of January 17, 2003, we reported on the consolidated balance sheets of RealNetworks, Inc. and subsidiaries as of December 31, 2002 and 2001, and the related consolidated statements of operations and comprehensive loss, shareholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2002, which are included in the 2002 annual report on Form 10-K of RealNetworks, Inc. In connection with our audits of the aforementioned consolidated financial statements, we also audited the related consolidated financial statement schedule of valuation and qualifying accounts. This consolidated financial statement schedule is the responsibility of the Company’s management. Our responsibility is to express an opinion on this consolidated financial statement schedule based on our audits.

     In our opinion, such consolidated financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.

/s/ KPMG LLP

Seattle, Washington

January 17, 2003

9389


SCHEDULE II — VALUATION AND QUALIFYING ACCOUNTS

REALNETWORKS, INC. AND SUBSIDIARIES

Years Ended December 31, 2003, 2002, 2001 2000
                                  
AdditionsAdditions
Balance atCharged toBalance atBalance atCharged toBalance at
BeginningCosts andEnd ofBeginningCosts andEnd of
DescriptionDescriptionof PeriodExpensesDeductionsPeriodDescriptionof PeriodExpensesDeductionsPeriod






(In thousands)
Year ended December 31, 2003:Year ended December 31, 2003: 
Valuation accounts deducted from assets 
 Allowance for doubtful accounts receivable $974 803 (499) $1,278 






 Allowance for sales returns 1,527 9,303 (9,250) 1,580 
 
 
 
 
 
(In thousands) Total 2,501 10,106 (9,749) 2,858 
Year ended December 31, 2002:Year ended December 31, 2002: Year ended December 31, 2002: 
Valuation accounts deducted from assets Valuation accounts deducted from assets 
 Allowance for doubtful accounts receivable $576 403 (5) 974  Allowance for doubtful accounts receivable 576 403 (5) 974 
 Allowance for sales returns 1,247 8,209 (7,929) 1,527  Allowance for sales returns 1,247 8,209 (7,929) 1,527 
 
 
 
 
   
 
 
 
 
 Total 1,823 8,612 (7,934) 2,501  Total 1,823 8,612 (7,934) 2,501 
Year ended December 31, 2001:Year ended December 31, 2001: Year ended December 31, 2001: 
Valuation accounts deducted from assets Valuation accounts deducted from assets 
 Allowance for doubtful accounts receivable 948 507 (879) 576  Allowance for doubtful accounts receivable 948 507 (879) 576 
 Allowance for sales returns 1,360 7,390 (7,503) 1,247  Allowance for sales returns 1,360 7,390 (7,503) 1,247 
 
 
 
 
   
 
 
 
 
 Total 2,308 7,897 (8,382) 1,823  Total 2,308 7,897 (8,382) 1,823 
Year ended December 31, 2000: 
Valuation accounts deducted from assets 
 Allowance for doubtful accounts receivable 828 1,107 (987) 948 
 Allowance for sales returns 1,154 9,119 (8,913) 1,360 
 
 
 
 
 
 Total 1,982 10,226 (9,900) 2,308 

94


EXHIBIT INDEXSCHEDULE — FINANCIAL STATEMENTS OF A 50%-OR-LESS-OWNED PERSON

MUSICNET, INC.

Financial Statements

December 31, 2003 and 2002
(With Independent Auditors’ Report Thereon)


MUSICNET, INC.

Table of Contents

     
ExhibitPage

1
2
3
4
5
6


INDEPENDENT AUDITORS’ REPORT

The Board of Directors

MusicNet, Inc.:

     We have audited the accompanying balance sheets of MusicNet, Inc. as of December 31, 2003 and 2002, and the related statements of operations, convertible preferred stock and stockholders’ deficit, and cash flows for each of the years in the three-year period ended December 31, 2003. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

     We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

     In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of MusicNet, Inc. as of December 31, 2003 and 2002, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2003 in conformity with accounting principles generally accepted in the United States of America.

     The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in note 2 to the financial statements, the Company has suffered recurring losses from operations that raise substantial doubt about the Company’s ability to continue as a going concern. Management’s plans in regard to these matters are also described in note 2. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.

/s/ KPMG LLP

Seattle, Washington
February 13, 2004


MUSICNET, INC.

BALANCE SHEETS

December 31, 2003 and 2002
           
20032002


ASSETS
Current assets:        
 Cash and cash equivalents $2,212,217   6,574,510 
 Trade accounts receivable from related parties  2,313,740   130,018 
 Prepaid license fees to related parties  158,830   818,565 
 Prepaid license fees  1,870,760   1,695,343 
 Prepaid advertising fee to related party     200,000 
 Prepaid expenses  784,601   892,292 
 Other receivables from related party  160,413   72,917 
   
   
 
  Total current assets  7,500,561   10,383,645 
Prepaid license fees to related parties, net of current portion     479,401 
Prepaid license fees, net of current portion  62,362   1,596,657 
Deposit held by related party  68,880   68,880 
Deposits  234,248   234,248 
Property and equipment, net  2,481,348   4,268,388 
Loan receivable from officer  806,250   761,250 
   
   
 
  Total assets $11,153,649   17,792,469 
   
   
 
LIABILITIES, CONVERTIBLE PREFERRED STOCK, AND STOCKHOLDERS’ DEFICIT
Current liabilities:        
 Accounts payable $103,151   583,761 
 Accrued expenses  2,772,875   2,106,255 
   
   
 
  Total current liabilities  2,876,026   2,690,016 
Convertible notes payable to related parties  9,200,000   6,200,000 
Convertible notes payable  1,886,205   1,886,205 
Accrued interest on convertible notes payable to related parties  569,500   77,500 
Accrued interest on convertible notes payable  122,603   9,431 
   
   
 
  Total liabilities  14,654,334   10,863,152 
   
   
 
Commitments and contingencies        
Convertible preferred stock, $0.001 par value. Authorized 47,200,000 shares; issued and outstanding 34,439,804 shares with an aggregate liquidation preference of $49,109,866 at December 31, 2003  47,380,598   35,943,599 
Stockholders’ deficit:        
 Common stock, Class A, $0.001 par value. Authorized zero and 3,000,000 shares at December 31, 2003 and 2002, respectively; issued and outstanding zero and 3,000,000 shares at December 31, 2003 and 2002, respectively     3,000 
 Common stock, Class B, $0.001 par value. Authorized zero and 44,000,000 shares at December 31, 2003 and 2002, respectively; issued and outstanding zero and 15,550 shares at December 31, 2003 and 2002, respectively     16 
 Common stock, $0.001 par value. Authorized 51,200,000 and zero shares at December 31, 2003, and 2002, respectively; issued and outstanding 15,550 and zero shares at December 31, 2003 and 2002, respectively  16    
 Additional paid-in capital  6,214   6,993,214 
 Accumulated deficit  (50,887,513)  (36,010,512)
   
   
 
  Total stockholders’ deficit  (50,881,283)  (29,014,282)
   
   
 
  Total liabilities, convertible preferred stock, and stockholders’ deficit $11,153,649   17,792,469 
   
   
 

See accompanying notes to financial statements.

2


MUSICNET, INC.

STATEMENTS OF OPERATIONS

Years ended December 31, 2003, 2002, and 2001
               
200320022001



Sales to related parties $6,411,539   1,263,533    
Cost of sales  (5,892,190)  (2,264,971)   
Amortization of prepaid royalty to related party     (583,333)   
Impairment of prepaid royalty to related party     (2,916,667)   
   
   
   
 
  Gross margin  519,349   (4,501,438)   
   
   
   
 
Operating expenses:            
 Product development  8,406,369   8,763,581   8,003,519 
 General and administrative  3,310,337   4,524,102   4,175,455 
 Selling and marketing  3,437,329   2,705,275   1,243,984 
 Amortization of maintenance fee        700,000 
   
   
   
 
   15,154,035   15,992,958   14,122,958 
   
   
   
 
  Operating loss  (14,634,686)  (20,494,396)  (14,122,958)
Other income (expense):            
 Interest income  87,860   93,509   766,164 
 Other income, net  274,997   709,999   31,310 
 Interest expense  (605,172)  (86,931)   
   
   
   
 
  Net loss $(14,877,001)  (19,777,819)  (13,325,484)
   
   
   
 

See accompanying notes to financial statements.

3


MUSICNET, INC.

STATEMENTS OF CONVERTIBLE PREFERRED STOCK AND STOCKHOLDERS’ DEFICIT

Years ended December 31, 2003, 2002, and 2001
                             
Convertible Preferred StockCommon StockAdditionalTotal


Paid-inAccumulatedStockholders’
SharesAmountSharesAmountCapitalDeficit(Deficit) Equity







Balance at December 31, 2000  5,000,000  $10,010,000   3,000,000  $3,000   6,987,000   (2,907,209)  4,082,791 
Issuance of Series A and B preferred stock, net of issuance costs of $262,495  14,000,000   14,737,505                
Issuance of Series B preferred stock, net of issuance costs of $17,125  1,913,044   2,068,093                
Issuance of Class B common stock upon exercise of employee stock options        1,001   1   409      410 
Net loss                 (13,325,484)  (13,325,484)
   
   
   
   
   
   
   
 
Balance at December 31, 2001  20,913,044   26,815,598   3,001,001   3,001   6,987,409   (16,232,693)  (9,242,283)
Issuance of Series C preferred stock, net of issuance costs of $171,999  6,838,236   9,128,001                
Issuance of Class B common stock upon exercise of employee stock options        14,549   15   5,805      5,820 
Net loss                 (19,777,819)  (19,777,819)
   
   
   
   
   
   
   
 
Balance at December 31, 2002  27,751,280   35,943,599   3,015,550   3,016   6,993,214   (36,010,512)  (29,014,282)
Issuance of Series D preferred stock, net of issuance costs of $53,000  3,688,524   4,446,999                
Conversion of Class A common stock into Series AA convertible preferred stock  3,000,000   6,990,000   (3,000,000)  (3,000)  (6,987,000)     (6,990,000)
Net loss                 (14,877,001)  (14,877,001)
   
   
   
   
   
   
   
 
Balance at December 31, 2003  34,439,804  $47,380,598   15,550  $16   6,214   (50,887,513)  (50,881,283)
   
   
   
   
   
   
   
 

See accompanying notes to financial statements.

4


MUSICNET, INC.

STATEMENTS OF CASH FLOWS

Years Ended December 31, 2003, 2002, and 2001
                 
200320022001



Cash flows from operating activities:            
 Net loss $(14,877,001) $(19,777,819) $(13,325,484)
 Adjustments to reconcile net loss to net cash used in operating activities:            
  Depreciation and amortization  2,238,331   1,790,149   742,398 
  Amortization of maintenance fee to related party        700,000 
  Amortization of prepaid royalty to related party     583,333    
  Loss on disposal of assets        41,577 
  Loss on impairment of prepaid royalty to related party     2,916,667    
  Amortization of prepaid license fees to related parties  1,952,175   705,034    
  Interest on loan receivable from officer  (45,000)  (11,250)   
  Change in certain assets and liabilities:            
   Trade accounts receivable from related parties  (2,183,722)      
   Prepaid license fee to related party  (250,000)  (2,250,000)  (1,600,000)
   Prepaid license fees  795,839   (1,445,000)   
   Prepaid advertising fee to related party  200,000      (200,000)
   Prepaid royalty and maintenance fees to investor        (4,200,000)
   Other receivables from related party  (87,496)  (129,609)  (73,326)
   Other assets  107,691   (979,037)  (147,503)
   Deposit held by related party        (36,005)
   Accounts payable  (480,610)  354,901   67,697 
   Accrued expenses  666,620   1,599,695   2,392,765 
   Accrued interest  605,172   86,931    
   Payable to related party     (219,988)  (3,475,711)
   Deferred revenue     (200,000)  200,000 
   
   
   
 
    Net cash used in operating activities  (11,358,001)  (16,975,993)  (18,913,592)
   
   
   
 
Cash flows from investing activities:            
 Purchases of property and equipment  (451,291)  (2,264,883)  (3,671,401)
 Proceeds from sale of property and equipment        15,000 
 Loan receivable from officer     (750,000)   
   
   
   
 
    Net cash used in investing activities  (451,291)  (3,014,883)  (3,656,401)
   
   
   
 
Cash flows from financing activities:            
 Proceeds from convertible notes payable  3,000,000   6,200,000    
 Net cash proceeds from issuances of preferred stock  4,446,999   9,128,001   16,805,598 
 Net cash proceeds from issuance of common stock     5,820   410 
   
   
   
 
    Net cash provided by financing activities  7,446,999   15,333,821   16,806,008 
   
   
   
 
    Net decrease in cash and cash equivalents  (4,362,293)  (4,657,055)  (5,763,985)
Cash and cash equivalents at beginning of year  6,574,510   11,231,565   16,995,550 
   
   
   
 
Cash and cash equivalents at end of year $2,212,217  $6,574,510  $11,231,565 
   
   
   
 
Supplemental disclosure of noncash activity:            
 Issuance of convertible promissory note in lieu of making cash payments $  $1,886,205  $ 

See accompanying notes to financial statements.

5


MUSICNET, INC.

NOTES TO FINANCIAL STATEMENTS

December 31, 2003, 2002, and 2001

(1) Nature of Business and Summary of Significant Accounting Policies

     (a) Nature of Business

     MusicNet, Inc., formerly “Havana, Inc.” and “Musicnet.com, Inc.,” (the Company) was incorporated on December 17, 1999 in the State of Delaware. The Company offers a music subscription service featuring on-demand downloads and streams of music from all the major recording labels. The Company has offices in New York, New York and Seattle, Washington.

     From inception through December 31, 2001, the Company had been in the development stage and its activities principally consisted of developing its product, entering into collaborative agreements, recruiting personnel, and obtaining financing. During its development stage, the Company did not generate revenues from its product and technology efforts. The Company commenced principal operations during 2002.

     (b) Cash and Cash Equivalents

     The Company’s cash and cash equivalents are comprised of a checking account and money market accounts held with major U.S. financial entities. The Company considers all highly liquid investments with an original maturity of three months or less when purchased to be cash equivalents.

     (c) Trade Accounts Receivable from Related Party

     Trade accounts receivable are recorded at the invoiced amount and do not bear interest. The trade accounts receivable balance at December 31, 2003 is due from a distributor that is a related party. The December 31, 2002 accounts receivable balance was due from a different distributor that is also a related party. The Company has not experienced any bad debts to date and does not anticipate credit losses from the accounts receivable balance due at December 31, 2003 from its one related party distributor. As such, the Company has not established an allowance for doubtful accounts at either December 31, 2003 or December 31, 2002.

     (d) Property and Equipment

Property and equipment are stated at cost. Depreciation and amortization are provided using the straight-line method over the following estimated useful lives:

Estimated
Useful Life

Computer equipment and software3 years
Furniture and fixtures3 years
Leasehold improvementsLesser of lease
term or 5 years
Building35 years

     Expenditures for maintenance and repairs are expensed as incurred.

     (e) Revenue Recognition

     The Company recognizes revenue from content subscription services. The Company recognizes revenue when the Company’s services have been provided, collection of the relevant receivable is probable, persuasive evidence of an arrangement exists and the sales price is fixed and determinable.

     During 2003, the Company generated all of its revenues from two related party distributors of the Company’s products. One distributor comprised approximately 89% of revenues while the second distributor

6


MUSICNET, INC.

NOTES TO FINANCIAL STATEMENTS — (Continued)

December 31, 2003, 2002, and 2001

comprised approximately 11% of revenues. During 2002, all of the Company’s revenue was generated from one related party distributor.

     (f) Cost of Sales

     Cost of sales includes content, publishing and technology costs. Cost of sales includes amortization of prepaid license fees to investors of $1,952,175, $705,034, and $0 in 2003, 2002, and 2001, respectively. Cost of sales also includes expenses associated with use of an related party’s digital rights management software of $116,115, $22,437, and $0 in 2003, 2002, and 2001, respectively.

     (g) Product Development, Advertising and Software Development

     Product development costs are expensed as incurred. Advertising costs are not significant in 2003, 2002, and 2001. Software development costs are required to be capitalized when a product’s technological feasibility has been established through the date the product is available for general release to customers. The Company has not capitalized any software development costs as technological feasibility is generally not established until a working model is completed, at which time substantially all development is complete.

     (h) Impairment of Long-Lived Assets

Effective January 1, 2002, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 144,Accounting for the Impairment or Disposal of Long-Lived Assets. SFAS No. 144 supersedes SFAS No. 121,Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of. SFAS No. 144 excludes goodwill from its impairment scope, allows different approaches in cash flow estimation, and extends discontinued operations treatment, previously applied only to operating segments, to more discrete business components. The impairment model under SFAS No. 144 is otherwise largely unchanged from SFAS No. 121, and adoption of this standard did not have a material effect on the Company’s financial statements.

     In accordance with SFAS No. 144, long-lived assets, such as property, plant, and equipment, and purchased intangibles subject to amortization, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its undiscounted estimated future cash flows, an impairment charge is recognized by the amount by which the carrying amount of the asset exceeds the fair value of the asset. Assets to be disposed of would be separately presented in the balance sheet and reported at the lower of the carrying amount or fair value less costs to sell, and are no longer depreciated. The assets and liabilities of a disposed group classified as held for sale would be presented separately in the appropriate asset and liability sections of the balance sheet.

     Intangible assets not subject to amortization are tested annually for impairment, and are tested for impairment more frequently if events and circumstances indicate that the asset might be impaired. An impairment loss is recognized to the extent that the carrying amount exceeds the asset’s fair value.

     In September 2002, the Company recognized an impairment loss on the prepaid royalty to investor of $2,916,667. Refer to note 5(c).

     (i) Income Taxes

     Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax

7


MUSICNET, INC.

NOTES TO FINANCIAL STATEMENTS — (Continued)

December 31, 2003, 2002, and 2001

credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. A valuation allowance is recorded to reduce deferred tax assets to amounts which are more likely than not to be realized.

     (j) Use of Estimates

     The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Significant items subject to such estimates and assumptions include the carrying amount of property and equipment and license fees and accrued liabilities for certain royalties. Actual results could differ from those estimates.

     (k) Financial Instruments and Concentrations of Risk

     The Company’s financial instruments consist of cash, cash equivalents, accounts receivable, and accounts payable. The fair value of these instruments approximates their financial statement carrying amounts due to their short maturities.

The Company is dependent on the five major record companies, four of whom are investors, for distribution rights of its music service. The original agreements were entered into during 2001 and 2002 for a three-year period. As these record companies represent a significant percentage of the music industry’s distributors, if these record companies discontinued supplying distribution rights to the Company or do not renew these agreements upon expiration in 2004 to 2005, it would have a material adverse impact on the Company’s financial position, results of operations, and liquidity.

(l)                     Stock-Based Compensation

The Company applies the intrinsic-value-based method of accounting prescribed by Accounting Principles Board (APB) Opinion No. 25,Accounting for Stock Issued to Employees, and related interpretations including Financial Accounting Standards Board (FASB) Interpretation No. 44,Accounting for Certain Transactions involving Stock Compensation, an interpretation of APB Opinion No. 25, issued in March 2000, to account for its fixed-plan stock options. Under this method, compensation expense is recorded on the date of grant only if the fair value of the underlying stock exceeded the exercise price. SFAS No. 123,Accounting for Stock-Based Compensation, established accounting and disclosure requirements using a fair-value-based method of accounting for stock-based employee compensation plans. As allowed by SFAS No. 123, and SFAS No. 148,Accounting for Stock-Based Compensation — Transition and Disclosure, the Company has elected to continue to apply the intrinsic-value-based method of accounting described above, and has adopted only the disclosure requirements of SFAS No. 123 and SFAS No. 148. The following table illustrates the

8


MUSICNET, INC.

NOTES TO FINANCIAL STATEMENTS — (Continued)

December 31, 2003, 2002, and 2001

effect on net loss if the fair-value-based method had been applied to all outstanding and unvested awards in each period.

              
200320022001



Net loss:            
 As reported $(14,877,001)  (19,777,819)  (13,325,484)
 Deduct stock-based employee compensation determined under fair value based method for all awards  (34,991)  (29,557)  (18,998)
   
   
   
 
  $(14,911,992)  (19,807,376)  (13,344,482)
   
   
   
 

     On the date of grant, the per share weighted average values of stock options granted to employees and officers during 2003, 2002 and 2001, was $0.04, $0.05, and $0.05, respectively.

The per share weighted average value of stock options granted to employees and officers during 2003, 2002, and 2001 on the date of grant was determined using the minimum value method with the following assumptions: expected dividend yield of 0%, risk-free interest rates ranging from 1.63% to 4.71% and an expected life of five years.

(m)                     Reclassifications

Certain reclassifications have been made to the 2002 and 2001 financial statements for consistent presentation.

Number(2) Liquidity

     The accompanying financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. As shown in the financial statements, the Company has incurred net losses and negative operating cash flows. The Company’s continuance as a going concern is dependent on its ability to raise capital and ultimately to achieve profitability.

     Management is presently evaluating capital sources to sustain the Company. No assurances can be given that the Company will be successful in raising additional capital or that the Company will achieve profitability or positive cash flows. If the Company is unable to raise adequate additional capital and achieve profitability and positive cash flows, there can be no assurance that the Company will continue as a going concern.

     The financial statements do not include adjustments relating to the recoverability of recorded asset amounts or the amounts or classification of liabilities that might be necessary should the Company be unable to continue as a going concern.

9


MUSICNET, INC.

NOTES TO FINANCIAL STATEMENTS — (Continued)

December 31, 2003, 2002, and 2001
(3) DescriptionProperty and Equipment

Property and equipment consist of the following at December 31, 2003 and 2002:

         
20032002


Computer equipment and software $6,147,731   5,758,883 
Furniture and fixtures  486,060   460,352 
Leasehold improvements  505,419   468,684 
Building  116,786   116,786 
Land  38,929   38,929 
   
   
 
   7,294,925   6,843,634 
Less accumulated depreciation and amortization  (4,813,577)  (2,575,246)
   
   
 
  $2,481,348   4,268,388 
   
   
 


(4) 
Accrued Expenses

 21.1     Accrued expenses consist of the following at December 31, 2003 and 2002:

         
20032002


Professional fees $251,370   214,075 
Payroll and related expenses  438,977   514,360 
Computer equipment and software support  155,469   503,467 
Publishing royalties and other cost of sales related accruals  1,825,771   218,503 
Other  101,288   655,850 
   
   
 
  $2,772,875   2,106,255 
   
   
 
(5) Related Party Transactions

     The Company has five investors that entered into arrangements with the Company relating to the Company’s offering of on demand downloads and streaming music. All agreements were entered into in April 2001 unless otherwise stated:

Subsidiaries of RealNetworks, Inc.
 23.1(a) The Company entered into subscription service agreements in April 2001 with three of its investors, in July 2001 with a fourth investor and in November 2002 with a convertible note holder. These agreements permit the Company to copy, store, transmit and distribute music in digital form to customers for a fee. In 2002, the Company renegotiated the terms of certain subscription services agreements entered into in 2001. A total of $250,000, $400,000, and $1,600,000 of prepaid service fees have been paid to investors under these agreements and $1,136,143, $705,034, and $0, was amortized as costs of sales in 2003, 2002, and 2001, respectively. These prepaid service fees are included as prepaid license fee to investors in the balance sheets at December 31, 2003 and 2002. Under an agreement with one investor, $200,000 was paid in 2001 for future advertising services. In 2003, the Company determined it would not use such services and expensed the full amount of the prepaid in 2003. Additionally, the Company entered into digital download agreements with certain investors and other distributors of music in 2002.
 Consent of KPMG LLP
 99.1(b) In April 2001, the Company entered into separate distribution agreements with two of its investors.

10


MUSICNET, INC.

NOTES TO FINANCIAL STATEMENTS — (Continued)

December 31, 2003, 2002, and 2001

Certification of Robert Glaser, Chairman and Chief Executive Officer of RealNetworks, Inc., Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
 99.2(c) In April 2001, the Company entered into an Infrastructure Software License Agreement (ISLA) with an investor under which the Company licensed a software solution for streaming recorded music content provided to end users. Under this agreement $4.2 million was paid to an investor in 2001 representing prepaid license fees of $3.5 million and $700,000 of prepaid maintenance fees. This license fee of $3.5 million had been included as prepaid royalty and maintenance fees to investors in the balance sheet at December 31, 2001. The Company amortized $583,333 of maintenance fees in 2002 with the remaining $2,916,667 recognized as an impairment loss upon the modification of the agreement in September 2002 to reflect diminished benefits arising from the license. As a part of this decision, the Company reduced its committed maintenance fee payments to $675,000 through April 2006, from $700,000 annually. Refer to note 6(b). Maintenance fees of $218,875, $100,000, and $700,000 were paid in 2003, 2002, and 2001, respectively. In addition to the license fee the Company pays a royalty for use of the Digital Rights Management (DRM) System software for the term of the agreement. The royalty expense recorded was $116,115, $22,437, and $0 in 2003, 2002, and 2001, respectively. Other arrangements with this investor include:

  Certification of Brian V. Turner, Senior Vice President, FinanceThe Company entered into several ancillary technology agreements with the investor such as the software development kit (SDK) license agreement and Operations, Chief Financial Officerthe intellectual property and Treasurer of RealNetworks, Inc., Pursuantsoftware license agreements that each expire in April 2006. There were no license fees to 18 U.S.C. Section 1350,the Company for these ancillary rights.
• A corporate services agreement for various corporate support services such as Adopted Pursuantfinance, tax, human resources and legal, etc. Corporate service expenses incurred under this agreement were $0, $0, and $1,147,000 for 2003, 2002, and 2001, respectively.
• Sub-leasing office space. Refer to Section 906note 6(a).
• During 2001, the Company reimbursed this investor approximately $3.7 million for operating and administrative expenses that were paid by the investor on behalf of the Sarbanes-Oxley ActCompany.
• In December 2001, the Company entered into a services agreement with the investor for the provision of streaming media services through August 2004. The agreement was amended in 2002 to adjust the term to end in January 2004 and reduce the minimum monthly fee commitment based on usage to $30,000. Refer to note 6(b). A total of $240,000 and $461,730 was paid under this agreement in 2003 and 2002, respectively.

(6) Commitments and Contingencies
(a) Office Space

The Company currently leases office space under a noncancelable operating lease with an investor which expires in September 2004. Future minimum payments under this lease are $619,920 in 2004. Rent expense under this lease was $826,564, $826,564, and $998,000, in 2003, 2002, and 2001, respectively. The Company currently also leases office space under a noncancelable operating lease with an unrelated party in New York. As of December 31, 2003, future minimum payments under all noncancelable operating leases are as follows:

      
2004 $1,088,416 
2005  468,496 
2006  39,041 
   
 
 Future minimum lease payments $1,595,953 
   
 

11


MUSICNET, INC.

NOTES TO FINANCIAL STATEMENTS — (Continued)

December 31, 2003, 2002, and 2001

Total rent and occupancy expense for 2003, 2002, and 2001, totaled $1,338,765, $1,021,786, and $998,000, respectively.

(b) Technology

As discussed in note 5(c) above, the Company pays an investor an annual maintenance and upgrade fee for the DRM which is $200,000 in 2004, $200,000 in 2005, and $50,000 in 2006. The fees to the same investor for the streaming media services are $30,000 in 2004.

(c) Warranties

The Company has entered into service level agreements providing warranties that certain levels of uptime reliability will be achieved. In the event that the Company fails to meet required levels of service, refunds may be due to its customer. To date, the Company has not provided credits or other concessions related to these service level agreements.

(7) Income Taxes

     The Company has accumulated a net operating loss carryforward of approximately $48 million through December 31, 2003. This carryforward will begin to expire in 2020. Certain research and development tax credits of approximately $714,000 will begin to expire in 2021.

     Because the Company has incurred losses since inception, and it is more likely than not that deferred tax assets will not be realizable, a valuation allowance entirely offsetting deferred tax assets has been established, thereby eliminating any deferred tax benefit in 2003 and 2002. The increase in the valuation allowance of approximately $5.4 million and $8.7 million in 2003 and 2002, respectively, is primarily the result of the net operating losses incurred each year.

The tax effects of temporary differences and carryforwards that give rise to significant portions of deferred tax assets and deferred tax liabilities at December 31, 2003 and 2002 are as follows:

           
20032002


Deferred tax assets:        
 Net operating loss carryforwards $16,312,000   11,116,000 
 Prepaid royalty  714,000   992,000 
 Research credit carryforward  714,000   394,000 
 Other  5,000   46,000 
 Accrued compensation accruals  172,000   71,000 
   
   
 
  Gross deferred tax assets  17,917,000   12,619,000 
Less valuation allowance  (17,900,000)  (12,547,000)
   
   
 
   17,000   72,000 
Deferred tax liabilities — property and equipment  (17,000)  (72,000)
   
   
 
  Net deferred tax assets $    
   
   
 

     Under certain provisions of the Internal Revenue Code of 1986, as amended, the availability of net operating loss and tax credit carryforwards may be subject to limitation if it should be determined that there has been a change in ownership of more than 50% of the stock. Such determination could limit the utilization of net operating loss and tax credit carryforwards.

12


MUSICNET, INC.

NOTES TO FINANCIAL STATEMENTS — (Continued)

December 31, 2003, 2002, and 2001
(8) Convertible Notes Payable

     In July 2002, the Company borrowed $2,325,000 from an existing investor by issuing a convertible promissory note which matures in July 2009. In November 2002, the Company borrowed an additional $3,875,000 from this investor by issuing another convertible promissory note which matures in November 2009. These notes carry interest at a rate of 6% per annum. All interest is payable on the maturity date. The principal amount of each note is convertible, in whole or in part, at any time at the option of the holder into shares of Series C Preferred Stock at a conversion price of $1.36 per share. All interest accrued on the principal amount converted is forfeited by the investor. The note automatically converts in the case of an acquisition of the Company or upon the occurrence of certain bankruptcy and insolvency events or upon a liquidation or dissolution of the Company. The Company may prepay each note at any time on or after the fourth anniversary of the date of such note.

     In April 2003, the Company borrowed an additional $3,000,000 from this investor by issuing a convertible promissory note which matures in April 2010. This note carries interest at a rate of 6% per annum. The principal amount of the note is convertible, in whole or in part, at any time at the option of the holder into shares of Series D Preferred Stock at a conversion price of $1.22 per share. All interest accrued on the principal amount converted is forfeited by the investor. The note automatically converts in the case of an acquisition of the Company or upon the occurrence of certain bankruptcy and insolvency events or upon a liquidation or dissolution of the Company. The Company may prepay this note at any time on or after the fourth anniversary of the date of such note.

     The Company recorded $492,000 and $77,500 of interest expense in 2003 and 2002, respectively, from these notes.

In November 2002, the Company issued a convertible promissory note in the principal amount of $1,886,205 to an unrelated party in lieu of making certain payments due to such party. The note carries interest at a rate of 6% per annum and matures in December 2005. Interest is payable only on the maturity date. The principal amount of the note and accrued interest thereon is convertible into Series C Preferred Stock at a conversion price of $1.36 per share only on the maturity date. The note cannot be prepaid. The Company recorded $113,172 and $9,431 of interest expense in 2003 and 2002, respectively, from this note.

(9) Convertible Preferred Stock

At December 31, 2003, convertible preferred stock consisted of the following:

             
Shares

Aggregate
Issued andLiquidation
AuthorizedOutstandingPreference



Series A  5,800,000   5,800,000  $10,614,000 
Series AA  3,000,000   3,000,000   4,530,000 
Series B  15,200,000   15,113,044   16,473,218 
Series C  17,000,000   6,838,236   12,992,648 
Series D  6,200,000   3,688,524   4,500,000 
   
   
   
 
   47,200,000   34,439,804  $49,109,866 
   
   
   
 

     The outstanding Series A, AA, B, C, and D Convertible Preferred Stock carry noncumulative dividends of 6% per annum on the original issue price. No dividends have ever been declared. As of December 31, 2003, the Series A, AA, B, C, and D Convertible Preferred Stock have per share liquidation preferences of $1.83,

13


MUSICNET, INC.

NOTES TO FINANCIAL STATEMENTS — (Continued)

December 31, 2003, 2002, and 2001

$1.51, $1.09, $1.90, and $1.22, respectively. Each class of preferred stock ranks pari passu with each other, and in priority to the Common Stock.

     The Preferred Stock is convertible at the option of the holder into Common Stock at a rate of the original issue price divided by the conversion price, which is equal to the liquidation preferences noted above for Series A, AA, B, and D Preferred Stock. The Series C Preferred Stock is convertible at the option of the holder into Common Stock at a rate of the original issue price ($1.36) divided by the conversion price, which is also $1.36. The conversion prices are subject to customary anti-dilution adjustments.

     The Preferred Stock shall automatically convert into Common Stock upon the closing of an underwritten initial public offering provided the offering raises at least $30,000,000 of cash proceeds to the Company at a price per share of not less than $10.00 (“Qualified Public Offering”). In addition, a series of Preferred Stock shall automatically convert into Common Stock if the holders of at least 60% of the then outstanding shares of such series of Preferred Stock vote to convert.

     Holders of the Preferred Stock are entitled to certain approval rights. So long as any shares of a particular class of Preferred Stock is outstanding, the Company may not, without first obtaining the approval of holders of at least 60 percent of the then outstanding shares of Series B, C, and D Preferred Stock and a majority of the then outstanding shares of Series A and AA Preferred Stock, voting together by class of Preferred Stock: (i) make or effect any amendments, waivers or other changes to the August 2003 amended and restated certificate of incorporation or the Company’s by-laws or adopt any certificate of designation if such amendment, waiver, change or adoption would materially and adversely change the rights, preferences or privileges of the particular class of Preferred Stock, or (ii) create any class or series of shares with rights, preferences or privileges which are senior to the particular class of Preferred Stock.

     Holders of Preferred Stock are entitled one vote for each share of Common Stock to which the Preferred Stock is convertible at any stockholders’ meeting. Except as required by law or the Company’s Amended and Restated Certificate of Incorporation, holders of Common Stock and Preferred Stock vote together as one class on all matters submitted to a vote of the stockholders.

A merger or consolidation of the Company into another entity in which the stockholders of the Company own less than 55% of the combined voting power of the then outstanding shares of the surviving entity, or the sale, lease or other disposition of all or substantially all assets of the Company will be deemed a liquidation event. Holders of convertible preferred stock are entitled to be paid out of the assets of the Company their share of such proceeds according to their respective liquidation preferences upon a liquidation event. These liquidation characteristics require classification of the convertible preferred stock outside of the equity section of the accompanying balance sheet.

(10) Common Stock

     Dividends on common stock are shared equally, on a per share basis, in any dividends that may be declared on the Common Stock subject to the prior rights of holders of Preferred Stock. If, after the payment to holders of the Preferred Stock their entire preference amounts, assets or surplus funds remain in the Company, the holders of Common Stock are entitled to receive on a pro rata basis all of such remaining assets and surplus funds.

     Holders of Common Stock are entitled to one vote per share at any stockholders’ meeting. Except as required by law or the Company’s Amended and Restated Certificate of Incorporation, holders of Common Stock and Preferred Stock vote together as one class on all matters submitted to a vote of the stockholders.

14


MUSICNET, INC.

NOTES TO FINANCIAL STATEMENTS — (Continued)

December 31, 2003, 2002, and 2001

In connection with the Company amending and restating its certificate of incorporation in August 2003, each share of Class A Common Stock was converted into shares of Series AA Preferred Stock and each share of Class B Common Stock was converted into Common Stock.

(11) Stock Option Plans

     The Company has adopted the 2000 Stock Option Plan (the Plan), which provides for the granting of incentive and nonqualified common stock options for key employees, directors and consultants. No options have been granted to consultants through December 31, 2003. The board of directors has reserved 3,444,444 shares of common stock to be issued in conjunction with the Plan. The board of directors is authorized to administer the Plan and establish the stock option terms, including grant price and vesting period.

     Incentive stock options typically vest over a five-year period and have an exercise price of not less than the fair market value of the stock on the grant date. During 2002, the Company modified the Plan such that outstanding nonqualified options and future nonqualified stock option grants are exercisable during continued employment or within two years from terminating employment. Previously, nonqualified stock options were exercisable during continued employment, or within ninety days of terminating employment. To date, no such option holders on the date of modification have exercised stock options and benefited from this modification. Should option holders as of the date of the modification benefit from the extended period of time after employment termination to exercise their stock option grants in the future, compensation expense may be required if the fair market value of the Company’s stock on the date of exercise exceeds the fair market value on the date of modification in 2002. Stock options typically expire ten years from the date of grant. If a participant owns more than 10% of the total voting power of all classes of the Company’s stock, then the exercise price per share of an incentive stock option shall not be less than 110% of the fair market value of the common stock on the grant date and the option term shall not exceed five years.

A summary of stock option activity is as follows:

             
Outstanding Options

SharesWeighted
Available forNumber ofAverage
GrantSharesExercise Price



Balance at December 31, 2000  2,000,000     $ 
Plan amendments  1,444,444       
Granted  (2,775,150)  2,775,150   3.08 
Forfeited  441,500   (441,500)  7.95 
Exercised     (1,001)  0.40 
   
   
     
Balance at December 31, 2001  1,110,794   2,332,649   2.05 
Granted  (870,000)  870,000   0.50 
Forfeited  302,460   (302,460)  3.52 
Exercised     (14,549)  0.40 
   
   
     
Balance at December 31, 2002  543,254   2,885,640   1.47 
Granted  (293,000)  293,000   0.50 
Forfeited  704,920   (704,920)  1.50 
Exercised         
   
   
     
Balance at December 31, 2003  955,174   2,473,720  $1.34 
   
   
     

15


MUSICNET, INC.

NOTES TO FINANCIAL STATEMENTS — (Continued)

December 31, 2003, 2002, and 2001

Options outstanding at December 31, 2003:

                     
Options Outstanding

Options Exercisable
Weighted
AverageWeightedWeighted
RemainingAverageAverage
ExerciseNumberContractualExerciseNumberExercise
PricesOutstandingLife (Years)PriceExercisablePrice






$ 0.40  1,427,106   7.66  $0.40   617,615  $0.40 
  0.50  812,100   9.39   0.50   177,600   0.50 
 10.00  234,514   6.75   10.00   163,614   10.00 
   
   
   
   
   
 
   2,473,720   8.78  $1.34   958,829  $2.06 
   
   
   
   
   
 

(12) 401(k) Plan

     Employees may participate in the Company’s 401(k) Plan (the Plan). Participating employees may contribute a portion of their salary to the Plan up to the maximum allowed by the federal tax guidelines. The Company may make discretionary contributions to the Plan. The Company made no contributions in 2003, 2002, or 2001.

(13) Legal Proceedings

     During 2001, the European Commission and the German Federal Cartel Office initiated certain requests for information relating to the Company and the online music business. Additionally, in October 2001, the Antitrust Division of the United States Department of Justice issued a Civil Investigation Demand (a request for information) to the Company relating to the online music business. In all instances noted, no complaint has been filed against the Company, and the Company is cooperating with the various regulatory authorities’ inquiries.

     The Company is also involved in various other claims and legal actions arising in the ordinary course of business whose ultimate disposition, in the opinion of management, will not have a material effect on the Company’s financial position, results of operations or liquidity.

(14) Loan and Put Agreement with Officer

     In October 2001, the Company executed an Offer Letter with an officer of the Company which gave the officer the option to borrow up to $750,000 at an interest rate of 6%, to be used solely for the purchase of a residence. The officer took a non-recourse promissory note for the amounts set forth above in September 2002. The amounts borrowed mature on the earlier of May 23, 2006 or nine months after termination of employment without cause. The Company recognized $45,000 and $11,250 of interest income on the loan in 2003 and 2002, respectively. In addition, the Company and officer entered into a Put Agreement in September 2002 in which the officer was granted a put right to require the Company to purchase all, but not less than all, of the shares that have been exercised under the officer’s stock option grants which have been owned by the officer for at least six months prior to the maturity date of the loan. As of December 31, 2003, the officer had not exercised any stock options. The put price is based on the then current fair value as determined by the board of directors, subject to the officer’s right to an appraisal. The put right will expire upon an IPO.

16


EXHIBIT INDEX

     
Exhibit
NumberDescription


 10.10 RealNetworks, Inc. Director Compensation Stock Plan
 14.1  RealNetworks, Inc. Code of Business Conduct and Ethics
 21.1  Subsidiaries of RealNetworks, Inc.
 23.1  Consent of KPMG LLP
 23.2  Consent of KPMG LLP
 31.1  Certification of Robert Glaser, Chairman and Chief Executive Officer of RealNetworks, Inc., Pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
 31.2  Certification of Roy B. Goodman, Senior Vice President, Chief Financial Officer and Treasurer of RealNetworks, Inc., Pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
 32.1  Certification of Robert Glaser, Chairman and Chief Executive Officer of RealNetworks, Inc., Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
 32.2  Certification of Roy B. Goodman, Senior Vice President, Chief Financial Officer and Treasurer of RealNetworks, Inc., Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002