Realnetworks 10Q 2001 Q3 Quarterly report

UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
_____________________

FORM 10-Q

[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

For the Quarterly Period Ended September 30, 2001

[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

Commission File Number 0-23137

REALNETWORKS, INC.

(Exact name of registrant as specified in its charter)


Washington (State of incorporation)		91-1628146 (I.R.S. Employer Identification Number)

2601 Elliott Avenue, Suite 1000 Seattle, Washington (Address of principal executive offices)		98121 (Zip Code)

(206) 674-2700
(Registrant’s telephone number, including area code)

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

The number of shares of the registrant’s Common Stock outstanding as of October 31, 2001 was 160,807,082.

TABLE OF CONTENTS


PART I. FINANCIAL INFORMATION
	Item 1. Financial Statements
	Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
	ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
PART II. OTHER INFORMATION
	ITEM 1. LEGAL PROCEEDINGS
SIGNATURES

REALNETWORKS, INC.

FORM 10-Q

FOR THE QUARTER ENDED September 30, 2001

TABLE OF CONTENTS


			Page

PART I.		FINANCIAL INFORMATION

Item 1.	Financial Statements		3

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		15

Item 3.	Quantitative and Qualitative Disclosures About Market Risk		40

PART II.		OTHER INFORMATION

Item 1.	Legal Proceedings		41

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

REALNETWORKS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS EXCEPT PER SHARE DATA)


			September 30,			December 31,
			2001			2000

ASSETS
Current assets:
	Cash, cash equivalents and short-term investments		$	348,207			364,710
	Trade accounts receivable, net of allowances for doubtful accounts and sales returns			8,458			8,647
	Deferred income taxes			9,780			10,777
	Prepaid expenses and other current assets			5,458			3,989

		Total current assets		371,903			388,123
Equipment and leasehold improvements, at cost:
	Equipment and software			33,580			28,979
	Leasehold improvements			25,296			25,670

		Total equipment and leasehold improvements		58,876			54,649
	Less accumulated depreciation and amortization			21,218			12,376

		Net equipment and leasehold improvements		37,658			42,273

Goodwill, net				70,434			104,861
Restricted cash equivalents				17,300			18,800
Deferred income taxes				11,459			3,365
Equity investments				24,694			20,055
Other				981			931

		Total assets	$	534,429			578,408

LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities:
	Accounts payable		$	4,182			7,727
	Accrued and other liabilities			36,300			36,552
	Deferred revenue, excluding non-current portion			34,062			38,522
	Accrued loss on excess office facilities, excluding non-current portion			4,364			—

		Total current liabilities		78,908			82,801

Deferred revenue, excluding current portion				16,017			12,747
Deferred rent				2,775			2,048
Accrued loss on excess office facilities, excluding current portion				8,206			—
Shareholders’ equity:
	Preferred stock, $0.001 par value per share, no shares issued and outstanding:
		Series A: authorized 200 shares		—			—
		Undesignated series: authorized 59,800 shares		—			—
	Common stock, $0.001 par value per share, authorized 1,000,000 shares; issued and outstanding 161,037 shares at September 30, 2001 and 159,214 shares at December 31, 2000			161			159
	Additional paid-in capital			632,418			692,245
	Deferred stock compensation			(1,270	)		(53,222	)
	Accumulated other comprehensive income (loss)			5,143			(13,384	)
	Accumulated deficit			(207,929	)		(144,986	)

		Total shareholders’ equity		428,523			480,812

		Total liabilities and shareholders’ equity	$	534,429			578,408

See accompanying notes to condensed consolidated financial statements

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REALNETWORKS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
AND COMPREHENSIVE LOSS
(IN THOUSANDS EXCEPT PER SHARE DATA)


					Quarters Ended						Nine Months Ended
					September 30,						September 30,

					2001			2000			2001			2000

Net revenues:
	Software license fees				$	26,751			39,725			84,416			111,850
	Service revenues					16,046			13,893			46,434			37,748
	Advertising					2,431			13,506			12,617			33,710

			Total net revenues			45,228			67,124			143,467			183,308

Cost of revenues:
	Software license fees					1,672			3,356			5,777			11,658
	Service revenues					6,077			3,753			17,217			9,899
	Advertising					1,418			2,876			4,953			6,709

			Total cost of revenues			9,167			9,985			27,947			28,266

			Gross profit			36,061			57,139			115,520			155,042

Operating expenses:
	Research and development (excluding non-cash stock based compensation of $361 and $(9,853) for the quarter and nine months ended September 30, 2001, respectively, and $24,908 and $67,143 for the comparable periods in 2000, included below)					12,500			16,095			43,556			41,019
	Sales and marketing (excluding non-cash stock based compensation of $0 and $(42) for the quarter and nine months ended September 30, 2001, respectively, and $1,195 and $3,256 for the comparable periods in 2000, included below)					17,540			27,506			56,020			77,152
	General and administrative					5,114			6,991			15,832			21,182
	Loss on excess office facilities					5,621			—			22,208			—
	Personnel reduction and related charges					3,893			—			3,893			—
	Goodwill amortization, acquisition charges, and stock based compensation					12,850			38,385			27,789			103,772

			Total operating expenses			57,518			88,977			169,298			243,125

			Operating loss			(21,457	)		(31,838	)		(53,778	)		(88,083	)
Other income (expense):
			Interest income			4,171			5,716			14,137			16,168
			Equity in net loss of MusicNet			(1,397	)		—			(2,334	)		—
			Impairment of equity investments			(2,495	)		—			(25,342	)		—
			Other, net			(365	)		(608	)		(1,309	)		(835	)

				Other income (expense), net		(86	)		5,108			(14,848	)		15,333

			Net loss before income taxes			(21,543	)		(26,730	)		(68,626	)		(72,750	)
Income tax provision (benefit)						(2,163	)		4,025			(5,683	)		4,025

				Net loss	$	(19,380	)		(30,755	)		(62,943	)		(76,775	)

Basic and diluted net loss per share					$	(0.12	)		(0.20	)		(0.39	)		(0.50	)

Shares used to compute basic and diluted net loss per share						161,203			154,992			160,132			153,392
Comprehensive loss:
		Net loss			$	(19,380	)		(30,755	)		(62,943	)		(76,775	)
		Unrealized gain (loss) on investments:
				Unrealized holding gains (losses)		5,561			(6,149	)		2,367			(7,914	)
				Adjustments for losses reclassified to net loss		2,059			—			16,519			—
		Foreign currency translation adjustment				97			94			(359	)		(85	)

				Comprehensive loss	$	(11,663	)		(36,810	)		(44,416	)		(84,774	)

See accompanying notes to condensed consolidated financial statements

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REALNETWORKS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)


				Nine Months Ended September 30,

				2001			2000

Cash flows from operating activities:
	Net loss			$	(62,943	)		(76,775	)
	Adjustments to reconcile net loss to net cash provided by operating activities:
		Depreciation and amortization of equipment and leasehold improvements			9,026			6,330
		Amortization of goodwill, related stock based compensation and acquisition charges			28,189			101,374
		Equity in net losses of equity method investments			2,673			—
		Accrued loss on excess office facilities			19,970			—
		Impairment of equity investments			25,342			—
		Income tax benefit related to stock options			1,391			3,934
		Deferred income taxes			(7,530	)		—
		Net change in certain operating assets and liabilities			(6,985	)		17,431

			Net cash provided by operating activities		9,133			52,294
Cash flows from investing activities:
	Purchases of equipment and leasehold improvements				(12,089	)		(17,669	)
	Purchases of short-term investments				(554,570	)		(624,396	)
	Sale and maturities of short-term investments				540,306			594,159
	Purchase of long-term equity investments				(18,878	)		(29,299	)
	Decrease (increase) in restricted cash				1,500			(5,100	)
	Payment of acquisition costs, net of cash acquired				(1,858	)		(3,526	)

			Net cash used in investing activities		(45,589	)		(85,831	)

Cash flows from financing activities:
	Repurchase of common stock				(750	)		—
	Net proceeds from sales of common stock and exercises of stock options				6,835			18,396

			Net cash provided by financing activities		6,085			18,396

Effect of exchange rate changes on cash					(570	)		(657	)

			Net decrease in cash and cash equivalents		(30,941	)		(15,798	)
Cash and cash equivalents at beginning of period					147,885			160,955

Cash and cash equivalents at end of period					116,944			145,157
Short-term investments at end of period					231,263			214,290

Total cash, cash equivalents and short-term investments at end of period				$	348,207			359,447

See accompanying notes to condensed consolidated financial statements

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REALNETWORKS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1 — SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

(a)

Description of Business

RealNetworks, Inc. and subsidiaries (RealNetworks or Company) is a leading global provider of software products and services for Internet media delivery. 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 Web.

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

(b)

Basis of Presentation

The accompanying unaudited condensed 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.

These financial statements reflect all adjustments, consisting only of normal, recurring adjustments that, in the opinion of the Company’s management, are necessary for a fair presentation of the results of operations for the periods presented. Operating results for the quarter and nine months ended September 30, 2001 are not necessarily indicative of the results that may be expected for any subsequent quarter or for the year ending December 31, 2001. Certain information and disclosures normally included in financial statements prepared in conformity with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission.

These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and related notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2000.

(c)

Cash, Cash Equivalents and Short-Term Investments

Cash, cash equivalents and short-term investments are comprised of the following (in thousands):


		September 30, 2001		December 31, 2000

Cash and cash equivalents		$	116,944		147,885
Short-term investments			231,263		216,825

	Total cash, cash equivalents and short-term investments	$	348,207		364,710

Restricted cash equivalents		$	17,300		18,800

Restricted cash equivalents represent (a) a restricted escrow account of $10,000,000 established in connection with a lease agreement for the Company’s corporate headquarters that will be maintained for the term of the lease, and (b) cash equivalents held as collateral against a $7,300,000 line of credit with a bank which represents collateral on the lease of a building located near the Company’s corporate headquarters.

The majority of short-term investments mature within twelve months from the date of purchase.

(d)

Revenue Recognition

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The Company recognizes 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. If, at the outset of the customer arrangement, the Company determines that the arrangement fee is 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.

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, for the Company, typically relates to the development of complex content delivery networks which include software licenses, consulting services and product support, revenue is recognized over the term of the support period commencing upon delivery of the Company’s technology to the customer.

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 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 recognized ratably over the term of the contract.

Service revenues include payments under support and upgrade contracts, GoldPass 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. 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 and RealJukebox, are recognized as revenue over the terms of the contracts. The Company may guarantee a minimum number of advertising impressions, click-throughs or other specified 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.

(e)

Net Loss Per Share

Basic net loss per share is computed by dividing net loss by the weighted average number of common shares outstanding during the period. Diluted net loss per share is computed by dividing net loss by the weighted average number of common and dilutive common equivalent shares outstanding during the period. As the Company had a net loss for the quarters and nine months ended September 30, 2001 and 2000, basic and diluted net loss per share are the same for those periods.

Excluded from the computation of diluted net loss per share for the quarter and nine months ended September 30, 2001 are options and warrants to acquire approximately 35,840,000 shares of common stock with a weighted-average exercise price of $7.87, and 274,000 shares of common stock issued in acquisitions that are subject to repurchase by the Company at a nominal price in certain circumstances. Excluded from the computation of diluted net loss per share for the quarter and nine months ended September 30, 2000 are options and warrants to acquire 41,446,000 shares of common stock with a weighted-average exercise price of $26.78. Also excluded are approximately 1,820,000 shares of common stock issued in acquisitions that are subject to repurchase by the Company at a nominal price in certain circumstances. Such potentially dilutive securities are excluded, as their effects are anti-dilutive.

(f)

Derivative Financial Instruments

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Effective January 1, 2001, the Company adopted Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities” (SFAS 133). The adoption of SFAS 133 did not impact the Company’s consolidated financial statements as of January 1, 2001.

SFAS 133, as amended, requires that all derivative instruments be recorded on the balance sheet at fair value. Changes in the fair value of derivatives are recorded each period in current results of operations or other comprehensive income (loss) depending on whether a derivative is designated as part of a hedge transaction, and if so, the type of risk being hedged.

For a derivative designated as a fair value hedge, the gain or loss of the derivative in the period of change and the offsetting loss or gain of the hedged item attributed to the hedged risk are recognized in results of operations. For a derivative designated as a cash flow hedge, the effective portion of the derivative’s gain or loss is initially reported as a component of other comprehensive income (loss) and subsequently reclassified into results of operations when the hedged exposure affects results of operations. The ineffective portion of the gain or loss of a cash flow hedge is recognized immediately in results of operations. For a derivative not designated as a hedging instrument, the gain or loss is recognized in results of operations in the period of change.

During the quarter and nine months ended September 30, 2001, the Company entered into foreign currency forward contracts to manage the foreign currency risk of certain intercompany balances denominated in a foreign currency. Although these instruments are effective as a hedge from an economic perspective, they did not qualify for hedge accounting under SFAS 133, as amended. The net gains on these contracts were not significant as of September 30, 2001 and for the quarter and nine months then ended, and are recorded in other assets.

(g)

Impairment of Long-Lived Assets and Goodwill

The Company reviews its long-lived assets, including goodwill, 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, including goodwill, is measured by a comparison of the carrying amount of an asset to future net 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 the fair value of the assets. Assets to be disposed of are reported at the lower of their carrying amount or fair value less costs to sell.

(h)

Recent Accounting Pronouncements

In July 2001, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 141, “Business Combinations” (SFAS 141), and No. 142, “Goodwill and Other Intangible Assets” (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 criteria intangible assets acquired in a purchase method business combination must meet to be recognized and reported apart from goodwill. SFAS 142 will require that goodwill and intangible assets with indefinite useful lives no longer be amortized, but instead tested for impairment at least annually in accordance with the provisions of SFAS 142. SFAS 142 will also require 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. 121, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of”.

The Company is required to adopt the provisions of SFAS 141 immediately. Any goodwill and any intangible asset determined to have an indefinite useful life that are acquired in a purchase business combination completed after June 30, 2001 will not be amortized, but will continue to be evaluated for impairment in accordance with the appropriate pre-SFAS 142 accounting literature. Goodwill and intangible assets acquired in business combinations completed before July 1, 2001 will continue to be amortized prior to the adoption of SFAS 142.

SFAS 141 will require, upon adoption of SFAS 142, that the Company evaluate its existing intangible assets and goodwill that were acquired in a prior purchase business combination, and to make any necessary reclassifications in order to conform with the new criteria in SFAS 141 for recognition apart from goodwill. Upon adoption of SFAS 142, the Company will be required to reassess the useful lives and residual values of all intangible assets acquired in purchase business combinations, and make any necessary amortization period adjustments by the end of the first interim period after

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adoption. In addition, to the extent an intangible asset is identified as having an indefinite useful life, the Company will be required to test the intangible asset for impairment in accordance with the provisions of SFAS 142 within the first interim period. Any impairment loss will be measured as of the date of adoption and recognized as the cumulative effect of a change in accounting principle in the first interim period.

In connection with the transitional goodwill impairment evaluation, SFAS 142 will require the Company to perform an assessment of whether there is an indication that goodwill and equity-method goodwill is impaired as of the date of adoption. To accomplish this the Company must 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 the date of adoption. The Company will then have up to six months from the date of adoption to determine the fair value of each reporting unit and compare it to the reporting unit’s carrying amount. To the extent a reporting unit’s carrying amount exceeds its fair value, an indication exists that the reporting unit’s goodwill may be impaired and the Company must perform the second step of the transitional impairment test. In the second step, the Company must compare the implied fair value of the reporting unit’s goodwill, determined by allocating the reporting unit’s fair value to all of it assets (recognized and unrecognized) and liabilities in a manner similar to a purchase price allocation in accordance with SFAS 141, to its carrying amount, both of which would be measured as of the date of adoption. This second step is required to be completed as soon as possible, but no later than the end of the year of adoption. Any transitional impairment loss will be recognized as the cumulative effect of a change in accounting principle in the Company’s statement of operations.

Because of the extensive effort needed to comply with adopting SFAS 141 and 142, it is not practicable to reasonably estimate the impact of adopting these statements on the Company’s consolidated financial statements at the date of this report, including whether any transitional impairment losses will be required to be recognized as the cumulative effect of a change in accounting principle.

NOTE 2 — 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), which is comprised of the Company’s Chief Executive Officer, President and Chief Operating Officer, and Senior Vice Presidents. The COC 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 COC does not review discrete financial information regarding profitability of the Company’s different products or services and, therefore, the Company does not have operating segments as defined by Statement of Financial Accounting Standards No. 131, “Disclosure About Segments of an Enterprise and Related Information.”

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):


		Quarters Ended				Nine Months Ended
		September 30,				September 30,

		2001		2000		2001		2000

United States		$	33,108		48,391		100,961		130,318
Europe			5,815		11,347		21,508		25,900
Asia			4,983		5,439		14,384		15,462
Rest of the world			1,322		1,947		6,614		6,394

	Subtotal		45,228		67,124		143,467		178,074
Microsoft license revenue			—		—		—		5,234

	Total	$	45,228		67,124		143,467		183,308

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

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		Quarters Ended				Nine Months Ended
		September 30,				September 30,

		2001		2000		2001		2000

Media delivery license revenue		$	26,751		39,725		84,416		106,616
Media delivery service revenue			16,046		13,893		46,434		37,748
Microsoft license revenue			—		—		—		5,234
Advertising revenue			2,431		13,506		12,617		33,710

	Total net revenues	$	45,228		67,124		143,467		183,308

Long-lived assets by geographic location are as follows (in thousands):


		September 30,		December 31,
		2001		2000

United States		$	107,168		146,280
Asia/Rest of the world			735		594
Europe			189		260

	Total	$	108,092		147,134

NOTE 3 — ACQUISITIONS

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 are dependent upon the related individuals remaining employed by the Company, and are expensed over the related employment term, and $0.7 million in professional fees and other costs. As of September 30, 2001, substantially all of these costs have been paid.

In July 2000, the Company acquired a privately held company accounted for under 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 shares (including options to purchase shares) of its common stock. Approximately 1,820,000 of those shares were 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 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 September 30, 2001, substantially all of these costs have been paid.

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

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		Aegisoft		NetZip

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):


		Aegisoft		NetZip

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 employees of the Company who had previously been employed by Netzip for an immaterial amount. These shares were restricted, pursuant to a restricted stock agreement, and the restrictions were to lapse at various dates based upon the former NetZip employees’ continued employment by the Company. The Company also released certain shares from 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, the Company recorded a benefit related to the reversal of accrued stock compensation of $(10.0) million for the nine months ended September 30, 2001. No stock compensation expense related to the NetZip acquisition was recognized in the quarter ended September 30, 2001 and none will be recognized in future periods.

Goodwill amortization, acquisition charges and stock based compensation for these and other acquisitions are as follows (in thousands):


		Quarters Ended				Nine Months Ended
		September 30,				September 30,

		2001		2000		2001			2000

Stock based compensation		$	361		26,103		(9,895	)		70,399
Goodwill amortization and acquisition charges			12,489		12,282		37,684			33,373

	Total	$	12,850		38,385		27,789			103,772

NOTE 4 — OTHER INVESTMENTS

RealNetworks has made investments through the purchase of voting capital stock of companies that are engaged in businesses that are complimentary to those of the Company. The Company’s investments in publicly traded companies are available for sale and are

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carried at current market value and are classified as long term as they are strategic in nature. The Company periodically evaluates whether the declines in fair value 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 that the quoted market price is less than its accounting basis. The Company considers 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, 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 the quarter ended September 30, 2001, the Company determined that an other-than-temporary impairment existed for one of its investments. In a similar analysis during the quarter ended June 30, 2001, the Company determined that such an impairment existed for two other investments. Impairment charges have been recorded to reflect these investments at fair value. For the quarter ended September 30, 2001, this resulted in a loss of $2.5 million, of which $2.1 million was reclassified to the consolidated statement of operations from accumulated other comprehensive loss. Impairment charges of $25.3 million were recognized during the nine months ended September 30, 2001, of which $16.5 million was reclassified to the consolidated statements of operations from accumulated other comprehensive loss.

NOTE 5 — INVESTMENT IN MUSICNET

In April 2001, the Company’s ownership interest in MusicNet, Inc. (MusicNet), a company formed to create a platform for online music subscription services, was reduced to 40% through the issuance of additional shares of capital stock to third parties. MusicNet previously was a consolidated subsidiary of the Company. In July 2001, the Company’s ownership interest in MusicNet was further reduced to 36.8% through MusicNet’s issuance of additional shares of capital stock to third parties. Effective April 2001, the Company’s investment in MusicNet is being accounted for under the equity method of accounting. The difference between the Company’s recorded basis in MusicNet before and after the issuances of capital stock was not significant.

NOTE 6 — LOSS ON EXCESS OFFICE FACILITIES

In October 2000, the Company entered into a 10-year lease agreement for additional office space nearby its corporate headquarters. During the quarter ended June 30, 2001, the Company re-evaluated its facilities requirements. As a result, the Company decided to permanently sublet all of this office space and recorded a loss of $16.6 million representing approximately $9.2 million of rent and operating expenses over the remaining life of the lease, net of expected sublease income and approximately $7.4 million for the write-down of leasehold improvements to their estimated fair value. During the quarter ended September 30, 2001, the market for Seattle office space significantly deteriorated and the Company has seen sub-lease rates decline significantly from earlier estimates and many prospective tenants have elected to defer their decisions to lease additional facilities. As a result, the Company re-evaluated its earlier estimates and recorded an additional loss on excess office facilities of $5.6 million during the quarter ended September 30, 2001. For the nine months ended September 30, 2001, the loss on excess office facilities was $22.2 million. As of September 30, 2001, $12.6 million is accrued for the loss on excess facilities.

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


Balance as of June 30, 2001	$	8,267
Revision of estimates		5,621
Less amounts paid, net of sublease income		(1,318	)

Balance as of September 30, 2001	$	12,570

NOTE 7 — PERSONNEL REDUCTION AND RELATED CHARGES

In July 2001, the Company reduced its staffing levels by approximately 15%. The Company recorded a charge of approximately $3.9 million during the quarter ended September 30, 2001 to reflect costs associated with implementing the staff reduction. These costs were primarily related to severance payments, but also included other miscellaneous costs such as professional fees and outplacement services for terminated employees, all of which

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were incurred as of September 30, 2001. Approximately $0.8 million of these costs were included in accounts payable and accrued expenses as of September 30, 2001.

NOTE 8 — STOCK OPTIONS

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 August 31, 2001, and the vesting periods for the new options remain 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.

NOTE 9 — LITIGATION

In August 1998, Venson M. Shaw and Steven M. Shaw filed a lawsuit against the Company and co-defendant Broadcast.com in the United States District Court for the Northern District of Texas — Dallas Division. The plaintiffs allege that the Company, individually and in combination with Broadcast.com, infringes on a certain patent by making, using, selling and/or offering to sell software products and services directed to media delivery systems for the Internet and corporate intranets. The plaintiffs seek to enjoin the Company from the alleged infringing activity and to recover damages in an amount no less than a reasonable royalty. The Company may be required to indemnify Broadcast.com under the terms of its license agreement. The plaintiffs filed a similar claim based on the same patent and seeking similar remedies as a separate lawsuit against Microsoft and Broadcast.com in the same court. The court has consolidated the lawsuit against Microsoft and Broadcast.com with the lawsuit against the Company and Broadcast.com. If the plaintiffs prevail in their claims, the Company could be required to pay damages or other royalties, in addition to complying with injunctive relief, which could have a material adverse effect on the Company’s operating results. Although no assurance can be given as to the outcome of this lawsuit, the Company believes that the allegations in this action are without merit, and intends to vigorously defend itself against these claims. The Company believes the ultimate outcome will not have a material adverse effect on its financial position or results of operations.

Between November 1999 and March 2000, fourteen lawsuits were filed against the Company in federal and/or state courts in California, Illinois, Pennsylvania, Washington and Texas. 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 the Company’s RealPlayer and RealJukebox products. Plaintiffs are seeking both damages and injunctive relief. The Company has filed answers denying the claims and has filed suit 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, that court granted RealNetworks’ motion to stay the court proceedings because the claims are subject to arbitration under RealNetworks’ End User License Agreement. Although no assurance can be given as to the outcome of these lawsuits, the Company believes that the allegations in these actions 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.

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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 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.

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Item 2. 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. We have identified a number of these forward-looking statements in the section below entitled “Special Note Regarding Forward-Looking Statements.” 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 our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q and any Current Reports on Form 8-K.

OVERVIEW

RealNetworks is a leading global provider of software products and services for Internet media delivery. We develop and market 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 Web.

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 version of RealPlayer 8, RealJukebox 2, RealDownload 4 and launched RealPlayer GoldPass, a for-pay media subscription service available to RealPlayer Plus customers. RealPlayer GoldPass gives subscribers access to a combination of premium software, services and content updated monthly. In December 2000, we released RealSystem iQ, a new foundational architecture for digital media delivery which greatly increases the reliability of Internet broadcasts, scales to large audiences, and provides greatly enhanced flexibility and cost-effectiveness for media delivery network deployments. In March 2001, we introduced RealArcade, a new 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. The RealSystem Media Commerce Suite is intended to provide a universal platform for secure distribution of digital movies, music, and other content. In September 2001, we announced RealOne, the successor to our GoldPass service, which incorporates our RealPlayer and RealJukebox products together with a new media browser and value-added services to create an immersing, multi-dimensional media experience for consumers. RealOne is due to be released in the fourth quarter of 2001.

We report revenues in three categories:

• Software license fees, which include revenues from sales of our RealPlayer Plus, RealJukebox Plus, RealEntertainment Center Plus, RealServers and related authoring and publishing tools, both directly to customers and indirectly through OEM channels, and sales of third-party products, including games.

• Service revenues, which include revenues from support and maintenance services that we sell to customers who purchase our RealPlayer Plus, RealJukebox Plus, RealEntertainment Center Plus, RealServers and related authoring and publishing tools, RealPlayer GoldPass subscription services, broadcast hosting services we provide through our Real Broadcast Network, and consulting services we offer to our customers.

• Advertising revenues, which are derived from the sale of advertising on our Web sites and the placement and distribution of RealChannels, LiveStations and advertising and promotional buttons and links included in the RealPlayer and the RealJukebox products.

In January 2000, we acquired NetZip, Inc. (NetZip), a privately-held developer and provider of Internet download management and utility software. In December 2000, we acquired Aegisoft Corp. (Aegisoft), a developer of secure digital media software. Both transactions were accounted for using the purchase method of accounting.

RESULTS OF OPERATIONS

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REVENUES

Software License Fees. Software license fees were $26.8 million for the quarter ended September 30, 2001, a decrease of 33% from $39.7 million for the quarter ended September 30, 2000. Software license fees were $84.4 million for the nine months ended September 30, 2001, a decrease of 25% from $111.9 million for the nine months ended September 30, 2000. We believe that the decreases were 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 decreases were due to a significant reduction in equity funding of new and Internet-related businesses in the second half of 2000 and the year to date 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 has contributed to certain of our customers and potential customers going out of business and others experiencing difficult financial situations. We believe that this environment has also resulted in current 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 our revenues in the first three quarters of 2001. Additionally, we have focused our consumer promotional activities to feature our GoldPass subscription service, which has characteristics of longer-term, recurring subscription revenue, unlike our software product offerings that generate one-time, non-recurring revenue. Finally, software license fees for the nine months ended September 30, 2000 included $5.2 million related to a three-year license agreement we entered into with Microsoft which expired in the quarter ended June 30, 2000. There was no such Microsoft-related revenue in the quarter or nine months ended September 30, 2001.

Service Revenues. Service revenues were $16.0 million for the quarter ended September 30, 2001, an increase of 15% from $13.9 million for the quarter ended September 30, 2000. Service revenues were $46.4 million for the nine months ended September 30, 2001, an increase of 23% from $37.7 million for the nine months ended September 30, 2000. The increases in service revenues were primarily attributable to our GoldPass subscription services, which we introduced in August 2000, partially offset by decreases in other product offerings including content hosting revenues. GoldPass accounted for approximately $8.0 million and $0.2 million of revenue for the quarters ended September 30, 2001 and 2000, respectively, and $18.1 million and $0.2 million for the nine months ended September 30, 2001 and 2000, respectively.

Advertising. Advertising revenues were $2.4 million for the quarter ended September 30, 2001, a decrease of 82% from $13.5 million for the quarter ended September 30, 2000. Advertising revenues were $12.6 million for the nine months ended September 30, 2001, a decrease of 63% from $33.7 million for the nine months ended September 30, 2000. The decreases in advertising revenues were due to a decline in the demand for Internet advertising, which resulted in lower average advertising rates, and that resulted in certain promotional contracts not being renewed. In addition, certain of our advertising customers have ceased operations.

GEOGRAPHIC REVENUES

International revenues represented 27% of total net revenues for the quarter ended September 30, 2001, compared to 28% for the quarter ended September 30, 2000. Revenues generated in Europe were 13% of total net revenues for the quarter ended September 30, 2001, compared to 17% for the quarter ended September 30, 2000, and revenues generated in Asia and the rest of the world were 14% of total net revenues for the quarter ended September 30, 2001, compared to 11% of total net revenues for the quarter ended September 30, 2000. The decrease of international revenues as a percentage of total net revenues for the quarter ended September 30, 2001 is primarily due to domestic revenues decreasing at a lower rate than international revenues. International revenues represented 30% of total net revenues for the nine months ended September 30, 2001, compared to 27% for the nine months ended September 30, 2000 (excluding revenues from the Microsoft license agreement). Revenues generated in Europe were 15% of total net revenues for the nine months ended September 30, 2001 and 2000, (excluding revenues from the Microsoft license agreement), and revenues generated in Asia and the rest of the world were 15% of total net revenues for the nine months ended September 30, 2001, compared to 12% of total net revenues for the nine months ended September 30, 2000 (excluding revenues from the Microsoft license agreement). The increase of international revenues as a percentage of total net revenues for the nine months ended September 30, 2001 is primarily due to domestic revenues decreasing at a greater rate than international revenues. At September 30, 2001, accounts receivable due from European and Asian customers represented approximately 47% of total accounts receivable. The functional currency of our foreign subsidiaries is the local currency of the country in which the subsidiary operates. Results of operations of our foreign subsidiaries are translated from local currency into U.S. dollars based on average monthly exchange rates. We currently do not hedge the majority of our foreign currency

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exposures and therefore are subject to the risk of changes in exchange rates. The costs of domestic and international revenues are substantially the same.

DEFERRED REVENUE

Deferred revenue is comprised of the unrecognized revenue related to support contracts, prepayments under OEM arrangements, 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 build-out. Because many of the agreements related 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 $29.5 million and $26.9 million at September 30, 2001 and December 31, 2000, respectively. The increase in deferred revenue for the quarter ended September 30, 2001 is primarily due to the receipt of a large cash prepayment under an existing contract. If, in the future, we enter into agreements with more established companies, we may not require these prepayments and we anticipate our deferred revenue balances may decline as a result.

COST OF REVENUES

Cost of Software License Fees. Cost of software license fees includes costs of product media, duplication, manuals, packaging materials, amounts paid for licensed technology, and fees paid to third-party vendors for order fulfillment. Cost of software license fees was $1.7 million for the quarter ended September 30, 2001, a decrease of 50% from $3.4 million for the quarter ended September 30, 2000, and decreased as a percentage of software license fees to 6% for the quarter ended September 30, 2001 from 8% for the quarter ended September 30, 2000. Cost of software license fees was $5.8 million for the nine months ended September 30, 2001, a decrease of 50% from $11.7 million for the nine months ended September 30, 2000, and decreased as a percentage of software license fees to 7% for the nine months ended September 30, 2001 from 10% for the nine months ended September 30, 2000. The decreases in costs were due primarily to lower sales volumes and the expiration of certain royalty agreements. The decreases in the percentage of software license fees were due to shifts in product mix.

Cost of Service Revenues. Cost of service revenues includes the cost of in-house and contract personnel providing support and consulting services, expenses incurred in providing our streaming media hosting services and cost of content included in our GoldPass subscription service offering. Cost of service revenues was $6.1 million for the quarter ended September 30, 2001, an increase of 62% from $3.8 million for the quarter ended September 30, 2000, and increased as a percentage of service revenues to 38% for the quarter ended September 30, 2001 from 27% for the quarter ended September 30, 2000. Cost of service revenues was $17.2 million for the nine months ended September 30, 2001, an increase of 74% from $9.9 million for the nine months ended September 30, 2000, and increased as a percentage of service revenues to 37% for the nine months ended September 30, 2001 from 26% for the nine months ended September 30, 2000. The increases in costs were primarily due to the introduction of our GoldPass subscription service in August 2000 and related costs of content, including our agreements with Major League Baseball (MLB) and the National Basketball Association (NBA). The fixed costs associated with the MLB and NBA contracts are expensed over the contract terms. The increases in the percentage of service revenues were due in part to shifts in product mix towards GoldPass.

Cost of Advertising. Cost of advertising includes the cost of personnel associated with maintenance of programming services, content creation and maintenance, fees paid to third parties for content included in our Web sites and ad delivery services. Cost of advertising was $1.4 million for the quarter ended September 30, 2001, a decrease of 51% from $2.9 million for the quarter ended September 30, 2000, but increased as a percentage of advertising revenues to 58% for the quarter ended September 30, 2001 from 21% for the quarter ended September 30, 2000. Cost of advertising was $5.0 million for the nine months ended September 30, 2001, a decrease of 26% from $6.7 million for the nine months ended September 30, 2000, but increased as a percentage of advertising revenues to 39% for the nine months ended September 30, 2001 from 20% for the nine months ended September 30, 2000. The decreases in costs were due primarily to lower sales volumes and the expiration of certain advertising contracts. The increases in the percentage of advertising revenues were due to cost of advertising decreasing at a lower rate than the decrease in advertising revenues, due to certain fixed costs associated with our Web sites and related directory services.

OPERATING EXPENSES

Research and Development

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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 is generally not established until substantially all development is complete. Research and development expenses, excluding non-cash stock compensation, were $12.5 million for the quarter ended September 30, 2001, a decrease of 22% from $16.1 million for the quarter ended September 30, 2000, but increased as a percentage of total net revenues to 28% for the quarter ended September 30, 2001 from 24% for the quarter ended September 30, 2000. Research and development expenses, excluding non-cash stock compensation, were $43.6 million for the nine months ended September 30, 2001, an increase of 6% from $41.0 million for the nine months ended September 30, 2000, and increased as a percentage of total net revenues to 30% for the nine months ended September 30, 2001 from 22% for the nine months ended September 30, 2000. The decrease in expenses for the quarter ended September 30, 2001 was primarily due to a reduction in personnel and increased efficiencies as part of an overall plan to control costs. The increase in expenses for the nine months ended September 30, 2001 was primarily due to increases in development personnel and related costs, contract labor and consulting expenses during the first half of the year 2001. The increases as a percentage of total net revenues were primarily a result of expenses decreasing at a lower rate than net revenues.

Sales and Marketing

Sales and marketing expenses consist primarily of salaries and related personnel costs, sales commissions, consulting fees, trade show expenses, advertising costs and costs of marketing collateral. Sales and marketing expenses, excluding non-cash stock compensation, were $17.5 million for the quarter ended September 30, 2001, a decrease of 36% from $27.5 million for the quarter ended September 30, 2000, and decreased as a percentage of total net revenues to 39% for the quarter ended September 30, 2001 from 41% for the quarter ended September 30, 2000. Sales and marketing expenses, excluding non-cash stock compensation, were $56.0 million for the nine months ended September 30, 2001, a decrease of 27% from $77.2 million for the nine months ended September 30, 2000, and decreased as a percentage of total net revenues to 39% for the nine months ended September 30, 2001 from 42% for the nine months ended September 30, 2000. The decreases in expenses were due to reductions in personnel and contract labor, decreases in advertising and marketing expenses and decreased advertising, promotions and expenses related to our overall corporate branding and marketing. The decreases in percentage of total net revenues were primarily a result of cost saving measures that reduced sales and marketing expenses more rapidly than the rate of the decline in net revenues.

General and Administrative

General and administrative expenses consist primarily of salaries and related personnel costs, and fees for professional and temporary services. General and administrative expenses were $5.1 million for the quarter ended September 30, 2001, a decrease of 27% from $7.0 million for the quarter ended September 30, 2000, and increased as a percentage of total net revenues to 11% for the quarter ended September 30, 2001 from 10% for the quarter ended September 30, 2000. General and administrative expenses were $15.8 million for the nine months ended September 30, 2001, a decrease of 25% from $21.2 million for the nine months ended September 30, 2000 and decreased as a percentage of total net revenues to 11% for the nine months ended September 30, 2001 from 12% for the nine months ended September 30, 2000. The decreases in expenses were primarily due to reductions in personnel and decreased litigation defense costs. The changes in the expenses as a percentage of total net revenues were due to expenses and net revenues decreasing at different rates in different periods.

Goodwill Amortization, Acquisition Charges and Stock-Based Compensation

Stock-based compensation for the quarters ended September 30, 2001 and 2000 was $0.4 million and $26.1 million, respectively. Goodwill amortization and acquisition charges for the quarters ended September 30, 2001 and 2000 were $12.5 million and $12.3 million, respectively. Stock-based compensation for the nine months ended September 30, 2001 and 2000 was a benefit of $(9.9) million and an expense of $70.4 million, respectively. Goodwill amortization and acquisition charges for the nine months ended September 30, 2001 and 2000 were $37.7 million and $33.4 million, respectively. While the changes between periods are due partly to the timing of acquisitions, particularly with respect to goodwill, the benefit related to stock-based compensation for the nine months ended September 30, 2001 was due to the voluntary resignation of certain former NetZip employees. These resignations resulted in our repurchase of approximately 738,000 shares of our common stock for an immaterial amount. The net effect of this repurchase was that we recorded a reversal of previously recorded stock-based compensation expense of $(25.4)

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million. As a result, we recorded a benefit related to the reversal of accrued stock compensation of $(10.0) million for the nine months ended September 30, 2001. No stock compensation expense related to the NetZip acquisition was recognized in the quarter ended September 30, 2001 and none will be recognized in future periods.

Loss on Excess Office Facilities

In October 2000, we entered into a 10-year lease agreement for additional office space nearby our corporate headquarters. During the quarter ended June 30, 2001, we re-evaluated our facilities requirements. As a result, we decided to permanently sublet all of this office space and recorded a loss of $16.6 million representing approximately $9.2 million of rent and operating expenses over the remaining life of the lease, net of expected sublease income and approximately $7.4 million for the write-down of leasehold improvements to their estimated fair value. During the quarter ended September 30, 2001, the market for Seattle office space significantly deteriorated and we have seen sub-lease rates drop significantly from earlier estimates and many prospective tenants have elected to defer their decisions to lease additional facilities. As a result, we re-evaluated our earlier estimates and recorded an additional loss on excess office facilities of $5.6 million during the quarter ended September 30, 2001. For the nine months ended September 30, 2001, the loss on excess office facilities was $22.2 million. As of September 30, 2001, $12.6 million is accrued for the loss on excess office facilities.

Personnel Reduction and Related Charges

In July 2001, we reduced our staffing levels by approximately 15%. We recorded a charge of approximately $3.9 million during the quarter ended September 30, 2001 to reflect costs associated with implementing the staff reduction. These costs were primarily related to severance payments, but also included other miscellaneous costs such as professional fees and outplacement services for terminated employees, all of which were incurred as of September 30, 2001. Approximately $0.8 million of these costs were included in accounts payable and accrued expenses as of September 30, 2001.

OTHER INCOME, NET

Other income, net consists primarily of interest earnings on our cash, cash equivalents and short-term investments, equity in the net loss of MusicNet, and impairment of certain equity investments.

For the quarter and nine months ended September 30, 2001, interest income declined from the comparable periods in 2000. The decreases were primarily due to lower effective interest rates and lower investment balances.

For the quarter and nine months ended September 30, 2001, equity in net losses of MusicNet were approximately $1.4 million and $2.3 million, respectively. In April 2001, MusicNet, which previously was a subsidiary of the Company, issued additional shares of capital stock reducing our ownership interest in MusicNet to 40%. In July 2001, our ownership interest in MusicNet was further reduced to 36.8% through MusicNet’s issuance of additional shares of capital stock. Effective April 2001, our investment in MusicNet is accounted for under the equity method of accounting.

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. The Company’s investments in publicly traded companies are available for sale and are carried at current market value and are classified as long term as they are strategic in nature. For investments with publicly quoted market prices, these factors include the time period and extent that the quoted market price is less than its accounting basis. 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 the quarter ended September 30, 2001, we determined that an other-than-temporary impairment had occurred for one of our investments. In a similar analysis during the quarter ended June 30, 2001, we determined that such an impairment existed for two other investments. Impairment charges have been recorded to reflect these investments at fair value. For the quarter ended September 30, 2001, this resulted in a loss of $2.5 million, of which $2.1 million was reclassified to the consolidated statement of operations from accumulated other comprehensive loss. Impairment charges of $25.3 million were recognized in the nine months ended September 30, 2001, of which $16.5 million was reclassified to the consolidated statement of operations from accumulated other comprehensive loss.

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INCOME TAXES

For the quarter and nine months ended September 30, 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 become deductible for income tax purposes. During the same periods, we 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 currently do not have any significant sources of capital gain income.

During the quarter and nine months ended September 30, 2000, we recorded an income tax provision, although we did not pay federal income taxes and do not expect to pay them in the near future, due primarily to tax deductions related to the exercise of employee stock options, the benefit of which is recorded directly to shareholder equity. As of September 30, 2001, we had net operating loss carryforwards of approximately $437 million, substantially all of which result from employee stock options, the realization of which will increase shareholders’ equity.

IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS

We are required to adopt the provisions of SFAS 141 immediately. Any goodwill and any intangible asset determined to have an indefinite useful life that are acquired in a purchase business combination completed after June 30, 2001 will not be amortized, but will continue to be evaluated for impairment in accordance with the appropriate pre- SFAS 142 accounting literature. Goodwill and intangible assets acquired in business combinations completed before July 1, 2001 will continue to be amortized prior to the adoption of SFAS 142.

SFAS 141 will require, upon adoption of SFAS 142, that we evaluate our existing intangible assets and goodwill that were acquired in prior purchase business combinations, and to make any necessary reclassifications in order to conform with the new criteria in SFAS 141 for recognition apart from goodwill. Upon adoption of SFAS 142, we will be required to reassess the useful lives and residual values of all intangible assets acquired in purchase business combinations, and make any necessary amortization period adjustments by the end of the first interim period after adoption. In addition, to the extent an intangible asset is identified as having an indefinite useful life, we will be required to test the intangible asset for impairment in accordance with the provisions of SFAS 142 within the first interim period. Any impairment loss will be measured as of the date of adoption and recognized as the cumulative effect of a change in accounting principle in the first interim period.

In connection with the transitional goodwill impairment evaluation, SFAS 142 will require us to perform an assessment of whether there is an indication that goodwill and equity-method goodwill is impaired as of the date of adoption. To accomplish this we must 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 the date of adoption. We will then have up to six months from the date of adoption to determine the fair value of each reporting unit and compare it to the reporting unit’s carrying amount. To the extent a reporting unit’s carrying amount exceeds its fair value, an indication exists that the reporting unit’s goodwill may be impaired and we must perform the second step of the transitional impairment test. In the second step, we must compare the implied fair value of the reporting unit’s goodwill, determined by allocating the reporting unit’s fair value to all of its assets (recognized and unrecognized) and liabilities in a manner similar to a purchase price allocation in accordance with SFAS 141, to its carrying amount, both of which would be measured as of the date of adoption. This second step is required to be completed as soon as possible, but no later than the end

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of the year of adoption. Any transitional impairment loss will be recognized as the cumulative effect of a change in accounting principle in our statement of operations.

Because of the extensive effort needed to comply with adopting SFAS 141 and 142, it is not practicable to reasonably estimate the impact of adopting these statements on our consolidated financial statements at the date of this report, including whether any transitional impairment losses will be required to be recognized as the cumulative effect of a change in accounting principle.

LIQUIDITY AND CAPITAL RESOURCES

Net cash provided by operating activities was $9.1 million and $52.3 million for the nine months ended September 30, 2001 and 2000, respectively. Net cash provided by operating activities for the nine months ended September 30, 2001 resulted primarily from net loss of $62.9 million, an increase in prepaid expenses and other assets of $2.1 million, decreases in deferred revenue of $1.3 million and accounts payable of $3.6 million, offset by non-cash charges of $28.2 million for goodwill amortization, acquisition charges, and stock- based compensation, $25.3 million for impairment on investments, and $20.0 million from the loss on excess office facilities, as well as depreciation and amortization of $9.0 million. Net cash provided by operating activities for the nine months ended September 30, 2000 resulted primarily from net loss of $76.8 million and an increase in accounts receivable of $6.1 million offset by non-cash charges of $101.4 million for goodwill amortization, acquisition charges, and stock based compensation, an increase in deferred revenue of $12.6 million, an increase in accrued and other liabilities of $12.0 million, and depreciation and amortization of $6.3 million.

Net cash used in investing activities was $45.6 million for the nine months ended September 30, 2001. This was primarily the result of the net purchase of short-term investments and equipment and leasehold improvements. Net cash used in investing activities was $85.8 million for the nine months ended September 30, 2000. This was primarily a result of purchases of long-term investments of $29.3 million, net purchases of short-term investments, and purchases of equipment and leasehold improvements.

Net cash provided by financing activities was $6.1 million and $18.4 million for the nine months ended September 30, 2001 and 2000, respectively. In both periods, net cash provided by financing activities was primarily a result of net proceeds from the exercise of stock options. For the nine months ended September 30, 2001, net cash provided by financing activities was partially impacted by our repurchase of approximately $0.8 million of our common stock.

In September 2001, we announced a share repurchase program. Our Board of Directors authorized the repurchase of up to $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 or from time-to-time without prior notice. As of September 30, 2001, we had repurchased 175,000 shares at an average cost of $4.28 per share.

At September 30, 2001, we had approximately $366 million in cash, cash equivalents, short-term investments and restricted cash equivalents and our principal commitments consisted of obligations under operating leases. Since our inception, we have experienced a substantial increase in our capital expenditures.

In January 1998, we entered into a lease agreement for a new location for our corporate headquarters. The lease commenced on April 1, 1999 and expires on April 1, 2011, with an option to renew the lease for either a three-or ten-year period. In October 2000, we entered into a 10-year lease agreement for additional office space for our corporate headquarters. During the quarter ended June 30, 2001, we re-evaluated our office space needs and subsequently decided to sublet all of this additional office space.

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 issue or issuer to a maximum of 5% of the total portfolio and requires that all investments mature in two years or less, with the average maturity being one year or less. 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 on our securities portfolio.

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We conduct our operations in ten primary functional currencies: the United States dollar, the Japanese yen, the British pound, the French franc, the euro, the Mexican peso, the Brazilian real, the Australian dollar, the Hong Kong dollar and the German mark. 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, France, Germany and the United Kingdom, where we invoice our customers primarily in yen, euros and pounds, 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 for the quarters or nine months ended September 30, 2001 and 2000.

On January 1, 1999, the participating member countries of the European Union converted to a common currency, the euro. On that same date they established fixed conversion rates between their existing sovereign currencies and the euro. Even though legacy currencies are scheduled to remain legal tender in the participating countries as denominations of the euro until January 1, 2002, the participating countries will no longer be able to direct independent interest rates for the legacy currencies. The authority to set monetary policy will now reside with the new European Central Bank. We do not anticipate any material impact from the euro conversion on our financial information systems, which currently accommodate multiple currencies. Due to numerous uncertainties, we cannot reasonably estimate the effect that the euro conversion issue will have on our pricing or market strategies or the impact, if any, it will have on our financial condition and results of operations.

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.

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 quarterly report on Form 10-Q. 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 you could lose all or part of your investment.

WE HAVE A LIMITED OPERATING HISTORY, WHICH MAKES IT DIFFICULT TO EVALUATE OUR BUSINESS

We were incorporated in February 1994 and have a relatively short operating history. We have limited financial results on which you can assess our future success. Our prospects must be considered in light of the risks, expenses and difficulties frequently encountered by growing companies in new and rapidly evolving markets, such as the streaming media software, media delivery systems and electronic commerce markets in which we operate.

To address the risks and uncertainties faced by our business, we must:

• establish and maintain broad market acceptance of our products and services and convert that acceptance into direct and indirect sources of revenues;

• maintain and enhance our brand name;

• continue to timely and successfully develop new products, product features and services and increase the functionality and features of existing products;

• successfully respond to competition from Microsoft and others, including competition from emerging technologies and solutions; and

• develop and maintain 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.

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WE HAVE A HISTORY OF LOSSES

We have incurred significant losses since our inception. As of September 30, 2001, we had an accumulated deficit of approximately $207.9 million. While we had net income in 1999, we had a net loss for the year ended December 31, 2000 and the quarter and nine months ended September 30, 2001, and we may not generate sufficient revenues to be profitable on a quarterly or annual basis in the future. We devote significant resources to developing, enhancing, selling and marketing our products and services. As a result, we will need to generate significant revenues to be profitable in the future.

OUR OPERATING RESULTS ARE LIKELY TO FLUCTUATE SIGNIFICANTLY, WHICH WOULD LIKELY CAUSE OUR STOCK PRICE TO FLUCTUATE

As a result of our limited operating history and the rapidly changing and uncertain nature of the markets in which we compete, our quarterly and annual revenues and operating results are likely to fluctuate from period-to-period, and period-to-period comparisons are not likely to be meaningful. These fluctuations are caused by a number of factors, many of which are beyond our control. Our future operating results could fall below the expectations of public market analysts or investors, which would likely significantly reduce the market price of our common stock. Fluctuations in our operating results will likely increase the volatility of our stock price.

Our research and development and sales and marketing efforts, and other business expenditures generally, are partially based on predictions regarding certain developments for media delivery and digital media distribution. To the extent that these predictions prove inaccurate, our revenues may not be sufficient to offset these expenditures, and our operating results may be harmed.

In recent periods, many Internet-related companies have experienced financial difficulties, in part as a result of their inability to access capital from financial markets. This has directly or indirectly impacted our current and prospective customers. The result is that some of these companies have ceased operations, some are continuing to experience financial difficulty, and sales cycles for some of our customers and potential customers have become longer than in the past. In addition, we continue to be impacted by the current near-term effects of a capital spending slowdown and general economic downturn, a trend that has been ongoing since the second half of 2000. In the event that a substantial number of our current or potential customers experience financial difficulties in the future, our ability to increase or maintain sales to such customers will be adversely affected and our ability to generate revenues from these companies will also be adversely impacted.

Since the launch of GoldPass in August 2000, we have focused our promotional activities to feature GoldPass, which has characteristics of longer-term, recurring subscription revenue, rather than product offerings that generate short-term, non-recurring revenue. This transition from one-time software sales to recurring subscriptions may not be successful and could harm our near-term operating results and future business prospects. In September 2001, we announced RealOne, the successor to our GoldPass service, which will incorporate our RealPlayer and RealJukebox products together in a new version of our player products, the RealOne Player. In addition to the features found in the RealPlayer and RealJukebox, the RealOne Player will contain a new media browser and value-added services to create an immersing, multi-dimensional media experience for consumers. RealOne is due to be released in the fourth quarter of 2001. If consumers do not accept the transition from GoldPass to RealOne or the combination of our RealPlayer and RealJukebox products into the RealOne Player, our operating results 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

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brand and technology franchise. Price concessions or the emergence of other pricing or 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.

We believe that the primary factors on which we compete in the media delivery market include:

• the quality, reliability, price and licensing terms of the overall media delivery solution;

• access to distribution channels necessary to achieve broad distribution and use of products;

• the availability of content for delivery over the Internet;

• the ability to license or develop and support secure formats and digital rights management systems for digital media delivery, particularly music and video;

• 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;

• features for creating, editing and adapting content for the Internet;

• ease of use and interactive user features in products;

• scalability of streaming media and media delivery technology and cost per user;

• the ability to obtain any necessary intellectual property rights underlying important streaming media and digital distribution technologies that gain market acceptance;

• 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

• ability to meet challenges caused by bandwidth constraints and other limitations of the Internet infrastructure.

Our failure to adequately address any of the above factors could harm our business and operating results.

Microsoft Corporation is a principal competitor in the development and distribution of streaming media and media distribution technology. Microsoft currently competes with us in the market for streaming media servers and players, digital rights management, 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 streaming media and media distribution.

Microsoft distributes its competing streaming media server, player and tools products by bundling them with its Windows operating systems and servers at no additional charge. While we also provide free downloads of certain of our products, including players, servers and tools, Microsoft’s practices have caused, and may continue to cause, pricing pressure on our revenue generating products. 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 and bundling contracts for its streaming media products with third parties such as Internet Service Providers (“ISPs”), content delivery networks, online service providers, content providers, entertainment companies, media companies, broadcasters, value-added resellers and original equipment manufacturers (“OEMs”), including third parties with whom we have relationships. Microsoft has also invested significant sums of money in, has provided substantial financial incentives to, or offered or conditioned placement on or through the

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Windows operating system, the Internet Explorer Web browser, and MSN service and websites 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. Such arrangements, together with Microsoft’s aggressive marketing of Windows operating systems and of its streaming media products, may reduce our share of the streaming media and digital distribution market.

Microsoft’s Windows Media Player competes with our media player products. The Windows Media Player is available for download from Microsoft’s Web site for free, and is fully integrated into Microsoft’s recently introduced operating system Windows XP and the Windows 98, Windows 2000 and Windows ME operating systems, the Internet Explorer Web browser, and MSN. With Windows XP, Microsoft no longer offers a stand-alone version of updated versions of Windows Media Player, which is commingled into the operating system so that it cannot be removed by OEMs or end users. Windows XP, a significant focus of which is 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 us or end users. 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, and attract more content in its formats, in the future than it has in the past and may be able to attract more users to its streaming or digital media products. In addition, Microsoft does not allow us to take full advantage of the features and functionality of the operating system 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.

Microsoft’s Windows Media Player also competes with our RealJukebox products and will compete with the personal music management features of the RealOne Player. Microsoft has also invested in other digital distribution technologies that compete with RealJukebox and that will compete with the RealOne Player. The Windows Media Player supports the Windows Media format, but not RealNetworks’ media formats. Microsoft also licenses Windows Media Technologies 7, a platform for authoring, delivering and playing digital media intended to compete with RealSystem, and supports and promotes other third party products competitive to our products. In addition, Microsoft gives away servers that support Windows Media Technologies with other of its servers, whereas we offer most versions of our competitive servers for sale. In some cases, Microsoft conditions 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 in the market for digital rights management technologies. We expect Microsoft 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, 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. Our player products may be disadvantaged if they cannot play content in Windows Media formats or secured by the Windows Media Digital Rights Management technology, or if such 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. We believe that Microsoft’s commitment to and presence in the media delivery industry has increased and 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 are developing and marketing 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 Computer’s end user license agreement. Apple also offers competitive music management software and hardware. We expect that Apple Computer will continue to devote significant resources to developing and marketing streaming media systems, and will continue to compete vigorously with us in the marketplace. Apple Computer 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 RealPlayer and RealJukebox products and Goldpass content subscription service. In connection with the deployment of RealSystem iQ in AOL’s Internet service, we also licensed our RealPlayer technology to AOL

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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 their 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.

Our streaming media and media delivery products also face competition from “fast download” media delivery technologies such as AVI, QuickTime and MP3. We also face competition from peer-to-peer file sharing services, which allow computer users to connect with each other and directly access and copy many types of program files, including music and other media, from one another’s hard drives, such as Napster, Gnutella, Morpheus and KaZaA, and a variety of other similar services that have arisen since certain services of Napster were shut down by court order. Such services allow consumers to directly access an expansive array of free content without relying on content providers to make the content available for streaming or digital download, and without relying on products such as the RealPlayer or RealJukebox to be able to play, record and store such content. Such services also will compete with our content subscription services, for which we intend to offer a for-pay, limited usage music subscription services in the fourth quarter of 2001. Other fast download or non-streaming IP-based content distribution methods are likely to emerge and could compete with our products and services, which could harm our business.

WE MAY BE UNABLE TO SUCCESSFULLY COMPETE IN OTHER PARTS OF OUR BUSINESS

GoldPass.In August 2000, we introduced our RealPlayer GoldPass subscription service, which provides customers access to a combination of premium software, services and content, updated monthly, in exchange for a monthly fee. The GoldPass subscription service is a relatively unproven business model for delivering media over the Internet and is a new business model for us. It is too early to predict whether GoldPass will be accepted by consumers or whether it will be financially viable. GoldPass competes with both traditional and online entertainment service providers and we anticipate increasing competition for online subscription service revenues from a wide range of companies, including AOL Time Warner, Microsoft and Yahoo!. Many of these providers have significantly more resources, including access to content, and experience in providing subscription or similar services to customers. In order to increase our subscription service revenues, we must continue to obtain premium digital content in order to increase subscriptions and overall customer satisfaction. To date, a limited amount of premium digital content has been made available for delivery over the Internet. If we are unable to obtain premium digital content, or if such content is only made available at commercially unreasonable rates, or if we do not successfully market our GoldPass services to our end users, our business could be harmed. In September 2001, we announced the upcoming release of RealOne, the successor to our GoldPass service, which will incorporate our RealPlayer and RealJukebox products together in a new version of our player products, the RealOne Player. Like GoldPass, it is too early to predict whether consumers will accept RealOne and RealOne will compete with both traditional and online entertainment service providers, many of which have significantly more resources and experience in providing such services to customers. If consumers do not accept the transition from GoldPass to RealOne or the combination of our RealPlayer and RealJukebox products together in the RealOne Player, our business could be harmed.

Media Hosting.Our media hosting service, the Real Broadcast Network, competes with a variety of companies that provide streaming media hosting and broadcast services. These companies include Yahoo! Broadcast Services (formerly Broadcast.com), Akamai and other emerging broadcast networks. 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. 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 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 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.

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 our Real.com Guide. We also compete with traditional media such as television, radio and print for a share of advertisers’ total advertising budgets. Our advertising sales force

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and infrastructure are still in early stages of development relative to those of many of our competitors. We cannot be certain that advertisers will place advertising with us or that revenues derived from such advertising will be meaningful. Recent slowdowns in funding for Internet-related companies have had a negative effect on Internet advertising markets. Internet advertising revenues across the industry have decreased substantially since the second half of 2000 and our advertising revenues declined sequentially in the first three quarters of 2001 from the previous year. In addition, certain of our advertising customers have ceased operations. 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, or if we lose Web site traffic, our business could be harmed.

Electronic Commerce.To compete successfully in the electronic commerce market, we must attract sufficient traffic to our Web sites by offering high-quality, competitively priced, desirable merchandise in a compelling, easy-to-purchase format. In addition, we must successfully leverage our existing user base to develop the market for our products and services. We may not compete successfully in the growing and rapidly changing market for electronic commerce. Our failure to do so could harm our business.

OUR INDUSTRY IS EXPERIENCING CONSOLIDATION THAT MAY INTENSIFY COMPETITION

The Internet and media distribution industries 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 business 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;

• 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 results 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 the competitive threat, which could also harm our operating results.

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 the market opportunity. It is too soon to determine whether consumers will adopt RealJukebox or the RealOne Player 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 certain of the features currently offered by RealJukebox and which in the future will be incorporated into our RealOne Player and other products. These products include WinAmp Player, MusicMatch Jukebox, Sonique Player, Liquid Audio Player, AOL 6.0 and Windows Media Player. Given the size and importance of the general market for music distribution, competitors will likely release additional products that directly compete with RealJukebox and the RealOne Player, which could harm our business. Our competitors may develop new features

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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 like Napster, Gnutella, Morpheus and KaZaA, and a variety of other similar services that have arisen since certain services of Napster were shut down by court order. Our inability to achieve widespread acceptance for our digital music architecture or our player products or to create new revenue streams from the new market segments, including digital music content, could harm the prospects for our business.

RealJukebox and the RealOne Player support or will support a variety of audio formats, including RealAudio, MP3, Liquid Audio, Windows Media Audio and IBM’s EMMS. However, technical formats and consumer preferences evolve very rapidly, and we may be unable to adequately address consumer preferences or fulfill the market demand to the extent it exists. We may be unable to license technologies, like codecs, that obtain widespread consumer use which would harm consumer acceptance of our products and services. We must also provide digital rights management solutions and other security mechanisms in order to address concerns of content providers, and 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.

We have had long-term relationships with recording companies, including major record labels, many of which offer their streaming content in our formats. However, recording companies and music publishers, including those with whom we have a relationship, may not make their desirable content available for download or playback in formats supported by our player products or may make the cost of licensing such content prohibitive, may impose technical restrictions designed to secure intellectual property rights that may impact the user experience or demand for our products and services, or may refrain from or delay participating in promotional opportunities with respect to our products and services.

We have recently announced the formation of a joint venture called MusicNet with three leading media companies to create a platform for online music subscription services. We have also entered into an agreement with MusicNet to license the MusicNet platform for sale to our own customers. The business models, technologies and market for online music subscription services are new and unproven. If these new online music subscription services do not achieve market acceptance our financial results and business prospects could be harmed. Our music subscription services will face competition from other new music services, including pressplay, a joint venture formed between two leading media companies that are not participants in MusicNet. Competing services, like pressplay, may be able to obtain more or better content, which could harm MusicNet’s ability to compete. 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 RELY ON CONTENT PROVIDED BY THIRD PARTIES TO INCREASE MARKET ACCEPTANCE OF OUR PRODUCTS AND SERVICES

If third parties do not develop or offer compelling 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 services 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, to develop and offer content in our formats that can be delivered using our server products and played back using our player products. We also rely on third-party content for our GoldPass subscription service. In some cases, we pay substantial fees to obtain content for the GoldPass service. 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 by companies such as AOL Time Warner, Microsoft and Yahoo!, who may have greater access to content or the ability to pay 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, or that we will be able to secure licenses to their content, to encourage and sustain broad market acceptance of our products and services. The failure to do so would harm our business.

While we have a number of short-term agreements with third parties to provide content from their Web sites in our formats, most third parties are not obligated to

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develop or offer content using our technology. In addition, some third parties have entered into and may in the future enter into agreements with our competitors, principally Microsoft, to develop or offer all or a substantial portion of their content in our competitors’ formats. 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 and 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.

Our success also depends on the availability of third-party content, especially music, that current users of our RealJukebox product, and future users of our 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 associated with obtaining necessary licensing rights, are contributing to the delay or unavailability of music content for distribution.

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 develop products and services that achieve widespread market acceptance or that fail to generate significant revenues 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.

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. Our products also may contain undetected errors that could cause increased development costs, loss of revenues, adverse publicity, reduced market acceptance of our products or services or lawsuits by customers.

THE RATE STRUCTURE OF SOME OF OUR ADVERTISING AND SPONSORSHIP ARRANGEMENTS SUBJECTS US TO FINANCIAL RISK

We generate advertising revenues in part through sponsored services and placements by third parties in our products and on our Web sites, in addition to banner advertising. We may receive sponsorship fees or a portion of transaction revenues in return for minimum levels of user impressions to be provided by us. These arrangements expose us to potentially significant financial risks in the event our usage levels decrease, including the following:

• the fees we are entitled to receive may be adjusted downwards;

• we may be required to “make good” on our obligations by providing alternative services;

• the sponsors may not renew the agreements or may renew at lower rates; and

• the arrangements may not generate anticipated levels of shared transaction revenues, or sponsors may default on the payment commitments in such agreements.

Accordingly, any leveling off or decrease of our user base or the failure to generate anticipated levels of shared transaction revenues could result in a meaningful decrease in our revenue levels. To the extent that our advertisers are experiencing slow-downs in their businesses or tighter resources to fund advertising, our anticipated revenue results could be harmed. Recent slowdowns in funding for Internet-related companies have had a negative effect on Internet advertising markets. Internet advertising revenues across the industry decreased substantially in the second half of 2000 and our advertising revenues declined sequentially in the first nine months of 2001 from the previous year. In addition, certain of our advertising customers have ceased operations.

WE DEPEND ON KEY PERSONNEL WHO MAY NOT CONTINUE TO WORK FOR US

Our success substantially depends on the continued employment of our executive officers and key employees, particularly Robert Glaser, our founder, Chairman of the Board

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and Chief Executive Officer. The loss of the services of Mr. Glaser or our other executive officers or key employees could harm our business. If any of these individuals were to leave RealNetworks, we could face 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. None of our executive officers has a contract that guarantees employment. Other than a $2 million insurance policy on the life of Mr. Glaser, 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 success also depends on our ability to attract, train and retain qualified personnel in all areas, especially those with management and product development skills. In particular, we must hire additional 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 areas. Competition for qualified 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 retaining and motivating our current personnel, our business could be harmed.

In making employment decisions, particularly in the Internet and high-technology industries, job candidates and even our current personnel often consider the value of stock options 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.

WE MAY NOT SUCCESSFULLY MANAGE OUR GROWTH

We cannot successfully implement our business model if we fail to manage our growth. Since our inception, we have rapidly and significantly increased our number of employees and expanded our operations domestically and internationally. Managing this substantial expansion has historically placed a significant strain on our management, operational and financial resources. In response to recent economic conditions, however, we reduced our staffing levels by approximately 140 employees in July 2001. We may not be able to attract or retain enough qualified personnel to manage the growth needed to implement our business model. If we do not attract or retain qualified personnel or do not successfully manage this growth, our business could be harmed.

POTENTIAL ACQUISITIONS INVOLVE RISKS WE MAY NOT ADEQUATELY ADDRESS

As part of our business strategy, we have acquired technologies and businesses in the past, and intend 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 number of significant risks. Financial risks related to acquisitions may harm our financial position, reported operating results or stock price, and include:

• potentially dilutive issuances of equity securities;

• use of cash resources;

• the incurrence of additional debt and contingent liabilities;

• 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 goodwill and 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:

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• difficulties in assimilating the operations, products, technology, information systems and 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 integrations;

• impairment of relationships with our employees, affiliates, advertisers and content providers;

• inability to maintain uniform standards, controls, procedures and policies;

• the assumption of known and unknown liabilities of the acquired company;

• entrance into markets in which we have no direct prior experience; and

• loss of key employees of the acquired company.

THE GROWTH OF OUR BUSINESS DEPENDS ON THE INCREASED USE OF THE INTERNET FOR COMMUNICATIONS, ELECTRONIC COMMERCE 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 business will be harmed if Internet usage does not continue to grow, particularly as a source of media information and entertainment and as a vehicle for commerce in goods and services. Our success also depends on the efforts of third parties to develop the infrastructure and complementary products and services necessary to maintain and expand the Internet as a viable commercial medium. We believe that other Internet-related issues, such as security, privacy, reliability, cost, speed, ease of use and access, quality of service and necessary increases in bandwidth availability, remain largely unresolved and may affect the amount and type of business that is conducted over the Internet, and impact our ability to sell our products and services and ultimately impact our business results.

If Internet usage grows, the Internet infrastructure may not 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 usage of our 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 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, our products and services, particularly our subscription services, may not achieve broad market acceptance and our business could be harmed.

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 significant business challenges for us. Internet access through cable television set-top boxes, digital subscriber lines or wireless connections could dramatically reduce the demand for our products and services by utilizing alternate technology that more efficiently transmits data and media. This could harm our business as currently conducted.

Also, our products and services may not achieve market acceptance or generate sufficient revenues to offset our costs of developing products and services compatible with broadband transmission formats and infrastructure. Development of products and services for a broadband transmission infrastructure involves a number of additional risks, including:

• changes in content delivery methods and protocols;

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• 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;

• the development of relationships by our current competitors with 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.

MORE INDIVIDUALS ARE UTILIZING NON-PC DEVICES TO ACCESS THE INTERNET AND WE MAY NOT BE SUCCESSFUL IN DEVELOPING A VERSION OF OUR PRODUCTS AND SERVICES THAT WILL GAIN WIDESPREAD ADOPTION BY USERS OF SUCH DEVICES

In the coming years, the number of individuals who access 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, is expected to increase dramatically. If we are unable to attract and retain a substantial number of alternative device manufacturers to license and incorporate our technology into their devices, we may fail to capture a sufficient share of an increasingly important portion of the market for digital media delivery. Further, a failure to develop revenue-generating relationships with a sufficient number of device manufacturers could harm our business prospects.

Our most popular products and services are primarily designed for rich, graphical environments such as those available on personal and laptop computers. The lower resolution, functionality and memory associated with alternative devices could make the use of our products and services difficult. Because we have limited experience to date in creating and shipping versions of our products and services optimized for users of alternative devices, it is difficult to predict the problems we may encounter in doing so and we may need to devote significant resources to create, support and maintain such versions.

We do not believe that clear standards have emerged with respect to non-PC wireless and cable-based systems. Likewise, no single company has yet gained a dominant position in the mobile device market. However, certain products and services in these markets support our technology, and certain support our competitors’ technology, especially that of 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. Other companies’ products and services or new standards may emerge 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.

WE COULD LOSE STRATEGIC RELATIONSHIPS THAT ARE ESSENTIAL TO OUR BUSINESS

The loss of certain current strategic relationships or key licensing arrangements, the inability to find other strategic partners or the failure of our existing relationships to achieve meaningful positive results for us could harm our business. We rely in part on strategic relationships to help us:

• increase adoption of our products through distribution arrangements;

• increase the amount and availability of compelling media content on the Internet to help boost demand for our products and services;

• acquire desirable or necessary technology components and intellectual property rights;

• enhance our brand;

• expand the range of commercial activities based on our technology;

• expand the distribution of our streaming media content without a degradation in fidelity; and

• increase the performance and utility of our products and services.

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 partners to provide multimedia content and technology, to provide alternative distribution channels, to provide more secure and easy-to-use electronic commerce solutions and to build out the

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necessary infrastructure for media delivery. We may not be successful in forming or managing strategic relationships.

OUR BUSINESS WILL SUFFER IF OUR SYSTEMS FAIL OR BECOME UNAVAILABLE

A reduction in the performance, reliability and availability of our Web sites and network infrastructure may harm our ability to distribute our products and services to our users, as well as 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 and access the content services on our Web sites. 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. 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 sophisticated 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. Any system error or failure that causes interruption in availability of products or content or an increase in response time could result in a loss of potential or existing business services customers, users, 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 located at a single leased facility in Seattle, Washington, an area that is at heightened risk of earthquake and volcanic events. We do not 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 our efforts, our network infrastructure and systems could be subject to service interruptions or damage and any resulting interruption of services could harm our business, operating results and reputation.

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 public networks. Any compromise of our ability to transmit such information and data securely, and costs associated with preventing or eliminating any problems, could harm our business. Online transmissions are subject to a number of security risks, including:

• our own or licensed encryption and authentication technology may be compromised, breached or otherwise be insufficient to ensure the security of customer information;

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• 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

• a third party could circumvent our security measures and misappropriate our, our partners’ and our customer’s proprietary information 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 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 AND FINANCIAL RISKS

We operate subsidiaries in Australia, Brazil, England, France, Germany, Hong Kong, Japan, Mexico, Singapore and South Korea, and market and sell products in a number of other countries. We have also entered into joint ventures internationally. For the quarter ended September 30, 2001, approximately 27% of our revenues were derived from international operations.

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 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 rely on the efforts and abilities of our foreign business partners 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 quickly 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.

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, including issues associated with establishing management systems infrastructures in individual markets 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 do not hedge the majority of our foreign currency exposures.

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

Our inability to protect our proprietary rights, and the costs of doing so, could harm our business. Our success and ability to compete partly depend 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. These efforts to protect our intellectual property rights 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.

As of September 30, 2001, we had 38 registered U.S. trademarks or service marks, and had applications pending for an additional 23 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.

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As of September 30, 2001, we had 17 U.S. patents and numerous patent applications on file relating to various aspects of our technology. We are preparing 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, disputes regarding the ownership of these technologies and rights associated with streaming media and digital distribution, and online businesses, are likely to arise in the future. 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. The existence and/or outcome of 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 several of such pending claims. 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.

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 by making, using, selling and/or offering to sell software products and services directed to media delivery systems for the Internet and corporate intranets. The plaintiffs seek to enjoin us from the alleged infringing activity and to recover damages in an amount no less than a reasonable royalty. We believe the allegations are without merit and intend to vigorously defend ourselves against these claims. However, litigation is inherently uncertain, and we may be unable to successfully defend ourselves against this claim.

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, 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

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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.

We do not know for certain how existing laws governing issues such as property ownership, copyright and other intellectual property issues, taxation, gambling, security, illegal or obscene content, retransmission of media, and personal privacy and data protection apply to the Internet. The vast majority of such 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. Most of the laws that relate to the Internet have not yet been interpreted. In addition to potential legislation from local, state and federal governments, our business may be directly or indirectly affected by labor guild agreements that impose fees, royalties or unanticipated payments regarding the distribution of audio or audiovisual works over the Internet. We are not a party to such agreements and have little ability to influence the degree such agreements favor or disfavor Internet distribution. Changes to or the interpretation of these laws and the entry into such industry agreements could:

• limit the growth of the Internet;

• create uncertainty in the marketplace that could reduce demand for our products and services;

• increase our cost of doing business;

• expose us to 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 otherwise 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.

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 will be determined by an arbitration supervised by the United States Copyright Office. The arbitration, known as a CARP proceeding, commenced July 30, 2001 and is expected to render an opinion on license terms and fees before the end of 2001. 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.

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. 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.

There are a large number of legislative proposals before the United States Congress and various state legislatures regarding privacy 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.

WE MAY BE SUBJECT TO MARKET RISK AND LEGAL LIABILITY IN CONNECTION WITH THE DATA COLLECTION CAPABILITIES OF OUR PRODUCTS AND SERVICES

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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 occasionally send information to servers at RealNetworks. Many of the services we provide also require that a user provide certain information to us. We post privacy policies concerning the use, collection and disclosure of our user data. Any failure by us to comply with our posted privacy policies 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, Washington and Texas. 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. 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. 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 periodically enter into arrangements to offer third-party products, services or content under the RealNetworks brand or via distribution on our Web sites, in products or service offerings. We may be subject to claims concerning these products, services or content 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 our agreements with these parties often provide that we will be indemnified against such liabilities, such indemnification may not be adequate. 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 37.0% 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

As of September 30, 2001, our executive officers, directors and affiliated persons beneficially owned approximately 37.0% of our common stock. Robert Glaser, our Chief Executive Officer and Chairman of the Board, beneficially owns approximately 33.2% of our common 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

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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) assets representing more than 50% of the book value of our assets prior to the 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 Mr. Glaser 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

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 September 30, 2001, the price of our common stock ranged from $3.26 to $42.00 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;

• 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 and 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.

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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

We may have to pay past sales or other taxes that we have not collected from our customers. 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.

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. 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. 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 current or 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 may have to pay such taxes out of our own funds.

WE DONATE A PORTION OF NET INCOME TO CHARITY

In those quarters in which we are profitable on a pro forma basis, we set aside 5% of our annual pre-tax net income (before goodwill amortization, acquisition charges, and stock-based compensation) which we intend to donate to charitable organizations. This reduces our net income.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 “believe,” “intend,” “plan,” “expect” and “anticipate” 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 Internet and the online media delivery market;

• the features and functionality of our future products, services and technologies;

• the future adoption of our current and future products, services and technologies, including the extension of our media delivery platform to mobile networks and devices;

• future revenue opportunities;

• the future growth of our customer base;

• our ability to successfully develop and introduce future products and services;

• future international revenues;

• future expense levels (including cost of revenues, research and development, capital expenditures, sales and marketing, general and administrative and income tax expenses);

• future sales and marketing efforts;

• future capital needs and whether our current cash, cash equivalents and short-term investments will be sufficient to meet our cash needs for the next twelve months;

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• the future levels of competition with Microsoft and other competitors;

• the effect of past and future acquisitions and the levels of future acquisitions by us;

• the future effectiveness of our intellectual property rights;

• the effect of current litigation in which we are involved; and

• future impact of interest rates on our operating results or cash flows.

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 Quarterly Report on Form 10-Q.

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 Quarterly Report on Form 10-Q 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 3. 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 market rate risk for changes in 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 cash equivalents and short-term investments consist of high quality securities, as specified in our investment policy guidelines. Investments in both fixed rate and floating rate interest-earning instruments carry a degree of interest rate risk. The fair value of fixed rate securities may be adversely affected by a rise in interest rates, while floating rate securities may produce less income than expected if interest rates fall. Additionally, there may be a degree of reinvestment risk, since as securities mature in a decreasing interest rate environment, 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 affected by changes in interest rates. In addition, we may incur losses in principal if we sell securities that have declined in market value due to changes in interest rates. Because we have historically held our short-term investments until maturity and the substantial majority of our investments mature within one year of purchase, we do 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, and as such, the descriptions under the captions “Interest Rate Risk” remain unchanged from those included in our Form 10-K for the year ended December 31, 2000.

Investment Risk. As of September 30, 2001, we had investments in voting capital stock of privately-held, technology companies for business and strategic purposes. These investments are included in other assets and are accounted for under the cost method since ownership is less than 20% and we do not have significant influence. Some of these securities do not have a quoted market price. Our investments in publicly traded companies are available for sale and 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 the quarter ended September 30, 2001, we determined that an other-than-temporary impairment had occurred on one of our investments. In a similar analysis during the quarter ended June 30, 2001, we determined that such an impairment existed for two other investments. Impairment charges have been recorded to reflect these investments at fair value. For the quarter ended September 30, 2001, this resulted in a loss of $2.5 million, of which $2.1 million was reclassified to the consolidated statement of operations from accumulated other comprehensive loss. Impairment charges of $25.3 million were recognized in the nine months ended September 30, 2001, of which $16.5 million was

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reclassified to the consolidated statements of operations from accumulated other comprehensive loss. Equity price fluctuations of plus or minus 10% of prices at September 30, 2001 would have had an approximate $151,000 impact on the value of our investments in publicly traded companies at September 30, 2001.

Foreign Currency Risk. International revenues accounted for approximately 27% of total net revenues in the quarter ended September 30, 2001. Our international subsidiaries incur most of their expenses in the local currency. Accordingly, all foreign subsidiaries use the local currency as their functional currency.

Our exposure to foreign exchange rate fluctuations arises in part from intercompany payables and receivables to and from our foreign subsidiaries. These intercompany accounts are denominated in the functional currency of the foreign subsidiary in order to centralize foreign exchange risk with the parent company in the United States. During the quarter and nine months ended September 30, 2001, we entered into foreign currency forward contracts to manage the foreign currency risk of certain of these intercompany accounts. At September 30, 2001 we had contracts outstanding to: (1) purchase 574,000 British Pounds Sterling for $838,000, with a fair value of $7,700, and (2) sell 369,055,000 Japanese Yen for $3,154,000, with a fair value of $52,000. Although these instruments are effective as a hedge from an economic perspective, they did not qualify for hedge accounting under SFAS No. 133, as amended.

We are also exposed to foreign exchange rate fluctuations as the financial results of foreign subsidiaries are translated into U.S. dollars in consolidation. As exchange rates vary, these results, when translated, may vary from expectations and adversely impact overall expected profitability. The effect of foreign exchange rate fluctuations for the quarter ended September 30, 2001 was not material.

PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

In August 1998, Venson M. Shaw and Steven M. Shaw filed a lawsuit against the Company and co-defendant Broadcast.com in the United States District Court for the Northern District of Texas — Dallas Division. The plaintiffs allege that the Company, individually and in combination with Broadcast.com, infringes on a certain patent by making, using, selling and/or offering to sell software products and services directed to media delivery systems for the Internet and corporate intranets. The plaintiffs seek to enjoin the Company from the alleged infringing activity and to recover damages in an amount no less than a reasonable royalty. Although no assurance can be given as to the outcome of this lawsuit, the Company believes that the allegations in this action are without merit, and intends to vigorously defend itself against these claims. The Company may be required to indemnify Broadcast.com under the terms of its license agreement. The plaintiffs filed a similar claim based on the same patent and seeking similar remedies as a separate lawsuit against Microsoft and Broadcast.com in the same court. The court has consolidated the lawsuit against Microsoft and Broadcast.com with the lawsuit against the Company and Broadcast.com. If the plaintiffs prevail in their claims, the Company could be required to pay damages or other royalties, in addition to complying with injunctive relief, which could have a material adverse effect on the Company’s operating results.

Between November 1999 and March 2000, fourteen lawsuits were filed against the Company in federal and/or state courts in California, Illinois, Pennsylvania, Washington and Texas. 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. 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 RealNetworks’ End User License Agreement. Although no assurance can be given as to the outcome of these lawsuits, the Company believes that the allegations in these actions are without merit, and intends to vigorously defend itself. 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 our business and our operating results.

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From time to time RealNetworks 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, 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 matters, though it believes these claims are without merit. The Company is not aware of 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.

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized, on November 13, 2001.

REALNETWORKS, INC.

/s/ Brian V. Turner

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

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Realnetworks (RNWK) 10-Q2001 Q3 Quarterly report

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