1
================================================================================
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 JUNE 30, 1998
OR
[ ] 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 91-1628146
(STATE OF INCORPORATION) (I.R.S. EMPLOYER IDENTIFICATION NUMBER)
1111 THIRD AVENUE, SUITE 2900 98101
SEATTLE, WASHINGTON (ZIP CODE)
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)
(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
July 31, 1998 was 29,432,018. In addition, there were 3,338,374 outstanding
shares of the registrant's Special Common Stock, par value $0.001 per share,
that automatically convert on a one-for-one basis into Common Stock on a bona
fide sale to a purchaser who is not an affiliate of the holder.
2
REALNETWORKS, INC.
FORM 10-Q
FOR THE QUARTER ENDED JUNE 30, 1998
TABLE OF CONTENTS
PAGE
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements..................................................4
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations............................................11
PART II. OTHER INFORMATION
Item 1. Legal Proceedings....................................................17
Item 2. Changes in Securities and Use of Proceeds............................17
Item 4. Submission of Matters to a Vote of Security Holders..................18
Item 6. Exhibits and Reports on Form 8-K.....................................18
3
3
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
REALNETWORKS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS EXCEPT PER SHARE DATA)
December 31, June 30,
1997 1998
------------ ------------
ASSETS
Current assets:
Cash, cash equivalents and short-term investments........................ $ 92,028 $ 98,033
Trade accounts receivable, net of allowance for doubtful
accounts and sales returns........................................... 5,073 5,345
Other receivables........................................................ 10,706 227
Prepaid expenses and other current assets................................ 2,052 2,847
------------ ------------
Total current assets................................................. 109,859 106,452
Property and equipment, net................................................... 5,143 5,348
Investment in joint venture................................................... 816 599
Other assets, net............................................................. 886 2,204
------------ ------------
Total assets......................................................... $ 116,704 $ 114,603
============ ============
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Accounts payable......................................................... $ 2,136 $ 2,881
Accrued compensation..................................................... 974 1,266
Other accrued expenses................................................... 2,679 5,843
Deferred revenue......................................................... 16,550 20,438
------------ ------------
Total current liabilities............................................ 22,339 30,428
Deferred revenue, net of current portion...................................... 15,500 10,667
Notes payable................................................................. 963 1,002
Shareholders' equity:
Preferred stock, $0.001 par value
Authorized 60,000 shares; no shares issued and outstanding -- --
Common stock, $0.001 par value
Authorized 292,952 shares; issued and outstanding 27,528 shares
at December 31, 1997 and 29,232 shares at June 30, 1998.............. 28 29
Special common stock, $0.001 par value
Authorized 7,048 shares; issued and outstanding 3,338 shares
at December 31, 1997 and June 30, 1998............................... 3 3
Additional paid-in capital............................................... 95,557 112,405
Accumulated deficit...................................................... (17,524) (39,716)
Accumulated other comprehensive loss..................................... (162) (215)
------------ ------------
Total shareholders' equity........................................... 77,902 72,506
------------ ------------
Total liabilities and shareholders' equity........................... $ 116,704 $ 114,603
============ ============
See accompanying notes to condensed consolidated financial statements
4
4
REALNETWORKS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS EXCEPT PER SHARE DATA)
QUARTER ENDED JUNE 30, SIX MONTHS ENDED JUNE 30,
----------------------------- -----------------------------
1997 1998 1997 1998
---------- ---------- ---------- ----------
Net revenues:
Software license fees...................... $ 5,532 $ 10,796 $ 10,070 $ 20,214
Service revenues........................... 907 3,495 2,189 6,117
Advertising................................ 571 765 1,107 1,227
---------- ---------- ---------- ----------
Total net revenues..................... 7,010 15,056 13,366 27,558
---------- ---------- ---------- ----------
Cost of revenues:
Software license fees...................... 591 1,800 1,134 3,386
Service revenues........................... 285 755 1,612 1,276
Advertising................................ 157 406 308 738
---------- ---------- ---------- ----------
Total cost of revenues................. 1,033 2,961 3,054 5,400
---------- ---------- ---------- ----------
Gross profit........................... 5,977 12,095 10,312 22,158
---------- ---------- ---------- ----------
Operating expenses:
Research and development................... 2,738 4,789 5,463 9,208
Sales and marketing........................ 4,811 8,135 9,161 14,965
General and administrative................. 1,325 2,467 2,496 4,567
Acquisition related charges................ -- -- -- 17,879
---------- ---------- ---------- ----------
Total operating expenses............... 8,874 15,391 17,120 46,619
---------- ---------- ---------- ----------
Operating loss......................... (2,897) (3,296) (6,808) (24,461)
Other income, net.............................. 231 1,192 436 2,269
---------- ---------- ---------- ----------
Net loss....................................... $ (2,666) $ (2,104) $ (6,372) $ (22,192)
========== ========== ========== ==========
Basic and diluted net loss per share........... $ (3.99) $ (0.07) $ (10.17) $ (0.70)
========== ========== ========== ==========
Shares used to compute basic and diluted
net loss per share........................ 685 32,119 640 31,551
See accompanying notes to condensed consolidated financial statements
5
5
REALNETWORKS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
Six Months Ended June 30,
-------------------------------
1997 1998
------------ ------------
Net cash provided by (used in) operating activities $ (5,658) $ 7,000
------------ ------------
Cash flows from investing activities:
Purchases of property and equipment....................................... (2,163) (1,713)
Purchases of short-term investments....................................... (10,614) (43,967)
Proceeds from sales and maturities of short-term investments.............. 8,948 16,106
Investment in joint venture............................................... (998) --
Increase in other assets.................................................. (279) --
Cash obtained through acquisition......................................... -- 203
------------ ------------
Net cash used in investing activities................................. (5,106) (29,371)
------------ ------------
Cash flow from financing activities:
Proceeds from issuance of note payable.................................... 991 --
Net proceeds from sales of common stock and exercise of
stock options and warrants.............................................. 17 526
------------ ------------
Net cash provided by financing activities............................. 1,008 526
------------ ------------
Effect of exchange rate changes on cash........................................ (10) (11)
------------ ------------
Net decrease in cash and cash equivalents............................. (9,766) (21,856)
Cash and cash equivalents at beginning of period............................... 14,738 62,255
------------ ------------
Cash and cash equivalents at end of period..................................... 4,972 40,399
Short-term investments at end of period........................................ 6,524 57,634
------------ ------------
Total cash, cash equivalents and short-term investments at end of period....... $ 11,496 $ 98,033
============ ============
See accompanying notes to condensed consolidated financial statements
6
6
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 (Company) is a leading provider of
branded software products and services that enable the delivery of streaming
media content over the Internet and intranets. Streaming technology enables the
transmission and playback of continuous "streams" of multimedia content, such as
audio, video, and animation, over the Internet and intranets. The Company's
products and services include its RealSystem, a streaming media solution that
includes RealAudio and RealVideo technology, an electronic commerce World Wide
Web (Web) site designed to promote the proliferation of streaming media products
and a network of advertising-supported content aggregation Web sites.
(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 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 six months ended June 30, 1998
are not necessarily indicative of the results that may be expected for any
subsequent quarter or for the year ending December 31, 1998. Certain information
and footnote disclosures normally included in financial statements prepared in
conformity with generally accepted accounting principles 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 financial statements and related notes included in the
Company's Annual Report on Form 10-K for the year ended December 31, 1997.
(c) Cash, Cash Equivalents and Short-Term Investments
Cash, cash equivalents and short-term investments are comprised of the
following:
December 31, 1997 June 30, 1998
----------------- -------------
(in thousands)
Cash and cash equivalents $62,255 $30,799
Short-term investments 29,773 57,634
Restricted cash equivalents -- 9,600
------- -------
$92,028 $98,033
======= =======
Restricted cash equivalents represent a restricted escrow account
established in connection with a lease agreement for new corporate offices. The
Company expects to take occupancy of the new facilities during the quarter
ending June 30, 1999.
7
7
(d) Revenue Recognition
On January 1, 1998, the Company adopted the provisions of Statement of
Position 97-2, Software Revenue Recognition (SOP 97-2), which provides specific
industry guidance and stipulates that revenue recognized from software
arrangements is to be allocated to each element of the arrangement based on the
relative fair values of the elements, such as software products, upgrades,
enhancements, post contract customer support, installation, or training. Under
SOP 97-2, the determination of fair value is based on objective evidence that is
specific to the vendor. If such evidence of fair value for each element of the
arrangement does not exist, all revenue from the arrangement is deferred until
such time that evidence of fair value does exist or until all elements of the
arrangement are delivered. The adoption of SOP 97-2 did not have a material
effect on revenue recognition for the quarter and six months ended June 30,
1998.
Prior to January 1, 1998, the Company recognized revenue from software
license fees upon delivery, net of an allowance for estimated returns, provided
that no significant obligations of the Company remain and collection of the
resulting receivable is deemed probable.
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. If the Company anticipates
providing ongoing support to the OEM in the form of future upgrades,
enhancements or other services over the term of the contract, revenue is
recognized on the straight-line method over the term of the contract.
The Company recognizes revenue from software license agreements with
value-added resellers (VAR), when the following conditions are met: the software
product has been delivered to the VAR, the fee to the Company is fixed or
determinable, and collectibility is probable.
Service revenues include payments under support and upgrade contracts,
and fees from consulting and content hosting. Support and upgrade revenues are
recognized ratably over the term of the contract, which typically is 12 months.
Other service revenues are recognized when the service is performed.
Revenues from advertising appearing on the Company's Web sites are
recognized ratably over the terms of the advertising contracts. The Company
guarantees to certain advertising customers a minimum number of page impressions
to be delivered to users of its Web sites for a specified period. To the extent
minimum guaranteed page impression deliveries are not met, the Company defers
recognition of the corresponding revenues until guaranteed page impression
delivery levels are achieved.
(e) Comprehensive Income
In June 1997, the Financial Accounting Standards Board issued Statement
of Financial Accounting Standards No. 130, Reporting Comprehensive Income
(Statement 130), which establishes standards for the reporting and disclosure of
comprehensive income and its components (revenues, expenses, gains and losses)
in a full set of general-purpose financial statements. Statement 130 is
effective for fiscal years beginning after December 15, 1997 and requires
reclassification of financial statements for earlier periods to be provided for
comparative purposes. The Company has not determined the manner in which it will
present the information required by Statement 130 in its annual financial
statements for the year ending December 31, 1998. The Company's total
comprehensive loss for the quarters ended June 30, 1997 and 1998 was
$(2,638,000) and $(2,143,000), respectively. The Company's total comprehensive
loss for the six months ended June 30, 1997 and 1998 was $(6,353,000) and
$(22,245,000), respectively. Total comprehensive loss for the quarters and six
months ended June 30, 1997 and 1998 consisted of net loss and foreign currency
translation adjustments.
8
8
(f) Net Loss Per Share
Basic earnings per share is computed by dividing the sum of net loss
plus accretion of redemption value of redeemable preferred stock by the weighted
average number of common shares outstanding during the period. Diluted earnings
per share is computed by dividing the sum of net loss plus accretion of
redemption value of redeemable preferred stock by the weighted average number of
common and dilutive common equivalent shares outstanding during the period. As
the Company had a net loss attributable to common shareholders in each of the
periods presented, basic and diluted net loss per share are the same.
The following table reconciles the Company's reported net loss to net
loss attributable to common shareholders used to compute basic and diluted net
loss per share:
Quarter Ended June 30, Six Months Ended June 30,
------------------------------ ------------------------------
1997 1998 1997 1998
-------- -------- -------- --------
(in thousands)
Net Loss $ (2,666) $ (2,104) $ (6,372) $(22,192)
Accretion of redemption value of
redeemable preferred stock
prior to conversion into
common stock (67) -- (134) --
-------- -------- -------- --------
Net loss attributable to common
shareholders $ (2,733) $ (2,104) $ (6,506) $(22,192)
======== ======== ======== ========
Excluded from the computation of diluted earnings per share for the quarter and
six months ended June 30, 1998 are options to acquire 7,604,000 shares of common
stock with a weighted-average exercise price of $6.81 and warrants to acquire
472,000 shares of common stock with a weighted-average exercise price of $9.41
because their effects would be anti-dilutive.
NOTE 2 - ACQUISITION
In March 1998, the Company completed the acquisition of Vivo Software,
Inc. (Vivo), a developer of streaming media creation tools. Under the terms of
the acquisition, the Company issued approximately 1,102,000 shares of its common
stock in exchange for all outstanding shares of Vivo common stock. In addition,
the Company issued options to purchase approximately 48,000 shares of the
Company's common stock in exchange for outstanding unvested options to purchase
Vivo common stock. The acquisition was accounted for using the purchase method
of accounting, and, accordingly, the results of Vivo's operations are included
in the Company's condensed consolidated financial statements from the date of
acquisition.
A summary of the purchase price for the acquisition is as follows (in
thousands):
Stock and stock options $16,526
Direct acquisition costs 445
Accrued expenses assumed 1,640
Other current liabilities assumed 1,021
Non-current liabilities assumed 36
-------
Total $19,668
=======
9
9
A summary of the allocation of the purchase price is as follows (in
thousands):
In-process research and development $ 17,729
Cash acquired 203
Other current assets acquired 148
Property and equipment 100
Goodwill 1,488
-----
Total $ 19,668
========
In-process research and development represents the fair value of
technologies acquired for use in the Company's own development efforts. The
Company determined the amount of the purchase price to be allocated to
in-process research and development based on the time and cost to incorporate
the acquired technology into the Company's development projects, expected
incremental revenues and expenses associated with the development projects
utilizing the acquired technology, and risks and uncertainties associated with
the acquired technology. Such risks and uncertainties include inherent
difficulties and uncertainties in incorporating the acquired technology into the
Company's development projects and risks related to the viability of and
potential changes to target markets. The Company also concluded that the
acquired technology had no alternative future use.
Goodwill represents the excess of the purchase price over the fair
value of identifiable tangible and intangible assets acquired and is amortized
using the straight-line method over its estimated life of five years.
The acquisition of Vivo was a tax free reorganization under the
Internal Revenue Code (IRC). Therefore, the charge for in-process research and
development is not deductible for income tax purposes. The Company acquired a
net operating loss carryforward of approximately $16,000,000, which expires from
2008 to 2012. Under the provisions of the IRC, the amount of these net operating
loss carryforwards available annually to offset future taxable income is
significantly limited. No value has been attributed to these net operating
losses in the purchase price allocation due to these limitations.
In connection with the acquisition, approximately 220,000 shares of
common stock issued were placed in escrow to secure indemnification obligations
of former shareholders of Vivo.
The following table presents pro forma results of operations as if the
acquisition had occurred at the beginning of each of the periods presented. The
pro forma results of operations exclude $17,879,000 of acquisition related
charges as the charges are not expected to have a continuing impact on the
Company's results of operations. The pro forma information is not necessarily
indicative of the combined results that would have occurred had the acquisition
taken place at the beginning of 1997 or at the beginning of 1998, nor is it
necessarily indicative of results that may occur in the future.
Pro forma
Six Months Ended June 30,
---------------------------------
1997 1998
-------- ---------
(in thousands except per share data)
Revenues $ 14,156 $ 28,211
Net loss (9,471) (5,443)
Net loss per share (6.31) (0.17)
10
10
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
THE FOLLOWING MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS CONTAINS FORWARD-LOOKING STATEMENTS THAT HAVE BEEN MADE
PURSUANT TO THE PROVISIONS OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF
1995. SUCH FORWARD LOOKING STATEMENTS ARE BASED ON CURRENT EXPECTATIONS,
ESTIMATES AND PROJECTIONS ABOUT THE COMPANY'S INDUSTRY, MANAGEMENT'S BELIEFS AND
CERTAIN ASSUMPTIONS MADE BY THE COMPANY'S MANAGEMENT. WORDS SUCH AS
"ANTICIPATES", "EXPECTS", "INTENDS", "PLANS", "BELIEVES", "SEEKS", "ESTIMATES"
AND SIMILAR EXPRESSIONS ARE INTENDED TO IDENTIFY SUCH FORWARD-LOOKING
STATEMENTS. THESE STATEMENTS ARE NOT GUARANTEES OF FUTURE PERFORMANCE AND ARE
SUBJECT TO CERTAIN RISKS, UNCERTAINTIES AND ASSUMPTIONS THAT ARE DIFFICULT TO
PREDICT. THE COMPANY'S ACTUAL ACTIONS OR RESULTS MAY DIFFER MATERIALLY FROM
THOSE DISCUSSED IN THE FORWARD-LOOKING STATEMENTS. SUCH RISKS AND UNCERTAINTIES
INCLUDE THOSE SET FORTH HEREIN UNDER "OVERVIEW", "RESULTS OF OPERATIONS", AND
"LIQUIDITY AND CAPITAL RESOURCES", IN THE SECTION TITLED "CERTAIN RISK FACTORS
THAT MAY AFFECT THE COMPANY'S BUSINESS, FUTURE OPERATING RESULTS AND FINANCIAL
CONDITION" INCLUDED IN THE COMPANY'S ANNUAL REPORT ON FORM 10-K FOR THE YEAR
ENDED DECEMBER 31, 1997, AND IN THE SECTIONS TITLED "RISK FACTORS" AND
"BUSINESS" INCLUDED IN THE COMPANY'S FINAL PROSPECTUS DATED NOVEMBER 21, 1997.
UNLESS REQUIRED BY LAW, THE COMPANY UNDERTAKES NO OBLIGATION TO UPDATE PUBLICLY
ANY FORWARD-LOOKING STATEMENTS, WHETHER AS A RESULT OF NEW INFORMATION, FUTURE
EVENTS OR OTHERWISE. HOWEVER, READERS SHOULD CAREFULLY REVIEW THE INFORMATION
SET FORTH IN OTHER REPORTS OR DOCUMENTS THAT THE COMPANY FILES FROM TIME TO TIME
WITH THE SECURITIES AND EXCHANGE COMMISSION.
OVERVIEW
RealNetworks is a leading provider of branded software products and
services that enable the delivery of streaming media content over the Internet
and intranets. The Company's products and services include its RealSystem, a
streaming media solution that includes RealAudio and RealVideo technology, an
electronic commerce Web site designed to promote the proliferation of streaming
media products and a network of advertising-supported content aggregation Web
sites.
In March 1998, the Company completed the acquisition of Vivo Software,
Inc. ("Vivo"), a developer of streaming media creation tools. Under the terms of
the acquisition, the Company exchanged approximately 1,102,000 shares of its
common stock in exchange for all outstanding shares of Vivo common stock. The
acquisition was accounted for using the purchase method of accounting. Of the
total purchase price, $17,729,000 was allocated to in-process research and
development and was charged to the Company's results of operations for the six
months ended June 30, 1998. The remaining purchase price of $1,939,000 was
allocated to tangible assets acquired and goodwill. Goodwill is amortized over
its estimated life of five years. See Note 2 of Notes to Condensed Consolidated
Financial Statements. Although the Company believes that the acquisition of Vivo
is in the best interests of the Company and its shareholders, acquisitions
involve a number of special risks, including: the integration of acquired
products and technologies in a timely manner; the integration of businesses and
employees with the Company's business; adverse effects on the Company's reported
operating results from acquisition-related charges and amortization of goodwill;
potential increases in stock compensation expense and increased compensation
expense resulting from newly-hired employees; distraction of the Company's
management from the day-to-day business and operations of the Company; the
assumption of unknown liabilities; and the possible failure to retain key
acquired personnel. Because most software business acquisitions involve the
purchase of significant amounts of intangible assets, acquisitions of such
businesses typically result in goodwill and amortization charges and may also
involve charges for acquired research and development projects. If the Company
were to incur additional charges for acquired in-process research and
development and amortization of goodwill with respect to future acquisitions,
such charges could have a material adverse effect on the Company's business,
financial condition and results of operations.
11
11
During the second quarter of 1998, the Company released RealSystem G2,
its next generation streaming media delivery system consisting of servers, tools
and client software, in preview form to the public prior to finalizing product
features, functionality and operability. The preview release of RealSystem G2
may cause certain customers to delay purchasing decisions until commercial
versions of the products are available, which could have a material adverse
effect on the Company's future revenues and quarterly results of operations. In
addition, software products as complex as those offered by the Company
frequently contain errors or failures, especially when new versions are
released. Although the Company conducts extensive product testing during product
development, there can be no assurance that, despite testing by the Company and
by current and potential customers, errors will not be found in new versions of
its products after commencement of commercial shipments. Potential errors could
result in the loss of revenue or delay in market acceptance of the Company's
products, diversion of development resources, damage to the Company's reputation
or increased service and warranty costs, any of which could have a material
adverse effect on the Company's business, financial condition and results of
operations. In addition, there can be no assurance that the Company will not
experience delays in the development, introduction, marketing and distribution
of the final version of RealSystem G2, which delays, if they were to occur,
could have a material adverse effect on the Company's business, financial
condition and results of operations.
In June 1997, the Company entered into a strategic agreement
("Agreement") with Microsoft Corporation ("Microsoft") pursuant to which the
Company granted Microsoft a nonexclusive license to its Standard Code (as
defined in the Agreement), which is comprised of certain substantial elements
of the source code of the Company's RealAudio/RealVideo Version 4.0 technology
included in its basic RealPlayer and substantial elements of its EasyStart
Server (currently known as the Basic Server), and related Company trademarks.
In July 1997, the Company delivered the Standard Code in exchange for a license
fee of $30,000,000. The Company recognizes revenue related to this Agreement
ratably over the three-year term of its ongoing obligations. The portion of the
license fee that has not yet been recognized as revenue is included in deferred
revenue.
Under the Agreement, Microsoft may sublicense its rights to the
Standard Code to third parties under certain conditions without additional
compensation to the Company. In addition, Microsoft has an option to receive
two additional deliveries of updated versions of the Standard Code. Microsoft's
right to receive the first delivery expired unexercised in July, 1998.
Microsoft may elect to receive a delivery of the then current version of the
Standard Code once before July, 1999, upon payment of a license fee of $35
million. If the Company elects in its sole discretion to grant an Event License
(as defined in the Agreement) to a third party, the Agreement provides for a
refund of a portion of the license fee paid by Microsoft, based on a declining
scale over the term of the Agreement.
In connection with the Agreement, Microsoft purchased a minority
interest in the Company in the form of 3,338,374 shares of nonvoting Series E
Preferred Stock at approximately $8.99 per share, which shares were converted
to Special Common Stock upon the completion of the Company's initial public
offering. All shares of Special Common Stock will automatically convert into
the same number of shares of Common Stock upon transfer by Microsoft to a
purchaser who is not affiliated with Microsoft. Microsoft has the right to
require the Company to register Microsoft's shares for sale under the
Securities Act of 1933. Rule 144 of the Securities Act provides, in general,
that any person who has beneficially owned shares for at least one year may
generally sell, within any three-month period, a number of shares that does not
exceed the greater of 1% of the shares of Common Stock then outstanding or the
reported average weekly trading volume in the Company's Common Stock (computed
over a four-week period). Sales of substantial numbers of shares of Special
Common Stock in the public market could have a material adverse effect on the
market price for the Company's Common Stock.
Although Microsoft is a shareholder of the Company, it is also a
competitor and its interests may not always be aligned with those of the Company
and the Company's other shareholders. Microsoft has indicated that, to the
extent the relationship between the parties becomes more competitive than
complementary, it is likely to re-evaluate its investment position in the
Company. Microsoft has not formally communicated to the Company its intentions
with respect to its investment position in the Company, but at times has
indicated informally that it may sell at least a portion of its shares. There
can be no assurance that any such issues, the evolving nature of the
relationship, or economic factors would not result in Microsoft selling all or a
portion of its holdings in the Company, which could have a material adverse
effect on the market price for the Company's Common Stock.
Microsoft recently introduced the Windows Media Player, which competes
with the Company's RealPlayer software, and is available for download from
Microsoft's Web site. Microsoft has stated publicly that future releases of its
new Windows 98 operating system, likely as early as the third quarter of 1998,
will include the Windows Media Player. The Windows Media Player is based in part
on technology Microsoft licensed from the Company under the Agreement, and can
therefore play audio and video content based on earlier versions of the
Company's RealAudio and RealVideo technology. Because Microsoft has not
exercised its option to receive subsequent versions of the Standard Code, the
Windows Media Player cannot play audio or video content based on the RealSystem
5.0 or G2 technology. Therefore, consumers who are using the Windows Media
Player to receive audio and video over the Internet will not be able to access
content available in the Company's newer formats. In addition, while Microsoft
currently distributes certain older versions of the RealPlayer with Internet
Explorer, which is distributed with the Windows operating system, Microsoft has
indicated to the Company that it will not distribute the RealPlayer with future
versions of Windows 98.
On July 23, 1998, Robert Glaser, the Company's Chief Executive Officer,
testified before the Senate Judiciary Committee that if a consumer already has
the RealPlayer on a computer system, and thereafter downloads the Windows Media
Player or installs Windows 98 with the Windows Media Player included on it, in a
number of circumstances the Windows Media Player will disable certain important
functions of the RealPlayer. As a result, certain of the Company's customers who
have downloaded the free RealPlayer or paid for the RealPlayer Plus, may find
that their product has ceased working. Because the Company raised the issue
right after the Windows Media Player was released, and because the Company
quickly posted a workaround solution on its Web site that the Company believes
will counteract the situation, the Company believes only a small number of
consumers will be impacted by the situation. In light of these recent events,
the Company's relationship with Microsoft has become more competitive.
Microsoft has a longer operating history, greater name recognition, and
significantly greater financial, technical, marketing, and distribution
resources than the Company. The Company's inability to sustain or maintain its
leadership position in its market segment could have a material adverse effect
on the Company's business, financial condition and results of operations and
on the market price for the Company's Common Stock.
In August 1997, the Department of Justice commenced an investigation
into horizontal merger activities within the streaming media industry. The
Department of Justice served several companies, including the Company and
Microsoft, with subpoenas to produce certain documents. The Company continues
to supply documents and information in response to the subpoenas. As a result
of the investigation, it is possible that the Department of Justice will require
certain actions by the Company, Microsoft or other companies in the streaming
media industry that could have a material adverse effect on the Company's
business, financial condition and results of operations.
12
12
Due to the foregoing factors, it is likely that the Company's operating
results in some future quarters will fall below the expectations of securities
analysts and investors, which would likely have a material adverse affect on the
trading price of the Company's common stock.
RESULTS OF OPERATIONS
REVENUES
Software License Fees. Software license fees were $10,796,000 for the
quarter ended June 30, 1998, an increase of 95% from $5,532,000 in the
comparable quarter of the prior year. Software license fees were $20,214,000 for
the six months ended June 30, 1998, an increase of 101% from $10,070,000 in the
comparable period of the prior year. The increases were due primarily to a
greater volume of products sold as a result of growing market acceptance of the
Company's products, the introduction of new products, successful product
promotions and increased sales from electronic distribution. In addition, in
June 1997, the Company entered into a $30,000,000 license agreement with
Microsoft. The agreement requires the Company to provide Microsoft with
engineering consultation services, certain error corrections and certain
technical support over a defined term. The Company recognizes revenue from the
agreement over the three-year term of the Company's ongoing obligations.
Included in software license fees for the quarter and six months ended June 30,
1998, were $2,418,000 and $4,836,000, respectively, related to the Microsoft
license agreement.
Service Revenues. Service revenues were $3,495,000 for the quarter
ended June 30, 1998, an increase of 285% from $907,000 in the comparable quarter
of the prior year. Service revenues were $6,117,000 for the six months ended
June 30, 1998, an increase of 179% from $2,189,000 in the comparable period of
the prior year. The increases were primarily due to the introduction of support
and upgrade contracts for the Company's RealPlayer Plus and a larger installed
base of the Company's products. The larger installed base of the Company's
products promotes increases in revenues through the purchase of support and
upgrade contracts and other services performed by the Company. Service revenues
for the six months ended June 30, 1997, also included $498,000 related to the
Company's RealNetworks Conference.
Advertising Revenues. Advertising revenues were $765,000 for the
quarter ended June 30, 1998, an increase of 34% from $571,000 in the comparable
quarter of the prior year. Advertising revenues were $1,227,000 for the six
months ended June 30, 1998, an increase of 11% from $1,107,000 in the comparable
period of the prior year. The increases in advertising revenues were due to a
larger sales force and greater success in attracting advertisers.
13
13
COST OF REVENUES
Cost of Software License Fees. Cost of software license fees includes
costs of product media, duplication, manuals, packaging materials, royalties
paid for licensed technology, and order fulfillment costs. Cost of software
license fees was $1,800,000 for the quarter ended June 30, 1998, an increase of
205% from $591,000 in the comparable quarter in the prior year, and increased as
a percentage of software license fees to 17% from 11%. Cost of software license
fees was $3,386,000 for the six months ended June 30, 1998, an increase of 199%
from $1,134,000 in the comparable period in the prior year, and increased as a
percentage of software license fees to 17% from 11%. These increases were due
primarily to higher sales volumes and royalties related to new third-party
technologies incorporated into the Company's products. The increases in cost of
software license fees as a percentage of software license fees were due to
changes in the mix of products sold.
Cost of Service Revenues. Cost of service revenues includes the cost of
in-house and contract personnel providing support and other services and
bandwidth expenses for hosting services. Cost of service revenues was $755,000
for the quarter ended June 30, 1998, an increase of 165% from $285,000 in the
comparable quarter in the prior year, but decreased as a percentage of service
revenues to 22% from 31%. Cost of service revenues was $1,276,000 for the six
months ended June 30, 1998, a decrease of 21% from $1,612,000 in the comparable
period in the prior year, and decreased as a percentage of service revenues to
21% from 74%. Cost of service revenues for the six months ended June 30, 1997,
includes $1,000,000 of costs associated with the Company's RealNetworks
Conference. Excluding the impact of the RealNetworks Conference, cost of service
revenues was $612,000, or 36% of service revenues, for the six months ended June
30, 1997. The increases in cost of service revenues excluding the RealNetworks
Conference were primarily due to increased staff and contract personnel to
provide services to a greater number of customers. The decreases in percentage
terms were primarily due to economies of scale in providing support services.
Cost of Advertising Revenues. Cost of advertising revenues includes
personnel associated with content creation, bandwidth expenses and fees paid to
third-parties for content included in the Company's Web sites. Cost of
advertising revenues was $406,000 for the quarter ended June 30, 1998, an
increase of 159% from $157,000 in the comparable quarter in the prior year, and
increased as a percentage of advertising revenues to 53% from 27%. Cost of
advertising revenues was $738,000 for the six months ended June 30, 1998, an
increase of 140% from $308,000 in the comparable period in the prior year, and
increased as a percentage of advertising revenues to 60% from 28%. These
increases were primarily due to increases in the quality and quantity of content
available on the Company's Web pages and increased costs associated with the
maintenance of newly developed Web sites.
Gross margins may be affected by the mix of distribution channels used,
the mix of products sold, licensed third-party technology incorporated into the
Company's products, the mix of product versus services revenues and the mix of
international versus U.S. revenues. If sales through indirect channels increase
as a percentage of total net revenues, service revenues increase as a percentage
of total net revenues, or sales of the Company's lower margin products increase
as a percentage of total net revenues, the Company's gross margins will be
adversely affected.
OPERATING EXPENSES
Research and Development. Research and development expenses consist
primarily of salaries and consulting fees to support product development and
costs of technology acquired from third parties to incorporate into products
under development. To date, all research and development costs have been
expensed as incurred because technological feasibility of the Company's products
is established upon completion of a working model. Costs incurred between
completion of a working model and general release of products have been
insignificant. Research and development expenses were $4,789,000 for the quarter
ended June 30, 1998, an increase of 75% from $2,738,000 in the comparable
quarter in the prior year, but decreased as a percentage of total net revenues
to 32% from 39%. Research and development expenses were $9,208,000 for the six
months ended June 30, 1998, an increase of 69% from $5,463,000 in the
comparable period in the prior year, but decreased as a percentage of total net
revenues to 33% from 41%. The increases in absolute dollars were primarily due
to increases in internal development personnel and consulting expenses. The
decreases in percentage terms were a result of revenues growing at a faster rate
than expenses. Research and development expenses were primarily related to the
14
14
development of new technology and products and enhancements made to existing
products. The Company believes that significant investments in research and
development is a critical factor in attaining its strategic objectives and, as a
result, expects to increase research and development expenditures in future
periods.
Sales and Marketing. Sales and marketing expenses consist principally
of salaries, commissions, consulting fees paid, trade show expenses,
advertising, promotional expenses and cost of marketing collateral. Sales and
marketing expenses were $8,135,000 for the quarter ended June 30, 1998, an
increase of 69% from $4,811,000 in the comparable quarter of the prior year, but
decreased as a percentage of total net revenues to 54% from 69%. Sales and
marketing expenses were $14,965,000 for the six months ended June 30, 1998, an
increase of 63% from $9,161,000 in the comparable period of the prior year, but
decreased as a percentage of total net revenues to 54% from 69%. The increases
in absolute dollars were due to the expansion of the Company's direct sales
organization, the creation of additional sales offices, promotions and expenses
related to the continued development of the "Real" brand. For the quarter ended
June 30, 1998, sales and marketing expenses included the net costs of the 1998
RealNetworks Conference. The decreases in percentage terms were a result of
revenues growing at a faster rate than expenses. The Company intends to continue
its branding and marketing efforts and, therefore, expects sales and marketing
expenses to increase significantly in future periods.
General and Administrative. General and administrative expenses consist
primarily of personnel costs, fees for professional services and corporate
infrastructure costs. General and administrative expenses were $2,467,000 for
the quarter ended June 30, 1998, an increase of 86% from $1,325,000 in the
comparable quarter of the prior year, but decreased as a percentage of total net
revenues to 16% from 19%. General and administrative expenses were $4,567,000
for the six months ended June 30, 1998, an increase of 83% from $2,496,000 in
the comparable period of the prior year, but decreased as a percentage of total
net revenues to 17% from 19%. The increases in absolute dollars were primarily a
result of increased personnel and facility expenses necessary to support the
Company's growth and costs associated with operating as a public company. The
decreases in percentage terms were due to revenues growing at a faster rate than
expenses. The Company expects general and administrative expenses to increase as
the Company expands its staff, incurs additional costs related to the growth of
its business, and incurs additional costs related to operating as a public
company.
Acquisition Related Charges. Acquisition related charges include
acquired in-process research and development and other acquisition related
costs. During the six months ended June 30, 1998, the Company incurred
$17,879,000 in expenses associated with the acquisition of Vivo. The Company
may, in the future, acquire businesses or technologies that are complimentary to
those of the Company, the results of which could include significant charges for
acquired in-process research and development and the amortization of acquired
intangible assets.
OTHER INCOME, NET
Other income, net consists primarily of earnings on the Company's cash,
cash equivalents and short-term investments. Other income, net was $1,192,000
and $2,269,000 for the quarter and six months ended June 30, 1998, respectively,
and $231,000 and $436,000 for the quarter and six months ended June 30, 1997,
respectively. The increases were due primarily to interest earned on proceeds
from the sales of common and preferred stock in 1997, including the Company's
initial public offering in November, 1997.
LIQUIDITY AND CAPITAL RESOURCES
Net cash provided by operating activities was $7,000,000 for the six
months ended June 30, 1998. Net cash used in operating activities was $5,658,000
for the six months ended June 30, 1997. Cash provided by operating activities
for the six months ended June 30, 1998, was due to a decrease in other
receivables and non-cash charges associated with depreciation and acquisition
related charges, partially offset by the reported net loss. Cash used in
operating activities for the six months ended June 30, 1997 was due primarily to
the reported net loss.
Net cash used in investing activities was $29,371,000 and $5,106,000
for the six months ended June 30, 1998 and 1997, respectively. Cash used in
investing activities for the six months ended June 30, 1998, was primarily a
result of net purchases of short-term investments and purchases of equipment.
Cash used in investing
15
15
activities for the six months ended June 30, 1997, was due to net purchases of
short-term investments and purchases of equipment.
Net cash provided by financing activities was $526,000 and $1,008,000
for the six months ended June 30, 1998 and 1997, respectively. Cash provided by
financing activities for the six months ended June 30, 1998, was a result of net
proceeds from the sales of common stock and the exercise of stock options and
warrants. Cash provided by financing activities for the six months ended June
30, 1997, was a result of the exercise of stock options and proceeds from a note
payable.
At June 30, 1998, the Company had $98,033,000 in cash, cash equivalents
and short-term investments. As of June 30, 1998, the Company's principal
commitments consisted of obligations under operating leases and $1,002,000 in
notes payable. Since its inception, the Company has experienced a substantial
increase in its capital expenditures to support expansion of the Company's
operations and information systems. In January 1998, the Company entered into a
lease agreement for a new location for its corporate offices. The Company
anticipates the new lease will require significant capital expenditures
associated with leasehold improvements. In the past, the Company has completed
acquisitions of businesses and technologies, and will continue to evaluate
acquisitions of, or investments in, businesses, products, joint-ventures, or
technologies that are complementary to the operations of the Company. Such
acquisitions or investments, which the Company believes have been, and will
continue to be, in the best interest of the Company, involve risks and may
require additional cash investments by the Company.
Since its inception, the Company has significantly increased its
operating expenses. The Company currently anticipates that it will continue to
experience significant growth in its operating expenses and that such expenses
will be a material use of the Company's cash resources. The Company believes
that its current cash, cash equivalents, and short-term investments will be
sufficient to meet its anticipated cash needs for working capital and capital
expenditures for at least the next 12 months. The Company may, in the future,
seek to raise additional funds through public or private equity financing, or
through other sources such as credit facilities. The sale of additional equity
securities could result in dilution to the Company's shareholders.
Although the Company believes that all of its current products are Year
2000 compliant, it has not yet completed sufficient internal testing of
recently developed and newly acquired technologies, and there can be no
assurance that the Company's current products do not contain undetected errors
related to Year 2000 that may result in material additional costs or
liabilities that could have a material adverse effect on the Company's
business, financial condition and results of operations. In addition, the
Company has on occasion agreed to indemnify certain of its customers for claims
and losses arising out of the failure of its products to be Year 2000
compliant. To the extent that the Company is not able to test the technology
provided to it by third-parties for its own use or for redistribution, or to
obtain assurances from such third-parties that their products are Year 2000
compliant, the Company may experience material additional costs or liabilities
that could have a material adverse effect on the Company's business, financial
condition, and results of operations. With regard to the Company's internal
processing and operational systems, the Company is in the process of
identifying and testing all systems for Year 2000 compliance. Although the
Company is not aware of any material operational issues or costs associated
with preparing internal systems for the Year 2000, there can be no assurance
that the Company will not experience material adverse effects from undetected
errors or the failure of such systems to be Year 2000 compliant. Any such
failures could have a material adverse effect on the Company's business,
financial condition and results of operations.
16
16
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
From time to time the Company has been, and continues to be, subject to
legal proceedings and claims in the ordinary course of its business, including
claims of alleged infringement of third-party trademarks and other intellectual
property rights by the Company and its licensees. Such claims, even if not
meritorious, could result in the expenditure of significant financial and
managerial resources.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
(c) Since April 1, 1998, the Company has issued and sold unregistered
securities as follows:
(1) An aggregate of 28,126 shares of Common Stock was issued
to one investor upon the cashless exercise of a warrant in April 1998. The
aggregate consideration received for such shares was the cancellation of a
warrant to acquire 39,841 shares of Common Stock at an exercise price of $9.41.
(2) An aggregate of 81,182 shares of Common Stock was issued
to two investors upon the cashless exercise of warrants in May 1998. The
aggregate consideration received for such shares was the cancellation of
warrants to acquire 119,522 shares of Common Stock at an exercise price of
$9.41.
(3) An aggregate of 26,096 shares of Common Stock was issued
to two investors upon the cashless exercise of warrants in June 1998. The
aggregate consideration received for such shares was the cancellation of
warrants to acquire 39,840 shares of Common Stock at an exercise price of $9.41.
(4) An aggregate of 2,826 shares of Common Stock was issued to
one investor upon the exercise of a warrant in June 1998. The aggregate
consideration received for such shares was $26,600.
(5) An aggregate of 6,437 shares of Common Stock was issued in
June 1998 to four individuals in exchange for 144,644 shares of Common Stock of
Vivo Software, Inc., a Massachusetts corporation. The aggregate consideration
received for such shares was valued at $99,900.
(6) Between April 1, 1998 and June 30, 1998, an aggregate of
289,932 shares of Common Stock had been issued to employees upon the exercise of
options. The aggregate consideration received for such shares was $133,193.
Use of Proceeds
The Company's registration statement under the Securities Act of 1933,
as amended, for its initial public offering became effective on November 21,
1997. Offering proceeds, net of aggregate expenses of approximately $4.6
million, were approximately $38.5 million. The Company has used all of the net
offering proceeds for the purchase of temporary investments consisting of cash,
cash equivalents and short-term investments. The Company has not used any of the
net offering proceeds for construction of plant, building or facilities,
purchases of real estate, acquisition of other businesses, or repayment of
indebtedness. None of the net offering proceeds were paid directly or indirectly
to directors, officers, or general partners of the Company or their associates,
persons owning 10% or more of any class of the Company's securities, or
affiliates of the Company.
17
17
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
An Annual Meeting of Shareholders of RealNetworks, Inc. was held on May
22, 1998. Matters voted on at the meeting and votes cast on each were as
follows:
1. To elect one director to serve until the 2001 Annual Meeting of
Shareholders or until his earlier retirement, resignation or removal, or the
election of his successor. The terms of office of Robert Glaser, Bruce Jacobsen,
and James Breyer, the other directors of the Company, continued after the
meeting.
For Withheld
--- --------
Mitchell Kapor 24,806,402 16,056
2. To approve an amendment to the Company's Amended and Restated 1996
Stock Option Plan to increase by 2,500,000 the number of shares of Common Stock
that may be issued thereunder.
For 22,650,735
Against 425,755
Abstain 11,432
Broker Non-Votes 1,734,536
3. To ratify the appointment of KPMG Peat Marwick LLP as independent
auditors for the Company's fiscal year ending December 31, 1998.
For 24,782,539
Against 31,920
Abstain 7,999
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits required by Item 601 of Regulation S-K:
10.1 RealNetworks, Inc. Amended and Restated 1996 Stock
Option Plan
27.1 Financial Data Schedule which is submitted
electronically to the Securities and Exchange
Commission for information purposes only and not
filed
(b) Reports on Form 8-K:
On April 8, 1998, the Company filed a report on Form 8-K
(as amended by Form 8-K/A filed on June 4, 1998 to include
Financial Statements of Business Acquired and Pro Forma
Financial Information ), that, pursuant to Item 2 of such
Form, announced that it had acquired all of the outstanding
capital stock of Vivo Software, Inc.
18
18
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 August 14, 1998.
REALNETWORKS, INC.
By /s/ Robert Glaser
------------------------------------
Robert Glaser
Chairman of the Board, Chief
Executive Officer and Treasurer
By /s/ Paul Bialek
------------------------------------
Paul Bialek
Senior Vice President, Finance and
Operations and Chief Financial Officer
19
19
INDEX TO EXHIBITS
Exhibit Number Description
-------------- -----------
10.1 RealNetworks, Inc. Amended and Restated 1996 Stock
Option Plan
27.1 Financial Data Schedule which is submitted
electronically to the Securities and Exchange
Commission for information purposes only and not
filed