- -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 ------------------------ FORM 10-QSB (MARK ONE) /X/ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2000 OR / / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM TO COMMISSION FILE NUMBER 1-14697 ------------------------ AUDIOHIGHWAY.COM (Exact name of small business issuer as specified in its charter) CALIFORNIA 77-0377306 (State or other jurisdiction of (IRS Employer incorporation or organization) Identification No.) 20300 STEVENS CREEK BLVD. 95014 CUPERTINO, CA (Zip Code) (Address of principal executive offices) (408) 861-4000 (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 Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes /X/ No / / Indicate the number of shares outstanding of each of the issuer's classes of common equity as of the latest practicable date. OUTSTANDING AT APRIL 30, CLASS 2000 - ------------- ------------- Common Stock, no par value 6,416,531 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- AUDIOHIGHWAY.COM FORM 10-QSB FOR THE QUARTER ENDED MARCH 31, 2000 TABLE OF CONTENTS PAGE -------- PART 1 -- FINANCIAL INFORMATION Item 1. Financial Statements................................ 3 Condensed Balance Sheets -- March 31, 2000 and December 31, 1999...................................... 3 Condensed Statements of Operations -- Three Months Ended March 31, 2000 and 1999................................ 4 Condensed Statements of Cash Flows -- Three Months Ended March 31, 2000 and 1999................................ 5 Notes to Condensed Financial Statements................. 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations....................... 7 PART II -- OTHER INFORMATION Item 1. Legal Proceedings................................... 16 Item 2. Changes in Securities and Use of Proceeds........... 16 Item 3. Defaults Upon Senior Securities..................... 16 Item 4. Submission of Matters to a Vote of Security Holders................................................... 16 Item 5. Other Information................................... 16 Item 6. Exhibits and Reports on Form 8-K.................... 16 Signatures.................................................. 17 2 PART I -- FINANCIAL INFORMATION ITEM 1: FINANCIAL STATEMENTS AUDIOHIGHWAY.COM CONDENSED BALANCE SHEETS (IN THOUSANDS) MARCH 31, DECEMBER 31, 2000 1999 --------- ------------ (UNAUDITED) ASSETS Current assets: Cash and cash equivalents................................. $ 5,331 $ 3,628 Investments............................................... 3,012 9,524 Accounts receivable, net.................................. 321 212 Other assets.............................................. 237 376 -------- -------- Total current assets.................................... 8,901 13,740 Property and equipment, net................................. 1,262 1,048 Other assets, net........................................... 1,036 1,007 -------- -------- $ 11,199 $ 15,795 ======== ======== LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Current maturities of long term debt...................... $ 312 $ 487 Accounts payable.......................................... 832 1,770 Accrued expenses and other current liabilities............ 358 1,260 -------- -------- Total current liabilities............................... 1,502 3,517 Long term debt.............................................. 150 111 Stockholders' equity Preferred Stock, no par value; 5,000 shares authorized; none outstanding........................................ 0 0 Common Stock, no par value; 50,000 shares authorized; 6,380 and 5,746 outstanding, respectively............... 34,593 33,162 Additional paid-in capital................................ 4,387 4,194 Notes receivable due from stockholders.................... (237) -- Accumulated deficit....................................... (29,196) (25,189) -------- -------- Total stockholders' equity.............................. 9,547 12,167 -------- -------- $ 11,199 $ 15,795 ======== ======== See Notes to Condensed Financial Statements 3 AUDIOHIGHWAY.COM CONDENSED STATEMENTS OF OPERATIONS (IN THOUSANDS EXCEPT PER SHARE AMOUNTS) THREE MONTHS ENDED MARCH 31, ------------------- 2000 1999 -------- -------- (UNAUDITED) Net revenues................................................ $ 868 $ 165 Costs and expenses: Costs of products sold through e-commerce................. 644 117 Operating and development................................. 1,014 698 Sales and marketing....................................... 2,661 825 General and administrative................................ 567 361 ------- ------- Total costs and expenses................................ 4,886 2,001 Loss from operations........................................ (4,018) (1,836) Other income (expenses): Interest (expense) income, net............................ 11 (418) Other..................................................... 0 (2) ------- ------- Net loss................................................ $(4,007) $(2,256) ======= ======= Basic and diluted net loss per share........................ $ (0.65) $ (0.49) Shares used in computing basic and diluted net loss per share..................................................... 6,119 4,627 See Notes to Condensed Financial Statements 4 AUDIOHIGHWAY.COM CONDENSED STATEMENTS OF CASH FLOWS (IN THOUSANDS) THREE MONTHS ENDED MARCH 31, ------------------- 2000 1999 -------- -------- (UNAUDITED) Net cash used in operating activities....................... $(4,545) $(1,769) ------- ------- Cash flows from investing activities: Proceeds on maturity of held-to-maturity investments...... 6,500 0 Acquisition of property and equipment..................... (290) (166) Acquisition of business................................... 0 (200) Issuance of note receivable............................... (150) (200) ------- ------- Net cash provided by (used in) investing activities..... 6,060 (366) Cash flows from financing activities: Repayment of long term debt............................... (32) (1,491) Proceeds from issuance of common stock.................... 220 12,041 ------- ------- Net cash provided by financing activities............... 188 10,550 ------- ------- Net change in cash and cash equivalents............... 1,703 8,415 Cash and cash equivalents at beginning of period............ 3,628 13,007 ------- ------- Cash and cash equivalents at end of period.................. $ 5,331 $21,422 ======= ======= Supplemental disclosure of non-cash investing and financing activities: Conversion of debt and accrued interest into common stock................................................... $ 412 $ -- ======= ======= Issuance of notes to stockholders in lieu of payments for warrant exercises....................................... $ 237 $ -- ======= ======= See Notes to Condensed Financial Statements 5 AUDIOHIGHWAY.COM NOTES TO CONDENSED FINANCIAL STATEMENTS MARCH 31, 2000 NOTE 1 -- THE COMPANY AND BASIS OF PRESENTATION audiohighway.com (the "Company") is a global Internet media company that offers a library of audio content via the World Wide Web (the "Web"). The accompanying unaudited condensed financial statements reflect all adjustments that, in the opinion of management, are necessary for a fair presentation of the results for the periods shown. The results of operations for such periods are not necessarily indicative of the results expected for a full year or for any future period. These financial statements should be read in conjunction with the financial statements and related notes incorporated by reference in the Company's Annual Report on Form 10-KSB for the year ended December 31, 1999. Certain prior period balances have been reclassified to conform to current period presentation. NOTE 2 -- EARNINGS (LOSS) PER SHARE Earnings (loss) per share is based on the weighted average number of common and common equivalent shares outstanding during the period. Common equivalents include stock options and warrants and convertible debt. Basic net earnings (loss) per share is computed by dividing the net earnings (loss) by the number of weighted average common shares outstanding. Diluted earnings (loss) per share reflects potential dilution from outstanding stock options and warrants using the treasury stock method and convertible debt using the if-converted method. A total of 1,320,838 options and warrants were excluded from the diluted earnings per share calculation, as their inclusion would be anti-dilutive. 6 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis provides information that the Company's management believes is relevant to an assessment and understanding of the Company's results of operations and financial condition for the quarterly periods ended March 31, 2000 and 1999. The following discussion should be read in conjunction with the Financial Statements and Notes thereto appearing elsewhere in this Report on Form 10-QSB and in conjunction with the Company's Annual Report on Form 10-KSB for the year ended December 31, 1999. Some of the information in this Report contains forward-looking statements which involve substantial risks and uncertainties. These statements can be identified by forward-looking words such as "may," "will," "expect," "anticipate," "believe," "estimate" and "continue" or similar words. Investors should read statements that contain these or similar words carefully because they (1) discuss our expectations about the Company's future performance; (2) contain projections of the Company's future operating results or of the Company's future financial condition; (3) state other "forward-looking" information. The Company believes it is important to communicate its expectations to its investors. There may be events in the future, however, that the Company is not accurately able to predict or over which it has no control. The risk factors discussed in "Business Risks," later in this Report, as well as any cautionary language in this Report, provide examples of risks, uncertainties and events that may cause the Company's actual results to differ materially from the expectations described in the forward-looking statements. Additional risks will be described from time to time in the Company's other filings with the SEC. Investors should be aware that the occurrence of any of the events described in the risk factors and elsewhere in this Report and in the Company's other periodic SEC filings could have a material and adverse effect on its business, results of operations and financial condition. GENERAL audiohighway.com ("audiohighway" or the "Company") is an online information and entertainment company which has developed a large and diverse library of audio content available free to the public on the Internet. The Company is implementing a second-generation business model that combines compelling content and e-commerce into an integrated Web platform. Management believes this multi-faceted approach will allow audiohighway to generate user traffic on a cost-effective basis, and convert that traffic into a future profitable revenue stream. Furthermore, management believes that its branding efforts will make its Web site an important destination for accessing and consuming audio and video on the Internet. The Company facilitates consumption of video and audio in one of three ways: (1) a pre-programmed "channel" format, which offers convenient access to a broad range of content; (2) individual selection, which allows users to browse through the content library and listen to their personally-selected choices; and (3) the Company's My JukeBox product, which allows users to "roll their own" digital audio/video programming via an easy point-and-click management system. Using these methods of content distribution, the Company is executing a strategy whereby it attracts user traffic through compelling content, maximizes user retention and visit frequency by offering registered users value-added member services including MP3 enabled e-mail, Internet voice mail and free Web sites. The Company's business plan contemplates converting this user traffic to advertising and e-commerce revenue. The Company accelerated this momentum during the first quarter of 2000 with a number of major initiatives, including the development of new content relationships, the introduction of additional member services and a complete upgrade of its e-commerce capabilities, scheduled for launch during the second quarter of 2000. These efforts have resulted in increased traffic to audiohighway.com which the Company hopes will in turn increase future revenues. 7 RESULTS OF OPERATIONS THREE MONTHS ENDED MARCH 31, 2000 COMPARED TO THE THREE MONTHS ENDED MARCH 31, 1999 Net revenues were $868,000 for the three months ended March 31, 2000 (the "2000 Quarter"), as compared to $165,000 for the same period in 1999 (the "1999 Quarter"). Company revenues are comprised of two major components; e-commerce sales including revenues generated by the Company's Mass Music and Audioshop Web sites, and advertising sales. E-commerce sales increased to $565,000 for the 2000 Quarter compared to $132,000 for the 1999 Quarter primarily due to increased promotional activity. Advertising sales increased to $303,000 for the 2000 Quarter compared to $33,000 for the 1999 Quarter primarily due to increased traffic. Cost of products sold through e-commerce exceeded revenue by $79,000 for the three months ended March 31, 2000. This was primarily attributable to aggressive pricing to meet competition and to increase market share and high fulfillment costs. Operating and development expenses were $1,014,000 for the three months ended March 31, 2000, up 45% from $698,000 for the 1999 Quarter. This increase was primarily the result of increased payroll expenses associated with increased staffing, data communications expenses, costs to produce and maintain the Company's Web site, use of consulting engineers and amortization of certain of the assets acquired from Mass Music, Inc. The Company employs outside consulting engineers to facilitate a portion of its development effort. Sales and marketing expenses were $2,661,000 for the three months ended March 31, 2000, up 223% from $825,000 for the same period in 1999. This increase is primarily attributable to the increased advertising and marketing expenses associated with promoting the Company's Web sites, increased payroll expenses associated with additional sales and marketing staff. The Company expects sales and marketing expenses to continue to increase substantially in future periods as the Company promotes its Web sites. General and administrative expenses ("G&A") were $567,000 for the three months ended March 31, 2000, up 57% compared to G&A expenses of $361,000 for the 1999 Quarter. This increase was primarily the result of increased staffing costs, accounting fees, legal fees and expenses incurred in connection with public company compliance. The operating loss was $4,018,000 for the three months ended March 31, 2000 compared to an operating loss for the same period in 1999 of $1,836,000, an increase of approximately 118%. As noted above, the increased loss was primarily the result of increased expenditures in the sales and marketing, and operating and development areas, offset by the $703,000 increase in revenue. The increased operating loss was anticipated in light of the need to substantially increase expenditures to expand the Company's business and its brand identity. INTEREST INCOME There was net interest income of $11,000 during the three months ended March 31, 2000 compared to net interest expense of $418,000 in the 1999 Quarter. This was primarily the result of retiring a substantial portion of the outstanding debt along with amortizing debt discounts through March 31, 1999. As a result of the factors described above, for the three months ended March 31, 2000, the Company incurred a net loss of $4,007,000 compared to a net loss of $2,256,000 for the same period in 1999, an increase of approximately 78%. LIQUIDITY AND CAPITAL RESOURCES The Company has financed its operations since inception almost entirely from the sale of equity and debt securities, supplemented with a bank line of credit. In December 1998, it completed its initial public offering of securities, in which it sold an aggregate of 2,530,000 units consisting of Common Stock and 8 redeemable Common Stock Purchase Warrants (the "Units"), at an initial public offering price of $6.50 per Unit. The offering netted the Company approximately $14,052,000 after deducting expenses related to the offering. In January 1999, the conditions for redemption set forth in the Common Stock Purchase Warrants were satisfied, and the Company redeemed its outstanding public warrants as of February 22, 1999. As a result, a total of approximately 1,269,000 warrants were exercised, which resulted in gross proceeds to the Company of approximately $12,374,000. The Company paid approximately $333,000 to holders of Warrants who chose not to redeem during the 30-day redemption period. As of March 31, 2000, the Company had $8,343,000 in cash and cash equivalents and investments, $3,012,000 of which was invested in high grade short-term debt instruments. As of March 31, 2000, the Company had $7,399,000 in working capital. The Company currently is financing its daily operations primarily through the application of the net proceeds from the IPO and its subsequent warrant call. During the three months ended March 31, 2000, the Company used $4,545,000 in operating activities compared to $1,769,000 in 1999. This increase was largely due to the significantly increased net loss in 2000. Also, $6,060,000 was provided by investing activities in the first quarter of 2000 primarily from the proceeds of held-to-maturity investments. By comparison, $366,000 was used in investing activities in the 1999 Quarter. Net cash provided by financing activities decreased in the 2000 Quarter, from $10,550,000 in 1999 to $188,000 in 2000, primarily because the net proceeds of the Company's warrant call were received in 1999. The $188,000 received in 2000 was primarily the result of the exercise of warrants. The Company believes that its current financial resources will be sufficient to fund its operations for at least the next 12 months. However, during that period, it may become necessary for the Company to raise additional funds to meet the expenditures required for operating its business. There can be no assurance that presently unforeseen events may result in the Company determining to raise additional funds. If the Company's cash balances and cash generated from operations is insufficient to satisfy its liquidity requirements, the Company may seek to raise such additional funds through public or private equity or debt financings. If additional funds are raised through the issuance of debt securities, these securities could have certain rights, preferences, and privileges senior to holders of Common Stock, and the terms of such debt could impose restrictions on the Company's operations. The sale of additional equity or debt securities could result in additional dilution to the Company's shareholders. Additional financing may not be available at all and, if available, such financing may not be obtainable on terms favorable to the Company. If the Company is unable to obtain this additional financing, it may be required to reduce the scope of its planned development and marketing efforts, which could seriously harm its business. The Company intends to make significant ongoing investments in research and development for future generation products and services. It also expects to have significant expenditures in sales and marketing and further content acquisition in order to attract customers to its Web site. There is no assurance that the Company's analysis of its capital requirements will be accurate, particularly in light of the fact that it is entering a new business in a new market. The Company's future expenditures and capital requirements will depend on a number of factors including the development and implementation of next generation technologies, technological developments on the Internet and the regulatory and competitive environment for Internet based products and services. NET OPERATING LOSS CARRYFORWARDS At December 31, 1999, the Company fully provided against its deferred tax assets. The Company believes sufficient uncertainty exists regarding the realizability of the deferred tax assets such that a full valuation allowance is required. At December 31, 1999, the Company had approximately $21,899,000 of federal net operating loss carryforwards for tax reporting purposes available to offset future taxable income; such carryforwards will expire beginning in 2009. Additionally, the Company has approximately 9 $10,335,000 of California net operating loss carryforwards for tax reporting purposes which will expire beginning in 2000. The Tax Reform Act of 1986 imposes limitations on the use of net operating loss carryforwards in the event of certain stock ownership changes. The sale of the Units sold in the Company's December 1998 IPO constituted such a change in ownership and therefore, utilization of the Company's net operating loss carryforwards may be limited. BUSINESS RISKS The future operating results of the Company are highly uncertain, and the following factors should be carefully reviewed in addition to the other information contained in this Quarterly Report on Form 10-QSB, in its Annual Report on Form 10-KSB for the year ended December 31, 1999, as well as in other public disclosures of the Company. Any of the following risks could materially and adversely affect our business, operating results and financial condition. HISTORY OF LOSSES AND ANTICIPATION OF FUTURE LOSSES. The Company was incorporated in June 1994 to deliver free, personalized audio via the Internet and was in the development stage until the fourth quarter of 1997. The Company first recognized revenues in November 1997 and has recorded increasing net losses each year since its inception. At March 31, 2000 the Company had an accumulated deficit of approximately $29,196,000. Accordingly, the Company has a limited operating history on which to base an evaluation of its business and prospects. The Company and its prospects must be considered in light of the early stage of development, particularly companies in new and rapidly evolving markets such as the market for Internet content, e-commerce and advertising. Almost none of the companies in these markets have achieved profitability and it is widely believed that many companies never will. To achieve and sustain profitability, the Company must, among other things, (i) provide diverse content of interest to Internet users, (ii) effectively develop new and maintain existing relationships with advertisers, advertising agencies and content providers, (iii) continue to develop and upgrade its technology and network infrastructure; (iv) respond to competitive developments, (v) successfully introduce enhancements to its existing products and services to address new technology standards and developments on the Internet, and (vi) attract, retain and motivate qualified personnel. The Company's operating results are also dependent on factors outside the control of the Company, such as the availability of desirable content. There can be no assurance that the Company will be successful in addressing these risks and the failure to do so would have a material adverse effect on the Company's business, results of operations and financial condition. Additionally, the limited operating history of the Company makes the prediction of future operating results difficult or impossible, and there can be no assurance that the Company's revenues will increase or even continue at their current level or generate sufficient cash from operations in future periods. The Company expects to continue to incur significant losses on a quarterly and annual basis for the foreseeable future. For these and other reasons, there is no assurance that the Company will ever achieve profitability or, if profitability is achieved, that it can be sustained. LIMITED OPERATING HISTORY; UNPREDICTABILITY OF FUTURE REVENUES; POTENTIAL FLUCTUATIONS IN QUARTERLY RESULTS. Because of the Company's limited operating history and the emerging and evolving nature of the markets in which it competes, the Company is unable to forecast accurately its revenues. Additionally, the long-term acceptance of Web-based advertising and e-commerce is as yet uncertain. The Company currently intends to continue to increase substantially its operating expenses in order to, among other things, (i) expand its distribution network capacity, (ii) fund increased sales and marketing activities, (iii) acquire additional content, (iv) develop and upgrade technology and (v) purchase additional equipment for its operations. The Company's expense levels are based, in part, on its expectations with regard to future revenues, and to a large extent such expenses are fixed, particularly in the short term. To the extent the Company is unsuccessful in increasing its revenues, the Company may be unable to appropriately adjust spending in a timely manner to compensate for any unexpected revenue shortfall or will have to reduce its operating expenses, causing it to forego potential revenue generating activities, either of which 10 could cause a material adverse effect in the Company's business, results of operations and financial condition. The Company's quarterly operating results may fluctuate significantly in the future as a result of a variety of factors, many of which are outside the Company's control. Factors that may affect the Company's quarterly operating results include (i) the cost of acquiring and the availability of content, (ii) price competition in the e-commerce arena, (iii) demand for Internet advertising, (iv) seasonal trends in advertising placements, (v) seasonal trends in the markets for the products offered on the Company's e-commerce sites, (vi) the advertising cycles for, or the addition or loss of, individual advertisers, (vii) the level of traffic on the Company's Web site, (viii) the amount and timing of capital expenditures and other costs relating to the expansion of the Company's operations, (ix) price competition or pricing changes in Internet advertising, (x) the level of and seasonal trends in the use of the Internet, (xi) technical difficulties or system downtime, (xii) the introduction of new products or services by the Company or its competitors and (xiii) general economic conditions and economic conditions specific to the Internet, such as electronic commerce and online media. Any one of these factors could cause the Company's revenues and operating results to vary significantly in the future. In addition, as a strategic response to changes in the competitive environment, the Company may from time to time make certain pricing, service or marketing decisions or acquisitions that could cause significant declines in the Company's quarterly operating results. DEPENDENCE ON CONTENT PROVIDERS; LICENSE FEES PAYABLE TO CONTENT PROVIDERS. The Company's future success depends in large part upon its ability to obtain rights to and deliver content of sufficient interest to end users over the Internet. The Company does not create its own content. Rather, the Company relies on third party content providers, such as record companies, recording artists, book publishers, news and financial information services and music publishers for the content it makes available to its subscribers. The Company's ability to maintain its existing relationships with such content providers and to build new relationships with additional content providers is critical to the success of its business. Although many of the Company's agreements with third party content providers are for an initial term of one year, with automatic renewal unless cancelled, the content providers may choose to terminate such agreements prior to the expiration of their terms. The Company's inability to secure licenses from content providers or the termination of a significant number of content provider agreements would decrease the availability of content that the Company can offer users. This may result in decreased traffic on the Company's Web sites and, as a result, decreased advertising and or e-commerce revenue, which could have a material adverse effect on the Company's business, results of operations and financial condition. The Company's agreements with most of its content providers are nonexclusive, and many of the Company's competitors offer, or could offer, content that is similar to or the same as that obtained by the Company from such nonexclusive content providers. Such direct competition could have a material adverse effect on the Company's business, results of operations and financial condition. License fees payable to content providers and other licensing agencies will continue to increase as the Company continues to accumulate content, as Web site traffic increases and as competition for such content increases. There is no assurance that the Company's content providers and other licensing agencies will enter into prospective agreements with the Company on the same or similar terms as those currently in effect or on terms acceptable to the Company if no agreement is in effect. If the Company is required to pay increased licensing fees, such increased payments could have a material adverse effect on the Company's business, results of operations and financial condition. UNCERTAIN ACCEPTANCE OF THE INTERNET AS AN ADVERTISING MEDIUM. The market for Internet advertising has only recently begun to develop, is rapidly evolving and is characterized by an increasing number of market entrants. As is typical in the case of a new and rapidly evolving industry, demand and market acceptance for recently introduced products and services are subject to a high level of uncertainty. The Company's ability to generate advertising revenue will depend on, among other factors, (i) the Company's success in generating traffic from users with demographic characteristics that are attractive to potential 11 advertisers, (ii) the continued development of the Internet as an advertising medium, (iii) pricing of advertising on other Web sites, (iv) the development and expansion of the Company's advertising sales force and (v) the establishment and maintenance of desirable advertising sales agency relationships. Many potential advertisers and their advertising agencies have only limited experience with the Internet as an advertising medium and have not historically devoted a significant portion of their advertising expenditures to Web-based advertising. There is no assurance that advertisers or advertising agencies will be persuaded to allocate or continue to allocate portions of their budgets to Web-based advertising or, if so persuaded, that they will find such advertising to be effective for promoting their products and services relative to traditional print and broadcast media. No standards have yet been widely accepted for the measurement of the effectiveness of Web-based advertising, and there can be no assurance that such standards will develop sufficiently to enable Web-based advertising to become a significant advertising medium. Acceptance of the Internet among advertisers and advertising agencies will also depend, to a large extent, on the level of use of the Internet by consumers and upon growth in the commercial use of the Internet. If widespread commercial use of the Internet does not continue to develop, or if the Internet does not develop as an effective and measurable medium for advertising, the Company's business, results of operations and financial condition could be materially adversely affected. MANAGEMENT OF GROWTH. The Company anticipates that continued significant expansion of its operations will be required in order to address potential market opportunities. The Company expects that it will need to increase its personnel significantly in the near future. The anticipated substantial growth is expected to place a significant strain on its managerial, operational and financial resources and systems. To manage its growth, the Company must implement, improve and effectively use its operational, management, marketing and financial systems and train and manage its employees. There can be no assurance that the Company will be able to manage effectively the expansion of its operations or that the Company's current personnel, systems, procedures and controls will be adequate to support the Company's operations. Any failure of management to manage effectively the Company's growth could have a material adverse effect on the Company's business, results of operations and financial condition. RISK OF SYSTEM FAILURE, DELAYS AND INADEQUACY. The performance, reliability and availability of the Company's Web site and network infrastructure are critical to its reputation and ability to attract and retain users, advertisers and content providers. The Company's network infrastructure is located at a single facility in Santa Clara, California. The Company's systems and operations are vulnerable to damage or interruption from fire, flood, earthquakes, power loss, telecommunications failure, Internet breakdowns, break-ins, hackers and similar events. The Company does not presently have redundant facilities or systems or a formal disaster recovery plan and does not carry sufficient business interruption insurance to compensate it for losses that may occur. Services based on sophisticated software and computer systems often encounter development delays and the underlying software may contain undetected errors that could cause system failures when introduced. Any system error or failure that causes interruption in availability of content, access to e-commerce order processing or an increase in response time could result in a loss of potential or existing business services to customers, users, advertisers or content providers and, if sustained or repeated, could reduce the attractiveness of the Company's Web site to such entities or individuals. In addition, because the Company's Web advertising revenues are directly related to the number of advertisements delivered by the Company to users, system interruptions that result in the unavailability of the Company's Web site or slower response times for users would reduce the number of advertisements delivered and reduce revenues. A sudden and significant increase in traffic on the Company's Web site could strain the capacity of the software, hardware and telecommunications systems deployed or used by the Company, which could lead to slower response times or system failures. The Company's operations also are, in part, dependent upon receipt of timely feeds from certain of its content providers, and any failure or delay in the transmission or receipt of such feeds, whether due to system failure of the Company, its content providers, satellites or otherwise, could disrupt the Company's operations. The Company is also dependent upon Web browsers, 12 Internet Service Providers ("ISPs") and online service providers ("OSPs") to provide Internet users access to the Company's Web site. Users may experience difficulties accessing or using the Company's Web site due to system failures or delays unrelated to the Company's systems. These difficulties may result in intermittent interruption in programming. Any sustained failure or delay could reduce the attractiveness of the Company's Web site to users, advertisers and content providers. The occurrence of any of the foregoing events could have a material adverse effect on the Company's business, results of operations and financial condition. SECURITY RISKS. Despite the implementation of security measures, the Company's networks may be vulnerable to unauthorized access, hackers, computer viruses and other disruptive problems. The Company's primary Web site did suffer a brief denial of service interruption on one occasion in 1999. Although the Company did not suffer any material adverse effects from this incident, a party who is able to circumvent security measures could misappropriate proprietary information or cause severe interruptions in the Company's Internet operations. ISPs and OSPs have in the past experienced, and may in the future experience, interruptions in service as a result of the accidental or intentional actions of Internet users, current and former employees or others. The Company may be required to expend significant capital or other resources to protect against the threat of security breaches or to alleviate problems caused by such breaches. Although the Company intends to continue to implement security measures, there can be no assurance that measures implemented by the Company will not be circumvented in the future. Eliminating computer viruses and alleviating other security problems may require interruptions, delays or cessation of service to users accessing the Company's Web sites, which could have a material adverse effect on the Company's business, results of operations and financial condition. DEPENDENCE ON SHORT-TERM ADVERTISING CONTRACTS. A substantial portion of the Company's Web advertising revenues are derived from short-term contracts. Consequently, many of the Company's advertising customers can cease advertising on the Company's Web site quickly and without penalty, thereby increasing the Company's exposure to competitive pressures. There is no assurance that the Company's current advertisers will continue to purchase advertisements or that the Company will be able to secure new advertising contracts from existing or future customers at attractive rates or at all. Any failure of the Company to achieve sufficient advertising revenue could have a material adverse effect on the Company's business, results of operations and financial condition. COMPETITION. The market for information services and entertainment on the Internet and otherwise is highly competitive, and the Company expects that competition will continue to intensify. The Company competes with (i) other Web sites and Internet broadcasters to acquire and provide content to attract users, (ii) other e-commerce Web sites for the sale of CDs, videos, DVDs, computer products, home electronics and associated products, (iii) online services, other Web site operators and advertising networks, as well as traditional media such as television, radio and print, for a share of advertisers' total advertising budgets and (iv) local radio and television stations and national radio and television networks for sales of advertising spots. There is no assurance that the Company will be able to compete successfully or that the competitive pressures faced by the Company, including those described below, will not have a material adverse effect on the Company's business, results of operations and financial condition. The Company also competes with online services, other Web site operators and advertising networks, as well as traditional media such as television, radio and print for a share of advertisers' total advertising budgets and with other e-commerce Web sites. The Company believes that the principal competitive factors for attracting advertisers include the number of users accessing the Company's Web site, the demographics of the Company's users, the Company's ability to deliver focused advertising and interactivity through its Web site and the overall cost-effectiveness and value of advertising offered by the Company. There is intense competition for the sale of advertising on high-traffic Web sites, which has resulted in a wide range of rates quoted by different vendors for a variety of advertising services, making it difficult to project levels of Internet advertising that will be realized generally or by any specific company. Any 13 competition for advertisers among present and future Web sites, as well as competition with other traditional media for advertising placements, could result in significant price competition. The number of companies selling Web-based advertising and the available inventory of advertising space have recently increased substantially. Accordingly, the Company has faced increased pricing pressure for the sale of advertisements. Reduction in the Company's Web advertising revenues would have a material adverse effect on the Company's business, results of operations and financial condition. Many of the Company's competitors and potential competitors have greater financial, sales and other resources than the Company. There is no assurance that the Company's business strategy will be successful, or that the Company will gain a market share or customer base that will be sufficient to justify continued operations. PRODUCT DEVELOPMENT AND TECHNOLOGICAL OBSOLESCENCE. The market for Internet information delivery is characterized by extensive research and development and rapid technological change, frequent new product introductions and technological innovation, resulting in short product life cycles, and evolving industry standards. Development by others of new or improved products, processes or technology may render the Company's products and services less competitive or obsolete. The emerging character of these products and services and their rapid evolution will require the Company to effectively use leading technologies, continue to develop its technological expertise, enhance its current services and continue to improve the performance, features and reliability of its network infrastructure. Changes in network infrastructure, transmission and content delivery methods and underlying software platforms and the emergence of new technologies could dramatically change the structure and competitive dynamic of the market for the Company's products and services. There is no assurance that the Company will be successful in responding quickly, cost effectively and sufficiently to these or other such developments. In addition, the widespread adoption of new Internet technologies or standards could require substantial expenditures by the Company to modify or adapt its Web site and services. A failure by the Company to rapidly respond to technological developments could have a material adverse effect on the Company's business, results of operations and financial condition. DEPENDENCE UPON KEY PERSONNEL. The Company's success depends, to a significant extent, upon a number of key employees and consultants. The loss of the services of one or more of these employees or consultants could have a material adverse effect on the business of the Company. In addition, competition for engineers, sales and marketing personnel and other employees needed to successfully run the Company has become increasingly intense in Silicon Valley and compensation payable to the limited number of potential candidates has been escalating. There is no assurance that the Company will be able to hire the highly skilled employees it needs at the time it needs to do such hiring or that it will be able to offer competitive compensation packages to enable the Company to retain such employees. A failure to do so could adversely impact the Company's ability to compete succeed in furthering its business prospects. GOVERNMENT REGULATION AND LEGAL UNCERTAINTY. Although there are currently few laws and regulations directly applicable to the Internet, it is likely that new laws and regulations will be adopted in the United States and elsewhere covering issues such as music licensing, broadcast license fees, copyrights, privacy, pricing, sales taxes and characteristics and quality of Internet services. The adoption of restrictive laws or regulations could slow Internet growth or expose the Company to significant liabilities associated with content available on its Web site. The application of existing laws and regulations governing Internet issues such as property ownership, libel and personal privacy is also subject to substantial uncertainty. There can be no assurance that current or new laws and regulations, or the application of existing laws and regulations (including laws and regulations governing issues such as property ownership, content, taxation, defamation and personal injury), will not expose the Company to significant liabilities, significantly slow Internet growth or otherwise cause a material adverse effect on the Company's business, results of operations or financial condition. 14 The Company currently does not collect sales or other taxes with respect to the sale of services or products in states and countries where the Company believes it is not required to do so. Some states and countries have sought to impose sales or other tax obligations on companies that engage in online commerce within their jurisdictions. A successful assertion by one or more states or countries that the Company should collect sales or other taxes on products and services, or remit payment of sales or other taxes for prior periods, could have a material adverse effect on the Company's business, results of operations and financial condition. The Communications Decency Act of 1996 (the "CDA") was enacted in 1996. Although those sections of the CDA that, among other things, proposed to impose criminal penalties on anyone distributing "indecent" material to minors over the Internet were held to be unconstitutional by the U.S. Supreme Court, there can be no assurance that similar laws will not be proposed and adopted. Although the Company does not currently distribute the types of materials that the CDA may have deemed illegal, the nature of such similar legislation and the manner in which it may be interpreted and enforced cannot be fully determined, and legislation similar to the CDA could subject the Company to potential liability, which in turn could have an adverse effect on the Company's business, financial condition and results of operations. Such laws could also damage the growth of the Internet generally and decrease the demand for the Company's products and services, which could adversely affect the Company's business, results of operations and financial condition. POTENTIAL LIABILITY FOR INTERNET CONTENT. As a distributor of Internet content, the Company faces potential liability for negligence, copyright, patent, trademark, defamation, indecency and other claims based on the nature and content of the materials that it makes available to Internet users. Such claims have been brought, and sometimes successfully pressed, against Internet content distributors. In addition, the Company could be exposed to liability with respect to the content or unauthorized duplication or broadcast of content. Although the Company maintains general liability insurance, the Company's insurance may not cover potential claims of this type or may not be adequate to indemnify the Company for all liability that may be imposed. In addition, although the Company generally requires its content providers to indemnify the Company for such liability, such indemnification may be inadequate. Any imposition of liability that is not covered by insurance, is in excess of insurance coverage or is not covered by an indemnification by a content provider could have a material adverse effect on the Company's business, results of operations and financial condition. 15 PART II -- OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS. In August 1999, Spirit Partners, L.P. and Gaines Berland, Inc. filed suit against the Company in the Supreme Court of the State of New York seeking damages according to proof, punitive damages in the amount of $3,000,000, attorneys' fees, costs and equitable relief, based on allegations of breach of contract, negligent misrepresentation and deceptive trade practices relating to the Company's redemption of its publicly traded warrants during February 1999. The Company removed the case to United States District Court for the Southern District of New York. Due to the nature of litigation generally and because the lawsuit is at an early stage, the Company cannot estimate the total expense, possible damages or settlement value, if any, that may ultimately be incurred in connection with the suit. However, the Company believes the suit is wholly without merit, intends to vigorously oppose the suit and believes that this matter will not have a material adverse effect on the Company's results of operations or financial condition. ITEM 2. CHANGES IN SECURITIES. None. ITEM 3. DEFAULTS UPON SENIOR SECURITIES. None. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. None. ITEM 5. OTHER INFORMATION. None. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K a. Exhibits 27.1 Financial Data Schedule b. Reports on Form 8-K during the quarter ended March 31, 2000: During the period covered by this report, the Company did not file any reports on Form 8-K. 16 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. AUDIOHIGHWAY.COM By: /s/ NATHAN M. SCHULHOF ----------------------------------------- Nathan M. Schulhof Date: May 12, 2000 CHIEF EXECUTIVE OFFICER By: /s/ GREG SUTYAK ----------------------------------------- Greg Sutyak CHIEF FINANCIAL OFFICER 17 EXHIBIT INDEX EXHIBIT NO. DESCRIPTION - --------------------- ----------- 27.1 Financial Data Schedule