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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
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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 March 31, 1999
OR
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
Commission File Number: 0-23137
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RealNetworks, Inc.
(Exact name of registrant as specified in its charter)
Washington 91-1628146
(State or other jurisdiction (I.R.S. Employer
of incorporation or organization) Identification No.)
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 May
1, 1999 was 67,885,612 (as adjusted to give effect to the two-for-one stock
split effected by the registrant on May 10, 1999). In addition, there were
40,000 outstanding shares of the registrant's Special Common Stock, par value
$0.001 per share, that automatically convert on a two-for-one basis into
Common Stock on a bona fide sale to a purchaser who is not an affiliate of the
holder.
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REALNETWORKS, INC.
FORM 10-Q
FOR THE QUARTER ENDED MARCH 31, 1999
TABLE OF CONTENTS
Page
----
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements............................................. 3
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations............................................ 10
Item 3. Quantitative and Qualitative Disclosure about Market Risk........ 33
PART II. OTHER INFORMATION
Item 1. Legal Proceedings................................................ 34
Item 2. Changes in Securities and Use of Proceeds........................ 34
Item 6. Exhibits and Reports on Form 8-K................................. 35
2
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
REALNETWORKS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands except per share data)
March 31, December 31,
1999 1998
--------- ------------
ASSETS
------
Current assets:
Cash, cash equivalents and short-term investments..... $ 89,120 $ 89,777
Trade accounts receivable, net of allowance for
doubtful accounts and sales returns.................. 5,031 4,941
Prepaid expenses and other current assets............. 3,276 3,212
-------- --------
Total current assets.................................. 97,427 97,930
Equipment and leasehold improvements, at cost:
Equipment and software................................ 12,497 10,914
Leasehold improvements................................ 7,384 1,441
-------- --------
Total equipment and leasehold improvements.......... 19,881 12,355
Less accumulated depreciation and amortization........ 6,945 6,082
-------- --------
Net equipment and leasehold improvements 12,936 6,273
-------- --------
Goodwill, net........................................... 8,516 9,048
Restricted cash equivalents............................. 13,700 13,700
Other assets............................................ 1,160 1,108
-------- --------
Total assets...................................... $133,739 $128,059
======== ========
LIABILITIES AND SHAREHOLDERS' EQUITY
------------------------------------
Current liabilities:
Accounts payable...................................... $ 3,256 $ 3,563
Accrued liabilities................................... 13,810 10,418
Deferred revenue, excluding non-current portion....... 30,145 23,742
-------- --------
Total current liabilities........................... 47,211 37,723
-------- --------
Deferred revenue, excluding current portion............. 2,617 5,833
Note payable............................................ 994 987
Shareholders' equity:
Preferred stock, $0.001 par value, no shares issued
and outstanding
Series A: authorized 200 shares..................... -- --
Undesignated series: authorized 59,800 shares....... -- --
Common stock, $0.001 par value
Authorized 295,791 shares; issued and outstanding
66,604 shares in 1999 and 61,975 shares in 1998.... 66 62
Special common stock, $0.001 par value
Authorized 4,209 shares; issued and outstanding 500
shares in 1999 and 2,586 shares in 1998............ 1 3
Additional paid-in capital............................ 117,765 117,515
Accumulated deficit................................... (34,674) (33,938)
Accumulated other comprehensive loss.................. (241) (126)
-------- --------
Total shareholders' equity........................ 82,917 83,516
-------- --------
Total liabilities and shareholders' equity $133,739 $128,059
======== ========
See accompanying notes to condensed consolidated financial statements
3
REALNETWORKS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
AND COMPREHENSIVE LOSS
(in thousands except per share data)
Quarter Ended March 31,
-------------------------
1999 1998
----------- ------------
Net revenues:
Software license fees............................. $ 17,010 $ 9,418
Service revenues.................................. 5,249 2,622
Advertising....................................... 1,266 462
----------- ------------
Total net revenues.............................. 23,525 12,502
----------- ------------
Cost of revenues:
Software license fees............................. 2,811 1,586
Service revenues.................................. 920 521
Advertising....................................... 550 332
----------- ------------
Total cost of revenues.......................... 4,281 2,439
----------- ------------
Gross profit.................................... 19,244 10,063
----------- ------------
Operating expenses:
Research and development.......................... 7,289 4,419
Sales and marketing............................... 10,215 6,830
General and administrative........................ 2,913 2,100
Goodwill amortization............................. 532 --
Acquisition charges............................... -- 8,723
----------- ------------
Total operating expenses........................ 20,949 22,072
----------- ------------
Operating loss.................................. (1,705) (12,009)
Other income, net................................. 969 1,077
----------- ------------
Net loss.......................................... $ (736) $(10,932)
=========== ============
Basic and diluted net loss per share.............. $ (0.01) $ (0.18)
=========== ============
Shares used to compute basic and diluted net loss
per share........................................ 67,457 62,084
Comprehensive loss:
Net loss.......................................... $ (736) $(10,932)
Translation adjustment............................ (115) (14)
----------- ------------
Comprehensive loss.............................. $ (851) $(10,946)
=========== ============
See accompanying notes to condensed consolidated financial statements
4
REALNETWORKS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
Quarter Ended
March 31,
------------------
1999 1998
-------- --------
Net cash provided by (used in) operating activities....... $ 6,697 $ (1,020)
-------- --------
Cash flows from investing activities:
Purchases of equipment and leasehold improvements....... (7,490) (637)
Purchases of short-term investments..................... (25,244) (25,594)
Proceeds from sales and maturities of short-term invest-
ments.................................................. 8,144 10,105
Cash obtained through acquisition....................... -- 203
-------- --------
Net cash used in investing activities................. (24,590) (15,923)
-------- --------
Cash flows from financing activities:
Net proceeds from exercise of stock options............. 252 2
-------- --------
Net cash provided by financing activities............. 252 2
-------- --------
Effect of exchange rate changes on cash................... (116) (5)
-------- --------
Net decrease in cash and cash equivalents............. (17,757) (16,946)
Cash and cash equivalents at beginning of period.......... 51,876 62,255
-------- --------
Cash and cash equivalents at end of period................ $ 34,119 $ 45,309
======== ========
Supplemental disclosure of noncash financing and investing
activities:
Common stock issued in business combination............... $ -- $ 16,526
See accompanying notes to condensed consolidated financial statements
5
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 media
delivery and distribution solutions designed for the Internet. The Company's
solutions enable consumers to experience and content providers to deliver a
broad range of multimedia content, including audio, video, text and animation.
The Company pioneered the development and commercialization of "streaming
media" systems that enable the creation, real-time delivery and playback of
multimedia content. The Company recently extended its media delivery platform
to include a digital music management system that allows consumers to acquire,
record, store, organize and play their personal music collections on personal
computers and digital playback devices.
(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 ended March 31, 1999 are not
necessarily indicative of the results that may be expected for any subsequent
quarter or for the year ending December 31, 1999. 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, 1998.
(c) Cash, Cash Equivalents and Short-Term Investments
Cash, cash equivalents and short-term investments are comprised of the
following:
March 31, December 31,
1999 1998
--------- ------------
(in thousands)
Cash and cash equivalents............................ $34,119 $51,876
Short-term investments............................... 55,001 37,901
------- -------
Total cash, cash equivalents and short-term
investments....................................... $89,120 $89,777
======= =======
Restricted cash equivalents.......................... $13,700 $13,700
======= =======
Restricted cash equivalents represent a restricted escrow account
established in connection with a lease agreement for new corporate
headquarters. Under certain circumstances, $10,000,000 of the escrow account
will be maintained for the term of the lease. The remaining $3,700,000 will be
released as the Company funds tenant improvements. The Company expects to take
occupancy of the new facilities during the quarter ending June 30, 1999.
(d) Revenue Recognition
The Company recognizes revenue in accordance with 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
6
REALNETWORKS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
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.
Revenue from software license fees is recognized upon delivery, net of an
allowance for estimated returns, provided all the requirements of SOP 97-2
have been met.
Revenue from software license agreements with original equipment
manufacturers (OEM) is recognized when the OEM delivers its product
incorporating the Company's software to the end user. In the case of
prepayments received from an OEM, the Company generally recognizes revenue
based on the actual products sold by the OEM. If the Company 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.
Service revenues include payments under support and upgrade contracts, and
fees from consulting and streaming media content hosting. Support and upgrade
revenues are recognized ratably over the term of the contract, which typically
is twelve 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 Loss
Statement of Financial Accounting Standards No. 130, "Reporting
Comprehensive Income" (SFAS 130), establishes standards for the reporting and
disclosure of comprehensive income and its components (revenues, expenses,
gains and losses) in a full set of financial statements. The Company's
comprehensive loss for the quarters ended March 31, 1999 and 1998 consisted of
net loss and the gross amount of foreign currency translation adjustments. The
tax effect of the translation adjustments was insignificant.
(f) Net Loss Per Share
Basic net loss per share is computed by dividing net loss by the weighted
average number of common shares outstanding during the period. Diluted net
loss per share is computed by dividing net loss by the weighted average number
of common and dilutive common equivalent shares outstanding during the period.
As the Company had a net loss attributable to common shareholders in each of
the periods presented, basic and diluted net loss per share are the same.
Excluded from the computation of diluted net loss per share for the quarters
ended March 31, 1999 and 1998 are options to acquire 18,004,000 and 15,110,000
shares of common stock, respectively, with weighted-average exercise prices of
$13.62 and $2.46, respectively, because their effects would be anti-dilutive.
7
REALNETWORKS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(g) Recent Accounting Pronouncements
In December 1998, the American Institute of Certified Public Accounts
(AICPA) issued Statement of Position 98-9, "Modification of SOP 97-2, Software
Revenue Recognition, with Respect to Certain Transactions" (SOP 98-9), which
amends certain elements of SOP 97-2, "Software Revenue Recognition" and is
effective for fiscal years beginning after March 15, 1999. RealNetworks
believes that the adoption of SOP 98-9 will not have a material effect on its
results of operations or financial position.
In June 1998, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 133, "Accounting for Derivative Instruments
and Hedging Activities" (SFAS 133). SFAS 133 establishes a new model for
accounting for derivatives and hedging activities and supersedes and amends
existing accounting standards and is effective for fiscal years beginning
after June 15, 1999. SFAS 133 requires that all derivatives be recognized in
the balance sheet at their fair market value, and the corresponding derivative
gains or losses be either reported in the statement of operations or as a
component of other comprehensive income depending on the type of hedge
relationship that exists with respect to such derivative. RealNetworks does
not expect the adoption of SFAS 133 to have a material impact on its
consolidated financial statements.
In March 1998, the AICPA issued SOP 98-1, "Accounting for the Costs of
Computer Software Developed or Obtained for Internal Use" (SOP 98-1). SOP 98-1
requires the capitalization of certain costs incurred in connection with
developing or obtaining software for internal use. The Company adopted SOP 98-
1 on January 1, 1999. The adoption of SOP 98-1 did not have a material impact
on the Company's consolidated financial statements for the quarter ended March
31, 1999.
NOTE 2--SEGMENT INFORMATION
The Company operates in one business segment, streaming media, for which the
Company receives revenues from its customers. The Company's Chief Operating
Decision Maker is considered to be the Company's Operating Committee (COC)
which is comprised of the Company's Chief Executive Officer and the Company's
Senior Vice Presidents. The COC reviews financial information presented on a
consolidated basis accompanied by disaggregated information about products and
services and geographical region for purposes of making decisions and
assessing financial performance. The COC does not review discrete financial
information regarding profitability of the Company's different products or
services and, therefore, the Company does not have operating segments as
defined by SFAS 131.
The Company's customers consist primarily of end users located in the United
States and various foreign countries. Revenues by geographic region are as
follows (in thousands):
Quarter Ended
March 31,
---------------
1999 1998
------- -------
North America............................................. $15,990 $ 8,012
Europe.................................................... 2,786 1,019
Asia...................................................... 1,975 913
Rest of world............................................. 357 141
------- -------
Subtotal................................................ 21,108 10,085
Microsoft license revenue................................. 2,417 2,417
------- -------
Total................................................... $23,525 $12,502
======= =======
8
REALNETWORKS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Revenue from external customers by product type is as follows (in
thousands):
Quarter Ended
March 31,
---------------
1999 1998
------- -------
Streaming media license revenue........................... $14,593 $ 7,001
Streaming media service revenue........................... 5,249 2,622
Microsoft license revenue................................. 2,417 2,417
Advertising revenue....................................... 1,266 462
------- -------
Total net revenues...................................... $23,525 $12,502
======= =======
Long-lived assets by geographic location are as follows (in thousands):
March 31, December 31,
1999 1998
--------- ------------
United States....................................... $20,692 14,538
Japan............................................... 412 454
Europe.............................................. 348 329
------- ------
Total............................................. $21,452 15,321
======= ======
NOTE 3--SUBSEQUENT EVENTS
(a) Stock Split
On April 27, 1999, the board of directors approved a 2-for-1 split of the
Company's Common Stock in the form of a stock dividend. The stock split was
effected on May 10, 1999. Accordingly, the accompanying consolidated financial
statements and notes thereto have been retroactively restated to reflect the
stock split.
(b) Pending Acquisition
On April 13, 1999, the Company entered into a definitive agreement to
acquire privately held Xing Technology Corp. (Xing), a developer and provider
of MP3 software. The Company will acquire Xing in exchange for shares of
common stock of the Company with a maximum value of $75 million. The
acquisition, which is expected to be accounted for as a pooling of interests
and is subject to certain customary conditions, is expected to be completed no
later than the third quarter of 1999.
9
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations
The discussion in this report contains forward-looking statements that
involve risks and uncertainties. RealNetworks' actual results could differ
materially from those discussed below. Factors that could cause or contribute
to such differences include, but are not limited to, those identified below,
and those discussed in the section titled "Factors that May Affect
RealNetworks' Business, Future Operating Results and Financial Condition",
included elsewhere in this Report. You should also carefully review the risk
factors set forth in other reports or documents RealNetworks files from time
to time with the Securities and Exchange Commission, particularly Quarterly
Reports on Form 10-Q and any Current Reports on Form 8-K.
Overview
We are a leading provider of media delivery and distribution solutions
designed for the Internet. Our solutions enable consumers to experience and
content providers to deliver a broad range of multimedia content, including
audio, video, text and animation. We pioneered the development and
commercialization of "streaming media" systems that enable the creation, real-
time delivery and playback of multimedia content. We believe that we have
established a leadership position in the market for these systems. We have
more than 60 million registered users of our RealPlayer product and believe
that 85% of all Web pages using streaming media use our technology. The broad
acceptance of the Internet as a means of content delivery, combined with
recent technological advances, has greatly increased the practicality and
popularity of a number of new online media delivery formats. In response, we
have extended our media delivery platform to include a digital music
management system that allows consumers to acquire, record, store, organize
and play their personal music collections on PCs and digital playback devices.
We were incorporated in February 1994 and were in the development stage
until July 1995, when we released the commercial version of RealAudio Version
1.0. From inception through December 31, 1995, our operating activities
related primarily to recruiting personnel, raising capital, purchasing
operating assets, conducting research and development, building the RealAudio
brand and establishing the market for streaming audio. During 1996, we
continued to invest heavily in research and development and marketing and in
building our domestic and international sales channels and our general and
administrative infrastructure. In August 1996, we began selling RealPlayer
Plus, a premium version of our RealPlayer product. RealPlayer continues to be
available for download free of charge from our websites. In June 1997, we
released the commercial version of RealVideo Version 4.0. In December 1997, we
released the commercial version of RealSystem Version 5.0, a streaming media
solution that includes RealAudio and RealVideo technology. In November 1998,
we released the commercial version of RealSystem G2, our latest generation
media delivery system. In May 1999, we released RealSystem MP, as well as a
beta version of RealJukebox.
Our revenues are reported in the following three categories:
. Software license fees include revenues from sales of our RealPlayer
Plus, RealServers and related authoring and publishing tools, OEM
sales of our products and sales of third-party products.
. Service revenues include support and maintenance services that we sell
to customers who purchase our RealPlayer Plus, RealServers and tools
products. We also provide broadcast hosting services through our Real
Broadcast Network and offer consulting services.
. Advertising revenues are derived from the sale of advertising on our
websites.
In March 1998, we acquired Vivo Software, a leading developer of streaming
media creation tools, in an acquisition accounted for using the purchase
method of accounting. On April 13, 1999, we
10
entered into a definitive agreement to acquire privately held Xing Technology,
a leading developer and provider of MP3 software, in exchange for shares of
our common stock having a maximum value of $75 million. The acquisition, which
we expect to account for as a pooling of interests, is subject to certain
customary conditions. It is expected to be completed no later than the third
quarter of 1999.
Results of Operations
Revenues
Software License Fees. Software license fees were $17.0 million for the
quarter ended March 31, 1999, an increase of 81% from $9.4 million in the
comparable quarter of the prior year. The increase was due primarily to a
greater volume of products sold, which resulted from growth in the demand for
streaming media on the Internet, the introduction of the RealSystem G2 in
November 1998, successful product promotions and increased sales of third-
party products. Software license fees for each of the quarters ended March 31,
1999 and 1998 included $2.4 million related to the Microsoft license agreement
we entered into in June 1997.
Service Revenues. Service revenues were $5.2 million for the quarter ended
March 31, 1999, an increase of 100% from $2.6 million in the comparable
quarter of the prior year. The increase was primarily due to a larger
installed base of our products from which we derive support and maintenance
revenues and increases in revenues from our consulting and streaming media
hosting services.
Advertising. Advertising revenues were $1.3 million for the quarter ended
March 31, 1999, an increase of 174% from $0.5 million in the comparable
quarter of the prior year. The increase in advertising revenues was due to
increased traffic on websites and increased effectiveness of our advertising
sales force.
Geographic Revenues. Excluding revenues from the Microsoft license
agreement, international revenues represented 21% of total net revenues in the
quarter ended March 31, 1998 and 24% of total net revenues in the quarter
ended March 31, 1999. Revenues generated in Europe were 10% and 13% of total
net revenues (excluding revenues from the Microsoft license agreement) in the
quarters ended March 31, 1998 and 1999, respectively, and revenues generated
in Japan/Asia Pacific were 9% of total net revenues (excluding revenues from
the Microsoft license agreement) in each of the quarters ended March 31, 1998
and 1999.
Cost of Revenues
Cost of Software License Fees. Cost of software license fees includes costs
of product media, duplication, manuals, packaging materials, amounts paid for
licensed technology and fees paid to third-party vendors for order
fulfillment. Cost of software license fees was $2.8 million for the quarter
ended March 31, 1999, an increase of 77% from $1.6 million in the comparable
quarter of the prior year, and remained a constant 17% of software license
fees. The increase in absolute dollars was due primarily to higher sales
volumes.
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 streaming media hosting services. Cost of service
revenues was $0.9 million for the quarter ended March 31, 1999, an increase of
77% from $0.5 million in the comparable quarter of the prior year, but
decreased as a percentage of service revenues to 18% from 20%. The increase in
absolute dollars was primarily due to increased staff and contract personnel
needed to provide services to a greater number of customers. The decrease as a
percentage of service revenues was primarily due to economies of scale in
providing support services to a larger customer base.
11
Cost of Advertising. Cost of advertising includes the cost of personnel
associated with content creation and maintenance and fees paid to third
parties for content included in our websites. Cost of advertising was $0.6
million for the quarter ended March 31, 1999, an increase of 66% from $0.3
million in the comparable quarter of the prior year, but decreased as a
percentage of advertising revenues to 43% from 72%. The increase in absolute
dollars was primarily due to increases in the quality and quantity of content
available on our websites, the addition of new websites and higher bandwidth
costs. The decrease as a percentage of advertising revenues was due to greater
economies of scale.
Our gross margins may fluctuate based on the mix of distribution channels
used and the mix of products sold.
Operating Expenses
Research and Development. Research and development expenses consist
primarily of salaries and consulting fees associated with product development
and costs of technology acquired from third parties to be incorporated into
products currently under development. To date, all research and development
costs have been expensed as incurred because technological feasibility is
generally not established until substantially all development is complete. We
believe that significant investment in research and development is a critical
factor in attaining our strategic objectives and, as a result, we expect to
increase research and development expenditures in future periods. Research and
development expenses were $7.3 million for the quarter ended March 31, 1999,
an increase of 65% from $4.4 million in the comparable quarter of the prior
year, but decreased as a percentage of total net revenues to 31% from 35%. The
increase in absolute dollars was primarily due to increases in internal
development personnel, consulting expenses and contract labor. Research and
development expenses were primarily related to the development of new
technology and products, including RealSystem MP and RealJukebox, and
enhancements made to existing products. The decrease in percentage terms was a
result of revenues growing at a faster rate than expenses.
Sales and Marketing. Sales and marketing expenses consist primarily of
salaries, sales commissions, consulting fees, trade show expenses, advertising
costs and cost of marketing collateral. We intend to increase our branding and
marketing efforts and therefore expect sales and marketing expenses to
increase significantly in future periods. Sales and marketing expenses were
$10.2 million for the quarter ended March 31, 1999, an increase of 50% from
$6.8 million in the comparable quarter of the prior year, but decreased as a
percentage of total net revenues to 43% from 55%. The increase in absolute
dollars was due to the expansion of our direct sales and marketing
organization, the creation of additional sales offices, promotions and other
expenses related to the continued development of the "Real" brand. The
decrease in percentage terms was a result of revenues growing at a faster rate
than expenses.
General and Administrative. General and administrative expenses consist
primarily of salaries, fees for professional services and bad debt expense. We
expect general and administrative expenses to increase as we expand our staff
and incur additional costs related to growth of our business. General and
administrative expenses were $2.9 million for the quarter ended March 31,
1999, an increase of 39% from $2.1 million in the comparable quarter of the
prior year, but decreased as a percentage of total net revenues to 12% from
17%. The increase in absolute dollars was primarily a result of increased
personnel and facility expenses necessary to support our growth. The decrease
in percentage terms was due to revenues growing at a faster rate than
expenses.
Goodwill Amortization and Acquisition Charges
In March 1998, we acquired Vivo Software, a developer of streaming media
creation tools. We issued approximately 2.2 million shares of our common stock
in exchange for all outstanding shares
12
of Vivo common stock and assumed options to purchase approximately 95,000
shares of our common stock. The acquisition was accounted for using the
purchase method of accounting and, accordingly, the results of Vivo's
operations are included in our financial statements since the date of
acquisition.
The purchase price was allocated to the fair value of the acquired assets
and assumed liabilities based on their fair values at the date of the
acquisition. A portion of the purchase price represents acquired in-process
research and development that has not yet reached technological feasibility
and has no alternative future use. Of the total purchase price, $8.6 million
was allocated to in-process research and development expense, $10.6 million
was allocated to goodwill, and $0.5 million was allocated to tangible assets.
Goodwill is amortized over its estimated life of five years.
The in-process research and development projects acquired in the acquisition
of Vivo consisted of the development of encoder tools and server and client
codecs. The encoder tools allow users to create media content to be streamed
over the Internet or intranets. The server and client codecs enhance the
compression and decompression of multimedia content streamed over the Internet
or intranets.
The percentage completion of the projects at the time of acquisition was as
follows:
Encoder tools..................................................... 40%-70%
Server codec...................................................... 30%
Client codec...................................................... 30%
We completed the development of the encoder tools in 1998. The total cost to
complete development of the encoder tools was approximately $1.0 million. The
server and client codec projects are expected to be complete in 1999. The
expected aggregate cost to complete the server and client codecs is
approximately $0.7 million.
Since the acquisition, we have continued to market and support Vivo's
existing products on a limited basis and will continue to do so until the in-
process projects are completed.
The acquisition of Vivo was a tax-free reorganization under the Internal
Revenue Code. Therefore, the charge for in-process research and development
and amortization of acquired intangible assets is not deductible for income
tax purposes.
Other Income, Net
Other income, net consists primarily of earnings on RealNetworks' cash, cash
equivalents and short-term investments. Other income, net was $1.0 million for
the quarter ended March 31, 1999 and $1.1 million for the quarter ended March
31, 1998.
Liquidity and Capital Resources
Net cash provided by operating activities was $6.7 million for the quarter
ended March 31, 1999. Net cash used in operating activities was $1.0 million
for the quarter ended March 31, 1998. Net cash provided by operating
activities in the quarter ended March 31, 1999 resulted primarily from an
increase in current liabilities of $6.4 million and from noncash charges
associated with depreciation and amortization of $1.3 million, partially
offset by the reported net loss of $0.7 million. Cash used in operating
activities for the quarter ended March 31, 1998 was primarily due to the
reported net loss, partially offset by non-cash acquisition charges.
Net cash used in investing activities was $24.6 million and $15.9 million
for the quarters ended March 31, 1999 and 1998, respectively, and was
primarily a result of net purchases of short-term investments and purchases of
equipment and leasehold improvements.
13
Net cash provided by financing activities was $252,000 and $2,000 for the
quarters ended March 31, 1999 and 1998, respectively, and was a result of net
proceeds from the exercise of stock options.
At March 31, 1999, we had $89.1 million in cash, cash equivalents and short-
term investments. As of March 31, 1999, our principal commitments consisted of
obligations under operating leases and a $1.0 million note payable. Since our
inception, we have experienced a substantial increase in our capital
expenditures to support expansion of our operations and information systems.
In January 1998, we entered into a lease agreement for a new location for
our corporate headquarters. The lease commenced on April 1, 1999 and expires
on April 1, 2011, with an option to renew the lease for either a three- or
ten-year period. We expect to occupy the new facilities in May 1999. We are
funding the tenant improvements, a portion of which may be financed through
equipment leases. In addition, we are in the process of upgrading and
replacing our existing internal information systems. We anticipate that the
costs of the tenant improvements and information systems will total
approximately $14.0 million in 1999.
We do not hold derivative financial instruments or equity securities in our
investment portfolio. Our cash equivalents and short-term investments consist
of high-quality securities, as specified in our investment policy guidelines.
The policy limits the amount of credit exposure to any one issue or issuer to
a maximum of 5% of the total portfolio and requires that all short-term
investments mature in two years or less, with the average maturity being one
year or less. These securities are subject to interest rate risk and will
decrease in value if interest rates increase. If market interest rates were to
increase immediately and uniformly by 10% from levels at March 31, 1999, the
fair value of the portfolio would decline by an immaterial amount. Because we
have historically held our fixed-income investments until maturity, we would
not expect our operating results or cash flows to be significantly affected by
a sudden change in market interest rates on our securities portfolio.
We conduct our operations in five primary functional currencies: the United
States dollar, the Japanese yen, the British pound, the French franc and the
German mark. Historically, neither fluctuations in foreign exchange rates nor
changes in foreign economic conditions have had a significant impact on our
financial condition or results of operations. We currently do not hedge our
foreign currency exposures and are therefore subject to the risk of exchange
rates. We invoice the customers of our international subsidiaries primarily in
U.S. dollars, except in Japan, where we invoice our customers primarily in
yen. We are exposed to foreign exchange rate fluctuations as the financial
results of foreign subsidiaries are translated into U.S. dollars in
consolidation. Our exposure to foreign exchange rate fluctuations also arises
from intercompany payables and receivables to and from our foreign
subsidiaries. Foreign exchange rate fluctuations did not have a material
impact in 1998 and 1997.
On January 1, 1999, the participating member countries of the European Union
converted to a common currency, the euro. On that same date they established
fixed conversion rates between their existing sovereign currencies and the
euro. Even though legacy currencies are scheduled to remain legal tender in
the participating countries as denominations of the euro until January 1,
2002, the participating countries will no longer be able to direct independent
interest rates for the legacy currencies. The authority to set monetary policy
will now reside with the new European Central Bank. We do not anticipate any
material impact from the euro conversion on our financial information systems,
which currently accommodate multiple currencies. Due to numerous
uncertainties, we cannot reasonably estimate the effect that the euro
conversion issue will have on our pricing or market strategies or the impact,
if any, it will have on our financial condition and results of operations.
Since our inception, we have significantly increased our operating expenses.
We currently anticipate that we will continue to experience significant growth
in our operating expenses and that
14
such expenses will be a material use of our cash resources. Not including the
estimated net proceeds we expect to receive from this offering, we believe
that our current cash, cash equivalents and short-term investments will be
sufficient to meet our anticipated cash needs for working capital and capital
expenditures for at least the next 12 months. In the future, we may seek to
raise additional funds through public or private equity financing, or through
other sources such as credit facilities. The sale of additional equity
securities could result in dilution to our shareholders.
Microsoft Relationship
In June 1997, we entered into a strategic agreement with Microsoft pursuant
to which we granted Microsoft a nonexclusive license to certain substantial
elements of the source code of our RealAudio/RealVideo Version 4.0 technology
and related RealNetworks trademarks for a license fee of $30.0 million. We are
recognizing revenue related to the agreement ratably over the three-year term
of our ongoing obligations.
Microsoft may sublicense its rights to the licensed source code to third
parties under certain conditions without further compensation to RealNetworks.
In addition, Microsoft was granted an option to receive two additional
deliveries of updated versions of the source code. Microsoft's right to
receive the first delivery expired unexercised in July 1998. Microsoft may
elect to acquire an updated version of the source code once before July 1999,
upon payment of a license fee of $35.0 million. Under certain conditions, if
we license our source code to a third party, the agreement provides for a
partial refund of the license fee paid by Microsoft, based on a declining
scale over the three-year term of the agreement.
In connection with the agreement, Microsoft made a $30.0 million minority
investment in RealNetworks in the form of 3.3 million shares of nonvoting
preferred stock. These shares were converted into nonvoting special common
stock concurrent with our initial public offering in November 1997. All shares
of special common stock automatically convert into two shares of common stock
upon sale or transfer by Microsoft to a third party not otherwise affiliated
with Microsoft. As of May 6, 1999, Microsoft had sold all 3.3 million shares
of its special common stock.
On July 23, 1998, Robert Glaser, our chief executive officer, testified
before the Senate Judiciary Committee that if a consumer had the RealPlayer on
his or her computer system, and then downloaded the Windows Media Player, the
Windows Media Player disabled important functions of our RealPlayer in certain
instances. As a result, some of our customers who had downloaded the free
RealPlayer, or paid for the RealPlayer Plus, found that their players did not
work. We quickly incorporated a workaround solution into our RealPlayer and
RealPlayer Plus and also posted this workaround solution on our website. We
believe the workaround solution corrected the problem at the time and, as a
result, we believe only a small number of customers were impacted by the
situation. However, we believe there is a continued risk that future versions
of Microsoft's products, especially Internet Explorer and the Windows Media
Player, may negatively impact the experience of our customers by displaying a
Windows Media Player when the customer seeks to play RealAudio or RealVideo
content, or by posting an error message when the customer tries to play
content available in RealNetworks' formats that may not be viewed through the
Windows Media Player, without telling the customer how to obtain the latest
RealPlayer. Such actions by Microsoft could materially reduce market share for
the RealPlayer and have a negative effect on demand for our server software
and tools. We have provided and will continue to seek to provide useful input
to Microsoft to address these situations so as to provide an optimal
experience for consumers. In light of these recent events, our relationship
with Microsoft has become more competitive. See "--Factors That May Affect Our
Business, Future Operating Results and Financial Condition--We may be unable
to successfully compete with Microsoft and other companies in the media
delivery market."
Year 2000 Compliance
The "Year 2000" problem exists because many existing computer programs use
only the last two digits to refer to a year. As a result, date-sensitive
computer programs may not be able to distinguish
15
whether a two-digit date designated as "00" refers to 1900 or 2000. This
problem could cause system failures or the creation of wrong information and
disrupt our operations.
We have developed a phased plan to achieve Year 2000 compliance for our
internal processing and operational systems and the current versions of our
software products. During the first quarter of 1999, we assessed the state of
our internal and external Year 2000 compliance. Currently, a plan to correct
problems found during the assessment is being developed and tested. During the
third quarter of 1999, we will implement this remediation plan, consisting of
upgrading and replacement of certain product versions, if necessary, and test
them for compliance.
We have publicly made Year 2000 readiness disclosures stating that the
current versions of our products are "Year 2000 compliant." "Year 2000
compliant" means that software products and systems are able to function
properly before, during and after the year 2000 without loss of functionality
due to date changes. This assurance assumes that:
. our products are configured and used in accordance with the related
documentation;
. the underlying operating system of the host machine for our products
and any other software used with or in such host machine are also Year
2000 compliant; and
. all other products, whether hardware, software, or firmware, used with
one of our products properly exchange data with it.
We are currently testing and will continue to test our products and systems
and may find errors or defects associated with Year 2000 date functions. We
have not tested our products on all platforms or all versions of operating
systems that we currently support. We believe that all of the current versions
of our products will be Year 2000 compliant by the end of 1999. We have not
specifically tested software obtained from third parties, such as licensed
software, shareware and freeware, that is incorporated into our products, but
we are seeking assurances from our vendors that licensed software is Year 2000
compliant. Despite our testing, testing by our current and potential
customers, and whatever assurances, if any, we may receive from developers of
technology incorporated into our products, our products and those of our
vendors may contain undetected errors or defects associated with Year 2000
date functions.
We rely on third parties for services and supplies such as
telecommunications, Internet service and utilities. We are seeking
confirmation from such service providers that their systems are Year 2000
compliant. Interruption of those services or supplies due to Year 2000 issues
could adversely affect our operations. We are also subject to external forces
that might generally affect industry and commerce, such as utility or
transportation company Year 2000 compliance failures and related service
interruptions. We are in the process of updating and upgrading our internal
information systems. Although the replacement of information systems is not in
direct response to Year 2000 concerns, we expect that all new internal
information systems implemented in 1999 will be Year 2000 compliant.
Known or unknown Year 2000 errors or defects in our internal systems and
products, lack of Year 2000 compliance by third-party software incorporated in
our products and/or interruption of services from our external service
providers due to Year 2000 problems could result in failure or disruption of
our products and operations, delay or loss of revenue, diversion of
development resources, damage to our reputation, claims or litigation and
increased service and warranty costs, any of which could impair our finances
or business prospects. Some commentators have predicted significant litigation
regarding Year 2000 compliance issues, and we are aware of such lawsuits
against other software vendors. Because of the unprecedented nature of such
litigation, we are uncertain whether or to what extent we may be affected by
it.
We currently respond to customer concerns about our products on a case-by-
case basis. In addition, we have posted a web page on our primary website
indicating the Year 2000 status of our
16
products. We believe that the purchasing patterns of customers and potential
customers may be affected by Year 2000 issues in a variety of ways, including
the decision to delay purchasing our products until the Year 2000. We believe
that it is not possible to predict the overall impact of these decisions.
At this stage in our analysis and remediation process, it is difficult to
specifically identify the cause and the magnitude of any adverse economic
impact of the most reasonably likely worst case Year 2000 scenario. Our
reasonably likely worst case scenario would include the unavailability of our
major internal systems to our employees and the failure of our products to
operate properly, causing customers' systems and/or operations to fail or be
disrupted. This worst case scenario also would include the failure of key
vendors and/or suppliers to correct their own Year 2000 issues, which could
cause failure or disruption of our operations or products. If a worst case
scenario occurs, we may incur expenses to repair our systems or upgrade our
products, face interruptions in the work of our employees, lose advertising,
service and product license revenue, be unable to support the broadcast of
other companies' content over the Internet, be unable to deliver downloads of
our products, incur increased warranty and service expenses and suffer damage
to our reputation. In addition, customers may sue us or otherwise seek
compensation for their losses. We have agreed to indemnify certain customers
for claims and losses if our products are not Year 2000 compliant. Any or all
of the above events could harm our business.
We have not yet fully developed a comprehensive contingency plan to address
situations that may result if we are unable to achieve Year 2000 readiness of
our critical operations. The cost of developing and implementing such a plan
may itself be material. To date, we have not incurred significant expenditures
for our Year 2000 remediation efforts. Although we do not anticipate the costs
to address our Year 2000 issues to be material, the costs of Year 2000
remediation work and the date on which we plan to complete such work are based
on management's best estimates. These estimates are derived from assumptions
about future events, including the availability of certain resources, third-
party remediation plans and other factors. In addition, undetected errors or
the failure of such systems to be Year 2000 compliant could create significant
record-keeping and operational deficiencies. Accordingly, if Year 2000
modifications, evaluations, assessments and conversions are not made or are
not completed in time, the Year 2000 problem could harm our business.
17
FACTORS THAT MAY AFFECT OUR BUSINESS, FUTURE OPERATING RESULTS AND FINANCIAL
CONDITION
We have a limited operating history, which makes it difficult to evaluate our
business
We were incorporated in February 1994 and have a limited operating history.
We have limited financial results on which you can assess our future success.
Our prospects must be considered in light of the risks, expenses and
difficulties frequently encountered by growing companies in new and rapidly
evolving markets, such as streaming media software, media delivery systems and
electronic commerce.
To address the risks and uncertainties we face, we must:
. establish and maintain broad market acceptance of our products and
services and convert that acceptance into direct and indirect sources
of revenue;
. maintain and enhance our brand name;
. continue to timely and successfully develop new products, product
features and services and increase the functionality and features of
existing products;
. successfully respond to competition from Microsoft and others; and
. develop and maintain strategic relationships to enhance the
distribution, features and utility of our products and services.
Our business strategy may be unsuccessful and we may be unable to address
the risks we face in a cost-effective manner, if at all. Our inability to
successfully address these risks will harm our business.
We have a history of losses and may never attain profitability
We have incurred significant losses since our inception and we may never
become profitable. As of March 31, 1999, we had an accumulated deficit of
approximately $34.7 million. We devote significant resources to developing,
enhancing, selling and marketing our products and services. As a result, we
will need to generate significant revenues to achieve and maintain
profitability. We may not continue our historical growth or generate
sufficient revenues for profitability. If we do achieve profitability, we may
not sustain or increase profitability on a quarterly or annual basis in the
future.
Our operating results are likely to fluctuate significantly
As a result of our limited operating history and the rapidly changing nature
of the markets in which we compete, our quarterly and annual revenues and
operating results are likely to fluctuate from period to period. These
fluctuations may be caused by a number of factors, many of which are beyond
our control. These factors include the following, as well as others discussed
elsewhere in this section:
. how and when we introduce new products and services and enhance our
existing products and services;
. the timing and success of our brand-building and marketing campaigns;
. our ability to establish and maintain strategic relationships;
. the demand for Internet advertising and sponsorships;
. the emergence and success of new and existing competition;
. varying operating costs and capital expenditures related to the
expansion of our business operations and infrastructure, domestically
and internationally, including the hiring of new employees;
18
. technical difficulties with our products, system downtime, system
failures or interruptions in Internet access;
. costs related to the acquisition of businesses or technology; and
. costs of litigation and intellectual property protection.
In addition, because the market for our products and services is relatively
new and rapidly changing, it is difficult to predict future financial results.
Our research and development and sales and marketing efforts, and business
expenditures generally, are partially based on predictions regarding certain
developments for media delivery. To the extent that these predictions prove
inaccurate, our revenues and operating expenses may fluctuate.
For these reasons, you should not rely on period-to-period comparisons of
our financial results as indications of future results. Our future operating
results could fall below the expectations of public market analysts or
investors and significantly reduce the market price of our common stock.
Fluctuations in our operating results will likely increase the volatility of
our stock price.
We may be unable to successfully compete with Microsoft and other companies in
the media delivery market
The market for software and services for media delivery over the Internet is
relatively new, constantly changing and intensely competitive. As media
delivery evolves into a central component of the Internet experience, more
companies are entering the market for, and expending increasing resources to
develop, media delivery software and services. We expect that competition will
continue to intensify.
Many of our current and potential competitors have longer operating
histories, greater name recognition, more employees and significantly greater
financial, technical, marketing, public relations and distribution resources
than we do. The competitive environment may require us to make changes in our
products, pricing, licensing, services or marketing to maintain and extend our
current brand and technology franchise. Price concessions or the emergence of
other pricing or distribution strategies of competitors may diminish our
revenues, impact our margins or lead to a reduction in our market share, any
of which will harm our business.
We believe that the primary competitive factors in the media delivery market
include:
. the quality and reliability of the overall media delivery solution;
. access to distribution channels necessary to achieve broad
distribution and use of products;
. the availability of content for delivery over the Internet and access
to necessary intellectual property rights;
. the ability to develop and support secure formats for digital media
delivery, particularly music and video;
. the size of the active audience for streaming media and its appeal to
content providers and advertisers;
. features for creating, editing and adapting content for the Internet;
. ease of use and interactive user features in products;
. ease of finding and accessing content over the Internet;
. scalability of streaming media and media delivery technology and cost
per user;
19
. pricing and licensing terms;
. compatibility with new and existing media formats;
. compatibility with the user's existing network components and software
systems; and
. challenges caused by bandwidth constraints and other limitations of
the Internet infrastructure.
Our failure to adequately address any of the above factors could harm our
business strategy and operating results.
Microsoft is a principal competitor in the development and distribution of
streaming media and media distribution technology. Microsoft currently
competes with us in the market for streaming media server and player software
and has announced its intent to compete in the market for digital distribution
of media. We believe that Microsoft's commitment to and presence in the media
delivery industry has increased and that Microsoft will continue to increase
competitive pressure in the overall market for streaming media and media
distribution.
Microsoft distributes its competing streaming media server and tools
products by bundling them with its Windows NT servers at no additional charge
and by making them available for download from its website for free. While we
also provide free downloads of certain of our products, including players,
servers and tools, Microsoft's practices have caused, and may continue to
cause, pricing pressure on our products. These practices could lead to longer
sales cycles, decreased sales and reduced market share. In addition, we
believe that Microsoft has used and may be able to use its dominant position
in the computer industry and its financial resources to secure preferential or
exclusive distribution and bundling contracts for its streaming media products
with third parties such as Internet service providers (ISPs), online service
providers, content providers, entertainment companies, media companies,
broadcasters, value added resellers (VARs) and original equipment
manufacturers (OEMs), including third parties with whom we have relationships.
Such arrangements, together with Microsoft's aggressive marketing of Windows
NT and of its streaming media products, may reduce our share of the streaming
media market.
Microsoft's Windows Media Player competes with our RealPlayer products. The
Windows Media Player is available for download from Microsoft's website for
free, and is bundled by Microsoft with its Windows 98 operating system and
with its Web browser, Internet Explorer. In addition, Microsoft has bundled
certain audio capabilities into a radio toolkit for Internet Explorer 5.0, its
latest Web browser. Internet Explorer 5.0 includes Web Events, which provides
links to multimedia content on the Internet, especially content in Microsoft's
streaming media formats. We expect that by leveraging its dominant position in
operating systems and tying streaming media into its operating system and its
browser, Microsoft will distribute substantially more copies of the Windows
Media Player in the future than it has in the past and may be able to attract
more users to its streaming media products. Currently, our RealPlayer has a
high degree of market penetration: we have over 60 million registered users
and estimate that over 85% of all Web pages on the Internet that use streaming
media do so using our formats. Our market position may be difficult to
sustain, particularly in light of Microsoft's efforts and dominant position in
operating systems.
On July 23, 1998, Robert Glaser, our chief executive officer, testified
before the Senate Judiciary Committee that if a consumer had the RealPlayer on
his or her computer system, and then downloaded the Windows Media Player, the
Windows Media Player disabled important functions of our RealPlayer in certain
instances. As a result, some of our customers who had downloaded the free
RealPlayer, or paid for the RealPlayer Plus, found that their players did not
work. We quickly incorporated a workaround solution into our RealPlayer and
RealPlayer Plus and also posted this workaround solution on our website. We
believe the workaround solution corrected the problem at the
20
time and, as a result, we believe only a small number of customers were
impacted by the situation. However, we believe there is a continued risk that
future versions of Microsoft's products, especially Internet Explorer and the
Windows Media Player, may negatively impact the experience of our customers by
displaying a Windows Media Player when the customer seeks to play RealAudio or
RealVideo content, or by posting an error message when the customer tries to
play content available in RealNetworks' formats that may not be viewed through
the Windows Media Player, without telling the customer how to obtain the
latest RealPlayer. Such actions by Microsoft could materially reduce market
share for the RealPlayer and have a negative effect on demand for our server
software and tools. We have provided and will continue to seek to provide
useful input to Microsoft to address these situations so as to provide an
optimal experience for consumers. In light of these recent events, our
relationship with Microsoft has become more competitive.
In addition to Microsoft, we face increasing competition from other
companies that are developing and marketing streaming media products.
Competitors include Apple Computer, which has just announced the availability
of QuickTime 4.0 with a streaming media server, Cisco Systems/Precept
Software, PictureTel/Starlight Networks and Oracle. As more companies enter
the market with products that compete with our servers, players and tools, the
competitive landscape could change rapidly to our disadvantage.
We do not believe that clear standards have emerged with respect to non-PC
wireless and cable-based systems. Likewise, no one company has gained a
dominant position in the mobile device market. Other companies' products and
services or new standards may emerge in any of these areas, which could reduce
demand for our products or render them obsolete.
In addition, our streaming media and media delivery products face
competition from non-streaming, "fast download" media delivery technologies
such as AVI, QuickTime and MP3. Other fast download or non-streaming IP-based
content distribution methods are likely to emerge and could compete with our
products and services, which could harm our business.
We may be unable to successfully compete in other parts of our business
Media Hosting. Our media hosting service, the Real Broadcast Network,
competes with a variety of companies that provide streaming media hosting
services. These companies include Broadcast.com (which has agreed to be
acquired by Yahoo!) and Intervu and emerging broadcast networks such as CMGI's
Magnitude Network and Enron Communications. We may not establish or sustain
our competitive position in this market segment. Some media hosting
competitors are also customers on whom we rely to help drive product download
traffic to our website through their broadcast events.
Website Destinations, Content and Advertising. While Internet advertising
revenues across the industry continue to grow, the number of websites
competing for advertising revenues is also growing rapidly. Our websites,
including Real.com, Film.com and LiveConcerts.com, compete for user traffic
and Internet advertising revenues with a wide variety of websites, Internet
portals and ISPs. In particular, aggregators of audio, video and other media,
such as Broadcast.com and Microsoft's Web Events, compete with our RealGuide.
We also compete with traditional media such as television, radio and print for
a share of advertisers' total advertising budgets. Our advertising sales force
and infrastructure are still in early stages of development relative to those
of our competitors. We cannot be certain that advertisers will place
advertising with us or that revenues derived from such advertising will be
meaningful. If we lose advertising customers, fail to attract new customers,
are forced to reduce advertising rates or otherwise modify our rate structure
to retain or attract customers, or if we lose website traffic, our business
could be harmed.
21
Electronic Commerce. The electronic commerce features of our websites
compete with a variety of other websites for consumer traffic. To compete
successfully in the electronic commerce market, we must attract sufficient
traffic to our websites by offering high-quality, competitively priced,
desirable merchandise in a compelling, easy-to-purchase format. In addition,
we must successfully leverage our existing user base to develop the market for
our products and services. We may not compete successfully in the growing and
rapidly changing market for electronic commerce. Our failure to do so could
harm our business.
Increased competition may result in price reductions, reduced margins, loss
of market share, loss of customers, and a change in our business and marketing
strategies, any of which could harm our business.
We may not be successful in the market for downloadable media and local media
delivery
In May 1999, we announced the RealSystem MP, a digital music architecture
enabling integration with a wide range of Internet services and hardware
devices. We also released a beta version of RealJukebox, our client software
based on the RealSystem MP. These products represent an extension of our
business into downloadable media and local media delivery, which is a
substantial evolution from our historical focus on streaming media products
and services. We do not know whether there is a sustainable market for
products such as RealSystem MP and RealJukebox. Even if that market exists, we
may be unable to develop a revenue model or sufficient demand to take
advantage of the market opportunity.
While over one million copies of RealJukebox have been downloaded since its
beta release on May 3, 1999, it is too soon to determine if RealJukebox will
be widely received in the marketplace. There are now a number of competitive
products on the market that offer certain of the features that RealJukebox
offers. In addition, given the size and importance of the general market for
music distribution, competitors will likely release products that directly
compete with RealJukebox, which could harm our business. Even if RealJukebox
achieves widespread market acceptance, it may not achieve a high level of use,
which would lead to a low rate of upgrade sales and electronic commerce
opportunities.
RealJukebox has been released only as an early beta version. Although we
tested this version prior to its release, it likely contains errors. We will
spend substantial development resources to continue to test the product, to
correct errors and to improve the product before we release a commercial
version of RealJukebox. We may never release a commercial version. Our
inability to commercially release RealJukebox, to achieve widespread
acceptance for RealSystem MP and RealJukebox, or to create new revenue streams
from new market segments could harm our business.
RealJukebox allows users to record and play back music in a variety of
technical formats, including RealAudio G2 and MP3. However, technical formats
and consumer preferences evolve very rapidly, and we may be unable to
adequately address consumer preferences or fulfill the market demand to the
extent it exists.
We have had long-term relationships with recording companies, including
major record labels, many of which offer their streaming content in our
formats. However, recording companies, including those with whom we have a
relationship, may be uncomfortable with some features of RealJukebox. As a
result, some record companies may decide to withhold content from RealJukebox,
or refrain from or delay participating in promotional opportunities with
respect to RealJukebox.
RealJukebox is intended to allow users of the product to acquire, record,
play back and manage music for their personal use. It is possible for a user
of RealJukebox to elect not to use the copyright-protection features it
contains and then violate the intellectual property rights of artists and
recording
22
companies by engaging in an authorized distribution of music. The laws
governing the recording, distribution and performance of digital music are new
and largely untested. While we believe we have developed RealJukebox to comply
with U.S. copyright laws, a court may find us in violation of these laws. The
Recording Industry Association of America, an industry group, recently pursued
legal action to enjoin the distribution of the Rio, an MP3 player made by
Diamond Multimedia. Similar action or other litigation in the United States or
abroad directed at us could harm our business, even if such litigation were
entirely without merit.
We may not successfully develop new products and services
Our growth depends on our ability to continue to develop leading edge media
delivery and digital distribution products and services. If we fail to develop
products and services that achieve widespread market acceptance or that fail
to generate significant revenues to offset development costs, our business and
operating results would be harmed. We may not timely and successfully
identify, develop and market new product and service opportunities. If we
introduce new products and services, they may not attain broad market
acceptance or contribute meaningfully to our revenues or profitability.
Because the markets for our products and services are rapidly changing, we
must develop new offerings quickly. We have experienced development delays and
cost overruns in our development efforts in the past and we may encounter such
problems in the future. Delays and cost overruns could affect our ability to
respond to technological changes, evolving industry standards, competitive
developments or customer requirements. Our products also may contain
undetected errors that could cause increased development costs, loss of
revenues, adverse publicity, reduced market acceptance of the products or
lawsuits by customers.
We rely on content provided by third parties to increase market acceptance of
our products
If third parties do not develop or offer compelling content to be delivered
over the Internet, our business will be harmed and our products may not
achieve or sustain broad market acceptance. We rely on third-party content
providers, such as radio and television stations, record labels, media
companies, websites and other companies, to develop and offer content in our
formats that can be delivered using our server products and played back using
our player products. While we have a number of short-term agreements with
third parties to provide content from their websites in our formats, most
third parties are not obligated to develop or offer content using our
technology. In addition, some third parties have entered into and may in the
future enter into agreements with our competitors, principally Microsoft, to
develop or offer all or a substantial portion of their content in our
competitors' formats. Microsoft has more resources to secure preferential and
even exclusive relationships with content providers. If Microsoft or another
competitor were to secure preferential or exclusive relationships with the
leading broadcasters, record companies or websites, it could result in less
demand for and use of our products. We cannot guarantee that third-party
content providers will continue to rely on our technology or offer compelling
content in our formats to encourage and sustain broad market acceptance of our
products. Their failure to do so would harm our business.
As we move into the market for digital distribution of media and local media
playback, our success depends on the availability of third-party content,
especially music, that users of our RealJukebox product can lawfully and
easily access, record and play back. If third parties are unwilling to offer
their content for free download or purchase by users of RealJukebox, our
product may not achieve or sustain market acceptance. Competitors could secure
exclusive distribution relationships with such content providers, which would
harm our business.
We depend on key personnel who may leave us at any time
Our success substantially depends on the continued employment of our
executive officers and key employees, particularly Robert Glaser, our chairman
of the board and chief executive officer. The loss
23
of the services of Mr. Glaser or any of our other executive officers or key
employees could harm our business. None of our executive officers has a
contract that guarantees employment. Other than the $2 million insurance
policy on the life of Mr. Glaser, we do not maintain "key person" life
insurance policies.
Our failure to attract, train or retain highly qualified personnel could harm
our business
Our success also depends on our ability to attract, train and retain
qualified personnel, specifically those with management and product
development skills. In particular, we must hire additional skilled software
engineers to further our research and development efforts. Competition for
such personnel is intense, particularly in high-technology centers such as the
Pacific Northwest. In making employment decisions, particularly in the
Internet and high-technology industries, job candidates often consider the
value of stock options they may receive in connection with their employment.
As a result of recent volatility in our stock price, we may be disadvantaged
in competing with companies that have not experienced similar volatility or
that have not yet sold their stock publicly. If we do not succeed in
attracting new personnel or retaining and motivating our current personnel,
our business could be harmed.
We may not successfully manage our growth
We cannot successfully implement our business model if we fail to manage our
growth. We have rapidly and significantly expanded our operations domestically
and internationally and anticipate further expansion to take advantage of
market opportunities. We have increased the number of our full-time employees
from 325 on January 1, 1998 to 490 on March 31, 1999. Managing this
substantial expansion has placed a significant strain on our management,
operational and financial resources. If our growth continues, we will need to
continue to improve our financial and managerial control and reporting systems
and procedures.
We are in the process of implementing new management information software
systems. This will affect many aspects of our business, including our
accounting, operations, electronic commerce, customer service, purchasing,
sales and marketing functions. The purchase, implementation and testing of
these systems has resulted, and will result, in significant capital
expenditures and could disrupt our day-to-day operations. If these systems are
not implemented as expected, our ability to provide products and services to
our customers on a timely basis will suffer and delays in the recording and
reporting of our operating results could occur.
The growth of our business depends on the increased use of the Internet for
communications, commerce and advertising
The growth of our business depends on the continued growth of the Internet
as a medium for communications, electronic commerce and advertising. Our
business will be harmed if Internet usage does not continue to grow,
particularly as a source of media information and entertainment and as a
vehicle for commerce in goods and services. Our success also depends on the
efforts of third parties to develop the infrastructure and complementary
products and services necessary to maintain and expand the Internet as a
viable commercial medium. The Internet may not be accepted as a viable
commercial medium for broadcasting multimedia content or media delivery for a
number of reasons, including:
. potentially inadequate development of the necessary infrastructure to
accommodate growth in the number of users and Internet traffic;
. lack of acceptance of the Internet as a medium for distributing
streaming media content or for media delivery;
. unavailability of compelling multimedia content;
24
. inadequate commercial support for Web-based advertising; and
. delays in the development or adoption of new technological standards
and protocols or increased governmental regulation, which could
inhibit the growth and use of the Internet.
In addition, we believe that other Internet-related issues, such as
security, reliability, cost, ease of use and quality of service, remain
largely unresolved and may affect the amount of business that is conducted
over the Internet.
If Internet usage grows, the Internet infrastructure may not be able to
support the demands placed on it by this growth, specifically the demands of
delivering high-quality media content. As a result, its performance and
reliability may decline. In addition, websites have experienced interruptions
in service as a result of outages and other delays occurring throughout the
Internet network infrastructure. If these outages or delays occur frequently
in the future, Internet usage, as well as the usage of our products, services
and websites, could grow more slowly or decline.
Changes in network infrastructure, transmission methods and broadband
technologies pose risks to our business
We believe that increased Internet use may depend on the availability of
greater bandwidth or data transmission speeds (also known as broadband
transmission). If broadband access becomes widely available, we believe it
presents both a substantial opportunity and a significant business challenge
for us. Internet access through cable television set-top boxes, digital
subscriber lines or wireless connections could dramatically reduce the demand
for our products and services by utilizing alternate technology that more
efficiently transmits data. This could harm our business as currently
conducted.
Development of products and services for a broadband transmission
infrastructure involves a number of additional risks, including:
. changes in content delivery methods and protocols;
. obtaining compelling content that takes advantage of broadband access
and helps drive market acceptance of our products and services;
. the emergence of new competitors, such as traditional broadcast and
cable television companies, which have significant control over access
to content, substantial resources and established relationships with
media providers;
. the development of relationships by our current competitors with
companies that have significant access to or control over the
broadband transmission infrastructure or content;
. the need to establish new relationships with non-PC based providers of
broadband access, such as providers of television set-top boxes and
cable television, some of which may be our competitors; and
. the general risks of new product and service development, including
the challenges to develop error-free products and enhancements,
develop compelling services and achieve market acceptance for these
products and services.
We depend on the efforts of third parties to develop and provide a
successful infrastructure for broadband transmission. Even if broadband access
becomes widely available, heavy use of the Internet may negatively impact the
quality of media delivered through broadband connections. If these third
parties experience delays or difficulties establishing a widespread broadband
transmission infrastructure or if heavy usage limits the broadband experience,
the release of our broadband products and services could be delayed. Even if a
broadband transmission infrastructure is developed for widespread use, our
products and services may not achieve market acceptance or generate sufficient
revenues to offset our development costs.
25
We could lose strategic relationships that are essential to our business
The loss of certain current strategic relationships, the inability to find
other strategic partners or the failure of our existing relationships to
achieve meaningful positive results for us could harm our business. We rely in
part on strategic relationships to help us:
. maximize adoption of our products through distribution arrangements;
. increase the amount and availability of compelling media content on
the Internet to help boost demand for our products and services;
. enhance our brand;
. expand the range of commercial activities based on our technology;
. expand the distribution of our streaming media content without a
degradation in fidelity; and
. increase the performance and utility of our products and services.
Many of these goals are beyond our traditional strengths. We anticipate that
the efforts of our strategic partners will become more important as the
multimedia experience over the Internet matures. For example, we may become
more reliant on strategic partners to provide multimedia content, provide more
secure and easy-to-use electronic commerce solutions and build out the
necessary infrastructure for media delivery. We may not be successful in
forming strategic relationships. In addition, the efforts of our strategic
partners may be unsuccessful. Furthermore, these strategic relationships may
be terminated before we realize any benefit.
Our industry is experiencing consolidation that may intensify competition
The Internet industry has recently experienced substantial consolidation and
a proliferation of strategic transactions. We expect this consolidation and
strategic partnering to continue. Acquisitions or strategic relationships
could harm us in a number of ways. For example:
. competitors could acquire or partner with companies with which we have
strategic relationships and discontinue our relationship, resulting in
the loss of distribution opportunities for our products and services
or the loss of certain enhancements or value-added features to our
products and services; or
. a competitor could be acquired by a party with significant resources
and experience that could increase the ability of the competitor to
compete with our products and services.
Recent announcements and consolidations that could affect our business
include:
. Microsoft's strategic investments in broadband initiatives, including
its recently announced $5 billion investment in AT&T;
. AT&T's acquisition of TCI and its announcement that it will acquire
MediaOne Communications;
. At Home's announcement that it will acquire Excite; and
. Yahoo!'s announcements that it will acquire Broadcast.com and
GeoCities.
Potential acquisitions involve risks we may not adequately address
The failure to adequately address the financial and operational risks raised
by acquisitions of technology and businesses could harm our business. We have
acquired complementary technologies
26
and businesses in the past, and intend to do so in the future. Financial risks
related to acquisitions include:
. potentially dilutive issuances of equity securities;
. use of cash resources;
. the incurrence of additional debt and contingent liabilities;
. large write-offs; and
. amortization expenses related to goodwill and other intangible assets.
Acquisitions also involve operational risks, including:
. difficulties in assimilating the operations, products, technology,
information systems and personnel of the acquired company;
. diversion of management's attention from other business concerns;
. impairment of relationships with our employees, affiliates,
advertisers and content providers;
. inability to maintain uniform standards, controls, procedures and
policies;
. entrance into markets in which we have no direct prior experience; and
. loss of key employees of the acquired company.
We currently have an agreement to acquire Xing Technology, an MP3 software
developer, in a transaction that we expect to account for as a pooling of
interests. We may not adequately integrate this or any future acquisitions. In
addition, we may not be able to account for future acquisitions as a pooling
of interests, which could harm our operating results.
Our business will suffer if our systems fail or become unavailable
A reduction in the performance, reliability and availability of our websites
and network infrastructure will harm our ability to distribute our products
and services to our users, as well as our reputation and ability to attract
and retain users, customers, advertisers and content providers. Our revenues
depend in large part on the number of users that download our products from
our websites and access the content services on our websites. Our systems and
operations could be damaged or interrupted by fire, flood, power loss,
telecommunications failure, Internet breakdown, earthquake and similar events.
Our systems are also subject to break-ins, sabotage, intentional acts of
vandalism and similar misconduct. Our computer and communications
infrastructure is located at a single leased facility in Seattle, Washington.
We are currently preparing to move our entire main headquarters and computer
and communications infrastructure to a new leased facility, also in Seattle,
Washington. This move involves risks associated with moving our
infrastructure, though we plan to temporarily operate multiple computer
systems to minimize the risk of system outage. We do not have fully redundant
systems or a formal disaster recovery plan, and we do not carry adequate
business interruption insurance to compensate us for losses that may occur
from a system outage.
Our electronic commerce and digital distribution activities are managed by
sophisticated software and computer systems. We may encounter delays in
developing these systems, and they may contain undetected errors that could
cause system failures. Any system error or failure that causes interruption in
availability of products or content or an increase in response time could
result in a loss of potential or existing business services customers, users,
advertisers or content providers. If we suffer sustained or repeated
interruptions, our products, services and websites could be less attractive to
such entities or individuals and our business would be harmed.
A sudden and significant increase in traffic on our websites could strain
the capacity of the software, hardware and telecommunications systems that we
deploy or use. This could lead to slower
27
response times or system failures. Our operations also depend on receipt of
timely feeds from our content providers, and any failure or delay in the
transmission or receipt of such feeds could disrupt our operations. We depend
on Web browsers, ISPs and online service providers to provide Internet users
access to our websites. Many of these providers have experienced significant
outages in the past, and could experience outages, delays and other
difficulties due to system failures unrelated to our systems. In addition,
certain ISPs have temporarily interrupted our website operations in response
to the heavy volume of e-mail transmission we generate and send to our large
user base. These types of interruptions could continue or increase in the
future.
Our network is subject to security risks that could harm our reputation and
expose us to litigation or liability
Online commerce and communications depend on the ability to transmit
confidential information securely over public networks. Any compromise of our
ability to transmit confidential information securely, and costs associated
with preventing or eliminating any problems, could harm our business. Online
transmissions are subject to a number of security risks, including:
. our own or licensed encryption and authentication technology may be
compromised, breached or otherwise insufficient to ensure the security
of customer information;
. we could experience unauthorized access, computer viruses and other
disruptive problems, whether intentional or accidental;
. a third party could circumvent our security measures and
misappropriate proprietary information or interrupt operations; and
. credit card companies could restrict online credit card transactions.
The occurrence of any of these or similar events could damage our reputation
and expose us to litigation or liability. We may also 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.
Our international operations involve risks
We operate subsidiaries in England, France, Germany and Japan, and market
and sell products in several other countries. For the quarter ended March 31,
1999, approximately 24% of our revenues, excluding revenues derived from our
license agreement with Microsoft, were derived from international operations.
We are subject to the normal risks of doing business internationally, as well
as risks specific to Internet-based companies in foreign markets. These risks
include:
. delays in the development of the Internet as a broadcast, advertising
and commerce medium in international markets;
. difficulties in managing operations due to distance, language and
cultural differences, including issues associated with establishing
management systems infrastructures in individual markets;
. unexpected changes in regulatory requirements;
. export and import restrictions, including those restricting the use of
encryption technology;
. tariffs and trade barriers and limitations on fund transfers;
. difficulties in staffing and managing foreign operations;
. longer payment cycles and problems in collecting accounts receivable;
. potential adverse tax consequences;
28
. exchange rate fluctuations;
. increased risk of piracy and limits on our ability to enforce our
intellectual property rights; and
. other legal and political risks.
Any of these factors could harm our business. We do not currently hedge our
foreign currency exposures. See "--Liquidity and Capital Resources."
We may be unable to adequately protect our proprietary rights
Our inability to protect our proprietary rights, and the costs of doing so,
could harm our business. Our success and ability to compete partly depend on
the superiority, uniqueness or value of our technology, including both
internally developed technology and technology licensed from third parties. To
protect our proprietary rights, we rely on a combination of patent, trademark,
copyright and trade secret laws, confidentiality agreements with our employees
and third parties, and protective contractual provisions. Despite our efforts
to protect our proprietary rights, unauthorized parties may copy or infringe
aspects of our technology, products, services or trademarks, or obtain and use
information we regard as proprietary. In addition, others may independently
develop technologies that are similar or superior to ours, which could reduce
the value of our intellectual property.
Companies in the computer industry have frequently resorted to litigation
regarding intellectual property rights. We may have to litigate to enforce our
intellectual property rights, to protect our trade secrets or to determine the
validity and scope of other parties' proprietary rights. From time to time, we
have received, and may receive in the future, notice of claims of infringement
of other parties' proprietary rights. For instance, in August 1998, Venson M.
Shaw and Steven M. Shaw filed a lawsuit against us and co-defendant
Broadcast.com in the United States District Court for the Northern District of
Texas--Dallas Division. The plaintiffs allege that we, individually and in
combination with Broadcast.com, infringe on a certain patent by making, using,
selling and/or offering to sell software products and services directed to
media delivery systems for the Internet and corporate intranets. The
plaintiffs seek to enjoin us from the alleged infringing activity and to
recover damages in an amount no less than a reasonable royalty. We believe the
allegations are without merit and intend to vigorously defend ourselves
against the claim. However, litigation is inherently uncertain, and we may be
unable to successfully defend ourselves against this claim.
Similar claims may involve our internally developed technology or technology
and enhancements that we license from third parties. Claims of this nature
could require us to spend significant amounts of time and money to defend
ourselves against them. If any of these claims were to prevail, we could be
forced to pay damages, comply with injunctions, or halt distribution of our
products while we re-engineer them or seek licenses to necessary technology,
which might not be available on reasonable terms. We could also be subject to
claims for indemnification resulting from infringement claims made against our
customers and strategic partners, which could increase our defense costs and
potential damages. Any of these events could harm our business.
We are subject to risks associated with governmental regulation and legal
uncertainties
We are not currently subject to direct regulation by any governmental agency
other than laws and regulations generally applicable to businesses, although
certain U.S. export controls and import controls of other countries, including
controls on the use of encryption technologies, may apply to our products. Few
existing laws or regulations specifically apply to the Internet. However, it
is likely that a number of laws and regulations may be adopted in the United
States and other countries with respect to the Internet. These laws may relate
to areas such as content issues (such as obscenity, indecency and defamation),
copyright and other intellectual property rights, encryption, use of key
escrow data,
29
caching of content by server products, electronic authentication or "digital
signatures," personal privacy, advertising, taxation, electronic commerce
liability, e-mail, network and information security and the convergence of
traditional communication services with Internet communications, including the
future availability of broadband transmission capability. Other countries and
political organizations are likely to impose or favor more and different
regulation than that which has been proposed in the United States, thus
furthering the complexity of regulation. The adoption of such laws or
regulations, and uncertainties associated with their validity and enforcement,
may affect the available distribution channels for and costs associated with
our products and services, and may affect the growth of the Internet. Such
laws or regulations may therefore harm our business.
We do not know for certain how existing laws governing issues such as
property ownership, copyright and other intellectual property issues,
taxation, illegal or obscene content, retransmission of media and personal
privacy and data protection apply to the Internet. The vast majority of such
laws were adopted before the advent of the Internet and related technologies
and do not address the unique issues associated with the Internet and related
technologies. Most of the laws that relate to the Internet have not yet been
interpreted. Changes to or the interpretation of these laws could:
. limit the growth of the Internet;
. create uncertainty in the marketplace that could reduce demand for our
products and services;
. increase our cost of doing business;
. expose us to significant liabilities associated with content available
on our websites or distributed or accessed through our products or
services; or
. lead to increased product development costs, or otherwise harm our
business.
On October 28, 1998, the Digital Millennium Copyright Act (DMCA) was
enacted. The DMCA includes statutory licenses for the performance of sound
recordings and for the making of recordings to facilitate transmissions. Under
these statutory licenses, we and our broadcast customers will be required to
pay licensing fees for sound recordings we deliver in original and archived
programming and through retransmissions of radio broadcasts. The DMCA does not
specify the rate and terms of the licenses, which will be determined either
through voluntary inter-industry negotiations or arbitration. Depending on the
rates and terms adopted for the statutory licenses, the DMCA could harm our
business.
The Child Online Protection Act and the Child Online Privacy Protection Act
(COPA) were enacted in October 1998. The COPA impose civil and criminal
penalties on persons distributing material harmful to minors (e.g., obscene
material) over the Internet to persons under the age of 17, or collecting
personal information from children under the age of 13. We do not currently
distribute the types of materials that we believe the COPA would deem illegal,
and do not knowingly collect and disclose personal information from such
minors. The manner in which the COPA may be interpreted and enforced cannot be
fully determined, and future legislation similar to the COPA could subject us
to potential liability, which in turn could harm our business. Such laws could
also damage the growth of the Internet generally and decrease the demand for
our products and services.
Provisions of our charter documents, shareholder rights plan and Washington
law could discourage our acquisition by a third party
Our articles of incorporation provide for a strategic transaction committee
of the board of directors currently comprised of Messrs. Glaser, Breyer and
Kapor. Without the prior approval of this committee, and subject to certain
limited exceptions, the board of directors does not have the authority to:
. adopt a plan of merger;
30
. authorize the sale, lease, exchange or mortgage of:
(A) assets representing more than 50% of the book value of our assets
prior to the transaction; or
(B) any other asset or assets on which our long-term business strategy
is substantially dependent;
. authorize our voluntary dissolution; or
. take any action that has the effect of any of the above.
We also entered into an agreement providing Mr. Glaser with a direct
contractual right to require us to abide by and perform all terms of the
articles with respect to the strategic transactions committee. This agreement
also provides that so long as Mr. Glaser owns a specified number of shares, we
will use our best efforts to cause him to be nominated to, elected to, and not
removed from the board of directors. In addition, the articles provide that
Mr. Glaser will serve, or will appoint another officer of RealNetworks to
serve, as our policy ombudsman, with the exclusive authority to adopt or
change our editorial policies as reflected on our websites or in other
communications or media in which we have a significant editorial or media
voice. The provisions with respect to the authority of the Strategic
Transactions Committee and the policy ombudsman may be amended only with the
approval of 90% of the shares entitled to vote on an amendment to the
articles.
We have adopted a shareholder rights plan that provides that shares of our
common stock have associated preferred stock purchase rights. These rights
become exercisable and detachable from the associated common stock only
following the acquisition by a person or a group of 15% or more of our
outstanding common stock or 10 days following the announcement of a tender or
exchange offer for 15% or more of our outstanding common stock. The rights
entitle our shareholders, other than the person or entity who has acquired or
made an exchange or tender offer for 15% or more of our outstanding common
stock, to acquire additional shares of our capital stock at a price equal to
one-half of the market price at the time of the event and, in certain
circumstances, would allow our shareholders to acquire capital stock in the
entity that has acquired or made an exchange or tender offer for 15% or more
of our outstanding common stock at a similar discount. The exercise of these
rights would make the acquisition of RealNetworks by a third party more
expensive to that party and has the effect of discouraging third parties from
acquiring our company without the approval of our board of directors, which
has the power to redeem these rights and prevent their exercise.
Washington law imposes restrictions on some transactions between a
corporation and certain significant shareholders. Chapter 23B.19 of the
Washington Business Corporation Act prohibits a "target corporation," with
some exceptions, from engaging in certain significant business transactions
with an "acquiring person," which is defined as a person or group of persons
that beneficially owns 10% or more of the voting securities of the target
corporation, for a period of five years after such acquisition, unless the
transaction or acquisition of shares is approved by a majority of the members
of the target corporation's board of directors prior to the acquisition. Such
prohibited transactions include, among other things:
. a merger or consolidation with, disposition of assets to, or issuance
or redemption of stock to or from the acquiring person;
. termination of 5% or more of the employees of the target corporation
as a result of the acquiring person's acquisition of 10% or more of
the shares; or
. allowing the acquiring person to receive any disproportionate benefit
as a shareholder.
After the five-year period, a "significant business transaction" may occur,
as long as it complies with certain "fair price" provisions of the statute. A
corporation may not opt out of this statute. This provision may have the
effect of delaying, deterring or preventing a change in control of
RealNetworks.
31
The foregoing provisions of our charter documents, shareholder rights plan
and Washington law, as well as those relating to a classified board of
directors and the availability of "blank check" preferred stock, could have
the effect of making it more difficult or more expensive for a third party to
acquire, or of discouraging a third party from attempting to acquire, control
of us. These provisions may therefore have the effect of limiting the price
that investors might be willing to pay in the future for our common stock.
Our stock price has been and may continue to be volatile
The trading price of our common stock has been and is likely to continue to
be highly volatile. For example, during the 52-week period ended May 14, 1999,
the price of our common stock ranged from $7.625 to $131.875 per share. Our
stock price could be subject to wide fluctuations in response to factors such
as:
. actual or anticipated variations in quarterly operating results;
. announcements of technological innovations, new products or services
by us or our competitors;
. changes in financial estimates or recommendations by securities
analysts;
. the addition or loss of strategic relationships;
. conditions or trends in the Internet, media streaming, media delivery
and online commerce markets;
. changes in the market valuations of other Internet, online service or
software companies;
. announcements by us or our competitors of significant acquisitions,
strategic partnerships, joint ventures or capital commitments;
. additions or departures of key personnel;
. sales of our common stock; and
. general market conditions.
In addition, the stock market in general, and the Nasdaq National Market and
the market for Internet and technology companies in particular, have
experienced extreme price and volume fluctuations that have often been
unrelated or disproportionate to the operating performance of these companies.
These broad market and industry factors may reduce our stock price, regardless
of our operating performance. The trading prices of the stocks of many
technology companies are at or near historical highs and reflect price-
earnings ratios substantially above historical levels. These trading prices
and price-earnings ratios may not be sustained.
We may be subject to assessment of sales and other taxes for the sale of our
products, license of technology or provision of services
We may have to pay past sales or other taxes that we have not collected from
our customers. We do not currently collect sales or other taxes on the sale of
our products, license of technology or provision of services in states and
countries other than those in which we have offices or employees. In October
1998, the Internet Tax Freedom Act (ITFA) was signed into law. Among other
things, the ITFA imposes a three-year moratorium on discriminatory taxes on
electronic commerce. Nonetheless, foreign countries or, following the
moratorium, one or more states, may seek to impose sales or other tax
obligations on companies that engage in such activities within their
jurisdictions. Our business would be harmed if one or more states or any
foreign country were able to require us to collect sales
32
or other taxes from current or past sales of products, licenses of technology
or provision of services, particularly because we would be unable to go back
to customers to collect sales taxes for past sales and may have to pay such
taxes out of our own funds.
We intend to donate a portion of net income to charity
If we achieve and sustain profitability, we intend to donate approximately
5% of our annual net income to charitable organizations. This will reduce our
net income.
Item 3. Quantitative and Qualitative Disclosures about Market Risk
Information relating to quantitative and qualitative disclosure about market
risk is set forth under the caption "Liquidity and Capital Resources" in Part
I, Item 2, Management's Discussion and Analysis of Financial Condition and
Results of Operations.
33
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
In August 1998, Venson M. Shaw and Steven M. Shaw filed a lawsuit against us
and co-defendant Broadcast.com in the United States District Court for the
Northern District of Texas--Dallas Division. The plaintiffs allege that we,
individually and in combination with Broadcast.com, infringe on a certain
patent by making, using, selling and/or offering to sell software products and
services directed to media delivery systems for the Internet and corporate
intranets. The plaintiffs seek to enjoin us from our alleged infringing
activity and to recover damages in an amount no less than a reasonable
royalty. Although we can give no assurance as to the outcome of this lawsuit,
we believe that the allegations in this action are without merit, and intend
to vigorously defend ourselves against these claims. We may be required to
indemnify Broadcast.com under the terms of our license agreement with it. The
plaintiffs filed a similar claim based on the same patent and seeking similar
remedies as a separate lawsuit against Microsoft and Broadcast.com in the same
court. The court has consolidated the lawsuit against Microsoft and
Broadcast.com with the lawsuit against RealNetworks and Broadcast.com.
On July 29, 1998, Left Bank Management, Inc. filed a lawsuit against us in
the U.S. District Court for the Western District of Washington. The plaintiff
alleges that we entered into an oral agreement with it in 1995 pursuant to
which the plaintiff claims it is entitled to 30% of our revenues from the use
of RealAudio technology to promote, sample or sell music. The plaintiff claims
breach of contract, unjust enrichment, promissory estoppel and breach of
implied-in-fact contract. We have denied each of the plaintiff's claims. In
response to our motion to dismiss, the plaintiff withdrew its claim for breach
of fiduciary duty. Although no assurance can be given as to the outcome of
this lawsuit, we believe the allegations in this action are without merit, and
we intend to vigorously defend ourselves against these claims.
From time to time we are, and expect to continue to be, subject to legal
proceedings and claims in the ordinary course of our business, including
contract-related claims and claims of alleged infringement of third-party
patents, trademarks and other intellectual property rights. These claims, even
if not meritorious, could force us to spend significant financial and
managerial resources. We currently are not aware of any legal proceedings or
claims that we believe will have, individually or taken together, a material
adverse effect on our business, prospects, financial condition and operating
results.
Item 2. Changes in Securities and Use of Proceeds
(d) Use of Proceeds
RealNetworks' 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. RealNetworks has used all of the
net offering proceeds for the purchase of temporary investments consisting of
cash, cash equivalents and short-term investments. RealNetworks 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
RealNetworks or their associates, persons owning 10% or more of any class of
RealNetworks' securities, or affiliates of RealNetworks.
34
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits required by Item 601 of Regulation S-K:
2.1 Agreement and Plan of Merger dated as of April 12, 1999 among
RealNetworks, Inc., XTC Acquisition Corp., Xing Technology
Corporation, Hassan Miah and Dean Kaplan
10.1 RealNetworks, Inc. Amended and Restated 1996 Stock Option Plan
10.2 First Lease Amendment dated November 13, 1998 between 2601 Elliott
LLC and RealNetworks, Inc.
27.1 Restated Financial Data Schedule which is submitted electronically
to the Securities and Exchange Commission for information purposes
only and is not filed
27.2 Financial Data Schedule which is submitted electronically to the
Securities and Exchange Commission for information purposes only
and is not filed
(b) Reports on Form 8-K:
None
35
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 May 14, 1999.
RealNetworks, Inc.
/s/ Paul Bialek
By___________________________________
Paul Bialek
Senior Vice President, Finance and
Operations and Chief Financial
Officer
36
INDEX TO EXHIBITS
Exhibit
Number Description
------- ----------------------------------------------------------------------
2.1 Agreement and Plan of Merger dated as of April 12, 1999 among
RealNetworks, Inc., XTC Acquisition Corp., Xing Technology
Corporation, Hassan Miah and Dean Kaplan
10.1 RealNetworks, Inc. Amended and Restated 1996 Stock Option Plan
10.2 First Lease Amendment dated November 13, 1998 between 2601 Elliott LLC
and RealNetworks, Inc.
27.1 Restated Financial Data Schedule which is submitted electronically to
the Securities and Exchange Commission for information purposes only
and is not filed
27.2 Financial Data Schedule which is submitted electronically to the
Securities and Exchange Commission for information purposes only and
is not filed