

Note 5	Acquisitions

Napster

On January 18, 2019, RealNetworks acquired an additional 42% interest in Rhapsody International, Inc. (doing business as Napster) bringing our aggregate ownership to 84% of Napster's outstanding equity, thus giving RealNetworks a majority voting interest. Napster's music streaming service provides users with broad access to digital music, offering on-demand streaming and conditional downloads through unlimited access to a catalog of millions of music tracks. Napster offers music services worldwide and generates revenue primarily through subscriptions to its music services either directly to consumers or through distribution partners.

Initially formed in 2007 and branded then as Rhapsody, Napster began as a joint venture between RealNetworks and MTV Networks, a division of Viacom International, Inc. Prior to the acquisition of the additional 42% interest in Napster, we accounted for our investment using the equity method of accounting.

Following the January 2019 acquisition, RealNetworks has the right to nominate directors constituting a majority of the Napster board of directors, however, Napster will continue to operate as an independent business with its own board of directors, strategy and leadership team. We are consolidating Napster's financial results into our financial statements for fiscal periods following the closing of the acquisition, and Napster is reported as a separate segment in RealNetworks' consolidated financial statements. Napster, however, remains a distinct legal entity and RealNetworks assumes no ownership or control over the assets or liabilities of Napster.

We have preliminarily recorded 100% of the estimated fair value of the assets acquired and liabilities assumed as of January 18, 2019 based on the results of an independent valuation. The 16% of Napster that we do not own is accounted for as a noncontrolling interest in our consolidated financial statements, and as part of this consolidation, the carrying value of our previous 42% equity method investment was remeasured to fair value on the acquisition date. The remeasurement to fair value of the historical 42% ownership interest resulted in the recognition of a $2.7 million gain in the first quarter of 2019, which is a component of the overall gain recognized as a part of this transaction. Our consolidated balance sheet reflects Napster's working capital deficit, which results in a consolidated working capital deficit. RealNetworks does not have any contractual or implied obligation to provide funding or other financial support to Napster, or to guarantee or provide other such support related to Napster's third party borrowing or Napster's other obligations on our consolidated balance sheet, except as discussed in Note 15 Commitments and Contingencies.

The terms of the transaction included initial cash consideration of $1.0 million and additional contingent consideration. Initial cash consideration of $0.2 million was paid at closing and the remainder of the initial cash consideration is included in accrued royalties, fulfillment and other current liabilities and will be paid when due with existing cash balances. With regards to contingent consideration, over the five years following the acquisition, RealNetworks will pay the lesser of the following:

(a) an additional $14.0 million to seller, or

(b) if RealNetworks sells the interest to a third party for less than $15.0 million, the actual amount received by RealNetworks, minus the $1.0 million initial payment.

In the event that RealNetworks sells such equity interest for consideration in excess of $15.0 million, RealNetworks will pay seller additional consideration, dependent on the sale price, which shall in no event exceed an additional $25.0 million. In order for seller to receive the full $40.0 million, the proceeds from the sale of Napster received by RealNetworks for the 42% equity interest acquired would have to exceed $60.0 million. These contingent consideration amounts were part of the total consideration at estimated fair value, as described in more detail below.

The following table summarizes the preliminary allocation of the total consideration to the estimated fair values of the assets acquired and liabilities assumed as of January 18, 2019 (in thousands):



Consideration, at estimated fair value:
Cash	$	1,000
Contingent consideration	11,600
RealNetworks' preexisting 42% equity interest in Napster	2,700
Effective settlement of Napster debt and warrants, held by RealNetworks	6,408
Total consideration	$	21,708

Assets acquired and liabilities assumed, at estimated fair value:
Cash and cash equivalents	$	10,138
Accounts receivable	20,838
Prepaid expenses and other current assets	12,879
Restricted cash	2,322
Equipment, software and leasehold improvements	474
Operating lease assets	2,314
Other long-term assets	77
Deferred tax assets, net	5,942
Intangible assets	23,700
Goodwill	48,474
Total assets acquired	127,158

Accounts payable	937
Accrued royalties and fulfillment	71,980
Accrued and other current liabilities	7,475
Deferred revenue, current portion	3,600
Notes payable	12,115
Deferred tax liabilities, net	6,061
Long-term lease liabilities	1,197
Other long-term liabilities	1,515
Total liabilities assumed	104,880
Total net assets acquired	22,278
Noncontrolling interests	570
Net assets acquired	$	21,708

Under the acquisition method of accounting, the purchase price is allocated to the assets acquired and the liabilities assumed based on their estimated fair values. Due to the complexity and limited time since closing the transaction, the purchase price allocation is subject to change, which may result from additional information becoming available and additional analyses being performed on these acquired assets and assumed liabilities. Such changes could impact estimated fair values of intangible assets, accrued royalties and fulfillment, deferred revenue, and assets and liabilities assumed, as well as the contingent consideration, noncontrolling interests, and gain recognized from consolidation. Purchase price allocation adjustments may be recorded during the measurement period (a period not to exceed 12 months from the acquisition date). The final purchase price allocation could result in material differences, which could have a material impact on our financial statements.

Acquired intangible assets have a total weighted average useful life of approximately 8 years, are being amortized using the straight line method, and are comprised of the following (in thousands):



Intangible category	Estimated fair value		Method used to calculate fair value	Estimated remaining useful life
Trade name and trademarks	$	6,800	Relief-from-royalty	15 years
Developed technology	5,900		Excess earnings	4 years
Customer relationships	5,900		Cost-to-replace	3 years
Partner relationships	5,100		Distributor method	8 years
Total	$	23,700

The estimated fair value amounts for each of these intangibles were determined using a fair value measurement categorized within Level 3 of the fair value hierarchy.

The fair value of the trade name and trademarks intangible asset was estimated using the income approach, utilizing the relief from royalty method, which values the assets by estimating the savings achieved by ownership of trade name and trademarks when compared with the cost of licensing them from an independent owner.

The fair value of developed technology was estimated using the income approach, utilizing the excess earnings method. Under this method, cash flows attributable to the asset are estimated by deducting economic costs, including operating expenses and contributory asset charges, from revenue expected to be generated by the asset.

The fair value of customer relationships was estimated using a cost-to-replace approach, whereby the number of subscribers and the cost to acquire subscribers are key estimates utilized in the valuation.

The fair value of partner relationships was estimated using the income approach, which uses market-based distributor data to value underlying distributor relationships. Revenue, earnings, and cash flow estimates associated with these underlying distributor relationships are key estimates in determining the fair value of the partner relationships intangibles.

The fair value of deferred revenue was estimated using the income approach, utilizing a cost to fulfill analysis by estimating the direct and indirect costs related to supporting remaining obligations plus an assumed operating margin.

The fair value of our preexisting 42% equity method investment has been remeasured to an estimated fair value of $2.7 million, which resulted in a pretax gain of $2.7 million, as our existing carrying value was zero. This gain, as well as the settlement of preexisting relationships and other purchase accounting adjustments discussed below, comprise the total gain of $12.3 million recognized in Other income (expenses) in the Consolidated statement of operations for the first quarter of 2019.

The fair value of our preexisting equity method investment was calculated using an average of the income and market approach to arrive at estimated total enterprise value. The income approach fair value measurement was based on significant inputs that are not observable in the market and thus represents a fair value measurement categorized within Level 3 of the fair value hierarchy. Key assumptions used in estimating future cash flows included projected revenue growth and operating expenses, as well as the selection of an appropriate discount rate. Estimates of revenue growth and operating expenses were based on internal projections and considered the historical performance of Napster's business. The discount rate applied was based on Napster's weighted-average cost of capital and included a small-company risk premium. The market approach fair value measurement was based on a market comparable methodology. We used a group of comparable companies and selected an appropriate EBITDA and revenue multiple to apply to Napster's trailing twelve months and projected 2019, 2020 and 2021 EBITDA (weighted 90%) and revenues (weighted 10%). Assumptions in both the income and market approaches are significant to the overall valuation of Napster and changes to these assumptions could materially impact the preliminary fair values of assets acquired and liabilities assumed, noncontrolling interests, total consideration, and gain on consolidation.

The fair value of the contingent consideration was estimated using multiple scenarios for each tranche of contingent consideration and then probability weighting each scenario and discounting them to estimated fair value of $11.6 million. This fair value calculation is directly impacted by the estimated total enterprise value described above. After the completion of the measurement period or in conjunction with changes in fair value unrelated to our preliminary estimate of fair value, the contingent consideration will be adjusted quarterly to fair value through earnings. Of the total amount of $11.6 million, we accrued $2.6 million and $9.0 million in Accrued royalties, fulfillment and other current liabilities, and Other long-term liabilities, respectively, as of March 31, 2019. See Note 6 Fair Value Measurements for details on the adjustment to this liability for the second quarter of 2019.

The effective settlement of Napster's debt and warrants totaling $6.4 million represents the estimated fair value of debt and warrants held between RealNetworks and Napster as of the acquisition date. The estimated fair value is derived from the estimated total enterprise value described above. The resulting net gain of $5.5 million is included in Other income (expenses) in the Consolidated statement of operations.

As discussed in Note 15 Commitments and Contingencies, the preexisting $2.8 million guarantee related to Napster's outstanding indebtedness on their revolving credit facility was eliminated upon the consolidation of Napster. This resulted in RealNetworks recording a gain of $2.8 million, which is included in Other income (expenses) in the Consolidated statement of operations.

Prior to our acquisition of Napster, we accounted for our investment under the equity method of accounting and recorded Napster 's foreign currency translation adjustments in our equity. As part of the acquisition method of accounting, we released these amounts and recorded a gain of $1.3 million, which is included in Other income (expenses) in the Consolidated statement of operations.

We recorded the fair value of noncontrolling interests on the acquisition date, estimated at $0.6 million, using the estimated total enterprise value described above.

We also recorded goodwill of $48.5 million, representing the intangible assets that do not qualify for separate recognition for accounting purposes, including the expected growth in Napster's business to business model and the assembled workforce. The goodwill is reported in our Napster segment and is not deductible for income tax purposes. As discussed above, during the measurement period, purchase price allocation adjustments or changes in assumptions used in determining the total estimated enterprise value of Napster could materially impact goodwill recognized. Moreover, future performance of the Napster business will factor into our goodwill impairment analysis.

We began consolidating Napster's results of operations and cash flows into our consolidated financial statements after January 18, 2019. For the quarter ended June 30, 2019, Napster's revenue and net loss including noncontrolling interests in our consolidated statements of operations was $28.6 million and $1.5 million, respectively. For the six months ended June 30, 2019, Napster's revenue and net loss including noncontrolling interests in our consolidated statements of operations was $52.9 million and $3.3 million, respectively.

The following table provides the supplemental pro forma revenue and net results of the combined entity had the acquisition date of Napster been the first day of our first quarter of 2018 rather than during our first quarter of 2019 (in thousands):



	Quarter Ended - Pro Forma (Unaudited) June 30,						Six Months Ended - Pro Forma (Unaudited) June 30,
	2019			2018			2019			2018
Net revenue	$	44,355		$	52,296		$	90,193		$	112,145
Net income (loss) attributable to RealNetworks ⁽¹⁾	(8,455		)	(4,694		)	(17,973		)	2,295

⁽¹⁾The pro forma net earnings attributable to RealNetworks for the quarter ended June 30, 2018 include $0.4 million of transaction costs, and for the six months ended June 30, 2018, pro forma net earnings attributable to RealNetworks include the acquisition related gain of $12.3 million and $1.2 million of transaction costs. The amounts in the supplemental pro forma earnings for the periods presented above fully eliminate intercompany transactions and conform Napster's accounting policies to RealNetworks'. These pro forma results also reflect amortization of acquisition-related intangibles and fair value adjustments to deferred revenue and contingent consideration.

The unaudited pro forma amounts are based upon the historical financial statements of RealNetworks and Napster and were prepared using the acquisition method of accounting and are not necessarily indicative of results for any current or future period. The purchase price allocation is preliminary and is subject to change prior to finalization. The final purchase price allocation could result in material differences, which could have a material impact on the accompanying pro forma amounts.

For the quarter and six months ended June 30, 2019, we incurred approximately $0.4 million and $1.2 million, respectively, in acquisition-related costs, including regulatory, legal, and other advisory fees, which we have recorded within general and administrative expenses.

Games

As described in more detail in our 2018 10-K, in order to acquire a full workforce, we purchased 100% of the shares of a small, privately-held Netherlands-based game development studio for net cash consideration of $4.2 million in April 2018.