10-K/A 1 form10-k_a.txt UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 AMENDMENT NO. 3 FORM 10-K/A [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (D) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 2000 or [_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES AND EXCHANGE ACT OF 1934 For the transition period from __________ to __________ Commission File Number 0-24363 INTERPLAY ENTERTAINMENT CORP. (Exact name of the registrant as specified in its charter) DELAWARE 33-0102707 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 16815 VON KARMAN AVENUE, IRVINE, CALIFORNIA 92606 (Address of principal executive offices) (949) 553-6655 (Registrant's telephone number, including area code) Securities registered pursuant of Section 12 (b) of the Act: None Securities registered pursuant of Section 12 (g) of the Act: COMMON STOCK, $0.001 PAR VALUE 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[_] Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [X] As of November 26, 2001, 44,985,708 shares of Common Stock of the Registrant were issued and outstanding and the aggregate market value of voting common stock held by non-affiliates was $15,593,907. DOCUMENTS INCORPORATED BY REFERENCE None. AMENDMENT NO. 3 TO THE ANNUAL REPORT ON FORM 10-K FILED BY INTERPLAY ENTERTAINMENT CORP. ON APRIL 17, 2001, AS AMENDED ON APRIL 30, 2001 AND ON AUGUST 31, 2001. The following Items amend the Annual Report on Form 10-K filed by Interplay Entertainment Corp. (the "Company") on April 17, 2001, as amended by Form 10-K/A on April 30, 2001 and August 31, 2001 (the "Form 10-K"), as permitted by rules and regulations promulgated by the Securities Exchange Commission. That Form 10-K is hereby amended and restated to insert those Items as set forth herein. All capitalized terms used herein but not defined shall have the meanings ascribed to them in the Form 10-K. ITEM 6. SELECTED FINANCIAL DATA The selected consolidated statements of operations data for the years ended December 31, 2000, 1999 and 1998 and the selected consolidated balance sheets data as of December 31, 2000 and 1999 are derived from the Company's audited consolidated financial statements included elsewhere in this Form 10-K. The selected consolidated statements of operations data for the eight months ended December 31, 1997 and for the years ended April 30, 1997 and 1996, and the selected consolidated balance sheets data as of December 31, 1998, 1997, April 30, 1997 and 1996 are derived from the Company's audited consolidated financial statements not included in this Form 10-K. The Company's historical results are not necessarily indicative of the results that may be achieved for any other period. The following data should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the Consolidated Financial Statements included elsewhere in this Form 10-K. Page 2
EIGHT MONTHS ENDED YEARS ENDED DECEMBER 31, DECEMBER 31, YEARS ENDED APRIL 30, ----------------------------------- ------------- --------------------- 2000 1999 1998 1997 1997 1996 --------- --------- --------- ------------- --------- --------- (Dollars in thousands, except per share amounts) STATEMENTS OF OPERATIONS DATA(1): Net revenues $ 104,582 $101,930 $ 126,862 $ 85,961 $ 83,262 $ 96,952 Cost of goods sold 54,061 61,103 71,928 44,864 62,480 49,939 ---------- --------- ---------- --------- --------- --------- Gross profit 50,521 40,827 54,934 41,097 20,782 47,013 Operating expenses: Marketing and sales 26,482 32,432 39,471 20,603 24,627 23,285 General and administrative 10,249 18,155 12,841 8,989 9,408 9,025 Product development 22,176 20,629 24,472 14,291 21,431 15,120 Other - 2,415 - - - - ---------- --------- ---------- --------- --------- --------- Total operating expenses 58,907 73,631 76,784 43,883 55,466 47,430 ---------- --------- ---------- --------- --------- --------- Operating loss (8,386) (32,804) (21,850) (2,786) (34,684) (417) Other expense (3,689) (3,471) (4,933) (2,273) (1,600) (807) ---------- --------- ---------- --------- --------- --------- Loss before income taxes (12,075) (36,275) (26,783) (5,059) (36,284) (1,224) Provision (benefit) for income taxes - 5,410 1,437 - (9,065) (480) ---------- --------- ---------- --------- --------- --------- Net loss $ (12,075) $(41,685) $ (28,220) $ (5,059) $(27,219) $ (744) ========== ========= ========== ========= ========= ========= Cumulative dividend on participating preferred stock $ 870 $ - $ - $ - $ - $ - Accretion of warrant 532 - - - - - ---------- --------- ---------- --------- --------- --------- Net loss available to common stockholders $ (13,477) $ (41,685) $ (28,220) $ (5,059) $ (27,219) $ (744) ========== ========= ========== ========= ========= ========= Net loss per share (2): Basic $ (0.45) $ (1.86) $ (1.91) $ (0.45) $ (2.46) $ (0.07) Diluted $ (0.45) $ (1.86) $ (1.91) $ (0.45) $ (2.46) $ (0.07) ========== ========= ========== ========= ========= ========= SELECTED OPERATING DATA: Net revenues by geographic region: North America $ 56,454 $ 49,443 $ 73,865 $ 51,833 $ 38,606 $ 54,702 International 35,077 30,310 35,793 24,642 32,006 24,579 OEM, royalty and licensing 13,051 22,177 17,204 9,486 12,650 17,671 Net revenues by platform: Personal computer $ 76,886 $ 65,397 $ 67,406 $ 42,520 $ 45,192 $ 60,254 Video game console 14,645 14,356 42,252 33,955 25,420 19,027 OEM, royalty and licensing 13,051 22,177 17,204 9,486 12,650 17,671 DECEMBER 31, APRIL 30, --------------------------------------------------- ---------------------- 2000 1999 1998 1997 1997 1996 --------- --------- --------- ------------- --------- --------- Balance Sheets Data: (Dollars in thousands) Working capital $ 123 $ (7,622) $ (3,135) $ 13,616 $ 7,890 $ 18,485 Total assets 59,081 56,936 74,944 77,821 69,005 68,511 Total debt 25,433 19,630 24,651 38,154 14,970 108 Stockholders' equity (deficit) 6,398 (2,071) 4,193 (1,267) 3,401 30,195 (1) Effective May 1, 1997, the Company changed its year end from April 30 to December 31. (2) See Note 9 of Notes to Consolidated Financial Statements for an explanation of the number of shares used in computing net income (loss) per share.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS You should read the following discussion and analysis in conjunction with the Consolidated Financial Statements and notes thereto and other information included or incorporated by reference herein. GENERAL We derive net revenues primarily from direct sales of interactive entertainment software for PCs and video game consoles to retailers and mass merchants, from indirect sales to software distributors in North America and internationally, and from direct sales to end-users through our catalogs and the Internet. We also derive royalty-based revenues from licensing arrangements, from the sale of products by third party distributors in North America and international markets, and from OEM bundling transactions. Page 3 We record revenues when we deliver products to customers in accordance with Statement of Position ("SOP") 97-2, "Software Revenue Recognition." For those agreements that provide the customers the right to create and sell multiple copies of a product in exchange for guaranteed amounts, we recognize revenue at the delivery of the product master or the first copy. We recognize per copy royalties on sales that exceed the guarantee as copies are duplicated. We generally are not contractually obligated to accept returns, except for defective, shelf-worn and damaged products. However, on a case-by-case negotiated basis, we permit customers to return or exchange product and may provide price concessions to our retail distribution customers on unsold or slow moving products. In accordance with Statement of Financial Accounting Standards ("SFAS") No. 48, "Revenue Recognition when Right of Return Exists," we record revenue net of a provision for estimated returns, exchanges, markdowns, price concessions, and warranty costs. We record such reserves based upon management's evaluation of historical experience, current industry trends and estimated costs. The amount of reserves ultimately required could differ materially in the near term from the amounts provided in the accompanying consolidated financial statements. We provide customer support only via telephone and the Internet. Customer support costs are not material and we charge such costs to expenses as we incur them. In order to expand our distribution channels and engage in software development in overseas markets, in 1995 we established operations in the United Kingdom and in 1997, we initiated a licensing strategy in Japan. In February 1999, we undertook a restructuring of our operations in the United Kingdom that included our investment in VIE Acquisition Group LLC, or VIE. In connection with our investment in VIE, we entered into an exclusive distribution agreement with Virgin Entertainment Interactive Limited, or Virgin, an entity controlled by VIE, and integrated our distribution operations with Virgin, which substantially reduced our sales and marketing personnel in Europe. As part of an April 2001 settlement between us and Virgin, VIE redeemed our LLC membership interest in VIE. Pursuant to such settlement, we agreed to assume responsibility for marketing functions in Europe. We also maintain European OEM and product development operations. International net revenues accounted for approximately 33.5% of our net revenues for the year ended December 31, 2000, 29.7% of our net revenues for the year ended December 31, 1999, and 28.2% of our net revenues for the year ended December 31, 1998. In January 1997, we formed a wholly-owned subsidiary, Interplay OEM, which had previously operated as a division of ours. Interplay OEM distributes our interactive entertainment software titles, as well as those of other software publishers, to computer and peripheral device manufacturers for use in bundling arrangements. During 2000, Interplay OEM expanded its bundling arrangements into the non-Information Technology marketplace and created a division named bundledirect.com, which transacts with value-added resellers and system builders. We also derive net revenues from the licensing of intellectual property and products to third parties for distribution in markets and through channels that are outside of our primary focus. OEM, royalty and licensing net revenues collectively accounted for net revenues of 12.5% for the year ended December 31, 2000, 21.8% for the year ended December 31, 1999, and 13.6% for the year ended December 31, 1998. OEM, royalty and licensing net revenues generally are incremental net revenues and do not have significant additional product development or sales and marketing costs, and accordingly do not have a significant impact on our operating losses. Cost of goods sold related to PC and video game console net revenues represents the manufacturing and related costs of interactive entertainment software products, including costs of media, manuals, duplication, packaging materials, assembly, freight and royalties paid to developers, licensors and hardware manufacturers. Cost of goods sold related to royalty-based net revenues primarily represents third party licensing fees and royalties paid by us. Typically, cost of goods sold as a percentage of net revenues for video game console products and affiliate label products are higher than cost of goods sold as a percentage of net revenues for PC based products due to the relatively higher manufacturing and royalty costs associated with video game console and affiliate label products. We also include in the cost of goods sold amortization of prepaid royalty and license fees we pay to third party software developers. We expense prepaid royalties over a period of six months commencing with the initial shipment of the title at a rate based upon the numbers of units shipped. We evaluate the likelihood of future realization of prepaid royalties quarterly, on a product-by-product basis, and charge the cost of goods sold for any amounts that we deem unlikely to realize through future product sales. For the year ended December 31, 2000, our net loss was $12.1 million. Our results from operations were adversely affected by several factors. The interactive entertainment software industry experienced lower prices for titles, especially with current generation video console platforms, such as Sony PlayStation and Nintendo N64. Sony introduced the PlayStation 2 in October 2000 but did not ship the number of units it originally forecasted. In addition, the sales of personal computers decreased for the year ended December 31, 2000 as compared to the same period in 1999. As a result of these factors, we experienced lower unit sales volume than we expected. We expect our unit sales volumes on next generation video console platforms to increase and our unit sales volume on personal Page 4 computer platforms to remain relatively constant in the 12 months ended December 31, 2001 as compared to the same period in 2000. Our operating results have fluctuated significantly in the past and likely will fluctuate significantly in the future, both on a quarterly and an annual basis. A number of factors may cause or contribute to such fluctuations, and many of such factors are beyond our control. We cannot assure you that we will be profitable in any particular period. It is likely that our operating results in one or more future periods will fail to meet or exceed the expectations of securities analysts or investors. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Factors Affecting Future Performance - Fluctuations in Operating Results; Uncertainty of Future Results; Seasonality." RESULTS OF OPERATIONS The following table sets forth consolidated statements of operations data and segment and platform data for the periods indicated expressed as a percentage of net revenues:
YEAR ENDED DECEMBER 31, ----------------------------------------- 2000 1999 1998 ----------- ----------- ----------- STATEMENTS OF OPERATIONS DATA: Net revenues 100.0 % 100.0 % 100.0 % Cost of goods sold 51.7 59.9 56.7 ----------- ----------- ----------- Gross margin 48.3 40.1 43.3 Operating expenses: Marketing and sales 25.3 31.8 31.1 General and administrative 9.8 17.8 10.1 Product development 21.2 20.2 19.3 Other - 2.4 - ----------- ----------- ----------- Total operating expenses 56.3 72.2 60.5 ----------- ----------- ----------- Operating loss (8.0) (32.1) (17.2) Other expense (3.5) (3.4) (3.9) ----------- ----------- ----------- Loss before income taxes (11.5) (35.5) (21.1) Provision for income taxes - 5.3 1.1 ----------- ----------- ----------- Net loss (11.5)% (40.8)% (22.2)% =========== =========== =========== SELECTED OPERATING DATA: Net revenues by segment: North America 54.0 % 48.5 % 58.2 % International 33.5 29.7 28.2 OEM, royalty and licensing 12.5 21.8 13.6 ----------- ----------- ----------- 100.0 % 100.0 % 100.0 % =========== =========== =========== Net revenues by platform: Personal computer 73.5 % 64.1 % 53.1 % Video game console 14.0 14.1 33.3 OEM, royalty and licensing 12.5 21.8 13.6 ----------- ----------- ----------- 100.0 % 100.0 % 100.0 % =========== =========== ===========
YEAR ENDED DECEMBER 31, 2000 COMPARED TO THE YEAR ENDED DECEMBER 31, 1999 NORTH AMERICAN, INTERNATIONAL AND OEM, ROYALTY AND LICENSING NET REVENUES Overall net revenues for the year ended December 31, 2000 increased 3 percent compared to the same period in 1999. This increase resulted from a 14 percent increase in North American net revenues and a 16 percent increase in International net revenues, offset by a 41 percent decrease in OEM, royalties and licensing, as described below. The increase in North American and International net revenues for the year ended December 31, 2000 was mainly because the titles released this year generated $5.7 million more sales volume and because of a decrease by $6.1 million in product returns and price concessions compared to 1999. Our efforts to focus on product planning and release fewer, but higher quality titles resulted in five fewer title releases across multiple platforms this year as Page 5 compared to last year. We expect that North American and International publishing net revenues in 2001 will increase compared to 2000. The decrease in OEM, royalty and licensing net revenues in the year ended December 31, 2000 compared to the same period in 1999 was due to decreased net revenues in the OEM business and in licensing transactions. The $5.1 million decrease in the OEM business was primarily due to a decrease in the volume of transactions which relates to the general market decrease in personal computer sales, and the decrease in licensing transactions is primarily due to the recognition of $2.3 million of deferred revenue for the shipment of a major title to a customer in 1999 without a comparable transaction in 2000. We expect that OEM, royalty and licensing net revenues in 2001 will increase compared to 2000. PLATFORM NET REVENUES PC net revenues increased 18 percent during the year ended December 31, 2000 compared to the same period in 1999 primarily due to the release of seven major hit titles such as Star Trek Klingon Academy, Icewind Dale, Sacrifice, Baldur's Gate II, Giants, Star Trek StarFleet Command II and Star Trek New Worlds, compared to six major hit titles released in 1999. In addition, we continue to experience strong sales from Baldur's Gate and Baldur's Gate: Tales of the Sword Coast, both of which were released prior to 2000. The increase in PC net revenues was partially offset by our release of 18 titles in 2000 compared to 28 titles in 1999. We expect our PC net revenues to decrease in 2001 due to our increased focus on next generation console titles. Video game console net revenues increased 2 percent in the year ended December 31, 2000 compared to the same period in 1999, due to higher unit sales of our major console title releases, partially offset by approximately 10 percent lower price points for current generation console titles. We released four major video game console titles in 2000, including MDK 2 (Dreamcast), Gekido (PlayStation), Caesar's Palace 2000 (PlayStation) and Wild Wild Racing (PlayStation 2), compared to three major video game console titles released in 1999. We expect our video game console net revenues to increase in 2001 as a result of a substantial increase in planned major title releases for new generation game consoles in 2001 compared to 2000. COST OF GOODS SOLD; GROSS MARGIN Cost of goods sold decreased 12 percent in the year ended December 31, 2000 compared to the same period in 1999, due to releasing a higher percentage of internally developed titles and the discontinuation of the affiliate label distribution business that typically has a higher cost of goods component relative to net sales. The 1999 period also reflects $1.7 million of non-recurring write-offs of prepaid royalties relating to titles that had been canceled mainly due to our discontinuation of our licensed sports product line during 1999. We expect our cost of goods sold to increase in 2001 as compared to 2000 due to an expected higher net revenues base from the planned release of more major next generation game console titles in the 2001 period. The 24 percent increase in gross profit margin was primarily due to a 33 percent increase in internally developed titles sold without a royalty component in cost of goods sold, and a 25 percent decrease in product returns and price concessions compared to the 1999 period. We expect our future gross profit margin to decrease in 2001 as compared to 2000 due to an increase in next generation video game console title releases, which typically have a higher cost of goods relative to net revenues. However, we expect a higher dollar gross profit on an increased net revenue base in 2001 compared to 2000. MARKETING AND SALES Marketing and sales expenses primarily consist of advertising and retail marketing support, sales commissions, marketing and sales personnel, customer support services and other related operating expenses. The 18 percent decrease in marketing and sales expenses for the year ended December 31, 2000 compared to the 1999 period is attributable primarily to $2.9 million for minimum operating charges payable to Virgin which did not repeat in 2000, a $1.3 million decrease in personnel costs and a $0.5 million decrease in advertising and retail marketing support expenditures. In addition, we amended our International Distribution Agreement with Virgin Interactive Entertainment Limited, or Virgin, effective January 1, 2000, which eliminated the fixed monthly overhead fees of approximately $2.3 million we incurred in the 1999 period. We expect our marketing and sales expenses to remain about the same in 2001 compared to 2000, due to continued planned decreases in advertising and retail marketing support expenditures and lower personnel costs, offset by the $1.3 million in overhead fees payable to Virgin in 2001 to be incurred in connection with the terms of our April 2001 settlement with Virgin. Page 6 GENERAL AND ADMINISTRATIVE General and administrative expenses primarily consist of administrative personnel expenses, facilities costs, professional fees, bad debt expenses and other related operating expenses. The 44 percent decrease in general and administrative expenses for the year ended December 31, 2000 compared to the same period in 1999 is primarily attributable to a $6.6 million decrease in bad debt expense and a $1.1 million decrease in personnel costs. We are continuing our efforts to reduce North American operating expenses and expect our general and administrative expenses to decrease in 2001 compared to 2000. PRODUCT DEVELOPMENT We charge product development expenses, which consist primarily of personnel and support costs, to operations in the period incurred. The 8 percent increase in product development expenses for the year ended December 31, 2000 compared to the same period in 1999 is due to a $1.5 million increase in expenditures devoted to our focus on developing next generation video game console platforms. We expect our product development expenses to remain approximately constant in absolute dollars in 2001 compared to 2000. OTHER OPERATING EXPENSE In 1999, we discontinued our direct and then existing affiliate distribution activities in Europe and appointed Virgin as our exclusive distributor in Europe. In connection with our exiting direct and then existing affiliated distribution activities, we restructured our operations by terminating employees, closing facilities, retiring redundant assets, and transitioning selected employees to the Virgin organization. We recorded a provision of $2.4 million as restructuring expenses and costs associated with the merger and integration of our European operations and the departure of two members of senior management. We recorded costs associated with closing facilities, related asset valuation issues, and costs associated with the write-down of redundant equipment in the aggregate amount of $1.6 million and severance and other employee related costs of $0.8 million. These amounts were recorded as a charge to operating expenses, classified as Other Operating Expense on the Statement of Operations. OTHER EXPENSE, NET Other expense consists primarily of interest expense on our lines of credit and foreign currency exchange transaction losses. The 6 percent decrease for the year ended December 31, 2000 compared to the same period in 1999 was due to a $0.6 million decrease in interest expense on lower average borrowings under our line of credit, partially by $0.7 million in foreign currency exchange transaction losses incurred in connection with European distribution activities. PROVISION (BENEFIT) FOR INCOME TAXES We did not record a tax provision for the year ended December 31, 2000, compared with a tax provision of $5.4 million for the year ended December 31, 1999. The tax provision recorded during 1999 represents an increase to the valuation allowance on the deferred tax asset due to the uncertainty of realization of the deferred tax asset in future periods. We have a deferred tax asset of approximately $39 million that has been fully reserved at December 31, 2000. This tax asset would reduce future provisions for income taxes and related tax liabilities when realized, subject to limitations. YEAR ENDED DECEMBER 31, 1999 COMPARED TO THE YEAR ENDED DECEMBER 31, 1998 NORTH AMERICAN, INTERNATIONAL AND OEM, ROYALTY AND LICENSING NET REVENUES Overall net revenues for the year ended December 31, 1999 decreased 20 percent compared to the same period in 1998. This decrease resulted from a 33 percent decrease in North American net revenues and a 15 percent decrease in International net revenues, offset by a 29 percent increase in OEM, royalties and licensing, as described below. The decrease in North American and International net revenues for the year ended December 31, 1999 was due primarily to the release of four fewer major titles across multiple platforms and the resulting $46.9 million decrease in sales volume in the 1999 period. Page 7 OEM, royalty and licensing net revenues increased $5.0 million in the year ended December 31, 1999 compared to the same period in 1998 due to a $1.8 million increase in net revenues in the OEM business and a $3.2 million increase in net revenues in licensing. PLATFORM NET REVENUES PC net revenues decreased 3 percent in the year ended December 31, 1999 compared to the same period in 1998 due to the release of four fewer titles overall, including one less major title, offset by continued sales of Baldur's Gate. We released six new major titles in 1999, such as Baldur's Gate: Tales of the Sword Coast, Descent 3, Freespace 2, Kingpin, Starfleet Command and Torment, compared to seven new major titles in 1998. Video game console net revenues decreased 66 percent in the year ended December 31, 1999 compared to the same period in 1998 due to our release of three fewer major titles. Major console title releases in the 1999 period included Baseball 2000 (PlayStation), Caesar's Palace II (Game Boy Color) and Incoming (Dreamcast). COST OF GOODS SOLD; GROSS MARGIN Cost of goods sold decreased 15 percent in the year ended December 31, 1999 compared to the same period in 1998 due to a 20 percent decrease in net revenues, which may have a higher cost of goods sold, and a shift in product mix. Video game console revenues, comprised 14 percent of total net revenues in 1999 compared to 33 percent in 1998. The decrease in cost of goods sold was offset by $1.7 million write-offs of prepaid royalties relating to titles that we canceled due to our discontinuation of our licensed sports product line. The 26 percent decrease in gross margin was due primarily to a high level of product returns and price concessions attributable to the inability of some of our titles to gain broad, market acceptance from customers, which reduced net sales substantially. MARKETING AND SALES Marketing and sales expenses primarily consist of advertising and retail marketing support, sales commissions, marketing and sales personnel, customer support services, monthly overhead and distribution fees payable to Virgin, and other related operating expenses. Marketing and sales expenses decreased 18 percent in the year ended December 31, 1999 compared to the same period in 1998. The decrease is attributable primarily to a $7.4 million decrease in advertising, specifically television advertising, and other marketing costs associated with fewer major titles released during the 1999 period. In addition, we reduced personnel and commission expense by $2.5 million in connection with the restructuring of European operations, including the new distribution arrangements we made with Virgin starting in February 1999. These decreases were offset by a $2.9 million provision for minimum operating charges payable to Virgin. GENERAL AND ADMINISTRATIVE General and administrative expenses primarily consist of administrative personnel expenses, facilities costs, professional fees, bad debt expenses and other related operating expenses. General and administrative expenses increased 41 percent in the year ended December 31, 1999 compared to the same period in 1998. The increase is attributable primarily to a provision for bad debt expense of $6.9 million in 1999 in response to, among other things, the deteriorating financial condition of some of our customers, which placed serious doubts on their ability and intent to pay. General and administrative expenses other than bad debt expense decreased $1.6 million in the 1999 period. This decrease is due primarily to the reorganization of our European operations and successful efforts to reduce North American general and administrative expenses. PRODUCT DEVELOPMENT We charge product development expenses, which consist primarily of personnel and support costs, to operations in the period incurred. Product development expenses decreased 16 percent in the year ended December 31, 1999 compared to the same period in 1998. The decrease is due to a $3.8 million reduction in expense achieved as a result of the reorganization of the development process. Page 8 OTHER OPERATING EXPENSE In 1999, we discontinued our direct and then existing affiliate distribution activities in Europe and appointed Virgin as our exclusive distributor in Europe. In connection with our exiting direct and then existing affiliated distribution activities, we restructured our operations by terminating employees, closing facilities, retiring redundant assets, and transitioning selected employees to the Virgin organization. We recorded a provision of $2.4 million as restructuring expenses and costs associated with the merger and integration of our European operations and the departure of two members of senior management. We recorded costs associated with closing facilities, related asset valuation issues, and costs associated with the write-down of redundant equipment in the aggregate amount of $1.6 million and severance and other employee related costs of $0.8 million. These amounts were recorded as a charge to operating expenses, classified as Other Operating Expense on the Statement of Operations. OTHER INCOME (EXPENSE) Other income (expense) primarily consists of interest expense on our line of credit. Other expense decreased in the year ended December 31, 1999 compared to the same period in 1998. This decrease was due primarily to decreased interest expense of $1 million on lower borrowings under our line of credit and the repayment of the Subordinated Secured Promissory Notes in June 1998. We repaid these borrowings with the proceeds of our initial public offering in June 1998 and the equity investments by Titus Interactive, S.A. in 1999. PROVISION (BENEFIT) FOR INCOME TAXES We recorded a tax provision of $5.4 million in the year ended December 31, 1999, compared with a tax provision of $1.4 million in the year ended December 31, 1998. The tax provision recorded during both periods represents an increase of the valuation allowance on the deferred tax asset due to the uncertainty of realization of the deferred tax asset in future periods. At the end of 1999, we had fully reserved for all deferred tax assets. LIQUIDITY AND CAPITAL RESOURCES We have funded our operations to date primarily through the use of lines of credit and equipment leases, through cash generated by the private sale of securities, from the proceeds from our initial public offering, from the proceeds from licensing agreements, and from operations. As of December 31, 2000 our principal sources of liquidity included cash of $2.8 million and our line of credit that expired on April 30, 2001. In addition, $4 million was available under on our supplemental line of credit with Titus. In April 2001, we repaid all amounts outstanding on the Titus line of credit and terminated the line of credit. In April 2001, we secured a new working capital line of credit from a bank and repaid all amounts outstanding on our former line of credit and supplemental line of credit. These lines of credit were terminated upon full payment. Our new working capital line of credit line bears interest at the bank's prime rate, or, at our option, a portion of the outstanding balance bears interest at LIBOR plus 2.5%, for a fixed short-term. At June 30, 2001, borrowings under the new working capital line of credit bore interest at various interest rates between 6.39 percent and 7 percent. Our new line of credit provides for borrowings and letters of credit of up to $15 million based in part upon qualifying receivables and inventory. Under the new line of credit the Company is required to maintain a $2 million personal guarantee by the Company's Chairman and Chief Executive Officer ("Chairman"). The new line of credit has a term of three years, subject to review and renewal by the bank on April 30 of each subsequent year. As of June 30, 2001, we are not in compliance with the financial covenants under the new line of credit pertaining to net worth and minimum earnings before interest, taxes, depreciation and amortization. If the bank does not waive compliance with the required covenants under the credit agreement, the bank could terminate the credit agreement and accelerate payment of all outstanding amounts. Because we depend on this credit agreement to fund our operations, the bank's termination of the credit agreement could cause material harm to our business, including our ability to continue as a going concern. In addition, in April 2001, we completed a private placement of 8,126,770 shares of Common Stock for $12.7 million, and received net proceeds of approximately $11.9 million. The shares were issued at $1.5625 per share, and included warrants to purchase one share of Common Stock for each share sold. The warrants are exercisable at $1.75 per share, and the warrants can be exercised immediately. The warrants expire in March 2006. The transaction provides for a registration statement covering the shares sold or issuable upon exercise of such warrants to be filed by April 16, 2001 and become effective by May 31, 2001. In the event that the agreed effective date of the registration statement is not met, we are subject to a two percent penalty per month, payable in cash, until the Page 9 registration statement is effective. We did not meet the effective date of the registration statement and we are incurring a monthly penalty of $254,000, payable in cash, until the effectiveness of the registration. This obligation will continue to accrue each month that the registration statement is not declared effective and does not have a limit on the amount payable to these investors. Because this payment is cumulative, this obligation could have a material adverse effect on our financial condition. Moreover, we may be unable to pay the total penalty due to the investors. In April 2001, our Chairman provided us with a $3 million loan, payable in May 2002, with interest at 10 percent. In connection with this loan to us and the $2 million guarantee he provided under the new line of credit from a bank, the Chairman received warrants to purchase 500,000 shares of our Common Stock at $1.75 per share, vesting upon issuance and expiring in April 2004. Our primary capital needs historically have been to fund working capital requirements necessary to fund our net losses, our sales growth, the development and introduction of products and related technologies, and the acquisition or lease of equipment and other assets used in the product development process. Our operating activities used cash of $23.2 million during the year ended December 31, 2000, primarily attributable to the $12.1 million net loss for the year, a $5.9 million increase in trade receivables, and a $12.1 million decrease in accounts payable and accrued liabilities, partially offset by a $2.7 million decrease in inventory. The increase in trade receivables at December 31, 2000 compared to December 31, 1999 was due to a $3.5 million increase in sales during the fourth quarter of 2000 compared to the same quarter in 1999 and a $2.6 million decrease in allowances for doubtful trade accounts receivable. We believe that our allowances for doubtful accounts receivable are adequate based on historical experience, and our current estimate of potential sales allowances and doubtful accounts. The decrease in accounts payable and accrued liabilities is due to increased borrowings under our line of credit and collections of increased trade receivables, along with reductions to these liabilities, which resulted from overall decreases in the related operating expenditures. The decrease in inventory is due to successful efforts to manage inventory, which reduced purchasing lead times and improved inventory turns. Cash provided by financing activities of $28.9 million for the year ended December 31, 2000 consisted primarily of the proceeds from the equity investments by Titus, borrowings on our line of credit and the release of restricted cash by the our senior creditor. Cash used in investing activities of $3.2 million for the year ended December 31, 2000 consisted of normal capital expenditures, primarily for office and computer equipment used in our operations. We do not currently have any material commitments with respect to any future capital expenditures. We have incurred significant net losses in recent periods, including losses of $12.1 million during fiscal 2000 and $41.7 million during fiscal 1999. These losses are due in part to the high fixed costs to developing our products, to the relatively short life cycle and limited period for sales of our products, and to failure of game console manufactures to timely introduce their products which use our software. To reduce our working capital needs, we have implemented various measures including a reduction of personnel, a reduction of fixed overhead commitments, and a scaling back of marketing programs. We will continue to pursue various alternatives to improve future operating results, including further expense reductions as long as they do not have an adverse impact on our ability to develop, market and sell successful new interactive entertainment software. We believe that funds available under our new line of credit, amounts received from the equity financings transactions discussed above, amounts to be received under various product license and distribution agreements and anticipated funds from operations will be sufficient to satisfy our short-term capital and commitments in the normal course of business at least through December 31, 2001. Our long-term capital commitments consist of lease commitments and potential loss contingencies. Historically, we have funded these requirements from normal operating cash flows and available balances from the existing line of credit. Should these funds be insufficient, additional funding may not be available or may only be available on unfavorable terms. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Factors Affecting Future Performance - Liquidity, Future Capital Requirements." FACTORS AFFECTING FUTURE PERFORMANCE Our future operating results depend upon many factors and are subject to various risks and uncertainties. Some of the risks and uncertainties which may cause our operating results to vary from anticipated results or which may materially and adversely affect our operating results are as follows: Page 10 WE CURRENTLY HAVE A NUMBER OF OBLIGATIONS THAT WE ARE UNABLE TO MEET WITHOUT GENERATING ADDITIONAL REVENUES OR RAISING ADDITIONAL CAPITAL. IF WE CANNOT GENERATE ADDITIONAL REVENUES OR RAISE ADDITIONAL CAPITAL IN THE NEAR FUTURE, WE MAY BECOME INSOLVENT AND OUR STOCK WOULD BECOME ILLIQUID OR WORTHLESS. As of September 30, 2001, our cash balance was approximately $2.2 million and our outstanding accounts payable and current debt totaled approximately $23.0 million. If we do not receive sufficient financing we may (i) liquidate assets, (ii) seek or be forced into bankruptcy and/or (iii) continue operations, but incur material harm to our business, operations or financial condition. Additionally, because of our financial condition, our Board of Directors has a duty to our creditors that may conflict with the interests of our stockholders. When a Delaware corporation is operating in the vicinity of insolvency, the Delaware courts have imposed upon the corporation's directors a fiduciary duty to the corporation's creditors. If we cannot obtain additional capital and become unable to pay our debts as they become due, our Board of Directors may be required to make decisions that favor the interests of creditors at the expense of our stockholders to fulfill its fiduciary duty. For instance, we may be required to preserve our assets to maximize the repayment of debts versus employing the assets to further grow our business and increase shareholder value. WE DEPEND, IN PART, ON EXTERNAL FINANCING TO FUND OUR CAPITAL NEEDS. IF WE ARE UNABLE TO OBTAIN SUFFICIENT FINANCING ON FAVORABLE TERMS, WE MAY NOT BE ABLE TO CONTINUE TO OPERATE OUR BUSINESS. Historically, our business has not generated revenues sufficient to create operating profits. To supplement our revenues, we have funded our capital requirements with debt and equity financing. Our ability to obtain additional equity or debt financing depends on a number of factors including our financial performance, the overall conditions in our industry, and our credit rating. If we cannot raise additional capital on favorable terms, we will have to reduce our costs by delaying, canceling, suspending or scaling back product development and marketing programs. We may also be forced to sell or consolidate operations. These measures could materially limit our ability to publish successful titles and may not decrease our costs enough to permit us to operate profitability, or at all. OUR STOCK PRICE MAY DECLINE SIGNIFICANTLY IF WE ARE DELISTED FROM THE NASDAQ NATIONAL MARKET. Our common stock currently is quoted on the Nasdaq National Market System. For continued inclusion on the Nasdaq National Market, we must meet certain tests, including a bid price of at least $1.00 and net tangible assets of at least $4 million. Although Nasdaq has suspended the bid price requirement until January 2, 2002, we would likely be subject to that requirement thereafter. We currently are not in compliance with either the net tangible assets requirement or the bid price requirement. Moreover, Nasdaq requires that we maintain an Audit Committee of our Board of Directors, composed of at least three independent directors. We currently do not meet the Audit Committee requirement. If we continue to fail to satisfy the listing standards on a continuous basis, Nasdaq may delist our common stock from its National Market System. If this occurs, trading of our common stock may be conducted on the Nasdaq SmallCap Market, if we qualify for listing at that time, in the over-the-counter market on the "pink sheets" or, if available, the NASD's "Electronic Bulletin Board." In any of those cases, investors could find it more difficult to buy or sell, or to obtain accurate quotations as to the value of our common stock. The trading price per share of our common stock likely would be reduced as a result. THE VARIABLE CONVERSION PRICE OF OUR SERIES A PREFERRED STOCK INCREASES OUR RISK OF BEING DELISTED FROM THE NASDAQ NATIONAL MARKET. The variable conversion price of our Series A Preferred Stock increases our risk of being delisted from the Nasdaq National Market in several ways (see "The variable conversion price of our Series A Preferred Stock could result in the issuance of a significant number of shares of our common stock if our stock price declines, which will have a dilutive impact on our stockholders"): o The substantial number of shares that are potentially issuable upon conversion of the Series A Preferred Stock and the short selling that may occur as a result of the future priced nature of those shares increases the risk that our stock price will stay below Nasdaq's minimum bid price requirement. Page 11 o If the returns on our Series A Preferred Stock are deemed "excessive" compared with those of public investors in our common stock, Nasdaq may deny inclusion or apply more stringent criteria to the continued listing of our common stock. o If Nasdaq determines that the past and prospective future issuances of common stock upon conversion by Titus of its Series A Preferred Stock constitutes a change in control of the Company or a change in its financial structure, we would need to satisfy all initial listing requirements as of that time, which currently we are unable to do. A SIGNIFICANT PERCENTAGE OF OUR REVENUES DEPEND ON OUR DISTRIBUTORS' DILIGENT SALES EFFORTS AND OUR DISTRIBUTORS' AND RETAIL CUSTOMERS' TIMELY PAYMENTS TO US. Since February 1999, Virgin has been the exclusive distributor for most of our products in Europe, the Commonwealth of Independent States, Africa and the Middle East. Our agreement with Virgin expires in February 2006. In August 2001, we entered into a Distribution Agreement with Vivendi Universal Interactive Publishing North America, or Vivendi, pursuant to which Vivendi will distribute substantially all our products in North America commencing in October 2001. Our agreement with Vivendi expires in December 2003, but may be extended with respect to certain named products. Virgin and Vivendi each have exclusive rights to distribute our products in substantial portions of the world. As a consequence, the distribution of our products by Virgin and Vivendi will generate a substantial majority of our revenues, and proceeds from Virgin and Vivendi from the distribution of our products will constitute a substantial majority of our operating cash flows. Therefore, our revenues and cash flows could fall significantly and our business and financial results could suffer material harm if: o either Virgin or Vivendi fails to deliver to us the full proceeds owed us from distribution of our products; o either Virgin or Vivendi fails to effectively distribute our products in their respective territories; or o either Virgin or Vivendi otherwise fails to perform under the distribution agreement. We typically sell to distributors and retailers on unsecured credit, with terms that vary depending upon the customer and the nature of the product. We confront the risk of non-payment from our customers, whether due to their financial inability to pay us, or otherwise. In addition, while we maintain a reserve for uncollectible receivables, the reserve may not be sufficient in every circumstance. As a result, a payment default by a significant customer could cause material harm to our business. THE TERMINATION OF OUR EXISTING CREDIT AGREEMENT HAS RESULTED IN A SUBSTANTIAL REDUCTION IN THE CASH AVAILABLE TO FINANCE OUR OPERATIONS. Pursuant to our credit agreement with LaSalle Business Credit Inc., or "LaSalle", entered into in April 2001, we agreed to certain covenants. We currently are not in compliance with some of those covenants. In October 2001, LaSalle notified us that the credit agreement was being terminated and we would no longer be able to continue to draw on the credit facility to fund future operations. We are currently negotiating with LaSalle the payment of the outstanding balance under the credit agreement, which is currently due and payable and is approximately $2.7 million on November 9, 2001. There can be no assurance that our discussions with LaSalle will result in a forbearance of amounts due. Because we depend on our credit agreement to fund our operations, LaSalle's termination of the credit agreement has significantly impeded our ability to fund our operations and has caused material harm to our business. We will need to enter into a new credit facility to fund our operations. There can be no assurance that we will be able to enter into a new credit agreement or that if we do enter into a new credit agreement, it will be on terms favorable to us. THE VARIABLE CONVERSION PRICE OF OUR SERIES A PREFERRED STOCK COULD RESULT IN THE ISSUANCE OF A SIGNIFICANT NUMBER OF SHARES OF OUR COMMON STOCK IF OUR STOCK PRICE DECLINES, WHICH WILL HAVE A DILUTIVE IMPACT ON OUR STOCKHOLDERS. Titus Interactive S.A. may convert each share of its Series A Preferred Stock into a number of shares of our common stock determined by dividing $27.80 by the lesser of (i) $2.78 or (ii) 85 percent of the average closing price Page 12 per share as reported by Nasdaq for the twenty trading days preceding the date of conversion. Consequently, the number of shares issuable to Titus upon conversion of its Series A Preferred Stock increase as our stock price declines. The table below sets forth the number of shares and the percentages of our common stock that Titus would own if Titus elected to convert its remaining 383,354 shares of Series A Preferred Stock. The share amounts and the percentages include, in addition to the shares of common stock Titus has the right to acquire upon conversion of its remaining Series A Preferred Stock, 19,474,761 shares of common stock already owned by Titus and 460,298 shares of common stock that Titus has the right to acquire upon exercise of warrants that currently are exercisable. The share amounts and percentages do not include any shares of common stock that Titus may elect to receive for accrued dividends on the Series A Preferred Stock at the time of its conversion to common stock. The share amounts and the percentages are based on the average closing price per share of the Company's common stock for the 20 trading days immediately preceding November 12, 2001, which was $0.61 per share, and on assumed average prices of $0.458, $0.305 and $0.153, which prices represent a 25%, 50% and 75% decline, respectively, in the November 12, 2001 average price. The percentages are also based on 44,985,708 shares of our common stock outstanding on November 12, 2001.
PERCENTAGE DECLINE IN ASSUMED PERCENTAGE OF November 12, 2001 AVERAGE SHARES OF OUTSTANDING Average Price PRICE COMMON STOCK COMMON STOCK --------------------- --------- ------------ ------------- -- $0.61 40,489,044 61.35% 25% $0.46 47,340,372 64.98% 50% $0.31 61,043,029 70.53% 75% $0.15 101,882,319 79.97%
TITUS INTERACTIVE SA CONTROLS A MAJORITY OF OUR VOTING STOCK AND CAN ELECT A MAJORITY OF OUR BOARD OF DIRECTORS AND PREVENT AN ACQUISITION OF THE COMPANY THAT IS FAVORABLE TO OUR OTHER STOCKHOLDERS. As of November 9, 2001, Titus owned approximately 52 percent of the total voting power of our capital stock. If Titus converted its remaining Series A Preferred Stock on November 9, 2001, Titus would own 61 percent of the total voting power of our capital stock. As a consequence, Titus can control substantially all matters requiring stockholder approval, including the election of directors, subject to our stockholders' cumulative voting rights, and the approval of mergers or other business combination transactions. Additionally, pursuant to the terms of our Series A Preferred Stock, Titus also has the ability to block approval of a merger or change in control that the other holders of our common stock may deem beneficial. At our 2001 annual stockholders meeting on September 18, 2001, Titus exercised its voting power to elect a majority of our Board of Directors. Three of the 6 members of the Board employees or directors of Titus, and Titus' Chief Executive Officer serves as our President. OUR LONG-TERM EXCLUSIVE DISTRIBUTION AGREEMENT WITH VIRGIN INTERACTIVE ENTERTAINMENT LIMITED MAY DISCOURAGE POTENTIAL ACQUIRORS FROM ACQUIRING US. Pursuant to the settlement agreement we entered into with Titus, Virgin Interactive Entertainment Limited, or Virgin, and their affiliate on April 11, 2001, during the seven-year term of our February 1999 distribution agreement with Virgin, we agreed not to sell, license our publishing rights, or enter into any agreement to either sell or license our publishing rights with respect to any products covered by the distribution agreement in the territory covered by the distribution agreement, with the exception of two qualified sales each year. The restrictions on sales and licensing of publishing rights until 2006 may discourage potential acquirors from entering into an acquisition transaction with us, or may cause potential acquirors to demand terms that are less favorable to our stockholders. In addition, we cannot terminate the distribution agreement without incurring penalties of a minimum of $10 million, subject to substantial increases pursuant to the terms of the distribution agreement, which also may discourage potential acquirors that already have their own distribution capabilities in territories covered by the distribution agreement. Page 13 A CHANGE OF CONTROL MAY CAUSE THE TERMINATION OF SOME OF OUR MATERIAL CONTRACTS WITH OUR LICENSORS AND DISTRIBUTORS. Some of our license, development and distribution agreements contain provisions that allow the other party to terminate the agreement upon a change in control of the Company. Titus recently converted a portion of their preferred stock into common stock, which as of November 9, 2001 gave Titus 52% of our total voting power. At our 2001 annual stockholders meeting on September 18, 2001, Titus exercised its voting power to elect a majority of our Board of Directors. Some of our third-party developers and licensors may assert that these events constitute a change in control of the Company and attempt to terminate their respective agreements with us. In particular, our license for "the Matrix" allows for the licensor to terminate the license if there is a substantial change of ownership or control without their approval. The loss of the Matrix license would materially harm our projected operating results and financial condition. THE UNPREDICTABILITY OF OUR QUARTERLY RESULTS MAY CAUSE OUR STOCK PRICE TO DECLINE. Our operating results have fluctuated in the past and may fluctuate in the future due to several factors, some of which are beyond our control. These factors include: o demand for our products and our competitors' products; o the size and rate of growth of the market for interactive entertainment software; o changes in personal computer and video game console platforms; o the timing of announcements of new products by us and our competitors and the number of new products and product enhancements released by us and our competitors; o changes in our product mix; o the number of our products that are returned; and o the level of our international and original equipment manufacturer royalty and licensing net revenues. Many factors make it difficult to accurately predict the quarter in which we will ship our products. Some of these factors include: o the uncertainties associated with the interactive entertainment software development process; o approvals required from content and technology licensors; and o the timing of the release and market penetration of new game hardware platforms. It is likely that in some future periods our operating results will not meet the expectations of the public or of public market analysts. Any unanticipated change in revenues or operating results is likely to cause our stock price to fluctuate since such changes reflect new information available to investors and analysts. New information may cause securities analysts and investors to revalue our stock and this may cause fluctuations in our stock price. THERE ARE HIGH FIXED COSTS TO DEVELOPING OUR PRODUCTS. IF OUR REVENUES DECLINE BECAUSE OF DELAYS IN THE INTRODUCTION OF OUR PRODUCTS, OR IF THERE ARE SIGNIFICANT DEFECTS OR DISSATISFACTION WITH OUR PRODUCTS, OUR BUSINESS COULD BE HARMED. We have incurred significant net losses in recent periods, including a net loss of $41.4 million in the nine months ended September 30, 2001, $12.1 million during 2000 and $41.7 million during 1999. Our losses stem partly from the significant costs we incur to develop our entertainment software products. Moreover, a significant portion of our operating expenses are relatively fixed, with planned expenditures based largely on sales forecasts. At the same time, most of our products have a relatively short life cycle and sell for a limited period of time after their initial release, usually less than one year. Page 14 Relatively fixed costs and short windows in which to earn revenues mean that sales of new products are important in enabling us to recover our development costs, to fund operations and to replace declining net revenues from older products. Our failure to accurately assess the commercial success of our new products, and our delays in releasing new products, could reduce our net revenues and our ability to recoup development and operational costs. OUR GROWING DEPENDENCE ON REVENUES FROM GAME CONSOLE SOFTWARE PRODUCTS INCREASES OUR EXPOSURE TO SEASONAL FLUCTUATIONS IN THE PURCHASES OF GAME CONSOLES. The interactive entertainment software industry is highly seasonal, with the highest levels of consumer demand occurring during the year-end holiday buying season. As a result, our net revenues, gross profits and operating income have historically been highest during the second half of the year. The impact of this seasonality will increase as we rely more heavily on game console net revenues in the future. Moreover, delays in game console software products largely depend on the timeliness of introduction of game console platforms by the manufacturers of those platforms, such as Microsoft and Nintendo. The introduction by a manufacturer of a new game platform too late in the holiday buying season could result in a substantial loss of revenues by us. Seasonal fluctuations in revenues from game console products may cause material harm to our business and financial results. IF OUR PRODUCTS DO NOT ACHIEVE BROAD MARKET ACCEPTANCE, OUR BUSINESS COULD BE HARMED SIGNIFICANTLY. Consumer preferences for interactive entertainment software are always changing and are extremely difficult to predict. Historically, few interactive entertainment software products have achieved continued market acceptance. Instead, a limited number of releases have become "hits" and have accounted for a substantial portion of revenues in our industry. Further, publishers with a history of producing hit titles have enjoyed a significant marketing advantage because of their heightened brand recognition and consumer loyalty. We expect the importance of introducing hit titles to increase in the future. We cannot assure you that our new products will achieve significant market acceptance, or that we will be able to sustain this acceptance for a significant length of time if we achieve it. We believe that our future revenue will continue to depend on the successful production of hit titles on a continuous basis. Because we introduce a relatively limited number of new products in a given period, the failure of one or more of these products to achieve market acceptance could cause material harm to our business. Further, if our products do not achieve market acceptance, we could be forced to accept substantial product returns or grant significant pricing concessions to maintain our relationship with retailers and our access to distribution channels. If we are forced to accept significant product returns or grant significant pricing concessions, our business and financial results could suffer material harm. OUR RELIANCE ON THIRD PARTY SOFTWARE DEVELOPERS SUBJECTS US TO THE RISKS THAT THESE DEVELOPERS WILL NOT SUPPLY US IN A TIMELY MANNER WITH HIGH QUALITY PRODUCTS OR ON ACCEPTABLE TERMS. Third party interactive entertainment software developers, such as Bioware Corp. and Planet Moon Studios develop many of our software products. Since we depend on these developers in the aggregate, we remain subject to the following risks: o limited financial resources may force developers out of business prior to their completion of projects for us or require us to fund additional costs; and o the possibility that developers could demand that we renegotiate our arrangements with them to include new terms less favorable to us. Increased competition for skilled third party software developers also has compelled us to agree to make advance payments on royalties and to guarantee minimum royalty payments to intellectual property licensors and game developers. Moreover, if the products subject to these arrangements, are not delivered timely, or with acceptable quality, or do not generate sufficient sales volumes to recover these royalty advances and guaranteed payments, we would have to write-off unrecovered portions of these payments, which could cause material harm to our business and financial results. Page 15 IF WE FAIL TO ANTICIPATE CHANGES IN VIDEO GAME PLATFORMS AND TECHNOLOGY, OUR BUSINESS MAY BE HARMED. The interactive entertainment software industry is subject to rapid technological change. New technologies could render our current products or products in development obsolete or unmarketable. Some of these new technologies include: o operating systems such as Microsoft Windows 2000; o technologies that support games with multi-player and online features; o new media formats such as online delivery and digital video disks, or DVDs; and o recent releases or planned releases in the near future of new video game consoles such as the Sony Playstation 2, the Nintendo Gamecube and the Microsoft Xbox. We must continually anticipate and assess the emergence of, and market acceptance of, new interactive entertainment software platforms well in advance of the time the platform is introduced to consumers. Because product development cycles are difficult to predict, we must make substantial product development and other investments in a particular platform well in advance of introduction of the platform. If the platforms for which we develop new software products or modify existing products are not released on a timely basis or do not attain significant market penetration, or if we develop products for a delayed or unsuccessful platform, our business and financial results could suffer material harm. New interactive entertainment software platforms and technologies also may undermine demand for products based on older technologies. Our success will depend in part on our ability to adapt our products to those emerging game platforms that gain widespread consumer acceptance. Our business and financial results may suffer material harm if we fail to: o anticipate future technologies and platforms and the rate of market penetration of those technologies and platforms; o obtain licenses to develop products for those platforms on favorable terms; or o create software for those new platforms on a timely basis. WE COMPETE WITH A NUMBER OF COMPANIES THAT HAVE SUBSTANTIALLY GREATER FINANCIAL, MARKETING AND PRODUCT DEVELOPMENT RESOURCES THAN WE DO. The interactive entertainment software industry is intensely competitive and new interactive entertainment software programs and platforms are regularly introduced. The greater resources of our competitors permit them to undertake more extensive marketing campaigns, adopt more aggressive pricing policies, and pay higher fees than we can to licensors of desirable motion picture, television, sports and character properties and to third party software developers. We compete primarily with other publishers of personal computer and video game console interactive entertainment software. Significant competitors include Electronic Arts Inc., Activision, Inc., and Vivendi Universal Interactive Publishing. Many of these competitors have substantially greater financial, technical and marketing resources, larger customer bases, longer operating histories, greater name recognition and more established relationships in the industry than we do. Competitors with more extensive customer bases, broader customer relationships and broader industry alliances may be able to use such resources to their advantage in competitive situations, including establishing relationships with many of our current and potential customers. In addition, integrated video game console hardware/software companies such as Sony Computer Entertainment, Nintendo, and Microsoft Corporation compete directly with us in the development of software titles for their respective platforms and they have generally discretionary approval authority over the products we develop for their platforms. Large diversified entertainment companies, such as The Walt Disney Company, many of which own substantial libraries of available content and have substantially greater financial resources, may decide to Page 16 compete directly with us or to enter into exclusive relationships with our competitors. We also believe that the overall growth in the use of the Internet and online services by consumers may pose a competitive threat if customers and potential customers spend less of their available home personal computing time using interactive entertainment software and more time using the Internet and online services. WE MAY FACE DIFFICULTY OBTAINING ACCESS TO RETAILERS NECESSARY TO MARKET AND SELL OUR PRODUCTS EFFECTIVELY. Retailers typically have a limited amount of shelf space and promotional resources, and there is intense competition among consumer software producers, and in particular producers of interactive entertainment software products, for high quality retail shelf space and promotional support from retailers. To the extent that the number of consumer software products and computer platforms increases, competition for shelf space may intensify and require us to increase our marketing expenditures. Due to increased competition for limited shelf space, retailers and distributors are in an improving position to negotiate favorable terms of sale, including price discounts, price protection, marketing and display fees and product return policies. Our products constitute a relatively small percentage of any retailer's sales volume, and we cannot assure you that retailers will continue to purchase our products or to provide our products with adequate levels of shelf space and promotional support. A prolonged failure in this regard may cause material harm to our business. BECAUSE WE SELL A SUBSTANTIAL PORTION OF OUR PRODUCTS ON A PURCHASE ORDER BASIS, OUR SALES MAY DECLINE SUBSTANTIALLY WITHOUT WARNING AND IN A BRIEF PERIOD OF TIME. We currently sell our products through our sales force to mass merchants, warehouse club stores, large computer and software specialty chains and through catalogs in the United States and Canada, as well as to certain distributors. Outside North America, we generally sell products to third party distributors. We make our sales primarily on a purchase order basis, without long-term agreements. The loss of, or significant reduction in sales to, any of our principal retail customers or distributors could cause material harm to our business. OUR CUSTOMERS HAVE THE ABILITY TO RETURN OUR PRODUCTS OR TO RECEIVE PRICING CONCESSIONS AND SUCH RETURNS AND CONCESSIONS COULD REDUCE OUR NET REVENUES AND RESULTS OF OPERATIONS. We are exposed to the risk of product returns and pricing concessions with respect to our distributors and retailers. We allow distributors and retailers to return defective, shelf-worn and damaged products in accordance with negotiated terms, and also offer a 90-day limited warranty to our end users that our products will be free from manufacturing defects. In addition, we provide pricing concessions to our customers to manage our customers' inventory levels in the distribution channel. We could be forced to accept substantial product returns and provide pricing concessions to maintain our relationships with retailers and our access to distribution channels. Product return and pricing concessions that exceed our reserves have caused material harm to our results of operations in the recent past and may do so again in the future. Substantial sales of our common stock by our existing stockholders may reduce the price of our stock and dilute existing stockholders. We have filed registration statements covering a total of approximately 49.5 million shares of our common stock for the benefit of the holders we describe below. Assuming the effectiveness of these registration statements, these shares would be eligible for immediate resale in the public market. o Universal Studios, Inc. (now owned by Vivendi) holds approximately 10.4%, of our outstanding common stock, all of which are being registered pursuant to registration statement number 333-59088, filed on April 17, 2001. o Titus currently holds approximately 43.3% of our outstanding common stock and, if Titus converted all of its shares of Series A Preferred Stock on November 9, 2001, would own approximately 61.1% of our common stock. All of the shares of common stock issuable to Titus upon the conversion of the preferred stock, and common stock issuable to Titus upon exercise of warrants, are being registered in our pending registration statements. o Pursuant to registration statement 333-59088, filed on April 17, 2001, we intend to register shares equal to approximately 38% of our currently outstanding common stock, held by a number of our investors as set forth in that registration statement. Page 17 o Employees and directors hold options and warrants to purchase 10.8% of our common stock, most of which are eligible for immediate resale. We may issue options to purchase up to an additional 2.2% of our common stock to employees and directors, which we anticipate will be freely tradable when issued. Although the holders described above are subject to restrictions on the transfer of our common stock, future sales by such holders could decrease the trading price of our common stock and, therefore, the price at which you could resell your shares. A lower market price for our shares also might impair our ability to raise additional capital through the sale of our equity securities. Any future sales of our stock would also dilute existing stockholders. WE DEPEND UPON THIRD PARTY LICENSES OF CONTENT FOR MANY OF OUR PRODUCTS. Many of our current and planned products, such as our Star Trek, Advanced Dungeons and Dragons, Matrix and Caesars Palace titles, are lines based on original ideas or intellectual properties licensed from other parties. From time to time we may not be in compliance with certain terms of these license agreements, and our ability to market products based on these licenses may be negatively impacted. Moreover, disputes regarding these license agreements may also negatively impact our ability to market products based on these licenses. For instance, we are in discussion with Infogrames about our failure to make scheduled royalty payments. If these discussions are not successful, Infogrames may terminate our agreement which would significantly impact our ability to market many of our most successful products. Additionally, we may not be able to obtain new licenses, or maintain or renew existing licenses, on commercially reasonable terms, if at all. For example, Viacom Consumer Products, Inc. has granted the Star Trek license to another party upon the expiration of our rights in 2002. If we are unable to maintain current licenses or obtain new licenses for the underlying content that we believe offers the greatest consumer appeal, we would either have to seek alternative, potentially less appealing licenses, or release products without the desired underlying content, either of which could limit our commercial success and cause material harm to our business . WE MAY FAIL TO MAINTAIN EXISTING LICENSES, OR OBTAIN NEW LICENSES FROM HARDWARE COMPANIES ON ACCEPTABLE TERMS OR TO OBTAIN RENEWALS OF EXISTING OR FUTURE LICENSES FROM LICENSORS. We are required to obtain a license to develop and distribute software for each of the video game console platforms for which we develop products, including a separate license for each of North America, Japan and Europe. We have obtained licenses to develop software for the Sony PlayStation and PlayStation 2, as well as video game platforms from Nintendo and Microsoft. In addition, each of these companies has the right to approve the technical functionality and content of our products for their platforms prior to distribution. Due to the competitive nature of the approval process, we must make significant product development expenditures on a particular product prior to the time we seek these approvals. Our inability to obtain these approvals could cause material harm to our business. Our sales volume and the success of our products depends in part upon the number of product titles distributed by hardware companies for use with their video game platforms. Even after we have obtained licenses to develop and distribute software, we depend upon hardware companies such as Sony Computer Entertainment, Nintendo and Microsoft, or their designated licensees, to manufacture the CD-ROM or DVD-ROM media discs that contain our software. These discs are then run on the companies' video game consoles. This process subjects us to the following risks: o we are required to submit and pay for minimum numbers of discs we want produced containing our software, regardless of whether these discs are sold, shifting onto us the financial risk associated with poor sales of the software developed by us; and o reorders of discs are expensive, reducing the gross margin we receive from software releases that have stronger sales than initially anticipated and that require the production of additional discs. As a result, video game console hardware licensors can shift onto us the risk that if actual retailer and consumer demand for our interactive entertainment software differs from our forecasts, we must either the bear the loss from overproduction or the lesser per-unit revenues associated with producing additional discs. Either situation could lead to material reductions in our net revenues. Page 18 If we fail to maintain any of our current licenses for console hardware, we will be unable to publish products for that console. Moreover, if we fail to maintain our license for the Microsoft Xbox, Microsoft could require us to repay an advance from them. Our agreements with Microsoft ancillary to our Xbox license require, among other things, that we continue development of our Matrix product, and that we maintain our credit agreement with LaSalle. Microsoft may consider the potential for termination of our Matrix license and our current non-compliances with the LaSalle credit agreement to be of sufficient materiality to require repayment of the advance. (See "A change of control may cause the termination of some of our material contracts with our licensors and distributors" and "Our failure to comply with the covenants in our existing credit agreement could result in the termination of the agreement and a substantial reduction in the cash available to finance our operations.") Our failure to maintain any console hardware license, or any requirement by Microsoft that we repay the advance to them, could cause material harm to our business. WE HAVE A LIMITED NUMBER OF KEY PERSONNEL. THE LOSS OF ANY SINGLE KEY PERSON OR THE FAILURE TO HIRE AND INTEGRATE CAPABLE NEW KEY PERSONNEL COULD HARM OUR BUSINESS. Our interactive entertainment software requires extensive time and creative effort to produce and market. The production of this software is closely tied to the continued service of our key product design, development, sales, marketing and management personnel. Our future success also will depend upon our ability to attract, motivate and retain qualified employees and contractors, particularly software design and development personnel. Competition for highly skilled employees is intense, and we may fail to attract and retain such personnel. Alternatively, we may incur increased costs in order to attract and retain skilled employees. Our failure to retain the services of key personnel, including competent executive management, or to attract and retain additional qualified employees could cause material harm to our business. OUR INTERNATIONAL SALES EXPOSE US TO RISKS OF UNSTABLE FOREIGN ECONOMIES, DIFFICULTIES IN COLLECTION OF REVENUES, INCREASED COSTS OF ADMINISTERING INTERNATIONAL BUSINESS TRANSACTIONS AND FLUCTUATIONS IN EXCHANGE RATES. Our net revenues from international sales accounted for approximately 20 percent of our total net revenues for the nine months ended September 30, 2001 and approximately 28 percent for the nine months ended September 30, 2000. Most of these revenues come from our distribution relationship with Virgin, pursuant to which Virgin became the exclusive distributor for most of our products in Europe, the Commonwealth of Independent States, Africa and the Middle East. To the extent our resources allow, we intend to continue to expand our direct and indirect sales, marketing and product localization activities worldwide. Our international sales and operations are subject to a number of inherent risks, including the following: o recessions in foreign economies may reduce purchases of our products; o translating and localizing products for international markets is time- consuming and expensive; o accounts receivable are more difficult to collect and when they are collectible, they may take longer to collect; o regulatory requirements may change unexpectedly; o it is difficult and costly to staff and manage foreign operations; o fluctuations in foreign currency exchange rates; o political and economic instability; o our dependence on Virgin as our exclusive distributor in Europe, the Commonwealth of Independent States, Africa and the Middle East; and o delays in market penetration of new platforms in foreign territories. These factors may cause material declines in our future international net revenues and, consequently, could cause material harm to our business. Page 19 A significant, continuing risk we face from our international sales and operations stems from exchange rate fluctuations. Because we do not engage in currency hedging activities, fluctuations in currency exchange rates have caused significant reductions in our net revenues from international sales and licensing due to the loss in value upon conversion into U.S. Dollars. We may suffer similar losses in the future. INADEQUATE INTELLECTUAL PROPERTY PROTECTIONS COULD PREVENT US FROM ENFORCING OR DEFENDING OUR PROPRIETARY TECHNOLOGY. We regard our software as proprietary and rely on a combination of patent, copyright, trademark and trade secret laws, employee and third party nondisclosure agreements and other methods to protect our proprietary rights. We own or license various copyrights and trademarks, and hold the rights to one patent application related to one of our titles. While we provide "shrinkwrap" license agreements or limitations on use with our software, it is uncertain to what extent these agreements and limitations are enforceable. We are aware that some unauthorized copying occurs within the computer software industry, and if a significantly greater amount of unauthorized copying of our interactive entertainment software products were to occur, it could cause material harm to our business and financial results. Policing unauthorized use of our products is difficult, and software piracy can be a persistent problem, especially in some international markets. Further, the laws of some countries where our products are or may be distributed either do not protect our products and intellectual property rights to the same extent as the laws of the United States, or are weakly enforced. Legal protection of our rights may be ineffective in such countries, and as we leverage our software products using emerging technologies such as the Internet and online services, our ability to protect our intellectual property rights and to avoid infringing others' intellectual property rights may diminish. We cannot assure you that existing intellectual property laws will provide adequate protection for our products in connection with these emerging technologies. WE MAY UNINTENTIONALLY INFRINGE ON THE INTELLECTUAL PROPERTY RIGHTS OF OTHERS, WHICH COULD EXPOSE US TO SUBSTANTIAL DAMAGES OR RESTRICT OUR OPERATIONS. As the number of interactive entertainment software products increases and the features and content of these products continue to overlap, software developers increasingly may become subject to infringement claims. Although we believe that we make reasonable efforts to ensure that our products do not violate the intellectual property rights of others, it is possible that third parties still may claim infringement. From time to time, we receive communications from third parties regarding such claims. Existing or future infringement claims against us, whether valid or not, may be time consuming and expensive to defend. Intellectual property litigation or claims could force us to do one or more of the following: o cease selling, incorporating or using products or services that incorporate the challenged intellectual property; o obtain a license from the holder of the infringed intellectual property, which license, if available at all, may not be available on commercially favorable terms; or o redesign our interactive entertainment software products, possibly in a manner that reduces their commercial appeal. Any of these actions may cause material harm to our business and financial results. OUR SOFTWARE MAY BE SUBJECT TO GOVERNMENTAL RESTRICTIONS OR RATING SYSTEMS. Legislation is periodically introduced at the state and federal levels in the United States and in foreign countries to establish a system for providing consumers with information about graphic violence and sexually explicit material contained in interactive entertainment software products. In addition, many foreign countries have laws that permit governmental entities to censor the content of interactive entertainment software. We believe that mandatory government-run rating systems eventually will be adopted in many countries that are significant markets or potential markets for our products. We may be required to modify our products to comply with new regulations, which could delay the release of our products in those countries. Page 20 Due to the uncertainties regarding such rating systems, confusion in the marketplace may occur, and we are unable to predict what effect, if any, such rating systems would have on our business. In addition to such regulations, certain retailers have in the past declined to stock some of our products because they believed that the content of the packaging artwork or the products would be offensive to the retailer's customer base. While to date these actions have not caused material harm to our business, we cannot assure you that similar actions by our distributors or retailers in the future would not cause material harm to our business. OUR DIRECTORS AND OFFICERS CONTROL A LARGE PERCENTAGE OF OUR VOTING STOCK AND MAY USE THIS CONTROL TO COMPEL CORPORATE ACTIONS THAT ARE NOT IN THE BEST INTERESTS OF OUR STOCKHOLDERS AS A WHOLE. Including Titus, our directors and executive officers beneficially own approximately 58 percent of our aggregate common stock. In the event Titus converts all of its shares of Series A Preferred Stock into common stock, the additional shares could increase Titus' ownership to approximately 66 percent. These stockholders can control substantially all matters requiring stockholder approval, including the election of directors, subject to our stockholders' cumulative voting rights, and the approval of mergers or other business combination transactions. This concentration of voting power could discourage or prevent a change in control that otherwise could result in a premium in the price of our common stock. WE MAY FAIL TO IMPLEMENT INTERNET-BASED PRODUCT OFFERINGS SUCCESSFULLY. We seek to establish an online presence by creating and supporting sites on the Internet and by offering our products through these sites. Our ability to establish an online presence and to offer online products successfully depends on: o increases in the Internet's data transmission capability; o growth in an online market sizeable enough to make commercial transactions profitable. Because global commerce and the exchange of information on the Internet and other open networks are relatively new and evolving, a viable commercial marketplace on the Internet may not emerge and complementary products for providing and carrying Internet traffic and commerce may not be developed. Even with the proper infrastructure, we may fail to develop a profitable online presence or to generate any significant revenue from online product offerings in the near future, or at all. If the Internet does not become a viable commercial marketplace, or if this development occurs but is insufficient to meet our needs or if such development is delayed beyond the point where we plan to have established an online service, our business and financial condition could suffer material harm. SOME PROVISIONS OF OUR CHARTER DOCUMENTS MAY MAKE TAKEOVER ATTEMPTS DIFFICULT, WHICH COULD DEPRESS THE PRICE OF OUR STOCK AND INHIBIT OUR ABILITY TO RECEIVE A PREMIUM PRICE FOR YOUR SHARES. Our Board of Directors has the authority, without any action by the stockholders, to issue up to 4,616,646 shares of preferred stock and to fix the rights and preferences of such shares. In addition, our certificate of incorporation and bylaws contain provisions that: o eliminate the ability of stockholders to act by written consent and to call a special meeting of stockholders; and o require stockholders to give advance notice if they wish to nominate directors or submit proposals for stockholder approval. These provisions may have the effect of delaying, deferring or preventing a change in control, may discourage bids for our common stock at a premium over its market price and may adversely affect the market price, and the voting and other rights of the holders, of our common stock. Page 21 OUR STOCK PRICE IS VOLATILE. The trading price of our common stock has previously fluctuated and could continue to fluctuate in response to factors that are largely beyond our control, and which may not be directly related to the actual operating performance of our business, including: o general conditions in the computer, software, entertainment, media or electronics industries; o changes in earnings estimates or buy/sell recommendations by analysts; o investor perceptions and expectations regarding our products, plans and strategic position and those of our competitors and customers; and o price and trading volume volatility of the broader public markets, particularly the high technology sections of the market. WE DO NOT PAY DIVIDENDS ON OUR COMMON STOCK. We have not paid any cash dividends on our common stock and do not anticipate paying dividends in the foreseeable future. INCREASES IN INTEREST RATES WILL INCREASE THE COST OF OUR DEBT. Our working capital line of credit bears interest at either the bank's prime rate or LIBOR, at our option, both of which are variable rates. As such, if interest rates increase, we will have to use more cash to service our debt, which could impede our ability to meet other expenses as they become due and could cause material harm to our business and financial condition. Page 22 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereto duly authorized, in the City of Irvine, State of California, on the 29th day of November, 2001. INTERPLAY ENTERTAINMENT CORP. By: /S/ HERVE CAEN ---------------------------- Herve Caen, President POWER OF ATTORNEY The undersigned directors and officers of Interplay Entertainment Corp. do hereby constitute and appoint Herve Caen and Nathan Peck, or either of them, with full power of substitution and resubstitution, as their true and lawful attorneys and agents, to do any and all acts and things in our name and behalf in our capacities as directors and officers and to execute any and all instruments for us and in our names in the capacities indicated below, which said attorney and agent, may deem necessary or advisable to enable said corporation to comply with the Securities Exchange Act of 1934, as amended and any rules, regulations and requirements of the Securities and Exchange Commission, in connection with this Amendment No. 3 to Annual Report on Form 10-K/A, including specifically but without limitation, power and authority to sign for us or any of us in our names in the capacities indicated below, any and all amendments (including post-effective amendments) hereto, and we do hereby ratify and confirm all that said attorneys and agents, or either of them, shall do or cause to be done by virtue hereof. Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, this Amendment No. 3 to Annual Report on Form 10-K/A has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
SIGNATURE TITLE DATE ----------------------------- ----------------------------------- ----------------- /S/ HERVE CAEN ----------------------------- President and Director November 29, 2001 Herve Caen (Principal Executive Officer) /S/ JEFFREY GONZALEZ ----------------------------- Chief Financial Officer November 29, 2001 Jeffrey Gonzalez (Principal Financial Officer and Principal Accounting Officer) ----------------------------- Director November 29, 2001 Eric Caen /S/ NATHAN PECK ----------------------------- Director November 29, 2001 Nathan Peck ----------------------------- Director November 29, 2001 Michel Henri Vulpillat /S/ MICHEL WELTER ----------------------------- Director November 29, 2001 Michel Welter ----------------------------- Director November 29, 2001 Brian Fargo /S/ MAREN STENSETH ----------------------------- Director November 29, 2001 Maren Stenseth
Page 23 INDEX TO CONSOLIDATED FINANCIAL STATEMENTS INTERPLAY ENTERTAINMENT CORP. AND SUBSIDIARIES CONSOLIDATED FINANCIAL STATEMENTS AND REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS PAGE ---- Report of Independent Public Accountants F-2 Consolidated Financial Statements Consolidated Balance Sheets at December 31, 2000 and 1999 F-3 Consolidated Statements of Operations for the years ended December 31, 2000, 1999 and 1998 F-4 Consolidated Statements of Stockholders' Equity (Deficit) for the years ended December 31, 2000, 1999 and 1998 F-5 Consolidated Statements of Cash Flows for the years ended December 31, 2000, 1999 and 1998 F-6 Notes to Consolidated Financial Statements F-7 Schedule II - Valuation and Qualifying Accounts S-1 Page F-1 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To Interplay Entertainment Corp.: We have audited the accompanying consolidated balance sheets of Interplay Entertainment Corp. (a Delaware corporation) and subsidiaries as of December 31, 2000 and 1999, and the related consolidated statements of operations, stockholders' equity (deficit) and cash flows for each of the three years in the period ended December 31, 2000. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Interplay Entertainment Corp. and subsidiaries as of December 31, 2000 and 1999, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2000, in conformity with accounting principles generally accepted in the United States. As discussed further in Note 15, subsequent to April 16, 2001, the date of our original report, the Company incurred losses of $20.8 million during the six months ended June 30, 2001, and as of that date, based on unaudited financial statements, the Company's current liabilities exceeded its current assets by $9.2 million and the Company has experienced, and expects to continue to experience, negative operating cash flows which will require the need for additional financing. Additionally, the Company is in violation of its debt covenants. These factors, among others, as described in Note 15, create a substantial doubt about the Company's ability to continue as a going concern and an uncertainty as to the recoverability and classification of recorded asset amounts and the amounts and classification of liabilities. The accompanying financial statements do not include any adjustments relating to the recoverability and classification of asset carrying amounts or the amount and classification of liabilities that might result should the Company be unable to continue as a going concern. Our audits were made for the purpose of forming an opinion on the accompanying financial statements taken as a whole. The supplemental Schedule II as shown on page S-1 is the responsibility of the Company's management and is presented for purposes of complying with the Securities and Exchange Commission's rules and is not part of the basic consolidated financial statements. This schedule has been subjected to the auditing procedures applied in the audits of the basic consolidated financial statements and, in our opinion, fairly states in all material respects the financial data required to be set forth therein in relation to the basic consolidated financial statements taken as a whole. /s/ Arthur Andersen LLP ARTHUR ANDERSEN LLP Orange County, California April 16, 2001, except for the matters discussed in Note 15 as to which the date is August 23, 2001 Page F-2
INTERPLAY ENTERTAINMENT CORP. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (Dollars in thousands) December 31, -------------------------- ASSETS 2000 1999 ---------- ---------- Current Assets: Cash $ 2,835 $ 399 Restricted Cash - 2,597 Trade receivables, net of allowances of $6,543 and $9,161, respectively 28,136 22,209 Inventories 3,359 6,057 Prepaid licenses and royalties 17,704 19,249 Other 772 874 ---------- --------- Total current assets 52,806 51,385 Property and Equipment, net 5,331 4,225 Other Assets 944 1,326 ---------- --------- $ 59,081 $ 56,936 LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT) Current Liabilities: Current debt $ 25,433 $ 19,630 Accounts payable 12,270 21,462 Accrued liabilities 14,980 17,915 ---------- --------- Total current liabilities 52,683 59,007 ---------- --------- Commitments and Contingencies (see Note 7) Stockholders' Equity (Deficit): Series A Preferred Stock, $.001 par value, authorized 5,000,000 shares; issued and outstanding 719,424 and zero shares, respectively 20,604 - Common Stock, $.001 par value, authorized 100,000,000 and 50,000,000 shares, respectively; issued and outstanding 30,143,636 and 29,989,125 shares, respectively 30 30 Paid-in capital 88,759 87,390 Accumulated deficit (103,259) (89,782) Accumulated other comprehensive income 264 291 ---------- --------- Total stockholders' equity (deficit) 6,398 (2,071) ---------- --------- $ 59,081 $ 56,936 ========== =========
The accompanying notes are an integral part of these consolidated financial statements. Page F-3
INTERPLAY ENTERTAINMENT CORP. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) YEARS ENDED DECEMBER 31, ------------------------------------------- 2000 1999 1998 ----------- ----------- ----------- Net revenues $ 104,582 $ 101,930 $ 126,862 Cost of goods sold 54,061 61,103 71,928 ----------- ----------- ----------- Gross profit 50,521 40,827 54,934 ----------- ----------- ----------- Operating expenses: Marketing and sales 26,482 32,432 39,471 General and administrative 10,249 18,155 12,841 Product development 22,176 20,629 24,472 Other - 2,415 - ----------- ----------- ----------- Total operating expenses 58,907 73,631 76,784 ----------- ----------- ----------- Operating loss (8,386) (32,804) (21,850) ----------- ----------- ----------- Other income (expense): Interest expense (2,992) (3,640) (4,620) Other (697) 169 (313) ----------- ----------- ----------- Total other income (expense) (3,689) (3,471) (4,933) ----------- ----------- ----------- Loss before provision for income taxes (12,075) (36,275) (26,783) Provision for income taxes - 5,410 1,437 ----------- ----------- ----------- Net loss $ (12,075) $ (41,685) $ (28,220) =========== =========== =========== Cumulative dividend on participating preferred stock $ 870 $ - $ - Accretion of warrant 532 - - ----------- ----------- ----------- Net loss available to common stockholders $ (13,477) $ (41,685) $ (28,220) =========== =========== =========== Net loss per share: Basic/diluted $ (0.45) $ (1.86) $ (1.91) =========== =========== =========== Weighted average number of common shares outstanding: Basic/diluted 30,046,701 22,418,463 14,762,644 =========== =========== ===========
The accompanying notes are an integral part of these consolidated financial statements. Page F-4
INTERPLAY ENTERTAINMENT CORP. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT) (DOLLARS IN THOUSANDS) ACCUMU- LATED OTHER COMPRE- COMPRE- PREFERRED STOCK COMMON STOCK ACCUMU- HENSIVE HENSIVE ---------------- ------------------ PAID-IN LATED INCOME INCOME SHARES AMOUNT SHARES AMOUNT CAPITAL DEFICIT (LOSS) (LOSS) TOTAL ------- ------- ---------- ------ -------- ---------- -------- --------- --------- Balance, December 31, 1997 - $ - 10,951,828 $ 11 $ 18,408 $ (19,877) $ 191 - $ (1,267) Issuance of common stock, net of issuance costs - - 5,056,102 5 24,390 - - - 24,395 Issuance of warrants - - - - 316 - - - 316 Exercise of warrants - - 2,272,417 2 8,599 - - - 8,601 Exercise of stock options - - 12,084 - 15 - - - 15 Proceeds from warrants - Compensation for stock options granted - - - - 190 - - - 190 Net loss - - - - - (28,220) - - (28,220) Other comprehensive income, net of income taxes: $(28,220) Foreign currency translation adjustment - - - - - - - 163 --------- Other comprehensive income - - - - - - 163 163 163 --------- Comprehensive loss - - - - - - - $(28,057) ------- ------- ---------- ------ -------- ---------- -------- ========= --------- Balance, December 31, 1998 - - 18,292,431 18 51,918 (48,097) 354 4,193 Issuance of common stock - - 11,408,736 12 34,838 - - 34,850 Exercise of stock options - - 287,958 - 608 - - 608 Compensation for stock options granted - - - - 26 - - 26 Net loss - - - - - (41,685) - $(41,685) (41,685) Other comprehensive income, net of income taxes: Foreign currency translation adjustment - - - - - - - (63) --------- Other comprehensive income - - - - - - (63) (63) (63) --------- Comprehensive loss - - - - - - - $(41,748) ------- ------- ---------- ------ -------- ---------- -------- ========= ---------- Balance, December 31, 1999 - - 29,989,125 30 87,390 (89,782) 291 - (2,071) Issuance of common stock, net of issuance costs - - 40,661 - 439 - - - 439 Issuance of Series A preferred stock 719,424 19,202 - - - - - - 19,202 Issuance of warrants - - - - 798 - - - 798 Exercise of stock options - - 113,850 - 42 - - - 42 Accretion of warrant - 532 - - - (532) - - - Accumulated accrued dividend on Series A Preferred Stock - 870 - - - (870) - - - Compensation for stock options granted - - - - 90 - - 90 Net loss - - - - - (12,075) - $(12,075) (12,075) Other comprehensive income, net of income taxes: Foreign currency translation adjustment - - - - - - - (27) --------- Other comprehensive income - - - - - - (27) (27) (27) --------- Comprehensive loss - - - - - - - $(12,102) ------- ------- ---------- ------ -------- ---------- -------- ========= ---------- Balance, December 31, 2000 719,424 $20,604 30,143,636 $ 30 $ 88,759 $(103,259) $ 264 $ 6,398 ======= ======= ========== ====== ======== ========== ======== ==========
The accompanying notes are an integral part of these consolidated financial statements. Page F-5
INTERPLAY ENTERTAINMENT CORP. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OF CASH FLOWS (DOLLARS IN THOUSANDS) Years Ended December 31, 2000 1999 1998 ----------- ---------- ---------- Cash flows from operating activities: Net loss $ (12,075) $ (41,685) $ (28,220) Adjustments to reconcile net loss to net cash used in operating activities-- Depreciation and amortization 2,512 3,023 3,415 Noncash expense for stock options 90 26 190 Noncash interest expense - 300 68 Write-off of other assets - 82 - Loss on asset valuation, restructuring - 410 - Deferred income taxes - 5,336 2,022 Minority interest in loss of subsidiary - (143) (117) Changes in assets and liabilities: Trade receivables, net (5,927) 14,198 693 Inventories 2,698 246 35 Income taxes receivable - - 1,427 Prepaid licenses and royalties 1,545 (1,121) (5,501) Other current assets 102 (489) 1,657 Other assets - - (3) Accounts payable (9,192) (1,941) 6,282 Accrued liabilities (2,935) (4,653) (166) Income taxes payable - 14 (607) ----------- ---------- ---------- Net cash used in operating activities (23,182) (26,397) (18,825) ----------- ---------- ---------- Cash flows used in investing activities: Purchase of property and equipment (3,236) (1,595) (1,684) ----------- ---------- ---------- Net cash used in investing activities (3,236) (1,595) (1,684) ----------- ---------- ---------- Cash flows from financing activities: Net borrowings (payments) on line of credit 6,215 (5,257) 1,229 Payments of subordinated secured promissory notes and warrants - - (6,054) Repayments on notes payable (412) - (76) Net proceeds from issuance of common stock 439 35,450 24,310 Net proceeds from issuance of Series A Preferred Stock and warrant 20,000 - - Proceeds from exercise of stock options 42 8 15 Reductions (additions) to restricted cash 2,597 (2,597) - Other financing activities - 236 - ----------- ---------- ---------- Net cash provided by financing activities 28,881 27,840 19,424 ----------- ---------- ---------- Effect of exchange rate changes on cash (27) (63) 163 ----------- ---------- ---------- Net increase (decrease) in cash 2,436 (215) (922) Cash, beginning of year 399 614 1,536 ----------- ---------- ---------- Cash, end of year $ 2,835 $ 399 $ 614 =========== ========== ========== Supplemental cash flow information: Cash paid during the year for interest $ 3,027 $ 3,608 $ 4,671 =========== ========== ========== Suplemental disclosure of non-cash financing activity: Common Stock issued under Multi-Product Agreement $ - $ 1,000 $ - =========== ========== ==========
The accompanying notes are an integral part of these consolidated financial statements. Page F-6 INTERPLAY ENTERTAINMENT CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) 1. LINE OF BUSINESS; RISK FACTORS Interplay Entertainment Corp., a Delaware corporation, and its subsidiaries (the "Company"), develop, publish, and distribute interactive entertainment software; and distribute selected software to computer and peripheral device manufacturers for use in bundling arrangements. The Company's software is developed for use on various interactive entertainment software platforms, including personal computers and next generation video game consoles, such as the Sony PlayStation 2, Microsoft Xbox and Nintendo GameCube. The Company incurred a net loss of $12.1 million and used cash in operating activities of $23.2 million for the year ended December 31, 2000. During 2000, the Company's working capital improved to a positive $123,000 at year end compared to a negative $7.6 million at the end of 1999. In April 2001, the Company obtained a new three year working capital line of credit with a bank and completed the sale of $12.7 million of Common Stock in a private placement transaction (see Notes 5, 8 and 14). The Company believes that funds available under its new line of credit, funds received from the sale of equity securities and anticipated funds from operations including licensing and distribution transactions, if any, will be sufficient to satisfy the Company's projected working capital and capital expenditure needs in the normal course of business at least through the end of 2001 (See Notes 5, 14 and 15). However, there can be no assurance that the Company will have or be able to raise sufficient funds to satisfy its projected working capital and capital expenditure needs beyond 2001. In addition to the continuing risks related to the Company's future liquidity, the Company also faces numerous other risks associated with its industry. These risks include dependence on new platform introductions by hardware manufactures, new product introductions by the Company, product delays, rapidly changing technology, intense competition, dependence on distribution channels and risk of customer returns. The Company's consolidated financial statements have been presented on the basis that the Company is a going concern. Accordingly, the consolidated financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts or the amounts and classification of liabilities or any other adjustments that might result should the Company be unable to continue as a going concern. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES CONSOLIDATION The accompanying consolidated financial statements include the accounts of Interplay Entertainment Corp. and its wholly-owned subsidiaries, Interplay Productions Limited (U.K.), Interplay OEM, Inc., Interplay Productions Pty Ltd (Australia), Interplay Co., Ltd., (Japan) and its 91 percent-owned subsidiary Shiny Entertainment, Inc. All significant intercompany accounts and transactions have been eliminated. REINCORPORATION On March 2, 1998, the Board of Directors of Interplay Productions approved a reincorporation plan. Under the reincorporation plan Interplay Productions formed a new entity in Delaware into which Interplay Productions was merged on May 29, 1998. The new entity was named Interplay Entertainment Corp. USE OF ESTIMATES The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Page F-7 RECLASSIFICATIONS Certain reclassifications have been made to the prior period's financial statements to conform to classifications used in the current period. For the 1999 period, the Company has reclassified $2.9 million of nonrecurring costs previously recorded as Other Expense on the Statement of Operations as Marketing and Sales Expense. These costs are associated with the 1999 Virgin Distribution agreement for certain minimum operating charges payable to Virgin of $2.9 million (see Note 11). RESTRICTED CASH Restricted cash as of December 31, 1999, represents cash collateral deposits made in accordance with the Company's amended Loan and Security Agreement (see Note 5). The restricted cash was released during 2000. INVENTORIES Inventories consist of CD-ROMs or DVDs, manuals, packaging materials and supplies, and packaged software finished goods ready for shipment, including video game console software. Inventories are valued at the lower of cost (first-in, first-out) or market. PREPAID LICENSES AND ROYALTIES Prepaid licenses and royalties consist of payments for intellectual property rights and advanced royalty payments to outside developers. In addition, such costs include certain other outside production costs generally consisting of film cost and amounts paid for digitized motion data with alternative future uses. Payments to developers represent contractual advanced payments made for future royalties. These payments are contingent upon the successful completion of milestones, which generally represent specific deliverables. Royalty advances are recoupable against future sales based upon the contractual royalty rate. The Company amortizes the cost of licenses, prepaid royalties and other outside production costs to cost of goods sold over six months commencing with the initial shipment in each region of the related title. The Company amortizes these amounts at a rate based upon the actual number of units shipped with a minimum amortization of 75 percent in the first month of release and a minimum of 5 percent for each of the next five months after release. This minimum amortization rate reflects the Company's typical product life cycle. Management evaluates the future realization of such costs quarterly and charges to cost of goods sold any amounts that management deems unlikely to be fully realized through future sales. Such costs are classified as current and noncurrent assets based upon estimated product release date. PROPERTY AND EQUIPMENT Property and equipment are stated at cost. Depreciation of computers, equipment and furniture and fixtures is provided using the straight-line method over a five year period. Leasehold improvements are amortized on a straight-line basis over the lesser of the estimated useful life or the remaining lease term. OTHER NON-CURRENT ASSETS Other non-current assets consist primarily of goodwill which the Company is amortizing on a straight-line basis over seven years (see Note 3). Accumulated amortization as of December 31, 2000 and 1999 was $2.1 million and $1.7 million, respectively. LONG-LIVED ASSETS As prescribed by Statement of Financial Accounting Standards ("SFAS") No. 121, "Accounting for the Impairment of Long-lived Assets and for Long-lived Assets to be Disposed of", the Company assesses the recoverability of its long-lived assets (including goodwill) by determining whether the asset balance can be recovered over the remaining depreciation or amortization period through projected undiscounted future cash flows. Cash flow projections, although subject to a degree of uncertainty, are based on trends of historical performance and management's estimate of future performance, giving consideration to existing and anticipated competitive and economic conditions. Page F-8 FAIR VALUE OF FINANCIAL INSTRUMENTS The carrying value of cash, accounts receivable, accounts payable and notes payable approximates the fair value. In addition, the carrying value of all borrowings approximates fair value based on interest rates currently available to the Company. REVENUE RECOGNITION Revenues are recorded when products are delivered to customers in accordance with Statement of Position ("SOP") 97-2, "Software Revenue Recognition". For those agreements that provide the customers the right to multiple copies in exchange for guaranteed amounts, revenue is recognized at the delivery of the product master or the first copy. Per copy royalties on sales that exceed the guarantee are recognized as earned. Guaranteed minimum royalties on sales that do not meet the guarantee are recognized as the minimum payments come due. The Company is generally not contractually obligated to accept returns, except for defective, shelf-worn and damaged products in accordance with negotiated terms. However, the Company permits customers to return or exchange product and may provide markdown allowances on products unsold by a customer. In accordance with SFAS No. 48, "Revenue Recognition when Right of Return Exists", revenue is recorded net of an allowance for estimated returns, exchanges, markdowns, price concessions and warranty costs. Such reserves are based upon management's evaluation of historical experience, current industry trends and estimated costs. The amount of reserves ultimately required could differ materially in the near term from the amounts included in the accompanying consolidated financial statements. Customer support provided by the Company is limited to telephone and Internet support. These costs are not material and are charged to expenses as incurred. PRODUCT DEVELOPMENT Product development expenses are charged to operations in the period incurred and consist primarily of payroll and payroll related costs. ADVERTISING COSTS The Company generally expenses advertising costs as incurred, except for production costs associated with media campaigns which are deferred and charged to expense at the first run of the ad. Cooperative advertising with distributors and retailers is accrued when revenue is recognized. Cooperative advertising credits are reimbursed when qualifying claims are submitted. INCOME TAXES The Company accounts for income taxes using the liability method as prescribed by the SFAS No. 109, "Accounting for Income Taxes." The statement requires an asset and liability approach for financial accounting and reporting of income taxes. Deferred income taxes are provided for temporary differences in the recognition of certain income and expense items for financial reporting and tax purposes given the provisions of the enacted tax laws. FOREIGN CURRENCY The Company follows the principles of SFAS No. 52, "Foreign Currency Translation," using the local currency of its operating subsidiaries as the functional currency. Accordingly, all assets and liabilities outside the United States are translated into U.S. dollars at the rate of exchange in effect at the balance sheet date. Income and expense items are translated at the weighted average exchange rate prevailing during the period. Gains or losses arising from the translation of the foreign subsidiaries' financial statements are included in the accompanying consolidated financial statements as other comprehensive income (loss). Losses resulting from foreign currency transactions amounted to $935,000, $125,000 and $288,000 during the years ended December 31, 2000, 1999 and 1998, respectively, and are included in other income (expense) in the consolidated statements of operations. Page F-9 NET LOSS PER SHARE The Company accounts for net loss per share in accordance with SFAS No. 128 "Earnings Per Share." Basic net loss per share is computed by dividing loss attributable to common stockholders by the weighted average number of common shares outstanding. Diluted net loss per share is computed by dividing loss attributable to common stockholders by the weighted average number of common shares outstanding plus the effect of any dilutive stock options and common stock warrants. For years ended December 31, 2000, 1999 and 1998, all options and warrants to purchase common stock were excluded from the diluted loss per share calculation, as the effect of such inclusion would be antidilutive. COMPREHENSIVE INCOME (LOSS) Comprehensive income (loss) of the Company includes net income (loss) adjusted for the change in foreign currency translation adjustments. The net effect of income taxes on comprehensive income (loss) is immaterial. STOCK-BASED COMPENSATION The Company accounts for employee stock options in accordance with the Accounting Principles Board Opinion No. 25 "Accounting for Stock Issued to Employees" and makes the necessary pro forma disclosures mandated by SFAS No. 123 "Accounting for Stock-based Compensation" (see Note 10). RECENT ACCOUNTING PRONOUNCEMENTS In June 1998, the Financial Accounting Standards Board ("FASB") issued SFAS No. 133 "Accounting for Derivative Instruments and Hedging Activities", which is effective for fiscal years beginning after June 15, 2000 as amended by SFAS No. 137 and SFAS No. 138. SFAS No. 133 establishes accounting and reporting standards for derivative instruments. The statement requires that every derivative instrument be recorded in the balance sheet as either an asset or liability measured at its fair value, and that changes in the derivative's fair value be recognized currently in the earnings unless specific hedge accounting criteria are met. The adoption of this standard did not have a material impact on the Company's results of operations. In December 1999, the Securities and Exchange Commission ("SEC") staff released Staff Accounting Bulletin ("SAB") No. 101, "Revenue Recognition," as amended by SAB No. 101A and SAB No. 101B, to provide guidance on the recognition, presentation and disclosure of revenue in financial statements. SAB No. 101 explains the SEC staff's general framework for revenue recognition, stating that certain criteria be met in order to recognize revenue. SAB No. 101 also addresses the question of gross versus net revenue presentation and financial statement and Management's Discussion and Analysis disclosures related to revenue recognition. The Company adopted SAB No. 101 effective January 1, 2000 and the adoption of this standard reduced net sales and cost of sales by approximately $1.7 million for the year ended December 31, 2000, but did not have an impact on the Company's gross profit or net loss. The Company did not apply this standard to the 1999 period as the impact would have been immaterial to the financial statements taken as a whole. In March 2000, the Financial Accounting Standards Board issued Interpretation No. 44, ("FIN 44"), Accounting for Certain Transactions Involving Stock Compensation - an Interpretation of APB 25. This Interpretation clarifies (a) the definition of employee for purposes of applying Opinion 25, (b) the criteria for determining whether a plan qualifies as a non-compensatory plan, (c) the accounting consequence of various modifications to the terms of a previously fixed stock option or award, and (d) the accounting for an exchange of stock compensation awards in a business combination. FIN 44 became effective July 1, 2000, but certain conclusions in FIN 44 cover specific events that occur after either December 15, 1998, or January 12, 2000. The adoption of FIN 44 did not have a material effect on the Company's financial position or results of operations. 3. ACQUISITION In 1995, the Company acquired a 91 percent interest in Shiny Entertainment, Inc. ("Shiny") for $3.6 million in cash and stock. The acquisition was accounted for using the purchase method. The allocation of purchase price included $3 million of goodwill. The purchase agreement requires the Company to pay the former owner of Shiny Page F-10 additional cash payments of up to $5.6 million upon the delivery and acceptance of five future Shiny interactive entertainment software titles, as defined. As of December 31, 2000, the Company had not been required to make any additional payments in accordance with the purchase agreement (see Note 7). In March 2001, the Company acquired the remaining nine percent equity interest in Shiny for $600,000 (see Note 14). 4. DETAIL OF SELECTED BALANCE SHEET ACCOUNTS INVENTORIES Inventories are stated at the lower of cost or market. Inventories consist of the following:
DECEMBER 31, ---------------------- 2000 1999 --------- --------- (DOLLARS IN THOUSANDS) Packaged software finished goods $ 2,628 $ 4,394 CD-ROMs, DVDs, manuals, packaging and supplies 731 1,663 --------- --------- $ 3,359 $ 6,057 ========= =========
OTHER CURRENT ASSETS Other current assets consist of the following:
DECEMBER 31, ---------------------- 2000 1999 --------- --------- (DOLLARS IN THOUSANDS) Prepaid expenses $ 689 $ 764 Deposits 83 110 --------- --------- $ 772 $ 874 ========= =========
PROPERTY AND EQUIPMENT Property and equipment consists of the following:
DECEMBER 31, ------------------------ 2000 1999 ---------- --------- (DOLLARS IN THOUSANDS) Computers and equipment $ 10,175 $ 14,651 Furniture and fixtures 123 849 Leasehold improvements 1,380 1,348 ---------- --------- 11,678 16,848 Less: Accumulated depreciation and amortization (6,347) (12,623) ---------- --------- $ 5,331 $ 4,225 ========== =========
For the years ended December 31, 2000, 1999 and 1998, the Company incurred depreciation expense of $2.1 million, $2.6 million and $3 million, respectively. During the year ended December 31, 2000, the Company disposed of fully depreciated equipment having an original cost of $8.3 million. Page F-11 ACCRUED LIABILITIES Accrued liabilities consist of the following:
DECEMBER 31, ---------------------- 2000 1999 --------- --------- (DOLLARS IN THOUSANDS) Royalties payable $ 7,258 $ 7,950 Accrued payroll 1,441 2,337 Payable to distributor 3,115 2,908 Accrued bundle and affiliate 547 1,563 Deferred revenue 1,708 2,039 Other 911 1,118 --------- --------- $ 14,980 $ 17,915 ========= =========
5. CURRENT DEBT Current debt consists of the following:
DECEMBER 31, ---------------------- 2000 1999 --------- --------- (DOLLARS IN THOUSANDS) Loan Agreement $ 24,433 $ 19,218 Supplemental line of credit from Titus 1,000 - Other - 412 --------- --------- $ 25,433 $ 19,630 ========= =========
LOAN AGREEMENT Borrowings under the Loan and Security Agreement ("Loan Agreement") bear interest at LIBOR (6.78 percent at December 31, 2000 and 6.48 percent at December 31, 1999) plus 4.87 percent (11.65 percent at December 31, 2000 and 11.35 percent at December 31, 1999). In April 2000, the Company amended its line of credit under the Loan Agreement with a financial institution to extend its current line of credit through April 2001. Under the terms of the Amendment the maximum credit line is $25 million. Within the total credit limit, the Company may borrow up to $7 million in excess of its borrowing base, which is based on qualifying receivables and inventory. At December 31, 2000, the Company had availability of $600,000 on its line of credit. In addition, the Company is required to maintain the $5 million personal guarantee by the Company's Chairman and Chief Executive Officer ("Chairman") and Titus is required to provide a $20 million corporate guarantee. The Company is currently in compliance with the terms of the Loan Agreement. In April 2001, the Company replaced its line of credit under a loan and security agreement with a new bank (see Note 14). SUPPLEMENTAL LINE OF CREDIT FROM TITUS In April 2000, the Company secured a $5 million supplemental line of credit with Titus expiring in May 2001. Amounts borrowed under this line are subject to interest at the maximum legal rate for parties other than financial institutions, currently 10 percent per annum, payable quarterly. In connection with this line of credit, Titus received a warrant for up to 100,000 shares of the Company's Common Stock at $3.79 per share that will expire in April 2010 and is exercisable if and to the extent that the Company borrows under the line of credit, as defined. At December 31, 2000, the Company had availability of $4 million on its supplemental line of credit. Subsequent to December 31, 2000, the Company borrowed an additional $2 million under the supplemental line, and during April 2001, the total outstanding balance plus accrued interest in the aggregate amount of approximately $3.1 million was paid in full. Page F-12 6. INCOME TAXES Loss before provision (benefit) for income taxes consists of the following:
YEARS ENDED DECEMBER 31, -------------------------------------------- 2000 1999 1998 ----------- ------------ ------------ (DOLLARS IN THOUSANDS) Domestic $ (10,801) $ (32,294) $ (25,038) Foreign (1,274) (3,981) (1,745) ----------- ------------ ------------ Total $ (12,075) $ (36,275) $ (26,783) =========== ============ ============
The provision (benefit) for income taxes is comprised of the following:
YEARS ENDED DECEMBER 31, ------------------------------------ 2000 1999 1998 -------- --------- --------- (DOLLARS IN THOUSANDS) Current: Federal $ - $ - $ - State - 8 8 Foreign - 66 (571) ------- -------- -------- - 74 (563) Deferred: Federal - 4,536 2,000 State - 800 - ------- -------- -------- - 5,336 2,000 ------- -------- -------- $ - $ 5,410 $ 1,437 ======= ======== ========
The Company files a consolidated U.S. Federal income tax return which includes substantially all of its domestic operations. The Company files separate tax returns for each of its foreign subsidiaries in the countries in which they reside. The Company's available net operating loss ("NOL") carryforward for Federal tax reporting purposes approximates $107.8 million and may be subject to certain limitations as defined under Section 382 of the Internal Revenue Code. The Federal NOL carryforwards expire through the year 2020. The Company's NOL's for State tax reporting purposes approximate $50.2 million and expire through the year 2005. A reconciliation of the statutory Federal income tax rate and the effective tax rate as a percentage of pretax loss is as follows:
YEARS ENDED DECEMBER 31, ------------------------------------------ 2000 1999 1998 ----------- ----------- ------------ Statutory income tax rate State and local income taxes, net of (34.0)% (34.0)% (34.0)% Federal income tax benefit (3.0) (3.0) (3.0) Valuation allowance 37.0 51.9 39.8 Other - - 2.6 ----------- ----------- ------------ - % 14.9 % 5.4 % =========== =========== ============
Page F-13 The components of the Company's net deferred income tax asset (liability) are as follows:
DECEMBER 31, ------------------------ 2000 1999 ----------- ---------- (DOLLARS IN THOUSANDS) Current deferred tax asset (liability): Prepaid royalties $ (7,081) $ (7,652) Nondeductible reserves 3,135 4,184 Accrued expenses 763 1,007 Foreign loss and credit carryforward 965 454 Federal and state net operating losses 39,672 35,952 Research and development credit carryforward 831 831 Other 294 314 ----------- ---------- $ 38,579 $ 35,090 =========== ========== Non-current deferred tax asset (liability): Depreciation expense $ 50 $ (126) Nondeductible reserves 389 318 Other (6) (5) ----------- ---------- $ 433 $ 187 =========== ========== Total deferred tax asset before valuation allowance $ 39,012 $ 35,277 Valuation allowance (39,012) (35,277) ----------- ---------- Net deferred tax asset $ - $ - =========== ==========
The valuation allowance relates primarily to net operating loss and tax credit carryforwards. Due to the uncertainty surrounding the realization of the favorable tax attributes in the short term, the Company recorded a valuation allowance against its net deferred tax assets at this time. 7. COMMITMENTS AND CONTINGENCIES LEASES The Company has various leases for the office space it occupies including its corporate offices in Irvine, California. The lease for corporate offices expires in June 2006 with one five-year option to extend the term of the lease. The Company has also entered into various office equipment operating leases. Future minimum lease payments under noncancelable operating leases are as follows: Year ending December 31 (Dollars in thousands): 2001 $ 1,864 2002 1,755 2003 1,758 2004 1,907 2005 1,789 Thereafter 3,648 ---------- $ 12,721 ========== Total rent expense was $2.8 million, $3.2 million and $2.4 million for the years ended December 31, 2000, 1999 and 1998, respectively. Page F-14 PENDING INTERNAL REVENUE SERVICE EXAMINATION The Internal Revenue Service ("the IRS") is currently examining the Company's consolidated federal income tax returns for the years ended April 30, 1992 through 1997 and December 31, 1997 and 1998. The IRS has challenged the timing of certain tax deductions taken by the Company, and has asserted that an additional tax liability is due. The Company disagrees with the IRS challenge, and is currently contesting such challenges. The potential losses to the Company as a result of these challenges are not reasonably estimable. Accordingly, no reserve has been established in the accompanying consolidated financial statements. Any losses which might be suffered by the Company as a result of this examination that could not be offset by the Company's NOL, could impact the Company's future cashflows and profitability. LITIGATION The Company is involved in various legal proceedings, claims and litigation arising in the ordinary course of business, including disputes arising over the ownership of intellectual property rights and collection matters. In the opinion of management, the outcome of known routine claims will not have a material adverse effect on the Company's business, financial condition or results of operations. The Company and the former owner of Shiny have a dispute over additional cash payments upon the delivery and acceptance of interactive entertainment software titles that Shiny was committed to deliver over time (see Note 3). The Company believes that no amounts are due under the applicable agreements. In March 2001, the Company settled this dispute with the former owner of Shiny which, among other things, amended the original purchase agreement of Shiny and modified the terms of additional cash payments for the delivery of future software titles (see Note 14). Virgin Interactive Entertainment Limited ("Virgin") has disputed an amendment effective as of January 2000 to the International Distribution Agreement with the Company, and claims that the Company is obligated, among other things, to pay a contribution to their overhead of up to approximately $9.3 million annually, subject to decrease by the amount of commissions earned by Virgin on its distribution of the Company's products. The Company settled this dispute with Virgin in April 2001 (see Note 14). EMPLOYMENT AGREEMENTS The Company has entered into employment agreements with certain key employees providing for, among other things, salary, bonuses and the right to participate in certain incentive compensation and other employee benefit plans established by the Company. Under these agreements, upon termination without cause or resignation for good reason, as defined, the employees may be entitled to certain severance benefits, as defined. These agreements expire between 2002 and 2004. NEW EUROPEAN CURRENCY On January 1, 1999, eleven of the fifteen member countries of the European Union ("Participating Countries") established fixed conversion rates between their existing sovereign currencies and a new European currency, the "euro". The euro was adopted by the Participating Countries as the common legal currency on that date. A significant portion of the Company's sales are made to Participating Countries and consequently, the Company anticipates that the euro conversion will, among other things, create technical challenges to adapt information technology and other systems to accommodate euro-denominated transactions and limit the Company's ability to charge different prices for its producers in different markets. While the Company believes that the conversion will not cause material disruption of its business, there can be no assurance that the conversion will not have a material effect on the Company's business or financial condition. Page F-15 8. STOCKHOLDERS' EQUITY PREFERRED STOCK AND COMMON STOCK In connection with the amendment of the Company's line of credit agreement in November 1998 (see Note 5), the Company issued its Chairman warrants to purchase 400,000 shares of the Company's Common Stock (the "Warrants") at an exercise price of $3.00 per share exercisable after May 20, 1999. The Warrants have a three year term and have no registration rights. The shares issuable upon exercise of the warrants are subject to the twelve month lockup agreement the employee entered into in connection with the Company's IPO. In connection with the issuance of the Warrants, the Company recorded an expense equal to the fair market value of the Warrants, which is approximately $316,000, with such expense being amortized as additional debt cost in 1999, which was the term of the guarantee. As consideration for the extension of a $5 million personal guarantee by the Company's Chairman under the Company's Loan Agreement (see Note 5), the Company agreed to assume the obligation of the Chairman under an agreement between the Chairman and the Company's former President, pursuant to which the Chairman granted certain put rights to the former President with respect to the 271,528 common stock options held by the former President. The Company recorded compensation expense of approximately $700,000 through December 31, 1998 related to these options and interest expense of $300,000 for the year ended 1999, in connection with the assumption of the put right. In May 1999, the Company issued 271,528 shares of Common Stock for the exercise of the former President's stock options in conjunction with an Agreement and General Release executed with the former President. The Company guaranteed the former President a value of $1 million for the stock through periodic sales or guarantee payments through January 2000. On the due dates of the payments, the Company has the option to either require that the former President sell shares on the open market or the Company may purchase the shares from the former president and retire them. Under the agreement, the Company did not repurchase any shares. In April 1999, the Company entered into a multi-product development agreement with a developer which provides for the delivery of ten titles to the Company during 1999 and 2000 in exchange for $0.5 million paid in cash installments and the issuance of 484,848 shares of the Company's Common Stock. The shares of Common Stock will be restricted as to transfer rights until such products are delivered and accepted by the Company. The arrangement also includes certain penalties to the developer in the event of noncompliance and the terms and conditions are subject to the approval by the Company's underwriters and lenders, if necessary. In 1999, the Company entered into an Agreement and Release with an employee and director of the Company. As a result of the Agreement and Release, the Company issued 56,208 shares of its Common Stock in consideration for payments of deferred compensation. During 1999, the Company completed two equity transactions with Titus which provided for the issuance of 10,795,455 shares of the Company's Common Stock for $35 million. In April 2000, the Company completed a $20 million transaction with Titus under a Stock Purchase Agreement and issued 719,424 shares of newly designated Series A Preferred Stock ("Preferred Stock") and a warrant for 350,000 shares of the Company's Common Stock, which has preferences under certain events, as defined. The Preferred Stock is convertible by Titus, redeemable by the Company, and accrues a 6 percent cumulative dividend per annum payable in cash or, at the option of Titus, in shares of the Company's Common Stock as declared by the Company's Board of Directors. The Company may redeem the Preferred Stock shares at the original issue price plus all accrued but unpaid dividends at any time after termination of Titus's guarantee of the Company's principal line of credit. Titus may convert the Preferred Stock shares into shares of Common Stock at any time after May 2001 or earlier under certain events as defined. The conversion rate is the lesser of $2.78 (7,194,240 shares of Common Stock) or 85 percent of the market price per share at the time of conversion, as defined. The Preferred Stock is entitled to the same voting rights as if it had been converted to Common Stock shares subject to a maximum of 7,619,047 votes. In October 2000, the Company's stockholders approved the issuance of the Preferred Stock to Titus. In connection with this transaction, Titus received a warrant for 350,000 shares of the Company's Common Stock exercisable at $3.79 per share at anytime. The fair value of the warrant was estimated on the date of the grant using the Black-Scholes pricing model with the following weighted average assumptions: dividend yield of zero percent; expected volatility of 92 percent; risk-free interest rate of 5.85 percent; and an expected life of one-year. This resulted in the Company allocating $19,202,000 to the Preferred Stock and $798,000 to the warrant which is included in paid in capital. The discount on the Preferred Stock is being accreted over a one-year period as a dividend to the Preferred Stock. As of December 31, Page F-16 2000, the Company had accreted $532,000. In addition, Titus received a warrant for 50,000 shares of the Company's Common Stock exercisable at $3.79 per share which became by Titus since the Company did not meet certain financial operating performance targets for the year ending December 31, 2000, as defined. Both warrants expire in April 2010. In April 2001, Titus' guarantee of the Company's principal line of credit was released and the Company may redeem the Preferred Stock at anytime thereafter (see Note 14). In connection with the $20 million corporate guarantee provided by Titus on the extension of the Company's line of credit (see Note 5), if the Company defaults on the line of credit agreement, and Titus is forced to pay on its corporate guarantee of such line, the Series A Preferred Stock conversion rights will be adjusted so as to make such shares convertible into and up to approximately 42.8 million shares of Common Stock. In the event that the Company is able to repay to Titus the amounts paid under the guarantee within six months, the conversion rate shall be returned to the level at which it existed prior to such adjustment. In the event that the Company is unable to repay such amounts within six months, the conversion rate shall be readjusted at the end of such six month period based on the average closing price of the Company's Common Stock for the last 20 trading days during such period. If such average price is $10.00 per share, the shares would be convertible into 7,194,240 shares of Common Stock, and if less than $10.00, the shares would be convertible into approximately an additional 5,000,000 shares for each dollar the average price is below $10.00, up to a maximum of approximately 42.8 million shares. The Common Stock shares issuable upon conversion of the Preferred Stock or the exercise of the warrants are subject to certain registration rights. In April 2001, Titus' guarantee of the Company's principal line of credit was released eliminating the potential for adjustment to the conversion rights into and up to approximately 42.8 million shares of Common Stock (see Note 14). In connection with this line of credit, Titus received a warrant to acquire up to 100,000 shares of the Company's Common Stock at $3.79 per share that will expire in April 2010 and is exercisable if and to the extent that the Company borrows under the line of credit, as defined (see Note 5). As of December 31, 2000, part of the warrant became exercisable for 20,000 shares of the Company's Common Stock. In August 2000, the Company issued a warrant to purchase up to 100,000 shares of the Company's Common Stock. The warrant vests at certain dates over a one year period and has exercise prices between $3.00 per share and $6.00 per share, as defined. The warrant expires in August 2003. During 2000, the Company's Board of Directors approved a resolution that increased the number of authorized shares of the Company's Common Stock from 50 million to 100 million. In March 2001, the Company completed a private placement of 8,126,770 shares of Common Stock for $12.7 million, and received net proceeds of approximately $11.5 million. The shares were issued at $1.5625 per share, and included warrants to purchase one share of Common Stock for each share sold. The warrants are exercisable at $1.75, and one half of the warrants can be exercised immediately with the other half exercisable after June 27, 2001, only if prior to this date, the Company's Common Stock trading price does not exceed $2.75 for a period of 20 consecutive trading days, as defined. The warrants also have a call provision by the Company if the Company's Common Stock trades at or above $3.00, as defined. If the Company issues additional shares of Common Stock at a per share price below the exercise price of the warrants, then the warrants are to be repriced, as defined, subject to stockholder approval. The warrants expire in March 2006. The transaction provides for registration rights with a registration statement to be filed by April 16, 2001 and become effective by May 31, 2001. In the event that the filing and effective dates of the registration statement are not met, the Company is subject to a two percent penalty per month, payable in cash or stock, until the filing and effective dates are met. (see Note 14). EMPLOYEE STOCK PURCHASE PLAN Under this plan, eligible employees may purchase shares of the Company's Common Stock at 85% of fair market value at specific, predetermined dates. During the year, the Board of Directors increased the number of shares authorized to 300,000. Of the 300,000 shares authorized to be issued under the plan, approximately 131,000 shares remained available for issuance at December 31, 2000. Employees purchased 40,661 and 72,225 shares in 2000 and 1999 for $89,000 and $127,000, respectively. Page F-17 9. LOSS PER SHARE Basic loss per share is calculated by dividing net loss available to common stockholders by the weighted average number of common shares outstanding and does not include the impact of any potentially dilutive securities. Diluted loss per share is the same as basic because the effect of outstanding stock options and warrants is anti-dillutive. There were options and warrants outstanding to purchase 4,449,967 and 3,740,780 shares of Common Stock at December 31, 2000 and 1999, respectively, and there were 484,848 shares of restricted Common Stock at December 31, 2000 and 1999, which were excluded from the loss per share computation. At December 31, 1998 there were options to purchase 2,132,738 shares of common stock, which were not included in the loss per share computation. The weighted average exercise price at December 31, 2000, 1999 and 1998 was $3.03, $3.30 and $4.73, respectively, for the options and warrants outstanding. 10. EMPLOYEE BENEFIT PLANS STOCK OPTION PLANS The Company has three stock option plans. Under the Incentive Stock Option, Nonqualified Stock Option and Restricted Stock Purchase Plan--1991 ("1991 Plan"), the Company was authorized to grant options to its employees to purchase up to 111,000 shares of common stock. Under the Incentive Stock Option and Nonqualified Stock Option Plan--1994 ("1994 Plan"), the Company was authorized to grant options to its employees to purchase up to 150,000 shares of common stock. Under the 1997 Stock Incentive Plan the Company may grant options to its employees, consultants and directors to purchase up to 4,000,000 shares of common stock. Options under all three plans generally vest from three to five years. Holders of options under the 1991 Plan and the 1994 Plan shall be deemed 100 percent vested in the event of a merger in which the Company is not the surviving entity, a sale of substantially all of the assets of the Company, or a sale of all shares of Common Stock of the Company. The Company has treated the difference, if any, between the exercise price and the estimated fair market value, as determined by the board of directors on the date of grant, as compensation expense for financial reporting purposes. Compensation expense for the vested portion aggregated $90,000, $26,000 and $190,000 for the years ended December 31, 2000, 1999 and 1998, respectively. The following is a summary of option activity pursuant to the Company's stock option plans:
YEARS ENDED DECEMBER 31, ------------------------------------------------------------------- 2000 1999 1998 --------------------- ---------------------- -------------------- WEIGHTED WEIGHTED WEIGHTED AVERAGE AVERAGE AVERAGE EXERCISE EXERCISE EXERCISE SHARES PRICE SHARES PRICE SHARES PRICE ---------- --------- ----------- -------- --------- -------- Options outstanding at beginning of period 3,340,780 $3.30 2,132,738 $4.73 1,838,972 $5.29 Granted 968,498 2.64 2,208,028 2.14 451,100 6.91 Exercised (123,711) 0.37 (287,958) 0.04 (12,084) 1.27 Canceled (655,600) 5.14 (712,028) 5.29 (139,750) 8.44 Rescinded - - - - (5,500) 8.00 ---------- --------- ----------- -------- ---------- ------- Options outstanding at end of period 3,529,967 $2.90 3,340,780 $3.30 2,132,738 $4.73 ========== ========= =========== ======== ========== ======= Options exercisable 1,496,007 1,209,734 1,448,143 ========== =========== ==========
Page F-18 The following outlines the significant assumptions used to calculate the fair value information presented utilizing the Black-Scholes Single Option approach with ratable amortization:
YEARS ENDED DECEMBER 31, ---------------------------------------- 2000 1999 1998 ------------ ------------ ------------ Risk free rate 6.2% 6.3% 5.1% Expected life 7.3 years 7.12 years 7.74 years Expected volatility 90% 90% 70% Expected dividends - - - Weighted-average grant-date fair value of options granted $ 2.14 $ 1.91 $ 2.95
A detail of the options outstanding and exercisable as of December 31, 2000 is as follows:
OPTIONS OUTSTANDING OPTIONS EXERCISABLE -------------------------------------------- ----------------------- WEIGHTED WEIGHTED WEIGHTED AVERAGE AVERAGE AVERAGE RANGE OF EXERCISE NUMBER REMAINING EXERCISE NUMBER EXERCISE PRICES OUTSTANDING CONTRACT LIFE PRICE OUTSTANDING PRICE ----------------- ----------- ------------- --------- ----------- --------- $ 0.15 - $ 0.47 572,874 1.24 $ 0.15 572,874 $ 0.15 $ 1.94 - $ 4.44 2,469,143 8.72 2.58 594,943 2.47 $ 4.50 - $ 6.66 96,500 6.99 5.18 53,100 5.38 $ 7.00 - $ 10.00 391,450 6.04 8.40 275,090 8.57 ----------- ------------- --------- ----------- --------- $ 0.15 - $ 10.00 3,529,967 7.16 $ 2.90 1,496,007 $ 2.81 =========== ============= ========= =========== =========
The following table shows pro forma net loss as if the fair value based accounting method prescribed by SFAS No. 123 had been used to account for stock based compensation cost:
YEARS ENDED DECEMBER 31, ------------------------------------------------ 2000 1999 1998 ----------- ---------- ---------- (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) Net loss available to common stockholders, as reported $ (13,477) $ (41,685) $ (28,220) Pro forma compensation expense (1,370) (1,242) (1,011) ----------- ---------- ---------- Pro forma net loss available to common stockholders $ (14,847) $ (42,927) $ (29,231) =========== ========== ========== Basic and diluted net loss as reported $ (0.45) $ (1.86) $ (1.91) Basic and diluted pro forma net loss $ (0.49) $ (1.91) $ (1.98) =========== ========== ==========
PROFIT SHARING 401(K) PLAN The Company sponsors a 401(k) plan ("the Plan") for most full-time employees. The Company matches 50 percent of the participant's contributions up to six percent of the participant's base compensation. The profit sharing contribution amount is at the sole discretion of the Company's board of directors. Participants vest at a rate of 20 percent per year after the first year of service for profit sharing contributions and 20 percent per year after the first two years of service for matching contributions. Participants become 100 percent vested upon death, permanent disability or termination of the Plan. Benefit expense for the years ended December 31, 2000, 1999 and 1998 was $267,000, $257,000 and $256,000, respectively. Page F-19 11. RELATED PARTIES The Company has amounts due from a business controlled by the Chairman of the Company. Net amounts due, prior to reserves, at December 31, 2000 and 1999 were $2.5 million. Such amounts at December 31, 2000 and 1999 are fully reserved. In connection with the amendment of the Company's line of credit agreement in November 1998 (see Note 5), the Company's Chairman provided a personal guarantee of $5 million secured by certain of the Chairman's personal assets. As consideration for making such guarantee, the Chairman received warrants to purchase 400,000 shares of the Company's Common Stock at an exercise price of $3.00 per share exercisable after May 1999 (see Note 8). The Company amended its line of credit in March 1999 and in conjunction with the amendment, the personal guarantee was extended. As consideration for extending the guarantee, the Company assumed an obligation to the Company's former President by the Chairman (see Note 8). The Company did not repurchase any shares from the former President under this obligation. In connection with the Company's new working capital line of credit obtained subsequent to year end and the retirement of the current debt existing under the Company's previous working capital line of credit arrangements (see Notes 5 and 15), the secured personal guarantee of $5 million previously provided by the Chairman was released, and a new personal guarantee for $2 million, secured by $1 million in cash, was provided to the new bank by the Chairman. In addition, the Chairman provided the Company with a $3 million loan, payable in May 2002, with interest at 10 percent. In connection with the new guarantee and loan, the Chairman received warrants to purchase 500,000 shares of the Company's Common Stock at $1.75 per share, expiring in April 2011. In connection with the International Distribution Agreement executed in February 1999, the Company subleases office space from Virgin. Rent expense paid to Virgin was $101,000 and $50,000 for the years ended December 31, 2000 and 1999. Restructuring of European Operations In 1999, the Company discontinued its direct and then existing affiliate distribution activities in Europe and appointed Virgin as its exclusive distributor in Europe. In connection with exiting its direct and then existing affiliated distribution activities, the Company restructured its operations by terminating employees, closing facilities, retiring redundant assets, and transitioning selected employees to the Virgin organization. In accordance with Emerging Issues Task Force ("EITF") Issue No. 94-3 "Liability Recognition for Certain Employee Termination Benefits and Other Costs Incurred in a Restructuring," the Company recorded a provision of $2.4 million as restructuring expenses and costs associated with the merger and integration of its European operations and the departure of two members of senior management. The Company recorded costs associated with closing facilities, related asset valuation issues, and costs associated with the write-down of redundant equipment in the aggregate amount of $1.6 million and severance and other employee related costs of $0.8 million. These amounts were recorded as a charge to operating expenses, classified as Other Operating Expense on the Statement of Operations. DISTRIBUTION AND PUBLISHING AGREEMENTS In February 1999, the Company entered into an International Distribution Agreement with Virgin which provides for the exclusive distribution of substantially all of the Company's products in Europe, CIS, Africa and the Middle East for a seven-year period, cancelable under certain conditions, subject to termination penalties and costs. Under the Agreement, the Company pays Virgin a monthly overhead fee, certain minimum operating charges, a distribution fee based on net sales, and Virgin provides certain market preparation, warehousing, sales and fulfillment services on behalf of the Company. The Company amended its International Distribution Agreement with Virgin effective January 1, 2000. Under the amended Agreement, the Company no longer pays Virgin an overhead fee or minimum commissions. In addition, the Company extended the term of the agreement through February 2007 and implemented an incentive plan that will allow Virgin to earn a higher commission rate, as defined. Virgin disputed the amendment to the International Distribution Agreement with the Company, and claimed that the Company was obligated, among other things, to pay a contribution to their overhead of up to approximately $9.3 million annually, subject to decrease by the amount of commissions earned by Virgin on its distribution of our products. The Company settled this dispute with Virgin in April 2001 (see Note 14). In connection with the International Distribution Agreement, the Company incurred distribution commission expense Page F-20 of $4.6 million and $3.4 million for the years ended December 31, 2000 and 1999, respectively. In addition, the Company recognized overhead fees of $3.9 million and certain minimum operating charges to Virgin of $2.9 million for the year ended December 31, 1999. The Company has also entered into a Product Publishing Agreement with Virgin which provides the Company with an exclusive license to publish and distribute substantially all of Virgin's products within North America, Latin America and South America for a royalty based on net sales. As part of terms of the April 2001 settlement between Virgin and the Company the Product Publishing Agreement was amended to provide for the Company to publish only one future title developed by Virgin (see Note 14). In connection with the Product Publishing Agreement with Virgin, the Company earned $63,000 and $41,000 for performing publishing and distribution services on behalf of Virgin for the years ended December 31, 2000 and 1999, respectively. As of December 31, 2000 and 1999, Virgin owed the Company $12.1 million and $9.1 million, and the Company owed Virgin $4.8 million and $7.8 million, respectively. The net amount outstanding as of December 31, 2000 was fully paid by Virgin in April 2001. In connection with the equity investments by Titus (see Note 8), the Company performs distribution services on behalf of Titus for a fee. In connection with such distribution services, the Company recognized fee income of $435,000 and $200,000 for the years ended December 31, 2000 and 1999, respectively. During the year ended December 31, 2000, the Company recognized $3 million in licensing revenue under a multi-product license agreement with Titus for the technology underlying one title and the content of three titles for multiple game platforms, extended for a maximum period of twelve years, with variable royalties payable to the Company from five to ten percent, as defined. The Company earned a $3 million non-refundable fully-recoupable advance against royalties upon signing and completing all of its obligations under the agreement. During the year ended December 31, 1999, the Company executed publishing agreements with Titus for three titles. As a result of these agreements, the Company recognized revenue of $2.6 million for delivery of these titles to Titus. In addition, during 2000 the Company borrowed $1 million from Titus under the supplemental line of credit (see Note 5). As of December 31, 2000 and 1999, Titus owed the Company $280,000 and zero and the Company owed Titus $1.1 million and $0.3 million, respectively. INVESTMENT IN AFFILIATE In connection with the International Distribution Agreement and Product Publishing Agreement, the Company has also entered into an Operating Agreement with Virgin Acquisition Holdings, LLC, which, among other terms and conditions, provides the Company with a 43.9 percent equity interest in VIE Acquisition Group LLC ("VIE"), the parent entity of Virgin. Under the Operating Agreement, the Company was obligated to make a cash payment of $9,000. However, the Company is not obligated to make any future contributions to the working capital of Virgin other than the monthly overhead fee discussed above. During 1999, Titus acquired a 50.1 percent equity interest in VIE and in 2000, Titus acquired the 6 percent originally owned by the two former members of the management of Interplay Productions Limited, the Company's United Kingdom subsidiary. The Company and Titus together held a 100 percent equity interest in VIE as of December 31, 2000. As part of the terms of the April 2001 settlement , VIE redeemed the Company's membership interest in VIE (see Note 14). The Company accounted for its investment in VIE in accordance with the equity method of accounting. The Company did not recognize any material income or loss in connection with its investment in VIE for the years ended December 31, 2000 and 1999. The Company recognizes sales to Virgin, net of sales commissions, only after Virgin recognizes sales of the Company's products to unaffiliated third parties. 12. CONCENTRATION OF CREDIT RISK The Company extends credit to various companies in the retail and mass merchandising industry. Collection of trade receivables may be affected by changes in economic or other industry conditions and could impact the Company's overall credit risk. Although the Company generally does not require collateral, the Company performs ongoing credit evaluations of its customers and reserves for potential credit losses are maintained. Page F-21 For the years ended December 31, 2000 and 1999, Virgin accounted for approximately 29 and 22 percent, respectively, of net revenues in connection with the International Distribution Agreement (see Note 11). No single customer accounted for ten percent or more of net revenues in the year ended December 31, 1998. 13. SEGMENT AND GEOGRAPHICAL INFORMATION The Company operates in one principal business segment. Information about the Company's operations in the United States and foreign markets is presented below:
YEARS ENDED DECEMBER 31, ------------------------------------------ 2000 1999 1998 ---------- ---------- ---------- Net revenues: (DOLLARS IN THOUSANDS) United States $ 104,377 $ 92,244 $ 94,727 United Kingdom 205 9,686 32,135 ---------- ---------- ---------- Consolidated net revenues $ 104,582 $ 101,930 $ 126,862 ========== ========== ========== Income (loss) from operations: United States $ (7,057) $ (28,824) $ (20,315) United Kingdom (1,329) (3,980) (1,535) ---------- ---------- ---------- Consolidated loss from operations $ (8,386) $ (32,804) $ (21,850) ========== ========== ========== Expenditures made for the acquisition of long-lived assets: United States $ 3,177 $ 1,595 $ 1,067 United Kingdom 59 - 422 Other - - 195 ---------- ---------- ---------- Total expenditures for long-lived assets $ 3,236 $ 1,595 $ 1,684 ========== ========== ==========
Net revenues were made to geographic regions as follows:
YEARS ENDED DECEMBER 31, --------------------------------------------------------------------- 2000 1999 1998 --------------------- --------------------- ------------------- AMOUNT PERCENT AMOUNT PERCENT AMOUNT PERCENT ---------- --------- ---------- --------- ---------- ------- (DOLLARS IN THOUSANDS) North America $ 56,454 54.0 % $ 49,443 48.5 % $ 73,865 58.2 % Europe 28,107 26.9 23,901 23.4 28,777 22.7 Rest of World 6,970 6.6 6,409 6.3 7,016 5.5 OEM, royalty and licensing 13,051 12.5 22,177 21.8 17,204 13.6 ---------- --------- ---------- --------- ---------- -------- $104,582 100.0 % $ 101,930 100.0 % $126,862 100.0 % ========== ========= ========== ========= ========== =========
Page F-22 Long-lived assets by geographic regions, net:
DECEMBER 31, DECEMBER 31, 2000 1999 -------------------- --------------------- AMOUNT PERCENT AMOUNT PERCENT --------- ------- ---------- ------- (DOLLARS IN THOUSANDS) North America $ 6,139 97.8 % $ 5,435 97.9 % Europe 76 1.2 47 0.9 Rest of World - - - - OEM, royalty and licensing 60 1.0 69 1.2 --------- ------- ---------- ------- $ 6,275 100.0 % $ 5,551 100.0 % ========= ======= ========== =======
14. SUBSEQUENT EVENTS REPLACEMENT OF CREDIT FACILITY In April 2001, the Company entered into a new three year loan and security agreement with a bank providing for a $15 million working capital line of credit. Advances under the line are limited to an advance formula of qualified accounts receivable and inventory, and bear interest at the banks prime rate, or at LIBOR plus 2.5% at the Company's option, as defined. The line is subject to review and renewal by the bank on April 30, 2002 and 2003, and is secured by substantially all of the Company's assets, plus a personal guarantee from the Chairman of $2 million, secured by $1 million in cash. The line requires that the Company meet certain financial covenants, as defined. The funds available from this transaction have been used to retire current debt under the Loan Agreement (see Note 5) existing at December 31, 2000, and to fund future operations. The working capital line of credit balance as of April 13, 2001 was $6.1 million. SALE OF COMMON STOCK In April 2001, the Company completed a private placement of 8,126,770 shares of Common Stock for 12.7 million, and received net proceeds of approximately $11.5 million. The shares were issued at $1.5625 per share, and included warrants to purchase one share of Common Stock for each share sold. The warrants are exercisable at $1.75 per share, and one-half of the warrants can be exercised immediately with the other half exercisable after June 27, 2001, if (and only if) the closing price of the Company's Common Stock as reported on Nasdaq does not equal or exceed $2.75 for 20 consecutive trading days prior to June 27, 2001. The Company may also require the holder to exercise the warrants if the closing price of the Company's Common Stock as reported on Nasdaq does not equal or exceed $3.00 for 20 consecutive trading days prior to June 27, 2001. The warrants expire in March 2006. The transaction provides for a registration statement covering the shares sold or issuable upon exercise of such warrants to be filed by April 16, 2001 and become effective by May 31, 2001. In the event that the filing and effective dates of the registration statement are not met, the Company is subject to a two percent penalty per month, payable in cash or stock, until the filing and effective dates are met. The funds available from this transaction have been used to retire current debt under the Loan Agreement (see Note 5) existing at December 31, 2000, and to fund future operations. Page F-23 UNAUDITED PRO-FORMA CONDENSED BALANCE SHEET In April 2001, current debt was reduced by approximately $11.5 million. The following pro-forma balance sheet reflects the Company's financial position as if the new financing, including the private placement of Common Stock, and the new working capital line of credit had been completed as of December 31, 2000.
UNAUDITED PRO-FORMA CONDENSED CONSOLIDATED BALANCE SHEET December 31, 2000 ASSETS Actual Pro-forma ------------ ------------ (DOLLARS IN THOUSANDS) Current Assets: Cash $ 2,835 $ 2,835 Trade receivables, net 28,136 28,136 Inventories 3,359 3,359 Prepaid licenses and royalties 17,704 17,704 Other 772 772 ------------ ------------ Total current assets 52,806 52,806 ------------ ------------ Property and Equipment, net 5,331 5,331 Other Assets 944 944 ------------ ------------ $ 59,081 $ 59,081 ============ ============ LIABILITIES AND STOCKHOLDERS' EQUITY Current Liabilities: Current debt $ 25,433 $ 13,887 Accounts payable 12,270 12,270 Accrued liabilities 14,980 14,980 ------------ ------------ Total current liabilities 52,683 41,137 ------------ ------------ Commitments and Contingencies Stockholders' Equity: Series A Preferred stock, $.001 par value, authorized 5,000,000 shares; issued and outstanding 719,424 shares 19,735 19,735 Common stock, $.001 par value, authorized 50,000,000 shares; issued and outstanding 30,143,636 and 37,979,906 proforma shares 30 38 Paid-in capital 88,759 100,297 Accumulated deficit (102,390) (102,390) Accumulated other comprehensive income 264 264 ------------ ------------ Total stockholders' equity 6,398 17,944 ------------ ------------ $ 59,081 $ 59,081 ============ ============
LOAN FROM CHAIRMAN AND CHIEF EXECUTIVE OFFICER In April 2001, the Chairman provided the Company with a $3 million loan, payable in May 2002, with interest at 10 percent. In connection with this loan to the Company and the $2 million guarantee on behalf of the Company for the credit facility, the Chairman received warrants to purchase 500,000 shares of the Company's Common Stock at $1.75 per share, expiring in April 2011. AMENDMENT TO SHINY PURCHASE AGREEMENT In March 2001, the Company entered into an amendment to the Shiny purchase agreement (see Notes 3 and 7) which, among other things, settles a dispute with the former owner of Shiny, and provide for the Company to Page F-24 acquire the remaining nine percent equity interest in Shiny for $600,000. The amendment also provides for additional cash payments to the former owner of Shiny for two interactive entertainment software titles to be delivered in the future. The former owner of Shiny will earn royalties after the future delivery of the two titles to the Company. SETTLEMENT OF DISPUTE WITH VIRGIN INTERACTIVE ENTERTAINMENT LIMITED In April 2001, the Company settled its dispute with Virgin (see Note 7) and amended the International Distribution Agreement, the Termination Agreement and the Product Publishing Agreement entered into in February 10, 1999 (see Note 11). As a result of the settlement, Virgin dismissed its claim for overhead fees, VIE Acquisition Group LLC ("VIE") redeemed the Company's membership interest in VIE and Virgin paid the Company $3.1 million in net past due balances owed under the International Distribution Agreement. In addition, the Company will pay Virgin a one-time marketing of $333,000 for the period ending June 30, 2001 and the monthly overhead fee was revised for the Company to pay $111,000 per month for a nine month period beginning April 2001, and $83,000 per month for a six month period beginning January 2002, with no further overhead commitment for the remainder of the term of the International Distribution Agreement. 15. SUBSEQUENT EVENT - FACTORS AFFECTING FUTURE PERFORMANCE AND GOING CONCERN As of June 30, 2001, the Company's current liabilities exceeded its current assets by $9.2 million. For the six months ended June 30, 2001, the Company incurred a net loss of $20.8 million based on its unaudited financial statements. However, net cash used in operating activities was $1.7 million as the Company's negative operating results were largely offset by strong trade receivable collections and conservative management of inventories and disbursements. During the same period last year, the net cash used in operating activities was $19.7 million. In June 2001, the Company experienced significant delays in the production and release of certain titles. These delays resulted in significant declines in the operating revenues of the Company as compared to budget for the quarter ended June 30, 2001. The Company has not released sufficient product during the three month period ended June 30, 2001 to generate a profitable level of revenues, or sufficient accounts receivable to maximize the use of its line of credit. The Company also anticipates that delays in product releases could continue in the short-term, and funds available under its new line of credit and from ongoing operations are not sufficient to satisfy the projected working capital and capital expenditure needs in the normal course of business. In addition, the Company is not in compliance with certain financial covenants set forth in the new line of credit agreement as of June 30, 2001 and these violations have not been cured as of August 23, 2001. If the bank does not waive compliance with the required covenants, terminates the credit agreement and demands acceleration of payment of the outstanding amounts, the Company would not have the funds to repay the bank and would be unable to continue to draw on the credit facility to fund future operations. The Company continues to implement cost reduction programs including a reduction of personnel, a reduction of fixed overhead commitments, cancelled or suspended development on future titles and have scaled back certain marketing programs. During the six months ended June 30, 2001, the Company incurred $2.2 million in write-offs of prepaid royalties for titles in development that have been canceled. The Company may continue to incur write-offs if additional projects are canceled in order to reduce future operating expenditures. The Company has, and expects to continue to, incur costs related to penalties arising from the April 2001 private placement registration statement not being declared effective (see Note 14). This obligation will continue to accrue each month that the registration statement is not declared effective and does not have a limit on the amount payable to these investors. As of August 23, 2001, this registration statement is not declared effective and the Company has accrued penalties of $508,000. The Company is seeking external sources of funding, including but not limited to, a sale or merger of the Company, a private placement of Company capital stock, the sale of selected assets, the licensing of certain product rights in selected territories, selected distribution agreements, and/or other strategic transactions sufficient to provide short-term funding, and potentially carry out management's long-term strategic objectives. However, there can be no assurance that the Company can complete the transactions necessary to provide the required funding on a timely basis in order to continue ongoing operations in the normal course of business. Page F-25 If the Company is unable to secure the required funding on a timely basis, it will continue to reduce its costs by selling or consolidating its operations, and by continuing to delay or cancel product development and marketing programs. In addition to the continuing risks related to the Company's future liquidity, the Company also faces numerous other risks associated with its industry. These risks include dependence on new platform introductions by hardware manufacturers, commercially successful new product introductions by the Company, new product introduction delays, rapidly changing technology, intense competition, dependence on distribution channels and risk of customer returns. CONVERSION OF SERIES A PREFERRED STOCK On August 13, 2001, Titus converted 336,070 shares of Series A Preferred Stock into 6,679,306 shares of Common Stock (See Note 8). Subsequent to this partial conversion, Titus owns 19,496,561 shares of Common Stock and 383,354 shares of Series A Preferred Stock with voting rights equivalent to 4,059,903 shares of Common Stock. Collectively, Titus has 48 percent of the total voting power of the Company capital stock as of August 13, 2001. DISTRIBUTION AGREEMENT In August 2001, the Company received an advance of $4 million for the North American distribution rights of a future title. The advance will be recouped against future distribution commissions payable, based on the future sales of the title. QUARTERLY FINANCIAL DATA (UNAUDITED) The Company's summarized quarterly financial data is as follow:
MARCH 31 JUNE 30 SEPTEMBER 30 DECEMBER 31 ---------- ---------- ------------ ----------- (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) Year ended December 31, 2000: Net revenues $ 18,143 $ 24,921 $ 31,631 $ 30,773 ========== ========== =========== =========== Gross profit $ 8,571 $ 13,465 $ 15,436 $ 13,061 ========== ========== =========== =========== Net loss $ (5,498) $ (1,903) $ 113 $ (4,772) ========== ========== =========== =========== Net loss per share basic/diluted $ (0.18) $ (0.08) $ (0.01) $ (0.18) ========== ========== =========== =========== Year ended December 31, 1999: Net revenues $ 21,620 $ 29,430 $ 23,636 $ 27,323 ========== ========== =========== =========== Gross profit $ 9,054 $ 11,814 $ 8,303 $ 11,609 ========== ========== =========== =========== Net loss $ (8,278) $ (6,921) $ (16,976) $ (9,563) ========== ========== =========== =========== Net loss per share basic/diluted $ (0.44) $ (0.33) $ (0.75) $ (0.35) ========== ========== =========== ===========
Page F-26 INTERPLAY ENTERTAINMENT CORP. AND SUBSIDIARIES SCHEDULE II--VALUATION AND QUALIFYING ACCOUNTS (AMOUNTS IN THOUSANDS)
TRADE RECEIVABLES ALLOWANCE ------------------------------------------------------------ PROVISIONS BALANCE AT FOR BEGINNING OF RETURNS RETURNS BALANCE AT OF AND AND END PERIOD PERIOD DISCOUNTS DISCOUNTS OF PERIOD ---------------------------- ------------ ------------ ---------- ---------- Year ended December 31, 1998 $ 14,461 $ 43,596 $ (39,626) $ 18,431 ============ ============ ========== ========== Year ended December 31, 1999 $ 18,431 $ 25,187 $ (34,457) $ 9,161 ============ ============ ========== ========== Year ended December 31, 2000 $ 9,161 $ 19,016 $ (21,634) $ 6,543 ============ ============ ========== ==========
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