-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, HRqTmk+eES6nM+UIQRh/cNDnuoJBSdmwYU/zJpGurcS9AxmXkN8d2w3Nea2McDtJ cDYaOk5wmGN0KBslIeDtsQ== 0000891618-97-001517.txt : 19970401 0000891618-97-001517.hdr.sgml : 19970401 ACCESSION NUMBER: 0000891618-97-001517 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 4 CONFORMED PERIOD OF REPORT: 19961231 FILED AS OF DATE: 19970331 SROS: NASD FILER: COMPANY DATA: COMPANY CONFORMED NAME: S3 INC CENTRAL INDEX KEY: 0000850519 STANDARD INDUSTRIAL CLASSIFICATION: COMPUTER COMMUNICATIONS EQUIPMENT [3576] IRS NUMBER: 770204341 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: 1934 Act SEC FILE NUMBER: 000-21126 FILM NUMBER: 97569602 BUSINESS ADDRESS: STREET 1: 2801 MISSION COLLEGE BOULEVARD CITY: SANTA CLARA STATE: CA ZIP: 95052 BUSINESS PHONE: (408) 588-8000 MAIL ADDRESS: STREET 1: 2801 MISSION COLLEGE BOULEVARD STREET 2: P.O. BOX 58058 CITY: SANTA CLARA STATE: CA ZIP: 95052-8058 10-K 1 FORM 10-K FOR THE YEAR ENDED DECEMBER 31, 1996 1 ================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D. C. 20549 ------------------------ FORM 10-K (MARK ONE) [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 1996 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM ____ TO ____ COMMISSION FILE NUMBER 0-21126 S3 INCORPORATED (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) DELAWARE 77-0204341 (STATE OF OTHER JURISDICTION (I.R.S. EMPLOYER IDENTIFICATION NO.) OF INCORPORATION OR ORGANIZATION) 2801 MISSION COLLEGE BOULEVARD, SANTA CLARA, CALIFORNIA 95052-8058 (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)
REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (408) 588-8000 SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT: NONE SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT: COMMON STOCK, $.0001 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 past 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 the Registrant's knowledge, in definitive proxy or information statements incorporated by reference to Part III of this Form 10-K or any amendment to this Form 10-K. [ ] The aggregate market value of voting stock held by non-affiliates of the Registrant was approximately $808,253,556 as of March 7, 1997, based upon the closing price on the Nasdaq National Market reported for such date. This calculation does not reflect a determination that certain persons are affiliates of the Registrant for any other purpose. 48,985,064 shares of the Registrant's Common Stock, $.0001 par value, were outstanding at March 7, 1997. DOCUMENTS INCORPORATED BY REFERENCE Items 10 (as to directors), 11 and 12 of Part III incorporate by reference information from the Registrant's Proxy Statement to be filed with the Securities and Exchange Commission in connection with the solicitation of proxies for the Registrant's 1997 Annual Meeting of Stockholders. ================================================================================ 2 PART I ITEM 1: BUSINESS. When used in this Report, the words "expects", "anticipates", "estimates" and similar expressions are intended to identify forward-looking statements. Such statements, which include statements concerning the timing of availability and functionality of products under development, trends in the personal computer ("PC") market, the percentage of export sales and sales to strategic customers, and the adoption or retention of industry standards, and the availability and cost of products from the Company's suppliers, are subject to risks and uncertainties, including those set forth under "Factors That May Affect Results" and elsewhere in this report, that could cause actual results to differ materially from those projected. These forward-looking statements speak only as of the date hereof. The Company expressly disclaims any obligation or undertaking to release publicly any updates or revisions to any forward-looking statements contained herein to reflect any change in the Company's expectations with regard thereto or any change in events, conditions or circumstances on which any such statement is based. GENERAL S3 Incorporated ("S3" or the "Company") is a leading supplier of high performance multimedia acceleration solutions for the PC market. The Company's accelerators are designed to work cooperatively with a PC's central processing unit ("CPU"), implementing functions best suited for a dedicated accelerator while allowing the CPU to perform the more general purpose computing functions of today's advanced multimedia user interface and applications. By complementing the computing power of the general purpose CPU, the Company's integrated software and silicon-based accelerator solutions significantly improve the multimedia performance of PCs while reducing overall system cost and complexity. S3 has been a pioneer in graphics acceleration since 1991, when it was the first company to ship in volume a single chip graphics accelerator with a local bus interface. S3 has since delivered new generations of high performance accelerator solutions with 32-bit and 64-bit multimedia products such as integrated 2D and 3D graphics and video accelerators, motion picture experts group ("MPEG") decoders and audio processors enabling more advanced graphics and integrated full-motion video acceleration. As the demand for greater multimedia capabilities in PCs increases, particularly the demand for 2D/3D technology, the Company is focused on delivering accelerator solutions for use in business desktop, home and mobile computing systems. S3's families of accelerator products and software are currently used by many of the world's leading original equipment PC manufacturers ("OEMs") and add-in card and motherboard manufacturers. S3 was incorporated on January 9, 1989 in the State of Delaware. The Company operates in one principal industry segment. MARKETS AND RECENT DEVELOPMENTS Throughout the development of the graphical user interface ("GUI") accelerator market, S3 has been a leader in the evolution of accelerator technology. In 1991, S3 developed the first single chip graphics accelerator to be shipped in volume that integrated all of the specialized functions required to accelerate GUI environments created by Windows, OS/2 and other advanced PC operating systems. In June 1995, S3 introduced the Cooperative Accelerator Architecture(TM) solution. Currently featured on the Compaq Presario line of desktop PCs, in addition to a number of add-in-cards, the Cooperative Accelerator Architecture is designed to be a three chip graphics, audio and MPEG solution for the PC motherboard. Products incorporated into the Cooperative Accelerator Architecture include the Trio64V+(TM) graphics/multimedia accelerator, Scenic/MX2(TM) MPEG decoder, which provides hardware-assisted audio and video synchronization support, 30-frames-per-second video decoding and CD-quality audio decoding, and S3's first audio digital-to-analog converter (DAC), the Sonic/AD(TM). In November 1995, S3 introduced the initial members of its ViRGE(R) family of 2D/3D graphics and video acceleration products, the ViRGE and ViRGE/VX(TM) accelerators. The ViRGE family, which is based on the Company's advanced S3d(TM) architecture 2 3 and is pin compatible with S3's Trio family of 2D integrated graphics accelerators, was developed to enable 3D graphics on mainstream PCs while continuing to provide 2D acceleration. In 1996, the Company expanded the breadth of its product line to introduce products for the mobile computing and audio markets and introduced second generation 2D/3D products. In January 1996, S3 entered the mobile computing market with the introduction of its first notebook PC product, the Aurora 64V+(TM) dual display 2D multimedia accelerator. In May 1996, the Company announced a worldwide marketing program, which identifies and promotes 3D software titles and hardware products that take advantage of the S3d acceleration technology. Hardware and software vendors in this program participate in co-marketing arrangements with S3 and its customers. In October 1996, the Company introduced its second generation 2D/3D products, the ViRGE/DX(TM) and ViRGE/GX(TM) accelerators. In November 1996, S3 announced its first integrated platform accelerator product, the Plato(TM)/PX 2D accelerator. The Plato/PX is targeted at entry-level PCs and is designed to enable PC manufacturers to provide graphics and video capability for network computing and Internet appliances. Also in November 1996, the Company introduced SonicVibes(TM), its first product in a new line of audio and communications products. The Company believes that accelerators will continue to evolve as end users demand applications with enhanced features. Rapid technology advances are expected by the Company to continue to result in PCs that incorporate more powerful CPUs (such as Intel's Pentium MMX and Pentium II), increased memory and storage capacity, enhanced connectivity features that utilize advanced network operating systems such as Novell Netware, OS/2 and enhanced versions of the Windows platform. The Company expects the PC, including systems for the business desktop, mobile, and home markets, to evolve from a personal productivity tool with a simple graphical user interface to an interactive, real time system with enhanced features. In addition, the increasing connectivity of PCs is driving demand for audio and communications functions. To address this market evolution, the Company has continued to develop products for the business desktop, mobile and home PC markets. The Company is developing products that build on its acceleration and on-chip power management technology to bring desktop equivalent multimedia acceleration and real time communications capabilities to the mobile market. The Company also continues to invest in 3D acceleration, which it believes will continue to be incorporated into home PCs to create a platform for games and entertainment and into business desktop, home and mobile PCs to create a platform for navigation and browsing for interactive, on-line services. S3 is seeking to expand its target markets through technology investments and product development efforts in PC system integration, audio processing, and wide area communications. There can be no assurance that the Company will be able to successfully complete the development of these products or to commence shipments of these products in a timely manner, or that product specifications will not change during the development period. In addition, even if successfully developed and shipped, there can be no assurance that the products described above will be successful in the marketplace. PRODUCTS AND TECHNOLOGY S3 currently offers graphics and video accelerators for desktop and mobile computers that are differentiated by a variety of features. All of S3's accelerator solutions are designed to complement the CPU by executing those functions most appropriate to a dedicated accelerator while allowing the CPU to execute the more general purpose computing functions. To reduce product manufacturing cost and to facilitate the development of future products, S3 optimizes accelerator functions by implementing the most frequently used functions in silicon, while the least used functions are implemented in software to be processed by the CPU. Graphics and Video Accelerator Products S3's graphics and video accelerator product line includes a broad array of products to support PC add-in card, motherboard and computer system OEM designs in both desktop and mobile computers. These products provide S3's customers with a range of price/performance options, including entry-level single-chip integrated DRAM-based 2D accelerators for desktop computers that support both discrete graphics memory as well as shared system/graphics memory architectures ("SMA"), mid-range DRAM and SGRAM-based 2D 3 4 accelerators for desktop computers, mid-range DRAM and SGRAM-based 2D/3D accelerators for desktop computers, high-end VRAM-based 2D/3D accelerators for PC add-in cards, and mid-range DRAM-based 2D accelerators for mobile computers. The Company's product line breadth and pin-compatible strategy allow its customers to migrate to higher performance, higher functionality solutions, while staying within a single accelerator architecture and family of compatible software drivers. The system OEM thereby has the flexibility of designing its own upgrades or selecting from a number of leading add-in card manufacturers that offer products based on the Company's products. Display memory supported by the Company's accelerators ranges from 1 to 4 megabytes of DRAM to 1 to 8 megabytes of VRAM. All of the Company's products support advanced levels of integration, including integrated RAMDAC and clock synthesis, video acceleration based on S3's Streams Processor(TM) technology, and video connectivity via S3's Scenic Highway(TM) local peripheral bus. The Company's accelerators support the industry standard VL and PCI local buses. Trio64V+. The Trio64V+ is a 64-bit, DRAM-based 2D graphics and video accelerator. It is pin compatible with S3's prior generation Trio64 accelerator and includes integrated RAMDAC and clock synthesis functions. Additionally, the Trio64V+ includes video acceleration based on S3's Streams Processor technology and video connectivity via S3's Scenic Highway local peripheral bus. Trio64V2. The Trio64V2(TM) is a 64-bit, DRAM and SDRAM-based graphics and video accelerator. The Trio64V2/DX(TM)is DRAM-based and pin compatible with S3's Trio64V+ accelerator. The Trio64V2/GX(TM) incorporates a synchronous memory interface to support SDRAM frame buffers for improved performance, increased resolutions and pixel depths and higher refresh rates. The Trio64V2 includes an enhanced RAMDAC, clock synthesis, enhanced video acceleration that includes vertical video filtering, and video connectivity. Plato/PX. Plato/PX is S3's first system integration platform, integrating onto a single chip a 64-bit, DRAM-based 2D graphics and video accelerator with the system logic necessary to implement the host CPU memory controller and PCI system interface. The Plato/PX accelerator eliminates the need for a separate graphics subsystem through the use of SMA technology, and has been designed to provide high-performance graphics and high-quality video capabilities for cost-sensitive motherboard designs, including motherboards for sub-$1,000 PCs, NetPCs, Network Computers and dedicated Web Browsers. The Plato/PX is otherwise functionally equivalent to a Trio64V+ with support for up to a 2 megabyte frame buffer and includes support for an integrated RAMDAC, clock synthesizer, video acceleration and video connectivity. ViRGE. ViRGE is a 64-bit, DRAM-based 2D/3D graphics and video accelerator. It is pin compatible with the Trio64V+ accelerator and includes the Trio64V+'s RAMDAC and clock synthesis functions. Additionally, the ViRGE accelerator includes video acceleration based on S3's Streams Processor technology and video connectivity via S3's Scenic Highway local peripheral bus. ViRGE/DX/GX. ViRGE/DX and ViRGE/GX are second generation 64-bit, 2D/3D graphics and video accelerators, utilizing DRAM and SGRAM, respectively. ViRGE/DX is pin compatible with the ViRGE 2D/3D accelerator and the Trio64V+ and Trio64V2 2D accelerators. ViRGE/GX is pin compatible with the Trio64V2 2D accelerator. Both the ViRGE/DX and ViRGE/GX include the RAMDAC and clock synthesis functions and enhanced video acceleration based on S3's Streams Processor technology and video connectivity via S3's Scenic Highway local peripheral bus. ViRGE/DX and ViRGE/GX accelerators provide significant performance improvement over the first generation ViRGE accelerators, and include SmartFilter(TM) technology for higher performance and higher quality texture mapping and a parallel processing perspective engine for increased throughput. ViRGE/DX and ViRGE/GX are designed to enable the next level of gaming applications as well as to deliver the 2D/3D platform required for emerging business desktop applications. These desktop applications include data visualization, accelerated VRML, 3D presentations and spreadsheets. ViRGE/VX. ViRGE/VX(TM) is a 64-bit, VRAM-based 2D/3D graphics and video accelerator. It is the industry's first VRAM-based accelerator to include an integrated RAMDAC and clock synthesis functions in a single chip. Additionally, ViRGE/VX supports enhanced video acceleration with vertical video filtering based on S3's Streams Processor technology and video connectivity via S3's Scenic Highway local peripheral bus. 4 5 ViRGE/GX2. ViRGE/GX2(TM), introduced in March 1997, is S3's third generation 64-bit, SGRAM-based 2D/3D graphics and video accelerator that supports TV-Out, DuoView dual-display capability, and Intel's Accelerated Graphics Port ("AGP") standard, and is digital versatile disc ("DVD") capable. ViRGE/GX2 includes advanced 3D and display technology designed to bridge the gap between mainstream consumer electronics and PC technology. These features include DuoView technology, which enables users to display different images simultaneously on separate monitors and is designed to increase the functionality of applications such as multi-player gaming, Web browsing and video conferencing. In addition, AGP support is intended to provide increased multimedia performance, while integrated TV-Out enables output from the PC to a TV. The Company also provides a scalable solution that combines either hardware or software MPEG-2 decoders with ViRGE/GX2's integrated DVD features. Aurora64V+. The Aurora64V+ is a 64-bit, DRAM-based 2D graphics and video accelerator for mobile computers. It includes the Trio64V+'s integrated RAMDAC and clock synthesis functions, a flat panel display interface and, through DuoView(TM) technology, the ability to simultaneously display information on the flat panel and either a computer monitor or television. DuoView technology also enables users to view multiple windows during video conferencing applications. Additionally, the Aurora64V+ includes video acceleration based on S3's Streams Processor technology and video connectivity via S3's Scenic Highway local peripheral bus. Audio and Communication Products In 1996, S3 introduced its first product in a new line of audio and communications products. This product line is intended to offer consumers high performance audio quality and integration while maintaining compatibility with existing software content. Future members of the family are being designed to integrate communications capabilities with the sound subsystem to increase integration and functionality on the PC platform. SonicVibes. The Company believes that its SonicVibes audio processor is the industry's first fully-integrated audio processor that uses the PCI, rather than the ISA bus. SonicVibes retains DOS games compatibility and FM synthesis while providing wavetable music synthesis to the PC motherboard. SonicVibes also provides an unlimited sound palette through its support of Microsoft's DirectMusic API. The Company believes the use of the PCI bus can enable higher performance than ISA bus-related audio products due to the significantly greater bandwidth supported by the PCI bus. This can enable additional interactive media applications, such as multi-player gaming. SonicVibes is designed to lower overall system cost through the integration of the sound capabilities of a traditional sound card onto a single-chip solution, and eliminating the need for external ROM and RAM memory that prior audio subsystems required. Software The Company believes that a complete solution for its customers must include not only high performance acceleration features implemented in silicon, but also a broad line of software, including BIOS, drivers and utilities, that are designed to optimize the performance of its accelerators. The software is shipped as an integral part of the Company's accelerator products. The Company maintains a flexible driver architecture, allowing its drivers to be easily upgraded for the enhanced features supported in next generation accelerator products. S3 uses a combination of in-house software developers and independent contractors to develop its software drivers. Strategic software, including BIOS and Windows 95 and Windows NT drivers, is developed by the Company's in-house software development team. The Company believes that software expertise is vital to determining the optimal trade-off between silicon and software for next generation accelerator performance and functionality enhancements. The Company has also developed extensive capabilities for testing its accelerators, software drivers and BIOS across a range of applications and OEM system configurations. 5 6 The Company's software includes the following drivers:
OPERATING SYSTEM DRIVERS MS-DOS SOFTWARE DRIVERS -------------------------------------------- ---------------------------------- IBM OS/2 Autodesk ADI 4.2 with support for Microsoft Windows 3.1 AutoCAD and SD Studio Microsoft Windows 95 Microstation Microsoft Windows NT SCO UNIX Open Desktop
In 1996, the Company expanded its end-user utility support. Designed to be included with drivers by the Company's OEMs, these utilities are intended to provide increased end-user ease-of-use support and extended control of S3 multimedia accelerator functions. The Company released the refresh utility for Windows 95, allowing the user to change refresh rates, and the color utility for Windows 95 and Windows NT 4.0, giving the user control of hue, saturation, contrast, and brightness for video playback. In September 1996, Packard Bell NEC released the Company's internally-developed TV-Tuner(TM) application, which displays live TV on the computer using Packard Bell NEC's TV-Tuner hardware. The application allows channel selection, volume control, record/playback features similar to a video cassette recorder, closed caption display, and it supports international video inputs such as NTSC, PAL and SECAM. The Company also developed OEM-specific display control utilities for its customers who use the Aurora64V+ accelerator. These utilities enable end-user utilization of the DuoView and mobile computing functions of the Aurora64V+ accelerator. Throughout 1996, the Company released several updates of its Galileo(TM) utility, which was the first end-user utility introduced in 1995 and provides ease-of-use support for resolution and color depth configuration changes and monitor centering. 3D Software(1) S3's software strategy for its traditional 2D graphics accelerators was achieved primarily through the development of software drivers to interface the acceleration hardware with industry-standard application programmer interfaces (APIs), including those for Windows and OS/2. Direct support for specific applications was limited primarily to leading DOS-based CAD programs such as AutoCAD and Microstation, due to the APIs' role in decoupling application programs from the actual graphics hardware. In the emerging 3D acceleration market of 1996, however, an absence of industry-standard 3D graphics APIs caused S3 to actively promote its own, proprietary DOS-based 3D API. This proprietary software has enabled the porting of specific 3D games and other 3D applications to the ViRGE hardware platforms. In addition, S3 supports multiple third-party proprietary APIs, including BRender and Renderware, that are favored by significant segments of the application software development community. S3 has also developed an OpenGL driver for the ViRGE family of 2D/3D accelerators to support CAD/engineering, modeling/rendering and other high-end 3D applications traditionally supported on workstation platforms. Specific titles that have been ported to the ViRGE architecture include Terminal Velocity, FX Fighter, MechWarrior 2, Screamer, Cyberspeed, Destruction Derby, Havoc, Descent II, VR Soccer, Mega Race 2, Web3D, 3D Maestro and Truespace. S3 is also actively developing a software driver for what has emerged as the standard API for 3D acceleration on the PC platform, Microsoft's Direct3D. S3 intends to support its proprietary API, Direct3D, and third-party APIs based on market acceptance of such APIs and S3's needs to support and promote new features of future accelerators. - --------------- (1) The software titles set forth below may be trademarks or registered trademarks of their respective owners. 6 7 Future Accelerators and Software The Company has in development several graphics and video accelerators, audio and communication accelerators and related software products for currently scheduled introduction throughout 1997. S3 believes that its extensive software, systems and silicon expertise, use of advanced design tools, centralized engineering group with strong design expertise, and close working relationships with strategic customers and software developers should position the Company to continue to rapidly and cost-effectively define, develop and market advanced accelerators and related software for the PC market. Recognizing the rapid conversion of consumer electronic products from analog to digital technology, the convergence of consumer and computing systems into new and evolving information access devices and the personal computer's inherent position as the most advanced and well-positioned digital platform, the Company intends to leverage its PC system architecture and multimedia acceleration expertise to develop new products for both computer and consumer applications that exploit these trends. S3's accelerator products are designed to improve the graphics performance of PCs using Intel and other x86-based microprocessors, and Microsoft Windows, Windows NT and IBM OS/2 operating systems, the predominant standards in today's PC market. Any shift away from such standards would require the Company to develop new products and may have a material adverse effect on the Company's operating results. The market for the Company's accelerator products is characterized by rapidly changing technology, evolving industry standards, frequent new product introductions, and significant price competition, resulting in short product life cycles and regular reductions of unit average selling prices over the life of a specific product. Products in the Company's market typically have a product life cycle of 12 to 24 months. See "Factors That May Affect Results -- Importance of New Products; Rapid Technological Change" and "-- Dependence on Accelerator Product Line." FACTORS THAT MAY AFFECT RESULTS Fluctuations in Quarterly Operating Results The Company's operating results have historically been, and will continue to be, subject to quarterly and other fluctuations due to a variety of factors, including changes in pricing policies by the Company, its competitors or its suppliers, anticipated and unanticipated decreases in unit average selling prices of the Company's products, availability and cost of products from the Company's suppliers, changes in the mix of products sold and in the mix of sales by distribution channels, the gain or loss of significant customers, new product introductions by the Company or its competitors, market acceptance of new or enhanced versions of the Company's products, seasonal customer demand, and the timing of significant orders. Operating results could also be adversely affected by general economic and other conditions affecting the timing of customer orders and capital spending, a downturn in the market for PCs, and order cancellations or rescheduling. In particular, the market for PCs in 1996 experienced a weakening in the trends for demand as compared with 1995 and grew at a lower rate as compared with 1995. These factors could adversely affect demand for the Company's products. In addition, the pricing environment for graphics accelerators has recently experienced and is expected to continue to experience increasing pricing pressures due in part to the alleviation of supply constraints that contributed to more stable pricing in 1995 and to aggressive pricing from certain of the Company's competitors. In particular, the Company's Trio family of integrated 2D accelerators, which accounted for a majority of the Company's revenues in 1996, experienced significant decreases in average selling prices in 1996. The Company expects that the graphics accelerator market will transition from 2D acceleration to 3D acceleration, and the Company has introduced its ViRGE family of 2D/3D accelerators in response to this expected transition. As a result of the entry of competitors into the 3D acceleration market, the Company anticipates that it may experience increased pricing pressures on average selling prices for the ViRGE family of 2D/3D accelerators. If the transition occurs slower than expected, if the Company's 2D/3D products do not achieve market acceptance, or if pricing pressures increase, the Company's operating results could be adversely affected. Further, because the Company is continuing to increase its operating expenses for personnel and new product development, the Company's operating results would be adversely affected if such budgeted sales levels were not achieved. PC graphics and multimedia subsystems include, in addition to the Company's products, a number of other components which are supplied by third-party manufacturers. Any 7 8 shortage of such components in the future could adversely affect the Company's business and operating results. Furthermore, it is possible that the Company's products may be found to be defective after the Company has already shipped significant volume production. There can be no assurance that the Company would be able to successfully correct such defects or that such corrections would be acceptable to customers, and the occurrence of such events could have a material adverse effect on the Company's business and operating results. Because the Company must order products and build inventory substantially in advance of product shipments, and because the markets for the Company's products are volatile and subject to rapid technological and price changes, there is a risk that the Company will forecast incorrectly and produce excess or insufficient inventories of particular products. In addition, the Company's customers may change delivery schedules or cancel orders without significant penalty. To the extent the Company produces excess or insufficient inventories of particular products, the Company's operating results could be adversely affected. The Company ships more product in the third month of each quarter than in either of the first two months of the quarter, with shipments in the third month higher at the end of the month. This pattern, which is common in the semiconductor industry, is likely to continue. The concentration of sales in the last month of the quarter may cause the Company's quarterly results of operations to be more difficult to predict. Moreover, a disruption in the Company's production or shipping near the end of a quarter could materially reduce the Company's net sales for that quarter. The Company's reliance on outside foundries and independent assembly and testing houses reduces the Company's ability to control, among other things, delivery schedules. Due to the foregoing factors, it is likely that in some future quarter or quarters the Company's operating results may be below the expectations of public market analysts and investors. In such event, the price of the Company's Common Stock would likely be materially and adversely affected. Importance of New Products; Rapid Technological Change The PC industry in general, and the market for the Company's products in particular, is characterized by rapidly changing technology, evolving industry standards, frequent new product introductions and significant price competition, resulting in short product life cycles and regular reductions of unit average selling prices over the life of a specific product. Products in the Company's market typically have a life cycle of 12 to 24 months, with regular reductions of unit average selling prices over the life of a specific product. The successful development and commercialization of new products required to replace or supplement existing products involve many risks, including the identification of new product opportunities, the successful and timely completion of the development process, and the selection of the Company's products by leading systems suppliers and add-in card and motherboard manufacturers for design into their products. There can be no assurance that the Company will successfully identify new product opportunities and develop and bring to market in a timely manner successful new products, that products or technologies developed by others will not render the Company's products or technologies noncompetitive, or that the Company's products will be selected for design into its customers' products. The Company is continually developing new products to address changing market needs, and its operating results may fluctuate from those in prior quarters or may be adversely affected in quarters in which it is undergoing a product transition or in which existing products are under price pressures due to competitive factors. The Company also intends to add increased functionality to its multimedia products, such as system logic, audio, communications or other additional functions. Market acceptance of the Company's products will also depend upon acceptance of other components, such as memory, that the Company's products are designed to work with. For example, the Company has recently introduced accelerators designed to work with synchronous graphics RAM ("SGRAM") and/or synchronous DRAM ("SDRAM") which the Company believes offer better performance for its price than the more expensive video RAM ("VRAM"). However, there can be no assurance that other memory technologies, such as Rambus DRAM, will not achieve a greater degree of market acceptance than SGRAMs or SDRAMs. If new products are not brought to market in a timely manner or do not address market needs or achieve market acceptance, then the Company's operating results will be adversely affected. The Company's 1994 operating results were adversely affected in part 8 9 because the Company had made a strategic decision to transition its product offerings from 32-bit to 64-bit accelerators during the first half of 1994, but due to a lack of PC system logic chipsets based on the PCI bus standard and a slower than anticipated shift from 32-to 64-bit graphics, sales of S3's PCI-based Vision64 family of accelerators were less than expected. During the same period of time, competitors' 32-bit integrated accelerator products offered a more competitive solution to the Company's customers and ultimately necessitated an adjustment in the valuation of the Company's 32-bit non-integrated inventory. In anticipation of a shift in demand from 2D to 3D technology, the Company has introduced and is continuing to develop products in its ViRGE family of 2D/3D multimedia accelerators. If the transition from 2D to 3D in the PC market is slower than the Company expects or if these products are not brought to market in a timely manner or do not address market needs or achieve market acceptance, the Company's operating results could be adversely affected. See "Management's Discussion and Analysis of Financial Condition and Results of Operations." Dependence on Foundries and Other Third Parties The Company currently relies on several independent foundries to manufacture its products either in finished form or wafer form. The Company currently has long-term supply arrangements with two of its foundries, a "take or pay" contract with Taiwan Semiconductor Manufacturing Company ("TSMC") and a joint venture foundry, United Semiconductor Corporation ("USC"). In 1995, the Company expanded and formalized its relationship with TSMC to provide additional capacity over the 1996 to 2000 timeframe. The foundry agreement with TSMC requires the Company to make certain annual advance payments to purchase certain committed capacity amounts to be applied against the following year's capacity or forfeit advance payments against such amounts. In addition, the Company entered into an agreement with United Microelectronics Corporation ("UMC") and Alliance Semiconductor Corporation to form a separate Taiwanese company, USC, for the purpose of building and managing a semiconductor manufacturing facility. The Company invested $53.0 million in 1996 and $36.4 million in 1995 for its 23.75% equity interest. The facility commenced production utilizing advanced submicron semiconductor manufacturing processes in late 1996. The Company has the right to purchase up to 31.25% of the output from the foundry. To the extent the Company purchases excess inventories of particular products or chooses to forfeit advance payments, the Company's operating results could be adversely affected. To the extent USC experiences operating losses, the Company will recognize its proportionate share of such losses and may be required to contribute additional capital. The Company believes that a number of manufacturers are expanding or planning to expand their fabrication capacity over the next several years, which could lead to overcapacity in the market and resulting decreases in costs of finished wafers. If the wafers produced by USC cannot be produced at competitive prices, USC could sustain operating losses. There can be no assurance that such operating losses will not have a material adverse effect on the Company's consolidated results of operations. The Company conducts business with its other current foundries by delivering written purchase orders specifying the particular product ordered, quantity, price, delivery date and shipping terms and, therefore, such foundries are generally not obligated to supply products to the Company for any specific period, in any specific quantity or at any specified price, except as may be provided in a particular purchase order. To the extent a foundry terminates its relationship with the Company or should the Company's supply from a foundry be interrupted or terminated for any other reason, such as a natural disaster or an injunction arising from alleged violations of third party intellectual property rights, the Company may not have a sufficient amount of time to replace the supply of products manufactured by that foundry. Until 1996, due to worldwide semiconductor supply constraints, especially with respect to advanced process technologies required by the Company's products, the Company was unable to obtain a sufficient supply of products to enable it to meet demand and was required to allocate available supply of its products among its customers. There can be no assurance that the Company will obtain sufficient advanced process technology foundry capacity to meet customer demand in the future. The Company is continuously evaluating potential new sources of supply. However, the qualification process and the production ramp-up for additional foundries has in the past taken, and could in the future take, longer than anticipated, and there can be no assurance that such sources will be able or willing to satisfy the Company's requirements on a timely basis or at acceptable quality or per unit prices. 9 10 Two of the Company's principal foundries, TSMC and UMC, and the Company's foundry joint venture, USC, are located in the Science-Based Industrial Park in Hsin Chu City, Taiwan. The Company currently expects these three foundries to supply the substantial portion of the Company's products in 1997. Disruption of operations at these foundries for any reason, including work stoppages, fire, earthquakes or other natural disasters, would cause delays in shipments of the Company's products, and could have a material adverse effect on the Company's results of operations. In addition, as a result of the rapid growth of the semiconductor industry based in the Science-Based Industrial Park, severe constraints have been placed on the water and electricity supply in that region. Any shortages of water or electricity could adversely affect the Company's foundries' ability to supply the Company's products, which could have a material adverse effect on the Company's results of operations. The Company is using multiple sources for certain of its products, which may require the Company's customers to perform separate product qualifications. The Company has not, however, developed alternate sources of supply for certain other products, and its newly introduced products are typically produced initially by a single foundry until alternate sources can be qualified. The requirement that a customer perform separate product qualifications or a customer's inability to obtain a sufficient supply of products from the Company may cause that customer to satisfy its product requirements from the Company's competitors, which would adversely affect the Company's results of operations. The Company's products are assembled and tested by a variety of independent subcontractors. The Company's reliance on independent assembly and testing houses to provide these services involves a number of risks, including the absence of adequate availability of certain packaging technologies, the absence of guaranteed capacity and reduced control over delivery schedules, quality assurance and costs. The Company also is subject to the risks of shortages and increases in the cost of raw materials used in the manufacture or assembly of the Company's products. Constraints or delays in the supply of the Company's products, whether because of capacity constraints, unexpected disruptions at the foundries or assembly or testing houses, delays in obtaining additional production at existing foundries or in obtaining production from new foundries, shortages of raw materials, or other reasons, could result in the loss of customers and other material adverse effects on the Company's operating results, including effects that may result should the Company be forced to purchase products from higher cost foundries or pay expediting charges to obtain additional supply. See "Business -- Sales, Marketing and Distribution" and "-- Manufacturing and Design Methodology." Transactions to Obtain Manufacturing Capacity; Future Capital Needs In order to obtain an adequate supply of wafers, especially wafers manufactured using advanced process technologies, the Company has entered into and may consider in the future various transactions, including the use of "take or pay" contracts that commit the Company to purchase specified quantities of wafers over extended periods, equity investments in or advances or issuances of equity securities to wafer manufacturing companies in exchange for guaranteed production capacity, or the formation of joint ventures to own and operate or construct foundries or to develop certain products. Any of such transactions would involve financial risk to the Company and could require the Company to commit substantial capital or provide technology licenses in return for guaranteed production capacity. In particular, the Company has entered into a "take or pay" contract with TSMC and has entered into the USC joint venture. The need to commit substantial capital may require the Company to seek additional equity or debt financing. The sale or issuance of additional equity or convertible debt securities could result in additional dilution to the Company's stockholders. There can be no assurance that such additional financing, if required, will be available when needed or, if available, will be on terms acceptable to the Company. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Liquidity and Capital Resources" and "Business -- Manufacturing and Design Methodology." 10 11 Dependence on Accelerator Product Line S3's products are designed to improve the graphics and multimedia performance of x86-based PCs and Microsoft Windows, Windows NT and IBM OS/2 operating systems, the predominant standards in today's PC market. Any shift away from such standards would require the Company to develop new products. The Company expects that additional specialized graphics processing and general purpose computing capabilities will be integrated into future versions of Intel and other x86-based microprocessors and that standard multimedia accelerators in the future will likely integrate memory, system logic, audio, communications or other additional functions. The Company has not previously offered either single function or integrated accelerator products that provide these functions, which have traditionally been provided by separate single function chips or chipsets. The Company has been and will continue to be required to expand the scope of its research and development efforts to provide these functions, which will require the hiring of engineers skilled in the respective areas and additional management and coordination among the Company's design and engineering groups. Alternatively, the Company may find it necessary or desirable to license or acquire technology to enable the Company to provide these functions, and there can be no assurance that any such technology will be available for license or purchase on terms acceptable to the Company. Furthermore, there is a limited amount of space on PC motherboards, and companies that offer solutions that provide the greatest amount of functionality within this limited space may have a competitive advantage. While the Company's strategy is to develop new and enhanced graphics and multimedia accelerator products that will be complementary to present and future versions of Intel and other x86-based microprocessors and integrate additional functionality, there can be no assurance that the Company will be able to develop such new or enhanced products in a timely manner or correctly anticipate the additional functionality that will be required to compete effectively in this market. There can be no assurance that, if developed, the Company's new or enhanced products that incorporate these functions will achieve market acceptance. There also can be no assurance that the market for graphics and multimedia accelerators will continue to grow in the future or that new technological developments or changes in standards will not result in decreased demand for graphics and multimedia accelerators or for the Company's products that are not compatible with such changed standards. For example, in 1996, there was an absence of an industry standard 3D graphics API. As a result, the Company developed and promoted its proprietary API. Microsoft has since introduced its Direct3D API, which has emerged as the standard API for 3D acceleration. While the Company's 3D accelerators currently support the Company's proprietary API and Microsoft's Direct 3D API, there can be no assurance that another API will emerge as an industry standard that the Company's accelerators will not support. While the PC industry in recent periods has been characterized by substantial demand, such demand has historically been cyclical, and there can be no assurance that this demand will continue in future periods or that demand for the Company's products will continue. The occurrence of any such events would have a material adverse effect on the Company's operating results. Substantial Competition The market for the Company's products is extremely competitive and is characterized by declining selling prices over the life of a particular product and rapid technological changes. The Company's principal competitors for graphics accelerators include ATI Technologies, Inc., Cirrus Logic, Inc., Matrox Graphics, Inc., and Trident Microsystems, Inc. The Company's principal competitors in the multimedia market include the companies named in the preceding sentence and a number of smaller companies which may have greater flexibility to address specific market needs. Potential competitors in these markets include both large and emerging domestic and foreign semiconductor companies. In particular, there is a significant number of established and emerging companies that have developed, are developing or have announced plans to develop 3D graphics chips, including Intel Corporation and Lockheed Martin Corporation, which have announced that they are jointly developing such chips, which are currently expected to become available in the second half of 1997, and Texas Instruments Incorporated, which has announced a development and marketing agreement with 3Dlabs Inc., Ltd. In addition, Microsoft has announced that it is developing a reference architecture, Talisman, with an alternative method of providing 3D functionality. Microsoft is working with a number of companies, including Cirrus Logic, Inc., Samsung Electronics Co., Ltd., Philips N.V. and Fujitsu Ltd., to implement this architecture. There can be no assurance that the Company's product offerings to address the 11 12 demand for the next generation of 2D/3D accelerators will be competitive, and if such product offerings are not competitive, the Company's results of operations in 1997 and future periods could be materially and adversely affected. To the extent the Company expands its product line to add products with additional functionality, such as audio, communications and system logic functions, it will encounter substantial competition from established semiconductor companies and may experience competition from companies designing chips based on different technologies, such as software-centric multimedia processors. Further, the need of PC manufacturers to rapidly introduce a variety of products aimed at different segments of the PC market may lead to the shift by such system OEMs to the purchase of graphics and multimedia add-in cards provided by others. Certain of the Company's competitors supply both add-in cards and accelerator chips, which may provide those competitors with an advantage over suppliers such as the Company that supply only accelerator chips. In addition, certain of the Company's potential competitors that supply add-in cards and/or motherboards, such as Intel Corporation, may seek to use their card/board business to leverage the startup of their graphics accelerator business. Certain of the Company's current and potential competitors have greater technical, manufacturing, financial and marketing resources than the Company. The Company believes that its ability to compete successfully depends upon a number of factors both within and outside of its control, including product performance, product features, product availability, price, quality, timing of new product introductions by the Company and its competitors, the emergence of new graphics and PC standards, customer support, and industry and general economic trends. There can be no assurance that the Company will have the financial resources, technical expertise, or marketing, distribution and support capabilities to compete successfully. The Company's future success will be highly dependent upon the successful development and introduction of new products that are responsive to market needs. There can be no assurance that the Company will be able to successfully develop or market any such products. See "Business -- Competition." Customer Concentration The Company's sales are concentrated within a limited customer base. One customer, Diamond Multimedia Systems, Inc. accounted for 15% of net sales in 1996, two customers, Diamond Multimedia Systems, Inc. and Intel Corporation, accounted for 17% and 12%, respectively, of net sales in 1995, and two customers, IBM and Digital Equipment Corporation, accounted for 19% and 16%, respectively, of net sales in 1994. The Company expects a significant portion of its future sales to remain concentrated within a limited number of strategic customers. There can be no assurance that the Company will be able to retain its strategic customers or that such customers will not otherwise cancel or reschedule orders, or in the event of canceled orders, that such orders will be replaced by other sales. In addition, sales to any particular customer may fluctuate significantly from quarter to quarter. The occurrence of any such events could have a material adverse effect on the Company's operating results. See "Business -- Sales, Marketing and Distribution." Management of Growth; Dependence on Key Personnel Since its inception, the Company has experienced significant growth in the number of its employees and in the scope of its operating and financial systems, resulting in increased responsibilities for the Company's management. To manage future growth effectively, the Company will need to continue to improve its operational, financial and management information systems, procedures and controls, and expand, train, motivate, retain and manage its employee base. The Company is in the process of implementing a new management information system. Any problems encountered in the implementation of such system could adversely affect the Company's operations. There can be no assurance that the Company will be able to manage its growth effectively, and failure to do so could have a material adverse effect on the Company's operating results. The Company's future success depends in part on the continued service of its key engineering, sales, marketing and executive personnel, including highly skilled semiconductor design personnel and software developers, and its ability to identify and hire additional personnel. Competition for such personnel is intense and there can be no assurance that the Company can retain and recruit necessary personnel to operate its business and support its future growth. In August 1996, the Company appointed a new President and Chief 12 13 Executive Officer to replace Terry N. Holdt, who retired, and in March 1997, the Company's Chief Financial Officer resigned, and there can be no assurance as to the effects of this management transition on the Company's business and operating results. The loss of key personnel could have a material adverse effect on the Company's business and operating results. The Company does not maintain key man insurance on any of its employees. See "Business Employees" and "Executive Officers of the Registrant." Importance of Intellectual Property; Litigation Involving Intellectual Property The Company's ability to compete will be affected by its ability to protect its proprietary information. The Company has filed several United States and foreign patent applications and to date has a number of issued United States patents. The Company relies primarily on its trade secrets and technological know-how in the conduct of its business. There can be no assurance that the steps taken by the Company to protect its intellectual property will be adequate to prevent misappropriation of its technology or that the Company's competitors will not independently develop technologies that are substantially equivalent or superior to the Company's technology. The semiconductor and software industries are characterized by frequent claims and related litigation regarding patent and other intellectual property rights. The Company is party to various claims of this nature. Although the ultimate outcome of these matters is not presently determinable, management presently believes that the resolution of all such pending matters will not have a material adverse effect on the Company's operating results. There can be no assurance that third parties will not assert additional claims or initiate litigation against the Company, its foundries, or its customers with respect to existing or future products. In addition, the Company may initiate claims or litigation against third parties for infringement of the Company's proprietary rights or to determine the scope and validity of the proprietary rights of the Company or others. Litigation by or against the Company has in the past, in the case of the Brooktree Corporation ("Brooktree") litigation, resulted and could in the future result in substantial expense to the Company and diversion of the efforts of the Company's technical and management personnel, whether or not litigation is determined in favor of the Company. In the event of litigation to determine the validity of any third-party claims, such litigation could result in significant expense to the Company and divert the efforts of the Company's technical and management personnel, whether or not litigation is determined in favor of the Company. In the event of an adverse result in any such litigation, the Company could be required to pay substantial damages, cease the manufacture, use, sale, offer for sale and importation of infringing products, expend significant resources to develop or obtain non-infringing technology, discontinue the use of certain processes or obtain licenses to the technology which is the subject of the litigation. There can be no assurance that the Company would be successful in such development or acquisition or that any such licenses, if available, would be available on commercially reasonable terms, and any such development or acquisition could require expenditures by the Company of substantial time and other resources. Any such litigation or adverse result therefrom could have a material adverse effect on the Company's operating results. In October 1995, Brooktree filed a complaint against the Company in the United States District Court for the Southern District of California, alleging that the Company's current products infringe a Brooktree patent. Such a lawsuit resulted in substantial expense to the Company to defend the action and diverted the efforts of the Company's technical and management personnel. In August 1996, the Company and Brooktree entered into a settlement and license agreement pursuant to which all claims and counterclaims between the parties were dismissed and the Company agreed to pay to Brooktree a license fee and royalties related to certain product revenues over a five-year period. International Operations Export sales accounted for 61%, 44% and 42% of the Company's net sales in 1996, 1995 and 1994, respectively, and the Company expects that export sales will continue to represent a significant portion of net sales, although there can be no assurance that export sales, as a percentage of net sales, will remain at current levels. In addition, a substantial proportion of the Company's products are manufactured, assembled and tested by independent third parties in Asia. Due to its export sales and independent third party manufacturing, assembly and testing operations, and its joint venture foundry, the Company is subject to the risks of conducting business internationally, including unexpected changes in, or impositions of, legislative or 13 14 regulatory requirements, fluctuations in the U.S. dollar, which could increase the sales price in local currencies of the Company's products in foreign markets or increase the cost of wafers purchased by the Company, delays resulting from difficulty in obtaining export licenses for certain technology, tariffs and other barriers and restrictions, potentially longer payment cycles, greater difficulty in accounts receivable collection, potentially adverse taxes, and the burdens of complying with a variety of foreign laws. In addition, the Company is subject to general geopolitical risks, such as political and economic instability and changes in diplomatic and trade relationships, in connection with its international operations. Two of the Company's independent foundries, UMC and TSMC, and the Company's joint venture foundry, USC, are located in Taiwan. The Company currently expects these three foundries to supply the substantial portion of the Company's products in 1997. The People's Republic of China and Taiwan at times experienced strained relations in 1995 and 1996, and the worsening of relations or the development of hostilities between the two parties could have a material adverse effect on the Company. Although the Company has not to date experienced any material adverse effect on its operations as a result of such regulatory, geopolitical, economic and other factors, there can be no assurance that such factors will not adversely impact the Company's operations in the future or require the Company to modify its current business practices. In addition, the laws of certain foreign countries may not protect the Company's intellectual property rights to the same extent as do the laws of the United States. Increased Leverage In connection with the sale of $103,500,000 aggregate principal amount of Convertible Subordinated Notes in September 1996, the Company's ratio of its long-term debt to its total capitalization increased from approximately 9.5% at June 30, 1996 to approximately 30.6% at December 31, 1996. As a result of this additional indebtedness, the Company's principal and interest obligations will increase substantially. The degree to which the Company is leveraged could adversely affect the Company's ability to obtain additional financing for working capital or other purposes and could make it more vulnerable to economic downturns and competitive pressures. The Company's increased leverage could also adversely affect its liquidity, as a substantial portion of available cash from operations may have to be applied to meet debt service requirements and, in the event of a cash shortfall, the Company could be forced to reduce other expenditures to be able to meet such requirements. See "Selected Consolidated Financial Data," and "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Liquidity and Capital Resources." Volatility of Stock Price The market price of the shares of Common Stock, like that of the common stock of many other semiconductor companies, has been and is likely to be highly volatile, and the market has from time to time experienced significant price and volume fluctuations that are unrelated to the operating performance of particular companies. The market price of the Common Stock could be subject to significant fluctuations in response to quarter-to-quarter variations in the Company's anticipated or actual operating results, announcements of new products, technological innovations or setbacks by the Company or its competitors, conditions in the semiconductor and PC industries, the commencement of, developments in or outcome of litigation, changes in or the failure by the Company to meet estimates of the Company's performance by securities analysts, market conditions for high technology stocks in general, and other events or factors. SALES, MARKETING AND DISTRIBUTION S3 markets and distributes its products through a direct sales organization supported by field applications engineers, as well as through a network of independent manufacturers' representatives and regional distributors. In North America, the Company uses a combination of independent manufacturers' representatives and a direct sales force operating from the Company's sales offices in California, Florida, Georgia, Oregon and Texas. In Asia, the Company operates from sales and distribution offices in Hong Kong, Japan, Singapore and Taiwan, and through manufacturers' representatives and local distributors located in People's Republic of China, Hong Kong, Japan, Korea and Taiwan. In Europe, the Company uses organizations that are both manufacturers' representatives and distributors in France, Germany, Italy and the United Kingdom. The loss of one or more representatives could have an adverse effect on the Company's operating results. The Company 14 15 has a global shipment program pursuant to which certain finished products are shipped directly to customers from the Company's independent assembly and testing houses. This program is intended to provide more timely delivery of such products to those customers by eliminating the intermediate step of shipping finished products to the Company's Santa Clara, California facility for repackaging and reshipment. The Company sells multimedia accelerators to leading systems manufacturers such as Acer Incorporated, AST Research Incorporated, Compaq Computer Corporation, Dell Computer Corporation, Gateway 2000, Inc., Hewlett-Packard Company, IBM, Packard Bell NEC, and Toshiba Corporation and to leading add-in board and motherboard manufacturers such as CNW International Limited, Diamond Multimedia Systems, Inc., DataExpert Corporation, ELSA GmbH, Intel Corporation, Micronics Computers, Inc., Number Nine Visual Technology Corporation, STB Systems, Inc. and Vtech Holdings Limited. Sales to these customers are typically made pursuant to specific purchase orders, which are cancelable without significant penalties. In 1996, one customer, Diamond Multimedia Systems, Inc. accounted for 15% of net sales. In 1995, two customers, Diamond Multimedia Systems, Inc. and Intel Corporation, accounted for 17% and 12%, respectively, of net sales. The Company expects a significant portion of its future sales to remain concentrated within a limited number of strategic customers. There can be no assurance that the Company will be able to retain its strategic customers or that such customers will not otherwise cancel or reschedule orders, or in the event of canceled orders, that such orders will be replaced by other sales. In addition, sales to any particular customer may fluctuate significantly from quarter to quarter. The occurrence of any such event could have a material adverse effect on the Company's operating results. Export sales accounted for 61%, 44%, and 42% of net sales in 1996, 1995, and 1994 respectively. Approximately 33% of export sales in 1996 were to affiliates of United States customers. Due to its export sales, the Company is subject to the risks of conducting business internationally, including those set forth above under "Factors That May Affect Results -- International Operations." CUSTOMER SUPPORT AND SERVICE The Company believes that customer service and technical support are important competitive factors in the accelerator market. The Company provides technical support for customers in major markets in North America, Europe and Asia. Distributors and manufacturers' representatives supplement the Company's efforts by providing additional customer service and technical support for S3's products. S3 also provides several other types of technical support, including software distribution through the World Wide Web, product demonstration software, evaluation boards and application notes. The Company works closely with its customers in tracking the progress of its product designs, providing applications design support and upgrading the customers' software to provide the latest enhancements under the Company's software maintenance program. S3 believes that close contact with its customers not only improves their level of satisfaction, but also provides important insights into defining the system requirements for next generation accelerators and related software products. MANUFACTURING AND DESIGN METHODOLOGY The Company currently relies on several independent foundries to manufacture all of its products. The Company's strategy is to utilize a number of qualified foundries that it believes provide cost, technology or capacity advantages for specific products. This strategy allows S3 to avoid the significant capital investment to construct an in-house wafer fabrication facility. As a result, S3 is able to focus its resources on product design and development, quality assurance, marketing, and customer support. The Company's accelerators are currently manufactured using a triple level metal CMOS process with line geometries as small as 0.45 micron. The Company will utilize a four level metal CMOS process with 0.35 micron line geometries for certain of its products scheduled for 1997 production. In order to provide increased functionality to meet the needs of the multimedia market without substantially increasing die size, the Company's products will have to be manufactured using increasingly smaller line geometries. The Company designs its products using proprietary circuit modules that are scalable in size to enable more rapid adoption of smaller line geometry manufacturing processes and a common design rule approach to operate within the process parameters of multiple foundries. 15 16 Multiple sources for certain products increase the Company's ability to supply its customers with those products and reduce the Company's dependence on any single foundry. However, the Company has not developed alternate sources of supply for certain products, and its newly introduced products are typically produced initially by a single foundry until alternate sources can be qualified. The Company currently has long-term supply agreements with only the two foundries described below. The Company conducts business with all but one of its current foundries by delivering written purchase orders specifying the particular product ordered, quantity, price, delivery date and shipping terms and, therefore, the foundries are generally not obligated to supply products to the Company for any specific period, in any specific quantity or at any specified price, except as may be provided in a particular purchase order. To the extent a foundry terminates its relationship with the Company or should the Company's supply from a foundry be interrupted or terminated for any other reason, such as a natural disaster, the Company may not have a sufficient amount of time to replace the supply of products manufactured by that foundry. Historically, certain foundries have also provided packaging and testing for S3's products and other activities necessary to deliver finished products. S3 pays those foundries only for fully tested products meeting predetermined specifications. In the assembly process, the silicon wafers are separated into individual die that are then assembled into packages and tested in accordance with the Company's test procedures. Following assembly, the packaged devices are further tested and inspected pursuant to the Company's quality assurance program before shipment to customers. To ensure the integrity of its foundries' quality assurance procedures, the Company develops detailed test procedures and specifications for each product and requires the foundry to use those procedures and specifications before shipping finished products or wafers. Product returns to date have not been significant. In 1995, the Company entered into two long-term manufacturing capacity arrangements. The Company entered into an agreement with UMC and Alliance Semiconductor Corporation to form, USC, a separate Taiwanese company, for the purpose of building and managing a semiconductor manufacturing facility in the Science-Based Industrial Park in Hsin Chu City, Taiwan. The facility began production utilizing advanced submicron semiconductor manufacturing processes in 1996. The Company has the right to purchase 31.25% of the output from the foundry. In addition, the Company expanded and formalized its relationship with TSMC to provide additional capacity over the 1996 to 2000 timeframe. The agreement with TSMC requires the Company to make certain annual advance payments to be applied against the following year's capacity. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Liquidity and Capital Resources." There can be no assurance that the Company will obtain sufficient sources of supply of product to meet customer demand in the future. Obtaining sufficient foundry capacity is particularly difficult during periods of high growth, and may become substantially more difficult if the Company's product requirements increase significantly. In addition, because the Company must order products and build inventory substantially in advance of product shipments, there is a risk that the Company will forecast incorrectly and produce excess or insufficient inventories of particular products. This inventory risk is heightened because certain of the Company's key customers place orders with short lead times. In addition, the Company's customers may change delivery schedules or cancel orders without significant penalty. To the extent the Company produces excess or insufficient inventories of particular products, the Company's operating results could be adversely affected. See "Factors That May Affect Results -- Dependence on Foundries and Other Third Parties" and "-- Transactions to Obtain Manufacturing Capacity; Future Capital Needs." PC graphics and multimedia subsystems include, in addition to the Company's products, a number of other components, which are supplied by third party manufacturers. Any shortage of such components in the future could adversely affect the Company's business and operating results. The Company uses an automated design environment based on advanced workstations, dedicated product simulators, system simulation with hardware and software modeling, and the use of a high level design description language in order to more rapidly define, develop and deliver new and enhanced products. The Company considers its computer-aided engineering ("CAE") and computer-aided design ("CAD") capabilities to be important to its future success in all areas of new product development and intends to continue to 16 17 enhance its CAE/CAD systems. Although the Company extensively tests its software and hardware products prior to their introduction, it is possible that design errors may be discovered after initial product sampling, resulting in delays in volume production or recall of products sold. The occurrence of any such errors could have a material adverse effect on the Company's product introduction schedule and operating results. RESEARCH AND DEVELOPMENT The Company believes that continued timely development and introduction of new products are essential to maintaining its competitive position. The Company currently conducts most of its product development effort in-house and, at December 31, 1996, had a staff of 369 research and development personnel, of whom approximately 30% are involved in software development. The Company also employs outside consultants to assist with software testing. The Company is focusing its current development efforts primarily on the development of enhanced versions of its existing family of graphics and multimedia accelerators and adding new functionality to its products for business desktop, mobile and home PC markets. In addition, the Company intends to continue to devote significant resources to the development of a broad range of high-performance software drivers to support its products. During 1996, 1995 and 1994, the Company spent approximately $63.4 million, $42.1 million and $17.9 million, respectively, on research and development activities. COMPETITION The markets in which the Company competes are extremely competitive and the Company expects that competition will increase. The principal factors of competition in the Company's markets include performance, product features, product availability, price, quality, timing of new product introductions by the Company and its competitors, the emergence of new graphics and PC standards, and customer support. Price competition in the industry is intense and may increase, which may have a material adverse effect on the Company's operating results. There can be no assurance that the Company will be able to compete successfully as to price or any of these other factors. The Company's principal competitors for graphics accelerators include ATI Technologies, Inc., Cirrus Logic, Inc., Matrox Graphics, Inc., and Trident Microsystems, Inc. The Company's principal competitors in the multimedia market include the companies named in the preceding sentence and a number of smaller companies which may have greater flexibility to address specific market needs. Potential competitors in these markets include both large and emerging companies that have announced plans to develop 3D graphics chips, including Intel Corporation and Lockheed Martin Corporation, which have announced a joint venture to develop such chips, and Texas Instruments Incorporated, which has announced a development and marketing agreement with 3Dlabs Inc. To the extent the Company expands its product line to add products with additional functionality, such as audio, communications and system logic functions, it will encounter substantial competition from established semiconductor companies and may experience competition from companies designing chips based on different technologies, such as softwarecentric multimedia processors. Certain of the Company's current and potential competitors have greater technical, manufacturing, financial and marketing resources than the Company. The Company's future success will be highly dependent upon the successful development and timely introduction of new products that are responsive to market needs at competitive prices. There can be no assurance that the Company will be able to successfully develop or market any such products. See "Factors That May Affect Results -- Substantial Competition." LICENSES, PATENTS AND TRADEMARKS The Company has filed several United States patent applications for its technology and to date has four issued United States patents. The Company attempts to protect its trade secrets and other proprietary information through agreements with its customers, suppliers, employees and consultants, and through other security measures. Although the Company intends to protect its rights vigorously, there can be no assurance that these measures will be successful or that any issued patents will provide the Company with adequate protection with respect to the covered products, technology or processes. 17 18 The semiconductor and software industries are characterized by frequent claims and related litigation regarding patent and other intellectual property rights. The Company is party to various claims of this nature. Although the ultimate outcome of these matters is not presently determinable, management presently believes that the resolution of all such pending matters will not have a material adverse effect on the Company's operating results. There can be no assurance that third parties will not assert additional claims or initiate litigation against the Company, its foundries or its customers with respect to existing or future products. In addition, the Company may initiate claims or litigation against third parties for infringement of the Company's proprietary rights or to determine the scope and validity of the proprietary rights of the Company or others. Litigation, such as the Brooktree litigation, by or against the Company could result in significant expense to the Company and divert the efforts of the Company's technical and management personnel, whether or not such litigation is determined in favor of the Company. In the event of an adverse result in any such litigation, the Company could be required to pay substantial damages, cease the manufacture, use, sale, offer for sale and importation of infringing products, expend significant resources to develop or obtain non-infringing technology, discontinue the use of certain processes or obtain licenses to the technology which is the subject of the litigation. There can be no assurance that the Company would be successful in such development or acquisition or that any such licenses, if available, would be available on commercially reasonable terms, and any such development or acquisition could require expenditures by the Company of substantial time and other resources. See "Factors That May Affect Results -- Importance of Intellectual Property; Litigation Involving Intellectual Property", "Legal Proceedings" and "Management's Discussion and Analysis of Financial Condition and Results of Operations." The Company has applied to the United States Patent and Trademark Office for registration of a number of trademarks and also holds common law rights in a number of trademarks. A U.S. registration has issued to the Company for the marks Galileo, S3, S3 (stylized), S3 On Board, S3 Trio64, S3d (stylized), Trio, True Acceleration, and ViRGE. The S3 corporate logo, S3 On Board design mark, Aurora, the Plato family of marks, S3D, SDAC, SonicVibes, Streams Processor, Innovations In Acceleration, No Compromise Acceleration, No Compromise Integration, Cooperative Accelerator Architecture, DuoView, the Scenic family of marks, SmartFilter, the Sonic family of marks, SonicVibes, the Trio family of marks, TV-Tuner, the ViRGE family of marks, and the Vision family of marks are trademarks of the Company. The Company has also applied for trademark registration of some of its trademarks in certain foreign jurisdictions. There can be no assurance that the Company will obtain the registrations for which it has applied. Other trademarks referenced in this document are owned by their respective companies. If the Company's use of a registered or unregistered trademark were found to violate a third party's common law or statutory trademark rights, the Company's business could be adversely affected. In addition, the laws of certain countries in which the Company's products are or may be developed, manufactured or sold, including Hong Kong, Japan and Taiwan, may not protect the Company's products and intellectual property rights to the same extent as the laws of the United States. BACKLOG Sales of the Company's products are made pursuant to standard purchase orders that are cancelable without significant penalties. In addition, purchase orders are subject to price renegotiations and to changes in quantities of products and delivery schedules in order to reflect changes in customers' requirements and manufacturing availability. The Company's business, and to a large and growing extent that of the entire semiconductor industry, is characterized by short lead time orders and quick delivery schedules. In addition, the Company's actual shipments depend on the manufacturing capacity of the Company's suppliers and the availability of products from such suppliers. As a result of the foregoing factors, the Company does not believe that backlog at any given time is a meaningful indicator of future sales. EMPLOYEES At December 31, 1996, the Company employed 636 individuals, of whom 86 were employed in operations, 369 in research and development, 119 in sales, marketing and technical support, and 62 in administration and other support functions. Approximately 75% of these employees hold engineering degrees. 18 19 Competition for personnel in the semiconductor, software and the PC industry in general is intense. The Company believes that its future success will depend, in part, on its ability to continue to attract, train, motivate, retain and manage highly skilled technical, marketing and management personnel. None of the Company's employees is represented by a labor union or is subject to a collective bargaining agreement. The Company believes that its relations with its employees are good. ITEM 2. PROPERTIES. In December 1995, the Company entered into a limited partnership arrangement with a developer to obtain a ground lease and develop and operate the Company's future Santa Clara facilities. In January 1997, the Company relocated its principal administrative, sales, marketing, research and development facility consisting of approximately 300,000 square feet of space in two buildings located in Santa Clara, California, the initial phase of the development. This space is leased for an initial 12-year term. The Company has an option to build an additional two buildings comprising approximately 300,000 square feet. The Company has vacated its previous Santa Clara facilities prior to the expiration of their lease terms in order to occupy the new facilities. The previous facilities consisted of approximately 159,000 square feet in four buildings in Santa Clara, California pursuant to leases that expire between July 1996 and May 2000. The Company has sublet two of the buildings in 1996 and in January 1997 terminated the lease on one building at no material cost. The Company presently expects to sublease the remaining facility for the remaining lease term that expires in May 1998 or negotiate a lease termination at no material cost, although there can be no assurance that the Company will be able to do so. The Company also leases office space in Georgia, Texas, Hong Kong, Japan and Taipei, Taiwan, and a warehouse in Singapore in order to provide sales, distribution and technical support to customers in the United States and Asia. Additional research and development offices are also leased in Saratoga, California, Colorado Springs, Colorado, and Bangalore, India. The facilities currently leased are currently sufficient for the Company's operations and are substantially fully utilized. In connection with the Company's investment in the real estate partnership, in February 1997, the Company (together with the developer) has obtained permanent nonrecourse financing for the construction of the Santa Clara facilities. The Company is not a guarantor on the permanent financing. ITEM 3: LEGAL PROCEEDINGS. In October 1995, Brooktree filed a complaint against the Company in the United States District Court for the Southern District of California, alleging that the Company's current products infringe a Brooktree patent. In August 1996, the Company and Brooktree entered into a settlement and license agreement pursuant to which all claims and counterclaims between the parties were dismissed. S3 made no admission of infringement or any other wrongdoing. The settlement requires S3 to pay to Brooktree a license fee and royalties related to certain product revenues over a five-year period, and each company has agreed not to sue the other with respect to video and graphics products over such five-year period. See "Factors That May Affect Results -- Importance of Intellectual Property; Litigation Involving Intellectual Property" and "Management's Discussion and Analysis of Financial Condition and Results of Operations." The semiconductor and software industries are characterized by frequent litigation regarding patent and other intellectual property rights. The Company is party to various claims of this nature. Although the ultimate outcome of these matters is not presently determinable, management believes that the resolution of all such pending matters will not have a material adverse effect on the Company's financial position or results of operations. ITEM 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. Not applicable. 19 20 EXECUTIVE OFFICERS OF THE REGISTRANT The executive officers of the Company and their ages as of March 28, 1997 are as follows:
NAME AGE ------------------------------ ---- Diosdado P. Banatao 50 Chairman of the Board Gary J. Johnson 37 President and Chief Executive Officer G. Ven Venkatesh 39 Executive Vice President Harry L. Dickinson 49 Sr. Vice President of Sales Paul G. Franklin 54 Sr. Vice President of Operations Neal D. Margulis 33 Sr. Vice President of Research and Technology Ronald T. Yara 50 Sr. Vice President of Strategic Marketing and Secretary
Mr. Banatao co-founded the Company and has served on a full-time basis as Chairman of the Board since January 1992. Mr. Banatao also served as President and Chief Executive Officer of the Company from its inception until January 1992. From December 1984 to December 1988, Mr. Banatao held various executive level positions at Chips & Technologies, Inc., a semiconductor company he co-founded, most recently as Vice President and General Manager of the Advanced Products Operation. From February 1984 to December 1984, Mr. Banatao served as Chief Technical Officer and Vice President of Engineering of Mostron, Inc., a single-board computer design company. From June 1981 to February 1984, he served as Director of Logic Products at Seeq Technology, Inc. a semiconductor manufacturer. Mr. Banatao holds a B.S.E.E. from the Mapua Institute of Technology and an M.S. in electrical engineering and computer science from Stanford University. Mr. Johnson, President and Chief Executive Officer, joined the Company in July 1994. From 1986 to June 1994, Mr. Johnson held various positions at National Semiconductor Corporation, a semiconductor manufacturer, including Managing Director/General Manager of the Wireless Networking Group, Operations and Marketing Director of the Wireless Communications Group and other senior marketing positions. From 1975 to 1986, he held various engineering positions at British Telecommunications, most recently Systems Development Manager. Mr. Johnson holds a B.Sc., CEng from Leicester Polytechnic, UK, and is a member of I.E.E. and I.E.E.E. Mr. Venkatesh, Executive Vice President, joined the Company in December 1996. Prior to joining the Company, Mr. Venkatesh served as President and Chief Executive Officer of Echelle, Incorporated, a startup company, from 1995 to 1996. From 1989 to 1994, Mr. Venkatesh was Corporate Vice President and General Manager of Adaptec, Incorporated, a supplier of high-performance I/O, connectivity and network products. Mr. Venkatesh attended the Btech Institute of Technology in Madras, India and holds an M.S.E.E. from the University of Massachusetts. Mr. Dickinson, Senior Vice President of Sales, joined the Company in February 1992. Prior to joining the Company, Mr. Dickinson served as Vice President of Sales of TransSwitch Corporation, a semiconductor company from 1990 to January 1992. From 1984 to 1990, Mr. Dickinson was the Director of Corporate Accounts for Mentor Graphics Corporation/SSD, (formerly Silicon Compiler Systems), a software company. Mr. Dickinson holds a B.S. in marketing from San Diego State University. Mr. Franklin, Senior Vice President of Operations, became an employee of the Company in September 1992. From March 1991 to September 1992 he was a consultant to the Company. Mr. Franklin was a consultant for a number of semiconductor companies from January 1990 through March 1991. From March 1986 to December 1989, Mr. Franklin was Vice President of Operations of Actel Corporation, a supplier of field programmable gate arrays. Prior to 1986 Mr. Franklin held various management positions at Monolithic Memories Inc., a supplier of semiconductor memories and programmable logic. Mr. Margulis, Senior Vice President of Research and Technology, joined the Company in December 1989 and has held various engineering and marketing positions. Prior to joining the Company, Mr. Margulis held various positions at Intel Corporation, a semiconductor and system manufacturer, in the microprocessor 20 21 group. His positions included design engineering and most recently Chief Applications Engineer for high performance processors. He earned a B.S.E.E. from the University of Vermont. Mr. Yara co-founded the Company and is currently Senior Vice President, Strategic Marketing and Secretary. From the inception of the Company in 1989 until December 1993, he served as Vice President, Marketing. From December 1984 to December 1989, Mr. Yara held various positions at Chips & Technologies, Inc., a semiconductor company he co-founded, most recently as Vice President of Business Development. From February 1975 to 1984, Mr. Yara served in various positions at Intel Corporation, most recently as Product Marketing Manager of Communication Products. He earned a B.S.E.E. from Purdue University and an M.S.E.E. from the University of Santa Clara. PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The Company's Common Stock is traded on the Nasdaq National Market under the symbol SIII. See "Item 8. -- Selected Quarterly Consolidated Data" on page 46 for the range of high and low closing sales prices for the Common Stock on the Nasdaq National Market, as reported by Nasdaq. On September 18 and September 20, 1996, the Company completed the sale of $90.0 million and $13.5 million aggregate principal amount of 5 3/4% Convertible Subordinated Notes due 2003 (the "Notes"). The Notes are convertible at the option of the holder into shares of Common Stock of the Company, at any time prior to redemption or maturity, at a conversion price of $19.22 per share (equal to a conversion rate of 52.0291 shares per $1,000 principal amount of Notes and representing in the aggregate 5,385,015 shares), subject to adjustment under certain circumstances. The Notes were sold by the Company to Lehman Brothers Inc., PaineWebber Incorporated and Cowen & Company, as initial purchasers (the "Initial Purchasers"), in a private placement in reliance upon Section 4(2) of the Securities Act of 1993 (the "Securities Act") and Regulation D promulgated under the Securities Act. The aggregate offering price of the Notes was $103.5 million and the aggregate discount to the Initial Purchasers was $3.1 million. The Company has been advised that the Initial Purchasers resold $97.05 million aggregate principal amount of the Notes to "qualified institutional buyers" in reliance on Rule 144A under the Securities Act, $3.35 million aggregate principal amount of the Notes to a limited number of institutions that are "accredited investors" within the meaning of Rule 501(a)(1), (2), (3) or (7) under the Securities Act, and $3.1 million aggregate principal amount of the Notes in sales outside the United States to persons other than U.S. persons in reliance upon Regulation S under the Securities Act. 21 22 ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA.
YEARS ENDED DECEMBER 31, ------------------------------------------------------------ 1996 1995 1994 1993 1992 -------- -------- -------- -------- -------- (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS AND RATIOS) STATEMENT OF INCOME DATA Net sales........................... $465,378 $316,309 $140,309 $112,969 $ 30,621 Gross margin(1)..................... 184,365 126,542 42,334 47,309 15,332 Research and development expenses... 63,382 42,080 17,913 11,539 4,512 Selling, marketing and administrative expenses........... 48,800 33,510 18,310 12,500 6,066 Income from operations.............. 72,183 50,952 6,111 23,270 4,754 Income before cumulative effect of accounting change................. 48,367 35,374 5,502 15,120 4,447 Net income(2)....................... $ 48,367 $ 35,374 $ 5,502 $ 18,620 $ 4,447 Per share amounts: Income before cumulative effect of accounting change Primary........................... $ 0.95 $ 0.75 $ 0.14 $ 0.41 $ 0.16 Assuming full dilution(3)......... $ 0.94 $ 0.75 $ 0.14 $ 0.41 $ 0.16 Net income Primary........................... $ 0.95 $ 0.75 $ 0.14 $ 0.50 $ 0.16 Assuming full dilution(3)......... $ 0.94 $ 0.75 $ 0.14 $ 0.50 $ 0.16 Common and equivalent shares used in computing per share amount Primary........................... 50,929 47,013 39,614 37,472 28,662 Assuming full dilution(3)......... 52,733 47,013 39,614 37,472 28,662 Ratio of earnings to fixed charges(4)........................ 38.75x -- 165.98x 137.34x 19.45x BALANCE SHEET DATA Cash and equivalents................ $ 94,616 $ 69,289 $ 25,772 $ 22,538 $ 5,583 Short-term investments.............. 62,768 24,630 8,800 21,997 -- Working capital..................... 232,329 144,620 59,727 55,057 6,370 Total assets........................ 480,462 321,643 89,460 81,660 15,600 Long-term obligations............... 20,852 24,761 813 384 1,179 Convertible subordinated notes...... 103,500 -- -- -- -- Redeemable convertible preferred stock............................. -- -- -- -- 16,761 Stockholders' equity (deficiency)... $267,100 $205,864 $ 68,878 $ 60,985 $ (9,938)
- --------------- (1) Gross margin was adversely impacted in 1994 by a pre-tax $9.9 million charge for adjusting the valuation of the Company's non-integrated 32-bit inventory. (2) Includes the cumulative effect of adopting SFAS 109 in 1993 which increased net income by $3.5 million ($0.09 per share). (3) Fully diluted earnings per share includes the effect of incremental shares issuable upon the conversion of the convertible subordinated notes and an adjustment to net income for the interest expense (net of income taxes) related to the notes. (4) For purposes of calculating the ratio of earnings to fixed charges, (i) earnings consist of consolidated income before income taxes plus fixed charges and (ii) fixed charges consist of interest expense incurred and the portion of rental expense under operating leases deemed by the Company to be representative of the interest factor. The Company had no fixed charges in 1995. 22 23 ITEM 7.MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS When used in this discussion, the words "expects," "anticipates," "estimates" and similar expressions are intended to identify forward-looking statements. Such statements, which include statements concerning the timing of availability and functionality of products under development, product mix, trends in average selling prices, trends in the PC market, the percentage of export sales and sales to strategic customers and the availability and cost of products from the Company's suppliers, are subject to risks and uncertainties, including those set forth below and in Item 1 of this Report under the caption "Business -- Factors That May Affect Results," that could cause actual results to differ materially from those projected. These forward-looking statements speak only as of the date hereof. The Company expressly disclaims any obligation or undertaking to release publicly any updates or revisions to any forward-looking statements contained herein to reflect any change in the Company's expectations with regard thereto or any change in events, conditions or circumstances on which any statement is based. RESULTS OF OPERATIONS The following table sets forth for the years indicated certain financial data as a percentage of net sales:
YEARS ENDED DECEMBER 31, ------------------------- 1996 1995 1994 ----- ----- ----- Net sales........................................... 100.0% 100.0% 100.0% Cost of sales....................................... 60.4 60.0 69.8 ----- ----- ----- Gross margin........................................ 39.6 40.0 30.2 Operating expenses: Research and development.......................... 13.6 13.3 12.8 Selling, marketing and administrative............. 10.5 10.6 13.0 ----- ----- ----- Total operating expenses....................... 24.1 23.9 25.8 ----- ----- ----- Income from operations.............................. 15.5 16.1 4.4 Other income, net................................... 0.5 1.4 0.5 ----- ----- ----- Income before income taxes.......................... 16.0 17.5 4.9 Provision for income taxes.......................... 5.6 6.3 1.0 ----- ----- ----- Net income.......................................... 10.4% 11.2% 3.9% ===== ===== =====
The Company's operating results have historically been, and will continue to be, subject to quarterly and other fluctuations due to a variety of factors, including changes in pricing policies by the Company, its competitors or its suppliers, anticipated and unanticipated decreases in unit average selling prices of the Company's products, availability and cost of products from the Company's suppliers, changes in the mix of products sold and in the mix of sales by distribution channels, the gain or loss of significant customers, new product introductions by the Company or its competitors, market acceptance of new or enhanced versions of the Company's products, seasonal customer demand, and the timing of significant orders. The Company's operating results may fluctuate from those in prior periods or may be adversely affected in periods in which it is undergoing a product line transition in which production and sales of new products are ramping up and in which existing products are under extreme price pressures due to competitive factors. If new products are not brought to market in a timely manner or do not address market needs or performance requirements, then the Company's operating results will be adversely affected. As a result of the foregoing, the Company's operating results and stock price may be subject to significant volatility, particularly on a quarterly basis. Any shortfall in net sales or net income from levels expected by securities analysts could have an immediate and significant adverse effect on the trading price of the Company's Common Stock. NET SALES The Company's net sales to date have been generated from the sale of its graphics and multimedia accelerators. The Company's products are used in, and its business is dependent on, the personal computer 23 24 industry with sales primarily in the U.S., Asia, and Europe. Net sales were $465.4 million in 1996, a 47% increase above the $316.3 million in 1995. Net sales increased in 1996 primarily as a result of the addition of the ViRGE product line and strong demand for the Company's 64-bit Trio products that resulted in increased unit shipments. The increased sales of the ViRGE and Trio family of accelerators was partially offset by a decrease in the 64-bit Vision family of accelerators, which has decreased significantly as the Company transitioned to sales of its ViRGE family of 2D/3D accelerators. The Company expects that the percentage of its net sales represented by any one product or type of product may change significantly from period to period as new products are introduced and existing products reach the end of their product life cycles. The increase in unit shipments was partially offset by lower overall average selling prices for all the product families. Due to competitive price pressures, the Company's products experience declining unit average selling prices over time, which at times can be substantial. Net sales were $316.3 million in 1995, a 125% increase above the $140.3 million in 1994. Net sales increased in 1995 primarily due to market demand for the Company's 64-bit products, increased product availability from the Company's qualified independent foundries and the addition of several new products to the Company's product line. The increase in unit shipments was partially offset by lower overall average selling prices. The pricing environment for 2D graphics accelerators, which accounted for a majority of the Company's net sales in 1996, has recently experienced and is expected to continue to experience increasing pricing pressures due in part to the alleviation of supply constraints that contributed to more stable pricing in 1995 and to aggressive pricing from certain of the Company's competitors. In particular, the Company's Trio family of integrated 2D accelerators experienced significant decreases in average selling prices in 1996. The Company expects that the graphics accelerator market will transition from 2D acceleration to 3D acceleration, and the Company has introduced its ViRGE family of 2D/3D accelerators in response to this expected transition. As a result of the entry of competitors into the 3D acceleration market, the Company anticipates that it may experience increased pricing pressures on average selling prices for the ViRGE family of 2D/3D accelerators. If the transition occurs slower than expected, if the Company's graphic products do not achieve market acceptance, or if the pricing pressures increase, then the Company's operating results could be adversely affected. Export sales accounted for 61%, 44%, and 42% of net sales in 1996, 1995, and 1994 respectively. Approximately 12% and 27% of export sales were shipped to Hong Kong and Taiwan, respectively and 33% of export sales in 1996 were to affiliates of United States customers. The Company expects that export sales will continue to represent a significant portion of net sales, although there can be no assurance that export sales as a percentage of net sales will remain at current levels. All sale transactions are denominated in U.S. dollars. One customer accounted for 15% of net sales in 1996, two customers accounted for 17% and 12% of net sales in 1995 and two customers accounted for 19% and 16% of net sales in 1994. The Company expects a significant portion of its future sales to remain concentrated within a limited number of strategic customers. There can be no assurance that the Company will be able to retain its strategic customers or that such customers will not otherwise cancel or reschedule orders, or in the event of canceled orders, that such orders will be replaced by other sales. In addition, sales to any particular customer may fluctuate significantly from quarter to quarter. The occurrence of any such events or the loss of a strategic customer could have a material adverse effect on the Company's operating results. The occurrence of any supply problems for the Company's products may adversely affect the rate of growth in net sales. Net sales may also be adversely affected by delays in the production ramp of customers' new programs and systems which incorporate the Company's products. In addition, the Company generally ships more product in the third month of each quarter than in either of the first two months of the quarter, with shipments in the third month higher at the end of the month. This pattern, which is common in the semiconductor industry, is likely to continue. The concentration of sales in the last month of the quarter may cause the Company's quarterly results of operations to be more difficult to predict. Moreover, a disruption in the Company's production or shipping near the end of a quarter could materially reduce the Company's net sales for that quarter. The Company's reliance on outside foundries and independent assembly and testing houses reduces the Company's ability to control, among other things, delivery schedules. 24 25 GROSS MARGIN Gross margin percentage was 40% in 1996 and 1995. The gross margin in 1996 was impacted by decreases in overall average selling prices of the 64-bit Trio family and ViRGE family of accelerators, offset by the decrease in the unit average costs resulting from the Company's foundries' conversion to 8-inch wafers and 0.45 micron technology and changes in the pricing strategies from independent foundries for finished goods inventory due to the alleviation of supply constraints in 1996 and shift in product mix from the Vision products to the ViRGE products. In the future, the Company's gross margin percentages may be affected by increased competition and related decreases in the unit average selling prices (particularly with respect to older generation products), timing of volume shipments of new products, the availability and cost of products from the Company's suppliers, changes in the mix of products sold, the profitability of the USC joint venture (the Company recognizes its proportionate share of USC profits and losses), the extent to which the Company forfeits or utilizes it production capacity rights with TSMC, the extent to which the Company will incur additional licensing fees and shifts in sales mix between add-in card and motherboard manufacturers and systems OEMs. Gross margin percentage increased to 40% in 1995 from 30% in 1994. The gross margin percentage increase in 1995 was primarily due to the gross margin in 1994 being adversely impacted by a pre-tax $9.9 million charge for adjusting the valuation of the Company's non-integrated 32-bit inventory to reflect a decline in its value and to a lesser extent to increase the reserve for excess inventory for those products. The market value of the Company's non-integrated 32-bit products declined primarily because competitors' integrated 32-bit accelerator products offered a more competitive solution. Additionally, the 1995 gross margin increased as the Company achieved proportionately greater decreases in unit average costs compared to decreases in overall average selling prices. The unit average cost decreases were principally the result of changes in the Company's design method and manufacturing strategy and shifts to lower cost foundries. The Company must order products and build inventory substantially in advance of product shipments and, because the markets for the Company's products are volatile and its products are subject to rapid technological and price changes, there is a risk that the Company will forecast incorrectly and produce excess or insufficient inventories of particular products. The Company's customers' ability to reschedule or cancel orders without significant penalty could adversely affect the Company's operating results, as the Company may be unable to adjust its purchases from its independent foundries to match such customers' changes and cancellations. To the extent the Company produces excess or insufficient inventories of particular products, the Company's operating results could be adversely affected. RESEARCH AND DEVELOPMENT EXPENSES The Company has made and intends to continue to make significant investments in research and development to remain competitive by developing new and enhanced products. Research and development expenses were $63.4 million in 1996, $42.1 million in 1995 and $17.9 million in 1994. Research and development spending increases reflect additions to the Company's engineering staff and initial product verification and nonrecurring engineering expenses related to the introduction of new products. Research and development spending is expected to increase in absolute dollars in 1997 as a result of product development activities currently underway for the desktop, mobile and home PC markets with a focus on video, 3D, audio and communications. Products in the Company's market typically have a life cycle of 12 to 18 months. The successful development and commercialization of new products required to replace or supplement existing products involve many risks, including the identification of new product opportunities, the successful and timely completion of the development process, and the selection of the Company's products by leading systems suppliers and motherboard and add-in card manufacturers for design into their products. There can be no assurance that the Company will successfully identify new product opportunities and develop and bring to the market in a timely manner successful new products, that products or technologies developed by others will not render the Company's products noncompetitive, or that the Company's products will be selected for design into its customers' products. In addition, it is possible that the Company's products may be found defective 25 26 after the Company has already shipped significant volume production. There can be no assurance that the Company would be able to successfully correct such problems or that such corrections would be acceptable to customers. The occurrence of any such events would have a material adverse effect on the Company's operating results. SELLING, MARKETING AND ADMINISTRATIVE EXPENSES Selling, marketing and administrative expenses were $48.8 million in 1996, $33.5 million in 1995, and $18.3 million in 1994. Selling and marketing costs have increased from year to year as a result of additional personnel, increased commissions associated with higher sales levels and increased marketing costs associated with the introduction of new products. Administrative costs have increased due to the hiring of additional personnel necessary to support the increased level of operations and the litigation costs in defending the Brooktree lawsuit, which was settled in August 1996. The Company anticipates that selling, marketing and administrative expenses will increase in absolute dollars in 1997. OTHER INCOME, NET Other income, net, decreased in 1996 to $2.2 million from $4.5 million in 1995. The decrease is attributable to the interest expense incurred on $103.5 million aggregate principal amount of convertible subordinated notes, which were issued by the Company in September 1996. Other income, net, increased in 1995 to $4.5 million from $0.8 million in 1994. Other income, net, increased in 1995 due to the higher average amounts of cash and short-term investments as a result of the net proceeds of $89.8 million from a follow-on common stock offering completed in May 1995. INCOME TAXES The Company's effective income tax rate was 35% in 1996, 36% in 1995 and 21% in 1994. The 1996 tax rate was lower due to an increase in tax credits as a result of the increase in research and development expenses in absolute dollars. In 1995, the effective income tax rate was higher than the federal statutory rate due to state income taxes partially offset by research and development credits. The 1994 tax rate was lower than the federal statutory rate in 1994 as research and development tax credits had a greater impact in 1994 due to the lower pre-tax income as a result of the pre-tax charge of $9.9 million discussed above. LIQUIDITY AND CAPITAL RESOURCES Cash, cash equivalents and short-term investments increased by $63.5 million in 1996 to $157.4 million from $93.9 million at the end of 1995. The Company generated $34.2 million from operating activities in 1996, offset by $120.5 million of cash used for investing activities, including the USC joint venture, net purchases of investments and investments in property, plant and equipment. In addition, the Company generated $111.6 million of cash from financing activities, primarily due to the net proceeds of $100.1 million from the issuance of convertible subordinated notes in the third quarter of 1996, net borrowings on the equipment financing and line of credit, and $7.0 million of proceeds from the sale of common stock under employee stock option and stock purchase plans. Cash provided by operating activities was $34.2 million in 1996, an increase of $10.4 million from $20.0 million in 1995. The increase was due to net income, lower accounts receivable, and higher accrued liabilities and income taxes payable, partially offset by an increase in inventory and prepaid expenses and other and a decrease in accounts payable. The decrease in accounts receivable is a result of greater linearity in sales in the fourth quarter of 1996 compared to the fourth quarter of 1995, in which a substantial proportion of shipments occurred in the third month of that quarter as compared to the first two months of that quarter. The increase in inventory is primarily due to higher levels of finished goods to support increased levels of business. Cash provided by operating activities for 1995 was $20.0 million primarily due to an increase in net income and to working capital management in 1995 as compared to 1994. The Company experienced an increase in inventory and accounts receivable due to a substantial increase in net sales. These increases were partially offset by increases in accounts payable and accrued liabilities. Cash used for operating activities in 1994 was 26 27 $3.1 million, reflecting increases in inventories and accounts receivable which more than offset other sources of cash provided by operating activities. Accounts receivable increased primarily as a result of the substantial increase in net sales in 1994 as compared to 1993 and to the concentration of sales in December 1994. Continued expansion of the Company's business is likely to require higher levels of accounts receivable and inventory. Investing activities for the years ended December 31, 1996, 1995, and 1994 reflected property and equipment purchases of $23.4 million, $17.6 million, and $7.6 million, respectively, sales and maturities of short-term investments, the 1996 investment in a real estate partnership for the Company's new headquarters facility of $2.1 million and the investment in joint venture of $53.0 million, as discussed below. Continued expansion of the Company's business may require higher levels of capital equipment purchases, foundry investments and other payments to secure manufacturing capacity. Financing activities provided cash of $111.6 million, $96.0 million, and $0.9 million for 1996, 1995, and 1994, respectively. The increase in 1996 primarily reflects the offering of $103.5 million aggregate principal amount of convertible subordinated notes completed in September 1996. Net proceeds from the sale of the notes were approximately $100.1 million. The notes mature in 2003. Interest is payable semi-annually at 5 3/4% per annum. The notes are convertible at the option of the note holders into the Company's common stock at an initial conversion price of $19.22 per share, subject to adjustment. Beginning in October 1999, the notes are redeemable at the option of the Company at an initial redemption price of 102% of the principal amount. The Company has reserved 5,385,016 shares of common stock (plus such additional number of shares that may be required pursuant to the operation of anti-dilution provisions) for the conversion of these notes. The 1995 amount primarily reflects the net proceeds of the follow-on common stock offering completed in May 1995. In 1995, the Company entered into two long-term manufacturing capacity arrangements. The Company entered into an agreement with UMC and Alliance Semiconductor Corporation to form USC, a separate Taiwanese company, for the purpose of building and managing a semiconductor manufacturing facility in the Science Based Industrial Park in Hsin Chu City, Taiwan, Republic of China. The Company invested $53.0 million in 1996 and $36.4 million in 1995 for its 23.75% equity interest. The facility commenced production utilizing advanced submicron semiconductor manufacturing processes in late 1996. The Company has the right to purchase up to 31.25% of the output from the foundry. In addition, the Company expanded and formalized its relationship with TSMC to provide additional capacity over the 1996 to 2000 timeframe. The agreement with TSMC requires the Company to make certain annual advance payments to be applied against the following year's capacity. The Company has signed promissory notes to secure these payments, which total $24.0 million as of December 31, 1996, over the term of the agreement. The Company paid $7.2 million in 1996. See Notes 1, 8, and 10 of Notes to Consolidated Financial Statements. Working capital at December 31, 1996 and December 31, 1995 was $232.3 million and $144.6 million, respectively. At December 31, 1996 the Company's principal sources of liquidity included cash and equivalents of $94.6 million and $62.8 million in short-term investments. In addition, the Company has a $25.0 million unsecured revolving line of credit that expires June 1, 1997. The Company had no borrowings outstanding under the line of credit as of December 31, 1996. In addition, the Company has available two separate secured equipment lines of credit totaling $10.0 million. The Company had $6.5 million outstanding under these secured equipment lines of credit at December 31, 1996. See Note 8 of Notes to Consolidated Financial Statements. The Company believes that its available funds and its anticipated funds from operations will satisfy the Company's projected working capital and capital expenditure requirements for at least the next 12 months, other than expenditures for future potential manufacturing agreements. In order to obtain an adequate supply of wafers, especially wafers manufactured using advanced process technologies, the Company has entered into and will continue to consider various possible transactions, including the use of "take or pay" contracts that commit the Company to purchase specified quantities of wafers over extended periods, equity investments in, advances or issuances of equity securities to wafer manufacturing companies in exchange for guaranteed production, or the formation of joint ventures to own and operate or construct wafer fabrication facilities. Manufacturing arrangements such as these may require 27 28 substantial capital investments, which may require the Company to seek additional equity or debt financing. There can be no assurance that such additional financing, if required, will be available when needed or, if available, will be on satisfactory terms. In addition, the Company may, from time to time, as business conditions warrant, invest in or acquire businesses, technology or products that complement the business of the Company. The cyclical nature of the semiconductor industry periodically results in shortages of advanced process wafer fabrication capacity such as the Company experiences from time to time. The Company's ability to maintain adequate levels of inventory is primarily dependent upon the Company obtaining sufficient supply of products to meet future demand, and any inability of the Company to maintain adequate inventory levels may adversely affect its relations with its customers. In addition, because the Company must order products and build inventory substantially in advance of product shipments, there is a risk that the Company will forecast incorrectly and produce excess or insufficient inventories of particular products because the Company's products are volatile and subject to rapid technological and price changes. This inventory risk is heightened because certain of the Company's key customers place orders with short lead times. The Company's customers' ability to reschedule or cancel orders without significant penalty could adversely affect the Company's liquidity, as the Company may be unable to adjust its purchases from its independent foundries to match such customer changes and cancellations. To the extent the Company produces excess or insufficient inventories of particular products, the Company's operating results could be adversely affected. In October 1995, Brooktree filed a complaint against the Company in the United States District Court for the Southern District of California, alleging that the Company's current products infringe a Brooktree patent. Such lawsuit resulted in substantial expense to the Company to defend the action and diverted the efforts of the Company's technical and management personnel. In August 1996, the Company and Brooktree entered into a settlement and license agreement pursuant to which all claims and counterclaims between the parties were dismissed and the Company agreed to pay to Brooktree a license fee and royalties related to certain product revenues over a five-year period. Such amount are not expected to significantly impact future results of operations. 28 29 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
PAGE(S) ------- Independent Auditors' Report....................................................... 30 Consolidated Statements of Income for the years ended December 31, 1996, 1995, and 1994............................................................................. 31 Consolidated Balance Sheets as of December 31, 1996 and 1995....................... 32 Consolidated Statements of Stockholders' Equity for the years ended December 31, 1996, 1995, and 1994............................................................. 33 Consolidated Statements of Cash Flows for the years ended December 31, 1996, 1995, and 1994......................................................................... 34 Notes to Consolidated Financial Statements......................................... 35 - 45 Selected Quarterly Consolidated Financial Data (Unaudited)......................... 46
29 30 INDEPENDENT AUDITORS' REPORT Board of Directors and Stockholders S3 Incorporated: We have audited the accompanying consolidated balance sheets of S3 Incorporated and subsidiaries as of December 31, 1996 and 1995, and the related consolidated statements of income, stockholders' equity and cash flows for each of the three years in the period ended December 31, 1996. Our audits also included the financial statement schedule at Item 14(a)(2). These financial statements and financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits. We conducted our audits in accordance with generally accepted auditing standards. 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, such consolidated financial statements present fairly, in all material respects, the financial position of S3 Incorporated and subsidiaries at December 31, 1996 and 1995, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1996 in conformity with generally accepted accounting principles. Also, in our opinion, the financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly in all material respects the information set forth therein. LOGO San Jose, California January 17, 1997 30 31 S3 INCORPORATED CONSOLIDATED STATEMENTS OF INCOME
YEARS ENDED DECEMBER 31, ---------------------------------- 1996 1995 1994 -------- -------- -------- (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) Net sales.................................................. $465,378 $316,309 $140,309 Cost of sales.............................................. 281,013 189,767 97,975 -------- -------- -------- Gross margin............................................... 184,365 126,542 42,334 Operating expenses: Research and development................................. 63,382 42,080 17,913 Selling, marketing and administrative.................... 48,800 33,510 18,310 -------- -------- -------- Total operating expenses.............................. 112,182 75,590 36,223 -------- -------- -------- Income from operations..................................... 72,183 50,952 6,111 Interest income.......................................... 4,328 4,481 1,020 Interest expense......................................... (1,971) -- (42) Other income (expense)................................... (128) 8 (160) -------- -------- -------- Other income, net.......................................... 2,229 4,489 818 -------- -------- -------- Income before income taxes................................. 74,412 55,441 6,929 Provision for income taxes................................. 26,045 20,067 1,427 -------- -------- -------- Net income................................................. $ 48,367 $ 35,374 $ 5,502 ======== ======== ======== Per share amounts: Primary............................................... $ 0.95 $ 0.75 $ 0.14 Assuming full dilution................................ $ 0.94 $ 0.75 $ 0.14 Common and equivalent shares used in computing per share amounts: Primary............................................... 50,929 47,013 39,614 Assuming full dilution................................ 52,733 47,013 39,614
See accompanying notes to consolidated financial statements. 31 32 S3 INCORPORATED CONSOLIDATED BALANCE SHEETS ASSETS
DECEMBER 31, --------------------- 1996 1995 -------- -------- (DOLLARS IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA) Current assets: Cash and equivalents................................................... $ 94,616 $ 69,289 Short-term investments................................................. 62,768 24,630 Accounts receivable (net of allowances of $2,648 in 1996 and $1,614 in 1995)................................................................ 76,120 84,210 Inventories............................................................ 53,466 43,293 Prepaid expenses and other............................................. 34,369 14,216 -------- -------- Total current assets.............................................. 321,339 235,638 Property and equipment -- net.......................................... 34,047 20,678 Production capacity rights............................................. 14,400 24,000 Investment in joint venture............................................ 93,430 36,425 Other assets........................................................... 17,246 4,902 -------- -------- Total............................................................. $480,462 $321,643 ======== ======== LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable....................................................... $ 51,160 $ 62,081 Notes payable.......................................................... 17,802 9,200 Accrued liabilities.................................................... 12,687 13,461 Income taxes payable................................................... 7,361 6,276 -------- -------- Total current liabilities......................................... 89,010 91,018 Notes payable.......................................................... 14,400 24,000 Other liabilities...................................................... 6,452 761 -------- -------- Total liabilities................................................. 109,862 115,779 -------- -------- Convertible subordinated notes......................................... 103,500 -- Commitments and contingencies (Notes 10 and 14) Stockholders' equity: Preferred stock, $.0001 par value; 5,000,000 shares authorized; none outstanding.................................................. -- -- Common stock, $.0001 par value; 70,000,000 shares authorized; 48,331,794 and 46,797,327 shares outstanding in 1996 and 1995.................... 169,411 156,474 Unrealized gain (loss) on short-term investments..................... (54) 14 Retained earnings.................................................... 97,743 49,376 -------- -------- Total stockholders' equity........................................... 267,100 205,864 -------- -------- Total............................................................. $480,462 $321,643 ======== ========
See accompanying notes to consolidated financial statements 32 33 S3 INCORPORATED CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
COMMON STOCK UNREALIZED --------------------- GAIN (LOSS) ON RETAINED SHARES AMOUNT INVESTMENTS EARNINGS TOTAL ---------- -------- -------------- -------- -------- (DOLLARS IN THOUSANDS) Balance at January 1, 1994................... 35,392,118 $ 52,485 $ -- $ 8,500 $ 60,985 Exercise of stock options.................... 858,382 367 -- -- 367 Employee stock purchase plan................. 206,174 706 -- -- 706 Tax benefit of stock option transactions..... -- 1,285 -- -- 1,285 Stock option compensation.................... -- 62 -- -- 62 Unrealized loss on investments............... -- -- (29) -- (29) Net income................................... -- -- -- 5,502 5,502 ---------- -------- ---- ------- -------- Balance at December 31, 1994................. 36,456,674 54,905 (29) 14,002 68,878 ---------- -------- ---- ------- -------- Issuance of common stock, net of issuance costs of $599.................................... 7,850,000 89,833 -- -- 89,833 Exercise of stock options.................... 2,330,911 2,969 -- -- 2,969 Employee stock purchase plan................. 159,742 1,222 -- -- 1,222 Tax benefit of stock option transactions..... -- 7,508 -- -- 7,508 Stock option compensation.................... -- 37 -- -- 37 Unrealized gain on investments............... -- -- 43 -- 43 Net income................................... -- -- -- 35,374 35,374 ---------- -------- ---- ------- -------- Balance at December 31, 1995................. 46,797,327 156,474 14 49,376 205,864 ---------- -------- ---- ------- -------- Exercise of stock options.................... 1,204,235 4,550 -- -- 4,550 Employee stock purchase plan................. 231,161 2,467 -- -- 2,467 Tax benefit of stock option transactions..... -- 4,725 -- -- 4,725 Stock compensation plan...................... 99,071 1,195 -- -- 1,195 Unrealized loss on investments............... -- -- (68) -- (68) Net income................................... -- -- -- 48,367 48,367 ---------- -------- ---- ------- -------- Balance at December 31, 1996................. 48,331,794 $169,411 $(54) $ 97,743 $267,100 ========== ======== ==== ======= ========
See accompanying notes to consolidated financial statements. 33 34 S3 INCORPORATED CONSOLIDATED STATEMENTS OF CASH FLOWS
YEARS ENDED DECEMBER 31, ----------------------------------- 1996 1995 1994 --------- -------- -------- (IN THOUSANDS) OPERATING ACTIVITIES Net income.............................................. $ 48,367 $ 35,374 $ 5,502 Adjustments to reconcile net income to net cash provided by (used for) operating activities: Deferred income taxes................................ (5,759) (3,334) (255) Depreciation and amortization........................ 10,713 6,789 3,954 Provision for inventory valuation adjustment......... -- -- 9,914 Production capacity rights........................... (7,200) -- -- Deferred rent........................................ (138) 6 387 Stock compensation................................... 1,195 37 62 Equity in income from joint venture.................. (3,999) -- -- Changes in assets and liabilities: Accounts receivable................................ 8,090 (50,458) (10,299) Inventories........................................ (10,173) (35,089) (12,859) Prepaid expenses and other......................... (6,975) (2,830) (459) Accounts payable................................... (10,921) 45,832 (69) Accrued liabilities and other...................... 5,163 10,769 (1,134) Income taxes payable............................... 5,810 12,891 2,112 -------- -------- -------- Net cash provided by (used for) operating activities.... 34,173 19,987 (3,144) -------- -------- -------- INVESTING ACTIVITIES Property and equipment purchases, net................... (23,403) (17,601) (7,642) Purchases of short-term investments..................... (74,798) (34,837) (18,002) Sales/maturities of short-term investments.............. 36,592 19,050 31,170 Investment in real estate partnership................... (2,100) -- -- Investment in joint venture............................. (53,006) (36,425) -- Other assets............................................ (3,778) (2,681) (36) -------- -------- -------- Net cash provided by (used for) investing activities.... (120,493) (72,494) 5,490 -------- -------- -------- FINANCING ACTIVITIES Sale of common stock, net............................... 7,017 94,024 1,073 Sale of convertible subordinated notes.................. 103,500 -- -- Debt issuance costs..................................... (3,370) -- -- Net borrowings (repayments) of notes payable............ (2,000) 2,000 -- Borrowings on equipment financing....................... 6,500 -- -- Repayments of capital leases............................ -- -- (185) -------- -------- -------- Net cash provided by financing activities............... 111,647 96,024 888 -------- -------- -------- Net increase in cash and equivalents.................... 25,327 43,517 3,234 CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD.......... 69,289 25,772 22,538 -------- -------- -------- CASH AND CASH EQUIVALENTS AT END OF PERIOD................ $ 94,616 $ 69,289 $ 25,772 ======== ======== ======== SUPPLEMENTAL CASH FLOW INFORMATION Interest paid........................................... $ 231 -- $ 42 Income taxes paid (refunded), net....................... $ 20,483 $ 9,105 $ (1,010) SUPPLEMENTAL NONCASH INVESTING AND FINANCING ACTIVITIES Notes payable for production capacity rights......... -- $ 31,200 --
See accompanying notes to consolidated financial statements. 34 35 S3 INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1996, 1995 AND 1994 1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES Organization S3 Incorporated was incorporated on January 9, 1989 and is a leading supplier of high performance multimedia accelerator solutions. The Company's products are used in, and its business is dependent on, the personal computer industry with sales primarily in the U.S., Asia, and Europe (see Note 13). Its products are manufactured, assembled and tested by independent wafer foundries and contract manufacturers. Basis of Presentation The consolidated financial statements include the accounts of S3 Incorporated and its wholly-owned subsidiaries (collectively, the Company). All significant intercompany balances and transactions have been eliminated. Investments in entities in which the Company does not have control, but has the ability to exercise significant influence over operating and financial policies are accounted for by the equity method. 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. Significant estimates include allowances for doubtful accounts and customer returns, deferred tax assets, the useful lives of fixed assets and intangible assets, inventory reserves and other reserves. Actual results could differ from those estimates, and such differences may be material to the financial statements. Cash Equivalents The Company considers all highly liquid debt investments purchased with a remaining maturity of three months or less to be cash equivalents. Short-Term Investments Short-term investments represent debt securities which are stated at fair value. The differences between amortized cost (cost adjusted for amortization of premiums and accretion of discounts which are recognized as adjustments to interest income) and fair value representing unrealized holding gains or losses are recorded as a separate component of stockholders' equity until realized. While the Company's intent is to hold debt securities to maturity, they are classified as available-for-sale because the sale of such securities may be required prior to maturity. Any gains and losses on the sale of debt securities are determined on a specific identification basis. Inventories Inventories consist of work in process and finished goods and are stated at the lower of cost (first-in, first-out) or market. The Company's products typically experience short product life cycles and the Company estimates the market value of its inventory based on anticipated selling prices adjusted for completion and selling costs. Should the Company experience a substantial unanticipated decline in selling price of its products and/or demand thereof, a material valuation adjustment and corresponding charge to operations could result. 35 36 S3 INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) YEARS ENDED DECEMBER 31, 1996, 1995 AND 1994 Required payments under a wafer supply agreement to secure future capacity are capitalized and amortized to inventory costs as the related product is received. Property and Equipment Property and equipment are stated at cost. Depreciation is provided using the straight-line method over estimated useful lives of three to five years. Leasehold improvements are amortized using the straight-line method over the shorter of the lease term or the assets useful lives. Long-Lived Assets Effective January 1, 1996, the Company adopted 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." SFAS 121 requires recognition of impairment of long-lived assets in the event the net book value of such assets exceeds the future undiscounted cash flows attributable to such assets. The Company annually evaluates the recoverability of its long-lived assets based on the estimated future undiscounted cash flows. Adoption of SFAS No. 121 had no material effect on the Company's financial statements. Wafer Fabrication Joint Venture Preproduction costs incurred by the wafer fabrication joint venture (see Note 10) during construction and equipping of the facility were capitalized by the Company and are being amortized over 5 years. Revenue Recognition Revenue from product sales direct to customers is generally recognized upon shipment. Accruals for estimated sales returns and allowances are recorded at the time of sale. Certain of the Company's sales are made to distributors under agreements allowing price protection and rights of return on unsold products by the distributors. The Company defers recognition of revenue on such sales until the product is sold by the distributors. Concentration of Credit Risk Financial instruments which potentially subject the Company to concentrations of credit risk consist primarily of cash equivalents, short-term investments, trade accounts receivable and foreign exchange contracts. The Company invests only in high credit quality short-term debt instruments and limits the amount of credit exposure to any one entity. A majority of the Company's trade receivables are derived from sales to manufacturers in the computer industry. The Company performs ongoing credit evaluations of its customers' financial condition and limits the amount of credit extended when deemed necessary but generally requires no collateral. The Company maintains reserves for potential credit losses, and all such losses to date have been within management's expectations. Fair Value of Financial Instruments Financial instruments include cash equivalents and short-term investments (see Note 2). Cash equivalents and short-term investments are stated at fair market values based on quoted market prices. The fair value of the Company's convertible subordinated notes approximated its carrying cost as of December 31, 1996. 36 37 S3 INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) YEARS ENDED DECEMBER 31, 1996, 1995 AND 1994 Research and Development Expenses Research and development is expensed as incurred. Income Taxes The Company accounts for income taxes using the asset and liability approach pursuant to SFAS No. 109, "Accounting for Income Taxes." Stock-Based Compensation The Company accounts for stock-based awards to employees using the intrinsic value method in accordance with APB No. 25, Accounting for Stock Issued to Employees. The Company adopted the disclosure requirements of SFAS No. 123, Accounting for Stock-Based Compensation (SFAS 123), which require the disclosure of pro forma net income and earnings per share as if the Company adopted the fair value-based method in measuring compensation expense as of the beginning of fiscal 1995. Per share amounts Primary per share data is computed based on the weighted average number of common and dilutive common equivalent shares outstanding. Common equivalent shares include stock options and shares subscribed under the employee stock purchase plan (computed using the treasury stock method). Fully diluted per share data is computed using the most dilutive assumptions and by adjusting the primary per share data and net income for the potential effect of the conversion of the 5 3/4% Convertible Subordinated Notes (see Note 7) outstanding during the period and the elimination of the related interest and deferred issue costs, net of income taxes. Reclassifications Certain prior year amounts have been reclassified to conform to the current year presentation. 2. SHORT-TERM INVESTMENTS The fair value and the amortized cost of available-for-sale securities at December 31, 1996 and 1995 are presented in the tables which follow. Fair values are based on quoted market prices obtained from an independent broker. Available-for-sale securities are classified as current assets as all maturities are within one year. For each category of investment securities the table presents gross unrealized holding gains and losses.
UNREALIZED UNREALIZED AMORTIZED MARKET HOLDING HOLDING COST VALUE GAINS LOSSES --------- ------- ---------- ---------- (IN THOUSANDS) December 31, 1996: Corporate Debt Securities...................... $41,634 $41,582 $3 $ 55 Foreign Government Securities.................. 2,698 2,697 -- 1 Mortgage-Backed Securities..................... 14,269 14,272 4 1 Debt securities of states of the United States and political subdivisions of the states..... 4,221 4,217 -- 4 -- ------- ------- --- Total................................ $62,822 $62,768 $7 $ 61 ======= ======= == ===
37 38 S3 INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) YEARS ENDED DECEMBER 31, 1996, 1995 AND 1994
UNREALIZED UNREALIZED AMORTIZED MARKET HOLDING HOLDING COST VALUE GAINS LOSSES --------- ------- ---------- ---------- (IN THOUSANDS) December 31, 1995: Corporate Debt Securities.............. $ 7,186 $ 7,182 $ 2 $6 U.S. Government Securities............. 3,533 3,534 1 -- Mortgage-Backed Securities............. 13,897 13,914 18 1 -- ------- ------- --- Total........................ $24,616 $24,630 $ 21 $7 ======= ======= === ==
3. INVENTORIES Inventories consist of:
DECEMBER 31, ------------------- 1996 1995 ------- ------- (IN THOUSANDS) Work in process.......................................... $22,556 $23,469 Finished goods........................................... 30,910 19,824 ------- ------ Total.......................................... $53,466 $43,293 ======= ======
4. INVESTMENTS Investment in USC The Company has a 23.75% equity investment in the stock of United Semiconductor Corporation (USC), which owns and operates a semiconductor manufacturing facility in Taiwan. Operations in 1995 consisted primarily of construction and other capitalizable preproduction activities and, therefore, the 1995 results of operations for the entity were immaterial. Summarized financial information of USC adjusted to conform with generally accepted accounting principles in the United States for the entity at December 31, 1996 and 1995 is as follows (in thousands):
RESULTS OF OPERATIONS DECEMBER 31, 1996 ------------------------------------------------------- --------------------- Sales.................................................. $60,656 Net income............................................. 16,850
DECEMBER 31, --------------------- FINANCIAL POSITION 1996 1995 ------------------------------------------------------- -------- -------- Current Assets......................................... $224,560 $144,031 Noncurrent Assets...................................... 409,765 46,564 Current Liabilities.................................... 89,734 5,414 Noncurrent Liabilities................................. 163,973 485 Stockholders' Equity................................... 380,618 184,696
Interest in Partnership In 1995, the Company entered into a limited partnership arrangement with a developer to obtain a ground lease and develop and operate the Company's future Santa Clara facilities. The Company's investment of $2.1 million represents 50% interest in Mission Real Estate L.P. (the partnership), in which the Company is a limited partner. 38 39 S3 INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) YEARS ENDED DECEMBER 31, 1996, 1995 AND 1994 In connection with the Company's investment in the real estate partnership, the Company (together with the developer) is subject to recourse provisions for the construction financing loan for up to $12.0 million. At December 31, 1996, the Company was a guarantor with respect to $8.9 million incurred under the construction financing loan agreement. Permanent nonrecourse financing has subsequently been obtained. The Company is not a guarantor on the permanent financing. 5. PROPERTY AND EQUIPMENT Property and equipment consist of:
DECEMBER 31, ------------------- 1996 1995 ------- ------- (IN THOUSANDS) Machinery and equipment.................................. $52,019 $29,108 Furniture and fixtures................................... 2,690 2,422 Leasehold improvements................................... 478 254 ------- ------- Total.......................................... 55,187 31,784 Accumulated depreciation and amortization................ (21,140) (11,106) ------- ------- Property and equipment, net.............................. $34,047 $20,678 ======= =======
6. ACCRUED LIABILITIES Accrued liabilities consist of:
DECEMBER 31, ------------------- 1996 1995 ------- ------- (IN THOUSANDS) Accrued compensation and benefits........................ $10,462 $11,264 Other.................................................... 2,225 2,197 ------- ------- $12,687 $13,461 ======= =======
7. CONVERTIBLE SUBORDINATED NOTES In September 1996, the Company completed a private placement of $103.5 million aggregate principal amount of convertible subordinated notes. The notes mature in 2003. Interest is payable semi-annually at 5 3/4% per annum. The notes are convertible at the option of the note holders into the Company's common stock at an initial conversion price of $19.22 per share, subject to adjustment. Beginning in October 1999, the notes are redeemable at the option of the Company at an initial redemption price of 102% of the principal amount. The Company has reserved 5,385,015 shares of common stock (plus such additional number of shares that may be required pursuant to the operation of anti-dilution provisions) for the conversion of these notes. Offering costs of approximately $3.4 million are included in other assets and are amortized on a straight-line basis over the term of the notes. In 1996, the Company recorded debt issuance cost amortization of $0.1 million. 8. LINE OF CREDIT AND NOTES PAYABLE The Company has a $25.0 million unsecured revolving line of credit that expires June 1, 1997. Borrowings bear interest at the bank's prime rate (8.25% at December 31, 1996). The most restrictive covenants under the agreement require the Company, among other things, to maintain a minimum tangible net worth of $224 million, a quick ratio of 1.15 to 1.0, maximum debt to tangible net worth, as defined, of 1.25 to 1.0 and 39 40 S3 INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) YEARS ENDED DECEMBER 31, 1996, 1995 AND 1994 annual profitability. The Company was in compliance with all financial covenants at December 31, 1996. The Company had no borrowings outstanding under the line of credit as of December 31, 1996. In addition, the Company has two separate secured equipment lines of credit totaling $10.0 million. The Company had $6.5 million outstanding under these secured equipment lines of credit at December 31, 1996. Borrowings bear interest at the prime rate (8.25% at December 31, 1996) and the Company is required to comply with the same financial covenants as its unsecured line of credit. In connection with a wafer supply agreement, the Company issued notes payable to a supplier (see Note 10). The notes bear interest at 10.0% per annum commencing on the individual notes' maturity date if such notes are not paid. Future payments of these notes are as follows (in thousands): 1997............................................... $ 9,600 1998............................................... 9,600 1999............................................... 4,800 ------- $24,000 =======
9. STOCKHOLDERS' EQUITY Common Stock In May 1995, the Company sold 7,850,000 shares of common stock in an underwritten public offering at a price of $12.13 per share. Preferred Stock The number of shares of preferred stock authorized to be issued is 5,000,000 with a par value of $0.0001 per share. The preferred stock may be issued from time to time in one or more series. The Board of Directors is authorized to provide for the rights, preferences, privileges and restrictions of the shares of such series. As of December 31, 1996, no shares of preferred stock had been issued. Employee Stock Purchase Plan Under the Company's 1993 Employee Stock Purchase Plan (the "Plan") 1,400,000 shares of common stock are reserved for issuance pursuant thereto. The Plan permits eligible employees to purchase shares at a price equal to 85% of the lower of the fair market value at the beginning or end of the offering period. At December 31, 1996, 597,077 shares have been issued under the Plan and 802,923 shares have been reserved for further issuance. The weighted average fair value of those purchase rights granted in 1996 and 1995 was $6.97 and $4.97, respectively. The Company's calculations were made using the Black-Scholes option pricing model with the following weighted average assumptions: expected life of 2 years for both years; expected interest rate of 6.1% and 5.6% for 1996 and 1995, respectively; expected volatility of 60% for both years; and no dividends during the expected term. Stock Plan Under the Company's stock option plans at December 31, 1996, 17,040,057 shares of common stock have been authorized for the grant of incentive or nonstatutory stock options and the direct award or sale of shares to employees, directors and consultants. Incentive stock options must be granted at not less than fair market value at the date of grant. The exercise price of nonstatutory options and the share price for shares sold generally may be no less than 85% of fair market value at the date of the grant or sale. At December 31, 1996, 9,614,249 shares of common stock are reserved for issuance under the plans and 694,150 shares were available for future grant. 40 41 S3 INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) YEARS ENDED DECEMBER 31, 1996, 1995 AND 1994 A summary of stock option activity is as follows:
NUMBER OF WEIGHTED AVERAGE SHARES PRICE PER SHARE ---------- ----------------- Balance, January 1, 1994....................... 5,256,132 $ 1.84 Options granted................................ 3,951,600 4.88 Options exercised.............................. (858,382) 0.45 Options canceled............................... (1,540,596) 6.38 ---------- Balance, December 31, 1994..................... 6,808,754 2.75 Options granted................................ 2,970,550 15.47 Options exercised.............................. (2,330,911) 1.27 Options canceled............................... (463,454) 6.61 ---------- Balance, December 31, 1995..................... 6,984,939 8.37 Options granted................................ 6,538,362 12.09 Options exercised.............................. (1,204,235) 3.83 Options canceled............................... (3,398,967) 15.28 ---------- Balance, December 31, 1996..................... 8,920,099 $ 9.06 =========
Options on 2,267,969, 2,030,259 and 1,717,140 shares were exercisable at December 31, 1996, 1995 and 1994 with a weighted average exercise price of $4.29, $3.51 and $0.69, respectively. These options generally vest over a period of four years and generally become exercisable beginning 6 months from the date of employment or grant. Options expire ten years from the date of grant. Common stock sold to employees, directors and consultants under stock purchase agreements is subject to repurchase at the Company's option upon termination of their employment or services at the original purchase price. This right expires ratably over four years. The Company repriced 2,713,657 options to $10.06, the market price on July 15, 1996. The repriced options are treated as canceled and regranted, however, they retain their original vesting terms. Stock Compensation Arrangement Pursuant to an incentive compensation plan for certain employees, the Company issued 99,071 shares of its common stock in 1996 and is committed to issue 99,071 shares of its common stock on June 30, 1997. The Company is accruing the related compensation cost ratably over the periods. Additional Stock Plan Information As discussed in Note 1, the Company continues to account for its stock-based awards using the intrinsic value method in accordance with Accounting Principles Board No. 25, Accounting for Stock Issued to Employees and its related interpretations. Accordingly, no compensation expense has been recognized for employee stock option and purchase plan arrangements. Under SFAS 123, the fair value of stock-based awards to employees is calculated through the use of option pricing models, even though such models were developed to estimate the fair value of freely tradable, fully transferable options without vesting restrictions, which significantly differ from the Company's stock option awards. These models also require subjective assumptions, including future stock price volatility and expected time to exercise, which greatly affect the calculated values. Adoption of SFAS 123 is optional; however, pro forma disclosures as if the Company adopted the cost recognition requirements under SFAS 123 in 1995 are presented below. 41 42 S3 INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) YEARS ENDED DECEMBER 31, 1996, 1995 AND 1994 The following table summarizes significant ranges of outstanding and exercisable options at December 31, 1996:
OPTIONS OUTSTANDING --------------------------- OPTIONS EXERCISABLE WEIGHTED ------------------------ AVERAGE WEIGHTED WEIGHTED RANGE OF REMAINING AVERAGE AVERAGE EXERCISE NUMBER CONTRACTUAL EXERCISE NUMBER EXERCISE PRICES OUTSTANDING LIFE (YRS) PRICE EXERCISABLE PRICE -------------- ----------- ----------- -------- ----------- -------- $0.12 - $ 3.44 1,326,821 6.04 $ 1.83 1,140,236 $ 1.60 3.56 - 8.72 1,843,521 7.67 5.64 870,111 5.56 8.97 - 10.06 3,576,941 9.00 10.05 54,095 9.77 10.13 - 23.38 2,172,816 9.33 14.74 203,527 12.49 ---------- --------- $0.12 - $23.38 8,920,099 8.37 $ 9.06 2,267,969 $ 4.29
The weighted average fair value at date of grant for options granted during 1996, 1995 and 1994 was $12.09, $15.65 and $4.49 per option, respectively. The Company's calculations were made using the Black-Scholes option pricing model with the following weighted average assumptions:
1996 1995 --------------------------- --------------------------- Expected Life............. 6 months following vesting 6 months following vesting Interest Rate............. 6.1% 5.6% Volatility................ 60% 60% Dividend Yield............ 0% 0%
The Company's calculations are based on a multiple option valuation approach and forfeitures are recognized as they occur. If the computed fair values of the 1996 and 1995 awards had been amortized to expense over the vesting period of the awards, pro forma net income would have been $35.3 million ($0.69 fully diluted earnings per share and $0.72 primary earnings per share) in 1996 and $30.3 million ($0.66 fully diluted and primary earnings per share) in 1995. However, because options vest over several years and grants prior to 1995 are excluded from these calculations, these amounts may not be representative of the impact on future years' earnings, assuming grants are made in those years. 10. LEASES AND COMMITMENTS Operating Leases The Company leases administrative facilities under operating leases that expire in 2008. During 1995, the Company entered into a limited partnership arrangement with a developer to obtain a ground lease and develop and operate the Company's Santa Clara, California facilities. In January 1997, prior to the expiration of the lease terms of the previous facilities, the Company relocated its principal administrative facilities to the new Santa Clara facilities at which time the Company's minimum operating lease payment of $369,000 commenced for the initial 12 year term. The Company has sublet a portion of its previous facilities for the remaining lease terms and has negotiated a lease termination on another facility at no material cost. The Company presently expects to sublease the remaining facility for the remaining lease term or negotiate a lease termination at no material cost, although there can be no assurance that the Company will be able to do so. The Company has been granted free rent periods under the leases on its facilities in Santa Clara. The accompanying statements of income reflect rent expense on a straight-line basis over the term of the leases. The difference between straight-line rent expense and actual cash payments is recorded as deferred rent. 42 43 S3 INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) YEARS ENDED DECEMBER 31, 1996, 1995 AND 1994 Future minimum annual payments under operating leases are as follows:
OPERATING LEASES ---------------- (IN THOUSANDS) 1997.......................................... $ 6,545 1998.......................................... 6,117 1999.......................................... 5,630 2000.......................................... 4,898 2001.......................................... 4,426 Thereafter.................................... 30,979 ------- Total minimum lease payments.................. $ 58,595 =======
The total of minimal rentals to be received in the future under non-cancellable subleases is $4,496,000 as of December 31, 1996. Rent expense for 1996, 1995, and 1994 was $3,483,000, $2,002,000, and $1,380,000, respectively. Wafer Supply Agreements and Commitments During 1995, the Company entered into two long-term manufacturing capacity arrangements. The Company entered into an agreement with United Microelectronics Corporation (UMC) and Alliance Semiconductor Corporation to form USC, a separate Taiwanese company, for the purpose of building and managing a semiconductor manufacturing facility in the Science Based Industrial Park in Hsin Chu City, Taiwan, Republic of China. The Company invested $36.4 million in 1995 and $53.0 in 1996 for its equity interest of 23.75%. The facility commenced production utilizing advanced submicron semiconductor manufacturing processes in 1996. The Company has the right to purchase up to 31.25% of the output from the foundry. In addition, in 1995 the Company expanded and formalized its relationship with Taiwan Semiconductor Manufacturing Company (TSMC) to provide additional capacity over the 1996 to 2000 timeframe. The agreement with TSMC requires the Company to make certain annual advance payments to be applied against the following year's capacity. The Company has signed promissory notes to secure these payments over the term of the agreement (see Note 8). In 1996 and 1995, the Company paid $7.2 million and $1.2 million, respectively. At December 31, 1996, the remaining advance payments (and corresponding promissory notes) totaled $24.0 million ($9.6 million in prepaid expenses and $14.4 million in production capacity rights). In the ordinary course of business, the Company places purchase orders with its wafer suppliers based on its existing and anticipated customer orders for its products. Should the Company experience a substantial unanticipated decline in the selling price of its products and/or demand thereof, it could result in a material loss on such purchase commitments. 43 44 S3 INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) YEARS ENDED DECEMBER 31, 1996, 1995 AND 1994 11. INCOME TAXES The provision for income taxes consists of:
YEARS ENDED DECEMBER 31, ------------------------------ 1996 1995 1994 ------- ------- ------ (IN THOUSANDS) Current tax expense: Federal...................................... $27,838 $20,796 $1,447 State........................................ 3,966 2,605 235 ------- ------- ------ 31,804 23,401 1,682 ------- ------- ------ Deferred tax expense: Federal...................................... (5,301) (2,897) (81) State........................................ (458) (437) (174) ------- ------- ------ (5,759) (3,334) (255) ------- ------- ------ Total........................................ $26,045 $20,067 $1,427 ======= ======= ======
The provision for income taxes differs from the amount computed by applying the federal statutory income tax rate to income before taxes as follows:
YEARS ENDED DECEMBER 31, ------------------------------- 1996 1995 1994 ------- ------- ------- (IN THOUSANDS) Tax computed at 35%........................... $26,044 $19,404 $ 2,425 State income taxes, net of federal effect..... 3,676 2,725 365 Tax credits................................... (3,396) (1,690) (1,210) Other......................................... (279) (372) (153) ------- ------- ------- Provision for income taxes.................... $26,045 $20,067 $ 1,427 ======= ======= ======= Effective tax rate............................ 35% 36% 21% ======= ======= =======
Significant components of the Company's deferred income tax asset are as follows:
DECEMBER 31, ------------------ 1996 1995 ------- ------ (IN THOUSANDS) Deferred tax asset: Reserves not currently deductible......................... $ 7,073 $1,177 Compensation expense not currently deductible............. 3,823 2,032 Other..................................................... 266 600 ------- ------ Total deferred tax asset.................................. 11,162 3,809 Deferred tax liabilities.................................. (1,594) -- ------- ------ Net deferred tax asset.................................... $ 9,568 $3,809 ======= ======
12. EMPLOYEE BENEFIT PLANS The Company implemented a nonqualified cash profit sharing plan in 1994 under which all employees are eligible to receive, on an annual basis, an equal cash bonus based on pretax profits. The cash bonus under this plan was $1,987,000, $1,175,000 and $303,000 in 1996, 1995 and 1994, respectively. 44 45 S3 INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) YEARS ENDED DECEMBER 31, 1996, 1995 AND 1994 The Company has a 401(k) tax-deferred savings plan whereby all employees meeting certain age and service requirements may contribute up to 20% of their eligible compensation (up to a maximum allowed under IRS rules). Contributions may be made by the Company at the discretion of the Board of Directors. No contributions by the Company have been made to the plan since its inception. 13. EXPORT SALES AND SIGNIFICANT CUSTOMERS The Company's primary operations are located in the United States. The Company sells its products into the personal computer market primarily in the U.S., Asia and Europe. Export sales accounted for 61%, 44%, and 42% of net sales in 1996, 1995, and 1994, respectively. Approximately 33%, 35%, and 28% of export sales in 1996, 1995, and 1994, respectively, were to affiliates of United States customers. In 1996, 12% and 27% of export sales were shipped to Hong Kong and Taiwan respectively. One customer accounted for 15% of net sales in 1996, two customers accounted for 17% and 12% of net sales in 1995 and two customers accounted for 19% and 16% of net sales in 1994. At December 31, 1996, two customers' accounts receivable represented 18% and 11% of accounts receivable. 14. CONTINGENCIES The semiconductor and software industries are characterized by frequent litigation regarding patent and other intellectual property rights. The Company is party to various claims of this nature. Although the ultimate outcome of these matters is not presently determinable, management believes that the resolution of all such pending matters will not have a material adverse effect on the Company's financial position or results of operations. 45 46 SELECTED QUARTERLY CONSOLIDATED DATA (UNAUDITED)(1)
FOURTH THIRD SECOND FIRST QUARTER QUARTER QUARTER QUARTER -------- -------- -------- -------- (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) YEAR ENDED DECEMBER 31, 1996 Net sales....................................... $132,041 $119,440 $103,825 $110,072 Gross margin.................................... 54,719 46,616 39,468 43,562 Income from operations.......................... 23,571 17,861 12,824 17,927 Net income...................................... $ 15,479 $ 11,788 $ 8,792 $ 12,308 Earnings per share: Primary....................................... $ 0.30 $ 0.23 $ 0.18 $ 0.25 Assuming full dilution(3)..................... $ 0.29 $ 0.23 $ 0.18 $ 0.25 Common and equivalent shares used in computing earnings per share: Primary....................................... 52,455 51,101 50,114 50,047 Assuming full dilution(3)..................... 57,840 52,932 50,114 50,047 Stock prices:(2) High............................................ $ 23.38 $ 20.00 $ 15.75 $ 17.63 Low............................................. $ 16.25 $ 10.06 $ 10.88 $ 11.88 YEAR ENDED DECEMBER 31, 1995 Net sales....................................... $103,536 $ 84,793 $ 70,558 $ 57,422 Gross margin.................................... 41,870 34,086 27,957 22,629 Income from operations.......................... 16,509 14,009 11,367 9,067 Net income...................................... $ 11,459 $ 9,860 $ 7,970 $ 6,085 Earnings per share: Primary....................................... $ 0.23 $ 0.20 $ 0.17 $ 0.15 Common and equivalent shares used in computing earnings per share: Primary....................................... 50,329 50,496 46,074 41,152 Stock prices:(2) High............................................ $ 19.94 $ 21.63 $ 18.00 $ 12.31 Low............................................. $ 13.06 $ 17.00 $ 10.13 $ 7.63
- --------------- (1) The following table presents selected unaudited consolidated financial results for each of the eight quarters in the two-year period ended December 31, 1996. In the Company's opinion, this unaudited information has been prepared on the same basis as the audited information and includes all adjustments (consisting of only normal recurring adjustments) necessary for a fair statement of the financial information for the period presented. (2) The Company's common stock trades on the Nasdaq National Market under the symbol SIII. The table indicates the range of the high and low closing prices, as reported by Nasdaq. (3) Fully diluted earnings per share includes the effect of incremental shares issuable upon the conversion of the convertible subordinated notes and an adjustment to net income for the interest expense (net of income taxes) related to the notes. At December 31, 1996, there were approximately 476 stockholders of record of the Company's common stock and approximately 31,452 beneficial stockholders. The Company has never declared or paid cash dividends on its capital stock and does not anticipate paying any cash dividends in the foreseeable future. The Company currently intends to retain future earnings for the development of its business. 46 47 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. Not applicable. PART III Certain information required by Part III is incorporated by reference from the Company's definitive Proxy Statement to be filed with the Securities and Exchange Commission in connection with the solicitation of proxies for the Company's 1997 Annual Meeting of Stockholders (the "Proxy Statement"). ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. The information required by this section is incorporated by reference from the information in the section entitled "Election of Directors -- Nominees" in the Proxy Statement. The required information concerning executive officers of the Company is contained in the section entitled "Executive Officers of the Registrant" in Part I of this Form 10-K. Item 405 of Regulation S-K calls for disclosure of any known late filing or failure by an insider to file a report required by Section 16 of the Exchange Act. This disclosure is contained in the section entitled "Section 16(a) Beneficial Ownership Reporting Compliance" in the Proxy Statement and is incorporated herein by reference. ITEM 11. EXECUTIVE COMPENSATION. The information required by this section is incorporated by reference from the information in the sections entitled "Election of Directors -- Directors' Compensation" and "Executive Compensation" in the Proxy Statement. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The information required by this section is incorporated by reference from the information in the section entitled "Security Ownership of Certain Beneficial Owners and Management" in the Proxy Statement. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. Not applicable. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. (a) The following documents are filed as a part of this Form 10-K: (1) FINANCIAL STATEMENTS: Reference is made to the Index to Consolidated Financial Statements under Item 8 in Part II of this Form 10-K. (2) FINANCIAL STATEMENT SCHEDULES: The following financial statement schedule of S3 Incorporated for the years ended December 31, 1996, 1995 and 1994 is filed as part of this Report and should be read in conjunction with the Consolidated Financial Statements of S3 Incorporated.
REFERENCE PAGE --------- Independent Auditors' Report on Financial Statement Schedule....... 30 Schedule II -- Valuation and Qualifying Accounts................... 50
47 48 All other schedules are omitted because they are not applicable or the required information is shown in the financial statements or notes thereto. (3) EXHIBITS: The exhibits listed below are required by Item 601 of Regulation S-K. Each management contract or compensatory plan or arrangement required to be filed as an exhibit to this Form 10-K has been identified.
EXHIBIT NUMBER NOTES DESCRIPTION OF DOCUMENT -------- ------ ---------------------------------------------------------------------- 3(i).1 (1) Restated Certificate of Incorporation. 3(i).2 (6) Certificate of Amendment of Restated Certificate of Incorporation. 3(ii) (1) Bylaws. 4.1 (1) Specimen Common Stock Certificate 4.2 (8) Indenture, dated as of September 12, 1996 between Registrant and State Street Bank and Trust Company of California, N.A., as Trustee, including the form of Note. 4.3 (9) Registration Rights Agreement, dated September 12, 1996, among Registrant, Lehman Brothers Inc., PaineWebber Incorporated and Cowen & Company. 10.1* 1989 Stock Plan of S3 Incorporated, as amended (the "1989 Plan"). 10.2* (1) Form of Incentive Stock Option Agreement under the 1989 Plan. 10.3* (1) Form of Nonstatutory Stock Option Agreement under the 1989 Plan. 10.4* (1) Form of Common Stock Purchase Agreement under the 1989 Plan. 10.5* (2) S3 Incorporated 1993 Employee Stock Purchase Plan. 10.6 (1) Form of Indemnification Agreement between the Registrant and its directors. 10.7 (3) Office Lease dated May 13, 1993, between the Registrant and San Tomas No. 2 Limited Partnership. 10.8 (3) First Amendment of Office Lease dated September 9, 1993, between the Registrant and San Tomas No. 2 Limited Partnership. 10.9 (4) Office Lease dated March 30, 1994, between the Registrant and San Tomas No. 1 Limited Partnership. 10.10 (4) Second Amendment of Office Lease dated March 30, 1994, between the Registrant and San Tomas No. 2 Limited Partnership. 10.11 (5) Foundry Venture Agreement among Registrant, Alliance Semiconductor Corporation and United Microelectronics Corporation dated as of July 8, 1995 10.12 (7) Lease between Mission Real Estate, L.P. and Registrant dated November 29, 1995. 21.1 (6) Subsidiaries of S3 Incorporated. 23.1 Independent Auditors' Consent. 24.1 Power of Attorney (see page 51 of this Form 10-K) 27.1 Financial Data Schedules
- --------------- * Indicates management contract or compensatory plan or arrangement. (1) Incorporated by reference from the Registrant's Registration Statement on Form S-1 (File No. 33-57114). 48 49 (2) Incorporated by reference to Exhibit 10.15 to the Registrant's Registration Statement on Form S-8 (File No. 33-65186). (3) Incorporated by reference to the exhibit of the same number to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1993. (4) Incorporated by reference to the exhibit of the same number to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1994. (5) Incorporated by reference to the exhibit of the same number to the Registrant's Current Report on Form 8-K filed July 25, 1995. (6) Incorporated by reference to the exhibit of the same number to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1995. (7) Incorporated by reference to Exhibit 10.14 to the Registrant's Annual Report on form 10-K for the year ended December 31, 1995. (8) Incorporated by reference to Exhibit 4.1 to Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1996. (9) Incorporated by reference to Exhibit 4.2 to Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1996. (b) REPORTS ON FORM 8-K: There were no Reports on Form 8-K filed by the Company during the quarter ended December 31, 1996. 49 50 SCHEDULE II VALUATION AND QUALIFYING ACCOUNTS YEARS ENDED DECEMBER 31, 1996, 1995 AND 1994 (IN THOUSANDS)
REVERSALS BALANCE AT CHARGED TO TO COSTS BALANCE AT BEGINNING COSTS AND AND END OF DESCRIPTION OF PERIOD EXPENSES EXPENSES DEDUCTIONS(1) PERIOD - --------------------------------------- ---------- ---------- --------- ------------- ---------- Allowance for doubtful accounts: 1996................................. $645 $1,522 $ -- $ (729) $1,438 1995................................. 375 1,014 -- (744) 645 1994................................. 114 725 -- (464) 375 Sales returns and allowances: 1996................................. $969 $ 241 $ -- $ -- $1,210 1995................................. 455 514 -- -- 969 1994................................. 303 152 -- -- 455
- --------------- (1) Deductions from these reserves are for the purpose for which these reserves were created. 50 51 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, thereunto duly authorized, on March 28, 1997. S3 INCORPORATED (Registrant) By: /s/ GARY JOHNSON ------------------------------------ Gary Johnson President and Chief Executive Officer March 28, 1997 POWER OF ATTORNEY KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Terry N. Holdt, Diosdado P. Banatao, and Ronald T. Yara, and each of them, his or her true and lawful attorneys-in-fact, each with full power of substitution, for him or her in any and all capacities, to sign any amendments to this report on Form 10-K and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that each of said attorneys-in-fact or their substitute or substitutes may do or cause to be done by virtue hereof. Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the date indicated: /s/ GARY J. JOHNSON - ------------------------------------------------------ Gary J. Johnson President, Chief Executive Officer (Principal Executive Officer and Director March 28, 1997 /s/ DALE R. LINDLY - ------------------------------------------------------ Dale R. Lindly Acting Chief Financial Officer (Principal Financial and Accounting Officer) March 28, 1997 /s/ DIOSDADO P. BANATAO - ------------------------------------------------------ Diosdado P. Banatao Chairman of the Board March 28, 1997 /s/ RONALD T. YARA - ------------------------------------------------------ Ronald T. Yara Director March 28, 1997 /s/ ROBERT P. LEE - ------------------------------------------------------ Robert P. Lee Director March 28, 1997 /s/ JOHN C. COLLIGAN - ------------------------------------------------------ John C. Colligan Director March 28, 1997 /s/ CARMELO J. SANTORO - ------------------------------------------------------ Carmelo J. Santoro Director March 28, 1997 /s/ TERRY N. HOLDT - ------------------------------------------------------ Terry N. Holdt Vice Chairman of the Board March 28, 1997 51 52 INDEX TO EXHIBITS
EXHIBIT NUMBER NOTES DESCRIPTION OF DOCUMENT -------- ------ -------------------------------------------------------------------------- 3(i).1 (1) Restated Certificate of Incorporation. 3(i).2 (6) Certificate of Amendment of Restated Certificate of Incorporation. 3(ii) (1) Bylaws. 4.1 (1) Specimen Common Stock Certificate 4.2 (8) Indenture, dated as of September 12, 1996 between Registrant and State Street Bank and Trust Company of California, N.A., as Trustee, including the form of Note. 4.3 (9) Registration Rights Agreement, dated September 12, 1996, among Registrant, Lehman Brothers Inc., PaineWebber Incorporated and Cowen & Company. 10.1* 1989 Stock Plan of S3 Incorporated, as amended (the "1989 Plan"). 10.2* (1) Form of Incentive Stock Option Agreement under the 1989 Plan. 10.3* (1) Form of Nonstatutory Stock Option Agreement under the 1989 Plan. 10.4* (1) Form of Common Stock Purchase Agreement under the 1989 Plan. 10.5* (2) S3 Incorporated 1993 Employee Stock Purchase Plan. 10.6 (1) Form of Indemnification Agreement between the Registrant and its directors. 10.7 (3) Office Lease dated May 13, 1993, between the Registrant and San Tomas No. 2 Limited Partnership. 10.8 (3) First Amendment of Office Lease dated September 9, 1993, between the Registrant and San Tomas No. 2 Limited Partnership. 10.9 (4) Office Lease dated March 30, 1994, between the Registrant and San Tomas No. 1 Limited Partnership. 10.10 (4) Second Amendment of Office Lease dated March 30, 1994, between the Registrant and San Tomas No. 2 Limited Partnership. 10.11 (5) Foundry Venture Agreement among Registrant, Alliance Semiconductor Corporation and United Microelectronics Corporation dated as of July 8, 1995 10.12 (7) Lease between Mission Real Estate, L.P. and Registrant dated November 29, 1995. 21.1 (6) Subsidiaries of S3 Incorporated. 23.1 Independent Auditors' Consent. 24.1 Power of Attorney (see page 51 of this Form 10-K) 27.1 Financial Data Schedules
- --------------- * Indicates management contract or compensatory plan or arrangement. (1) Incorporated by reference from the Registrant's Registration Statement on Form S-1 (File No. 33-57114). (2) Incorporated by reference to Exhibit 10.15 to the Registrant's Registration Statement on Form S-8 (File No. 33-65186). (3) Incorporated by reference to the exhibit of the same number to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1993. (4) Incorporated by reference to the exhibit of the same number to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1994. (5) Incorporated by reference to the exhibit of the same number to the Registrant's Current Report on Form 8-K filed July 25, 1995. (6) Incorporated by reference to the exhibit of the same number to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1995. 53 (7) Incorporated by reference to Exhibit 10.14 to the Registrant's Annual Report on form 10-K for the year ended December 31, 1995. (8) Incorporated by reference to Exhibit 4.1 to Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1996. (9) Incorporated by reference to Exhibit 4.2 to Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1996. EX-10.1 2 1989 STOCK PLAN OF S3 INCORPORATED 1 Exhibit 10.1 1989 STOCK PLAN OF S3 INCORPORATED (Amended and Restated Effective as of March 11, 1997) 2 TABLE OF CONTENTS
Page ---- SECTION 1. ESTABLISHMENT AND PURPOSE. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 SECTION 2. DEFINITIONS. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 (a) Board of Directors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 (b) Change in Control . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 (c) Code . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 (d) Committee . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 (e) Company . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 (f) Employee . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 (g) Exchange Act . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 (h) Exercise Price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 (i) Fair Market Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 (j) ISO . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 (k) Nonstatutory Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 (l) Offeree . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 (m) Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 (n) Optionee . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 (o) Outside Director . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 (p) Plan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 (q) Purchase Price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 (r) Service . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 (s) Share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 (t) Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 (u) Stock Option Agreement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 (v) Stock Purchase Agreement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 (w) Subsidiary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 (x) Total and Permanent Disability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 SECTION 3. ADMINISTRATION. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 (a) Committee Procedures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 (b) Committee Responsibilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 SECTION 4. ELIGIBILITY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 (a) General Rule . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 (b) Outside Directors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 (c) Limitation On Grants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 (d) Ten-Percent Shareholders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 (e) Attribution Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 (f) Outstanding Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 SECTION 5. STOCK SUBJECT TO PLAN . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 (a) Basic Limitation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 (b) Additional Shares . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 SECTION 6. TERMS AND CONDITIONS OF AWARDS OR SALES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 (a) Stock Purchase Agreement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 (b) Duration of Offers and Nontransferability of Rights . . . . . . . . . . . . . . . . . . . . . . . . . 6 (c) Purchase Price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 (d) Withholding Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 (e) Restrictions on Transfer of Shares . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
-i- 3 SECTION 7. TERMS AND CONDITIONS OF OPTIONS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 (a) Stock Option Agreement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 (b) Number of Shares . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 (c) Exercise Price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 (d) Withholding Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 (e) Exercisability and Term . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 (f) Nontransferability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 (g) Exercise of Options Upon Termination of Service . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 (h) Leaves of Absence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 (i) No Rights as a Stockholder . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 (j) Modification, Extension and Renewal of Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 (k) Restrictions on Transfer of Shares . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 SECTION 8. PAYMENT FOR SHARES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 (a) General Rule . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 (b) Surrender of Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 (c) Services Rendered . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 (d) Cashless Exercise . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 SECTION 9. ADJUSTMENT OF SHARES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 (a) General . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 (b) Reorganizations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 (c) Reservation of Rights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 SECTION 10. LEGAL AND REGULATORY REQUIREMENTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 SECTION 11. NO EMPLOYMENT RIGHTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 SECTION 12. DURATION AND AMENDMENTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 (a) Term of the Plan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 (b) Right to Amend or Terminate the Plan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 (c) Effect of Amendment or Termination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 SECTION 13. EMPLOYEES BASED OUTSIDE OF THE UNITED STATES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 SECTION 14. EXECUTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
-ii- 4 1989 STOCK PLAN OF S3 INCORPORATED (Amended and Restated Effective as of March 11, 1997) SECTION 1. ESTABLISHMENT AND PURPOSE. The Plan was established in 1989 to offer selected employees, directors, advisers and consultants an opportunity to acquire a proprietary interest in the success of the Company, or to increase such interest, by purchasing Shares of the Company's Common Stock. The Plan provides both for the direct award or sale of Shares and for the grant of Options to purchase Shares. Options granted under the Plan may include Nonstatutory Options as well as ISOs intended to qualify under Code section 422. The Plan was again amended and restated effective January 1, 1994 to increase the amount of shares authorized to be issued under the Plan, to include changes to the Plan to conform the Plan to the deductibility requirements of Code Section 162(m), to add automatic grant procedures for non-employee directors and to authorize shares to be issued for such grants, and to delete certain provisions that were required before the Company became a public company. This amendment and restatement increases the amount of shares authorized to be issued under the Plan by 1,500,000 shares. SECTION 2. DEFINITIONS. (a) "Board of Directors" shall mean the Board of Directors of the Company, as constituted from time to time. (b) "Change in Control" means the occurrence of either of the following events: (i) A change in the composition of the Board of Directors, as a result of which fewer than one-half of the incumbent directors are directors who either: (A) Had been directors of the Company 24 months prior to such change; or (B) Were elected, or nominated for election, to the Board of Directors with the affirmative votes of at least a majority of the directors who had been directors of the Company 24 months prior to such change and who were still in office at the time of the election or nomination; or (ii) Any "person" (as such term is used in sections 13(d) and 14(d) of the Exchange Act) by the acquisition or aggregation of securities is or becomes the beneficial owner, directly or indirectly, of securities of the Company representing 20% or more of the combined voting power of the Company's then outstanding securities ordinarily (and apart from rights accruing under special circumstances) having the right to vote at elections of directors (the "Base Capital Stock"); except that any change in the relative beneficial ownership of the Company's securities by any person resulting solely from a reduction in the aggregate number of outstanding shares of Base Capital Stock, and any decrease thereafter in such person's ownership of securities, shall be disregarded until such person increases in any manner, directly or indirectly, such person's beneficial ownership of any securities of the Company. For purposes of this Subsection (ii), the term "person" shall not include an employee benefit plan maintained by the Company. (c) "Code" shall mean the Internal Revenue Code of 1986, as amended. (d) "Committee" shall mean the committee designated by the Board of Directors, which is authorized to administer the Plan under Section 3 hereof. The Committee shall have membership composition -1- 5 which enables the Plan to qualify under Rule 16b-3 with regard to the grant of Options or other rights under the Plan to persons who are subject to Section 16 of the Exchange Act. (e) "Company" shall mean S3 Incorporated, a Delaware corporation. (f) "Employee" shall mean (i) any individual who is a common-law employee of the Company or of a Subsidiary, (ii) a member of the Board of Directors and (iii) an independent contractor or advisor who performs services for the Company or a Subsidiary. Service as a member of the Board of Directors or as an independent contractor or advisor shall be considered employment for all purposes of the Plan except the second sentence of Section 4(a) and Section 4(b). (g) "Exchange Act" shall mean the Securities Exchange Act of 1934, as amended. (h) "Exercise Price" shall mean the amount for which one Share may be purchased upon exercise of an Option, as specified by the Committee in the applicable Stock Option Agreement. (i) "Fair Market Value" shall mean (i) the closing price of a Share on the principal exchange which the Shares are trading, on the date on which the Fair Market Value is determined (if Fair Market Value is determined on a date which the principal exchange is closed, Fair Market Value shall be determined on the last immediately preceding trading day), or (ii) if the Shares are not traded on an exchange but are quoted on the Nasdaq National Market or a successor quotation system, the closing price on the date on which the Fair Market Value is determined, or (iii) if the Shares are not traded on an exchange or quoted on the Nasdaq National Market or a successor quotation system, the fair market value of a Share, as determined by the Committee in good faith. Such determination shall be conclusive and binding on all persons. (j) "ISO" shall mean an employee incentive stock option described in Code section 422. (k) "Nonstatutory Option" shall mean an employee stock option that is not an ISO. (l) "Offeree" shall mean an individual to whom the Committee has offered the right to acquire Shares under the Plan (other than upon exercise of an Option). (m) "Option" shall mean an ISO or Nonstatutory Option granted under the Plan and entitling the holder to purchase Shares. (n) "Optionee" shall mean an individual who holds an Option. (o) "Outside Director" shall mean a member of the Board of Directors who is not a common-law employee of the Company or of a Subsidiary. (p) "Plan" shall mean this 1989 Stock Plan of S3 Incorporated, as amended from time to time. (q) "Purchase Price" shall mean the consideration for which one Share may be acquired under the Plan (other than upon exercise of an Option), as specified by the Committee. (r) "Service" shall mean service as an Employee. (s) "Share" shall mean one share of Stock, as adjusted in accordance with Section 9 (if applicable). (t) "Stock" shall mean the Common Stock of the Company. -2- 6 (u) "Stock Option Agreement" shall mean the agreement between the Company and an Optionee which contains the terms, conditions and restrictions pertaining to his Option. (v) "Stock Purchase Agreement" shall mean the agreement between the Company and an Offeree who acquires Shares under the Plan which contains the terms, conditions and restrictions pertaining to the acquisition of such Shares. (w) "Subsidiary" shall mean any corporation, if the Company and/or one or more other Subsidiaries own not less than 50 percent of the total combined voting power of all classes of outstanding stock of such corporation. A corporation that attains the status of a Subsidiary on a date after the adoption of the Plan shall be considered a Subsidiary commencing as of such date. (x) "Total and Permanent Disability" shall mean that the Optionee is unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or which has lasted, or can be expected to last, for a continuous period of not less than six months. SECTION 3. ADMINISTRATION. (a) Committee Procedures. The Board of Directors shall designate one of the members of the Committee as chairman. The Committee may hold meetings at such times and places as it shall determine. The acts of a majority of the Committee members present at meetings at which a quorum exists, or acts reduced to or approved in writing by all Committee members, shall be valid acts of the Committee. (b) Committee Responsibilities. Subject to the provisions of the Plan, the Committee shall have full authority and discretion to take the following actions: (i) To interpret the Plan and to apply its provisions; (ii) To adopt, amend or rescind rules, procedures and forms relating to the Plan; (iii) To authorize any person to execute, on behalf of the Company, any instrument required to carry out the purposes of the Plan; (iv) To determine when Shares are to be awarded or offered for sale and when Options are to be granted under the Plan; (v) To select the Offerees and Optionees; (vi) To determine the number of Shares to be offered to each Offeree or to be made subject to each Option; (vii) To prescribe the terms and conditions of each award or sale of Shares, including (without limitation) the Purchase Price, the vesting of the award (including accelerating the vesting of awards) and to specify the provisions of the Stock Purchase Agreement relating to such award or sale; (viii) To prescribe the terms and conditions of each Option, including (without limitation) the Exercise Price, the vesting or duration of the Option (including accelerating the vesting of the Option), to determine whether such Option is to be classified as an ISO or as a Nonstatutory Option, and to specify the provisions of the Stock Option Agreement relating to such Option; -3- 7 (ix) To amend any outstanding Stock Purchase Agreement or Stock Option Agreement, subject to applicable legal restrictions and to the consent of the Offeree or Optionee who entered into such agreement; (x) To prescribe the consideration for the grant of each Option or other right under the Plan and to determine the sufficiency of such consideration; (xi) To determine the disposition of each Option or other right under the Plan in the event of an Optionee's or Offeree's divorce or dissolution of marriage; (xii) To determine whether Options or other rights under the Plan will be granted in replacement of other grants under an incentive or other compensation plan of an acquired business; (xiii) To correct any defect, supply any omission, or reconcile any inconsistency in the Plan, any Stock Option Agreement or any Stock Purchase Agreement; and (xiv) To take any other actions deemed necessary or advisable for the administration of the Plan. Subject to the requirements of applicable law, the Committee may designate persons other than members of the Committee to carry out its responsibilities and may prescribe such conditions and limitations as it may deem appropriate, except that the Committee may not delegate its authority with regard to the selection for participation of or the granting of Options or other rights under the Plan to persons subject to Section 16 of the Exchange Act. All decisions, interpretations and other actions of the Committee shall be final and binding on all Offerees, all Optionees, and all persons deriving their rights from an Offeree or Optionee. No member of the Committee shall be liable for any action that he has taken or has failed to take in good faith with respect to the Plan, any Option, or any right to acquire Shares under the Plan. SECTION 4. ELIGIBILITY. (a) General Rule. Only Employees shall be eligible for designation as Optionees or Offerees by the Committee. In addition, only individuals who are employed as common-law employees by the Company or a Subsidiary shall be eligible for the grant of ISOs. (b) Outside Directors. Any other provision of the Plan notwithstanding, the participation of Outside Directors in the Plan shall be subject to the following restrictions: (i) Outside Directors shall only be eligible for the grant of Nonstatutory Options as described in this Section 4(b). (ii) Each Outside Director shall automatically be granted a Nonstatutory Option to purchase 40,000 Shares (subject to adjustment under Section 9) as a result of their appointment as an Outside Director. Upon the conclusion of each regular annual meeting of the Company's shareholders following the meeting at which they were appointed, each Outside Director who will continue serving as a member of the Board thereafter shall receive a Nonstatutory Option to purchase 20,000 Shares (subject to adjustment under Section 9). All such Nonstatutory Options shall vest and become exercisable at the rate of 25% upon each one-year anniversary of the date the option is granted to the Outside Director. (iii) All Nonstatutory Options granted to an Outside Director under this Section 4(b) shall also become exercisable in full in the event of (A) the termination of such Outside Director's -4- 8 service because of death or Total and Permanent Disability or (B) a Change in Control of the Company. (iv) The Exercise Price of all Nonstatutory Options granted to an Outside Director under this Section 4(b) shall be equal to 100% of the Fair Market Value of a Share on the date of grant, payable in one of the forms described in Sections 8(a), (b) and (d). (v) All Nonstatutory Options granted to an Outside Director under this Section 4(b) shall terminate on the earliest of (A) the 10th anniversary of the date of grant of such Nonstatutory Options, (B) the date 90 days after the termination of such Outside Director's service for any reason other than death, Total and Permanent Disability or voluntary retirement as an Outside Director at or after the age of 60, or (C) the date 12 months after the termination of such Outside Director's service because of death, Total and Permanent Disability or voluntary retirement as an Outside Director at or after the age of 60. (c) Limitation On Grants. No Employee shall be granted Options to purchase more than 1,500,000 Shares in any fiscal year of the Company. (d) Ten-Percent Shareholders. An Employee who owns more than 10 percent of the total combined voting power of all classes of outstanding stock of the Company or any of its Subsidiaries shall not be eligible for the grant of an ISO unless such grant satisfies the requirements of Code section 422(c)(6). (e) Attribution Rules. For purposes of Subsection (d) above, in determining stock ownership, an Employee shall be deemed to own the stock owned, directly or indirectly, by or for his brothers, sisters, spouse, ancestors and lineal descendants. Stock owned, directly or indirectly, by or for a corporation, partnership, estate or trust shall be deemed to be owned proportionately by or for its shareholders, partners or beneficiaries. (f) Outstanding Stock. For purposes of Subsection (d) above, "outstanding stock" shall include all stock actually issued and outstanding immediately after the grant. "Outstanding stock" shall not include shares authorized for issuance under outstanding options held by the Employee or by any other person. SECTION 5. STOCK SUBJECT TO PLAN. (a) Basic Limitation. Shares offered under the Plan shall be authorized but unissued Shares or treasury Shares. The aggregate number of Shares which may be issued under the Plan (upon exercise of Options or other rights to acquire Shares) shall not exceed 19,510,253 Shares. The Company has reserved an additional 600,000 Shares exclusively for grants of Options to Outside Directors described in Section 4(b). Effective January 1, 1997 and on each January 1 thereafter for the remaining term of the Plan, the aggregate number of Shares which may be issued under the Plan to individuals other than Outside Directors (upon exercise of Options or other rights to acquire Shares) shall be increased by a number of Shares equal to 3 1/4 percent of the total number of Shares of the Common Stock of the Company outstanding at the end of the most recently concluded calendar year. Any Shares that have been reserved but not issued as Shares or Options during any calendar year shall remain available for grant during any subsequent calendar year. Notwithstanding the foregoing, no more than 8,900,000 Shares shall be available for the grant of ISOs for the remaining term of the Plan. The aggregate number of Shares which may be issued under the Plan shall at all times be subject to adjustment pursuant to Section 9. The number of Shares which are subject to Options or other rights outstanding at any time under the Plan shall not exceed the number of Shares which then remain available for issuance under the Plan. The Company, during the term of the Plan, shall at all times reserve and keep available sufficient Shares to satisfy the requirements of the Plan. -5- 9 (b) Additional Shares. In the event that any outstanding Option or other right for any reason expires or is canceled or otherwise terminated, the Shares allocable to the unexercised portion of such Option or other right shall again be available for the purposes of the Plan. If Shares are forfeited before any dividends have been paid with respect to the Shares, then such Shares shall again be available for award or sale under the Plan. SECTION 6. TERMS AND CONDITIONS OF AWARDS OR SALES. (a) Stock Purchase Agreement. Each award or sale of Shares under the Plan (other than upon exercise of an Option) shall be evidenced by a Stock Purchase Agreement between the Offeree and the Company. Such award or sale shall be subject to all applicable terms and conditions of the Plan and may be subject to any other terms and conditions which are not inconsistent with the Plan and which the Committee deems appropriate for inclusion in a Stock Purchase Agreement. The provisions of the various Stock Purchase Agreements entered into under the Plan need not be identical. (b) Duration of Offers and Nontransferability of Rights. Any right to acquire Shares under the Plan (other than an Option) shall automatically expire if not exercised by the Offeree within 30 days after the grant of such right was communicated to him by the Committee. Such right shall not be transferable and shall be exercisable only by the Offeree to whom such right was granted. (c) Purchase Price. The Purchase Price shall be determined by the Committee at its sole discretion. The Purchase Price shall be payable in one of the forms described in Sections 8(a) and (c). (d) Withholding Taxes. As a condition to the purchase of Shares, the Offeree shall make such arrangements as the Committee may require for the satisfaction of any federal, state or local withholding tax obligations that may arise in connection with such purchase. (e) Restrictions on Transfer of Shares. Any Shares awarded or sold under the Plan shall be subject to such special forfeiture conditions, rights of repurchase, rights of first refusal and other transfer restrictions as the Committee may determine. Such restrictions shall be set forth in the applicable Stock Purchase Agreement and shall apply in addition to any general restrictions that may apply to all holders of Shares. SECTION 7. TERMS AND CONDITIONS OF OPTIONS. (a) Stock Option Agreement. Each grant of an Option under the Plan shall be evidenced by a Stock Option Agreement between the Optionee and the Company. Such Option shall be subject to all applicable terms and conditions of the Plan and may be subject to any other terms and conditions which are not inconsistent with the Plan and which the Committee deems appropriate for inclusion in a Stock Option Agreement. The provisions of the various Stock Option Agreements entered into under the Plan need not be identical. (b) Number of Shares. Each Stock Option Agreement shall specify the number of Shares that are subject to the Option and shall provide for the adjustment of such number in accordance with Section 9. The Stock Option Agreement shall also specify whether the Option is an ISO or a Nonstatutory Option. (c) Exercise Price. Each Stock Option Agreement shall specify the Exercise Price. The Exercise Price of an ISO shall not be less than 100 percent of the Fair Market Value of a Share on the date of grant, except as otherwise provided in Section 4(d). Subject to the preceding sentence, the Exercise Price under any Option shall be determined by the Committee at its sole discretion. The Exercise Price shall be payable in one of the forms described in Sections 8(a), (b) and (d). -6- 10 (d) Withholding Taxes. As a condition to the exercise of an Option, the Optionee shall make such arrangements as the Committee may require for the satisfaction of any federal, state or local withholding tax obligations that may arise in connection with such exercise. The Optionee shall also make such arrangements as the Committee may require for the satisfaction of any federal, state or local withholding tax obligations that may arise in connection with the disposition of Shares acquired by exercising an Option. (e) Exercisability and Term. Each Stock Option Agreement shall specify the date when all or any installment of the Option is to become exercisable. The Stock Option Agreement shall also specify the term of the Option. The term shall not exceed 10 years from the date of grant, except as otherwise provided in Section 4(d). Subject to the preceding three sentences, the Committee at its sole discretion shall determine when all or any installment of an Option is to become exercisable and when an Option is to expire. (f) Nontransferability. During an Optionee's lifetime, his Option(s) shall be exercisable only by him and shall not be transferable. In the event of an Optionee's death, his Option(s) shall not be transferable other than by will or by the laws of descent and distribution. (g) Exercise of Options Upon Termination of Service. Each Stock Option Agreement shall set forth the extent to which the Optionee shall have the right to exercise the Option following termination of the Optionee's Service with the Company and its Subsidiaries, and the right to exercise the Option of any executors or administrators of the Optionee's estate or any person who has acquired such Option(s) directly from the Optionee by bequest or inheritance. Such provisions shall be determined in the sole discretion of the Committee, need not be uniform among all Options issued pursuant to the Plan, and may reflect distinctions based on the reasons for termination of Service. (h) Leaves of Absence. An Optionee's Service shall be deemed to continue while the Optionee is on military leave, sick leave or other bona fide leave of absence (as determined by the Committee). The foregoing notwithstanding, in the case of an ISO granted under the Plan, Service shall not be deemed to continue beyond the first 90 days of such leave, unless the Optionee's reemployment rights are guaranteed by statute or by contract. (i) No Rights as a Stockholder. An Optionee, or a transferee of an Optionee, shall have no rights as a stockholder with respect to any Shares covered by his Option until the date of the issuance of a stock certificate for such Shares. No adjustments shall be made, except as provided in Section 9. (j) Modification, Extension and Renewal of Options. Within the limitations of the Plan, the Committee may modify, extend or renew outstanding options or may accept the cancellation of outstanding options (to the extent not previously exercised), whether or not granted hereunder, in return for the grant of new Options at the same or a different price. The foregoing notwithstanding, no modification of an Option shall, without the consent of the Optionee, impair his rights or increase his obligations under such Option. (k) Restrictions on Transfer of Shares. Any Shares issued upon exercise of an Option shall be subject to such special forfeiture conditions, rights of repurchase, rights of first refusal and other transfer restrictions as the Committee may determine. Such restrictions shall be set forth in the applicable Stock Option Agreement and shall apply in addition to any general restrictions that may apply to all holders of Shares. SECTION 8. PAYMENT FOR SHARES. (a) General Rule. The entire Purchase Price or Exercise Price of Shares issued under the Plan shall be payable in lawful money of the United States of America at the time when such Shares are purchased, except as provided in Subsections (b), (c) and (d) below. -7- 11 (b) Surrender of Stock. To the extent that a Stock Option Agreement so provides, payment may be made all or in part with Shares which have already been owned by the Optionee or his representative for more than 12 months and which are surrendered to the Company in good form for transfer. Such Shares shall be valued at their Fair Market Value on the date when the new Shares are purchased under the Plan. (c) Services Rendered. At the discretion of the Committee, Shares may be awarded under the Plan in consideration of services rendered to the Company or a Subsidiary prior to the award. If Shares are awarded without the payment of a Purchase Price in cash, the Committee shall make a determination (at the time of the award) of the value of the services rendered by the Offeree and the sufficiency of the consideration to meet the requirements of Section 6(c). (d) Cashless Exercise. To the extent that a Stock Option Agreement so provides, payment may be made all or in part by delivery (on a form prescribed by the Committee) of an irrevocable direction to a securities broker to sell Shares and to deliver all or part of the sale proceeds to the Company in payment of the aggregate Exercise Price. SECTION 9. ADJUSTMENT OF SHARES. (a) General. In the event of a subdivision of the outstanding Stock, a declaration of a dividend payable in Shares, a declaration of a dividend payable in a form other than Shares in an amount that has a material effect on the value of Shares, a combination or consolidation of the outstanding Stock (by reclassification or otherwise) into a lesser number of Shares, a recapitalization or a similar occurrence, the Committee shall make appropriate adjustments in one or more of (i) the number of Shares available for future grants under Section 5, (ii) the number of Shares covered by each outstanding Option, (iii) the Exercise Price under each outstanding Option, (iv) the number of shares covered by each outstanding award or (v) the Purchase Price of each outstanding award. (b) Reorganizations. In the event that the Company is a party to a merger or other reorganization, outstanding Options shall be subject to the agreement of merger or reorganization. Such agreement may provide for the assumption of outstanding Options by the surviving corporation or its parent or for their continuation by the Company (if the Company is a surviving corporation); provided, however, that if assumption or continuation of the outstanding Options is not provided by such agreement then the Committee shall have the option of offering the payment of a cash settlement equal to the difference between the amount to be paid for one Share under such agreement and the Exercise Price, in all cases without the Optionees' consent. (c) Reservation of Rights. Except as provided in this Section 9, an Optionee or Offeree shall have no rights by reason of any subdivision or consolidation of shares of stock of any class, the payment of any dividend or any other increase or decrease in the number of shares of stock of any class. Any issue by the Company of shares of stock of any class, or securities convertible into shares of stock of any class, shall not affect, and no adjustment by reason thereof shall be made with respect to, the number or Exercise Price of Shares subject to an Option. The grant of an Option pursuant to the Plan shall not affect in any way the right or power of the Company to make adjustments, reclassifications, reorganizations or changes of its capital or business structure, to merge or consolidate or to dissolve, liquidate, sell or transfer all or any part of its business or assets. SECTION 10. LEGAL AND REGULATORY REQUIREMENTS. Shares shall not be issued under the Plan unless the issuance and delivery of such Shares complies with (or is exempt from) all applicable requirements of law, including (without limitation) the Securities Act of 1933, as amended, the rules and regulations promulgated thereunder, state securities laws and regulations and the regulations of any stock exchange on which the Company's securities may then be -8- 12 listed, and the Company has obtained the approval or favorable ruling from any governmental agency which the Company determines is necessary or advisable. SECTION 11. NO EMPLOYMENT RIGHTS. No provision of the Plan, nor any right or Option granted under the Plan, shall be construed to give any person any right to become, to be treated as, or to remain an Employee. The Company and its Subsidiaries reserve the right to terminate any person's Service at any time and for any reason. SECTION 12. DURATION AND AMENDMENTS. (a) Term of the Plan. The amended and restated Plan, as set forth herein, shall become effective on March 11, 1997. The Plan shall terminate automatically 10 years after its adoption by the Board of Directors and may be terminated on any earlier date pursuant to Subsection (b) below. (b) Right to Amend or Terminate the Plan. The Board of Directors may amend the Plan at any time and from time to time except that the provisions of Section 4(b) relating to the amount, price and timing of the Option grants to Outside Directors shall not be amended more than once in any six-month period after the Plan becomes effective, except as may be required by the Code or ERISA. Rights and obligations under any Option granted before amendment of the Plan shall not be materially altered, or impaired adversely, by such amendment, except with consent of the person to whom the Option was granted. An amendment of the Plan shall be subject to the approval of the Company's stockholders only to the extent required by applicable laws, regulations or rules. (c) Effect of Amendment or Termination. No Shares shall be issued or sold under the Plan after the termination thereof, except upon exercise of an Option granted prior to such termination. The termination of the Plan, or any amendment thereof, shall not affect any Share previously issued or any Option previously granted under the Plan. -9- 13 SECTION 13. EMPLOYEES BASED OUTSIDE OF THE UNITED STATES. Notwithstanding any provision of the Plan to the contrary, in order to foster and promote achievement of the purposes of the Plan or to comply with provisions of laws or regulations in other countries in which the Company and its Subsidiaries operate or have employees, the Committee, in its sole discretion, shall have the power and authority to (i) determine which Employees outside the United States are eligible to participate in the Plan, (ii) modify the terms and conditions of any Options granted to Employees outside the United States and (iii) establish subplans, modified option exercise procedures and other terms and procedures to the extent such actions may be necessary or advisable. SECTION 14. EXECUTION. To record the adoption of the amended and restated Plan by the Board of Directors effective as of March 11, 1997, the Company has caused its authorized officer to execute the same. S3 INCORPORATED By /s/ GARY J. JOHNSON ------------------------------- Gary J. Johnson President and Chief Executive Officer -10- EX-23.1 3 INDEPENDENT AUDITORS' CONSENT 1 EXHIBIT 23.1 INDEPENDENT AUDITORS' CONSENT We consent to the incorporation by reference in Registration Statements No. 33-60666, 33-82280, 33-89388, 33-65186, 33-92372 and 333-23819 of S3 Incorporated on Form S-8 of our report dated January 17, 1997 appearing in the Annual Report on Form 10-K of S3 Incorporated for the year ended December 31, 1996. DELOITTE & TOUCHE LLP San Jose, California March 27, 1997 EX-27.1 4 FINANCIAL DATA SCHEDULE
5 THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM S3 INCORPORATED CONSOLIDATED BALANCE SHEET AND CONSOLIDATED STATEMENT OF INCOME FOR THE PERIOD ENDED DECEMBER 31, 1996 AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS. 1,000 0 YEAR DEC-31-1996 JAN-01-1996 DEC-31-1996 1 94,616 62,768 78,768 2,648 53,466 321,339 55,187 21,140 480,462 89,010 103,500 0 0 169,411 97,689 480,462 465,378 465,378 281,013 281,013 112,182 1,522 1,971 74,412 26,045 48,367 0 0 0 48,367 0.95 0.94
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