-----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, Pie1VNjqE2uKzBZeW+lq7apnnWMfD8kA0R3J+/NlvZVyu+jmAV6Jl8+HW49E1c5P VgzSlfQoEzHAEWC3PB0wBA== 0000891618-98-003566.txt : 19980804 0000891618-98-003566.hdr.sgml : 19980804 ACCESSION NUMBER: 0000891618-98-003566 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 3 CONFORMED PERIOD OF REPORT: 19980628 FILED AS OF DATE: 19980803 SROS: NASD FILER: COMPANY DATA: COMPANY CONFORMED NAME: AUREAL SEMICONDUCTOR INC CENTRAL INDEX KEY: 0000892433 STANDARD INDUSTRIAL CLASSIFICATION: PRINTED CIRCUIT BOARDS [3672] IRS NUMBER: 943117385 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-Q SEC ACT: SEC FILE NUMBER: 000-22626 FILM NUMBER: 98675824 BUSINESS ADDRESS: STREET 1: 4245 TECHNOLOGY DR CITY: FREMONT STATE: CA ZIP: 94538-6339 BUSINESS PHONE: 5102524245 MAIL ADDRESS: STREET 1: 4245 TECHNOLOGY DR CITY: FREMONT STATE: CA ZIP: 94538-6339 FORMER COMPANY: FORMER CONFORMED NAME: MEDIA VISION TECHNOLOGY INC DATE OF NAME CHANGE: 19931210 10-Q 1 FORM 10-Q FOR PE 6/28/98 1 SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934. FOR THE QUARTERLY PERIOD ENDED JUNE 28, 1998 Commission File Number 0-20684 AUREAL SEMICONDUCTOR INC. (Exact name of registrant as specified in its charter) DELAWARE 94-3117385 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification Number) 4245 TECHNOLOGY DRIVE FREMONT, CA 94538 (Address of principal executive offices) Telephone: (510) 252-4245 Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate by check mark whether the registrant has filed all documents required to be filed by Section 12, 13 or 15 (d) of the Securities Exchange Act of 1934 subsequent to the distribution of securities under a plan confirmed by a court. Yes [X] No [ ] At July 28, 1998 42,246,789 shares of common stock, $0.001 par value, of the registrant were outstanding. 2 AUREAL SEMICONDUCTOR INC. FORM 10-Q Table of Contents
Page PART I. FINANCIAL INFORMATION Item 1. Financial Statements.......................................................................... 3 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations................................................................................... 11 PART II. OTHER INFORMATION Item 1. Legal Proceedings............................................................................. 21 Item 4. Submission of Matters to a Vote of Security Holders........................................... 21 Item 6. Exhibits and Reports on Form 8-K.............................................................. 22
2 3 PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS AUREAL SEMICONDUCTOR INC. INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) The Interim Condensed Consolidated Financial Statements of Aureal Semiconductor Inc. (the "Company") have been prepared by the Company, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principals have been omitted pursuant to such rules and regulations. The disclosures included in the Interim Condensed Consolidated Financial Statements should be read in conjunction with the Company's audited financial statements at December 28, 1997 and the notes thereto included in the Company's 1997 Annual Report on Form 10-K. The preparation of financial statements in conformity with generally accepted accounting principles and pursuant to the rules and regulations of the Securities and Exchange Commission requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. The Interim Condensed Consolidated Financial Statements reflect, in the opinion of management, all adjustments (which include only normal recurring adjustments) necessary for a fair presentation of financial position, results of operations and cash flows for such periods. The results of operations for the fiscal quarter ended June 28, 1998 are not necessarily indicative of the results that may be expected for any subsequent quarter or the entire fiscal year ending January 2, 1999. 3 4 AUREAL SEMICONDUCTOR INC. CONDENSED CONSOLIDATED BALANCE SHEETS (DOLLARS IN THOUSANDS)
June 28, December 28, 1998 1997 --------- --------- (Unaudited) ASSETS: Current assets: Cash and cash equivalents $ 116 $ 135 Restricted cash -- 109 Accounts receivable 3,453 21 Inventories 5,138 511 Deferred fair value of debt-related warrants 847 3,000 Prepaid expenses and other current assets 772 462 --------- --------- Total current assets 10,326 4,238 Property and equipment: Machinery and equipment 3,353 3,785 Furniture, fixtures and improvements 646 599 --------- --------- 3,999 4,384 Accumulated depreciation and amortization (2,169) (3,170) --------- --------- Net property and equipment 1,830 1,214 Long-term portion of fair value of debt-related warrants, other assets 1,405 898 --------- --------- Total assets $ 13,561 $ 6,350 ========= ========= LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT): Current liabilities: Accounts payable $ 1,486 $ 1,523 Accrued compensation and benefits 1,375 1,115 Other accrued liabilities 987 1,365 Current portion of pre-petition claims 893 880 --------- --------- Total current liabilities 4,741 4,883 Line of credit 385 21,975 Long-term portion of pre-petition claims and deferred obligations 2,199 3,641 --------- --------- Total liabilities 7,325 30,499 --------- --------- Stockholders' equity (deficit): Preferred stock, $0.001 par value, Authorized Shares - 5,000,000: Series A: Authorized shares - 500; Issued and outstanding Shares - 500 in 1998 -- -- Series B: Authorized shares - 60,000; Issued and outstanding Shares - 39,375 in 1998 -- -- Series C: Authorized shares - 1,500; Issued and outstanding Shares - 600 in 1998 -- -- Additional paid-in capital 51,231 -- Common stock, $0.001 par value: Authorized shares - 100,000,000; Issued and outstanding shares - 42,196,687 in 1998 and 41,850,205 in 1997 42 42 Additional paid-in capital 116,559 114,352 Accumulated deficit (161,596) (138,543) --------- --------- Total stockholders' equity (deficit) 6,236 (24,149) --------- --------- Total liabilities and stockholders' equity (deficit) $ 13,561 $ 6,350 ========= =========
See accompanying notes. 4 5 AUREAL SEMICONDUCTOR INC. CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
Quarter Ended Two Quarters Ended ------------- ------------------- June 28, 1998 June 29, 1997 June 28, 1998 June 29, 1997 ------------- ------------- ------------- ------------- (Unaudited) (Unaudited) Net sales $ 3,436 $ 695 $ 7,018 $ 1,122 Cost of sales 2,033 23 4,826 43 -------- -------- -------- -------- Gross Margin 1,403 672 2,192 1,079 Operating expenses: Research and Development 2,916 1,561 5,534 2,999 Sales and Marketing 1,628 896 2,984 1,674 General and Administrative 816 597 1,676 1,181 Amortization of Reorganization Asset -- 625 -- 1,250 -------- -------- -------- -------- Total operating expenses 5,360 3,679 10,194 7,104 Operating loss (3,957) (3,007) (8,002) (6,025) Amortization of debt-related warrants (577) -- (1,327) -- Interest expense (963) (643) (1,994) (1,165) Other income (expense) 51 148 391 204 -------- -------- -------- -------- Loss from operations before income taxes (5,446) (3,502) (10,932) (6,986) Provision for income taxes -- -- -- -- -------- -------- -------- -------- Net loss $ (5,446) $ (3,502) $(10,932) $ (6,986) ======== ======== ======== ======== Accretion / dividends related to preferred stock $(12,121) -- $(12,121) -- ======== ======== ======== ======== Net Loss Attributable to Common Stockholders $(17,567) -- $(23,053) -- ======== ======== ======== ======== Basic and diluted loss per share $ (0.42) $ (0.09) $ (0.55) $ (0.18) ======== ======== ======== ======== Shares used in calculating per share amounts 42,134 39,501 42,052 39,403 ======== ======== ======== ========
See accompanying notes. 5 6 AUREAL SEMICONDUCTOR INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS)
Two Quarters Ended -------------------------------- June 28, June 29, 1998 1997 ----------- -------- (Unaudited) OPERATING ACTIVITIES Net loss $(10,932) $ (6,986) Adjustments to reconcile net loss to net cash used in operating activities: Depreciation and amortization 2,026 1,601 Changes in operating assets and liabilities: Restricted cash 109 (103) Accounts receivable (3,432) (114) Inventories (4,845) (245) Prepaid expenses and other current assets (549) 116 Other assets (465) -- Accounts payable (57) (187) Accrued compensation and benefits, and other accrued liabilities (315) (48) -------- -------- Net cash used in operating activities (18,460) (5,966) -------- -------- INVESTING ACTIVITIES Acquisition of property and equipment (1,038) (179) -------- -------- Net cash used in investing activities (1,038) (179) -------- -------- FINANCING ACTIVITIES Proceeds from Lines of Credit 18,984 6,770 Repayment on Lines of Credit (9,074) (500) Principal payments on pre-petition claims (1,211) (458) Proceeds from issuance of preferred and common stock, net of issuance costs 10,780 331 -------- -------- Net cash provided by financing activities 19,479 6,143 -------- -------- Net (decrease) in cash and cash equivalents (19) (2) Cash and cash equivalents at beginning of period 135 18 -------- -------- Cash and cash equivalents at end of period $ 116 $ 16 ======== ======== SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION Interest paid $ 2,439 $ 877 SUPPLEMENTAL DISCLOSURE OF NON-CASH FINANCING ACTIVITIES Conversion of Line of Credit balance to Preferred stock $ 28,685 -- Accretion / dividends on Preferred Stock $ 12,121 -- Valuation of debt-related warrants issued $ 1,848 --
See accompanying notes. 6 7 AUREAL SEMICONDUCTOR INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) 1. THE COMPANY AND RECENT FINANCIAL EVENTS Aureal Semiconductor Inc., together with its subsidiaries Crystal River Engineering, Inc. and Aureal Semiconductor Limited (combined, the "Company") specialize in the design and marketing of audio semiconductor technologies for use in both the PC and consumer electronics markets. Crystal River Engineering, Inc. ("CRE"), founded in 1987 and acquired by Aureal in 1996, has been a pioneer in the development of 3D audio technologies. Aureal Semiconductor Limited, located in Hong Kong, was established in the first quarter of 1998 as a sales, technical support and field engineering office. The Company's business involves both the development and sale of audio processing semiconductor chips, as well as the licensing of technology which is designed to define and develop advanced audio standards in the marketplace. The Company's stock symbol on the OTC Bulletin Board is AURL. During March 1998, the Company completed the sale of $5 million of Aureal Series A Preferred Stock. On June 5, 1998 the Company completed three financing transactions, which had the combined effect of increasing the Company's borrowing capacity and providing additional equity for the Company. The transactions included the following: o The sale of $5 million of Aureal Series C Preferred Stock to DDJ Capital Management, LLC. Approximately $3.66 million of the offering was used to pay down the outstanding balance on the existing Line of Credit. The remaining $1.34 million was utilized for working capital purposes. o The remaining balance of $31.5 million on the existing Line of Credit was exchanged for 39,375 shares of Aureal Series B Preferred Stock. o A new $40 Million Revolving Credit Facility was established with Goldman Sachs Credit Partners LP ("Goldman Sachs") and the Technology Finance Division of Transamerica Business Credit Corporation ("Transamerica"). In addition to the above financing transactions, on June 26, 1998, the Company completed the sale of $1 million of Aureal Series C Preferred Stock. The proceeds of the offering were utilized to pay down outstanding borrowings under the Credit Facility. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Presentation The Interim Condensed Consolidated Financial Statements of Aureal Semiconductor Inc. have been prepared by the Company, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in the financial statements prepared in accordance with generally accepted accounting principles have been omitted pursuant to such rules and regulations. The disclosures included in the Interim Condensed Consolidated Financial Statements should be read in conjunction with the Company's audited financial statements at December 28, 1997 and the notes thereto included in the Company's 1997 Annual Report on Form 10-K. The Interim Condensed Consolidated Financial Statements reflect, in the opinion of management, all adjustments (which include only normal recurring adjustments) necessary for a fair presentation of financial position, results of operations and cash flows for such periods. The results of operations for the fiscal quarter and two quarters ended June 28, 1998 are not necessarily indicative of the results that may be expected for any subsequent quarter or the entire fiscal year ending January 2, 1999. The preparation of financial statements in conformity with generally accepted accounting principles and pursuant to the rules and regulations of the Securities and Exchange Commission requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. 7 8 Inventories Inventories are stated at the lower-of-cost-or-market value on a weighted-average costing method. The Company does not consider any inventory to be raw material since the Company's point of purchase is for fabricated silicon wafers or finished silicon dies. Net inventories at June 28, 1998 and December 28, 1997 consist of the following, in thousands:
June 1998 December 1997 --------- ------------- Work in process $3,791 $ 243 Finished goods 1,347 268 ------ ------ Total Inventories $5,138 $ 511 ====== ======
Property and Equipment Property and equipment are stated at cost and depreciated utilizing the straight-line method over their estimated useful lives (one and one-half to five years). Fixed assets with approximately $1.4 million in gross value and zero net book value were retired during the first quarter of 1998 as they were determined to no longer be in use. Revenue Recognition The Company's major sources of revenue consist of sales of proprietary design, advanced audio semiconductor chips, and licensing of related audio technologies. Revenue is recognized upon shipment for product sales. Software licensing revenues are recognized upon shipment of licensed product if a non-cancelable contract has been signed, the fees are fixed and determinable, collection of the recognized fees is reasonably assured and there are no remaining significant obligations. Concentration of Financial Instrument and Credit Risks Financial instruments, which potentially subject the Company to concentration of market risk, consist primarily of the Company's line of credit. This market risk on the line of credit relates to changes in the prime lending rate, as the line of credit bears interest rates which fluctuate with changes in the prime lending rate. Credit risk for the Company consists primarily of trade receivables. Most of the Company's trade receivables are the result of sales to foreign companies. Concentration of credit risk is limited by the use of commercial letters of credit for many of these international customers. Additionally, the Company has established an allowance for doubtful accounts based on the credit risk of specific customers. Valuation of Warrants In June 1998, the Company issued 1,350,000 warrants ("Credit Facility Warrants") to purchase the Company's Common Stock to the lenders under the Company's new Credit Facility (see Note 4). The fair value of the Credit Facility Warrants was estimated to be $1.8 million. Amortization of the $1.8 million asset, as additional interest expense over the two-year life of the Credit Facility commenced in June 1998 at the rate of $0.23 million per complete fiscal quarter. In 1997, the Company recorded the estimated fair value of warrants issued to related parties in association with both the amendment of the line of credit ("Debt Warrants"), and the sale of common stock ("Equity Warrants"). The fair value of the Debt Warrants and the Equity Warrants were estimated to be $5.0 million and $1.5 million, respectively. Amortization of the $5.0 million asset, as additional interest expense over the life of the loan, commenced in August 1997 at the rate of $0.75 million per quarter. With the conversion of the loan in June 1998, into preferred stock of the Company, the remaining balance of the Debt Warrant valuation was eliminated as part of the net book value of the debt. 8 9 Loss Per Share SFAS No. 128 "Earnings per Share" requires that the calculation for basic earnings per share ("EPS") exclude the dilutive effect of common stock equivalents in the calculation for basic net income (loss) per share. Diluted EPS under SFAS No. 128 is calculated using the weighted average number of common shares and common stock equivalent shares outstanding during the period. Common equivalent shares are computed using the treasury stock method for outstanding warrants and stock options. Common equivalent shares are excluded from the diluted EPS computation only if their effect is anti-dilutive. No common stock equivalents were included in the calculations for any fiscal period presented, as, due to the net loss position, any affect would be anti-dilutive. SFAS No. 130 "Reporting Comprehensive Income" was adopted by the Company in the first quarter of 1998. SFAS No. 130 requires companies to report a new, additional measure of income, however the Company has no material items of other comprehensive income in any period presented. Amortization of Intangibles At December 31, 1994, upon its emergence from Chapter 11 Bankruptcy Protection, the reorganization value of the Company in excess of its net assets generated a $44.1 million intangible value that was classified as a reorganization asset in the consolidated balance sheet of the Company ("Reorganization Asset"). The value of the Reorganization Asset was reduced in the second quarter of 1995 as the Company exited the retail products business. The net remaining Reorganization Asset was amortized at the rate of $625,000 per quarter through 1997, and was completely amortized as of December 28, 1997. 3. ELIMINATION / CONVERSION OF PREVIOUS LINE OF CREDIT WITH RELATED PARTIES On June 5, 1998, the Company completed two transactions with the combined effect of fully paying down the entire outstanding balance and eliminating the Company's previous line of credit with related parties. The sale of 500 shares of Aureal Series C Preferred Stock (the "Series C Preferred") for $5.0 million was made to DDJ Capital Management, LLC. $3.66 million of the proceeds from the sale were used to pay down the outstanding balance under the line of credit. The Series C Preferred Stock carries an 8% accretion rate over its three-year term, and provides for conversion to Common Stock of the Company or redemption at the option of the Company. It is convertible at the lesser of a fixed value of $2.50 per Common share or a discount from the then-current market price for the Company's Common Stock at the date of conversion. The remaining $31.5 million balance of the line of credit was exchanged for 39,375 shares of Aureal 8% Series B Preferred Stock (the "Series B Preferred"), with a face value of $39,375,000, and the line of credit was terminated. The lenders under the line of credit released their lien on all the assets of the Company as part of the termination of the line of credit agreement. The Series B Preferred Stock provides for conversion to Common Stock of the Company at the rate of one share of Common Stock for every $2.50 face value of Series B Preferred. The 8% annual dividend, payable quarterly may be paid in cash or in additional shares of Series B Preferred, at the option of the Company. The Company has the option to redeem the Series B Preferred at its face value at any time during its five-year term. 4. NEW CREDIT FACILITY In conjunction with the conversion and elimination of the previous line of credit, on June 5, 1998, the Company entered into a new $40 million Revolving Credit Facility with Goldman Sachs and Transamerica. Terms of the new Credit Facility provide for up to $32.5 million availability for borrowings related to specific Company accounts receivable, ("Tranche A"), with an additional $7.5 million of availability unrelated to specific collateral requirements ("Tranche B"). Interest on borrowings under the two-year agreement is at the rates of Prime plus three percent for Tranche A borrowings and Prime plus five percent for Tranche B borrowings. The Company is subject to certain covenant restrictions under the Credit Facility and has paid a $600,000 fee to the lenders in connection with the initiation of the Credit Facility. As of June 28, 1998 the Company was in compliance with all of the covenant requirements. 9 10 Also in conjunction with the establishment of the new Credit Facility, the Company issued 1.35 million warrants to the lenders under the Credit Facility. These warrants are exercisable at any time over their five-year life at the exercise price of $2.156 per share of Common Stock. 5. PREFERRED STOCK During the first half of 1998, the Company issued three series of preferred stock. The net proceeds from all the preferred stock issuances were used to reduce the Company's outstanding debt and for working capital purposes. In March, the Company issued $5 million of Series A Preferred Stock (the "Series A Preferred"). The Series A Preferred shares include conversion rights to Aureal Common Stock at the lesser of a $2.50 fixed conversion rate or a variable conversion pricing dependent upon the underlying price of the Common Stock at the time of conversion. The Series A Preferred shares bear accretion at an 8% annual rate over their three-year term. On June 5, 1998, the Company sold $5 million of Series C Preferred to DDJ Capital Management, LLC ("DDJ"). The terms of the Series C Preferred are virtually identical to the Series A Preferred. On June 26, 1998, the Company sold an additional $1 million of Series C Preferred to non-affiliates. Also on June 5, 1998, the Company exchanged 39,375 shares of Series B Preferred for the entire $31.5 million outstanding balance of the Company's previous line of credit. The Series B Preferred bear a face value of $1,000 per share and an 8% annual dividend rate. The dividends may be paid in cash or in additional Series B Preferred shares, at the option of the Company. The $10.7 million difference between the fair market value of the Series B Preferred shares and the net book value of the exchanged debt (less unamortized fees associated therewith) was charged directly to accumulated deficit at the time of the transaction. Accretion related to the beneficial conversion features of the Series A Preferred and the Series C Preferred, and the dividend/accretion rate of 8% on all three series of preferred stock totaled $1.4 million in the second quarter of 1998. 6. INCOME TAXES The Company was not required to provide for income taxes in the first two quarters of 1998 or 1997 due to its net operating losses. No tax benefit has been recorded for the losses due to the uncertainty as to the realizability. At December 28, 1997, the Company had available net operating loss carryforwards ("NOL's") of approximately $285 million to reduce future taxable income. The NOL's expire on various dates through 2012. In connection with the adoption of fresh start accounting, any tax benefit resulting from the use of the NOL's generated prior to the bankruptcy plan confirmation in 1994 will be applied as a direct addition to stockholders' equity. 10 11 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS THE FOLLOWING DISCUSSION SHOULD BE READ IN CONJUNCTION WITH THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS INCLUDED ELSEWHERE HEREIN AND THE AUDITED CONSOLIDATED FINANCIAL STATEMENTS AND NOTES THERETO AND MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS FOR THE YEAR ENDED DECEMBER 28, 1997, CONTAINED IN FORM 10-K FILED WITH THE SECURITIES AND EXCHANGE COMMISSION. FORWARD-LOOKING STATEMENTS IN THIS REPORT ARE MADE PURSUANT TO THE SAFE HARBOR PROVISIONS OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995. INVESTORS ARE CAUTIONED THAT SUCH FORWARD-LOOKING STATEMENTS INVOLVE RISKS AND UNCERTAINTIES, INCLUDING, BUT NOT LIMITED TO, DEPENDENCE ON THE PC AND CONSUMER ELECTRONICS INDUSTRIES AND ON PRODUCT LINES BASED ON NEW TECHNOLOGIES; FOUNDRY CAPACITY, AVAILABILITY AND RELIABILITY; COMPETITION AND PRICING PRESSURES, AND OTHER RISKS DETAILED BELOW AND FROM TIME TO TIME IN THE COMPANY'S FILINGS WITH THE SECURITIES AND EXCHANGE COMMISSION. OVERVIEW The Company's objective is to be a leading supplier of high quality, advanced audio solutions to both the PC and consumer electronics marketplaces. The Company's operating strategy combines the development and sale of audio processing semiconductor chips with the licensing of technology to strategic partners in order to define and develop advanced audio standards in the marketplace. This strategy encompasses the following primary elements: o Create value in the Aureal and A3D logos - Aureal is working to establish consumer association between the Aureal and A3D brand names and high quality audio. This high quality branding strategy can be utilized on multiple components of an entire audio solution in the PC arena. o Offer low-cost PC audio acceleration - Aureal continues to develop and offer high-feature audio accelerator chips at prices competitive with lower-featured offerings from other manufacturers. In addition, the Company is currently expanding its PC product offerings in response to the evolving market for audio and audio communications components. Both audio cards and audio communications combination cards are being developed for distribution. This expansion of the Company's business model allows Aureal to approach the PC market with a complete spectrum of audio components targeted to provide solutions at various feature/price points in the market. o Provide integrated audio components to the consumer market - Aureal is developing devices targeted to the consumer electronics marketplace which provide lower system cost through integration of digital, analog and other audio system functions. On July 15, 1998, Diamond Multimedia Systems, Inc. ("Diamond") and the Company jointly announced that they had entered into a strategic alliance to develop and market next-generation audio solutions for the PC marketplace. Under this agreement, Diamond will utilize Aureal's Vortex and A3D audio technologies exclusively for products sold under Diamond's award-winning "Monster Sound" PCI audio accelerator brand. On June 15, 1998, the Company announced that Compaq Computer Corporation, the world's leading personal computer company, would begin featuring Aureal's A3D Interactive 3D audio technology on its new line of Presario desktop computers. Compaq's marketing materials, including point-of-sale displays in retail stores and website presentation have begun to actively support Aureal's A3D technology. In April 1998, the Company introduced A3D 2.0, a significant enhancement to the existing version of A3D that was originally introduced in September 1996. A3D 2.0, which is incorporated in a growing number of PC game titles, is backward compatible with the original A3D technology. A3D is currently incorporated into a number of major PCs (including computer lines from Dell Computer Corporation and Compaq), as well as a number of PC add-in audio cards under various brand names. The new A3D 2.0 includes Aureal Wavetracing Technology (which enables real-time acoustic reflections, reverb and occlusion rendering features), more 3D sources, a higher sample rate and larger Head-Related Transfer Function (HRTF) filters. Together, all of these feature enhancements provide for improved three-dimensional rendering of audio for interactive applications. Also during the first half of 1998, key design wins for the Vortex AU8820 and A3D were announced and chip sales in volume were commenced. The AU8820 is currently implemented in sound cards utilized or marketed by Dell Computer Corporation, Turtle Beach Systems, Aztech Systems Ltd. and TerraTec Electronic GmbH. These customers, in addition to Compaq, are actively promoting Aureal's A3D technology. 11 12 Early 1998 marked the first shipments of audio semiconductor chips by Aureal after two years of development work in the digital audio design area. Many of the audio sound card applications utilizing the Vortex AU8820 chip are based on Aureal's card reference design and have won widespread acclaim as well as numerous awards from various PC publications. In addition, Aureal's A3D Interactive audio technology has been widely recognized as the industry standard for three-dimensional sound presentation. Aureal's Vortex AU8820 PCI-based digital audio processor chip is a feature-rich audio solution designed for the PC. In conjunction with Aureal's A3D three-dimensional audio technology, the Company is offering an audio solution for the PC that takes advantage of the benefits of PCI technology. The Company believes that the market for PCI audio is expanding rapidly, and will be a significant market by year-end 1998. Contributing to the move from ISA-based to PCI-based audio systems for PCs are the requirements put forth by both Microsoft Corporation and Intel Corporation relative to Windows qualifications. With announced "design-wins" including Dell Computer Corp. (utilizing sound cards incorporating the AU8820 chip) and Compaq Computer Corporation (A3D implementation on the Presario line of desktop PCs), Aureal technology has begun to appear in market-leading PCs. Aureal's A3D technology is also gaining acceptance from PC game developers, and is currently supported by a number of major game developers including Activision, Lucas Arts, Interplay, GT Interactive, Broderbund, Electronic Arts, Sierra On-Line and Ubi Soft. Many of these developers, as well as PC hardware manufacturers are working with Aureal to support A3D and Aureal brand recognition through use of the Aureal and A3D logos on packages and advertisements. RESULTS OF OPERATIONS Net Sales Net sales for the second quarter of 1998 were $3.4 million, compared to $3.6 million in the previous quarter and $0.7 million in the second quarter of 1997. Year-to-date revenues for 1998 of $7.0 million represent the sale of several hundred thousand AU8820 chips, along with minor revenues from technology licensing. In addition, with the July 1998 announcement of the strategic alliance between Aureal and Diamond, Aureal anticipates commencement of audio board sales in the third quarter of the year. This will allow the Company to offer both chip and board level products to various segments of the PC market. The Company believes that this expansion of product categories will allow Aureal to better address the needs of a broader cross section of the market over time. Gross Margin Gross margin rose from 22% in the first quarter of 1998 to 41% in the second quarter as the AU8820 product moved from initial ramp-up into higher volume production. Cost reductions associated with the higher production levels and higher yield from silicon wafers both contributed to the margin improvement. Gross margin percentages in the prior year were significantly higher, although on limited revenues, as the majority of such revenues were technology licensing based. The Company does not anticipate that license revenues will be a significant portion of overall revenues in the future. Gross margin percentages could vary and potentially be reduced on some card-level products that the Company anticipates selling in future quarters. 12 13 Research and Development Expenditures for research and development continue to be the most significant area of spending for the Company as it allocates significant resources to create future audio products for both the PC and consumer electronics markets. Spending in this area yields both short-term and long-term product developments - as the Company looks to continue to bring new and improved products to the audio forefront. Spending increased $0.3 million from the first quarter to the second quarter of the year ($2.6 million to $2.9 million) as prototype runs of the Company's newest semiconductor product were commenced during the second quarter. In addition, the Company has continued to increase the staffing in the research and development area, both with employees and some specific project contract work. Year-to-date expenditures in this area increased from $3.0 million in 1997 to $5.5 million in 1998, and have generally increased each quarter over the last two years as development efforts on both software and hardware based technology have expanded. The Company expects that the level of spending on research and development will fluctuate, but is not expected to decline significantly in absolute dollars in future periods. Selling and Marketing Selling and marketing expenses for the second quarter of 1998 were $1.6 million, an increase of $0.3 million over the previous quarter. This increase over the first quarter of the year is primarily attributable to expenses incurred to design and launch an advertising campaign designed to increase the visibility of A3D to the end-user. This campaign includes media advertising in various PC-related magazines. The substantial increase in year-to-date expenditures ($3.0 million in 1998 versus $1.7 million in 1997) is primarily attributable to costs, including selling commissions, related to the commencement of AU8820 sales in 1998. General and Administrative General and administrative expenses for the second quarter were $0.8 million, flat with the level of expense in the first quarter. Quarterly and year-to-date expenses ($1.7 million) rose from the prior year ($0.6 million and $1.2 million, respectively) due primarily to increases in recruiting and employment consulting expenses as the Company has added significant staff in the first half of this year. Amortization of Reorganization Asset The Reorganization Asset originated pursuant to the Company's valuation upon its exit from bankruptcy protection in December 1994, whereby the fair value of the Company exceeded its net assets by $44.1 million. The Reorganization Asset value was fully amortized at year-end 1997 (at the rate of $625,000 per fiscal quarter, during 1997). Interest Expense Interest expense for the first half of both years consisted primarily of interest on the line of credit at the rate of prime plus 5%. The expense in 1998 ($2.0 million year-to-date, $1.0 million for the second quarter) increased over the prior year ($1.2 million year-to-date, $0.6 million for the quarter) as the balance under the line of credit grew over the period. During 1997 and 1998 to-date, the line of credit has been a major source of working capital for the Company, and has expanded over that time. Proceeds from the sale of equity capital over that time period have been utilized periodically to pay down the balance of the debt. With the pay down and elimination of the TCW line of credit in June 1998 through the exchange for Series B Preferred Stock of the Company, the interest expense is expected to decline significantly. The new Credit Facility with Goldman Sachs and Transamerica carries a lower interest rate than the prior line to the extent borrowings are based on eligible accounts receivable borrowing availability. 13 14 Amortization of Debt-Related Warrants In August 1997, in conjunction with the expansion and extension of the TCW Line of Credit, the Company issued 3.15 million warrants to the lenders to purchase the Company's Common Stock. Utilizing the Black-Scholes valuation method, the estimated fair value of the warrants was determined to be $5.0 million. This value was amortized over the estimated life of the loan at the rate of $0.75 million per quarter. When the loan was converted in June 1998, the remaining unamortized deferred costs related to the warrants were netted against the outstanding loan balance and eliminated as a reduction of the conversion value of the Series B Preferred shares. In connection with the new Credit Facility, the Company issued to the lenders, in June 1998, 1.35 million warrants to purchase the Company's Common Stock. The fair value of these warrants was estimated utilizing the Black-Scholes valuation method as approximately $1.8 million, and is being amortized over the two-year term of the Credit Facility. Other Income The Company recognized net other income of $51,000 and $340,000 in the second and first quarters of 1998, respectively. This compares to $148,000 and $56,000 in the corresponding quarters of 1997. The income recognized in all quarters shown was primarily due to various receipts and credits resulting from favorable resolutions to previously recorded liabilities. Income Taxes The Company was not required to provide income taxes in the first two quarters of either 1998 or 1997 due to its net operating losses. No tax benefit has been recorded for the net operating loss carryforwards due to the uncertainty as to their realizability. 14 15 LIQUIDITY AND CAPITAL RESOURCES At June 28, 1998, the Company had working capital of $5.6 million and stockholders' equity of $6.2 million. In quarterly financial statements since 1995, the Company has generally shown negative working capital amounts and stockholders' deficit amounts. The stockholder equity of $6.2 million is largely the result of the issuance of preferred stock in the first half of 1998, both for cash and in exchange for the $31.5 million line of credit balance. These transactions have resulted in significant Paid-in Capital increases, however the Company continues to maintain a substantial accumulated deficit developed as losses have been recorded over the last three years. The Company recognized a net loss of $5.4 million in the second quarter of 1998 ($10.9 million year-to-date) as well as direct charges to accumulated deficit of $12.1 million in the second quarter related to dividends and accretion on preferred stock. Of that amount, $10.7 million is a one-time charge related to the difference between the conversion/redemption value of the Series B Preferred Stock ($39.4 million) and the net carrying value of the debt for which it was exchanged ($28.7 million). Other dividends and value accretion related to the Series A, B and C Preferred Stock resulted in an additional charge of $1.4 million in the second quarter. Working capital used to support operating activities has totaled $18.5 million in the first half of 1998, averaging roughly $3.1 million per month. This has resulted from the growth of accounts receivable and inventory over that time, as well as increased operating losses. The Company believes that it will move closer to generating cash flow from operations as revenues are expected to grow in subsequent quarters. Such revenue growth is dependent upon the Company's success in promoting both the Vortex semiconductor design and A3D audio technology as valuable components to a PC's audio system. The acceptance of PCI audio (the underlying data-bus technology utilized for both Vortex and A3D) as the standard for the PC is also key to the Company's immediate growth plans. To the extent such PCI acceptance and utilization does not materialize as rapidly as expected, Aureal's growth could be significantly impacted. The Company believes that the $40 million Credit Facility, of which $0.4 million was drawn as of June 28, 1998, will provide adequate financial resources to sustain business for at least the next year. The Company may be required to seek additional financing to expand its business. There can be no assurance that the Company will be able to generate positive cash flows in the future or to obtain financing on favorable terms, if at all. Capital expenditures of $1.0 million during the first half of 1998 consisted primarily of hardware and software tools utilized in the Company's research and development activities. Increased levels of capital expenditures are anticipated during future quarters of 1998. 15 16 RISK FACTORS In evaluating the Company's business, certain factors, including those discussed below and those included in documents previously filed with the Securities and Exchange Commission, should be considered in addition to the other information in this Form 10-Q. History of Losses and Accumulated Deficit; Expectation of Future Losses The Company emerged from Chapter 11 Reorganization in December 1994. Since that time the Company has incurred losses, in the aggregate amount of $162 million, from (1) operating and eliminating its previous retail products business in 1995, (2) during the research and development phases of its advanced audio technologies business operations in 1996 and 1997, and (3) as it began to sell advanced audio products in the first half of 1998. While the majority of the Company's revenues in 1996 and 1997 were generated through technology licensing transactions, the Company anticipates that the majority of its revenues will come from the sale of audio products in 1998 and future years. There can be no assurance that the Company will be able to sell significant volumes of its products in the future, and the Company's ability to attain profitability or generate positive cash flows is dependent thereon. New Technologies and Products Developed with New Technologies The Company's success depends on its ability to develop and market new technologies aimed at advancing the level of audio quality in the PC and consumer electronics devices. With respect to the PC market, audio technology is shifting from utilization of the ISA bus to utilization of the more advanced (higher bandwidth) PCI bus. This change enables advanced digital audio functionality including positional 3D audio, streaming audio and higher quality presentation. There can be no assurance that the shift from ISA-based audio to PCI-based audio will occur in a timeframe for the Company to benefit from its PCI-based products and technologies. As new technologies are developed, there can be no assurance that markets will develop for them, or that markets will develop on a timely basis for the Company to benefit therefrom. The success of new products depends on a number of factors, including timely completion of product development, market acceptance of the Company's and its customer's new products and the Company's ability to offer new products at competitive prices. Incorporating the Company's new products into its OEM customers' new product designs requires the anticipation of market trends and performance and functionality requirements of OEMs and the production of products that can be available in a timely manner consistent with the OEMs' development and production schedules. A failure in any of these areas could have a material adverse effect on the Company's results of operations. Each successive generation of microprocessors has provided increased performance, which could in the future result in a microprocessor capable of performing advanced audio functions to an extent that the need or preference for the Company's products could be diminished or eliminated. Conversely, each new generation of technology, including digital audio technology, generally requires increased processing power. In this regard, Intel Corporation has created the MMX functionality with its Pentium line of processors and is promoting the processing power of MMX for data and signal intensive functions such as graphics and audio processing. The Company believes that advanced audio processing, done in conjunction with either video or graphics processing is best performed with a separate accelerator chip in addition to the host processor. There can be no assurance that the increased capabilities of microprocessors in the future will not adversely affect demand for the Company's products. Product Concentration and Expansion of Business Model Substantially all of the Company's revenues are related to advanced audio solutions for the PC and consumer electronics markets and the Company expects this to continue for the foreseeable future. The Company is just embarking on an expansion of its semiconductor business model to provide for an increased number of audio related products including audio cards and audio communications combination cards. This expansion may require additional working capital funds to provide for incremental inventory as well as broader marketing programs. The failure of this market to continue to grow, any reduction in demand as a result of increased competition in this market, technological change, failure by the Company to introduce new versions of products acceptable to the marketplace or other similar factors would have a material adverse effect on the Company's results of operations. 16 17 Competition and Pricing Pressures The markets in which the Company competes are intensely competitive and are characterized by evolving industry standards resulting in relatively short product life cycles, significant pricing and performance improvement pressures, and frequent new product introductions. The Company expects competition to increase in the future from existing competitors and from other companies that may enter the markets with products that may be less costly or provide higher performance or additional features. The Company is unable to predict the timing and nature of any such competitive product offerings. In general, product prices in the semiconductor industry have decreased over the life of a particular product. The willingness of prospective customers to design the Company's products into their products depends to a significant extent upon the ability of the Company to price its products at levels that are cost-effective for such customers. As the markets for the Company's products mature and competition increases, the Company anticipates that prices for its products will generally decline over time. If the Company is unable to reduce its costs sufficiently to offset declines in product prices or is unable to introduce new, higher performance products with higher product prices, the Company's results of operations could be materially adversely affected. The Company anticipates that it will compete for the development of new technologies and for the sale of semiconductor products with a number of companies who have more extensive resources including financial, manufacturing, technical, marketing and distribution. In addition, some of those firms may have greater intellectual property rights, broader product lines and longer-standing relationships with customers than the Company. The Company's competitors may also include a number of emerging companies. Dependence on Credit Facility Because it has not been profitable to date, the Company has funded its losses through a combination of equity and debt financing. In June 1998, the Company entered into a Credit Facility with Goldman Sachs and Transamerica, which provides for an aggregate maximum borrowing line of $40 million. The interest rate on this Credit Facility is generally the prime rate plus 3% to 5%. Accordingly, while the Credit Facility provides for working capital, the high cost of servicing any borrowings thereunder could negatively effect the Company's liquidity. The can be no assurance that the Credit Facility will provide sufficient funding to meet the Company's future needs. In the event the Company is required to secure additional capital, there can be no assurance that such capital will be available on acceptable terms or at all. The Company's inability to secure such potential future financing, if necessary, would have a material adverse effect on the Company's business, financial condition and results of operations. Factors Inhibiting Takeover The Company is subject to the provisions of Section 203 of the Delaware General Corporation Law, which imposes certain restrictions on the ability of a third party to effect an unsolicited change in control of the Company. In addition, the Company's Amended and Restated Certificate of Incorporation does not provide for cumulative voting in the election of directors, and certain provisions of the Company's Amended and Restated Certificate of Incorporation and Bylaws, including the provision which divides the Board of Directors into three separate classes, may have the effect of delaying or preventing changes in control or management of the Company. Trading in the Non-NASDAQ Over-the-Counter Market; Disclosure Relating to Low Priced Stock The Company's Common Stock trades only on the OTC Bulletin Board and the trading volume has been generally light. The Company does not currently meet the requirements of the NASDAQ National Market or other national stock exchanges. There can be no assurance that the Company will, in the future, meet such listing requirements or that it will be accepted for trading on any such national exchange. Because the Company's Common Stock trades on the Non-NASDAQ Over-the-Counter market, an investor may find it more difficult to dispose of, or to obtain accurate quotations as to the market value of, the Company's Common Stock. In addition, because that Company's securities are not listed on NASDAQ, trading in the Common Stock is also subject to certain rules promulgated under the Securities Exchange Act of 1934, which require additional disclosure by broker-dealers in connection with any trades involving a stock defined as a penny stock (generally, a non-NASDAQ equity security that has a market price of less than $5.00 per share, subject to certain exceptions). The additional burdens imposed upon broker-dealers by such requirements may discourage broker-dealers from effecting transactions in the Company's Common Stock, and severely limit the market liquidity of the Company's Common Stock and the ability of purchasers of the Company's Common Stock to resell such securities in the secondary market. 17 18 Risk of Additional Shares Sold in the Public Market Because the holders of the Series A Preferred and Series C Preferred shares may convert such shares into shares of the Company's Common Stock at variable conversion prices, the exact number of shares of Common Stock which the Company may issue upon conversion of Series A Preferred and Series C Preferred shares is not presently known, and may fluctuate based on the market value of the Company's Common Stock. Because of the variable conversion price feature of the Series A Preferred and Series C Preferred shares, holders of such shares may have incentive to take certain actions, including shorting the Company's Common Stock, to decrease the market price of such Common Stock. Upon a decrease in the market price of the Company's Common Stock, holders of the Series A Preferred and Series C Preferred shares may elect to convert such shares at the variable conversion price and thereby receive a greater number of shares of the Company's Common Stock. Short selling is illegal if used to manipulate the price of a company's securities for profit, and the Company has no knowledge that any holders of Series A Preferred or Series C Preferred shares intends to take any action which may cause the price of the Company's Common Stock to fall. However, there can be no assurance that holders of the Company's Series A Preferred or Series C Preferred shares will not short the Company's Common Stock or take such other actions, the effect of which may be to drive down the market price of the Company's Common Stock. Concentration of Stock Ownership Currently, three parties control approximately 75% of the outstanding Common Stock, each of who control at least 10% individually. There can be no assurance that the liquidity of the market for the Common Stock will be maintained at or increase over its current levels, and the trading price for the Common Stock may be influenced by the volume and liquidity of the market for the Common Stock. Sales of a large percentage of the Company's total outstanding Common Stock may have an adverse effect on its market price. Dependence on Foundries The Company is a "fabless" semiconductor firm, which depends on outside manufacturing resources for production of all of its semiconductor products. Currently the Company utilizes two foundries, one domestic and one foreign for production of its existing products. Both of these foundries have indicated to the Company that they have the manufacturing availability to provide for the Company's planned production of each of its products for the next twelve months; however the Company's production relationship with each foundry is based only upon purchase orders and there is no assurance that either foundry will continue to provide adequate manufacturing capacity to the Company for its current level of production or any potential increases in production levels. In the event either or both foundries cease to manufacture the Company's semiconductor products, the Company would have to contract with alternative foundries. There can be no assurance that the Company would be able to contract with alternative foundries in a timely manner or at all. The failure to do so would have a material adverse effect on the Company's business, financial condition and results of operations. The manufacture of semiconductor products is a highly complex and precise process. Minute levels of contaminants in the manufacturing environment, defects in the masks used to print circuits on silicon wafers, difficulties in the fabrication process or other factors can cause a substantial percentage of wafers to be rejected or a significant number of die on each wafer to be non-functional. Many of these yield problems are difficult to diagnose, and potentially time-consuming or expensive to remedy. There can be no assurance that the Company's foundries will not experience irregularities or adverse yield fluctuations in the manufacturing process of the Company's products in the future, which could have a material adverse effect on the Company's business, financial condition and results of operations. Dependence on Key Personnel The Company's success depends to a significant extent upon continued services of key engineering, marketing, sales and management personnel. The Company's employees may voluntarily terminate their employment with the Company at any time. The Company recognizes the value of the contributions of each of its employees and has developed compensation programs, including stock option plans for the granting of options to all employees, designed to retain its employees. Competition for such employees is intense and the loss of the services of such employees could have a material adverse effect on the Company's business, financial condition and results of operations. 18 19 Dependence on Proprietary Technology The Company's ability to compete successfully will depend, in part, on its ability to protect its proprietary technology. The Company relies on a combination of patents, trade secret, copyright and trademark laws, nondisclosure agreements and other contractual provisions and technical measures to protect its proprietary rights. There can also be no assurance that such measures will be adequate or safeguard the proprietary technology underlying the Company's products, or that its agreements with employees, consultants and others who participate in the development of its products will not be breached, that the Company will have adequate remedies for any breach or that the Company's proprietary information or trade secrets will not otherwise become known. Moreover, notwithstanding the Company's efforts to protect its intellectual property, there can be no assurance that competitors will not be able to develop products which are equal or superior to the Company's products without infringing any of the Company's intellectual property rights. In addition, effective protection of intellectual property rights may be unavailable or limited in certain countries. Accordingly, there can be no assurance that the Company's means of protecting its intellectual property will be adequate or that the Company's competitors will not independently develop similar technologies or products. Although the Company does not believe that its products infringe the proprietary rights of any third parties, there can be no assurance that infringement or invalidity claims (or claims for indemnification resulting from infringement claims) will not be asserted against the Company or that any such assertions will not materially adversely affect the Company's business, financial condition or results of operations. Irrespective of the validity or the successful assertion of such claims, the Company could incur significant cost with respect to the defense thereof which could have a material adverse effect on the Company's business, financial condition or results of operations. In February 1998, the Company was served with a suit for patent infringement filed by Creative Technology Ltd., a Singapore corporation ("Creative"), and its subsidiary, E-MU Systems, Inc., a California corporation ("E-MU") in the U.S. District Court, Northern District of California. The suit alleges that the Company's Vortex AU8820 Digital Audio Processor infringes on a patent that describes a specific implementation for an electronic musical instrument designed by E-MU. Creative and E-MU seek, among other things, a preliminary and permanent injunction against continuing acts of infringement by the Company and an accounting of damages plus interest. The Company believes that the action is without merit and has commenced vigorous defense of this action. Shiva Holdings Limited ("Shiva") filed a cross-complaint against the Company in December 1997 in the Superior Court of Santa Clara, California. The cross-complaint alleges breach of contract; breach of implied covenant of good faith and fair dealing, fraud and negligent misrepresentation in connection with the Agreement for Purchase of Certain Assets entered into between Shiva and the Company in February 1996. The Company had filed an action against Shiva for breach of contract and specific performance in connection with the failure of Shiva to perform under the February 1996 agreement between the companies. All claims in these actions were settled in July 1998 with the termination of the agreement without monetary exchange between the parties. Litigation may be necessary to resolve the claims asserted by Creative, E-MU and any other claims asserted in the future to defend against claims of infringement or invalidity or to enforce and protect the Company's intellectual property rights. There can be no assurance that the Company will prevail in any such litigation, and any such litigation, whether or not determined in the Company's favor or settled by the Company, would be costly and would divert the efforts and attention of the Company's management and technical personnel from normal business operations, which could have a material adverse effect on the Company's business, financial condition and results of operations. Adverse determinations in litigation could result in the loss of the Company's proprietary rights, subject the Company to significant liabilities, require the Company to seek licenses from third parties or prevent the Company from licensing its technology, any of which could have a material adverse effect on the Company's business, financial condition and results of operations. 19 20 Year 2000 Compliance The Company uses a number of computer software programs and operating systems in its internal operations, including applications used in financial systems and various administrative functions. To the extent that these software applications contain source code that is unable to appropriately interpret the upcoming calendar year 2000, some level of modification or even possibly replacement of such applications could be necessary. Given the information known at this time about the Company's systems, it is currently not anticipated that such "Year 2000" costs will have a material impact on the Company. The Company is not aware that any of its key suppliers or customers are not fully "Year 2000" compliant. If any of its key suppliers or customers are not yet fully "Year 2000" compliant, there can be no assurance that such non-compliance would not have a material adverse effect on the Company's business, financial condition or results of operations. 20 21 PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS In February 1998, the Company was served with a suit for patent infringement filed by Creative Technology Ltd., a Singapore corporation ("Creative"), and its subsidiary, E-MU Systems, Inc., a California corporation ("E-MU") in the U.S. District Court, Northern District of California. The suit alleges that the Company's Vortex AU8820 Digital Audio Processor infringes on a patent that describes a specific implementation for an electronic musical instrument designed by E-MU. Creative and E-MU seek, among other things, a preliminary and permanent injunction against continuing acts of infringement by the Company and an accounting of damages plus interest. The Company believes that the action is without merit and has commenced vigorous defense of this action. Shiva Holdings Limited ("Shiva") filed a cross-complaint against the Company in December 1997 in the Superior Court of Santa Clara, California. The cross-complaint alleges breach of contract; breach of implied covenant of good faith and fair dealing, fraud and negligent misrepresentation in connection with the Agreement for Purchase of Certain Assets entered into between Shiva and the Company in February 1996. The Company had filed an action against Shiva for breach of contract and specific performance in connection with the failure of Shiva to perform under the February 1996 agreement between the companies. All claims in these actions were settled in July 1998 with the termination of the agreement without monetary exchange between the parties. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS The Annual Meeting of Stockholders was held on May 20, 1998 at which the stockholders voted on proposals as follows:
Number of Shares Voted For Withheld --------- -------- Election of Directors: L. William Krause 33,050,447 14,741 Thomas K. Smith, Jr 33,050,447 14,741
Voted For Voted Against Abstained --------- ------------- --------- Ratify appointment of Arthur Andersen, LLP as independent accountants of the Company for the 1998 fiscal year 33,046,693 4,528 13,967
21 22 ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibit index at page 23. (b) Reports on Form 8-K: On June 15, 1998, the Company filed a Form 8-K with the Securities and Exchange Commission ("SEC") disclosing the completion of three financing transactions. These included (1) the sale of $5 million of Aureal Series C Preferred Stock, (2) the conversion and termination of the Company's previous line of credit in exchange for 39,375 shares of Aureal Series B Preferred Stock, and (3) the establishment of a new $40 million Revolving Credit Facility with Goldman Sachs and Transamerica. In conjunction with the SEC's review of a Form S-2 filed to register shares of Aureal Common Stock, the SEC requested that certain amendments be made to wording in the above Form 8-K. An amended Form 8-K/A was filed in response to such request on July 2, 1998. On March 16, 1998, the Company filed a Form 8-K disclosing the sale of $5 million of Aureal Series A Preferred Stock. This Form 8-K was amended via filing of Form 8-K/A's on June 3, 1998 and July 2, 1998, again in response to SEC comments related to the review of the above referenced Form S-2. SIGNATURES Pursuant to the requirements of the Securities and Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. AUREAL SEMICONDUCTOR INC. Date: July 31, 1998 By: /s/ Kenneth A. Kokinakis --------------------------------- Kenneth A. Kokinakis President and Chief Executive Officer Date: July 31, 1998 By: /s/ David J. Domeier --------------------------------- David J. Domeier Vice President of Finance and Chief Financial Officer 22 23 EXHIBIT INDEX
Exhibit No. Description of Document ----------- ----------------------- 2.1 Agreement and Plan of Reorganization among the Company, Aureal Acquisition Corporation, a wholly-owned subsidiary of the Company and Crystal River Engineering, Inc., dated as of May 7, 1996 (1) 2.2 Second Amended Joint Plan of Reorganization dated November 10, 1994 (4) 3.1 Second Amended and Restated Certificate of Incorporation of the Company dated May 8, 1996 (2) 3.2 Restated Bylaws of Aureal Semiconductor Inc. (6) 4.1 Common Stock Purchase Agreement by and among the Company and certain beneficial owners of 5% or more of the Company's Common Stock, as amended (3) 4.2 Common Stock Purchase Agreement by and among the Company and certain entities and individuals dated June 10, 1996 (5) 4.3 Common Stock Purchase Agreement by and among the Company and certain entities and individuals dated August 6, 1997 (8) 4.4 Preferred Stock Regulation D Subscription Agreement (10) 4.5 Certificate of Designation of Series A Preferred Stock of Aureal Semiconductor Inc. (10) 4.6 Preferred Stock Registration Rights Agreement (Common Stock underlying Series A Preferred Stock) (10) 4.7 Aureal Semiconductor Inc. Regulation D Subscription Agreement for Series C Preferred Stock (11) 4.8 Certificate of Designation of Series C Preferred Stock of Aureal Semiconductor Inc. (11) 4.9 Registration Rights Agreement (Common Stock underlying Series C Preferred Stock) (11) 4.10 Loan and Security Agreement (Goldman and TBCC Credit Facility) (11) 4.11 Form of Warrant (Goldman and TBCC Warrants) (11) 4.12 8% Series B Convertible Preferred Stock Purchase Agreement (11) 4.13 Certificate of Designation of 8% Series B Convertible Preferred Stock for Aureal Semiconductor Inc. (11) 4.14 Amendment Number 4 to Registration Rights Agreement (11) 10.1 Second Amended and Restated Loan Agreement between TCW Special Credits and the Company dated August 6, 1997 increasing the loan commitment from $20 million to $31.5 million (9) 10.2 1995 Stock Option Plan (3)
23 24
Exhibit No. Description of Document ----------- ----------------------- 10.3 Form of incentive option agreement and non-statutory stock option agreement used under 1995 Stock Option Plan (3) 10.4 1994 Stock Option Plan (4) 10.5 Form of incentive option agreement and non-statutory stock option agreement used under 1994 Stock Option Plan (4) 10.6 Industrial Space Sublease with Chemical Waste Management, Inc. dated September 13, 1995 (3) 10.7 Form of Indemnity Agreement for Directors and Officers (6) 10.8 1996 Outside Directors Stock Option Plan (7) 10.9* Manufacturing, Purchase and Distribution Agreement between Diamond Multimedia Systems, Inc. and Aureal dated July 3, 1998 11.1 Computation of Earnings (Loss) Per Share (See Pages 5 and 9) 27.1 Financial Data Schedule (Edgar Only)
* Confidential treatment has been requested for portions of this document. (1) Incorporated by reference to the exhibits filed with Form 8-K dated May 22, 1996. (2) Incorporated by reference to the exhibits filed with Form S-8 (Registration number 333-09531) filed August 2, 1996. (3) Incorporated by reference to the exhibits filed with Form 10-K for the year ended December 31, 1995. (4) Incorporated by reference to the exhibits filed with Form 10-K for the year ended December 31, 1994. (5) Incorporated by reference to the exhibits filed with Form S-3 (Registration number 333-3870) filed June 26, 1996. (6) Incorporated by reference to the exhibits filed with Form 10-Q for the quarter ended September 29, 1996. (7) Incorporated by reference to the exhibits filed with Form 10-K for the year ended December 29, 1996. (8) Incorporated by reference to the exhibits filed with Form S-3 (As Post-Effective Amendment No. 1, Registration number 333-3870) filed September 12, 1997. (9) Incorporated by reference to the exhibits filed with Form 10-Q for the quarter ended September 28, 1997. (10) Incorporated by reference to the exhibits filed with Form 8-K dated March 16, 1998. (11) Incorporated by reference to the exhibits filed with Form 8-K dated June 15, 1998. 24 EX-10.9 2 MANUFACTURING, PURCHASE AND DISTRIBUTION AGMNT. 1 Exhibit 10.9 MANUFACTURING, PURCHASE AND DISTRIBUTION AGREEMENT This Manufacturing, Purchase and Distribution Agreement (the "Agreement") is entered into by and between Aureal Semiconductor Inc., a Delaware corporation ("Aureal") with principal offices at 4245 Technology Drive, Fremont, California 94538 and Diamond Multimedia Systems, Inc., a Delaware corporation and its wholly owned subsidiaries ("Diamond"), with principal offices at 2880 Junction Avenue, San Jose, California 95134-1922 and is effective as of July 3, 1998 (the "Effective Date"). Recitals A. Aureal possesses certain knowledge, expertise and know-how relating to PCI Audio Chip design and manufacturing, audio sound card design and three-dimensional audio technology. Aureal has implemented and embodied certain of these audio technologies in its Vortex integrated circuit products which are defined in Exhibit A (the "Aureal Chips"). B. Diamond and Aureal desire to enter into a partnership arrangement in which Diamond will be the preferred provider of Add-In Sound Cards (defined below) which incorporate the Aureal Chips for certain defined markets and Aureal will be Diamond's preferred provider of audio products for all Diamond Add-In Sound Card products and motherboard applications. NOW, THEREFORE, in consideration of the mutual covenants and promises contained herein, and other good and valuable consideration, the receipt and sufficiency of which are hereby acknowledged, the parties agree as follows: Agreement 1. Definitions. 1.1 "Add-In Sound Cards" means finished board level products containing the Aureal Audio Products for Personal Computers. 1.2 "Aureal Audio Products" means audio only products developed by Aureal to include audio integrated circuits, Add-In Sound Cards, and other audio related components for the Personal Computer as listed on Exhibit A. 1.3 "Commercial Distributor" means an entity that is licensed to distribute computer hardware or software products in large volume shipments to End-Users or other Resellers. 1.4 "Dealer" means an entity that has the right to distribute pre-packaged computer hardware or software products directly to End Users through retail channels. 1.5 "End-User" means an individual or entity that licenses or purchases products for his, her or its own personal or business purposes, and not for license or resale to others. 1.6 "Named OEMs" means OEM customers listed on Exhibit C. 1 2 1.7 "OEM" means an entity which manufactures computer equipment or computer hardware for distribution with other third-party hardware and software components as a complete system under its own brand name to End Users and Resellers. 1.8 "Diamond Channel" means The Reseller, OEM's and Commercial Distributor. 1.9 "Proprietary Rights" means copyrights, patent rights, trade secret rights, trademark rights and other intellectual and proprietary rights. 1.10 "Resellers" means Dealers, Retailers and System Integrators. 1.11 "Retailer" means a customer who resells the Add-In Sound Cards to customers who intend to use such products and do not have an intention to resell them. 1.12 "Systems Integrator" means an entity which obtains or licenses third-party hardware and software for distribution as a complete system to End Users. 2. Manufacturing and Purchase. 2.1 Manufacturing. Aureal will design, manufacture and supply Diamond with its Add-In Sound Card products. Diamond and Aureal will jointly specify the Add-In Sound Cards for the relationship which Aureal shall manufacture through its chosen subcontractor. The Diamond designed card can not be sold to other customers without Diamond's consent. A card with similar functionality but without Diamond-designed circuitry shall not be considered a Diamond-designed card. Diamond retains the right to qualify such manufacturing subcontractor pursuant to Diamond's standard qualification procedures. Diamond's qualification of Aureal's manufacturing subcontractor shall not be unreasonably withheld. 2.2 Aureal's Sale Obligation. Subject to the Phase Out Period in Section 2.4 and the terms and conditions of this Agreement (including, but not limited to, Section 3 "Minimum Purchase Commitments"), Aureal agrees that it will provide Add-In Sound Cards to Diamond [****]. Additionally, nothing in this Agreement shall prohibit Aureal from selling, either directly or through other direct and indirect distribution channels, Aureal Chips in conjunction or in connection with or for incorporation into any audio technology other than Add-In Sound Cards. 2.3 Diamond Purchase Obligation. Subject to the Phase Out Period in Section 2.4, Aureal will sell the Aureal Add-In Sound Cards to Diamond pursuant to the terms and conditions set forth in Sections 2 and 5. Diamond will exclusively use the Aureal Add-In Sound Cards for the Diamond Channels. Diamond does not have a similar restriction on the Named OEM channels, however if Diamond uses a non-Aureal chip in the Named OEM channels, Diamond can not use the Monster brand name for such products. Aureal and Diamond will cooperate on sales opportunities which require a different business model on a case by case basis. 2.4 Phase Out Period. [****] Confidential Treatment Requested 2 3 2.4.1 Diamond. [****] 2.4.2 Aureal. [****] 2.5 Specifications of Aureal Products. From time to time, Aureal and Diamond will mutually agree upon the specifications and functionality of the Aureal Audio Products to be supplied by Aureal hereunder, and Aureal and Diamond will work together to use commercially reasonable efforts to provide to Diamond, Aureal Audio Products in accordance with such agreed upon specifications and including such agreed upon functionality. 2.6 Prices. 2.6.1 Motherboard. [****] 2.6.2 Add-In Sound Card. Aureal will sell Add-In Sound Cards to Diamond for the Diamond Channel pursuant to the pricing formulas set out in Exhibit B. 3. Minimum Purchase Commitments. Aureal's obligation in Section 2.2 ("Aureal's Sale Obligation") is subject to, among other things, [****] ("Diamond's Minimum Commitment"). The prices of such Add-In Sound Cards shall be set forth in Exhibit B. These purchase orders shall be non-cancelable. If Diamond fails to purchase such amounts, it shall submit payment for the balance due for each of the quarters' remaining commitments, at the end of each quarter. 4. Warranties 4.1 Customer Response. Aureal shall deliver the Add-In Sound Card product to Diamond based upon an agreed specification. Within 5 days after receipt, Diamond shall accept the deliverable in writing or provide Aureal with a written statement of defects for the Add In Sound Card. Aureal shall promptly correct the defects and redeliver the Add-In Sound Card as soon as practicable. 4.2 Limited Software Warranty. Aureal warrants to Diamond that the Software furnished with Aureal Audio Products will substantially conform with Aureal's published specifications for such Software on the date of the order for such Aureal Audio Products for a period of ninety (90) days after delivery of the first copy of the first version of the software for the Aureal Audio Products to Diamond. This warranty shall apply only if the Software is properly used in accordance with the procedures described in the documentation supplied by Aureal. Defects in the Software will be reported to Aureal in a form and with supporting information reasonably requested by Aureal to enable Aureal to document and reproduce the error at Aureal's facilities, and to diagnose and correct the defect. THE FOREGOING IS DIAMOND'S SOLE AND EXCLUSIVE REMEDY FOR BREACH OF WARRANTY BY AUREAL WITH RESPECT TO THE SOFTWARE. 4.3 Limited Hardware Warranty. For a period of one year after delivery of a particular Aureal Audio Product to Diamond, Aureal warrants to Diamond that such Hardware will substantially conform with the published specifications for the Hardware on the date of the order if properly used in accordance with procedures described in the documentation supplied by Aureal. Diamond shall notify Aureal of any nonconformance during the warranty period, and subject to Aureal's standard RMA [****] Confidential Treatment Requested 3 4 procedures, obtain a return material authorization ("RMA") for the nonconforming Hardware from Aureal, and ship the nonconforming Hardware to Aureal's designated repair facility, freight prepaid, within five (5) days of receipt of the RMA with a statement which includes the RMA number, sufficient information to identify the original purchase order and a brief statement explaining the alleged nonconformity. Aureal's exclusive obligation with respect to nonconforming Hardware shall be, at Aureal's option, to repair or replace such Hardware, or to refund to Diamond the purchase price paid for the Hardware. THE FOREGOING IS DIAMOND'S SOLE AND EXCLUSIVE REMEDY FOR BREACH OF WARRANTY BY AUREAL WITH RESPECT TO THE HARDWARE. 4.4 Limitation on Warranty. The warranties set forth above shall not apply to any Add-In Sound Card which has been modified, repaired or altered, except by Aureal, or which has not been maintained in accordance with any handling or operating instructions supplied by Aureal, or which has been subjected to unusual physical or electrical stress, misuses, abuse, negligence or accidents. The warranties herein are between Aureal and Diamond and do not entitle Diamond's customers to any service directly by Aureal. 4.5 Disclaimer of Warranties. THE FOREGOING WARRANTIES ARE THE SOLE WARRANTIES, EXPRESS OR IMPLIED, GIVEN BY AUREAL IN CONNECTION WITH THE ADD-IN SOUND CARDS AND AUREAL DISCLAIMS ALL OTHER WARRANTIES, INCLUDING WARRANTIES OF MERCHANTABILITY, FITNESS FOR A PARTICULAR PURPOSE AND NONINFRINGEMENT OF THIRD PARTY RIGHTS. AUREAL DOES NOT WARRANT THAT THE SOFTWARE WILL OPERATE CONTINUOUSLY OR BE ERROR-FREE. 4.6 Hardware and Software Design Defects. Diamond and Aureal shall meet and confer on a regular basis to discuss product performance and reliability issues. In the event that defects are identified by either party in either the hardware or software portions of the products each problem will be assigned a mutually agreed upon severity code. Severity code 1 problems shall be those defects that cause interruption of the operation of the user's computer in such a way that requires the computer to be rebooted to continue, corrupts data, or results in the non-operation of major functionality of the product where such non-operation cannot be restored by a user initiated workaround. Severity code 2 problems shall be those that are not code 1 problems, but are of greater than cosmetic or nuisance level problems and include but are not limited to issues that impair normal performance, or cause abnormal endings to operation of the user's applications. Severity code 3 problems are those which are primarily cosmetic in nature and do not impair the performance of the product or the users normal operation of the product. Aureal will use its best efforts to correct level 1 problems within 5 working days of such problems identification to a level that allows the problem to be replicated. If a solution is not found within 10 working days, Diamond shall be entitled to relief from its obligation to accept future deliveries of affected products and relief from minimum purchase quantities on a prorated basis after such 10 working day period until a solution has been implemented to correct such code 1 problem. Aureal shall use commercially reasonable efforts to correct severity code 2 problems within 10 working days of their identification to a level that allows reproduction of the problem. For severity code 3 problems Aureal shall use commercially reasonable efforts to correct such problems in the next regularly scheduled release of a hardware or software update. 5. General Order, Delivery and Payment Terms. 4 5 5.1 Purchase Orders. The terms of this Agreement will govern all purchase orders issued by one party ("Diamond") to the other party ("Aureal") hereunder (except for shipping addresses, quantities and delivery dates specified therein) and all inconsistent terms and conditions on purchase orders, acknowledgments or invoices issued to or by either party are superseded and of no force or effect. All purchase orders are subject to acceptance by the Aureal at its principal place of business and unless the Aureal rejects a purchase order within five (5) days after receipt thereof, such purchase order shall be deemed accepted. 5.2 Releases. Add-In Sound Cards shall be released for shipment in accordance with the applicable release procedures regarding quality control, inspection, permits and certifications, all as more particularly described in Exhibit F ("Release Procedures") attached hereto. Aureal and Diamond will jointly define the Release Procedures. 5.3 Rescheduling and Cancellation. No purchase orders submitted by Diamond to Aureal hereunder may be canceled. Shipments of purchase orders may be rescheduled at no charge, provided that (i) no purchase order is rescheduled more than one time; (ii) shipment dates are not extended more than ninety (90) days beyond that originally specified in the purchase order; and (iii) quantities specified in purchase orders are not increased or decreased by more than twenty-five percent (25%), provided however, that this Section shall not apply to the quantities purchased under Section 3, Minimum Purchase Commitments. 5.4 Shipping. Aureal will use commercially reasonable efforts to ship Aureal Audio Products ordered by Diamond in the quantities and by the dates specified in purchase orders but Aureal shall have no liability for failing to so ship such products. In the event inventory is insufficient to meet purchase orders, the Aureal will use commercially reasonable efforts to allocate available inventory to all of its customers on a reasonably equitable basis. All shipments by a Aureal will be shipped F.O.B. Aureal's shipping point. 5.5 Acceptance. Each Aureal Audio Product must conform in all material respects to the applicable Specifications. Unless Diamond gives written notice of rejection within thirty (30) days of shipment, the products shall be deemed accepted. Should Diamond notify Aureal within said thirty (30) day period that the product is non-conforming, then Diamond, upon receipt of authorization from Aureal, shall promptly return the non-conforming product to Aureal in accordance with Aureal's return material procedure, accompanied by a written explanation of the reasons for the return. Aureal's exclusive obligation with respect to non-conforming product shall be, at Aureal's option, to repair or replace such product or to refund to Diamond the purchase price paid for the product. 5.6 Payments. All invoices shall be paid for by the Diamond within thirty (30) days after the date of the Aureal's invoice. Aureal will not invoice the Diamond for Products until they have been shipped. Payments shall be delivered to Aureal as follows: Aureal Semiconductor Inc. Attn: Accounts Receivable 4245 Technology Drive Fremont, CA 95438 5 6 5.6.1 Revenue Sharing. Aureal and Diamond will meet on a monthly basis to review and reconcile the revenue sharing model as set forth in Exhibit B. Diamond and Aureal will appoint designated persons at their respective companies to administer the revenue sharing program. 5.7 Taxes. The prices hereunder do not include state, federal or local taxes, duties, penalties or interest and the Diamond is responsible for the payment of all taxes imposed as a result of the transactions contemplated by this Agreement, other than those based on the Aureal's net income. 5.8 Audit Rights. Both parties, at their own initial expense, may audit or have a third party audit the records and supporting documentation of the other party relating to the costs and other required information to calculate the revenue sharing information set forth in Exhibit B. Audits will be conducted not more than once per quarter during normal business hours. Each party will provide the other with reasonable access to its premises during normal business hours. 6. Ownership. 6.1 Aureal Rights. Notwithstanding anything else, as between the parties, Aureal retains (i) all Proprietary Rights in and to the Aureal Chips (including all technology and know-how incorporated therein or used in the development thereof) and all copies, modifications, improvements and derivative works thereof (by whomever produced), and all related documentation and materials and (ii) all of its service marks, trademarks, trade names or any other designations (and notwithstanding anything else herein, Diamond may not use any name, mark or designation used by Aureal or its licensors except for use in advertising or marketing the Aureal Audio Products as expressly provided in Exhibit D). 6.2 Diamond Rights. Notwithstanding anything else, as between the parties, Diamond retains all of its service marks, trademarks, trade names or any other designations (and notwithstanding anything else herein, Aureal may not use any name, mark or designation used by Diamond or its licensors except for use in advertising or marketing the Aureal Chips and Add-In Sound Cards as expressly provided herein). 7. Distribution of Add-In Sound Cards. 7.1 Distribution by Diamond. The parties agree that subject to the terms and conditions of this Agreement, Diamond has the (i) non-exclusive right to distribute Add-In Sound Cards to the Diamond Channel on a worldwide basis as a product jointly branded with Aureal and (ii) non-exclusive right to distribute Add-In Sound Cards to OEM's under its own brand name or in conjunction with Aureal. [****]. Diamond will receive [****]. 7.2 Distribution by Aureal. The parties agree that subject to the terms and conditions of this Agreement, Aureal has [****]. Diamond and Aureal agree to meet and discuss the direct marketing programs of both Diamond and Aureal on or before December 31, 1998 to review the impact of such programs on the retail and distribution channels and the impact on the minimum purchase quantities and the minimum margin requirements for extension of this Agreement for the purpose of revisiting those commitments in light of the volumes being sold through direct marketing programs. Furthermore, in recognition of the sales and marketing efforts Diamond will do to promote the Aureal brand under this Agreement, [****]. [****] Confidential Treatment Requested 6 7 7.3 Diamond Option. Aureal is developing certain products including a audio/modem combo card. Aureal shall give Diamond the right to distribute such products through the Diamond channels provided the parties can agree on reasonable minimum purchase requirements. Diamond shall have 15 business days from Aureal's written offer to include these products into this agreement. If Diamond chooses not to add these products to this relationship, Aureal is free to distribute them under the Aureal brand name or other brand name in all markets and sales channels. 7.4 Named OEM Program. Aureal will provide a Diamond option to OEM's for inclusion of a customized Diamond interfaces and brand name into product on a licensed basis between Diamond and the Named OEM. Aureal will use its best efforts to make Diamond aware of all such opportunities. Aureal will notify a Diamond designated sales representative when Aureal intends to visit a Named OEM for sales visits. Diamond will have the right to make a joint sales call to the Named OEM. If the Named OEM does not want the Diamond option, Aureal will proceed to sell the Named OEM a product directly from Aureal or through Aureal's contract manufacturer. Diamond is not precluded from providing the Named OEM with another audio chip solution. Diamond and Aureal will meet on a regular basis to review various upcoming opportunities at the Named OEM's. 7.5 [****] Program. To the extent Aureal produces [****] products and offers them to Diamond, Diamond agrees to include such products for sale in the Diamond channel. Aureal and Diamond agree to meet promptly upon inclusion of such products into the agreement to determine minimum purchase commitments for the current period. 7.6 Branding. 7.6.1 The branding of Add-In Sound Cards distributed under this Section 7.6 shall be in accordance with the procedures and requirements set forth in Section 9 ("Labeling and Joint Marketing Obligations") and Exhibit D ("Branding Procedure") attached hereto. In its distribution efforts, will use the then-current names used by Aureal for the Aureal Chips (but will not represent or imply that it is Aureal or is a part of Aureal), and with respect to any jointly-branded product, neither party will represent or imply that it is the other party or a part of the other party. 7.6.2 Each party ("Licensor") grants to the other party ("Licensee") a non-exclusive, non-transferable, limited license to use all trademarks, service marks, trade names, logos or other words or symbols set forth in Exhibit E ("Trademarks") (collectively, the "Marks") solely in connection with the marketing and distribution of the Add-In Sound Cards sold by Aureal to Diamond. The Marks of each Licensor are and will remain their exclusive property. Licensee will not take any action that jeopardizes Licensor's proprietary rights, or acquire any rights, in the Marks, except the limited use rights specified herein. Licensee understands and agrees that use of the Marks shall not create any right, title or interest in or to the use of the Marks and that all such uses and goodwill associated with the Marks will be to the benefit of Licensor. Except as otherwise agreed in writing, Licensee will not register, directly or indirectly, any trademark, service mark, trade name, copyright, company name or other proprietary or commercial right which is identical or confusingly similar to the Marks or which are translations thereof in any other language(s). Upon Licensor's request, Licensee will execute such instruments and take such actions that may be appropriate to register, maintain or renew the registration of the Marks in Licensor's [****] Confidential Treatment Requested 7 8 name and/or protect Licensor's interest in the Marks. Licensee may use the Marks solely in connection with Licensee's permitted activities under this Agreement, provided Licensee clearly identifies Licensor's ownership of such Marks. Licensor reserves the right to require Licensee to submit all advertising and marketing material to Licensor for review and approval prior to release by Licensee. Licensor may require Licensee to discontinue use of any advertising and marketing materials that Licensor reasonably believes will have a detrimental effect on Licensor's business. Licensee shall cooperate with Licensor upon request to ensure that Licensee's use of the Marks conform to the Licensor trademark policies and use guidelines as in effect from time to time. 7.7 Rights and Obligations of Customers. Where applicable and reasonably possible, all distributions of Add-In Sound Cards must be subject to a license agreement with terms (i) no less restrictive or materially less protective of each party's rights in the Add-In Sound Cards than this Agreement and (ii) disclaiming each party's warranties and limiting each party's liability consistent with the terms of this Agreement. For each jurisdiction in which Add-In Sound Cards are distributed, each party has the responsibility to use commercially reasonable efforts (i) to use a license agreement that is enforceable under and complies with the laws of such jurisdiction and (ii) to use its diligent efforts to ensure that its Resellers, OEM's and End-Users comply with the terms relating to each party's rights as contained in such license agreements. 7.8 Sales Reports. Both parties will cooperate in preparing and implementing training, sales and marketing presentations. Diamond agrees to provide Aureal with periodic reports on or before the 5th day of each month containing the following information: a) Inventory report on Add-In Sound Cards b) Two quarter rolling sales forecasts c) Individual product sales and backlog data by region and channel. Aureal and Diamond Sales and Marketing representatives will meet on a monthly basis to review sales and promotion opportunities throughout the Diamond Channel. 8. Covenants. 8.1 Diamond Covenants. Diamond agrees: 8.1.1 that it will be responsible for the support and maintenance of all Add-In Sound Cards distributed by them in accordance with support and maintenance procedures to be negotiated in good faith and mutually agreed upon by the parties; 8.1.2 to use its diligent efforts to successfully market and distribute Add-In Sound Cards on a continuing basis and to comply with good business practices and all laws and regulations relevant to this Agreement or the subject matter hereof; 8.1.3 to use reasonable efforts to keep Aureal informed as to any problems encountered with the Aureal Chips and any resolutions arrived at for those problems, and to communicate promptly to Aureal any and all modifications, design changes or improvements of the Aureal Chips suggested by any customer, employee or agent. Diamond further agrees (i) that Aureal shall have any and 8 9 all right, title and interest in and to any such suggested modifications, design changes or improvements of the Aureal Chips, without the payment of any additional consideration therefor either to Diamond, or its employees, agents or customers and (ii) that it will cooperate with Aureal in connection with the foregoing; and 8.1.4 to conduct its business in a manner which favorably reflects upon Aureal. 8.2 Mutual Covenants. Each party agrees: 8.2.1 to comply with all export laws and restrictions and regulations of the Department of Commerce or other United States or foreign agency or authority, and not to export, or allow the export or re-export of any Proprietary Information (as defined in Section 11.1 ("Obligation") below), Aureal Chips or any direct product thereof in violation of any such restrictions, laws or regulations, or to Afghanistan,] or any Group Q, S, W, Y or Z country specified in the then current Supplement No. 1 to Section 770 of the U.S. Export Administration Regulations (or any successor supplement or regulations) and in the event Diamond requests that a Product be shipped to a location requiring any licenses or permits in addition to those already possessed by the Aureal, the Diamond shall obtain and bear all expenses relating to such licenses or permits, or obtain exemptions therefrom, and shall, at the Aureal's request, demonstrate compliance with all applicable laws and regulations prior to delivery thereof by such Aureal; 8.2.2 to, in addition to and without in any way limiting the obligations of each party hereunder, use all reasonable methods to protect the other party's rights with respect to the Aureal Audio Products and Proprietary Information (as applicable) as it uses to protect its own or any third party's software, confidential information or rights; 8.2.3 that all advertising and marketing materials relating to the Products and/or the other party shall be accurate in all material respects; and 8.2.4 to designate one of its employees as the contact person for the administration of this Agreement ("Contract Representative") and to advise the other party of such employee's name, mailing address and telephone number. 8.2.5 to use commercially reasonable efforts to ensure that neither this Agreement (or any term hereof) nor the performance of or exercise of rights under this Agreement, is restricted by, contrary to, in conflict with, ineffective under any law or regulation known by a party to be applicable to it. To the extent any such law or regulation requires registration or approval of the Agreement or requires tax withholding by a party under the Agreement or any termination payment or compulsory licensing with regard to the Agreement, such party shall satisfy such obligations. 9. Labeling and Joint Marketing Obligations. 9.1 Proprietary Notices. Diamond shall not remove any copyright notices or proprietary legends contained within the Aureal Chips and Add-In Sound Cards. Further, Diamond shall include a copyright notice on all Add-In Sound Cards containing Aureal Chips (and all packaging, specification sheets and advertising for such products) that reflects the copyright ownership of Diamond and Aureal as follows: 9 10 (C) 19__ Diamond and its licensors. All rights reserved. In addition, anytime software utilizing the Aureal Chips displays copyright information to the End-user, a notice substantively similar to the following shall be included therein: Aureal 3D(TM) technology is provided by Aureal Semiconductor Inc. (C) 1987-1998 Aureal Semiconductor Inc., All Rights Reserved. A3D Interactive(TM) and logos are trademarks of Aureal Semiconductor Inc. 9.2 Marking by Diamond. Subject to Section 7.6 ("Branding"), Diamond hereby agrees to mark all products designed, made for or by, and sold by Diamond, which incorporate the Aureal Audio Products (as well as all packaging, specification sheets and advertising for such products) with the applicable Aureal trademarks and copyright and/or patent notices, in a form reasonably acceptable to Aureal or as detailed in Exhibit D. 9.3 Display of Logos. Diamond shall be required to prominently display the Aureal 3D(TM) logo (or any other appropriate logo so designated by Aureal upon prior approval from Diamond, which shall not be unreasonably withheld), as provided by Aureal, on the front of the outside package and booklet of all Add-In Sound Cards that incorporate the Aureal Chips. The size and location (on the front of the box) of such display shall be noticeable and readily apparent to the average consumer as detailed in Exhibit D. Diamond shall make available to its system integrator customers the right to include the Aureal 3D(TM) logo on their products as described in this section. 9.4 Advertising. Diamond agrees that all advertising, marketing or promotional materials that Diamond transmits or distributes that mention the 3-D audio technology or capabilities of products incorporating the Aureal Chips, shall prominently display the A3D logo in all advertising and give prominent credit to Aureal as the provider of the audio technology as detailed in Exhibit D. Aureal shall have the opportunity to review and approve all packaging, which approval shall not be unreasonably withheld. Aureal will have input into the creative process for advertising and promotion and will jointly be involved with Diamond on the administration of the promotion funds identified in this agreement. 9.5 Additional Obligations. The parties will also perform the obligations with respect to joint marketing of the Products as set forth in Exhibit D ("Branding Procedure") attached hereto. 9.6 Marketing and Advertising Funds. Diamond will set aside a marketing budget to be jointly administered between the companies in the amounts set forth in Exhibit B. Diamond and Aureal representatives will meet to identify and approve specific marketing and advertising programs in which to use the agreed upon budget together with a specific budget for each such program. The parties will mutually agree on which party, Diamond or Aureal, will administer the specific programs in accordance with the budget requirements. The representatives will meet on a weekly basis to review the programs. 9.7 Future Products. Aureal and Diamond will collaborate on other prospective board design integration and chip feature implementations for future products and also on [****] implementations. 10. Limitation of Liability. NOTWITHSTANDING ANYTHING ELSE IN THIS AGREEMENT OR OTHERWISE, NEITHER PARTY WILL BE LIABLE WITH RESPECT TO ANY SUBJECT MATTER OF 10 [****] Confidential Treatment Requested 11 THIS AGREEMENT UNDER ANY CONTRACT, NEGLIGENCE, STRICT LIABILITY OR OTHER LEGAL OR EQUITABLE THEORY (I) FOR ANY SPECIAL, INCIDENTAL, CONSEQUENTIAL OR INDIRECT DAMAGES OR LOST DATA OR (II) FOR COST OF PROCUREMENT OF SUBSTITUTE GOODS, TECHNOLOGY OR SERVICES. THIS LIMITATION SHALL APPLY EVEN IF A PARTY HAS BEEN ADVISED OF THE POSSIBILITY OF SUCH DAMAGES. 11. Indemnities. 11.1 By Aureal. Aureal shall defend, indemnify and hold Diamond and its officers, directors, agents and employees harmless from liability resulting from infringement by the Aureal Audio Products of any patent, copyright or trade secret provided that: (i) Aureal is promptly notified of any and all threats, claims and proceedings related thereto; (ii) Aureal shall have sole control of the defense and/or settlement thereof and Diamond shall not settle or compromise any such claim without Aureal's prior written consent; (iii) Diamond furnishes to Aureal, upon request, all information available to Diamond related to the defense of such claim; and (iv) Diamond provides Aureal with reasonable assistance at Aureal's expense. The foregoing obligation of Aureal does not apply (i) to the extent that such infringement results from Aureal Audio Products or portions or components thereof that are (A) not supplied by Aureal; (B) modified after shipment by Diamond; (C) combined with other products, processes, methods or materials, where such other products, processes, methods or materials were required to sustain the infringement action (ii) where Diamond continues the allegedly infringing activity after being notified thereof or after being informed of modifications that would have avoided the alleged infringement, or (iii) to the extent that Diamond's use of the Aureal Audio Products is incident to an infringement not resulting primarily from the Aureal Audio Products. Diamond shall indemnify Aureal and its officers, directors, agents and employees from all damages, settlements, attorneys' fees and expenses related to a claim of infringement or misappropriation excluded from Aureal's indemnity obligation by this sentence. 11.2 By Diamond. Subject to Aureal's obligations under Section 11.1 ("By Aureal"), Diamond shall hold Aureal and its officers, directors, agents and employees harmless from liability resulting from (i) infringement by any Diamond product not attributable to the Aureal Audio Product and (ii) Diamond's distribution of the such product, provided that: (i) Diamond is promptly notified of any and all threats, claims and proceedings related thereto; (ii) Diamond shall have sole control of the defense and/or settlement thereof; (iii) Aureal furnishes to Diamond, upon request, information available to Aureal for such defense; and (iv) Aureal provides Diamond with reasonable assistance at Diamond's expense. 12. Confidentiality. 12.1 Obligation. Each party agrees that (i) all inventions, algorithms, processes, technology, know-how and ideas and all other business, technical and financial information it obtains from the other and (ii) the terms and conditions of this Agreement shall constitute the confidential property of the other party ("Proprietary Information"). Except as expressly allowed in this Agreement, the receiving party will hold in confidence and not use or disclose any Proprietary Information of the disclosing party and shall similarly bind its employees in writing. The receiving party shall not be obligated under this Section with respect to information the receiving party can document: (a) is or has become readily publicly available through no fault of the receiving party or its employees or agents; or 11 12 (b) is received from a third party lawfully in possession of such information and lawfully empowered to disclose such information and provided the receiving party abides by all restrictions imposed by such third party; or (c) was rightfully in the possession of the receiving party prior to its disclosure by the other party provided the receiving party abides by all restrictions imposed on its possession of such information; or (d) was independently developed by the receiving party without use of the disclosing party's Proprietary Information. (e) is required to be disclosed subject to Securities Exchange Commission or other regulatory agency requirements. 12.2 Injunctive Relief. Each party agrees that any breach of the confidentiality obligations contained in this Section 12 may cause irreparable harm for which monetary damages will not be an adequate remedy, and that each party shall, in addition to any other remedies available to it, be entitled to seek all equitable remedies including injunctive relief to prevent any such breach by the other party. 13. Term and Termination. 13.1 Term. This Agreement shall commence upon the Effective Date and shall continue for a period of two (2) years unless terminated earlier pursuant to Section 12.2 below. Thereafter, this Agreement shall renew for a successive one (1) year period to include the following minimum purchase commitment. [****]. 13.2 Review Period. On or before December 31, 1998 both parties will review the progress under this Agreement. Either party may decide at that time to terminate the Agreement and will be no longer bound by its terms. If the parties agree to continue, Aureal and Diamond will negotiate minimum purchase commitments for each quarter in 1999. Provided however, that the minimum purchase commitment will not be less than an aggregate of [****]. 13.3 Termination for Breach. This Agreement may be terminated by a party for cause immediately upon the occurrence of any of the following events: (1) if the other ceases to do business, or otherwise terminates its business operations; or (2) if the other materially breaches any material provision of this Agreement and fails to fully cure such breach within thirty (30) days (ten (10) days in the case of a failure to pay and immediately in the case of a breach of Section 11 ("Confidentiality")) of written notice describing the breach; or (3) if the other ceases to fully support the audio PC business on a commercial basis; or [****] Confidential Treatment Requested 12 13 (4) failure of Diamond to met the minimum purchase commitment as set forth in Section 3, or as amended pursuant to Section 13.2 or adjusted in accordance with Section 4.3. (5) if the other shall seek protection under any bankruptcy, receivership, trust deed, creditors arrangement, composition or comparable proceeding, or if any such proceeding is instituted against the other (and not dismissed within ninety (90) days). 13.4 Effect of Termination. In the event of any termination of this Agreement, the parties shall return to each other or destroy all copies of all Proprietary Information and shall provide to each other a certificate of an authorized representative to the effect that such return or destruction has occurred. If the Agreement is terminated due to Diamond's failure to meet Section 3, Diamond shall immediately pay Aureal the balance due to reach the then current quarterly requirement. Furthermore, all outstanding and unaccepted purchase orders for Aureal Audio Products as of the effective termination date will no longer be of any force or effect and purchase orders which have been accepted shall be shipped by Aureal. Each party may continue to distribute Add-In Sound Cards remaining in their respective inventory as of the effective termination date pursuant to the terms of this Agreement. 13.5 Survival. Sections 4.5 ("Warranty Disclaimer"), 5 ("General Order, Delivery and Payment Terms"), 6 ("Ownership"), or 10 ("Limitation of Liability"), 11 ("Indemnities"), 12 ("Confidentiality"), 13 ("Term and Termination") and 14 ("General") of this Agreement shall survive any termination or expiration hereof. In particular, upon any termination or expiration of this Agreement, each party shall retain all amounts received from the other party prior to termination. 14. General. 14.1 Governing Law. This Agreement will be governed in all respects by the laws of the United States of America and the State of California, without regard to conflicts of laws provisions thereof and without regard to the United Nations Convention on Contracts for the International Sale of Goods. All disputes arising under this Agreement shall be brought in the Superior Court of the State of California in Santa Clara County or the Federal District Court located in San Jose as permitted by law. The Superior Court of Santa Clara County and Federal District Court located in San Jose shall have nonexclusive jurisdiction over disputes arising under or related to this Agreement. Diamond and Aureal hereby submit to the personal jurisdiction of the above courts. 14.2 No Agency. Aureal and Diamond are strictly independent contractors and shall so represent themselves to all third parties. Neither party has the right to bind the other in any manner whatsoever except as expressly provided in this Agreement, and nothing in this Agreement will be interpreted to make either party the agent, legal representative, employer or franchiser of the other, or to make the parties partners or joint ventures. 14.3 Assignability. This Agreement shall not be assigned by either party or by operation of law, without the prior written consent of the other party. However, either party may assign this Agreement upon prior written notice in connection with a merger, consolidation, reorganization or sale of all or substantially all of such party's business, stock or assets that are related to the performance of this Agreement. Any attempted assignment in contravention of this Section will be null and void. This 13 14 Agreement will be binding upon and inure to the benefit of the parties, their successors and permitted assigns. 14.4 Waiver. The waiver of one breach or default under this Agreement will not constitute a waiver of any subsequent breach or default. Any provision of this Agreement held illegal or unenforceable, will be deemed amended to conform to applicable laws and regulations, or if it cannot be so amended without materially altering the intention of the parties, it will be stricken and the remainder of this Agreement will continue in full force and effect. WITHOUT LIMITING THE FOREGOING, THE PARTIES AGREE THAT IF ANY REMEDY UNDER THIS AGREEMENT IS DETERMINED TO HAVE FAILED OF ITS ESSENTIAL PURPOSE, ALL LIMITATIONS OF LIABILITY AND EXCLUSIONS OF DAMAGES SET FORTH IN THIS AGREEMENT SHALL REMAIN IN FULL FORCE AND EFFECT. 14.5 Notices. All notices in connection with this Agreement shall be deemed given upon actual receipt by the party being notified after being deposited in the U.S. mail, postage prepaid, first class, certified or registered, return receipt requested, or sent by overnight courier, charges prepaid, in each case sent to a party's address as set forth in the opening paragraph of this Agreement or to such other address designated by a party hereto by notice in accordance with this Section. 14.6 Attorneys' Fees. The prevailing party in any action or to enforce the terms of this Agreement shall be entitled to reimbursement by the other party for all costs (including reasonable attorneys' fees) incurred in connection with such proceeding, in addition to any other remedies to which it may be entitled. 14.7 Integration. This Agreement and its attached Exhibits constitutes the entire and exclusive agreement between the parties hereto with respect to its subject matter and merges all other communications and discussions, oral or written. Diamond acknowledges that it is not entering into this Agreement on the basis of any representations not expressly contained in the Agreement. No employee, agent or other representative of Aureal has any authority to bind Aureal with regard to any statement, representation or warranty unless the same is specifically set forth or incorporated by reference in this Agreement. Other than as specified herein, this Agreement may only be supplemented, modified or waived in writing signed by all parties. 14.8 Counterparts. This Agreement may be executed in counterparts, each of which will be deemed an original, but all of which together will constitute one in the same instrument. 14.9 Press Releases. On the Effective Date of this Agreement, the parties will release mutually agreeable joint press releases announcing the relationship established by this Agreement. 14.10 Section Headings. The Section headings in the Agreement are inserted only as a matter of convenience and shall not be used in the interpretation thereof. 14 15 IN WITNESS WHEREOF, the parties have executed this Agreement as of the date first written above. DIAMOND MULTIMEDIA SYSTEMS, INC. AUREAL SEMICONDUCTOR INC. By: /s/ William J. Schroeder By: /s/ Kenneth A. Kokinakis -------------------------- --------------------------------- (Signature) (Signature) William J. Schroeder KENNETH A. KOKINAKIS ---------------------------- ------------------------------------- (Printed Name) (Printed Name) President and CEO PRESIDENT AND CHIEF EXECUTIVE OFFICER -------------------------- ------------------------------------- (Title) (Title) 15 EX-27.1 3 FINANCIAL DATA SCHEDULE
5 THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE CONSOLIDATED FINANCIAL STATEMENTS FOR THE FISCAL QUARTER ENDED JUNE 28, 1998, AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS. 1,000 3-MOS JAN-03-1999 DEC-29-1997 JUN-28-1998 116 0 3,453 0 5,138 10,326 3,999 2,169 13,561 4,741 0 0 0 42 6,194 13,561 3,436 3,436 2,033 2,033 5,360 0 1,540 (5,446) 0 (5,446) 0 0 0 (5,446) (0.42) (0.42)
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