-----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, IbZgfQaEWPgqzp3fwwZ3lLsDXxzxrYJn8FIs1bmz5PtRyGbKITlG0OO0OLUAToc1 o4pL/AKG9+dqB+m4RQ4lGA== 0000891618-99-003898.txt : 19990819 0000891618-99-003898.hdr.sgml : 19990819 ACCESSION NUMBER: 0000891618-99-003898 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 3 CONFORMED PERIOD OF REPORT: 19990704 FILED AS OF DATE: 19990818 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: 0103 FILING VALUES: FORM TYPE: 10-Q SEC ACT: SEC FILE NUMBER: 000-22626 FILM NUMBER: 99695465 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 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 JULY 4, 1999 Commission File Number 0-20684 AUREAL 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 August 1, 1999, 9,961,165 shares of common stock, $0.001 par value, of the registrant were outstanding. This report on Form 10-Q contains 23 pages. The exhibit index is on page 23. 2 AUREAL 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 Item 3. Qualitative and Quantitative Disclosure of Market Risks....................................20 PART II. OTHER INFORMATION Item 1. Legal Proceedings.........................................................................21 Item 4. Submission of Matters to a Vote of Security Holders.......................................21 Item 5. Other Information.........................................................................21 Item 6. Exhibits and Reports on Form 8-K..........................................................21
2 3 PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS AUREAL INC. INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) We have prepared the Interim Condensed Consolidated Financial Statements of Aureal Inc. 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 our audited financial statements at January 3, 1999 and the notes thereto included in our 1998 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 us 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 our opinion, 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 July 4, 1999 are not necessarily indicative of the results that may be expected for any subsequent quarter or the entire fiscal year ending January 2, 2000. 3 4 AUREAL INC. CONDENSED CONSOLIDATED BALANCE SHEETS (DOLLARS IN THOUSANDS)
July 4, 1999 Jan. 3, 1999 ------------ ------------- (Unaudited) ASSETS: Current assets: Cash and cash equivalents $ 4,238 $ 87 Restricted cash -- 6 Accounts receivable 4,775 4,781 Inventories 6,644 3,916 Deferred fair value of debt related warrants -- 924 Prepaid loan fees and other current assets 554 757 --------- --------- Total current assets 16,211 10,471 Property and equipment: Machinery and equipment 5,330 4,636 Furniture, fixtures and improvements 686 639 --------- --------- 6,016 5,275 Accumulated depreciation and amortization (3,601) (2,795) --------- --------- Net property and equipment 2,415 2,480 Other long-term assets 161 687 --------- --------- Total assets $ 18,787 $ 13,638 ========= ========= LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT): Current liabilities: Line of credit $ -- $ 4,329 Accounts payable 6,773 5,966 Accrued compensation and benefits 1,799 1,765 Other accrued liabilities 1,343 1,061 Current portion of pre-petition claims 982 936 --------- --------- Total current liabilities 10,897 14,057 Long-term portion of pre-petition claims and deferred obligations 303 889 --------- --------- Total liabilities 11,200 14,946 Stockholders' equity (deficit): Preferred stock, $0.001 par value, authorized shares-5,000,000: Series A: Authorized shares - 500; Issued and outstanding shares - 35 and 249, respectively -- -- Series B: Authorized shares - 60,000; 40,966 shares issued and outstanding in 1998 -- -- Series C: Authorized shares - 1,500; 600 shares issued and outstanding in 1998 -- -- Additional paid-in capital 387 51,421 Common stock, $0.001 par value: Authorized shares - 200,000,000; Issued and outstanding shares - 9,961,165 and 3,178,422, respectively 10 48 Additional paid-in capital 192,203 119,790 Accumulated deficit (185,013) (172,567) --------- --------- Total stockholders' equity (deficit) 7,587 (1,308) --------- --------- Total liabilities and stockholders' equity (deficit) $ 18,787 $ 13,638 ========= =========
The accompanying notes are an integral part of these financial statements. 4 5 AUREAL INC. CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
Quarter Ended Six Months Ended ------------------------------- --------------------------------- July 4, June 28, July 4, June 28, 1999 1998 1999 1998 (Unaudited) (Unaudited) Net sales $ 8,063 $ 3,436 $ 20,641 $ 7,018 Cost of sales 5,013 2,033 13,334 4,826 -------- -------- -------- -------- Gross Margin 3,050 1,403 7,307 2,192 Operating expenses: Research and Development 3,635 2,916 6,999 5,534 Sales and Marketing 2,930 1,628 5,002 2,984 General and Administrative 2,620 816 3,787 1,676 -------- -------- -------- -------- Total operating expenses 9,185 5,360 15,788 10,194 -------- -------- -------- -------- Operating loss (6,135) (3,957) (8,481) (8,002) Amortization of debt related warrants (1,078) (577) (1,309) (1,327) Interest expense (699) (963) (1,132) (1,994) Other income (expense), net (30) 51 (40) 391 -------- -------- -------- -------- Loss from operations before income taxes (7,942) (5,446) (10,962) (10,932) Provision for income taxes -- -- -- -- -------- -------- -------- -------- Net loss $ (7,942) $ (5,446) $(10,962) $(10,932) ======== ======== ======== ======== Accretion/dividends related to preferred stock $ (290) $(12,121) $ (1,484) $(12,121) ======== ======== ======== ======== Net loss attributable to common stockholders $ (8,232) $(17,567) $(12,446) $(23,053) ======== ======== ======== ======== Net loss per share: basic and diluted $ (1.14) $ (6.25) $ (2.27) $ (8.22) -------- -------- -------- -------- Weighted average common shares outstanding 7,221 2,809 5,488 2,803 ======== ======== ======== ========
The accompanying notes are an integral part of these financial statements. 5 6 AUREAL INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS)
Six Months Ended -------------------------- July 4, June 28, 1999 1998 (Unaudited) OPERATING ACTIVITIES Net loss from operations $(10,962) $(10,932) Adjustments to reconcile net loss from operations to net cash used in operating activities: Depreciation and amortization 2,979 2,026 Changes in operating assets and liabilities: Restricted cash 6 109 Accounts receivable 6 (3,432) Inventories (2,728) (4,845) Prepaid expenses and other current assets (706) (549) Other assets 242 (465) Accounts payable 688 (57) Accrued compensation and benefits, and other accrued liabilities 318 (315) -------- -------- Net cash used in operating activities (10,157) (18,460) -------- -------- INVESTING ACTIVITIES Acquisition of property and equipment (751) (1,038) -------- -------- Net cash used in investing activities (751) (1,038) -------- -------- FINANCING ACTIVITIES Proceeds from Line of Credit 27,180 18,984 Repayment on Line of Credit (31,554) (9,074) Principal payments on pre-petition claims (540) (1,211) Proceeds (expenses) from issuance of stock, net of issuance costs 19,973 10,780 -------- -------- Net cash provided by financing activities 15,059 19,479 -------- -------- Net increase/(decrease) in cash and cash equivalents 4,151 (19) Cash and cash equivalents at beginning of period 87 135 -------- -------- Cash and cash equivalents at end of period $ 4,238 $ 116 ======== ======== SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION Interest paid $ 637 $ 2,439 SUPPLEMENTAL DISCLOSURE OF NON-CASH INVESTING AND FINANCING ACTIVITIES Conversion of Line of Credit balance to preferred stock -- $ 28,685 Accretion/dividends on preferred stock $ 1,484 $ 12,121 Valuation of debt-related warrants issued -- $ 1,848
The accompanying notes are an integral part of these financial statements. 6 7 AUREAL INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) 1. THE COMPANY AND RECENT FINANCIAL EVENTS Aureal Inc., together with our subsidiaries Crystal River Engineering, Inc. and Aureal Semiconductor Limited, is a producer of digital audio semiconductor and board-level products and advanced digital audio technologies for the personal computer and consumer electronics markets. Crystal River Engineering, which was founded in 1987 and which we acquired in the second quarter of 1996, has been a pioneer in the development of 3D audio technologies. Aureal Semiconductor Limited, located in Hong Kong, was established in March 1998 as a sales, technical support and field engineering office. Our business involves the development and sale of audio processing semiconductor chips and audio-based add-in cards for use in PCs, as well as the licensing of technology that is designed to define and develop advanced audio standards in the marketplace. Our stock symbol on the OTC Bulletin Board is AURL. On April 5, 1999, we announced a capital restructuring plan which included a subscription rights offering, the conversion of our outstanding series B preferred stock to common stock and a one-for-fifteen reverse stock split. Under the subscription rights offering, we offered for sale $20 million of our common stock, at a price of $0.60 per share (pre-reverse split). Stockholders of our common stock on April 22, 1999 were offered, on a pro-rata basis, the opportunity to purchase new shares of our common stock. Our two largest stockholders, Oaktree Capital Management LLC and TCW Special Credits, agreed to purchase any unsubscribed shares of this rights offering up to a maximum amount of $20 million. Oaktree and TCW, holders of all of our series B preferred stock, converted their shares of series B preferred stock into 20.5 million shares of common stock upon the closing of the rights offering. In consideration of this conversion, we issued an additional 26.2 million shares of common stock to these holders. We did not register these additional 26.2 million shares, but we granted standard demand and piggyback registration rights to Oaktree and TCW. As a result of these actions, most of our preferred stock converted to common stock. We also announced a one-for-fifteen reverse stock split. The split was effected as of June 10, 1999, at which point we had 9,960,577 shares outstanding after the split. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Presentation We, the management of Aureal Inc., have prepared the following Interim Condensed Consolidated Financial Statements 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 our audited financial statements at January 3, 1999 and the financial footnotes included in our 1998 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 ended July 4, 1999 are not necessarily indicative of the results that may be expected for any subsequent quarter or the entire fiscal year ending January 2, 2000. Cash and Cash Equivalents and Short Term Investments We consider cash invested in highly liquid financial instruments with an original maturity of three months or less to be cash equivalents. Cash investments in highly liquid financial instruments with original maturities greater than three months but not longer than fifteen months are classified as short-term investments. 7 8 Inventories Inventories are stated at the lower-of-cost-or-market value on a first-in first-out basis. We do not consider any inventory to be raw material, since our initial point of purchase is for fabricated silicon wafers. Net inventories at July 4, 1999 and January 3, 1999 consisted of the following, in thousands:
July 4, 1999 January 3, 1999 ------------ --------------- Work-In-Process .............. $1,158 $2,460 Finished Goods ............... 5,486 1,456 ------ ------ Total Inventories .. $6,644 $3,916 ====== ======
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). Leasehold improvements are amortized utilizing the straight-line method over their estimated useful lives or the term of the lease whichever is shorter. Maintenance and repairs are expensed as incurred. Revenue Recognition Our major sources of revenue consist of sales of proprietary design, advanced audio semiconductor chips and boards, and licensing of related audio technologies. Revenue is recognized upon shipment for product sales. Licensing revenues are recognized upon delivery of licensed product if a non-cancelable contract has been signed, the fees are fixed and determinable, collection of the recognized fees is probable, and there are no remaining significant obligations. Comprehensive income Statement of Financial Accounting Standards No. 130 requires that we disclose all non-owner changes in equity, such as cumulative foreign currency translation adjustments, certain minimum pension liabilities and gains and losses on available-for-sale securities. During the first half of both 1999 and 1998, we had no elements of comprehensive income. Concentration of Financial Instrument Risks and Credit Risks Financial instruments which potentially subject us to concentration of market risk consist primarily of our line of credit. Concentration of market risk on the line of credit is related to changes in the prime lending rate, as the majority of our debt bears interest rates which fluctuate with changes in the prime lending rate. Our credit risk consists primarily of trade receivables. Some of these trade receivables are the result of sales to foreign companies. We have established an allowance for doubtful accounts based on the credit risks of the business in general. Valuation of Warrants In connection with the establishment of a credit facility in June 1998, we issued warrants to purchase 1.35 million shares of our common stock. The fair value of these warrants was estimated utilizing the Black-Scholes valuation method as approximately $1.8 million. This value was being amortized over the two-year term of the credit facility. These warrants were issued in consideration of the Tranche B portion of this credit facility. When the Tranche B portion of this credit facility was terminated in May 1999, the remaining unamortized value of $0.9 million was expensed. Loss Per Share The Financial Accounting Standards Board has issued Statement of Financial Accounting Standards No. 128, which is effective for financial statements for periods ending after December 15, 1997. Statement of Financial Accounting Standards No. 128 requires that the calculation for basic earnings per share exclude the dilutive effect of common stock equivalents in the calculation for basic net income (loss) per share. Diluted earnings per share under Statement of Financial Accounting Standards No. 128, is calculated using the weighted average number of common shares and common stock equivalent shares outstanding during the period. Common equivalent shares 8 9 are computed using the treasury stock method for outstanding warrants and stock options. Common equivalent shares are excluded from the diluted earnings per share 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 our net loss position, any affect would be anti-dilutive. 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 $1.5 million during the first two quarters of 1999. These charges were recorded directly to accumulated deficit and are included as a component of net loss per share attributable to common stockholders. Loss per share figures for prior periods have been restated to reflect the effect of the one-for-fifteen reverse stock split effected June 10, 1999. 3. CREDIT FACILITY In connection with our May 1999 capital restructuring, the outstanding balance under our previous line of credit was re-paid and new terms were agreed upon with Transamerica Business Credit Corporation. This new agreement is a $12.2 million credit facility at an interest rate of prime plus 3%. We are subject to certain covenant restrictions under this facility. This agreement is in force until September 30, 1999. We are currently renegotiating the terms of this agreement to include a reduction in the interest rate, an extension of the term to two years and an increase in the total dollars available to borrow under the line. Our previous line of credit was entered into on June 5, 1998 with Transamerica Business Credit Corporation and Goldman Sachs Credit Partners L.P. This was a two year $40 million revolving credit facility partially secured by our assets. Terms of the credit facility provided for up to $32.5 million borrowing availability related to specific accounts receivable, referred to as Tranche A, with an additional $7.5 million of availability unrelated to specific collateral requirements, referred to as Tranche B. Interest on borrowings under the two-year agreement was at the rates of prime plus 3% for Tranche A borrowings and prime plus 5% percent for Tranche B borrowings. We were subject to certain covenant restrictions under the credit facility and paid a $600,000 fee to the lenders in connection with the initiation of this credit facility. 4. EQUITY FUNDING On April 5, 1999, we announced a capital restructuring plan which included a subscription rights offering, the conversion of our outstanding series B preferred stock to common stock and a one-for-fifteen reverse stock split. Under the subscription rights offering, we offered for sale $20 million of our common stock, at a price of $0.60 per share (pre-reverse split). Stockholders of our common stock on April 22, 1999 were offered, on a pro-rata basis, the opportunity to purchase new shares of our common stock. Our two largest stockholders, Oaktree Capital Management LLC and TCW Special Credits, agreed to purchase any unsubscribed shares of this rights offering up to a maximum amount of $20 million. Oaktree and TCW, holders of all of our series B preferred stock, converted their shares of series B preferred stock into 20.5 million shares of common stock upon the closing of the rights offering. In consideration of this conversion, we issued an additional 26.2 million shares of common stock to these holders. We did not register these additional 26.2 million shares, but we granted standard demand and piggyback registration rights to Oaktree and TCW. As a result of these actions, most of our preferred stock converted to common stock. We also announced a one-for-fifteen reverse stock split. These actions should make it possible for us to qualify for NASDAQ national market listing in the near future. At our 1999 annual meeting of stockholders, our stockholders approved a one-for-fifteen reverse stock split and an increase in the number of shares for the stock option plan. The reverse split was effected on June 10, 1999, and these actions have been reflected in the accompanying consolidated financial statements. 5. INCOME TAXES We were not required to provide for income taxes in the first two quarters of 1999 or 1998 due to our net operating losses. No tax benefit has been recorded for the losses due to the uncertainty as to the realizability. At January 3, 1999, we had available net operating loss carryforwards of approximately $308 million to reduce future taxable income. 9 10 INDUSTRY SEGMENTS AND MAJOR CUSTOMERS Aureal operates in a single segment which includes three product revenue groups. During the second quarter of 1999 we generated $4.2 million in revenues from the sale of chips, $3.6 million from the sale of board-level products and $0.3 million in revenues from licensing agreements. During the same period in 1998, revenues from chips were $3.2 million and $0.2 million from licensing agreements and miscellaneous audio revenues. 10 11 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS THIS REPORT CONTAINS FORWARD-LOOKING STATEMENTS WITHIN THE MEANING OF SECTION 27A OF THE SECURITIES ACT OF 1933 AND SECTION 21E OF THE SECURITIES EXCHANGE ACT OF 1934. ANY FORWARD-LOOKING STATEMENTS MADE HEREIN ARE MADE PURSUANT TO THE SAFE HARBOR PROVISIONS OF THE PRIVATE SECURITIES LITIGATION ACT OF 1995. INVESTORS ARE CAUTIONED THAT ACTUAL RESULTS MAY DIFFER MATERIALLY FROM THOSE PROJECTED IN ANY FORWARD-LOOKING STATEMENTS DUE TO A NUMBER OF FACTORS INCLUDING, BUT NOT LIMITED TO, OUR DEPENDENCE ON THE PERSONAL COMPUTER AND CONSUMER ELECTRONICS INDUSTRIES AND ON PRODUCT LINES BASED ON NEW TECHNOLOGIES; FOUNDRY AND FACTORY CAPACITY, AVAILABILITY AND RELIABILITY; COMPETITION AND PRICING PRESSURES; OUR ABILITY TO SECURE ADDITIONAL FINANCING; AND OTHER RISKS DETAILED BELOW AND FROM TIME TO TIME IN OUR FILINGS WITH THE SECURITIES AND EXCHANGE COMMISSION. FOR A FURTHER DISCUSSION OF THE RISKS RELATING TO OUR BUSINESS, SEE THE RISK FACTORS SECTION OF MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONS AND RESULTS OF OPERATIONS. OVERVIEW Aureal Inc., together with our subsidiaries Crystal River Engineering, Inc. and Aureal Semiconductor Limited, is a producer of digital audio semiconductor and board-level products and advanced digital audio technologies for the personal computer and consumer electronics markets. We contract with independent silicon manufacturers, which in the semiconductor industry are called foundries, for production of our semiconductor products, and thus we do not fabricate our own semiconductor products. The foundry that manufactures the majority of our semiconductor products is one of the three largest foundries in the world that manufactures products exclusively for outside customers. Our objective is to be a leading provider of advanced digital audio solutions for the personal computer and consumer electronics markets. During the first half of 1999, a number of significant events occurred for us: o In June 1999, we completed a capital restructuring which included a $20 million subscription rights offering of common stock, the conversion of all of our series B and C preferred stock and a one-for-fifteen reverse stock split. o In May 1999, our stockholders voted to change our name from Aureal Semiconductor Inc. to Aureal Inc. We believe our new name more accurately reflects our focus as a digital audio imaging hardware and software company. o Also in May 1999, we announced the introduction of the Vortex Advantage soundcard - a new, low-cost audio sub-system for systems integrators. o In April 1999, we announced that Sony Electronics had begun shipping two new VAIO brand PCs incorporating our Vortex2 audio processors. With the introduction of these machines, Sony became the first manufacturer to design Vortex2 audio processors directly onto a PC motherboard. o Also in April 1999, we announced the availability of a new digital audio accelerator for desktop and notebook PCs, the Vortex AU8810. This new chip is a low-cost, motherboard solution resulting from the integration of audio and modem capabilities. o March 1999, we released our A3D 2.0 software development kit, which enables the creation of interactive 3D audio content, to the general development community. This kit had previously only been available to selected game developers. We received an extremely positive response to the new kit, with demand for CDs and Internet downloads of the kit reaching into the thousands. o Also in March 1999, we announced the formation of a partnership with Flatland Online, Inc. As part of this partnership, we have integrated our A3D 2.0 standard into Flatland's tools and web browser extension software providing easy-to-use positional audio for the 3D web enhanced by our Aureal Wavetracing technology. o In February 1999, we received Computer Gaming World's prestigious Gaming Hardware of the Year award for our Vortex2 audio processor. This event was significant because it was the first time that the award was presented to an audio hardware company, signifying a shift in industry focus from graphics to audio. Also in February, we began web-based distribution of our A3D Pro sound design software. This marked our first foray into electronic commerce. o In January 1999, we began direct sales to systems integrators. We also announced an extension of our relationship with Compaq Computer Corporation, in which Compaq agreed to ship our Vortex sound card products in their new Presario 5600 desktop computer products. We are headquartered in Fremont, California and have offices in Austin, Texas and Hong Kong. In June 1999 we leased a 100,000 square foot building in Fremont, California. The move to this location will be 11 12 completed in August 1999 and will consolidate employees from two previously occupied locations in Fremont and allow for future growth. Leases for two smaller locations will expire over the next several months. As of July 4, 1999, we employed 140 people. Of this total, 107 were engaged in engineering functions, 20 were in sales and marketing activities, and 13 were engaged in administrative support. In addition, we utilize the services of contractor consultants to supplement our employee workforce. Aureal, Aureal 3D, A3D and the A3D logo are registered trademarks of Aureal Inc. Other trademarks referred to in this document belong to their respective owners. RESULTS OF OPERATIONS Second quarter and six months of 1999 compared to second quarter and six months of 1998 Net sales Net sales for the second quarter of 1999 were $8.1 million compared to $3.4 million in the second quarter of 1998. This 138% increase in sales was the result of the continued commercial success in the marketplace of our Vortex and Vortex2 products. During the second quarter of 1999, we introduced new sound cards based on our low-cost Vortex AU8810 chip. We also saw continued channel growth from our AU8820 chips, AU8820 sound cards, AU8830 chips and AU8830 sound cards. Year to date revenues in 1999 were $20.6 million compared to $7.0 million in the prior year. Revenues from the year and second quarter of 1998 consisted mainly of sales of our AU8820 chips. Licensing revenues in the second quarters of 1999 and 1998 were $0.3 and $0.2 million, respectively. Gross margin Gross margin for the second quarter of 1999 was 38%. This was a 4 point or 12% increase in gross margin over the 34% reported in the first quarter of 1999. This increase was attributable to lower materials costs for our AU8820 and AU8810 chips, favorable pricing agreements for testing and significantly less startup costs for new products. Our gross margin in the second quarter of 1998 was 41% and reflected product cost reduction and one-time favorable variances in product costs. Gross margin was positively affected in all quarters by revenues from licensing. While we anticipate the continuation of revenues from technology licensing agreements, we do not believe that they will be a significant percentage of our total revenues in the future. We believe that our gross margins could vary depending upon market demand for our various products, new product introductions and the timing and volumes of licensing revenues. Research and development Expenditures for research and development continue to be significant as resources are allocated 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 we continue to bring new and improved products to the audio forefront. Research and development expenses increased from $2.9 million in the second quarter of 1998 to $3.6 million in the second quarter of 1999 but declined as a percentage of net sales from 85% to 45%, respectively. Year-to-date research and development expenditures in 1999 were $7.0 million compared to $5.5 million in 1998. This was a 27% increase in dollar expenditures year-to-year. We expect research and development to continue to be a significant area of investment for us as we develop new technologies and explore new audio frontiers. We expect that the level of spending on research and development will fluctuate as a percentage of net sales, but we do not expect it to decline significantly in absolute dollars in the future. Sales and marketing During the second quarter of 1999, we continued our direct sales efforts to expand our presence in the system integrator channel. To affect this new distribution strategy, we increased selling and marketing headcount, advertising expenses, trade-show participation and travel and commission expenditures. This resulted in an 80% increase in spending in this area between the second quarters of 1999 and 1998, respectively and a 68% increase between 1999 and 1998 on a year-to-date basis. While year-to-date sales and marketing expenses increased in absolute dollar terms from $3.0 million in 1998 to $5.0 million in 1999, these costs decreased as a percentage of net 12 13 sales from 43% in 1998 to 24% in 1999. As we expand our distribution model, we expect sales and marketing expenses will continue to increase in absolute dollars in the future. General and administrative General and administrative expenses for the second quarter of 1999 increased to $2.6 million from $0.8 million in 1998. This increase was the result of increased headcount and legal fees. For the second quarter of 1999, legal fees were $1.5 million. These fees were primarily for services directly related to a series of lawsuits between Creative Technology Ltd. and us. For the six months 1999 compared to 1998, general and administrative expenses increased to $3.8 million from $1.7 million but decreased as a percentage of net sales from 24% in 1998 to 18% in 1999. We expect that general and administrative expenses will increase in absolute dollar terms over the next several periods due to headcount increases, the costs associated with providing expanded infrastructure for our organization and continuing legal fees. Interest expense Interest expense for the second quarters of 1999 and 1998 decreased to $0.7 million from $1.0 million, respectively. This decrease was primarily the result of our recent capital restructuring. The $20.0 million capital infusion in May 1999 allowed us to pay off our previous line of credit. Interest expense for the second quarter of 1999 also included a non-recurring charge of $0.5 million in expensed loan fees that related to the previous credit facility. In June 1998, we paid down and eliminated our previous line of credit in connection with the exchange for our series B preferred stock. This resulted in the decline of interest expense based on the lower outstanding balance of our borrowings. On a year-to-date basis, interest expense declined from $2.0 million in 1998 to $1.1 million in 1999. Amortization of debt-related warrants In connection with the establishment of a credit facility in June 1998, we issued warrants to purchase 1.35 million shares of our common stock. The fair value of these warrants was estimated utilizing the Black-Scholes valuation method as approximately $1.8 million. This value was being amortized over the two-year term of the credit facility. These warrants were issued in consideration of the Tranche B portion of this credit facility. When the Tranche B portion of this credit facility was terminated in May 1999; the remaining unamortized value of $0.9 million was expensed. In August 1997, in conjunction with the expansion and extension of our prior line of credit, we issued warrants to purchase 3.15 million shares of our common stock to our lenders. Using 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 line of credit at the rate of $0.75 million per quarter. When the line of credit was converted to preferred stock 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. Income taxes We were not required to provide for income taxes in either the first half of 1999 or 1998, respectively due to our net operating losses. No tax benefit has been recorded for the net operating loss carryforwards due to the uncertainty as to their realizability. 13 14 LIQUIDITY AND CAPITAL RESOURCES As of July 4, 1999, we had working capital of $5.3 million and stockholders' equity of $7.6 million. The $10.2 million net cash used in operations during the first half of 1999 was approximately $8.3 million less than we used in the first half of 1998. This decrease was primarily due to lower levels of inventory and accounts receivable build. Net cash used for investing in equipment and software tools stayed constant at $0.2 million in the second quarters of both 1999 and 1998. These capital expenditures consisted primarily of purchases of hardware and software tools utilized in our research and development activities. Capital expenditures are anticipated to increase significantly during 1999, to an estimated level of approximately $3 million for the year. Financing for second quarter of 1999 cash outlays was provided by our previous line of credit and cash received from our rights offering. We expect that in the next six months we will need additional cash to expand our business and to finance additional inventory and accounts receivable. It is extremely difficult to estimate the cash flows, and the timing of these cash flows, due to our lack of significant sales and customer payment history. We can make no assurance that we will be able to generate positive cash flows in the future. On April 5, 1999, we announced a capital restructuring plan which included a subscription rights offering, the conversion of our outstanding series B preferred stock to common stock and a one-for-fifteen reverse stock split. Under the subscription rights offering, we offered for sale $20 million of our common stock, at a price of $0.60 per share (pre-reverse split). Stockholders of our common stock on April 22, 1999 were offered, on a pro-rata basis, the opportunity to purchase new shares of our common stock. Our two largest stockholders, Oaktree Capital Management LLC and TCW Special Credits, agreed to purchase any unsubscribed shares of this rights offering up to a maximum amount of $20 million. Oaktree and TCW, holders of all of our series B preferred stock, converted their shares of series B preferred stock into 20.5 million shares of common stock upon the closing of the rights offering. In consideration of this conversion, we issued an additional 26.2 million shares of common stock to these holders. We did not register these additional 26.2 million shares, but we granted standard demand and piggyback registration rights to Oaktree and TCW. As a result of these actions, most of our preferred stock converted to common stock. We also announced a one-for-fifteen reverse stock split. These actions should make it possible for us to qualify for NASDAQ national market listing in the near future. In connection with our May 1999 capital restructuring, the outstanding balance under our previous line of credit was re-paid and new terms were agreed upon with Transamerica Business Credit Corporation. This new agreement is a $12.2 million credit facility at an interest rate of prime plus 3%. We are subject to certain covenant restrictions under this facility. This agreement is in force until September 30, 1999. We are currently renegotiating the terms this agreement to include a reduction in the interest rate, an extension of the term to two years and an increase in the total dollars available to borrow under the line. At July 4, 1999, we had no borrowings under our credit facility with Transamerica. Our unused borrowing availability under the line was $4.0 million. At quarter-end July 4, 1999, our financial ratios were out of compliance with financial covenant requirements for the credit facility; however, at July 29, we had secured a waiver of non-compliance for these specific covenants. DISCLOSURE REGARDING THE YEAR 2000 Year 2000 Readiness Disclosure: Some computer, software, and other equipment include computer code in which calendar year data is abbreviated to only two digits. As a result of this design protocol, some of these systems could fail to operate or fail to produce correct results if the year "00" is interpreted to mean 1900 instead of 2000. These problems are widely expected to increase in frequency and severity as the year 2000 approaches and are commonly referred to as the "year 2000 problem." Assessment: The year 2000 problem affects some of the computers, software and other equipment that we use, operate or maintain for our operations. We have developed a year 2000 readiness plan to assess our exposure to the year 2000 problem, implement solutions and develop necessary contingency plans. This plan has been reported to our board of directors and progress is reported to them on a regular basis. To date we have obtained verification and validation from the majority of our independent third party software and hardware suppliers of the year 2000 compliance of their products. 14 15 Internal infrastructure: Of the systems we are currently using, the components of our mission critical software are year 2000 compliant as are the majority of the software packages we employ as engineering tools. Upon completion of the evaluation and assessment of all of our software packages and hardware, we will commence the process of modifying, upgrading and replacing the systems that have been assessed as adversely affected. We expect to complete this process before the occurrence of any material disruption of our business. In addition to computers and software packages, there are office equipment such as fax machines, telephone switches, security systems and other common devices which may be affected by the year 2000 problem. Of these pieces of equipment, we have identified our voice mail system as needing replacement or upgrade and this will be completed in August 1999. Products and software programs: We have tested our products for year 2000 problems. This testing was completed during the first quarter of 1999. Our engineering staff performed compliance testing on all A3D drivers, utilities and supporting software using testing methods and measurements that specifically addressed potential risks to seamless integration into the year 2000 environment. Our A3D product passed both functional and usage tests without errors due to year 2000 non-compliance. We estimate the cost of completing any required modifications, upgrades or replacements of our internal systems to not be significant. All systems that we have tested to date are year 2000 compliant, except for our voice mail system which we will upgrade in August 1999. We believe that the systems that we have not tested can be replaced or modified in the normal course of business. Suppliers: We are contacting our suppliers and checking the web sites of third-party suppliers of components used in the manufacture of our products to determine if these suppliers are certifying that the components they provide us are year 2000 compliant. To date, we believe all critical components that we obtain from third party suppliers are year 2000 compliant. We expect that we will be able to resolve any significant year 2000 problems with any third-party suppliers of components; however, there can be no assurance that these suppliers will resolve any or all year 2000 problems before the occurrence of a material disruption to the operation of our business. Any failure of these third parties to timely resolve year 2000 problems with their systems could have a material adverse effect on our business, operating results and financial condition. Most likely consequences of year 2000 problems: We expect to identify and resolve all year 2000 problems before they materially adversely affect our business operations; however, we believe that it is not possible to determine with complete certainty that all year 2000 problems affecting us have been identified or corrected. The number of devices that could be affected and the interactions among these devices are simply too numerous. In addition, no one can accurately predict how many year 2000 problem-related failures will occur or the severity, duration, or financial consequences of these perhaps inevitable failures. As a result, we believe that we could experience a significant number of operational inconveniences and inefficiencies for us, our contract manufacturers, and our customers that will divert management's time and attention and financial and human resources from ordinary business activities. We also believe that it is possible that there may be business disputes alleging that we failed to comply with the delivery terms of contracts. Contingency plans: We will develop contingency plans to be implemented if our efforts to correct identifiable year 2000 problems are not effective. Depending on the systems identified as non-compliant, these plans could include: accelerated replacement of affected equipment or software, short to medium-term use of backup equipment and software; increased work hours for our personnel; and use of contract personnel to correct on an accelerated schedule any year 2000 problems that arise or to provide manual workarounds for information systems. Our implementation of any of these contingency plans could have a material adverse effect on our business, operating results and financial condition. 15 16 Disclaimer: The discussion of our efforts and expectations relating to year 2000 compliance are forward-looking statements. Our ability to achieve year 2000 compliance and the level of incremental costs associated therewith, could be adversely affected by, among other things, the availability and cost of programming and testing resources, third party suppliers' ability to modify proprietary software, and unanticipated problems identified in the ongoing compliance review. RISK FACTORS In addition to the other information in this report or incorporated in this report by reference, you should consider carefully the following factors in evaluating Aureal and our business: WE HAVE COMPLETED A ONE-FOR-FIFTEEN REVERSE STOCK SPLIT AND THE MARKET PRICE OF OUR COMMON STOCK MAY DECLINE Our stock price may decline as a result of the one-for-fifteen reverse stock split we effected in June 1999. Many companies that have announced and then effected reverse stock splits have seen their stock price fall, both before and after the reverse split is effected. Our stockholders approved the one-for-fifteen reverse split in our common stock in May 1999. While a reverse stock split does not in any way affect the value of, or your investment in, Aureal, the markets may react negatively to it which could cause our stock price to decline further. We cannot assure you that, as a result of the reverse stock split, our stock price will not decline to a price that is less than fifteen times the price of our stock prior to the reverse stock split. WE HAVE SUSTAINED LOSSES IN THE PAST AND WE EXPECT TO SUSTAIN LOSSES IN THE FUTURE We emerged from bankruptcy protection in December 1994. Since that time, we have recorded an accumulated deficit of $185 million as of July 4, 1999. This deficit is comprised of $168 million of incurred losses and $17 million of accretion and dividends on our preferred stock. We generated the majority of our revenues in 1997 and 1996 through technology licensing transactions. The majority of our revenues in 1998 and the first two quarters of 1999 came from the sale of advanced audio products. We expect that the majority of our future revenues will be derived from the sale of advanced audio products. However, we will not be profitable unless we sell significant volumes of our advanced audio products in the future. A DIRECTOR OF AUREAL HAS VOTING CONTROL OVER A SUBSTANTIAL AMOUNT OF OUR STOCK AND MAY, THEREFORE, INFLUENCE OUR AFFAIRS As of July 4, 1999, Richard Masson, a director of Aureal, is deemed to have voting control over approximately 77% of our common stock as a result of his affiliations with Oaktree and TCW. As a result of the amount of our stock deemed to be under the stockholder voting control of Mr. Masson, he may directly and indirectly influence the affairs of Aureal requiring stockholders' approval. Accordingly, Mr. Masson can be deemed to be able to control all matters requiring approval by our stockholders, including the election of directors and the approval of mergers or other business combinations. INVESTORS MAY FIND IT DIFFICULT TO TRADE OUR COMMON STOCK ON THE OVER-THE-COUNTER ELECTRONIC BULLETIN BOARD Our common stock trades only on the Over-the-Counter Electronic Bulletin Board. In prior periods, we did not meet the requirements for listing on the NASDAQ National Market or any national stock exchange. However, we believe that our common stock will qualify for listing on the NASDAQ National Market now that we have completed our $20 million rights offering and effected a one-for-fifteen reverse stock split. Because our common stock trades on the Bulletin Board, an investor may find it very difficult to sell or to obtain accurate quotations as to the market value of our common stock. Furthermore, because our common stock is not listed on the NASDAQ National Market, trading in our common stock is also subject to certain rules promulgated by the SEC under the Securities Exchange Act of 1934. These rules require additional disclosure by broker-dealers in connection with any trades involving a stock defined as a penny stock. Generally, a penny stock is any non-NASDAQ National Market listed 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 16 17 affecting transactions in our common stock and may limit the ability of purchasers of our common stock to resell our common stock in the secondary market. WE EXPECT THE AVERAGE SELLING PRICE OF OUR PRODUCTS TO DECREASE WHICH MAY REDUCE GROSS MARGINS AND REVENUES Product prices in the audio technology industry generally decrease over the life of a particular product. The willingness of prospective customers to design our products into their products depends to a significant extent upon our ability to price our products at levels that are cost-effective for these customers. As the markets for our products mature and competition increases, we anticipate that prices for our products will decline over time. If we are unable to reduce our costs sufficiently to offset declines in our product prices, or if we are unable to introduce new, higher performance products with higher product prices, our gross margins and revenues could decline. WE DEPEND ON A CREDIT FACILITY TO FUND OUR BUSINESS OPERATIONS Because we have not been profitable to date, we have had to fund our losses through a combination of equity and debt financings. In June 1999, we entered into a credit facility that provides for an aggregate maximum borrowing of $12.2 million. The interest rate on the credit facility is generally the prime rate plus 3.0%. Accordingly, while the credit facility provides us with needed working capital, the high cost of servicing any borrowing under it could negatively affect our liquidity. In addition, the credit facility may not be sufficient to meet our working capital requirements. In the event we must secure capital in addition to the line of credit, there can be no assurance that such capital will be available on acceptable terms or at all. Our inability to secure future financing, if necessary, would materially adversely affect our business, financial condition and results of operations. TO COMPETE EFFECTIVELY IN THE AUDIO TECHNOLOGY MARKET, WE NEED TO DEVELOP NEW AUDIO TECHNOLOGIES THAT ARE WIDELY ACCEPTED BY OUR CUSTOMERS Our success depends on our ability to develop and market new audio technologies aimed at advancing the level of audio quality in personal computers and consumer electronics devices. To be successful, we must timely develop new products that we can sell at competitive prices to our customers who will design them into their products. In order for our customers to design our advanced audio products into their personal computers and consumer electronic products, we must: o anticipate market trends; o anticipate the performance and functionality requirements of our current and potential customers; o develop and produce products that meet the timing and pricing requirements of our current and potential customers; and o produce products that can be available in a timely manner consistent with our current and potential customers' development and production schedules. We are expanding our business model to provide for an increased number of audio-related products, including audio cards and audio communications combination cards. We may require additional working capital funds for this expansion to provide for incremental inventory and broader marketing programs. A number of factors may limit the success of our expansion, and each could negatively impact our business and results of operations. These factors include: o the failure of the market for advanced audio products to grow; o reduced demand for our products as a result of increased competition in this market; unforeseen technological change; and o our potential failure to introduce new versions of products that our customers and the market accept. A failure to develop new audio technologies that will be accepted by our customers could materially adversely affect our ability to generate revenues. NEW GENERATIONS OF MICROPROCESSORS AND OTHER NEW TECHNOLOGIES MAY DECREASE DEMAND FOR OUR PRODUCTS We also face the risk that new generations of microprocessors that are capable of performing the function of advanced audio products will greatly reduce demand for our products. 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 diminishes or eliminates the need or preference for our products. In addition, each new generation of technology, including digital audio technology, generally requires 17 18 increased processing power. The increased capabilities of microprocessors in the future may lower demand for our products which will materially adversely affect our business, financial condition and results of operations. INTENSE COMPETITION IN THE MARKET FOR AUDIO PRODUCTS AND ADVANCED AUDIO TECHNOLOGIES COULD PREVENT AUREAL FROM INCREASING REVENUE AND PREVENT AUREAL FROM ACHIEVING PROFITABILITY The markets for audio products and advanced audio technologies are intensely competitive and are characterized by evolving industry standards that result in: o short product life cycles; o significant pressure to improve price and performance; and o frequent new product introductions. We expect competition to increase from existing competitors and from other companies that may enter the markets for advanced audio products with devices that may be less costly or provide higher performance or additional features than the products we currently offer. However, we are unable to predict the timing and nature of any such competitive product offerings. In addition, we anticipate that we 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. Furthermore, some of these competitors have greater intellectual property rights, broader product lines and longer-standing relationships with their customers than we do. In addition to our established competitors, we may also face competition from a number of emerging companies. To remain competitive, we believe we must, among other things, invest significant resources in developing new products and enhancing our current products and maintaining customer satisfaction. If we fail to do so, our products will not compete favorably with those of our competitors and our revenue could be materially adversely affected. WE MAY NOT HAVE AN ADEQUATE SUPPLY OF OUR PRODUCTS BECAUSE WE DEPEND ON FOUNDRIES AND FACTORIES TO PRODUCE OUR PRODUCTS AND OUR PRODUCTS ARE DIFFICULT TO MANUFACTURE We do not manufacture our own products, and we depend on outside manufacturing resources for production of all of our products. Currently, we utilize one foreign semiconductor foundry and one contract manufacturer for production of our board level products. These facilities have indicated to us that they have the manufacturing availability to provide for our planned levels of production of each of our products for the next 12 months; however, our production relationship with them is based only upon purchase orders. Consequently, they may not continue to adequately provide manufacturing capacity to us for our current level of production or any potential increases in our production levels. In the event that they cease to manufacture our products, we would have to contract with alternative facilities. However, we may not be able to timely contract with alternative facilities or to contract with them at all. Such a situation could materially adversely affect our ability to sell products to our customers, which in turn would hurt our 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 wafers, difficulties in the fabrication process and other factors can cause a substantial percentage of wafers to be rejected or a significant number of die on each wafer not to function. Many of these problems are difficult to diagnose and potentially time-consuming or expensive to remedy. The foundries that we employ may, in the future, experience irregularities or adverse yield fluctuations in the manufacturing processes of our products. In such event, our business, financial condition and results of operations may be materially adversely affected. OUR CHARTER DOCUMENTS AND DELAWARE LAW MAY INHIBIT A TAKEOVER OF AUREAL Provisions in our amended and restated certificate of incorporation and bylaws may have the effect of delaying or preventing a change of control or changes in our management. These provisions include, among others: o the division of the board of directors into three separate classes; o the right of the board to elect the director to fill a space created by the expansion of the board; o the ability of the board to alter our bylaws; and o the requirement that at least 10% of the outstanding shares are needed to call a special meeting of stockholders. 18 19 Furthermore, because we are incorporated in Delaware, we are subject to the provisions of section 203 of the Delaware General Corporation Law. These provisions prohibit certain large stockholders, in particular those owning 15% or more of the outstanding voting stock, from consummating a merger or combination with a corporation unless (1) 66 2/3% of the shares of voting stock not owned by this large stockholder approve the merger or combination or (2) the board of directors approves the merger or combination or the transaction which resulted in the large stockholder owning 15% or more of our outstanding voting stock. WE MAY NOT BE ABLE TO RETAIN OUR KEY ENGINEERING, MARKETING, SALES AND MANAGEMENT PERSONNEL THAT WE NEED TO SUCCESSFULLY MANAGE OUR BUSINESS Our success depends to a significant extent upon the continued services of key engineering, marketing, sales and management personnel. Our employees may voluntarily terminate their employment with us at any time. We recognize the value of the contributions of each of our employees, and we have developed compensation programs, including stock programs open to all employees, designed to retain our employees. However, competition for these employees is intense, particularly in Silicon Valley, and the loss of the services of any one of these employees could materially adversely affect our business, financial condition and results of operations. OUR PRODUCTS EMPLOY PROPRIETARY TECHNOLOGY AND THIS TECHNOLOGY MAY INFRINGE ON THE INTELLECTUAL PROPERTY RIGHTS OF THIRD PARTIES Our ability to compete successfully will depend, in part, on our ability to protect our proprietary technology. We rely on a combination of patents, trade secrets, copyright and trademark laws, nondisclosure agreements and other contractual provisions and technical measures to protect our proprietary rights. Nevertheless, such measures may not be adequate or safeguard the proprietary technology underlying our advanced audio products. In addition, employees, consultants and others who participate in the development of our products may breach their agreements with us regarding our intellectual property, and we may not have adequate remedies for any such breach. We also realize that our proprietary information and trade secrets may become known through other means not currently foreseen by us. Moreover, notwithstanding our efforts to protect our intellectual property, our competitors may be able to develop products that are equal or superior to our products without infringing on any of our intellectual property rights. In addition, we may not be able to effectively protect our intellectual property rights in certain countries. Our failure to protect our proprietary technology may materially adversely affect our financial condition and results of operations. Although we do not believe that our products infringe the proprietary rights of any third parties, third parties may still assert infringement or invalidity claims, or claims for indemnification resulting from infringement claims, against us. The assertion of these claims could materially adversely affect our business, financial condition and results of operations. In addition, irrespective of the validity or the successful assertion of any claims, we could incur significant costs in defending against these claims. In defending claims of alleged infringement, we could incur significant expenses and waste resources that could have a material adverse affect on our business, financial condition and results of operations. WE ARE INVOLVED IN LAWSUITS WITH CREATIVE AND E-MU WHICH COULD NEGATIVELY IMPACT OUR BUSINESS In February 1998, Creative Technology Ltd. and its subsidiary, E-Mu Systems, Inc., served us with a lawsuit for patent infringement that Creative and E-Mu filed in the U.S. District Court, Northern District of California. The lawsuit asserts that our original Vortex product 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 alleged continuing acts of infringement by us and an accounting of damages plus interest. In response, we filed a motion for summary judgment. In August 1998, E-Mu and Creative filed a motion for a preliminary injunction with respect to our original Vortex and updated Vortex2 products. In October 1998, the court denied Creative's motion for preliminary injunction. At that time, our motion for summary judgment was also denied. We believe that the actions that Creative and E-Mu filed are without merit, and we are vigorously defending against these actions. In December 1998, we filed a lawsuit alleging patent infringement against Creative and E-Mu. We believe that Creative and E-Mu have infringed on two of our patents, Patent No. 5,596,644 entitled "Method and Apparatus for Efficient Presentation of Hi-Quality 3-Dimensional Audio" and Patent No. 5,802,180 entitled "Method and Apparatus for Efficient Presentation of 3-Dimensional Audio Including Ambient Effects." 19 20 Additional litigation may be necessary to resolve the claims asserted by Creative and E-Mu and to resolve our claims against Creative and E-Mu and any other claims asserted in the future to defend against claims of infringement or invalidity or to enforce and protect our intellectual property rights. We cannot assure you that we will prevail in any litigation with either of them. Also, any litigation, whether or not determined in our favor or settled by us, would be costly and would divert the efforts and attention of our management and technical personnel from normal business operations; this could materially adversely affect our business, financial condition and results of operations. Adverse determinations in litigation could result in the loss of our proprietary rights, subject us to significant liabilities, require us to seek licenses from third parties or prevent us from producing certain core products. Any of these results could have a material adverse affect on our business, financial condition and results of operations. THE FAILURE OF OUR KEY SUPPLIERS AND CUSTOMERS TO BE YEAR 2000 COMPLIANT COULD NEGATIVELY IMPACT OUR BUSINESS We use a number of computer software programs and operating systems in our internal operations, including applications used in financial business systems and various administration 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 possible replacement of such source code or applications could be necessary. Given the current information, we currently do not anticipate that such year 2000 costs will have a material impact upon us. We have requested and obtained information regarding year 2000 compliance from suppliers and providers of all of our mission critical software systems. Based on the information we currently have, all mission critical systems appear to be year 2000 compliant. We are currently contacting major vendors and customers to obtain year 2000 compliance certificates. The failure of any of our key suppliers or customers to be year 2000 compliant could have a material adverse effect on our business, financial condition and results of operations. ITEM 3. QUALITATIVE AND QUANTITATIVE DISCLOSURE OF MARKET RISKS There has not been a material change in our exposure to interest rate and foreign currency risks since the date of the 1998 Form 10-K. Interest Rate Risk. Our expose to market risk for changes in interest rate relates primarily to our cash equivalents. We do not invest in derivative financial instruments. Our cash equivalent investments are in money market accounts with high-credit quality issuers. The table below presents principal amounts and related interest rates for our cash equivalent investments at July 4, 1999. Our cash equivalent investments are held in fully liquid money market accounts with no maturity dates. Foreign Currency Exchange Risk. We transact business with customers and suppliers located in foreign countries. All of these transactions are denominated in US dollars and therefore, we have no significant cash flows that are transacted in foreign currencies. The table below presents our cash equivalents and related interest rates at July 4, 1999:
Carrying Interest amount rate -------------- --------- (In thousands) Cash Equivalents $3,701 4.8%
20 21 PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS In February 1998, Creative Technology Ltd. and its subsidiary, E-Mu Systems, Inc., served us with a lawsuit for patent infringement that Creative and E-Mu filed in the U.S. District Court, Northern District of California. The lawsuit asserts that our original Vortex product 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 alleged continuing acts of infringement by us and an accounting of damages plus interest. In response, we filed a motion for summary judgment. In August 1998, E-Mu and Creative filed a motion for a preliminary injunction with respect to our original Vortex and updated Vortex2 products. In October 1998, the court denied Creative's motion for preliminary injunction. At that time, our motion for summary judgment was also denied. Creative appealed the denial of the preliminary injunction, and on May 6, 1999, the Federal Court of Appeals affirmed the District Court's ruling denying the preliminary injunction. A trial is currently scheduled for winter of 1999. We believe that the actions that Creative and E-Mu filed are without merit, and we are vigorously defending against these actions. In December 1998, we filed a lawsuit alleging patent infringement against Creative and E-Mu. We believe that Creative and E-Mu have infringed on two of our patents, Patent No. 5,596,644 entitled "Method and Apparatus for Efficient Presentation of Hi-Quality 3-Dimensional Audio" and Patent No. 5,802,180 entitled "Method and Apparatus for Efficient Presentation of 3-Dimensional Audio Including Ambient Effects." In October 1998, Creative Labs, the U.S. based subsidiary of Creative, filed a second lawsuit against us. This new lawsuit claims we have engaged in "false advertising" and "unfair business practices." These complaints center primarily on a comparison chart prepared by Aureal and published by third parties on the world-wide-web. We believe that this action is without merit and have commenced a vigorous defense of this action. We have filed a response denying these allegations and filed counterclaims against Creative Labs. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS The Annual Meeting of Stockholders was held on May 19, 1999 at which the stockholders voted on five proposals. Proposal number one was to re-elect Kenneth A. Kokinakis as a director for a three-year period. Proposal number two was to approve an amendment to our restated certificate of incorporation to change our name from Aureal Semiconductor Inc. to Aureal Inc. Proposal number three was to approve a one-for-fifteen reverse stock split. Proposal number four was to approve an amendment to increase by 3,333,333 the maximum number of shares that may be issued under the 1995 stock option plan and to increase the employee grant limit from 80,000 shares to 500,000. Proposal number five was to ratify the appointment of independent accountants. The results of the votes cast by our stockholders are shown in the table below:
Non-Votes and For Against Abstain Broker Non-Votes --- ------- ------- ---------------- Proposal 1 65,859,782 0 148,552 -- Proposal 2 64,815,287 1,169,630 23,417 -- Proposal 3 64,335,874 975,224 15,091 682,145 Proposal 4 52,247,709 3,549,173 52,289 10,159,163 Proposal 5 65,620,898 68,766 318,670 --
ITEM 5. OTHER INFORMATION On August 6, 1999, Thomas K. Smith, Jr. resigned from our board of directors concurrent with his separation from his employer Trust Company of the West, a wholly owned subsidiary of the TCW Group, Inc. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibit index at page 23. (b) Reports on Form 8-K: We filed no reports on Form 8-K during the second quarter ended July 4, 1999. 21 22 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 INC. Date: August 17, 1999 By: /s/Kenneth A. Kokinakis --------------------------- Kenneth A. Kokinakis President and Chief Executive Officer Date: August 17, 1999 By: /s/David J. Domeier --------------------------- David J. Domeier Senior Vice President of Finance Chief Financial Officer 22 23 EXHIBIT INDEX Exhibit No. Description of Document ----------- ----------------------- 2.1 Agreement and Plan of Reorganization among Aureal, Aureal Acquisition Corporation, a wholly-owned subsidiary of Aureal 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 Aureal dated May 8, 1996 (2) 3.2 Restated Bylaws of Aureal Semiconductor Inc. (5) 4.3 Common Stock Purchase Agreement by and among Aureal and certain entities and individuals dated August 6, 1997 (7) 4.4 Preferred Stock Regulation D Subscription Agreement (Series A Preferred Stock) (8) 4.5 Certificate of Designation of Series A Preferred Stock of Aureal Semiconductor Inc. (8) 4.6 Preferred Stock Registration Rights Agreement (Common stock underlying series A preferred stock)(8) 4.7 Aureal Semiconductor Inc. regulation D Subscription Agreement for Series C Preferred Stock (9) 4.8 Certificate of Designation of Series C Preferred Stock of Aureal Semiconductor Inc. (9) 4.9 Registration Rights Agreement ( Common Stock underlying Series C Preferred Stock) (9) 4.10 Loan and Security Agreement (Goldman and TBCC Credit Facility) (9) 4.11 Form of Warrant (Goldman and TBCC Warrants) (9) 4.12 8% Series B Convertible Preferred Stock Purchase Agreement (9) 4.13 Certificate of Designation of 8% Series B Convertible Preferred Stock for Aureal Semiconductor, Inc. (9) 4.14 Amendment Number 4 to Registration Rights Agreement (9) 4.20 Form of Registration Rights Agreement among Oaktree, TCW and Aureal Semiconductor, Inc. (11) 10.2 1995 Stock Option Plan (3) 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 (5) 10.8 1996 Outside Directors Stock Option Plan (6) 10.9 Manufacturing, Purchasing and Distribution Agreement between Diamond Multimedia Systems, Inc. and Aureal dated July 3, 1998 (10) 10.10 Industrial space sublease with Lam Research Corporation, dated June 7, 1999. 27.1 Financial Data Schedule (Edgar Only) - -------------------- (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 10-Q for the quarter ended September 29, 1996 (6) Incorporated by reference to the exhibits filed with Form 10-K for the year ended December 29, 1996. (7) 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. (8) Incorporated by reference to the exhibits filed with Form 8-K dated March 16, 1998 (9) Incorporated by reference to the exhibits filed with Form 8-K dated June 15, 1998. (10) Incorporated by reference to the exhibits filed with Form 10-Q for the quarter ended June 28,1998. (11) Incorporated by reference to exhibits filed with Form S-3 (Registration number 333-75631) filed April 2, 1999. 23 EX-10.10 2 INDUSTRIAL SPACE SUBLEASE, DATED JUNE 7, 1999 1 EXHIBIT 10.10 AUREAL-LAM SUBLEASE - PAGE 1 Rev #6 SUBLEASE This Sublease ("Sublease") is entered into between Lam Research Corporation, ("Lam"), a California corporation, and Aureal Semiconductor Inc. ("Aureal") effective on June 7, 1999. Whereas Lam has leased some 103,060 square feet of commercial space located at 45757 Northport Loop West, Fremont, CA (the "Premises") from WHC-Six Real Estate Limited Partnership and WHC-Six Real Estate Limited Partnership subsequently assigned the Lease to California Public Employees Retirement System ("Landlord") pursuant to a real property lease dated April 24, 1995 and a First Amendment to Standard Form Lease dated October 24, 1996 (which lease and Amendment shall collectively be referred to as the "Lease"); Whereas, Lam desires to sublease the Premises (as that term is defined in the Lease) to Aureal; Whereas Aureal is willing to sublease the Premises from Lam subject to the terms of the Lease, and pursuant to the terms and conditions set forth herein; and A depiction of the Premises is attached as Exhibit "A"; Based on the mutual promises contained herein and other good and valuable consideration, the parties agree as follows: 1. DEMISE. Subject to the approval of the Landlord and in consideration for the rents and all other charges and payments payable by Aureal, and for the agreements, terms and conditions to be performed by Aureal in this Sublease, Lam does hereby sublease to Aureal and Aureal does hereby hire and take from Lam, the Premises located at 45757 Northport Loop West, Fremont, CA upon the agreements, terms and conditions of this Sublease for the Term hereinafter stated. 2. USE. Aureal may use the space rented from Lam under this Sublease for general office, light industrial and warehouse uses and such other uses as are permitted under the Lease. 3. TERM. The term of this Sublease shall be for the period beginning on the date (the "Commencement Date") that is thirty (30) days after the satisfaction of the following conditions (the "Commencement Conditions"): (a) the execution of the Sublease by both parties; (b) the delivery of written notice to Aureal that the environmental closure of Lam's existing operations in the Premises have been completed; (c) Landlord's consent to the Sublease and (d) Lam's delivery of the Premises to Aureal. Subject to Aureal's right to extend the term and Lam's right of termination, the term shall expire on December 31, 2001. If the Commencement Conditions have not been satisfied 2 AUREAL-LAM SUBLEASE - PAGE 2 Rev #6 by July 1, 1999, then Aureal shall have the right to terminate this Sublease at any time prior to the satisfaction of the Commencement Conditions by providing Lam written notice of such election. Whether or not Aureal terminates the Sublease, Aureal shall not be entitled to damages or compensation of any kind due to Lam's inability or failure to fulfill the Commencement Conditions. 4. EARLY POSSESSION. Aureal may take possession of the Premises immediately following the satisfaction of the Commencement Conditions to prepare the building for occupancy. Aureal's obligation to comply with the terms and conditions of the Lease incorporated into this Sublease and this Sublease shall commence upon the start of Aureal's possession of the Premises excepting only that Aureal's obligation to pay rent shall not begin until the Commencement Date. Aureal shall pay those expenses described in paragraph 3.3 of the Lease, to the extent those expenses arise from Aureal's early possession of the Premises, but Aureal shall not otherwise pay Additional Rent during this period. 5. SECURITY DEPOSIT. Aureal shall deliver to Lam a security deposit in the amount of $100,000 within three business days of delivery of a fully executed copy of this Sublease. That deposit shall be held by Lam as security for Aureal's full and faithful performance of each and every term, covenant and condition of the Sublease, and Lam may retain the deposit, or any part thereof, to remedy the breach or failure to fulfill any such term, covenant or condition which (if a notice and cure period applies) Aureal has failed to cure within any applicable notice and cure period set forth in the Sublease. In the event that Lam does retain all or any portion of the deposit, such action shall be in addition to, and not in lieu of, any other rights or remedies that Lam may have under this Sublease and shall not be construed as an election of remedies. Lam shall not be required to keep the Security Deposit separate from its general funds and Aureal shall not be entitled to any interest on the deposit. If Lam so uses or applies all or any portion of the Security Deposit, Aureal shall within ten (10) days after written demand deposit with Lam in cash an amount sufficient to restore the Security Deposit to the full original amount. The Security Deposit or so much thereof as has not theretofore been applied or retained by Lam pursuant to this paragraph 5, shall be returned to Aureal within thirty (30) days after the later of the expiration of the term or the date which Aureal vacates the Premises. 6. RENT. Rent under this Sublease has two components: (1) Base Rent, as set forth below; and (2) Additional Rent, as described in the Lease and as modified or supplemented by the additional items described herein. The intent of the parties is for Aureal to pay all expenses imposed on Lam by virtue of the Lease (except for Lam's obligation for Base Rent under the Lease, the cost to Lam to maintain the property insurance required by the Lease, any obligations of Lam which relate to events that occurred prior to Aureal's occupancy (or, if sooner, the Commencement Date), and Lam's obligation to pay any brokerage commission that it has assumed the obligation to pay), plus those expenses incurred by Lam for mechanical maintenance and landscaping performed by Lam plus any amortized expenses as described in paragraph 13, below, as 3 AUREAL-LAM SUBLEASE - PAGE 3 Rev #6 Additional Rent under this Sublease, calculated (where applicable) in the manner described in the Lease. Rent shall be due and payable to Lam by Aureal on the same dates on which Rent is due under the Lease. At each anniversary of the Commencement Date, when the Landlord changes the Additional Rent payment due, and at such other mutually agreeable times, the parties shall conduct a reconciliation of the Additional Rent to provide that Aureal is paying (and has paid) to lam the sum of Additional Rent that Lam is paying (and has paid) to Landlord in addition to the other amounts described herein. Lam will provide a credit against the following month(s) Additional Rent for any excess payments revealed by the reconciliation. At a reasonable time following the conclusion of the Sublease, the parties will also do a reconciliation of Additional Rent payments and will render payment to the other any sums due based on that reconciliation. Aureal's obligation to pay rent under this Sublease shall abate only to the extent that Lam's obligation to pay rent to Landlord shall be abated under the terms of the Lease. 6.1 Base Rent. Monthly Base rent for the Premises is as follows: Commencement Date - December 31, 2001: $74,160 per month; and Provided that the term of the lease is extended as provided herein; January 1, 2002 - June 30, 2005: $108,150 per month. 6.2 First Month's Rent. Aureal shall pay the first month's Base Rent within three (3) business days of completion of the Commencement Conditions. Additional Rent for the first month will be due on the Commencement Date. 6.3 Prorated Rent. If the Commencement Date occurs in the middle of a month, Base Rent for the second month of the lease term will be charged at a prorated rate (calculated to reflect Aureal's occupancy during the prior month). 6.4 Payment of Property Taxes. Aureal shall pay all property taxes due and payable by Lam under the Lease for the term of the Sublease. Such amounts shall be prorated and paid for any period in which Aureal is obligated to pay Additional Rent. Lam shall give Aureal notice of the property taxes due as soon as reasonably possible (but, in any event, no later than sixty days before the next installment is delinquent) and Aureal shall pay the sum due in the next installment at least thirty days before such installment is delinquent. In the event that Lam does not know the actual amount of property taxes due at least sixty days before the delinquent date for the next installment, Lam will provide Aureal with a good faith estimate. Aureal will pay the estimate, and the parties will reconcile the difference promptly after the sum is determined. Provided that Aureal's payment is complete and timely, Aureal shall 4 AUREAL-LAM SUBLEASE - PAGE 4 Rev #6 nor be responsible for any late payment fees arising out of such property taxes. 7. PROVISIONAL RIGHT TO EXTEND. Prior to December 31, 2000, Aureal shall have the provisional option to extend the Sublease through June 30, 2005. Written notice of such election must be provided to Lam. and Lam shall have thirty days after receipt of such notice to provide written notice to Aureal whether or not such extension will be permitted by Lam. Lam may only refuse to permit such extension based on a good faith belief, held by Lam at the time the refusal is communicated to Aureal, that Lam intends to use or reoccupy the Premises. If Lam does not permit such extension, then Aureal shall owe no Base Rent to Lam for the final three months of its occupancy of the Premises (although the obligation to pay Additional Rent for that period as well as any other sums due under this Sublease shall continue). Provided that Lam does not provide such notice and provided that Lam has not previously provided Aureal with notice of termination, as described below, Aureal's tenancy shall be extended under the terms and conditions of this Sublease until June 30, 2005 with the following modification: Aureal's Base Rent shall increase as provided in section 6, above. Except for the rent credit described herein, Aureal shall have no claim for damages, costs or expenses should Lam decide not to permit Aureal to extend the term of this Sublease. 8. RIGHT TO TERMINATE SUBLEASE. After December 1, 2000, either Lam or Aureal has the right to terminate this Sublease by providing twelve (12) months written notice to the other party of such termination. Such right may only be exercised within ten days before the end of each calendar quarter: i.e. between March 21 and March 31; between June 20 and June 30; between September 20 and September 30 and between December 21 and December 31. If Lam elects to terminate the Sublease in this manner, it shall do so based on a good faith belief, held by Lam at the time the notice of termination is given, that it intends to use or reoccupy the Premises at the termination of the Sublease. If the Sublease terminates based on Lam's notice. Aureal shall be excused from the payment of Base Rent to Lam during the final three (3) months of its occupancy of the Premises (although it shall still be obligated to pay Additional Rent and any other sums due under this Sublease for the entire period, including the final three months). Except for the rent credit described herein, Aureal shall have no claim for damages, costs or expense should Lam decide to terminate this Sublease. Aureal's right to a rent credit provided under the provisions of this paragraph 8, shall not be cumulative with Aureal's right to a rent credit under the circumstances set forth in the preceding paragraph 7 (i.e. Aureal shall be entitled to only one rent credit if Lam decides to terminate this Sublease or to refuse to allow Aureal to extend the term). If, after Lam has given notice of termination, circumstances change such that Lam does not intend to use or occupy the Premises at the anticipated conclusion of the term of this Sublease, Lam will provide written notice to Aureal of such change of condition. Within fifteen (15) business days after delivery of such written notice, Aureal may provide written notice to Lam that it will continue its occupancy of the Premises under the terms of this Sublease (and at the Rent continue its occupancy of the Premises under the terms of this Sublease (and at the Rent obligations then prevailing). Aureal's occupancy shall thereafter continue, under the terms of this Sublease (including, without limitation, Lam's right to terminate the 5 AUREAL-LAM SUBLEASE - PAGE 5 Rev #6 Sublease as provided herein) except that Aureal shall not receive the three month rent credit described above. However, should Lam subsequently provide notice of its intent to terminate pursuant to this provision, Aureal shall again be entitled to the rent credit mentioned above. 9. RESTORATION. As its sole expense, at the conclusion of the Sublease, Aureal shall clean and restore the Premises to the condition that they existed at the time that Aureal took possession thereof except for the following items: (1) normal wear and tear, (2) any maintenance required by Lam or Landlord (without prejudice to Lam or Landlord's rights to collect the costs of such maintenance from Aureal as Additional Rent or otherwise), (3) damage and destruction covered by Landlord under Article XII of the Lease, (4) any condemnation covered by Article XIII of the Lease and (5) contamination of hazardous materials, except to the extent that the tenant must restore the premises from hazardous materials contamination under the Lease. 10. CONDITION. Lam shall deliver to Aureal the Premises, including, but not limited to, the HVAC, roof and roof membrane, parking lot, plumbing and electrical, in good working condition. In addition, Lam shall make the following improvements to the Premises before July 1, 1999: (1) shampoo the carpets; (2) patch walls and paint as needed; (3) remove the existing furniture and communications equipment (cabling and patch panel board excepted); and (4) deliver the Premises in "broom clean" condition. Except as so provided, Lam will make no tenant improvements to the Premises nor provide Aureal with any allowance for Tenant Improvements. Aureal has the obligation under this Sublease to do a physical inspection of the Premises, and to engage whatever expert assistance it may require, to satisfy itself as to the condition of the Premises. 11. PARKING AND COMMON AREA ACCESS. Subject to the terms and conditions of the Lease, Aureal shall have the right to use the parking lot and other common areas on the real property on which the Premises are situated. 12. SIGNAGE. Signage shall be permitted, with the Landlord's approval and subject to any governmental rule or regulation, as permitted in the Lease. 13. ADA; Other Laws and Regulations. To Lam's actual knowledge, it has not received any notices that the Premises are in violation of the Americans with Disabilities Act ("ADA"). Aureal acknowledges that it has been informed that it may be required to construct improvements on the Premises or invest substantial sums in the Premises to comply with governmental laws, rules or regulations (including the ADA) arising out of Aureal's alterations to the Premises or particular use of the Premises. Aureal has conducted its own independent investigation concerning its obligations under the ADA, as well as other governmental acts, rules and regulations, and is satisfied with that investigation. Aureal agrees to indemnify and hold harmless Lam and Landlord from any claim, cost or obligation arising from Aureal's violation or non-compliance with any governmental law, rule or regulation (including the ADA) arising out of Aureal's alterations to the premises or particular use of the Premises. If there is a change in the 6 AUREAL-LAM SUBLEASE - PAGE 6 Rev #6 law after the Commencement Conditions are fulfilled which requires Aureal to invest substantial sums on the improvement of the Premises then, to the extent those sums are not paid by the Landlord under the Lease. Lam shall make or have made those alterations at its own expense and will amortize those expenses in Aureal's Additional Rent costs over an appropriate period, as provided in paragraph 16 of this Sublease. 14. LEASE OBLIGATIONS. (A) Except as expressly set forth below in Paragraphs 14(B) or 14(C) or contrary to the terms of this Sublease, the Lease is incorporated herein in its entirety by this reference. For the purpose of this Sublease, all references in the Lease to "Landlord" shall be deemed to mean Lam and all references to "Tenant" shall be deemed to mean Aureal, all references to "Premises" shall be deemed to mean Premises and all references to "Lease" shall mean this Sublease. (B) The following provisions of the Lease are specifically excluded from incorporation into this Sublease: Article I, paragraphs 1, 3, 4, 5, 7, 8, 9, 10, 12, 13 and 14, Sections 3.2, 3.4, 3.6, 4.2, 4.4, 11.11, 15.8, 15.9, 21.1 and 21.8, paragraph 3 of the Amendment to the Lease and all provisions of the Addendum to the Lease except for paragraphs 8 and 9. The following provisions of the Lease are modified in that all references in these paragraphs to "Landlord" shall be deemed to mean the California Public Employees Retirement System ("CALPERS" i.e. Landlord under the Sublease): Sections 8.1, 9.1, Article X, XII, XIII, XVI, XVII, and paragraph 8 of the Addendum. To the extent any of the provisions of the Lease incorporated herein are inconsistent with this Sublease, the terms of the Sublease shall prevail. Except as excluded from the Sublease, the following provisions of the Lease are modified in that all references in these paragraphs to "Landlord" shall be deemed to mean (i) either Lam or CALPERS (when the provision refers to the Landlord's representations or ability to exercise a power or right) or (ii) both (when the provision refers to the Tenant's representations, duty or obligation): Sections 5.3, 5.4, 6.2, 6.3, 6.4, 6.6, 6.7, 7.6, 7.7, 8.3, 9.4, Articles XI, XIV, and XXL. Article XV of the Lease is modified by changing the notice and cure periods, as set forth in this Sublease, but otherwise incorporated herein. (C) Notwithstanding the foregoing incorporation of the terms and conditions of the Lease, Lam shall not be responsible for the performance of any obligations to be performed by the Landlord under the Lease and Aureal agrees to look solely to the Landlord for the performance of such obligations. At Aureal's written request, Lam covenants to use good faith and all reasonable efforts to enforce against Landlord all provisions of the Lease benefiting Aureal. Aureal shall reimburse Lam for all reasonable costs incurred by Lam in enforcing such covenants against Landlord, except to the extent Landlord is required to reimburse Lam or directly pay for such reasonable costs pursuant to the Lease. (D) Aureal agrees to indemnify and hold harmless Lam from and against any and all claims, liabilities, losses, damages and expenses (including reasonable attorneys' fees) incurred by Lam arising out of, from or in connection with (i) the use or occupancy of the Premises by Aureal, (ii) any breach or default by Aureal under this Sublease, or (iii) the failure of Aureal to perform any obligation under the terms and provisions of the Lease assumed by Aureal hereunder or required to be performed by Aureal as provided herein. 7 AUREAL-LAM SUBLEASE - PAGE 7 Rev #6 (E) Lam hereby agrees to indemnify and hold harmless Aureal from and against any and all claims, liabilities, losses, damages and expenses (including reasonable attorneys' fees) incurred by Aureal arising out of, from or in connection with (i) Lam's breach or default of any provision of this Sublease or any provisions of the Lease not assumed by Aureal hereunder, (ii) acts or omissions of Lam under the Lease in connection with the Premises prior to the Commencement Date of this Sublease, or (iii) any contamination of the Premiss with hazardous materials caused by Lam. 15. DEFAULT. Section 15.1 of the Lease is incorporated herein with the following modifications: the notice to cure period is shortened from seven (7) days to five (5) days in section 15.1(a) and the notice to cure period is shortened from thirty (30) days to twenty (20) days in section 15.1(h). If Lam assumes possession of the Premises, it shall be entitled, but not obligated, to seek another subtenant for the Premises. 15.1 HOLDING OVER. If Aureal remains in possession of all or any part of the Premises after the expiration of the Term of this Sublease (or any approved extension thereof) without the prior written consent of Lam, Lam shall have the right to seek immediate eviction of Aureal, in addition to any other remedies at law or equity. In addition, Aureal shall be obligated to pay Lam double Base Rent during any holdover period, in addition to Additional Rent, attorneys' fees, expert fees and costs of litigation. Any such holding over shall still be subject to every other term, condition and covenant of this Sublease. 16. MAINTENANCE. As a modification to Aureal's maintenance obligations under the Sublease, Lam shall provide routine landscaping (not including any parking lot maintenance) and maintenance and repairs to the roof and HVAC systems of the Premises, and Aureal shall pay Lam for the cost of such maintenance and repairs (where such costs shall include, but not be limited to, a reasonable amount for Lam's labor in performing such maintenance and repairs, in addition to any equipment, parts or tooling charges) through Additional Rent. Lam shall indemnify Aureal to the extent Lam's failure to fulfill its obligations under this paragraph result in costs or expenses being imposed on Aureal that would not be imposed if Lam had fulfilled those obligations in a reasonable manner. Except as provided herein, Aureal shall assume and fulfill all other maintenance or repair obligations on the Premises, to the same extent required by Lam under the Lease. Aureal shall also be responsible for the cost of all standard operating expenses, such as utilities, janitorial costs and interior maintenance. Without prejudice to Lam's rights under the Lease vis-a-vis Landlord, Lam, not Aureal, shall bear the costs of any major repair or replacement of items to be maintained by Lam or Aureal under the Lease if such costs are incurred during the first year following the Commencement Date and those costs do not arise from the repair of anything damaged by the acts or negligence of Aureal or its agents or invitees. After the first year following the Commencement Date, any costs for replacement of items that, by standard accounting practice, should be capitalized shall be amortized over the reasonable useful life of the item according to Generally Accepted Accounting Principles and amortization of such capitalized costs will be added to Aureal's Additional Rent. 8 AUREAL-LAM SUBLEASE - PAGE 8 Rev #6 17. TENANT IMPROVEMENTS. There is no allowance for Tenant Improvements under this Sublease and to the extent that the Lease provides such an allowance, such allowance may be used only for Lam for its own benefit. Aureal may, at its own expense, make tenant improvements provided that, before Aureal makes any tenant improvements or changes to the Premises, Aureal shall first obtain Lam and Landlord's written approval of such changes. Aureal may use the contractor of its choice for such tenant improvements, and Lam's consent to those improvements shall not be unreasonably withheld. All such improvements or changes shall comply with all laws, regulations and building codes applicable thereto. 18. INSURANCE. Aureal shall maintain insurance on the Premises as required by paragraph 5 of the Amendment to the Lease except that Aureal shall not be required to carry flood (as distinguished from water damage) or earthquake insurance on the Premises. Aureal shall pay for this insurance itself but shall not be obligated to pay the costs of Lam's property insurance on the Premises through Additional Rent or otherwise. Lam's insurers shall retain full subrogation rights against Aureal. 19. FINANCIAL STATEMENTS. Within thirty (30) days after Lam's request, Aureal shall deliver to Lam Aureal's then current public financial statements. Such statements shall be audited by a certified public accountant and shall include a balance sheet and statement of profit and loss for the most current calendar year, all prepared in accordance with generally accepted accounting principles, consistently applied. 20. ADDITIONAL MEASURES. At no cost to Lam, Aureal shall take such reasonable, additional actions as are necessary for Lam to comply with all applicable laws, rules and regulations relating to the Premises and to permit Lam's compliance with the Lease. Aureal shall conduct itself in a way so as to avoid imposing obligations upon Lam which are not created by the terms of this Sublease. 21. ENTIRE AGREEMENT. This Sublease in conjunction with the attachments and the provisions of the Lease incorporated herein constitute an integrated agreement and supersede all prior written or oral negotiations and agreements between the parties relating to this Sublease. 22. REPRESENTATIONS AND WARRANTIES. Lam and Aureal each make the following representations and warranties, each of which is material to the execution of this Sublease: (1) It is a corporation, duly organized, validly existing and in good standing under the laws of its state of incorporation. (2) The person executing the Sublease on its behalf has full power and authority to execute and deliver this Sublease. (3) This Sublease, once executed, is a legal, valid and binding obligation on it. 9 AUREAL-LAM SUBLEASE - PAGE 9 Rev #6 (4) That it is aware of any event, cause or condition which would constitute a breach any term or condition of the Lease by the execution of this Sublease. 23. CONSTRUCTION OF AGREEMENT. This agreement is governed by California law. The parties agree that this Sublease represents an agreement that has been mutually negotiated and agreed to by the parties, each possessing equal bargaining power, so that there will be no presumption in favor of either party in construing any ambiguities in the agreement. Should any provision of this agreement be held illegal or unenforceable, the remaining terms of this agreement shall not be affected thereby and the illegal or unenforceable provision shall be replaced by a mutually agreeable provision which reflects the intent of the parties. This agreement may not be modified or altered except by an agreement in writing signed by an authorized representative of both parties. 24. ASSIGNMENT AND SUBLETTING. Aureal may only assign this Agreement or sublease the premises with the written consent of Lam (which shall not be unreasonably withheld) and the Landlord. 25. CONSENT REQUIREMENT. This Sublease is conditional upon receipt of Landlord's consent. If such consent is not obtained, all prepaid deposits will be returned and neither party will have any remedy against the other for breach or other cause arising out of this Sublease. 26. EXERCISE OF LAM'S RIGHT TO TERMINATE THE LEASE. Should Lam be entitled to terminate the Lease, pursuant to the existing terms of the Lease, Lam shall be permitted under this Sublease to exercise its termination rights without remedy to Aureal except that Aureal's obligations under this Sublease will terminate to the extent that Lam's obligations under the Lease do so; however, Lam will take reasonable steps to minimize the impact of that decision on Aureal. 27. BROKER. Lam and Aureal each warrant and represent to the other that neither has had any dealings with any real estate broker, agent or finder in connection with the negotiation of this Sublease or the introduction of the parties to this transaction, except for the parties respective brokers: Jay Phillips of CB Richard Ellis for Aureal and Tom McGovern of CRESA for Lam. The commission for the brokers shall be paid by Lam pursuant to the terms of a separate written agreement between Lam and its broker. Each party further represents and warrants that it knows of no other real estate broker, agent or finder who is or might be entitled to a commission or a fee in connection which this Sublease. In the event of any additional claim for brokers' or finders' fees with respect to this Lease, Aureal shall indemnify, hold harmless, protect and defend Lam from and against such claims if they shall be based upon any statement or representation or agreement made by Aureal and Lam shall indemnify, hold harmless, protect and defend Aureal from and against such claims if they shall be based on any statement, representation or agreement made by Lam. 10 AUREAL-LAM SUBLEASE-PAGE 10 REV #6 Wherefore, the parties affix their signatures to this Sublease as evidence of their agreement to its terms and conditions. Lam Research Corporation Aureal Semiconductor Inc. by /s/ JOHN MILLER by /s/ DAVE DOMEIER -------------------------------- ------------------------------------- its DIRECTOR OF FACILITIES its SR. V.P. FINANCE ------------------------------- ------------------------------------ EX-27.1 3 FINANCIAL DATA SCHEDULE
5 THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS FOR THE PERIOD ENDED JULY 4, 1999 AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS. 1,000 YEAR JAN-02-2000 JAN-04-1999 JUL-04-1999 4,238 0 5,026 251 6,644 16,211 6,016 (3,601) 18,787 10,897 0 0 0 10 0 0 20,641 20,641 13,334 13,334 15,788 0 1,132 (10,962) 0 (10,962) 0 0 0 (10,962) (2.27) (2.27)
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