-----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, N2aPMLUqefMRi2Th1lhD/is+yPdFYrfRuFP1AJ2IVEnyhjnBDxl6ZwOFDhIFD2/n w3Hrojq0LQEcItYGHUwwLQ== 0000891618-99-005292.txt : 19991118 0000891618-99-005292.hdr.sgml : 19991118 ACCESSION NUMBER: 0000891618-99-005292 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 3 CONFORMED PERIOD OF REPORT: 19991003 FILED AS OF DATE: 19991117 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: 99759299 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 PERIOD ENDED OCTOBER 3, 1999 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 OCTOBER 3, 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) 45757 NORTHPORT LOOP WEST 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 November 1, 1999, 9,965,943 shares of common stock, $0.001 par value, of the registrant were outstanding. This report on Form 10-Q contains 21 pages. The exhibit index is on page 21. 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........................................9 Item 3. Qualitative and Quantitative Disclosure of Market Risks.........18 PART II. OTHER INFORMATION Item 1. Legal Proceedings...............................................19 Item 5. Other Information...............................................19 Item 6. Exhibits and Reports on Form 8-K................................19
2 3 PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS AUREAL INC CONDENSED CONSOLIDATED BALANCE SHEETS (DOLLARS IN THOUSANDS)
October 3, 1999 Jan. 3, 1999 --------------- ------------ (Unaudited) ASSETS: Current assets: Cash and cash equivalents $ 263 $ 87 Restricted cash -- 6 Accounts receivable 8,890 4,781 Inventories 3,239 3,916 Deferred fair value of debt related warrants -- 924 Prepaid loan fees and other current assets 791 757 --------- --------- Total current assets 13,183 10,471 Property and equipment: Machinery and equipment 6,346 4,636 Furniture, fixtures and improvements 888 639 --------- --------- 7,234 5,275 Accumulated depreciation and amortization (3,978) (2,795) --------- --------- Net property and equipment 3,256 2,480 Other long-term assets 161 687 --------- --------- Total assets $ 16,600 $ 13,638 ========= ========= LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT): Current liabilities: Line of credit $ 4,149 $ 4,329 Accounts payable 6,793 5,966 Accrued compensation and benefits 2,280 1,765 Other accrued liabilities 978 1,061 Current portion of pre-petition claims 982 936 --------- --------- Total current liabilities 15,182 14,057 Long-term portion of pre-petition claims and deferred obligations 262 889 --------- --------- Total liabilities 15,444 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 394 51,421 Common stock, $0.001 par value: Authorized shares - 200,000,000; Issued and outstanding Shares - 9,965,943 and 3,178,422, respectively 10 48 Additional paid-in capital 192,221 119,790 Accumulated deficit (191,469) (172,567) --------- --------- Total stockholders' equity (deficit) 1,156 (1,308) --------- --------- Total liabilities and stockholders' equity (deficit) $ 16,600 $ 13,638 ========= =========
The accompanying notes are an integral part of these financial statements. 3 4 AUREAL INC. CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
Quarter Ended Nine Months Ended ---------------------------- ---------------------------- October 3, September 27, October 3, September 27, 1999 1998 1999 1998 (Unaudited) (Unaudited) Net sales $ 11,153 $ 7,535 $ 31,794 $ 14,553 Cost of sales 7,120 5,390 20,454 10,216 -------- -------- -------- -------- Gross margin 4,033 2,145 11,340 4,337 Operating expenses: Research and development 5,312 3,014 12,311 8,548 Sales and marketing 2,723 1,511 7,725 4,495 General and administrative 2,214 1,192 6,001 2,868 -------- -------- -------- -------- Total operating expenses 10,249 5,717 26,037 15,911 -------- -------- -------- -------- Operating loss (6,216) (3,572) (14,697) (11,574) Amortization of debt related warrants -- (231) (1,309) (1,558) Interest expense (227) (300) (1,358) (2,294) Other income (expense), net (6) 5 (47) 396 -------- -------- -------- -------- Loss from operations before income taxes (6,449) (4,098) (17,411) (15,030) Provision for income taxes -- -- -- -- -------- -------- -------- -------- Net loss $ (6,449) $ (4,098) $(17,411) $(15,030) ======== ======== ======== ======== Accretion/dividends related to preferred stock $ (7) $ (1,891) $ (1,491) $(14,012) ======== ======== ======== ======== Net loss attributable to common stockholders $ (6,456) $ (5,989) $(18,902) $(29,042) ======== ======== ======== ======== Net loss per share: basic and diluted $ (0.65) $ (2.10) $ (2.71) $ (10.31) -------- -------- -------- -------- Weighted average common shares outstanding 9,964 2,846 6,980 2,818 ======== ======== ======== ========
The accompanying notes are an integral part of these financial statements. 4 5 AUREAL INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS)
Nine Months Ended --------------------------- October 3, September 27, 1999 1998 (Unaudited) OPERATING ACTIVITIES Net loss $(17,411) $(15,030) Adjustments to reconcile net loss to net cash used in operating activities: Depreciation and amortization 3,858 2,709 Changes in operating assets and liabilities: Restricted cash 6 102 Accounts receivable (4,340) (5,610) Inventories 908 (3,741) Prepaid expenses and other current assets (1,446) (613) Other assets 242 (465) Accounts payable 708 1,995 Accrued compensation and benefits, and other accrued liabilities 432 (342) -------- -------- Net cash used in operating activities (17,043) (20,995) -------- -------- INVESTING ACTIVITIES Acquisition of property and equipment (1,969) (1,676) -------- -------- Net cash used in investing activities (1,969) (1,676) -------- -------- FINANCING ACTIVITIES Proceeds from Line of Credit 39,157 28,465 Repayment on Line of Credit (39,382) (15,546) Principal payments on pre-petition claims (581) (911) Proceeds from issuance of stock, net of issuance costs 19,994 10,818 -------- -------- Net cash provided by financing activities 19,188 22,826 -------- -------- Net increase/(decrease) in cash and cash equivalents 176 155 Cash and cash equivalents at beginning of period 87 135 -------- -------- Cash and cash equivalents at end of period $ 263 $ 290 ======== ======== SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION Interest paid $ 801 $ 2,739 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 $ 1,491 $ 14,012 Valuation of debt-related warrants issued -- $ 1,848
The accompanying notes are an integral part of these financial statements. 5 6 AUREAL INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) 1. THE COMPANY Aureal Inc., together with our subsidiaries Crystal River Engineering, Inc. and Aureal Limited, is a producer of digital audio semiconductor and board-level products and advanced digital audio technologies primarily for the personal computer market. 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. We established Aureal Limited, located in Hong Kong, 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. 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 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 periods. 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 October 3, 1999 are not necessarily indicative of the results that may be expected for the 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. 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 October 3, 1999 and January 3, 1999 consisted of the following, in thousands:
October 3, 1999 January 3, 1999 --------------- --------------- Work-In-Process ........ $1,275 $2,460 Finished Goods ......... 1,964 1,456 ------ ------ Total Inventories... $3,239 $3,916 ====== ======
6 7 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 nine months of both 1999 and 1998, we had no significant 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 at rates that 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 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 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 stock and the series C preferred stock, and the dividend / accretion rate of 8% on the series A, series B and series C preferred stock totaled $1.5 million during the first three 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. 7 8 3. CREDIT FACILITY Effective September 30, 1999, our existing line of credit was amended to (1) increase the total availability to $25.0 million, (2) add PNC Bank, National Association as an additional lender with Transamerica Business Credit Corporation, and (3) reduce the interest rate on borrowings to prime plus 2%. In addition, the amended line of credit provides for the issuance of standby letters of credit up to a limit of $1.5 million. As part of this line expansion, an affiliate of Oaktree Capital Management, LLC provided to the lenders a guarantee, on behalf of Aureal, for up to $5.0 million of availability, which is not subject to specific asset-based requirements. The lenders under the credit facility hold a lien against substantially all of Aureal's assets. We are subject to certain covenant restrictions under this facility. This agreement is scheduled to terminate on July 2, 2001. 4. EQUITY FUNDING During the second quarter of this year, we effected 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 effected the one-for-fifteen reverse stock split on June 10, 1999, at which point, we had 9,960,577 shares outstanding. 5. INCOME TAXES We were not required to provide for income taxes in the first three 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. 6. INDUSTRY SEGMENTS AND MAJOR CUSTOMERS We operate in a single segment, which includes three product revenue groups. During the third quarter of 1999, we generated $3.2 million in revenues from the sale of semiconductor chips, $7.7 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 semiconductor chips were $5.7 million, with $1.7 million from board-level products and $0.1 million from licensing agreements and miscellaneous audio revenues. 8 9 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 INDUSTRY 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 Limited, is a producer of digital audio semiconductor and board-level products and advanced digital audio technologies for the personal computer market. 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 market. To date in 1999, a number of significant events occurred for us: - - During September 1999, we announced and began shipping two new audio boards, the Vortex SQ1500 and the Vortex2 SQ2500, for the retail market. We are distributing these boards initially through a number of national electronics retailers as well as our e-commerce website. - - In August 1999, we moved our Fremont operations into a larger building, which we have leased for a minimum of two and one-half years. We have options to extend the lease, if the sub-lessor agrees, at the time of the extension. - - 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. - - 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. - - Also in May 1999, we announced the introduction of the Vortex Advantage soundcard - a new, low-cost audio sub-system for systems integrators. - - 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. - - 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. - - In 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. - - 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. - - In February 1999, we received Computer Gaming World's prestigious Gaming Hardware of the Year award for our Vortex2 audio processor. This was the first time that the award was presented to an audio hardware company. Also in February, we began web-based distribution of our A3D Pro sound design software - - 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. 9 10 We are headquartered in Fremont, California and have offices in Austin, Texas and Hong Kong. As of November 1, 1999, we employed 128 people. Of this total, 78 were engaged in engineering functions, 34 were in sales and marketing activities, and 16 were engaged in administrative support. In addition, we utilize the services of contractor consultants to supplement our employee workforce. Aureal, A3D, Vortex SQ1500, and Vortex2 2500 are trademarks, and Vortex is a registered trademark of Aureal Inc. Other names referred to in this document may be trademarks of their respective owners. RESULTS OF OPERATIONS Third quarter and nine months of 1999 compared to the third quarter and nine months of 1998 Net sales Net sales for the third quarter of 1999 of $11.2 million increased 48% over the $7.5 million generated in the same quarter of 1998. The sales increase reflected increased volumes of products shipped to many of our OEM and system integrator customers, as well as initial shipments of our Vortex SQ1500 and Vortex2 SQ2500 audio boards to the retail market. Year-to-date revenues for 1999 of $31.8 million more than doubled the $14.6 million 1998 amount. The most significant area of growth from 1998 to 1999 has been the emergence of Aureal's board-level products. Board-level products accounted for 69% of our revenues in the third quarter and 61% year-to-date, as compared to 22% for the same quarter and 11% year-to-date in 1998. Audio boards, including an Aureal audio semiconductor chip, generally have a higher average selling price than a direct chip sale. All of our system integrator and retail revenues consist of board-level sales, and our OEM revenues consist of both chip and board-level sales. In addition, sales of audio chips to manufacturers of PC "motherboards" are an increasing portion of our quarterly sales. Licensing revenue in all periods discussed was not significant. Gross margin Gross margin for both the third quarter and year-to-date in 1999 was 36%. The gross margin on the sale of our products for any period is affected by both the margins on the individual products and the mix of products sold during the period. In addition, the market into which a product is sold, OEM, system integrator or retail, can have an impact on the gross margin recognized on any specific product. Gross margins for the third quarter and year-to-date in 1998 were 28% and 30%, respectively. Gross margins were adversely affected in 1998 due to costs incurred in the "start-up" phase of the AU8830 chip. We have experienced some reductions in the cost of the chips and surrounding processing as a result of the manufacturing maturity and increasing volumes of parts being manufactured during 1999. Research and development Expenditures for research and development continue to be significant as resources are allocated to create future audio products and technologies. Spending in this area yields both short-term and long-term product developments as we continue to bring new and improved products to the market. Research and development expenses increased from $3.0 million in the third quarter of 1998 to $5.3 million in the third quarter of 1999. During the third quarter of 1999, we incurred significant expenditures for chip and audio technology development. In addition, we invested in the development of new audio loudspeaker and internet audio technologies. The Aureal Vortex Player, a software package designed to provide full internet audio capabilities over time, began shipping with our Aureal Vortex boards late in the third quarter of 1999. Year-to-date research and development expenditures increased 44% from $8.5 million for the first nine months of 1998 to $12.3 million for the first nine months of 1999. Certain development efforts ended late in the third quarter and early fourth quarter of 1999. As a result, some reductions in force, both employees and outside contractors and consultants, are being made during the fourth quarter to reduce costs on certain programs going forward. We expect research and development to continue to be a significant area of investment for us as we develop new audio technologies and products. 10 11 Sales and marketing During the third quarter of 1999, we continued our direct sales efforts to expand our presence in the system integrator channel. In addition, toward the end of the quarter we incurred expenses related to the introduction of our new Vortex SQ1500 and Vortex2 SQ2500 audio boards in the retail market. This effort included development of Aureal's own retail e-commerce website as well as advertising and promotional expenditures that focused on Aureal's entry into the retail audio board market. While year-to-date sales and marketing expenses increased in absolute dollar terms from $4.5 million in 1998 to $7.7 million in 1999, these costs decreased as a percentage of net sales from 31% in 1998 to 24% in 1999. As we expand our distribution model and revenues increase, 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 third quarter of 1999 increased to $2.2 million from $1.2 million in 1998. The most significant individual component of this increase was legal fees, as we prepared for the scheduled November trial against Creative Technology Ltd. relative to alleged patent infringement. For the first nine months of 1999, general and administrative expenses increased to $6.0 million compared to $2.9 million for the same period of 1998, again primarily as a result of increased legal costs. Interest expense Interest expense for the third quarter of 1999 decreased to $0.2 million from $0.3 million in the same period in 1998. Relatively low interest costs in the third quarters of both years resulted from infusions of equity capital in the second quarters of both years, and our subsequent paydowns of debt in June of each year. On a year-to-date basis, interest expense declined from $2.3 million in 1998 to $1.4 million in 1999, primarily due to the reduced debt balances as a result of the equity capital infusions in both 1998 and 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 (pre-reverse split) 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 original two-year term of the credit facility. These warrants were issued in consideration for 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 (pre-reverse split) 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 nine months 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. 11 12 LIQUIDITY AND CAPITAL RESOURCES As of October 3, 1999, we had a working capital deficit of $2.0 million, classifying all outstanding balances under our line of credit as current liabilities, and stockholders' equity of $1.2 million. We used $17.0 million of cash to support operations during the first nine months of 1999 as compared to $21.0 million for the same period in 1998. While operating losses were greater in 1999, investments in inventories, accounts receivable and other current assets were reduced from the requirements for 1998. Financing for our 1999 year-to-date cash outlays was provided by a combination of our line of credit and cash received from our June 1999 rights offering. We expect that in the next twelve months we will need additional cash to fund and 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 are working to increase revenues and control costs to provide for positive cash flow operations in the future, however, we can make no assurances that we will achieve such positive cash flow from operations within the near future. We anticipate that our available line of credit will continue to provide sufficient funding for the foreseeable future. On June 10, 1999, we completed 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 was converted to common stock. In connection with our second quarter 1999 capital restructuring, the outstanding balance under our line of credit was re-paid and new terms were agreed upon with Transamerica Business Credit Corporation. Effective September 30, 1999 our line of credit was amended to (1) increase the total availability to $25.0 million, (2) add PNC Bank, National Association as an additional lender with Transamerica Business Credit Corporation, and (3) reduce the interest rate on borrowings to prime plus 2%. In addition, the amended line of credit provides for the issuance of standby letters of credit up to a limit of $1.5 million. As part of this line expansion, an affiliate of Oaktree Capital Management, LLC provided to the lenders a guarantee, on behalf of Aureal, for up to $5.0 million of availability, which is not subject to specific asset-based requirements. We are subject to certain covenant restrictions under this facility. This agreement is scheduled to terminate on July 2, 2001. At October 3, 1999, we had a $4.1 million outstanding balance under our line of credit. Our unused borrowing availability under the line was $4.9 million. 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. 12 13 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. In addition to computers and software packages, some office equipment such as fax machines, telephone switches, security systems and other common devices may be affected by the year 2000 problem. Of these pieces of equipment, we identified our voice mail system as having year 2000 issues, and upgraded it in October 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. 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. 13 14 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 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 $191 million as of October 3, 1999. This deficit is comprised of $174 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 three quarters of 1999 were derived 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 October 3, 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. Accordingly, Mr. Masson can be considered 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. 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 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 ADVANCED AUDIO 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 advanced audio 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 advanced audio 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. 14 15 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. Our current line of credit provides for an aggregate maximum borrowing of $25.0 million. The interest rate on the credit facility is generally the prime rate plus 2.0%. 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, we cannot guarantee that 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. 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, we must: - anticipate market trends; - anticipate the performance and functionality requirements of our current and potential customers; - develop and produce products that meet the timing and pricing requirements of our current and potential customers; and - produce products that can be available in a timely manner consistent with our current and potential customers' development and production schedules. We have expanded our business model to provide for an increased number of audio-related products, including audio cards and audio communications combination cards. We anticipate continuing to increase the number of products within our line to include additional audio cards as well as speaker products in the future. 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: - the failure of the market for advanced audio products to grow; - reduced demand for our products as a result of increased competition in this market; - unforeseen technological change; and - 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 New generations of microprocessors that are capable of performing advanced audio functions may greatly reduce demand for our advanced audio 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 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 ADVANCE AUDIO PRODUCTS AND TECHNOLOGIES COULD PREVENT US FROM INCREASING REVENUE AND ACHIEVING PROFITABILITY The markets for advanced audio products and technologies are intensely competitive and are characterized by evolving industry standards that result in: - short product life cycles, - significant pressure to improve price and performance; and - frequent new product introductions. 15 16 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 materially adversely affect our financial condition and results of operations. During September 1999, Taiwan sustained significant damage as a result of a major earthquake and related aftershocks. The foundry we depend upon for our semiconductor products is located in Taiwan. It sustained some damage and was non-operational for a number of days due to power outages. While there was some minor delay in the delivery of some chips in process at the time of the earthquake, no significant impact to our chip delivery schedule is currently expected as a result of the earthquake. Other factories that supply a number of electronic components to the PC industry were impacted to various degrees by the earthquake and resultant power outages. While we are not aware of any specific product shortages that may adversely impact our products, as a result of the earthquake, these shortages may occur. If the events in Taiwan impact the availability of components for our products, the manufacture of our products could be delayed, which could adversely impact our business. 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: - the division of the board of directors into three separate classes; - the right of the board to elect the director to fill a space created by the expansion of the board; - the ability of the board to alter our bylaws; and - the requirement that at least 10% of the outstanding shares are needed to call a special meeting of stockholders. 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 16 17 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 alleging 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. The case is currently scheduled for trial in November 1999. 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." 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 17 18 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 rates relate primarily to our borrowings under our line of credit and any cash equivalents. Our line of credit calls for interest at the rate of prime plus 2%. As of October 3, 1999, we did not hold any significant cash equivalents. During much of the third quarter, and currently, we are a "net borrower" whereas we utilized any daily positive cash flows to pay down our line of credit, and thus did not hold any significant cash equivalent balances for any period of time. Our line of credit balance as of October 3, 1999 was $4.1 million. 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. 18 19 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 alleging 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. The case is currently scheduled for trial in November 1999. We believe that the actions that Creative and E-Mu filed are without merit, and we are vigorously defending against these actions. 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. 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." ITEM 5. OTHER INFORMATION Mr. L. William Krause resigned from the Board of Directors effective September 30, 1999. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibit index at page 21. (b) Reports on Form 8-K: We filed no reports on Form 8-K during the third quarter ended October 3, 1999. 19 20 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: November 16, 1999 By: /s/ Kenneth A. Kokinakis ------------------------------------- Kenneth A. Kokinakis President and Chief Executive Officer Date: November 16, 1999 By:/s/David J. Domeier ---------------------------------- David J. Domeier Senior Vice President of Finance Chief Financial Officer 20 21 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 (TBCC Credit Facility) (9) 4.11 Amendments #1, #2, #7 and #8 to Loan and Security Agreement (TBCC Credit Facility) 4.12 Form of Warrant (TBCC Warrants) (9) 4.13 8% Series B Convertible Preferred Stock Purchase Agreement (9) 4.14 Certificate of Designation of 8% Series B Convertible Preferred Stock for Aureal Semiconductor, Inc. (9) 4.15 Amendment Number 4 to Registration Rights Agreement (9) 4.20 Form of Registration Rights Agreement among Oaktree, TCW and Aureal Semiconductor, Inc. (10) 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) 10.7 Form of indemnity agreement for directors and officers (5) 10.8 1996 Outside Directors Stock Option Plan (6) 10.10 Industrial space sublease with Lam Research Corporation, dated June 7, 1999. (11) 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 exhibits filed with Form S-3 (Registration number 333-75631) filed April 2, 1999. (11) Incorporated by reference to exhibits filed with Form 10-Q for the quarter ended July 4, 1999. 21 EX-4.11 2 AMENDMENTS #1, #2, #7, AND #8 TO LOAN AND SECURITY 1 EXHIBIT 4.11 AMENDMENT NUMBER ONE AND WAIVER TO LOAN AND SECURITY AGREEMENT THIS AMENDMENT NUMBER ONE AND WAIVER TO LOAN AND SECURITY AGREEMENT (this "AMENDMENT") dated as of March ___, 1999, is entered into among AUREAL SEMICONDUCTOR INC., a Delaware corporation ("Borrower"), on the one hand, and, on the other hand, Agent (as hereinafter defined) and the financial institutions (collectively, the "Lenders" and individually, a "Lender") that are signatories to that certain Loan and Security Agreement, dated as of June 5, 1998 (as amended, restated, supplemented, or otherwise modified from time to time, the "Loan Agreement"), entered into between Borrower, Lenders, and TRANSAMERICA BUSINESS CREDIT CORPORATION, a Delaware corporation, as agent (herein, in such capacity, referred to as "Agent") for Lenders thereunder, in light of the following: W I T N E S S E T H WHEREAS, the Parties desire to amend the Loan Agreement, in accordance with the amendment provisions of Section 16.1 thereof, as set forth herein; NOW, THEREFORE, for good and valuable consideration, the receipt and sufficiency of which are hereby acknowledged, the parties agree to amend the Loan Agreement, effective immediately, as follows: 1. DEFINITIONS. Capitalized terms used herein and not otherwise defined herein shall have the meanings ascribed to them in the Loan Agreement, as amended hereby. 2. AMENDMENTS TO LOAN AGREEMENT. Upon the effectiveness of this Amendment, the parties hereby agree as follows: (a) The Loan Agreement hereby is amended to add the following new Section 2.2(d): (d) Anything to the contrary in the Agreement notwithstanding, Agent shall impose, and Borrower hereby consents to the establishment of, a reserve against the Maximum Tranche B Amount equal to 35% of the Maximum Tranche B Amount (i.e., $2,625,000.00). Agent may not change the amount of the reserve established under this subsection without the prior written consent of all of the Lenders. (b) Section 2.11(b) of the Loan Agreement hereby is amended and restated in its entirety to read as follows: (b) Supplemental Origination Fee. A one-time supplemental origination fee in the amount of $200,000, such fee to be fully earned on the Effective Date and due and payable on the first anniversary of the Effective Date or such earlier date (if any) on which this Agreement is terminated; provided, however, if all of the Obligations owing to Goldman Sachs Credit Partners L.P., a Bermuda limited -1- 2 partnership ("Goldman"), have been paid in full, in cash, on or prior to March 31, 1999, and all of the Commitments of Goldman are terminated on or prior to March 31, 1999, then, in connection therewith, Goldman hereby agrees to waive Goldman's Pro-Rata Share of the supplemental origination fee. (c) Section 3.6 of the Loan Agreement is hereby amended and restated in its entirety to read as follows: 3.6 EARLY TERMINATION BY BORROWER. Borrower has the option, at any time upon 5 days prior written notice to Agent to terminate this Agreement by paying to Agent, for the ratable benefit of the Lender Group, in cash, the Obligations, in full, together with a premium (the "Early Termination Premium") equal to $250,000; provided, however, if the Obligations owing to Goldman have been paid in full, in cash, on or prior to March 31, 1999, and all of the Commitments of Goldman are terminated on or prior to March 31, 1999, then, in connection therewith, Goldman hereby agrees to waive Goldman's Pro-Rata Share of the Early Termination Premium and surrender Goldman's Warrant to Borrower. 3. WAIVERS OF EXISTING EVENTS OF DEFAULT. Upon the effectiveness of this Amendment, Lender hereby waives each of the Events of Default existing as of the date of this Amendment and identified on Schedule A attached to this Amendment (each, a "Specified Event of Default"). Such waiver is specific in time and in intent and does not constitute, nor should it be construed as constituting, except to the extent expressly set forth herein, a waiver or modification of any term of, or right, power, or privilege under, the Loan Agreement, the other Loan Documents, or any agreement, contract, indenture, document, or instrument mentioned therein. Such waiver does not preclude any exercise of any right, power, or privilege under any Loan Document, based upon any Event of Default other than the Specified Events of Default. 4. CONDITION PRECEDENTS TO AMENDMENT. The satisfaction of each of the following unless waived or deferred by Agent in its sole discretion, shall constitute conditions precedent to the effectiveness of this Amendment and each and every provision hereof: (a) The representations and warranties in the Loan Agreement as amended by this Amendment, and the other Loan Documents shall be true and correct in all respects on and as of the date hereof, as though made on such date (except to the extent that such representations and warranties relate solely to an earlier date). (b) No injunction, writ, restraining order, or other order of any nature prohibiting, directly or indirectly, the consummation of the transactions contemplated herein shall have been issued and remain in force by any governmental authority against the Agent or Lenders. (c) Agent shall have received fully executed counterpart signatures to this Amendment. -2- 3 (d) Agent shall have received fully executed counterpart signatures to that certain Amendment Number Two to Put Agreement, dated as of the date hereof, by and among each of the funds managed by, or other affiliates of, Oaktree Capital Management LLC identified on Schedule 1A thereto or TCW Special Credits identified on Schedule 1 thereto and Goldman Sachs Credit Partners, L.P., a Bermuda limited partnership. (e) Agent shall have received fully executed counterpart signatures to that certain Amendment Number Two to Put Agreement, dated as of the date hereof, by and among each of the funds managed by, or other affiliates of, Oaktree Capital Management LLC identified on Schedule 1A thereto or TCW Special Credits identified on Schedule 1 thereto and Transamerica Business Credit Corporation, a Delaware corporation. 5. CONSTRUCTION. This Amendment shall be governed by and construed in accordance with the laws of the State of New York without giving effect to its conflicts-of-laws principles (other than any provisions thereof validating the choice of the laws of the State of New York as the governing law). 6. ENTIRE AMENDMENT. This Amendment, and terms and provisions hereof, constitute the entire agreement among the parties pertaining to the subject matter hereof and supersedes any and all prior or contemporaneous amendments relating to the subject matter hereof. Except as expressly amended hereby, the Loan Agreement and other Loan Documents shall remain unchanged and in full force and effect. To the extent any terms or provisions of this Amendment conflict with those of the Loan Agreement or other Loan Document, the terms and provisions of this Amendment shall control. This Amendment shall be deemed part of and is hereby incorporated into the Loan Agreement. 7. COUNTERPARTS; TELEFACSIMILE EXECUTION. This Amendment may be executed in any number of counterparts, all of which taken together shall constitute one and the same instrument and any of the parties hereto may execute this Amendment by signing any such counterpart. Delivery of an executed counterpart of this Amendment by telefacsimile shall be equally as effective as delivery of an original executed counterpart of this Amendment. Any party delivering an executed counterpart of this Amendment by telefacsimile also shall deliver an original executed counterpart of this Amendment, but the failure to deliver an original executed counterpart shall not affect the validity, enforceability, and binding effect of this Amendment. 8. AMENDMENTS. This Amendment cannot be altered, amended, changed or modified in any respect or particular unless each such alteration, amendment, change or modification shall have been agreed to by each of the parties and reduced to writing in its entirety and signed and delivered by each party. 9. MISCELLANEOUS. (a) Upon the effectiveness of this Amendment, each reference in the Loan Agreement to "this Agreement", "hereunder", "herein", "hereof" or words of like import referring to the Loan Agreement shall mean and refer to the Loan Agreement as amended by this Amendment. -3- 4 (b) Upon the effectiveness of this Amendment, each reference in the Loan Documents to the "Loan Agreement", "thereunder", "therein", "thereof" or words of like import referring to the Loan Agreement shall mean and refer to the Loan Agreement as amended by this Amendment. [Signature page follows.] -4- 5 IN WITNESS WHEREOF, the parties have caused this Amendment to be executed and delivered as of the date first written above. TRANSAMERICA BUSINESS CREDIT CORPORATION, a Delaware corporation, as Agent and a Lender By: ------------------------------------- Title: ---------------------------------- GOLDMAN SACHS CREDIT PARTNERS L.P., a Bermuda limited partnership By: ------------------------------------- Title: ---------------------------------- AUREAL SEMICONDUCTOR INC. a Delaware corporation By: ------------------------------------- Title: ---------------------------------- S-1 6 SCHEDULE A SPECIFIED EVENTS OF DEFAULT (1) Borrower has failed to maintain the minimum Tangible Net Worth required by Section 7.20(a) of the Loan Agreement for the quarter ending January 3, 1999. (2) Borrower has failed to maintain the minimum Profitability required by Section 7.20(b) of the Loan Agreement for the quarter ending January 3, 1999. (3) Borrower has failed to maintain the minimum Total Revenues required by Section 7.20(c) of the Loan Agreement for the quarter ending January 3, 1999. Each of the items identified in paragraphs (1), (2), and (3) above constitute an Event of Default under Section 8.2 of the Loan Agreement. 7 AMENDMENT NUMBER TWO TO LOAN AND SECURITY AGREEMENT THIS AMENDMENT NUMBER TWO TO LOAN AND SECURITY AGREEMENT (this "Amendment") dated as of March ___, 1999, is entered into among AUREAL SEMICONDUCTOR INC., a Delaware corporation ("Borrower"), on the one hand, and, on the other hand, Agent (as hereinafter defined) and the financial institutions (collectively, the "Lenders" and individually, a "Lender") that are signatories to that certain Loan and Security Agreement, dated as of June 5, 1998 (as amended, restated, supplemented, or otherwise modified from time to time, the "Loan Agreement"), entered into between Borrower, Lenders, and TRANSAMERICA BUSINESS CREDIT CORPORATION, a Delaware corporation, as agent (herein, in such capacity, referred to as "Agent") for Lenders thereunder, in light of the following: W I T N E S S E T H WHEREAS, the Parties desire to amend the Loan Agreement, in accordance with the amendment provisions of Section 16.1 thereof, as set forth herein; NOW, THEREFORE, for good and valuable consideration, the receipt and sufficiency of which are hereby acknowledged, the parties agree to amend the Loan Agreement, effective immediately, as follows: 1. DEFINITIONS. Capitalized terms used herein and not otherwise defined herein shall have the meanings ascribed to them in the Loan Agreement, as amended hereby. 2. AMENDMENTS TO LOAN AGREEMENT. Upon the effectiveness of this Amendment, the parties hereby agree as follows: (a) Section 2.2(d) of the Loan Agreement hereby is deleted in its entirety from the Loan Agreement. (b) Section 2.11(b) of the Loan Agreement hereby is amended and restated in its entirety to read as follows: (b) Supplemental Origination Fee. A one-time supplemental origination fee in the amount of $200,000, such fee to be fully earned on the Effective Date and due and payable on the first anniversary of the Effective Date or such earlier date (if any) on which this Agreement is terminated; provided, however, if all of the Obligations owing to Goldman Sachs Credit Partners L.P., a Bermuda limited partnership ("Goldman"), have been paid in full, in cash, on or prior to May 26, 1999, and all of the Commitments of Goldman are terminated on or prior to May 26, 1999, then, in connection therewith, Goldman hereby agrees to waive Goldman's Pro-Rata Share of the supplemental origination fee. -1- 8 (c) Section 3.6 of the Loan Agreement is hereby amended and restated in its entirety to read as follows: 3.6 Early Termination by Borrower. Borrower has the option, at any time upon 5 days prior written notice to Agent to terminate this Agreement by paying to Agent, for the ratable benefit of the Lender Group, in cash, the Obligations, in full, together with a premium (the "Early Termination Premium") equal to $250,000; provided, however, if the Obligations owing to Goldman have been paid in full, in cash, on or prior to May 26, 1999, and all of the Commitments of Goldman are terminated on or prior to May 26, 1999, then, in connection therewith, Goldman hereby agrees to waive Goldman's Pro-Rata Share of the Early Termination Premium and surrender Goldman's Warrant to Borrower. 3. CONDITION PRECEDENTS TO AMENDMENT. The satisfaction of each of the following unless waived or deferred by Agent in its sole discretion, shall constitute conditions precedent to the effectiveness of this Amendment and each and every provision hereof: (a) The representations and warranties in the Loan Agreement as amended by this Amendment, and the other Loan Documents shall be true and correct in all respects on and as of the date hereof, as though made on such date (except to the extent that such representations and warranties relate solely to an earlier date). (b) No injunction, writ, restraining order, or other order of any nature prohibiting, directly or indirectly, the consummation of the transactions contemplated herein shall have been issued and remain in force by any governmental authority against the Agent or Lenders. (c) Agent shall have received fully executed counterpart signatures to this Amendment. (d) Agent shall have received fully executed counterpart signatures to that certain Amendment Number Three to Put Agreement, dated as of the date hereof, by and among each of the funds managed by, or other affiliates of, Oaktree Capital Management LLC identified on Schedule 1A thereto or TCW Special Credits identified on Schedule 1 thereto and Goldman Sachs Credit Partners, L.P., a Bermuda limited partnership. (e) Agent shall have received fully executed counterpart signatures to that certain Amendment Number Three to Put Agreement, dated as of the date hereof, by and among each of the funds managed by, or other affiliates of, Oaktree Capital Management LLC identified on Schedule 1A thereto or TCW Special Credits identified on Schedule 1 thereto and Transamerica Business Credit Corporation, a Delaware corporation. 5. CONSTRUCTION. This Amendment shall be governed by and construed in accordance with the laws of the State of New York without giving effect to its conflicts-of-laws principles (other than any provisions thereof validating the choice of the laws of the State of New York as the governing law). -2- 9 6. ENTIRE AMENDMENT. This Amendment, and terms and provisions hereof, constitute the entire agreement among the parties pertaining to the subject matter hereof and supersedes any and all prior or contemporaneous amendments relating to the subject matter hereof. Except as expressly amended hereby, the Loan Agreement and other Loan Documents shall remain unchanged and in full force and effect. To the extent any terms or provisions of this Amendment conflict with those of the Loan Agreement or other Loan Document, the terms and provisions of this Amendment shall control. This Amendment shall be deemed part of and is hereby incorporated into the Loan Agreement. 7. COUNTERPARTS; TELEFACSIMILE EXECUTION. This Amendment may be executed in any number of counterparts, all of which taken together shall constitute one and the same instrument and any of the parties hereto may execute this Amendment by signing any such counterpart. Delivery of an executed counterpart of this Amendment by telefacsimile shall be equally as effective as delivery of an original executed counterpart of this Amendment. Any party delivering an executed counterpart of this Amendment by telefacsimile also shall deliver an original executed counterpart of this Amendment, but the failure to deliver an original executed counterpart shall not affect the validity, enforceability, and binding effect of this Amendment. 8. AMENDMENTS. This Amendment cannot be altered, amended, changed or modified in any respect or particular unless each such alteration, amendment, change or modification shall have been agreed to by each of the parties and reduced to writing in its entirety and signed and delivered by each party. 9. MISCELLANEOUS. (a) Upon the effectiveness of this Amendment, each reference in the Loan Agreement to "this Agreement", "hereunder", "herein", "hereof" or words of like import referring to the Loan Agreement shall mean and refer to the Loan Agreement as amended by this Amendment. (b) Upon the effectiveness of this Amendment, each reference in the Loan Documents to the "Loan Agreement", "thereunder", "therein", "thereof" or words of like import referring to the Loan Agreement shall mean and refer to the Loan Agreement as amended by this Amendment. [Signature page follows.] -3- 10 IN WITNESS WHEREOF, the parties have caused this Amendment to be executed and delivered as of the date first written above. TRANSAMERICA BUSINESS CREDIT CORPORATION, a Delaware corporation, as Agent and a Lender By: ------------------------------------- Title: ---------------------------------- GOLDMAN SACHS CREDIT PARTNERS L.P., a Bermuda limited partnership By: ------------------------------------- Title: ---------------------------------- AUREAL SEMICONDUCTOR INC. a Delaware corporation By: ------------------------------------- Title: ---------------------------------- 11 AMENDMENT NUMBER SEVEN TO LOAN AND SECURITY AGREEMENT THIS AMENDMENT NUMBER SEVEN (this "Amendment"), to LOAN AND SECURITY AGREEMENT, dated as of June 5, 1998, among AUREAL INC., a Delaware corporation formerly known as Aureal Semiconductor Inc. (the "Borrower"), the financial institutions from time to time parties thereto as lenders (the "Lenders") and TRANSAMERICA BUSINESS CREDIT CORPORATION, as agent (in such capacity, the "Agent") for the Lenders, is made as of September 14, 1999 among the Borrower, the undersigned Lenders and the Agent. W I T N E S S E T H : WHEREAS, the Borrower, the Lenders and the Agent are parties to the Loan and Security Agreement, dated as of June 5, 1998 (as heretofore amended, the "Loan Agreement"; capitalized terms used herein shall have the meanings assigned to such terms in the Loan Agreement unless otherwise defined herein); and WHEREAS, the Borrower has requested that the Lenders amend certain provisions of the Loan Agreement and certain other Loan Documents, and the Lenders are agreeable to such requests on the terms and subject to the conditions set forth herein. NOW, THEREFORE, in consideration of the foregoing and for other good and valuable consideration, the parties hereto hereby agree as follows: 1. AMENDMENTS TO LOAN AGREEMENT. Effective as of the date hereof, and subject to the satisfaction of the conditions to effectiveness set forth in Section 7 hereof, the Loan Agreement is hereby amended as follows: (a) The definition of "Average Unused Portion of the Maximum Amount" in Section 1.1 is amended by inserting after the word "month" the following: ", less (c) the average amount of undrawn Letters of Credit outstanding during the immediately preceding month." (b) The definition of "Loan Documents" in Section 1.1 is amended by inserting after the words "the Warrants," the following: "the Letters of Credit, the Letter of Credit Agreement, the Guaranty,". 12 (c) The definition of "Material Adverse Change" in Section 1.1 is amended by deleting the word "Borrower" from each place it appears and substituting therefor the following: "any Loan Party." (d) The definition of "Maximum Amount" in Section 1.1 is amended and restated as follows: "'Maximum Amount' means $12,187,000." (e) The definition of "Maximum Tranche B Amount" in Section 1.1 is amended and restated as follows: "'Maximum Tranche B Amount' means $5,000,000." (f) The definition of "Obligations" in Section 1.1 is amended by inserting after the phrase "principal," the following: "reimbursement obligations,". (g) The definition of "Pro Rata Share" in Section 1.1 is amended by inserting after the phrase "to make Tranche A Advances and receive payments of principal and interest with respect thereto" the following: "and to purchase participations in Letters of Credit and receive payment with respect thereto." (h) The definition of "Revolving Facility Usage" in Section 1.1 is amended by inserting after the phrase "Tranche B Advances outstanding" the following: ", plus (c) the aggregate undrawn face amount of all Letters of Credit outstanding." (i) The definition of "Tranche A Availability" in Section 1.1 is amended and restated as follows: "'Tranche A Availability' means the amount that Borrower is entitled to borrow as Tranche A Advances under Section 2.1 and the undrawn face amount of Letters of Credit the Borrower is entitled to request under Section 2.13, such amount being the difference derived when (a) the aggregate principal amount of Tranche A Advances then outstanding (including any amounts that the Lender Group may have paid for the account of Borrower pursuant to any of the Loan Documents and that are reimbursed by Borrower by being charged to the Loan Account as Tranche A Advances) plus the aggregate undrawn face amount of Letters of Credit then outstanding is subtracted from (b) the lesser of (i) the Maximum Tranche A Amount or (ii) the Borrowing Base." (j) Section 1.1 is amended by adding the following definitions in their proper alphabetical order: -2- 13 "'Federal Funds Effective Rate' means for any day, the rate equal to the weighted average of the rates on overnight federal funds transactions with members of the Federal Reserve System arranged by federal funds brokers, as such weighted average is published for such day (or, if such day is not a Business Day, for the immediately preceding Business Day) by the Federal Reserve Bank of New York, or, if such rate is not so published for such Business Day, the average of the quoted rates for such Business Day on such transactions received by the Agent from three federal funds brokers of recognized standing selected by the Agent. Each determination by the Agent of the Federal Funds Effective Rate shall, in the absence of manifest error, be conclusive." "'Guaranty' means the Guaranty, in the form of Exhibit G-1 attached hereto, made by OCM in favor of the Agent." "'Issuing Bank' means Bank of America or another bank selected by the Agent and reasonably acceptable to the Borrower." "'Letter of Credit Agreement' means the agreement entered into by the Agent and the Issuing Bank pursuant to which the Agent causes the Issuing Bank to issue Letters of Credit for the account of the Borrower in accordance with the terms of this Agreement." "'Letters of Credit' means the letters of credit issued for the account of the Borrower under Section 2.13, and all amendments, renewals, extensions or replacements thereof." "'Loan Parties' means the Borrower and OCM." "'OCM' means OCM Opportunities Fund II, L.P., a Delaware limited partnership." (k) Section 2.1(a) is amended by deleting the phrase "not to exceed" and substituting therefor "which, when combined with the aggregate undrawn face amount of all outstanding Letters of Credit, does not exceed." (l) Section 2.1(b) is amended and restated as follows: -3- 14 "(b) The Lenders shall have no obligation to make further Tranche A Advances hereunder to the extent they would cause (i) the aggregate outstanding amount of Tranche A Advances plus the aggregate undrawn face amount of all outstanding Letters of Credit to exceed the lesser of the Borrowing Base and the Maximum Tranche A Amount or (ii) the aggregate outstanding amount of all Advances plus the aggregate undrawn face amount of all outstanding Letters of Credit to exceed the Maximum Amount." (m) Section 2.2(b) is amended by deleting "the outstanding Obligations" and substituting therefor "the aggregate outstanding amount of all Advances plus the aggregate undrawn face amount of all outstanding Letters of Credit." (n) Section 2.2(d) is amended and restated as follows: "(d) Anything to the contrary in Sections 2.1 and 2.2 notwithstanding, the Borrower shall not borrow Tranche B Advances when Tranche A Availability is greater than zero. (o) Section 2.2 is amended by adding at the end thereof a new clause (e) as follows: "(e) The Lenders shall have no obligation to make Tranche B Advances unless the OCM Guaranty is in full force and effect." (p) Section 2.4(b) is amended and restated as follows: "(b) Apportionment, Application, and Reversal of Payments. All payments shall be remitted to Agent. Except with respect to defaulting Lenders, all Collections shall be applied: first, to pay any fees or expense reimbursements then due to Agent from Borrower; second, to pay any fees or expense reimbursements then due to the Lenders from Borrower; third, to pay interest due in respect of all Advances; fourth, to pay the outstanding principal of Tranche A Advances; fifth, to pay the outstanding principal of Tranche B Advances; and sixth, ratably to pay any other Obligations due to Agent or any Lender by Borrower. For purposes of the foregoing, "payment in full" with respect to interest shall include interest accrued after the commencement of any Insolvency Proceeding irrespective of whether a claim for such interest is allowable in such Insolvency Proceeding." -4- 15 (q) Section 2.6(a)(ii) is amended by deleting the phrase "5 percentage points" and substituting therefor "2 percentage points." (r) Section 2.11(d) is amended and restated as follows: "(d) Letter of Credit Fees. (i) On the first day of each month (commencing October 1, 1999) during the term of this Agreement and on the Maturity Date, a letter of credit fee equal to 3.25% per annum of the daily average amount of the Letters of Credit outstanding during the preceding month or during the interim period ending on the Maturity Date, as the case may be; and (ii) for the sole account of the Agent, on the first day of each month (commencing October 1, 1999) during the term of this Agreement and on the Maturity Date, all customary fees charged to the Agent by the Issuing Bank which relate directly to the opening, amending or drawing under Letters of Credit." (s) Article 2 is amended by adding at the end thereof a new Section 2.13 as follows: "2.13. Letters of Credit. (a) The Agent, upon the request of the Borrower, shall use its best efforts during the term of this Agreement, subject to the terms and conditions of this Agreement, to cause the Issuing Bank to issue for the account of the Borrower Letters of Credit of a tenor and containing terms reasonably acceptable to the Agent and the Issuing Bank, in a maximum aggregate face amount outstanding at any time not to exceed One Million Five Hundred Thousand Dollars ($1,500,000), provided that no Letter of Credit shall have an expiration date after the Maturity Date. The Agent shall have no obligation to use its best efforts to cause the Issuing Bank to issue Letters of Credit to the extent they would cause (i) the aggregate outstanding amount of Tranche A Advances plus the aggregate undrawn amount of all outstanding Letters of Credit to exceed the lesser of the Borrowing Base and the Maximum Tranche A Amount or (ii) the aggregate outstanding amount of all Advances plus the aggregate undrawn amount of all Letters of Credit to exceed the Maximum Amount. -5- 16 (b) Unless otherwise previously agreed in writing by the Borrower and the Agent, the initial term of (i) any documentary Letter of Credit shall not exceed one hundred twenty (120) days from the date of issuance and (ii) any standby Letter of Credit shall not exceed one calendar year from the date of issuance, subject to automatic renewal unless notice to the contrary is given by the Agent or the Issuing Bank in writing by the applicable date specified in such Letter of Credit. Each Letter of Credit shall state that, except as otherwise provided therein, such Letter of Credit is governed by the Uniform Customs and Practice for Documentary Credits (as most recently published by the International Chamber of Commerce). Notwithstanding the purpose of any Letter of Credit or any reference therein or herein to a Subsidiary or Affiliate of the Borrower, each Letter of Credit shall be deemed issued for the account of the Borrower and the obligations arising in connection therewith shall be part of the Obligations. (c) Immediately upon issuance or amendment of any Letter of Credit in accordance with the procedures set forth in this Section 2.13, each Lender shall be deemed to have irrevocably and unconditionally purchased and received from the Agent, without recourse or warranty, an undivided interest and participation, to the extent of such Lender's Pro Rata Share, of the liability and obligations under and with respect to such Letter of Credit and the Letter of Credit Agreement (including, without limitation, all obligations of the Borrower with respect thereto) and any security therefor or guaranty pertaining thereto. (d) Whenever the Borrower desires the issuance of a Letter of Credit, the Borrower shall deliver to the Agent a written irrevocable request no later than 10:00 a.m. (California time) at least five (5) Business Days (or such shorter period as may be agreed to by the Agent) in advance of the proposed date of issuance. The transmittal by the Borrower of each such request shall be deemed to be a representation and warranty by the Borrower that the Letter of Credit may be issued in accordance with and will not violate any of the requirements of this Section 2.13. Prior to the date of issuance of each Letter of Credit, the Borrower shall provide to the Agent a precise -6- 17 description of the documents and the text of any certificate to be presented by the beneficiary of such Letter of Credit which, if presented by such beneficiary on or prior to the expiration date of such Letter of Credit, would require the Issuing Bank to make payment under such Letter of Credit. The Agent, in its reasonable judgment, may require changes in any such documents and certificates prior to the date of issuance of any such Letter of Credit. No Letter of Credit shall require payment against a conforming draft to be made thereunder prior to the second Business Day after the date on which such draft is presented. (e) In the event of any request for drawing under any Letter of Credit, (i) the Borrower shall be deemed to have timely given a borrowing request to the Agent to make Tranche A Advances on the date on which such drawing is honored in an amount equal to the amount of such drawing and (ii) without regard to satisfaction of the applicable conditions specified in Article 3 and the other terms and conditions of borrowings contained herein, the Lenders shall, on the date of such drawing, make Tranche A Advances in the amount of such drawing, the proceeds of which shall be applied directly by the Agent to reimburse the Issuing Bank for the amount of such drawing or payment. If for any reason, proceeds of Tranche A Advances are not received by the Agent on such date in an amount equal to the amount of such drawing, the Borrower shall reimburse the Agent, on the Business Day immediately following the date of such drawing, in an amount in same day funds equal to the excess of the amount of such drawing over the amount of such Advances, if any, which are so received, plus accrued interest on such amount at the rate applicable to Tranche A Advances. (f) As among the Borrower, the Agent and each Lender, the Borrower assumes all risks of the acts and omissions of the Agent and the Issuing Bank or misuse of the Letters of Credit by the respective beneficiaries of such Letters of Credit other than the gross negligence or willful misconduct of the Agent or the Issuing Bank as determined by a court of competent jurisdiction in a final nonappealable judgment. In furtherance and not in limitation of the foregoing, neither the Agent nor any of the Lenders shall be responsible (i) for the form, validity, sufficiency, accuracy, genuineness or -7- 18 legal effects of any document submitted by any party in connection with the application for and issuance of or any drawing honored under such Letters of Credit even if it should in fact prove to be in any or all respects invalid, insufficient, inaccurate, fraudulent or forged, (ii) for the validity or sufficiency of any instrument transferring or assigning or purporting to transfer or assign any such Letter of Credit, or the rights or benefits thereunder or proceeds thereof, in whole or in part, which may prove to be invalid or ineffective for any reason, (iii) for failure of the beneficiary of any such Letter of Credit to comply fully with conditions required in order to draw upon such Letter of Credit, (iv) for errors, omissions, interruptions or delays in transmission or delivery of any messages, by mail, cable, telegraph, telex, telecopy or otherwise, whether or not they be in cipher, (v) for errors in interpretation of technical terms, (vi) for any loss or delay in the transmission or otherwise of any document required in order to make a drawing under any such Letter of Credit, or of the proceeds thereof, (vii) for the misapplication by the beneficiary of any such Letter of Credit of the proceeds of any drawing honored under such Letter of Credit, and (viii) for any consequences arising from causes beyond the control of the Issuing Bank, the Agent or the Lenders. None of the above shall affect, impair, or prevent the vesting of any of the Agent's rights or powers hereunder. Any action taken or omitted to be taken by the Agent under or in connection with any Letter of Credit, if taken or omitted in the absence of gross negligence or willful misconduct, shall not create any liability of the Agent to the Borrower or any Lender. (g) The obligations of the Borrower to reimburse the Agent for drawings honored under the Letters of Credit and the obligations of the Lenders under this Section 2.13 shall be unconditional and irrevocable and shall be paid strictly in accordance with the terms of this Agreement under all circumstances including, without limitation, the following circumstances: (i) any lack of validity or enforceability of this Agreement, any Letter of Credit, any Letter of Credit Agreement or any other agreement or instrument relating thereto; (ii) the existence of any claim, setoff, defense or other right which the Borrower or any Affiliate of the Borrower may have at any time -8- 19 against a beneficiary or any transferee of any Letter of Credit (or any Persons or entities for whom any such beneficiary or transferee may be acting), the Agent, any Lender or any other Person, whether in connection with this Agreement, the other Loan Documents, the transactions contemplated herein or therein or any unrelated transaction; (iii) any draft, demand, certificate or other documents presented under any Letter of Credit proving to be forged, fraudulent, invalid or insufficient in any respect or any statement therein being untrue or inaccurate in any respect; (iv) the surrender or impairment of any security for the performance or observance of any of the terms of any of the Loan Documents; (v) payment by the Issuing Bank under any Letter of Credit against presentation of a demand, draft or certificate or other document which does not comply with the terms of such Letter of Credit; (vi) failure of any drawing under a Letter of Credit or any non-application or misapplication by the beneficiary of the proceeds of any drawing; or (vii) the fact that a Potential Default or Event of Default shall have occurred and be continuing." (t) The introductory paragraph of Section 3.2 is amended by inserting after the phrase "all Advances" in each place it appears the following: "and Letters of Credit." (u) Section 3.2(d) is amended and restated as follows: "(d) the amount of the Revolving Facility Usage, after giving effect to the requested Advance or Letter of Credit, shall not exceed the lesser of the Availability and the Maximum Amount." (v) Section 4.1(f) is deleted in its entirety. (w) The introductory paragraph of Article 5 is amended by (i) inserting after the phrase "the making of each Advance made thereafter" the following: "and the issuance of each Letter of Credit issued thereafter" and (ii) inserting after the phrase "the making of such Advance" the following: "and the issuance of such Letter of Credit." (x) The introductory paragraph of Article 6 is amended by inserting after the phrase "final payment of the Obligations" the following: "and no Letters of Credit are outstanding." -9- 20 (y) The introductory paragraph of Article 7 is amended by inserting after the phrase "final payment of the Obligations" the following: "and no Letters of Credit are outstanding." (z) Section 8.2 is amended by (i) deleting the word "or" at the end of clause (b) thereof and (ii) inserting at the end of such Section the following: "or (d) If OCM fails or neglects to perform, keep or observe any term, provision, condition, covenant or agreement contained in any Loan Document to which OCM is a party and such failure continues for a period of 10 Business Days;" (aa) Section 8.4 is amended by deleting "Borrower's" and substituting therefor "any Loan Party's." (bb) Section 8.5 is amended by deleting "Borrower" and substituting therefor "any Loan Party." (cc) Section 8.6 is amended by deleting "Borrower" from each place it appears and substituting therefor "any Loan Party." (dd) Section 8.7 is amended by deleting "Borrower" from the first place it appears and substituting therefor "any Loan Party." (ee) Section 8.8 is amended by (i) deleting "Borrower's" from each place it appears and substituting therefor "a Loan Party's" and (ii) adding after the phrase "payment date thereof;" the following: "provided, however, that none of the foregoing liens, levies or assessments on the properties or assets of OCM shall be an Event of Default unless such liens, levies or assessments could be reasonably expected to result in a Material Adverse Change;" (ff) Section 8.9 is amended by (i) deleting "Borrower's" and substituting therefor "any Loan Party's" and (ii) deleting "Borrower" and substituting therefor "such Loan Party." (gg) Section 8.10 is amended by (i) deleting "Borrower" and substituting therefor "any Loan Party" and (ii) deleting "Borrower's" and substituting therefor "such Loan Party's." (hh) Section 8.12 is amended by deleting "Borrower" from each place it appears and substituting therefor "any Loan Party." (ii) Section 9.1(b) is amended by inserting immediately after the phrase "the Lender Group" the following: ", or cease using best efforts to cause the Issuing Bank to issue -10- 21 any Letters of Credit or to amend, renew, extend or replace any Letters of Credit." (jj) Section 9.1 is amended by (i) deleting the word "and" at the end of clause (m) thereof, (ii) deleting the period at the end of clause (n) thereof and substituting therefor "; and" and (ii) inserting at the end of such Section a new clause (o) as follows: "(o) With respect to all Letters of Credit outstanding at the time of the acceleration of the Obligations under Section 9.1(a) or otherwise at any time after the Maturity Date, require the Borrower to deposit in a cash collateral account established by or on behalf of the Agent an amount equal to 105% of the aggregate then undrawn and unexpired amount of such Letters of Credit (and the Borrower agrees to forthwith deposit such amounts in such account). Amounts held in such cash collateral account shall be under the sole dominion and control of the Agent and applied by the Agent to the payment of drafts drawn under such Letters of Credit, and the balance, if any, in such cash collateral account, after all such Letters of Credit shall have expired or been fully drawn upon shall be applied to repay the other Obligations. After all such Letters of Credit shall have expired or been fully drawn upon and all Obligations shall have been paid in full, the balance, if any, in such cash collateral account shall be returned to the Borrower or to such other Person as may be lawfully entitled thereto." (kk) Section 16.1(b) is amended by (i) inserting after "principal," the following: "reimbursement obligation," and (ii) inserting after the phrase "or other amounts due to" the following: "the Agent or." (ll) Schedule C-1 to the Loan Agreement is amended and restated in the form of Schedule C-1 attached hereto. (mm) The Loan Agreement is amended by adding thereto a new Exhibit G-1 in the form of Exhibit G-1 attached hereto. 2. AMENDMENT TO COPYRIGHT SECURITY AGREEMENT. Effective as of the date hereof, and subject to the satisfaction of the conditions to effectiveness set forth in Section 7 hereof, Section 2(g) of the Copyright Security Agreement is deleted in its entirety. -11- 22 3. AMENDMENT TO PATENT SECURITY AGREEMENT. Effective as of the date hereof, and subject to the satisfaction of the conditions to effectiveness set forth in Section 7 hereof, Section 2(g) of the Patent Security Agreement is deleted in its entirety. 4. AMENDMENT TO TRADEMARK SECURITY AGREEMENT. Effective as of the date hereof, and subject to the satisfaction of the conditions to effectiveness set forth in Section 7 hereof, Section 2(g) of the Trademark Security Agreement is deleted in its entirety. 5. AMENDMENT TO STOCK PLEDGE AGREEMENT. Effective as of the date hereof, and subject to the satisfaction of the conditions to effectiveness set forth in Section 7 hereof, Section 3 of the Stock Pledge Agreement is amended and restated as follows: "3. [Intentionally Deleted]." 6. AMENDMENT TO DEPOSIT ACCOUNT SECURITY AGREEMENT. Effective as of the date hereof, and subject to the satisfaction of the conditions to effectiveness set forth in Section 7 hereof, Section 5 of the Deposit Account Security Agreement is amended and restated as follows: "5. [Intentionally Deleted]." 7. CONDITIONS TO EFFECTIVENESS. This Amendment shall become effective upon the Agent's receipt of an amendment fee of $50,000 for the ratable benefit of the Lenders and the following documents, in each case in form and substance satisfactory to the Agent: (a) This Amendment, duly executed by the Borrower and the Required Lenders. (b) The guaranty, substantially in the form of Exhibit G-1 (the "Guaranty"), duly executed by OCM Opportunities Fund II, L.P. ("OCM"). (c) Certified copies of (A) the resolutions of the Board of Directors of OCM (together with the Borrower, the "Loan Parties") approving the Guaranty and the transactions contemplated thereby, (B) the partnership agreement of OCM as amended through the date hereof and (C) all documents evidencing other necessary actions and government approvals, if any, with respect to the Guaranty, this Amendment, the Loan Agreement as amended hereby and the documents contemplated hereby or delivered in connection herewith (the "Amendment Documents"). (d) A certificate of the Secretary or an Assistant Secretary of OCM certifying the name and true signature of an authorized officer of OCM who is authorized to sign the Guaranty. -12- 23 (e) A certificate signed by an authorized officer of the Borrower certifying that (i) the representations and warranties contained in Section 8 hereof are true and correct in all material respects on and as of the date of such certificate as though made on and as of such date (except to the extent such representations and warranties expressly relate to an earlier date, in which case such representations and warranties were true and correct on and as of such earlier date), (ii) the representations and warranties contained in the Loan Agreement are true and correct in all material respects on and as of the date of such certificate as though made on and as of such date (except to the extent such representations and warranties expressly relate to an earlier date, in which case such representations and warranties were true and correct on and as of such earlier date), (iii) no Potential Default or Event of Default has occurred and is continuing and (iv) there has occurred no Material Adverse Change since July 4, 1999. (f) Any agreements and other instruments required pursuant to the Loan Agreement, this Amendment or the Letter of Credit Agreement to cause to be issued any Letters of Credit. (g) A legal opinion of counsel to OCM covering such matters relating to the transactions contemplated by the Guaranty as the Agent shall reasonably request (h) A certificate of an authorized officer of OCM to the effect that OCM is Solvent and will be Solvent after giving effect to the consummation of the transactions contemplated by this Amendment. (i) Such other documents, instruments, opinions, evidence, materials and information as the Agent may reasonably request. 8. REPRESENTATIONS AND WARRANTIES OF THE BORROWER. The Borrower represents and warrants as follows: (a) Since July 4, 1999, there has occurred no Material Adverse Change. (b) No Potential Default or Event of Default has occurred and is continuing. (c) The representations and warranties contained in the Loan Agreement are true and correct in all material respects on the date hereof as though made on and as of the date hereof, except to the extent that such representations and warranties expressly relate solely to an earlier date (in which case such representations and warranties were true and correct on and as of such earlier date). -13- 24 (d) Each Amendment Document to which any Loan Party is a party constitutes the legal, valid and binding obligations of the such Loan Party, enforceable against such Loan Party in accordance with its terms, except as enforceability may be limited by bankruptcy, insolvency and other laws affecting creditors' rights generally and by general principles of equity. (e) The execution, delivery and performance by each Loan Party of the Amendment Documents to which it is a party, and the consummation of the transactions contemplated thereby, are within such Loan Party's powers, have been duly authorized by all necessary action on the part of such Loan Party and do not (i) contravene such Loan Party's Governing Documents, (ii) violate any law or regulation, (iii) conflict with or result in the breach of, or constitute a default under, any contract, loan agreement, indenture, mortgage, deed of trust, lease or other instrument binding on or affecting such Loan Party or any of its properties or (iv) except for the Liens created under the Loan Documents, result in or require the creation or imposition of any Lien upon or with respect to any of the properties of such Loan Party. (f) No consent of any Person, and no permit, approval or authorization of, exemption by, notice or report to, or registration, filing or declaration with, any Governmental Authority is required in connection with the execution, delivery, performance, validity or enforceability of any Amendment Document and the transactions contemplated thereby. 9. EXPENSES. The Borrower shall pay for all of the reasonable costs and expenses incurred by the Agent in connection with the transactions contemplated by the Amendment Documents, including, without limitation, the reasonable fees and expenses of counsel to the Agent. 10. MISCELLANEOUS. (a) Except as expressly amended herein, all of the terms and provisions of the Loan Agreement and the other Loan Documents are ratified and confirmed in all respects and shall remain in full force and effect. (b) Upon the effectiveness of this Amendment, all references in the Loan Documents to the Loan Agreement shall mean the Loan Agreement as amended by this Amendment and all references in the Loan Agreement to "this Agreement," "hereof," "herein," or similar terms, shall mean and refer to the Loan Agreement as amended by this Amendment. -14- 25 (c) The execution, delivery and effectiveness of this Amendment shall not, except as expressly provided herein, operate as an amendment to or waiver of any right, power or remedy of the Agent or the Lenders under any of the Loan Documents, or constitute an amendment or waiver of any provision of any of the Loan Documents. (d) This Amendment may be executed by the parties hereto individually or in combination, in one or more counterparts, each of which shall be an original and all of which shall constitute one and the same agreement. This Amendment may be executed and delivered by telecopier with the same force and effect as if the same were a fully executed and delivered original manual counterpart. (e) This Amendment shall constitute a Loan Document. 11. GOVERNING LAW. THE VALIDITY, INTERPRETATION AND ENFORCEMENT OF THIS AMENDMENT SHALL BE GOVERNED BY THE LAWS OF THE STATE OF NEW YORK WITHOUT GIVING EFFECT TO THE CONFLICTS OF LAW PRINCIPLES THEREOF (OTHER THAN SECTION 5-1401 OF THE NEW YORK GENERAL OBLIGATIONS LAW). -15- 26 IN WITNESS WHEREOF, the parties hereto have caused this Amendment to be duly executed and delivered by their respective duly authorized officers. AUREAL INC., formerly known as Aureal Semiconductor Inc. By: ------------------------------------- Name: Title: TRANSAMERICA BUSINESS CREDIT CORPORATION, as Agent and as Lender By: ------------------------------------- Name: Title: -16- 27 Schedule C-1 Commitments
Commitment to Make Commitment to Make Total Commitments Pro Rata Lender Tranche A Advances Tranche B Advances* of Lenders Share - ----------------------------------------------------------------------------------------------------- Transamerica Business $12,187,000 $5,000,000 $12,187,500 100% Credit Corporation Total of All Lenders $12,187,000 $5,000,000 $12,187,000 100% - -----------------------------------------------------------------------------------------------------
* Tranche B is a Sublimit of Tranche A 28 AMENDMENT NUMBER EIGHT TO LOAN AND SECURITY AGREEMENT THIS AMENDMENT NUMBER EIGHT (this "Amendment"), to LOAN AND SECURITY AGREEMENT, dated as of June 5, 1998, among AUREAL INC., a Delaware corporation formerly known as Aureal Semiconductor Inc. (the "Borrower"), TRANSAMERICA BUSINESS CREDIT CORPORATION ("TBCC"), PNC BANK, NATIONAL ASSOCIATION ("PNC" and, together with TBCC, the "Lenders") and TBCC, as agent (in such capacity, the "Agent") for the Lenders, is made as of September 30, 1999 among the Borrower, the Lenders and the Agent. W I T N E S S E T H : WHEREAS, the Borrower, TBCC and the Agent are parties to the Loan and Security Agreement, dated as of June 5, 1998 (as heretofore amended, the "Loan Agreement"; capitalized terms used herein shall have the meanings assigned to such terms in the Loan Agreement unless otherwise defined herein); and WHEREAS, the parties hereto wish to amend the Loan Agreement to, among other things, increase the maximum amount of the credit facility and include PNC as a Lender under the Loan Agreement and the other Loan Documents. NOW, THEREFORE, in consideration of the foregoing and for other good and valuable consideration, the parties hereto hereby agree as follows: 1. AMENDMENTS TO LOAN AGREEMENT. Effective as of the date hereof, and subject to the satisfaction of the conditions to effectiveness set forth in Section 3 hereof, the Loan Agreement is hereby amended as follows: (a) The definition of "Maximum Amount" in Section 1.1 is amended and restated as follows: "'Maximum Amount' means $25,000,000." (b) The definition of "Maximum Tranche A Amount" in Section 1.1 is amended and restated as follows: "'Maximum Tranche A Amount' means $25,000,000." (c) The definition of "Maximum Tranche B Amount" in Section 1.1 is amended and restated as follows: "'Maximum Tranche B Amount' means $5,000,000." 29 (d) Section 1.1 is amended by adding the following definitions in their proper alphabetical order: "'Eligible Equipment' means the Equipment of the Borrower located in the United States, which is free from any claim of title or Lien in favor of any Person (other than Liens in favor of the Agent) and with respect to which no event has occurred and no condition exists which could be reasonably expected to impair substantially the Borrower's ability to use such Equipment in the ordinary course of its business and which the Agent, in good faith, shall deem eligible to serve as collateral for Advances. No Equipment of the Borrower shall be Eligible Equipment unless the Agent has a perfected first priority Lien thereon. No Equipment of the Borrower shall be Eligible Equipment unless (i) it is located on property owned by the Borrower or (ii) it is located on property leased by the Borrower or in a contract warehouse which is subject to a Collateral Access Agreement executed by the mortgagee, lessor or contract warehouseman, as the case may be, and segregated or otherwise separately identifiable from goods of others, if any, stored on the premises." "'Orderly Liquidation Value of Equipment' means the orderly liquidation value of Eligible Equipment as determined from time to time by an appraiser selected by the Agent. The Orderly Liquidation Value of Equipment is equal to $624,120 on September 30, 1999, as such amount may be adjusted from time to time pursuant to Section 4.6." (e) Section 2.1(a) is amended by deleting the phrase "80% of Eligible Accounts (net of the Foreign Accounts Reserve), less the amount, if any, of the Dilution Reserve" and substituting therefor "an amount equal to the sum of (i) 85% of Eligible Accounts (net of the Foreign Accounts Reserve), less the amount, if any, of the Dilution Reserve plus (ii) 75% of the Orderly Liquidation Value of Eligible Equipment." (f) Section 2.6(a) is amended and restated as follows: "(a) Interest Rate. Except as provided in clause (c) below, all Obligations shall bear interest at a per annum rate of 2 percentage points above the Reference Rate." -2- 30 (g) Section 2.6(d) is amended as follows: (i) by deleting "$500,000" from each place it appears and substituting therefor "200,000"; (ii) by deleting "(y) during the period commencing on the Effective Date and ending on the earlier to occur of the first anniversary of the Effective Date" and substituting therefor "(y) during the period commencing on July 1, 1999 and ending on the earlier to occur of June 30, 2000"; and (iii) by deleting "(z) during the period commencing on the first anniversary of the Effective Date and ending on the earlier to occur of the second anniversary of the Effective Date" and substituting therefor "(z) during the period commencing on July 1, 2000 and ending on the earlier to occur of June 30, 2001." (h) Section 3.4 of the Loan Agreement is hereby amended by deleting "June 5, 2000" and substituting therefor "July 2, 2001." (i) Section 3.6 is amended by deleting "$250,000" and substituting therefor "the product of (a) $20,000 and (b) the number of months (rounded upwards to the nearest whole number) from the date this Agreement is terminated to the Maturity Date." (j) Section 4.6 is amended by inserting at the end thereof the following: "Without limiting the generality of the foregoing, the Borrower agrees that the Agent may from time to time hire appraisers to redetermine the Orderly Liquidation Value of the Equipment and the Borrower shall reimburse the Agent for the fees, costs and expenses associated with such appraisal." (k) Section 7.20(a) is amended and restated as follows: "(a) [Intentionally omitted]." (l) Section 7.20(b) is amended and restated as follows: "(b) Profitability. Achieve EBITDA of not less than the amount shown below for the period corresponding thereto (amounts in brackets ($) are negative): -3- 31
Period Minimum EBITDA - -------------------------------------------------------------------------------- the fiscal quarter ending on or about September 30, 1999 ($7,600,000) the fiscal quarter ending on or about December 31, 1999 ($4,500,000) the fiscal quarter ending on or about March 31, 2000 ($300,000) the fiscal quarter ending on or about June 30, 2000 ($1,100,000) the fiscal quarter ending on or about September 30, 2000 $500,000 each fiscal quarter ending thereafter $1,500,000"
(m) Section 7.20(c) is amended and restated as follows: "(c) Total Revenues. Achieve total revenues, determined in accordance with GAAP on a basis consistent with past practice, of not less than the amount shown below for the period corresponding thereto: 32
Period Minimum Total Revenue - ------------------------------------------------------------------------------------ the fiscal quarter ending on or about September 30, 1999 $7,900,000 the fiscal quarter ending on or about December 31, 1999 $12,900,000 the fiscal quarter ending on or about March 31, 2000 $16,100,000 the fiscal quarter ending on or about June 30, 2000 $12,900,000 the fiscal quarter ending on or about September 30, 2000 $16,200,000 each fiscal quarter ending thereafter $20,200,000"
(n) Section 7.21 is amended and restated as follows: "7.21 Capital Expenditures. Make capital expenditures in excess of: (a) $2,250,000 during the fiscal year ending on or about December 31, 1999; or (b) $1,500,000 during the fiscal year ending on or about December 31, 2000; or (c) $2,250,000 during the period commencing on the first day immediately following the end of the fiscal year ending on or about December 31, 2000 and ending on the Maturity Date." (o) Section 17.9 is amended by adding the following at the beginning of such Section: "If (a) either (i) TBCC is liquidated, dissolved, merged or consolidated with any Person in a transaction in which TBCC is not the surviving entity or (ii) Aegon Corporation or one of its Affiliates ceases to own, directly or indirectly, a majority of the capital stock of TBCC, (b) TBCC (or its successor) ceases to conduct business as an asset based lender and (c) the Pro Rata Share of the Commitments of PNC Bank, National Association ("PNC") is equal to or greater than 50%, then PNC shall have the option to succeed TBCC as Agent or appoint a successor Agent to succeed TBCC as Agent, in each case subject to the terms set forth below." (p) Schedule C-1 to the Loan Agreement is amended and restated in the form of Schedule C-1 attached hereto. -5- 33 2. ASSIGNMENT. (a) Immediately after giving effect to the amendments set forth in Section 1 hereof, TBCC hereby sells and assigns to PNC, and PNC hereby purchases and assumes from TBCC, that interest in and to TBCC's rights and obligations under the Loan Documents as of the date hereof with respect to the Obligations owing to TBCC, and the Commitments to make Advances and participate in Letters of Credit, as is set forth on Annex A hereto. (b) TBCC (i) represents and warrants to PNC that TBCC is the legal and beneficial owner of the interest being assigned by TBCC hereunder and that such interest is free and clear of any adverse claim; (ii) makes no representation or warranty and assumes no responsibility with respect to any statements, warranties or representations made in or in connection with the Loan Documents or the execution, legality, validity, enforceability, genuineness, sufficiency or value of the Loan Documents or any other instrument or document furnished pursuant thereto; and (iii) makes no representation or warranty and assumes no responsibility with respect to the financial condition of Borrower or any of its Subsidiaries or the performance or observance by Borrower or any of its Subsidiaries of any of its obligations under the Loan Documents or any other instrument or document furnished pursuant thereto. (c) PNC (i) confirms that it has received copies of the Loan Agreement and the other Loan Documents, together with copies of the financial statements referred to therein and such other documents and information as it has deemed appropriate to make its own credit analysis and decision to enter into this Assignment Agreement; (ii) agrees that it will, independently and without reliance, as it shall deem appropriate at the time, continue to make its own credit decisions in taking or not taking action under the Loan Documents; (iii) confirms that it is eligible as an assignee under the terms of the Loan Agreement; (iv) appoints and authorizes the Agent to take such action as agent on its behalf and to exercise such powers under the Loan Documents as are delegated to Agent by the terms thereof, together with such powers as are reasonably incidental thereto; and (v) agrees that it will perform in accordance with their terms all of the obligations which by the terms of the Loan Documents are required to be performed by it as a Lender. (d) TBCC and PNC agree that (i) all amounts accrued with respect to the Commitments, the Advances and the Letters of Credit prior to PNC's payment of the amount (the "Specified Amount") referred to in Section 3(f) of this Amendment to TBCC shall be for the account of TBCC and (ii) all such amounts accrued after PNC's payment of the Specified Amount to -6- 34 TBCC shall be for the account of the Lenders based upon their respective shares of the Commitments and the Advances. (e) Upon PNC's payment of the Specified Amount to TBCC, (i) PNC shall be a party to the Loan Agreement and, to the extent provided herein, have the rights and obligations of a Lender thereunder and under the other Loan Documents and (ii) TBCC shall, to the extent provided herein, relinquish its rights and be released from its obligations under the Loan Agreement and the other Loan Documents. 3. CONDITIONS TO EFFECTIVENESS. This Amendment shall become effective upon the Agent's receipt of the following, each of which shall be in form and substance satisfactory to the Agent: (a) This Amendment, duly executed by the Borrower and the Lenders and duly consented to by OCM. (b) An amendment fee, for the ratable benefit of the Lenders, in an amount equal to $200,000 in immediately available funds, which shall be fully earned and non-refundable upon the effectiveness of this Amendment. (c) Certified copies of the resolutions of the Board of Directors of the Borrower approving this Amendment, the Loan Agreement as amended hereby and the other documents contemplated hereby or delivered in connection herewith (collectively, the "Amendment Documents"). (d) A certificate of the Secretary or an Assistant Secretary of the Borrower certifying the name and true signature of an authorized officer of the Borrower who is authorized to sign the Amendment Documents. (e) A certificate signed by an authorized officer of the Borrower certifying that (i) the representations and warranties contained in Section 4 hereof are true and correct in all material respects on and as of the date of such certificate as though made on and as of such date (except to the extent such representations and warranties expressly relate to an earlier date, in which case such representations and warranties were true and correct on and as of such earlier date), (ii) the representations and warranties contained in the Loan Agreement are true and correct in all material respects on and as of the date of such certificate as though made on and as of such date (except to the extent such representations and warranties expressly relate to an earlier date, in which case such representations and warranties were true and correct on and as of such earlier date), (iii) no Potential Default or Event of Default has occurred and is continuing and (iv) there has occurred no Material Adverse Change since July 4, 1999. -7- 35 (f) An amount from PNC, for the benefit of TBCC, equal to PNC's outstanding Advances (immediately after giving effect to this Amendment). (g) A legal opinion of counsel to the Borrower covering such matters relating to the transactions contemplated by this Amendment as the Agent shall reasonably request. (h) Information with respect to the status of the Creative Technology, Ltd. litigation filed in the United States District Court for the Northern District of California (Case No. 98-0770 WHO), which shall be satisfactory to the Lenders. (i) Such other documents, instruments, opinions, evidence, materials and information as the Agent may reasonably request. 4. REPRESENTATIONS AND WARRANTIES OF THE BORROWER. The Borrower represents and warrants as follows: (a) Since July 4, 1999 there has occurred no Material Adverse Change. (b) After giving effect to this Amendment, no Default or Event of Default has occurred and is continuing. (c) The representations and warranties contained in Section 5 of the Loan Agreement are true and correct in all material respects on the date hereof as though made on and as of the date hereof, except to the extent that such representations and warranties expressly relate solely to an earlier date (in which case such representations and warranties were true and correct on and as of such earlier date). (d) The Amendment Documents constitute the legal, valid and binding obligations of the Borrower, enforceable against the Borrower in accordance with their respective terms, except as enforceability may be limited by bankruptcy, insolvency and other laws affecting creditors' rights generally and by general principles of equity. (e) The execution, delivery and performance by the Borrower of the Amendment Documents, and the consummation of the transactions contemplated thereby, are within the Borrower's corporate powers, have been duly authorized by all necessary corporate action on the part of the Borrower, and do not (i) contravene the Borrower's Governing Documents, (ii) violate any law or regulation, (iii) conflict with or result in the breach of, or constitute a default under, any contract, loan agreement, indenture, mortgage, deed of trust, lease or other instrument binding on or affecting the Borrower or any of its -8- 36 properties or (iv) except for the Liens created under the Loan Documents, result in or require the creation or imposition of any Lien upon or with respect to any of the properties of the Borrower. (f) No consent of any Person, and no permit, approval or authorization of, exemption by, notice or report to, or registration, filing or declaration with, any Governmental Authority or other Person is required in connection with the execution, delivery, performance, validity or enforceability of the Amendment Documents and the transactions contemplated thereby. 5. EXPENSES. The Borrower shall pay for all of the reasonable costs and expenses incurred by the Agent in connection with the transactions contemplated by this Amendment, including, without limitation, the reasonable fees and expenses of counsel to the Agent. 6. MISCELLANEOUS. (a) Except as expressly amended herein, all of the terms and provisions of the Loan Agreement and the other Loan Documents are ratified and confirmed in all respects and shall remain in full force and effect. (b) Upon the effectiveness of this Amendment, all references in the Loan Documents to the Loan Agreement shall mean the Loan Agreement as amended by this Amendment and all references in the Loan Agreement to "this Agreement," "hereof," "herein," or similar terms, shall mean and refer to the Loan Agreement as amended by this Amendment. (c) The execution, delivery and effectiveness of this Amendment shall not, except as expressly provided herein, operate as an amendment to or waiver of any right, power or remedy of the Agent or the Lenders under any of the Loan Documents, or constitute an amendment or waiver of any provision of any of the Loan Documents. (d) This Amendment may be executed by the parties hereto individually or in combination, in one or more counterparts, each of which shall be an original and all of which shall constitute one and the same agreement. This Amendment may be executed and delivered by telecopier with the same force and effect as if the same were a fully executed and delivered original manual counterpart. (e) This Amendment shall constitute a Loan Document. -9- 37 7. GOVERNING LAW. THE VALIDITY, INTERPRETATION AND ENFORCEMENT OF THIS AMENDMENT SHALL BE GOVERNED BY THE LAWS OF THE STATE OF NEW YORK WITHOUT GIVING EFFECT TO THE CONFLICTS OF LAW PRINCIPLES THEREOF (OTHER THAN SECTION 5-1401 OF THE NEW YORK GENERAL OBLIGATIONS LAW). -10- 38 IN WITNESS WHEREOF, the parties hereto have caused this Amendment to be duly executed and delivered by their respective duly authorized officers. AUREAL INC., formerly known as Aureal Semiconductor Inc. By: ------------------------------------- Name: Title: TRANSAMERICA BUSINESS CREDIT CORPORATION, as Agent and a Lender By: ------------------------------------- Name: Title: PNC BANK, NATIONAL ASSOCIATION, as a Lender By: ------------------------------------- Name: Title: -11- 39 The undersigned Loan Party hereby consents to this Amendment and acknowledges that the execution, delivery and performance of this Amendment does not in any way affect its obligations under the Guaranty, all of which obligations are ratified and confirmed, remain absolute and unconditional and are not subject to any defense, setoff or counterclaim. OCM OPPORTUNITIES FUND II, L.P. By: Oaktree Capital Management, LLC, its General Partner By: ------------------------------------- Name: Title: By: ------------------------------------- Name: Title: -12- 40 Commitments
Commitment to Make Commitment to Make Total Commitments Pro Rata Lender Tranche A Advances Tranche B Advances* of Lenders Share - ----------------------------------------------------------------------------------------------------- Transamerica Business Credit $12,500,000 $2,500,000 $12,500,000 50% Corporation PNC Bank, National Association $12,500,000 $2,500,000 $12,500,000 50% Total of All Lenders $25,000,000 $5,000,000 $25,000,000 100%
* Tranche B is a Sublimit of Tranche A 41 Annex A Assignment from Transamerica Business Credit Corporation ("TBCC") to PNC Bank, National Association ("PNC") A. Total Commitment of TBCC Immediately Prior to Assignment $25,000,000 1. Commitment to Make Tranche A Advances $25,000,000 2. Commitment to Make Tranche B Advances* $5,000,000 B. Assigned Share of Commitment to Make Tranche A Advances 50% C. Assigned Share of Commitment to Make Tranche B Advances 50% D. Total Commitment of TBCC Immediately After Assignment $12,500,000 1. Commitment to Make Tranche A Advances $12,500,000 2. Commitment to Make Tranche B Advances* $2,500,000 E. Total Commitment of PNC Immediately After Assignment $12,500,000 1. Commitment to Make Tranche A Advances $12,500,000 2. Commitment to Make Tranche B Advances* $2,500,000 ====================================================================================
* Tranche B is a Sublimit of Tranche A EX-27.1 3 FINANCIAL DATA SCHEDULE (EDGAR ONLY)
5 THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS FOR THE PERIOD ENDED OCTOBER 3, 1999 AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS. 1,000 9-MOS JAN-02-2000 JAN-04-1999 OCT-03-1999 263 0 9,121 231 3,239 13,183 7,234 (3,978) 16,600 15,182 262 0 0 10 1,146 16,600 31,794 31,794 20,454 20,454 26,037 0 1,358 (17,411) 0 (17,411) 0 0 0 (17,411) (2.71) (2.71)
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