-----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, LI6JX335vuUdF3WiZ06gEdQVlylVSo2+NuiiBo+3gkXkiC0We2HpgMh+i2gI62oJ oWWH6HJK+/wKIiuGA/tKmA== 0000912057-96-013564.txt : 19981229 0000912057-96-013564.hdr.sgml : 19981229 ACCESSION NUMBER: 0000912057-96-013564 CONFORMED SUBMISSION TYPE: 10KSB PUBLIC DOCUMENT COUNT: 4 CONFORMED PERIOD OF REPORT: 19960331 FILED AS OF DATE: 19960701 DATE AS OF CHANGE: 19981228 FILER: COMPANY DATA: COMPANY CONFORMED NAME: FRACTAL DESIGN CORP CENTRAL INDEX KEY: 0000930884 STANDARD INDUSTRIAL CLASSIFICATION: 7372 IRS NUMBER: 770276903 STATE OF INCORPORATION: CA FISCAL YEAR END: 0331 FILING VALUES: FORM TYPE: 10KSB SEC ACT: SEC FILE NUMBER: 000-26822 FILM NUMBER: 96589375 BUSINESS ADDRESS: STREET 1: 335 SPRECKLES DRIVE CITY: APTOS STATE: CA ZIP: 95003 BUSINESS PHONE: 4086885300 MAIL ADDRESS: STREET 1: 335 SPRACKELS DR CITY: APTOS STATE: CA ZIP: 95003 10KSB 1 FORM 10-KSB - - -------------------------------------------------------------------------------- - - -------------------------------------------------------------------------------- SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-KSB [X] Annual report under Section 13 or 15(d) of the Securities Exchange Act of 1934 For the fiscal year ended March 31, 1996 [ ] Transition report under Section 13 or 15(d) of the Securities Exchange Act of 1934 For the transition period from ______________ to ____________ Commission file number 0-26822 ------- FRACTAL DESIGN CORPORATION (Exact Name of Registrant as Specified in Its Charter) California 77-0276903 ---------- ---------- (State or Other Jurisdiction of (I.R.S. Employer Incorporation or Organization) Identification No.) 335 Spreckels Drive, Aptos, CA 95003 (408) 688-5300 (Address, Including Zip Code and Telephone Number, Including Area Code, of Registrant's Principal Executive Offices) Securities registered under Section 12(b) of the Exchange Act: Name of Each Exchange Title of Each Class on Which Registered ------------------- --------------------- N/A N/A - - ---------------------------------- ----------------------------------- Securities registered under Section 12(g) of the Exchange Act: Common Stock - - ------------------------------------------------------------------------------- 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. [X] Yes [ ] No Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-B is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-KSB or any amendment to this Form 10-KSB. [X] State revenues of the registrant for the most recent fiscal year. $21,780,000 as of March 31, 1996. - - --------------------------------- As of June 21, 1996, the aggregate market value of the 6,724,744 shares of the registrant's common stock held by non-affiliates of the registrant was $100,871,160 based on the $15.00 last sale price of the registrant's common stock on the Nasdaq National Market on that date. As of June 21, 1996, 11,695,304 shares of the registrant's common stock were issued and outstanding. Documents incorporated by reference: None ---------------------------------- Transitional Small Business Disclosure Format. [ ] Yes [X] No - - -------------------------------------------------------------------------------- - - -------------------------------------------------------------------------------- TABLE OF CONTENTS Page ---- PART I. Item 1. Description of Business. . . . . . . . . . . . . . . . . . . . . 1 Item 2. Description of Property. . . . . . . . . . . . . . . . . . . . . 9 Item 3. Legal Proceedings. . . . . . . . . . . . . . . . . . . . . . . . 9 Item 4. Submission of Matters to a Vote of Security Holders. . . . . . . 9 PART II. Item 5. Market for Common Equity and Related Stockholder Matters . . . . 10 Item 6. Management's Discussion and Analysis of Financial Condition and Results of Operations . . . . . . . . . . . . . . . . . . . 10 Item 7. Financial Statements . . . . . . . . . . . . . . . . . . . . . . 23 Item 8. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. . . . . . . . . . . . . . . . . . . . 36 PART III. Item 9. Directors, Executive Officers, Promoters and Control Persons; Compliance with Section 16(a) of the Exchange Act . . . . . . . 37 Item 10. Executive Compensation . . . . . . . . . . . . . . . . . . . . . 40 Item 11. Security Ownership of Certain Beneficial Owners and Management . 41 Item 12 Certain Relationships and Related Transactions . . . . . . . . . 44 PART IV. Item 13. Exhibits and Reports on Form 8-K . . . . . . . . . . . . . . . . 45 PART I EXCEPT FOR HISTORICAL INFORMATION CONTAINED HEREIN, THE MATTERS SET FORTH HEREIN INCLUDE FORWARD-LOOKING STATEMENTS THAT ARE DEPENDENT ON CERTAIN RISKS AND UNCERTAINTIES INCLUDING THOSE DISCUSSED HEREIN, THE COMPANY'S REGISTRATION STATEMENT ON FORM S-4, DECLARED EFFECTIVE ON APRIL 26, 1996, AND THE COMPANY'S OTHER FILINGS WITH THE COMMISSION. ITEM 1. DESCRIPTION OF BUSINESS. Fractal Design Corporation was incorporated in California in April 1991 and is a leading provider of software tools for the creation, editing and manipulation of computer graphic images and digital art. Fractal's principal product, FRACTAL DESIGN PAINTER ("PAINTER") for Macintosh and Windows, is used primarily by artists, graphics professionals and animators in a number of industries, including print and electronic publishing, print and broadcast advertising and entertainment and content development. Creative professionals use PAINTER and other Fractal products to create and modify images for brochures, books, magazines and print and broadcast advertisements; to provide on-screen graphics for television broadcasts; to edit digital video projects and create animation; to develop multimedia content and to author World Wide Web pages for the Internet. Fractal provides intuitive and powerful software tools for the creation, editing and manipulation of computer graphic images and digital art. Fractal's products provide technologically advanced software tools that unite traditional artistic techniques and tangible media with digital technology, faithfully capturing the subtleties of the artist's gesture and translating them to the computer screen. Fractal's paint and image-editing products, which incorporate Natural-Media capabilities and currently operate on the Macintosh and Windows platforms, closely simulate the techniques of traditional artists' tools and the look of tangible artwork, while also offering innovative features that extend the creative abilities of artists, graphics professionals and animators and enable them to achieve effects not possible with traditional methods and tools. Fractal sells its products worldwide through distributors and mail-order catalogs, to hardware and software manufacturers for bundling with other products, and directly to registered users. ACQUISITION OF RAY DREAM, INC. On May 24, 1996, Fractal acquired Ray Dream, Inc., a California corporation which designs, develops and markets graphics software application tools emphasizing three-dimensional effects for the personal computer market (see "Products" for a description of Ray Dream's products). As a result of the acquisition, Ray Dream has become a wholly-owned subsidiary of Fractal. Unless the context otherwise requires, "the Company" refers herein to the combined company, and "Fractal" and "Ray Dream" refer herein to the separate companies prior to the acquisition. As consideration for 100% of the outstanding shares of Ray Dream capital stock, Fractal issued an aggregate 3,165,660 shares of Fractal common stock and reserved 219,459 shares of Fractal common stock for issuance upon exercise of previously outstanding options to purchase Ray Dream stock. Fractal also assumed an outstanding warrant to purchase Ray Dream common stock which, when vested, will be exercisable for up to 437,604 shares of Fractal common stock. Information with respect to Ray Dream is included throughout this Report, but Ray Dream's financial statements are not included in Fractal's financial statements contained herein. Pro forma financial and other information with respect to the acquisition of Ray Dream is contained in Fractal's Form S-4, declared effective on April 26, 1996, and the Company's Form 8-K, filed on June 6, 1996. PRODUCTS The Company's products include PAINTER, DABBLER, POSER and several other products that are sold separately as complementary add-ons to PAINTER and DABBLER (see also "Ray Dream Products" below). -1- PAINTER PAINTER, first introduced in August 1991, is an advanced paint and image-editing application targeted at artists, animators and graphics professionals. PAINTER 4.0, the current version of this product, was introduced in 1995 and operates on the Macintosh and Windows platforms. Key features of PAINTER include: - PRESSURE-SENSITIVE INPUT. PAINTER supports pressure-sensitive drawing tablets, which enables an artist to use a stylus to paint and draw with PAINTER much as he or she would with traditional artists' tools. For example, if an artist selects the chalk tool and strokes lightly on the digital pad, the chalk image lightly covers the peaks of the paper appearing on the computer screen. When pressed more heavily, the chalk fills the paper's valleys. Other tools exhibit thick or thin strokes depending on the pressure applied. - CUSTOMIZED BRUSHES. Physical bristle modeling heightens PAINTER'S ability to simulate Natural-Media tools by providing control over bristle characteristics like thickness and clumpiness. The "Capture Brush" feature lets the user define and re-use a customized brush shape from thousands of possible options to create unique image effects. - A WIDE VARIETY OF POWERFUL IMAGE-EDITING CAPABILITIES. PAINTER allows users to control the focus and orientation of an image and change its surface texture. PAINTER'S "image warp" feature can distort the surface of an image as if it were a sheet of pliable film. Combined with the cloning feature, a scanned photograph can be transformed into an entirely new style, like a chalk drawing or a Van Gogh-style painting. - POWERFUL IMAGE COMPOSITION TOOLS. Multiple floating selections (called "floaters"), consisting of separate images or design objects, allow for a highly flexible visual environment. Floaters may be layered, grouped, feathered, and stored in special portfolios. Images may be saved with floaters still floating and then reopened to make additional composition changes. - COLOR AND GRADATIONS. PAINTER'S "Color Selection Tool" feature allows the user to create and blend a nearly unlimited variety of different colors. PAINTER'S "edit gradation" feature enables users to create smooth gradations of color. - EASY-TO-UNDERSTAND, SPACE-SAVING INTERFACE. PAINTER'S wide array of tools are placed at the user's fingertips within "drawers" that can be opened or closed by the user as needed. The interface is customizable, so it can be tailored to an individual's method of working. - MULTIPLE UNDO. PAINTER enables up to 32 levels of undo. This permits the artist or designer to reverse the creation of the image step-by-step, in a manner not possible with traditional media. This provides art and graphics professionals with the ability to experiment with different possible approaches before finalizing a project, thereby improving productivity. - SCRIPTING. PAINTER enables the user to record and play back an editable "script" that is composed of all actions the user has made with PAINTER in the creation of graphical images. One application of this feature is that an artist can apply the same "script" to each frame of a movie to automate what would otherwise be a highly repetitive manual task. - ANIMATION AND VIDEO-EDITING TOOLS. To achieve image animation, PAINTER creates frame stacks, or sets of images that can be individually manipulated with PAINTER'S tools. Two-to-five-layer onion skinning lets a user see multiple frames, including those before and after the current frame. PAINTER also can be used to alter video imported from outside sources, and PAINTER'S visual effects may be applied to single or multiple frames within an animation stack. PAINTER also supports export of animation files formatted for Video for Windows and QuickTime for Macintosh, two popular video formats. -2- - THE "IMAGE HOSE." This unique feature paints with pictures instead of dabs of color, casting a series of small detailed images with every brush stroke. The Image Hose can create random natural and man-made patterns and textures or ordered tiled patterns, that would be difficult or tedious to create manually. - DIRECT SUPPORT FOR IMAGE SCANNING. PAINTER provides direct support for an image scanner, which allows scanned images to immediately appear in PAINTER'S image window where they may be cloned or edited. - SHAPES. PAINTER includes a drawing layer that floats above the bitmap canvas of an image, allowing the seamless blending of raster-based paint and vector-based draw images. - MOSAICS. This new Natural-Media feature allows users to design images in the style of historic tile mosaics, by "painting" with tiles on a canvas or over scanned photographs or images. The mosaic tiles are independent objects that automatically carve their shape and may be erased or reshaped easily. - NET PAINTING. This feature allows real-time collaborative artwork creation between users on networked computers, including over the Internet. Because PAINTER sends scripts over the network, rather than screen images, it can be used effectively over low bandwidth connections. As of March 31, 1996, PAINTER 4.0 was available on the Macintosh platform in English, Japanese, French, and German, and on the Windows platform in English and German. As of March 31, 1996, the suggested retail price for the English version of this product was $549. DABBLER DABBLER, which was first introduced for the Macintosh and Windows platforms in March 1994, offers many of the Natural-Media tools and textures found in PAINTER in a less sophisticated, learn-to-draw-and-paint format for beginning artists and hobbyists of all ages. DABBLER allows the user to experiment with a wide variety of tools, color options, and technique and style adjustments. DABBLER includes tutorials licensed on an exclusive basis from Walter Foster Publishing, a leading publisher of how-to art books. Although DABBLER can be utilized by mouse-based users, performance is enhanced by using a pressure-sensitive digital tablet. A localized version of DABBLER is marketed in Japan under the name "Art School." In October 1995, Fractal shipped DABBLER 2.0 for Macintosh and Windows, an enhanced version of DABBLER containing, among other improvements, more extensive instructional tutorials, a greater variety of paint tools and textures and animation capabilities. DABBLER 2.0 has a suggested retail price of $69 (English version). POSER POSER, introduced on the Macintosh platform in May 1995, is a modeling application that allows users to create images of human figures which can be posed, rendered with surface textures and multiple lights, and easily incorporated into artwork and designs. Model images created with POSER can be exported for use in graphics design, illustration, multimedia and 3D software. POSER is designed to work with 2D and 3D design applications such as PAINTER, Adobe Photoshop, Macromedia Director and several other products. As of March 31, 1996, the suggested retail price for POSER was $199. In March 1996, Fractal released POSER for the Windows platform. OTHER PRODUCTS The Company also offers a variety of accessory products that complement and extend its core product line. These include libraries of textures and brushes for use in creating images and designs with the Company's software, such as Trees & Leaves, Patterns & Nature, Grains & Weaves, Miles of Tiles, Walls & Reliefs and Sensational Surfaces. Sales of these products historically have not represented a material portion of revenues. In addition, as a result of Fractal's recent acquisition of Ray Dream, Inc. (see below), the Company's product line includes graphics software application tools emphasizing three-dimensional effects and animation for the personal computer market. -3- RAY DREAM PRODUCTS The flagship product of this line, Ray Dream STUDIO, integrates four components into one cohesive 3D illustration and animation package, and is composed of Ray Dream DESIGNER, Ray Dream ANIMATOR, DREAM MODELS and the Extensions Portfolio. STUDIO is available for the following major personal computer operating platforms: Apple Macintosh, Apple Power Macintosh, Microsoft Windows 3.x, Microsoft Windows 95, and Microsoft Windows NT. The product is cross-platform compatible, capable of importing and exporting graphics and animation information into the major file formats supported by other graphics applications in each operating environment. By combining powerful, advanced 3D techniques with an easy-to-use intuitive graphical interface and a step-by-step interactive user-assistance system, DESIGNER enables both experienced and first-time users to create full- color, high resolution images with the visual impact and photorealism of three dimensions. Ray Dream ANIMATOR then lets these users transform these three dimensional images into animations through the use of high-end features such as inverse kinematics, movies as textures, and deformations that enhance the realism and impact of the computer-generated scenes. Other products include ADDDEPTH, which allows both graphics novices and professional artists to add the impact of 3D to two dimensional typefaces and line art via a palette of easy-to-use controls. Ray Dream has also invented a patented edge-smoothing technology utilized in its JAG product for the Macintosh that allows users to enhance resolution and clarity, regardless of the paint, animation, multimedia, or photo-retouching software employed. MARKETING, DISTRIBUTION AND PRODUCT SUPPORT MARKETING The Company believes that favorable product reviews and word-of-mouth among creative professionals are critical to create greater awareness and commercial acceptance of its products. The Company promotes its products principally through ongoing contact with industry press and analysts and participation in trade shows, such as Seybold, MacWorld, PC Expo and Siggraph. These efforts typically include close contact with art and graphics professionals to generate increased awareness and to obtain feedback on the features and functionality of its products. In addition, the Company seeks to generate awareness of its products through selective advertising in industry publications. The Company uses direct marketing to identify potential customers and to conclude mail order and telephone sales. The Company also directly markets new versions of its products and new products through mailings to its existing registered customer base and to users of complementary graphics products. In addition, the Company sponsors an annual design contest that invites artists to enter their artwork created with PAINTER and DABBLER. Winning designs often are used in promotional materials. DISTRIBUTION The Company sells its products worldwide through multiple distribution channels including distributors and mail order catalogs, hardware and software manufacturers for bundling with other products, and directly to registered users. During fiscal 1995, Fractal's sales to Ingram Micro accounted for 25% of Fractal's net revenues. During fiscal 1996, Fractal's sales to the three largest distributors accounted for 17%, 17%, and 11%, respectively, of Fractal's net revenues. DOMESTIC DISTRIBUTION. Fractal's primary domestic sales channel is through independent, non-exclusive distributors who sell Fractal's products to retail stores and specialized resellers focused on graphics and design systems. As of March 31, 1996, Fractal had four domestic distributors: Ingram Micro, Merisel, Tech Data and Douglas Stewart. Fractal also sells its products to mail order distributors, including Mac and PC Connection, Mac and Micro Warehouse, Mac and PC Zone and Mac Mall. Fractal offers distributors discounts based upon sales volume, and enters into arrangements for the funding of co-promotional efforts with distributors. -4- Fractal enters into agreements with its domestic and significant international distributors and dealers that typically are cancelable by either party upon specified prior notice. These agreements generally do not contain required purchase commitments by the distributor or dealer. As is common practice in the software industry, Fractal typically offers distributors and bundling partners certain product exchange provisions and price protection. As a result of Fractal's acquisition of Ray Dream, the Company also markets the Ray Dream products as was previously done by Ray Dream, i.e., primarily to distributors for resale, including mail order distributors, and will derive a substantial portion of its revenues from direct mail offerings. INTERNATIONAL DISTRIBUTION. As of March 31, 1996 Fractal distributed its products through 32 software distributors in 28 countries. During fiscal 1995 and fiscal 1996, international sales represented approximately 28% and 46% of Fractal's net revenues, respectively, and approximately 11% and 29% of Fractal's net revenues were from customers located in Japan. Through its wholly-owned subsidiary, Fractal Design International, Fractal has an employee in Japan providing customer service and technical support and an office in Europe providing marketing support. Through its acquisition of Ray Dream, Inc., the Company also has increased its presence in Europe, where Ray Dream has a French subsidiary and relationships with a variety of distributors and resellers. SOFTWARE AND HARDWARE BUNDLING ARRANGEMENTS. The Company also distributes its products through bundling arrangements with hardware suppliers, particularly drawing tablet manufacturers such as Wacom, Summagraphics, and CalComp. From time to time, Fractal also bundles its products with complementary products from other software companies, and Ray Dream has, in the past, bundled its products with products from Corel Corporation. DIRECT SALES. The Company also markets and sells its products directly to registered users in its installed base. The Company fulfills these orders through independent sales fulfillment firms. Ray Dream markets directly to prospects and to its users via its own catalog. Marketing activities include direct mailings of newsletters, brochures and product upgrade offers, including mailings targeted at users of complementary products, such as Photoshop users. PRODUCT SUPPORT The Company offers free telephone customer support during its normal business hours. The Company also currently provides customer support via the Internet and maintains a forum on both CompuServe and America Online to provide technical information to customers. RESEARCH AND PRODUCT DEVELOPMENT The Company has a continuing program of product development directed toward the enhancement of existing products based upon current and anticipated customer needs and desired features. The Company works closely with artists, animators and graphics professionals to understand and address their needs. The Company also solicits suggestions from artists and creative professionals in focus groups and at trade shows, and uses this feedback to develop and implement new features for its products. To date, Fractal's development efforts have focused primarily on its painting and image-editing products, and currently are focused on new product development, the porting of PAINTER to a popular version of the UNIX operating system and completing international localizations of its software. As of March 31, 1996, 16 people were employed by Fractal in product development and quality assurance. In the fiscal years ended March 31, 1996 and 1995, Fractal expended $2.6 million, and $1.5 million, respectively, on research and product development. To date, Ray Dream's development efforts have focused primarily on three-dimensional illustration and animation products and are currently focused on Release 4.1 of Designer and Studio and a new product, now -5- known as FRACTAL DESIGN EXPRESSION. As of May 24, 1996, 15 people were employed by Ray Dream in product development and quality assurance. Fractal typically develops its application software on the Macintosh platform and ports applications to the Windows operating environment using proprietary software developed by Altura Software, Inc., a private company affiliated with one of the Company's directors and principal shareholders. Fractal also relies on Altura for certain technical assistance in the porting process, and relies on Altura to develop software and techniques for porting Fractal's products to new platforms, such as UNIX and Windows 95. The Company believes that its relationship with Altura has enabled Fractal to port applications to Windows in significantly less time than through internal efforts, and has shortened the product development cycle by permitting Fractal to maintain a single software code base. If the agreement with Altura were terminated or the Company's relationship with Altura is impaired for any reason, or if Altura should have financial difficulties or lose key personnel, the Company's ability to timely introduce versions of its products on the Windows platform would be substantially impaired. In such event, there can be no assurance that the Company would be able to attract and assimilate highly qualified technical personnel to port Fractal's software to the Windows platform or any other platforms on a timely basis. Any interruption in the availability or quality of these services and software from Altura for any reason could have a material adverse effect on the Company's business, operating results and financial condition. Ray Dream typically develops its software on the Windows operating environment and ports its applications to the Macintosh platform using its own proprietary software. COMPETITION The markets for the Company's products are intensely competitive, subject to rapid change and characterized by constant demand for new product features, and pressure to accelerate the release of new products and product enhancements and to reduce prices. A number of companies currently offer products that compete directly or indirectly with one or more of the Company's products. These companies include, among others, in the paint, draw and image-editing software market, Adobe Systems Incorporated, Corel Corporation, Micrografx Incorporated, Macromedia, Inc. (including its subsidiary, Fauve Software, a provider of image-editing and paint software), Silicon Graphics, Inc. (through its Alias Research subsidiary), and Microsoft Corporation (through its SOFTIMAGE division); and in the learn-to-draw-and-paint market, Microsoft Corporation, Adobe Systems Incorporated and Broderbund Software, Inc. The Company's competitors in the 3D drawing and illustration software market include, among others, Strata, Inc., Macromedia, Inc., Adobe Systems Incorporated, Corel Corporation, Autodesk, Inc., (through its Kinetix division), Visual Software, Inc., (which recently merged with Micrografx Incorporated) Caligari Corporation and Specular International Ltd. Many of the Company's competitors or potential competitors have significantly greater financial, managerial, technical, and marketing resources than the Company. A variety of potential actions by any of the Company's competitors, including a reduction of product prices, increased promotion, announcement or accelerated introduction of new or enhanced products or features, product giveaways or product bundling could have a material adverse effect on the Company's business, results of operations and financial condition. Although PAINTER includes significantly different features and functionality than other paint and image-editing products, such as Adobe Photoshop, common features in these programs may render them competitive for certain users, particularly users interested primarily in paint tools for image editing and enhancement. In addition, recent versions of Photoshop have included features, such as multiple floating images, that were first introduced in earlier released versions of PAINTER. There can be no assurance that future versions of other graphics-related products, including Photoshop, will not include features and functionality that are similar to or superior to features in PAINTER. Also, there can be no assurance that third parties will not introduce software products to compete with POSER, which Fractal released on the Macintosh platform in May 1995 and on the Windows operating system in March 1996. Increased competition resulting from any such release could have a material adverse effect on the Company's business, results of operations and financial condition. Ray Dream has licensed to Corel Corporation source and object code for versions 3 and 4 of DESIGNER and version 1 of ADDDEPTH for incorporation into major Corel products for distribution by Corel. Corel has the right to modify the programs to integrate them into significant Corel software application programs, including word processing, graphics, or computer aided design software, and is currently marketing a modified form of DESIGNER -6- in its CorelDraw6 suite of graphics and multimedia programs, which retails for $695. There can be no assurance that Corel, a significant competitor in the graphics market, will not reduce prices for its products that incorporate DESIGNER or ADDDEPTH to make such products competitive with Ray Dream's products. Additionally, certain potential customers of Ray Dream may determine that the versions of DESIGNER and ADDDEPTH included in significant Corel products satisfy their requirements, and having purchased or determined to purchase such Corel products, may choose to forego a purchase of subsequent versions of DESIGNER or ADDDEPTH from the Company. The Company believes that the primary competitive factors affecting the market for its products include product price, features, quality, performance, ease-of-use, name recognition and reputation, the quality of documentation and customer support, and access to channels of distribution. Although the Company believes that it competes favorably with respect to these factors, there can be no assurance that the Company will be able to continue to compete effectively with respect to these or any other factors. The Company's present or future competitors may be able to develop products comparable or superior to those offered by the Company or adapt more quickly than the Company to new technologies or evolving customer requirements. In order to be successful in the future, the Company must respond to technological change, customer requirements and competitors' current products and innovations. In particular, while the Company is currently developing additional products and product enhancements that it believes address customer requirements, there can be no assurance that it will successfully complete the development or introduction of these additional product enhancements on a timely basis or that these products and product enhancements will achieve market acceptance. Accordingly, there can be no assurance that the Company will be able to continue to compete effectively in its markets, that competition will not intensify or that future competition will not have a material adverse effect on the Company's business, results of operations and financial condition. INTELLECTUAL PROPERTY The Company regards its software as proprietary and relies primarily on a combination of copyright, trademark and trade secret laws, employee and third-party nondisclosure agreements, and other intellectual property protection methods to protect its products and technology. The Company also has one patent with respect to its Natural-Media technology and has one patent application pending. However, the Company believes that the ownership of patents is not presently a significant factor in its business and that its success does not depend on the ownership of patents, but primarily on the innovative skills, technical competence and marketing abilities of its personnel. The Company licenses certain components of its products and related technologies used in its product and service offerings, including certain color and file formats utilized in its paint and drawing products. The Company also licenses its POSER product from a third party software developer. Although the Company has a perpetual license to distribute this product, ownership of this software was retained by the developer. Unlike internally developed products, license arrangements with third party software developers may limit the Company's ability to create upgrades to its products. The Company generally has no signed license agreements with the end users of its products and does not copy-protect its software. In addition, existing copyright laws afford only limited protection, and it may be possible for unauthorized third parties to copy the Company's products or to reverse engineer or obtain and use information that the Company regards as proprietary. There can be no assurance that the Company's competitors will not independently develop technologies that are substantially equivalent or superior to Fractal's technologies. Policing unauthorized use of the Company's products is difficult, and while the Company is unable to determine the extent to which software piracy of its products exists, software piracy can be expected to be a persistent problem. In addition, the laws of certain countries in which the Company's products are or may be distributed do not protect the Company's products and intellectual property rights to the same extent as the laws of the United States. Ray Dream has licensed to Corel Corporation source and object code for versions 3 and 4 of DESIGNER and version 1 of ADDDEPTH for incorporation into major Corel products for distribution by Corel. Corel has the right to modify the programs to integrate them into significant Corel software application programs, including word processing, graphics, or computer aided design software, and is currently marketing a modified form of DESIGNER in its CorelDraw6 suite of graphics and multimedia programs, which retails for $695. There can be no assurance that Corel will not become a significant competitor -7- with RayDream's products. Additionally, certain potential customers of the Company may determine that the versions of DESIGNER and ADDDEPTH included in significant Corel products satisfy their requirements, and having purchased or determined to purchase such Corel products, may choose to forego a purchase of subsequent versions of DESIGNER or ADDDEPTH from the Company. Any of the foregoing could have a material adverse effect on the business, operating results and financial condition of the Company. There can be no assurance that third parties will not claim infringement by the Company with respect to current or future products, and the Company expects that it will increasingly be subject to such claims as the number of products and competitors in the graphics software market grows and the functionality of such products overlaps with other industry segments. From time to time, the Company has received notices alleging that its products infringe patents or other intellectual property rights of third parties. The Company cannot predict the effect, if any, that these claims, including the costs of defending any litigation or similar proceeding that may arise from such claims, will have upon its business, operating results and financial condition. Any such third party claims, whether or not they are meritorious, could result in costly litigation or require the Company to enter into royalty or licensing agreements. Such royalty or license agreements, if required, may not be available on terms acceptable to the Company or at all. If the Company were found to have infringed upon the proprietary rights of third parties, it could be required to pay damages, cease sales of the infringing products and redesign or discontinue such products, any of which could have a material adverse effect on the Company's business, operating results and financial condition. MANUFACTURING The principal materials and components used in the Company's products include computer media (diskettes and CD-ROMs), packaging and user manuals. Manufacturing involves the duplication of computer media and user manuals, assembly of components, sample testing the product and final packaging. The Company currently relies upon third parties to manufacture components of its products and assemble completed packages in accordance with the Company's specifications. The Company believes that there is an adequate supply of and source for the raw materials used in its products and that multiple sources are available for manufacturing and assembling its products. The Company's products are generally shipped as orders are received and, accordingly, Fractal has historically operated with little backlog. EMPLOYEES As of March 31, 1996, Fractal had 66 full-time employees, of whom 16 were engaged in product development and quality assurance, 36 in sales, marketing and technical support and 14 in manufacturing and administration. With Fractal's acquisition of Ray Dream, Inc., the company added an additional 42 full-time employees, of whom 15 were engaged in product development and quality assurance, 20 in sales, marketing and technical support and 7 in manufacturing and administration. The Company's employees are not represented by any collective bargaining organization, and the Company regards its relations with employees to be good. The Company's ability to introduce new products and product features on a timely basis depends substantially on the continued efforts of Mark Zimmer, Thomas Hedges, Eric Hautemont, Pierre Berkaloff, Pascal Belloncle and John Stockholm, who are extensively involved in product development and engineering. The Company does not carry key man insurance on its executive officers. The Company also is dependent on its ability to retain and motivate high quality personnel, especially its management and highly skilled development teams. The loss of the services of any of its executive officers or other key employees could have a material adverse effect on the business, operating results or financial condition of the Company. The Company's future success also depends on its continuing ability to identify, hire, train and retain other highly qualified technical and managerial personnel. Competition for such personnel is intense and Fractal has experienced difficulty in identifying and hiring qualified engineering personnel, particularly personnel with expertise on the Windows operating environment. There can be no assurance that the Company will be able to attract, assimilate or retain other highly qualified technical and managerial personnel in the future. The inability to attract and retain the necessary technical and managerial personnel could have a material adverse effect upon the Company's business, operating results and financial condition. -8- ITEM 2. DESCRIPTION OF PROPERTY. Fractal currently leases approximately 10,800 square feet of office and warehouse space in Aptos, California. On April 9, 1996, Fractal signed a letter-of-intent for approximately 29,600 square feet, increasing to approximately 41,000 square feet on December 1, 1998, of office and warehouse space in nearby Scotts Valley, California. The Company plans to relocate its operations later this calendar year. The initial term of the proposed lease will be for seven years with two, three year renewal options. It also gives the Company the right of first refusal on any of the remaining approximately 14,000 square feet in the building. The target commencement date is no earlier than July 1, 1996 and no later than September 1, 1996. Ray Dream, Inc. leases approximately 8,000 square feet of office space in Mountain View , California. Ray Dream's leases expire on dates between June 30, 1996 and September 30, 1996. The Company plans to relocate Ray Dream's operations to the new location in Scotts Valley later this calendar year. ITEM 3. LEGAL PROCEEDINGS. None.* * From time to time, the Company has received notices alleging that its products infringe patents or other intellectual property rights of third parties. The Company cannot predict the effect, if any, that these claims, including the costs of defending any litigation or similar proceeding that may arise from such claims, will have upon its business, operating results and financial condition. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY-HOLDERS. None.* * The shareholders of Fractal approved, on May 24, 1996 (fiscal year 1997), Fractal's acquisition of Ray Dream, Inc. -9- PART II ITEM 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The Common Stock of the Company is traded on the Nasdaq National Market ("NASDAQ") under the symbol "FRAC." The following table sets forth the high and low sales prices for the common Stock from November 9, 1995, the date of the Company's initial public offering, through June 21, 1996: Fiscal Year 1996 Low High ---------------- --- ---- Third Quarter (from November 9, 1995) $11.250 $18.250 Fourth Quarter $10.000 $15.500 Fiscal Year 1997 ---------------- First Quarter (through June 21, 1996) $11.50 $18.625 At June 21, 1996, there were approximately 163 shareholders of record of the Company's common stock. The Company has not paid dividends on its common stock and has no present intention of paying dividends in the foreseeable future. The Company presently intends to retain future earnings for reinvestment in its business. In addition, the Company is prohibited from paying dividends under its existing credit facility. Any future determination relating to dividend policy will be made at the discretion of the Board of Directors of the Company and will depend on a number of factors, inducing future earnings, capital requirements, financial condition and future prospects of the Company and such other factors as the Board of Directors may deem relevant. Prior to the termination of the Company's Subchapter S Corporation status, the Company made distributions to its shareholders of tax basis Subchapter S Corporation profits. See Note 4 of Notes to Consolidated Financial Statements. The Company has never paid any other dividends on its capital stock. ITEM 6. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. INTRODUCTION Fractal Design Corporation was founded in 1991 to develop, market and support software for the creation, editing and manipulation of computer graphic images and digital art. Fractal began shipments of its principal product, FRACTAL DESIGN PAINTER, in August 1991, and initiated shipments of its most recent release of this product, PAINTER 4.0, in the quarter ending December 31, 1995. PAINTER employs Fractal's proprietary Natural-Media technology, which enables artists, animators and graphics professionals to simulate closely the techniques of traditional artists' tools and the look of tangible media while offering innovative effects and productivity advantages made possible by digital technologies. Sales of PAINTER have been the primary source of Fractal's net revenues since inception, and currently are expected to constitute a significant portion of the Company's net revenues for the foreseeable future. In March 1994, Fractal introduced FRACTAL DESIGN DABBLER, a consumer-level product targeted at beginning artists and hobbyists. DABBLER integrates many of the advanced Natural-Media features developed for PAINTER, with a simplified interface and extensive tutorials. The newest release of this product, DABBLER 2.0 for both the Macintosh and Windows began shipping in October 1995. In June 1995, Fractal began shipping FRACTAL DESIGN POSER, a modeling and rendering application that allows users to create and manipulate a variety of human figures for graphic design, illustration, multimedia applications and 3D graphics applications. Fractal distributes its products in the United States and internationally through multiple distribution channels including distributors and mail-order catalogs, hardware and software manufacturers for bundling with other products, and directly to registered users. -10- Fractal's quarterly and annual net revenues have been affected historically by, among other factors, the timing of releases of new products and new versions of existing products. Historically, sales volumes of new products have increased in the first few months following introduction of a new product due to the purchase of initial inventory by distributors and resellers and the purchase of upgrades by existing users. Thereafter, net revenues have tended to decline and stabilize to a relatively constant level. Toward the end of a product or product version life cycle, revenues tend to decline significantly, and Fractal may experience returns from distributors in anticipation of new products or product versions. The Company anticipates that Ray Dream's quarterly and annual net revenues likely will be affected by similar factors. In March 1996 Fractal released several products, including POSER for Windows and foreign language releases of PAINTER 4.0 for Macintosh (Japanese, German and French) and Windows (German). A UNIX version of PAINTER 4.0 originally was scheduled for release in mid-calendar 1996, and now is scheduled for release in the quarter ending December 31, 1996. Due to the inherent uncertainties of software development, the Company cannot accurately predict the exact timing of shipment of a new product, localization or version release on any particular platform. Any delays in the scheduled release of these or any other products or product versions, or any failure to achieve market acceptance among new and upgrade customers, could have a material adverse effect on the Company's business, results of operations and financial condition. On May 24, 1996, Fractal acquired Ray Dream, Inc., a California corporation which designs, develops and markets graphics software application tools emphasizing three-dimensional effects for the personal computer market (see "Products" for a description of Ray Dream's products). As a result of the acquisition, Ray Dream has become a wholly-owned subsidiary of Fractal. As consideration for 100% of the outstanding shares of Ray Dream capital stock, Fractal issued an aggregate 3,165,660 shares of Fractal common stock and reserved 219,459 shares of Fractal common stock for issuance upon exercise of previously outstanding options to purchase Ray Dream stock. Fractal also assumed an outstanding warrant to purchase Ray Dream common stock which, when vested, will be exercisable for up to 437,604 shares of Fractal common stock. The transaction will be accounted as a pooling-of-interests. Transaction fees of approximately $1.7 million will be recorded in the first quarter of fiscal 1997. RESULTS OF OPERATIONS Fractal's results of operations for the fiscal year ending March 31, 1996 do not reflect the acquisition of Ray Dream and involve a number of risks and uncertainties which are described under the caption "Additional Factors That May Affect Future Results." The issuance of Fractal common stock in connection with the acquisition will have the effect of reducing the Company's net income per share from levels otherwise expected and could reduce the market price of the Company's common stock unless revenue growth or cost savings and other business synergies sufficient to offset the effect of such issuance can be achieved. -11- The following table sets forth Fractal's consolidated statement of income data as a percentage of net revenues for the periods indicated: Years Ended March 31, ------------------------ 1996 1995 ---- ---- Net revenues 100.0% 100.0% Cost of net revenues 19.4 19.4 ---- ---- Gross margin 80.6 80.6 ---- ---- Operating expenses: Research and development 12.2 11.6 Sales and marketing 41.4 44.1 General and administrative 7.5 7.2 ---- ---- 61.1 62.9 ---- ---- Income from operations 19.5 17.7 Interest income (expense), net 2.1 (0.2) ---- ---- Income before income taxes 21.7 17.5 Provision for income taxes (8.2) (3.6) ---- ---- Net income 13.4% 13.9% ---- ---- ---- ---- YEARS ENDED MARCH 31, 1996 AND 1995 NET REVENUES Net revenues include revenues from gross sales of software products, less promotional discounts and sales return reserves. Net revenues in fiscal 1996 increased 66% to $21.8 million from $13.1 million in fiscal 1995. This increase was due to a 66% increase in revenues from the sales of PAINTER. This increase was favorably affected by sales of PAINTER 3.1J (the localized version of PAINTER 3.1 for the Japanese market) and the newest release of PAINTER VERSION 4.0. Revenues also were favorably affected by sales of POSER. International revenues represented 46% and 28%, respectively, of net revenues in fiscal 1996 and 1995. These increases primarily reflected increases in sales in Europe and Asia, particularly Japan, that were attributable to additional international distribution relationships entered into during these periods. Fractal's U.S. and international sales are principally denominated in U.S. dollars. Movements in currency exchange rates did not have material impact on total revenues in the periods presented. However, there can be no assurance that future movements in currency exchange rates will not have a material adverse effect on the Company's future revenues and results of operations. GROSS PROFIT Cost of net revenues includes the cost of manuals, diskettes and their duplication, packaging materials, assembly and shipping, as well as royalties (including royalties paid on instructional content licensed for use in DABBLER and on color and file formats licensed for use in Fractal's paint and image editing products), reserves for obsolescence and the purchase price of any resold third party products. Cost of net revenues also includes personnel, facilities and related costs for materials management, shipping and receiving. Gross profit increased 66% to $17.6 million in fiscal 1996 from $10.6 million in fiscal 1995, primarily as a result of higher net revenues. Gross profit as a percentage of net revenues remained stable at 80.6% in fiscal 1996 and 1995. RESEARCH AND DEVELOPMENT Research and development expenses consist primarily of personnel, outside consultants and equipment costs required to conduct the Company's product development efforts. Research and development expenses were $2.6 million and $1.5 million in fiscal 1996 and 1995, respectively, representing 12.2% and 11.6% of net revenues, respectively. The increase in the amount of research and development expenses over these periods was due primarily to increases in the number of employees and related expenses to support the continued enhancement, design, development and localization of Fractal's software products, including the use of outside contractors to port versions of Macintosh products to Windows and for the localization and translation of the software and documentation for international markets. Research and development expenditures are charged to operations as incurred. Statement of Financial Accounting Standards No. 86, "Accounting for the Costs of Computer Software to be Sold, Leased or Otherwise Marketed," requires capitalization of certain software development costs subsequent to the establishment of technological feasibility. Based on the Company's product development process, technological feasibility is established upon completion of a working model. Costs incurred by Fractal between completion of the working model and the point at which the product is ready for general release have been insignificant, and accordingly, have not been capitalized as software development costs. SALES AND MARKETING Sales and marketing expenses include advertising, trade shows and other promotional expenses, compensation and sales commissions, travel, public relations, personnel and facilities expenses. Fractal's sales and marketing expenses were $9.0 million and $5.8 million in fiscal 1996 and 1995, respectively, representing 41.4% -12- and 44.1% of net revenues, respectively. The increase in sales and marketing expenses over these periods was due primarily to increased marketing activities, such as advertising, participation in trade shows, direct mail campaigns and increased staffing in sales and marketing and commissions paid on higher levels of sales. GENERAL AND ADMINISTRATIVE General and administrative expenses are comprised primarily of the costs of Fractal's finance and administration functions. General and administrative expenses were $1.6 million and $0.9 million in fiscal 1996 and 1995, respectively, representing 7.5% and 7.2% of net revenues, respectively. The amount of general and administrative expenses increased from fiscal 1995 to fiscal 1996 primarily due to increased staffing and related costs necessary to support higher levels of operations, professional fees, compensation related to stock options issued during April and May 1995, and directors and officers liability insurance. The Company will record future compensation in the aggregate amount of $412,000 in connection with stock options granted during April and May 1995. The compensation will be recognized over the remainder of the four-year vesting periods of the options. As the result of the Company's acquisition of Ray Dream, Inc. on May 24, 1996, the Company expects to record a one-time charge, including professional services and severance costs, of approximately $1.7 million in the quarter ending June 30, 1996. INCOME TAXES Fractal's effective income tax rate was 38% and 20.5% for the fiscal years 1996 and 1995, respectively. Fractal's effective tax rate of 20.5% for fiscal 1995 compared to a combined statutory rate of approximately 40% was due to the recognition of $630,000 of deferred tax assets which were previously reserved. The Company anticipates its effective tax rate in future periods will more closely approximate the statutory rates in effect for those periods, except for utilization of Ray Dream's net operating loss carry-forwards. FACTORS THAT MAY AFFECT FUTURE RESULTS The Company has experienced in the past and expects in the future to continue to experience significant fluctuations in quarterly operating results. The Company has at times recognized a substantial portion of its net revenues in the last month or last few weeks of a quarter. The Company generally ships products as orders are received and, therefore, has little or no backlog. As a result, quarterly sales and operating results generally depend on a number of factors that are difficult to forecast, including, among others, products and updates scheduled to ship near the end of a quarter and the volume and timing of and ability to fulfill orders received within the quarter. Operating results also may fluctuate due to factors such as demand for the Company's products, introduction, localization or enhancement of products by the Company and its competitors, market acceptance of new products, reviews in the industry press concerning the products of the Company or its competitors, changes or anticipated changes in pricing by the Company or its competitors, mix of distribution channels through which products are sold, mix of products sold, returns from the Company's distributors, product announcements by Apple, Microsoft and PC manufacturers and general economic conditions. As a result, Fractal believes that period-to-period comparisons of its results of operations are not necessarily meaningful and should not be relied upon as any indication of future performance. See also "Additional Factors That May Affect Future Results." In addition, because the Company's staffing and other operating expenses are based in part on anticipated net revenues, a substantial portion of which may not be generated until the end of each quarter, delays in the receipt or shipment of orders and ability to achieve anticipated revenue levels can cause significant variations in operating results from quarter to quarter. The Company may be unable to adjust spending in a timely manner to compensate for any unexpected revenue shortfall. Accordingly, any significant shortfall in sales of the Company's products in relation to the Company's expectations could have an immediate adverse impact on the Company's business, operating results and financial condition. In addition, the Company currently intends to increase its operating expenses to fund greater levels of research and product development, increase its sales and marketing operations and expand distribution channels. To the extent that such expenses precede or are not subsequently -13- followed by increased net revenues, the Company's business, operating results and financial condition could be materially and adversely affected. In the future, the Company may make acquisitions of complementary companies, products or technologies. Managing acquired businesses entails numerous operational and financial risks, including difficulties in assimilating acquired operations, diversion of management's attention to other business concerns, amortization of acquired intangible assets and potential loss of key employees or customers of acquired operations. There can be no assurance that the Company will be able to effectively complete or integrate acquisitions, and failure to do so could have a material adverse effect on the Company's operating results. In addition, Fractal's acquisition of Ray Dream (see Item 1 for a complete discussion) is expected to affect the Company's future results of operations and all components thereof, including Net Revenues, Gross Profit Research and Development expenses, Sales and Marketing expenses, General and Administrative expenses and Income Taxes. There can be no assurance that the integration of Fractal and Ray Dream will be completed without a disruption of Fractal's and Ray Dream's businesses and a material adverse effect on the Company's financial condition and future results of operations. IMPORTANCE OF THE MACINTOSH PLATFORM AND APPLE COMPUTER; INCREASED PRESENCE ON THE WINDOWS PLATFORM Although Fractal offers PAINTER on both the Macintosh and Windows platforms, approximately 77% of the sales of PAINTER during fiscal 1996 were for the Macintosh platform, which historically has been a popular platform among art and graphics professionals. To the extent that other operating systems, such as Windows 95 and Windows NT, continue to become more prevalent among Fractal's customers, Fractal may be required to modify its development, personnel recruiting, marketing and distribution efforts to more effectively address these platforms. Apple Computer recorded a $740 million loss in its second quarter of fiscal 1996, significantly exceeding its first quarter loss of $69 million. These announcements, and the overall perception of Apple Computer, have negatively impacted Fractal's Macintosh based business. While North America Macintosh- based Painter revenue increased in fiscal 1996, the growth rate has declined during this period, including an absolute decline in the fourth quarter compared to the fourth quarter of the prior year. This trend in the past has been offset by growth in international markets on the Macintosh platform, but there can be no guarantee that this will continue to be the case. The Company is reviewing the balance of its sales and marketing efforts between the Macintosh and Windows environment to determine if additional investments or changes in its sales and marketing programs are necessary to address the relative momentum in the Macintosh and Windows environments. The Company currently does not anticipate a reversal of the trend of the Macintosh environment losing market share in the graphics market to the Windows environment. In addition, Fractal believes that sales of Ray Dream's products, including DESIGNER and STUDIO, overseas are substantially dependent upon the acceptance of the Windows 95 operating system abroad, and that slow adoption of the Windows 95 operating system abroad could adversely affect sales of Ray Dream's products, and thus could adversely affect the operating results of the Company. LIQUIDITY AND CAPITAL RESOURCES As of March 31, 1996, Fractal's principal sources of liquidity are its cash, cash equivalents and short-term investments of $29.1 million. On November 9, 1995, Fractal completed its initial public offering of common stock. The net proceeds from the offering were $23.5 million, after deducting underwriting discounts, commissions and expenses. The Company uses its working capital to finance ongoing operations, fund the development and introduction of new products and acquire capital equipment. Fractal's operating activities provided cash of $1.3 million and $2.7 million in the fiscal years ended March 31, 1996 and 1995, respectively, principally as a result of net income, offset by changes in working capital. -14- On September 1, 1995, Fractal entered into a line of credit agreement which provides for borrowings of up to $600,000 at variable interest rates equal to the bank's reference rate (8.25% as of March 31, 1996) plus 1%. No amounts were outstanding under this line at March 31, 1996. The line of credit agreement expires on August 1, 1996, is unsecured and includes restrictive covenants which require the Company to maintain certain financial ratios and minimum net worth, as defined. The Company believes that expected cash flows from operations and existing cash balances, will be sufficient to meet its currently anticipated working capital and capital expenditure requirements for the next 12 months. In addition to Fractal's acquisition of Ray Dream, Inc., the Company's capital requirements also may be affected by other acquisitions of businesses, products and technologies that are complementary to the Company's business. Although the Company regularly evaluates such opportunities, no such transactions are being actively pursued by the Company as of the date of this filing on Form 10-KSB. Any such transaction, if consummated, may use a portion of the Company's working capital or require the issuance of equity. In addition, the Company's operating results may be affected by changes in the financial condition of any of its distributors. The Company is aware that two of its distributors, Merisel and DTP (Germany), have recently experienced financial difficulties. The Company believes that its allowance for doubtful accounts receivable together with its insurance coverage should be sufficient to cover exposure to amounts which may ultimately be uncollectible from such distributors. During the next twelve months, the Company expects significant cash disbursements for the one-time charge of $1.7 million associated with Fractal's acquisition of Ray Dream, as well as the Company's relocation to Scotts Valley, California. Potential risks and uncertainties include, among others, fluctuations in the volume and timing of product orders, changes in demand for the Company's products, the timing of the introduction, localization or enhancement of products by the Company and its competitors, market acceptance of new products, localization and upgrades, reviews in the industry press concerning the products of the Company or its competitors, pricing changes, changes in distribution mix, returns from the Company's distributors and general economic conditions. ADDITIONAL FACTORS THAT MAY AFFECT FUTURE RESULTS INTEGRATION OF RAY DREAM OPERATIONS; POTENTIAL ADVERSE EFFECT ON FINANCIAL RESULTS The realization of the benefits sought from the acquisition of Ray Dream depends on the ability of the Company to better utilize product development capabilities, sales and marketing capabilities, administrative organizations and facilities than either company could do separately. In addition, the Company anticipates that it will be able to use Ray Dream's net operating loss carry forwards. These benefits may not be achieved if the activities of Fractal and Ray Dream are not integrated in a coordinated, timely and efficient manner, and there can be no assurance that this will occur. The combination of the two organizations will also require the dedication of management resources, which will temporarily detract attention from the day-to-day business of the Company. There can be no assurance that the integration will be completed without disrupting Fractal and Ray Dream's businesses. Should Fractal and Ray Dream not be able to achieve integration in a timely and coordinated fashion, it could result in a material adverse effect on operating results. Following the acquisition, the Company intends to seek to reduce operating costs over time by eliminating duplicative operations and facilities that otherwise would have been required by each of the two companies operating on a stand-alone basis. There can be no assurance that these steps will reduce costs to the extent, or as quickly as, planned or that these steps will not adversely affect continuing revenues and results of operations. These reductions could have a material adverse effect on employee morale and on the ability of the Company to retain the key management, engineering and sales and marketing personnel who are critical to the Company's future operations. -15- If the anticipated savings in operating costs are not achieved, or if the acquisition has other adverse effects that are not currently anticipated, the acquisition could result in a reduction in per share earnings of the Company (as compared to the per share earnings that either or both of the companies would have achieved if the acquisition had not occurred). Even if the effects of the acquisition prove to be as anticipated, there can be no assurance that future earnings will not be adversely affected by any number of economic, market or other factors that are not related to the acquisition. PRODUCT TRANSITIONS AND PRODUCT RETURNS From time to time, the Company and its competitors and Apple, Microsoft and PC manufacturers, may announce new products, product versions, capabilities or technologies that have the potential to replace or shorten the life cycles of the Company's existing products. Fractal has historically experienced increased returns of a particular product version following the announcement of a planned release of a new version of that product. For example, following the new product announcement of PAINTER 4.0, Fractal received approximately $1,050,000 worth of returns of the previous version of PAINTER from its distributors. These returns were adequately covered by previously established reserves. Although the Company provides allowances for anticipated returns, there can be no assurance that product returns will not exceed such allowances in the future. The Company also typically offers free upgrades to purchasers of a product following announcement of a new release and before shipment of the new version of that product. In addition, the Company may offer price discounts for new products and product releases in order to facilitate market acceptance. The announcement of currently planned or other new products may cause customers to delay their purchasing decisions in anticipation of such products, which could have a material adverse effect on business, operating results and financial condition of the Company. PRODUCT CONCENTRATION; LACK OF PRODUCT REVENUE DIVERSIFICATION Fractal currently markets three primary products, PAINTER, DABBLER and POSER. Sales of PAINTER have been the primary source of Fractal's net revenues since inception, and currently are expected to constitute a substantial majority of the Company's net revenues for the foreseeable future. Sales of Ray Dream's principal products, DESIGNER and STUDIO, have and are expected to continue to constitute a substantial majority of the Company's net revenues for the foreseeable future. Continued market acceptance of PAINTER, DESIGNER and STUDIO is therefore critical to the future success of the Company. Any decline in demand for or failure to achieve continued market acceptance of these products or any new version of these products as a result of competition, technological change, failure of the Company to timely release new versions of these products, or otherwise, could have a material adverse effect on the business, operating results and financial condition of the Company. There can be no assurance that localization of these versions will be accomplished and the products released on a timely basis, or that the product will operate successfully in commercial use or achieve market acceptance. DEPENDENCE ON AND NEED FOR NEW PRODUCTS AND PRODUCT VERSIONS; POTENTIAL DELAYS IN PRODUCT RELEASES The market for graphics software products is characterized by rapid technological developments, evolving industry standards, swift changes in customer requirements and computer operating environments, and frequent new product introductions and enhancements. As a result, the success of the Company depends substantially upon its ability to continue to enhance its existing products, to develop and introduce in a timely manner new products incorporating technological advances and to meet increasing customer expectations. To the extent one or more competitors introduce products that better address customer needs, the Company's business could be adversely affected. There can be no assurance that the Company will be successful in developing and marketing enhancements to its existing products or new products on a timely basis or that any new or enhanced products will adequately address the changing needs of the marketplace. Also, negative reviews of the Company's new products or product versions in industry publications could have a material adverse effect on product sales. The Company depends substantially upon internal efforts for the development of new products and product enhancements. Both Fractal and Ray Dream have in the past experienced delays in the development of new products and product versions, most recently in Fractal's release of DABBLER 2.0 and PAINTER 4.0 for UNIX, -16- and Ray Dream's release of DESIGNER 3, each of which was released or is scheduled to be released several months later than originally scheduled. There can be no assurance that the Company will not experience further delays in connection with its current product development or future development activities. Also, software products as complex as those offered by the Company may contain undetected errors when first introduced or as new versions are released. Fractal and Ray Dream have in the past discovered software errors in certain of their new products and enhancements after the introduction of these products. For example, Ray Dream's release of DESIGNER 3 was affected by product errors sufficient to necessitate various updates and an interim release of the product in June 1994. There can be no assurance that errors will not be found in new products or releases after commencement of commercial shipments, resulting in adverse product reviews and a loss of or delay in market acceptance, which could have a material adverse effect upon the Company's business, operating results and financial condition. Fractal has scheduled the release of a UNIX version of PAINTER 4.0 in the quarter ending December 31, 1996, and a new product, EXPRESSION, in the quarter ending September 30, 1996. Due to the inherent uncertainties of software development, the exact timing of shipment of a new product, localization or version release on any particular platform cannot be accurately predicted. For example, the Company has scheduled the next release of POSER for the quarter ending December 31, 1996. This product originally was scheduled to ship in September 1996. Also, the Company currently believes it will be in a position to accelerate shipment of a new product, currently named VOODOO, to the quarter ending September 31, 1996. Any such or other delays in the scheduled release of these or any other products or product versions, or any failure to achieve market acceptance among new and upgrade customers, could have a material adverse effect on the business, results of operations and financial condition of the Company. The Company uses certain products and technologies of both domestic and foreign third party software developers, including both complete products offered as extensions of the companies' product lines and technologies used in the enhancement of internally developed products. For example, the Company licenses its POSER and EXPRESSION products from third party software developers. Such products and technologies are obtained from third party providers under contractual license agreements, which in some cases are for limited time periods and in some cases provide that such licenses may be terminated under certain circumstances. There can be no assurance that the Company will be able to maintain adequate relationships with any such third party providers (including, in particular, Ray Dream's relationships to be maintained by the Company after the acquisition), that these third party providers will commit adequate development resources to maintain these products and technologies, or that the license agreements for limited time periods will be renewed upon termination. In such circumstances, the Company's inability to obtain or develop substitute technology could adversely affect its business, results of operations and financial condition. Unlike internally developed products, these license arrangements also may limit the companies' ability to timely create and release product upgrades and to effectively control the product development process. From time to time, the Company has worked and may continue to work with foreign third-party developers in the development of future products and components to existing products. There can be no assurance that products developed in conjunction with these third-party developers, which may make use of unproven and untested technologies, will be produced in a timely fashion (if at all), will be free of significant defects, or ultimately will be accepted by customers. LIMITED OPERATING HISTORY; UNCERTAIN PROFITABILITY; FLUCTUATING RATES OF GROWTH The Company has only a limited operating history on which an evaluation of its business and prospects can be based. Fractal was incorporated in April 1991 and commenced shipment of its initial product in August 1991. Although Fractal has experienced revenue growth in recent periods, and has experienced profitability on a quarterly basis since the quarter ended March 31, 1994, there can be no assurance that the net revenues of the Company will continue at their current level or will grow, or that the Company will be able to achieve sustained profitability on a quarterly or annual basis. Fractal's historical net revenue growth rates both domestically and internationally have varied significantly between monthly and quarterly periods. Therefore, recent net revenue comparisons should not be taken as indicative of the rate of net revenue growth, if any, that can be expected in the future. Ray Dream was incorporated in December 1989 and commenced shipment of its initial product in December 1990. Ray Dream incurred operating losses in each fiscal year since inception, and at December 31, 1995, had an accumulated deficit of $2.6 million. Although Ray Dream experienced annual revenue growth -17- during the three years ended December 31, 1995, there can be no assurance that growth in revenues from sales of Ray Dream's products will continue following the acquisition. DEPENDENCE ON KEY PERSONNEL AND DIFFICULTY OF IDENTIFYING AND HIRING CERTAIN PERSONNEL The future performance of Fractal and Ray Dream is substantially dependent on the performance of its executive officers and key employees. In particular, Fractal's ability to introduce new products and product features on a timely basis depends substantially on the continued efforts of Mark Zimmer, Thomas Hedges, Eric Hautemont, Pierre Berkaloff, Pascal Belloncle and John Stockholm, who are extensively involved in product development and engineering. Fractal recently announced that Stephen Manousos, Fractal's Vice President, Sales, has informed the Company that he will resign as Vice President, Sales effective June 30, 1996. To replace Mr. Manousos, the Company promoted Karen Bria from Director of International Sales & Marketing to Vice President, International Sales and Marketing and Michael Popolo from Area Sales Manager for the Eastern Region and Canada to Vice President, North American Sales (see Part III, Item 9 "Directors, Executive Officers, Promoters and Control Persons; compliance with Section 16(A) of the Exchange Act"). There can be no assurance that the Company will be able to successfully complete the transition of Mr. Manousos' replacements, and any failure to do so could have a material adverse effect on the Company's sales and results of operations. The future success of the Company also depends on its continuing ability to identify, hire, train and retain other highly qualified technical and managerial personnel. Competition for such personnel is intense and Fractal and Ray Dream have experienced difficulty in identifying and hiring qualified engineering personnel, particularly in hiring experienced programmers on the Windows operating environment. There can be no assurance that the Company will be able to attract, assimilate or retain other highly qualified technical and managerial personnel in the future. The inability to attract and retain the necessary technical and managerial personnel could have a material adverse effect upon the Company's business, operating results and financial condition. HIGHLY COMPETITIVE MARKETS The markets for graphics software products such as those offered by the Company are intensely competitive, subject to rapid change and characterized by constant demand for new product features, pressure to accelerate the release of new products and product enhancements and to reduce prices. A number of companies currently offer products that compete directly or indirectly with one or more of the Company's products. Competitors of the Company include, among others, in the paint, draw and image-editing software markets, Adobe Systems Incorporated, Corel Corporation, Micrografx Incorporated, Macromedia, Inc. (through its subsidiary, Fauve Software, a provider of image-editing and paint software) Silicon Graphics, Inc. (through its Alias/Wavefront division), and Microsoft Corporation (through its SOFTIMAGE division); and in the learn-to- draw-and-paint market, Microsoft Corporation, Adobe Systems Incorporated and Broderbund Software, Inc. The Company's competitors in the 3D drawing and illustration software market include, among others, Strata, Inc., Macromedia, Inc., Adobe Systems Incorporated, Corel Corporation, Autodesk, Inc. (through its Kinetix division), Visual Software, Inc., which recently merged with Micrografx Incorporated, Caligari Corporation and Specular International Ltd. Many of the Company's competitors or potential competitors have significantly greater financial, managerial, technical, and marketing resources. The Company anticipates that it may need to reduce the price on some of its flagship products in order to penetrate the market for Windows software, and such price reductions could have a material adverse effect on the Company's business, operating results and financial condition. A variety of potential actions by any of these competitors, including a reduction of product prices, increased promotion, announcement or accelerated introduction of new or enhanced products or features, acquisitions of software applications or technologies from third parties, product giveaways or product bundling could have a material adverse effect on the business, operating results and financial condition of the Company. In the event of price erosion, the Company may be unable to successfully reposition itself to accommodate these shifting marketing conditions. In addition, the consummation of the acquisition may induce more highly capitalized competitors of the Company either to enter the 3D drawing and illustration market or to acquire companies that compete with the Company. Potential participants in such activity could include, among others, Adobe Systems Incorporated, Corel Corporation, Micrografx Incorporated and Autodesk, Inc. Other companies that currently market products in the "high end" graphics market, such as Microsoft's SOFTIMAGE division and Silicon Graphics Inc.'s Alias/Wavefront division may also alter their development and marketing focus to compete with the Company. -18- Such actions could have a material adverse effect on the Company's business, operating results and financial condition. Although PAINTER includes significantly different features and functionality than other paint and image-editing products, such as Adobe Photoshop, common features in these programs may render them competitive for certain users, particularly users interested primarily in paint tools for image editing and enhancement. In addition, recent versions of Photoshop have included features, such as multiple floating images, that were first introduced in earlier released versions of PAINTER. There can be no assurance that future versions of other graphics-related products, including Photoshop, will not include features and functionality that are similar to or superior to features in PAINTER. Also, there can be no assurance that third parties will not introduce software products to compete with POSER. Increased competition resulting from any such release could have a material adverse effect on the Company's business, operating results and financial condition. Autodesk, Inc.'s 3D Studio product provides a substantially similar feature set to STUDIO and DESIGNER, although the Autodesk product is currently shipping solely for the Microsoft DOS platform, and is priced significantly higher than STUDIO. There can be no assurance, however, that Autodesk will not offer products at prices that are competitive with STUDIO, which could have a material adverse effect on the Company's operating results. Ray Dream has licensed to Corel Corporation source and object code for versions 3 and 4 of DESIGNER and version 1 of ADDDEPTH for incorporation into major Corel products for distribution by Corel. Corel has the right to modify the programs to integrate them into significant Corel software application programs, including word processing, graphics, or computer aided design software, and is currently marketing a modified form of DESIGNER in its CorelDraw6 suite of graphics and multimedia programs, which retails for $695. There can be no assurance that Corel, a significant competitor in the graphics market, will not reduce prices for its products that incorporate DESIGNER or ADDDEPTH to make such products competitive with Ray Dream's products. Additionally, certain potential customers of Ray Dream may determine that the versions of DESIGNER and ADDDEPTH included in significant Corel products satisfy their requirements, and having purchased or determined to purchase such Corel products, may choose to forego a purchase of subsequent versions of DESIGNER or ADDDEPTH from Ray Dream. Any of the foregoing could have a material adverse effect on the business, operating results and financial condition of the Company. Present or future competitors may be able to develop products comparable or superior to those offered by the companies or adapt more quickly to new technologies or evolving customer requirements. In addition, developers of personal computer operating systems, including Apple Computer, Inc. and Microsoft Corporation, may incorporate 3D functionality into their operating systems, which may be superior to or incompatible with the products of the Company, thus adversely affecting the Company's operating results. In particular, while the Company currently is developing additional product enhancements to its products that it believes address customer requirements, there can be no assurance that the development or introduction of these additional product enhancements will be successfully completed on a timely basis or that these product enhancements will achieve market acceptance. Accordingly, there can be no assurance that the Company will be able to continue to compete effectively in its markets, that competition will not intensify or that future competition will not have a material adverse effect on the business, operating results and financial condition of the Company. DEPENDENCE ON DISTRIBUTORS Fractal sells its software products primarily to distributors for resale, including mail-order distributors. Sales to a limited number of distributors have constituted, and are anticipated to continue to constitute, a significant portion of the Company's net revenues. For the fiscal years ended March 31, 1995 and 1996, aggregate sales to Fractal's five principal distributors, including Ingram Micro, Inc., represented 46% and 57%, respectively, of Fractal's net revenues and sales to Ingram Micro represented 25% and 17%, respectively, of net revenues. Ray Dream also markets its software products primarily to distributors for resale, including mail order distributors, but derives a substantial portion of its revenues from direct mail offerings by Ray Dream or direct mail organizations with which Ray Dream contracts. Internationally, Ray Dream distributes its products principally through a network of resellers and distributors. For the fiscal years ended December 31, 1995 and 1994, sales to Ray Dream's primary distributor, Ingram Micro, Inc., accounted for 13% and 18% of net revenues, respectively. -19- Any termination or significant disruption of any relationship with any major distributor or retailer, particularly the relationships with Ingram Micro, or a significant reduction in sales volume attributable to the Company's principal resellers, could materially and adversely affect the business, operating results and financial condition of the Company. The distribution channels through which consumer software products are sold have been characterized by rapid change, including consolidations and financial difficulties of distributors and retailers, including certain of the Company's current distributors. The bankruptcy, deterioration in financial condition or other business difficulties of a distributor or retailer could render the Company's accounts receivable from such entity uncollectible, which could result in a material adverse effect on the Company's business, operating results and financial condition. For example, the Company is aware that one of its distributors, Merisel, has recently experienced financial difficulties. In addition, one of the Company's distributors in Germany, DTP Partner, has recently filed for bankruptcy and owes the Company a total of approximately $80,000. Insurance maintained by the Company is expected to cover only a portion of any losses resulting from the nonpayment of receivables by distributors or retailers. Retailers of the companies' products typically have a limited amount of shelf space and promotional resources for which there is intense competition, and the companies depend in part upon promotional efforts of distributors in placing products with retailers. There can be no assurance that distributors and retailers will continue to purchase the companies' products or provide the companies' products with adequate levels of shelf space and promotional support. Failure of distributors or retailers to do so could have a material and adverse effect on the business, operating results and financial condition of the Company. Ray Dream anticipates that the announcement of the acquisition, and related uncertainty with respect to the future channels of distribution for Ray Dream's products, may have a material adverse effect on its relationships with distributors and their activities in promoting Ray Dream's products. Some current Ray Dream and Fractal distributors may perceive that the combination of Fractal and Ray Dream will adversely affect distribution relationships in regions where, upon consummation of the Merger, there will be overlapping distribution and marketing channels. This may result in diminished promotional activity on the part of these distributors, in light of concerns that their distribution contracts may be terminated. Ray Dream's direct mail distribution of its products exposes the Company to additional risks, including, among others, rising costs of paper in printing marketing materials, reliance on the costs and operations of the United States and international postal services, susceptibility to weather conditions and similar circumstances beyond the Company's control. GRAPHICS SOFTWARE MARKET The market for graphics software in general, and the painting, drawing, image-editing and 3D illustration and animation segments of such market addressed by Fractal's and Ray Dream's products in particular, are relatively new. The future financial performance of the Company will depend in part on the continued expansion of this market and these market segments and the growth in the demand for other applications developed by the Company, as well as increased acceptance of its products by art and graphics professionals. The growth in the use of desktop graphics software has been fueled by rapid increases in the performance of computers available to desktop users, and there can be no assurance as to the continued rate of performance increases in these computers. There can be no assurance that the graphics software market and the painting, drawing, image-editing and 3D graphics segments of the market will continue to grow, that the Company will be able to respond effectively to the evolving requirements of the market and market segments, including the shift to Internet- based publishing, or that art and graphics professionals will accept the Company's products. If the Company is not successful in developing, marketing, localizing and selling applications that gain commercial acceptance in these markets and market segments on a timely basis, the Company's business, operating results and financial condition could be materially and adversely affected. MANAGEMENT OF POTENTIAL GROWTH; INTEGRATION OF POTENTIAL ACQUISITIONS In recent years, Fractal has experienced expansion of its operations that has placed significant demands on Fractal's administrative, operational and financial resources, which demands are expected to intensify as a result of the acquisition of Ray Dream. To manage future growth, if any, the Company must improve its financial and management controls, reporting systems and procedures on a timely basis and expand, train and manage its work force. There can be no assurance that the Company will be able to perform such actions successfully. The -20- Company intends to continue to invest in improving its financial systems and controls in connection with higher levels of operations. In the future, the Company may make additional acquisitions of complementary companies, products or technologies. Managing acquired businesses entails numerous operational and financial risks, including difficulties in assimilating acquired operations, diversion of management's attention to other business concerns, amortization of acquired intangible assets and potential loss of key employees or customers of acquired operations. There can be no assurance that the Company will be able to effectively achieve growth, or manage any such growth, and failure to do so could have a material adverse effect on the Company's operating results. DEPENDENCE ON THIRD PARTY PORTING SOFTWARE AND ASSISTANCE Fractal typically develops its application software on the Macintosh platform and ports applications to the Windows operating environment using proprietary software developed by Altura Software, Inc. ("Altura"), a private company affiliated with one of Fractal's directors and principal shareholders. Fractal also relies on Altura for certain technical assistance in the porting process, and relies on Altura to develop software and techniques for porting Fractal's products to new platforms, such as UNIX and Windows 95. If the agreement with Altura were terminated or Fractal's relationship with Altura is impaired for any reason, or if Altura should have financial difficulties or lose key personnel, Fractal's ability to introduce versions of its products on the Windows platform on a timely basis would be substantially impaired. In such event, there can be no assurance that Fractal would be able to attract and assimilate highly qualified technical personnel to port Fractal's software to the Windows platform or any other platforms on a timely basis. The Company also relies from time to time on other third parties for engineering services, including, for example, the current efforts to port POSER to the Windows operating environment. Any interruption in the availability or quality of these services and software from Altura or any other third party for any reason could have a material adverse effect on the Company's business, operating results and financial condition. PROPRIETARY RIGHTS The success and ability of the Company to compete is dependent in part upon its proprietary technology. While the Company relies on trademark, trade secret and copyright laws to protect its technology, the Company believes that factors such as the technological and creative skills of its personnel, new product developments, frequent product enhancements, name recognition and customer support are more essential to establishing and maintaining a technology leadership position. Fractal has one patent with respect to its Natural-Media technology and has one patent application pending. Ray Dream has one patent with respect to its edge-smoothing technology and one patent with respect to three-dimensional manipulation techniques. However, the Company believes that the ownership of patents is not presently a significant factor in their businesses and that its success does not depend on the ownership of patents, but primarily on the innovative skills, technical competence and marketing abilities of their personnel. Also, there can be no assurance that others will not develop technologies that are similar or superior to those of the Company. The source code for the Company's proprietary software is protected both as a trade secret and as a copyrighted work. Despite these precautions, it may be possible for a third party to copy or otherwise obtain and use their products or technology without authorization, or to develop similar technology independently. In addition, effective copyright and trade secret protection may be unavailable or limited in certain foreign countries. The Company generally enters into confidentiality or license agreements with employees, consultants and vendors, and generally control access to and distribution of its software, documentation and other proprietary information. To license their products, the companies primarily rely on "shrink wrap" licenses that are not signed by the end-user and, therefore, may be unenforceable under the laws of certain jurisdictions. Despite efforts to protect proprietary rights, unauthorized parties may attempt to copy aspects of the Company's products or to obtain and use information that is regarded as proprietary. Policing such unauthorized use is difficult. There can be no assurance that the steps taken by the Company will prevent misappropriation of its technology or that such agreements will be enforceable. In addition, litigation may be necessary in the future to enforce intellectual property rights, to protect trade secrets or to determine the validity and scope of the proprietary rights of others. Such litigation could result in substantial costs and diversion of resources and could have a material adverse effect on the business, operating results and financial condition of the Company. -21- The Company licenses its POSER and EXPRESSION products from third party software developers. Such products are obtained under contractual license agreements, which in some cases are for limited time periods and in some cases provide that such licenses may be terminated under certain circumstances. The Company relies on representations from such third party developers that they own the technology that the Company licenses from them, particularly with respect to POSER and DABBLER and EXPRESSION. Any disruption in the licensing arrangements or breach of such representations could have a material adverse impact on the Company's business, operating results and financial condition. Ray Dream has licensed to Corel Corporation source and object code for versions 3 and 4 of DESIGNER and version 1 of ADDDEPTH for incorporation into major Corel products for distribution by Corel. Corel has the right to modify the programs to integrate them into significant Corel software application programs, including word processing, graphics, or computer aided design software, and is currently marketing a modified form of DESIGNER in its CorelDraw6 suit of graphics and multimedia programs, which retails for $695. There can be no assurance that Corel, a significant competitor in the graphics market, will not reduce prices for its products that incorporate DESIGNER or ADDDEPTH to make such product competitive with Ray Dream's products. Additionally, certain potential customers of Ray Dram may determine that the versions of DESIGNER and ADDDEPTH included in significant Corel products satisfy their requirements, and having purchased or determined to purchase such Corel products, may choose to forego a purchase of subsequent versions of DESIGNER or ADDDEPTH from Ray Dream. Any of the foregoing could have a material adverse effect on the business, operating results and financial conditions of the Company. There can be no assurance that third parties will not claim infringement by the Company with respect to current or future products, and the Company expects that it will increasingly be subject to such claims as the number of products and competitors in the graphics software market grows and the functionality of such products overlaps with other industry segments. From time to time, Fractal and Ray Dream have received notice alleging that their products infringe patents or other intellectual property rights of third parties. Any such third party claims, whether or not they are meritorious, could result in costly litigation or require the Company to enter into royalty or licensing agreements. Such royalty or license agreements, if required, may not be available on terms acceptable to the Company, or at all. If either Fractal or Ray Dream were found to have infringed upon the proprietary rights of third parties, it could be required to pay damages, cease sales of the infringing products and redesign or discontinue such products, any of which could have a material adverse effect on the business, operating results and financial condition of the Company. SHARES ELIGIBLE FOR FUTURE SALE Fractal issued 3,165,660 shares of Fractal Common Stock in the acquisition of Ray Dream and reserved 219,459 shares of Fractal Common Stock for issuance upon exercise of previously outstanding Ray Dream options. Fractal assumed an outstanding Ray Dream warrant, which became a warrant exercisable for 437,604 shares of Fractal Common Stock. In general, the shares issued or reserved for issuance in the acquisition, other than to Ray Dream affiliates, in exchange for outstanding shares of Ray Dream Capital are freely tradeable following the acquisition (and any applicable vesting). The issuance of shares after the acquisition upon the exercise of the assumed Ray Dream options has been registered pursuant to a registration statement on Form S-8 filed by Fractal, and effective, upon closing of the acquisition. In addition, certain persons who, following the acquisition, are holders of 6,286,464 shares of Fractal common stock (on an as-converted basis) have agreed that they will not transfer, sell, exchange, pledge or otherwise dispose of any Fractal Common Stock until the date Fractal shall have publicly released financial results for a period that includes at least 30 days of combined operations of Fractal and Ray Dream (the "Affiliates Expiration Date"). Immediately after the Affiliates Expiration Date, these shares will be eligible for sale in the public market, subject to compliance with Rules 144 and 145 under the Securities Act. In addition, upon expiration on May 6, l996 of certain lock-up agreements entered into at the time of Fractal's initial public offering of securities, substantially all of the shares of Fractal common stock outstanding prior to the Merger became freely tradeable in the public market, subject in the case of affiliates to compliance with the volume restrictions of Rule 144 and the additional restrictions upon sales by affiliates as described above. The sale of any of the foregoing shares may cause substantial fluctuations in the price of Fractal common stock over short time periods. -22- ITEM 7. FINANCIAL STATEMENTS. REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Shareholders of Fractal Design Corporation In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of income, of shareholders' equity (deficit) and of cash flows present fairly, in all material respects, the financial position of Fractal Design Corporation and its subsidiaries at March 31, 1996 and 1995, and the results of their operations and their cash flows for the years then ended, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. /s/ PRICE WATERHOUSE LLP PRICE WATERHOUSE LLP San Jose, California April 22, 1996, except as to Note 11, which is as of May 24, 1996 -23- CONSOLIDATED BALANCE SHEETS (in thousands, except share data) ASSETS March 31, ---------------------- 1996 1995 -------- -------- Current assets: Cash and cash equivalents. . . . . . . . . . . . . . $ 5,422 $3,345 Short-term investments . . . . . . . . . . . . . . . 23,683 488 Accounts receivable, less allowance for doubtful accounts of $91 and $139. . . . . . . . . . . . . . 4,070 1,644 Inventories. . . . . . . . . . . . . . . . . . . . . 804 254 Deferred income taxes. . . . . . . . . . . . . . . . 1,446 863 Other current assets . . . . . . . . . . . . . . . . 1,462 352 -------- -------- Total current assets . . . . . . . . . . . . . . . 36,887 6,946 Property and equipment, net. . . . . . . . . . . . . . 587 383 -------- -------- $37,474 $7,329 -------- -------- -------- -------- LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities: Bank borrowings. . . . . . . . . . . . . . . . . . . $ -- $ 440 Accounts payable . . . . . . . . . . . . . . . . . . 2,482 713 Accrued liabilities. . . . . . . . . . . . . . . . . 4,364 2,437 Income taxes payable . . . . . . . . . . . . . . . . 118 1,045 -------- -------- Total current liabilities. . . . . . . . . . . . . 6,964 4,635 -------- -------- Mandatorily redeemable convertible preferred stock (Note 8). . . . . . . . . . . . . . . . . . . . . . . -- 2,140 -------- -------- Commitments (Note 5) . . . . . . . . . . . . . . . . . -- -- Shareholders' equity (deficit): Preferred Stock: $.001 par value, 5,000,000 shares authorized; none issued and outstanding . . . . . . -- -- Common Stock: $.001 par value, 50,000,000 shares authorized; 8,513,496, and 4,808,656 shares issued 5 and outstanding . . . . . . . . . . . . . . . . . . 9 Additional paid-in capital . . . . . . . . . . . . . 27,144 52 Retained earnings. . . . . . . . . . . . . . . . . . 3,357 497 -------- -------- Total shareholders' equity 30,510 554 -------- -------- $37,474 $7,329 -------- -------- -------- -------- The accompanying notes are an integral part of these consolidated financial statements. -24- CONSOLIDATED STATEMENTS OF INCOME (in thousands, except per share data)
Years Ended March 31, ------------------------- 1996 1995 ---------- ---------- Net revenues . . . . . . . . . . . . . . . . $21,780 $13,133 Cost of net revenues . . . . . . . . . . . . 4,219 2,545 ---------- ---------- Gross profit . . . . . . . . . . . . . . . . 17,561 10,588 ---------- ---------- Operating expenses: Research and development . . . . . . . . 2,647 1,520 Sales and marketing. . . . . . . . . . . 9,020 5,789 General and administrative . . . . . . . 1,640 944 ---------- ---------- Total operating expenses. . . . . 13,307 8,253 ---------- ---------- Income from operations . . . . . . . . . . . 4,254 2,335 Interest income (expense), net . . . . . . . 464 (30) ---------- ---------- Income before income taxes . . . . . . . . . 4,718 2,305 Provision for income taxes . . . . . . . . . 1,794 473 ---------- ---------- Net income . . . . . . . . . . . . . . . . . $2,924 $1,832 ---------- ---------- ---------- ---------- Net income per share . . . . . . . . . . . . $ 0.36 $ 0.25 ---------- ---------- ---------- ---------- Number of shares used to compute net income per share . . . . . . . . . . . . . 8,147 7,234 ---------- ---------- ---------- ----------
The accompanying notes are an integral part of these consolidated financial statements. -25- CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (DEFICIT) (in thousands)
Retained Common Stock Additional Earnings ----------------- Paid-in (Accumulated Shares Amount Capital Deficit) Total ------- ------- --------- --------- --------- Balance at March 31, 1994. . . . . . 4,800 $ 5 $ 45 $(1,267) $(1,217) Exercise of stock options . . . . . 9 -- 7 -- 7 Accretion to redemption value of mandatorily redeemable convertible preferred stock. . . . -- -- -- (68) (68) Net income. . . . . . . . . . . . . -- -- -- 1,832 1,832 ------- ------- --------- --------- --------- Balance at March 31, 1995. . . . . . 4,809 5 52 497 554 Accretion to redemption value of mandatorily redeemable convertible preferred stock . . . . -- -- -- (64) (64) Sale of common stock, net of issuance costs of $2,598. . . . . . 2,579 3 24,774 -- 24,777 Conversion of mandatorily redeemable convertible preferred stock. . . . . . . . . . 1,057 1 2,203 -- 2,204 Exercise of stock options and warrants . . . . . . . . . . . . . 68 -- 115 -- 115 Net income. . . . . . . . . . . . . -- -- -- 2,924 2,924 ------- ------- --------- -------- --------- Balance at March 31, 1996. . . . . . 8,513 $ 9 $27,144 $3,357 $30,510 ------- ------- --------- -------- --------- ------- ------- --------- -------- ---------
The accompanying notes are an integral part of these consolidated financial statements. -26- CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands) Years Ended March 31, ---------------------- 1996 1995 -------- -------- CASH FLOWS FROM OPERATING ACTIVITIES: Net income . . . . . . . . . . . . . . . . . . . . . . $2,924 $1,832 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization . . . . . . . . . . . 262 145 Deferred taxes. . . . . . . . . . . . . . . . . . . (583) (863) Changes in assets and liabilities: Accounts receivable, net. . . . . . . . . . . . . . (2,426) (651) Inventories . . . . . . . . . . . . . . . . . . . . (550) (139) Other current assets. . . . . . . . . . . . . . . . (1,110) (118) Accounts payable. . . . . . . . . . . . . . . . . . 1,769 189 Accrued liabilities . . . . . . . . . . . . . . . . 1,927 1,309 Income taxes payable. . . . . . . . . . . . . . . . (927) 1,045 -------- -------- Net cash provided by operating activities . . . . 1,286 2,749 -------- -------- CASH FLOWS FROM INVESTING ACTIVITIES: Capital expenditures. . . . . . . . . . . . . . . . (466) (323) Purchases of short-term investments . . . . . . . . (23,690) (488) Sales of short-term investments . . . . . . . . . . 495 -- -------- -------- Net cash used in investing activities . . . . . . (23,661) (811) -------- -------- CASH FLOWS FROM FINANCING ACTIVITIES: Issuance of mandatorily redeemable convertible preferred stock, net . . . . . . . . . -- 2,072 Proceeds from issuance of common stock, net . . . . 24,777 -- Repayment on notes payable. . . . . . . . . . . . . (440) -- Issuance of common stock upon exercise of warrants and stock options . . . . . . . . . . . . 115 7 Repayment of notes payable to shareholders. . . . . -- (972) -------- -------- Net cash provided by financing activities . . . . 24,452 1,107 -------- -------- Net increase in cash and cash equivalents. . . . . . . . 2,077 3,045 Cash and cash equivalents at beginning of period . . . . 3,345 300 -------- -------- Cash and cash equivalents at end of period . . . . . . . $5,422 $3,345 -------- -------- -------- -------- SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION: Cash paid during the year for: Interest . . . . . . . . . . . . . . . . . . . . . . $ 67 $ 126 Income taxes . . . . . . . . . . . . . . . . . . . . $3,118 $ 292 SUPPLEMENTAL SCHEDULE OF NON-CASH TRANSACTIONS: Accretion of mandatorily redeemable convertible $ 64 $ 68 preferred stock . . . . . . . . . . . . . . . . . . . Conversion of mandatorily redeemable convertible preferred stock . . . . . . . . . . . . . . . . . . . $2,204 $ -- The accompanying notes are an integral part of these consolidated financial statements. -27- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1. THE COMPANY AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Fractal Design Corporation (the "Company") provides software tools for the creation, editing and manipulation of computer graphic images and digital art. The Company operates in one business segment. The following is a summary of the Company's significant accounting policies. PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries, Fractal Design Foreign Sales Corporation and Fractal Design International. All significant intercompany accounts and transactions have been eliminated. USE OF ESTIMATES The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reported period. Actual results could differ from those estimates. REVENUE RECOGNITION The Company sells its products worldwide through distributors and mail order catalogs, to hardware and software manufacturers for bundling with other products, and directly to end users. Revenue from the sale of software products, including sales to distributors, is recognized when the software has been shipped, collection of the receivable is probable and there are no significant obligations remaining. Allowances for estimated future returns and exchanges are provided at the time of sale based on the Company's return policies and historical returns experience. The Company periodically offers customers free upgrades to new product releases for a limited period of time after the announcement of a new product. The Company's policy is to defer revenue based on its estimate of the number of users expected to upgrade, if and when a free upgrade is offered, in accordance with SOP 91-1 and FAS 48. This estimate is based on the Company's historical experience. The per unit amount of revenue that is deferred is equal to the objective price to be charged by the Company to its existing installed user base. The Company recognizes the revenue related to free upgrades when the customer has requested the upgrade and the new product is shipped. At March 31, 1996 and 1995 there were no material obligations to provide free upgrades. The Company provides for future warranty costs based upon historical experience. The Company provides a limited amount of free telephone technical support to customers. These activities are generally considered insignificant post contract customer support obligations. Estimated costs of these activities are accrued at the time revenue is recognized. Revenues from significant customers which represented 10% or more of net revenues for the respective periods were as follows: Years Ended March 31, -------------------- 1996 1995 -------- -------- Customer A . . . . . . . . . . . . . . 17% 25% Customer B . . . . . . . . . . . . . . 17% -- Customer C . . . . . . . . . . . . . . 11% -- Revenue from foreign customers was 45% and 28% of the Company's net revenues in fiscal 1996 and 1995, respectively. Net revenues from customers in Europe and Asia accounted for 13% and 32% of net revenues, respectively, in fiscal 1996 and 14% and 13% of net revenues, respectively, in fiscal 1995. -28- CASH, CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS The Company invests certain of its excess cash in debt instruments of the U.S. Government. All highly liquid debt instruments with an original maturity of three months or less are considered cash equivalents; those with original maturities greater than three months and all municipal obligations are considered short-term investments. The Company accounts for short-term investments in accordance with the Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities" ("SFAS 115"). SFAS 115 requires investment securities to be classified as either held to maturity, trading or available for sale. The Company has classified all short-term investments as available for sale. At March 31, 1996, short-term investments consist primarily of municipal obligations with maturities of less than one year from their date of purchase. At that date, the fair value of the investments approximated cost. INVENTORIES Inventories are stated at the lower of cost, using the first-in, first-out method, or market. PROPERTY AND EQUIPMENT Property and equipment are stated at cost. Depreciation and amortization are computed using the straight-line method based upon estimated useful lives of the assets ranging from one to five years. STOCK COMPENSATION In October 1995, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation" ("FAS 123"). FAS 123 requires companies that elect not to adopt the fair value based method of accounting for stock compensation plans to make pro forma disclosures of net income and earnings per share as if they had adopted the fair value accounting method. Upon adopting FAS 123 in fiscal 1997, the Company plans to present the required pro forma disclosures rather than change its present method of accounting for employee stock options. CONCENTRATION OF CREDIT RISK Financial instruments which potentially subject the Company to concentration of credit risk consist principally of cash, cash equivalents, short-term investments and accounts receivable. The Company invests primarily in municipal obligations and holds deposits in money market accounts of high quality financial institutions. The Company's accounts receivable are derived from sales to distributors, resellers and end-users, serving a variety of industries located primarily in the United States, Europe and the Far East. At March 31, 1996, three customers accounted for 33%, 17% and 11% of accounts receivable, respectively, and at March 31, 1995, two customers accounted for 41% and 11% of accounts receivable, respectively. The Company performs ongoing credit evaluations of its customers and to date has not experienced any material losses. SOFTWARE DEVELOPMENT COSTS Costs related to the conceptual formation and design of internally developed software are expensed as research and development as incurred. It is the Company's policy that certain internal software development costs incurred after technological feasibility has been demonstrated and which meet recoverability tests are capitalized and amortized over the estimated economic life of the product. To date, the Company has incurred no significant internal software development costs which meet the criteria for capitalization. -29- INCOME TAXES The Company accounts for income taxes using the asset and liability method. Under the asset and liability method, deferred income tax assets and liabilities are determined based on the differences between the financial reporting and tax bases of assets and liabilities and are measured using currently enacted tax rates and laws. The Company elected to be taxed as a Subchapter S Corporation from its inception through September 30, 1993, whereby the tax effects of the Company's activities accrued directly to its shareholders. Effective October 1, 1993, the Company elected to terminate its status as a Subchapter S Corporation for income tax purposes. As a result, deferred income taxes were established on the date the Subchapter S Corporation status was terminated. NET INCOME PER SHARE Net income per share is computed using the weighted-average number of shares of common stock and common equivalent shares, when dilutive, from mandatorily redeemable convertible preferred stock (using the if-converted method) and from stock options and warrants (using the treasury stock method). Pursuant to Securities and Exchange Commission Staff Accounting Bulletins, common and common equivalent shares, options and warrants issued by the Company during the 12-month period prior to the Company's initial public offering have been included in the calculation as if they were outstanding for all periods prior to and including September 30, 1995. For the years ended March 31, 1996 and 1995, accretion to the redemption value of mandatorily redeemable convertible preferred stocks was $64,000 and $68,000, respectively, resulting in net income attributable to common shareholders of $2,860,000 and $1,764,000, respectively. SHAREHOLDERS' EQUITY Common Stock as of March 31, 1996 reflects the sale of 2,375,000 shares of common stock issued in the Company's initial public offering completed November 9, 1995. Aggregate net proceeds to the Company were $23,540,000. In addition, Common Stock also reflects (i) the conversion of all the Mandatorily Redeemable Convertible Preferred Stock outstanding into an aggregate of 1,057,505 shares of common stock, (ii) the exercise of warrants to purchase 52,873 shares of the Company's common stock at an exercise price of $2.00 per share and (iii) the termination of the redemption rights on the 204,082 shares of Mandatorily Redeemable Common Stock. -30- NOTE 2. BALANCE SHEET COMPONENTS A summary of balance sheet components follows (in thousands): March 31, ------------------- 1996 1995 Inventories: ------ ------ Raw materials. . . . . . . . . . . . . . . . . . . . $ 562 $ 173 Finished goods . . . . . . . . . . . . . . . . . . . 242 81 ------ ------ $ 804 $ 254 ------ ------ ------ ------ Property and equipment: Furniture and fixtures . . . . . . . . . . . . . . . $ 133 $ 108 Equipment and software . . . . . . . . . . . . . . . 1,009 555 ------ ------ 1,142 663 Less: Accumulated depreciation and amortization . . 555 280 ------ ------ $ 587 $ 383 ------ ------ ------ ------ Accrued liabilities: Reserve for returns and exchanges. . . . . . . . . . $1,746 $ 1,117 Payroll and related. . . . . . . . . . . . . . . . . 1,366 632 Marketing and advertising. . . . . . . . . . . . . . 634 343 Other. . . . . . . . . . . . . . . . . . . . . . . . 618 345 ------ ------ $4,364 $2,437 ------ ------ ------ ------ NOTE 3. BANK BORROWINGS The Company had a $900,000 line of credit with a bank with interest at 2% per annum above the bank's prime rate, of which $440,000 was outstanding at March 31, 1995. On August 23, 1995, the Company converted the outstanding balance of $440,000 under its existing line of credit to a demand loan with a bank. Interest accrued on the loan at a rate equal to the bank's reference rate plus 1.5%. The remaining outstanding balance of $421,000 was paid in full on November 16, 1995. In addition, on September 1, 1995, the Company entered into a line of credit agreement which provides for borrowings of up to $600,000 at variable interest rates equal to the bank's reference rate (8.25% as of March 31, 1996) plus 1%. No amounts were outstanding under this line at March 31, 1996. The line of credit agreement expires on August 1, 1996, is unsecured and includes restrictive covenants which require the Company to maintain certain financial ratios and minimum net worth, as defined. NOTE 4. RELATED PARTY TRANSACTIONS Distribution and notes payable to shareholders In September 1993, in connection with the termination of the Company's Subchapter S Corporation status (see Note 1), the Company distributed to its shareholders undistributed tax basis Subchapter S Corporation profits of $1,500,000. The distribution to shareholders consisted of $600,000 of cash and the issuance of $900,000 of 7% unsecured notes payable. The Company repaid the notes payable during fiscal 1995. Other related party transactions Businesses owned by two shareholders have provided technical and administrative services to the Company. Amounts paid to these two firms totaled $214,000 and $129,000 for the years ended March 31, 1996 and 1995, respectively. Amounts due to the firms for services rendered totaled $24,000 and $10,000 at March 31, 1996 and 1995, respectively. The Company believes that the terms of the agreements for these services are no less favorable than could be obtained from third-party suppliers. NOTE 5. COMMITMENTS AND CONTINGENCIES The Company leases its office facilities and certain office equipment under various operating leases. Total rent expense under the leases was $288,000 and $139,000 for the years ended March 31, 1996 and 1995, respectively. On April 9, 1996, the Company signed a letter of intent for approximately 29,600 square feet, increasing to approximately 41,000 square feet on December 1, 1998, of office and warehouse space in nearby Scotts Valley, California. The Company plans to relocate its operations later this calendar year without any anticipated material disruption to the Company's business or operations. The initial term of the proposed lease will be for seven years with two three-year renewal options. It also gives the Company the right of first refusal on any of the remaining approximately 14,000 square feet in the building. The target commencement date is no earlier than July 1, 1996 and no later than September 1, 1996. Minimum lease payments for the proposed seven-year lease total $4,563,000 over the lease term. Ray Dream, Inc. leases approximately 8,000 square feet of office space in Mountain View, California. Ray Dream's leases expire on dates between June 30, 1996 and September 30, 1996. The Company plans to relocate Ray Dream's operations to the new location in Scotts Valley later this calendar year without any anticipated material dislocation to Fractal's business or operations. -31- Aggregate future minimum lease payments under noncancelable operating leases with initial terms of one year or more are as follows at March 31, 1996: Years Ended March 31, --------------------- 1997. . . . . . . . . . . . . . $132,000 1998. . . . . . . . . . . . . . 4,000 ---------- $136,000 ---------- ---------- In the normal course of business, the Company from time to time receives inquiries with regard to possible patent infringement. Management believes that it is unlikely that the outcome of the inquiries received thus far will have a material adverse effect on the Company's financial position or results of operations. -32- NOTE 6. INCOME TAXES The provision for income taxes is as follows (in thousands): Years Ended March ------------------- 1996 1995 -------- -------- Current: Federal. . . . . . . . . . . . . . . . . . . . $1,855 $ 846 State. . . . . . . . . . . . . . . . . . . . . 522 472 Foreign. . . . . . . . . . . . . . . . . . . . -- 18 -------- -------- 2,377 1,336 -------- -------- Deferred: Federal. . . . . . . . . . . . . . . . . . . . (513) (679) State. . . . . . . . . . . . . . . . . . . . . (70) (184) -------- -------- (583) (863) -------- -------- $1,794 $ 473 -------- -------- -------- -------- The Company provides a valuation allowance for deferred tax assets when it is more likely than not, based on available evidence, that some portion or all of the deferred tax assets will not be realized. Based on a re- evaluation of the reliability of future tax benefits based on income earned in 1995, creating available tax carrybacks, the Company released $630,000 of the previously established valuation allowance during fiscal 1995. Significant components of the Company's deferred tax assets were as follows (in thousands): Years Ended March 31, --------------------- 1996 1995 -------- -------- Reserves and accruals. . . . . . . . . . . . . . . . $1,068 $ 676 Deferred revenue . . . . . . . . . . . . . . . . . . 66 25 Research and development credit. . . . . . . . . . . -- -- Other. . . . . . . . . . . . . . . . . . . . . . . . 312 162 -------- -------- 1,446 863 Deferred tax asset valuation allowance . . . . . . . -- -- -------- -------- Net deferred tax asset . . . . . . . . . . . . . . . $1,446 $ 863 -------- -------- -------- -------- A reconciliation of the provision for income taxes to the amount computed by applying the statutory federal income tax rate is as follows: Years Ended March 31, --------------------- 1996 1995 -------- -------- Statutory rate . . . . . . . . . . . . . . . . . . . 34.0% 34.0% State income taxes, net of federal tax benefit . . . 6.4 8.9 Release of previously established valuation allowance . . . . . . . . . . . . . . . . . . . . . -- (27.3) Research and development credits . . . . . . . . . . (1.3) (8.4) Foreign income taxes . . . . . . . . . . . . . . . . -- 4.1 Other, net . . . . . . . . . . . . . . . . . . . . . (1.2) 9.2 -------- ------- Effective tax rate . . . . . . . . . . . . . . . . . 37.9% 20.5% -------- ------- -------- ------- NOTE 7. STOCK OPTION PLAN The 1993 Stock Option Plan (the "Plan"), as amended, authorizes the Board of Directors to grant incentive stock options and nonstatutory stock options to employees, officers, directors and consultants for up to 2,000,000 shares of Common Stock. Under the Plan, incentive stock options are granted at a price that is not less -33- than 100% of the fair value of the stock at the date of grant, as determined by the Board of Directors. Nonqualified stock options are to be granted at a price that is not less than 85% of the fair value of the stock at the date of grant, as determined by the Board of Directors. Options generally vest over a four year period and are exercisable for a period of ten years after the date of grant. Options granted to a shareholder who owns more than 10% of the outstanding stock of the Company at the time of grant must be at a price not less than 110% of the fair value of the stock on the date of grant, and are exercisable for a period not to exceed five years. A summary of the Plan activity is as follows: Available Options Price for grant outstanding per share --------- ----------- --------- Balance at March 31, 1994. . . . . 15,064 374,936 Additional shares reserved. . . 1,610,000 -- -- Options granted . . . . . . . . (1,081,873) 1,081,873 $0.75-$2.20 Options exercised . . . . . . . -- (8,656) $0.75-$0.825 Options canceled. . . . . . . . 713,779 (713,779) $0.75-$2.20 ----------- ----------- Balance at March 31, 1995. . . . . 1,256,970 734,374 Additional shares reserved. . . 300,000 -- -- Options granted . . . . . . . . (600,800) 600,800 $2.00-$13.50 Options exercised . . . . . . . -- (15,562) $0.75 Options canceled. . . . . . . . 24,875 (24,875) $0.75-$2.00 ----------- ----------- Balance at March 31, 1996. . . . . 981,045 1,294,737 ----------- ----------- ----------- ----------- Options to purchase 271,598 and 46,095 shares were exercisable at March 31, 1996 and March 31, 1995, respectively, at prices ranging from $0.75 to $9.00. In September 1994, each non-employee director of the Company received an option to purchase 50,000 shares of the Company's Common Stock at an exercise price of $0.75 per share ($0.825 per share in the case of one director). In May 1995, each non-employee director received an option to purchase 10,000 shares of Common Stock at an exercise price of $2.00 per share ($2.20 per share in the case of one director). Each such option has a term of ten years, and vests over four years from the date of grant. In September 1994, the Board of Directors approved a proposal under which option holders could elect to cancel certain options in exchange for grants of new options with exercise prices equal to the fair market value of the Company's Common Stock on the date of the Board's approval. Options for the purchase of a total of 698,561 shares were canceled in exchange for newly issued options for the purchase of 698,561 shares. During April and May 1995, the Company granted to employees stock options for the purchase of 357,300 shares of Common Stock at exercise prices ranging from $2.00 to $3.50 per share. Management will amortize approximately $508,000 of compensation expense over the four-year vesting periods relating to these options. Such compensation expense was $329,000 during fiscal 1996. On August 29, 1995, the Company's Board of Directors adopted the 1995 Director Stock Option Plan and the 1995 Stock Option Plan. The plans were approved by the Company's shareholders on September 15, 1995. A total of 175,000 shares of Common Stock were reserved for issuance under the 1995 Director Stock Option Plan, which provides that each person who becomes a non-employee director of the Company after the date of the Company's initial public offering will be granted a nonstatutory stock option to purchase 20,000 shares of Common Stock (the "First Option") on the date on which the optionee first becomes a non-employee director of the Company. Thereafter, on the date of each annual meeting of the Company's shareholders at which each non-employee director is elected, each such non-employee director shall be granted an additional option to purchase 5,000 shares of Common Stock (a "Subsequent Option") if, on such date, he or she shall have served on the Company's Board of Directors for at least six months. The options generally become exercisable in -34- installments of 25% of the total number of shares subject to the First Option on each of the first, second, third and fourth anniversaries of the date of grant of the First Option, and each Subsequent Option becomes exercisable as to 50% on the first and second anniversaries of the date of grant of that Subsequent Option. The exercise price of all stock options granted under the Directors' Plan is equal to the fair market value of a share of the Company's Common Stock on the date of grant of the option. Options granted under the Directors' Plan have a term of ten years. The Company's 1995 Stock Option Plan (the "1995 Option Plan") was adopted by the Board of Directors on August 29, 1995 and will replace the 1993 Option Plan. The maximum aggregate number of shares that may be optioned and sold under the 1995 Option Plan is the sum of (i) 1,180,420 shares plus (ii) such number of shares as are subject to outstanding and unexercised stock options under the Company's 1993 Option Plan, as of the date of adoption of the 1995 Option Plan by the shareholders, and which options are canceled or otherwise terminated without exercise; provided that the total number of shares available under the 1995 Option Plan shall in no event exceed 2,291,344. The 1995 Option Plan provides for (i) the granting to employees (including officers and employee directors) of "incentive stock options" within the meaning of Section 422 of the Code and (ii) the granting to employees and consultants of nonstatutory stock options. The exercise price of all incentive stock options granted under the 1995 Option Plan must be at least equal to the fair market value of the Common Stock of the Company on the date of grant. The exercise price of any incentive stock option granted to an optionee who owns stock representing more than 10% of the voting power of all classes of stock of the Company must equal at least 110% of the fair market value of the Common Stock on the date of grant. The exercise price of nonstatutory stock options generally must equal at least 85% of the fair market value of the Common Stock on the date of grant. NOTE 8. MANDATORILY REDEEMABLE CONVERTIBLE PREFERRED STOCK AND WARRANTS In September and November 1994, the Company issued 1,057,505 shares of Series A Mandatorily Redeemable Convertible Preferred Stock (the "Series A Stock") for $2.00 per share. Proceeds to the Company totaled $2,072,000, net of issuance costs. The Series A Stock was redeemable at the option of the holders of at least two thirds of the outstanding Series A Stock in three annual installments at a price equal to the sum of $2.00 per share plus $0.12 per annum from the date of issuance subject to adjustment for antidilution. The excess of the redemption price over the original issuance price of the Series A Stock was charged to retained earnings as an accretion to redemption value with a corresponding increase in the value of the Series A Stock. The cumulative accretion for the Series A Stock was $68,000 at March 31, 1995 and $132,000 at November 9, 1995. Upon the closing of the Company's initial public offering on November 9, 1995, the Mandatorily Redeemable Convertible Preferred Stock was converted into common stock and the aggregate amount of the Mandatorily Redeemable Convertible Preferred Stock of $2,204,000 at that date was credited to additional paid-in capital. In connection with the issuance of Series A Stock, the Company issued warrants to purchase 52,873 shares of Common Stock at an exercise price of $2.00 per share. The warrants were exercisable for a period of five years after date of issuance. The warrants expired upon the consummation of the Company's initial public offering. A total of 52,873 shares of Common Stock were issued upon conversion of the warrants. NOTE 9. MANDATORILY REDEEMABLE COMMON STOCK On July 21, 1995, the Company and certain shareholders entered into an agreement (the "Agreement") to sell 204,082 and 122,449 shares, respectively, of Common Stock to Adobe Ventures, L.P. ("Adobe"), a subsidiary of Adobe Systems, Inc., for $6.125 per share. Aggregate net proceeds to the Company were $1,236,000. Upon the closing of the Company's initial public offering, the mandatory redemption rights of this stock were automatically terminated. -35- NOTE 10. 401(k) PLAN AMENDMENT On August 29, 1995, the Board of Directors approved an amendment to the Company's 401(k) plan which provides for matching contributions to be made by the Company in the form of Company Common Stock. A total of 100,000 shares of the Company's Common Stock has been reserved for matching contributions under the 401(k) plan. NOTE 11. SUBSEQUENT EVENT On May 24, 1996, Fractal acquired Ray Dream, Inc., a California corporation which designs, develops and markets graphics software application tools emphasizing three-dimensional effects for the personal computer market (see "Products" for a description of Ray Dream's products). As a result of the acquisition, Ray Dream has become a wholly-owned subsidiary of Fractal. As consideration for 100% of outstanding shares of Ray Dream capital stock, Fractal issued an aggregate 3,165,660 shares of Fractal common stock and reserved 219,459 shares of Fractal common stock for issuance upon exercise of previously outstanding options to purchase Ray Dream stock. Fractal also assumed an outstanding warrant to purchase Ray Dream common stock which, when vested, will be exercisable for up to 437,604 shares of Fractal common stock. The transaction will be accounted as a pooling-of-interests. Transaction fees of approximately $1.7 million will be recorded in the first quarter of fiscal 1997. The Company reports its financial results on a March 31 fiscal year-end basis, whereas Ray Dream reported its financial results on a December 31 calendar year-end basis. For the purposes of pooling-of-interests, accounting revenues and net income of Fractal for the years ended March 31, 1996 and 1995 will be combined with those of Ray Dream for the years ended December 31, 1995 and 1994. Ray Dream's net change in equity for the three months ended March 31, 1996 will be reflected as an adjustment to retained earnings. The following table summarizes the restated consolidated revenues and net income of the Company after giving effect to this transaction (in thousands, except per share data): Year Ended March 31, 1996 Year Ended March 31, 1995 ------------------------- ------------------------- Net Revenues Net Income Net Revenues Net Income ------------ ---------- ------------ ---------- As presently reported. . $21,780 $2,924 $13,133 $1,832 Subsequent Pooling . . . 7,749 2 5,343 (73) ------------ ---------- ------------ ---------- As restated. . . . . . . $29,529 $2,926 $18,476 $1,759 ------------ ---------- ------------ ---------- ------------ ---------- ------------ ---------- Net income (loss) per share, as restated. . . $ 0.25 $ 0.17 ---------- ---------- ---------- ---------- ITEM 8. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. -36- PART III ITEM 9. DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS; COMPLIANCE WITH SECTION 16(a) OF THE EXCHANGE ACT The following table sets forth information as of June 21, 1996, regarding the directors and executive officers of Fractal: Name Age Position ---- --- -------- Mark Zimmer 40 Chief Executive Officer and Chairman of the Board Thomas Hedges 46 Vice President, Engineering and Vice Chairman of the Board Eric Hautemont 30 President and Director Leslie E. Wright 42 Chief Operating Officer and Chief Financial Officer Karen J. Bria 34 Vice President, International Sales and Marketing Joseph C. Consul 36 Vice President, Operations John E. Derry 44 Vice President, Creative Design Steve I. Guttman 38 Vice President, Marketing Michael Popolo 36 Vice President, North American Sales Braden L. Rippetoe 46 Vice President, Finance Craig W. Johnson (2) 49 Secretary and Director Arthur J. Collmeyer (1) 54 Director Lee Jay Lorenzen (2) 36 Director Stephen E. Manousos 45 Director Alain Rossmann 40 Director Anthony Sun 43 Director Thomas I. Unterberg (1) 64 Director (1) Member of the Audit Committee of the Board of Directors. (2) Member of the Compensation Committee of the Board of Directors. MR. ZIMMER, a founder of Fractal, has been Chief Executive Officer and a director of Fractal since its inception and Chairman of the Board since May 1996. Mr. Zimmer founded Fractal Software, a predecessor of Fractal, with Mr. Hedges in 1985 and was a partner in Fractal Software from 1985 to 1990. Mr. Zimmer served as President of Fractal until May 1996. At Fractal Software Mr. Zimmer co-developed two graphics software programs, ImageStudio and ColorStudio. He also developed the initial versions of Painter that became the initial product of Fractal. From 1981 to 1985, Mr. Zimmer co-founded and served at TRICAD, a software firm specializing in computer-aided design. Prior to that time, Mr. Zimmer worked at Calma Corporation, a computer aided design software company where he designed several versions of CAD software. MR. HEDGES, a founder of Fractal, has served as Vice President, Engineering and a director of Fractal since its inception. From March 1993 until May 1996, Mr. Hedges served Fractal as Chairman of the Board. He as served as Vice-Chairman of the Board since May 1996. From 1985 to 1990, Mr. Hedges was a partner in Fractal Software with Mr. Zimmer where he co-developed ImageStudio, ColorStudio, and the initial versions of Painter. From 1975 to 1985, Mr. Hedges was a lead scientist and software engineer at Calma Corporation. MR. HAUTEMONT has been President and a director of Fractal since May 1996. Mr. Hautemont was a co-founder of Ray Dream, and served as President, Chief Executive Officer and a director of Ray Dream from December 1989 until May 1996. Prior to forming Ray Dream, Mr. Hautemont was a consultant to Matra Technology, Inc. from October 1988 to December 1989. MR. WRIGHT has served as Chief Operating Officer of Fractal since April 1995, and as Chief Financial Officer since April 1994. From April 1994 to May 1996, Mr. Wright also served as Vice President, Finance and -37- Administration of Fractal. From 1984 to 1994, Mr. Wright served in various positions with ASK Group, Inc., a software company, most recently as Executive Vice President and Chief Financial Officer. MS. BRIA was promoted to Vice President, International Sales & Marketing in May 1996, after serving as Director of International Sales & Marketing since June 1994, and Director of Marketing from April 1993 to May 1995. From August 1991 to March 1993, Ms. Bria served as Director of the Asia Pacific Region for PLI, a graphics peripheral company. Prior to that time, Ms. Bria served as Director of Asia Pacific Sales & Marketing for Borland International from 1987 to 1991. Prior to Borland, from 1983 to 1987, Ms. Bria served in various sales roles for the Santa Cruz Operation, Inc., most recently as International Sales manager, where she was responsible for building SCO's entire international distribution channel for UNIX PC operating systems and applications. MR. CONSUL has served as Vice President, Operations of Fractal since May 1996. From October 1991 to May 1996, Mr. Consul served as Chief Financial Officer of Ray Dream, Inc. Mr. Consul was elected Vice President, Finance and Administration of Ray Dream, Inc. in April 1994. From December 1989 to August 1991, Mr. Consul served as Director of Finance and Administration for XA Systems Corporation. Prior to December 1989, Mr. Consul was Corporate Controller for Adobe Systems, Inc. MR. DERRY has served as Vice President, Creative Design of Fractal since March 1994, after serving as Creative Director since September 1992. From June 1989 to March 1992, Mr. Derry served as Director, Creative Services of Time Arts Inc., a multi-platform creative graphics software company ("Time Arts"). In this position, Mr. Derry was chief interface designer for Oasis, a paint application for the Macintosh. From 1987 to 1989, Mr. Derry was Creative Director of ChromaSet, a San Francisco pre-press facility. From 1985 to 1987, Mr. Derry served as Director of Application Development at Time Arts. MR. GUTTMAN has served as Vice President, Marketing of Fractal since July 1994. From July 1989 to July 1994, Mr. Guttman served in various positions with Adobe Systems Incorporated, most recently as Senior Product Marketing Manager in charge of Macintosh graphics products. From 1981 to 1987, he worked in engineering and management capacities for PMB Systems Engineering, a Bechtel subsidiary. MR. POPOLO has served as Vice President, North American Sales of Fractal since May 1996, after serving as Area Sales Manager for the Eastern Region and Canada since March 1992. From August 1986 to March 1992, Mr. Popolo was employed at Letraset USA in various sales positions, including Regional Account Manager, OEM Manager, and National Sales Manager. MR. RIPPETOE has served as Vice President, Finance of Fractal since May 1996, after serving as Controller from May 1995. From May 1994 to October 1994, Mr. Rippetoe served as Corporate Controller for Interactive Network, a company providing interactive entertainment systems for live sporting events and game shows. From May 1986 to March 1994 Mr. Rippetoe served in various positions with The ASK Group, Inc., a software company, most recently as Vice President, Treasurer. MR. JOHNSON has been Secretary of Fractal since January 1994 and a director of Fractal since January 1994. Mr. Johnson has been a Director in Venture Law Group, A Professional Corporation, and a Partner in its predecessor partnership, since February 1993. From 1980 to February 1993, Mr. Johnson was a member of the law firm of Wilson, Sonsini, Goodrich & Rosati, P.C. Mr. Johnson is also a director of Collagen Corporation, a biomaterials company, and Retix, a network equipment manufacturer. MR. COLLMEYER has been a director of Fractal since January 1994. From July 1994 until January 1995, Mr. Collmeyer served as President and Chief Executive Officer of Dyna Logic Corporation, a development stage company specializing in field programmable gate arrays. Prior to that time, Mr. Collmeyer served as an officer of Weitek Corporation, a producer of graphics-related semiconductors, for 12 years, most recently as Chief Executive Officer. Prior to joining Weitek, Mr. Collmeyer served for seven years as Vice President of Research and Development and as General Manager of the Microelectronics Division of Calma Corporation, and for five years each with Xerox Corporation and Motorola Inc. in various engineering roles. He also presently serves as a director of Weitek Corporation. -38- MR. LORENZEN, a founder of Fractal, has served Fractal as a director since its inception. Since November 1990, Mr. Lorenzen has owned and currently serves as President of Altura Software, Inc., a company providing porting software and services. In 1985, Mr. Lorenzen founded Ventura Software Inc., a provider of desktop publishing products, for which he served as a Director and Vice President of Research and Development until 1991. Prior to 1985, Mr. Lorenzen worked for Digital Research and Xerox Corporation developing user interface technology. Mr. Lorenzen also is a director of several private companies, including Aptos Post, Jump Software, Inc., a developer and distributor of consumer music software, PGSoft, Inc., a developer and distributor of disk storage management utility software, and InfoHut, Inc., a developer and distributor of Internet advertising and multimedia kiosk software and services. MR. MANOUSOS, a founder of Fractal, served as Vice President, Sales from March 1992 until June 1996, Vice President, Sales and Marketing from February 1993 until July 1994, and Vice President, Operations from the inception of Fractal until March 1992. He has also served as a director of Fractal since its inception. From 1981 to present, Mr. Manousos also has owned and operated Aptos Post, Inc. ("Aptos Post"), a Postscript image setting service bureau. Prior to that time, Mr. Manousos published a weekly newspaper in Aptos and served as an editor on the National Desk of the Los Angeles Times. MR. ROSSMANN has served as a director of Fractal since May 1996. From December 1989 to May 1996, Mr. Rossmann served as a director of Ray Dream. Mr. Rossmann founded Libris, Incorporated in September 1994 and currently serves as President, Chief Executive Officer, and director of Libris. From June 1991 until March 1994, Mr. Rossmann was President and Chief Executive Officer of EO, Inc. Prior to that time Mr. Rossmann had been the Vice President of Operations of C Cube Microsystems from May 1989 to March 1991. Prior to such time, Mr. Rossmann was a co-founder and served as Vice President of Marketing and Sales of Radius Inc. from July 1986 to February 1989. MR. SUN has been a director of Fractal since May 1996. From October 1991 to May 1996, Mr. Sun served as a director of Ray Dream. Mr. Sun has been a general partner at Venrock Associates, a venture capital firm, since 1979. He is a director of Cognex Corporation, a computer systems company, Conductus, Inc., a superconductive electronics company, Gupta Corporation, a client/server software company, Inference Corporation, a client/server and Internet help desk software company, Komag, Inc., a computer storage component company, Photonics Corporation, a computer peripherals company, and StrataCom, Inc., a telecommunications company. MR. UNTERBERG has been a director of Fractal since September 1994. He is co-founder and has served as Managing Director of Unterberg Harris, an investment banking firm, since June 1989. He was Managing Director of Shearson Lehman Brothers Inc. from 1987 to 1989. Prior to that time, he was Chairman of the Board, Chief Executive Officer and Senior Managing Director of L.F. Rothschild, Unterberg Towbin Holdings Inc., and was associated with such firm or its predecessors since 1956. Mr. Unterberg also is a director of The AES Corporation, an independent power producer, AES China Generating Co. Ltd., a subsidiary of AES (serving China's power market), Electronics for Imaging, Inc., the manufacturer of the Fiery server for color desktop publishing and Systems and Computer Technology Corporation, a supplier of software and facilities management services to the utility, educational and government markets. -39- ITEM 10. EXECUTIVE COMPENSATION The following table sets forth information for Named Executive Officers with respect to executive compensation for the fiscal years ended March 31, 1995 and March 31, 1996. SECURITIES UNDERLYING OTHER OPTIONS (#) ANNUAL LONG-TERM ALL OTHER FISCAL COMPENSATION COMPENSATION COMPENSATION NAME AND PRINCIPAL POSITION YEAR SALARY ($) BONUS ($) ($) (1) AWARDS ON ($) (2) - - --------------------------- ------ --------- -------- ------------ ------------ ------------ Mark Zimmer 1996 $187,927 $130,625 $12,845 12,500 $3,293 President and Chief 1995 176,537 75,000 11,064 50,000 1,656 Executive Officer Thomas Hedges 1996 169,941 85,750 13,083 12,500 3,293 Vice President, Engineering 1995 170,079 56,250 11,153 50,000 1,656 Stephen E. Manousos 1996 130,349 86,133 12,294 10,500 3,293 Vice President, Sales 1995 145,196 56,250 10,064 42,000 1,656 Leslie E. Wright 1996 154,504 78,750 12,000 100,000 3,293 Chief Operating Officer, 1995 119,159 62,500 11,500 75,000 693 Vice President, Finance and Administration and Chief Financial Officer Steve I. Guttman 1996 130,347 68,906 12,000 25,000 3,293 Vice President, Marketing (3) 1995 87,893 37,500 8,000 100,000 2,547 Karen J. Bria (4) 1996 77,797 167,531 --- 6,000 --- Director, International 1995 97,341 20,961 --- 16,500 --- Sales and Marketing
_____________________________________ (1) Represents automobile expense allowance (2) Represents health insurance premiums and, in the case of Mr. Guttman, relocation expenses in fiscal year 1995. (3) Mr. Guttman joined Fractal in July 1994 (4) Information with respect to Ms. Bria, who was not an executive officer of the Company as of March 31, 1996, pursuant to Item 402(a)(2)(iii) of Regulation S-B. OPTION GRANTS IN LAST FISCAL YEAR The following table sets forth information for Named Executive Officers with respect to grants of options to purchase Common Stock of Fractal made during the fiscal year ended March 31, 1996: INDIVIDUAL GRANTS (1) NUMBER OF SECURITIES % OF TOTAL UNDERLYING OPTIONS GRANTED EXERCISE OPTIONS TO EMPLOYEES IN PRICE EXPIRATION NAME GRANTED (#) FISCAL YEAR (1) $/SHARE DATE - - ------------------- ----------- --------------- -------- ---------- Mark Zimmer 12,500 2.08% $2.20 5/01/05 Thomas Hedges 12,500 2.08 2.20 5/01/05 Stephen E. Manousos 10,500 1.75 2.00 5/01/05 Leslie E. Wright 100,000 16.64 2.00 5/01/05 Steve I. Guttman 25,000 4.16 2.00 5/01/05 Karen J. Bria (2) 6,000 1.00 2.00 4/20/05 ____________________ (1) Options to purchase a total of 600,800 shares of Common Stock were granted under Fractal's 1993 and 1995 Stock Option Plan during the fiscal year ended March 31, 1996. These options vest over a period of four years, provided however, that the stock options of the officers listed vest automatically in the event of any sale of all or substantially all of Fractal's assets or any merger, consolidation or stock sale which results in the holders of Fractal's capital stock immediately prior to such transaction owning less than 50% of the voting power of Fractal's capital stock immediately after such transaction. -40- (2) Information with respect to Ms. Bria, who was not an executive officer of the Company as of March 31, 1996, is provided pursuant to Item 402(a)(2)(iii) of Regulation S-B. AGGREGATE OPTION EXERCISES IN LAST FISCAL YEAR AND FISCAL YEAR END OPTION VALUES The following table sets forth information for the Named Executive Officers with respect to options to purchase Common Stock of Fractal held as of March 31, 1996: NUMBER OF SECURITIES VALUE OF UNEXERCISED UNDERLYING UNEXERCISED IN-THE-MONEY OPTIONS AT OPTIONS AT FISCAL YEAR FISCAL YEAR-END ($)(1) END (#) EXERCISABLE/ EXERCISABLE/ NAME UNEXERCISABLE UNEXERCISABLE - - ---- ---------------------- ------------------------ Mark Zimmer 18,750 / 43,750 $214,219 / $482,656 Thomas Hedges 18,750 / 43,750 214,219 / 482,656 Stephen Manousos 21,000 / 31,500 241,500 / 349,125 Leslie E. Wright 28,125 / 146,875 323,438 / 1,564,063 Steve I. Guttman 31,250 / 93,750 359,375 / 1,046,875 Karen J. Bria (2) 8,062 / 14,438 92,713 / 158,537 - - ------------ (1) Based on a closing price of $12.25 on March 29, 1996, the last trading day before March 31, 1996. (2) Information with respect to Ms. Bria, who was not an executive officer of the Company as of March 31, 1996, is provided pursuant to Item 402(a)(2)(iii) of Regulation S-B. DIRECTOR COMPENSATION The Company reimburses its directors for their out-of-pocket expenses incurred in the performance of their duties as directors of the Company. The Company does not pay fees to its directors for attendance at meetings. In September 1994, each non-employee director of the Company received an option to purchase 50,000 shares of the Company's Common Stock at an exercise price of $0.75 per share ($0.825 per share in the case of Mr. Lorenzen). In May 1995, each non-employee director received an option to purchase 10,000 shares of Common Stock at an exercise price of $2.00 per share ($2.20 per share in the case of Mr. Lorenzen). Each such option has a term of ten years, and vests over four years from the date of grant. Such options become fully exercisable in the event of any sale of all or substantially all of the Company's assets or any merger, consolidation or stock sale which results in the holders of the Company's capital stock immediately prior to such transaction owning less than 50% of the voting power of the Company's capital stock immediately after such transaction. The Company's non-employee directors also are eligible to receive certain stock options under the Company's 1995 Directors' Stock Option plan. ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. (a) SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS. The following table set forth information for certain beneficial owners as of March 31, 1996. Information with respect to beneficial ownership after Fractal's acquisition of Ray Dream is set forth in the Company's Registration Statement on Form S-4, declared effective April 26, 1996. -41-
AMOUNT AND NATURE OF NAME AND ADDRESS OF BENEFICIAL PERCENT TITLE OF CLASS OF BENEFICIAL OWNER OWNERSHIP (1) OF CLASS - - -------------- ------------------- -------------- ---------- Common Stock Mark Zimmer (2) 1,069,690 12.53% c/o Fractal Design Corporation 335 Spreckels Drive Aptos, CA 95003 Common Stock Thomas I. Hedges (3) 919,690 10.78 Fractal Design Corporation 335 Spreckels Drive Aptos, CA 95003 Common Stock Lee Jay Lorenzen (4) 989,868 11.59 c/o Altura Software, Inc. 510 Lighthouse Avenue, Suite 5 Pacific Grove, CA 93950 Common Stock Thomas I. Unterberg and entities 695,000 8.15 affiliated with Unterberg Harris (5) c/o Unterberg Harris 275 Battery Street, Suite 2980 San Francisco, CA 94111 Common Stock Stephen Thomas (6) 516,374 6.07 1901 Diamond Cluster Carrollton, TX 75010
- - ------------------ (1) Beneficial ownership is determined in accordance with the rules of the Securities and Exchange Commission. In computing the number of shares beneficially owned by a person and the percentage ownership of the person, shares of Common Stock subject to options or warrants held by that person that are exercisable on or before May 30, 1996 are deemed outstanding. Such shares, however, are not deemed outstanding for purposes of computing the ownership of each other person. Except as indicated in the footnotes to this table and pursuant to applicable community property laws, the shareholder named in the table has sole voting and investment power with respect to the shares set forth opposite such shareholder's name. (2) Includes 1,047,815 shares held in joint tenancy and 21,875 shares issuable upon exercise of options within 60 days of March 31, 1996 under Fractal's 1993 Stock Option Plan. (3) Includes 897,815 shares held in joint tenancy and 21,875 shares issuable upon exercise of options within 60 days of March 31, 1996 under Fractal's 1993 Stock Option Plan. (4) Includes 962,936 shares held by a family trust for which Mr. Lorenzen is a trustee, 1,932 shares which Mr. Lorenzen holds as a custodian, and 25,000 shares issuable upon exercise of options within 60 days of March 31, 1996 under Fractal's 1993 Stock Option Plan. (5) Includes 52,500 shares held by Thomas I. Unterberg. In addition, includes 105,000 shares held by Unterberg Harris L.L. C., 52,999 shares held by Unterberg Harris Private Equity Partners, C.V., 209,501 shares held by Unterberg Harris Private Equity Partners, L.P., 262,500 shares held by Unterberg Harris Interactive Media, L.P. I. (the "Unterberg Entities"), and 12,500 shares issuable upon exercise of options within 60 days of March 31, 1996 under Fractal's 1993 Stock Option Plan held by Mr. Unterberg directly. Mr. Unterberg disclaims beneficial ownership of all shares held by the Unterberg Entities, except to the extent of his pecuniary interests therein. (6) Includes 516,374 shares held in joint tenancy. -42- (b) SECURITY OWNERSHIP OF MANAGEMENT. The following table set forth information the Company's directors, named individually, and the Company's officers and directors as a group, as of March 31, 1996. Information with respect to beneficial ownership after Fractal's acquisition of Ray Dream is set forth in the Company's Registration Statement on Form S-4, declared effective April 26, 1996.
AMOUNT AND NATURE OF NAME AND ADDRESS OF BENEFICIAL PERCENT TITLE OF CLASS OF BENEFICIAL OWNER OWNERSHIP (1) OF CLASS - - -------------- ------------------- -------------- ---------- Common Stock Mark Zimmer (see (a) above) Common Stock Thomas Hedges (see (a) above) Common Stock Lee Jay Lorenzen (see (a) above) Common Stock Thomas I. Unterberg (see (a) above) Common Stock Stephen E. Manousos (2) 365,192 4.28% c/o Fractal Design Corporation 335 Spreckels Drive Aptos, CA 95003 Common Stock Arthur Collmeyer (3) 38,125 * 350 Bean Avenue Los Gatos, CA 95030 Common Stock Craig W. Johnson (4) 38,125 * c/o Venture Law Group 2800 Sand Hill Road Menlo Park, CA 94025 Common Stock All directors and executive officers 4,220,173 48.25% as a group (10 persons)(5)
- - --------------------- * Less than 1 percent. (1) See Note 1 to (a) above. (2) Includes 341,567 shares held in a family trust for which Mr. Manousos is a trustee and 23,625 shares issuable upon exercise of options within 60 days of March 31, 1996 under Fractal's 1993 Stock Option Plan. (3) Includes 25,000 shares issuable upon exercise of options within 60 days of March 31, 1996 under Fractal's 1993 Stock Option Plan. (4) Includes 5,000 shares issuable upon exercise of options within 60 days of March 31, 1996 under Fractal's 1993 Stock Option Plan. Also includes 20,000 shares issuable upon exercise of options within 60 days of March 31, 1996 under Fractal's Stock Option Plan held by an affiliated partnership. (5) Includes 630,000 shares beneficially owned by the Unterberg Entities affiliated with Mr. Unterberg for which he disclaims beneficial ownership other than to the extent of his pecuniary interest therein. Also includes 232,968 shares issuable upon exercise of options within 60 days of March 31, 1996 under Fractal's 1993 Stock Option Plan. -43- (c) CHANGES IN CONTROL. None. ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. Aptos Post, an image setting service bureau, provides services to Fractal in connection with the preparation and printing of product manuals and other materials. During the fiscal years ended March 31, 1995 and 1996, Fractal paid an aggregate of $80,200 and $151,000, respectively, to Aptos Post in connection with these services. Stephen E. Manousos, a director of Fractal, and Lee Jay Lorenzen, a director and a principal shareholder of Fractal, own 51% and 49% equity interests, respectively, in Aptos Post and are officers of such company. Fractal has entered into an agreement with Altura Software, Inc. ("Altura") under which Altura provides technical services to Fractal in connection with the porting of Fractal's products. Under this Agreement, Fractal licenses software from Altura, including software that facilitates the porting of Macintosh program applications to the Windows platform, in exchange for certain payments which totaled less than $60,000 and $63,000 in the fiscal years ended March 31, 1995 and 1996, respectively. Lee Jay Lorenzen, one of Fractal's directors and principal shareholders, is President of Altura and beneficially owns a majority of Altura's capital stock. During 1994, Fractal sold an aggregate of 1,057,505 shares of its Series A Preferred Stock and warrants to purchase an aggregate of 52,873 shares of Fractal's Common Stock, at a purchase price of $2.00 per unit, with each unit consisting of one share of Series A Preferred Stock and a warrant to purchase one-twentieth of one share of Common Stock. The warrants were exercised on November 14, 1995 in an aggregate net amount of 52,691 shares of Common Stock at an exercise price of $2.00 per share. The following officers, directors and holders of more than 5% of the voting securities of Fractal invested more than $60,000 in this financing: Shares of Series A Warrants to Purchase Name Preferred Stock Common Stock - - ---- ------------------ -------------------- Lee Jay Lorenzen and certain affiliated trusts ............. 149,194 7,460 Entities affiliated with Thomas I. Unterberg ........... 650,000 32,500 Craig Johnson, secretary and a director of the Company, is a director and shareholder of Venture Law Group, Fractal's corporate counsel. Unterberg Harris, an investment bank at which Mr. Unterberg, one of Fractal's directors, is a managing director, served as lead-manager for Fractal's initial public offering in November 1995. In connection with this transaction, Unterberg Harris received underwriting discounts of $645,000. Fractal believes that the foregoing transactions were on terms no less favorable to Fractal than Fractal could have obtained from unaffiliated third parties. All future transactions between Fractal and its officers, directors and principal shareholders and their affiliates will be approved by a majority of the disinterested members of the Board of Directors, and will be on terms no less favorable to the Company than could be obtained from unaffiliated third parties. Fractal has entered into indemnification agreements with each of its directors and executive officers. The agreements require Fractal to indemnify such individuals for certain liabilities to which they may be subject as a result of their affiliation with Fractal, to the fullest extent allowed by law. -44- PART IV ITEM 13. EXHIBITS AND REPORTS ON FORM 8-K. (a) Exhibits The following exhibits are filed herewith or incorporated herein by reference.
Exhibit Number Description - - ---------- ------------- 3.1** Articles of Incorporation of the Registrant. 3.2*** Bylaws of the Registrant. 10.1** Form of Indemnification Agreement with the Registrant's officers and directors. 10.2** 1993 Stock Option Plan, as amended, and forms of option agreement thereunder. 10.3** 1995 Stock Option Plan and form of option agreement thereunder. 10.4** 1995 Directors' Option Plan and form of Option Agreement. 10.5** Amended and Restated Investor Rights Agreement among the Registrant and certain security holders of the Registrant, dated as of July 21, 1995. 10.6** Distribution Agreement by and between the Registrant and Ingram Micro, Inc. dated December 5, 1991. 10.7** Distribution Agreement by and between the Registrant and Merisel dated April 14, 1992. 10.8** Distribution Agreement by and between the Registrant and Letraset Japan Limited dated June 24, 1992. 10.9** Distribution Agreement by and between the Registrant and Tech Data dated March 26, 1993. 10.10** Software Distribution Agreement by and between the Registrant and Altura Software, Inc. dated October 4, 1993. 10.11** International Software Distribution Agreement by and between the Registrant and Media Vision, Inc. dated September 29, 1994, and General Amendment thereto dated January 1, 1995. 10.12** Software Purchase, Sale, License, Development and Maintenance Agreement between the Registrant, Fractal Software, Mark Zimmer and Thomas Hedges, dated May 6, 1991; and Amendment No. 1 thereto dated September 7, 1994. 10.13** License Agreement by and between the Registrant and Pantone, Inc. dated February 15, 1992, and Amendment No. 2 of said License dated October 1, 1994. 10.14** Amended and Restated Exclusive Publishing Agreement by and between the Registrant and Walter Foster Publishing ("Publisher") dated August 28, 1995. 10.15** Software Licensing and Distribution Agreement by and between the Registrant and Larry Weinberg dated June 17, 1994. 10.16** Amended and Restated Software License, Development and Maintenance Agreement, dated as of September 9, 1994, between the Registrant and Altura Software, Inc., Lee J. Lorenzen and Stephen R. Thomas and First Amendment thereto, dated April 20, 1995. 10.17** Services and Confidentiality Agreement by and between the Registrant and Inquiry Handling Service, Inc., dated October 13, 1994. 10.18** Lease by and between the Registrant and Mal Hetzer & Associates and Charles P. Holcomb and Lois A. Holcomb, as co-trustees under that certain Declaration of Trust dated August 31, 1990. 10.19** Lease by and between the Registrant and A. M. Hetzer dated March 1, 1992. 10.20** Second Lease Agreement by and between the Registrant and A. M. Hetzer dated April 22, 1993. 10.21** Sublease by and between the Registrant and Mal Hetzer & Associates dated December 17, 1993. 10.22** Promissory Note and Security Agreement between the Registrant and Coast Commercial Bank dated August 23, 1995 in connection with a term loan in the amount of $440,000. 10.23** Promissory Note and Security Agreement between the Registrant and Coast Commercial Bank dated September 1, 1995 in connection with a line-of-credit of up to $600,000. 10.24** Common Stock Purchase Agreement between the Registrant and Adobe Ventures, L.P., dated July 21, 1995.
-45-
Exhibit Number Description - - ---------- ------------- 10.25** Contract Addendum dated October 2, 1995, to Lease by and between the Registrant and Mal Hetzer & Associates and Charles P. Holcomb and Lois A. Holcomb, as co-trustees under that certain Declaration of Trust dated August 31, 1990. 10.26** First, Second and Third Addendums dated September 30, 1994, August 27, 1995 and September 14, 1995, respectively, to Lease by and between the Registrant and A.M. Hertzer dated March 1, 1992. 10.27** Employment Agreement by and between the Registrant and Eric Hautemont dated February 17, 1996. 10.28** Form of Non-Competition Agreement dated as of February 17, 1996 between the Registrant, Ray Dream and certain key employees of Ray Dream. 10.29** Ray Dream, Inc. 1992 Stock Option Plan and forms of option agreements thereunder. 10.30**+ Software Development and Purchasing Agreement by and between Ray Dream and a third party software developer, dated June 15, 1995. 10.31**+ Warrant to Purchase Shares of Common Stock of Ray Dream, dated June 15, 1995. 10.32** Software License Agreement by and between Corel Corporation and Ray Dream, dated November 23, 1994; and Addendum No. 1 thereto dated December 1, 1995. 10.33* Agreement and Plan of Reorganization dated February 17, 1996 by and among the Registrant, Fractal Acquisition Corporation and Ray Dream, Inc. 10.34* Form of Agreement of Merger among the Registrant, Fractal Acquisition Corporation and Ray Dream, Inc. 10.35*** Assumed 1992 Ray Dream, Inc. Stock Option Plan. 10.36 Letter of Intent dated April 9, 1996 for lease of office space in Scotts Valley, California. 11.1** Statement re Computation of Pro Forma Net Income (Loss) Per Share. 21.1** Subsidiaries of the Registrant. 23.1 Consent of Price Waterhouse LLP, Independent Accountants, with respect to financial statements of Registrant. 24.1 Power of Attorney (included on page 47). 27 Financial Data Schedule.
- - -------------- * Incorporated by reference to the corresponding document previously filed as an Exhibit to the Company's Form S-4 (File No. 333-2110), declared effective April 26, 1996. ** Incorporated by reference to the corresponding document previously filed as an Exhibit to Registrant's Registration Statement on Form SB-2 (File No. 33-96942-LA), declared effective November 9, 1995. *** Incorporated by reference to the corresponding document previously filed as an Exhibit to the Company's Registration Statement on Form S-8, filed with the Commission and effective on May 24, 1996. + Confidential Treatment Requested. (b) REPORTS ON FORM 8-K None.* * The Company filed with the Commission a report on Form 8-K on June 6, 1996 in connection with the acquisition of Ray Dream, Inc. -46- SIGNATURES In accordance with the Exchange Act, the Registrant, Fractal Design Corporation, a corporation organized and existing under the laws of the State of California, has caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Aptos, State of California, on this 28th day of June, 1996. FRACTAL DESIGN CORPORATION By: /s/ MARK ZIMMER ------------------------------ Mark Zimmer Chief Executive Officer POWER OF ATTORNEY KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Mark Zimmer, his or her attorney-in-fact and agent, with the power of substitution and resubstitution, for him or her and in his or her name, place or stead, in any and all capacities, to sign any amendments to this report on Form 10-KSB, and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, granting into said attorney-in-fact and agent, full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully as he or she might or could do in person, and ratifying and confirming all that said attorney-in-fact and agent, or his or her substitute or substitutes, may do or cause to be done by virtue hereof. Pursuant to the requirements of the Exchange Act, this form has been signed by the following persons in the capacities and on the dates indicated. Signature Title Date --------------- ------- -------- /s/ MARK ZIMMER Chief Executive Officer and June 26, 1996 ------------------------ Chairman of the Board of Mark Zimmer Directors (Principal Executive Officer) /s/ THOMAS HEDGES Vice-President, Engineering June 26, 1996 ------------------------ and Vice-Chairman of the Thomas Hedges Board of Directors /s/ ERIC HAUTEMONT President and Director June 26, 1996 ----------------------- Eric Hautemont /s/ LESLIE WRIGHT Chief Operating Officer and June 26, 1996 ----------------------- Chief Financial Officer Leslie Wright (Principal Financial Officer) /s/ BRADEN RIPPETOE Vice President, Finance June 26, 1996 ----------------------- (Principal Accounting Braden Rippetoe Officer) /s/ CRAIG JOHNSON Secretary and Director June 26, 1996 ----------------------- Craig Johnson /s/ ARTHUR COLLMEYER Director June 26, 1996 ----------------------- Arthur Collmeyer /s/ LEE JAY LORENZEN Director June 26, 1996 ----------------------- Lee Jay Lorenzen /s/ STEPHEN E. MANOUSOS Director June 26, 1996 ----------------------- Stephen E. Manousos /s/ ALAIN ROSSMANN Director June 26, 1996 ----------------------- Alain Rossmann /s/ ANTHONY SUN Director June 26, 1996 - - ------------------------ Anthony Sun /s/ THOMAS UNTERBERG Director June 26, 1996 - - ------------------------ Thomas Unterberg -47- EX-10.36 2 EXHIBIT 10.36 [LETTERHEAD] April 9, 1996 Mr. Brad Krouskup TOENISKOETTER & BREEDING, INC. 1960 The Alameda, #20 San Jose, CA 95126 RE: Fractal Design/5550 Scotts Valley Drive Letter of Intent Dear Brad: We have revised the subject Letter of Intent ("LOT") for the above referenced lease for your review and approval. 1. LANDLORD: American Development II, a California general partnership ("Landlord") 2. TENANT: Fractal Design Corporation ("Tenant") 3. LOCATION: 5550 Scotts Valley Drive, Scotts Valley, CA. 4. USE: Tenant will use and occupy the Premises for the purpose of general, administrative and sales offices, product service, software engineering and product storage. Any other use will be required to conform to existing and future governmental restrictions and will be subject to Landlord's approval which will not be unreasonably withheld. 5. INITIAL PREMISES: Tenant's Initial Premises will be approximately 29,571 square feet of rentable building area, consisting of approximately 27,510 rsf, being the entire second (2nd) floor and approximately 2,061 rsf on the first (1st) floor. Tenant's first floor area shall include exclusive use of the at grade truck door and freight elevator. The rentable square footage will include the usable area within the Premises, determined in accordance with BOMA standards plus a load factor for common areas not to exceed eight percent (8%) of the usable square feet. 6. EXPANSION PREMISES: On December 1, 1998 Tenant shall expand into an additional approximate 11,467 rentable square foot area, being the first floor area surrounding the shipping/receiving area. The monthly rent for said April 9, 1996 Mr. Krouskup Page Two Expansion Premises will be at the same per square foot rate as the Initial Premises. The Lease Term for the Expansion Premises shall co-terminate with the Lease Term for the Initial Premises. Landlord shall also provide a Tenant Improvement Allowance as provided in Paragraph 11. 7. RIGHT OF FIRST REFUSAL: If at any time, during the subject Lease Term all or any portion of the remaining approximate 14,282 rentable square feet on the first floor becomes available for lease, Tenant shall have the Right of First Refusal to lease said space. Said Right may be exercised by Tenant in the event Landlord or its current tenant (Comerica) agree to a Letter of Intent with a third party tenant. By exercising its Right, Tenant agrees to lease said space upon the same terms and conditions as contained in the third party Letter of Intent. Tenant shall respond to Landlord within five (5) business days of receipt of written notice. 8. LEASE COMMENCEMENT DATE: The Lease Term will commence thirty (30) days after Landlord's substantial completion of the Tenant improvements and receipt of a certificate of occupancy but no earlier than July 1, 1996 and no later than September 1, 1996. 9. LEASE TERM: Seven (7) years. 10. OPTIONS TO RENEW: Two (2), three (3) year Options to Renew. The monthly rent for each Option period will be the equivalent of ninety-five percent (95%) of the then fair market rate. 11. TENANT IMPROVEMENT ALLOWANCE: Landlord shall provide Tenant with an allowance for interior improvements in an amount equal to ten dollars ($10.00) per rentable square foot. April 9, 1996 Mr. Krouskup Page Three Landlord shall contract with Toeniskoetter & Breeding, Inc., Construction who will provide general contractor services and cost estimating at a fee equal to five percent (5%) of the reimbursable construction costs. All subcontractor costs will be competitively bid and will be subject to Tenant's review and approval prior to construction. Tenant shall provide Landlord all information necessary for the construction of the Initial Premises as soon as reasonably possible. 12. BASE NNN RENT: Tenant shall pay to Landlord Base Triple Net (NNN) Rent in an amount equal to $1.15 per square foot per month, subject to increases as provided for in Paragraph 13. 13. RENT ADJUSTMENTS: The Base NNN Rent shall be increased at the beginning of the third (3rd), fifth (5th) and seventh (7th) years of the term to reflect increases in the Consumer Price Index. However, in no event shall the increases be less than four percent (4%) nor more than eight percent (8%) per adjustment. 14. OPERATING EXPENSES: Tenant shall pay, as additional rent, its proportional share of the triple net expenses which shall include interior and exterior building maintenance (excluding janitorial within the Premises), real property taxes and building insurance, estimated to be approximately eighteen cents ($.18) per square foot per month. 15. UTILITIES: Electrical utilities for the Premises will be separately metered, provided that such costs are reasonable. In the event of no separation of meters, Tenant shall pay its pro-rata share, subject to engineered audit of electrical costs for the building. All other utilities will be billed on a proportional basis. 16. ADVANCED RENT/ SECURITY DEPOSIT: Upon full execution of the Lease Agreement, Tenant shall pay to Landlord a sum equal to the first two (2) months of rent due under the Lease. One half of such amount will be credited toward to the first months rent payment and the balance shall serve as Security Deposit. April 9, 1996 Mr. Krouskup Page Five The parties agree that the elements of the transaction contemplated by this LOI are subject to definitive written agreements, satisfactory in form and substance to, and executed by, Landlord and Tenant and subject to appropriate corporate approvals as necessary. The parties mutually intend that nothing herein shall bind the parties in any way or create any liability between the parties unless and until such definitive written agreements are executed and delivered by the parties. We appreciate the coordinated effort between yourself and Mr. Lon Hansen of Comerica Bank. We acknowledge the stated contingency concerning Comerica Bank in your February 27, 1996 letter. Sincerely, COOPER/BRADY CORPORATE REAL ESTATE SERVICES AGENT FOR FRACTAL DESIGN CORPORATION /s/ JOHN BRADY /s/ FLETCHER BAKER John Brady Fletcher Baker If the above LOI terms and conditions are acceptable, please acknowledge acceptance by signing this letter below. ACCEPTED: AMERICAN DEVELOPMENT II FRACTAL DESIGN A California General Partnership CORPORATION By: /s/ BRAD KROUSKUP By: /s/ LES WRIGHT -------------------------- ---------------------- Brad W. Krouskup Les Wright General Partner, TBI-SVII Chief Operating Officer ACKNOWLEDGMENT: COMERICA BANK - CALIFORNIA By: /s/ LON HANSEN ------------------------- Lon Hansen NOTICE TO LESSOR AND LESSEE: COOPER/BRADY CORPORATE REAL ESTATE SERVICES, BROKER IS NOT AUTHORIZED TO GIVE LEGAL OR TAX ADVISE: NO REPRESENTATION OR RECOMMENDATION IS MADE BY COOPER/BRADY CORPORATE REAL ESTATE SERVICES, OR ITS AGENTS OR EMPLOYEES AS TO THE LEGAL EFFECT OR TAX CONSEQUENCES OF THIS DOCUMENT OR ANY TRANSACTION RELATED THERETO, SINCE THESE ARE MATTERS WHICH WOULD BE DISCUSSED WITH YOUR ATTORNEY. SCHEDULE OF LEASE COMMISSIONS TENANT: FRACTAL DESIGN CORP. ------------------------------------------------------ FOR PROPERTY AT: 5550 Scotts Valley Drive, Scotts Valley, CA ------------------------------------------------- Commissions shall be payable on execution of a lease by Landlord and Tenant, in accordance with the following rates: 6% of the total base rental for the first 36 months in which rent is to be paid, plus 4% of the total base rental for the next 24 months in which rent is to be paid, plus 3% of the total base rental for the remainder of the term. The above rates are subject to the following provisions: 1. PAYMENT OF LEASE COMMISSIONS: Commissions shall be due and payable one-half (1/2) on execution of a lease and one-half (1/2) on lease commencement date, or when Tenant takes occupancy of the premises, whichever occurs first. 2. ADDITIONAL SPACE TAKEN: If a lease for which a commission is payable hereunder contains an option(s) to expand, or Tenant leases additional space whether by virtue of such option or otherwise, then Landlord shall pay a leasing commission in accordance with the provisions of this Schedule on the additional rental to be paid, calculated at the commission rate applicable hereunder to the years of the lease in which the additional rental is payable. Said commission shall be earned and payable at the time the additional space is leased. In the event Landlord fails to make payments within the time limits set forth herein, then from the date due until paid the delinquent amount shall bear interest at the maximum rate permitted in the state in which the office Broker executing this Schedule is located. If Broker is required to institute legal action against Landlord relating to this Schedule or any agreement of which it is a part, Broker shall be entitled to reasonable attorneys' fees and costs. Landlord hereby acknowledges receipt of a copy of this Schedule and agrees that it shall be binding upon its heirs, successors and assignees. In the event Landlord sells or otherwise disposes of its interest in the Property, Landlord shall remain liable for payment of the commissions provided for in this Schedule. BROKER: LANDLORD: COOPER/BRADY CORPORATE AMERICAN DEVELOPMENT II REAL ESTATE SERVICES By: /s/ BRAD KROUSKUP By: /s/ JOHN BRADY ------------------------------ -------------------------- Date: 4/19/96 ---------------------------- Date: 3/26/96 ------------------------ TENANT: COMERICA BANK - CALIFORNIA By: /s/ LON HANSEN ------------------------------ Date: 4/19/96 ---------------------------- However, in no event shall the commission payable for the Initial Premises exceed five ($5.00) dollars per rentable square foot. EX-23.1 3 EXHIBIT 23.1 FRACTAL DESIGN CORPORATION EXHIBIT 23.1 CONSENT OF INDEPENDENT ACCOUNTANTS We hereby consent to the incorporation by reference in the Registration Statement on Form S-8 (No. 333-04599) of our report dated April 22, 1996, except as to Note 11, which is as of May 24, 1996, which appears on page 23 of this Form 10-K. /s/ PRICE WATERHOUSE LLP Price Waterhouse LLP San Jose, California June 28, 1996 EX-27 4 EXHIBIT 27
5 THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE COMPANY'S FORM 10-KSB FOR FISCAL YEAR 1996 AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS. 1,000 YEAR MAR-31-1996 APR-01-1995 MAR-31-1996 5,422 23,683 4,070 91 804 36,887 1,142 555 37,474 6,964 0 0 0 9 30,501 37,474 21,780 21,780 4,219 4,219 13,307 0 (464) 4,718 1,794 0 0 0 0 2,924 0.36 0.36
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