-----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, UdhDccokg/lnW3i4hpPTVw9OxrzvfyQ4qotbhOATyRYv2UlOTTaDaWFdqncpBnL6 Ekv6gwjiGfbB6tlhfecntw== 0000891618-98-002408.txt : 19980515 0000891618-98-002408.hdr.sgml : 19980515 ACCESSION NUMBER: 0000891618-98-002408 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 3 CONFORMED PERIOD OF REPORT: 19980331 FILED AS OF DATE: 19980514 SROS: NASD FILER: COMPANY DATA: COMPANY CONFORMED NAME: DIAMOND MULTIMEDIA SYSTEMS INC CENTRAL INDEX KEY: 0000936734 STANDARD INDUSTRIAL CLASSIFICATION: COMPUTER PERIPHERAL EQUIPMENT, NEC [3577] IRS NUMBER: 770390654 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-Q SEC ACT: SEC FILE NUMBER: 000-25580 FILM NUMBER: 98621264 BUSINESS ADDRESS: STREET 1: 2880 JUNCTION AVE CITY: SAN JOSE STATE: CA ZIP: 95134 BUSINESS PHONE: 4083257000 MAIL ADDRESS: STREET 1: 2880 JUNCTION AVE CITY: SAN JOSE STATE: CA ZIP: 95134 10-Q 1 FORM 10-Q FOR PERIOD ENDED MARCH 31, 1998 1 SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q (Mark One) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended March 31, 1998 or [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from _______ to ________ Commission File Number 0-25580 DIAMOND MULTIMEDIA SYSTEMS, INC. (Exact name of registrant as specified in its charter) DELAWARE 77-0390654 (State or other jurisdiction of (I.R.S. Employer Identification No.) incorporation or organization) 2880 JUNCTION AVENUE, SAN JOSE, CALIFORNIA 95134 (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code: (408) 325-7000 Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] The number of shares outstanding of the registrant's common stock at April 17, 1998 was 34,767,973. 2 DIAMOND MULTIMEDIA SYSTEMS, INC. INDEX TO FORM 10-Q
Page ---- PART I - FINANCIAL INFORMATION: ITEM 1- Financial Statements Consolidated Condensed Balance Sheets as of March 31, 1998 and December 31, 1997 3 Consolidated Condensed Statements of Operations for the three months ended March 31, 1998 and 1997 4 Consolidated Condensed Statements of Cash Flows for the three months ended March 31, 1998 and 1997 5 Notes to Consolidated Condensed Financial Statements 6 ITEM 2 - Management's Discussion and Analysis of Financial Condition and Results of Operations 8 PART II - OTHER INFORMATION ITEM 1 - Legal proceedings 26 ITEM 2 - Changes in securities 26 ITEM 3 - Defaults Upon Senior Securities 26 ITEM 4 - Submission of Matters to a Vote of Security Holders 26 ITEM 5 - Other Information 26 ITEM 6 - Exhibits and Reports on Form 8-K 26 SIGNATURES 27
2 3 PART I - FINANCIAL INFORMATION ITEM 1 - FINANCIAL STATEMENTS DIAMOND MULTIMEDIA SYSTEMS, INC. AND SUBSIDIARIES CONSOLIDATED CONDENSED BALANCE SHEETS (UNAUDITED; IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
MARCH 31, DECEMBER 31, 1998 1997 --------- --------- ASSETS Current assets: Cash and cash equivalents $ 94,787 $ 85,929 Short-term investments 6,142 4,136 Trade accounts receivable, net of allowance for doubtful accounts of $2,034 and $2,440 as of March 31, 1998 and December 31, 1997 102,856 98,777 Inventories 92,456 78,647 Prepaid expenses and other current assets 6,958 6,350 Income taxes receivable 5,915 24,929 Deferred income taxes 13,731 14,679 --------- --------- Total current assets 322,845 313,447 Property, plant and equipment, net 18,470 15,216 Other assets 3,416 3,616 Goodwill and other intangibles, net 5,031 5,275 --------- --------- Total assets $ 349,762 $ 337,554 ========= ========= LIABILITIES Current liabilities: Current portion of long-term debt $ 35,301 $ 36,455 Trade accounts payable 95,471 98,764 Accrued liabilities 20,883 17,667 Income taxes payable 5,518 2,274 --------- --------- Total current liabilities 157,173 155,160 Long-term debt, net of current portion 1,747 1,873 --------- --------- Total liabilities 158,920 157,033 --------- --------- STOCKHOLDERS' EQUITY Preferred stock, par value $.001; Authorized - 8,000 shares at March 31, 1998 and December 31, 1997; none issued and outstanding -- -- Common stock, par value $.001; Authorized - 75,000 at March 31, 1998 and December 31, 1997 Issued and outstanding - 34,742 at March 31, 1998 and 34,491 at December 31, 1997 35 34 Additional paid-in capital 310,270 307,877 Distributions in excess of net book value (56,775) (56,775) Accumulated deficit (62,688) (70,615) --------- --------- Total stockholders' equity 190,842 180,521 --------- --------- Total liabilities and stockholders' equity $ 349,762 $ 337,554 ========= =========
The accompanying notes are an integral part of these consolidated condensed financial statements. 3 4 DIAMOND MULTIMEDIA SYSTEMS, INC. AND SUBSIDIARIES CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS (UNAUDITED; IN THOUSANDS, EXCEPT PER SHARE DATA)
THREE MONTHS ENDED MARCH 31, -------------------------- 1998 1997 --------- --------- Net sales $ 186,196 $ 112,402 Cost of sales 144,570 92,817 --------- --------- Gross profit 41,626 19,585 --------- --------- Operating expenses: Research and development 7,092 5,692 Selling, general and administrative 23,158 22,511 Amortization of intangibles 244 1,316 --------- --------- Total operating expenses 30,494 29,519 --------- --------- Income (loss) from operations 11,132 (9,934) Interest income, net 336 543 Other expense, net (144) (55) --------- --------- Income (loss) before provision (benefit) for income taxes 11,324 (9,446) Provision (benefit) for income taxes 3,397 (3,495) --------- --------- Net income (loss) $ 7,927 ($ 5,951) ========= ========= Net income (loss) per share: Basic $ 0.23 $( 0.17) Diluted $ 0.22 $( 0.17) Shares used in per share calculations: Basic 34,781 34,179 Diluted 36,521 34,179
The accompanying notes are an integral part of these consolidated condensed financial statements. 4 5 DIAMOND MULTIMEDIA SYSTEMS, INC. AND SUBSIDIARIES CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS (UNAUDITED; IN THOUSANDS)
THREE MONTHS ENDED MARCH 31, ---------------------------- 1998 1997 --------- --------- Cash flows from operating activities: Net income (loss) $ 7,927 $( 5,951) Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: Depreciation and amortization 1,701 2,619 Provision for doubtful accounts (54) 429 Provision for excess and obsolete inventories 4,920 556 Deferred income taxes 948 (1,660) Changes in assets and liabilities: Trade accounts receivables (4,025) 4,421 Inventories (18,729) (3,215) Prepaid expenses and other assets (408) 2,003 Income taxes receivable 19,014 -- Trade accounts payable and other liabilities 3,167 (25,080) --------- --------- Net cash provided by (used in) operating activities 14,461 (25,878) --------- --------- Cash flows from investing activities: Purchases of property and equipment (4,711) (1,970) Purchases of short-term investments (2,006) -- --------- --------- Net cash used in investing activities (6,717) (1,970) --------- --------- Cash flows from financing activities: Proceeds from issuance of common stock 2,394 268 Repurchases of common stock -- (4) Proceeds from term loans and revolving credit facilities 22,971 7,064 Payments and maturities of term loans and revolving credit facilities (24,032) (1,365) Repayments of capital lease financings (219) (195) --------- --------- Net cash provided by financing activities 1,114 5,768 --------- --------- Net increase (decrease) in cash and cash equivalents 8,858 (22,080) Cash and cash equivalents at beginning of period 85,929 120,147 --------- --------- Cash and cash equivalents at end of period $ 94,787 $ 98,067 ========= ========= Supplemental Disclosure of cash flow information: Income taxes paid during the period $ 10 $ 1,400 ========= ========= Interest paid during the period $ 553 $ 155 ========= =========
The accompanying notes are an integral part of these consolidated condensed financial statements. 5 6 DIAMOND MULTIMEDIA SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS (Unaudited) 1. BASIS OF PRESENTATION The accompanying unaudited condensed consolidated financial statements have been prepared by the Company in accordance with generally accepted accounting principles for interim financial information and pursuant to rules and regulations of the Securities and Exchange Commission. In the opinion of management, all adjustments (consisting only of normal recurring adjustments) considered necessary for a fair presentation have been included. These financial statements should be read in conjunction with the Company's consolidated financial statements and notes thereto contained in the Company's Form 10-K for the fiscal year ended December 31, 1997. Operating results for the quarter ended March 31, 1998 may not necessarily be indicative of the results to be expected for any other interim period or for the full year. 2. INVENTORIES Inventories are stated at the lower of cost (determined on a first-in, first-out basis) or market. Inventories consisted of (in thousands):
March 31, 1998 December 31, 1997 -------------- ----------------- Raw materials $35,550 $29,876 Work in process 45,465 40,286 Finished goods 11,441 8,485 ------- ------- $92,456 $78,647 ======= =======
The Company had approximately $4 million of inventory in excess of its normal short-term needs for certain product lines at March 31, 1998. Management has developed a program to reduce this inventory to desired levels over the near term; however, it is reasonably possible that the program will not be wholly successful and that a material loss could ultimately result on the disposal of this inventory. No estimate can be made of the range of amounts of such loss. 3. COMPUTATION OF NET INCOME (LOSS) PER SHARE The Company adopted Financial Accounting Standards Board No. 128 "Earnings Per Share" (EPS) and accordingly all prior periods have been restated. Basic EPS is computed as net income (loss) divided by the weighted average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution that could occur from common shares issuable through stock options, warrants and other convertible securities. Common equivalent shares are excluded from the computation of net loss per share as their effect is antidilutive. 6 7 The following is a reconciliation of the numerator (net income) and denominator (number of shares) used in the basic and diluted EPS calculation: (Dollar amounts, in thousands)
Three Months Ended March 31, ------------------------------- 1998 1997 -------- -------- Basic: Net income (loss) $ 7,927 $( 5,951) Average Common Shares Outstanding 34,781 34,179 -------- -------- Basic EPS $ 0.23 $( 0.17) ======== ======== Diluted: Net income (loss) $ 7,927 $( 5,951) Average Common Shares Outstanding 34,781 34,179 Stock options 1,740 -- Total Shares 36,521 34,179 -------- -------- Diluted EPS $ 0.22 $( 0.17) ======== ========
Common equivalent shares of 1,222,000 have been excluded from the calculation of dilituve earnings per share for the three months ended March 31, 1998 as their effect is anti-dilutive. 4. LITIGATION The Company has been named as a defendant in several putative class action lawsuits which were filed in June and July 1996 and June 1997 in the California Superior Court for Santa Clara County and the U.S. District Court for the Northern District of California. Certain executive officers and directors of the Company are also named as defendants. The plaintiffs purport to represent a class of all persons who purchased the Company's Common Stock between October 18, 1995 and June 20, 1996 (the "Class Period"). The complaints allege claims under the federal securities laws and California law. The plaintiffs allege that the Company and the other defendants made various material misrepresentations and omissions during the Class Period. The complaints do not specify the amount of damages sought. The Company believes that it has good defenses to the claims alleged in the lawsuits and will defend itself vigorously against these actions. These cases are in the early stages and no trial date has been set. The ultimate outcome of these actions cannot be presently determined. Accordingly, no provision for any liability or loss that may result from adjudication or settlement thereof has been made in the accompanying consolidated financial statements. The Company is also party to other claims and pending legal proceedings that generally involve employment and trademark issues. These cases are, in the opinion of management, ordinary and routine matters incidental to the normal business conducted by the Company. In the opinion of management, the ultimate disposition of such proceedings will not have a materially adverse effect on the Company's consolidated financial position or future results of operations. 5. COMPREHENSIVE NET INCOME The Company has adopted the provisions of Statement of Financial Accounting Standards No. 132, "Reporting Comprehensive Income", effective January 1, 1998. This statement requires the disclosure of comprehensive income and its components in a full set of general-purpose financial statements. Comprehensive income is defined as net income plus revenues, expenses, gains and losses that, under generally accepted accounting principles, are excluded from net income. The components of comprehensive income which are 7 8 excluded from net income are not significant, individually or in the aggregate, and therefore, no separate statement of comprehenisve income has been presented. 6. SUBSEQUENT EVENT On May 11, 1998 Diamond Multimedia Systems, Inc. announced that it entered into an agreement to acquire Micronics Computers, Inc. ("Micronics") at a price of $2.45 per share, or approximately $31.6 million, to be consummated as a cash tender offer. Micronics is a supplier of high-performance system boards and multimedia peripherals for personal computers. The acquisition, if completed, will be treated as a purchase for accounting purposes and is subject to regulatory approval and other customary conditions. The Company expects to take a one-time charge during the second quarter in connection with the acquisition of Micronics. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The discussion and analysis below contains trend analysis and other forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Actual results could differ materially from those projected in the forward-looking statements as a result of the risk factors set forth under "Certain Factors That May Affect Future Performance" below and elsewhere in this report. The following discussion should be read in conjunction with the Company's consolidated financial statements and the notes thereto. All references to years represent fiscal years unless otherwise noted. OVERVIEW Diamond Multimedia Systems, Inc. ("Diamond" or the "Company") designs, develops, manufactures and markets multimedia and connectivity products for IBM-compatible personal computers ("PCs"). The Company is a leading supplier of graphics and multimedia accelerator subsystems for PCs, and is expanding its position in the interactive multimedia market by providing advanced solutions for home, business and professional desktop computer users, enabling them to create, access and experience compelling new media content from their desktops and through the Internet. Diamond accelerates multimedia from the Internet to the hard drive with products that include the Stealth series of media accelerators, the Monster series of entertainment 3D and audio accelerators, the Fire series of professional 3D graphics and SCSI accelerators, and the Supra(R) series of modems. Headquartered in San Jose, CA, Diamond has sales, marketing and technical facilities in several locations including Vancouver (WA), Albany (OR), Atlanta (GA), Dallas (TX), Singapore, Sydney, Hong Kong, Seoul, Tokyo, Starnberg (Germany), Saarbrecken (Germany), Paris, and Winnersh (U.K.). Diamond's products are sold through regional, national and international distributors as well as directly to major computer retailers, VARs and OEMs worldwide. NET SALES Net sales for the first quarter of 1998 increased $73.8 million (66%) to $186.2 million compared to the first quarter of 1997. The increase in net sales was primarily attributable to strong shipments of the Viper and Monster 3D series of graphic accelerator cards as well as an increase in sales of the Fire series of professional 3D graphics. As a percentage of net sales, international net sales represented 46% of net sales in the first quarter of 1998 compared to 30% of net sales in the first quarter of 1997. The increase in the percentage of international sales was primarily due to significant increases in product shipments to Europe in the first quarter of 1998 relative to the corresponding prior year period. Additionally, the percentage of international net sales derived from shipments to countries outside of Europe also increased, albeit at a slower rate than in Europe, in the first quarter of 1998 compared to corresponding prior year period. 8 9 In the current transition of mainstream PC graphics subsystem architectures from 2D graphics and the PCI bus to 3D graphics and the accelerated graphics port (AGP), which began in 1997 and is expected to continue through 1998, controller and memory chip selection and the timely introduction of new products have been and will continue to be critical factors. The Company expects that the timing and speed of the PCI-to-AGP bus transition and the SGRAM-to-SDRAM memory transition are likely to lead to an excess inventory of PCI and SGRAM-based products at the Company and in the distribution channel that is likely to result in lower average selling prices, lower gross margins, end-of-life inventory write-offs, and higher price protection charges during the second quarter of 1998. The Company estimates and accrues for potential inventory write-offs and price protection charges. However, there can be no assurance that these estimates and accruals will be sufficient, and additional inventory write-offs and price protection charges may be required, the result of which could have a material effect on operating results during the second quarter of 1998. Inventory levels of the Company's products in the two-tier distribution channels used by the Company ("Channel Inventory Levels") generally are maintained in a range of one to three months of customer demand. These Channel Inventory Levels tend toward the low end of the months-of-supply range when demand is stronger, sales are higher and products are in short supply. Conversely, when demand is slower, sales are lower and products are abundant, then Channel Inventory Levels tend toward the high end of the months-of-supply range. Frequently, in such situations, the Company attempts to ensure that distributors devote their working capital, sales and logistics resources to the Company's products to a greater degree than to those of competitors. Similarly, the Company's competitors attempt to ensure that their own products are receiving a disproportionately higher share of the distributors' working capital and logistics resources. In an environment of slower demand and abundant supply of products, price declines are more likely to occur and, should they occur, are more likely to be severe. Further, in such an event, high Channel Inventory Levels may result in substantial price protection charges. Such price protection charges have the effect of reducing net sales and gross profit. Consequently, the Company, in taking steps to bring its Channel Inventory Levels down to a more desirable level, may cause a shortfall in net sales during one or more accounting periods. This situation may also result in price protection charges as prices are decreased, having an adverse impact on operating results. While the Company believes that its Channel Inventory Levels for many of its products are appropriate at this time, there are certain products which currently have a Channel Inventory Level that is higher than desirable. The Company accrues for potential price protection on unsold channel inventory. However, there can be no assurance that these estimates or accruals will be sufficient. Should the estimates or accruals not be sufficient, additional price protection charges may be required, the result of which could have a material adverse effect on operating results during the second quarter of 1998. GROSS MARGIN Gross profit for the first quarter of 1998 increased $22.0 million to $41.6 million compared to $19.6 million in the first quarter of 1997. Gross margin (gross profit as a percentage of net sales) increased to 22.4% of net sales during the first quarter of 1998 from 17.4% for the first quarter of 1997. The increase was primarily due to the relatively high margin obtained from the Company's Viper, Monster 3D and Fire GL series of graphic accelerator cards, which experienced strong shipments in the first quarter of 1998. Further, the gross margin was positively impacted by significantly higher shipment volume levels over which indirect manufacturing costs could be absorbed. RESEARCH AND DEVELOPMENT Research and development (R&D) expenses increased $1.4 million (25%) to $7.1 million for the first quarter of 1998, compared to the corresponding period in 1997. This increase was primarily due to higher personnel-related expenses and the material and outside service costs associated with new product development, including products that will offer various functions or combinations of functions including graphics, digital video, 3D animation, 3D CAD, sound, modem, telephony and other functions increasingly being implemented on personal computers. As a percentage of sales, R&D expenses were 3.8% and 5.1% in the first quarter of 1998 and 1997, respectively. The decrease in expenses as a percentage of net sales is primarily attributable to the increase in net sales during the first quarter of 1998 compared to the first quarter of 1997. 9 10 SELLING, GENERAL AND ADMINISTRATIVE Selling, general and administrative (SG&A) expenses increased $0.6 million (3%) to $23.2 million for the first quarter of 1998 compared to the first quarter of 1997. This increase in expense was partially offset by a decline in sales and promotional expenses, including fewer expenses attributable to channel sales incentive programs during the first quarter of 1998 compared to the first quarter of 1997. As a percentage of sales, SG&A expenses were 12.4% and 20.0% in the first quarter of 1998 and 1997, respectively. The decrease in expenses, as a percentage of sales, is primarily from the increase in net sales during the first quarter of 1998 compared to the corresponding period of 1997. AMORTIZATION OF INTANGIBLE ASSETS The Company incurred amortization expense of $0.2 million in the first quarter of 1998 compared to $1.3 million in the corresponding prior year period. The decrease in expense in the first quarter of 1998 is primarily due to the write-off of $9.9 million of intangible assets during the second quarter of 1997 which significantly reduced the remaining outstanding balance to be amortized. These expenses relate to amortization of purchased technology and goodwill from the Supra Corporation and SPEA Software AG acquisitions, which occurred in the third and fourth quarters of 1995, respectively. This decrease in expense was offset in part by amortization expense arising from the $2 million of goodwill created by Company's acquisition of Binar Graphics, Inc. which occurred in November 1997. NET INTEREST INCOME (EXPENSE) AND OTHER EXPENSE Net interest income was $0.3 million and $0.5 million in the first quarter of 1998 and 1997, respectively. Net interest income declined due to higher interest expense incurred because of larger average borrowings outstanding during the first quarter of 1998 compared to the first quarter of 1997. Other expense remained relatively flat during the first quarters of 1998 and 1997. PROVISION (BENEFIT) FOR INCOME TAXES The Company's effective tax rate in the first quarter of 1998 was 30% compared to an income tax benefit rate of 37% for the corresponding period in 1997 when a pre-tax loss was incurred. Differences from the statutory rate consisted principally of the effect of state income taxes, federal tax-exempt interest income and the research and development tax credit. LIQUIDITY AND CAPITAL RESOURCES Cash and cash equivalents increased by $8.9 million during the first quarter of 1998. Operating activities provided $14.5 million in cash, and the primary sources of cash were as follows: net income of $7.9 million; a decrease in income taxes receivables and a decrease in trade accounts payable and other liabilities of $19.0 million and $3.2 million, respectively, and depreciation and amortization expense of $1.7 million. These sources of cash from operating activities were offset in part by an increase in inventories, net of the provision for obsolescence, of $13.8 million, and an increase in trade receivables, net of the provision for doubtful accounts of $4.0 million. The Company used $6.7 million in cash from investing activities for the purchase of property and equipment of $4.7 million and purchases of short-term investments of $2.0 million. Net cash provided by financing activities was $1.1 million, primarily due to proceeds of $23.0 million from term loans and revolving credit facilities and proceeds of $2.4 million from the issuance of common stock. These proceeds were partially offset by payments and maturities of term loans and revolving credit facilities of $24.0 million. 10 11 At March 31, 1998, the Company had $94.8 million of cash and cash equivalents and $6.1 million of short-term investments. Further, as of such date, the Company had lines of credit and bank credit facilities totaling $61.2 million, of which $24.2 million was unused and available. The Company expects to spend approximately $12 million for capital equipment in 1998, principally relating to computer and office equipment and including, in particular, an enhanced enterprise-wide business management, resource planning and decision support application. On May 11, 1998 Diamond Multimedia Systems, Inc. announced that it entered into an agreement to acquire Micronics Computers, Inc. ("Micronics") at a price of $2.45 per share, or approximately $31.6 million, to be consummated as a cash tender offer. Micronics is a supplier of high-performance system boards and multimedia peripherals for personal computers. The acquisition, if completed, will be treated as a purchase for accounting purposes and is subject to regulatory approval and other customary conditions. The Company expects to take a one-time charge during the second quarter in connection with the acquisition of Micronics. The Company believes that its cash balances and available credit under existing bank lines will be sufficient to meet anticipated operating and investing requirements for the short term. There can be no assurance that additional capital beyond the amounts currently forecasted by the Company will not be required nor that any such required additional capital will be available on reasonable terms, if at all, at such time or times as required by the Company. CERTAIN FACTORS THAT MAY AFFECT FUTURE PERFORMANCE In addition to other information in this Form 10-Q, the following are important factors that should be considered carefully in evaluating the Company and its business. POTENTIAL FLUCTUATIONS IN FUTURE OPERATING RESULTS The Company's operating results have fluctuated significantly in the past on a quarterly and an annual basis and is likely to continue to fluctuate significantly in the future depending on a number of factors. The accompanying sections explain in greater detail certain important factors that the Company has identified which may affect the future performance of the Company. The Company develops products in the highly competitive multimedia graphics, video, sound, modem and SCSI adapter markets. These products are very susceptible to product obsolescence and typically exhibit a high degree of volatility of shipment volumes over their relatively short product life cycles. The timing of introductions of new products in one calendar quarter as opposed to an adjacent quarter can materially affect the relative sales volumes in those quarters. In addition, product releases by competitors and accompanying pricing actions can materially and adversely affect the Company's revenues and gross margins. Similarly, the Company sells its products to retail customers (mass merchandisers and large chains who sell products primarily off-the-shelf directly to end users) retail distribution customers (distributors which resell to smaller retail chains and large individual end users) and OEM customers (customers which use the Company's products in conjunction with other products to produce complete computer systems for sales through both direct and indirect distribution channels to end users). Reliance on these customers for almost all of the Company's sales means that the Company typically has little or no direct visibility into end user customer demand. OEM customers tend to provide the Company with forecasts for product requirements but actual order lead times remain less than 90 days. Retail and retail distribution customers typically do not forecast product requirements and order lead times are typically very short, as these customers tend to reorder for stock in quantities that approximate recent sales volumes. Accordingly, this means that future operating results are dependent on continued sales to customers where the vast majority of the normal volume of orders are placed with the Company within the same calendar quarter as the requested date of shipment by the customer. Because the lead times of firm orders are typically short, the Company does not have the ability to predict with any certainty the future operating results of the Company. Therefore, sudden changes that are out of the control of the Company such as general economic conditions, the actions or inaction of competitors, customers, third party vendors of operating system software, central processing unit hardware, and independent software application vendors can have and have had material adverse effects on the Company's performance. Other factors which may have a material adverse effect on the Company's future performance, include the management of growth of the Company, latent defects that can exist in the Company's products, competition for 11 12 the available supply of components, dependence on subcontract manufacturers, dependence on and development of adequate information technology systems, intellectual property rights and dependence on key personnel. Each of these factors is discussed more thoroughly in the accompanying sections and all of these sections should be read carefully together to evaluate the risks associated with the Company's Common Stock. Due to these factors, it is likely that the operating results of the Company in some future quarter or quarters will fall below the expectations of securities analysts and investors. In such an event, the trading price of the Company's Common Stock could be materially and adversely affected. REVENUE VOLATILITY AND DEPENDENCE ON ORDERS RECEIVED AND SHIPPED IN A QUARTER The volume and timing of orders received during a quarter are difficult to forecast. Retail and retail distribution customers generally order without forecasts on an as-needed basis and, accordingly, the Company has historically operated with a relatively small backlog. Moreover, the Company has emphasized its ability to respond quickly to customer orders as part of its competitive strategy. This strategy, combined with current industry supply and demand conditions as well as the Company's emphasis on minimizing inventory levels, has resulted in customers placing orders with relatively short delivery schedules and increased demand on the Company to carry inventory for its customer base. This has the effect of increasing such short lead time orders as a portion of the Company's business and reducing the Company's ability to accurately forecast net sales. Because retail and retail distribution customers' orders are more difficult to predict, there can be no assurance that the combination of these orders, OEM's orders, and backlog in any quarter will be sufficient to achieve either sequential or year-over-year growth in net sales during that quarter. If the Company does not achieve a sufficient level of retail and retail distribution orders in a particular quarter, the Company's revenues and operating results would be materially adversely affected. Also, at any time and with no advance notice, during periods of uncertainty in the personal computer industry's outlook for future demand or pricing, the Company's customers may choose to draw down their inventory levels thereby adversely impacting the Company's revenue during the period of adjustment. The second and third quarters of 1997 comprised such a period due to the transition from older slower speed modems and 2D graphics products to new higher speed modems and 3D graphics products. In the current transition of mainstream PC graphics subsystem architectures from 2D graphics and the PCI bus to 3D graphics and the accelerated graphics port (AGP), which began in 1997 and is expected to continue through 1998, controller and memory chip selection and the timely introduction of new products have been and will continue to be critical factors. The Company expects to see the effects of the PCI-to-AGP transition and the SGRAM-to-SDRAM memory transition in the second quarter of 1998, which will result in significant pricing pressures on the Company's remaining PCI-based and SGRAM-based graphics inventory and the inventory of such products in the distribution channel. As a result, the net sales and gross margins of the Company are likely to be materially and adversely affected by declining prices for the PCI-based and SGRAM-based products and any significant price protection claims associated with such price declines. Also, as is common in the personal computer industry, a disproportionate percentage of the Company's net sales in any quarter may be generated in the last month or weeks of a quarter. As a result, a shortfall in sales in any quarter as compared to expectations may not be identifiable until at or near the end of the quarter. In addition, from time to time, a significant portion of the Company's net sales may be derived from a limited number of customers, the loss of one or more of which could adversely impact operating results. Notwithstanding the difficulty in forecasting future sales and the relatively small level of backlog at any given time, the Company generally must plan production, order components and undertake its development, sales and marketing activities and other commitments months in advance. Accordingly, any shortfall in net sales in a given quarter may materially impact the Company's operating results and cash balances in a magnified way due to the Company's inability to adjust expenses or inventory levels during the quarter to match the level of net sales for the quarter. Excess inventory could also result in cash flow difficulties as well as added costs of goods sold and expenses associated with inventory write-offs or sell-offs. Conversely, in its efforts to adjust inventory levels to a slower order rate, the Company may overcorrect its component purchases and inventory levels, thereby experiencing periodic shortages of inventory and delivery delays, and negatively impacting its net sales, 12 13 market share and customer satisfaction levels in the current quarter or in future quarters. There can be no assurances that such an occurrence will not adversely impact the Company operating results. DECLINING SELLING PRICES AND OTHER FACTORS AFFECTING GROSS MARGINS The Company's markets are characterized by intense ongoing competition and coupled with a past history and a current trend of declining average selling prices. A decline in selling prices may cause the net sales in a quarter to be lower than the revenue of a preceding quarter or corresponding prior year's quarter even if more units were sold during such quarter than in the preceding or corresponding prior year's quarter. Accordingly, it is likely that the Company's average selling prices will decline, and that the Company's net sales and margins may decline in the future, from the levels experienced to date. (See also Short Product Life Cycles; Dependence on New Products) The Company's gross margins may also be adversely affected by shortages of, or higher prices for, key components for the Company's products, including its modems, 3D graphics accelerators, SCSI I/O host bus adapters and 3D audio accelerators products, some of which have been impacted from time-to-time by a scarcity in the supply of associated chipsets and other components. For example, the recent agreement by Symbios (the sole supplier of the Company's SCSI controllers) to be acquired by Adaptec (the Company's chief competitor in the SCSI host bus adapter card market) may, if such acquisition is consummated, result in the unavailability of SCSI controllers for the Company's SCSI products, or the unavailability of such controllers or software support under economically reasonable prices, terms, conditions or timing. Additionally, the acquisition, if consummated, may lead to caution or reluctance on the part of the Company's customers or potential customers, both direct and indirect, to do business with Adaptec's competitors who have historically used Symbios controllers. In addition, the Company's net sales, average selling prices and gross margins will be adversely affected if the market prices for certain components used or expected to be used by the Company, such as DRAM, SDRAM, SGRAM or RDRAM memory, DVD drives, multimedia controller chips or bundled software, decline more rapidly than the Company is able to process component inventory bought earlier at higher prices into finished products, book and ship the related orders, and move such products through third-party distribution channels, some of which may be price protected, to the final customer. For example, operating results were negatively impacted in the second and third quarters of 1996 by declining market prices for the Company's products, caused in part by a sharp reduction in the market price for DRAMs. The Company might experience such declining prices and tighter margins in the second quarter of 1998 due to the effect of product transitions, including the PCI-to-AGP transition and the SGRAM-to-SDRAM memory transition. Conversely, an increase in the price of semiconductor components that are in scarce supply, such as high-speed DRAMs, may adversely impact the Company's gross margin due to higher unit costs, and a decrease in the supply of such semiconductor components may adversely impact the Company's net sales due to lower unit shipments. SEASONALITY The Company believes that, due to industry seasonality, demand for its products is strongest during the fourth quarter of each year and is generally slower in the period from April through August. This seasonality may become more pronounced and material in the future to the extent that a greater proportion of the Company's sales consist of sales into the retail/mass merchant channel, that PCs become more consumer-oriented or entertainment-driven products, or that the Company's net sales becomes increasingly based on entertainment-centric products. Also, to the extent the Company is successful in expanding its European operations, it may experience relatively weak demand in third calendar quarters due to historically weak summer sales in Europe. MANAGEMENT OF GROWTH In recent years, the Company has experienced a significant expansion in the overall level of its business and the scope of its operations, including manufacturing, research and development, marketing, technical support, customer service, sales and logistics. In addition, through its acquisitions of Supra in September 1995 and Spea in November 1995, the Company increased the scope of its product lines and multinational operations. This expansion in scope has resulted in a need for significant investment in infrastructure, processes and information systems, as well as the integration of the operations of Supra and Spea into the Company's infrastructure. This 13 14 requirement includes, without limitation: Securing adequate financial resources to successfully integrate and manage the acquired businesses; retention of key employees; integration of management information, product data management, control and telecommunications systems; consolidation of geographically dispersed manufacturing and distribution facilities; consolidation and coordination of suppliers; rationalization of distribution channels; establishment and documentation of business processes; and integration of various functions and groups of employees. Each of these requirements poses significant, material challenges. For example, the Company established a restructuring reserve in the second quarter of 1997 to account for the expected expenses of, among other actions, integrating customer service and distribution from Supra into Diamond, transitioning manufacturing from Supra's facility in Oregon to a subcontractor facility in Mexico, and integrating technical support from Diamond's San Jose, California facility to Supra's technical support organization in Oregon. Moreover, Spea historically has not been profitable and the Company's management took significant steps to reduce expenses at Spea and integrate its operations with those of the Company. Accordingly, the Company reorganized Spea to function principally as follows: a product localization and marketing operation for Europe; a sales, technical support and customer service operation for Central Europe; and a product development and launch facility for professional 3D graphics, including CAD and digital animation, for the Company's worldwide markets. The Company discontinued manufacturing, test, packaging and logistics operations at Spea effective October 1, 1996. Prior to its acquisition by the Company, Spea made certain investments including entering into the shared ownership (at 49.5%) with Philips Semiconductor (at 50.5%) of a 3D graphics semiconductor design subsidiary, SP3D. The Company's 49.5% ownership of SP3D is carried on the Company's balance sheet at approximately $3.4 million. Philips Semiconductor has full day-to-day operating management control of SP3D and holds the majority of seats on the SP3D board. There can be no assurance that the Company will be able to achieve a reasonable return on this asset, or that the asset will not need to be written down, in whole or in part, during subsequent accounting periods. The Company's future operating results will depend in large measure on its success in implementing operating, manufacturing and financial procedures and controls, improving communication and coordination among the different operating functions, integrating certain functions such as sales, procurement and operations, strengthening management information and telecommunications systems, and continuing to hire additional qualified personnel in all areas. Moreover, the Company has selected and is implementing a new enterprise resource planning (ERP) system to be fully operational in late 1998 in order to properly manage the increasing complexity of its international multi-product business and avert potential Year 2000 issues with its current management information system. There can be no assurance that the Company will be able to manage these activities and implement these additional systems, procedures and controls successfully, and any failure to do so could have a material adverse effect upon the Company's short-term and long-term operating results. SHORT PRODUCT LIFE CYCLES; DEPENDENCE ON NEW PRODUCTS The market for the Company's products is characterized by frequent new product introductions and rapid product obsolescence. These factors typically result in short product life cycles, frequently ranging from six to twelve months. The Company must develop and introduce new products in a timely manner that compete effectively on the basis of price and performance and that address customer needs and meet customer requirements. To do this, the Company must continually monitor industry trends and make difficult choices regarding the selection of new technologies and features to incorporate into its new products, as well as the timing of the introduction of such new products, all of which may impair the orders for or the prices of the Company's existing products. The success of new product introductions depends on various factors, some of which are outside the Company's direct control. Such factors may include: selection of new products; selection of controller or memory chip architectures; timely completion and introduction of new product designs; trade-offs between the time of first customer shipment and the optimization of software for speed, stability and compatibility; development of supporting content by independent software application vendors; development and production of collateral product literature; prompt delivery to OEM accounts of prototypes; support of OEM prototypes; ability to rapidly ramp manufacturing volumes; and coordination of advertising, press relations, channel promotion and VAR evaluation programs. In the current transition of mainstream PC graphics subsystem architectures from 2D graphics and the PCI bus to 3D graphics and the accelerated graphics port (AGP), which began in 1997 and is expected to continue 14 15 through 1998, controller and memory chip selection and the timely introduction of new products have been and will continue to be critical factors. The Company expects to see the effects of the PCI-to-AGP transition and the SGRAM-to-SDRAM memory transition in the second quarter of 1998, which will result in significant pricing pressures on the Company's remaining PCI-based and SGRAM-based graphics inventory and the inventory of such products in the distribution channel. As a result, the net sales and gross margins of the Company are likely to be materially and adversely affected by declining prices for the PCI-based and SGRAM-based products and any significant price protection claims associated with such price declines. In addition, in the current transition from the widely accepted V.34 modem protocol (33.6Kbps) through the new higher speed proprietary K56flex and x2 protocols (56Kbps) to the new international standard V.90 protocol (56Kbps), the chip selection to implement and deploy such a standard and the industry alliances to convert such support into revenue and market share have been and will continue to be critical factors. There can be no assurance that the Company will select the proper chips to implement and support its efforts in the various markets or that the Company will execute its strategy in a timely manner during this transition period. Each new product cycle presents new opportunities for current or prospective competitors of the Company to gain a product advantage or increase their market share. If the Company does not successfully introduce new products within a given product cycle, the Company's sales will be adversely affected for that cycle and possibly for subsequent cycles. Any such failure could also impair the Company's brand name and ability to command retail shelf space and OEM design wins in future periods. Moreover, because of the short product life cycles coupled with the long lead times for procuring many of the components used in the Company's products, the Company may not be able, in a timely manner, or at all, to reduce its component procurement commitments, software license commitments, production rates or inventory levels in response to unexpected delays in product launch, shortfalls in sales, technological obsolescence or declines in prices or, conversely, to increase production in response to unexpected increases in demand, particularly if such demand increases are in a new product or new technology area where component supply may be hard to secure. Therefore, changes in actual or expected demand could result in excess inventory, inventory write downs, price protection and gross margin compression or, conversely, in lost sales and revenue compression due to product or component unavailability. The Company expects that the timing and speed of the PCI-to-AGP bus transition and the SGRAM-to-SDRAM memory transition are likely to lead to an excess inventory of PCI and SGRAM-based products at the Company and in the distribution channel that is likely to result in lower average selling prices, lower gross margins and higher price protection charges during the second quarter of 1998. The Company estimates and accrues for potential inventory write-offs and price protection charges. However, there can be no assurance that these estimates and accruals will be sufficient, and additional inventory write-offs and price protection charges may be required, the result of which could have a material effect on operating results during the second quarter of 1998. NEW OPERATING SYSTEMS The PC industry has been characterized by significant operating system changes, such as the introduction of Windows 95 in 1995 and Windows NT 4.0 in 1996, and the introduction of significant new operating system components, such as Microsoft's Direct X and ActiveX for Windows 95. While new operating systems can provide new market opportunities, such as the growing market for graphical user interface (GUI) accelerators that occurred with the introduction of Windows 3.0 and the growth in the PC games market with the introduction of Windows 95, new operating systems and operating system components also place a significant research and development burden on the Company. New drivers, applications and user interfaces must be developed for new operating systems and operating system components in order to maintain net sales levels and customer satisfaction. Perhaps more significantly, such drivers, applications and interfaces customarily are ported to the recently shipped portion of the Company's installed base. This effort involves a substantial software engineering, compatibility testing and customer technical support investment with only limited near-term incremental revenue return since these driver updates are usually provided via electronic distribution at no cost to the Company's installed customer base. In addition, the installation of this software may result in technical support calls, thereby generating expenses that do not have offsetting revenue. Moreover, during the introductory period of a major new operating system release such as Windows 95, such installed base support may reduce the research and development and customer technical support resources available for launching new products. For example, after substantial investment in porting the Company's software, graphics accelerator and modem products to Windows 95, the Company was at year-end 1996 still developing for final release improved, accelerated Windows 95 drivers for the Viper Pro Video series of accelerator add-in cards. While this product line did not at that time represent a revenue opportunity for the Company, the Company nevertheless believed that it was important to make the significant software development investment represented by this effort in order to maintain relations with its installed customer base and its reputation for reliable on-going product support. 15 16 Furthermore, new operating systems for which the Company prospectively develops driver support may not be successful, or the drivers themselves may not be successful or accepted by customers, and a reasonable financial return on the corollary research and development investment may never be achieved. Microsoft has announced that it expects to release for initial end-user shipment in June 1998 a new operating system, Windows 98, an upgrade to the Windows 95 operating system. The Company expects that there will be hesitation on the part of end users to purchase new computer equipment incorporating Windows 95 as the date of the introduction of Windows 98 nears, and possibly for a period of time immediately following such introduction. If an unusually large number of customers delay purchase of new systems, or add-on multimedia peripherals, such a delay could affect the short term timing of the sales of the Company which may have a negative effect on the Company's results in the second and third quarters of 1998. DEPENDENCE ON THIRD PARTY SOFTWARE DEVELOPERS The Company's business strategy includes developing relationships with major independent software application vendors that serve the 3D graphics and 3D audio markets, including the 3D computer games market and the professional 3D graphics market. The Company believes that the availability of a sufficient number of high quality, commercially successful entertainment 3D software titles will be a significant factor in the sale of multimedia hardware to the PC-based interactive 3D entertainment market. The Company also believes that compelling professional 3D graphics applications developed for PCs or ported from traditional workstations, such as those supplied by Silicon Graphics and Sun Microsystems, to PCs based on advanced Intel microprocessors and the Microsoft NT operating system will be significant factors in the sale of 3D graphics hardware to the PC-based NT workstation market. The Company depends on independent software application developers and publishers to create, produce and market software entertainment titles and professional graphics applications that will operate with the Company's 3D products, such as Monster, Stealth, Viper and Fire GL. Only a limited number of software developers are capable of creating high quality professional 3D and entertainment 3D software. Competition for these resources is intense and is expected to increase. There can be no assurance that the Company will be able to attract the number and quality of software developers and publishers necessary to develop a sufficient number of high quality, commercially successful software titles and applications that are compatible with the Company's 3D products. Further, in the case of the Company's entertainment 3D products, there can be no assurance that third parties will publish a substantial number of entertainment 3D software titles or, if entertainment 3D software titles are available, that they will be of high quality or that they will achieve market acceptance. The development and marketing of game titles that do not fully demonstrate the technical capabilities of the Company's entertainment 3D products could create the impression that the Company's products offer less compelling performance over competing 3D games platforms, such as TV games console platforms. This may slow or stop any migration from the current widespread use of TV games consoles to the use of computer games on PCs, or the enhancement of PCs to operate such games. Further, because the Company has no control over the content of the entertainment titles produced by software developers and publishers, the entertainment 3D software titles developed may represent only a limited number of game categories and are likely to be of varying quality. SEMICONDUCTOR OR SOFTWARE DEFECTS Product components may contain undetected errors or "bugs" when first supplied to the Company that, despite testing by the Company, are discovered only after certain of the Company's products have been installed and used by customers. There can be no assurance that errors will not be found in the Company's products due to errors in such products' components, or that any such errors will not impair the market acceptance of these products or require significant product recalls. Problems encountered by customers or product recalls could materially adversely affect the Company's business, financial condition and results of operations. Further, the Company continues to upgrade the firmware, software drivers and software utilities that are incorporated into or included with its hardware products. The Company's software products, and its hardware products incorporating such software, are extremely complex due to a number of factors including the products' advanced functionality, the diverse operating environments in which the products may be deployed, the need for interoperability, and the multiple versions of such products that must be supported for diverse operating 16 17 platforms, languages and standards. These products may contain undetected errors or failures when first introduced or as new versions are released. The Company generally provides a five-year warranty for its products and, in general, the Company's return policies permit return within thirty days after receipt of products that do not meet product specifications. There can be no assurance that, despite testing by the Company, by its suppliers and by current or potential customers, errors will not be found in new products after commencement of commercial shipments, resulting in loss of or delay in market acceptance or product acceptance or in warranty returns. Such loss or delay would likely have a material adverse effect on the Company's business, financial condition and results of operations. Additionally, new versions or upgrades to operating systems or independent software vendor titles or applications may require upgrades to the Company's software products to maintain compatibility with these new versions or upgrades. There can be no assurance that the Company will be successful in developing new versions or enhancements to its software or that the Company will not experience delays in the upgrade of its software products. In the event that the Company experiences delays or is unable to maintain compatibility with operating systems and independent software vendor titles or applications, the Company's business, financial condition and results of operations could be materially adversely affected. MARKET ANTICIPATION OF NEW PRODUCTS, NEW TECHNOLOGIES OR LOWER PRICES Since the environment in which the Company operates is characterized by rapid new product and technology introductions and generally declining prices for existing products, the Company's customers may from time to time postpone purchases in anticipation of such new product introductions or lower prices. If such anticipated changes are viewed as significant by the market, such as the introduction of a new operating system or microprocessor architecture, then this may have the effect of temporarily slowing overall market demand and negatively impacting the Company's operating results. For example, the substantial pre-release publicity surrounding the release of Windows 95 may have contributed to a slowing of the consumer PC market in the summer of 1995. Moreover, a similar reaction has likely occurred in the modem market as a result of the announcements of modems based on 56 Kbps technology which became available in 1997, or in the overall PC market in anticipation of Intel Corporation's transition to MMX-based microprocessors during 1997. Additionally, the substantial publicity by Intel Corporation for its MMX technology may have confused and slowed the market for add-in multimedia accelerators, such as those sold by the Company, during the first half of 1997. If so, these effects may continue into future periods for these or similar events. Other anticipated new product releases that may influence future market growth or the timing of such growth include Microsoft's expected release of its Windows 98 operating system in June 1998, Intel's release of its Pentium II CPU and the associated chipsets supporting the AGP and 2x AGP architectures, and Intel's release of its "Merced" workstation CPU slated for first customer shipment in 1999. The potential negative impact on the Company's operating results as a result of customer decisions to postpone purchases in favor of new and "publicized" technology can be further magnified if products or components based on such new technology are not available in a timely manner or in sufficient supply to meet the demand caused by the market's shift to the new technology from an older technology. For example, the Company believes that the PC market may have slowed in early 1997 in part as customers waited for the availability of Intel's new MMX-enabled Pentium CPUs. Further, the Company's operating results could be adversely affected if the Company makes poor selections of chip architectures or chip suppliers to pursue 3D graphics, AGP or 56Kbps modem market opportunities and, as a result, is unable to achieve market acceptance of its new products or is unable to secure enough supply of such components. If the Company or any of its competitors were to announce a product that the market viewed as having more desirable features or pricing than the Company's existing products, demand for the Company's existing products could be curtailed, even though the new product is not yet available. For example, the Company's next-generation eight-megabyte SDRAM-based graphics accelerators, due to commence shipment in the second quarter of 1998, has a memory cost component roughly equivalent to four-megabyte SGRAM-based graphics accelerators. There can be no assurance that market anticipation of this new product release or similar competitive releases will not reduce demand for the Company's current graphics products and materially and adversely affect the Company's operating results for the second quarter of 1998. Similarly, if the Company's 17 18 customers anticipate that the Company may reduce its prices in the near term, they might postpone their purchases until such price reductions are effected, reducing the Company's near-term shipments and revenue. In general, market anticipation of new products, new technologies or lower prices, even though potentially positive in the longer term, can negatively impact the Company's operating results in the short term. COMPONENT SHORTAGES; RELIANCE ON SOLE OR LIMITED SOURCE SUPPLIERS The Company is dependent on sole or limited source suppliers for certain key components used in its products, particularly chipsets that provide graphics, digital video, DVD, television (TV), sound or other multimedia functions, random access memory (including DRAM, RDRAM, SDRAM and SGRAM) chips, and speakerphone modem and fax/modem chipsets. Although the price and availability of many semiconductor components improved during 1996 and 1997, these components are periodically in short supply and on allocation by semiconductor manufacturers. For example, it is expected that the Company may experience substantial constraints in the supply of high-performance SGRAMs and high-performance 3D graphics chips for the foreseeable future. There can be no assurances that the Company can obtain adequate supplies of such components, or that such shortages or the costs of these components will not adversely affect future operating results. The Company's dependence on sole or limited source suppliers, and the risks associated with any delay or shortfall in supply, can be exacerbated by the short life cycles that characterize multimedia and communications ASIC chipsets and the Company's products in general. Although the Company maintains ongoing efforts to obtain required supplies of components, including working closely with vendors and qualifying alternative components for inclusion in the Company's products, component shortages continue to exist from time to time, and there can be no assurances that the Company can continue to obtain adequate supplies or obtain such supplies at their historical or competitive cost levels. Conversely, in its attempt to counter actual or perceived component shortages, the Company may overpurchase certain components, resulting in excess inventory and reducing the Company's liquidity or, in the event of unexpected inventory obsolescence or a decline in the market value of such inventory, causing inventory write-offs or sell-offs that adversely affect the Company's gross margin and profitability. In addition, such inventory sell-offs by the Company or its competitors could trigger channel price protection charges, further reducing the Company's gross margins and profitability. As noted above, supply and demand conditions for semiconductor components are unpredictable and may change from time to time. During periods of oversupply, prices are likely to fall and certain vendors of such semiconductor chips may liquidate their inventories in a rapid manner. If such semiconductor vendors are suppliers to the Company's competitors, then such actions could enable competitors of the Company to enjoy a cost advantage vis-a-vis the Company, and any resultant price reduction for such competitors' products could force the Company to reduce its prices, thereby depressing the Company's net sales and gross margins in one or more operating periods. For example, the recent agreement by Symbios (the sole supplier of the Company's SCSI controllers) to be acquired by Adaptec (the Company's chief competitor in the SCSI host bus adapter card market) may, if such acquisition is consummated, result in the unavailability of SCSI controllers for the Company's SCSI products, or the unavailability of such controllers or software support under economically reasonable prices, terms, conditions or timing. Additionally, the acquisition, if consummated, may lead to caution or reluctance on the part of the Company's customers or potential customers, both direct and indirect, to do business with Adaptec's competitors who have historically used Symbios controllers. During periods of component oversupply and associated price deflation, customers of the Company, particularly those comprising channels that do not receive price protection from the Company, may seek to draw down the inventory that they hold since such inventory likely would bear a price deflation risk. As a consequence, the Company may see its orders, unit shipments or average selling prices depressed from time to time during such price-deflation and inventory-reduction periods, including potentially the second quarter of 1998, which could adversely affect net sales and gross margin in the related operating period or periods. When the PC or PC peripherals markets emerge from a period of oversupply, such as that experienced in the second quarter of 1997, certain manufacturers, distributors and resellers may be unprepared for a possible rapid increase in market demand. Accordingly, the Company may not have sufficient inventory, scheduled component purchase orders or available manufacturing capacity to meet any rapid increase in market demand, 18 19 thereby missing orders and revenue opportunities, causing customer dissatisfaction and losing market share. The Company experienced such a situation in the second half of 1997 and in the first quarter of 1998 as the Company experienced a shortage of various components, restricting the Company's ability to manufacture quantities of certain products in sufficient quantities or in a linear fashion during the quarter to meet market demand. For certain products, the Company continues to experience such restrictions in the second quarter of 1998. In addition, the Company believes that in the near term the Company will continue to be subjected to restricted supply and increasing prices on certain semiconductor components including certain graphics controllers and memories. The inability of the Company to obtain product components at their historical or planned cost levels, resulting in the Company being forced to pay higher prices to achieve timely delivery, would directly affect the cost of the Company's products and could materially and adversely affect the Company's gross margin. There can be no assurance that the Company will be able to obtain adequate supplies of components or that such shortages or the costs of these components will not adversely impact the Company's future operating results. Conversely, there can be no assurance that the Company will not see the value of its inventory depreciate if components in a shortage condition emerge from that condition and experience a significant oversupply condition. For example, this situation may occur during the second quarter of 1998 with certain graphics chips that support only SGRAM memory. DEPENDENCE ON SUBCONTRACTORS The Company relies on independent surface mount technology ("SMT") and printed circuit board ("PCB") subcontractors to manufacture, assemble or test the Company's products. The Company typically procures its components, assembly and test services and assembled products through purchase orders and does not have specific volume purchase agreements with each of its subcontractors. Most of the Company's subcontractors could cease supplying the services, products or components at any time with limited or no penalty. In the event that it becomes necessary for the Company to replace a key subcontractor, the Company could incur significant manufacturing set-up costs and delays. There can be no assurance that the Company would be able to find suitable replacement subcontractors. The Company's emphasis on maintaining low inventory may exacerbate the effects of any shortage that may result from the use of sole-source subcontractors during periods of tight supply or rapid order growth. The Company's ability to respond to greater than anticipated market demand may be constrained by the availability of SMT or PCB subcontracting services. Further, various of the Company's subcontractors are located in international locations that, while offering low labor costs, may present heightened process control, quality control, political, infrastructure, transportation, tariff, regulatory, legal, import, export, economic or supply risks. DEPENDENCE ON GRAPHICS AND MULTIMEDIA ACCELERATOR MARKET Sales of graphics and multimedia accelerator subsystems accounted for greater than 80% and 65% of the Company's net sales in the first quarter of 1998 and 1997, respectively. Although the Company has introduced DVD and audio subsystems, ISDN adapters and SCSI host bus adapters, and has entered the PC modem and communications market through the acquisition of Supra Corporation, graphics accelerator subsystems are expected to continue to account for a majority of the Company's sales for the foreseeable future. A decline in demand or average selling prices for graphics accelerator subsystems, whether as a result of new competitive product introductions, price competition, excess supply, widespread cost reduction, technological change, incorporation of the products' functionality onto personal computer motherboards or otherwise, would have a material adverse effect on the Company's sales and operating results. MIGRATION TO PERSONAL COMPUTER MOTHERBOARDS The Company's graphics and multimedia accelerator subsystems are individual products that function within personal computers to provide additional multimedia functionality. Historically, as a given functionality becomes technologically stable and widely accepted by personal computer users, the cost of providing such functionality is typically reduced by means of large scale integration into semiconductor chips, which can be subsequently incorporated onto personal computer motherboards. The Company expects that such migration will not occur in a substantial way with 3D graphics or Intel's accelerated graphics port (AGP) in the near term, although the Company recognizes that such migration could occur with respect to the functionality provided by some of the Company's current products. While the Company believes that a market will continue to exist for add-in subsystems that provide advanced or multiple functions and offer flexibility in systems configuration, such as 3D graphics, 3D audio, MPEG-2 digital video, high-speed I/O and modems, there can be no assurance 19 20 that the incorporation of new multimedia functions onto personal computer motherboards or into CPU microprocessors, such as under Intel's MMX or AGP technologies, will not adversely affect the future market for the Company's products. In large part, the continuation of a robust market for add-in graphics and video subsystems may depend on the timing and market acceptance of 3D graphics and digital video MPEG-2 acceleration. This, in turn, may depend on the availability of compelling 3D and MPEG-2 content, including games and entertainment, broadcast digital video, PC video phones, desktop video conferencing, and digital video, audio and VRML on the Internet. Similarly, the robustness of the modem market may depend largely on the widespread adoption of 56Kbps and digital subscriber line (xDSL) technologies in both client-side modems attached to the PC and server-side modems provided by Internet Service Providers and telephone network central offices. The timing of major technology introductions and the market acceptance of these new technologies and standards are largely out of the control of the Company. RISKS ASSOCIATED WITH RECENTLY ANNOUNCED ACQUISITION In addition to the risks described under "-Management of Growth," the Company faces significant risks associated with its proposed acquisition of Micronics Computers, Inc. ("Micronics"). There can be no assurance that the Company will realize the benefits of this transaction. In order to successfully integrate Micronics, the Company must, among other things, retain key personnel; integrate, from an engineering, manufacturing and sales and marketing perspective, the acquired business into the Company's overall operations; and consolidate excess facilities. The diversion of the attention of management from the day-to-day operations of the Company, or difficulties encountered in the integration process, could have a material adverse effect on the Company's operating results. See Note 6 of Notes to Consolidated Condensed Financial Statements. COMPETITION The market for the Company's products is highly competitive. The Company competes directly against a large number of suppliers of graphics and multimedia accelerator products for the PC such as Matrox Graphics Inc., STB Systems Inc. and ATI Technologies Inc., and indirectly against PC systems OEMs to the extent that they manufacture their own add-in subsystems or incorporate on PC motherboards the functionality provided by the Company's products. In certain markets where the Company is a relatively new entrant, such as modems, sound cards and SCSI host adapters, the Company may face dominant competitors including 3Com (modems), Creative Technology (sound cards) and Adaptec (SCSI host bus adapters). In addition, the Company's markets are expected to become increasingly competitive as multimedia functions continue to converge and companies that previously supplied products providing distinct functions (for example, companies today primarily in the sound, fax/modem, telephony, digital signal processing, central processing unit or motherboard markets) emerge as competitors across broader or more integrated product categories. In addition, manufacturers of chipsets or other components used in the Company's products could become future competitors of the Company to the extent that such manufacturers elect to integrate forward into the add-in subsystem or value-added software market, or as such multimedia chipset manufacturers provide increasingly higher quality and more sophisticated software to their chipset customers, including subsystem suppliers competitive to the Company. Also, certain of the Company's current and potential competitors have significantly greater market presence, name recognition and financial and technical resources relative to the Company, and many have long-standing market positions and established brand names in their respective markets. In addition, certain of the Company's current and potential competitors also have a competitive cost advantage as a result of being located in areas that impose significantly lower taxes than the United States or offer a substantially lower cost of labor or provide governmental subsidies, such as research and development and training funds. Many of the Company's current and potential competitors also design and manufacture their own graphics acceleration, video, sound, fax/modem or other multimedia processing chipsets. While the Company believes that its semiconductor vendor flexibility enables it to select, within certain limits, from among the most advanced and price competitive chipsets available on the open market, the captive semiconductor operations of certain of the Company's current and potential competitors could provide them with significant advantages, including greater control over semiconductor architecture and technology, component design, component performance, systems and software design, availability and cost. 20 21 The Company also believes that the strategy of certain of its current and potential competitors is to compete largely on the basis of price, which may result in significant price competition and lead to lower margins for the Company's products or otherwise adversely affect the market for the Company's products. To the extent that semiconductor availability is relatively robust and software drivers and reference hardware designs from multimedia chipset manufacturers are of high quality and sophistication, then competitors who sell such reference designs and compete largely on price with little valued added engineering may have a competitive cost or expense advantage relative to the Company. There can be no assurance that the Company will be able to continue to compete successfully in its current and future markets, or will be able to compete successfully against current and new competitors, as the Company's technology, markets and products continue to evolve. DISTRIBUTION RISKS The Company sells its products through a network of domestic and international distributors, and directly to major retailers/mass merchants, VARs and OEM customers. The Company's future success is dependent on the continued viability and financial stability of its customer base. The computer distribution and retail channels historically have been characterized by rapid change, including periods of widespread financial difficulties and consolidation and the emergence of alternative sales channels, such as direct mail order, telephone sales by PC manufacturers and electronic commerce on the World Wide Web. The loss of, or reduction in, sales to certain of the Company's key customers as a result of changing market conditions, competition, or customer credit problems could have a material adverse effect on the Company's operating results. Likewise, changes in distribution channel patterns, such as increased commerce on the Internet, increased use of mail-order catalogues, increased use of consumer-electronics channels for personal computer sales, or increased use of channel assembly to configure PC systems to fit customers' requirements could affect the Company in ways not yet known. Moreover, additions to or changes in the types of products the Company sells, such as the introduction of professional-grade products or the migration toward more communications-centric products, may require specialized value-added reseller channels, relations with which the Company has only begun to establish. Inventory levels of the Company's products in the two-tier distribution channels used by the Company ("Channel Inventory Levels") generally are maintained in a range of one to three months of customer demand. These Channel Inventory Levels tend toward the low end of the months-of-supply range when demand is stronger, sales are higher and products are in short supply. Conversely, when demand is slower, sales are lower and products are abundant, then Channel Inventory Levels tend toward the high end of the months-of-supply range. Frequently, in such situations, the Company attempts to ensure that distributors devote their working capital, sales and logistics resources to the Company's products to a greater degree than to those of competitors. Similarly, the Company's competitors attempt to ensure that their own products are receiving a disproportionately higher share of the distributors' working capital and logistics resources. In an environment of slower demand and abundant supply of products, price declines are more likely to occur and, should they occur, are more likely to be severe. Further, in such an event, high Channel Inventory Levels may result in substantial price protection charges. Such price protection charges have the effect of reducing net sales and gross profit. Consequently, the Company, in taking steps to bring its Channel Inventory Levels down to a more desirable level, may cause a shortfall in net sales during one or more accounting periods. This situation may also result in price protection charges as prices are decreased, having an adverse impact on operating results. While the Company believes that its Channel Inventory Levels for many of its products are appropriate at this time, there are certain products which have a Channel Inventory Level that is higher than desirable. The Company accrues for potential price protection on unsold channel inventory. However, there can be no assurance that any estimates, reserves or accruals will be sufficient or that any future price reductions will not have a material adverse effect on operating results, including during the second quarter of 1998. PRODUCT RETURNS; PRICE PROTECTION The Company frequently grants limited rights to customers to return certain unsold inventories of the Company's products in exchange for new purchases ("Stock Rotation"), as well as price protection on unsold inventory. Moreover, certain of the Company's retail customers will readily accept returned product from their own retail customers, and these returned products are, in turn, returned to the Company for credit. The Company estimates returns and accrues for potential price protection on unsold channel inventory. The Company expects 21 22 significant price protection charges due to the transition from PCI to AGP-based graphics accelerators and from SGRAM to SDRAM-based graphics accelerators during the second quarter of 1998. However, there can be no assurance that any estimates, reserves or accruals will be sufficient or that any future returns or price reductions will not have a material adverse effect on operating results, including through the mechanisms of Stock Rotation or price protection, particularly in light of the rapid product obsolescence which often occurs during product transitions. The short product life cycles of the Company's products, the evolving markets for new multimedia and connectivity technologies such as the new 56 Kbps modem and 3D graphics technologies, and the difficulty in predicting future sales through the distribution channels to the final end customer all increase the risk that new product introductions, price reductions by the Company or its competitors, or other factors affecting the personal computer and add-in subsystems industry could result in significant and unforeseen product returns, with such returns creating a material adverse effect on the Company's financial performance. In addition, there can be no assurance that new product introductions by competitors or other market factors, such as the integration of graphics acceleration or modem connectivity by OEMs onto system motherboards, will not require the Company to reduce prices in a manner or at a time that gives rise to significant price protection charges and has a material adverse impact upon the Company's gross margins. Furthermore, the markets that the Company serves include end users who buy from computer retail and consumer electronics mass merchant outlets to upgrade their existing PCs. Such customers frequently decide to return products to the retail outlets from which they earlier purchased the product. Such returns are made for a variety of reasons, including the customer changing his or her mind regarding his or her purchase decision, the customer has difficulty with the installation or use of the product, the product does not offer the features, functions, or performance that the customer expected or the customer experiences incompatibilities between the product and his or her existing PC hardware or software. Since many of the products that the Company sells incorporate advanced computer technology, the Company expects that end-user customer returns, including warranty returns, will be a continuing negative attribute of the PC installed-base upgrade market. There can be no assurance that the Company will be able to achieve gross margins in the PC installed-base upgrade market that will be high enough to offset the expenses of end-user customer returns and still generate an acceptable return on sales to the Company. OEM CUSTOMER RISKS The Company currently has a limited number of OEM customers. While the Company is seeking to increase its sales to OEMs, certain OEMs maintain internal add-in subsystem design and manufacturing capabilities or have long-standing relationships with competitors of the Company, and there can be no assurance that the Company will be successful in its efforts to increase its OEM sales. Moreover, developing supplier relationships with major PC systems OEMs and installing the processes, procedures and controls required by such OEMs can be an expensive and time-consuming process, and there can be no assurance that the Company will achieve an acceptable financial return on this investment. Further, to the extent that PC systems OEM's selection criteria are weighted toward multimedia subsystem suppliers that have their own captive SMT manufacturing operations, then the Company's sole reliance on outside SMT subcontract manufacturers may be a negative factor in winning such PC systems suppliers' OEM contracts. It is expected that OEM revenue will carry a lower gross margin percentage compared to sales to other channels due to perceived lower expenses to support such OEM revenue and the buying power exercised by large OEMs. Furthermore, many large OEMs require that distribution hubs be established local to their factories to supply such factories on very short notice. Such hubs represent a cash drain on the Company to support the required inventory, and a product obsolescence and inventory write-off risk as the price of such inventory may decline or reach the end of its useful life or design-in life before such inventory, which may be specific to a certain OEM, is completely consumed. The Company's contractual relationship with Dell Computer Corporation may represent such a product obsolescence and inventory write-off risk. The Company's products are priced for and generally aimed at the higher performance and higher quality segment of the market. Therefore, to the extent that OEMs focus on low-cost solutions rather than high-performance solutions, an increase in the proportion of the Company's sales to OEMs may result in an increase in the proportion of the Company's revenue that is generated by lower-selling-price or lower-gross-margin 22 23 products, particularly with respect to the Company's audio and modem products, which could adversely affect future gross margins and operating results of the Company. RAPID TECHNOLOGICAL CHANGE The markets for the Company's products are characterized by rapidly changing technology, evolving industry standards, frequent new product introductions and rapid product obsolescence. For example, 3D technology is evolving rapidly in the graphics and audio markets, memory architectures and speeds are changing rapidly, and DVD and MPEG-2 decryption techniques and navigation technologies are still being refined. Product life cycles in the Company's markets frequently range from six to twelve months. The Company's success will be substantially dependent upon its ability to continue to develop and introduce competitive products and technologies on a timely basis with features and functionalities that meet changing customer requirements in a cost-effective manner. Further, if the Company is successful in the development and market introduction of new products, it must still correctly forecast customer demand for such new products so as to avoid either excessive unsold inventory or excessive unfilled orders related to the products. The task of forecasting such customer demand is unusually difficult for new products, for which there is little sales history, and for indirect channels, where the Company's customers are not the final end customers. Moreover, whenever the Company launches new products, it must also successfully manage the corollary obsolescence and price erosion of those of its older products that are impacted by such new products, as well as any resulting price protection charges and Stock Rotations from its distribution channels. In the second quarter of 1998, the Company expects to face product technology cycle challenges in the PCI-to-AGP graphics bus transition, the SGRAM-to-SDRAM memory architecture transition and the K56flex to V.90 modem protocol transition. RISKS OF INTERNATIONAL SALES The Company's international sales are subject to a number of risks generally associated with international business operations, including the effect on demand for the Company's products in international markets as a result of a strengthening or weakening U.S. dollar, the effect of currency fluctuations on consolidated multinational financial results, any state-imposed restrictions on the repatriation of funds, any import and export duties and restrictions, certain international economic conditions, the expenses, time and technical resources required to localize the Company's various products and to support local languages, the logistical difficulties of managing multinational operations and dispersed product inventory designed or manufactured to meet specific countries' requirements, and the delays and expenses associated with homologating the Company's telecommunications products and securing the necessary governmental approvals for shipment to various countries. The Company's international sales can also be affected if inventory sold by the Company to its international distributors and OEMs and held by them or their customers does not sell through to final end customers, which may impact international distributor or OEM orders in the succeeding periods. The Company believes that it generally has less information with respect to the inventory levels held by its international OEMs and distributors as compared to their domestic counterparts, and that the supply chain to such international customers is longer, and that therefore the Company generally has less visibility on how this held inventory might affect future orders to and sales by the Company. In the event that international OEMs or distributors change their desired inventory levels, there can be no assurance that the Company's net sales to such customers will not decline at such time or in future periods, or that the Company will not incur price protection charges with respect to such customers. INFORMATION TECHNOLOGY AND TELECOMMUNICATIONS SYSTEMS The Company is currently making significant investments in establishing systems, processes and procedures to more efficiently and effectively manage its worldwide business and enable communications and data sharing among its employees and various business units. This effort comprises a significant investment of expense and capital funds, as well as a drain on management resources, for the installation of information technology ("IT") and telecommunications equipment and IT applications. As part of this program to install IT systems throughout the Company, management has begun installation of an enhanced enterprise-wide business management, 23 24 resource planning and decision support application. Further, in order to more effectively manage the Company's business and avert Year 2000 issues, the Company is implementing this new ERP application and the associated IT equipment in order for it to be fully operational no later than by the beginning of 1999. Such an effort is expected to comprise a further substantial investment of expenses and management resources by the Company. YEAR 2000 COMPLIANCE Many existing computer systems and applications, and other control devices, use only two digits to identify a year in the date field, without considering the impact of the upcoming change in the century. As a result, such systems and applications could fail or create erroneous results unless corrected so that they can process data related to the year 2000. The Company relies on its systems, applications and devices in operating and monitoring all major aspects of its business, including financial systems (such as general ledger, accounts payable and payroll modules), customer services, infrastructure, embedded computer chips, networks and telecommunications equipment and end products. The Company also relies, directly and indirectly, on external systems of business enterprises such as customers, suppliers, creditors, financial organizations, and of governmental entities, both domestic and international, for accurate exchange of data. The Company's current estimate is that the costs associated with the year 2000 issue, and the consequences of incomplete or untimely resolution of the year 2000 issue, will not have a material adverse effect on the result of operations or financial position of the Company in any given year. However, despite the Company's efforts to address the year 2000 impact on its internal systems, the Company has not fully identified such impact or whether it can resolve it without disruption of its business and without incurring significant expense. In addition, even if the internal systems of the Company are not materially affected by the year 2000 issue, the Company could be affected through disruption in the operation of the enterprises with which the Company interacts. See "--Information Technology and Telecommunications Systems." CAPITAL NEEDS There can be no assurance that additional capital beyond the amounts currently forecasted by the Company will not be required or that any required additional capital will be available on reasonable terms, if at all, at such time or times as required by the Company. Any shortfall in capital resources compared to the Company's level of operations or any inability to secure additional capital as needed could impair the Company's ability to finance inventory, accounts receivable and other operational needs. Such capital limitations could also impair the Company's ability to invest in research and development, improve customer service and support, deploy information technology systems, and expand manufacturing and other operations. Failure to keep pace with competitive requirements in any of these areas could have a material adverse effect on the Company's business and operating results. Moreover, any need to raise additional capital through the issuance of equity securities may result in additional dilution to earnings per share. PROPRIETARY RIGHTS While the Company had 4 issued U.S. Patents and 18 pending U.S. Patent Applications at March 31, 1998, it nonetheless relies primarily on a combination of trademark, copyright and trade secret protection together with licensing arrangements and nondisclosure and confidentiality agreements to establish and protect its proprietary rights. There can be no assurance that the Company's measures to protect its proprietary rights will deter or prevent unauthorized use of the Company's technology, brand or other proprietary or intellectual property. In addition, the laws of certain foreign countries may not protect the Company's proprietary rights to the same extent as do the laws of the United States or the EC. As is typical in its industry, the Company from time to time is subject to legal claims asserting that the Company has violated the proprietary rights of third parties. In the event that a third party was to sustain a valid claim against the Company, and any required licenses were not available on commercially reasonable terms, the Company's operating results could be materially and adversely affected. Litigation, which could result in substantial cost to and diversion of the resources of the Company, may also be necessary to enforce proprietary rights of the Company or to defend the Company against claimed infringement of the proprietary rights of others. STOCK PRICE VOLATILITY The trading price of the Company's Common Stock has been subject to significant fluctuations to date, and could be subject to wide fluctuations in the future in response to quarter-to-quarter variations in operating results, announcements of technological innovations, new products or significant OEM systems design wins by the Company or its competitors, general conditions in the markets for the Company's products or the computer industry, the price and availability of purchased components, general financial market conditions, market conditions for PC or semiconductor stocks, changes in earnings estimates by analysts, or other events or factors. In this regard, the Company does not endorse and accepts no responsibility for the estimates or recommendations issued by stock research analysts from time to time. In addition, the public stock markets in general, and technology stocks in particular, have experienced extreme price and trading volume volatility. This volatility has significantly affected the market prices of securities of many high technology companies for reasons frequently unrelated to the operating performance of the specific companies. These broad market fluctuations may adversely affect the market price of the Company's Common Stock. DEPENDENCE ON KEY PERSONNEL The Company's future success will depend to a significant extent upon the efforts and abilities of its senior management and professional, technical, sales and marketing personnel. The competition for such personnel is intense, particularly in the San Jose, California area ("Silicon Valley"). There can be no assurance that the Company will be successful in retaining its existing key personnel or in attracting and retaining the additional 24 25 key personnel that it requires. The loss of services of one or more of its key personnel or the inability to add or replace key personnel could have a material adverse effect on the Company. The salary, performance bonus and stock option packages necessary to recruit or retain key personnel, particularly in Silicon Valley, may significantly increase the Company's expense levels or result in dilution to the Company's earnings per share. The Company does not carry "key person" life insurance on any of its employees. LEGAL MATTERS The Company has been named as a defendant in several putative class action lawsuits which were filed in June and July, 1996 and June, 1997 in the California Superior Court for Santa Clara County and the U.S. District Court for the Northern District of California. Certain executive officers and directors of the Company are also named as defendants. The plaintiffs purport to represent a class of all persons who purchased the Company's Common Stock between October 18, 1995 and June 20, 1996 (the "Class Period"). The complaints allege claims under the federal securities laws and California law. The plaintiffs allege that the Company and the other defendants made various material misrepresentations and omissions during the Class Period. The complaints do not specify the amount of damages sought. The Company believes that it has good defenses to the claims alleged in the lawsuits and will defend itself vigorously against these actions. These cases are in the early stages and no trial date has been set. The ultimate outcome of these actions cannot be presently determined. Accordingly, no provision for any liability or loss that may result from adjudication or settlement thereof has been made in the accompanying consolidated financial statements. The Company is also party to other claims and pending legal proceedings that generally involve employment and patent issues. These cases are, in the opinion of management, ordinary and routine matters incidental to the normal business conducted by the Company. In the opinion of management, the ultimate disposition of such proceedings will not have a materially adverse effect on the Company's consolidated financial position or future results of operations. 25 26 PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS The Company has been named as a defendant in several putative class action lawsuits which were filed in June and July 1996 and June 1997 in the California Superior Court for Santa Clara County and the U.S. District Court for the Northern District of California. Certain executive officers and directors of the Company are also named as defendants. The plaintiffs purport to represent a class of all persons who purchased the Company's Common Stock between October 18, 1995 and June 20, 1996 (the "Class Period"). The complaints allege claims under the federal securities laws and California law. The plaintiffs allege that the Company and the other defendants made various material misrepresentations and omissions during the Class Period. The complaints do not specify the amount of damages sought. The Company believes that it has good defenses to the claims alleged in the lawsuits and will defend itself vigorously against these actions. These cases are in the early stages and no trial date has been set. The ultimate outcome of these actions cannot be presently determined. Accordingly, no provision for any liability or loss that may result from adjudication or settlement thereof has been made in the accompanying consolidated financial statements. The Company is also party to other claims and pending legal proceedings that generally involve employment and trademark issues. These cases are, in the opinion of management, ordinary and routine matters incidental to the normal business conducted by the Company. In the opinion of management, the ultimate disposition of such proceedings will not have a materially adverse effect on the Company's consolidated financial position or future results of operations. ITEM 2. CHANGES IN SECURITIES Not applicable. ITEM 3. DEFAULTS UPON SENIOR SECURITIES Not applicable. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable. ITEM 5. OTHER INFORMATION Not applicable. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K A. Exhibit Exhibit # Description of Document --------- ----------------------- 10.27 Line of Credit Agreement between the Registrant and Imperial Bank dated January 23, 1998. 27.1 Financial Data Schedule B. Reports on Form 8-K The Company did not file any reports on Form 8-K during the quarter ended March 31, 1998. 26 27 SIGNATURES Pursuant to the requirements of the Securities and Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. DIAMOND MULTIMEDIA SYSTEMS, INC. Date: May 14, 1998 /s/ William J. Schroeder ------------------------------------------ William J. Schroeder President and Chief Executive Officer Date: May 14, 1998 /s/ James M. Walker ------------------------------------------ James M. Walker Senior Vice President and Chief Financial Officer 27 28 INDEX TO EXHIBITS Exhibit Number Description - ------- ----------- 10.27 Line of Credit Agreement between the Registrant and Imperial Bank dated January 23, 1998. 27.1 Financial Data Schedule 28 EX-10.27 2 LINE OF CREDIT AGREEMENT 1 EXHIBIT 10.27 LOAN AGREEMENT THIS LOAN AGREEMENT is entered into as of January 23, 1998 (this "Loan Agreement") between DIAMOND MULTIMEDIA SYSTEMS, INC., a Delaware corporation (herein called "Borrower"), and IMPERIAL BANK (herein called "Bank"). 1. COMMITMENT. A. COMMITMENT. Subject to all the terms and conditions of this Loan Agreement and prior to the termination of its commitment as hereinafter provided, Bank hereby agrees to make loans (each a "Loan" and collectively, "Loans") to Borrower, in such amounts as Borrower shall request pursuant to this Section 1.A., at any time from the date hereof through January 21, 1999 (the "Maturity Date"), in an aggregate principal amount not to exceed $15,000,000.00 (the "Commitment"). If at any time or for any reason, the outstanding principal amount of the Loan Account (as hereinafter defined) is greater than the Commitment, Borrower shall immediately pay to Bank, in cash, the amount of such excess. Any commitment of Bank, pursuant to the terms of this Loan Agreement, to make Loans shall expire on the Maturity Date, subject to Bank's right to renew said commitment in its sole and absolute discretion at Borrower's request. Any such renewal of said commitment shall not be binding upon Bank unless it is in writing and signed by an officer of Bank. Provided that no Event of Default has occurred and is continuing, all or any portion of the Loans advanced by Bank which are repaid by Borrower shall be available for reborrowing in accordance with the terms hereof. Borrower promises to pay to Bank the entire outstanding principal balance (and all accrued unpaid interest thereon) of the Loan Account on the Maturity Date. (1) LOANS. The amount of each Loan made by Bank to Borrower hereunder shall be debited to the loan ledger account of Borrower maintained by Bank for the Commitment (herein called the "Loan Account") and Bank shall credit the Loan Account with all loan repayments in respect thereof made by Borrower. When Borrower desires to obtain a Loan, Borrower shall notify Bank (which notice shall be signed by an officer of Borrower and shall be irrevocable) in accordance with Section 2 hereof, to be received no later than 3:00 p.m. Pacific time one (1) Banking Day before the day on which the Loan is to be made. Loans may only be used for working capital purposes, the issuance of letters of credit, or the purchase of foreign exchange futures contracts. (a) LETTER OF CREDIT USAGE AND SUBLIMIT. Subject to the availability of the Commitment and in reliance on the representations and warranties of Borrower set forth herein, at any time and from time to time from the date hereof through the Banking Day immediately prior to the Maturity Date, Bank shall issue for the account of Borrower such standby and commercial letters of credit ("Letters of Credit") as Borrower may request, which request shall be made by delivering to Bank a duly executed letter of credit application on Bank's standard form; provided, however, that the outstanding and undrawn amounts under all such Letters of Credit (i) shall not at any time exceed $15,000,000 and (ii) shall be deemed to constitute Loans for the purpose of calculating availability under the Commitment. Unless Borrower shall have deposited with Bank cash collateral in an amount sufficient to cover all undrawn amounts under each such Letter of Credit and Bank shall have agreed in writing, no Letter of Credit shall have an expiration date that is later than 90 days after the Maturity Date. All Letters of Credit shall be in form and substance acceptable to Bank in its sole discretion and shall be subject to the terms and conditions of Bank's form application and letter of credit agreement. Borrower will pay any standard issuance and other fees that Bank notifies Borrower will be charged for issuing and processing Letters of Credit for Borrower. (b) FOREIGN EXCHANGE USAGE AND SUBLIMIT. Subject to the availability of the Commitment and in reliance on the representations and warranties of Borrower set forth herein, at any time and from time to time from the date hereof through the Banking Day immediately prior to the Maturity Date. Bank shall arrange the purchase by Borrower of foreign exchange futures contracts ("Exchange Contracts") as Borrower may request, which request shall be made by delivering to Bank a duly executed exchange contract application on Bank's standard form; provided, however, that the maximum aggregate notional contract amount under all such Exchange Contracts shall not at any time exceed $10,000,000; provided, further, that 10% of the maximum aggregate notional contract amount under all such Exchange Contracts shall be deemed to constitute outstanding Loans for the purpose of calculating availability under the 1. 2 Commitment. Unless Borrower shall have deposited with Bank cash collateral in an amount sufficient to cover all undrawn amounts under each such Exchange Contract and Bank shall have agreed in writing, no Exchange Contract shall have a due date that is later than the Maturity Date. All Exchange Contracts shall be in form and substance acceptable to Bank in its sole discretion and shall be subject to the terms and conditions of Bank's form exchange contract application. Borrower will pay any standard issuance and other fees that Bank notifies Borrower will be charged for issuing and processing Exchange Contracts for Borrower. After and during the continuance of an Event of Default, Bank may, in its sole and absolute discretion, terminate any or all of the Exchange Contracts. Borrower agrees to indemnify and hold harmless Bank from and against all loss, costs and expense associated with any such termination of any Exchange Contract. (2) INTEREST PAYMENTS ON LOANS. Except as otherwise provided in the Interest Rate Addendum, Borrower further promises to pay to Bank from the date of the advance of the initial Loan through the Maturity Date, on or before the twenty-first (21st) day of each month, interest on the average daily unpaid balance of the Loan Account during the immediately preceding month at a rate of interest equal to the rate of interest which Bank has announced as its prime lending rate ("Prime Rate"), which shall vary concurrently with any change in the Prime Rate. Interest shall be computed at the above rate on the basis of the actual number of days during which the principal balance of the Loan Account is outstanding divided by 360, which shall for interest computation purposes be considered one (1) year. 2. LOAN REQUESTS. Requests for Loans hereunder shall be in writing duly executed by Borrower in a form satisfactory to Bank and shall contain a certification setting forth the matters referred to in Section 1, which shall disclose that Borrower is entitled to the amount and type of Loan being requested. Bank is hereby authorized to charge Borrower's deposit account with Bank for all sums due Bank under this Loan Agreement. 3. DELIVERY OF PAYMENTS. Payment to Bank of all amounts due hereunder shall be made at its Santa Clara Valley Regional office, or at such other place as may be designated in writing by Bank from time to time. If any payment date fall on a day that is not a day that Bank is open for the transaction of business ("Banking Day"), the payment due date shall be extended to the next Banking Day. 4. LATE CHARGE. If any interest payment, principal payment or principal balance payment required hereunder is not received by Bank on or before ten (10) days from the date in which such payment becomes due, Borrower shall pay to Bank, a late charge equal to the lesser of (a) five percent (5.0%) of the amount of such unpaid payment, in addition to said unpaid payment or (b) the maximum amount permitted to be charged by applicable law, until remitted to Bank; provided, however, nothing contained in this SECTION 4, shall be construed as any obligation on the part of Bank to accept payment of any past due payment or less than the total unpaid principal balance of the Loan Account following the Maturity Date. All payments shall be applied first to any late charges due hereunder, next to accrued interest then payable and the remainder, if any, to reduce any unpaid principal due under the Loan Account. 5. DEFAULT INTEREST. From and after the Maturity Date or such earlier date as all sums owing under the Loan Account becomes due and payable by acceleration or otherwise, or upon the occurrence of an Event of Default, at the option of Bank all sums owing under the Loan Account shall bear interest until paid in full at a rate equal to the lesser of (a) five percent (5.0%) per annum in excess of the then applicable interest rate provided for in SECTION 1.A(2) hereof or (b) the maximum amount permitted to be charged by applicable law, until all obligations hereunder are repaid in full or the Event of Default is waived or cured to the satisfaction of Bank, as applicable. 6. DEFINITIONS. As used in this Loan Agreement and unless otherwise defined herein, all initially capitalized terms shall have the meanings set forth on EXHIBIT A attached hereto and incorporated herein by this reference. 7. REPRESENTATIONS AND WARRANTIES. Borrower represents and warrants to Bank: (a) That Borrower is a corporation, duly organized and existing in the State of Delaware and is authorized and in good standing to do business in the State of California. The execution, delivery and performance of each of the Loan Documents are within Borrower's corporate powers, have been duly authorized and are not in conflict with law or the terms of any charter, by-law or other incorporation papers, or of any indenture, agreement or undertaking to which Borrower is a party or by which Borrower is bound or affected; 2. 3 (b) Borrower has good title to its assets and the same are not subject to any liens or encumbrances other than Permitted Liens; (c) Any and all financial information submitted by Borrower to Bank,whether previously or in the future, is and will be true and correct; (d) There is no litigation or other proceeding pending or threatened against or affecting Borrower, and Borrower is not in default with respect to any order, writ, injunction, decree or demand of any court or other governmental or regulatory authority except as disclosed in EXHIBIT B; (e)(i) The consolidated balance sheets of Borrower dated as of September 30, 1997, and the related consolidated profit and loss statements for the fiscal year then ended, copies of which have heretofore been delivered to Bank by Borrower, and all other statements and data submitted in writing by Borrower to Bank in connection with Borrower's request for credit are true and correct, and said balance sheet and profit and loss statement accurately present the financial condition of Borrower as of the dates thereof and the results of the operations of Borrower for the period covered thereby, and have been prepared in accordance with GAAP, (ii) since such dates, there have been no material adverse changes in the financial condition of Borrower, and (iii) Borrower has no knowledge of any liabilities, contingent or otherwise, which are not reflected in said balance sheet, and Borrower has not entered into any special commitments or substantial contracts which are not reflected in said balance sheet, other than in the ordinary and normal course of its business, which may have a Material Adverse Effect upon its financial condition, operations or business as now conducted; (f) If the Borrower has a pension, profit sharing or retirement plan subject to ERISA, such plan has been and will continue to be funded in accordance with its terms and otherwise complies with and continues to comply with the requirements of ERISA; (g) Borrower has no liability for any delinquent local, state or federal taxes, and, if Borrower has contracted with any government agency, it has no liability for renegotiation of profits; and (h) Borrower, as of the date hereof, possesses all necessary trademarks, trade names, copyrights, patents, patent rights, and licenses to conduct its business as now operated, without any known conflict with valid trademarks, trade names, copyrights, patents, patent rights and license rights of others. 8. NEGATIVE COVENANTS. Borrower agrees that so long as any loans, obligations or liabilities remain outstanding or unpaid to Bank or the commitment of Bank hereunder is in effect, neither Borrower, nor any of its subsidiaries ("Subsidiaries") will, without the prior written consent of Bank: A. Make any substantial change in the character of its business as now conducted; B. Create, incur, assume or permit to exist any Indebtedness other than loans from Bank except obligations now existing as shown in the financial statements referenced in SECTION 7(g)(i), excluding those being refinanced by Bank, and Permitted Indebtedness; or sell or transfer, either with or without recourse, any accounts or notes receivable or any monies due or to become due; C. Create, incur, assume or permit to exist any mortgage, pledge, encumbrance, lien or charge of any kind (including the charge upon property at any time purchased or acquired under conditional sale or other title retention agreement) upon any asset now owned or hereafter acquired by it, other than Permitted Liens and liens in favor of Bank; D. Sell, dispose of or grant a security interest in any asset now owned or hereafter acquired by it, other than to Bank (other than the disposing of such asset in the ordinary and normal course of its business as now conducted or other assets which are obsolete or otherwise considered surplus), or execute any financing statements covering any assets in favor of any secured party or Person; 3. 4 E. Make any loans or advances to any Person or other entity other than in the ordinary and normal course of its business as now conducted (provided that such loans or advances are not made to any Person or entity which is controlled by or under common control with Borrower) or make any investment, other than Permitted Investments, in the securities of any Person or other entity other than the United States Government; provided, that Borrower may make loans, investments or advances to its 100% owned subsidiaries not exceeding $10,000,000 in the aggregate above existing amounts shown on the September 30, 1997 consolidating balance sheet; F. Use the proceeds of any Loan to purchase or carry margin stock (as defined in Regulation U of the Board of Governors of the Federal Reserve system); G. Purchase or otherwise acquire all or substantially all of the assets or business of any Person or other entity; or liquidate, dissolve, merge or consolidate, or commence any proceedings therefor; or, except in the ordinary and normal course of its business as now conducted, sell (including, without limitation, the selling of any property or other asset accompanied by the leasing back of the same) any assets including any fixed assets, any property, or other assets necessary for the continuance of its business as now conducted. Notwithstanding the foregoing, Borrower may proceed with any acquisition, merger or consolidation (as described above) for a total aggregate consideration of up to $75,000,000 during the term of this agreement, provided that no more than $20,000,000 of the acquisition price is paid in cash in any one transaction (or $30,000,000 in the aggregate for all acquisitions, mergers, or consolidations during the term of this Agreement), and (1) so long as no Event of Default has occurred and is continuing or would exist after giving effect to such transaction, and (2) Borrower is the surviving corporation, if applicable. In the event that Bank approval is required under this subsection, Bank agrees to respond in writing within three (3) business days of receipt of the written request and information necessary to make a decision; and H. Declare or pay any dividend or make any other distribution on any of its capital stock now outstanding or hereafter issued or purchase, redeem or retire any of such stock other than in dividends or distributions payable in Borrower's or any such Subsidiary's capital stock, except for the repurchase of up to $600,000 in any one fiscal year. 9. AFFIRMATIVE COVENANTS. Borrower affirmatively covenants that so long as any loans, obligations or liabilities remain outstanding or unpaid to Bank or the commitment of Bank hereunder is in effect, it will: A. Furnish Bank from time to time such financial reports, statements and information as Bank may reasonably request and inform Bank immediately upon the occurrence of a material adverse change therein; B. Promptly after the same are available, deliver to Bank copies of all such proxy statements, financial statements and reports as Borrower shall send to its shareholders, if any, and copies of all reports which Borrower may file with the Securities Exchange Commission or any governmental authority at any time substituted therefor; C. Promptly notify Bank of any attachment or other legal process levied against any of its Property and any information received by Borrower relative thereto; D. Reimburse Bank upon demand for any and all legal costs, including reasonable attorneys' fees, and other expense incurred in collecting any sums payable by Borrower under the Loan Account or any other obligation secured hereby, enforcing any term or provision of this Loan Agreement or otherwise or in the preparation and enforcement of any agreement relating hereto; E. Maintain public liability, property damage and workers' compensation insurance and insurance on all its insurable property against fire and other hazards with responsible insurance carriers to the extent usually maintained by similar businesses; F. In the event the unpaid balance of the Loan Account shall exceed the maximum amount of outstanding loans to which Borrower is entitled under SECTION 1 hereof, Borrower shall immediately pay to Bank for credit to the Loan Account the amount of such excess; 4. 5 G. Maintain and preserve all rights, franchises and other authority adequate and necessary for the conduct of its business and maintain and preserve its existence in the State of its incorporation and any other state(s) in which Borrower conducts its business, except with respect to such other state(s), as the failure to do so would not have a Material Adverse Effect: H. Maintain public liability, property damage and workers compensation insurance and insurance on all its insurable property against fire and other hazards with responsible insurance carriers to the extent usually maintained by similar businesses. Borrower shall provide evidence of property insurance in amounts and types acceptable to Bank, and certificates naming Bank as a loss payee; I. Pay and discharge, before the same becomes delinquent and penalties accrue thereon, all taxes, assessments and governmental charges upon or against it or any of its properties, and any of its other liabilities at any time existing, except to the extent and so long as: (1) the same are being contested in good faith and by appropriate proceedings in such manner as not to cause any Material Adverse Effect or the loss of any right of redemption from any sale thereunder; and (2) it shall have set aside on its books reserves (segregated to the extent required by GAAP); J. Maintain a standard and modern system of accounting in accordance with GAAP on a basis consistently maintained; permit Bank's representatives to have access to, and to examine its properties, books and records at all reasonable times; provided that Bank shall use its best efforts to not interfere with the conduct of Borrower's business; K. Maintain its properties, equipment and facilities in good order and repair; L. Maintain its principal operating accounts and banking activities with Bank; and M. Promptly notify the Bank in writing of the occurrence of any Event of Default hereunder or any event which upon notice and lapse of time would be an Event of Default. 10. FINANCIAL COVENANTS AND INFORMATION. All financial covenants and financial information referenced herein shall be interpreted and prepared in accordance with GAAP as used in the United States of America applied on a basis consistent with previous years. Compliance with the financial covenants shall be calculated and monitored on a quarterly basis, except as shall be expressly stated to the contrary, Borrower affirmatively covenants that so long as any loans, obligations or liabilities remain outstanding or unpaid to Bank or any commitment is outstanding hereunder, it will, on a consolidated basis: A. At all times, maintain a Minimum Tangible Net Worth (meaning all assets, excluding any value for goodwill, trademarks, patents, copyrights, organization expense and other similar intangible items, less total liabilities, plus long term Subordinated Debt) of not less than the sum of [$ ] plus [ ] of net profit after tax plus [ ] of the proceeds of any public stock offerings; B. At all times maintain a Maximum Ratio of Total Liabilities (meaning all liabilities, excluding long term Subordinated Debt) to Tangible Net Worth (as defined in Section 10.A. hereof) not to exceed [ ]; C. At all times maintain a Minimum Quick Ratio (meaning all cash plus Accounts divided by current liabilities plus [ ] of any outstanding Letters of Credit) of not less than [ ]; D. Measured on a quarterly basis on the last day of each fiscal quarter, have a minimum net profit of not less than $1.00; E. As soon as it is available, but not later than forty-five (45) days after and as of the end of each quarter, deliver to Bank an internally-prepared consolidating financial statement consisting of a balance sheet and profit and loss statement, in form satisfactory to Bank, all in reasonable detail, and certified by an appropriate officer of Borrower, subject, however, to year-end audit adjustments, and a Compliance Certificate in the form of EXHIBIT C attached hereto and incorporated herein by this reference, certified by an officer of Borrower; 5. 6 F. As soon as it is available, but not later than forty-five (45) days after and as of the end of the first three fiscal quarters of each fiscal year, deliver to Bank a copy of Borrower's 10-Q report as filed with the Securities Exchange Commission; G. As soon as it is available, but not later than sixty (60) days after the end of Borrower's fiscal year, deliver to Bank unqualified copies of Borrower's consolidated financial statements together with changes in financial position, all in reasonable detail and stating in comparative form the figures as of the close of and for the previous fiscal year, audited by an independent certified public accountant selected by Borrower but acceptable to Bank, including Borrower's 10-K report as filed with the Securities Exchange Commission. H. Upon the reasonable request of Bank, deliver to Bank current budgets, sales projections, operating plans and other financial exhibits and information in form and substance satisfactory to Bank; I. Upon any officer becoming aware, deliver immediately to Bank written notice of an Event of Default or event which with notice or lapse of time would constitute an Event of Default; and J. Upon any officer becoming aware, deliver immediately to Bank written notice of any pending or threatened litigation claiming, or reasonably likely to result in damages against Borrower in an amount in excess of $500,000. 11. LOAN FEE. In addition to any other amounts due, or to become due, concurrent with the execution hereof, in connection with the Commitment, Borrower shall deliver to Bank a loan fee in the amount of [ ]. 12. DEFAULT AND REMEDIES. The occurrence of any one or more of the following shall constitute an "Event of Default"; (a) Default be made in the payment of any obligation by Borrower under any Loan Document; (b) Except for any failure to pay as described in clause (a) above, breach be made in any warranty, statement, promise, term or condition, contained herein or in any other Loan Document and the same shall not have been cured to the satisfaction of Bank within ten (10) days after Borrower shall have received notice thereof or any Responsible Officer of Borrower became aware thereof, whether by written notice from Bank, or otherwise; provided, that if the default cannot by its nature be cured within the ten (10) day period or cannot after diligent attempts by Borrower be cured within a reasonable time then Borrower shall have an additional reasonable period (which shall not in any case exceed thirty (30) days) to attempt to cure such default, and within such reasonable time period the failure to have cured such default shall not be deemed an Event of Default; provided further, that no cure period shall exist for breaches in respect of Borrower's obligations under SECTION 8, SUBSECTIONS 9.A, 9.B, 9.C, 9.D, 9.F, 9.G, 9.H, 9.I and 9.L, and SECTION 10 of this Loan Agreement); provided further, that no loans will be required to be made during such cure period; (c) Any statement, warranty or representation made by Borrower at any time proves false; (d) Borrower defaults in the repayment of any principal of or the payment of any interest on any indebtedness exceeding in the aggregate principal amount $500,000 or breaches or violates any term or provision of any promissory note, loan agreement, mortgage, indenture or other evidence of such indebtedness pursuant to which amounts outstanding in the aggregate exceed $500,000 if the effect of such breach is to permit the acceleration of such indebtedness, whether or not waived by the note holder or obligee, and such failure shall not have been cured to Bank's satisfaction within fifteen (15) calendar days after Borrower shall become aware thereof, whether by written notice from Bank or otherwise, or there has in fact been an acceleration of such indebtedness; (e) Borrower becomes insolvent or makes an assignment for the benefit of creditors; 6. 7 (f) Any proceeding be commenced by Borrower under any bankruptcy, reorganization, arrangement, readjustment of debt or moratorium law or statute or, any such a proceeding is commenced against Borrower and is not dismissed or stayed within ten (10) days (provided that no Loans will be made prior to the dismissal of such proceeding); (g) Any money judgment, writ of attachment, garnishment, execution or other legal process be entered against Borrower or issued against any material Property of Borrower which is not fully covered by insurance (subject to reasonable deductibles) and remains unvacated, unbonded, unstayed or unpaid or undischarged for more than fifteen (15) days (whether or not consecutive) or in any event later than five (5) days prior to the date of any proposed sale thereunder, or if any assessment for taxes against Borrower other than against any of its real property, is made by the Federal or State government or any department thereof; (h) The occurrence of a Termination Event with respect to any Pension Plan if the aggregate liability of Borrower and its ERISA Affiliates under ERISA as a result thereof, when added to the amount of all other such liabilities incurred since the date hereof, exceeds $500,000; (i) Any change in Borrower's financial condition, prospects or operations which has a Material Adverse effect; or (j) There shall occur a sale, transfer, disposition or encumbrance (whether voluntary or involuntary), or an agreement shall be entered into to do so, with any Person or group of Persons (as such terms are defined pursuant to Federal securities laws) with respect to more than 20% of the issued and outstanding capital stock of the Borrower and, as a result thereof, such Person or group of Persons has the ability to direct or cause the direction of the management and policies of the Borrower. Upon the occurrence and during the continuance of an Event of Default, Bank may, at its option and without demand or presentment first made and without notice to Borrower, all of which are hereby expressly waived, do any one or more of the following: (i) Terminate its obligation to make loans to Borrower as provided in SECTION 1 hereof; or (ii) Declare all Indebtedness of Borrower to Bank immediately due and payable. Bank shall have the right to enforce one or more remedies hereunder successively or concurrently, and any such action shall not estop or prevent Bank from pursuing any further remedy which it may have hereunder or by law. 13. RECORDS RETENTION. Borrower authorizes Bank to destroy all invoices, delivery receipts, reports and other types of documents and records submitted to Bank in connection with the transactions contemplated herein at any time subsequent to four (4) months from the time such items are delivered to Bank. 14. ATTORNEYS' FEES; EXPENSES. Borrower agrees to reimburse Bank for (i) its reasonable attorneys' fees and expenses incurred in connection with the negotiation, preparation, execution and delivery of the Loan Documents and (ii) its reasonable out-of-pocket expenses incurred in connection with its due diligence and closing of this Agreement. 15. GOVERNING LAW; JUDICIAL REFERENCE. A. GOVERNING LAW. This Agreement shall be deemed to have been made in the State of California and the validity, construction, interpretation, and enforcement hereof, and the rights of the parties hereto, shall be determined under, governed by, and construed in accordance with the internal laws of the State of California, without regard to principles of conflicts of law. B. JUDICIAL REFERENCE. (1) Other than (a) nonjudicial foreclosure and all matters in connection therewith regarding security interests in real or personal property; or (b) the appointment of a receiver, or the exercise of other provisional remedies (any and all of which may be initiated pursuant to applicable law), each controversy, dispute or claim between the parties arising out of or relating to this Loan Agreement or the other Loan documents, which controversy, dispute or claim is not settled in writing within thirty (30) days after the "Claim Date" (defined as the date on which a party subject to this Loan Agreement gives written notice to all other parties that a controversy, dispute or claim exists), will be settled by a 7. 8 reference proceeding in California in accordance with the provisions of Section 638 et seq. of the California Code of Civil Procedure, or their successor section ("CCP"), which shall constitute the exclusive remedy for the settlement of any controversy, dispute or claim concerning this Loan Agreement, including whether such controversy, dispute or claim is subject to the reference proceeding and except as set forth above, the parties waive their rights to initiate any legal proceedings against each other in any court or jurisdiction other than the Superior Court in the County where the real property, if any, is located or Santa Clara County, if none (the "Court"). The referee shall be a retired Judge of the Court selected by mutual agreement of the parties, and if they cannot so agree within forty-five (45) days after the Claim Date, the referee shall be promptly selected by the Presiding Judge of the Court (or his/her representative). The referee shall be appointed to sit as a temporary judge, with all of the powers for a temporary judge, as authorized by law, and upon selection should take and subscribe to the oath of office as provided for in Rule 244 of the California Rules of Court (or any subsequently enacted Rule). Each party shall have one peremptory challenge pursuant to CCP Section 170.6. The referee shall (x) be requested to set the matter for hearing within sixty (60) days after the date of selection of the referee and (y) try any and all issues of law or fact and report a statement of decision upon them, if possible, within ninety (90) days of the Claim Date. Any decision rendered by the referee will be final, binding and conclusive and judgement shall be entered pursuant to CCP Section 644 in any court in the State of California having jurisdiction. Any party may apply for a reference proceeding at any time after thirty (30) days following notice to any other party of the nature of the controversy, dispute or claim, by filing a petition for a hearing and/or trial. All discovery permitted by this Loan Agreement shall be completed no later than fifteen (15) days before the first hearing date established by the referee. The referee may extend such period in the event of a party's refusal to provide requested discovery for any reason whatsoever, including, without limitation, legal objections raised to such discovery or unavailability of a witness due to absence or illness. No party shall be entitled to "priority" in conducting discovery. Depositions may be taken by either party upon seven (7) days written notice, and request for production or inspection of documents shall be responded to within ten (10) days after service. All disputes relating to discovery which cannot be resolved by the parties shall be submitted to the referee whose decision shall be final and binding upon the parties. Pending appointment of the referee as provided herein, the Superior Court is empowered to issue temporary and/or provisional remedies, as appropriate. (2) Except as expressly set forth in this Loan Agreement, the referee shall determine the manner in which the reference proceeding is conducted including the time and place of all hearings, the order of presentation of evidence, and all other questions that arise with respect to the course of the reference proceedings. All proceedings and hearings conducted before the referee, except for trial, shall be conducted without a court reporter except that when any party so requests, a court reporter will be used at any hearing conducted before the referee. The party making such a request shall have the obligation to arrange for and pay for the court reporter. The costs of the court reporter at the trial shall be borne equally by the parties. (3) The referee shall be required to determine all issues in accordance with existing case law and the statutory laws of the State of California. The rules of evidence applicable to proceedings at law in the State of California will be applicable to the reference proceedings. The referee shall be empowered to enter equitable as well as legal relief, to provide all temporary and/or provisional remedies and to enter equitable orders that will be binding upon the parties. The referee shall issue a single judgment at the close of the reference proceeding which shall dispose of all of the claims of the parties that are the subject of the reference. The parties hereto expressly reserve the right to contest or appeal from the final judgment or any appealable order or appealable judgment entered by the referee. The parties hereto expressly reserve the right to findings of fact, conclusions of laws, a written statement of decision, and the right to move for a new trial or a different judgment, which new trial, if granted, is also to be a reference proceeding under this provision. (4) In the event that the enabling legislation which provides for appointment of a referee is repealed (and no successor statute is enacted), any dispute between the parties that would otherwise be determined by the reference procedure herein described will be resolved and determined by arbitration. The arbitration will be conducted by a retired judge of the Court, in accordance with the California Arbitration Act, Section 1280 through Section 1294.2 of the CCP as amended from time to time. The limitations with respect to discovery as set forth hereinabove shall apply to any such arbitration proceeding. 8. 9 16. MISCELLANEOUS PROVISIONS. A. Nothing herein shall in any way limit the effect of the conditions set forth in any other security or other agreement executed by Borrower, but each and every condition hereof shall be in addition thereto. B. No failure or delay on the part of Bank, in the exercise of any power, right or privilege hereunder shall operate as a waiver thereof, nor shall any single or partial exercise thereof. C. All rights and remedies existing under this Loan Agreement or any other Loan Document are cumulative to, and not exclusive of, any rights or remedies otherwise available. D. All headings and captions in this Loan Agreement and any related documents are for convenience only and shall not have any substantive effect. E. This Loan Agreement may be executed in any number of counterparts, each of which when so delivered shall be deemed an original, but all such counterparts shall constitute but one and the same instrument. Each such agreement shall become effective upon the execution of a counterpart hereof or thereof by each of the parties hereto and telephonic notification that such executed counterparts has been received by Borrower and Bank. Bank: Borrower: IMPERIAL BANK DIAMOND MULTIMEDIA SYSTEMS, INC. By: /s/ KENNETH W. LE DEIT By: /s/ RONALD R. MATSUSHIMA ------------------------------ ---------------------------- Name: Kenneth W. Le Deit Name: Ronald R. Matsushima Title: Assistant Vice President Title: Corporate Treasurer LIST OF EXHIBITS AND SCHEDULES EXHIBIT A: Definitions SCHEDULE 1 TO EXHIBIT A: List of Specific Permitted Indebtedness SCHEDULE 2 TO EXHIBIT A: List of Specific Permitted Investments EXHIBIT B: Litigation EXHIBIT C: Compliance Certificate 9. 10 EXHIBIT A DEFINITIONS "ACCOUNTS" means any right to payment for goods sold or leased, or to be sold or to be leased, or for services rendered or to be rendered no matter how evidenced, including accounts receivable, contract rights, chattel paper, instruments, purchase orders, notes, drafts, acceptances, general intangibles and other forms of obligations and receivables. "CAPITAL LEASE" means, as to any Person, any lease of any Property by such person as lessee that is, or should be in accordance with Financing Accounting Standards Board Statement No. 13, classified and accounted for as a "capital lease" on the balance sheet of such Person prepared in accordance with GAAP. "CAPITAL LEASE OBLIGATION" means, with respect to any Capital Lease, the amount of the obligation of the lessee thereunder that, in accordance with GAAP, would appear on a balance sheet of such lessee in respect of such Capital Lease or otherwise be disclosed in a note to such balance sheet. "CONTINGENT OBLIGATION" means, as applied to any Person, any direct or indirect liability, contingent or otherwise, of that Person with respect to any indebtedness, lease, dividend, letter of credit or other obligation of another, including, without limitation, any such obligation directly or indirectly guaranteed, endorsed (otherwise than for collection or deposit in the ordinary course of business), co-made or discounted or sold with recourse by that Person, or in respect of which that Person is otherwise directly or indirectly liable, including, without limitation any such obligation for which that Person is in effect liable through any agreement (contingent or otherwise) to purchase, repurchase or otherwise acquire such obligation or any security therefor, or to provide funds for the payment or discharge of such obligation (whether in the form of loans, advances, capital stock purchases, capital contributions or otherwise), or to maintain the solvency of the obligor of such obligation, or to make payment for any products, materials or supplies or for any transportation, services or lease regardless of the non-delivery or non-furnishing thereof, in any such case if the purpose or intent of such agreement is to provide assurance that such obligation will be paid or discharged, or that any agreements relating thereto will be complied with, or that the holders of such obligation will be protected (in whole or in part) against loss in respect thereof. The amount of any Contingent Obligation of any Person shall be deemed to be an amount equal to the maximum amount of such Person's liability with respect to the stated or determinable amount of the primary obligation for which such Contingent Obligation is incurred or, if not stated or determinable, the maximum reasonably anticipated liability in respect thereof (assuming such Person is required to perform thereunder). "ERISA" means the Employee Retirement Income Security Act of 1974, and any regulations issued pursuant thereto, as amended or replaced and as in effect from time to time. "ERISA AFFILIATE" means, with respect to any Person, any Person (or any trade or business, whether or not incorporated) that is under common control with that Person, within the meaning of Section 414 of the Internal Revenue Code of 1986, as amended or replaced and as in effect from time to time. "EVENT OF DEFAULT" has the meaning set forth in SECTION 12. "GAAP" means generally accepted accounting principles set forth in the opinions and pronouncements of the Accounting Principles Board of the American Institute of Certified Public Accountants and statements and pronouncements of the Financial Accounting Standards Board or in such other statements by such other Person as may be approved by the significant segment of the accounting profession, which are applicable to the circumstances as of the date of determination. "INDEBTEDNESS" means, as to any Person, without duplication, (a) all indebtedness of such Person for borrowed money, including, without limitation, all of such indebtedness outstanding under this Loan Agreement and any of the other Loan Documents, (b) all Capital Lease Obligations of such Person, (c) to the extent of the outstanding indebtedness thereunder, any obligation of such Person representing an extension of credit to such Person, whether or not for borrowed money, (d) any obligation of such Person for the deferred purchase price of Property or services (other than (i) trade or other accounts payable in the ordinary course of business in accordance with customary industry terms and (ii) deferred franchise Exhibit A Page 1 of 4 11 fees), (e) all Contingent Obligations, (f) any obligation of such Person of the nature described in clauses (a), (b), (c), (d) or (e) above, that is secured by a Lien on assets of such Person and which is non-recourse to the credit of such Person, but only to the extent of the fair market value of the assets so subject to the Lien, (g) obligations of such Person arising under acceptance facilities or under facilities for the discount of accounts receivable of such Person, (h) any obligation of such Person to reimburse the issuer of any letter of credit issued for the account of such Person upon which a draw has been made, and (i) any lease having the effect of indebtedness, whether or not the same shall be treated as such on the balance sheet of Borrower under GAAP. "INTEREST RATE ADDENDUM" means that certain Libor and Competitive Rate Addendum to Loan Agreement dated of even date herewith. "LIEN" means any mortgage, pledge, security interest, lien or other charge or encumbrance, including the lien or retained security title of a conditional vendor, upon or with respect to any property or assets. "LOAN ACCOUNT" has the meaning set forth in SECTION 1.A(1). "LOAN DOCUMENTS" means this Loan Agreement, the Interest Rate Addendum, and that certain Agreement to Provide Insurance (Real or Personal Property) dated of even date herewith, each as executed by Borrower in favor of Bank, together with all other documents entered into or delivered pursuant to any of the foregoing, in each case as originally executed or as the same may from time to time be modified, amended, supplemented or restated. "LOANS" means individually and collectively, the Loans advanced pursuant to SECTION 1. "MATERIAL ADVERSE EFFECT" means any set of circumstances or events which (a) has or could reasonably be expected to have any material adverse effect upon the validity or enforceability of any material provision of any Loan Document, (b) is or could reasonably be expected to be material and adverse to the condition (financial or otherwise) or business operations of Borrower, (c) materially impairs or could reasonably be expected to materially impair the ability of Borrower, to perform its material Obligations, (d) materially impairs or could reasonably be expected to materially impair the value of any material assets of Borrower, or (e) materially impairs or could reasonably be expected to materially impair the ability of Bank to enforce any of its legal remedies pursuant to the Loan Documents. "MATURITY DATE" has the meaning set forth in SECTION 1.A. "PBGC" means the Pension Benefit Guaranty Corporation or any successor thereof established under ERISA. "PENSION PLAN" means any "employee pension benefit plan" that is subject to Title IV of ERISA and which is maintained for employees of Borrower or any of its ERISA Affiliates, other than a Multiemployer Plan. "PERMITTED INDEBTEDNESS" means the following: (1) indebtedness of Borrower or Indebtedness and Contingent Obligations of its Subsidiaries in favor of Bank arising under this Loan Agreement and the other Loan Documents; (2) the existing Indebtedness and Contingent Obligations disclosed on SCHEDULE 1 attached hereto and incorporated herein by this reference; provided that the principal amount thereof is not increased and the terms thereof are not modified to impose more burdensome terms upon Borrower or any of its Subsidiaries; (3) the Subordinated Debt; (4) accrued dividends on the preferred stock of Borrower; and (5) extensions, renewals, refinancings, modifications, amendments and restatements of any indebtedness permitted under this Loan Agreement, other than Indebtedness referred to in clause (3) above; provided Exhibit A Page 2 of 4 12 that the principal amount thereof is not increased or the terms thereof are not modified to impose more burdensome terms upon Borrower. "PERMITTED INVESTMENTS" means the investments listed in SCHEDULE 2 to EXHIBIT A. "PERMITTED LIENS" means the following: (i) liens for taxes, fees, assessments or other governmental charges or levies, either not delinquent or being contested in good faith by appropriate proceedings; (ii) liens and security interests (a) upon or in any equipment acquired or held by Borrower to secure the purchase price of such equipment or indebtedness incurred solely for the purpose of financing the acquisition of such equipment and in an amount not greater than the lesser of the purchase price of such equipment or the fair market value of such equipment on the date of the acquisition, or (b) existing on such equipment at the time of its acquisition, provided that the lien and security interest is confined solely to the property so acquired and improvements thereon, and the proceeds of such equipment; (iii) liens consisting of leases or subleases and licenses and sublicenses granted to others in the ordinary course of Borrower's business not interfering in any material respect with the business of Borrower and any interest or title of a lessor or licensor under any lease or license, as applicable; (iv) liens securing claims or demands of materialmen, mechanics, carriers, warehousemen, landlords and other like persons or entities imposed without action of such parties, provided that the payment thereof is not yet required; (v) liens incurred or deposits made in the ordinary course of Borrower's business in connection with worker's compensation, unemployment insurance, social security and other like laws; (vi) liens arising from judgments, decrees or attachments in circumstances not constituting an Event of Default; (vii) easements, reservations, rights-of-way, restrictions, minor defects or irregularities in title and other similar charges or encumbrances affecting real property not interfering in any material respect with the ordinary conduct of Borrower's business; (viii) liens in favor of customs and revenue authorities arising as a matter of law to secure payment of customs duties in connection with the importation of goods; (ix) liens that are not prior to Bank's security interest which constitute rights of set-off of a customary nature; (x) any interest or title of a lessor in equipment subject to any Capitalized Lease otherwise permitted hereunder; and (xi) any liens arising from the filing or any financing statements relating to true leases otherwise permitted hereunder. "PERSON" means any individual, sole proprietorship, partnership, joint venture, trust, unincorporated organization, association, corporation, limited liability company, institution, public benefit corporation, firm, joint stock company, estate, entity or governmental agency. "PROPERTY" means any interest in any kind of property or asset, whether real, personal or mixed, whether tangible or intangible. Exhibit A Page 3 of 4 13 "SUBORDINATED DEBT" means indebtedness of Borrower, the repayment of principal and interest of which is fully subordinated in time and right of payment to the Loans, and has been approved in Bank's sole and absolute discretion and in writing. "TERMINATION EVENT" means (a) a "reportable event" as defined in Section 4043 of ERISA (other than a "reportable event" that is not subject to the provision for 30 day notice to the PBGC), (b) the withdrawal of Borrower or any of its ERISA Affiliates from a Pension Plan during any plan year in which it was a "substantial employer" as defined in Section 4001(a)(2) of ERISA, (c) the filing of a notice of intent to terminate a Pension Plan or the treatment of an amendment to a Pension Plan as a termination thereof pursuant to Section 4041 of ERISA, (d) the institution of proceedings to terminate a Pension Plan by the PBGC or (e) any other event of condition which might reasonably be expected to constitute grounds under ERISA for the termination of, or the apportionment of a trustee to administer, any Pension Plan. Exhibit A Page 4 of 4 14 SCHEDULE 1 TO EXHIBIT A SPECIFIC PERMITTED INDEBTEDNESS 1. $30,000,000 unsecured line of credit form Sanwa Bank. 2. [ ] unsecured line of credit from BHF Bank 3. [ ] unsecured line of credit to Borrower's subsidiary SPEA Software GmbH from BHF Bank, guaranteed by Borrower Schedule 1 to Exhibit A Page 1 of 1 15 SCHEDULE 2 TO EXHIBIT A SPECIFIC PERMITTED INVESTMENTS Investments made in accordance with Borrower's investment policy, provided that Borrower's investment policy has been disclosed to and approved in advance by Bank: The following subsidiaries are 100% owned by Borrower: 1. Diamond Multimedia Systems International, Inc. 2. Diamond Multimedia Systems Limited 3. Diamond Multimedia Contract Services Limited 4. Diamond Multimedia Systems GmbH 5. Supra Corporation, Communications Division 6. Spea Software GmbH (subsidiary of Supra Corporation) 7. Diamond Multimedia Systems Service Company Limited 8. Diamond Multimedia Systems KK 9. Supra GmbH 10. Supra Corp. (Inactive) 11. Diamond Multimedia Systems SARL 12. Spea Software GmbH (Sub. of Supra GmbH not Supra Corp. USA) 13. Spea UK (inactive) 14. Diamond Multimedia Systems Pty Ltd. (Australia) 15. Diamond Multimedia Systems International Inc. (Barbados) 16. Diamond Multimedia Systems Korea, Inc. 17. Diamond Multimedia Systems, Inc. Hong Kong 18. Diamond Multimedia Systems, Inc. Singapore Schedule 2 to Exhibit A Page 1 of 1 16 EXHIBIT B LITIGATION The Borrower has been named as a defendant in several putative class action lawsuits which were filed in June and July, 1996 and June, 1997 in the California Superior Court for Santa Clara County and the U.S. District Court for the Northern District of California. Certain executive officers and directors of the Borrower are also named as defendants. The plaintiffs purport to represent a class of all persons who purchased the Borrower's Common Stock between October 18, 1995 and June 20, 1996 (the "Class Period"). The complaints allege claims under the federal securities laws and California law. The plaintiffs allege claims under the federal securities laws and California law. The plaintiffs allege that the Borrower and the other defendants made various material misrepresentations and omissions during the Class Period. The complaints do not specify the amount of damages sought. The Borrower believes that it has good defenses to the claims alleged in the lawsuits and will defend itself vigorously against these actions. The Borrower is also party to other claims and pending legal proceedings that generally involve employment and trademark issues. These cases are, in the opinion of management of the Borrower, ordinary and routine matters incidental to the normal business conducted by the Borrower. In the opinion of management of the Borrower, the ultimate disposition of such proceedings will not have a materially adverse effect on the Borrower's consolidated financial position or future results of operations. Exhibit B Page 1 of 1 17 LIBOR AND COMPETITIVE RATE ADDENDUM TO LOAN AGREEMENT This Libor and Competitive Rate Addendum ("Addendum") is dated as of January 23, 1998, and is by and between DIAMOND MULTIMEDIA SYSTEMS, INC. ("Borrower") and Imperial Bank ("Bank"). This Addendum amends and supplements the Loan Agreement of even date herewith to which it is attached (the "Loan Agreement") and forms a part of and is incorporated into the Loan Agreement. In the event of any inconsistency between the terms herein and the terms of the Loan Agreement, the terms herein shall in all cases govern and control. All capitalized terms herein, unless otherwise defined herein, shall have the meanings set forth in the Loan Agreement. 1. ADVANCES. 1.1 PRIME LOANS. Advances permitted pursuant to the terms of the Loan Agreement or this Addendum which bear interest in relation to Bank's Prime Rate shall be referred to herein as "Prime Loans" and each such advance shall be a "Prime Loan." Each Prime Loan shall bear interest at an annual rate equal to the Bank's Prime Rate. "Prime Rate" shall mean the rate of interest publicly announced by Bank from time to time in Inglewood, California, as its prime rate for lending. The Prime Rate is not intended to be the lowest rate of interest charged by Bank in connection with extensions of credit to borrowers. 1.2 LIBOR LOANS. Advances permitted pursuant to the terms of the Loan Agreement or this Addendum which bear interest in relation to the Libor Rate shall be referred to herein as "Libor Loans" and each such advance shall be a "Libor Loan." Each Libor Loan shall bear interest at the Libor Rate, as defined below. A Libor Loan shall be in the minimum amount of [ ] or such greater amount which is an integral multiple of Fifty Thousand Dollars ($50,000). No Libor Loan shall be made after the last Business Day that is at least one (1) month prior to the Maturity Date described in the Loan Agreement. 1.3 COMPETITIVE RATE LOANS. Advances permitted pursuant to the terms of the Loan Agreement or this Addendum which bear interest in relation to the Competitive Rate shall be referred to herein as "Competitive Rate Loans" and each such advance shall be a "Competitive Rate Loan." Each Competitive Rate Loan shall bear interest at the Competitive Rate, as defined below. A Competitive Rate Loan shall be in the minimum amount of [ ] or such greater amount which is an integral multiple of Fifty Thousand Dollars ($50,000). No Competitive Rate Loan shall be made after the last Business Day that is at least one (1) month prior to the Maturity Date described in the Loan Agreement. 2. INTEREST ON FIXED RATE LOANS. 2.1 RATE OF INTEREST. Each Fixed Rate Loan shall bear interest on the unpaid principal amount thereof from the Loan Date through the date paid (whether by acceleration or otherwise) at a rate equal to (i) in the case of Libor Loans, the sum of the Applicable Margin plus the Libor Rate for the Interest Period or (ii) in the case of Fixed Rate Loans, the Competitive Rate for the Interest Period. The "Applicable Margin" shall mean [ ] basis points for borrowings under [ ] and [ ] basis points for borrowings of and over. (a) "Business Day" means any day on which Bank is open for business in the State of California. (b) "Competitive Rate" shall mean the rate quoted by Bank to Borrower from time to time at Borrower's request, for money outstanding for the particular specified period of [ ] days or less. (c) "Competitive Rate Loan" shall mean any Loan which bears interest at the Competitive Rate. (d) "Fixed Rate Loan" shall mean, collectively, Libor Loans and Competitive Rate Loans. (e) "Governmental Regulation" means any (i) United States Federal, state or foreign law or regulation (including without limitation Regulation D); and (ii) the adoption or making of any interpretation, application, directive or request applying to a class of lenders, including Bank, of or under any United States Federal, state, or any foreign law or 18 regulation (whether or not having the force of law) by any court or by any governmental, central banking, monetary or taxing authority charged with the interpretation or administration of such law or regulation. (f) "Interest Period" shall mean (i) in the case of a Libor Loan, a period of [ ] months, commencing on the applicable Loan Date, as selected by Borrower pursuant to Section 2.2 or (ii) in the case of a Competitive Rate Loan, the interest period selected by Borrower which shall be [ ] in duration; provided, however, that Borrower may not select an Interest Period that would otherwise extend beyond the Maturity Date of the Loan. Borrower may also select a twelve (12) month Interest Period for Libor Loans if and when Bank notifies Borrower that such interest Period is available, as determined by Bank in its sole discretion. (g) "Libor Base Rate" shall mean with respect to any Interest Period, the rate equal to the arithmetic mean (rounded upwards, if necessary, to the nearest 1/16 of 1%) of: (i) the offered rates per annum for deposits in U.S. Dollars for a period equal to such Interest Period which appears at 11:00 a.m., London time, on the Reuters Screen LIBOR Page on the Business Day that is two (2) Business Days before the first day of such Interest Period, in each case if at least four (4) such offered rates appear on such page, or (ii) if clause (i) is inapplicable, (x) the offered rate per annum for deposits in U.S. Dollars for a period equal to such Interest Period which appears as of 11:00 a.m., London time on the Telerate Monitor on Telerate Screen 3750 on the Business Day which is two (2) Business Days before the first day of such Interest Period; or (y) if clause (x) above is inapplicable, the arithmetic mean (rounded upwards, if necessary, to the nearest 1/16 of 1%) of the interest rates per annum offered by at least three (3) prime banks selected by Bank at approximately 11:00 a.m. London time, on the Business Day which is two (2) Business Days before such date for deposits in U.S. Dollars to prime banks in the London interbank market, in each case for a period equal to such Interest Period in an amount equal to the amount to which the Libor Rate applies. (h) "Libor Loan" shall mean any Loan which bears interest at a rate based upon the Libor Rate. (i) "Libor Rate" shall mean, for the applicable Interest Period for a Libor Loan, a rate per annum (rounded upwards, if necessary, to the nearest 1/16 of 1%) equal to (i) the Libor Base Rate for such interest Period divided by (ii) 1.00 minus the Reserve Requirement Rate (expressed as a decimal faction) for such Interest Period. (j) "Loan Date" shall mean the date on which a Fixed Rate Loan is made, a Fixed Rate Loan is continued, or a Prime Loan is converted to a Fixed Rate Loan. (k) "Regulatory Change" means, with respect to Bank, any change on or after the date of the Loan Agreement and this Addendum in any Governmental Regulation, including the introduction of any new Governmental Regulation or the rescission of any existing Governmental Regulation. (l) "Reserve Requirement Rate" means, for any Interest Period, the aggregate of the rates, effective as of the Business Day which is two (2) Business Days before the first day of the Interest Period, at which: (i) reserves (including any marginal, supplemental or emergency reserves) are required to be maintained during such Interest Period under Regulation D against "Eurocurrency liabilities" (as such term is used in Regulation D) by member banks of the Federal Reserve System; and (ii) any additional reserves are required to be maintained by Bank by reason of any Regulatory Change against (x) any category of liabilities which includes deposits by reference to which the Libor Rate is to be determined as provided in the definition of "Libor Base Rate;" or (y) any category of extensions of credit or other assets which include Libor Loans. (m) "Reuters Screen LIBOR Page" means the display designated as page LIBOR on the Reuters Monitor Money Rates Service or such other page as may replace the LIBOR page on that service for the purpose of displaying London interbank offered rates of major banks. 2.2 DETERMINATION OF INTEREST RATES. Subject to the terms and conditions of the Loan Agreement and this Addendum, Borrower, at its option, may request an advance in the form of a Fixed Rate Loan, a continuation of a Fixed Rate Loan, or a conversion of a Prime Loan into a Fixed Rate Loan, only upon delivery to Bank of an irrevocable written notice received by Bank Page 2 of 6 19 at least three (3) Business Days prior to the requested Loan Date, specifying (i) the principal amount of such Fixed Rate Loan, (ii) the requested Loan Date, and (iii) the selected Interest Period. Upon receiving such notice, Bank shall determine (which determination shall be in accordance with SECTION 2.1 and shall, absent manifest error, be final, conclusive and binding upon all parties hereto) the Libor Rate or Competitive Rate, as the case may be, applicable to such Fixed Rate Loan two (2) Business Days prior to the Loan Date, and shall promptly give notice thereof (in writing or by telephone confirmed in writing) to Borrower. If Borrower shall fail to notify Bank of its selected Interest Period for a Libor Loan (including the continuation of an existing Libor Loan or the conversion of a Prime Loan into a Libor Loan), the Borrower shall be deemed to have selected an Interest Period of three (3) months. 2.3 INTEREST PAYMENT DATES. Accrued interest on Fixed Rate Loans shall be due and payable in full on the last day of the Interest Period; provided, however, that if the Interest Period is longer than ninety (90) days, then interest will be due on a quarterly basis and on the last day of the relevant Interest Period. 2.4 COMPUTATION OF INTEREST AND FEES. All computations of interest and fees payable pursuant to the Loan Agreement shall be calculated on the basis of a three hundred sixty (360) day year for the actual number of days elapsed (less the date of repayment). 2.5 RECORDATION BY BANK. Bank is hereby authorized to record the Loan Date, the applicable Interest Period, the principal amount, and the interest rate of each Fixed Rate Loan made (or continued or converted) by Bank, and the date and amount of each payment or prepayment of principal thereof, in Bank's records. Any such recordation shall constitute prima facie evidence of the accuracy of the information recorded; provided that the failure to make any such recordation shall not in any way affect the Borrower's obligations hereunder. 3. CONVERSION TO PRIME LOANS. 3.1 ELECTION BY BORROWER. Subject to all the terms and conditions of this Addendum, Borrower may elect from time to time to convert a Fixed Rate Loan to a Prime Loan by giving Bank at least three (3) Business Days' prior irrevocable notice of such election, and any such conversion of a Fixed Rate Loan shall be made on the last day of the Interest Period with respect thereto. 3.2 FAILURE OF NOTICE BY BORROWER. If Borrower otherwise fails to give notice specifying its requests with respect to any Fixed Rate Loans that are scheduled to become due, such failure shall be deemed, in the absence of any notice from Borrower to the contrary, to be notice of a requested advanced in the form of a Prime Loan in a principal amount equal to the amount of said Fixed Rate Loan. 4. PREPAYMENTS. 4.1 VOLUNTARY PREPAYMENT BY BORROWER. Subject to the terms and conditions of the Loan Agreement and this Addendum, Borrower may, upon at least three (3) Business Days' irrevocable notice to Bank as provided herein, at any time and from time to time on any Business Day prepay any Prime Loan or Libor Loan in whole or in part, without penalty or premium, other than customary actual "Breakage Fees" and "Prepayment Costs" as defined below, resulting from prepayment of any Libor Loan prior to the expiration of the Interest Period relating thereto; provided, however, that if Borrower prepays (including voluntarily or mandatory prepayment, voluntary or mandatory conversion into a Prime Loan, or acceleration) a Competitive Rate Loan prior to the last day of the Interest Period of such Loan, Borrower shall pay on the date of such prepayment, in addition to the outstanding principal amount of the Loan, an amount equal to the Competitive Rate Loan Product (as defined below). The "Competitive Rate Loan Product" shall mean the product of: (1) the principal amount of the Loan; (2) the Prime Rate, and (3) the number of days in the Interest Period divided by 360. The notice of prepayment shall specify the date and amount of the prepayment, and the Loan to which the prepayment applies. Each partial prepayment of a Libor Loan shall be in an amount not less than Fifty Thousand Dollars ($50,000) or such greater amount which is an integral multiple of Fifty Thousand Dollars ($50,000); provided, that unless a Libor Loan is prepaid in full, no prepayment shall be made if, after giving effect to such prepayment, the aggregate principal amount of Libor Loans having the same Interest Period shall be less than One Million Dollars ($1,000,000). Notice of prepayment having been delivered as aforesaid, the principal amount of the prepayment specified in such notice shall become due and payable on the prepayment date set forth in such notice. All payments of principal under this Section 4 shall be accompanied by accrued but unpaid interest on the amount being prepaid through the date of such prepayment. 4.2 BREAKAGE FEES. If for any reason (including voluntary or mandatory prepayment, voluntary or mandatory conversion of a Libor Loan into a Prime Loan, or acceleration), Bank receives all or part of the principal amount of a Libor Loan prior to the last day of the Interest Period for such Loan, Borrower shall immediately notify Borrower's account officer at Bank and, on demand Page 3 of 6 20 by Bank, pay Bank the Breakage Fees, defined as the amount (if any) by which (i) the additional interest which would have been payable on the amount so received had it not been received until the last day of such Interest Period exceeds (ii) the interest which would have been recoverable by Bank (without regard to whether Bank actually so invests said funds) by placing the amount so received on deposit in the certificate of deposit markets or the offshore currency interbank markets or United States Treasury investment products, as the case may be, for a period starting on the date on which it was so received and ending on the last day of such Interest Period at the interest role determined by Bank in its reasonable discretion. Bank's determination as to such amount shall be conclusive and final, absent manifest error. 4.3 PREPAYMENT COSTS. Borrower shall pay to Bank, upon the demand of Bank, such other amount or amounts as shall be sufficient (in the sole good faith opinion of Bank) to compensate it for any loss, costs or expense incurred by it as a result of any prepayment by Borrower (including voluntary or mandatory prepayment, voluntary or mandatory conversion of a LIBOR Rate Loan into a Prime Loan, or prepayment due to acceleration) of all or part of the principal amount of a LIBOR Rate Loan prior to the last day of the Interest Period for such Loan (including without limitation any failure by Borrower to borrow a LIBOR Rate Loan on the Loan Date for such borrowing specified in the relevant notice of borrowing hereunder). Such costs shall include, without limitation, any interest or fees payable by Bank to lenders of funds obtained by it in order to make or maintain its loans based on the London interbank eurodollar market. Bank's determination as to such costs shall be conclusive and final, absent manifest error. 5. REMEDIES UPON EVENTS OF DEFAULT. 5.1 CONVERSION TO PRIME LOANS. If any Event of Default has occurred and is continuing under the Loan Agreement or this Addendum, then in addition to all other remedies available to Bank under the Loan Agreement, at the option of Bank and without demand or notice, all Fixed Rate Loans then outstanding shall be automatically converted to Prime Loans on the last day of each respective Interest Period for each Fixed Rate Loan. 5.2 INDEMNITY. Borrower agrees to pay and indemnify Bank for, and to hold Bank harmless from, any and all cost, loss or expense (including without limitation any such cost, loss or expense arising from interest or fees payable by Bank to lenders of funds obtained by it in order to maintain its Fixed Rate Loans hereunder, or in its reemployment of funds obtained in connection with the making or maintaining of Fixed Rate Loans) which Bank may sustain or incur as a consequence of any default by Borrower in connection with or related to: (a) payment of the principal amount of or interest on Fixed Rate Loans, (b) making a borrowing or conversion of a Fixed Rate Loan after Borrower has given a notice thereof in accordance with this Addendum, or (c) making a prepayment of a Fixed Rate Loan after Borrower has given a notice thereof in accordance with this Addendum, or any prepayment (whether optional or mandatory) of any Fixed Rate Loan prior to the end of the applicable Interest Period for such Loan. 6. ADDITIONAL PROVISIONS REGARDING FIXED RATE LOANS. 6.1 LIBOR RATE TAXES. All payments of principal, interest, fees, costs, expenses and all other amounts payable to Borrower pursuant to the Loan Agreement and this Addendum shall be made free and clear of and without reduction by reason of all present and future income, stamp and other taxes or other charges whatsoever imposed, assessed, levied or collected by any national government or any political subdivision or taxing authority thereof or any organization of which it is a member (excluding (i) any taxes imposed on or measured by the overall net income or gross receipts of Bank by any such entity, and (ii) any taxes which would have been imposed even if no provisions for Libor Loans had appeared in this Addendum) (collectively, "Libor Taxes"). If any Libor Taxes are required to be withheld from any amounts payable to Bank, Borrower shall pay such additional amounts as may be necessary so as to yield to Bank a net amount equal to the total amount of the payments provided for in this Addendum or under the Loan Agreement which Bank would have received if such amounts had not been subject to Libor Taxes. If any Libor Taxes are payable directly by Borrower, they shall be paid by Borrower prior to the date on which penalties attach for failure to timely pay such Libor Taxes. Within forty five (45) days after the date on which payment of any such Libor Taxes is due pursuant to applicable law, Borrower will furnish Bank the original receipt for the full payment of such Libor Taxes or, if such is not available, evidence of such payment satisfactory in form and substance to Bank. Borrower shall indemnify and hold Bank harmless against, and will reimburse to Bank, upon demand, any incremental taxes, interest or penalties that may become payable by Bank as a result of any failure by Borrower to pay any Libor Taxes when due. 6.2 INABILITY TO DETERMINE FAIR INTEREST RATE. If at any time Bank, in its sole and absolute discretion, determines that: (i) the amount of the Libor Loans for periods equal to the corresponding Interest Periods are not available to Bank in the offshore currency interbank markets, (ii) the Libor Rate does not accurately reflect the cost to Bank of lending the Libor Loan, or (iii) by Page 4 of 6 21 reason of any changes arising after the date of the Loan Agreement affecting the London interbank eurodollar market, adequate and fair means do not exist for ascertaining the applicable interest rate on the basis provided for in SECTIONS 2.1 and 2.2 above, then Bank shall promptly give notice thereof to Borrower. Upon the giving of such notice, Bank's obligation to make Libor Loans shall terminate, unless Bank and the Borrower agree in writing to a different interest rate applicable to Libor Loans, or until such time as Bank notifies Borrower that the circumstances giving rise to Bank's notice no longer exist. While such circumstances continue to exist, (x) any requested Libor Loan shall be treated as a request for a Prime Loan, (y) any Prime Loan that was to have been converted to a Libor Loan shall be continued as a Prime Loan, and (z) any outstanding Libor Loan shall be converted retroactively, on the first day of the then current Interest Period with respect thereto, to a Prime Loan. 6.3 ILLEGALITY OR IMPRACTICABILITY. If (i) due to any Governmental Regulation it shall become unlawful for Bank to continue to Fund or maintain any Libor Loans, or to perform its obligations hereunder, or (ii) due to any contingency occurring after the date of the Loan Agreement which has a material adverse effect on the London interbank eurodollar market, it has become impracticable for Bank to continue to Fund or maintain any Libor Loans, or to perform its obligations hereunder, then Bank shall promptly give notice thereof to Borrower. Upon the giving of such notice, Bank's obligation to make Libor Loans shall terminate, and in such event, (x) any requested Libor Loan shall be treated as a request for a Prime Loan, (y) any Prime Loan that was to have been converted to a Libor Loan shall be continued as a Prime Loan, and (z) any outstanding Libor Loan shall be converted retroactively, on the first day of the then current Interest Period with respect thereto, to a Prime Loan. 6.4 GOVERNMENTAL REGULATIONS; INCREASED COSTS. Borrower shall pay to Bank, within 15 days after demand by Bank, from time to time such amounts as Bank may determine to be necessary to compensate it for any increased costs incurred by Bank that Bank determines are attributable to its making or maintaining of any Libor Loans to Borrower (such increases in costs and reductions in amounts receivable being herein called "Additional Costs"), in each case resulting from any Regulatory Change which: (a) imposes a new tax or changes the basis of taxation of any amounts payable to Bank under the Loan Agreement or this Addendum in respect of any Libor Loans (other than changes which affect taxes measured by or imposed on the overall net income of Bank by the jurisdiction in which such Bank has its principal office); or (b) imposes or modifies any reserve, special deposit or similar requirements relating to any extensions of credit or other assets of, or any deposits or other liabilities with or for the account of Bank (including any Libor Loans or any deposits referred to in the definition of Libor Based Rate); or (c) imposes any other condition affecting the Loan Agreement (or any of such extensions of credit or liabilities); or (d) imposes or modifies a Governmental Regulation regarding capital adequacy which has or would have the effect of reducing the rate of return on capital of Bank or any person or entity controlling Bank ("Parent") as a consequence of its obligations hereunder to a level below that which Bank (or its Parent) could have achieved but for such adoption, change or compliance (taking into consideration its policies with respect to capital adequacy) by an amount deemed by Bank to be material. Bank will notify Borrower of any event occurring after the date of the Loan Agreement which will entitle Bank to Additional Costs pursuant to this SECTION 6.4 as promptly as practicable after it obtains knowledge thereof and determines to request such compensation. Bank will furnish Borrower with a statement setting forth the basis and amount of such request by Bank for Additional Costs under this SECTION 6.4. Determinations and allocations by Bank for purposes of this SECTION 6.4 of the effect of any Regulatory Change on its costs of maintaining its obligations to make Libor Loans or of making or maintaining Libor Loans or on amounts receivable by it in respect of Libor Loans, and of the additional amounts required to compensate Bank in respect of any Additional Costs, shall be conclusive and final, absent manifest error. Page 5 of 6 22 This Addendum is executed as of the date first written above. BORROWER BANK DIAMOND MULTIMEDIA SYSTEMS, INC. IMPERIAL BANK a Delaware corporation a California banking corporation By /s/ RONALD R. MATSUSHIMA By /s/ KENNETH W. LE DEIT ---------------------------------- ---------------------------------- Its Corporate Treasurer Its AVP ---------------------------------- ---------------------------------- Page 6 of 6 EX-27.1 3 FINANCIAL DATA SCHEDULE
5 1,000 3-MOS DEC-31-1998 JAN-01-1998 MAR-31-1998 94,787 6,142 104,890 2,034 92,456 322,845 30,076 11,606 349,762 157,173 1,747 0 0 35 190,807 349,762 186,196 186,196 144,570 144,570 30,548 (54) (192) 11,324 3,397 7,927 0 0 0 7,927 0.23 0.22
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