UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
For the Quarterly Period Ended September 30, 2002
OR
o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
Commission File Number 0-23137
REALNETWORKS, INC.
(206) 674-2700
(Exact name of registrant as specified in its charter)
(State of incorporation)
(I.R.S. Employer Identification Number)
Seattle, Washington
(Address of principal executive offices)
(Zip Code)
(Registrant’s telephone number, including area code)
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 of the registrant’s Common Stock outstanding as of November 11, 2002 was 157,721,220.
1
REALNETWORKS, INC.
FORM 10-Q
FOR THE QUARTER ENDED SEPTEMBER 30, 2002
TABLE OF CONTENTS
| Page | ||
|
|
||
| PART I. FINANCIAL INFORMATION | ||
| Item 1. Financial Statements | 3 | |
| Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations | 16 | |
| Item 3. Quantitative and Qualitative Disclosures About Market Risk | 46 | |
| Item 4. Controls and Procedures | 47 | |
| PART II. OTHER INFORMATION | ||
| Item 1. Legal Proceedings | 48 | |
| Item 6. Exhibits and Reports on Form 8-K | 49 |
2
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
REALNETWORKS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except per share data)
September 30,
December 31,
2002
2001
$
324,553
344,509
6,356
5,854
6,011
7,244
—
5,225
336,920
362,832
35,234
31,298
26,034
24,965
61,268
56,263
29,525
20,721
31,743
35,542
17,300
17,300
27,247
92,940
—
360
61,004
57,816
2,113
1,070
$
476,327
567,860
$
6,689
9,950
31,524
30,853
32,970
31,462
3,945
5,288
75,128
77,553
14,720
15,380
23,217
7,149
3,215
2,899
—
—
—
—
159
160
617,691
628,919
(1,469
)
(914
)
(689
)
56,463
(255,645
)
(219,749
)
360,047
464,879
$
476,327
567,860
See accompanying notes to condensed consolidated financial statements
3
REALNETWORKS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
AND COMPREHENSIVE LOSS
(in thousands, except per share data)
Quarters Ended
Nine Months Ended
September 30,
September 30,
2002
2001
2002
2001
$
15,554
26,751
57,163
84,416
28,202
16,046
74,466
46,434
1,662
2,431
4,839
12,617
45,418
45,228
136,468
143,467
1,493
1,672
5,305
5,777
11,720
6,077
29,992
17,217
454
1,418
1,597
4,953
13,667
9,167
36,894
27,947
31,751
36,061
99,574
115,520
12,252
12,500
36,846
43,556
18,818
17,540
55,501
56,020
4,561
5,114
14,557
15,832
17,207
5,621
17,207
22,208
3,595
3,893
3,595
3,893
398
12,850
930
27,789
56,831
57,518
128,636
169,298
(25,080
)
(21,457
)
(29,062
)
(53,778
)
1,551
4,171
5,975
14,137
(1,609
)
(1,397
)
(5,132
)
(2,334
)
(4,399
)
(2,495
)
(5,103
)
(25,342
)
105
(365
)
3,381
(1,309
)
(4,352
)
(86
)
(879
)
(14,848
)
(29,432
)
(21,543
)
(29,941
)
(68,626
)
5,957
(2,163
)
5,955
(5,683
)
$
(35,389
)
(19,380
)
(35,896
)
(62,943
)
$
(0.22
)
(0.12
)
(0.22
)
(0.39
)
159,961
161,203
159,897
160,132
$
(35,389
)
(19,380
)
(35,896
)
(62,943
)
(33,769
)
5,561
(55,468
)
2,367
—
2,059
(1,705
)
16,519
74
97
21
(359
)
$
(69,084
)
(11,663
)
(93,048
)
(44,416
)
See accompanying notes to condensed consolidated financial statements
4
REALNETWORKS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
Nine Months Ended
September 30,
2002
2001
$
(35,896
)
(62,943
)
8,716
9,026
930
28,189
5,384
2,673
14,725
19,970
5,103
25,342
—
1,391
5,585
(7,530
)
(2,400
)
—
(1,336
)
(6,985
)
811
9,133
(4,700
)
(12,089
)
(467,682
)
(554,570
)
469,145
540,306
(2,675
)
(18,878
)
—
1,500
3,312
—
(2,422
)
(1,858
)
(5,022
)
(45,589
)
(21,250
)
(750
)
6,822
6,835
(14,428
)
6,085
10
(570
)
(18,629
)
(30,941
)
104,182
147,885
85,553
116,944
239,000
231,263
$
324,553
348,207
$
1,003
—
See accompanying notes to condensed consolidated financial statements
5
REALNETWORKS, INC. AND SUBSIDIARIES
NOTE 1 — SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
(a) Description of Business
RealNetworks, Inc. and subsidiaries (RealNetworks or Company) is a leading global provider of software products and services for Internet media delivery. The Company develops and markets software products and services designed to enable users of personal computers and other consumer electronic devices to send and receive audio, video and other multimedia services using the Web.
Inherent in the Company’s business are various risks and uncertainties, including its limited operating history and the limited history of commerce on the Internet. The Company’s success may depend in part upon the emergence of the Internet and corporate intranets as a communications medium, the acceptance of the Company’s technology and services by the marketplace and the Company’s ability to generate license, service and advertising revenues from the use of its technology and services on the Internet.
(b) Basis of Presentation
The accompanying unaudited condensed consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation.
These financial statements reflect all adjustments, consisting only of normal, recurring adjustments that, in the opinion of the Company’s management, are necessary for a fair presentation of the results of operations for the periods presented. Operating results for the quarter and nine months ended September 30, 2002 are not necessarily indicative of the results that may be expected for any subsequent quarter or for the year ending December 31, 2002. Certain information and disclosures normally included in financial statements prepared in conformity with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission.
These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and related notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2001.
(c) Cash, Cash Equivalents and Short-Term Investments
Cash, cash equivalents and short-term investments are comprised of the
following (in thousands):
September 30, 2002
December 31, 2001
$
85,553
104,182
239,000
240,327
$
324,553
344,509
$
17,300
17,300
Restricted cash equivalents represent (a) a restricted escrow account of $10,000,000 established in connection with a lease agreement for the Company’s corporate headquarters that will be maintained for the term of the lease, and (b) cash equivalents held as collateral against a $7,300,000 letter of credit with a bank which represents collateral on the lease of a building located near the Company’s corporate headquarters.
6
The majority of short-term investments mature within twelve months from the date of purchase.
The Company has classified all marketable debt and equity securities for which there is a determinable fair market value and there are no restrictions on the Company’s ability to sell within the next twelve months as available-for-sale. Available-for-sale securities are carried at fair value, with unrealized gains and losses reported as a separate component of shareholders’ equity, net of applicable income taxes. Realized gains and losses and declines in value judged to be other-than-temporary on available-for-sale securities are included in other income (expense). The cost basis for determining realized gains and losses on available-for-sale securities is determined using the specific identification method. In instances where there are multiple cost bases for the same security, the Company uses the average cost method in determining the cost of the security sold.
(d) Other Investments
The Company has investments that are accounted for under the cost method of accounting. The cost method is used to account for equity investments in companies in which the Company holds less than a 20 percent voting interest, does not exercise significant influence and the related securities do not have a quoted market price.
The Company also has investments that are accounted for under the equity method of accounting. Under the equity method of accounting, the Company’s share of the investee’s earnings or loss is included in the Company’s consolidated operating results. In cases where the Company has loaned the investee funds and is the only source of financing, the Company may record more than its relative share of the investee’s losses.
(e) Revenue Recognition
The Company recognizes revenue pursuant to the requirements of Statement of Position No. 97-2, “Software Revenue Recognition” (SOP 97-2), as amended by Statement of Position No. 98-9, “Software Revenue Recognition with Respect to Certain Arrangements.”
Under SOP 97-2, revenue attributable to an element in a customer arrangement is recognized when persuasive evidence of an arrangement exists and delivery has occurred, provided the fee is fixed or determinable, collectibility is probable and the arrangement does not require significant customization of the software. If at the outset of the customer arrangement, the Company determines that the arrangement fee is not fixed or determinable or that collectibility is not probable, the Company defers the revenue and recognizes the revenue when the arrangement fee becomes due and payable.
For multiple element arrangements when Company-specific objective evidence of fair value exists for all of the undelivered elements of the arrangement, but does not exist for one or more of the delivered elements in the arrangement, the Company recognizes revenue under the residual method. Under the residual method, at the outset of the arrangement with a customer, the Company defers revenue for the fair value of its undelivered elements such as consulting services and product support and upgrades, and recognizes the revenue for the remainder of the arrangement fee attributable to the elements initially delivered, such as software licenses, when the criteria in SOP 97-2 have been met. If specific objective evidence does not exist for an undelivered element in a software arrangement, which, for the Company, typically relates to the development of complex content delivery networks which include software licenses, consulting services and product support, revenue is recognized over the term of the support period commencing upon delivery of the Company’s technology to the customer.
Revenue from software license agreements with original equipment manufacturers (OEM) is recognized when the OEM delivers its product incorporating the Company’s software to the end user. In the case of prepayments received from an OEM, the Company generally recognizes revenue based on the actual products sold by the OEM. If the Company provides ongoing support to the OEM in the form of future upgrades, enhancements or other services over the term of the contract, revenue is recognized ratably over the term of the contract.
Service revenues include GoldPass/RealOne and standalone media subscription services, payments under support and upgrade contracts, fees from consulting services and streaming media content hosting. Media subscription service revenues are recognized ratably over the period that services are provided. Support and upgrade revenues are recognized ratably over the term of the contract, which typically is twelve months. Other service revenues are recognized when the services are performed.
7
Fees generated from advertising appearing on the Company’s Web sites, and from advertising included in the Company’s products and e-commerce and other links in the RealPlayer, RealJukebox and GoldPass/RealOne products, are recognized as revenue over the terms of the contracts. The Company may guarantee a minimum number of advertising impressions, click-throughs or other criteria on the Company’s Web sites or products for a specified period. To the extent these guarantees are not met, the Company defers recognition of the corresponding revenues until guaranteed delivery levels are achieved.
(f) Net Income (Loss) Per Share
Basic net income (loss) per share is computed by dividing net income (loss) by the weighted average number of common shares outstanding during the period. Diluted net income per share is computed by dividing net income by the weighted average number of common and dilutive common equivalent shares outstanding during the period.
Excluded from the computation of diluted net income (loss) per share for the quarter and nine months ended September 30, 2002 are options and warrants to acquire approximately 36,589,000 shares of common stock with a weighted-average exercise price of $7.24. Also excluded in the quarter and nine months ended September 30, 2002, are approximately 407,000 shares of common stock issued in acquisitions that are subject to repurchase by the Company at a nominal price in certain circumstances. Excluded from the computation of diluted net loss per share for the quarter and nine months ended September 30, 2001 are options and warrants to acquire approximately 35,840,000 shares of common stock with a weighted-average exercise price of $7.87. Also excluded in the quarter and nine months ended September 30, 2001, are approximately 274,000 shares of common stock issued in acquisitions that are subject to repurchase by the Company at a nominal price in certain circumstances. Such potentially dilutive securities are excluded, as their effects are anti-dilutive.
(g) Derivative Financial Instruments
The Company conducts business internationally in several currencies. As such, it is exposed to adverse movements in foreign currency exchange rates. A portion of this risk is managed using derivative financial instruments, but fluctuations could impact the Company’s results of operations and financial position. The Company’s foreign currency exchange risk management program reduces, but does not eliminate, the impact of currency exchange rate movements.
Generally, the Company’s practice is to manage the majority of its material foreign exchange exposures associated with short-term intercompany balances through the use of foreign currency forward exchange contracts. These contracts require the Company to exchange currencies at rates agreed upon at the contract’s inception. Because the impact of movements in currency exchange rates on forward contracts offsets the related impact on the short-term intercompany balances, these financial instruments help alleviate the risk that might otherwise result from certain changes in currency exchange rates. The Company does not designate its foreign exchange forward contracts related to short-term intercompany accounts as hedges and, accordingly, the Company adjusts these instruments to fair value through results of operations. However, the Company may periodically hedge a portion of its foreign exchange exposures associated with material firmly committed transactions and long-term investments.
All derivatives, whether designated in hedging relationships or not, are recorded on the balance sheet at fair value. If the derivative is designated a hedge, then depending on the nature of the hedge, changes in fair value will either be offset against the change in fair value of the hedged assets, liabilities, or firm commitments through results of operations, or be recognized in other comprehensive income until the hedged item is recognized in results of operations.
At September 30, 2002, the following foreign currency contracts were
outstanding and recorded at fair value (in thousands):
Contract Amount
Contract Amount
(Local Currency)
(US Dollars)
Fair Value
(GBP)500
$
760
$
17
(YEN)276,125
$
2,332
$
74
8
No derivative instruments were outstanding at September 30, 2002, which were designated as hedges for accounting purposes.
(h) Comprehensive Loss
The Company’s comprehensive loss for the quarters and nine months ended September 30, 2002 and 2001 consisted of net loss, net unrealized gains and losses on investments and the gross amount of foreign currency translation adjustments. The tax effect of the foreign currency translation adjustments and unrealized gains and losses on investments has been taken into account if applicable.
The components of accumulated other comprehensive income (loss) are as follows
(in thousands):
September 30,
December 31,
2002
2001
$
(146
)
57,027
(543
)
(564
)
$
(689
)
56,463
(i) New Accounting Policies
The Company adopted Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets” (SFAS 142) effective January 1, 2002. The impact of adopting SFAS 142 is discussed in Note 3.
In October 2001, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (SFAS 144), which is effective for fiscal years beginning after December 15, 2001. SFAS 144 supersedes certain provisions of APB Opinion No. 30 “Reporting the Results of Operations-Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions” and supersedes SFAS 121. The Company adopted SFAS 144 as of January 1, 2002. The adoption of SFAS 144 did not affect the Company’s consolidated financial position or results of operations.
In June 2002, the FASB issued Statement of Financial Accounting Standards No. 146, “Accounting for Costs Associated with Exit or Disposal Activities” (SFAS 146), which is effective for fiscal years beginning after December 31, 2002, with early application encouraged. SFAS 146 supercedes Emerging Issues Task Force Issue No. 94-3, “Liabilities Recognized for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).” The Company does not expect the adoption of SFAS 146 to have a material effect on its consolidated financial position or results of operations.
NOTE 2 — SEGMENT INFORMATION
The Company has one reporting segment, media delivery, for which the Company receives revenues from its customers. The Company’s Chief Operating Decision Maker is considered to be the Company’s Chief Executive Officer, President and Chief Financial Officer. The Chief Executive Officer, President and Chief Financial Officer review financial information presented on a consolidated basis accompanied by disaggregated information about products and services and geographical regions for purposes of making decisions and assessing financial performance. The Chief Executive Officer, President and Chief Financial Officer do not review discrete financial information regarding profitability of the Company’s different products or services and, therefore, the Company has only one operating segment as defined by Statement of Financial Accounting Standards No. 131, “Disclosure About Segments of an Enterprise and Related Information.”
The Company’s customers consist primarily of end users located in the United States and various foreign countries. Revenues by geographic region are as follows (in thousands):
9
Quarters Ended September 30,
Nine Months Ended September 30,
2002
2001
2002
2001
$
34,048
33,108
98,310
100,961
6,078
5,815
20,313
21,508
4,447
4,983
14,697
14,384
845
1,322
3,148
6,614
$
45,418
45,228
136,468
143,467
The Company generates revenues from four different product types: consumer license and service, consumer subscription services, systems and advertising. Consumer license and service revenues are derived from sales of the Company’s RealPlayer Plus, RealJukebox Plus and other related products, revenues from support and maintenance services that the Company sells to customers who purchase these products and third-party products, including games. Consumer subscription services revenues consist of the Company’s RealOne and related subscription services. Systems revenues are derived from sales of the Company’s media delivery software, including RealServers and Helix system software and related authoring and publishing tools, support and maintenance services sold to customers who purchase these products, broadcast hosting services provided through the Company’s Real Broadcast Network and consulting services the Company offers to its customers. Advertising revenues are derived from sales of advertising on the Company’s Web sites and client software and within the media streams that the Company hosts on behalf of its corporate customers.
Revenues from external customers by product type are as follows (in thousands):
Quarters Ended September 30,
Nine Months Ended September 30,
2002
2001
2002
2001
$
6,820
11,008
23,500
35,933
21,398
7,970
52,820
18,118
15,538
23,819
55,309
76,799
1,662
2,431
4,839
12,617
$
45,418
45,228
136,468
143,467
Long-lived assets by geographic location are as follows (in thousands):
September 30,
December 31,
2002
2001
$
92,024
92,551
564
627
159
180
$
92,747
93,358
NOTE 3 — BUSINESS COMBINATIONS, GOODWILL AND INTANGIBLE ASSETS
In April 2002, the Company acquired, for cash and common stock valued at approximately $5.1 million, a privately held company engaged in the business of developing Internet media software and technology. The purchase price includes amounts payable to certain former shareholders of the acquired company who are eligible to receive additional cash and common stock valued at approximately $3.1 million over a thirty-month period provided that they remain employed by RealNetworks during such period. These costs will be recognized as compensation cost over the related employment period. The acquisition was accounted for as a purchase transaction and, accordingly, RealNetworks’ results include the results for the acquired company since the transaction date. Goodwill of $2.3 million and acquired technology of $0.9 million were recorded as a result of the acquisition. The Company had previously made an equity investment in the acquired company and its investment balance at the time of acquisition was included in the purchase price allocation. Pro forma results are not presented, as they are not material to the Company’s overall financial statements.
10
Goodwill amortization, acquisition charges and stock based compensation
are as follows (in thousands):
Quarters Ended
Nine Months Ended
September 30,
September 30,
2002
2001
2002
2001
$
—
12,489
—
37,684
398
361
930
(9,895
)
$
398
12,850
930
27,789
In July 2001, the FASB issued Statement of Financial Accounting Standards No. 141, “Business Combinations” (SFAS 141), and SFAS 142. SFAS 141 requires that the purchase method of accounting be used for all business combinations initiated after June 30, 2001 as well as all purchase method business combinations completed after June 30, 2001. SFAS 141 also specifies certain criteria that intangible assets acquired in a purchase method business combination must meet in order to be recognized and reported apart from goodwill. SFAS 142 requires that goodwill and intangible assets with indefinite useful lives no longer be amortized, but instead be tested for impairment at least annually in accordance with the provisions of SFAS 142. SFAS 142 also requires that intangible assets with definite useful lives be amortized over their respective estimated useful lives to their estimated residual values, and reviewed for impairment in accordance with Statement of Financial Accounting Standards No. 121, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of” (SFAS 121), which was superceded by SFAS 144.
The provisions of SFAS 141 were adopted effective July 1, 2001. No business combinations were completed during the period from July 1, 2001 to December 31, 2001. Goodwill and intangible assets acquired in business combinations completed before July 1, 2001 have been amortized through December 31, 2001.
As of January 1, 2002, the Company had no recorded intangible assets apart from goodwill of $57.8 million, net of accumulated amortization. During the quarter ended March 31, 2002, the Company completed its transitional goodwill impairment test. Based upon the Company’s analysis, there was no impairment of goodwill upon adoption of SFAS 142 on January 1, 2002. The Company plans to conduct its annual impairment testing during the fourth quarter of each year. As of September 30, 2002, goodwill net of accumulated amortization was $60.1 million and acquired technology was $0.9 million, which is being amortized at $0.3 million per year.
Net loss and loss per share for the quarter and nine months ended
September 30, 2001 adjusted to exclude goodwill amortization expense are as
follows (in thousands, except per share data):
Quarter Ended
Nine Months Ended
September 30, 2001
September 30, 2001
$
(19,380
)
(62,943
)
12,348
37,044
$
(7,032
)
(25,899
)
$
(0.12
)
(0.39
)
0.08
0.23
$
(0.04
)
(0.16
)
Net loss and net loss per share for the years 2001, 2000 and 1999 adjusted to exclude goodwill amortization expense are as follows (in thousands, except per share data):
11
2001
2000
1999
$
(74,763
)
(110,121
)
6,926
49,391
42,413
2,128
$
(25,372
)
(67,708
)
9,054
$
(0.47
)
(0.72
)
0.05
0.31
0.28
0.01
$
(0.16
)
(0.44
)
0.06
$
(0.47
)
(0.72
)
0.04
0.31
0.28
0.01
$
(0.16
)
(0.44
)
0.05
NOTE 4 — OTHER INVESTMENTS
RealNetworks has made minority equity investments for business and strategic purposes through the purchase of voting capital stock of companies. The Company’s investments in publicly traded companies are accounted for as available-for-sale, carried at current market value and are classified as long-term as they are strategic in nature. The Company periodically evaluates whether declines in fair value, if any, of its investments are other-than-temporary. This evaluation consists of a review of qualitative and quantitative factors. For investments with publicly quoted market prices, these factors include the time period and extent for which the quoted market price is less than its accounting basis. The Company also considers other factors to determine whether declines in fair value are other-than-temporary, such as the investee’s financial condition, results of operations and operating trends. The evaluation also considers publicly available information regarding the investee companies. For investments in private companies with no quoted market price, the Company considers similar qualitative and quantitative factors and also considers the implied value from any recent rounds of financing completed by the investee. During 2001, certain of the Company’s investments were written down to fair value based upon the Company’s analysis that the declines in fair value were other-than-temporary resulting in impairment charges of $2.5 million and $25.3 million for the quarter and nine months ended September 30, 2001, respectively. Based upon an evaluation of the facts and circumstances at September 30, 2002, the Company determined that other-than-temporary declines in fair value had occurred for two of its privately held investments. As a result, impairment charges of $4.4 million were recorded in the quarter ended September 30, 2002 to reflect changes in the fair value of these investments in results of operations. Additionally, during the quarter ended June 30, 2002, the Company determined that other-than-temporary declines in fair value had occurred for three of its publicly traded investments. Impairment charges for other-than-temporary declines in the fair value of investments for the nine months ended September 30, 2002 were $5.1 million.
As of September 30, 2002, the Company owned marketable equity securities of a Japanese company, representing approximately 14% of the investee’s outstanding shares, accounted for as available-for-sale securities. The market value of these shares has increased from the Company’s original cost resulting in a carrying value at September 30, 2002 of $17.3 million. The increase over the Company’s cost basis, net of tax effects, is reflected as a component of accumulated other comprehensive income (loss). During the nine months ended September 30, 2002, the Company sold a portion of its holdings recognizing a gain of $2.4 million which was reclassified from accumulated other comprehensive income (loss) to net loss. Excluding the effect of this sale, the fair value of the Company’s investment declined by $54.6 million during the nine months ended September 30, 2002. This decline is reflected as a component of other comprehensive loss. The market for the investee’s shares is relatively limited, the share price is volatile and the investment is strategic in nature. Accordingly, there can be no assurance that a gain can be realized through the disposition of these shares.
NOTE 5 — INVESTMENT IN MUSICNET
In 2001, the Company announced the formation of MusicNet, Inc. (MusicNet), a venture with four media companies to create a platform for online music subscription services. MusicNet, which previously was a subsidiary of the Company, issued additional shares of
12
capital stock in April and July 2001 reducing the Company’s ownership interest. The Company’s investment in MusicNet is accounted for under the equity method of accounting. As a result, the Company records in its statement of operations its equity share in MusicNet’s net income (loss) which was a loss of $1.6 million and $5.1 million for the quarter and nine months ended September 30, 2002, respectively. In July 2002, the Company and the other investors contributed additional capital to MusicNet to fund its business. The Company received a convertible note, convertible into additional shares of MusicNet capital stock, in exchange for its additional investment. The Company anticipates that MusicNet will continue to incur losses in the foreseeable future and will require additional funding to support the development of its business model. Based on the nature and terms of the convertible note, in the quarter ended September 30, 2002, for purposes of calculating the Company’s equity in net loss of MusicNet, the convertible note was treated on an “as if” converted basis. For the quarter ended September 30, 2002, the loss of $1.6 million recorded by the Company represents 36.8% of MusicNet’s quarterly loss. As of September 30, 2002, the Company’s ownership interest in MusicNet was approximately 28.6% and the carrying value for its investment was $6.4 million. In the quarter and nine months ended September 30, 2002, the Company recognized approximately $315,000 and $1,053,000, respectively, of revenue related to agreements with MusicNet and was reimbursed $0 and $124,000 for the quarter and nine months ended September 30, 2002, respectively, for certain administrative services provided to MusicNet on a transitional basis, which has been accounted for as a reduction of related expenses.
NOTE 6 — LOSS ON EXCESS OFFICE FACILITIES
In October 2000, the Company entered into a 10-year lease agreement for additional office space located near its corporate headquarters in Seattle, Washington. During 2001, the Company re-evaluated its facilities requirements and, as a result, decided to permanently sublet all of this office space. The market for office space in Seattle has significantly declined from the date the Company entered into this lease. As a result, the Company recorded losses of $5.6 million and $22.2 million during the quarter and nine months ended September 30, 2001, respectively. For the nine months ended September 30, 2001, these losses represented approximately $15.2 million of rent and operating expenses over the remaining life of the lease, net of expected sublease income and approximately $7.0 million for the write-down of leasehold improvements to their estimated fair value. The Company’s estimates are based upon many factors including projections of sublease rates and the time period required to locate tenants. During the quarter ended September 30, 2002, the Seattle real estate market continued to display significant weakness, which is reflected in both increasing vacancy rates and declining rental rates. Based on discussions with prospective tenants, the Company concluded that the excess office facilities are not likely to be sublet at rates used in the original loss estimates. As a result, the Company recorded additional losses of $17.2 million during the quarter and nine months ended September 30, 2002. The Company regularly evaluates the market for office space in Seattle. If the market for such space declines further in future periods, the Company may have to revise its estimates which may result in additional losses on excess office facilities.
A summary of activity for the accrued loss on excess office facilities is
as follows (in thousands):
$
12,437
17,207
(2,482
)
$
27,162
NOTE 7 — PERSONNEL REDUCTION, RESTRUCTURING, AND RELATED CHARGES
In August 2002, the Company implemented a restructuring plan to reduce costs, which included reducing its staffing levels by approximately 10%, closing selected offices, and canceling its annual user conference. The Company recorded a charge of approximately $3.6 million during the quarter ended September 30, 2002 to reflect costs associated with implementing this plan. These costs were primarily related to severance payments, but also included other miscellaneous costs such as professional fees, outplacement services for terminated employees, office closures, and tradeshow deposit forfeitures, all of which were incurred as of September 30, 2002. The Company expects payments for restructuring costs to be completed in 2003. In July 2001, the Company reduced its staffing levels by approximately 15%. The Company recorded a charge of approximately $3.9 million during the quarter ended September 30, 2001 to reflect costs associated with implementing the staff reduction.
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A summary of activity for the 2002 personnel reduction, restructuring, and
related charges is as follows (in thousands):
Professional
Office
Tradeshow
Severance
Services
Closures
Deposits
Total
$
—
295
—
—
295
1,721
395
966
513
3,595
(1,621
)
(588
)
(118
)
(419
)
(2,746
)
$
100
102
848
94
1,144
NOTE 8 — REPURCHASE OF COMMON STOCK
The Company’s Board of Directors authorized the repurchase of up to an aggregate of $50 million of the Company’s outstanding common stock. Any purchases of common stock under the share repurchase program will be made from time-to-time, in the open market, through block trades or otherwise. Depending on market conditions and other factors, these purchases may be commenced or suspended at any time without prior notice. During the nine months ended September 30, 2002, the Company repurchased approximately 4.3 million shares at an average cost of $4.77 per share for a total of $20.4 million. Since the program’s inception, the Company has repurchased approximately 6.7 million shares at an average cost of $4.95 per share for a total of $33.2 million.
NOTE 9 — LITIGATION
In August 1998, Venson M. Shaw and Steven M. Shaw filed a lawsuit against the Company and co-defendant Broadcast.com in the United States District Court for the Northern District of Texas — Dallas Division. The plaintiffs allege that the Company, individually and in combination with Broadcast.com, infringes on a certain patent by making, using, selling and/or offering to sell software products and services directed to media delivery systems for the Internet and corporate intranets. The plaintiffs seek to enjoin the Company from the alleged infringing activity and to recover damages in an amount no less than a reasonable royalty. The Company may be required to indemnify Broadcast.com under the terms of its license agreement. The plaintiffs filed a similar claim based on the same patent and seeking similar remedies as a separate lawsuit against Microsoft and Broadcast.com in the same court. The court has consolidated the lawsuit against Microsoft and Broadcast.com with the lawsuit against the Company and Broadcast.com. If the plaintiffs prevail in their claims, the Company could be required to pay damages or other royalties, in addition to complying with injunctive relief, which could have a material adverse effect on the Company’s operating results. Although no assurance can be given as to the outcome of this lawsuit, the Company believes that the allegations in this action are without merit, and intends to vigorously defend itself against these claims. Accordingly, no amounts have been accrued for this matter at September 30, 2002. The Company believes the ultimate outcome will not have a material adverse effect on its financial position or results of operations.
Between November 1999 and March 2000, fourteen lawsuits were filed against the Company in federal and/or state courts in California, Illinois, Pennsylvania, Texas and Washington. The plaintiffs have voluntarily dismissed all of the state court cases with the exception of the case pending in California. The remaining actions, which seek to certify classes of plaintiffs, allege breach of contract, invasion of privacy, deceptive trade practices, negligence, fraud and violation of certain federal and state laws in connection with various communications features of the Company’s RealPlayer and RealJukebox products. Plaintiffs are seeking both damages and injunctive relief. The Company has filed answers denying the claims and has filed suit in Washington State Court to compel the state court plaintiffs to arbitrate the claims as required by the Company’s End User License Agreements. The Washington State Court has granted the Company’s motion to compel arbitration. However, the California trial court has entered an order stating that it is not bound by the Washington court’s decision. That order is currently under review by the California Court of Appeal. On February 10, 2000, the federal Judicial Panel on Multidistrict Litigation transferred all pending federal cases to the federal district court for the Northern District of Illinois. On the same day, that court granted RealNetworks’ motion to stay the court proceedings because the claims are subject to arbitration under RealNetworks’ End User License Agreement. Although no assurance can be
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given as to the outcome of these lawsuits, the Company believes that the allegations in these actions are without merit, and intends to vigorously defend itself. Accordingly, no amounts have been accrued for this matter as of September 30, 2002. The Company believes the ultimate outcome will not have a material adverse effect on its financial position or results of operations. If the plaintiffs prevail in their claims, the Company could be required to pay damages or other penalties in addition to complying with injunctive relief, which could harm the Company’s business and its operating results.
From time to time RealNetworks is, and expects to continue to be, subject to legal proceedings and claims in the ordinary course of its business, including employment claims, contract-related claims and claims of alleged infringement of third-party patents, trademarks and other intellectual property rights. These claims, even if not meritorious, could force the Company to spend significant financial and managerial resources. The Company currently has a number of such claims threatened against it relating to intellectual property infringement or employment, though it believes these claims are without merit. In July 2002, a lawsuit was filed against the Company in federal court in Boston alleging that the Company willfully infringes certain patents relating to “the downloading of data from a server computer to a client computer.” The plaintiff seeks to enjoin the Company from the alleged infringing activity and to recover treble damages arising from the alleged infringement. The Company has filed a counterclaim against the plaintiff seeking a declaratory judgment that the patents at issue are invalid and unenforceable due to plaintiff’s inequitable conduct, as well as its reasonable attorneys fees and costs. Although no assurance can be given as to the outcome of this lawsuit, the Company believes that the plaintiff’s allegations in this action are without merit and intends to vigorously defend itself against these claims. The Company is not aware of any legal proceedings or claims that the Company believes will have, individually or taken together, a material adverse effect on the Company’s business, prospects, financial condition or results of operations. However, the Company may incur substantial expenses in defending against third party claims. In the event of a determination adverse to the Company, the Company may incur substantial monetary liability, and/or be required to change its business practices. Either of these could have a material adverse effect on the Company’s financial position and results of operations.
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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The discussion in this report contains forward-looking statements that involve risks and uncertainties. We have identified a number of these forward-looking statements in the section below entitled “Special Note Regarding Forward-Looking Statements.” RealNetworks’ actual results could differ materially from those discussed below. Factors that could cause or contribute to such differences include, but are not limited to, those identified below, and those discussed in the section titled “Factors that May Affect Our Business, Future Operating Results and Financial Condition”, included elsewhere in this Report. You should also carefully review the risk factors set forth in other reports or documents that RealNetworks files from time to time with the Securities and Exchange Commission, particularly our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q and any Current Reports on Form 8-K.
OVERVIEW
RealNetworks is a leading global provider of software products and services for Internet media delivery. We develop and market software products and services designed to enable users of personal computers and other consumer electronic devices to send and receive audio, video and other multimedia services using the World Wide Web.
We were incorporated in February 1994 and were in the development stage until July 1995, when we released the commercial version of RealAudio Version 1.0, the first version of our RealPlayer products. In August 1996, we began selling RealPlayer Plus, a premium version of our RealPlayer product. Since its initial release, RealPlayer has been available for download free of charge from our websites. In December 1997, we released the commercial version of RealSystem Version 5.0, a streaming media solution that included RealAudio and RealVideo technology. In September 1999, we released the commercial versions of RealJukebox and RealJukebox Plus, a personal music management system. In August 2000, we released the gold version of RealPlayer 8, RealJukebox 2 and launched RealPlayer GoldPass, a for-pay media subscription service available to RealPlayer Plus customers. In March 2001, we introduced RealArcade, a new end-to-end platform for the digital distribution of PC games benefiting both developers and consumers. In June 2001, we launched RealSystem Media Commerce Suite, a platform for Internet media commerce that is intended to provide a universal platform for secure distribution of digital movies, music, and other content. In December 2001, we launched our RealOne subscription service which incorporates our RealPlayer and RealJukebox products together with a new media browser and value-added services to create a multi-dimensional media experience for consumers. In June 2002, we launched RealOne Europe, a European edition of our RealOne subscription service. In July 2002, we launched Helix, an open, comprehensive Internet media delivery platform and community to enable creation of digital media products and applications for any format, operating system or device. In September 2002, we launched RealOne Player Version 2.0.
We report revenues in three categories:
| - | Software license fees, which include revenues from sales of our RealPlayer Plus and RealJukebox Plus and other related products, and sales of our media delivery system software, including RealServers and Helix system software, and related authoring and publishing tools, both directly to customers and indirectly through OEM channels, and sales of third-party products, including games. | |
| - | Service revenues, which include revenues from RealPlayer GoldPass/RealOne subscription services, including our RealOne Music subscription service, support and maintenance services that we sell to customers who purchase our RealPlayer Plus and RealJukebox Plus and other related products, and who purchase our media delivery system software including RealServers and Helix system software, and related authoring and publishing tools, broadcast hosting services we provide through our Real Broadcast Network and consulting services we offer to our customers. | |
| - | Advertising revenues, which are derived from sales of advertising on our Web sites and client software and within the media streams that we host on behalf of our corporate customers. |
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Our critical accounting policies and estimates are as follows:
| • | Revenue recognition | ||
| • | Estimating sales returns and the allowance for doubtful accounts | ||
| • | Estimating losses on excess office facilities |
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| • | Determining whether declines in the fair value of investments are other-than-temporary and estimating fair market value of investments in privately held companies | ||
| • | Valuation of goodwill | ||
| • | Valuation of deferred income tax assets |
Revenue Recognition
As described below, significant management judgments and estimates must be made and used in connection with the revenue recognized in any accounting period. Material differences may result in the amount and timing of our revenue for any period if our management made different judgments or utilized different estimates.
We recognize revenue pursuant to the requirements of Statement of Position No. 97-2, “Software Revenue Recognition” (SOP 97-2), as amended by Statement of Position No. 98-9, “Software Revenue Recognition with Respect to Certain Arrangements.” Under SOP 97-2, revenue attributable to an element in a customer arrangement is recognized when persuasive evidence of an arrangement exists and delivery has occurred, provided the fee is fixed or determinable, collectibility is probable and the arrangement does not require significant customization of the software.
For all sales, except those completed via credit card transactions through the Internet, we use either a binding purchase order or signed agreement, depending on the nature of the transaction, as evidence of an arrangement. For sales made via the Internet, we use the customer’s authorization to charge their credit card as evidence of an arrangement. Sales through our distributors are evidenced by a master agreement governing the relationship together with binding purchase orders on a transaction by transaction basis.
For software license fees in single element arrangements and multiple element arrangements which do not include customization or consulting services, delivery typically occurs when the product is made available to the customer for download or when products are shipped to customers. For service and advertising revenues, delivery typically occurs when services have been performed.
At the time of each transaction, we assess whether the fee associated with our revenue transactions is fixed and determinable and whether or not collection is reasonably assured. We assess whether the fee is fixed and determinable based on the payment terms associated with the transaction. If a significant portion of a fee is due after our normal payment terms, is based upon a variable matrix such as a minimum level of distribution or is subject to refund, we account for the fee as not being fixed and determinable. In these cases, we defer revenue and recognize it when it becomes due and payable.
We assess the probability of collection based on a number of factors, including past transaction history and the current financial condition of the customer. We do not request collateral from our customers but often require payments before or at the time products and services are delivered. If we determine that collection of a fee is not reasonably assured, we defer revenue until the time collection becomes reasonably assured, which is generally upon receipt of cash.
For multiple element arrangements, when company-specific objective evidence of fair value exists for all of the undelivered elements of the arrangement, but does not exist for one or more of the delivered elements in the arrangement, we recognize revenue under the residual method. Under the residual method, at the outset of the arrangement with a customer, we defer revenue for the fair value of its undelivered elements such as consulting services and product support and upgrades, and recognize the revenue for the remainder of the arrangement fee attributable to the elements initially delivered, such as software licenses, when the criteria in SOP 97-2 have been met. Company-specific objective evidence is established for support and upgrades of standard products for which no installation or customization is required based upon the amounts we charge when support and upgrades are sold separately. Company-specific objective evidence is established for consulting and installation services based on the hourly rates we charge for our employees when they are performing these services provided we have the ability to accurately estimate the hours required to complete a project based upon our experience with similar projects. For multiple element arrangements involving installation or customization, company-specific objective evidence is established for support and maintenance arrangements if our customers have an optional annual renewal rate specified in the arrangement and the rate is substantive.
If specific objective evidence of fair value does not exist for an undelivered element in a software arrangement, which, for us, typically relates to the development of
17
complex content delivery networks which include software licenses, consulting services and product support, revenue is recognized over the term of the support period commencing upon delivery of our technology to the customer. In these cases, delivery is defined as when the content delivery network is installed and operating in accordance with contract specifications.
Revenue from software license agreements with original equipment manufacturers (OEM) is recognized when the OEM delivers its product incorporating our software to the end user. In the case of prepayments received from an OEM, we typically recognize revenue based on the actual products sold by the OEM. If we provide ongoing support to the OEM in the form of future upgrades, enhancements or other services over the term of the contract, revenue is recognized ratably over the term of the contract.
Service revenues include payments under GoldPass/RealOne and standalone media subscription services, support and upgrade contracts and fees from consulting services and streaming media content hosting. Media subscription service revenues are recognized ratably over the period that services are provided. Support and upgrade revenues are recognized ratably over the term of the contract, which typically is twelve months. Other service revenues are recognized when the services are performed.
Fees generated from advertising are recognized as advertising is delivered over the terms of the contracts. We may guarantee a minimum number of advertising impressions, click-throughs or other criteria on our Web sites or products for a specified period. To the extent these guarantees are not met, we defer recognition of the corresponding revenues until guaranteed delivery levels are achieved.
Sales Returns and the Allowance for Doubtful Accounts
The preparation of our consolidated financial statements requires us to make estimates and assumptions that affect the reported amount of assets and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reported period. Specifically, we must make estimates of potential future product returns related to current period product revenue. We analyze historical returns, current economic trends, and changes in customer demand and acceptance of our products when evaluating the adequacy of the sales returns and other allowances. Significant judgments and estimates must be made and used in connection with establishing reserves for sales returns and the allowance for doubtful accounts in any accounting period. Material differences may result in the amount and timing of our revenue for any period if we made different judgments or utilized different estimates. Similarly, we must make estimates of the uncollectibility of our accounts receivables. We specifically analyze the age of accounts receivable and analyze historical bad debts, customer concentrations, customer credit-worthiness and current economic trends when evaluating the adequacy of the allowance for doubtful accounts.
Loss on Excess Office Facilities
We have made significant estimates in determining the appropriate amount of accrued loss on excess office facilities. If we made different estimates, our loss on excess office facilities would be significantly different from that recorded, which could have a material impact on our operating results. We have revised our original estimate twice in the last five quarters. The significant factors we considered in making our estimates are discussed in the following pages under “Loss on Excess Office Facilities.”
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Impairment of Investments
As part of the process of preparing our consolidated financial statements we periodically evaluate whether any declines in the fair value of our investments are other-than-temporary. Significant judgments and estimates must be made to assess whether an other-than-temporary decline in fair value of investments has occurred and to estimate the fair value of investments in privately held companies. See “Other Income (Expense), Net” in the following pages for a discussion of the factors we considered in evaluating whether declines in fair value of our investments were other-than-temporary and the factors we considered in estimating the fair value of investments in private companies.
Valuation of Goodwill
We assess the impairment of goodwill on an annual basis or whenever events or changes in circumstances indicate that the fair value of the reporting unit to which goodwill relates is less than the carrying value. Factors we consider important which could trigger an impairment review include the following:
| • | Poor economic performance relative to historical or projected future operating results; | |
| • | Significant negative industry, economic or company specific trends; | |
| • | Changes in the manner of our use of the assets or the plans for our business; and | |
| • | Loss of key personnel. |
If we were to determine that the fair value of a reporting unit was less than its carrying value, including goodwill, based upon the annual test or the existence of one or more of the above indicators of impairment, we measure impairment based on a comparison of the implied fair value of reporting unit goodwill with the carrying amount of goodwill. The implied fair value of goodwill is determined by allocating the fair value of a reporting unit to its assets (recognized and unrecognized) and liabilities in a manner similar to a purchase price allocation. The residual fair value after this allocation is the implied fair value of reporting unit goodwill. To the extent the carrying amount of reporting unit goodwill is greater than the implied fair value of reporting unit goodwill, we would record an impairment charge for the difference.
Valuation of Deferred Income Tax Assets
In accordance with generally accepted accounting principles, we must periodically assess the likelihood that our deferred tax assets will be recovered from future taxable income and to the extent that recovery is not likely, a valuation allowance must be established. The establishment of a valuation allowance and increases to such an allowance result in either increases to income tax expense or reduction of income tax benefits in the statement of operations. Factors we consider in making such an assessment include, but are not limited to, past performance and our expectation of future taxable income, macro-economic conditions and issues facing our industry, existing contracts, backlog, and our ability to project future results and any appreciation of our investments and other assets.
As of December 31, 2001, we had recorded net deferred tax assets of $5.6 million. Due to the net losses incurred during the nine months ended September 30, 2002, difficult economic conditions facing our industry and our customers and declines in the fair value of our investments, we determined that it was appropriate to increase our valuation allowance to reduce our net deferred tax assets as of September 30, 2002 to zero.
RESULTS OF OPERATIONS
REVENUES
Software License Fees. Software license fees were $15.6 million for the quarter ended September 30, 2002, a decrease of 42% from $26.8 million for the quarter ended September 30, 2001. Software license fees were $57.2 million for the nine months ended September 30, 2002, a decrease of 32% from $84.4 million for the nine months ended September 30, 2001. These decreases are due in part to focusing our consumer promotional activities to feature our RealOne and stand-alone subscription services. In June 2002, we also launched a European edition of our RealOne subscription service. Both of these factors have resulted in a shift of revenue from software license fees to service revenues. Additionally, the English language version of our RealPlayer Plus and RealJukebox Plus products, which have previously contributed significantly to software license fees, are now combined in our RealOne subscription offering, the revenue from which is included in
19
service revenues. We believe that the decreases were also due to continued cutbacks in capital and information technology spending by our customers and potential customers caused by macroeconomic conditions and that these macroeconomic conditions resulted in decreased system software sales during the periods presented. The current economic environment has resulted in many current and potential customers delaying or foregoing purchases, has caused sales cycles to increase and become less predictable and has, in some cases, caused certain customers to adopt the media delivery products of our primary competitor because it bundles its competing media delivery products with its operating system. In particular, customers and potential customers in the systems software and telecommunication industries have become increasingly cautious in their buying decisions due to the difficult macroeconomic conditions in those industries. We believe the macroeconomic environment has also impacted sales to, and the rate of adoption of our systems software products by, customers in the corporate enterprise, broadcast hosting, non-PC device manufacturer and original equipment manufacturer market segments. No assurance can be given when, or if, customers in these markets, particularly telecommunications customers, will begin to increase capital spending levels.
Service Revenues. Service revenues were $28.2 million for the quarter ended September 30, 2002, an increase of 76% from $16.0 million for the quarter ended September 30, 2001. Service revenues were $74.5 million for the nine months ended September 30, 2002, an increase of 60% from $46.4 million for the nine months ended September 30, 2001. The increases in service revenues were primarily attributable to growth in subscribers to our RealOne and stand-alone subscription services, which we launched in December 2001 as the successor to our GoldPass subscription services, partially offset by decreases in other product offerings including content hosting revenues. Our subscription services accounted for approximately $21.4 million and $8.0 million of service revenues for the quarters ended September 30, 2002 and 2001, respectively, and $52.8 million and $18.1 million for the nine months ended September 30, 2002 and 2001, respectively. Reasons for increases in subscription revenues are described in more detail in “Revenues By Product Type — Subscription Services” below. We believe the decreased revenues in our other product offerings, including content hosting, are due primarily to the macro-economic conditions described above in “Software License Fees.”
Advertising. Advertising revenues were $1.7 million for the quarter ended September 30, 2002, a decrease of 32% from $2.4 million for the quarter ended September 30, 2001. Advertising revenues were $4.8 million for the nine months ended September 30, 2002, a decrease of 62% from $12.6 million for the nine months ended September 30, 2001. We believe the decreases in advertising revenues were due to the continued depressed environment for Internet advertising, which resulted in lower volumes and lower average advertising rates.
REVENUES BY PRODUCT TYPE
Consumer . Consumer revenues are derived from sales of our RealPlayer Plus, RealJukebox Plus and other related products, revenues from support and maintenance services that we sell to customers who purchase these products and third-party products, including games. Consumer revenues were $6.8 million for the quarter ended September 30, 2002, a decrease of 38% from $11.0 million for the quarter ended September 30, 2001. Consumer revenues were $23.5 million for the nine months ended September 30, 2002, a decrease of 35% from $35.9 million for the nine months ended September 30, 2001. The decreases were primarily due to a change in focus of our promotional activities to feature our RealOne and stand-alone subscription services over our traditional consumer products. Additionally, as discussed above, the English language version of our RealPlayer Plus and RealJukebox Plus products, which have previously contributed significantly to consumer revenues, are now combined in our RealOne subscription offering, the revenue from which is included in subscription services. In June 2002, we also launched a European edition of our RealOne subscription service which has also caused a shift from consumer revenue to subscription services revenue.
Subscription Services. Subscription services revenues, which consist of our Gold Pass/RealOne and stand-alone subscription services, were $21.4 million for the quarter ended September 30, 2002, an increase of 168% from $8.0 million for the quarter ended September 30, 2001. Subscription services revenues were $52.8 million for the nine months ended September 30, 2002, an increase of 192% from $18.1 million for the nine months ended September 30, 2001. The increases were primarily attributable to the increased focus of our promotional activities on our RealOne and stand-alone subscription services and the related increase in paying subscribers. We believe that the continued increase in the content available to RealOne subscribers has resulted in a broader reach among consumers, thereby leading to greater consumer adoption rates and higher revenues. For example, newly available on our subscription services since the quarter ended September 30, 2001, is content from partners such as ABCNEWS.com, NASCAR, CBS Survivor Insider, CNN, E! Networks, FOXSports.com, Big Brother and others. Additionally, in June 2002 we launched a European edition of our RealOne subscription service with premium content from partners such as BBC, Champions League Soccer from UEFA, Big Brother 3, CNN Europe and MTV Europe. We believe this will continue to cause a shift from consumer revenue
20
to subscription services revenue in the European market. Our subscription services offerings represent a relatively new business model for Internet media delivery and a new business model for us and, to date, we have not faced significant direct competition with these offerings. We cannot predict with accuracy how these subscription offerings will perform in the future, at what rate subscription revenues will grow, if at all, or the nature or potential impact of anticipated competition.
Systems. Systems revenues are derived from sales of our media delivery system software, including RealServers and Helix system software, and related authoring and publishing tools, support and maintenance services that we sell to customers who purchase these products, broadcast hosting services we provide through our Real Broadcast Network and consulting services we offer to our customers. Systems revenues were $15.5 million for the quarter ended September 30, 2002, a decrease of 35% from $23.8 million for the quarter ended September 30, 2001. Systems revenues were $55.3 million for the nine months ended September 30, 2002, a decrease of 28% from $76.8 million for the nine months ended September 30, 2001. We believe the decreases were due primarily to macroeconomic trends that are affecting many Internet-related systems business. These trends include continued cutbacks in capital and information technology spending by our customers and potential customers. The current economic environment has also resulted in many current and potential customers delaying or foregoing purchases, has caused sales cycles to increase and become less predictable and has, in some cases, caused certain customers to adopt the media delivery products of our primary competitor because it bundles its competing media delivery products with its operating system. In particular, customers and potential customers in the systems software and telecommunication industries have become increasingly cautious in their buying decisions due to downturns in those industries. The macroeconomic environment has also impacted sales to, and the rate of adoption of our systems software products by, customers in the corporate enterprise, broadcast hosting, non-PC device manufacturer and original equipment manufacturer market segments. No assurance can be given when, or if, customers in these markets, particularly telecommunications customers, will increase capital spending levels.
Advertising. Advertising revenues were $1.7 million for the quarter ended September 30, 2002, a decrease of 32% from $2.4 million for the quarter ended September 30, 2001. Advertising revenues were $4.8 million for the nine months ended September 30, 2002, a decrease of 62% from $12.6 million for the nine months ended September 30, 2001. See “Revenues— Advertising” above for analysis.
GEOGRAPHIC REVENUES
International revenues represented 25% of total net revenues for the quarter ended September 30, 2002, compared to 27% for the quarter ended September 30, 2001. International revenues represented 28% of total net revenues for the nine months ended September 30, 2002, compared to 30% for the nine months ended September 30, 2001. International revenues decreased as a percentage of total net revenues in the first nine months of 2002 primarily due to the significantly increased U.S.-based subscription services revenue coupled with a significant decline in revenues generated in Latin America as a result of adverse financial conditions in that region. Revenues generated in Europe were 13% of total net revenues for both the quarters ended September 30, 2002 and 2001, and revenues generated in Asia and the rest of the world were 12% of total net revenues for the quarter ended September 30, 2002, compared to 14% for the quarter ended September 30, 2001. Revenues generated in Europe were 15% of total net revenues for the nine months ended September 30, 2002 and 2001, and revenues generated in Asia and the rest of the world were 13% of total net revenues for the nine months ended September 30, 2002, compared to 15% for the nine months ended September 30, 2001. At September 30, 2002, accounts receivable due from international customers represented approximately 14% of trade accounts receivable. The functional currency of our foreign subsidiaries is the local currency of the country in which the subsidiary operates. Results of operations of our foreign subsidiaries are translated from local currency into U.S. dollars based on average monthly exchange rates. We currently manage a portion of our foreign currency exposures through the use of foreign currency exchange forward contracts and therefore are still subject to some risk of changes in exchange rates. Our foreign currency exchange risk management program reduces, but does not eliminate, the impact of currency exchange rate movements. The costs of both domestic and international revenues are substantially the same.
DEFERRED REVENUE
Deferred revenue is comprised of the unrecognized revenue related to support contracts, prepayments under OEM arrangements, and other prepayments for which the earnings process has not been completed. Revenue from contracts with customers developing content delivery networks is generally recognized over the term of the arrangement commencing upon the customer’s deployment of our technology in their network. Because many of the agreements related to the content delivery networks have been with companies that have had
21
limited operating histories, we have historically required prepayments from such customers to mitigate our credit risk. Cash prepayments associated with these contracts are recorded as deferred revenue and amounted to $26.2 million and $27.2 million at September 30, 2002 and December 31, 2001, respectively. The decrease in deferred revenue related to these contracts during the nine months ended September 30, 2002 is primarily due to prepayments received under contracts occurring at a slower rate than recognition of revenue on existing contracts. We believe the decrease has been largely due to the decrease in new systems contracts in recent periods, which represent a significant portion of deferred revenue. We believe the decrease in new systems contracts results primarily from current macroeconomic conditions as discussed in “Revenues by Product Type — Systems” above.
COST OF REVENUES
Cost of Software License Fees. Cost of software license fees includes costs of product media, duplication, manuals, packaging materials, amounts paid for licensed technology, fees paid to third-party vendors for order fulfillment and royalties paid on sales of games and other third-party products. Cost of software license fees was $1.5 million for the quarter ended September 30, 2002, a decrease of 11% from $1.7 million for the quarter ended September 30, 2001, but increased as a percentage of software license fees to 10% for the quarter ended September 30, 2002 from 6% for the quarter ended September 30, 2001. Cost of software license fees was $5.3 million for the nine months ended September 30, 2002, a decrease of 8% from $5.8 million for the nine months ended September 30, 2001, but increased as a percentage of software license fees to 9% for the nine months ended September 30, 2002 from 7% for the nine months ended September 30, 2001. The decrease in costs was due primarily to lower sales in our systems business and a shift from consumer license revenue to subscription services revenue. These decreases reduced royalty and other product fulfillment costs such as shipping and packaging costs. The increase in cost of software license fees as a percentage of software license fees revenue was due to a lower percentage of software license fee revenue from systems licenses, which typically have higher margins than other components of software license fees.
Cost of Service Revenues. Cost of service revenues includes the cost of content included in our RealOne and stand-alone subscription service offerings, cost of in-house and contract personnel providing support and consulting services and expenses incurred in providing our streaming media hosting services. Cost of service revenues was $11.7 million for the quarter ended September 30, 2002, an increase of 93% from $6.1 million for the quarter ended September 30, 2001, and increased as a percentage of service revenues to 42% for the quarter ended September 30, 2002 from 38% for the quarter ended September 30, 2001. Cost of service revenues was $30.0 million for the nine months ended September 30, 2002, an increase of 74% from $17.2 million for the nine months ended September 30, 2001, and increased as a percentage of service revenues to 40% for the nine months ended September 30, 2002 from 37% for the nine months ended September 30, 2001. The increase in costs was primarily due to costs associated with the licensing of media content included in our RealOne and stand-alone subscription services, which has fixed and variable components, as well as increased customer service and technical support costs associated with the growth of our subscription services. Costs of content include our agreements with Major League Baseball, the National Basketball Association, ABCNEWS.com, NASCAR, CBS Survivor Insider, CNN, E! Networks, FOXSports.com, Big Brother and other providers of subscription services media content. The increase in costs for the nine months ended September 30, 2002 were partially offset by credits we received during the quarter ended June 30, 2002, for previous overbilling by bandwidth service providers. The costs of content are expensed over the periods the content is available to our subscription services customers. The increases as a percentage of service revenues for the quarter and nine months ended September 30, 2002 were due to shifts in product mix towards our subscription services, which are characterized by relatively higher costs of revenues than our other service offerings.
Our RealOne and stand-alone subscription services are a relatively new and growing portion of our business and are characterized by relatively higher costs of revenues than our other products and services, primarily due to the cost of licensing media content to provide these services. As a result, if this portion of our business continues to grow as a percentage of revenues, we anticipate that our cost of service revenues may grow at an increased rate relative to net revenues which may continue to lead to reductions in our gross margins in the future.
Cost of Advertising. Cost of advertising includes the cost of personnel associated with maintenance of programming services, content creation and maintenance and ad delivery services. Cost of advertising was $0.5 million for the quarter ended September 30, 2002, a decrease of 68% from $1.4 million for the quarter ended September 30, 2001, and decreased as a percentage of advertising revenues to 27% for the quarter ended September 30, 2002 from 58% for the quarter ended September 30, 2001. Cost of advertising was $1.6 million for the nine months ended September 30, 2002, a decrease of 68% from $5.0 million for the nine
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months ended September 30, 2001, and decreased as a percentage of advertising revenues to 33% for the nine months ended September 30, 2002 from 39% for the nine months ended September 30, 2001. The decrease in costs was primarily due to lower sales volumes and shifting programming personnel to other areas of our business. The decreases in percentage terms for the quarter and nine months ended September 30, 2002 were due to the costs decreasing at a faster rate than the decrease in advertising revenues.
OPERATING EXPENSES
Research and Development. Research and development expenses consist primarily of salaries and related personnel costs, consulting fees associated with product development and costs of technology acquired from third parties to incorporate into products currently under development. To date, all research and development costs have been expensed as incurred because technological feasibility for software products is generally not established until substantially all development is complete. Research and development expenses, excluding non-cash stock based compensation, were $12.3 million for the quarter ended September 30, 2002, a decrease of 2% from $12.5 million for the quarter ended September 30, 2001, and decreased as a percentage of total net revenues to 27% for the quarter ended September 30, 2002 from 28% for the quarter ended September 30, 2001. Research and development expenses, excluding non-cash stock based compensation, were $36.8 million for the nine months ended September 30, 2002, a decrease of 15% from $43.6 million for the nine months ended September 30, 2001, and decreased as a percentage of total net revenues to 27% for the nine months ended September 30, 2002 from 30% for the nine months ended September 30, 2001. The decreases in expenses were primarily due to the effects of a reduction in personnel and related personnel costs in each of the third quarters of 2002 and 2001 as part of an overall plan to reduce costs. The decrease in percentage terms was primarily a result of research and development expenses decreasing at a faster rate than the decrease in net revenues, resulting from organizational efficiencies derived from personnel reductions.
Sales and Marketing. Sales and marketing expenses consist primarily of salaries and related personnel costs, sales commissions, credit card fees, subscriber acquisition costs, consulting fees, trade show expenses, advertising costs and costs of marketing collateral. Sales and marketing expenses, excluding non-cash stock based compensation, were $18.8 million for the quarter ended September 30, 2002, an increase of 7% from $17.5 million for the quarter ended September 30, 2001, and increased as a percentage of total net revenues to 41% for the quarter ended September 30, 2002 from 39% for the quarter ended September 30, 2001. Sales and marketing expenses, excluding non-cash stock based compensation, were $55.5 million for the nine months ended September 30, 2002, a decrease of 1% from $56.0 million for the nine months ended September 30, 2001, but increased as a percentage of total net revenues to 41% for the nine months ended September 30, 2002 from 39% for the nine months ended September 30, 2001. The increase in expenses for the quarter ended September 30, 2002 was primarily due to increased credit card fees and subscriber acquisition costs, both related to our RealOne and stand-alone subscriptions services, partially offset by decreases in sales and marketing expenses related to system software sales. Subscriber acquisition costs increased due to an increase in the number of content partners that refer new subscribers to us via their Websites and a corresponding increase in related payments to such partners. The decrease in expenses for the nine months ended September 30, 2002 was primarily due to the effects of reductions in personnel and contract labor in the third quarter of 2001 and 2002. The increase in percentage terms for the quarter ended September 30, 2002 was a result of sales and marketing expenses increasing at a faster rate than the increase in net revenues, while the increase in percentage terms for the nine months ended September 30, 2002 was a result of sales and marketing expenses decreasing at a slower rate than the rate of the decline in net revenues.
General and Administrative. General and administrative expenses consist primarily of salaries, related personnel costs, and fees for professional and temporary services. General and administrative expenses were $4.6 million for the quarter ended September 30, 2002, a decrease of 11% from $5.1 million for the quarter ended September 30, 2001, and decreased as a percentage of total net revenues to 10% for the quarter ended September 30, 2002 from 11% for the quarter ended September 30, 2001. General and administrative expenses were $14.6 million for the nine months ended September 30, 2002, a decrease of 8% from $15.8 million for the nine months ended September 30, 2001, and were 11% of total net revenues for each of the nine months ended September 30, 2002 and 2001. The decreases in expenses for the quarter and nine months ended September 30, 2002 were primarily due to decreased legal expenses and a reduction in personnel and related personnel costs. The decrease in percentage terms for the quarter ended September 30, 2002 was due to expenses decreasing at a greater rate than the rate of decline in net revenues.
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Loss on Excess Office Facilities. In October 2000, we entered into a 10-year lease agreement for additional office space located near our corporate headquarters in Seattle, Washington. During 2001, we re-evaluated our facilities requirements and, as a result, decided to permanently sublet all of this office space. The market for office space in Seattle has significantly declined from the date we entered into this lease. As a result, we recorded losses of $5.6 million and $22.2 million during the quarter and nine months ended September 30, 2001, respectively. For the nine months ended September 30, 2001, these losses represented approximately $15.2 million of rent and operating expenses over the remaining life of the lease, net of expected sublease income and approximately $7.0 million for the write-down of leasehold improvements to their estimated fair value. During the quarter ended September 30, 2002, the Seattle real estate market continued to display significant weakness, which is reflected in both increasing vacancy rates and declining rental rates. Based on discussions with prospective tenants, we concluded that the excess office facilities are not likely to be sublet at rates used in the original loss estimates. As a result, we recorded additional losses of $17.2 million during the quarter and nine months ended September 30, 2002. Our estimates are based upon many factors including projections of sublease rates and the time period required to locate tenants. As of September 30, 2002, $27.2 million has been accrued for the loss on excess office facilities. We regularly evaluate the market for office space in Seattle. If the market for such space declines further in future periods, we may have to revise our estimates which may result in additional losses on excess office facilities.
Personnel Reduction, Restructuring and Related Charges. In August 2002, we implemented a restructuring plan to reduce costs, which included reducing our staffing levels by approximately 10%, closing selected offices, and canceling our annual user conference. We recorded a charge of approximately $3.6 million during the quarter and nine months ended September 30, 2002 to reflect costs associated with implementing this restructuring. These costs were primarily related to severance payments, but also included other miscellaneous costs such as professional fees, outplacement services for terminated employees, office closures, and tradeshow deposit forfeitures, all of which were incurred as of September 30, 2002. We expect payments to be made under the restructuring plan to be completed in 2003. In July 2001, we reduced our staffing levels by approximately 15%. We recorded a charge of approximately $3.9 million during the quarter and nine months ended September 30, 2001 to reflect costs associated with implementing the staff reduction.
Goodwill Amortization, Acquisition Charges and Stock-Based Compensation. Goodwill amortization, acquisition charges and stock-based compensation for the quarter ended September 30, 2002 were $0.4 million and were $12.9 million for the quarter ended September 30, 2001. Goodwill amortization, acquisition charges and stock-based compensation for the nine months ended September 30, 2002 were $0.9 million and were $27.8 million for the nine months ended September 30, 2001. During the quarter ended March 31, 2002, we completed our transitional goodwill impairment test as required under SFAS 142. Based upon our analysis, we determined that no goodwill impairment had occurred as of January 1, 2002, upon adoption of SFAS 142. Under SFAS 142, goodwill is no longer amortized, but instead tested for impairment at least annually.
In April 2002, we acquired, for cash and common stock valued at approximately $5.1 million, a privately held company engaged in the business of developing Internet media software and technology. The purchase price includes amounts payable to certain former shareholders of the acquired company who are eligible to receive additional cash and common stock valued at approximately $3.1 million over a thirty-month period provided that they remain employed by RealNetworks during such period. These costs will be recognized as compensation cost over the related employment period. The acquisition was accounted for as a purchase transaction and, accordingly, our results include the results for the acquired company since the transaction date. Goodwill of $2.3 million and acquired technology of $0.9 million were recorded as a result of the acquisition. We had previously made an equity investment in the acquired company and our investment balance at the time of acquisition was included in the purchase price allocation. Pro forma results are not presented, as they are not material to our overall financial statements.
Stock-based compensation was $0.4 million for each of the quarters ended September 30, 2002 and 2001. Stock-based compensation for the nine months ended September 30, 2002 was an expense of $0.9 million, compared to a benefit of $(9.9) million for the nine months ended September 30, 2001. The difference was primarily due to the voluntary resignation of certain former employees in the quarter ended June 30, 2001 resulting in a reversal of previously recognized stock compensation expense.
OTHER INCOME (EXPENSE), NET
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Other income (expense), net consists primarily of interest earnings on our cash, cash equivalents and short-term investments, our equity share in the net losses of MusicNet and gains and losses on our equity investments.
For the quarter and nine months ended September 30, 2002, interest income declined from the comparable periods in 2001. The decreases were primarily due to lower effective interest rates and lower investment balances. Lower cash balances were primarily the result of cash used to repurchase our common stock.
MusicNet is a venture formed with four media companies to create a platform for online music subscription services. MusicNet, which previously was a subsidiary, issued additional shares of capital stock in April and July 2001 thereby reducing our ownership interest to approximately 36.8%. We account for our interest in MusicNet using the equity method of accounting. As a result, we record in our statement of operations our equity share in MusicNet’s net income (loss) which was a loss of $1.6 million and $5.1 million for the quarter and nine months ended September 30, 2002, respectively. In July 2002, we and the other investors in MusicNet contributed additional capital to MusicNet to funds its business. We received a convertible note, convertible into additional shares of MusicNet capital stock, in exchange for our additional investment. We anticipate that MusicNet will continue to incur losses in the foreseeable future and will require additional funding to support the development of its business model. Based on the nature and terms of the convertible note, in the quarter ended September 30, 2002, for purposes of calculating our equity in net loss of MusicNet, the convertible note was treated on an “as if” converted basis. As a result, for the quarter ended September 30, 2002, the loss of $1.6 million recorded by us represents 36.8% of MusicNet’s quarterly loss. As of September 30, 2002, our ownership interest in MusicNet was approximately 28.6% and the carrying value for our investment was $6.4 million. In the quarter and nine months ended September 30, 2002, we recognized approximately $315,000 and $1.1 million, respectively, of revenue related to agreements with MusicNet and were reimbursed $0 and $124,000 for the quarter and nine months ended September 30, 2002, respectively, for certain administrative services provided to MusicNet on a transitional basis which has been accounted for as a reduction of related expenses.
We have made minority equity investments for business and strategic purposes through the purchase of voting capital stock of companies. Our investments in publicly traded companies are accounted for as available-for-sale, carried at current market value and are classified as long-term as they are strategic in nature. We periodically evaluate whether any declines in fair value of our investments are other-than-temporary. This evaluation consists of a review of qualitative and quantitative factors. For investments with publicly quoted market prices, these factors include the time period and extent that the quoted market price is less than its accounting basis. We consider additional factors to determine whether declines in fair value are other-than-temporary, such as the investee’s financial condition, results of operations and operating trends. The evaluation also considers publicly available information regarding the investee companies. For investments in private companies with no quoted market price, we consider similar qualitative and quantitative factors and also consider the implied value from any recent rounds of financing completed by the investee. During 2001, certain of these investments were written down to fair value based upon our analysis that the declines in fair value were other-than-temporary resulting in impairment charges of $2.5 million and $25.3 million for the quarter and nine months ended September 30, 2001, respectively. Based upon an evaluation of the facts and circumstances during the quarter and nine months ended September 30, 2002, we determined that other-than-temporary declines in fair value had occurred for two of our privately held investments. As a result, impairment charges of $4.4 million were recorded in the quarter ended September 30, 2002 to reflect changes in the fair value of these investments in the results of operations. Additionally, during the quarter ended June 30, 2002, we determined that other-than-temporary declines in fair value had occurred for three of our publicly traded investments. Impairment charges for other-than-temporary declines in the fair value of investments for the nine months ended September 30, 2002 were $5.1 million.
As of September 30, 2002, we owned marketable equity securities of a Japanese company, representing approximately 14% of the outstanding shares which are accounted for as available-for-sale securities. The market value of these shares has increased from the original cost, resulting in a carrying value at September 30, 2002 of $17.3 million. The increase over our cost basis, net of tax effects, is reflected as a component of accumulated other comprehensive income (loss). During the nine months ended September 30, 2002, we sold a portion of our holdings recognizing a gain of $2.4 million which was reclassified from accumulated other comprehensive income to other income (expense), net. Excluding the effect of this sale, the fair value of our investment declined by $54.6 million during the nine months ended September 30, 2002. The market for this investee’s
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shares is relatively limited, the share price is volatile and our investment is strategic in nature. Accordingly, there can be no assurance that a gain can be realized through the disposition of these shares.
INCOME TAXES
During the quarter and nine months ended September 30, 2002, we recognized income tax expense of $6.0 million related to increasing our valuation allowance for net deferred tax assets. In addition, we did not recognize a deferred tax benefit for losses incurred during the nine months ended September 30, 2002.
We must assess the likelihood that our deferred tax assets will be recovered from future taxable income. In making this assessment, all available evidence must be considered including the current economic climate, our expectations of future taxable income and our ability to project such income and the appreciation of our investments and other assets. Because of unfavorable economic conditions and uncertainty, significant net losses, and significant declines in the value of our investments, we determined that it was appropriate to increase our valuation allowance for net deferred tax assets which resulted in a charge for deferred income tax expense.
For the quarter and nine months ended September 30, 2001, we recorded an income tax benefit due primarily to the future tax benefit to be received on the loss on excess office facilities when the losses become deductible for income tax purposes. During the same periods, we also recorded impairment losses for other-than-temporary declines in fair value of investments. We did not record a related income tax benefit for these losses, which can only be utilized to offset future capital gains, as we did not have any significant sources of capital gain income as of September 30, 2001.
NEW ACCOUNTING POLICIES
In October 2001, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (SFAS 144), which is effective for fiscal years beginning after December 15, 2001. SFAS 144 supersedes certain provisions of APB Opinion No. 30 “Reporting the Results of Operations-Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions” and supersedes SFAS 121. We adopted SFAS 144 as of January 1, 2002. The adoption of SFAS 144 did not affect our consolidated financial position or results of operations.
In June 2002, the FASB issued Statement of Financial Accounting Standards No. 146, “Accounting for Costs Associated with Exit or Disposal Activities” (SFAS 146), which is effective for fiscal years beginning after December 31, 2002, with early application encouraged. SFAS 146 supercedes Emerging Issues Task Force Issue No. 94-3, “Liabilities Recognized for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).” We do not expect the adoption of SFAS 146 to have a material effect on our consolidated financial position or results of operations.
LIQUIDITY AND CAPITAL RESOURCES
Net cash provided by operating activities was $0.8 million for the nine months ended September 30, 2002 and $9.1 million for the nine months ended September 30, 2001. Net cash provided by operating activities for the nine months ended September 30, 2002 was the result of significant non-cash components comprising our net loss, primarily an increase in accrued loss on excess office facilities of $14.7 million, non-cash depreciation expense of $8.7 million, equity in net losses of equity method investments of $5.4 million and impairment of equity investments of $5.1 million. Net cash provided by operating activities for the nine months ended September 30, 2001 was the result of significant non-cash components comprising our net loss, primarily non-cash depreciation expense of $9.0 million, $25.3 million for impairment of investments, $20.0 million from the loss on excess office facilities and non-cash charges of $28.2 million for goodwill amortization, acquisition charges, and stock-based compensation.
Net cash used in investing activities was $5.0 million for the nine months ended September 30, 2002. This was primarily the result of purchases of equipment and leasehold improvements and cash used for acquisitions. Net cash used in investing activities was $45.6 million for the nine months ended September 30, 2001. This was primarily the result of the
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net purchase of short-term investments of approximately $14.3 million, purchase of long-term equity investments and purchases of equipment and leasehold improvements.
Net cash used in financing activities was $14.4 million for the nine months ended September 30, 2002. This was primarily due to our repurchase of approximately $21.3 million of our common stock, partially offset by proceeds from exercises of employee stock options. Net cash provided by financing activities was $6.1 million for the nine months ended September 30, 2001. This was due to net proceeds from the exercise of stock options.
In September 2001, we announced a share repurchase program. Our Board of Directors authorized the repurchase of up to an aggregate of $50 million of our outstanding common stock. Any purchases of common stock under our share repurchase program will be made from time-to-time, in the open market, through block trades or otherwise. Depending on market conditions and other factors, these purchases may be commenced or suspended at any time without prior notice. During the nine months ended September 30, 2002, we repurchased approximately 4.3 million shares at an average cost of $4.77 per share.
At September 30, 2002, we had $341.9 million in cash, cash equivalents, short-term investments and restricted cash equivalents. Our principal commitments were substantially the same as those at December 31, 2001, including office leases and contractual payments due to content and other service providers. We believe that our current cash, cash equivalents and short-term investments will be sufficient to meet our anticipated cash needs for working capital and capital expenditures for at least the next 12 months.
We do not hold derivative financial instruments or equity securities in our short-term investment portfolio. Our cash equivalents and short-term investments consist of high quality securities, as specified in our investment policy guidelines. The policy limits the amount of credit exposure to any one non-U.S. Government or non-U.S. Agency issue or issuer to a maximum of 5% of the total portfolio. These securities are subject to interest rate risk and will decrease in value if interest rates increase. Because we have historically had the ability to hold our fixed income investments until maturity, we would not expect our operating results or cash flows to be significantly affected by a sudden change in market interest rates in our securities portfolio.
FACTORS THAT MAY AFFECT OUR BUSINESS, FUTURE OPERATING RESULTS AND FINANCIAL CONDITION
You should carefully consider the risks described below together with all of the other information included in this quarterly report on Form 10-Q. The risks and uncertainties described below are not the only ones facing our company. If any of the following risks actually occurs, our business, financial condition or operating results could be harmed. In such case, the trading price of our common stock could decline, and you could lose all or part of your investment.
WE HAVE A RELATIVELY LIMITED OPERATING HISTORY, WHICH MAKES IT DIFFICULT TO EVALUATE OUR BUSINESS
We were incorporated in February 1994 and have a relatively limited operating history. We have limited financial results on which you can assess our future success. Our prospects must be considered in light of the risks, expenses and difficulties frequently encountered by growing companies in new and rapidly evolving markets, such as the streaming media software and media delivery systems markets in which we operate.
To address the risks and uncertainties faced by our business, we must meet many challenges including:
| - establishing and maintaining broad market acceptance of our products and services and converting that acceptance into direct and indirect sources of revenues; | ||
| - establishing and maintaining our brand name; | ||
| - timely and successfully developing new products, product features and services and increasing the functionality and features of existing products and services; | ||
| - developing subscription services products that result in high degrees of consumer satisfaction and high levels of consumer usage; | ||
| - successfully responding to competition from Microsoft and others, including competition from emerging technologies and solutions; and | ||
| - developing and maintaining strategic relationships to enhance the distribution, features and utility of our products and services. |
Our business strategy may be unsuccessful and we may be unable to address the risks we face in a cost-effective manner, if at all. If we are unable to successfully address these risks our business will be harmed.
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WE HAVE A HISTORY OF LOSSES
We have incurred significant losses since our inception. As of September 30, 2002, we had an accumulated deficit of approximately $255.6 million. We had a net loss for the quarter and nine months ended September 30, 2002, and for the years ended December 31, 2001 and 2000, and we may not generate sufficient revenues to be profitable on a quarterly or annual basis in the future. We devote significant resources to developing, enhancing, selling and marketing our products and services. As a result, we will need to generate significant revenues to be profitable in the future.
OUR OPERATING RESULTS ARE LIKELY TO FLUCTUATE SIGNIFICANTLY, WHICH MAY CAUSE OUR STOCK PRICE TO FLUCTUATE
As a result of our relatively brief operating history and the rapidly changing and uncertain nature of the markets in which we compete, our quarterly and annual revenues and operating results are likely to fluctuate from period-to-period, and period-to-period comparisons are not likely to be meaningful. These fluctuations are caused by a number of factors, many of which are beyond our control. Our future operating results could fall below the expectations of public market analysts or investors, which would likely significantly reduce the market price of our common stock. Fluctuations in our operating results will likely increase the volatility of our stock price.
Our research and development and sales and marketing efforts, and other business expenditures generally, are partially based on predictions regarding certain developments for media delivery and digital media distribution. To the extent that these predictions prove inaccurate, our revenues may not be sufficient to offset these expenditures, and our operating results may be harmed.
REVENUES MAY BE HARMED IF GENERAL ECONOMIC CONDITIONS DO NOT IMPROVE
In recent periods, general adverse economic conditions have caused many customers and prospective customers of our media delivery system software to experience financial difficulties. As a result, some of these companies have ceased or consolidated operations, some are continuing to experience financial difficulty, sales cycles for many of our customers and potential customers have become longer and less predictable than in the past and, in some cases, certain customers have adopted the media delivery products of our primary competitor because it bundles its competing media delivery products with its operating system. In particular, customers and potential customers in the systems software and telecommunication industries have become increasingly cautious in their buying decisions due to the difficult macroeconomic conditions in those industries. The macroeconomic environment has also impacted sales to, and the rate of adoption of our systems software products by, customers in the corporate enterprise, broadcast hosting and non-PC device manufacturer market segments. No assurance can be given when, or if, customers in these markets, particularly telecommunications customers, will increase capital spending levels. In the event that a substantial number of our current or potential customers experience financial difficulties in the future, the rate of adoption of our products may be slowed, our ability to increase or maintain sales to such customers will be adversely affected and our ability to generate revenues from these companies will also be adversely impacted. Further, if U.S. or global economic conditions worsen, our business, operating results, and financial condition could be harmed. Our revenues are dependent on the health of the economy and the growth of our customers.
Our consumer subscription services are a new business model for us and we believe these services represent a discretionary spending item for consumers. Accordingly, the development of these services could be negatively impacted by a general decline in consumer spending levels or other changes in consumer habits caused by macroeconomic conditions, which would harm our business and our business prospects.
OUR RESTRUCTURING EFFORTS MAY NOT BE EFFECTIVE
In July 2001 and August 2002, we took steps to better align our resources with the levels required to operate efficiently in the prevailing market. Through these steps, we reduced our headcount and are attempting to sublease certain of our excess facility capacity. While we believe that these steps will help us achieve greater operating efficiency, we have no prior history with such measures and cannot predict whether they will be effective. These measures could adversely impact the employees that we wish to retain, our customers and/or our vendors, which could harm our ability to operate as intended and which would harm our business.
THERE ARE A NUMBER OF RISKS ASSOCIATED WITH OUR RECENTLY ANNOUNCED HELIX INITIATIVE
We recently announced the introduction of Helix, a combination of technology and a new licensing model designed to create an open, comprehensive platform and community to enable the creation of digital media products and applications for multiple formats, operating systems and devices. Under the new licensing model, Helix community members can access, use and modify certain RealNetworks source code. This enables a large group of developers to extend the Helix technology to other platforms, fix software bugs and create
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their own applications using the Helix platform. In addition, we recently announced the introduction of the Helix Universal Server, our server product built on the Helix Platform that supports every major digital media format.
Because these initiatives and products were introduced so recently, there are a number of risks associated with them, including risks associated with open source and community source technology licensing, development and business models and the risks typically associated with the introduction of new products and technologies. We do not exercise control over many aspects of the development of the open source technology that comprises our Helix initiative and, accordingly, there can be no assurance that the industry will adopt the Helix Platform or the Helix Community, or that third parties will develop and introduce technologies or products based on them. Further, there can be no assurance that new or existing customers will license the Helix Universal Server. While we have invested substantial resources in the development of these initiatives and products, there can be no assurance that they will be accepted by the market, that we will derive substantial revenue from such initiatives and products or that the introduction of Helix and the Helix Universal Server will not adversely affect our sales.
WE MAY BE UNABLE TO SUCCESSFULLY COMPETE WITH MICROSOFT AND OTHER COMPANIES IN THE MEDIA DELIVERY MARKET
The market for software and services for media delivery over the Internet is relatively new, constantly changing and intensely and increasingly competitive. As media delivery evolves into a central component of the Internet experience, more companies are entering the market for, and expending increasing resources to develop, media delivery software and services. We expect that competition will continue to intensify. Increased competition could hurt our business and the trading price of our stock. Increased competition may also result in price reductions, reduced margins, loss of customers, and a change in our business and marketing strategies, any of which could harm our business.
Many of our current and potential competitors have longer operating histories, greater name recognition, more employees and significantly greater financial, technical, marketing, public relations and distribution resources than we do. In addition, new competitors with potentially unique or more desirable products or services are entering the market all the time. The competitive environment may require us to make changes in our products, pricing, licensing, services or marketing to maintain and extend our current brand and technology franchise. Price concessions or the emergence of other pricing, licensing and distribution strategies or technology solutions of competitors may diminish our revenues, impact our margins or lead to a reduction in our market share, any of which will harm our business. Other changes we have to make in response to competition could cause us to expend significant financial and other resources, disrupt our operations, strain relationships with partners, or release products and enhancements before they are thoroughly tested, any of which could harm our operating results and stock price.
Microsoft is a principal competitor in the development and distribution of digital media and media distribution technology. Microsoft currently competes with us in the market for digital media servers and players, content creation tools, digital rights management, and other technology and services related to digital distribution of media, and has announced its intention to compete with our RealOne service in the market for subscription services. Microsoft’s commitment to and presence in the media delivery industry has increased and we expect that Microsoft will continue to increase competitive pressure in the overall market for digital media and media distribution.
Microsoft distributes its competing streaming media server, player and tools products by bundling them with its Windows operating systems and NT servers. Microsoft’s practices have caused, and may continue to cause, pricing pressure on our revenue generating products and services. Microsoft’s practices have led in some cases, and could continue to lead to, longer sales cycles, decreased sales, loss of existing and potential customers and reduced market share. In addition, we believe that Microsoft has used and may continue to use its monopoly position in the computer industry and its financial resources to secure preferential or exclusive distribution and bundling contracts for its media delivery technologies and products with third parties such as ISPs, content delivery networks, online service providers, content providers, entertainment companies, media companies, broadcasters, VARs and OEMs, including third parties with whom we have relationships. Microsoft has also invested significant sums of money in, has provided substantial financial incentives to, or offered or conditioned placement on or through the Windows operating system, the Internet Explorer Web browser and Microsoft’s MSN service to certain of our current and potential customers and content suppliers, and we expect this trend to continue, which may cause those customers to stop using or reduce their use of our products and services and which may cause those content suppliers to withhold desirable media
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content from us or end users of our products and services. Such arrangements, together with Microsoft’s aggressive marketing of its Windows operating systems, server products and digital media products, may reduce our share of the streaming media and digital distribution market.
Microsoft’s Windows Media Player competes with our media player products. Certain versions of the Windows Media Player are available for download from Microsoft’s Web site for free, and the Windows Media Player is integrated into Microsoft’s recently introduced Windows XP operating system and the Windows 98, Windows 2000 and Windows ME operating systems, the Internet Explorer Web browser, and Microsoft’s MSN service. Windows XP, a significant focus of which is media delivery, gives very prominent and persistent placement to Microsoft’s Windows Media Player, Windows Media Guide, music services, and other media delivery services in the operating system and on the end user’s desktop. In some cases, the Windows Media Player may override default playback settings set by end users or by us. New versions of Internet Explorer and MSN Explorer also prominently feature and promote Windows Media. We expect that by leveraging its monopoly position in operating systems and tying streaming or digital media into its operating systems and its Web browser, Microsoft will distribute substantially more copies of the Windows Media Player, and attract more content providers to use Microsoft’s technology, in the future than it has in the past and may be able to attract more users to its streaming or digital media products. In addition, Microsoft does not allow our products to take full advantage of the features and functionality of Windows XP that it makes available to the Windows Media Player. In light of Microsoft’s efforts and dominant position in operating systems, our market position may be difficult to sustain.
Microsoft’s Windows Media Player also competes with our RealJukebox products and with the personal music management features of the RealOne Player. Microsoft has also invested in other digital distribution technologies that compete with RealJukebox and with the RealOne Player. The Windows Media Player supports the Windows Media format, but not RealNetworks’ media formats. Microsoft also licenses Windows Media Technologies, a platform for authoring, delivering and playing digital media intended to compete with our system software products, and supports and promotes other third party products competitive to our products. In addition, Microsoft provides servers that support Windows Media Technologies at no additional cost to customers who purchase its Windows servers, whereas we offer most versions of our competitive servers for sale. In some cases, Microsoft conditions use of the Windows Media Digital Rights Management and security technologies supported by Windows XP to support for Windows Media formats and use of Windows Media Player and servers. We compete with Microsoft in the market for digital rights management technologies. We expect Microsoft and other competitors to devote significantly greater resources to product development in the music management and digital media categories in the future.
Microsoft also competes with us to attract broadcasters and owners of high quality or popular content to promote and deliver such content in Microsoft’s formats, in some cases on an exclusive or preferential basis. While we have rights to play back certain content in Microsoft formats through our player products under a limited set of conditions, we may not secure necessary rights from Microsoft to enable our products to play back all such content or content in Microsoft’s newest formats at all, or on commercially reasonable terms. Our player products may be disadvantaged if they cannot play content in Windows Media formats or content that is secured by the Windows Media Digital Rights Management technology, or if such content providers do not also make their content available in RealNetworks’ media formats using digital rights management systems supported by us. In some cases, we believe Microsoft uses its financial resources and monopoly leverage to obtain rights to such content, and to incent content providers to prepare their content in Microsoft’s formats. In addition, Microsoft has recently announced its intention to compete with our RealOne subscription service, and may use similar incentives to induce content providers to offer content for its proposed subscription service. Microsoft’s commitment to and presence in the media delivery industry has increased and we believe that Microsoft will continue to increase competitive pressure in the overall market for streaming media and media distribution.
In addition to Microsoft, we face competition from other companies that develop and market streaming media products. For example, Apple Computer offers the QuickTime streaming media technology, including a free media player and a free streaming media server, and licenses for free source code to the server under the conditions of Apple’s end user license agreement. Apple also offers competitive music management software and hardware. Apple has recently begun to devote significant resources to developing and marketing digital media products and we expect they will continue to do so to enable them to compete vigorously with us in the marketplace. Apple has also enlisted the open source code development community to assist its development of competitive products. Companies such as AOL Time Warner and Yahoo! and many smaller competitors also offer various products that compete with our player products and content subscription services. In connection with the
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deployment of our RealSystem software in AOL’s Internet service, we also licensed our RealPlayer technology to AOL for use with its own Internet service media player application. Such licensing may impact the number of end users of our player products if AOL users only use AOL applications. As more companies enter the market with products that compete with our servers, players and tools, the competitive landscape could change rapidly to our disadvantage. If our player products and formats do not continue to achieve a high level of consumer adoption and usage, our revenues and business could be harmed.
OUR SUBSCRIPTION SERVICES MAY NOT BE SUCCESSFUL
In August 2000, we introduced our RealPlayer GoldPass subscription service, which provided customers access to a combination of premium software, services and content in exchange for a monthly fee. In December 2001, we launched our RealOne subscription service, which incorporates features of our RealPlayer and RealJukebox products together in a new version of our player products, the RealOne Player. Members of RealOne also have access to premium subscription content and are able to take advantage of certain enhanced features of the RealOne Player. These subscription services are a relatively new business model for delivering media over the Internet and represent a new business model for us. It is too early to predict whether consumers will accept our subscription services, whether the gross margins resulting from our subscription services will be consistent with our historical gross margins or whether the service will otherwise be financially viable. To date, gross margins associated with our subscription services are significantly lower than gross margins in our business historically, and we expect this trend will continue to negatively impact our overall gross margins. Our subscription services compete with both traditional and online entertainment service providers although, to date, we have not faced significant direct competition with our subscription service offerings. We anticipate increasing competition for online subscription service revenues from a wide range of companies, including AOL Time Warner, Microsoft and Yahoo!. Many of these providers have significantly more resources, including access to content, and experience in providing subscription or similar services to customers.
We must continue to obtain premium digital content in order to maintain and increase subscriptions and subscription service revenues and overall customer satisfaction. It is too early to predict whether our subscription business will require highly popular content to increase or maintain subscriptions, and whether we will be able to obtain such content on a consistent basis, or on commercially acceptable terms. To date, a limited amount of premium digital content has been made available for delivery over the Internet that can only be accessed through a for-pay service and not for free. If we are unable to obtain premium digital content on commercially reasonable terms, or at all, or if we do not successfully market our subscription services to our end users, our business could be harmed. In addition, the slower than anticipated adoption of broadband may impact the desirability of our services as users encounter low-quality content over slower connections.
IF WE DO NOT CONTINUE TO ADD SUBSCRIBERS TO OUR SUBSCRIPTION SERVICES OR IF WE EXPERIENCE EXCESSIVE RATES OF SUBSCRIBER CHURN, OUR REVENUES AND BUSINESS WILL BE HARMED.
Our subscription services have become an increasingly important source of our total revenues. The growth in subscribers represents a major growth opportunity for us and also creates substantial risks. In order to increase our subscriber numbers and subscription revenues, we must continue to add new subscribers each quarter while minimizing the rate of loss of existing subscribers. If our marketing and promotional activities fail to add significant numbers of new subscribers or if too many of our subscribers cancel their membership, because they are dissatisfied with the service or otherwise, our revenues and business will suffer. In addition, if the costs of such marketing and promotional activities increase as we continue to add new subscribers, our margins and operating results will suffer.
Many of our subscribers are subscribers to our standalone premium subscription service products, some of which are seasonal in nature, such as our Major League Baseball and NASCAR offerings. We have limited experience with these types of offerings and cannot predict how the seasonal nature of these offerings will impact our subscriber growth rates or future subscriber retention levels. No assurance can be given that these stand-alone subscribers will remain subscribers to our subscription services at the end of any season or that they will renew their subscriptions for following seasons. In addition, no assurance can be given that the gross margins associated with these offerings will be consistent with our historical gross margins or our gross margins for our other subscription products, such as SuperPass.
OUR ONLINE MUSIC SERVICES INITIATIVES MAY NOT BE SUCCESSFUL
In 2001, we announced the formation of a joint venture called MusicNet with four leading media companies to create a technology platform for online music subscription services. We also entered into an agreement with MusicNet to license the MusicNet platform and service for sale to our own customers. In December 2001, we began offering the RealOne Music subscription service, a for-pay, limited usage music subscription service based on
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the MusicNet platform. The business models, technologies and market for online music subscription services are new and unproven. Consumers may not accept certain features of our current RealOne Music subscription offering, including the inability to copy or “burn” RealOne Music content onto CD’s, the expiration of a subscriber’s rights to access RealOne Music content at the end of each month of the subscription, and the availability of a limited selection of content from certain major record labels. To date, consumer adoption and usage of our RealOne Music offering has not been significant. If RealOne Music is unable to improve the features of its music service offering, it may not achieve market acceptance and our financial results and business prospects could be harmed. In addition, we record in our statement of operations our equity share in MusicNet’s net income (loss) which was a loss of $1.6 million and a loss of $5.1 million for the quarter and nine months ended September 30, 2002, respectively. We anticipate that MusicNet will continue to incur losses in the foreseeable future and will need additional funding to support the development of its business model. No assurance can be made that MusicNet will ever contribute net income to our statement of operations or that losses recorded from MusicNet will not increase in the future.
Our music subscription services will face competition from traditional offline music distribution competitors and from other new online music services, including pressplay, a joint venture formed between two leading media companies that are not participants in MusicNet, the Rhapsody music service recently launched by Listen.com, and other online efforts of the leading media companies, including the recent announcements by Universal Music Group and Sony Music Entertainment of their intentions to begin making downloads from their catalogs available for purchase online at reduced prices without restrictions on CD-burning or portability. RealOne Music also faces significant competition from “free” peer-to-peer services, like KaZaA and Morpheus, that allow consumers to directly access an expansive array of free content without securing licenses from content providers. Competing services, like pressplay and Rhapsody, may be able to obtain more or better music content or may be able to license such content on more favorable terms than MusicNet, which could harm the ability of MusicNet and our music subscription services to compete effectively in the marketplace. MusicNet also is a licensee of our technology and has used our digital music architecture to build its technology platform. If MusicNet is not successful and other online music subscription services do not license our technology, our business and business prospects could be harmed.
The Antitrust Division of the U.S. Department of Justice and certain European antitrust regulatory authorities have recently commenced investigations into music licensing and other business practices related to online music businesses, including the business of MusicNet. If the business of MusicNet is harmed or materially modified as a result of these investigations, our financial results and business prospects could be harmed.
WE MAY BE UNABLE TO SUCCESSFULLY COMPETE IN OTHER PARTS OF OUR BUSINESS
Media Hosting. Our media hosting service, the Real Broadcast Network, competes with a variety of companies that provide streaming media hosting and broadcast services. These companies include Akamai, Digital Island, Yahoo! Broadcast Services and other emerging broadcast networks. Some of these competitors have cost or other advantages over our services and offer other services that the Real Broadcast Network does not offer, such as creating corporate intranet portals or hosting in media formats not supported by the Real Broadcast Network. We may not establish or sustain our competitive position in this market segment. In recent periods, many of the customers of the Real Broadcast Network have either gone out of business or reduced their usage of our media hosting services. Some of our media hosting competitors are also customers on whom we rely to help drive product download traffic to our Web sites through their broadcast events. We also sell servers and tools to companies that compete with the Real Broadcast Network. If our relationship with these companies becomes more competitive, such companies may reduce their level of usage and purchases of our products or services.
Web Site Destinations, Content and Advertising. Our Web sites and the Real.com Network compete for user traffic and Internet advertising revenues with a wide variety of Web sites, Internet portals and ISPs. In particular, aggregators of audio, video and other media, such as Yahoo! Broadcast Services and Microsoft’s Windows Media Guide, compete with us.
We cannot be certain that advertisers will place advertising with us or that revenues derived from such advertising will be meaningful. Internet advertising revenues across the industry have decreased substantially since the second half of 2000 and our advertising revenues have substantially declined since that time. We cannot predict when, or if, advertising revenues will stabilize and it is unlikely that they will return to previous levels. If we lose advertising customers, fail to attract new customers, are
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forced to reduce advertising rates or otherwise modify our rate structure to retain or attract customers, our business could be harmed. Our business could also be harmed if we lose Web site traffic or if the usage of our player products fails to produce a sufficient amount of advertising inventory.
WE MAY NOT BE SUCCESSFUL IN THE MARKET FOR DOWNLOADABLE MEDIA AND PERSONAL MUSIC MANAGEMENT SYSTEMS
The market for products that enable the downloading of media and that provide a personal music management system is relatively new and still evolving. We may be unable to develop a revenue model or sufficient demand to take advantage of this market opportunity. We cannot predict whether consumers will adopt RealJukebox or the RealOne Player as their primary application to play, record, download and manage their digital music. There are a number of competitive products on the market that offer certain of the music management features currently offered by RealJukebox and by the RealOne Player. These products include WinAmp Player, MusicMatch Jukebox, Sonique Player, Liquid Player, AOL and Windows Media Player. Given the size and importance of the general market for music distribution, competitors will likely release additional products that directly compete with RealJukebox and the RealOne Player, which could harm our business. Our competitors may develop new features and technology not available in RealJukebox or the RealOne Player, including advanced codecs and digital rights management technology, which could harm our business.
RealJukebox and the RealOne Player also face competition from the emergence of widespread peer-to-peer file sharing services and programs such as KaZaA and Morpheus, and a variety of other similar services that have arisen since certain services of Napster were shut down by court order. Such services allow consumers to directly access an expansive array of content without relying on content providers to make the content available for streaming or digital download, and without relying on products such as our RealJukebox or our RealOne Player to be able to play, record and store such content. Our inability to achieve widespread acceptance for our digital music architecture or our player products or to create new revenue streams from the new market segments, including digital music content, could harm the prospects for our business.
We must also provide digital rights management solutions and other security mechanisms in order to address concerns of content providers, and we cannot be certain that we can develop, license or acquire such solutions, or that content licensors or consumers will accept them. In addition, consumers may be unwilling to accept the use of digital rights management technologies that limit their use of content, especially with large amounts of free content readily available. In connection with the continued development of our products, particularly with respect to the adaptation of our products on non-PC devices, we may need to license other digital rights management solutions to support our products. No assurance can be given that such solutions will be available to us at reasonable rates, upon reasonable terms, or at all, which could harm the development of our products and our business.
OUR INDUSTRY IS EXPERIENCING CONSOLIDATION THAT MAY INTENSIFY COMPETITION
The Internet and media distribution industries are undergoing substantial change which has resulted in increasing consolidation and a proliferation of strategic transactions. Many companies in these industries have been going out of business or are being acquired by competitors. As a result, we are increasingly competing with larger competitors that have substantially greater resources than we do. We expect this consolidation and strategic partnering to continue. Acquisitions or strategic relationships could harm us in a number of ways. For example:
| - competitors could acquire or enter into relationships with companies with which we have strategic relationships and discontinue our relationship, resulting in the loss of distribution opportunities for our products and services or the loss of certain enhancements or value-added features to our products and services; | ||
| - competitors could obtain exclusive access to desirable multimedia content and prevent that content from being available in our formats, thus decreasing the use of our products and services to distribute and experience the content that audiences most desire, and hurting our ability to attract advertisers to our Web sites and product offerings; | ||
| - suppliers of important or emerging technologies could be acquired by a competitor or other company which could prevent us from being able to utilize such technologies in our offerings, and disadvantage our offerings relative to those of competitors; |
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| - a competitor could be acquired by a party with significant resources and experience that could increase the ability of the competitor to compete with our products and services; and | ||
| - other companies with related interests could combine to form new, formidable competition, which could preclude us from obtaining access to certain markets or content, or which could dramatically change the market for our products and services. |
Any of these events could put us at a competitive disadvantage which could cause us to lose customers, revenue and market share. They could also force us to expend greater resources to meet new or additional competitive threats, which could also harm our operating results.
WE RELY ON CONTENT PROVIDED BY THIRD PARTIES TO INCREASE MARKET ACCEPTANCE OF OUR PRODUCTS AND SERVICES
If third parties do not develop or offer compelling content to be delivered over the Internet, or grant necessary licenses to us or our customers to distribute or perform such content, our business will be harmed and our products and services may not achieve or sustain broad market acceptance. We rely on third-party content providers, such as radio and television stations, record labels, media companies, Web sites and other companies, to develop and offer content in our formats that can be delivered using our server products and played back using our player products. We also rely entirely on third-party content for the programming and content offerings that comprise our RealOne and stand-alone subscription services. In some cases, we pay substantial fees to obtain content for these services. In order to provide a compelling subscription service, we must be able to offer unique and in some cases exclusive content and programming to our customers. We face competition in the market for subscription content services from companies such as AOL Time Warner, Microsoft and Yahoo!, who may have greater access to content or the ability to pay substantially higher fees to content providers. We cannot guarantee that third-party content providers will continue to rely on our technology or offer compelling content in our formats, nor can we guarantee that we will be able to secure licenses to their content at all or at commercially reasonable rates, to encourage and sustain broad market acceptance of our products and services. The failure to do so would harm our business and our business prospects.
While we have a number of short-term agreements with third parties to provide content from their Web sites in our formats, most third parties are not obligated to develop or offer content using our technology. In addition, some third parties have entered into and may in the future enter into agreements with our competitors, principally Microsoft, to develop or offer all or a substantial portion of their content in our competitors’ formats and using their digital rights management technology. This may prevent such content from being playable through our products. Microsoft has substantially more resources than us that may enable it to secure preferential and even exclusive relationships with content providers, including preferential placement on or through the Windows Operating System, Internet Explorer or MSN. There could be less demand for and use of our products if Microsoft or another competitor were to secure preferential or exclusive relationships with the leading content providers, Web sites or broadcasters.
Our success also depends on the availability of third-party content, especially music, that current users of our RealJukebox and RealOne Player can lawfully and easily access, record and play back. Our products may not achieve or sustain market acceptance if third parties are unwilling to offer their content for free download, streaming or purchase by users of our player products. Current concerns regarding the secure distribution of music over the Internet, and the difficulties and high costs associated with obtaining necessary or desirable licensing rights, are contributing to the delay or unavailability of music content for distribution.
WE MAY NOT SUCCESSFULLY DEVELOP NEW PRODUCTS AND SERVICES
Our growth depends on our ability to continue to develop leading edge media delivery and digital distribution products and services. Our business and operating results would be harmed if we fail to develop products and services that achieve widespread market acceptance or that fail to generate significant revenues or gross profits to offset our development and operating costs. We may not timely and successfully identify, develop and market new product and service opportunities. If we introduce new products and services, they may not attain broad market acceptance or contribute meaningfully to our revenues or profitability. Competitive or technological developments may require us to make substantial, unanticipated investments in new products and technologies, and we may not have sufficient resources to make these investments. If we are unable to be a
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technological leader in our market our business is likely to be harmed. In addition, with the recent introduction of our Helix initiative, we no longer exercise control over many aspects of the development of the open source technology that comprises our Helix initiative and accordingly, there can be no assurance that the industry will adopt the Helix Platform or the Helix Community, or that third parties will develop and introduce technologies or products based on them.
Because the markets for our products and services are changing rapidly, we must develop new offerings quickly. We have experienced development delays and cost overruns in our development efforts in the past and we may encounter such problems in the future. Delays and cost overruns could affect our ability to respond to technological changes, evolving industry standards, competitive developments or customer requirements. Our products also may contain undetected errors that could cause increased development costs, loss of revenues, adverse publicity, reduced market acceptance of our products or services or lawsuits by customers.
RealJukebox and the RealOne Player support or will support a variety of audio formats, including RealAudio, MP3, Liquid Audio, Windows Media Audio, Apple QuickTime, MPEG-4 and IBM’s EMMS. Support for some formats, including Windows Media Audio and Apple QuickTime, requires the user to have additional third party software installed. However, technical formats and consumer preferences evolve very rapidly, and we may be unable to adequately address consumer preferences or fulfill the market demand to the extent it exists. We may be unable to license technologies, like codecs, that obtain widespread consumer and developer use which would harm consumer and developer acceptance of our products and services. In addition, our codecs and formats may not continue to be in demand or desirable as other third party codecs and formats become more readily available.
WE DEPEND ON KEY PERSONNEL WHO MAY NOT CONTINUE TO WORK FOR US
Our success substantially depends on the continued employment of our executive officers and key employees, particularly Robert Glaser, our founder, Chairman of the Board and Chief Executive Officer. The loss of the services of Mr. Glaser or any of our other executive officers or key employees could harm our business. If any of these individuals were to leave RealNetworks, we could face substantial difficulty in hiring qualified successors and could experience a loss in productivity while any such successor obtains the necessary training and experience. A number of our key employees have reached or will soon reach the five-year anniversary of their RealNetworks hiring date and, as a result, will have become or will shortly become fully vested in their initial stock option grants. While most personnel are typically granted additional five-year stock options subsequent to their hire date to provide additional incentive to remain at RealNetworks, the initial option grant is typically the largest and an employee may be more likely to leave our employ upon completion of the vesting period for the initial option grant. None of our executive officers has a contract that guarantees employment. We do not maintain “key person” life insurance policies. If we do not succeed in retaining and motivating existing personnel, our business could be harmed.
OUR FAILURE TO ATTRACT, TRAIN OR RETAIN HIGHLY QUALIFIED PERSONNEL COULD HARM OUR BUSINESS
Our success also depends on our ability to attract, train or retain qualified personnel in all areas, especially those with management and product development skills. In particular, we must hire additional experienced management personnel to help us continue to grow and manage our business, and skilled software engineers to further our research and development efforts. At times, we have experienced difficulties in hiring personnel with the proper training or experience, particularly in technical and media areas. Competition for qualified personnel is intense, particularly in high-technology centers such as the Pacific Northwest, where our corporate headquarters are located. If we do not succeed in attracting new personnel or in retaining and motivating our current personnel, our business could be harmed.
In making employment decisions, particularly in the Internet and high-technology industries, our current employees and prospective job candidates often consider the value of stock options they hold or that they may receive in connection with their employment. As a result of recent volatility in our stock price, we may be disadvantaged in competing with companies that have not experienced similar volatility or that have not yet sold their stock publicly.
POTENTIAL ACQUISITIONS INVOLVE RISKS WE MAY NOT ADEQUATELY ADDRESS
As part of our business strategy, we have acquired technologies and businesses in the past, and expect that we will to continue to do so in the future. The failure to adequately address the financial, legal and operational risks raised by acquisitions of
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technology and businesses could harm our business. Acquisition or business combination transactions are accompanied by a number of significant risks. Financial risks related to acquisitions may harm our financial position, reported operating results or stock price, and include:
| - potentially dilutive issuances of equity securities; | ||
| - use of cash resources; | ||
| - the incurrence of debt and contingent liabilities; | ||
| - large write-offs and difficulties in assessment of the relative percentages of in-process research and development expense that can be immediately written off as compared to the amount which must be amortized over the appropriate life of the asset; and | ||
| - amortization expenses related to other intangible assets. |
Acquisitions also involve operational risks that could harm our existing operations or prevent realization of anticipated benefits from an acquisition. These operational risks include:
| - difficulties in assimilating the operations, products, technology, information systems or personnel of the acquired company; | ||
| - diversion of management’s attention from other business concerns and the potential disruption of our ongoing business; | ||
| - the difficulty of incorporating acquired technology or content and rights into our products and services and unanticipated expenses related to such integrations; | ||
| - impairment of relationships with our employees, affiliates, advertisers and content providers; | ||
| - inability to maintain uniform standards, controls, procedures and policies; | ||
| - the assumption of known and unknown liabilities of the acquired company; | ||
| - entrance into markets in which we have no direct prior experience; and | ||
| - subsequent loss of key employees of the acquired company. |
WE MAY NOT BE SUCCESSFUL IN MAKING STRATEGIC INVESTMENTS
We have made, and in the future we may continue to make, strategic investments in other companies. These investments have been made in, and future investments will likely be made in, immature businesses with unproven track records and technologies. Such investments have a high degree of risk, with the possibility that we may lose the total amount of our investments. We may not be able to identify suitable investment candidates, and, even if we do, we may not be able to make those investments on acceptable terms, or at all. In addition, even if we make investments, we may not gain strategic benefits from those investments.
THE GROWTH OF OUR BUSINESS DEPENDS ON THE INCREASED USE OF THE INTERNET FOR COMMUNICATIONS, ELECTRONIC COMMERCE AND ADVERTISING
The growth of our business depends on the continued growth of the Internet as a medium for media consumption, communications, electronic commerce and advertising. Our business will be harmed if Internet usage does not continue to grow, particularly as a source of media information and entertainment and as a vehicle for commerce in goods and services. Our success also depends on the efforts of third parties to develop the infrastructure and complementary products and services necessary to maintain and expand the Internet as a viable commercial medium. We believe that other Internet-related issues, such as security, privacy, reliability, cost, speed, ease of use and access, quality of service and necessary increases in bandwidth availability, remain largely unresolved and may affect the amount and type of business that is conducted over the Internet, and may impact our ability to sell our products and services and ultimately impact our business results and prospects.
If Internet usage grows, the Internet infrastructure may not be able to support the demands placed on it by such growth, specifically the demands of delivering high-quality
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media content. As a result, its performance and reliability may decline. In addition, Web sites have experienced interruptions in service as a result of outages, system attacks and other delays occurring throughout the Internet network infrastructure. If these outages, attacks or delays occur frequently or on a broad scale in the future, Internet usage, as well as the usage of our products, services and Web sites, could grow more slowly or decline.
RATE OF ADOPTION OF BROADBAND TECHNOLOGIES POSES RISKS TO OUR BUSINESS
We believe that increased Internet use and especially the increased use of media over the Internet may depend on the availability of greater bandwidth or data transmission speeds (also known as broadband transmission). If broadband technologies do not become widely available or widely adopted, our products and services, particularly our subscription services, may not achieve broad market acceptance and our business and prospects could be harmed. To date, we believe that broadband technologies have been adopted at a slower rate than expected, which we believe has slowed the level of use of media over the Internet and may harm our business if the rate of adoption does not increase.
CHANGES IN NETWORK INFRASTRUCTURE, TRANSMISSION METHODS AND BROADBAND TECHNOLOGIES POSE RISKS TO OUR BUSINESS
If broadband access becomes widely available, we believe it presents both a substantial opportunity and a significant business challenge for us. Internet access through cable television set-top boxes, digital subscriber lines or wireless connections could dramatically reduce the demand for our products and services by utilizing alternate technology that more efficiently transmits data and media. This could harm our business as currently conducted.
Also, our products and services may not achieve market acceptance or generate sufficient revenues to offset our costs of developing products and services compatible with broadband transmission formats and infrastructure. Development of products and services for a broadband transmission infrastructure involves a number of additional risks, including:
| - changes in content delivery methods and protocols; | ||
| - the emergence of new competitors, such as traditional broadcast and cable television companies, which have significant control over access to content, substantial resources and established relationships with media providers; | ||
| - the development by our current competitors, particularly Microsoft and AOL Time Warner, of relationships with, or ownership interests in, companies that have significant access to or control over the broadband transmission infrastructure or content; and | ||
| - the need to establish new relationships with non-PC based providers of broadband access, such as providers of television set-top boxes and cable television, some of which may compete with us. |
MORE INDIVIDUALS ARE UTILIZING NON-PC DEVICES TO ACCESS THE INTERNET AND WE MAY NOT BE SUCCESSFUL IN DEVELOPING A VERSION OF OUR PRODUCTS AND SERVICES THAT WILL GAIN WIDESPREAD ADOPTION BY USERS OF SUCH DEVICES
In the coming years, the number of individuals who access the Internet through devices other than a personal computer, such as personal digital assistants, cellular telephones, television set-top devices, game consoles and Internet appliances, is expected to increase dramatically. Manufacturers of these types of products are increasingly investing in media-related applications, but development of these devices is still in an experimental stage and business models are new and unproven. If we are unable to attract and retain a substantial number of alternative device manufacturers to license and incorporate our technology into their devices, we may fail to capture a sufficient share of an increasingly important portion of the market for digital media delivery. Further, a failure to develop revenue-generating relationships with a sufficient number of device manufacturers could harm our business prospects.
We do not believe that clear standards have emerged with respect to non-PC wireless and cable-based systems, though participants in those industries generally express support for the evolution of industry-wide standards which our technology may or may not support, and which may disfavor proprietary solutions. Likewise, no single company has yet gained a dominant position in the mobile device market. However, certain third party products and
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services in these markets support our technology, and certain support our competitors’ technology, especially that of Microsoft, which can use its monopoly position in the operating system business and other financial resources to gain access to these markets, potentially to our exclusion. Other companies’ products and services, including industry-standard technologies like MPEG-4 and 3GPP, or new standards may emerge or become dominant in any of these areas, and differing standards may emerge among different global markets, which could reduce demand for our technology and products or render them obsolete.
We have also recently announced our Helix initiative, which is aimed, in part, at stimulating development of Internet media technology on non-PC devices. If the open-source features of Helix do not successfully stimulate development of technology on non-PC devices using our platform, our business and prospects could be harmed.
WE COULD LOSE STRATEGIC RELATIONSHIPS THAT ARE ESSENTIAL TO OUR BUSINESS
The loss of certain current strategic relationships or key licensing arrangements, the inability to find other strategic partners or the failure of our existing relationships to achieve meaningful positive results for us could harm our business. We rely in part on strategic relationships to help us:
| - increase adoption of our products through distribution arrangements; | ||
| - increase the amount and availability of compelling media content on the Internet to help boost demand for our products and services, including our RealOne subscription service; | ||
| - acquire desirable or necessary technology components and intellectual property rights; | ||
| - establish and maintain our brands; | ||
| - expand the range of commercial activities based on our technology; | ||
| - expand the distribution of our streaming media content without a degradation in fidelity; and | ||
| - increase the performance and utility of our products and services. |
We would be unable to accomplish many of these goals without the assistance of third parties. For example, we may become more reliant on strategic partners to provide multimedia content and technology, to provide alternative distribution channels, to provide more secure and easy-to-use electronic commerce solutions and to build out the necessary infrastructure for media delivery. We may not be successful in forming or managing strategic relationships and, in particular, we may meet resistance in forging such relationships if our potential strategic partners desire to minimize their dependency on any one technology provider.
OUR BUSINESS WILL SUFFER IF OUR SYSTEMS FAIL OR BECOME UNAVAILABLE
A reduction in the performance, reliability or availability of our Web sites and network infrastructure may harm our ability to distribute our products and services to our users, as well as our reputation and ability to attract and retain users, customers, advertisers and content providers. Our revenues depend in large part on the number of users that download our products from our Web sites, access the content services on our Web sites and use our subscription services. Our systems and operations are susceptible to, and could be damaged or interrupted by, outages caused by fire, flood, power loss, telecommunications failure, Internet breakdown, earthquake and similar events. Our systems are also subject to human error, security breaches, power losses, computer viruses, break-ins, “denial of service” attacks, sabotage, intentional acts of vandalism and tampering designed to disrupt our computer systems, Web sites and network communications, and our systems could be subject to greater vulnerability in periods of high employee turnover, such as after our recent staff reduction. A sudden and significant increase in traffic on our Web sites could strain the capacity of the software, hardware and telecommunications systems that we deploy or use. This could lead to slower response times or system failures.
Our operations also depend on receipt of timely feeds from our content providers, and any failure or delay in the transmission or receipt of such feeds could disrupt our operations. We also depend on Web browsers, ISPs and online service providers to provide Internet users access to our Web sites. Many of these providers have experienced significant outages in the past, and could experience outages, delays and other difficulties due to system failures unrelated to our systems. In addition, certain ISPs have temporarily interrupted our Web site operations and ability to communicate with
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certain customers in response to the heavy volume of email transmissions we generate and send to our large user base. These types of interruptions could continue or increase in the future.
Our electronic commerce and digital distribution activities are managed by sophisticated software and computer systems. We must continually develop and update these systems over time as our business and business needs grow and change, and these systems may not adequately reflect the current needs of our business. We may encounter delays in developing these systems, and the systems may contain undetected errors that could cause system failures, authentication or payment processing problems, or security issues. We have on occasion experienced system errors and failures that cause interruption in availability of products or content or an increase in response time, and any such errors or failures could result in a loss of potential or existing business services customers, users, subscribers, advertisers or content providers. If we suffer sustained or repeated interruptions, our products, services and Web sites could be less attractive to such entities or individuals and our business could be harmed.
Real Broadcast Network’s business is dependent on providing customers with efficient and reliable services to enable such customers to broadcast content to large audiences on a live or on-demand basis. Real Broadcast Network’s operations are also dependent in part upon transmission capacity provided by third-party telecommunications network providers. Any failure of such network providers to provide the capacity we require may result in a reduction in, or interruption of, service to our customers. If we do not have access to third-party transmission capacity, we could lose customers and if we are unable to obtain such capacity on terms commercially acceptable to us, our business and operating results could suffer.
Our computer and communications infrastructure is located at a single leased facility in Seattle, Washington, an area that is at heightened risk of earthquake and volcanic events. We do not have fully redundant systems or a formal disaster recovery plan, and we may not have adequate business interruption insurance to compensate us for losses that may occur from a system outage. Despite our efforts, our network infrastructure and systems could be subject to service interruptions or damage and any resulting interruption of services could harm our business, operating results and reputation.
OUR NETWORK IS SUBJECT TO SECURITY RISKS THAT COULD HARM OUR BUSINESS AND REPUTATION AND EXPOSE US TO LITIGATION OR LIABILITY
Online commerce and communications depend on the ability to transmit confidential information and licensed intellectual property securely over private and public networks. Any compromise of our ability to transmit such information and data securely, and costs associated with preventing or eliminating any problems, could harm our business. Online transmissions are subject to a number of security risks, including:
| - our own or licensed encryption and authentication technology, and access and security procedures, may be compromised, breached or otherwise be insufficient to ensure the security of customer information or intellectual property; | ||
| - we could experience unauthorized access, computer viruses, system interference or destruction, “denial of service” attacks and other disruptive problems, whether intentional or accidental, that may inhibit or prevent access to our Web sites or use of our products and services; and | ||
| - someone could circumvent our security measures and misappropriate our, our partners’ or our customers’ proprietary information or content or interrupt operations. |
The occurrence of any of these or similar events could damage our business, hurt our ability to distribute products and services and collect revenue, threaten the proprietary or confidential nature of our technology, harm our reputation, and expose us to litigation or liability. We may be required to expend significant capital or other resources to protect against the threat of security breaches or hacker attacks or to alleviate problems caused by such breaches or attacks.
OUR INTERNATIONAL OPERATIONS INVOLVE OPERATIONAL AND FINANCIAL RISKS
We operate subsidiaries in ten foreign countries, and market and sell products in a number of other countries. We have also entered into joint ventures internationally. For the quarter ended September 30, 2002, approximately 25% of our revenues were derived from international operations.
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A key part of our strategy is to develop localized products and services in international markets through joint ventures, subsidiaries and branch offices. If we do not successfully implement this strategy, we may not recoup our international investments and we may lose worldwide market share. To date, we have only limited experience in developing localized versions of our products and services and marketing and operating our products and services internationally, and we often rely on the efforts and abilities of our foreign business partners in such activities. We believe that in light of the potential size of the customer base and the audience for content, and the substantial anticipated competition, we need to continue to expand quickly into international markets in order to effectively obtain and maintain market share. International markets we have selected may not develop at a rate that supports our level of investment. In particular, international markets typically have been slower in adoption of the Internet as an advertising and commerce medium, which is reflected in our international revenue results.
In addition to uncertainty about our ability to continue to generate revenues from our foreign operations and expand our international presence, there are certain risks inherent in doing business on an international level, including difficulties in managing operations due to distance, language and cultural differences, including issues associated with establishing management systems infrastructures in individual markets and exchange rate fluctuations.
Any of these factors could harm our future international operations, and consequently our business, operating results and financial condition. We currently manage a portion of our foreign currency exposures. Our foreign currency exchange risk management program reduces, but does not eliminate, the impact of currency exchange rate movements.
WE MAY BE UNABLE TO ADEQUATELY PROTECT OUR PROPRIETARY RIGHTS AND MAY BE SUBJECT TO INTELLECTUAL PROPERTY INFRINGEMENT CLAIMS, WHICH ARE COSTLY TO DEFEND AND COULD LIMIT OUR ABILITY TO USE CERTAIN TECHNOLOGIES IN THE FUTURE
Our inability to protect our proprietary rights, and the costs of doing so, could harm our business. Our success and ability to compete partly depend on the superiority, uniqueness or value of our technology, including both internally developed technology and technology licensed from third parties. To protect our proprietary rights, we rely on a combination of patent, trademark, copyright and trade secret laws, confidentiality agreements with our employees and third parties, and protective contractual provisions. These efforts to protect our intellectual property rights may not be effective in preventing misappropriation of our technology. These efforts also may not prevent the development and design by others of products or technologies similar to or competitive with, or superior to those we develop. Any of these results could reduce the value of our intellectual property.
As of September 30, 2002, we had 44 registered U.S. trademarks or service marks, and had applications pending for several more U.S. trademarks. We also have several unregistered trademarks. In addition, RealNetworks has several foreign trademark registrations and pending applications. Many of our marks begin with the word “Real” (such as RealOne, RealAudio and RealVideo). We are aware of other companies that use “Real” in their marks alone or in combination with other words, and we do not expect to be able to prevent all third-party uses of the word “Real” for all goods and services.
As of September 30, 2002, we had 19 U.S. patents and numerous patent applications on file relating to various aspects of our technology. We intend to increase our investment in filing additional patent applications on other features of our technology. Patents with respect to our technology may not be granted and, if granted, may be challenged or invalidated. Issued patents may not provide us with any competitive advantages and may be challenged by third parties.
Many of our current and potential competitors dedicate substantially greater resources to protection and enforcement of their intellectual property rights, especially patents. Many parties are actively developing streaming media and digital distribution-related technologies, e-commerce and other Web-related technologies, as well as a variety of online business methods and models. We believe that these parties will continue to take steps to protect these technologies, including, but not limited to seeking patent protection. As a result, disputes regarding the ownership of these technologies and rights associated with streaming media, digital distribution and online businesses are likely to arise in the future and may be very costly. In addition to existing patents and intellectual property rights, we anticipate that additional third-party patents related to our products and services will be issued in the future. If a blocking patent has been issued or is issued in the future, we would need to either obtain a license or design
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around the patent. We may not be able to obtain such a license on acceptable terms, if at all, or design around the patent, which could harm our business.
Companies in the technology and content-related industries have frequently resorted to litigation regarding intellectual property rights. We may be forced to litigate to enforce or defend our intellectual property rights, to protect our trade secrets or to determine the validity and scope of other parties’ proprietary rights. Any such litigation could be very costly and could distract our management from focusing on operating our business. In addition, we believe these industries are experiencing an increased level of litigation to determine the applicability of current laws to, and impact of new technologies on, the use and distribution of content over the Internet and through new devices, especially in the music industry, and as we develop products and services that provide or enable the provision of content in such ways, our litigation risk may increase. The existence and/or outcome of such litigation could harm our business.
From time to time we receive claims and inquiries from third parties alleging that our internally developed technology or technology we license from third parties may infringe the third parties’ proprietary rights, especially patents. Third parties have also asserted and most likely will continue to assert claims against us alleging infringement of copyrights, trademark rights, trade secret rights or other proprietary rights, or alleging unfair competition or violations of privacy rights. We are now investigating a number of such pending claims. In July 2002, a lawsuit was filed against the Company in federal court in Boston, alleging that the Company willfully infringes certain patents relating to “the downloading of data from a server computer to a client computer.” The plaintiff seeks to enjoin the Company from the alleged infringing activity and to recover treble damages from the alleged infringement. The Company has filed a counterclaim against the plaintiff seeking a declaratory judgment that the patents at issue are invalid and unenforceable due to plaintiff’s inequitable conduct, as well as its reasonable attorneys fees and costs. We could be required to spend significant amounts of time and money to defend ourselves against such claims. If any of these claims were to prevail, we could be forced to pay damages, comply with injunctions, or stop distributing our products and services while we re-engineer them or seek licenses to necessary technology, which might not be available on reasonable terms. We could also be subject to claims for indemnification resulting from infringement claims made against our customers and strategic partners, which could increase our defense costs and potential damages. Any of these events could require us to change our business practices and harm our business.
In August 1998, Venson M. Shaw and Steven M. Shaw filed a lawsuit against us and co-defendant Broadcast.com in the United States District Court for the Northern District of Texas — Dallas Division. The plaintiffs allege that we, individually and in combination with Broadcast.com, infringe on a certain patent by making, using, selling and/or offering to sell software products and services directed to media delivery systems for the Internet and corporate intranets. The plaintiffs seek to enjoin us from the alleged infringing activity and to recover damages in an amount no less than a reasonable royalty. We believe the allegations are without merit and intend to vigorously defend ourselves against these claims. However, litigation is inherently uncertain, and we may be unable to successfully defend ourselves against this claim.
WE ARE SUBJECT TO RISKS ASSOCIATED WITH GOVERNMENTAL REGULATION AND LEGAL UNCERTAINTIES
Few existing laws or regulations specifically apply to the Internet, other than laws and regulations generally applicable to businesses. Certain U.S. export controls and import controls of other countries, including controls on the use of encryption technologies, may apply to our products. Many laws and regulations, however, are pending and may be adopted in the United States, individual states and local jurisdictions and other countries with respect to the Internet. These laws may relate to many areas that impact our business, including content issues (such as obscenity, indecency and defamation), copyright and other intellectual property rights, encryption, caching of content by server products, personal privacy, taxation, e-mail, sweepstakes, promotions, network and information security and the convergence of traditional communication services with Internet communications, including the future availability of broadband transmission capability and wireless networks. These types of regulations are likely to differ between countries and other political and geographic divisions. Other countries and political organizations are likely to impose or favor more and different regulation than that which has been proposed in the United States, thus furthering the complexity of regulation. In addition, state and local governments may impose regulations in addition to, inconsistent with, or stricter than federal regulations. The adoption of such laws or regulations, and uncertainties associated with their validity, interpretation, applicability and enforcement, may affect the available distribution channels for and costs associated with our products and services, and may affect the growth of the Internet. Such laws or regulations may harm our business. Our products and services may also become subject to investigation and regulation of foreign data protection and e-commerce authorities, including those in the European Union. Such activities could result in additional product and distribution costs for us in order to comply with such regulation.
We do not know for certain how existing laws governing issues such as property ownership, copyright and other intellectual property issues, taxation, gambling, security, illegal or obscene content, retransmission of media, and personal privacy and data protection apply to the Internet. The vast majority of such laws were adopted before the advent of the Internet and related technologies and do not address the unique issues
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associated with the Internet and related technologies. Most of the laws that relate to the Internet have not yet been interpreted. In addition to potential legislation from local, state and federal governments, labor guild agreements and other laws and regulations that impose fees, royalties or unanticipated payments regarding the distribution of media over the Internet may directly or indirectly affect our business. While we and our customers may be directly affected by such agreements, we are not a party to such agreements and have little ability to influence the degree such agreements favor or disfavor Internet distribution or our business models. Changes to or the interpretation of these laws and the entry into such industry agreements could:
| - limit the growth of the Internet; | ||
| - create uncertainty in the marketplace that could reduce demand for our products and services; | ||
| - increase our cost of doing business; | ||
| - expose us to increased litigation risk, substantial defense costs and significant liabilities associated with content available on our Web sites or distributed or accessed through our products or services, with our provision of products and services, and with the features or performance of our products and Web sites; | ||
| - lead to increased product development costs or otherwise harm our business; and/or | ||
| - decrease the rate of growth of our user base and limit our ability to effectively communicate with and market to our user base. |
The Digital Millennium Copyright Act (DMCA) includes statutory licenses for the performance of sound recordings and for the making of recordings to facilitate transmissions. Under these statutory licenses, we and our broadcast customers may be required to pay licensing fees for digital sound recordings we deliver in original and archived programming and through retransmissions of radio broadcasts. The DMCA does not specify the rate and terms of the licenses, which are determined by arbitration proceedings, known as CARP proceedings, supervised by the United States Copyright Office. The CARP panel rendered an opinion on February 20, 2002 setting a royalty rate for non-interactive, non-subscription webcasting services and for re-transmission of terrestrial radio stations’ programming over the Internet. The panel has set a royalty rate per streamed performance of music significantly in excess of the rate requested by webcasters, and set a rate for webcasters of twice that set by traditional broadcasters for re-transmissions of their signals over the Internet. The rate is retroactive to October 1998 and applies through December 31, 2002, at which time a new CARP will commence to review the rate for the next two-year period. On June 20, 2002, the Copyright Office modified the decision of the CARP and announced a lower rate for the compulsory webcast license, but the rate is only available as a flat fee per listener per song and therefore poses economic challenges for webcasters with significant audiences but little or no revenue. Congress may pass legislation that affects the CARP rate and standard, but the outcome of particular legislation cannot be predicted at this time. While we do not currently offer a non-interactive, non-subscription webcasting service and these types of services are not directly affected by this rate, many of our systems software and Real Broadcast Network customers are affected by this rate, which may negatively impact our revenues. There are three other CARPs in process for 2002-2003 which will set rates for subscription music services and services that deliver digital downloads of music, and the outcome of these CARPs will also likely affect our business in ways that we cannot predict. Depending on the rates and terms adopted for the statutory licenses, our business could be harmed both by increasing our own cost of doing business, as well as by increasing the cost of doing business for our customers. We anticipate future CARPs relating to music subscription delivery services, which may also adversely affect the online distribution of music and, in particular, our RealOne Music subscription service.
The Child Online Protection Act and the Child Online Privacy Protection Act impose civil and criminal penalties on persons distributing material harmful to minors (e.g., obscene material) over the Internet to persons under the age of 17, or collecting personal information from children under the age of 13. We do not knowingly distribute harmful materials to minors or collect personal information from children under the age of 13. The manner in which these Acts may be interpreted and enforced cannot be fully determined, and future legislation similar to these Acts could subject us to potential liability if we were deemed to be non-compliant with such rules and regulations, which in turn could harm our business.
There are a large number of legislative proposals before the United States Congress and various state legislatures regarding intellectual property, digital rights management,
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copy protection requirements, privacy, email marketing and security issues related to our business. It is not possible to predict whether or when such legislation may be adopted, and certain proposals, if adopted, could materially and adversely affect our business through a decrease in user registration and revenue, and influence how and whether we can communicate with our customers.
WE MAY BE SUBJECT TO MARKET RISK AND LEGAL LIABILITY IN CONNECTION WITH THE DATA COLLECTION CAPABILITIES OF OUR PRODUCTS AND SERVICES
Many of our products are interactive Internet applications that by their very nature require communication between a client and server to operate. To provide better consumer experiences and to operate effectively, our products occasionally send information to servers at RealNetworks. Many of the services we provide also require that a user provide certain information to us. We post extensive privacy policies concerning the collection, use and disclosure of user data involved in interactions between our client and server products. Any failure by us to comply with our posted privacy policies and existing or new legislation regarding privacy issues could impact the market for our products and services, subject us to litigation and harm our business.
Between November 1999 and March 2000, fourteen lawsuits were filed against us in federal and/or state courts in California, Illinois, Pennsylvania, Texas and Washington. The plaintiffs have voluntarily dismissed all of the state court cases with the exception of the case pending in California. The remaining actions, which seek to certify classes of plaintiffs, allege breach of contract, invasion of privacy, deceptive trade practices, negligence, fraud and violation of certain federal and state laws in connection with various communications features of our RealPlayer and RealJukebox products. Plaintiffs are seeking both damages and injunctive relief. We have filed answers denying the claims and have filed suit in Washington State Court to compel the state court plaintiffs to arbitrate the claims as required by our End User License Agreements. The Washington State Court has granted our motion to compel arbitration. However, the California trial court has entered an order stating that it is not bound by the Washington court’s decision. That order is currently under review by the California Court of Appeal. On February 10, 2000, the federal Judicial Panel on Multidistrict Litigation transferred all pending federal cases to the federal district court for the Northern District of Illinois. On the same day, that court granted RealNetworks’ motion to stay the court proceedings because the claims are subject to arbitration under our End User License Agreement. Although no assurance can be given as to the outcome of these lawsuits, we believe that the allegations in these actions are without merit, and intend to vigorously defend ourselves. If the plaintiffs prevail in their claims, we could be required to pay damages or other penalties, in addition to complying with injunctive relief, which could harm our business and our operating results.
WE MAY BE SUBJECT TO LEGAL LIABILITY FOR THE PROVISION OF THIRD-PARTY PRODUCTS, SERVICES OR CONTENT
We periodically enter into arrangements to offer third-party products, services or content under the RealNetworks brand or via distribution on our Web sites, in products or service offerings. We may be subject to claims concerning these products, services or content by virtue of our involvement in marketing, branding, broadcasting or providing access to them, even if we do not ourselves host, operate, provide, or provide access to these products, services or content. While our agreements with these parties often provide that we will be indemnified against such liabilities, such indemnification may not be adequate. It is also possible that, if any information provided directly by us contains errors or is otherwise negligently provided to users, third parties could make claims against us, including, for example, claims for intellectual property infringement. Investigating and defending any of these types of claims is expensive, even if the claims do not result in liability. If any of these claims do result in liability, we could be required to pay damages or other penalties, which could harm our business and our operating results.
OUR DIRECTORS AND EXECUTIVE OFFICERS BENEFICIALLY OWN APPROXIMATELY 36.8% OF OUR STOCK; THEIR INTERESTS COULD CONFLICT WITH YOURS; SIGNIFICANT SALES OF STOCK HELD BY THEM COULD HAVE A NEGATIVE EFFECT ON OUR STOCK PRICE; SHAREHOLDERS MAY BE UNABLE TO EXERCISE CONTROL
As of September 30, 2002, our executive officers, directors and affiliated persons beneficially owned approximately 36.8% of our common stock. Robert Glaser, our Chief Executive Officer and Chairman of the Board, beneficially owns approximately 33.6% of our common stock. As a result, our executive officers, directors and affiliated persons will have significant influence to:
| - elect or defeat the election of our directors; | ||
| - amend or prevent amendment of our articles of incorporation or bylaws; |
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| - effect or prevent a merger, sale of assets or other corporate transaction; and | ||
| - control the outcome of any other matter submitted to the shareholders for vote. |
Management’s stock ownership may discourage a potential acquirer from making a tender offer or otherwise attempting to obtain control of RealNetworks, which in turn could reduce our stock price or prevent our shareholders from realizing a premium over our stock price.
PROVISIONS OF OUR CHARTER DOCUMENTS, SHAREHOLDER RIGHTS PLAN AND WASHINGTON LAW COULD DISCOURAGE OUR ACQUISITION BY A THIRD PARTY
Our articles of incorporation provide for a strategic transaction committee of the board of directors. Without the prior approval of this committee, and subject to certain limited exceptions, the board of directors does not have the authority to:
| - adopt a plan of merger; | ||
| - authorize the sale, lease, exchange or mortgage of: |
| (A) assets representing more than 50% of the book value of our assets prior to the transaction; or | ||
| B) any other asset or assets on which our long-term business strategy is substantially dependent; |
| - authorize our voluntary dissolution; or | ||
| - take any action that has the effect of any of the above. |
RealNetworks also entered into an agreement providing Mr. Glaser with certain contractual rights relating to the enforcement of our charter documents and Mr. Glaser’s roles and authority within RealNetworks.
We have adopted a shareholder rights plan that provides that shares of our common stock have associated preferred stock purchase rights. The exercise of these rights would make the acquisition of RealNetworks by a third party more expensive to that party and has the effect of discouraging third parties from acquiring RealNetworks without the approval of our board of directors, which has the power to redeem these rights and prevent their exercise.
Washington law imposes restrictions on some transactions between a corporation and certain significant shareholders. The foregoing provisions of our charter documents, shareholder rights plan, our agreement with Mr. Glaser and Washington law, as well as those relating to a classified board of directors and the availability of “blank check” preferred stock, could have the effect of making it more difficult or more expensive for a third party to acquire, or of discouraging a third party from attempting to acquire, control of us. These provisions may therefore have the effect of limiting the price that investors might be willing to pay in the future for our common stock.
OUR STOCK PRICE HAS BEEN AND MAY CONTINUE TO BE VOLATILE
The trading price of our common stock has been and is likely to continue to be highly volatile. For example, during the 52-week period ended September 30, 2002, the price of our common stock ranged from $3.32 to $9.28 per share. Our stock price could be subject to wide fluctuations in response to factors such as:
| - actual or anticipated variations in quarterly operating results; | ||
| - announcements of technological innovations, new products or services by us or our competitors; | ||
| - changes in financial estimates or recommendations by securities analysts; | ||
| - the addition or loss of strategic relationships or relationships with our key customers; | ||
| - conditions or trends in the Internet, streaming media, media delivery and online commerce markets; |
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| - changes in the market valuations of other Internet, online service or software companies; | ||
| - announcements by us or our competitors of significant acquisitions, strategic partnerships, joint ventures or capital commitments or of significant new product developments or changes in business strategy; | ||
| - legal, regulatory or political developments; | ||
| - additions or departures of key personnel; | ||
| - sales of our common stock; and | ||
| - general market conditions. |
In addition, the stock market in general, and the Nasdaq National Market and the market for Internet and technology companies in particular, have experienced extreme price and volume fluctuations that have often been unrelated or disproportionate to the operating performance of these companies. These broad market and industry factors have in the past and may in the future reduce our stock price, regardless of our operating performance.
WE MAY BE SUBJECT TO ASSESSMENT OF SALES AND OTHER TAXES FOR THE SALE OF OUR PRODUCTS, LICENSE OF TECHNOLOGY OR PROVISION OF SERVICES
We may have to pay past sales or other taxes that we have not collected from our customers. We do not currently collect sales or other taxes on the sale of our products, license of technology or provision of services in states and countries other than those in which we have offices or employees.
In October 1998, the Internet Tax Freedom Act (ITFA) was signed into law. Among other things, the ITFA imposed a three-year moratorium on discriminatory taxes on electronic commerce which expired October 20, 2001. In November 2001, the moratorium was extended another three years until November 2004. Nonetheless, foreign countries or, following the moratorium, one or more states, may seek to impose sales or other tax obligations on companies that engage in such activities within their jurisdictions. Specifically, the European Union will begin to subject many Internet products, including ours, to value added taxes beginning in mid-2003. Our business would be harmed if one or more states or any foreign country were able to require us to collect sales or other taxes from current or past sales of products, licenses of technology or provision of services, particularly because we would be unable to go back to customers to collect sales taxes for past sales and may have to pay such taxes out of our own funds.
WE DONATE A PORTION OF NET INCOME TO CHARITY
In periods where we achieve profitability (excluding the effects of goodwill and other acquisition charges), we intend to donate 5% of our annual pre-tax net income to charitable organizations, which will reduce our net income for those periods. The non-profit RealNetworks Foundation manages our charitable giving efforts. We have contributed over $2.5 million to the RealNetworks Foundation over the past several years.
SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS
We have made forward-looking statements in this document, all of which are subject to risks and uncertainties. When we use words such as “anticipate,” “expect,” “intend,” “plan,” “believe,” “seek” and “estimate” or similar words, we are making forward-looking statements. Forward-looking statements include information concerning our possible or assumed future business success or financial results. Such forward-looking statements include, but are not limited to, statements as to our expectations regarding:
| - the future development and growth of, and opportunities for, the Internet and the online media delivery market; | ||
| - the features and functionality of our future products, services and technologies; | ||
| - the future adoption of our current and future products, services and technologies; | ||
| - future revenue opportunities; | ||
| - the future growth of our customer base; | ||
| - our ability to successfully develop and introduce future products and services; |
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| - future expense levels (including cost of revenues, research and development, sales and marketing and general and administrative); | ||
| - future sales and marketing efforts; | ||
| - future capital needs and capital expenditures; | ||
| - the effect of past and future acquisitions; | ||
| - future charges for impairment of long-lived assets and goodwill; | ||
| - future prepayment requirements in our customers’ contracts and the associated effect on deferred revenues; | ||
| - future rates of growth of our costs of service revenues and future reductions in gross margins; | ||
| - the impact of our interest in MusicNet on our operating results; | ||
| - whether we will pay federal income taxes in the near future; | ||
| - potential effects of interest rates on our operating results; | ||
| - the future effectiveness of our intellectual property rights; and | ||
| - the impact of current litigation in which we are involved. |
You should note that an investment in our common stock involves certain risks and uncertainties that could affect our future business success or financial results. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors, including those set forth in “Factors That May Affect Our Business, Future Operating Results and Financial Condition” and elsewhere in this Quarterly Report on Form 10-Q.
We believe that it is important to communicate our expectations to our investors. However, there may be events in the future that we are not able to predict accurately or over which we have no control. Before you invest in our common stock, you should be aware that the occurrence of the events described in the “Factors That May Affect Our Business, Future Operating Results and Financial Condition” and elsewhere in this Quarterly Report on Form 10-Q could materially and adversely affect our business, financial condition and operating results. We undertake no obligation to publicly update any forward-looking statements for any reason, even if new information becomes available or other events occur in the future.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
The following discussion about our market risk involves forward-looking statements. Actual results could differ materially from those projected in the forward-looking statements.
Interest Rate Risk. Our exposure to interest rate risk from changes in market interest rates relates primarily to our short-term investment portfolio. We do not hold derivative financial instruments or equity investments in our short-term investment portfolio. Our short-term investments consist of high quality securities as specified in our investment policy guidelines. Investments in both fixed and floating rate instruments carry a degree of interest rate risk. The fair value of fixed rate securities may be adversely impacted due to a rise in interest rates, while floating rate securities may produce less income than expected if interest rates fall. Additionally, in a falling rate environment there may be a degree of reinvestment risk since as securities mature the proceeds are reinvested at a lower rate, generating less interest income. Due in part to these factors, our future interest income may be adversely impacted due to changes in interest rates. In addition, we may incur losses in principal if we are forced to sell securities which have declined in market value due to changes in interest rates. Because we have historically had the ability to hold our short-term investments until maturity and the substantial majority matures within one year of purchase, we would not expect our operating results or cash flows to be significantly impacted by a sudden change in market interest rates. There have been no material changes in our investment methodology regarding our cash equivalents and short-term investments, and as such, the descriptions under the captions “Interest Rate Risk” remain unchanged from those included in our Annual Report on Form 10-K for the year ended December 31, 2001.
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Investment Risk. As of September 30, 2002, we had investments in voting capital stock of both public and privately-held technology companies for business and strategic purposes. Some of these securities do not have a quoted market price. Our investments in publicly traded companies are carried at current market value and are classified as long-term as they are strategic in nature. We periodically evaluate whether any declines in fair value of our investments are other-than-temporary. This evaluation consists of a review of qualitative and quantitative factors. Equity price fluctuations of plus or minus 10% of prices at September 30, 2002 would have had an approximate $1.8 million impact on the value of our investments in publicly traded companies at September 30, 2002, related primarily to our investment in a publicly traded Japanese company.
Foreign Currency Risk. The Company conducts business internationally in several currencies. As such, it is exposed to adverse movements in foreign currency exchange rates.
The Company’s exposures to foreign exchange rate fluctuations arise in part from: (1) translation of the financial results of foreign subsidiaries into U.S. dollars in consolidation, (2) the re-measurement of non-functional currency assets, liabilities and intercompany balances into US dollars for financial reporting purposes, and (3) non-US dollar denominated sales to foreign customers.
A portion of these risks is managed through the use of financial derivatives, but fluctuations could impact the Company’s results of operations and financial position.
Generally, the Company’s practice is to manage foreign currency risk for the majority of material short-term intercompany balances through the use of foreign currency forward contracts. These contracts require the Company to exchange currencies at rates agreed upon at the contract’s inception. Because the impact of movements in currency exchange rates on forward contracts offsets the related impact on the short-term intercompany balances, these financial instruments help alleviate the risk that might otherwise result from certain changes in currency exchange rates. The Company does not designate its foreign exchange forward contracts related to short-term intercompany accounts as hedges and, accordingly, the Company adjusts these instruments to fair value through results of operations. However, the Company may periodically hedge a portion of its foreign exchange exposures associated with material firmly committed transactions and long-term investments.
The Company’s foreign currency risk management program reduces, but does not entirely eliminate, the impact of currency exchange rate movements.
Historically, neither fluctuations in foreign exchange rates nor changes in foreign economic conditions have had a significant impact on our financial condition or results of operations. Foreign exchange rate fluctuations did not have a material impact on our financial results for the quarters and nine months ended September 30, 2002 and 2001.
At September 30, 2002, we had the following foreign currency contracts
outstanding (in thousands):
Contract Amount
Contract Amount
(Local Currency)
(US Dollars)
Fair Value
(GBP)500
$
760
$
17
(YEN)276,125
$
2,332
$
74
All derivatives, whether designated in hedging relationships or not, are recorded on the balance sheet at fair value.
Item 4. Controls and Procedures
| (a) | Evaluation of Disclosure Controls and Procedures. Based on their evaluation as of a date within 90 days of the filing date of this Quarterly Report on Form 10-Q, the Company’s principal executive officer and principal financial officer have concluded that the Company’s disclosure controls and procedures (as defined in Rules 13a-14(c) and 15d-14(c) under the Securities Exchange Act of 1934 (the “Exchange Act”)) are effective to ensure that information required to be |
47
| disclosed by the Company in reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms. | |||
| (b) | Changes in Internal Controls. There were no significant changes in the Company’s internal controls or in other factors that could significantly affect these controls subsequent to the date of their evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. |
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
In August 1998, Venson M. Shaw and Steven M. Shaw filed a lawsuit against the Company and co-defendant Broadcast.com in the United States District Court for the Northern District of Texas — Dallas Division. The plaintiffs allege that the Company, individually and in combination with Broadcast.com, infringes on a certain patent by making, using, selling and/or offering to sell software products and services directed to media delivery systems for the Internet and corporate intranets. The plaintiffs seek to enjoin the Company from the alleged infringing activity and to recover damages in an amount no less than a reasonable royalty. The Company may be required to indemnify Broadcast.com under the terms of its license agreement. The plaintiffs filed a similar claim based on the same patent and seeking similar remedies as a separate lawsuit against Microsoft and Broadcast.com in the same court. The court has consolidated the lawsuit against Microsoft and Broadcast.com with the lawsuit against the Company and Broadcast.com. If the plaintiffs prevail in their claims, the Company could be required to pay damages or other royalties, in addition to complying with injunctive relief, which could have a material adverse effect on the Company’s operating results. Although no assurance can be given as to the outcome of this lawsuit, the Company believes that the allegations in this action are without merit, and intends to vigorously defend itself against these claims. The Company believes the ultimate outcome will not have a material adverse effect on its financial position or results of operations.
Between November 1999 and March 2000, fourteen lawsuits were filed against the Company in federal and/or state courts in California, Illinois, Pennsylvania, Texas and Washington. The plaintiffs have voluntarily dismissed all of the state court cases with the exception of the case pending in California. The remaining actions, which seek to certify classes of plaintiffs, allege breach of contract, invasion of privacy, deceptive trade practices, negligence, fraud and violation of certain federal and state laws in connection with various communications features of the Company’s RealPlayer and RealJukebox products. Plaintiffs are seeking both damages and injunctive relief. The Company has filed answers denying the claims and has filed suit in Washington State Court to compel the state court plaintiffs to arbitrate the claims as required by the Company’s End User License Agreements. The Washington State Court has granted the Company’s motion to compel arbitration. However, the California trial court has entered an order stating that it is not bound by the Washington court’s decision. That order is currently under review by the California Court of Appeal. On February 10, 2000, the federal Judicial Panel on Multidistrict Litigation transferred all pending federal cases to the federal district court for the Northern District of Illinois. On the same day, that court granted RealNetworks’ motion to stay the court proceedings because the claims are subject to arbitration under RealNetworks’ End User License Agreement. Although no assurance can be given as to the outcome of these lawsuits, the Company believes that the allegations in these actions are without merit, and intends to vigorously defend itself. The Company believes the ultimate outcome will not have a material adverse effect on its financial position or results of operations. If the plaintiffs prevail in their claims, the Company could be required to pay damages or other penalties in addition to complying with injunctive relief, which could harm the Company’s business and its operating results.
48
From time to time RealNetworks is, and expects to continue to be, subject to legal proceedings and claims in the ordinary course of its business, including employment claims, contract-related claims and claims of alleged infringement of third-party patents, trademarks and other intellectual property rights. These claims, even if not meritorious, could force the Company to spend significant financial and managerial resources. The Company currently has a number of such claims threatened against it relating to intellectual property infringement or employment, though it believes these claims are without merit. In July 2002, a lawsuit was filed against the Company in federal court in Boston, alleging that the Company willfully infringes certain patents relating to “the downloading of data from a server computer to a client computer.” The plaintiff seeks to enjoin the Company from the alleged infringing activity and to recover treble damages arising from the alleged infringement. The Company has filed a counterclaim against the plaintiff seeking a declaratory judgment that the patents at issue are invalid and unenforceable due to plaintiff’s inequitable conduct, as well as its reasonable attorneys fees and costs. Although no assurance can be given as to the outcome of this lawsuit, the Company believes that the plaintiff’s allegations in this action are without merit and intends to vigorously defend itself against these claims. The Company is not aware of any legal proceedings or claims that the Company believes will have, individually or taken together, a material adverse effect on the Company’s business, prospects, financial condition or results of operations. However, the Company may incur substantial expenses in defending against third party claims. In the event of a determination adverse to the Company, the Company may incur substantial monetary liability, and/or be required to change its business practices. Either of these could have a material adverse effect on the Company’s financial position and results of operations.
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits Required by Item 601 of Regulation S-K:
Exhibit Number
Description
10.1
Form of Stock Option Agreement under the RealNetworks, Inc.
1996 Stock Option Plan, as amended and restated
10.2
Form of Stock Option Agreement under the RealNetworks, Inc.
2000 Stock Option Plan, as amended and restated
10.3
Forms of Stock Option Agreement under the RealNetworks, Inc.
2002 Director Stock Option Plan
99.1
Certification of Robert Glaser, Chairman and Chief Executive
Officer of RealNetworks, Inc., Pursuant to 18 U.S.C. Section
1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley
Act of 2002
99.2
Certification of Brian V. Turner, Senior Vice President,
Finance and Operations, Chief Financial Officer and Treasurer
of RealNetworks, Inc., Pursuant to 18 U.S.C. Section 1350, as
Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of
2002
(b) Reports on Form 8-K:
None
49
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized, on November 14, 2002.
| REALNETWORKS, INC. |
| By | /s/ Brian V. Turner | |||
|
|
||||
|
Brian V. Turner
Senior Vice President, Finance and Operations, Chief Financial Officer and Treasurer (Principal Financial and Accounting Officer) |
50
CERTIFICATION
I, Robert Glaser, certify that:
Date: November 14, 2002
51
1.
I have reviewed this quarterly report on Form 10-Q of RealNetworks, Inc.;
2.
Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this quarterly
report;
3.
Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and cash
flows of the registrant as of, and for, the periods presented in this
quarterly report;
4.
The registrant’s other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and
have:
a)
designed such disclosure controls and procedures to ensure
that material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within
those entities, particularly during the period in which this
quarterly report is being prepared;
b)
evaluated the effectiveness of the registrant’s disclosure
controls and procedures as of a date within 90 days prior to the
filing date of this quarterly report (the “Evaluation Date”); and
c)
presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5.
The registrant’s other certifying officer and I have disclosed, based on
our most recent evaluation, to the registrant’s auditors and the audit
committee of registrant’s board of directors (or persons performing the
equivalent functions):
a)
all significant deficiencies in the design or operation of
internal controls which could adversely affect the registrant’s
ability to record, process, summarize and report financial data and
have identified for the registrant’s auditors any material
weaknesses in internal controls; and
b)
any fraud, whether or not material, that involves management
or other employees who have a significant role in the registrant’s
internal controls; and
6.
The registrant’s other certifying officer and I have indicated in this
quarterly report whether there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation, including
any corrective actions with regard to significant deficiencies and
material weaknesses.
/s/ Robert Glaser
Robert Glaser
Chairman and Chief Executive Officer
(Principal Executive Officer)
Table of Contents
CERTIFICATION
I, Brian V. Turner, certify that:
Date: November 14, 2002
52
1.
I have reviewed this quarterly report on Form 10-Q of RealNetworks, Inc.;
2.
Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to
make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by
this quarterly report;
3.
Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and cash
flows of the registrant as of, and for, the periods presented in this
quarterly report;
4.
The registrant’s other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and
have:
a)
designed such disclosure controls and procedures to ensure
that material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within
those entities, particularly during the period in which this
quarterly report is being prepared;
b)
evaluated the effectiveness of the registrant’s disclosure
controls and procedures as of a date within 90 days prior to the
filing date of this quarterly report (the “Evaluation Date”); and
c)
presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5.
The registrant’s other certifying officer and I have disclosed, based on
our most recent evaluation, to the registrant’s auditors and the audit
committee of registrant’s board of directors (or persons performing the
equivalent functions):
a)
all significant deficiencies in the design or operation of
internal controls which could adversely affect the registrant’s
ability to record, process, summarize and report financial data and
have identified for the registrant’s auditors any material
weaknesses in internal controls; and
b)
any fraud, whether or not material, that involves management
or other employees who have a significant role in the registrant’s
internal controls; and
6.
The registrant’s other certifying officer and I have indicated in this
quarterly report whether there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation, including
any corrective actions with regard to significant deficiencies and
material weaknesses.
/s/ Brian V. Turner
Brian V. Turner
Senior Vice President, Finance and Operations,
Chief Financial Officer and Treasurer
(Principal Financial Officer)
Table of Contents
INDEX TO EXHIBITS
| Exhibit Number | Description | |
|
|
|
|
| 10.1 | Form of Stock Option Agreement under the RealNetworks, Inc. 1996 Stock Option Plan, as amended and restated | |
| 10.2 | Form of Stock Option Agreement under the RealNetworks, Inc. 2000 Stock Option Plan, as amended and restated | |
| 10.3 | Forms of Stock Option Agreement under the RealNetworks, Inc. 2002 Director Stock Option Plan | |
| 99.1 | Certification of Robert Glaser, Chairman and Chief Executive Officer of RealNetworks, Inc., Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 | |
| 99.2 | Certification of Brian V. Turner, Senior Vice President, Finance and Operations, Chief Financial Officer and Treasurer of RealNetworks, Inc., Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |
53
EXHIBIT 10.1
STOCK OPTION AGREEMENT
THIS STOCK OPTION AGREEMENT (this "Agreement") is entered into effective as of the effective date (the "Grant Date") set forth in the Notice of Grant of Stock Options and Option Agreement attached hereto (the "Notice of Grant"), by RealNetworks, Inc., a Washington corporation (the "Company"), and you (the "Holder").
RECITALS
A. The Company has adopted the RealNetworks, Inc. 1996 Stock Option Plan, as amended and restated (the "Plan"), a copy of which has been provided to the Holder (capitalized terms that are used but not defined in this Agreement will have the meanings given those terms in the Plan).
B. The Holder is an employee of the Company or one of its Affiliates (as defined in the Plan), and has been designated by the Administrative Committee to receive a stock option under the Plan.
NOW, THEREFORE, the Company and the Holder covenant and agree as follows:
1. GRANT OF THE OPTION. Subject to the terms of this Agreement and the Plan, the Company hereby grants to the Holder a stock option (the "Option") to acquire from the Company the number of shares of the Common Stock, par value $.001, of the Company (the "Common Stock") set forth in the Notice of Grant, at the price set forth in the Notice of Grant (the "Option Price"). The Option is not intended to qualify as an "incentive stock option", as that term is defined in Section 422 of the Internal Revenue Code of 1986, as amended.
2. TERM OF THE OPTION. Unless earlier terminated in accordance with the
provisions of the Plan, the Option will terminate on the earliest to occur
of (a) the expiration of Twenty (20) years from the Grant Date; (b) the
expiration of ninety (90) days following termination of the Holder's
employment with the Company for any reason other than death, Disability or
Cause (as defined in Section 7.2(b) of the Plan); (c) the expiration of One
(1) year following termination of the Holder's employment with the Company
on account of death or Disability; and (d) the date of termination of the
Holder's employment with the Company for Cause (as defined in Section 7.2(b)
of the Plan); provided, however, that, in the case of termination of the
Holder's employment with the Company for any reason other than death,
Disability or Cause (as defined in Section 7.2(b) of the Plan), if the
Holder dies after such termination but prior to termination of the Option as
set forth in this Section 2 above, the Option will not terminate as set
forth in this Section 2 above, but rather shall terminate on the earlier to
occur of the expiration of Twenty (20) years from the Grant Date or the
expiration of One (1) year following the Holder's death.
3. VESTING. The vesting schedule applicable to the Option shall be as set forth in the Notice of Grant, subject to sub-paragraphs (a) and (b) below. On any scheduled vesting date, vesting actually will occur only if you remain an employee of the Company or any of its Affiliates (as defined in the Plan) through the vesting date.
(a) Notwithstanding anything in this Agreement to the contrary, if the Company terminates Holder's employment for any reason other than for Cause (as defined in Section 7.2(b) of the Plan) and Holder executes and delivers a Settlement Agreement and Release ("Release") satisfactory to the Company on or before the Effective Date (as defined in the Release), the vesting schedule set forth below shall apply instead of the vesting schedule described in the Notice of Grant.
VESTING UPON EXECUTION OF RELEASE. 1/60 of the shares subject to the Option shall vest upon the completion of one month of employment following the date on which the
vesting of the Option commences, and an additional 1/60 of the shares subject to the Option shall vest upon the completion of each successive month of employment thereafter, up to the Holder's date of termination (as defined in the Release).
(b) If the Holder's employment with the Company terminates for any reason other than the Holder's death, the Option will not vest further following such termination. If the Holder's employment with the Company terminates due to the Holder's death, the Option will fully vest on the date of termination of employment. In either case, to the extent the Option is vested, it shall be exercisable only prior to its termination as provided in Section 2.
4. OTHER LIMITATIONS OF THE OPTION. The Option is subject to all of the
provisions of the Plan, including but not limited to Section 4.2 (which
permits adjustments to the Option upon the occurrence of certain corporate
events such as stock dividends, extraordinary cash dividends,
reclassifications, recapitalizations, reorganizations, split-ups, spin-offs,
combinations, exchanges of shares, and warrants or rights offerings) and
Section 7.1 (which applies in the event of an Approved Transaction or
Control Purchase).
5. EXERCISE OF THE OPTION. To exercise the Option, the Holder must do the following:
(a) deliver to the Company a written notice, in the form attached to this Agreement as Exhibit A, specifying the number of shares of Common Stock for which the Option is being exercised;
(b) tender payment of the aggregate Option Price for the shares for which the Option is being exercised, which payment may be made (i) in cash or by check; or (ii) by such other means as the Administrative Committee, in its sole discretion, shall permit at the time of exercise;
(c) pay, or make arrangements satisfactory to the Administrative Committee for payment to the Company of all federal, state and local taxes, if any, required to be withheld by the Company in connections with the exercise of the Option; and
(d) execute and deliver to the Company the documents required by the Plan and any other documents required from time to time by the Administrative Committee in order to promote compliance with applicable laws, rules and regulations.
6. DELIVERY OF SHARE CERTIFICATE. As soon as practicable after the Option has been duly exercised, the Company will deliver to the Holder a certificate for the shares of Common Stock for which the Option was exercised. Unless the Option has expired or been exercised in full, the Company and the Holder agree to execute a new Stock Option Agreement, covering the remaining shares of Common Stock that may be acquired upon exercise of the Option, which will be identical to this Agreement except as to the number of shares of Common Stock subject thereto. In lieu of replacing this Agreement in such manner, the Company may affix to this Agreement an appropriate notation indicating the number of shares for which the Option was exercised and return this Agreement to the Holder.
7. NONTRANSFERABILITY. The Option is not transferable other than by will or the laws of descent and distribution, and the Option may be exercised during the lifetime of the Holder only by the Holder or the Holder's court appointed legal representative.
8. WARRANTIES AND REPRESENTATIONS OF THE HOLDER. By executing this Agreement, the Holder accepts the Option, acknowledges receipt of a copy of the Plan and the Prospectus, and agrees to comply with all of the provisions of this Agreement.
9. RIGHTS OF THE SHAREHOLDER. The Holder will have no rights as a shareholder of the Company on account of the Option or on account of shares of Common Stock which will be acquired upon exercise of the Option (but with respect to which no certificates have been issued).
10. TAX WITHHOLDING. The Holder agrees to pay, or to make arrangements satisfactory to the Administrative Committee for payment to the Company of, all federal, state and local income and employment taxes, if any, required to be withheld by the Company in connection with the exercise of the Option or any sale, transfer or other disposition of any shares of Common Stock acquired upon exercise of the Option. If the Holder fails to do so, then the Holder hereby authorizes the Company to deduct all or any portion of such taxes from any payment of any kind otherwise due to the Holder.
11. POLICY ON AVOIDANCE OF INSIDER TRADING. The Holder acknowledges that he/she has received and read the RealNetworks Policy on Avoidance of Insider Trading, and, if applicable, the Addendum to the Policy on Avoidance of Insider Trading, and the Holder agrees to comply with the Policy's terms, together with the terms of the Addendum, if applicable.
12. FURTHER ASSURANCES. The Holder agrees from time to time to execute such additional documents as the Company may reasonably require to effectuate the purposes of the Plan and this Agreement.
13. BINDING EFFECT. This Agreement shall be binding upon the Holder and the Holder's heirs, successors and assigns.
14. ENTIRE AGREEMENT; MODIFICATIONS. This Agreement and the exhibits hereto, together with the Plan and agreements referenced in this Agreement and/or the Plan, constitutes the entire agreement and understanding between the Company and the Holder regarding the subject matter hereof. Except as otherwise provided in the Plan, no modification of the Option or this Agreement, or waiver of any provision of this Agreement or the Plan, shall be valid unless in writing and duly executed by the Company and the Holder. The failure of any party to enforce any of that party's rights against the other party for breach of any of the terms of this Agreement shall not be construed as a waiver of such rights as to any continued or subsequent breach.
15. COST OF LITIGATION. In any action at law or in equity to enforce any of the provisions or rights under this Agreement, the unsuccessful party to such litigation, as determined by the court in a final judgement or decree, shall pay the successful party or parties all costs, expenses and reasonable attorneys' fees incurred by the successful party or parties (including without limitation costs, expenses and fees in any appellate proceedings), and if the successful party recovers judgment in any such action or proceeding, such costs, expenses and attorney's fees shall be included as part of the judgment.
16. GOVERNING LAW. This Agreement shall be governed by the laws of the State of Washington.
17. SEVERABILITY. If any provision of this Agreement shall be judicially determined to be invalid, illegal or unenforceable, the validity, legality and enforceability of the remaining provisions shall not in any way be affected or impaired thereby.
EXHIBIT A
FORM OF EXERCISE OF OPTION
To: RealNetworks, Inc.
2601 Elliott Avenue, #1000
Seattle, WA 98121
The undersigned holds Option Number NQ-___ (the "Option"), represented by a Stock Option Agreement dated effective as of ____________ (the "Agreement"), granted to the undersigned pursuant to the RealNetworks, Inc. 1996 Stock Option Plan, as Amended and Restated (the "Plan"). The undersigned hereby exercises the Option and elects to purchase ______________ shares (the "Shares") of Common Stock of RealNetworks, Inc. (the "Company") pursuant to the Option. This notice is accompanied by full payment of the Option Price of $______ per share for the Shares in cash or by check or in another manner permitted by Section 5(c) of the Agreement. The undersigned has also paid, or made arrangements satisfactory to the Administrative Committee administering the Plan for payment of, all federal, state and local taxes, if any, required to be withheld by the Company in connection with the exercise of the Option.
SIGNATURE OF HOLDER
EXHIBIT 10.2
STOCK OPTION AGREEMENT
THIS STOCK OPTION AGREEMENT (this "Agreement") is entered into effective as of the effective date (the "Grant Date") set forth in the Notice of Grant of Stock Options and Option Agreement attached hereto (the "Notice of Grant"), by RealNetworks, Inc., a Washington corporation (the "Company"), and you (the "Holder").
RECITALS
A. The Company has adopted the RealNetworks, Inc. 2000 Stock Option Plan, as amended and restated (the "Plan"), a copy of which has been provided to the Holder (capitalized terms that are used but not defined in this Agreement will have the meanings given those terms in the Plan).
B. The Holder is an employee of the Company or one of its Affiliates (as defined in the Plan), and has been designated by the Administrative Committee to receive a stock option under the Plan.
NOW, THEREFORE, the Company and the Holder covenant and agree as follows:
1. GRANT OF THE OPTION. Subject to the terms of this Agreement and the Plan, the Company hereby grants to the Holder a stock option (the "Option") to acquire from the Company the number of shares of the Common Stock, par value $.001, of the Company (the "Common Stock") set forth in the Notice of Grant, at the price set forth in the Notice of Grant (the "Option Price"). The Option is not intended to qualify as an "incentive stock option", as that term is defined in Section 422 of the Internal Revenue Code of 1986, as amended.
2. TERM OF THE OPTION. Unless earlier terminated in accordance with the
provisions of the Plan, the Option will terminate on the earliest to occur
of (a) the expiration of Twenty (20) years from the Grant Date; (b) the
expiration of ninety (90) days following termination of the Holder's
employment with the Company for any reason other than death, Disability or
Cause (as defined in Section 7.2(b) of the Plan); (c) the expiration of One
(1) year following termination of the Holder's employment with the Company
on account of death or Disability; and (d) the date of termination of the
Holder's employment with the Company for Cause (as defined in Section 7.2(b)
of the Plan); provided, however, that, in the case of termination of the
Holder's employment with the Company for any reason other than death,
Disability or Cause (as defined in Section 7.2(b) of the Plan), if the
Holder dies after such termination but prior to termination of the Option as
set forth in this Section 2 above, the Option will not terminate as set
forth in this Section 2 above, but rather shall terminate on the earlier to
occur of the expiration of Twenty (20) years from the Grant Date or the
expiration of One (1) year following the Holder's death.
3. VESTING. The vesting schedule applicable to the Option shall be as set forth in the Notice of Grant, subject to sub-paragraphs (a) and (b) below. On any scheduled vesting date, vesting actually will occur only if you remain an employee of the Company or any of its Affiliates (as defined in the Plan) through the vesting date.
(a) Notwithstanding anything in this Agreement to the contrary, if the Company terminates Holder's employment for any reason other than for Cause (as defined in Section 7.2(b) of the Plan) and Holder executes and delivers a Settlement Agreement and Release ("Release") satisfactory to the Company on or before the Effective Date (as defined in the Release), the vesting schedule set forth below shall apply instead of the vesting schedule described in the Notice of Grant.
VESTING UPON EXECUTION OF RELEASE. 1/60 of the shares subject to the Option shall vest upon the completion of one month of employment following the date on which the
vesting of the Option commences, and an additional 1/60 of the shares subject to the Option shall vest upon the completion of each successive month of employment thereafter, up to the Holder's date of termination (as defined in the Release).
(b) If the Holder's employment with the Company terminates for any reason other than the Holder's death, the Option will not vest further following such termination. If the Holder's employment with the Company terminates due to the Holder's death, the Option will fully vest on the date of termination of employment. In either case, to the extent the Option is vested, it shall be exercisable only prior to its termination as provided in Section 2.
4. OTHER LIMITATIONS OF THE OPTION. The Option is subject to all of the
provisions of the Plan, including but not limited to Section 4.2 (which
permits adjustments to the Option upon the occurrence of certain corporate
events such as stock dividends, extraordinary cash dividends,
reclassifications, recapitalizations, reorganizations, split-ups, spin-offs,
combinations, exchanges of shares, and warrants or rights offerings) and
Section 7.1 (which applies in the event of an Approved Transaction or
Control Purchase).
5. EXERCISE OF THE OPTION. To exercise the Option, the Holder must do the following:
(a) deliver to the Company a written notice, in the form attached to this Agreement as Exhibit A, specifying the number of shares of Common Stock for which the Option is being exercised;
(b) tender payment of the aggregate Option Price for the shares for which the Option is being exercised, which payment may be made (i) in cash or by check; or (ii) by such other means as the Administrative Committee, in its sole discretion, shall permit at the time of exercise;
(c) pay, or make arrangements satisfactory to the Administrative Committee for payment to the Company of all federal, state and local taxes, if any, required to be withheld by the Company in connections with the exercise of the Option; and
(d) execute and deliver to the Company the documents required by the Plan and any other documents required from time to time by the Administrative Committee in order to promote compliance with applicable laws, rules and regulations.
6. DELIVERY OF SHARE CERTIFICATE. As soon as practicable after the Option has been duly exercised, the Company will deliver to the Holder a certificate for the shares of Common Stock for which the Option was exercised. Unless the Option has expired or been exercised in full, the Company and the Holder agree to execute a new Stock Option Agreement, covering the remaining shares of Common Stock that may be acquired upon exercise of the Option, which will be identical to this Agreement except as to the number of shares of Common Stock subject thereto. In lieu of replacing this Agreement in such manner, the Company may affix to this Agreement an appropriate notation indicating the number of shares for which the Option was exercised and return this Agreement to the Holder.
7. NONTRANSFERABILITY. The Option is not transferable other than by will or the laws of descent and distribution, and the Option may be exercised during the lifetime of the Holder only by the Holder or the Holder's court appointed legal representative.
8. WARRANTIES AND REPRESENTATIONS OF THE HOLDER. By executing this Agreement, the Holder accepts the Option, acknowledges receipt of a copy of the Plan and the Prospectus, and agrees to comply with all of the provisions of this Agreement.
9. RIGHTS OF THE SHAREHOLDER. The Holder will have no rights as a shareholder of the Company on account of the Option or on account of shares of Common Stock which will be acquired upon exercise of the Option (but with respect to which no certificates have been issued).
10. TAX WITHHOLDING. The Holder agrees to pay, or to make arrangements satisfactory to the Administrative Committee for payment to the Company of, all federal, state and local income and employment taxes, if any, required to be withheld by the Company in connection with the exercise of the Option or any sale, transfer or other disposition of any shares of Common Stock acquired upon exercise of the Option. If the Holder fails to do so, then the Holder hereby authorizes the Company to deduct all or any portion of such taxes from any payment of any kind otherwise due to the Holder.
11. POLICY ON AVOIDANCE OF INSIDER TRADING. The Holder acknowledges that he/she has received and read the RealNetworks Policy on Avoidance of Insider Trading, and, if applicable, the Addendum to the Policy on Avoidance of Insider Trading, and the Holder agrees to comply with the Policy's terms, together with the terms of the Addendum, if applicable.
12. FURTHER ASSURANCES. The Holder agrees from time to time to execute such additional documents as the Company may reasonably require to effectuate the purposes of the Plan and this Agreement.
13. BINDING EFFECT. This Agreement shall be binding upon the Holder and the Holder's heirs, successors and assigns.
14. ENTIRE AGREEMENT; MODIFICATIONS. This Agreement and the exhibits hereto, together with the Plan and agreements referenced in this Agreement and/or the Plan, constitutes the entire agreement and understanding between the Company and the Holder regarding the subject matter hereof. Except as otherwise provided in the Plan, no modification of the Option or this Agreement, or waiver of any provision of this Agreement or the Plan, shall be valid unless in writing and duly executed by the Company and the Holder. The failure of any party to enforce any of that party's rights against the other party for breach of any of the terms of this Agreement shall not be construed as a waiver of such rights as to any continued or subsequent breach.
15. COST OF LITIGATION. In any action at law or in equity to enforce any of the provisions or rights under this Agreement, the unsuccessful party to such litigation, as determined by the court in a final judgement or decree, shall pay the successful party or parties all costs, expenses and reasonable attorneys' fees incurred by the successful party or parties (including without limitation costs, expenses and fees in any appellate proceedings), and if the successful party recovers judgment in any such action or proceeding, such costs, expenses and attorney's fees shall be included as part of the judgment.
16. GOVERNING LAW. This Agreement shall be governed by the laws of the State of Washington.
17. SEVERABILITY. If any provision of this Agreement shall be judicially determined to be invalid, illegal or unenforceable, the validity, legality and enforceability of the remaining provisions shall not in any way be affected or impaired thereby.
EXHIBIT A
FORM OF EXERCISE OF OPTION
To: RealNetworks, Inc.
2601 Elliott Avenue, #1000
Seattle, WA 98121
The undersigned holds Option Number NQ-___ (the "Option"), represented by a Stock Option Agreement dated effective as of ____________ (the "Agreement"), granted to the undersigned pursuant to the RealNetworks, Inc. 2000 Stock Option Plan, as Amended and Restated (the "Plan"). The undersigned hereby exercises the Option and elects to purchase ______________ shares (the "Shares") of Common Stock of RealNetworks, Inc. (the "Company") pursuant to the Option. This notice is accompanied by full payment of the Option Price of $______ per share for the Shares in cash or by check or in another manner permitted by Section 5(c) of the Agreement. The undersigned has also paid, or made arrangements satisfactory to the Administrative Committee administering the Plan for payment of, all federal, state and local taxes, if any, required to be withheld by the Company in connection with the exercise of the Option.
SIGNATURE OF HOLDER
EXHIBIT 10.3
REALNETWORKS, INC.
STOCK OPTION AGREEMENT
[INITIAL GRANT A]
RealNetworks, Inc. (the "Company"), has granted to _________ (the "Optionee"), an option to purchase a total of ____ shares of the Company's Common Stock, par value $.001 per share (the "Optioned Stock"), at the price determined as provided herein, and in all respects subject to the terms, definitions and provisions of the Company's 2002 Director Stock Option Plan (the "Plan") adopted by the Company which is incorporated herein by reference. The terms defined in the Plan shall have the same defined meanings herein.
1. Nature of the Option. This Option is a nonstatutory option and is not
intended to qualify as an "incentive stock option," as that term is defined in
Section 422 of the Internal Revenue Code of 1986, as amended.
2. Exercise Price. The exercise price is $____ for each share of Common Stock.
3. Exercise of Option. This Option shall be exercisable during its term in accordance with the provisions of Section 8 of the Plan as follows:
(i) Right to Exercise.
(a) This Option shall become exercisable in installments cumulatively with respect to one-third (1/3) of the Optioned Stock one year after the date of grant, and as to an additional one-third (1/3) of the Optioned Stock on each anniversary of the date of grant, so that one hundred percent (100%) of the Optioned Stock shall be exercisable three (3) years after the date of grant, provided that the Optionee remains a Director on such dates.
(b) This Option may not be exercised for a fraction of a share.
(c) In the event of Optionee's death, disability or other termination of service as a Director, the exercisability of the Option is governed by Section 8 of the Plan.
(ii) Method of Exercise. This Option shall be exercisable by written notice which shall state the election to exercise the Option and the number of Shares in respect of which the Option is being exercised. Such written notice, in the form attached hereto as Exhibit A (or such other notice as the Company may specify), shall be signed by the Optionee and shall be delivered in person or by mail to the Company. The written notice shall be accompanied by payment of the exercise price.
4. Method of Payment. Payment of the exercise price shall be by any of the following, or a combination thereof, at the election of the Optionee:
(i) cash;
(ii) check; or
(iii) delivery of a properly executed exercise notice, together with such other documentation as the Company and the broker, if applicable, shall require to effect an exercise of the Option and delivery to the Company of the sale or loan proceeds required to pay the exercise price.
5. Restrictions on Exercise. This Option may not be exercised if the issuance of such Shares upon such exercise or the method of payment of consideration for such shares would constitute a violation of any applicable federal or state securities or other law or regulations, or if such issuance would not comply with the requirements of any stock exchange upon which the Shares may then be listed. As a condition to the exercise of this Option, the Company may require Optionee to make any representation and warranty to the Company as may be required by any applicable law or regulation.
6. Non-Transferability of Option. This Option may not be transferred in any manner otherwise than by will or by the laws of descent or distribution and may be exercised during the lifetime of the Optionee only by the Optionee. The terms of this Option shall be binding upon the executors, administrators, heirs, successors and assigns of the Optionee.
7. Term of Option. This Option may not be exercised more than ten (10) years from the date of grant of this Option, and may be exercised during such period only in accordance with the Plan and the terms of this Option.
RealNetworks, Inc.
(a Washington corporation)
Optionee acknowledges receipt of a copy of the Plan, a copy of which is attached hereto, and represents that he or she is familiar with the terms and provisions thereof, and hereby accepts this Option subject to all of the terms and provisions thereof. Optionee hereby agrees to accept as binding, conclusive and final all decisions or interpretations of the Board upon any questions arising under the Plan.
EXHIBIT A
DIRECTOR STOCK OPTION EXERCISE NOTICE
RealNetworks, Inc.
2601 Elliott Avenue, Suite 1000
Seattle, WA 98121
Attention: Corporate Secretary
1. Exercise of Option. The undersigned ("Optionee") hereby elects to exercise Optionee's option to purchase ____ shares of the Common Stock, par value $.001 per share (the "Shares"), of RealNetworks, Inc. (the "Company") under and pursuant to the Company's 2002 Director Stock Option Plan and the Director Option Agreement dated ________ (the "Agreement).
2. Representations of Optionee. Optionee acknowledges that Optionee has received, read and understood the Agreement.
3. Federal Restrictions on Transfer. Optionee understands that the Shares must be held indefinitely unless they are registered under the Securities Act of 1933, as amended (the "1933 Act"), or unless an exemption from such registration is available, and that the certificate(s) representing the Shares may bear a legend to that effect. Optionee understands that the Company is under no obligation to register the Shares and that an exemption may not be available or may not permit Optionee to transfer Shares in the amounts or at the times proposed by Optionee.
4. Tax Consequences. Optionee understands that Optionee may suffer adverse tax consequences as a result of Optionee's purchase or disposition of the Shares. Optionee represents that Optionee has consulted with any tax consultant(s) Optionee deems advisable in connection with the purchase or disposition of the Shares and that Optionee is not relying on the Company for any tax advice.
5. Delivery of Payment. Optionee herewith delivers to the Company the aggregate purchase price for the Shares that Optionee has elected to purchase and has made provision for the payment of any federal or state withholding taxes required to be paid or withheld by the Company.
6. Entire Agreement. The Agreement is incorporated herein by reference. This Exercise Notice and the Agreement constitute the entire agreement of the parties and supersede in their entirety all prior undertakings and agreements of the Company and Optionee with respect to the subject matter hereof. This Exercise Notice and the Agreement are governed by Washington law except for that body of law pertaining to conflict of laws.
Submitted by: Accepted by:
OPTIONEE: REALNETWORKS, INC.
By: By:
-------------------------------- --------------------------------
Its:
-------------------------------
Dated: Dated:
---------------------------- ----------------------------
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REALNETWORKS, INC.
STOCK OPTION AGREEMENT
[INITIAL GRANT B AND SUBSEQUENT OPTION]
RealNetworks, Inc. (the "Company"), has granted to _________ (the "Optionee"), an option to purchase a total of ____ shares of the Company's Common Stock, par value $.001 per share (the "Optioned Stock"), at the price determined as provided herein, and in all respects subject to the terms, definitions and provisions of the Company's 2002 Director Stock Option Plan (the "Plan") adopted by the Company which is incorporated herein by reference. The terms defined in the Plan shall have the same defined meanings herein.
1. Nature of the Option. This Option is a nonstatutory option and is not
intended to qualify as an "incentive stock option," as that term is defined in
Section 422 of the Internal Revenue Code of 1986, as amended.
2. Exercise Price. The exercise price is $____ for each share of Common Stock.
3. Exercise of Option. This Option shall be exercisable during its term in accordance with the provisions of Section 8 of the Plan as follows:
(i) Right to Exercise.
(a) This Option shall become exercisable as to 100% of the Optioned Stock one year after the date of grant; provided that the Optionee remains a Director on such date.
(b) This Option may not be exercised for a fraction of a share.
(c) In the event of Optionee's death, disability or other termination of service as a Director, the exercisability of the Option is governed by Section 8 of the Plan.
(ii) Method of Exercise. This Option shall be exercisable by written notice which shall state the election to exercise the Option and the number of Shares in respect of which the Option is being exercised. Such written notice, in the form attached hereto as Exhibit A (or such other notice as the Company may specify), shall be signed by the Optionee and shall be delivered in person or by mail to the Company. The written notice shall be accompanied by payment of the exercise price.
4. Method of Payment. Payment of the exercise price shall be by any of the following, or a combination thereof, at the election of the Optionee:
(ii) cash;
(iii) check; or
(iv) delivery of a properly executed exercise notice, together with such other documentation as the Company and the broker, if applicable, shall require to effect an exercise of
the Option and delivery to the Company of the sale or loan proceeds required to pay the exercise price.
5. Restrictions on Exercise. This Option may not be exercised if the issuance of such Shares upon such exercise or the method of payment of consideration for such shares would constitute a violation of any applicable federal or state securities or other law or regulations, or if such issuance would not comply with the requirements of any stock exchange upon which the Shares may then be listed. As a condition to the exercise of this Option, the Company may require Optionee to make any representation and warranty to the Company as may be required by any applicable law or regulation.
6. Non-Transferability of Option. This Option may not be transferred in any manner otherwise than by will or by the laws of descent or distribution and may be exercised during the lifetime of the Optionee only by the Optionee. The terms of this Option shall be binding upon the executors, administrators, heirs, successors and assigns of the Optionee.
7. Term of Option. This Option may not be exercised more than ten (10) years from the date of grant of this Option, and may be exercised during such period only in accordance with the Plan and the terms of this Option.
RealNetworks, Inc.
(a Washington corporation)
Optionee acknowledges receipt of a copy of the Plan, a copy of which is attached hereto, and represents that he or she is familiar with the terms and provisions thereof, and hereby accepts this Option subject to all of the terms and provisions thereof. Optionee hereby agrees to accept as binding, conclusive and final all decisions or interpretations of the Board upon any questions arising under the Plan.
EXHIBIT A
DIRECTOR STOCK OPTION EXERCISE NOTICE
RealNetworks, Inc.
2601 Elliott Avenue, Suite 1000
Seattle, WA 98121
Attention: Corporate Secretary
1. Exercise of Option. The undersigned ("Optionee") hereby elects to exercise Optionee's option to purchase ____ shares of the Common Stock, par value $.001 per share (the "Shares"), of RealNetworks, Inc. (the "Company") under and pursuant to the Company's 2002 Director Stock Option Plan and the Director Option Agreement dated ________ (the "Agreement).
2. Representations of Optionee. Optionee acknowledges that Optionee has received, read and understood the Agreement.
3. Federal Restrictions on Transfer. Optionee understands that the Shares must be held indefinitely unless they are registered under the Securities Act of 1933, as amended (the "1933 Act"), or unless an exemption from such registration is available, and that the certificate(s) representing the Shares may bear a legend to that effect. Optionee understands that the Company is under no obligation to register the Shares and that an exemption may not be available or may not permit Optionee to transfer Shares in the amounts or at the times proposed by Optionee.
4. Tax Consequences. Optionee understands that Optionee may suffer adverse tax consequences as a result of Optionee's purchase or disposition of the Shares. Optionee represents that Optionee has consulted with any tax consultant(s) Optionee deems advisable in connection with the purchase or disposition of the Shares and that Optionee is not relying on the Company for any tax advice.
5. Delivery of Payment. Optionee herewith delivers to the Company the aggregate purchase price for the Shares that Optionee has elected to purchase and has made provision for the payment of any federal or state withholding taxes required to be paid or withheld by the Company.
6. Entire Agreement. The Agreement is incorporated herein by reference. This Exercise Notice and the Agreement constitute the entire agreement of the parties and supersede in their entirety all prior undertakings and agreements of the Company and Optionee with respect to the subject matter hereof. This Exercise Notice and the Agreement are governed by Washington law except for that body of law pertaining to conflict of laws.
Submitted by: Accepted by:
OPTIONEE: REALNETWORKS, INC.
By: By:
-------------------------------- --------------------------------
Its:
-------------------------------
Dated: Dated:
----------------------------- -----------------------------
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EXHIBIT 99.1
CERTIFICATION PURSUANT TO
SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002
(18 U.S.C. SECTION 1350)
I, Robert Glaser, Chairman and Chief Executive Officer of RealNetworks, Inc., certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that the Quarterly Report of RealNetworks, Inc. on Form 10-Q for the fiscal quarter ended September 30, 2002 fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934 and that information contained in such Quarterly Report on Form 10-Q fairly presents in all material respects the financial condition and results of operations of RealNetworks, Inc.
Date: November 14, 2002
By: /s/ Robert Glaser
-----------------------------------------
Name: Robert Glaser
Title: Chairman and Chief Executive Officer
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EXHIBIT 99.2
CERTIFICATION PURSUANT TO
SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002
(18 U.S.C. SECTION 1350)
I, Brian V. Turner, Senior Vice President, Finance and Operations, Chief Financial Officer and Treasurer of RealNetworks, Inc., certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that the Quarterly Report of RealNetworks, Inc. on Form 10-Q for the fiscal quarter ended September 30, 2002 fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934 and that information contained in such Quarterly Report on Form 10-Q fairly presents in all material respects the financial condition and results of operations of RealNetworks, Inc.
Date: November 14, 2002
By: /s/ Brian V. Turner
---------------------------------------
Name: Brian V. Turner
Title: Senior Vice President, Finance and
Operations, Chief Financial Officer
and Treasurer
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