UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D. C. 20549
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FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE
ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2001
OR
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM _________________ TO
_____________________.
Commission File Number 000-25977
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LIQUID AUDIO, INC.
(Exact name of registrant as specified in its charter)
Delaware 77-0421089
------------------------------- -----------------
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
800 Chesapeake Drive, Redwood City, CA 94063
----------------------------------------- ----------
(Address of principal executive offices) (Zip Code)
(650) 549-2000
---------------------------------------------------
(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) had been subject to such filing
requirements for the past 90 days. X Yes No
--- ---
As of July 31, 2001, there were 22,633,624 shares of registrant's Common Stock
outstanding.
LIQUID AUDIO, INC.
INDEX
PART I. FINANCIAL INFORMATION..................................................1
ITEM 1. FINANCIAL STATEMENTS...............................................1
Condensed Consolidated Balance Sheets as of
June 30, 2001 and December 31, 2000
Condensed Consolidated Statements of Operations for
the three and six months ended June 30, 2001 and 2000
Condensed Consolidated Statements of Cash Flows for
the six months ended June 30, 2001 and 2000
Notes to Condensed Consolidated Financial Statements
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS ......................................12
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK........31
PART II. OTHER INFORMATION....................................................32
ITEM 1. LEGAL PROCEEDINGS..................................................32
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS..........................32
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K...................................33
SIGNATURES....................................................................34
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Liquid Audio, Inc.
Condensed CONSOLIDATED Balance SheetS
(in thousands)
June 30, December 31,
2001 2000
---------- ------------
(unaudited)
Assets
Current assets:
Cash and cash equivalents .......................... $ 103,645 $ 96,398
Short-term investments ............................. -- 27,378
Accounts receivable from third parties, net ........ 295 725
Accounts receivable from related parties, net ...... 506 1,253
Other current assets ............................... 648 2,307
--------- ---------
Total current assets ........................... 105,094 128,061
--------- ---------
Restricted cash and cash equivalents .................... 826 --
Investment in strategic partner ......................... 154 1,089
Property and equipment, net ............................. 5,591 8,860
Other assets ............................................ 170 200
--------- ---------
Total assets .............................. $ 111,835 $ 138,210
========= =========
Liabilities and stockholders' equity
Current liabilities:
Accounts payable ................................... $ 2,267 $ 3,314
Accrued expenses and other current liabilities ..... 3,979 3,522
Deferred revenue from third parties ................ 301 440
Deferred revenue from related parties .............. 876 987
Capital lease obligations, current portion ......... 69 120
Equipment loan, current portion .................... 437 589
--------- ---------
Total current liabilities ...................... 7,929 8,972
--------- ---------
Capital lease obligations, non-current portion .......... -- 28
Equipment loan, non-current portion ..................... -- 143
Note payable to related party ........................... 361 393
--------- ---------
Total liabilities ......................... 8,290 9,536
--------- ---------
Stockholders' equity:
Common stock ....................................... 23 23
Additional paid-in capital ......................... 202,858 202,877
Unearned compensation .............................. (101) (333)
Accumulated deficit ................................ (99,211) (73,910)
Accumulated other comprehensive income (loss) ...... (24) 17
--------- ---------
Total stockholders' equity ................ 103,545 128,674
--------- ---------
Total liabilities and stockholders' equity $ 111,835 $ 138,210
========= =========
See accompanying notes to condensed consolidated financial statements
1
LIQUID AUDIO, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts; unaudited)
Three Months Ended Six Months Ended
June 30, June 30,
---------------------- ---------------------
2001 2000 2001 2000
-------- -------- -------- --------
Net revenues:
License.................................................... $ 194 $ 612 $ 484 $ 843
Services ................................................... 362 1,215 787 1,616
Business development (related party) ....................... 468 1,627 1,414 3,990
-------- -------- -------- --------
Total net revenues ............................... 1,024 3,454 2,685 6,449
-------- -------- -------- --------
Cost of net revenues:
License .................................................... 128 78 287 96
Services ................................................... 364 849 1,075 1,370
Business development (related party) ....................... -- 68 -- 68
Non-cash cost of revenue ................................... 98 (4) 181 (1)
-------- -------- -------- --------
Total cost of net revenues ....................... 590 991 1,543 1,533
-------- -------- -------- --------
Gross profit ................................................... 434 2,463 1,142 4,916
Operating expenses:
Sales and marketing ........................................ 3,061 4,248 7,717 7,745
Non-cash sales and marketing ............................... (72) 86 (63) 191
Research and development ................................... 4,731 5,842 9,961 10,762
Non-cash research and development .......................... (26) (25) (17) 26
General and administrative ................................. 3,078 1,410 6,272 3,318
Non-cash general and administrative ........................ (21) 16 (16) 49
Strategic marketing--equity instruments .................... 340 514 652 1,075
Restructuring .............................................. 3,672 -- 3,672 --
-------- -------- -------- --------
Total operating expenses ......................... 14,763 12,091 28,178 23,166
-------- -------- -------- --------
Loss from operations ........................................... (14,329) (9,628) (27,036) (18,250)
Other income (expense), net .................................... 1,176 2,147 2,835 4,461
Net loss in equity investment .................................. (881) (237) (1,100) (453)
-------- -------- -------- --------
Net loss ................................................... $(14,034) $ (7,718) $(25,301) $(14,242)
======== ======== ======== ========
Net loss per share:
Basic and diluted .......................................... $ (0.62) $ (0.35) $ (1.12) $ (0.65)
======== ======== ======== ========
Weighted average shares .................................... 22,593 22,013 22,563 21,806
======== ======== ======== ========
See accompanying notes to condensed consolidated financial statements
2
Liquid Audio, Inc.
Condensed CONSOLIDATED StatementS of Cash Flows
(in thousands; unaudited)
Six Months Ended June 30,
-------------------------
2001 2000
---------- ----------
Cash flows from operating activities:
Net loss ....................................................... $ (25,301) $ (14,242)
Adjustments to reconcile net loss to net cash used in operating
activities:
Depreciation and amortization .............................. 2,193 1,461
Amortization of unearned compensation ...................... (101) 265
Allowance for doubtful accounts and sales returns reserve .. 1,055 133
Net loss in equity investment .............................. 1,100 453
Strategic marketing-equity instruments ..................... 652 1,075
Non-cash cost of revenue ................................... 186 --
Loss on disposal of and write-down of property and equipment 1,742 --
Common stock issued for legal settlement ................... -- 354
Other ...................................................... (32) (13)
Changes in assets and liabilities:
Accounts receivable from third parties ................ 379 (1,083)
Accounts receivable from related parties .............. (257) (1,181)
Other assets .......................................... 176 (136)
Accounts payable ...................................... (1,047) 1,770
Accrued expenses and other current liabilities ........ 457 269
Deferred revenue from third parties ................... (139) 85
Deferred revenue from related parties ................. (111) 49
--------- ---------
Net cash used in operating activities ................. (19,048) (10,741)
--------- ---------
Cash flows from investing activities:
Acquisition of property and equipment .......................... (689) (3,280)
Proceeds from sale of fixed assets ............................. 25 --
Sales (purchases) of short-term investments, net ............... 27,384 (45,442)
Equity investment .............................................. (165) --
--------- ---------
Net cash provided by (used in) investing activities ... 26,555 (48,722)
--------- ---------
Cash flows from financing activities:
Proceeds from issuance of common stock, net of repurchases ..... 163 705
Payments made under capital leases ............................. (79) (92)
Payments made under equipment loan ............................. (295) (294)
--------- ---------
Net cash provided by (used in) financing activities ... (211) 319
--------- ---------
Effect of exchange rates on cash and cash equivalents ............... (49) --
--------- ---------
Net increase (decrease) in cash and cash equivalents ................ 7,247 (59,144)
Cash and cash equivalents at beginning of period .................... 96,398 138,692
--------- ---------
Cash and cash equivalents at end of period .......................... $ 103,645 $ 79,548
========= =========
Supplemental disclosures:
Cash paid for interest ......................................... $ 40 $ 89
Non-cash investing and financing activities:
Issuance of warrants in connection with strategic marketing
agreements ................................................. $ 151 $ 1,075
Issuance of common stock upon exercise of warrant .............. $ -- $ 107
Issuance of common stock for intellectual property ............. $ -- $ 16
See accompanying notes to condensed consolidated financial statements
3
LIQUID AUDIO, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
NOTE 1 - THE COMPANY AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:
The Company
Liquid Audio, Inc. (the "Company") was incorporated in California in
January 1996 and reincorporated in Delaware in April 1999. In July 2000, the
Company established a wholly-owned subsidiary in the United Kingdom, Liquid
Audio Europe PLC, to develop sales in Europe. The Company was formed with the
goal of becoming the premier provider of software applications and services that
enable the secure delivery and sale of digital music over the Internet. The
Company's end-to-end solutions enable the secure distribution, promotion and
sale of high quality music files while providing consumers with the ability to
access, preview and purchase that music via the Internet.
Basis of presentation
The accompanying unaudited condensed consolidated financial statements have
been prepared by the Company and reflect all adjustments, which are in the
opinion of management, necessary for a fair presentation of the interim periods
presented. The results of operations for the three months ended June 30, 2001
are not necessarily indicative of the results to be expected for any subsequent
quarter or for the year ending December 31, 2001. Certain information and
footnote disclosures normally included in financial statements prepared in
accordance with accounting principles generally accepted in the United States of
America have been condensed or omitted pursuant to the Securities and Exchange
Commission's rules and regulations. A condensed consolidated statement of
comprehensive loss has not been presented because the components of
comprehensive loss are not material.
These unaudited condensed consolidated interim financial statements and
notes included herein should be read in conjunction with the Company's audited
consolidated financial statements and notes as included in the Company's Annual
Report on Form 10-K for the year ended December 31, 2000 as filed with the
Securities and Exchange Commission (the "SEC") on March 30, 2001.
Reclassifications
Certain reclassifications have been made to the prior periods' consolidated
financial statements to conform to the current period presentation. The
statement of operations reflects reclassifications to allocate the non-cash
compensation expense related to the issuance of stock options from a single line
presentation within operating expenses to the respective amounts in cost of net
revenues, sales and marketing, research and development and general and
administrative expense. The reclassifications had no effect on net loss,
stockholders' equity or cash flows.
Revenue recognition
Software license revenues are recognized when persuasive evidence of an
arrangement exists, delivery has occurred, no significant Company obligations
with regard to implementation or integration exist, the fee is fixed or
determinable and collection is probable as prescribed in Statement of Position
("SOP") No. 97-2, "Software Revenue Recognition." For arrangements with multiple
elements, the total fee from the arrangement is allocated among each element
based upon vendor specific objective evidence ("VSOE") of fair value. VSOE of
fair value for the service elements is based upon the standard hourly rate the
Company charges for services when such services are sold separately. VSOE of
fair value for annual maintenance is established based upon the optional stated
renewal rate. When VSOE of fair value exist for all undelivered elements, the
Company accounts for the delivered elements, primarily the license portion,
based upon the "residual method" as prescribed by SOP No. 98-9, "Modification of
SOP 97-2 with Respect to Certain Transactions." The Company recognizes revenue
allocated to maintenance ratably over the contract period, which is generally
twelve months.
4
LIQUID AUDIO, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
Business development revenue primarily consists of license and maintenance
fees derived from contractual agreements with the Company's strategic partners.
These U.S. dollar-denominated, non-refundable fees are based upon agreements
whereby the strategic partners are contractually obligated to pay to the Company
a fixed fee for the right to license and use the Company's proprietary
technology in various countries. The total fee from business development
agreements are allocated among the various elements of the contracts based on
VSOE of fair value. The fees are recognized by the Company as earned, the
specific timing of which depends on the terms and conditions of the particular
contractual arrangements, including payment terms. When VSOE of fair value does
not exist for the undelivered elements, the total fee from the business
development arrangement is recognized ratably over the period of the contract.
The Company also generates license and service revenues from digital music
kiosk sales and hosting services. Revenue derived from hosting services include
subscription fees from artists for encoding and storing music files, e-commerce
services and transaction reporting. Music delivery services revenue include
transaction fees from sales of digital recorded music through the Company's
website affiliates and fees from music retailers and websites related to the
sample digital music clips delivery service. Revenue from kiosk sales consist of
software licenses and services revenue from equipment and kiosk-related
services. The Company bears full credit risk with respect to substantially all
sales.
Restricted cash
At June 30, 2001, the Company had a cash balance of $826,000 in the form of
certificates of deposit which were restricted from withdrawal. The amount serves
as collateral to a letter of credit issued by the Company's bank to the
Company's lessor as security deposit on a long-term lease.
Principles of consolidation
The financial statements include the accounts of the Company and its
subsidiary. Significant intercompany transactions and balances have been
eliminated. Investments in entities in which the Company can exercise
significant influence, but are less than majority owned and not otherwise
controlled by the Company, are accounted for under the equity method.
Recent accounting pronouncements
In July 2001, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 141, Business
Combinations, and SFAS No. 142, Goodwill and Other Intangible Assets. SFAS No.
141 addresses financial accounting and reporting for business combinations and
supercedes Accounting Principles Board ("APB") No. 16, Business Combinations.
The provisions of SFAS No. 141 are required to be adopted July 1, 2001. The most
significant changes made by SFAS No. 141 are: (1) requiring that the purchase
method of accounting be used for all business combinations initiated after June
30, 2001, (2) establishing specific criteria for the recognition of intangible
assets separately from goodwill and (3) requiring unallocated negative goodwill
to be written off immediately as an extraordinary gain.
SFAS No. 142 primarily addresses the accounting for goodwill and intangible
assets subsequent to their acquisition and supercedes APB No. 17, Intangible
Assets. The provisions of SFAS No. 142 are required to be adopted as of January
1, 2002 for calendar-year entities. The most significant changes made by SFAS
No. 142 are: (1) goodwill and indefinite lived intangible assets will no longer
be amortized, (2) goodwill will be tested for impairment at least annually at
the reporting unit level, (3) intangible assets deemed to have an indefinite
life will be tested for impairment at least annually and (4) the amortization
period of intangible assets with finite lives will no longer be limited to forty
years.
The Company adopted SFAS No. 141 effective July 1, 2001 which will result
in the Company accounting for any business combination consummated on or after
that date under the purchase method of accounting. The Company will also apply
the non-amortization provisions of SFAS No. 142 for any business combination
5
LIQUID AUDIO, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
consummated on or after July 1, 2001. The adoption of SFAS No. 141 will not
change the method of accounting used in previous business combinations. The
Company believes that adopting SFAS No. 141 and 142 will not have a material
impact on its financial position or results of operations.
NOTE 2 - BALANCE SHEET COMPONENTS (IN THOUSANDS):
June 30, December 31,
2001 2000
------- ------------
Accounts receivable from third parties, net:
Accounts receivable ........................................... $ 886 $ 1,313
Less: allowance for doubtful accounts and sales returns reserve (591) (588)
------- -------
$ 295 $ 725
======= =======
The allowance for doubtful accounts and sales returns reserve increased by
$51,000 and $271,000 for the six months ended June 30, 2001 and the year ended
December 31, 2000, respectively. Write-offs against the allowance for doubtful
accounts and sales returns reserve were $48,000 and $43,000 for the six months
ended June 30, 2001 and the year ended December 31, 2000, respectively.
June 30, December 31,
2001 2000
-------- ------------
Accounts receivable from related parties, net:
Accounts receivable ........................................... $ 1,555 $ 1,298
Less: allowance for doubtful accounts and sales returns reserve (1,049) (45)
------- -------
$ 506 $ 1,253
======= =======
The allowance for doubtful accounts and sales returns reserve increased by
$1,004,000 and $45,000 for the six months ended June 30, 2001 and the year ended
December 31, 2000, respectively. No write-offs against the allowance for
doubtful accounts and sales returns reserve were made for the six months ended
June 30, 2001 and the year ended December 31, 2000.
June 30, December 31,
2001 2000
-------- ---------
Property and equipment:
Computer equipment and purchased software ....................... $ 12,248 $ 12,190
Website and software development costs .......................... 235 399
Furniture and fixtures .......................................... 829 774
Leasehold improvements .......................................... 690 682
-------- --------
14,002 14,045
Less:
Accumulated depreciation and amortization.................... (7,169) (5,185)
Asset impairment ............................................ (1,242) --
-------- --------
$ 5,591 $ 8,860
======== ========
Property and equipment includes $195,000 and 784,000 of equipment under capital
leases at June 30, 2001 and December 31, 2000, respectively. Accumulated
depreciation and amortization for equipment under capital leases was $174,000
and $734,000 at June 30, 2001 and December 31, 2000, respectively.
6
June 30, December 31,
2001 2000
-------- ------------
Accrued expenses and other current liabilities:
Compensation and benefits ................. $1,667 $2,321
Restructuring ............................. 824 --
Consulting and professional services ...... 454 475
Accrued marketing expenses ................ 87 48
Other ..................................... 947 678
------ ------
$3,979 $3,522
====== ======
NOTE 3 - RELATED PARTIES:
Investment in Liquid Audio Japan
The Company owns 9.76% of the outstanding shares of Liquid Audio Japan
("LAJ") and accounts for its investment under the equity method of accounting.
The Company's proportionate share of loss for the six months ended June 30, 2001
is $1,100,000.
LAJ stopped making its contractual payment as scheduled. Accordingly, no
revenue was recognized during the three months ended June 30, 2001. In June
2001, the Company and LAJ mutually agreed to terminate the licensing and
reseller agreements between the two companies. As a result, Liquid Audio Japan
will rename its company and no longer distribute the Company's technology nor
utilize the Company's digital distribution platform to offer services to the
Japanese music market. According to the mutual termination agreement, Liquid
Audio Japan has approximately 90 days to cease using Liquid Audio trademarks,
including the company name; return all of the Company's products, technology and
licenses; and, transition existing customer relationships to the Company. The
Company intends to continue working with its Japanese customers and plans to
establish a new office in Tokyo to directly service and manage existing
relationships and to build new ones with label, retail and consumer electronic
companies.
Investment in Liquid Audio Korea
In December 1998, the Company signed an agreement with another strategic
partner to establish a Korean corporation, Liquid Audio Korea Co. Ltd. ("LAK"),
to develop a local business to enable the digital delivery of music to customers
in Korea. LAK is the exclusive reseller and distributor of the Company's
software products in Korea, under an agreement expiring on December 31, 2003.
The recapitalization of LAK has not been finalized and LAK is still unable to
resume its contractual payments. Accordingly, the Company is deferring revenue
from LAK until such time the recapitalization is finalized and contractual
payments are resumed.
Liquid Audio Greater China
In June 2000, the Company signed an agreement with a strategic partner to
establish a British Virgin Islands corporation, Liquid Audio Greater China
("LAGC"). LAGC is the exclusive reseller of the Company's products in Taiwan and
Hong Kong and will work to develop business services that enable the digital
delivery of music in those local markets. The Company owns 40% of the
outstanding common stock of LAGC and accounts for its investment in LAGC using
the equity method of accounting. LAGC stopped making its contractual payments in
late 2000 as scheduled and the Company has recognized revenue from LAGC up to
the amount of cash received which was attributable to the outstanding
receivable.
7
Liquid Audio South East Asia
In September 2000, the Company signed an agreement with a strategic partner
to establish a Singaporean corporation, Liquid Audio South East Asia ("LASE").
LASE is the exclusive reseller of the Company's products in Singapore, Thailand,
Malaysia, Indonesia, Philippines, Australia and New Zealand and will work to
develop business services that enable the digital delivery of music in those
local markets. The strategic partner of LASE did not make its contractual
payments in late 2000 as scheduled. Until such time contractual payments are
made, the Company is deferring recognition of revenue from LASE.
Total business development revenue
Total business development revenues are summarized as follows (in
thousands):
Three Months Ended Six Months Ended
June 30, June 30,
------------------ -----------------
2001 2000 2001 2000
------ ------ ------ ------
Liquid Audio Japan and strategic partner ......... $ -- $ 980 $ 946 $3,343
Liquid Audio South East Asia and strategic partner -- -- -- --
Liquid Audio Greater China and strategic partner . 468 353 468 353
Liquid Audio Korea and strategic partner ......... -- 294 -- 294
------ ------ ------ ------
$ 468 $1,627 $1,414 $3,990
====== ====== ====== ======
Of the total fees earned from Liquid Audio Japan and strategic partner,
$167,000 were earned from the strategic partner in Liquid Audio Japan in the six
months ended June 30, 2000, and relate to a non-refundable service fee of
$1,000,000 received in March 1999 and recognized ratably over the one-year term
of the service agreement. The remaining amounts earned from Liquid Audio Japan
and strategic partner relate to software licensing and maintenance fees for all
other periods
The total fees earned from Liquid Audio South East Asia through the
strategic partner, Liquid Audio Greater China and Liquid Audio Korea primarily
consist of software licensing and maintenance fees.
At June 30, 2001 and December 31, 2000, fees billed or received in advance
of recognition as business development revenues were $876,000 and $987,000,
respectively. These amounts are classified as deferred revenue from related
parties on the balance sheet.
8
NOTE 4 - NET LOSS PER SHARE:
Basic and diluted net loss per share is computed by dividing the net loss
available to common stockholders for the period by the weighted average number
of common shares outstanding during the period. The calculation of diluted net
loss per share excludes potential common shares if the effect is anti-dilutive.
Potential common shares consist of unvested restricted common stock, incremental
common shares issuable upon the exercise of stock options and common shares
issuable upon the exercise of common stock warrants.
The following table sets forth the computation of basic and diluted net
loss per share for the periods indicated (in thousands, except per share
amounts):
Three Months Ended Six Months Ended
June 30, June 30,
------------------------- ------------------------
2001 2000 2001 2000
----------- --------- -------- ------------
Numerator:
Net loss.................................. $ (14,034) $ (7,718) $(25,301) $(14,242)
========== ======== ======== ========
Denominator:
Weighted average shares................... 22,602 22,107 22,572 21,921
Weighted average unvested common shares
subject to repurchase (9) (94) (9) (115)
---------- -------- -------- --------
Denominator for basic and diluted calculation 22,593 22,013 22,563 21,806
========== ======== ======== ========
Net loss per share:
Basic and diluted......................... $ (0.62) $ (0.35) $ (1.12) $ (0.65)
========== ======== ======== ========
The following table sets forth potential shares of common stock that are
not included in the diluted net loss per share calculation above because to do
so would be anti-dilutive for the periods indicated (in thousands):
Three Months Ended Six Months Ended
June 30, June 30,
----------------------- -----------------------
2001 2000 2001 2000
------- ---------- --------- ----------
Common stock options................................. 2,960 1,975 2,891 1,787
Common stock warrants................................ 875 578 875 592
Unvested common stock subject to repurchase.......... 9 94 9 115
NOTE 5 - STRATEGIC MARKETING -- EQUITY AGREEMENTS:
In June 1999, the Company signed an Advertising Agreement with Amazon.com,
Inc. ("Amazon.com") to collaborate on event-based advertising using the
Company's digital delivery services. In connection with this agreement, the
Company issued a fully vested warrant to purchase approximately 254,000 shares
of common stock to Amazon.com. The warrant was valued at $2,022,000 and was
recognized as strategic marketing-equity instruments expense ratably over the
one-year term of the agreement, which ended in June 2000. As a result, $844,000
was recognized as strategic marketing-equity instruments expense in the six
months ended June 30, 2000.
In August 1999, the Company signed a Digital Audio Co-Marketing and
Distribution Agreement with Yahoo! to promote the distribution of digital music
on its web site. In connection with this agreement, the Company granted Yahoo!
three warrants totaling 250,000 shares of common stock. The first warrant for
83,334 shares vested immediately. The first warrant was valued at $903,000 and
was recognized ratably over the one-year term of the agreement as strategic
marketing-equity instruments expense. The second warrant for 83,333 shares
vested in August
9
2000. The second warrant was initially valued at $426,000 and was recognized
ratably over the one-year period ending at the vesting date as strategic
marketing-equity instruments expense. The second warrant was revalued at each
balance sheet date through the vesting date. As a result, the original charge of
$426,000 was reduced to $312,000 based on current fair market value. The third
warrant for 83,333 shares will vest in August 2001. The third warrant was
initially valued at $105,000 and is recognized ratably over the one-year period
ending at the vesting date. The third warrant will be revalued at each balance
sheet date through the vesting date based on current fair market value. In the
six months ended June 30, 2001, $0, $0 and $61,000 were recognized as strategic
marketing-equity instruments expense for the first, second and third warrants,
respectively. In the six months ended June 30, 2000, $445,000, $(214,000) and $0
were recognized as strategic marketing-equity instruments expense for the first,
second and third warrants, respectively.
In July 2000, the Company signed an agreement with Virgin Holdings, Inc.
("Virgin"), an affiliate of EMI Recorded Music, to promote the distribution of
digital music over the Internet using the Company's technology. Pursuant to this
agreement, the Company issued 150,000 shares of common stock to Virgin. These
shares were valued at $1,181,000 and are being recognized as strategic
marketing-equity instruments expense ratably over the one-year term of the
agreement. As a result, $591,000 was recognized as strategic marketing-equity
instruments expense in the six months ended June 30, 2001.
In December 2000, the Company signed an agreement with BMG Entertainment
("BMG") to obtain the right to distribute BMG sound recordings and related
artwork through kiosks. In connection with this agreement, the Company issued
50,000 shares of common stock to BMG. These shares were valued at $195,000 and
are being recognized as non-cash cost of net revenues ratably over the one-year
term of the agreement. As a result, $96,000 was recognized as non-cash cost of
net revenues in the six months ended June 30, 2001. Additionally, the Company
granted a warrant for a total of 233,300 shares of common stock. Of the total,
77,768 shares vest in December 2001, and the cost will be remeasured each
quarter until a commitment for performance has been reached or the warrant
vests, based on current fair market value. At June 30, 2001, the 77,768 shares
under this warrant was valued at $178,000, of which $90,000 was recognized as
non-cash cost of net revenues in the six months ended June 30, 2001. The
unamortized portion will be remeasured at each balance sheet date through the
vesting date and amortized over the remaining vesting period. If BMG renews the
agreement after December 2001, the remaining shares will vest at 6,481 shares
per month commencing January 2002 for one year and 6,480 shares per month
commencing January 2003 for one year. Such shares will be valued at the fair
market value of the Company's common stock upon BMG renewing the agreement at
each renewal date.
NOTE 6 - RESTRUCTURING:
In May 2001, the Company adopted a corporate restructuring program to
reduce expenses to preserve the Company's cash position while the digital music
market develops. The restructuring included a worldwide workforce reduction, a
consolidation of three Redwood City, California offices into one facility and
other expense management initiatives. A restructuring charge of $3,672,000 was
recorded in operating expense in the three months ended June 30, 2001.
The restructuring charge included involuntary employee separation costs of
$1,116,000 for 79 employees worldwide, 20 in sales and marketing, 32 in research
and development, 13 in general and administrative and 6 in operations functions
in the U.S., and 2 in sales and marketing, 3 in research and development and 3
in operations functions outside the U.S.
Lease costs of $824,000 were accrued in the three months ended June 30,
2001 pertaining to the estimated future obligations for non-cancelable lease
payments for excess facilities that were vacated due to reductions in workforce.
Asset impairment costs of $1,732,000 were recorded, primarily for property
and equipment, furniture and fixtures, computer software and leasehold
improvements for assets no longer in use from de-emphasized business lines,
reductions in workforce and excess facilities.
10
A summary of the restructuring cost is outlined as follows (in thousands):
Severance Asset
and Benefits Facilities Impairments Total
------------- ----------- -------------- -----------
Severance and benefits..................... $ 1,116 $ -- $ -- $ 1,116
Accrued lease costs........................ -- 824 -- 824
Property and equipment impairment.......... -- -- 1,732 1,732
------------ ---------- ----------- -----------
Total...................................... 1,116 824 1,732 3,672
Cash paid.................................. (1,116) -- -- (1,116)
Non-cash................................... -- -- (1,732) (1,732)
------------ ---------- ----------- -----------
Restructuring reserve balance at June
30, 2001.......................... $ -- $ 824 $ -- $ 824
============ ========== =========== ===========
Remaining cash expenditures related to net lease expense due to the
consolidation of facilities will be paid over the lease terms through the second
quarter of 2002.
11
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
The following Management's Discussion and Analysis contains forward-looking
statements within the meaning of Federal securities laws. You can identify these
statements because they use forward-looking terminology such as "may," "will,"
"expect," "anticipate," "estimate," "continue," "believe," "intend" or other
similar words. These words, however, are not the exclusive means by which you
can identify these statements. You can also identify forward-looking statements
because they discuss future expectations, contain projections of results of
operations or of financial conditions, characterize future events or
circumstances or state other forward-looking information. We have based all
forward-looking statements included in Management's Discussion and Analysis on
information currently available to us, and we assume no obligation to update any
such forward-looking statements. Although we believe that the expectations
reflected in such forward-looking statements are based on reasonable
assumptions, actual results could differ materially from those projected in the
forward-looking statements. Potential risks and uncertainty include, among
others, those set forth under the caption "Additional Factors Affecting Future
Results" included in this "Management's Discussion and Analysis of Financial
Condition and Results of Operations."
While we believe that the discussion and analysis in this report is
adequate for a fair presentation of the information, we recommend that you read
this discussion and analysis with "Management's Discussion and Analysis"
included in our Annual Report on Form 10-K for the year ended December 31, 2000
filed with the SEC.
Overview
We are a leading provider of software products and services that enable
artists, record companies and retailers to create, syndicate and sell music
digitally over the Internet. Our products and services are based on an open
technical architecture that is designed to support a variety of digital music
formats. From our inception in January 1996 through early 1997, we devoted
substantially all of our efforts to product development, raising capital and
recruiting personnel. We first generated revenues in the first quarter of 1997
through the licensing of our Liquifier Pro, Liquid Server and Liquid Player
software products. In November 1997, we introduced a subscription-based hosting
service for digital recorded music using our technology. In July 1998, to
enhance consumer access to the music we were hosting, we launched the Liquid
Music Network ("LMN"), a syndicated network that currently links over 1,000
affiliated music-related and music retailer websites.
In early 1999, we began to place greater emphasis on developing and
marketing our digital music delivery services. Since that time, we have invested
significant resources to increase our distribution reach by expanding the LMN,
building our syndicated music catalog available for sale, actively participating
in standards initiatives and establishing our international presence. We also
have established international initiatives within the Pacific Rim and a
subsidiary in Europe to lay the groundwork for offering digital music download
services to consumers in these markets. As a provider of digital music delivery
services, we expect our revenue sources to expand beyond software license sales
to include sales of digital recorded music and digital music subscriptions.
Revenues from digital music sales and transaction fees from our music delivery
services represented less than 8%, 6% and 1% of total net revenues in the six
months ended June 30, 2001 and the twelve months ended December 31, 2000 and
1999, respectively. Our Liquid Music Network began offering syndicated music
through music retailer websites in the third quarter of 1999.
To date, we have derived our revenues primarily from the licensing of
software products and service fees associated with business development
contracts. Business development revenues primarily consist of license and
maintenance fees from agreements under which we give our strategic related
partners (the "Partners") the right to license and use our digital recorded
music delivery technology. These U.S. dollar-denominated, non-refundable fees
are allocated among the various elements of the contract based on vendor
specific objective evidence ("VSOE") of fair value. When VSOE of fair value
exist for the undelivered elements, primarily maintenance, we account for the
license portion based on the "residual method" as prescribed by SOP No. 98-9,
"Modification of SOP 97-2 with Respect to Certain Transactions." When VSOE of
fair value does not exist for the undelivered elements, we recognize the total
fee from a business development contract ratably over the term of the contract.
The total fee from business development arrangements is recognized when payment
becomes due if extended payment terms exist. Revenue recognition is deferred if
the Partners stop making their contractual payments. We also license our
software
12
products to record companies, artists and websites. Software license revenues
are recognized when persuasive evidence of an arrangement exists, the fee is
fixed and determinable, collection is probable and delivery has occurred.
Services revenues from maintenance fees related to our licensed software
products and hosting fees from record companies and artists are recognized over
the service period, typically one year. We intend to increase our services
revenues by significantly expanding our music delivery services. Revenue derived
from hosting services include subscription fees from artists for encoding and
storing music files, e-commerce services and transaction reporting. Music
delivery services revenue include transaction fees from sales of digital
recorded music through our LMN website affiliates and fees from music retailers
and websites related to the sample digital music clips delivery service. Revenue
from kiosk sales consists of software licenses and services revenue from
equipment and kiosk-related services. We bear full credit risk with respect to
substantially all sales.
Business development revenues as a percentage of total net revenues were
53%, 63% and 48% in the six months ended June 30, 2001 and the twelve months
ended December 31, 2000 and 1999, respectively. Liquid Audio Korea ("LAK")
stopped making its contractual payments as scheduled. LAK is undergoing a
recapitalization through the addition of new investment. Until such time the
recapitalization is finalized and contractual payments are resumed, we are
deferring recognition of revenue from LAK. In late 2000, Liquid Audio Greater
China and Liquid Audio South East Asia through our strategic partner, and in the
second quarter of 2001, Liquid Audio Japan ("LAJ"), did not make their
contractual payments as scheduled. We are pursuing collection for the missed
payments. No revenue will be recognized until payments are on schedule. We may
be unsuccessful in receiving any additional payments from these customers.
In June 2001, we and LAJ mutually agreed to terminate the licensing and
reseller agreements between the two companies. As a result, Liquid Audio Japan
will rename its company and no longer distribute our technology nor utilize our
digital distribution platform to offer services to the Japanese music market.
According to the mutual termination agreement, Liquid Audio Japan has
approximately 90 days to cease using Liquid Audio trademarks, including the
company name; return all of our products, technology and licenses; and,
transition existing customer relationships to us. We intend to continue working
with its Japanese customers and plan to establish a new office in Tokyo to
directly service and manage existing relationships and to build new ones with
label, retail and consumer electronic companies.
In the first six months of 2001, approximately 53% of total net revenues
came from sales to two customers, Liquid Audio Japan and Liquid Audio Greater
China. In 2000, approximately 53% of total net revenues came from sales to two
customers, Liquid Audio Japan and Liquid Audio South East Asia through our
strategic partner. In 1999, approximately 73% of total net revenues came from
sales to three customers, Adaptec, Inc., Super Stage, Inc. and Liquid Audio
Korea. International revenues represented approximately 59%, 69% and 49% of
total net revenues in the six months ended June 30, 2001 and the twelve months
ended December 31, 2000 and 1999, respectively. We expect international revenues
will continue to represent a significant portion of our total net revenues.
In May 2001, we adopted a corporate restructuring program to reduce
expenses to preserve our cash position while the digital music market develops.
The restructuring included a worldwide workforce reduction , a consolidation of
three Redwood City, California offices into one facility and other expense
management initiatives. We are de-emphasizing our efforts in less productive,
non-core business areas that do not directly support secure digital download
opportunities, including digital music kiosks, music hosting for independent
artists and labels, music clips service and encoding services. We plan to focus
on software licensing and digital music delivery services that complement our
secure digital download business. We plan to support the emerging market for
digital music subscriptions, enabling major portals, online retailers and secure
audio device manufacturers to offer subscription-based digital music download
services. This strategy leverages and enhances both our core digital download
services and our player software licensing business. We recorded a restructuring
charge of $3.7 million in the second quarter of 2001.
We have a limited operating history upon which investors may evaluate our
business and prospects. Since inception we have incurred significant losses, and
as of June 30, 2001 we had an accumulated deficit of approximately $99.2
million. We expect to incur additional losses and continued negative cash flow
from operations through at least 2002. Our revenues may not increase or even
continue at their current levels or we may not achieve or maintain profitability
or generate cash from operations in future periods. The digital music market may
never
13
develop to the extent that we are able to generate positive cash flows.
Our prospects must be considered in light of the risks, expenses and
difficulties frequently encountered by companies in their early stages of
development, particularly companies in new and rapidly evolving markets such as
the digital delivery of recorded music. We may not be successful in addressing
these risks, and our failure to do so would harm our business.
14
Results of Operations
The following table sets forth, for the periods presented, certain data
derived from our unaudited condensed statement of operations as a percentage of
total net revenues. The operating results in any period are not necessarily
indicative of the results that may be expected for any future period.
Three Months Ended Six Months Ended
----------------------- -------------------
June 30, June 30,
2001 2000 2001 2000
------ ------ ------ ------
Net revenues:
License .............................. 19% 18% 18% 13%
Services ............................. 35 35 29 25
Business development (related party) . 46 47 53 62
------ ------ ------ ------
Total net revenues ................ 100 100 100 100
------ ------ ------ ------
Cost of net revenues:
License .............................. 12 2 11 2
Services ............................. 36 25 40 21
Business development (related party) . -- 2 -- 1
Non-cash cost of revenue ............. 10 -- 7 --
------ ------ ------ ------
Total cost of net revenues ........ 58 29 58 24
------ ------ ------ ------
Gross profit ............................ 42 71 42 76
------ ------ ------ ------
Operating expenses:
Sales and marketing .................. 299 123 287 120
Non-cash sales and marketing ......... (7) 2 (2) 3
Research and development ............. 462 169 371 167
Non-cash research and development .... (3) -- (1) --
General and administrative ........... 301 41 234 51
Non-cash general and administrative .. (2) -- (1) 1
Strategic marketing-equity instruments 33 15 24 17
Restructuring ........................ 358 -- 137 --
------ ------ ------ ------
Total operating expenses .......... 1,441 350 1,049 359
------ ------ ------ ------
Loss from operations .................... (1,399) (279) (1,007) (283)
Other income (expense), net ............. 114 62 106 69
Net loss in equity investment ........... (86) (7) (41) (7)
------ ------ ------ ------
Net loss ................................ (1,371)% (224)% (942)% (221)%
====== ====== ====== ======
Three Months Ended June 30, 2001 and 2000
Total Net Revenues
Total net revenues decreased 70% to $1.0 million for the three months ended
June 30, 2001 from $3.5 million in the comparable period of 2000.
License. License revenues decreased 68% to $194,000 for the three months
ended June 30, 2001 from $612,000 in the comparable period of 2000. This
decrease was due to a reduction in kiosk software and other technology licenses
as a result of our de-emphasis in the digital music kiosk business area.
Services. Services revenues decreased 70% to $362,000 for the three months
ended June 30, 2001 from $1.2 million in the comparable period of 2000. This
decrease was due to decreases in encoding services, kiosk-related equipment
sales, promotion and advertising services and Liquid Muze Previews service in
the 2001 period.
15
Business Development (Related Party). Business development revenues
decreased 71% to $468,000 for the three months ended June 30, 2001 from $1.6
million in the comparable period of 2000. The decrease was primarily due to the
deferment of revenue from Liquid Audio Japan and Liquid Audio Korea due to those
customers stopping scheduled payments to us, partially offset by an increase in
software licensing and related maintenance revenues from Liquid Audio Greater
China, resulting from revenue recognition of up to the amount of cash received
from Liquid Audio Greater China which was attributable to the outstanding
receivable.
Total Cost of Net Revenues
Our gross profit decreased to approximately 42% of total net revenues for
the three months ended June 30, 2001 from approximately 71% of total net
revenues in the comparable period of 2000. Total cost of net revenues decreased
40% to $590,000 in the 2001 period from $991,000 in the 2000 period.
License. Cost of license revenues primarily consists of royalties paid to
third-party technology vendors and costs of documentation, duplication and
packaging. Cost of license revenues increased 64% to $128,000 for the three
months ended June 30, 2001 from $78,000 in the comparable period of 2000. Cost
of license revenues increased due to the addition of technology licenses in 2001
and product mix differences.
Services. Cost of services revenues primarily consists of compensation for
customer service, encoding and professional services personnel, kiosk-related
equipment and an allocation of our occupancy costs and other overhead
attributable to our services revenues. Cost of services revenues decreased 57%
to $364,000 for the three months ended June 30, 2001 from $849,000 in the
comparable period of 2000. The decrease in cost of services revenues was due the
reduction in the number of encoding, customer service and professional services
personnel and kiosk-related equipment due to our corporate restructuring.
Business Development (Related Party). Cost of business development revenues
primarily consists of kiosk-related equipment and royalties paid to third-party
technology vendors. Cost of business development revenues was $0 for the three
months ended June 30, 2001 and $68,000 in the comparable period of 2000.
Non-Cash Cost of Revenues. Non-cash cost of revenues consist of expenses
associated with the value of common stock and warrants issued to partners as
part of our content acquisition agreements and stock-based employee compensation
arrangements. Common stock expense is based on the fair value of the stock at
the time it was issued. Warrant expense is based on the estimated fair value of
the warrants based on the Black-Scholes option pricing model and the provisions
of EITF 96-18. In December 2000, we signed an agreement with BMG Entertainment
("BMG") to obtain the right to distribute BMG sound recordings and related
artwork through kiosks. In connection with this agreement, we issued 50,000
shares of common stock to BMG, valued at $195,000 and are being recognized
ratably over the initial one-year term of the agreement; as a result, $49,000
was recognized as non-cash cost of revenues. Also in connection with this
agreement, we granted a warrant for a total of 233,300 shares of common stock.
Of the total, 77,768 shares vest in December 2001, and the cost will be
remeasured each quarter until a commitment for performance has been reached or
the warrant vests, based on current fair market value. At June 30, 2001, the
77,768 shares under this warrant were valued at $178,000, of which $55,000 was
recognized as non-cash cost of revenues for the three months ended June 30,
2001. The unamortized portion will be remeasured at each balance sheet date
through the vesting date and amortized over the remaining vesting period. If BMG
renews the agreement after December 2001, the remaining shares will vest at
6,481 shares per month commencing January 2002 for one year and 6,480 shares per
month commencing January 2003 for one year. Such shares will be valued at the
fair market value of our common stock upon BMG renewing the agreement at each
renewal date. Stock compensation expense for customer service, encoding and
professional services personnel was $(6,000) and $(4,000) for the three months
ended June 30, 2001 and 2000, respectively. We expect quarterly amortization
related to these options to be less than $1,000 for the third quarter of 2001.
This future compensation charge would be reduced if customer service, encoding
or professional services employees who hold the applicable options terminate
employment prior to the expiration of their option vesting period.
16
Operating Expenses
Sales and Marketing. Sales and marketing expenses consist primarily of
compensation for our sales, marketing and business development personnel,
compensation for customer service and professional services personnel
attributable to sales and marketing activities, advertising, trade show and
other promotional costs, design and creation expenses for marketing literature
and our website and an allocation of our occupancy costs and other overhead.
Sales and marketing expenses decreased 28% to $3.1 million for the three months
ended June 30, 2001 from $4.2 million in the comparable period of 2000. This
decrease was primarily due to decreases in the number of sales and marketing
personnel due to our corporate restructuring and expense management initiatives,
advertising and promotional programs.
Research and Development. Research and development expenses consist
primarily of compensation for our research and development, network operations
and product management personnel, payments to outside contractors and, to a
lesser extent, depreciation on equipment used for research and development and
an allocation of our occupancy costs and other overhead. Research and
development expenses decreased 19% to $4.7 million for the three months ended
June 30, 2001 from $5.8 million in the comparable period of 2000. This decrease
was primarily due to decreases in the number of personnel and outside
contractors due to our corporate restructuring and expense management
initiatives.
General and Administrative. General and administrative expenses consist
primarily of compensation for personnel and payments to outside contractors for
general corporate functions, including finance, information systems, human
resources, facilities, legal and general management, fees for professional
services, bad debt expense and an allocation of our occupancy costs and other
overhead. General and administrative expenses increased 118% to $3.1 million for
the three months ended June 30, 2001 from $1.4 million in the comparable period
of 2000. This increase was primarily due to an increase in the allowance of
doubtful accounts related to accounts receivables from related parties and legal
fees related to patent infringement claims against us (see Part II, Item 1
"Legal Proceedings").
Strategic Marketing--Equity Instruments. Strategic marketing-equity
instruments consist of expenses associated with the value of common stock and
warrants issued to partners as part of our strategic marketing agreements.
Common stock expense is based on the fair value of the stock at the time it was
issued. Warrant expense is based on the estimated fair value of the warrants
based on the Black-Scholes option pricing model and the provisions of EITF
96-18. Strategic marketing-equity instruments expense was $340,000 and $514,000
in the three months ended June 30, 2001 and 2000, respectively. In June 1999, we
signed an advertising agreement with Amazon.com, Inc. ("Amazon.com") to
collaborate on event-based advertising using our digital delivery services. In
connection with this agreement, we issued a fully vested warrant to purchase
approximately 254,000 shares of common stock to Amazon.com. The warrant was
valued at $2.0 million and was recognized ratably over the one-year term of the
agreement; as a result, $337,000 was recognized as strategic marketing-equity
instruments expense in the three months ended June 30, 2000. In August 1999, we
signed a Digital Audio Co-Marketing and Distribution Agreement with Yahoo! to
promote the distribution of digital music on its web site. In connection with
this agreement, we granted Yahoo! three warrants totaling 250,000 shares of
common stock. The first warrant for 83,334 shares vested immediately. The first
warrant was valued at $903,000 and was recognized ratably over the one-year term
of the agreement. The second warrant for 83,333 shares vested in August 2000.
The second warrant was initially valued at $426,000 and was recognized ratably
over the one-year period ending at the vesting date. The second warrant was
revalued at each balance sheet date through the vesting date. As a result, the
original charge of $426,000 was reduced to $312,000 based on current fair market
value. The third warrant for 83,333 shares will vest in August 2001. The third
warrant was initially valued at $105,000 and is recognized ratably over the
one-year period ending at the vesting date. The third warrant will be revalued
at each balance sheet date through the vesting date based on current fair market
value. In the three months ended June 30, 2001, $0, $0 and $45,000 were
recognized as strategic marketing-equity instruments expense for the first,
second and third warrants, respectively. In the three months ended June 30,
2000, $223,000, $(46,000) and $0 were recognized as strategic marketing-equity
instruments expense for the first, second and third warrants, respectively. In
July 2000, we signed an agreement with Virgin Holdings, Inc. ("Virgin"), an
affiliate of EMI Recorded Music, to promote the distribution of digital music
over the Internet using our technology. Pursuant to this agreement, we issued
150,000 shares of common stock to Virgin. These shares were valued at $1.2
million and are being recognized ratably over the one-year term of the
agreement. As a result,
17
$295,000 was recognized as strategic marketing-equity instruments expense in the
three months ended June 30, 2001.
Non-Cash Sales and Marketing, Research and Development and General and
Administrative. Non-cash sales and marketing, research and development and
general and administrative expenses relate to stock-based employee compensation
arrangements. The total unearned compensation recorded by us from inception to
June 30, 2001 was $3.6 million. We recognized $(119,000) and $77,000 of stock
compensation expense for the three months ended June 30, 2001 and 2000,
respectively. We expect quarterly amortization related to those options to be
between $33,000 and $22,000 per quarter during the remainder of 2001 and annual
amortization to be approximately $46,000 during 2002. These future compensation
charges would be reduced if sales and marketing, research and development and
general and administrative employees who hold the applicable options terminate
employment prior to the expiration of their option vesting period.
Other Income (Expense), Net. Interest income consists of earnings on our
cash, cash equivalents and short-term investments. Interest expense consists of
expenses related to our financing obligations, which include borrowings under
equipment loans and capital lease obligations. Other income (expense), net
decreased to $1.2 million for the three months ended June 30, 2001 from $2.1
million in the comparable period of 2000. This decrease was primarily due to
interest received on higher average cash and cash equivalent balances in the
2000 period resulting from proceeds of the initial and follow-on public
offerings of our common stock in July 1999 and December 1999, respectively.
Net Loss in Equity Investment. Net loss in equity investment consist of our
share of losses from our investment in a related party using the equity method
of accounting under a 3-month lag. Net loss in equity investment was $881,000
and $237,000 for the three months ended June 30, 2001 and 2000, respectively.
The expenses represent our share of the loss of Liquid Audio Japan.
Six Months Ended June 30, 2001 and 2000
Total Net Revenues
Total net revenues decreased 58% to $2.7 million for the six months ended
June 30, 2001 from $6.4 million in the comparable period of 2000.
License. License revenues decreased 43% to $484,000 for the six months
ended June 30, 2001 from $843,000 in the comparable period of 2000. This
decrease was due to a reduction in kiosk software and other technology licenses
as a result of our de-emphasis in the digital music kiosk business area.
Services. Services revenues decreased 51% to $787,000 for the six months
ended June 30, 2001 from $1.6 million in the comparable period of 2000. This
decrease was due to decreases in encoding services, kiosk-related equipment
sales, promotion and advertising services and Liquid Muze Previews service in
the 2001 period.
Business Development (Related Party). Business development revenues
decreased 65% to $1.4 million for the six months ended June 30, 2001 from $4.0
million in the comparable period of 2000. The decrease was primarily due to the
deferment of revenue from Liquid Audio Japan in the second quarter of 2001 and
Liquid Audio Korea in the first half of 2001 due to those customers stopping
scheduled payments to us.
Total Cost of Net Revenues
Our gross profit decreased to approximately 42% of total net revenues for
the six months ended June 30, 2001 from approximately 76% of total net revenues
in the comparable period of 2000. Total cost of net revenues remained flat at
$1.5 million for the six months ended June 30, 2001 and 2000.
18
License. Cost of license revenues increased 199% to $287,000 for the six
months ended June 30, 2001 from $96,000 in the comparable period of 2000. Cost
of license revenues increased due to the addition of technology licenses in 2001
and product mix differences.
Services. Cost of services revenues decreased 22% to $1.1 million for the
six months ended June 30, 2001 from $1.4 million in the comparable period of
2000. The decrease in cost of services revenues was due the reduction in the
number of encoding, customer service and professional services personnel and
kiosk-related equipment due to our corporate restructuring.
Business Development (Related Party). Cost of business development revenues
was $0 for the six months ended June 30, 2001 and $68,000 in the comparable
period of 2000.
Non-Cash Cost of Revenues. Non-cash cost of revenue was $181,000 for the
six months ended June 30, 2001 and $(1,000) in the comparable period of 2000.
Operating Expenses
Sales and Marketing. Sales and marketing expenses remained flat at $7.7
million for the six months ended June 30, 2001 and 2000. The increase in the
number of sales and marketing personnel through the first quarter of 2001
compared to the first six months of 2000 were offset by reduction of such
personnel in the second quarter of 2001 due to our corporate restructuring and
expense management initiatives, advertising and promotional programs.
Research and Development. Research and development expenses decreased 7% to
$10.0 million for the six months ended June 30, 2001 from $10.8 million in the
comparable period of 2000. This decrease was primarily due to decreases in the
number of personnel and outside contractors due to our corporate restructuring
and expense management initiatives.
General and Administrative. General and administrative expenses increased
89% to $6.3 million for the six months ended June 30, 2001 from $3.3 million in
the comparable period of 2000. This increase was primarily due to an increase in
the allowance of doubtful accounts related to accounts receivables from related
parties and legal fees related to patent infringement claims against us (see
Part II, Item 1 "Legal Proceedings").
Strategic Marketing--Equity Instruments. Strategic marketing-equity
instrument expense was $652,000 for the six months ended June 30, 2001 and $1.1
million in the comparable period in 2000.
Non-Cash Sales and Marketing, Research and Development and General and
Administrative. We recognized $(96,000) and $266,000 of non-cash sales and
marketing, research and development and general and administrative expenses for
the six months ended June 30, 2001 and 2000, respectively.
Other Income (Expense), Net. Other income (expense), net decreased to $2.8
million for the six months ended June 30, 2001 from $4.5 million in the
comparable period of 2000. This decrease was primarily due to interest received
on higher average cash and cash equivalent balances in the 2000 period resulting
from proceeds of the initial and follow-on public offerings of our common stock
in July 1999 and December 1999, respectively.
Net Loss in Equity Investment. Net loss in equity investment was $1.1
million and $453,000 for the six months ended June 30, 2001 and 2000,
respectively.
Liquidity and Capital Resources
Since inception, we have financed our operations primarily through the
initial and follow-on public offerings of common stock, private placements of
our preferred stock, equipment financing, lines of credit and short-term loans.
As of June 30, 2001, we had raised $65.9 million and $93.7 million through our
initial and follow-on public offerings of common stock, respectively, and $29.8
million through the sale of our preferred stock. At June 30, 2001, we had
approximately $103.6 million of cash, cash equivalents and short-term
investments.
19
Net cash used in operating activities was $19.0 million and $10.7 million
for the six months ended June 30, 2001 and 2000, respectively. Net cash used for
operating activities in the 2001 period was primarily the result of net losses
from operations, depreciation and amortization of $2.2 million, amortization of
unearned compensation of $(101,000), strategic marketing-equity instruments
charges of $652,000, non-cash cost of revenue of $186,000, an increase in the
allowance for doubtful accounts and sales returns reserve of $1.1 million,
equity investment losses of $1.1 million, loss on disposal of and increase in
the asset impairment for property and equipment of $1.7 million, other charges
of $(32,000) and a net decrease in working capital items of $542,000. The net
decrease in working capital items include an increase in accounts receivable of
$122,000, decrease in other assets of $176,000, decrease in accounts payable of
$1.0 million, increase in accrued expenses and other liabilities of $457,000 and
an decrease in deferred revenue of $250,000. Net cash used for operating
activities in the 2000 period was primarily the result of net losses from
operations, depreciation and amortization of $1.5 million, amortization of
unearned compensation of $265,000, strategic marketing-equity instruments
charges of $1.1 million, an increase in the allowance for doubtful accounts and
sales returns reserve of $133,000, equity investment losses of $453,000, common
stock issued for legal settlement of $354,000, other charges of $(13,000) and a
net decrease in working capital items of $227,000. The net decrease in working
capital items include an increase in accounts receivable of $2.3 million,
increase in other assets of $136,000, increase in accounts payable of $1.8
million, increase in accrued expenses and other liabilities of $269,000 and an
increase in deferred revenue of $134,000.
Net cash provided by (used in) investing activities was $26.6 million and
$(48.7) million for the six months ended June 30, 2001 and 2000, respectively.
Net cash provided by (used in) investing activities in each of these periods was
primarily related to net sales (purchases) of short-term investments and the
acquisition of property and equipment in both periods.
Net cash provided by (used in) financing activities was $(211,000) and
$319,000 for the six months ended June 30, 2001 and 2000, respectively. The net
cash used in financing activities for the 2001 period is due primarily to
payments made under our equipment loan and capital leases. The net cash provided
in financing activities for the 2000 is due primarily to proceeds from the
issuance of stock under the employee stock purchase plan, partially offset by
payments made under our equipment loan and capital leases.
We had a bank equipment loan facility that provided for advances of up to
$3.0 million through November 1999. Borrowings under the equipment loan facility
are repayable in monthly installments over three years and bear interest at the
bank's prime interest rate plus 0.25%. Borrowings are secured by the related
equipment and other assets. Under the equipment loan facility, we had borrowed
amounts totaling $1.8 million through June 30, 2001. We also have lease
financing agreements that provide for the lease of computers and office
equipment of up to $1.0 million. As of June 30, 2001, we had borrowed $737,000
under the lease financing agreements. Our other significant commitments consist
of obligations under non-cancelable operating leases, which totaled $8.0
million, net of rental income of $248,000, as of June 30, 2001 and are payable
in monthly installments through 2005 and a note payable to related party in the
amount of $361,000 that was issued in the three months ended March 31, 1999. The
note payable to related party is repayable in Japanese yen and bears interest at
0.5% above a Japanese bank's prime rate. The principal is due on December 31,
2003, with quarterly interest payments.
We have no material commitments for capital expenditures or strategic
investments. We may use cash to acquire or license technology, products or
businesses related to our current business. In addition, we anticipate that we
will experience a decline in our operating expenses for the foreseeable future
and that our operating expenses will be a material use of our cash resources.
We believe that existing cash and cash equivalents and financing available
under lease agreements will be sufficient to meet our anticipated cash needs for
working capital and capital expenditures for the foreseeable future, although we
may seek to raise additional capital during that period. The sale of additional
equity or convertible debt securities could result in additional dilution to our
stockholders. There can be no assurance that financing will be available in
amounts or on terms acceptable to us, if at all.
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Market Risk
At June 30, 2001, we had an investment portfolio of money market funds,
commercial securities and U.S. Government bonds. We had a related party loan at
June 30, 2001 of $361,000, which was denominated in Japanese yen and bore
interest at 0.5% above a Japanese bank's prime rate. These instruments, like all
fixed income instruments, are subject to interest rate risk. The fixed income
portfolio will fall in value and the strategic related partner note payable
interest would increase if there were an increase in interest rates. If market
interest rates were to increase immediately and uniformly by 10% from levels as
of December 31, 2000, the decline of the fair value of the fixed income
portfolio and strategic related partner note payable would not be material.
As a global concern, we face exposure to adverse movements in foreign
currency exchange rates. These exposures may change over time as business
practices evolve and could seriously harm our financial results. Substantially
all of our international sales are currently denominated in U.S. dollars. An
increase in the value of the U.S. dollar relative to foreign currencies could
make our products and services more expensive and therefore, reduce the demand
for our products and services. Reduced demand for our products and services
could seriously harm our financial results. Currently, we do not hedge against
any foreign currencies and as a result, could incur unanticipated gains or
losses.
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ADDITIONAL FACTORS AFFECTING FUTURE RESULTS
Our Limited Operating History in the New Market of Digital Delivery of Music
over the Internet Increases the Possibility that the Value of Your Investment
Will Decline
We incorporated in January 1996. We did not start generating revenues until
the first quarter of 1997. In early 1999 we began to place greater emphasis on
developing and marketing our digital music delivery services. Accordingly, we
are still in the early stages of development and have only a limited operating
history upon which you can evaluate our business. You should evaluate our
chances of financial and operational success in light of the risks,
uncertainties, expenses, delays and difficulties associated with starting a new
business, many of which may be beyond our control.
We Have a History of Losses, We Expect Losses to Continue and We Might Not
Achieve or Maintain Profitability
Our accumulated deficit as of June 30, 2001 was approximately $99.2
million. We had net losses of approximately $24.2 million and $33.7 million in
1999 and 2000, respectively, and $25.3 million in the six months ended June 30,
2001. Given the level of our planned operating and capital expenditures, we
expect to continue to incur losses and negative cash flows through at least
2002. Even if we ultimately do achieve profitability, we may not be able to
sustain or increase profitability on a quarterly or annual basis. If our
revenues grow more slowly than we anticipate, or if our operating expenses
exceed our expectations and cannot be adjusted accordingly, our business will be
harmed.
Fluctuations in Our Quarterly Revenues and Operating Results Might Lead to
Reduced Prices for Our Stock
Our quarterly results of operations have varied in the past, and you should
not rely on quarter-to-quarter comparisons of our results of operations as an
indication of our future performance. In some future periods, our results of
operations are likely to be below the expectations of public market analysts and
investors. In this event, the price of our common stock would likely decline.
Factors that have caused our results to fluctuate in the past and that are
likely to affect us in the future include the following:
o competition for consumers from traditional retailers as well as
providers of online music services;
o the announcement and introduction of new products and services by us
and our competitors;
o our ability to increase the number of websites that will use our
platform for digital music delivery;
o the timing of our partners' introduction of new products and services
for digital music sales; and
o variability and length of the sales cycle associated with our product
and service offerings.
In addition, other factors may also affect us, including:
o market adoption and growth of sales of digitally downloaded recorded
music over the Internet;
o our ability to attract significant numbers of music recordings to be
syndicated in our format;
o our ability to provide reliable and scalable service, including our
ability to avoid potential system failures;
o market acceptance of new and enhanced versions of our products and
services; and
o the price and mix of products and services we offer.
Some of these factors are within our control and others are outside of our
control.
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Several of Our Customers Have Had Limited Operating Histories, Are Unprofitable
and Might Have Difficulty Meeting Their Payment Obligations to Us
Several of our significant customers, including our international partners
Liquid Audio Japan, Liquid Audio Korea, Liquid Audio Greater China and Liquid
Audio South East Asia through our strategic partner, have had limited operating
histories and have not achieved profitability. We believe that this will be true
of other customers in the future. As of June 30, 2001, 53% and 65% of our
accounts receivable from third parties and accounts receivables from related
parties, respectively, or $470,000 and $1.0 million, respectively, were more
than 30 days past due. You should evaluate the ability of these companies to
meet their payment obligations to us in light of the risks, expenses and
difficulties encountered by companies with limited operating histories. If one
or more of our customers were unable to pay for our services in the future, or
paid more slowly than we anticipate, recognition of revenue might be delayed and
our business might be harmed.
If Our Relationships with Our International Partners Terminate, Our Revenues
Might Decline
We derive a portion of our revenues from business development fees from
relationships with our international partners, including Liquid Audio Korea,
Liquid Audio Japan, Liquid Audio Greater China and Liquid Audio South East Asia
through our strategic partner. We recently terminated our relationship with
Liquid Audio Japan. Consequently, we do not expect additional revenue will be
generated from Liquid Audio Japan. If one of our remaining relationships does
not generate a similar amount of revenue in subsequent periods or if a party is
unable to make its scheduled payments to us, then our future revenues could be
lower than we anticipate and our business could be harmed. Furthermore, the
commercial terms for these relationships could cause our revenues to vary from
period-to-period, which might result in unpredictability of our revenues.
Our Revenues Would Be Negatively Effected by the Loss of a Significant Customer
We have derived, and we believe that we will continue to derive, a
substantial portion of our net revenues from a limited number of customers and
projects. Our ten largest customers for 1999, 2000 and the six months ended June
30, 2001 represented approximately 86%, 78% and 86%, respectively, of our total
net revenues. The loss of any significant customer or any significant reduction
of total net revenues generated by significant customers, without an increase in
revenues from other sources, would harm our business. The volume of products or
services we sell to specific customers is likely to vary year to year, and a
major customer in one year may not use our services in a subsequent year. A
customer's decision not to use our services in a subsequent year might harm our
business.
We Face and Might Face Intellectual Property Infringement Claims that Might Be
Costly to Resolve
From time to time, we receive letters from corporations and other entities
suggesting that we review patents to which they claim rights or claiming that we
infringe on their patent rights. Such claims may result in our being involved in
litigation. Although we do not believe we infringe the proprietary rights of any
party, we cannot assure you that parties will not assert additional claims in
the future or that any claims will not be successful. We could incur substantial
costs and diversion of management resources to defend any claims relating to
proprietary rights, which could harm our business. In addition, we are obligated
under certain agreements to indemnify the other party for claims that we
infringe on the proprietary rights of third parties. If we are required to
indemnify parties under these agreements, our business could be harmed. If
someone asserts a claim against us relating to proprietary technology or
information, we might seek licenses to this intellectual property. We might not
be able to obtain licenses on commercially reasonable terms, or at all. The
failure to obtain the necessary licenses or other rights might harm our
business. See "Other Information--Legal Proceedings."
If Artists and Record Labels Are Not Satisfied that They Can Securely, Digitally
Deliver Their Music Over the Internet, We Might Not Have Sufficient Content to
Attract Consumers
Our success depends on our ability to aggregate a sufficient amount and
variety of digital recorded music for syndication. In particular, until a
significant number of artists and their record labels adopt a strategy of
digitally delivering music over the Internet, the growth of our business might
be limited. We currently do not create our own content; rather, we rely on
record companies and artists for digital recorded music to be syndicated using
our format.
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We believe record companies will remain reluctant to distribute their recorded
music digitally unless they are satisfied that the digital delivery of their
music over the Internet will not result in the unauthorized copying and
distribution of that music. If record companies do not believe that recorded
music can be securely delivered over the Internet, they will not allow the
digital distribution of their recorded music and we might not have sufficient
content to attract consumers. If we cannot offer a sufficient amount and variety
of digital recorded music for syndication, our business might be harmed.
If Standards for the Secure, Digital Delivery of Recorded Music Are Not Adopted,
the Piracy Concerns of Record Companies and Artists Might Not Be Satisfied, and
They Might Not Use Our Platform for Digital Delivery of Their Music
Because other digital recorded music formats, such as MP3, do not contain
mechanisms for tracking the source or ownership of digital recordings, users are
able to download and distribute unauthorized or "pirated" copies of copyrighted
recorded music over the Internet. This piracy is a significant concern to record
companies and artists, and is the reason many record companies and artists are
reluctant to digitally deliver their recorded music over the Internet. The
Secure Digital Music Initiative (the "SDMI") is a committee formed by the
Recording Industry Association of America (the "RIAA") to propose a standard
format for the secure digital delivery and use of recorded music. If a standard
format is not adopted, however, unsecure copies of recorded music may continue
to be available on the Internet, and record companies and artists might not
permit the digital delivery of their music. Additionally, as long as pirated
recordings are available, many consumers will choose free pirated recordings
rather than paying for legitimate recordings. Accordingly, if a standard format
for the secure digital delivery of music is not adopted, our business might be
harmed.
We have designed our current products to be adaptable to different music
industry and technology standards. Numerous standards in the marketplace,
however, could cause confusion as to whether our products and services are
compatible. If a competitor were to establish the dominant industry standard,
our business would be harmed.
We Might Need Additional Capital in the Future and Additional Financing Might
Not Be Available
We currently anticipate that our available cash resources and financing
available under existing lease agreements will be sufficient to meet our
anticipated working capital and capital expenditure requirements for the
foreseeable future. However, we may need to raise additional funds through
public or private debt or equity financing in order to:
o take advantage of opportunities, including acquisitions of
complementary businesses or technologies;
o develop new products or services; or
o respond to competitive pressures.
Any additional financing we may need may not be available on terms
favorable to us, or at all. If adequate funds are not available or are not
available on acceptable terms, we might not be able to take advantage of
unanticipated opportunities, develop new products or services, or otherwise
respond to unanticipated competitive pressures, and our business could be
harmed. Our forecast of the period of time through which our financial resources
will be adequate to support our operations is a forward-looking statement that
involves risks and uncertainties, and actual results could vary materially as a
result of a number of factors, including those set forth in this "Additional
Factors Affecting Future Results" section.
Our Future Success Depends on Our Key Personnel
Our future success depends to a significant extent on the continued service
of our key technical, sales and senior management personnel and their ability to
execute our growth strategy. The loss of the services of any of our senior level
management, or other key employees, could harm our business. Our future
performance will depend, in part, on the ability of our executive officers to
work together effectively. Our executive officers may not be successful in
carrying out their duties or running our company. Any dissent among executive
officers could impair our ability to make strategic decisions quickly in a
rapidly changing market.
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Our future success also depends on our ability to attract, retain and
motivate highly skilled employees. Competition for employees in our industry is
intense. Although we provide compensation packages that include incentive stock
options, cash incentives and other employee benefits, the volatility and current
market price of our common stock may make it difficult for us to attract,
assimilate and retain highly qualified employees in the future. We have from
time to time in the past experienced, and we expect to continue to experience in
the future, difficulty in hiring and retaining highly skilled employees with
appropriate qualifications.
We Depend on Proprietary Rights to Develop and Protect Our Technology
Our success and ability to compete substantially depends on our internally
developed technologies and trademarks, which we protect through a combination of
patent, copyright, trade secret and trademark laws. Patent applications or
trademark registrations may not be approved. Even if they are approved, our
patents or trademarks may be successfully challenged by others or invalidated.
If our trademark registrations are not approved because third parties own these
trademarks, our use of these trademarks would be restricted unless we enter into
arrangements with the third-party owners, which might not be possible on
commercially reasonable terms or at all.
The primary forms of intellectual property protection for our products and
services internationally are patents and copyrights. Patent protection
throughout the world is generally established on a country-by-country basis. To
date, we have applied for four patents outside the United States. Copyrights
throughout the world are protected by several international treaties, including
the Berne Convention for the Protection of Literary and Artistic Works. Despite
these international laws, the level of practical protection for intellectual
property varies among countries. In particular, United States government
officials have criticized countries such as China and Brazil for inadequate
intellectual property protection. If our intellectual property is infringed in
any country without a high level of intellectual property protection, our
business could be harmed.
We generally enter into confidentiality or license agreements with our
employees, consultants and corporate partners, and generally control access to
and distribution of our technologies, documentation and other proprietary
information. Despite our efforts to protect our proprietary rights from
unauthorized use or disclosure, parties may attempt to disclose, obtain or use
our solutions or technologies. The steps we have taken may not prevent
misappropriation of our solutions or technologies, particularly in foreign
countries where laws or law enforcement practices may not protect our
proprietary rights as fully as in the United States.
We have licensed, and we may license in the future, certain proprietary
rights to third parties. While we attempt to ensure that the quality of our
brand is maintained by our business partners, they may take actions that could
impair the value of our proprietary rights or our reputation. In addition, these
business partners may not take the same steps we have taken to prevent
misappropriation of our solutions or technologies.
Companies Might Not Develop or Consumers Might Not Adopt Devices That Will Play
Digitally Downloaded Music
We believe that the market for digitally recorded music delivered over the
Internet will not develop significantly until consumers are able to enjoy this
music other than solely through the use of a personal computer. Several consumer
electronics companies have introduced or announced plans to introduce devices
that will allow digital music delivered over the Internet to be played away from
the personal computer. If companies fail to introduce additional devices,
consumers do not adopt these devices or our products and services are
incompatible with these devices, our business would be harmed. In addition,
digital music can be transferred to a compact disc, but that transfer requires a
compact disc recorder ("CD-R"). Many desktop computer manufacturers offer CD-Rs
in their computers. If companies do not continue to offer CD-Rs in their
computers, consumers do not adopt CD-Rs or our products and services are
incompatible with CD-Rs, our business might be harmed.
If We Do Not Increase the Number of Websites that Use Our Platform, Our Business
Will Not Grow
In order to grow our business, we need to increase the number of websites,
including websites operated by music retailers, that use our technology and our
syndicated content to digitally deliver recorded music. To increase the number
of websites, we must do the following:
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o offer competitive products and services that meet industry standards;
o attract more music content;
o make it easy and cost-effective for music-related websites to sell
digital music;
o develop relationships with online retailers, music websites, online
communities, broadband providers and Internet broadcasters; and
o develop relationships with international music websites, retailers and
broadband providers.
Any failure to achieve one or more of these objectives would harm our
business. We may not be successful in achieving any of these objectives.
Due to the Many Factors that Influence Market Acceptance, Consumers Might Not
Accept Our Platform
Our success will depend on growth in consumer acceptance of our platform as
a method for digital delivery of recorded music over the Internet. Factors that
might influence market acceptance of our platform include the following, over
which we have little or no control:
o the availability of sufficient bandwidth on the Internet to enable
consumers to download digital recorded music rapidly and easily;
o the willingness of consumers to invest in computer technology that
facilitates the downloading of digital music;
o the cost of time-based Internet access;
o the number, quality and variety of digital recordings available for
purchase through our system relative to those available through other
online digital delivery companies, digital music websites, music
swapping or sharing websites or through traditional physical delivery
of recordings;
o the availability of portable devices to which digital recorded music
can be transferred;
o the fidelity and quality of the sound of the digital recorded music;
and
o the level of consumer comfort with the process of downloading and
paying for digital music over the Internet, including ease of use and
lack of concern about transaction security.
The Market for Digital Delivery of Music Over the Internet is Highly
Competitive, and if We Cannot Compete Effectively, Our Ability to Generate
Meaningful Revenues Would Suffer Dramatically
Competition among companies in the business of digital delivery of music
over the Internet is intense. If we do not compete effectively or if we
experience pricing pressures, reduced margins or loss of market share resulting
from increased competition, our business might be harmed.
Competition is likely to increase as new companies enter the market and
current competitors expand their products and services or merge with other
competitors. Many of these potential competitors are likely to enjoy substantial
competitive advantages, including the following:
o larger audiences;
o larger technical, production and editorial staffs;
o greater brand recognition;
o access to more recorded music content;
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o a more established Internet presence;
o a larger advertiser base; and
o substantially greater financial, marketing, technical and other
resources.
New Competitors Could Enter the Industry with Alternative Business Models,
Which, if Successful, Could Harm Our Business
New competitors may enter our market with alternative business models. For
example, companies may provide free music downloading from a website, earning
revenues on an advertising or subscription basis. This model could be more
attractive to consumers. If we are unable to compete with such companies or
adapt our business model, products or services to a more consumer-favorable
model, our business could be harmed.
If Musicnet and Pressplay/Duet License Content to Our Competitors, Our Business
Could be Harmed
The major U.S. record companies have recently formed ventures for the
licensing of their content to online music service providers. BMG Entertainment,
EMI, Real Networks and Warner Music Group have formed a venture called
"Musicnet." Also, Universal Music Group and Sony Music Entertainment, Inc. have
formed a venture called "Pressplay/Duet." If Musicnet or Pressplay/Duet launch
their services, they may license significant quantities of content to other
third party online music service providers.
The press has reported that Pressplay/Duet entered into distribution
agreements with Yahoo! and Microsoft Network and that Musicnet intends to
license its service to America Online, Real Networks and Napster. If our
competitors obtain licenses for significant amount of content from Musicnet and
Pressplay/Duet, they may be able to develop a more compelling consumer product
and our business could be harmed.
If Our Platform Does Not Provide Sufficient Rights Reporting Information, Record
Companies and Artists Are Unlikely to Digitally Deliver Their Recorded Music
Using Our Platform
Record companies and artists must be able to track the number of times
their recorded music is downloaded so that they can make appropriate payments to
music rights organizations, such as the American Society of Composers, Authors
and Publishers, Broadcast Music Incorporated and SESAC, Inc. If our products and
services do not accurately or completely provide this rights reporting
information, record companies and artists might not use our platform to
digitally deliver their recorded music, and our business might be harmed.
Our Business Might Be Harmed if We Fail to Price Our Products and Services
Appropriately
The price of Internet products and services is subject to rapid and
frequent change. We may be forced, for competitive or technical reasons, to
reduce or eliminate prices for certain of our products or services. If this
happens, our business might be harmed.
Our Business Might Be Harmed if Challenges Against Intellectual Property Laws by
New Digital Music Delivery Technologies Are Successful
New music sharing technologies allowing users to locate and download copies
of digital music stored on the hard drives of other users without payment have
been introduced into the market. Because some digital recorded music formats,
such as MP3, do not contain mechanisms for tracking the source of ownership of
digital recordings, users are able to download copies of copyrighted recorded
music over the Internet without being required to compensate the owners of these
copyrights. These downloads are a significant concern to record companies and
artists. The Recording Industry Association of America has filed a suit seeking
a permanent injunction against the use of these file-sharing technologies for
exchange of copyrighted works. Several recording artists have also taken legal
action against companies providing music sharing technology. If the injunction
is denied, and it is determined that this file sharing technology is
non-infringing, record companies and artists may limit their use of the Internet
to sell and distribute their copyrighted materials. Even if the technology is
determined to be infringing, it may be difficult to prevent this type of file
sharing because of the non-centralized character of these technologies. As long
as
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digital music copies are available through file sharing without payment,
legally or illegally, consumers may choose not to pay for downloads from retail
and other music delivery sites in our Liquid Music Network, which could harm our
business.
We Might Not Be Able to Scale Our Technology Infrastructure to Meet Demand for
Our Products and Services
Our success will depend on our ability to scale our technology
infrastructure to meet the demand for our products and services. Adding this new
capacity will be expensive, and we might not be able to do so successfully. In
addition, we might not be able to protect our new or existing data centers from
unexpected events as we scale our systems. To the extent that we do not address
any capacity constraints effectively, our business would be harmed.
We Might Not Be Successful in Our Attempts to Keep Up With Rapid Technological
Change and Evolving Industry Standards
The markets for our products and services are characterized by rapidly
changing technology, evolving industry standards, changes in customer needs,
emerging competition, and frequent new product and service introductions. Our
future success will depend, in part, on our ability to:
o use leading technologies effectively;
o continue to develop our strategic and technical expertise;
o enhance our current products and services;
o develop new products and services that meet changing customer needs;
o advertise and market our products and services; and
o influence and respond to emerging industry standards and other
technological changes.
This must be accomplished in a timely and cost-effective manner. We may not
be successful in effectively using new technologies, developing new products or
services or enhancing our existing products or services on a timely basis. These
new technologies or enhancements may not achieve market acceptance. Our pursuit
of necessary technological advances may require substantial time and expense.
Finally, we may not succeed in adapting our services to new technologies as they
emerge.
We Might Not Be Successful in the Development and Introduction of New Products
and Services
We depend in part on our ability to develop new or enhanced products and
services, such as our subscription-based service offering, in a timely manner
and to provide new products and services that achieve rapid and broad market
acceptance. We may fail to identify new product and service opportunities
successfully and develop and bring to market new products and services in a
timely manner. In addition, product innovations may not achieve the market
penetration or price stability necessary for profitability.
As the online medium continues to evolve, we plan to leverage our
technology by introducing complementary products and services as additional
sources of revenue. Accordingly, we may change our business model to take
advantage of new business opportunities, including business areas in which we do
not have extensive experience. For example, we will continue to devote
significant resources to the development of digital music delivery services, as
well as our software licensing business. If we fail to develop these or other
businesses successfully, our business would be harmed.
We Might Experience Delays in the Development of New Products and Services
We must continue to innovate and develop new versions of our software to
remain competitive in the market for digital delivery of recorded music
solutions. Our software products and services development efforts are inherently
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difficult to manage and keep on schedule. Our failure to manage and keep those
development projects on schedule might harm our business.
Our Products and Services Might Contain Errors
We offer complex products and services. They may contain undetected errors
when first introduced or when new versions are released. If we market products
and services that have errors or that do not function properly, then we may
experience negative publicity, loss of or delay in market acceptance, or claims
against us by customers, any of which might harm our business.
We Might Have Liability for the Content of the Recorded Music That We Digitally
Deliver
Because we digitally deliver recorded music to third parties, we might be
sued for negligence, copyright or trademark infringement or other reasons. These
types of claims have been brought, sometimes successfully, against providers of
online products and services in the past. Others could also sue us for the
content that is accessible from our website through links to other websites.
These claims might include, among others, claims that by hosting, directly or
indirectly, the websites of third parties, we are liable for copyright or
trademark infringement or other wrongful actions by these third parties through
these websites. Our insurance may not adequately protect us against these types
of claims and, even if these claims do not result in liability, we could incur
significant costs in investigating and defending against these claims.
We have taken steps to prevent these claims. For example, we have
arrangements with companies that use our hosting services that will allow us to
delete potentially infringing or misappropriating materials quickly and
securely. We also have put into place indemnification agreements with music
content providers, where practicable. Under the Digital Millenium Copyright Act
of 1999, Internet service providers are insulated from several types of these
claims, upon compliance with the requirement that they appoint an agent to
receive claims relating to their service, and we have appointed an agent.
System Failures or Delays Might Harm Our Business
Our operations depend on our ability to protect our computer systems
against damage from fire, water, power loss, telecommunications failures,
computer viruses, vandalism and other malicious acts, and similar unexpected
adverse events. Our corporate headquarters are located in northern California.
California is currently experiencing power outages due to a shortage in the
supply of power within the state. Although we maintain a comprehensive disaster
recovery plan, if the power outages increase in severity, they could disrupt our
operations. Interruptions or slowdowns in our services have resulted from the
failure of our telecommunications providers to supply the necessary data
communications capacity in the time frame we required, as well as from
deliberate acts. Despite precautions we have taken, unanticipated problems
affecting our systems could in the future cause temporary interruptions or
delays in the services we provide. Our customers might become dissatisfied by
any system failure or delay that interrupts our ability to provide service to
them or slows our response time. Sustained or repeated system failures or delays
would affect our reputation, which would harm our business. Slow response time
or system failures could also result from straining the capacity of our software
or hardware due to an increase in the volume of products and services delivered
through our servers. While we carry business interruption insurance, it might
not be sufficient to cover any serious or prolonged emergencies, and our
business might be harmed.
We Might Be Unable to License or Acquire Technology
We rely on certain technologies that we license or acquire from third
parties, including Dolby Laboratories Licensing Corporation, Fraunhofer
Institut, RSA Data Security, Inc. and Thomson Consumer Electronics Sales GmbH.
These technologies are integrated with our internally developed software and
used in our products, to perform key functions and to enhance the value of our
platform. These third-party licenses or acquisitions may not continue to be
available to us on commercially reasonable terms or at all. Any inability to
acquire these licenses or software on commercially reasonable terms might harm
our business.
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Difficulties Presented by International Economic, Political, Legal, Accounting
and Business Factors Could Harm Our Business in International Markets
A key component of our strategy is to expand into international markets.
The following risks are inherent in doing business on an international level and
we have little or no control over them:
o unexpected changes in regulatory requirements;
o export restrictions;
o export controls relating to encryption technology;
o longer payment cycles;
o problems in collecting accounts receivable;
o political and economic instability; and
o potentially adverse tax consequences.
In addition, other factors that may also affect us and over which we have
some control include the following:
o difficulties in staffing and managing international operations;
o differences in music rights reporting structures; and
o seasonal reductions in business activity.
We have entered into individual agreements in Japan, Korea, greater China
and south east Asia, and we may enter into similar arrangements in the future in
other countries. We also established a wholly-owned subsidiary in the United
Kingdom. One or more of the factors listed above may harm our present or future
international operations and, consequently, our business.
Our Management and Internal Systems Might Be Inadequate to Handle the Potential
Growth of Our Personnel
To manage future growth, our management must continue to improve our
operational and financial systems and expand, train, retain and manage our
employee base. Our management may not be able to manage our growth effectively.
If our systems, procedures and controls are inadequate to support our
operations, our expansion would be halted and we could lose our opportunity to
gain significant market share. Any inability to manage growth effectively may
harm our business.
Risks Related to Our Industry
Internet Security Concerns Could Hinder E-Commerce
A significant barrier to e-commerce and communications over the Internet
has been the need for secure transmission of confidential information. Internet
usage may not increase at the rate we expect unless some of those concerns are
adequately addressed and found acceptable by the market. Internet usage could
also decline if any well-publicized compromise of security occurs. We may incur
significant costs to protect against the threat of security breaches or to
alleviate problems caused by these breaches. Protections may not be available at
a reasonable price or at all. If a third person were able to misappropriate a
user's personal information, users could bring claims against us.
Imposition of Sales and Other Taxes On E-Commerce Transactions Might Hinder
E-Commerce
30
We do not collect sales and other taxes when we sell our products and
services over the Internet. State or local governments may seek to impose sales
tax collection obligations on out-of-state companies, such as ours, which engage
in or facilitate e-commerce. A number of proposals have been made at the state
and local level that would impose additional taxes on the sale of products and
services through the Internet. These proposals, if adopted, could substantially
impair the growth of e-commerce and could reduce our opportunity to derive
profits from e-commerce. Moreover, if any state or local government or foreign
country were to successfully assert that we should collect sales or other taxes
on the exchange of products and services on our system, our business might be
harmed.
In 1998, Congress passed the Internet Freedom Act, which imposes a
three-year moratorium on state and local taxes on Internet-based transactions.
We cannot assure you that this moratorium will be extended. Failure to renew
this moratorium would allow various states to impose taxes on e-commerce, which
might harm our business.
Demand for Our Products and Services Might Decrease if Growth in the Use of the
Internet Declines
Our future success substantially depends upon the continued growth in the
use of the Internet. The number of users on the Internet may not increase and
commerce over the Internet may not become more accepted and widespread for a
number of reasons, including the following, over which we have little or no
control:
o actual or perceived lack of security of information, such as credit
card numbers;
o lack of access and ease of use;
o inconsistent quality of service and lack of availability of
cost-effective, high speed service;
o possible outages due to damage to the Internet;
o excessive governmental regulation; and
o uncertainty regarding intellectual property rights.
If the necessary infrastructure, products, services or facilities are not
developed, or if the Internet does not grow as a commercial medium, our business
would be harmed.
Government Regulation of the Internet Might Harm Our Business
The applicability to the Internet of existing laws governing issues such as
property ownership, libel and personal privacy is uncertain. In addition,
governmental authorities may seek to further regulate the Internet with respect
to issues such as user privacy, pornography, acceptable content, e-commerce,
taxation, and the pricing, characteristics and quality of products and services.
Finally, the global nature of the Internet could subject us to the laws of a
foreign jurisdiction in an unpredictable manner. Any new legislation regulating
the Internet could inhibit the growth of the Internet and decrease the
acceptance of the Internet as a communications and commercial medium, which
might harm our business.
In addition, the growing use of the Internet has burdened the existing
telecommunications infrastructure and has caused interruptions in telephone
service. Telephone carriers have petitioned the government to regulate the
Internet and impose usage fees on Internet service providers. Any regulations of
this type could increase the costs of using the Internet and impede its growth,
which could in turn decrease the demand for our services or otherwise harm our
business.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
See "Market Risk" in Part I, Item 2, Management's Discussion and Analysis
of Financial Condition and Results of Operations.
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PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
In July and August 2001, several law firms announced that they had filed
class action lawsuits in the United States District Court for the Southern
District of New York on behalf of purchasers of the our securities during the
period between July 8, 1999 and December 6, 2000. The complaint names us,
certain former and current officers and directors of the Company, Lehman
Brothers Inc., BancBoston Robertson Stephens, Inc. and U.S. Bancorp Piper
Jaffray Inc. and allege violation of Sections 11, 12(a) (2) and 15 of the
Securities Act of 1933, as amended, and Section 10(b) of the Securities Exchange
Act of 1934 and Rule 10b-5 promulgated thereunder. To date, we have not been
served with any complaints.
On or about April 7, 2000, Sightsound, Inc. ("Sightsound") filed an Amended
Complaint against one of our customers in the United States District Court for
the Eastern District of Pennsylvania (Pittsburgh). The suit alleges that our
customer infringes one or more of three patents (United States Patent Nos.
5,191,573; 5,675,734 and 5,996,440). Sightsound claims damages of $20 million
plus an unspecified royalty. We have entered into an agreement with our customer
whereby we have agreed to assume control of the defense and pay the defense
costs, while reserving our rights as to indemnification obligations. The
customer filed an Answer to the Amended Complaint on April 27, 2000 denying the
material allegations of the complaint, and asserting counterclaims for
declaratory judgment of noninfringement and patent invalidity. A trial date had
been set for September 28, 2001 in the matter, but that date will be reset after
the Court rules on pending matters.
On March 31, 2000, Intouch Group, Inc. ("Intouch") filed a lawsuit against
us in the United States District Court for the Northern District of California
alleging patent infringement. The Complaint names us, Amazon.com, Inc.,
Listen.com, Inc., Entertaindom LLC, DiscoverMusic.com, Inc. and Muze, Inc. It
alleges that these parties infringe, or induce infringement of, the claims of
U.S. Patent Nos. 5,237,157 (the"`157 patent") and 5,963,916 (the"`916 patent")
by operating a web site and/or a kiosk that allows interactive previewing of
pre-recorded music products. The Complaint seeks unspecified damages and
injunctive relief. We answered Intouch's first amended complaint, denying the
material allegations of the amended complaint, and asserting counterclaims for
declaratory judgment of non-infringement, patent invalidity and inequitable
conduct. In May 2001, the parties reached an agreement in principle to settle
Intouch's claims on the `157 patent. Fact discovery is currently ongoing, and is
scheduled to close on September 27, 2001. Expert discovery is scheduled to close
on December 13, 2001. The trial date has been set for April 15, 2002. We believe
that we have meritorious defenses to Intouch's claims and we intend to
vigorously defend against such claims. However, we cannot assure that we will be
successful in defending these lawsuits. If there is a finding of infringement,
we might be required to pay substantial damages to Intouch and could be enjoined
from selling any of our products or services that are held to infringe Intouch's
patents unless and until we are able to negotiate a license from them.
On August 14, 2000, a former employee filed a charge of discrimination with
the California Department of Fair Employment and Housing against us, and several
of our employees and former employees. The charge alleges sexual harassment and
unlawful retaliation. While we believed the charge was without merit, we reached
an out-of-court settlement in April 2001 with the former employee whereby we
agreed to pay her $40,000.
From time to time we receive letters from corporations or other business
entities notifying us of alleged infringement of patents held by them or
suggesting that we review patents to which they claim rights. These corporations
or entities often indicate a willingness to discuss licenses to their patent
rights.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
The effective date of our first registration statement, filed on Form S-1
under the Securities Act of 1933 (No. 333-82521) relating to our initial public
offering of common stock, was July 8, 1999. A total of 4,800,000 shares of
common stock were sold at a price of $15.00 per share to an underwriting
syndicate led by Lehman Brothers Inc., BancBoston Robertson Stephens Inc. and
U.S. Bancorp Piper Jaffray Inc. Offering proceeds, net of aggregate expenses of
approximately $6.1 million, were approximately $65.9 million.
32
The effective date of our second registration statement, filed on Form S-1
under the Securities Act of 1933 (No. 333-91541) relating to our follow-on
public offering of common stock, was December 14, 1999. A total of 2,946,076
shares of Common Stock were sold at a price of $33.63 per share to an
underwriting syndicate led by Lehman Brothers Inc., BancBoston Robertson
Stephens Inc., U.S. Bancorp Piper Jaffray Inc., Dain Rauscher Wessells and
Fidelity Capital Markets. An additional 503,924 shares of Common stock were sold
on behalf of selling stockholders as part of the same offering. Offering
proceeds to us, net of aggregate expenses of approximately $5.4 million, were
approximately $93.7 million. Offering proceeds to selling shareholders, net of
expenses of approximately $847,000, were approximately $16.1 million.
From the time of receipt through June 30, 2001, our proceeds were applied
toward general corporate purposes, including the purchase of temporary
investments consisting of cash, cash equivalents and short-term investments,
working capital and capital expenditures, enhancing research and development and
attracting key personnel.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
None.
(b) Reports on Form 8-K
On August 8, 2001, we filed a report on Form 8-K which announced that our
Board of Directors approved the adoption of a Preferred Stock Rights Agreement.
A copy of our press release announcing this matter was attached and incorporated
by reference therein.
33
LIQUID AUDIO, INC.
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.
DATE: August 14, 2001 LIQUID AUDIO, INC.
/s/ Gerald W. Kearby
-----------------------------------------
GERALD W. KEARBY
President, Chief Executive Officer and
Director (Principal Executive Officer)
/s/ Michael R. Bolcerek
-----------------------------------------
MICHAEL R. BOLCEREK
Senior Vice President and Chief
Financial Officer (Principal Financial
and Accounting Officer)
34