S-1 1 a97792orsv1.htm FORM S-1 Lindows, Inc.
 

As filed with the Securities and Exchange Commission on April 20, 2004
Registration Number 333-[            ]


UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549


Form S-1

REGISTRATION STATEMENT
UNDER THE SECURITIES ACT OF 1933


Lindows, Inc.

(Exact name of Registrant as specified in its charter)
         
Delaware   7372   33-0976700
(State or other jurisdiction of
incorporation or organization)
  (Primary Standard Industrial
Classification Code Number)
  (I.R.S. Employer
Identification Number)


9333 Genesee Ave., 3rd Floor

San Diego, California 92121
(858) 587-6700
(Address, including zip code, and telephone number,
including area code, of Registrant’s principal executive offices)


Michael L. Robertson

Chairman and Chief Executive Officer
Lindows, Inc.
9333 Genesee Ave., 3rd Floor
San Diego, California 92121
(858) 587-6700
(Name, address, including zip code, and telephone number,
including area code, of agent for service)


Copies to:

     
Steven G. Rowles, Esq.
Michael S. Umansky, Esq.
Clint B. Davis, Esq.
Morrison & Foerster LLP
3811 Valley Centre Drive, Suite 500
San Diego, California 92130
  Matthew W. Sonsini, Esq.
Clay B. Simpson, Esq.
Wilson Sonsini Goodrich & Rosati
Professional Corporation
650 Page Mill Road
Palo Alto, California 94304


     Approximate date of commencement of proposed sale to the public: As soon as practicable after the effective date of this Registration Statement.

     If any of the securities being registered on this form are to be offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act of 1933, check the following box.     o

     If this Form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, please check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.     o

     If this Form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.     o

     If delivery of the prospectus is expected to be made pursuant to Rule 434, please check the following box.     o


CALCULATION OF REGISTRATION FEE

         


Title of Each Class of Proposed Maximum Aggregate Offering Amount of
Securities to be Registered Price(1) Registration Fee

Common Stock, $0.0001 par value
  $57,500,000   $7,286


(1)  Estimated solely for the purpose of computing the amount of the registration fee pursuant to Rule 457(o) promulgated under the Securities Act of 1933, as amended.

     The Registrant hereby amends this Registration Statement on such date or dates as may be necessary to delay its effective date until the Registrant shall file a further amendment which specifically states that this Registration Statement shall thereafter become effective in accordance with Section 8(a) of the Securities Act of 1933, as amended, or until the Registration Statement shall become effective on such date as the Commission, acting pursuant to said Section 8(a), may determine.




 

The information in this preliminary prospectus is not complete and may be changed. We may not sell these securities until the registration statement filed with the Securities and Exchange Commission is effective. This preliminary prospectus is not an offer to sell these securities and we are not soliciting offers to buy these securities in any jurisdiction where the offer or sale is not permitted.

Subject to completion, dated April 20, 2004

     
 
(LINDOWS, INC. CORPORATION LOGO)
  Lindows, Inc.

             
Shares
of Common Stock


This is our initial offering of our shares to the public, and no public market currently exists for our shares. We expect that the public offering price will be between $                    and $                     per share.  

                 
THE OFFERING PER SHARE TOTAL

Public Offering Price
  $       $    
Underwriting Discount
  $       $    
Proceeds to Lindows
  $       $    

We have granted the underwriters the right to purchase up to                    additional shares from us within 30 days after the date of this prospectus to cover any over-allotments. The underwriters expect to deliver shares of common stock to purchasers on                     , 2004.  

Proposed Nasdaq National Market Symbol: LINE
  OpenIPO®: The method of distribution being used by the underwriters in this offering differs somewhat from that traditionally employed in firm commitment underwritten public offerings. In particular, the public offering price and allocation of shares will be determined primarily by an auction process conducted by the underwriters and other securities dealers participating in this offering. A more detailed description of this process, known as an OpenIPO, is included in “Plan of Distribution” beginning on page 84.


This offering involves a high degree of risk. You should purchase

shares only if you can afford a complete loss of your investment.
See “Risk Factors” beginning on page 5.


Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of these securities or determined if this prospectus is truthful or complete. Any representation to the contrary is a criminal offense.

(WR HAMBRECHT + CO LOGO)

Roth Capital Partners

The date of this prospectus is                     , 2004


 

(LINSPIRE LOGO)
(LINSPIRE SCREENSHOT)
(SCREENSHOTS OF THE LINSPIRE OPERATING SYSTEM DESKTOP)
(LINSPIRE SCREENSHOT)


 

Business Model Graphics


 

      You should rely only on the information contained in this prospectus. We have not, and the underwriters have not, authorized any other person to provide you with different information. If anyone provides you with different or inconsistent information, you should not rely on it. We are not, and the underwriters are not, making an offer to sell these securities in any jurisdiction where the offer or sale is not permitted. You should assume that the information appearing in this prospectus is accurate as of the date on the front cover of this prospectus only. Our business, financial condition, results of operations, and prospects may have changed since that date.


TABLE OF CONTENTS

         
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      Lindows, Lindows.com, LindowsOS, Linspire, CNR and our logos are our trademarks. We have applied to register Linspire, Lindows.com, LindowsOS, and CNR with the U.S. Patent and Trademark Office. Other service marks, trademarks and trade names referred to in this prospectus are the property of their respective owners.

      OpenIPO is a registered service mark of WR Hambrecht + Co, LLC.


 

PROSPECTUS SUMMARY

      You should read this entire prospectus carefully, especially “Risk Factors” and our financial statements and the related notes, before deciding to invest in our common stock. References in this prospectus to our restated certificate of incorporation and restated bylaws refer to the restated certificate of incorporation and restated bylaws that will be in effect upon the completion of this offering.

Lindows, Inc.

Overview

      We are a developer and vendor of Linux-based operating systems, application software and services designed specifically for desktop and laptop computers in homes, schools and businesses. We use technology and software developed by the collaboration of independent Linux developers, referred to as the open source community, with our own technology and software to offer affordable, easy-to-use software products and services, many of which are similar in feel and functionality to our higher-priced competitors. The cornerstone of our product line is our Linspire operating system. We also offer Linux application software and services developed by us and others. We sell and distribute our products and services both through the Internet using our proprietary CNR technology and by pre-installing them on third-party computer hardware. Our CNR technology reduces the complexity of installing, managing and updating Linux application software.

Industry Background

      According to International Data Corporation, or IDC, worldwide client operating system revenues were approximately $10.4 billion in 2002. IDC data shows that Microsoft captured 96.1% of this revenue through its Microsoft Windows products during the same period.

      The application software market is larger and more fragmented than the desktop operating system market, with many competitors selling consumer, education and business oriented application software for various platforms.

      International and emerging markets are increasingly important to the personal computer operating system industry. According to IDC, the value of personal computers sold into the U.S. has declined as a percentage of the worldwide personal computer market from 38.9% in 2000 to 32.0% in 2003.

The Linux Desktop Opportunity

      As the prices for personal computers, or PCs, have continued to decline, the relative cost of the Microsoft Windows operating system has increased. In value-priced PCs and laptops, which we consider to be those with a manufacturer’s suggested retail price, or MSRP, of less than $600, the Microsoft Windows operating system and bundled software can be the most expensive component. As computer manufacturers continue to compete on price, and value conscious consumers look to save money, we believe that operating systems based on Linux technology will increasingly be offered on value-priced computers.

Our Solution

      We have developed a simple and comprehensive solution allowing homes, schools and businesses to use a Linux-based operating system and to install and maintain application software on PCs. Our Linux-based desktop solution, the Linspire operating system, is:

  •  Easy to use — The Linspire operating system presents the user with an intuitive and comfortable graphical user interface.
 
  •  A full-featured platform — The Linspire operating system is configured to perform many common tasks such as email and Internet browsing.

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  •  CNR equipped — Our proprietary CNR technology allows users to license, install, manage, update, and configure programs available from our software Warehouse on the Linspire.com website.
 
  •  Hardware compatible — We believe the Linspire operating system is able to work with many of the most popular machines and peripheral devices on the market today.
 
  •  File compatible — Users can work with many common file types used by Microsoft’s office suite.
 
  •  Stable and secure — We believe the Linspire operating system is currently less prone to virus attacks than other desktop operating systems not based on Linux.

      As a result of these features, more than 550 hardware manufacturers, systems builders and software and hardware resellers have participated in our channel distribution programs by licensing the right to distribute the Linspire operating system or sell hardware pre-installed with the Linspire operating system. We refer to participants in our channel distribution programs as our channel partners.

Strategy

      We generate revenue from the sale of affordable desktop operating systems, application software and services for desktop and laptop computers. We seek to build a large installed base of computers running our Linspire operating system, to which we will offer value-added applications and services. The key elements of our strategy are:

  •  broaden distribution of the Linspire operating system by making it available on a large scale, quickly and at a low cost;
 
  •  use CNR technology to drive revenues from our value-added software and services;
 
  •  focus on products and services primarily for desktop and laptop users;
 
  •  support and leverage the open source community;
 
  •  increase our penetration into international and emerging markets; and
 
  •  increase awareness of Linspire and our other brands.

Risks Affecting Us

      We are subject to a number of risks, which you should be aware of before you decide to buy our common stock. These risks are discussed in “Risk Factors.” If we are unable to expand our distribution channels and convince desktop and laptop users that our Linux-based products and services are affordable and effective alternatives to Microsoft’s products and services, we will fail to achieve our business objectives. From inception through December 31, 2003, we had an accumulated deficit of $11,858,805. We expect to continue to incur significant losses over the next several years, and we may never become profitable.

Corporate Information

      We were incorporated in Delaware in July 24, 2001 under the name “Lindoz, Inc.” We changed our name to “Lindows.com, Inc.” in September 2001 and to “Lindows, Inc.” in March 2004. We also conduct business under the trademark “Linspire.”

      Our principal executive offices are located at 9333 Genesee Ave., 3rd Floor, San Diego, California 92121, and our telephone number is (858) 587-6700. Our corporate website address is www.lindowsinc.com. Our branded commerce website is www.linspire.com. The information contained in, or that can be accessed through, our websites should not be considered a part of, nor is such information incorporated into, this prospectus.

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The Offering

 
Common stock offered                      shares
 
Common stock to be outstanding after this offering                      shares
 
Use of proceeds We expect to use a majority of the net proceeds of this offering to further develop the distribution channels for our Linux-based operating system, application software and services, to expand our sales and marketing activities, to continue to develop existing and new products, technologies and services, to increase personnel, and to repay substantially all of our outstanding debt obligations to our founder of approximately $10,400,000. To a lesser extent, we anticipate using net proceeds of this offering for working capital and other general corporate purposes. In addition, we may use a portion of the net proceeds from this offering to acquire products, technologies or businesses that are complementary to our current or future business and product lines.
 
Proposed Nasdaq National Market symbol LINE

      The number of shares of common stock to be outstanding after this offering is based on the shares outstanding as of December 31, 2003. This number excludes as of December 31, 2003:

  •  4,309,938 shares of our common stock subject to outstanding options under our 2001 stock incentive plan, having a weighted average exercise price of $0.0095 per share; and
 
  •  1,985,150 shares of our common stock reserved for future issuance under our 2001 stock incentive plan.

      In addition, except where we state otherwise, the information we present in this prospectus reflects:

  •  a one-for                     reverse stock split to be effected before the completion of this offering;
 
  •  the conversion of all our outstanding preferred stock into 52,750,000 shares of common stock upon the closing of this offering;
 
  •  the adoption of our restated certificate of incorporation and restated bylaws to be effective upon the closing of this offering; and
 
  •  no exercise of the underwriters’ over-allotment option.

      This offering will be made through the OpenIPO process, in which the allocation of shares and the public offering price are primarily based on an auction in which prospective purchasers are required to bid for the shares. This process is described under “Plan of Distribution.”

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Summary Financial Data

      The following tables summarize the financial data for our business. For a more detailed explanation of our financial condition and operating results, you should read “Selected Financial Data,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our financial statements and related notes included elsewhere in this prospectus. The pro forma information included in the statement of operations and balance sheet data has been computed as described in Note 1 to the financial statements. The pro forma as adjusted balance sheet data reflects the balance sheet data at December 31, 2003 adjusted for the conversion of all outstanding shares of preferred stock into 52,750,000 shares of common stock and the receipt of the estimated net proceeds from the sale of the shares of common stock in this offering, at an assumed initial public offering price per share of $                    , after deducting estimated underwriting discounts and commissions and offering expenses.

                         
Period from
July 24, 2001
(inception) to Years ended December 31,
December 31,
2001 2002 2003



Net revenues
  $     $ 63,131     $ 2,074,002  
Cost of sales
          415,077       605,567  
     
     
     
 
Gross profit (loss)
          (351,946 )     1,468,435  
Loss from operations
    (1,146,138 )     (6,651,667 )     (3,793,187 )
     
     
     
 
Net loss
  $ (1,127,391 )   $ (6,656,212 )   $ (4,075,202 )
     
     
     
 
Net loss per common share — basic and diluted
  $ (0.95 )   $ (2.37 )   $ (0.78 )
Weighted average shares — basic and diluted
    1,185,850       2,808,112       5,239,163  
Pro forma net loss per share
                  $ (0.07 )
Pro forma shares used in computing pro forma net loss per share
                    57,989,163  
                     
 
                         
As of December 31, 2003

Pro forma
Actual Pro forma As adjusted



Balance Sheet Data:
                       
Cash and cash equivalents
  $ 250,720     $ 250,720     $    
Working capital
    (1,776,555 )     (1,776,555 )        
Total assets
    933,737       933,737          
Total indebtedness
    4,703,181       4,703,181          
Convertible preferred stock
    5,275                
Stockholders’ equity (deficit)
    (6,093,852 )     (6,093,852 )        

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RISK FACTORS

      Any investment in our common stock involves a high degree of risk. You should consider carefully the following information about the risks described below, together with the other information contained in this prospectus, before you decide whether to buy our common stock. If any of the following risks actually occur, our business, financial condition, results of operations, and future growth prospects would likely be materially and adversely affected. In these circumstances, the market price of our common stock could decline, and you may lose all or part of the money you paid to buy our common stock.

Risks Related to Our Business and Industry

We may lack the financial, operational and sales and marketing resources to compete effectively with Microsoft and other operating system and application software providers, which may limit our commercial opportunity.

      Our primary competitor, Microsoft Corporation, has significantly more financial, operational and sales and marketing resources than we do. In addition, the desktop computer market is dominated by Microsoft’s Windows operating system. Accordingly, it will be difficult for us to compete effectively against Microsoft and other companies whose products are compatible with the Microsoft Windows operating system. We also will likely face intense competition from other established operating system developers, including Red Hat, Novell, Sun Microsystems, and Apple, among others. These competitors may be able to leverage their existing service organizations and provide better levels of support on a more cost-effective basis than we can, and their greater resources, installed base, brand recognition, and more established distribution and other collaborative relationships may make it difficult for us to effectively access and exploit existing and future distribution channels to attract and retain an adequate customer base. We also face competition from many smaller Linux-based operating system providers. If we are unable to compete effectively against existing and future competitors, our business will not succeed.

If we fail to continue to establish and maintain distribution and other collaborative relationships, we may not be able to attract and retain a sufficient customer base.

      Our success depends in part on our ability to continue to establish and maintain distribution and other collaborative relationships with hardware manufacturers, systems builders and software and hardware resellers, which we refer to as channel partners. These relationships allow us to offer our products and services to a much larger customer base than we would otherwise be able to access through our direct sales and marketing efforts. If our channel partners fail to realize adequate financial benefits from these relationships, we may not be able to maintain existing channel partnering relationships or establish new relationships on attractive terms. In addition, most of our existing channel partnering relationships do not, and any future channel partnering relationships may not, afford us any exclusive marketing or distribution rights. As a result, many of the companies with which we have channel partnering relationships may pursue alternative technologies and develop alternative products and services in addition to or in lieu of our products and services, either on their own or in collaboration with others, including our competitors.

Our business may not succeed because our open source software business model is unproven.

      We have not demonstrated the success of our open source software business model, which gives our customers the right to freely copy and distribute some of the software in our operating system and in the applications we develop and distribute. There is uncertainty in connection with open source business models, particularly as to whether or not businesses based on open source software can operate profitably. Few open source software products have gained widespread

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commercial acceptance. In addition, because our business model also contemplates developing and distributing products based on and including technology that is not open source, we may alienate the Linux and open source communities, which could harm our product development efforts and reputation, increase our cost structure and decrease our revenue. We also face risks that independent developers may develop competing open source solutions or choose to take proprietary products in which we have invested significant time and resources and make similar products available on an open source basis, making our proprietary solutions less attractive and decreasing our revenue. If our business model should fail to gain both widespread commercial and open source community acceptance, we will not be able to sustain our revenue and our business could fail.

The market for Linux solutions may not grow as we anticipate, which would limit our commercial opportunity.

      Our strategy for marketing our Linux solutions depends in part upon our belief that homes, schools and businesses will increasingly adopt Linux solutions. If homes, schools and businesses, which at present favor Microsoft, UNIX and other non-Linux operating systems, do not increasingly adopt Linux operating systems and related solutions, a market for our products will not develop. Factors that may keep homes, schools and businesses from adopting Linux solutions include:

  •  technical difficulty in installing and configuring many of the currently available Linux-based operating systems and software applications;
 
  •  lack of well-financed companies pursuing the adoption of Linux in the desktop computer market, coupled with the lack of computers pre-installed with a Linux operating system;
 
  •  few high quality applications developed for Linux-based desktop operating systems as compared with their Microsoft Windows-based counterparts;
 
  •  lack of compatibility with the majority of applications created for personal computers; and
 
  •  greater familiarity with and previous significant investments by consumers in Microsoft Windows and other competing systems.

Our fee-based contract model may encounter customer resistance, which could cause us to lose revenues.

      Many of our Linux-based products and services require customers to pay a service or license fee. Customers and potential customers who believe we should distribute our services and products without cost may resist this distribution model. To the extent we are unsuccessful in promoting or defending this distribution model, our revenues and reputation in the open source community could be harmed.

Our marketing and distribution strategy may adversely impact revenues from licensing our operating system.

      Our marketing and distribution strategy relies in part on making our Linspire operating system available to consumers at a low cost by working with our channel partners to pre-install PCs and hard drives with the Linspire operating system and by free promotional distributions of the Linspire operating system. This strategy is designed to grow our Linspire operating system installed base so that we can increase revenues through the sale of application software and services. The availability of the Linspire operating system at no charge, or at a low price, may adversely affect the price at which we can license our Linspire operating system directly to consumers from our website, which could reduce our revenues.

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We rely in part on an indirect sales channel for distribution of our products, and disruption of any part of this channel could adversely affect the sales of our products and services.

      We sell our products and services through an indirect sales channel in which our channel partners sell our products and services to their customers, either on a stand-alone basis or incorporated in products that they manufacture. We have no written agreement or other relationship with many of the retailers and resellers of our products and services, and therefore cannot control the relationships through which our products and services are ultimately sold to homes, schools and businesses. As a result, our distribution channel could be affected by disruptions in the relationships between our distributors and their customers. We also cannot guarantee that our distributors will market our products effectively or continue to devote the resources necessary to provide us or our customers with effective sales, marketing and technical support. Disruptions in our distribution channel or poor marketing and support by third parties could lead to decreased sales or slower than expected growth.

We rely on one distributor for the exclusive distribution of our products and services in Japan, and this distributor has acquired a competing product.

      In 2003, our distribution arrangement with Livedoor Co., Ltd., a Japanese information technology company, accounted for approximately 11% of our net revenue. Our new distribution agreement with Livedoor provides Livedoor the exclusive right to market, sell and support the Japanese versions of our products and services in Japan in exchange for nonrefundable exclusive licensing fees of $1,069,000 payable in four installments ending on February 17, 2005. The agreement remains in effect through August 29, 2005. Our future sales to Livedoor will be affected by the success of our products and services in the Japanese market. We expect that Livedoor will continue to represent a significant portion of our revenues in 2004. However, Livedoor does not have a commitment to purchase a specific amount of our products in future periods, and there can be no assurance that they will continue as our Japanese distributor. Livedoor also recently acquired Turbolinux, and may intend to market Turbolinux’s competing operating system product in Japan during the period of our agreement. Consequently, our business and results of operations could be adversely affected by the loss of the Livedoor relationship or the reduction, delay or cancellation of Livedoor orders.

Because we recently adopted an alternative name strategy for our commerce website and our products and services, our existing and potential customers, channel partners, industry vendors, and investors may not recognize our new brand, which may cause our revenues to decline.

      In response to our foreign litigation with Microsoft Corporation, we recently adopted an alternative name strategy for our commerce website and our products and services. We also have changed the location of our commerce website from www.lindows.com to www.linspire.com. Because we have previously marketed our products and services under the Lindows name, some of our existing and potential customers, channel partners, industry vendors, and investors may not recognize our new brand. To increase awareness of our new brand, we will need to spend significant amounts on marketing activities. These expenditures may not increase our brand recognition or result in increased revenues sufficient to cover such marketing expenses. In addition, even if brand recognition increases, the number of new customers or the number of transactions on our commerce website may not increase. Furthermore, depending on the outcome of our litigation with Microsoft and the success of our alternative name strategy, we may choose to return to our prior name strategy or may be forced to make additional changes in our name strategy, including changing our corporate name and abandoning our Lindows trademark. Any further changes in our name strategy will cause us to incur additional expenses and may result in a decline in our revenues. Please see “Business — Legal Proceedings” for more description of our litigation with Microsoft.

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Our reliance on independent third parties to develop software included in our products and services could result in delays or unreliable products and services and damage to our reputation.

      Our operating systems and application software consist of many different software code components, including the heart of Linux technologies, the Linux kernel. Most of this software is developed by independent third parties over whom we have no control. We cannot guarantee that we have selected or will select in the future the most reliable software code components available in the market or that we will successfully integrate the many components of our products. In addition, if any of this third-party software is not reliable or available, we may have to develop it ourselves, which would significantly increase our development expenses and delay our time to market. Our customers could be dissatisfied if any of these products fails to work as designed or if adequate product support is not provided, which could damage our reputation and lead to litigation.

If third-party application software providers do not continue to make their new applications compatible with our Linux-based operating systems, our software will not be competitive.

      Our products will not be competitive unless new software applications developed by third parties continue to be compatible with our Linux-based operating system. We believe the availability of compatible third-party application software products depends in part on third-party developers’ perception and analysis of the relative benefits of developing, maintaining and upgrading software for Linux-based operating systems versus software for the larger Microsoft Windows market. This analysis is based on factors such as the perceived strength of our business and products, the anticipated potential revenue that may be generated, acceptance by customers of our operating system, and the costs of developing compatible software products. Our limited operating history, financial losses in prior years and minority market share in the operating system market may cause software developers to question our prospects for success, in which case developers could be less inclined to develop new application software or upgrade existing software for our Linux-based operating systems. We intend to encourage the development of additional applications that operate on Linux-based operating systems by attracting third-party developers to the Linux platform and maintaining our existing developer relationships through marketing and technical support for third-party developers. If we are not successful in achieving these goals, however, our products will not be competitive and our sales will be adversely affected.

Security and privacy breaches may expose us to liability and cause us to lose customers.

      Our security measures may not prevent security breaches that could harm our business. Currently, a significant number of our users provide us with credit card and other financial information and authorize us to bill their credit card accounts directly for our products and services. We rely on encryption and authentication technology licensed from third parties to effect secure transmission of this confidential information. Advances in computer capabilities, new discoveries in the field of cryptography or other developments may result in a compromise or breach of the technology used by us to protect customer transaction data. Any compromise of our security could harm our reputation and, therefore, our business. In addition, a party who is able to circumvent our security measures could misappropriate proprietary information, cause interruptions in our operations or expose customers to computer viruses.

      Our servers are also vulnerable to computer viruses, physical or electronic break-ins and similar disruptions, and we have experienced attacks on our system that resulted in the compromise of unsecured, noncustomer related data. We may need to expend significant resources to protect against security breaches or to address problems caused by breaches. These issues are likely to become more difficult as we expand the number of places where we operate. Security breaches could damage our reputation and expose us to liability or losses. Our insurance policies carry low coverage limits, which may not be adequate to reimburse us for losses caused by security breaches.

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      In addition, our users may be targeted by parties using fraudulent emails to misappropriate passwords, credit card numbers or other personal information. In addition to harming our users, fraudulent emails could damage our reputation, reduce our ability to attract new users to our websites and diminish the value of our brand names.

We are vulnerable to system failures, which could adversely affect the sales of our products and services and harm our business.

      We rely on our commerce website to sell our application software and services, and to a lesser extent, our operating systems. Any interruption in the availability of our commerce website will likely reduce our revenues, and our future revenues could be harmed if our users believe that our system is unreliable. Our systems are vulnerable to damage or interruption from earthquakes, floods, fires, power loss, telecommunication failures, terrorist attacks, computer viruses, computer denial-of-service attacks, and similar events. The majority of our systems are not redundant, and our disaster recovery planning is not sufficient for all eventualities. Our systems are also subject to break-ins, sabotage and intentional acts of vandalism. Despite any precautions we may take, the occurrence of a natural disaster, a decision by our third-party hosting provider to close a facility we use without adequate notice for financial or other reasons, or other unanticipated problems at our hosting facility could result in lengthy interruptions in our services. In addition, the failure by our hosting facility to provide our required data communications capacity could result in interruptions in our service. We do not carry business interruption insurance sufficient to compensate us for losses that may result from interruptions in our service as a result of system failures.

      Any interruption in the availability of our websites would place increased burdens on our engineering staff and create a large volume of user questions and complaints that would need to be addressed by our customer support personnel. Additionally, any unscheduled interruption in our services would likely result in a loss of revenues and could cause some users to switch to our competitors.

      Our infrastructure could prove unable to handle a larger volume of customer transactions. Any failure to accommodate transaction growth could impair customer satisfaction, lead to a loss of customers, impair our ability to add customers, or increase our costs, all of which would harm our business.

We may be unable to predict the future course of open source technology development, which could reduce the market appeal of our products and damage our reputation.

      Different groups of open source software programmers typically compete with one another to develop new technology. Typically, the technology developed by one group will become more widely used than that developed by others. If we adopt new technology and incorporate it into our products and competing technology becomes more widely used or accepted, the market appeal of our products may be reduced, which could result in harm to our reputation, decreased revenue or increased expense to alter our technology.

There are few technology barriers to entry in the open source market, which may increase the competitive threats we face and limit the demand for our products and services.

      One of the characteristics of open source software is that anyone can modify the existing software or develop new software that competes with existing open source software. Such competition can develop without the degree of overhead and lead time required in the case of traditional proprietary software companies. It is also possible for a competitor with greater resources than ours to develop its own open source operating system solution, potentially reducing the demand for our solutions.

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We may encounter difficulties managing our growth, which could adversely affect our results of operations.

      We will need to expand and effectively manage our organization and operations in order to successfully extend our product and service offerings and geographic reach. We increased the number of our full-time employees from two as of August 31, 2001 to 62 as of March 31, 2004. We expect to continue to grow as needed to meet our strategic objectives. If we continue to grow, it is possible that our management, employees, systems, and facilities currently in place may not be adequate. Our need to effectively manage our operations, growth and various projects requires that we continue to improve our operational, financial and management controls, reporting systems and procedures. If we are unable to successfully implement these tasks on a larger scale, our operations and financial results could be adversely affected.

We must achieve sufficient market penetration of our products in order to compete successfully.

      In order for us to successfully market our products on a wide scale, we must achieve sufficient market penetration and broad recognition as a leading provider of Linux-based software solutions for the desktop computer. We may lack the economic and managerial resources necessary to promote this growth. We expect to increase our sales and marketing expenses in future periods as we attempt to build our installed base, and there can be no assurance that these efforts will be successful.

If we do not successfully integrate the operations of any future acquisitions, we may incur unexpected costs and experience disruptions to our business.

      As part of our business strategy, we may enter into business combinations and acquisitions in the future. Our management team has limited experience making acquisitions, and we have made no acquisitions to date. Future acquisitions may entail numerous operational and financial risks, including:

  •  exposure to unknown liabilities;
 
  •  disruption of our business and diversion of our management’s time and attention to developing acquired technologies;
 
  •  increased amortization expenses;
 
  •  higher than expected acquisition and integration costs;
 
  •  impairment of relationships with key suppliers, distributors or customers of acquired businesses due to changes in management and ownership;
 
  •  inability to retain key employees of acquired businesses; and
 
  •  incurrence of substantial debt or dilutive issuances of securities to pay for acquisitions.

      Although we periodically engage in preliminary discussions with respect to acquisitions of companies, we are not currently a party to any such agreements or commitments.

If we are unable to attract and retain key management and staff, we may be unable to successfully extend our product and service offerings.

      We are a small company, with approximately 60 employees, and our success depends on our continued ability to attract, retain and motivate highly qualified management and personnel. In the software industry, there is substantial and continuous competition for highly skilled business, product development, technical, and other personnel. If we are not able to attract and retain the necessary personnel to accomplish our business objectives, we may experience constraints that will impede our ability to extend our product and service offering and cause our stock price to decline. In addition,

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while we have entered into employment agreements with Michael L. Robertson, our Chairman and Chief Executive Officer, Kevin B. Carmony, our President and Chief Operating Officer, Chad H. Olson, our Chief Financial Officer, and Thomas C. Welch, our Chief Technology Officer, none of these agreements guarantees the services of the individual for a specified period of time. Furthermore, we do not carry “key person” insurance covering members of senior management. If we lose Mr. Robertson, Mr. Carmony, Mr. Olson, Mr. Welch, or other key personnel, we may not be able to find suitable replacements, and our business may be harmed as a result.

We may not be able to meet the operational and financial challenges that we will encounter as our international operations continue to expand.

      Approximately 25% of our revenues are from customers outside of the U.S. As we expand our international operations, we will face a number of additional challenges associated with the conduct of business overseas. For example:

  •  we may have difficulty managing and administering a globally-dispersed business;
 
  •  fluctuations in exchange rates may negatively affect our operating results;
 
  •  we may have to comply with a wide variety of foreign laws;
 
  •  we may not be able to adequately protect our intellectual property rights overseas due to the uncertainty of laws and enforcement in certain countries relating to the protection of intellectual property rights;
 
  •  export controls and times of crisis could prevent us from shipping our products into and out of certain markets;
 
  •  changes in import/export duties and quotas could affect the competitive pricing of our products and services and reduce our market share in some countries; and
 
  •  economic or political instability in some international markets could result in the forfeiture of some foreign assets and the loss of sums spent developing and marketing those assets.

      Any failure by us to effectively manage the challenges associated with the international expansion of our operations could adversely affect our business, operating results and financial condition.

Customer complaints or negative publicity about our customer service could affect use of our products and services adversely and, as a result, our business could suffer.

      Customer complaints or negative publicity about our customer service could diminish consumer confidence in and use of our products and services. We have limited customer service personnel and rely heavily on self-service, web-based support. Our web-based support system is not equipped to handle all customer service issues and complaints effectively. If we do not handle customer service and complaints effectively, our reputation may suffer and we may lose our customers’ confidence. Additionally, expanding our customer service capabilities would require significant personnel expense, which could impact our results of operations.

Risks Related to Financial Results and Need for Financing

We have incurred significant operating losses since our inception. We expect to incur significant additional operating losses in the future and may not achieve profitability.

      The extent of our future operating losses and the timing of our reaching profitability are highly uncertain, and we may never achieve profitability. We have generated operating losses each year since our inception in July 2001. As of December 31, 2003, we had an accumulated deficit of $11,858,805. Our future product development and sales and marketing activities will require

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significant expenditures. We expect to continue to incur additional operating losses and capital expenditures over the next several years and anticipate that our expenses will increase substantially in the foreseeable future as we continue to develop the distribution channels for our products and services and expand our product development and sales and marketing activities. If we do not achieve profitability on the timeline we anticipate, or at all, our ability to achieve our development and expansion goals would be adversely affected.

Our quarterly financial results are likely to fluctuate significantly and may not meet our expectations or those of third parties.

      Our revenue and operating results have fluctuated and may continue to fluctuate from quarter to quarter. We base our current and projected future expense levels in part on our estimates of future sales. Our expenses are, to a large extent, fixed in the short term. We may not be able to adjust our spending quickly enough to achieve our projected operating results for a quarter if our revenue in that quarter falls short of our expectations for any reason. Factors that are likely to cause our quarterly net revenue and operating results to fluctuate include those disclosed in these risk factors and the following:

  •  our ability to attract and retain new customers and maintain customer satisfaction;
 
  •  the level of adoption of Linux in homes, schools and businesses generally;
 
  •  the timing of product releases and upgrades of our Linux-based operating system and software applications, and other new or enhanced products and services introduced by us or by our competitors;
 
  •  any changes in our business practices or the contractual terms underlying our arrangements with customers which may require changes in how we recognize revenue;
 
  •  the amount and timing of operating costs and capital expenditures relating to the expansion of our business, operations and infrastructure;
 
  •  the costs and results of litigation that involves us;
 
  •  the success of our brand-building and marketing campaigns;
 
  •  consumer acceptance of the Internet and other online services for commerce and, in particular, for the license of software products;
 
  •  government regulations related to use of the Internet for commerce or licenses and distribution of software;
 
  •  price competition; and
 
  •  general economic conditions and economic conditions specific to the Internet, online commerce and the software industry.

      If our future operating results fall below expectations of securities analysts or investors, the market price of our common stock may decline.

The report of our independent auditors expresses substantial doubt about our ability to continue as a going concern.

      We have received an audit report from our independent auditors containing an explanatory paragraph stating that our historical losses and negative cash flows from operations raise substantial doubt about our ability to continue as a going concern. We believe that the successful completion of this offering will provide us with the necessary working capital to continue as a going concern.

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Our short operating history makes it difficult to evaluate our business and prospects.

      We were originally incorporated in July 2001 and began selling products in January 2002. As a result, we have limited historical financial data upon which to base planned operating expenses or forecast accurately our future operating results. Further, our limited operating history will make it difficult for investors and securities analysts to evaluate our business and prospects. You must consider our business and prospects in light of the risks and difficulties we may face as an early stage company with limited operating history. These risks and difficulties include challenges in accurate financial planning as a result of limited historical data and the uncertainties resulting from having had a relatively limited time period in which to implement and evaluate our business strategies as compared to older companies with longer operating histories. Our failure to address these risks and difficulties successfully would harm our business.

We likely will need to raise additional funds to pursue our growth strategy or continue our operations and we may be unable to raise capital when needed.

      We believe that the net proceeds from this offering, together with our current cash and cash equivalents, should be sufficient to fund our operations for at least the next 24 months. However, we anticipate that we may need to raise additional capital in the future to facilitate long-term expansion, to respond to competitive pressures or to respond to unanticipated financial requirements. We cannot be certain that we will be able to obtain additional financing on commercially reasonable terms or at all. If we raise additional funds through the issuance of equity, equity-related or debt securities, such securities may have rights, preferences or privileges senior to those of our common stock, and our stockholders will experience dilution of their ownership interests. A failure to obtain additional financing or an inability to obtain financing on acceptable terms could require us to incur indebtedness that has high rates of interest or substantial restrictive covenants, issue equity securities that will substantially dilute the ownership interests of existing stockholders, or scale back, or fail to address opportunities for expansion or enhancement of, our operations. Since our inception, we have experienced negative cash flow from operations and expect to experience negative cash flow from operations for the foreseeable future.

We are recording non-cash stock-based compensation, which may result in an increase of our net losses.

      Stock-based compensation represents an expense arising from the difference between the deemed fair value of common stock for financial reporting purposes at the time of an option grant or stock issuance and the option exercise price or price paid for the stock. Stock-based compensation is amortized on an accelerated basis over the vesting period of the option or issuance. From inception through December 31, 2003, deferred stock-based compensation related to option grants and stock issuances to our employees totaled approximately $750,000, which is being amortized on an accelerated basis as the options or stock are earned, generally over a period of four or five years. We have also modified the terms of one of our option grants to accelerate the vesting of the option. This modification may increase our future net losses if the optionee’s employment terminates before the end of the original option vesting period. Also, we have granted options to consultants which, for expense recognition purposes, are remeasured at each reporting date during the vesting period. This remeasurement and the corresponding effect on the related expense may result in an increase in our net losses for a given period.

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Risks Related to Our Intellectual Property and Litigation

We are currently involved in costly trademark litigation and an adverse outcome may cause us to lose the goodwill of our brand name or require us to pay significant fines or damages.

      We are currently involved in litigation with Microsoft Corporation. Microsoft initiated an action against us in the State of Washington in December 2001 alleging that our use of the Lindows mark violates U.S. trademark law and U.S. and Washington’s unfair competition laws. Between November 2003 and February 2004, Microsoft initiated similar trademark infringement actions against us in Finland, Sweden, the Netherlands, France, Canada, Spain, and Mexico. Microsoft has also threatened to bring trademark infringement actions against our distributors in South Africa. As of the date of this prospectus, however, we have not received notice from Microsoft that actions have been initiated in South Africa. Microsoft has also included two of our channel partners in connection with the France and Canada lawsuits. The Microsoft lawsuits abroad have forced us to adopt an alternative name strategy for our commerce website and our products and services, pending resolution of the litigation, and we may be forced to change our corporate name and abandon our Lindows trademark. These changes have resulted in additional expense and may result in a loss of goodwill associated with our brand name, customer confusion and a loss of sales. We also may be liable for substantial fines, attorneys’ fees and costs, and other monetary damages, which may exceed the amount we are able to pay. Furthermore, we may have to indemnify channel partners for losses they may suffer as a result of the Microsoft litigation.

      We are also in litigation with our insurance carrier relating to the Microsoft litigation. With respect to the Microsoft lawsuit in the U.S., we obtained a decision from the court that our carrier is obligated to bear the cost of our legal defense and that it breached its contract with us by refusing to defend. That decision may be appealed to an appellate court, but the only remaining issues to be decided by the court currently hearing the case are issues related to damages we are seeking against the carrier for its breach of contract, our bad faith claim against the carrier for its failure to defend, and the carrier’s obligation to pay any liability that we may have to Microsoft. With respect to the foreign litigation brought by Microsoft, we recently brought suit against the same insurance carrier to enforce its obligations to us regarding the foreign litigation.

      If our carrier successfully appeals the decision relating to its obligation to bear the cost of our legal defense with respect to Microsoft’s U.S. litigation, we may be forced to reimburse our carrier for some or all of the legal fees and costs it has paid to us, and continues to pay to us, in the Microsoft U.S. litigation. Additionally, although we believe our carrier is contractually bound to indemnify us for damages or other amounts we may be forced to pay Microsoft as a result of the U.S. litigation, up to the applicable policy limits, the court has not ruled on this point. Even if we are successful on an appeal by our carrier relating to its obligation to bear the cost of our legal defense, our carrier might have no obligation to reimburse us for any damages or other amounts we may be forced to pay Microsoft as a result of the U.S. litigation.

      If we are unsuccessful in our lawsuit relating to the foreign litigation, we also may be forced to reimburse our carrier for some or all legal fees and costs it has paid to us, and continues to pay to us, relating to the foreign litigation, and our carrier might have no obligation to reimburse us for any amounts we may be forced to pay Microsoft as a result of the foreign litigation.

      We may not prevail in our lawsuits with Microsoft or our insurance carrier. Each of these lawsuits has resulted in significant expenses and has been, and is expected to continue to be, a diversion of management’s time and other resources well into the future. Please see “Business — Legal Proceedings” for more description of our litigation with Microsoft and our insurance carrier.

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We could be prevented from selling or developing most of our software if the GNU General Public License and similar licenses under which most of our products are developed and licensed are not enforceable.

      The Linux kernel and our operating system and application software have been developed and licensed under the GNU General Public License and similar open source licenses. These licenses state that any program licensed under them may be liberally copied, modified and distributed. The GNU General Public License is a subject of litigation in the case of The SCO Group, Inc. v. International Business Machines Corp., pending in the United States District Court for the District of Utah. It is possible that a court would hold these licenses to be unenforceable in that litigation or that someone could assert a claim for proprietary rights in a program developed and distributed under them. Any ruling by a court that these licenses are not enforceable, or that Linux-based operating systems, or significant portions of them, may not be liberally copied, modified or distributed, would have the effect of preventing us from selling or developing most of our products.

We are vulnerable to claims that our products infringe third-party intellectual property rights, which could divert management attention, be costly to defend and prevent us from using or selling the challenged technology.

      We are vulnerable to claims that our products infringe third-party intellectual property rights in part because our products are comprised of distinct software components, many of which are developed by numerous independent parties. Claims for infringement of intellectual property rights often seek damages and injunctive relief. In particular, third parties may assert claims for patent or copyright infringement, claims based on trade secret theories or trademark infringement claims against us with respect to our brands, trademarks and logos. The risk of patent and copyright infringement claims is exacerbated by the fact that much of the code in our products is developed by numerous independent parties over whom we exercise no supervision or control. It is further exacerbated by our lack of access to unpublished software patent applications. Claims of patent or copyright infringement could require us to seek to obtain licenses from third parties in order to continue offering our products, reengineer our products or discontinue the sale of our products in the event reengineering could not be accomplished on a timely basis. Defending patent infringement, copyright infringement, trademark, or trade secret claims, even claims without significant merit, can be expensive and can divert management’s attention. An adverse legal decision affecting our intellectual property could materially harm our business.

Our products may contain defects that may be costly to correct, may delay market acceptance of our products and may expose us to litigation.

      Despite testing by ourselves and our customers, defects have been and may continue to be found in our products after commencement of commercial shipments. The risk of product defects is exacerbated by the fact that much of the code in our products is developed by independent parties over whom we exercise no supervision or control. If errors are discovered, we may have to make significant expenditures of capital to eliminate them and may not be able to successfully correct them in a timely manner or at all. Errors and failures in our products could result in a loss of, or delay in, market acceptance of our products and could damage our reputation and our ability to convince commercial users of the benefits of Linux-based operating systems and other open source software products.

      In addition, failures in our products could cause system failures for our customers who may assert warranty and other claims for substantial damages against us. Although our license agreements with our customers typically contain provisions designed to limit our exposure to potential product liability claims, it is possible that these provisions may not be effective or enforceable under the laws of some jurisdictions. In addition, our insurance policies may not adequately limit our exposure to this type of claim. These claims, even if unsuccessful, could be costly and time consuming to defend.

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Our efforts to protect our trademarks may not be adequate to prevent third parties from infringing our intellectual property rights.

      Our collection of trademarks is valuable intellectual property. The protective steps we have taken in the past have been, and may in the future continue to be, inadequate to deter infringement of our trademark rights. Although we do not believe that we have suffered any material harm from infringement to date, we may be unable to detect the unauthorized use of, or take appropriate steps to enforce, our trademark rights in a timely manner. We have trademark applications pending in the U.S. Effective trademark protection may not be available in every country in which we offer or intend to offer our products and services. Failure to adequately protect our trademark rights could damage or even destroy our brand and impair our ability to compete effectively. Furthermore, defending or enforcing our trademark rights could result in the expenditure of significant financial and managerial resources.

Risks Related to the Securities Markets and Ownership of Our Common Stock

Our stock price may be volatile and you may not be able to sell your shares at or above the offering price.

      Following this offering, the market price for our common stock is likely to be volatile, in part because our shares have not been traded publicly. In addition, the market price of our common stock may fluctuate significantly in response to a number of factors, most of which we cannot control, including those disclosed in these risk factors and the following:

  •  significant contracts, new technologies, acquisitions, commercial relationships, joint ventures, or capital commitments;
 
  •  disputes or other developments relating to proprietary rights, including copyrights, service marks, trademarks, trade dress, trade secrets, and similar intellectual property, litigation matters, and our ability to protect our products and technologies;
 
  •  potential adverse developments in litigation concerning open source software generally and Linux in particular;
 
  •  conditions or trends in the Linux, software or high-technology industries;
 
  •  fluctuations in stock market prices and trading volumes of similar companies or of the markets generally;
 
  •  variations in our quarterly operating results;
 
  •  changes in or our failure to meet or exceed securities analysts’ or investors’ expectations of our quarterly financial results;
 
  •  changes in accounting principles;
 
  •  sales of large blocks of our common stock, or the expectation that such sales may occur, including sales by our executive officers, directors and significant stockholders;
 
  •  discussion of our business, products, financial performance, prospects, or our stock price by the financial and software and high-technology press and online investor communities such as chat rooms; and
 
  •  economic and political factors, including wars, terrorism and political unrest.

Future sales of our common stock may depress our stock price.

      Our current stockholders hold a substantial number of shares of our common stock that they will be able to sell in the public market in the near future. Significant portions of these shares are held

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by a small number of stockholders. Sales by our current stockholders of a substantial number of shares after this offering, or the expectation that such sale may occur, could significantly reduce the market price of our common stock. Additionally, sales by our executive management team of any shares of common stock after this offering could reduce the market price of our common stock. Although the holders of approximately 95% of our capital stock outstanding as of March 31, 2003 have agreed with the underwriters of this offering to be bound by a 180-day lock-up agreement that prohibits these holders from selling or transferring their stock other than in specific circumstances, the restrictions set forth in the lock-up agreement permit sales made in accordance with applicable securities rules and regulations, subject only to volume limitations described in “Shares Eligible for Future Sale.” Additionally, WR Hambrecht + Co, at its discretion, can waive the restrictions of the lock-up agreement at an earlier time without prior notice or announcement and allow all of our stockholders to sell their shares of our common stock in the public market subject only to applicable securities rules and regulations. We also intend to register all common stock that we have issued or reserved for issuance under our 2001 stock incentive plan and 2004 stock incentive plan, as well as 3,081,800 shares of common stock held by our President, approximately 30 days after the closing of this offering. Once we register these shares, they can be freely sold in the public market, subject to any restrictions under the securities laws and, in some cases, the lock-up agreements described in “Plan of Distribution.” If any of these stockholders cause a large number of securities to be sold in the public market, the sales could reduce the trading price of our common stock. These sales also could impede our ability to raise future capital. Please see “Shares Eligible for Future Sale” for a description of sales that may occur in the future.

Our executive officers and directors and their affiliates will exercise control over stockholder voting matters in a manner that may not be in the best interests of all of our stockholders.

      Immediately after this offering, our executive officers and directors and their affiliates will together control approximately                     % of our outstanding common stock. As a result, these stockholders will collectively be able to control all matters requiring approval of a majority of our stockholders, including the election of directors and approval of significant corporate transactions. The concentration of ownership may delay, prevent or deter a change in control of our company even when such a change may be in the best interests of all stockholders, could deprive our stockholders of an opportunity to receive a premium for their common stock as part of a sale of our company or our assets and might affect the prevailing market price of our common stock.

As a new investor, you will incur substantial dilution as a result of this offering and future equity issuances.

      The initial public offering price will be substantially higher than the pro forma, net tangible book value per share of our outstanding common stock. As a result, investors purchasing common stock in this offering will incur immediate dilution of $                     per share. This dilution is due in large part to earlier investors in our company having paid substantially less than the initial public offering price when they purchased their shares. Investors who purchase shares of common stock in this offering will contribute approximately                     % of the total amount we have raised to fund our operations but will own only approximately                     % of our common stock. The exercise of outstanding options and future equity issuances, including future public offerings or future private placements of equity securities and any additional shares issued in connection with acquisitions, will result in further dilution to investors. As a result of dilution, investors purchasing stock in this offering may receive significantly less than the purchase price paid in this offering in the event of a liquidation. Please see “Dilution” for more information regarding the dilution you will incur upon purchasing our common stock in this offering.

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We may become involved in securities class action litigation that could divert management’s attention and harm our business.

      The stock market has from time to time experienced significant price and volume fluctuations that have affected the market prices for the common stock of software and high-technology companies. These broad market fluctuations may cause the market price of our common stock to decline. In the past, following periods of volatility in the market price of a particular company’s securities, securities class action litigation has often been brought against that company. We may become involved in this type of litigation in the future. If we are found liable, then we could be required to pay substantial monetary damages. Further, even if we successfully defend ourselves, we could be forced to spend a substantial amount of money in litigation expenses, our management could be required to spend valuable time in the defense against these claims and our reputation could suffer, any of which could harm our business.

Being a public company will increase our administrative costs, financial reporting burdens and associated risks, and may make it more difficult for us to attract and retain key personnel.

      As a public company, we will incur significant legal, accounting and other expenses that we did not incur as a private company. In addition, the Sarbanes-Oxley Act of 2002 and new rules subsequently implemented by the Securities and Exchange Commission, have required changes in corporate governance practices of public companies. Similarly, the Nasdaq Stock Market has revised its requirements for companies that are Nasdaq-listed. We expect these new rules and regulations to increase our legal and financial compliance costs and to make some activities more time consuming and costly. For example, partially in connection with becoming a public company, we have engaged auditors to perform our first independent audit, added independent directors, created several board committees, retained a transfer agent, a bank note company, and a financial printer, adopted an insider trading policy and will have all of the internal and external costs of preparing and distributing periodic public reports in compliance with our obligations under the securities laws. Furthermore, we must make improvements to our internal controls and procedures to be compliant with the requirements of the Sarbanes-Oxley Act of 2002 and with an accepted internal control framework. As we are at an early stage of development, we have limited accounting personnel and other resources with which to address these internal controls and procedures requirements. Furthermore, there can be no assurance that we will successfully implement the necessary policies, systems and procedures in a timely manner or that once implemented, our new internal control procedures will operate as intended. In addition, the new rules could make it more difficult or more costly for us to obtain certain types of insurance, including directors’ and officers’ liability insurance, and we may be forced to accept reduced policy limits and coverage or incur substantially higher costs to obtain the same or similar coverage. The impact of these events could also make it more difficult for us to attract and retain qualified persons to serve on our board of directors, our board committees or as executive officers. We are presently evaluating and monitoring developments with respect to new and proposed rules and cannot predict or estimate the amount of the additional costs we may incur or the timing of such costs.

Anti-takeover provisions in our organizational documents and Delaware law may discourage or prevent a change in control, even if an acquisition or management change would be beneficial to our stockholders.

      Our restated certificate of incorporation and restated bylaws contain provisions that may delay or prevent a change in control, discourage bids at a premium over the market price of our common

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stock and adversely affect the market price of our common stock and the voting and other rights of the holders of our common stock. These provisions include:

  •  dividing our board of directors into three classes serving staggered three-year terms;
 
  •  prohibiting our stockholders from calling a special meeting of stockholders;
 
  •  permitting the issuance of additional shares of our common stock or preferred stock without stockholder approval;
 
  •  prohibiting our stockholders from making certain changes to our restated certificate of incorporation or restated bylaws except with 66 2/3% stockholder approval; and
 
  •  requiring advance notice for raising matters of business or making nominations at stockholders’ meetings.

      We are also subject to provisions of the Delaware corporation law that, in general, prohibit any business combination with a beneficial owner of 15% or more of our common stock for five years unless the holder’s acquisition of our stock was approved in advance by our board of directors. Although we believe these provisions collectively provide for an opportunity to receive higher bids by requiring potential acquirors to negotiate with our board of directors, they would apply even if the offer may be considered beneficial by some stockholders. In addition, these provisions may frustrate or prevent any attempts by our stockholders to replace or remove our current management by making it more difficult for stockholders to replace members of our board of directors, which is responsible for appointing the members of our management

We will have broad discretion in how we use the proceeds of this offering, and we may not use these proceeds effectively, which could hinder our results of operations and cause our stock price to decline.

      We will have considerable discretion in the application of the net proceeds of this offering. We expect to use the net proceeds of this offering to further develop the distribution channels for our Linux-based operating system, application software and services, to expand our sales and marketing activities, to continue to develop existing and new products, technologies and services, to increase personnel, and to repay substantially all of our outstanding debt obligations to our founder of approximately $10,400,000. In addition, we may use a portion of the net proceeds from this offering to acquire products, technologies or businesses that are complementary to our current or future business and product lines. We cannot specify with certainty all of the particular uses for the net proceeds to be received upon the completion of this offering. The amount and timing of our expenditures will depend on several factors, including the status of our product development efforts, sales and marketing activities, technological advances, competition, and amount of cash generated or used by our operations. Accordingly, our management will have broad discretion in the application of the net proceeds and investors will be relying on the judgment of our management regarding the application of the proceeds of this offering. We reserve the right to change the use of these proceeds as a result of certain contingencies such as the results of our distribution efforts, competitive developments, opportunities to acquire products, technologies or businesses, and other factors. We may use the net proceeds for corporate purposes that do not yield a significant return or any return at all for our stockholders, which may cause our stock price to decline.

We have never paid cash dividends on our capital stock, and we do not anticipate paying dividends in the foreseeable future.

      We have paid no cash dividends on any of our classes of capital stock to date, and we currently intend to retain our future earnings, if any, to fund the development and growth of our business. In addition, the terms of any future debt or credit facility may preclude us from paying any dividends. As a result, capital appreciation, if any, of our common stock will be your sole source of potential gain for the foreseeable future.

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SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

      This prospectus contains forward-looking statements that are based on our management’s beliefs and assumptions and on information currently available to our management. The forward-looking statements are contained principally in the sections entitled “Prospectus Summary,” “Risk Factors,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and “Business.” In some cases, you can identify forward-looking statements by terms such as “anticipates,” “believes,” “could,” “estimates,” “expects,” “intends,” “may,” “plans,” “potential,” “predicts,” “projects,” “should,” “will,” “would,” and similar expressions intended to identify forward-looking statements.

      Forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause our actual results, performance or achievements to be materially different from any future results, performances or achievements expressed or implied by the forward-looking statements. We discuss many of these risks in this prospectus in greater detail under the heading “Risk Factors.” Given these uncertainties, you should not place undue reliance on these forward-looking statements. Also, forward-looking statements represent our management’s beliefs and assumptions only as of the date of this prospectus. You should read this prospectus and the documents that we reference in this prospectus and have filed as exhibits to the registration statement, of which this prospectus is a part, completely and with the understanding that our actual future results may be materially different from what we expect.

      Except as required by law, we assume no obligation to update these forward-looking statements publicly, or to update the reasons actual results could differ materially from those anticipated in these forward-looking statements, even if new information becomes available in the future.

      You should rely only on the information contained in this prospectus. We have not authorized anyone to provide you with information that is different. We are offering to sell and seeking offers to buy shares of common stock only in jurisdictions where offers and sales are permitted. The information contained in this prospectus is accurate only as of the date of this prospectus, regardless of the time of delivery of this prospectus or of any sale of our common stock.

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USE OF PROCEEDS

      We estimate that the net proceeds from this offering will be approximately $                    , based upon an assumed initial public offering price of $                     per share and after deducting estimated underwriting discounts and commissions and offering expenses. If the underwriters exercise their over-allotment option in full, we estimate that our net proceeds will be approximately $                     million.

      We expect to use a majority of the net proceeds of this offering to further develop the distribution channels for our Linux-based operating system, application software and services, to expand our sales and marketing activities, to continue to develop existing and new products, technologies and services, to increase personnel, and to repay substantially all of our outstanding debt obligations of approximately $10,400,000. To a lesser extent, we anticipate using the remaining net proceeds of this offering for working capital and other general corporate purposes.

      In addition, we may use a portion of the net proceeds from this offering to acquire products, technologies or businesses that are complementary to our own, but we currently have no commitments or agreements relating to any of these types of transactions.

      We believe that the net proceeds from this offering, together with our existing cash and cash equivalents, will be sufficient to meet our projected operating requirements for at least the next 24 months. We expect to satisfy our future cash needs through cash flows from operations, the sale of equity securities and debt financings.

      As of the date of this prospectus, we cannot specify with certainty all of the particular uses for the net proceeds to be received upon the completion of this offering. The amount and timing of our expenditures will depend on several factors, including the status of our product development efforts, sales and marketing activities, technological advances, competition, and the amount of cash generated or used by our operations. Accordingly, our management will have broad discretion in the application of the net proceeds and investors will be relying on the judgment of our management regarding the application of the proceeds of this offering. We reserve the right to change the use of these proceeds based on these and other factors.

      The approximately $10,400,000 of net proceeds that we intend to use to repay outstanding debt obligations will be paid to Michael L. Robertson, our founder, Chairman and Chief Executive Officer, as payment in full of all remaining outstanding amounts under a revolving line of credit. Mr. Robertson has advanced us funds under the line of credit since July 2002, including advances of $5,600,000 during 2004. Amounts borrowed under this loan are used for our operating expenses. The loan bears interest at the rate of 10% simple interest per year and matures on June 30, 2005.

      Pending the uses described above, we plan to invest the net proceeds of this offering in short- and medium-term, interest-bearing obligations, investment-grade instruments, certificates of deposit or direct or guaranteed obligations of the U.S. government.

DIVIDEND POLICY

      We have never declared or paid any cash dividends on our capital stock. We currently intend to retain all available funds and any future earnings to support operations and to finance the growth and development of our business, and do not intend to pay cash dividends on our common stock for the foreseeable future. Any future determination related to dividend policy will be made at the discretion of our board of directors.

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CAPITALIZATION

      The following table sets forth our capitalization at December 31, 2003:

  •  on an actual basis;
 
  •  on a pro forma basis after giving effect to the conversion of all outstanding shares of preferred stock into 52,750,000 shares of common stock; and
 
  •  on a pro forma as adjusted basis to reflect the conversion of all outstanding shares of preferred stock into 52,750,000 shares of common stock, the receipt of the estimated net proceeds from this offering, calculated as described under “Use of Proceeds,” and the filing of a restated certificate of incorporation to provide for authorized capital stock of                      shares of common stock and                      shares of preferred stock.

      You should read the following table together with our financial statements and related notes and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in this prospectus.

                           
As of December 31, 2003

Pro forma
Actual Pro forma As adjusted



(unaudited)
Cash and cash equivalents
  $ 250,720     $ 250,720     $    
Long-term debt, including accrued but unpaid interest of $303,181
    4,703,181       4,703,181        
Stockholders’ deficit:
                       
Series A Convertible Preferred stock, $0.0001 par value; 80,000,000 shares authorized and 52,750,000 shares issued and outstanding, actual; 80,000,000 shares authorized and no shares issued and outstanding, pro forma; 10,000,000 shares authorized and no shares issued and outstanding, pro forma as adjusted
    5,275              
Common stock, $0.0001 par value; 70,000,000 shares authorized and 5,995,537 shares issued and outstanding, actual; 70,000,000 shares authorized and 58,745,537 shares issued and outstanding, pro forma; 100,000,000 shares authorized and           shares issued and outstanding, pro forma as adjusted
    600       5,875          
Additional paid in capital
    6,016,466       6,016,466          
Deferred compensation
    (248,243 )     (248,243 )     (248,243 )
Stock subscription receivable
    (9,145 )     (9,145 )     (9,145 )
Accumulated deficit
    (11,858,805 )     (11,858,805 )     (11,858,805 )
     
     
     
 
 
Total stockholders’ equity deficit
    (6,093,852 )     (6,093,852 )        
     
     
     
 
Total capitalization
  $ (1,390,671 )   $ (1,390,671 )   $    
     
     
     
 

      The number of shares in the table above excludes, as of December 31, 2003:

  •  4,309,938 shares of our common stock subject to outstanding options under our 2001 stock incentive plan, having a weighted average exercise price of $0.0095 per share; and
 
  •  1,985,150 shares of common stock reserved for issuance under our 2001 stock incentive plan.

      All share amounts have been retroactively adjusted to give effect to a one-for                     reverse stock split of our common stock before the completion of this offering.

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DILUTION

      If you invest in our common stock, your interest will be diluted to the extent of the difference between the public offering price per share of our common stock and the pro forma as adjusted net tangible book value per share of our common stock after this offering. As of December 31, 2003, we had a net tangible book value of $(6,093,852) million, or $(1.08) per share of common stock, not taking into account the conversion of our outstanding preferred stock. Net tangible book value per share is equal to our total tangible assets (total assets less intangible assets) less total liabilities, divided by the number of shares of our outstanding common stock. Our pro forma net tangible book value as of December 31, 2003 was $(6,093,852), or $(0.10) per share of common stock. Pro forma net tangible book value per share represents the amount of our total tangible assets less our total liabilities, divided by the pro forma number of shares of common stock outstanding as of December 31, 2003. Our pro forma net tangible book value and pro forma net tangible book value per share amounts give effect to the assumed automatic conversion of all outstanding shares of our convertible preferred stock into shares of common stock upon the closing of the offering.

      Dilution in pro forma net tangible book value per share represents the difference between the amount per share paid by purchasers of shares of common stock in this offering and the pro forma net tangible book value per share of common stock immediately after the completion of this offering. After giving effect to our sale of                      shares of common stock in this offering at an assumed initial public offering price of $                     per share and after deducting underwriting discounts and commissions and estimated offering expenses payable by us, our adjusted pro forma net tangible book value as of December 31, 2003 would have been $                     million, or $                     per share. This amount represents an immediate increase in pro forma net tangible book value of $                     per share to our existing stockholders and an immediate dilution in pro forma net tangible book value of $                     per share to new investors. The following table illustrates this per share dilution:

                   
Assumed initial public offering price per share
          $    
 
Historical net tangible book value per share as of December 31, 2003
  $ (1.08 )        
 
Increase per share due to conversion of all shares of preferred stock
    0.98          
     
         
 
Pro forma net tangible book value per share as of December 31, 2003
  $ (0.10 )        
 
Increase in net tangible book value per share attributable to new investors
               
     
         
Pro forma net tangible book value per share after this offering
               
             
 
Dilution per share to new investors
          $    
             
 

      If the underwriters exercise their option to purchase additional shares in this offering, our adjusted pro forma net tangible book value at December 31, 2003 would have been $                     million, or $                     per share, representing an immediate increase in pro forma net tangible book value of $                     per share to our existing stockholders and an immediate dilution in pro forma net tangible book value of $                     per share to new investors purchasing shares in this offering.

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      The following table summarizes, on a pro forma basis as of December 31, 2003, after giving effect to the assumed automatic conversion of all outstanding shares of our convertible preferred stock into common stock upon the closing of the offering, the total number of shares of common stock purchased from us, the total consideration paid to us and the average price per share paid by existing stockholders and by new investors, based on an assumed initial public offering price of $                     per share before deducting estimated underwriting discounts and commissions and offering expenses payable by us:

                                           
Shares purchased Total consideration Average


price per
Number Percent Amount Percent share





Existing stockholders
    58,745,537         %   $ 5,047,459         %   $ .0859  
New investors
                                       
     
     
     
     
         
 
Total
            100.0 %   $       $ 100.0 %        
     
     
     
     
         

      If the underwriters exercise their over-allotment option in full, our existing stockholders would own                     % and our new investors would own                     % of the total number of shares of our common stock outstanding after this offering.

      The above discussion and tables assume no exercise of any stock options outstanding as of December 31, 2003. As of December 31, 2003, we had options outstanding to purchase a total of 4,309,938 shares of common stock with a weighted average exercise price of $0.0095 per share. We have also adopted a new 2004 stock incentive plan that will become effective upon the completion of this offering. To the extent that any of these options are exercised, there will be further dilution to new investors. In addition, we may choose to raise additional capital due to market conditions or strategic considerations even if we believe we have sufficient funds for our current or future operating plans. To the extent that additional capital is raised through the sale of equity or convertible debt securities, the issuance of these securities could result in further dilution to our stockholders.

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SELECTED FINANCIAL DATA

      The following selected financial data reflect our historical results of operations and balance sheet data. Our statement of operations data set forth below for the period from July 24, 2001 (inception) to December 31, 2001 and for the years ended December 31, 2002 and 2003 and the selected balance sheet data as of December 31, 2002 and 2003, are derived from our audited financial statements included in this prospectus. The balance sheet data set forth below as of December 31, 2001 are derived from our audited financial statements that are not included in this prospectus. The financial information presented below may not be indicative of our future performance. You should read these selected financial data together with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our financial statements and related notes included elsewhere in this prospectus.

                           
Period from
July 24, 2001 Years ended
(inception) to
December 31, December 31, December 31,
2001 2002 2003



Statements of Operations Data:
                       
Net revenues
  $     $ 63,131     $ 2,074,002  
Cost of revenues
          415,077       605,567  
     
     
     
 
Gross profit (loss)
          (351,946 )     1,468,435  
Operating expenses:
                       
 
Research and development
    779,524       2,453,126       3,272,109  
 
Sales and marketing
    67,059       843,772       1,044,040  
 
General and administrative
    299,555       3,002,823       945,473  
     
     
     
 
Total Operating expenses
    1,146,138       6,299,721       5,261,622  
     
     
     
 
Loss from operations
    (1,146,138 )     (6,651,667 )     (3,793,187 )
Interest income
    18,747       15,018       1,770  
Interest expense
          (19,563 )     (283,785 )
     
     
     
 
Net loss
  $ (1,127,391 )   $ (6,656,212 )   $ (4,075,202 )
     
     
     
 
Net loss per common share — basic and diluted
  $ (0.95 )   $ (2.37 )   $ (0.78 )
Weighted average shares — basic and diluted
    1,185,850       2,808,112       5,239,163  
Pro forma net loss per share(1)
                  $ (0.07 )
Pro forma shares used in computing pro format net loss per share(1)
                    57,989,163  
                         
As of December 31,

2001 2002 2003



Balance Sheet Data:
                       
Cash and cash equivalents
  $ 2,906,193     $ 113,318     $ 250,720  
Working capital
    3,381,838       (1,045,068 )     (1,776,555 )
Total assets
    4,183,735       1,027,999       933,737  
Accounts payable and accrued expenses
    235,645       449,806       404,943  
Total indebtedness
          1,499,261       4,703,181  
Convertible preferred stock
    5,275       5,275       5,275  
Stockholders’ equity (deficit)
    3,882,405       (2,457,799 )     (6,093,852 )

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(1)  The pro forma net loss per share assumes conversion of all shares of our outstanding preferred stock into shares of common stock. The pro forma shares used in calculating the pro forma net loss per share assume the conversion of the following preferred shares outstanding:

         
Year ended
December 31,
2003

Net loss
  $ (4,075,202 )
     
 
Weighted average common shares outstanding
    5,239,163  
Common shares issuable upon conversion of outstanding preferred shares
    52,750,000  
     
 
Total weighted average shares outstanding used in computing pro forma net loss per share
    57,989,163  
     
 
Pro forma net loss per share
    (0.07 )
     
 

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

      The following discussion should be read in conjunction with our “Selected Financial Data” and our financial statements and the related notes contained elsewhere in this prospectus. In addition to historical information, the following discussion and analysis contains forward-looking statements that are subject to risks and uncertainties. Actual results may differ substantially from those referred to herein due to a number of factors, including but not limited to risks described in the section entitled “Risk Factors” and elsewhere in this prospectus. Except as may be required by applicable law, we undertake no obligation to publicly update any forward-looking statements for any reason, even if new information becomes available or other events occur in the future.

Overview

      We are a developer and vendor of Linux-based operating systems, application software and services designed specifically for desktop and laptop computers in homes, schools and businesses. We use technology and software developed by the collaboration of independent Linux developers, referred to as the open source community, with our own technology and software to offer affordable, easy-to-use software products and services, many of which are similar in feel and functionality to our higher-priced competitors. The cornerstone of our product line is our Linspire operating system. We also offer Linux application software and services developed by us and others. We sell and distribute our products and services both through the Internet using our proprietary CNR technology and by pre-installing them on third-party computer hardware. Our CNR technology reduces the complexity of installing, managing and updating Linux application software.

      We were incorporated in the State of Delaware in July 2001 and launched our product offerings in January 2002 through our commerce website. We are in the early stages of implementing our business plan and have not generated significant revenues. We have experienced significant net losses and negative cash flows from operations in each fiscal period since inception, and as of December 31, 2003, we had an accumulated deficit of $11,858,805. We expect to continue to incur operating losses over the next several years. Our brief operating history provides limited financial data useful in evaluating our business and prospects. The rapidly evolving nature of Linux desktop computing makes it likely that we will implement one or more changes to our business model, which could affect our financial results. We have, however, increased sales of our products and services through a combination of factors, including establishing and strengthening our existing relationships with early software adopters, building a distribution channel with our channel partners, obtaining new desktop customers, and cross-selling our products and services to end users.

     Sources of Revenues

      We have derived the substantial majority of our historical revenues from sales of our Linspire operating system, application software and services from our commerce website. The majority of these transactions were from early adopters who have purchased in relatively small quantities. We have also generated revenues from licensing our products to various channel partners throughout the U.S. and worldwide.

      We anticipate that a significant component of our historical revenue mix, sales of Insider memberships (which gave Insider members access to pre-release products and services and other benefits), will not be material to our financial results in the future.

      We plan to continue to encourage widespread adoption of our Linspire operating system both domestically and internationally, principally by working with our channel partners to pre-install our operating system and software products on desktops, laptops and other computer hardware. We offer a number of incentives to our channel partners, including discounted pricing and an opportunity for large volume channel partners to participate in revenue sharing programs. Our strategy of

27


 

investment in the widespread distribution of our operating system at a low cost is intended to significantly increase revenues from back-end sales of add-on software and services to end-users.

      We also believe that, over time, increased consumer awareness of Linux as a high-quality, low-cost desktop computing alternative will boost the demand for our Linspire operating system, leading to increasing revenues.

      During 2003, one customer, our Japanese channel partner, accounted for approximately 11% of total revenues. We expect this customer to continue to account for a significant percentage of our total revenues in 2004. No customer accounted for more than 10% of our total revenues in 2002. Approximately 25% of our revenues in 2003 were from customers outside of the U.S. We expect foreign revenues to increase as a percentage of total revenues, as we continue to target international and emerging markets.

      Our revenues are generated from two main categories, channel partner revenues and end-user revenues, as discussed below:

     Channel Partner Revenues

      Channel partner revenues are derived from the licensing of our products and services to our channel partners who then resell or distribute those products and services to end users. To date, more than 550 channel partners have participated in our channel distribution programs by licensing the right to distribute the Linspire operating system or sell hardware pre-installed with the Linspire operating system.

      The main types of channel partner revenues are:

  •  flat-fee licensing fees from our channel partners to pre-install our base Linspire operating system on an unlimited number of computer systems;
 
  •  per-unit licensing fees from our channel partners to pre-install our Linspire operating system, bundled application software and services on computer systems;
 
  •  revenues from our channel partners who resell the retail box version of our Linspire operating system, application software and services; and
 
  •  revenues from our channel partners who license or sell our Linspire operating system, application software or services for a particular language or to a particular geographic market.

      Channel partner revenues were $21,947 in 2002 and $410,774 in 2003.

     End-User Revenues

      End-user revenues are derived from sales of software products and services directly to home, school and business end users. End users who run the Linspire operating system can purchase software products and services over the Internet directly from their Linspire desktop using our CNR technology.

      Each time a computer running the Linspire operating system is connected to the Internet for the first time, our CNR technology automatically records this connection on our servers. We refer to this connection as a light up. We use light ups to monitor the growth of our installed base, the effectiveness of our marketing and distribution efforts and the quality and breadth of our products and services.

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      The table below shows our accumulated light ups from September 2002 through March 2004.

LINE GRAPH

From September 2002 through May 2003, our tracking system did not distinguish between a light up from an initial connection to our servers and a light up from a reinstallation. As a result, light ups recorded from September 2002 through May 2003 include any reinstallations that occurred during this period, which has the effect of overstating our accumulated light ups. We are unable to estimate the number of such reinstallations during this period. The darker portion of the above table reflects all light ups, including any light ups resulting from reinstallations, during this period. In June 2003, we eliminated the duplicative effects of reinstallations from our tracking system. The lighter portion of the above table reflects initial installation light ups only. Light ups are affected by a number of factors including promotional activities, new software releases and channel partner marketing activities. As a result of these factors, light ups may fluctuate in future periods and may not be indicative of financial performance.

      End-user revenues come from those who acquired the Linspire operating system directly from us or from one of our channel partners. In each case, our CNR technology provides us with the opportunity of generating optional add-on sales to these Linspire users.

      The primary products and services sold to generate end-user revenues are:

  •  LinspirePlus service — Purchase of this service allows users to easily install over 1,800 open-source software products at no additional charge and to purchase commercial Click-N-Buy products at a discount to list price.
 
  •  Click-N-Buy software products — Software products such as games, word processors, spreadsheets, and other commercial software programs sold individually.
 
  •  VirusSafe — Anti-virus service over a specified period of time.
 
  •  SurfSafe — Web filtering service over a specified period of time.
 
  •  Support services — Fees paid for technical support.

      In the future, we plan to add additional products and services to our Warehouse for license or sale directly to the end user using CNR technology.

      End-user revenues were $41,184 in 2002 and $1,663,228 in 2003.

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     Cost of Revenues and Operating Expenses

      Cost of revenues are expensed as incurred and consist primarily of royalties, product costs, fees paid for third-party credit verification services, credit card fees, depreciation, and bandwidth charges associated with the delivery of our software to our end users. Our operating expenses are classified into four categories: sales and marketing, research and development, general and administrative, and stock-based compensation. Stock-based compensation charges have been allocated to income statement expense categories based on the assigned department of the employee to whom the charge relates. We allocate the costs of overhead, such as rent, communication charges, depreciation for office furniture, and equipment and employee benefit costs to each functional area that uses overhead and facilities services based on its employee headcount.

      Sales and marketing expenses consist primarily of salaries and benefits, stock-based compensation charges, and related expenses, including travel expenses, as well as public relations, advertising, promotional costs, and allocated overhead costs.

      Research and development expenses consist primarily of salaries and benefits, stock-based compensation charges, consultant and contractor costs, expenses for engineers, developers and quality assurance personnel, and allocated overhead costs. We generally expense all of our development costs as incurred.

      General and administrative expenses consist primarily of salaries and benefits, stock-based compensation charges, benefits and related expenses for our executive, finance and administrative personnel, third party professional service fees, business insurance, other corporate expenses, and allocated overhead.

      Stock-based compensation expenses relate to the fair value of options issued to non-employees, as well as option grants to employees in situations where the deemed fair value of our common stock for financial reporting purposes is higher than the option exercise price at the date of grant.

Application of Critical Accounting Policies

      Our discussion and analysis of our financial condition and results of operations are based upon our financial statements, which have been prepared in accordance with accounting principles generally accepted in the U.S. The preparation of our financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues, and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we have and will evaluate these estimates, including those related to our allowance for doubtful accounts, income taxes, impairment analyses, commitments, contingencies, and accrued liabilities. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from our estimates under different assumptions or conditions.

      We consider the following accounting policies to be both those most important to the portrayal of our financial condition and those that require the most subjective judgment:

  •  revenue recognition;
 
  •  accounting for stock-based compensation; and
 
  •  accounting for income taxes.

     Revenue Recognition

      We recognize revenue in accordance with Statement of Position No. 97-2, “Software Revenue Recognition” (“SOP 97-2”), as amended by SOP 98-4 and SOP 98-9. We recognize revenues when

30


 

all of the following criteria are met: (1) persuasive evidence of an arrangement exists (upon contract signing or receipt of an authorized purchase order from the customer); (2) delivery has occurred (upon delivery of the software product or performance of services in accordance with contract specifications); (3) the fee is deemed fixed and determinable (free of contingencies or significant uncertainties such as refund/adjustment provisions or extended payment terms); and (4) collection is probable (there are no indicators of non-payment based upon history with the customer and/or upon completion of applicable credit review procedures). Billings made or payments received in advance of the delivery of product or the provision of services are deferred until the period of performance or delivery, as applicable. As of December 31, 2003, we had deferred revenue amounts of $1,706,839, of which we estimate that $1,446,120 will be recognized as revenue during 2004.

      Our revenue recognition methods with respect to our various products and services consist of several key categories, as follows:

     The Linspire Operating System and Other Desktop Products

      Our primary products, the Linspire operating system and application software, are sold directly to end users through our commerce website using our CNR technology. Customers can download our products directly from the website or can request shipment of software products on compact disc. Most of our customers pay for their purchases using a credit card. We offer a 15-day return policy, and as a result, revenues are not recorded until such return privileges expire. Purchasers of the Linspire operating system and other desktop products are not entitled to upgrade rights under the terms of our software license agreement; however, when the release of a new version of a software product is imminent and we expect that the new version will be provided to a customer due to the customer’s purchase of the current version of the product, revenue is deferred until the new version has been delivered to the customer. Post-contract customer support is provided online through databases of frequently asked questions which may be accessed on our commerce website. We also provide post-contract support via email. The cost of providing this post-contract customer support historically has been insignificant.

     Services

      Several of our products, including our LinspirePlus service and customer support, are sold as services, with access to these services over a certain period included in the price. Our virus protection, Internet security and access to LinspirePlus are generally sold as annual services. Revenues associated with such services are deferred and recognized on a straight-line basis over the entire term of the service period. For services sold on a lifetime basis, revenues are recognized ratably over the estimated life of the customer relationship, generally ranging from three to five years in duration.

     Builder and Manufacturers Programs

      Builders of computer systems and manufacturers of computer hardware, such as disc drives and motherboards, can become channel partners by paying monthly or annual program fees or by paying per-unit licensing fees for each unit of our product installed. These channel partners are entitled to technical support relating to each channel partner’s specific hardware. High volume channel partners may participate in revenue sharing programs for products and services that their customers buy.

      Revenues associated with monthly and annual builder and manufacturer programs are deferred and recognized on a straight-line basis over the term of the contract, which in general ranges from one month to one year. Per unit license fees are recognized as revenue as the builder or manufacturer sells the products.

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     Reseller Arrangements

      Revenues from arrangements with resellers are recognized based on the terms of the arrangement. In general, revenues are recognized when all goods and services have been delivered to the reseller, return obligations have been fulfilled and service obligations have lapsed. We provide technical support as part of most of our arrangements with resellers, including when-and-if available upgrades. To the extent we provide technical support to resellers, this revenue is recognized ratably over the term of the reseller arrangement which generally ranges from 12 to 24 months.

     Bundled Software

      We offer bundled packages of software and services to our customers. For such arrangements with multiple elements, we allocate revenues to each element of the transaction based upon the sales price of the products and services when they are sold on a stand-alone basis. When the fair value of an undelivered element has not been established and the only undelivered element is a service, revenue is deferred and recognized on a straight-line basis over the term of the service period, generally ranging from 12 to 36 months.

     Accounting for Deferred Stock-Based Compensation

      We record deferred stock-based compensation charges in the amount by which the deemed fair value of our common stock for financial reporting purposes is less than the exercise price of an option at the date of grant. Because there has been no public market for our stock, our board of directors has determined an estimate of the fair value of our common stock for financial reporting purposes based upon several factors, including, but not limited to, our operating and financial performance and comparable stock sales. We amortize the deferred compensation charges on an accelerated basis over the vesting period of the underlying option awards, which is generally four years. In connection with the grant of stock options during the years ended December 31, 2002 and 2003, we recorded $194,944 and $490,835 in deferred stock-based compensation within stockholders’ equity, respectively. These options resulted in the recording of compensation charges because the deemed fair value of the underlying common stock for financial reporting purposes was greater than the exercise prices determined by the board of directors on the date of grant. The determination of the fair value of the underlying shares of common stock involves subjective judgment and the consideration of a variety of factors, and as a result the amount of the compensatory charge is not based on an objective measure such as the trading price of the common stock since there was no public market for our common stock prior to this offering. As of December 31, 2003, we had an aggregate of $248,243 of deferred stock-based compensation remaining to be amortized. We estimate that this deferred compensation balance will be amortized as follows: $166,555 in 2004; $67,268 in 2005; $13,359 in 2006; and $1,061 in 2007. We anticipate that we will record additional stock-based compensation expense related to options granted subsequent to December 31, 2003. The amount of stock-based compensation amortization actually recognized in future periods could decrease if options for which accrued but unvested compensation has been recorded are forfeited. We have elected not to record the fair value of employee stock-based awards. The impact of recording employee stock-based awards at fair value, using the Black-Scholes option-pricing model, is further described in the notes to our financial statements.

      In the past, we have awarded a limited number of stock options to non-employee consultants. For these options, we recognize the stock-based expense over the vesting periods of the underlying awards, based on an estimate of the fair value of the awards at each financial reporting date using the Black-Scholes option-pricing model.

     Accounting for Income Taxes

      Since inception, we have incurred losses for both book and tax purposes; accordingly, we have not recorded any tax expense for the period from July 24, 2001 (inception) to December 31, 2001 or

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for the years ended December 31, 2002 and 2003. Significant management judgment is required in determining our deferred tax assets and liabilities and any valuation allowance recorded against our net deferred tax assets. This process involves the assessment of our net operating loss carry forwards and credits, as well as assessing temporary differences resulting from differing treatment of items, such as bad debt reserves and stock option compensation, for tax and accounting purposes. To the extent we experience a cumulative change in ownership of more than 50% within a three-year period, our ability to utilize our net operating loss carryforwards may be limited. While we do not believe that we have experienced a change in ownership as defined under Sections 382 and 383 of the Internal Revenue Code, determining whether such a change has occurred is complex and requires significant judgment. We must assess the likelihood that deferred tax assets will be recovered, and to the extent we believe that recovery is not likely, we establish a valuation allowance. Based on our historical results and due to uncertainties related to our future ability to recover our deferred tax assets, primarily consisting of certain net operating loss carry forwards and tax credits, we do not believe that it is more likely than not that we will realize the value of our deferred taxes. Therefore, we have recorded a full valuation allowance on our net deferred tax assets as of December 31, 2003. As a result, we carry no deferred tax assets on our balance sheet as of December 31, 2003.

Results of Operations

 
Comparison of the Period from July 24, 2001 (Inception) to December 31, 2001 and the Years Ended December 31, 2002 and 2003
                           
Period from
July 24, 2001 Years ended
(inception) to December 31
December 31
2001 2002 2003



Revenues
  $     $ 63,131     $ 2,074,002  
Cost of revenues
          415,077       605,567  
     
     
     
 
 
Gross profit (loss)
          (351,946 )     1,468,435  
Operating expenses:
                       
 
Research and development
    779,524       2,453,126       3,272,109  
 
Sales and marketing
    67,059       843,772       1,044,040  
 
General and administrative
    299,555       3,002,823       945,473  
     
     
     
 
 
Total operating expenses
    1,146,138       6,299,721       5,261,622  
     
     
     
 
Operating loss
    (1,146,138 )     (6,651,667 )     (3,793,187 )
Interest income (expense)
    18,747       (4,545 )     (282,015 )
     
     
     
 
Net loss
  $ (1,127,391 )   $ (6,656,212 )   $ (4,075,202 )
     
     
     
 

      Revenue. We had no revenues in the period from July 24, 2001 (inception) to December 31, 2001. Revenue increased from $63,131 in 2002 to $2,074,002 in 2003.

      The increase in revenue from 2002 to 2003 was primarily due to an increase in our customer base. We launched our commerce website and began selling our products in January 2002. Most of our customer sales in 2002 consisted of Insider memberships, which gave Insider members access to pre-release beta software, the Linspire operating system, our Warehouse, and other benefits for periods ranging from one to three years. Therefore, revenues from sales of such memberships were deferred and are being amortized over the period in which the Insider membership benefits are provided. As a result, much of the approximately $1,200,000 related to the Insider memberships sold in 2002 was deferred and partially recognized as revenue in 2003. We expect the remainder of these revenues will be recognized in 2004. Revenues recognized from Insider memberships sold during

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2002 and 2003 totaled approximately $29,000 and $637,000, respectively. In addition, in 2003, we entered into a licensing arrangement with a Japanese company whereby the Japanese company became the exclusive distributor of our products in Japan for the term of the license in exchange for a non-refundable license fee of $1,575,000. These license fees, net of withholding taxes of $157,500, are amortized from the payment date over a two-year period through May 2005, which represents the term of the underlying agreement, resulting in revenues of approximately $228,000 in 2003. Deferred revenue at December 31, 2003 relating to this licensing arrangement was approximately $605,000, which will be recognized during 2004 and 2005.

      In late 2003 and into 2004, we entered into several agreements with larger channel partners that manufacture computer components, whereby the channel partner will pay us a per-unit license fee to include our Linspire operating system products on its hardware. Although, to date, revenues from such channel partner agreements have not been significant, we expect revenues from these channel partners to increase in the future. We expect that increasing channel partner sales will lead to increased light ups from end users and additional purchases of application software and services through the use of our Warehouse.

      As of December 31, 2003, we had deferred revenue of $1,706,839 million, which represented sales for which we had received payment but revenues have been deferred. This deferred revenue is being recognized as revenue over periods which range from one month to up to five years. We expect that deferred revenue as of December 31, 2003, will be recognized as revenue in subsequent years as follows: $1,446,120 in 2004; $183,777 in 2005; $26,380 in 2006; $26,380 in 2007; and $24,182 in 2008. Because of the deferral of recognition of a portion of our revenues, our revenues and operating results will not increase at the same rate as our operating expenses incurred to support deferred revenue to be recognized in future periods.

      Cost of Revenues. Cost of revenues increased from $415,077 in 2002 to $605,567 in 2003. This increase was due primarily to expenses associated with our commerce website and customer sales growth, such as bandwidth charges for web hosting, fees paid for third-party credit verification services and credit card fees, all of which are expensed as incurred. Gross profit improved in 2003 principally because our revenues increased relative to fixed costs of sales. As our revenues increase, and our product and/or customer mix changes, our cost of revenues may change significantly and gross margin may not remain at its current level.

      Sales and Marketing. Sales and marketing expenses were $67,059 in 2001 as compared to $843,772 in 2002 and $1,044,040 in 2003. The increases in sales and marketing expenses were primarily due to the increase in headcount. In addition, during 2003 we started investing in the sponsorship of key Linux events such as the Desktop Linux Summit. We expect our operating expenses to increase in the near term as we expand our selling and marketing efforts and administrative infrastructure to attract and support increased sales.

      Research and Development. Research and development expenses increased from $779,524 in 2001 to $2,453,126 in 2002 to $3,272,109 in 2003. These increases were primarily due to increased consultant costs as well as increased labor costs resulting from additional employees. We expect that our research and development expenses will increase in the future as we develop new products and continue to maintain and support our current products. However, we expect these expenses will likely decrease as a percentage of total operating expenditures over time.

      General and Administrative. General and administrative expenses increased from $299,555 in 2001 to $3,002,823 in 2002 and decreased from $3,002,823 in 2002 to $945,473 in 2003. The decrease in 2003 general and administrative expenses from 2002 resulted primarily from reimbursements of approximately $1,441,000 received in 2003 from our insurance carrier for legal fees incurred in 2002 and 2003 related to the Microsoft litigation. In 2002, we incurred approximately $1,366,000 in legal fees, primarily related to the Microsoft litigation. Our insurance carrier now pays for such legal costs directly. As a result, we do not expect such reimbursements to similarly affect our general and administrative expenses in future periods. Also, in 2002, general and administrative

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expenses include an expense of $750,000 related to a note receivable which we have fully reserved. Please see “Business — Legal Proceedings” for a description of these legal proceedings. We expect our general and administrative expenses to increase substantially in the future associated with the increased costs of being a public company. In particular, increases are expected in insurance costs, professional fees and payroll related costs.

      We have not presented quarter-to-quarter comparisons of our net revenue and operating results as we believe they are not meaningful to an understanding of our operating results and should not be relied upon as indications of future performance due to the evolving nature of our business model.

Liquidity and Capital Resources

      We have funded our operations principally through the initial $5,000,000 equity investment by our founders and through borrowings under the $10,000,000 revolving line of credit with our Chairman and Chief Executive Officer, founder and majority stockholder. At December 31, 2003, we had cash totaling $250,720, and at December 31, 2002 and 2001, we had cash totaling $113,318 and $2,906,193, respectively.

      Net cash used in operating activities was $830,028 for the period from July 24, 2001 (inception) through December 31, 2001, $3,860,960 in 2002 and $2,462,576 in 2003. Net cash used in operating activities was primarily used to fund operating losses in each period. The decrease in net cash used in operating activities in 2003 was primarily due to reimbursement in 2003 of approximately $1,441,000 for legal fees incurred in 2002 primarily related to the Microsoft litigation. This decrease in net cash used was offset in part by an increase in labor costs in 2003 primarily due to an increase in headcount. The increase in net cash used in operating activities from 2001 to 2002 was primarily due to $1,080,000 in legal fees incurred in 2002 related to the Microsoft litigation and an increase in headcount.

      Net cash used in investing activities was $1,263,779 in the period from July 24, 2001 (inception) through December 31, 2001, $414,784 in 2002 and $325,424 in 2003. Net cash used in investing activities in 2003 and 2002 were for capital expenditures relating to the purchase of computers, software, and office furniture and equipment. Total capital expenditures for the period from July 24, 2001 (inception) through December 31, 2001 were $513,779, primarily for computers and software, of which $280,450 related to the capitalization of costs paid to third parties associated with the development of our commerce website. We also loaned $750,000 to another company in the form of a convertible promissory note during the period from July 24, 2001 (inception) through December 31, 2001. We fully reserved this note receivable during 2002.

      Net cash provided by financing activities was $5,000,000 for the period from July 24, 2001 (inception) through December 31, 2001, $1,482,869 in 2002 and $2,925,402 in 2003, primarily from borrowings under our revolving line of credit, the exercise of stock options and the issuance of Series A Convertible Preferred stock.

      On February 12, 2004, we amended our revolving line of credit with our Chief Executive Officer to increase the total amount available under the line to $10,000,000 and extend the maturity date of principal and interest payments to June 30, 2005. As of December 31, 2003, we had borrowed $4,400,000 under the loan agreement. During 2004, we borrowed the remaining amount of $5,600,000 available under the line, resulting in a total principal amount owing of $10,000,000, as well as accrued interest of approximately $420,000.

      As of December 31, 2003, we had a working capital deficit of approximately $1,777,000, long-term debt of approximately $4,703,000 and an accumulated deficit of approximately $11,859,000. As a result, we have received an audit report from our independent auditors containing an explanatory paragraph stating that our historical losses and negative cash flows from operations raise substantial doubt about our ability to continue as a going concern.

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      Our ability to fund our future operations is dependent upon obtaining additional debt or equity financing adequate to fulfill our development and marketing activities, and achieving a level of revenues adequate to support our cost structure. We believe that the proceeds generated by revenues from operations, the sale of common stock in this offering and cash on hand will be sufficient to meet our working capital requirements and contractual commitments for at least the next 24 months.

      Our anticipated capital requirements may change, and we may need additional financing earlier than we anticipate depending upon numerous factors, including the following:

  •  the development of the Linux desktop market;
 
  •  the cost of developing improved functionality of our products and services;
 
  •  the cost of expanding our sales and distribution capabilities;
 
  •  our ability to establish and maintain channel partnerships;
 
  •  the extent to which we acquire or invest in other products, technologies and businesses; and
 
  •  the cost of responding to competitive pressures.

      If we raise additional funds through the sale of equity or convertible debt securities, these transactions may dilute the value of our outstanding common stock. We may also decide to issue securities, including debt securities, which have rights, preferences and privileges senior to our common stock. We cannot assure you that we will be able to raise additional funds on terms favorable to us or at all. If future financing is not available or is not available on acceptable terms, we may not be able to fund our future needs. This may prevent us from increasing our market share, capitalizing on new business opportunities or remaining competitive in our industry.

      For the period from July 24, 2001 (inception) through December 31, 2001 and in the years ended December 31, 2002 and 2003, we did not have any relationships with unconsolidated entities or financial partnerships, often referred to as special purpose entities, established for the purposes of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. In addition, we do not engage in trading activities involving non-exchange traded contracts. As such, we do not believe we are materially exposed to any financing, liquidity, market, or credit risks that could arise if we had engaged in these relationships.

      At December 31, 2003, our outstanding commitments included:

                                         
Payments due by period

Less than More than
Total 1 year 1 - 3 years 3 - 5 years 5 years





Contractual Obligations:
                                       
Operating lease
  $ 1,445,456     $ 506,698     $ 938,758     $     $  
Note payable (including accrued interest)
    4,703,181 *           4,703,181              
     
     
     
     
     
 
Total
  $ 6,148,637     $ 506,698     $ 5,641,939     $     $  
     
     
     
     
     
 


This note payable was subsequently increased to approximately $10,400,000, the full balance of which is anticipated to be paid from the net proceeds of this offering.

Legal Uncertainties

      Microsoft Corporation has initiated lawsuits against us in the U.S. and in several foreign countries alleging, among other things, that our Lindows name infringes various Microsoft WINDOWS trademarks. These lawsuits have forced us to adopt an alternative name strategy for our commerce website and our products and services, pending resolution of the litigation, which has

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resulted in additional expense and may result in a loss of goodwill associated with our brand name, customer confusion and a loss of sales. We also may be liable for substantial fines, attorneys’ fees and costs and other monetary damages, which may exceed any amount we are able to pay.

      We are also in litigation with our insurance carrier relating to the Microsoft litigation. With respect to the Microsoft lawsuit in the U.S., we obtained a decision from the court that our carrier is obligated to defend us and that it breached its contract with us by refusing to defend. That decision may be appealed, but the only remaining issues to be decided by the court currently hearing the case are issues related to damages for the carrier’s breach of contract, our bad faith claim against the carrier for its failure to defend and the carrier’s obligation to pay any liability that we may have to Microsoft. With respect to the foreign litigation brought by Microsoft, we recently brought suit against the same insurance carrier to enforce its obligations to us regarding the foreign litigation.

      If our carrier successfully appeals the decision relating to its obligation to bear the cost of our legal defense with respect to Microsoft’s U.S. litigation, we may be forced to reimburse our carrier for some or all of the legal fees and costs it has paid to us, and continues to pay to us, in the Microsoft U.S. litigation. Additionally, although we believe our carrier is contractually bound to indemnify us for damages or other amounts we may be forced to pay Microsoft as a result of the U.S. litigation, up to the applicable policy limits, the court has not ruled on this point.

      If we are unsuccessful in our lawsuit relating to the foreign litigation, we also may be forced to reimburse our carrier for some or all legal fees and costs it has advanced to us, and continues to advance to us, relating to the foreign litigation, and our carrier might have no obligation to reimburse us for any amounts we may be forced to pay Microsoft as a result of the foreign litigation.

      Additionally, we have initiated a lawsuit against Xandros, Inc., Linux Global Partners, Inc., Michael Bego, and William Jay Roseman alleging these parties fraudulently induced us to loan Xandros, Inc. $750,000 in exchange for convertible promissory notes, and that Xandros, Inc. then failed to repay the promissory notes when they became due. We are seeking $750,000, plus interest, attorneys’ fees and punitive damages. This lawsuit is in the discovery phase, and may proceed for an extended period of time. We intend to pursue the lawsuit vigorously, but cannot assure you that it will be resolved in our favor. Additionally, even if the court rules in our favor, we cannot assure you that we will be able to collect the amounts owed. We fully reserved this note payable in 2003.

      Although we believe in the merits of our claims and defenses in each of these lawsuits, we may not prevail. Each of these lawsuits has resulted in significant expenses and has been, and is expected to continue to be, a diversion of management’s time and other resources well into the future. Please see “Business — Legal Proceedings” for more description of our litigation.

Recent Accounting Pronouncements

      In December 2003, the Securities and Exchange Commission released Staff Accounting Bulletin No. 104, “Revenue Recognition,” (“SAB 104”). SAB 104 revises or rescinds portions of the interpretative guidance related to revenue recognition included in Topic 13 of the codification of the staff accounting bulletins. We have assessed the impact of SAB 104 and concluded that the adoption of SAB 104 did not have a material impact on our financial statements.

      In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity,” (“SFAS 150”). SFAS 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). Many of those instruments were previously classified as equity. SFAS 150 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after

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June 15, 2003. Our adoption of SFAS 150 has had no effect on our financial position or results of operations.

      In April 2003, the FASB issued SFAS No. 149, “Amendment of Statement No. 133 on Derivative Instruments and Hedging Activities,” (“SFAS 149”). SFAS 149 amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts. SFAS 149 clarifies under what circumstances a contract with an initial net investment meets the characteristic of a derivative, clarifies when a derivative contains a financing component, amends the definition of an underlying to conform it to language used in FASB Interpretation No. 45, and amends certain other existing pronouncements. SFAS 149 is effective for contracts entered into or modified after June 30, 2003 and for hedging relationships designated after June 30, 2003. All provisions of SFAS 149, except those related to forward purchases or sales of “when-issued” securities, should be applied prospectively. The adoption of SFAS 149 had no effect on our financial position or results of operations.

      In December 2003, the FASB issued additional guidance clarifying the provisions of FASB Interpretation No. 46, “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51,” or (“FIN 46-R”). FIN 46-R provides a deferral of FIN 46 for certain entities. FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. We believe that the adoption of this standard will not have a material impact on our financial statements.

      FASB Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others” (“FIN 45”), was issued in November 2002. FIN 45 requires that upon issuance of a guarantee, the guarantor must disclose and recognize a liability for the fair value of the obligation it assumes under that guarantee. The initial recognition and measurement requirement of FIN 45 is effective for guarantees issued or modified after December 31, 2002. The disclosure requirements of FIN 45 are effective for interim and annual periods ending after December 15, 2002, and are applicable to certain guarantees issued by us before December 31, 2002. We adopted FIN 45 disclosure requirements as of December 31, 2002. The adoption of the provisions for recognition and initial measurement did not have a material impact on our financial position, results of operations or cash flows.

      In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure.” SFAS No. 148 is an amendment to SFAS No. 123 providing alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation and also provides additional disclosures about the method of accounting for stock-based employee compensation. Amendments are effective for financial statements for fiscal years ending after December 15, 2002. We have currently chosen not to adopt the voluntary change to the fair value based method of accounting for stock based employee compensation, pursuant to SFAS No. 148, which, if adopted, could have a material effect on its financial position or results of operations.

Qualitative and Quantitative Disclosure about Market Risk

      Market risk represents the risk of loss arising from adverse changes in market rates and foreign exchange rates. The primary objective of our investment activities is to preserve principal while at the same time maximizing the income we receive from our investments without significantly increasing risk. Some of the securities that we invest in may be subject to market risk. This means that a change in prevailing interest rates may cause the value of the investment to fluctuate. For example, if we purchase a security that was issued with a fixed interest rate and the prevailing interest rate later rises, the value of our investment will probably decline. To minimize this risk, we intend to maintain our portfolio of cash equivalents and short-term investments in a variety of highly

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liquid securities, including money market funds, commercial paper and government and non-government debt securities. In general, money market funds are not subject to market risk because the interest paid on such funds fluctuates with changes in prevailing interest rates.

      At December 31, 2003, we had a $4,400,000 principal balance (plus accrued but unpaid interest of $303,181) outstanding under our revolving credit line with our Chief Executive Officer. This amount was subsequently increased to $10,000,000 in the aggregate. The amounts outstanding under this credit line bear interest at a fixed interest rate of 10% per annum. Accordingly, our interest expense relating to this credit line is not subject to changes in prevailing interest rates.

      We derive a majority of our revenues from sales within the U.S. We do, however, have business relationships with foreign customers which constitute approximately 25% of our revenues. Substantially all of the payments by these foreign customers for the year ended December 31, 2003 were made in U.S. dollars, although there can be no assurance that future sales to foreign customers will continue to be denominated in U.S. dollars. Given that our transactions in foreign currencies are negligible, we have not historically hedged against foreign currency risks. This could change in the future if we enter into transactions whereby the sales price is denominated in foreign currency or where we face other foreign currency risks where we determine it is appropriate to enter into hedging transactions.

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BUSINESS

      We are a developer and vendor of Linux-based operating systems, application software and services designed specifically for desktop and laptop computers in homes, schools and businesses. We use technology and software developed by the collaboration of independent Linux developers, referred to as the open source community, with our own technology and software to offer affordable, easy-to-use software products and services, many of which are similar in feel and functionality to our higher-priced competitors. The cornerstone of our product line is our Linspire operating system. We also offer Linux application software and services developed by us and others. We sell and distribute our products and services both through the Internet using our proprietary CNR technology and by pre-installing them on third-party computer hardware. Our CNR technology reduces the complexity of installing, managing and updating Linux application software.

The Linux Desktop Market

     Industry Background

      According to International Data Corporation, or IDC, worldwide client operating system revenues were approximately $10.4 billion in 2002. IDC data shows Microsoft captured 96.1% of this revenue through its Microsoft Windows products during the same period.

      The application software market is larger and more fragmented than the desktop operating system market, with many competitors selling consumer, education and business oriented application software for various platforms.

      International and emerging markets are increasingly important to the personal computer operating system industry. According to IDC, the value of personal computers sold into the U.S. has declined as a percentage of the worldwide personal computer market from 38.9% in 2000 to 32.0% in 2003.

      Operating systems are complex to design and typically take several years to develop. Until the advent of the Linux operating system, almost all operating systems were developed as proprietary products licensed to an end user for a fee. The base engine for the Linux operating system, known as the kernel, is open source code, which is available for no charge, as are other Linux-based building blocks such as the graphical user interface.

     The History of Linux

      In 1991, Linus Torvalds developed an operating system now known as Linux. Developers worldwide collaborate on improving and updating Linux-based operating systems. We believe users of Linux-based operating systems enjoy benefits not provided to users of other operating systems for the desktop including:

  •  reduced licensing costs;
 
  •  ability to modify the source code; and
 
  •  reputation for stability and security.

      While Linux-based operating systems have achieved significant market share in the server market, they have not yet penetrated the desktop computing market to a material extent.

     The Linux Desktop Opportunity

      As the prices for personal computers, or PCs, have continued to decline, the relative cost of the Microsoft Windows operating system has increased. In value-priced PCs and laptops, which we consider to be those with a manufacturer’s suggested retail price, or MSRP, of less than $600, the Microsoft Windows operating system and bundled software can be the most expensive component. As computer manufacturers continue to compete on price, and value conscious consumers look to

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save money, we believe that operating systems based on Linux technology will increasingly be offered on value-priced computers.

     Challenges to Adoption

      Despite the market acceptance of Linux in the server market, there have existed a number of factors limiting the adoption of Linux on the desktop, including:

  •  Complexity — Technical difficulty in installing and configuring Linux-based operating systems and software applications have made it unattractive for businesses and individuals to migrate from other operating systems.
 
  •  Distribution — Lack of well-financed companies pursuing the adoption of Linux in the desktop computer market, coupled with the lack of computers pre-installed with a Linux-based operating system, have made it difficult for Linux to capture market share.
 
  •  Limited software applications — There are relatively few high quality software applications developed for Linux-based desktop operating systems as compared with their Microsoft Windows-based counterparts.
 
  •  Compatibility — The majority of the applications created for PCs are currently only compatible with Microsoft Windows. Proprietary file formats make it difficult for Microsoft Windows users to share data and work product with non-Microsoft Windows users.

      Our technology and business model are designed to overcome these hurdles and increase acceptance of our Linux-based operating system.

Our Solution

      We have developed a simple and comprehensive solution allowing homes, schools and businesses to use a Linux-based operating system and to install and maintain application software on PCs. Our Linux-based desktop solution, Linspire, is:

  •  Easy to use — The Linspire operating system presents the user with an intuitive and comfortable graphical user interface, in which programs and files are represented by icons and information from multiple programs or files can be displayed in overlapping windows.
 
  •  A full-featured platform — The Linspire operating system is configured to perform many common tasks, including email, Internet web browsing, instant messaging, multimedia and audio playback, networking, and printing.
 
  •  CNR equipped — Our proprietary CNR technology allows users to license, install, manage, and configure programs available from our Warehouse on the Linspire.com website, usually with just one mouse click. CNR technology also allows users to keep both their operating system and application software updated at all times.
 
  •  Hardware compatible — We believe the Linspire operating system is able to work with many of the most popular machines and peripheral devices on the market today, including laser and inkjet printers, displays, digital cameras, network cards, and storage devices.
 
  •  File compatible — Users can view and edit most Microsoft Word, Microsoft Excel and Microsoft PowerPoint files and view other popular graphic file types, such as Adobe Acrobat files. Consumers also can view and play popular media files types, such as Flash, QuickTime and Real Audio.
 
  •  Stable and secure — Based on the Linux kernel, the Linspire operating system provides a stable and secure computing environment. We believe the Linspire operating system is less prone to viruses than other desktop operating systems.

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      As a result of these features, more than 550 hardware manufacturers, systems builders and software and hardware resellers have participated in our channel distribution programs by licensing the right to distribute the Linspire operating system or sell hardware pre-installed with the Linspire operating system. We refer to participants in our channel distribution programs as our channel partners.

Our Desktop Business Model

      We generate revenue from the sale of affordable desktop operating systems, application software and services for desktop and laptop computers. We seek to build a large installed base of computers running our Linspire operating system, to which we will offer value-added applications and services.

     Value-Price Leader

      Due to the collaborative model of open source software development, we believe we have a substantial cost advantage over providers of proprietary code operating systems in providing software to our customers. We believe that these competitors have significantly higher expenses for research and development. We plan to encourage the adoption of our Linspire operating system by maintaining a significant price advantage over Microsoft Windows and other proprietary code operating systems. In addition, we believe our value-price products and services will be attractive to consumers in international and emerging markets.

     Widespread Distribution Strategy

      We seek to make the Linspire operating system widely available, quickly and at a low price. Our goal is to make the Linspire operating system readily available by working with our channel partners to pre-install PCs and hard drives with the Linspire operating system. We anticipate this distribution strategy can significantly grow our installed base by making the Linspire operating system available to consumers with no installation process, saving time and money. By accelerating widespread adoption of the Linspire operating system, we intend to increase revenues through the sale of value-added application software and services.

      One of the ways in which we intend to implement our distribution strategy is through smaller computer manufacturers. Approximately half of all desktop computers today are sold by smaller manufacturers, which we define as those having less than 3% market share. We offer a low cost licensing program, which we believe is particularly appealing to smaller manufacturers. These smaller manufacturers seek to be price-competitive with larger companies such as Dell that, because of their size, may have inherent advantages when negotiating volume discounts with proprietary code operating system suppliers. By using the Linspire operating system, smaller manufacturers can better compete with larger builders in the value-priced computer segment. For example, there are Linspire operating system computers being sold today for under $200, and it may be difficult for even a larger builder to match this price after obtaining a Microsoft Windows license. We believe this pricing pressure eventually will encourage a broader range of computer manufacturers to offer computers using value-priced operating systems, such as the Linspire operating system.

      We are also implementing our distribution strategy with established vendors in the computer industry, as exemplified by our relationship with Seagate Technology, a leading manufacturer of computer hard drives. Seagate pre-installs the Linspire operating system on certain Seagate hard drives and sells those pre-installed hard drives in the U.S., as well as Mexico and other Spanish-speaking countries. In addition to providing us with revenue, Seagate is helping to expand our installed base in the U.S. and emerging markets.

      Similarly, Elektra, a retail store chain with over 800 stores throughout Mexico, sells a low-cost computer with Linspire pre-installed. According to Elektra, since December 2003 and as of April

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2004, Elektra’s best selling computer was the Linspire system, outselling all other desktop computers it offers running other operating systems.

     Builder Friendly

      To facilitate our distribution strategy, we have created affordable, easy-to-implement license programs. For example, we have a web-based builder program, which allows manufacturers, builders and resellers of all sizes to become channel partners by pre-installing the Linspire operating system on either a flat rate or per unit basis, without onerous licensing agreements. At a channel partner’s request, we will test and certify that its hardware configurations are compatible with our Linspire operating system. We believe proprietary code operating systems are generally more expensive and usually require licensees to enter into complex agreements and submit to audits.

     Revenue Share Programs

      We have implemented revenue share programs with our higher volume channel partners in order to create additional incentives for the license and distribution of the Linspire operating system and application software. Each channel partner that distributes the Linspire operating system with its products is assigned a builder number. These builder numbers are encoded into each copy of the Linspire operating system that the channel partner pre-installs or distributes. This system allows us to track incremental revenue generated by participating channel partners and share a percentage of the revenue from add-on products and services based upon sales volume and other factors. We believe this revenue sharing program gives us a competitive advantage in attracting channel partners.

     Value-Added Application Software and Services

      We seek to sell value-added application software and services to Linspire operating system users. Our CNR technology built into the Linspire operating system allows users to easily install, manage and update software from our Warehouse, generally with one click of a mouse. Our Warehouse carries over 1,800 software programs comprised of applications that are included with an annual service fee as well as commercial applications for which we receive a portion of the sales price. We also have developed or licensed several software products which we sell under the Linspire brand name to our customers, including LinspireOffice and Linspire DVD. Furthermore, we sell services such as VirusSafe virus protection, SurfSafe web filtering and extended customer support services.

     Digital Delivery

      Digital delivery is a driver of the scalability of our business model and is the backbone of our proprietary CNR technology. CNR provides easy access to an extensive software library, which includes tools such as productivity software, office suites, virus protection, web filtering, games, and utilities. Unlike some competing operating systems, our technology was conceived and developed in the Internet era and has been optimized to take advantage of Internet connectivity.

Strategy

      Our objective is to enhance our position as a leading developer and vendor of Linux-based desktop operating systems, application software and services designed specifically for desktop and laptop computers in homes, schools and businesses. The key elements of our strategy are:

     Broaden Distribution of the Linspire Operating System

      We believe most home, school and business users do not install operating systems, but rather use the operating system that comes pre-installed on their PC. By providing the Linspire operating system to a wide range of value-priced computer hardware manufacturers, systems builders and

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resellers, we believe the Linspire operating system can gain traction throughout many desktop and laptop market segments, fostering acceptance of our products and services.

     Use CNR Technology to Drive Revenues from our Value-added Software and Services

      CNR’s digital delivery technology complements our distribution strategy by enabling the sale of value-added application software and services to Linspire operating system users. Our proprietary CNR technology allows purchasers of our LinspirePlus service to download over 1,800 software titles from our Warehouse, generally with one click of a mouse.

      We assist software developers in creating and publishing Linux-compatible software that can be used with our products and services. Developers may choose to share their products for free or sell them at an agreed upon price. There are selected commercial software programs, known as “Click-N-Buy” programs, which are offered at discounted prices to purchasers of our LinspirePlus service.

     Focus on Products and Services Primarily for Desktop and Laptop Users

      Our strategy is to focus on desktop and laptop solutions rather than to try to compete in the server and other software markets. We believe this focused strategy gives our products and services a competitive edge. Our desktop business model is scalable and web-based, which distinguishes us from some other Linux companies which rely on consulting revenue.

     Increase Our Penetration Into International Markets and Emerging Markets

      Computers pre-installed with the Linspire operating system are available in over 20 countries. We intend to continue to expand our sales and marketing efforts internationally. We believe that there exists a demand in emerging markets for value-priced desktop operating systems such as the Linspire operating system. We have developed a version of the Linspire operating system program for the Spanish-speaking market and have developed language packs for the translation of key parts of the Linspire operating system user-interface into over a dozen non-English languages. We have also developed an international template that allows us to either establish partnerships or set up local offices to take advantage of international opportunities.

     Support and Leverage the Open Source Community

      We intend to continue to promote acceptance of Linux software on the desktop through a variety of means, including strengthening and establishing strategic alliances and sharing our development efforts with third-party developers. The strength and synergy of these relationships is crucial to the expansion of the Linux community, the technical advancement and widespread distribution of Linux and the continued development of third-party applications suitable for Linux-based operating systems.

      Our Linspire Insiders are members of the open source community who believe in our vision and provide us with critical input in the form of early testing of new Linspire operating system versions and our Warehouse products. The Linspire Insiders also support other Linspire operating system users through postings on message boards and forums.

      We provide financial support and marketing services to open source projects that develop ease-of-use features, which we believe will broaden the user base of the Linspire operating system, as well as open source projects such as building file systems and graphical user interfaces. Representative open source projects that we have financially supported include:

     
Debian — Linux distribution
  Nvu — Web authoring system
GAIM — Instant messenger client
  Reiser4 — File system
KDE — Graphical user interface
  WINE — Microsoft Windows compatibility environment
Mozilla — Internet web browser and email
   

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      For the past two years we have sponsored the Desktop Linux Summit, which is a conference for industry leaders that sell, market or promote desktop Linux-based products, services, applications, and technologies.

     Increase Brand Awareness

      We recently adopted “Linspire” as an alternative name for our commerce website and our products and services. We believe that building greater awareness of our brands within and beyond our existing customers is important for our continued growth. We intend to promote our brands aggressively through a variety of online and offline marketing and promotional techniques.

Products and Services

     The Linspire Operating System

  •  Linspire 4.5 — Linspire 4.5 is our full-featured operating system, which combines the stability and cost-savings of Linux with the ease of a comfortable graphical user interface using windows and icons. In addition, Linspire 4.5 features our proprietary CNR technology that enables easy installation of software and services on Linspire 4.5.
 
  •  Linspire 4.5 Developers Edition — Our developers edition includes over 100 developer tools and utilities and is designed for professional programmers designing and writing software to run on Linux-based computers.
 
  •  LinspireLive — LinspireLive is a bootable CD-ROM that allows consumers with Microsoft Windows installed on their computer to experience the power and ease of use of the Linspire operating system without reconfiguring their hard disk or operating system.
 
  •  Linspire Laptop Edition — Linspire Laptop Edition is a version of the Linspire operating system that is designed specifically for laptop computers, including improved power management, compatibility with wireless technology and the ability to take advantage of keyboard shortcuts to browsers and email programs.
 
  •  Linspire International Editions — We provide language packs for over 50 languages for our Linspire operating system users. In addition, we have more completely translated and localized versions of the Linspire operating system for the Spanish and Japanese languages.

      The Linspire operating system has the following key advantages over other operating systems for the desktop:

     Ease of Use

      The Linspire operating system includes several features to make it easy for mainstream computer buyers to install and use, including:

  •  Comfortable Look — The Linspire operating system uses a graphical user interface of icons, windows, menus, and tool bars that will feel natural, intuitive and comfortable to most users. The interface is designed to be graphically appealing and easy to use.
 
  •  Easy Installation — The Linspire operating system features a simple, step-by-step installation, easy enough for anyone from the most seasoned computer expert to a complete novice. Depending on the speed of the user’s computer, total installation time is usually around 10 minutes. Many users skip this step, since the Linspire operating system comes pre-installed, tested and certified on a number of affordable PCs.
 
  •  CNR Technology — CNR allows users to license, install, manage, and update hundreds of programs available on the Linspire.com website automatically, usually with just one mouse click. CNR allows users to keep their operating system and application software updated.

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  CNR Aisles (a collection of software products from our Warehouse grouped together) make it easy to set up multiple computers with predetermined software sets.
 
  •  Plug & Play Functionality — The Linspire operating system automatically detects and configures many peripherals, such as USB devices and wireless cards.
 
  •  Audio Assist Tutorials — Several tutorials, each using video animation and audio narration, walk the user through step-by-step instructions for performing many basic computing tasks with the Linspire operating system.
 
  •  Internet Connectivity — The Linspire operating system automatically detects and configures the Internet connection for most systems, and provides dialers and step-by-step instructions to connect to many of the more popular dial-up Internet service providers, such as Earthlink, NetZero and Juno.

     Full-featured Platform

      The Linspire operating system comes with a substantial library of built-in programs which enable users to perform many common tasks without having to install additional software, including:

  •  Web Browsing — The Linspire Internet Suite features tabbed browsing to keep windows organized, group bookmarking to save several pages under one bookmark and pop-up blocking to stop advertisements from appearing on the desktop.
 
  •  Email — The Linspire Internet Suite includes an email program that can handle multiple accounts, address books, spell checking, font formatting, embedded graphics, and spam mail filtering.
 
  •  Instant Messaging and Chat — The instant messenger included with the Linspire operating system can sign on to multiple accounts at one time and is compatible with the ICQ, MSN, Yahoo!, and AOL IM networks.
 
  •  Networking — The Linspire operating system allows a user to connect to Microsoft Windows networks and share files and printers between the Linspire operating system and Microsoft Windows machines.
 
  •  Integrated Access to Search and eCommerce Engines — Integration with popular websites such as Google, Yahoo!, Amazon, and eBay brings the rich resources of the Internet to the Linspire operating system desktop.
 
  •  SIP Dialer — SIP, or Session Initiating Protocol, allows the Linspire operating system computer to make Voice Over Internet Protocol, or VoIP, telephone calls without the need for additional software. Calls made through a SIP-enabled personal computer (or a SIPphone) to another SIP device are free of traditional long-distance phone charges.
 
  •  Desktop Sharing — The Linspire operating system allows a user to access the desktop of his or her computer from other computers via the Internet.

     Stability and Security

      Linux has a reputation for its stability and security. We believe the Linspire operating system is currently less prone to virus attacks than other desktop operating systems not based on Linux. In addition to the option of password protection at both the administrator and user levels, the Linspire operating system comes pre-configured with a firewall to help protect users from unauthorized access.

     Hardware Compatibility

      We believe that our Linspire operating system can be run on many of the most popular hardware configurations for desktop and laptop computers. We work with computer and component manufacturers to ensure hardware compatibility with the Linspire operating system. Our engineers test hardware configurations for compatibility and recommend modifications if a device is found to be

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incompatible. We maintain a database of hundreds of hardware products on our website to help consumers achieve this compatibility.

     File Compatibility

      We sell and distribute a variety of Linspire operating system compatible software programs designed to work with files created by programs such as Microsoft Word, Microsoft Excel and Microsoft PowerPoint. We believe that file compatibility is an important driver of adoption by individuals and organizations currently using Microsoft software.

      The table below summarizes some commonly used file types and the compatible programs available to Linspire operating system users:

             
File type Extension Program(s) used



Microsoft Excel Spreadsheet
    .xls     StarOffice, OpenOffice
Microsoft Word Document
    .doc     StarOffice, OpenOffice
Microsoft PowerPoint Presentation
    .ppt     StarOffice, OpenOffice
StarOffice Text Document
    .sxw     StarOffice, OpenOffice
StarOffice Spreadsheet
    .sxc     StarOffice, OpenOffice
StarOffice Presentation
    .sxi     StarOffice, OpenOffice
Adobe Acrobat File
    .pdf     Adobe Acrobat Reader
Real Audio Stream
    .ram     RealPlayer
Real Video File
    .rm     RealPlayer
Quicktime Movie File (External)
    .mov     MPlayer,Xine
Media Type mpeg-1 (External)
    .mpg     MPlayer,Xine
Media Type mpeg-1 (Inline)
    .mpg     MPlayer,Xine
Media Type mpeg-4
    .mp4     MPlayer,Xine
Media Type avi
    .avi     MPlayer,Xine
MS Media Type wmv (External)
    .wmv     MPlayer,Xine
Macromedia Flash
    .swf     Macromedia Flash is included in the operating system
MP3 Audio File
    .mp3     XMMS, which is included in the operating system
OGG Audio File
    .ogg     XMMS, which is included in the operating system
MP3 Audio Stream
    .m3u     XMMS, which is included in the operating system
WAV Audio File
    .wav     XMMS, which is included in the operating system
Java Games
    .jav     Java is included in the operating system
HTML Web Pages
    .html     Mozilla, which is included in the operating system
JPG Graphic File
    .jpg     Mozilla, which is included in the operating system
PNG Graphic File
    .png     Mozilla, which is included in the operating system
GIF Graphic File
    .gif     Mozilla, which is included in the operating system

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File type Extension Program(s) used



EPS Graphic File
    .eps     Mozilla, which is included in the operating system
BMP Graphic File
    .bmp     Mozilla, which is included in the operating system

     Warehouse

      CNR technology allows Linspire operating system users to install new software and updates from our Warehouse located on the Linspire.com website. Installation times vary depending upon the size of the software application and the speed of the users Internet connection. Users can browse through hundreds of software titles. For each title, a user can typically find screenshots, descriptions, specifications, and comparisons. Once a paying customer finds a desired software application, he or she can click the CNR button, and the software is automatically downloaded and installed. Additionally, a record of the selected software title will be saved in the user’s My.Linspire.com account, so that the user can run it at no extra charge on his or her other computers.

      There are over 1,800 software programs made available through our Warehouse. Examples of software categories available at our Warehouse include:

         
Software category Description Example programs



Audio and MP3
  Music authoring, playback and CD creation software   Lsongs, XMMS, Sweep, K3B
Business & Finance
  Office productivity programs including word processors, spreadsheets and presentation software   StarOffice, OpenOffice, HancomSheet, Moneydance, GnuCash, Scribus
Desktop Enhancements
  Programs to add functionality or customize the Linspire operating system user interface   Elements Wallpaper, Language translations for the Linspire operating system
Games
  Entertainment software   Doom, Quake II, Tetris, Math Scrabble
Home & Education
  Teaching tools and programs for hobbies   Tux Typing, LargoRecipes
Internet
  Browsers, Internet messaging and other communications software   Opera, LimeWire, Ximian Evolution
Multimedia & Design
  Development and visual display software   RealPlayer, Acrobat Reader, GIMP, Digikam
Software Development
  Tools for programmers   KDevelop, Qt Designer, Nano
Utilities
  Programs to increase productivity of a computer and its peripherals   Screen Capture, Citrix Client
Web Authoring
  Tools to create web pages and websites   Nvu, Quanta Plus, Bluefish

     LinspirePlus Service

      By purchasing our LinspirePlus service for $49.95 per year or $4.95 per month, a user can install a large number of software titles from our Warehouse at no additional charge. There are also some commercial software programs, known as “Click-N-Buy” programs, which are offered at

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discounted prices to purchasers of the LinspirePlus service. The LinspirePlus service includes the following benefits:

  •  easily searchable online library of over 1,800 business, home, education, and entertainment software titles;
 
  •  free automatic updates and upgrades for most software;
 
  •  discounts on all commercial software;
 
  •  easy installation;
 
  •  a lifetime license to use any software installed from the Warehouse on multiple computers; and
 
  •  web-based support for our Warehouse products.

      LinspirePlus customers also have access to CNR Express, which enables them to install some of the larger programs from our Warehouse in a few minutes or less, even over a modem connection. CNR Express pre-installs certain large files on the computer’s hard drive, thus eliminating the need to download these files via the Internet.

     Services

      We offer our VirusSafe service on an annual basis for $29.95 per year for LinspirePlus customers, and $39.95 per year for other users. VirusSafe is designed to protect a Linspire operating system computer from unwanted and hazardous viruses, and features automated virus definition updating and the ability to prevent transfer of Microsoft Windows-based viruses to other non-Linux computers. VirusSafe gives users the option to repair, rename or delete infected files.

      SurfSafe is a comparable annual service also priced at $29.95 per year for LinspirePlus customers and $39.95 per year for other users. SurfSafe’s web filtering is designed to protect the Linspire operating system user and his or her family from Internet pornography or other objectionable material, and updates are made to our database of objectionable websites daily. SurfSafe may be left permanently on or activated by an adult using a password. SurfSafe requires no additional configuration or software and works with any Internet connection.

Key Channel Partners

      In an effort to increase market acceptance of our Linspire operating system, we have established distribution relationships with the following companies, each of which was among our top 15 hardware manufacturer channel partners or top 15 reseller channel partners in terms of volume of Linspire operating system copies distributed or purchased in 2003:

  •  Avatar — Avatar is the result of an alliance between Prophecy Technology, LLC, a memory and computer components distributor, and PC Chips, a motherboard manufacturer. Avatar provides computers with the Spanish-language version of Linspire pre-installed to Elektra, a retail chain with over 800 stores throughout Mexico.
 
  •  Elitegroup Computer System (ECS) — ECS is a manufacturer and distributor of mainboards and barebones systems and desktop and laptop complete systems and is shipping desktop computer systems pre-installed with Linspire 4.5 into the Fry’s Electronics chain of over 30 stores in the U.S., and is shipping laptop computer systems pre-installed with Linspire 4.5 Laptop Edition into their worldwide channels.
 
  •  Livedoor Co., Ltd. — Livedoor is a Japanese information technology company that has the exclusive right to market, sell and support the Japanese versions of the Linspire operating system, LinspireLive, Linspire Laptop Edition, LinspireOffice, and VirusSafe to consumers, resellers, distributors, and manufacturers in Japan. Livedoor accounted for approximately 11% of our revenue in 2003.

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  •  MicrotelPC — MicrotelPC is a system builder that assembles and manufacturers complete desktop and laptop computer systems pre-installed with the Linspire operating system and Linspire Laptop Edition and offers the products to consumers and businesses through strategic accounts with Walmart.com and Amazon.com. In addition, MicrotelPC also offers our complete software retail package product line.
 
  •  PC Club — PC Club is a retailer offering consumers and businesses computer components, barebones systems, software products, training, services, and complete desktop and laptop computer systems. PC Club offers the Linspire operating system pre-installed on desktop computer systems and Linspire Laptop Edition pre-installed on laptops. In addition, PC Club offers our complete software retail package product line.
 
  •  Procure 1 — Procure 1 is a distributor of name brand computer hardware and software products to resellers. Procure 1 currently distributes our complete software retail package product line to Fry’s Electronics, Micro Center, PC Club, and PC Mall.
 
  •  Questar — Questar is focused on the localization, republishing, channel development, sales and support activities of innovative software products for the Italian market. Questar has an exclusive territory distribution agreement with us to distribute Linspire in Italy.
 
  •  Seagate Technology — Seagate designs, manufactures and markets hard disc drives for enterprise, PC, notebook and consumer electronics applications. We have an agreement with Seagate under which Seagate pre-installs the Linspire operating system on certain Seagate hard drives and sells those pre-installed hard drives in the U.S., as well as Mexico and other Spanish-speaking markets.
 
  •  Wintergreen Systems — Wintergreen is a system builder. It assembles and manufacturers compete desktop, laptop and web station computer systems pre-installed with the Linspire operating system and sells these products to consumers and businesses through strategic accounts with Tigerdirect.com, PCWarehouse.com, Ubid.com, and Smartbargains.com. In addition, Wintergreen also offers our complete software retail package product line.

Sales and Marketing

     Sales

      We sell our products worldwide directly through our Linspire.com website and indirectly through our channel partners. We permit channel partners to distribute the Linspire operating system with their own hardware in exchange for royalty payments to us. We currently have channel partner agreements in place with over 450 hardware manufacturers. These agreements are typically non-exclusive and most have no stated minimum purchase or license obligations. We also sell our Linspire operating system and application software directly to academic institutions, for which special terms are available.

     Linspire.com

      Our website, Linspire.com, serves as the primary delivery mechanism and customer interface for many of our offerings. Linspire.com offers extensive resources for Linspire operating system customers, including systems and software updates and downloads through our Warehouse. Linspire.com is also a commerce site for our licenses and support offerings. Additionally, Linspire.com offers users access to news, documentation, educational materials and case studies. Our website serves the interests and needs of a wide spectrum of Linux computer users and professionals, from mainstream computer users to professional resellers and systems integrators.

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     Marketing

      Our marketing efforts use a broadcast model focused on building end-user awareness and demand for our products and seek to educate potential end users of the Linspire operating system of its advantages over competing operating systems. Our outbound marketing programs include weekly press releases, as well as regular communications from our Chairman and Chief Executive Officer, Michael Robertson, in the form of “Michael’s Minute” and email newsletters. We have also built several websites to market Linspire to specialized market segments, including tryoutlinux.com, desktoplinuxsummit.com and koobox.com.

      We regularly run special promotions to encourage the adoption and use of the Linspire operating system. We place ads on the Internet, which may include digital coupons for discounts on our products. We distribute our Linspire operating system through CDs packaged with various publications focused on computer users.

      We also market add-on products and services to our current user base through our Warehouse. We continue to increase the number of products available from the Warehouse through regular investigation of available open source software and through our software publishing partnership programs. We also notify our existing customers of new programs of interest through messaging systems built into our Linspire operating system.

Support

      Registered users of Linspire can seek help through online technical support, which has a 24-hour response time. We have invested in a scalable e-support infrastructure, which we believe allows us to effectively serve a greater number of customers with less headcount than our competitors as our installed base grows. Our support organization is designed to provide the majority of our customers with self-service, web-based support.

      We also offer Premium Phone Support and Always On-Call Support, which provide extended support hours for our customers.

      Our support service focuses on four main areas:

  •  Installation and Configuration — Provides users with assistance on Linspire operating system product and service acquisition, downloads, installation, configuration, usage, and setup.
 
  •  Linspire Operating System Questions — Linspire.com will answer questions regarding Linspire operating system capabilities, features, settings, usage, and tips.
 
  •  CNR — Linspire.com will assist with questions or issues regarding its CNR technology, including CNR Express, CNR features, login and logout, usage, and settings.
 
  •  Warehouse Programs — Linspire representatives will answer installation, start up and basic usage questions with respect to third-party programs included in our Warehouse or distributed with the Linspire operating system.

      Our Linspire Insiders support other Linspire operating system users through postings on message boards and forums. Many Linspire Insiders move on to participate in our Linspire Consultants Program and offer assistance to homes, schools and businesses, informing them how to set up, use and maintain their Linspire products and services.

Engineering and Development

      We have invested, and intend to continue to invest, significant resources in product and technology development. Our engineering team is organized into four components: an operating system team, a services team, a web team, and an applications team. Our operating system team focuses on developing and upgrading the Linspire operating system and also works directly with third parties to certify their hardware with the Linspire operating system upon request. The products

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certified include motherboards, laptops, printers and other devices. Our services team maintains and improves our proprietary CNR technology, our Warehouse and our services such as VirusSafe and SurfSafe. The services team not only monitors all open source and commercial applications within the Warehouse, but builds and updates our proprietary server technology that allows CNR to function. Our web team focuses on all aspects of our commerce engine, including forms, e-support, mailing tools, administrative and reporting tools, and auxiliary or related websites. Our applications team develops proprietary application software and related back-end services, such as LPhoto and LSongs.

      We are currently focusing our development efforts on improving or adding functionality to the Linspire operating system and our CNR technology. Our software engineers collaborate with open source software development teams working via the Internet. This collaboration enables us to use the latest technical advances, coordinate plans for development of new features and timing of releases on the Linux desktop and leverage the development of the Linux kernel and other open source projects.

      Our software development engineers perform extensive testing of the Linspire operating system and our CNR technology to ensure that they are properly assembled and work coherently from the user’s perspective. We use industry standard methods of quality assurance testing to ensure that our technologies are solidly engineered and ready for use by our customers when shipped.

Intellectual Property

      Our success and ability to compete depend in part on our ability to protect the proprietary components of the Linspire operating system and CNR technology. We rely on trademark, copyright and trade secret laws and restrictions in the United States and other jurisdictions, together with contractual restrictions, to protect our proprietary rights. We typically enter into confidentiality and invention agreements with our employees and contractors, and nondisclosure agreements with our channel partners to limit access to and distribution and disclosure of our proprietary information.

      Our Linux-based operating systems, application software and services rely on a combination of open source and proprietary software programs. The open source programs have been developed and made available for licensing under the GNU General Public License and similar open source licenses. These licenses generally permit anyone to copy, modify and re-distribute the open source software, provided that any re-distribution includes access to the source code of the modified software, and includes the right to further copy, modify and re-distribute the source and object code. The proprietary technologies include software programs that we have developed ourselves and software programs developed by third parties. These proprietary programs cannot be modified, copied or distributed without our consent.

      We have pursued registration of some of our trademarks in the United States with the U.S. Patent and Trademark Office. We have federal registrations pending for our trademarks “Lindows.com,” “LindowsOS,” and “CNR.” We also have a federal registration pending for our trademark “Linspire.” Microsoft has initiated opposition proceedings to our applications for “Lindows.com” and “LindowsOS” on the grounds that Microsoft believes those marks infringe upon Microsoft’s “WINDOWS” trademarks. Microsoft has also sued us in the United States and several other countries alleging, among other things, that the Lindows name infringes various Microsoft WINDOWS trademarks. We have asserted that Microsoft’s WINDOWS trademarks are unenforceable and invalid because we believe the term “windows” is generic, and a generic term can never be subject to trademark protection. We also have asserted that Microsoft committed fraud on the U.S. Patent and Trademark Office and is pursuing its opposition for anti-competitive purposes. Finally, we have asserted that the use of the Lindows name does not result in confusion with Microsoft’s WINDOWS trademarks.

      The U.S. Patent and Trademark Office has suspended the opposition proceedings pending a final resolution of the U.S. lawsuit. We are vigorously defending all the lawsuits that Microsoft has

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initiated in an effort to preserve the goodwill of the Lindows name. However, we may not prevail, and we are currently prohibited from using the “Lindows” name in several foreign countries as a result of Microsoft’s lawsuits. Accordingly, in an effort to avoid violating court orders in foreign countries, we have recently adopted “Linspire” as an alternative name for our commerce website and products and services. As a result of our alternative name strategy, we could lose the benefit of our existing trademark applications for the Lindows name, as well as the goodwill associated with the Lindows name.

      Over time, we intend to introduce new trademarks, service marks and brand names and maintain registrations on trademarks that remain valuable to our business. Please see “Business — Legal Proceedings” for more description of our litigation with Microsoft.

      Despite our efforts to protect our trademark rights, unauthorized third parties have in the past attempted and in the future may attempt to infringe our trademark rights. We cannot be certain that we will succeed in preventing the continued infringement of our tradename and trademarks in these circumstances or that we will be able to prevent this type of unauthorized use in the future. The laws of some foreign countries do not protect our trademark rights to the same extent as do the laws of the United States. In addition, policing unauthorized use of our trademark rights is difficult, expensive and time consuming. The loss of any material trademark or trade name could have a material adverse effect on our business, operating results and financial condition.

      Although we do not believe that our products infringe the rights of third parties, third parties may assert infringement claims against us which may result in costly litigation or require us to obtain a license to third-party intellectual property rights. There can be no assurance that such licenses will be available on reasonable terms or at all, which could have a material adverse effect on our business, operating results and financial condition.

Competition

      In the general market for desktop operating systems, we compete with both Linux-based and non-Linux-based operating systems. Our non-Linux-based competitors include a number of large and well-established companies that have significantly greater financial resources, larger development staffs and more extensive marketing and distribution capabilities. These competitors include Microsoft, Apple, Novell, IBM, Sun Microsystems, and SCO. In the newer and rapidly evolving Linux-based desktop operating system market, we compete with a number of well-respected vendors and development projects including Red Hat’s Fedora, Mandrake, Xandros, Turbolinux, which was recently acquired by Livedoor and SuSE, which was recently acquired by Novell. Some of these competitors have established and stable customer bases and continue to attract new customers, with Red Hat being one of the most dominant players in the market. In addition, we face potential competition from several companies with larger customer bases and greater financial resources and name recognition than we have, such as Sun Microsystems, Corel Corp. and Cygnus Solutions, each of which has indicated a growing interest in the Linux-based operating system market. The desktop application software market is more fragmented than the desktop operating system market, with many competitors selling consumer, education and business-oriented application software for various platforms.

      We compete primarily on the basis of product cost, performance, reliability, and functionality; name and reputation of the vendor; distribution strength and number of channel partners; service and support; and strength of relationships in the open source community. We believe that we compare favorably to many of our current competitors with respect to some or all of these factors.

Employees

      As of March 31, 2004, we had a total of 62 employees. Of the total employees, 38 were in software engineering, 11 in sales and marketing, 6 in customer service and technical support, and 7 in finance and administration. Our future success will depend in part on our ability to attract, retain

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and motivate highly qualified technical and management personnel, for whom competition is intense. Our employees are not represented by any labor union and are not organized under a collective bargaining agreement, and we have never experienced a work stoppage. We believe our relations with our employees are good.

Facilities

      Our headquarters are currently located in a leased facility in San Diego, California, consisting of approximately 26,280 square feet under a three-year lease that will expire on September 30, 2006. We believe that additional space will be required as our business expands and will be available on acceptable terms.

Legal Proceedings

     Microsoft Litigation

      On December 20, 2001, Microsoft initiated an action against us in U.S. District Court for the Western District of Washington. This action asserts that our use of the Lindows mark violates U.S. trademark law and U.S. and Washington state unfair competition laws. Microsoft seeks injunctive relief preventing us from using the name Lindows in connection with our software or other computer products or services. Microsoft also seeks monetary damages, including treble damages, attorneys’ fees and costs.

      We have asserted several defenses and a counterclaim in this lawsuit. We assert that Microsoft’s WINDOWS trademarks are unenforceable and invalid because we believe the term “windows” is generic, and a generic term can never be subject to trademark protection. We also assert that Microsoft committed fraud on the U.S. Patent and Trademark Office and is pursuing this action for anti-competitive purposes. Finally, we assert that the use of the Lindows name does not result in confusion with Microsoft’s WINDOWS trademarks.

      Microsoft requested that the court bar us from using the Lindows mark pending the court proceedings, but the court was unwilling to do so. We asked the court to rule in our favor without the need for a jury trial, but the court declined.

      Trial has been postponed a number of times. The court postponed trial indefinitely pending Microsoft’s appeal of the court’s February 10, 2004 ruling. In that ruling, the court determined that it would instruct the jury to consider whether “windows” was a generic term before Microsoft introduced software with that name in November 1985. Microsoft had argued that the jury should consider whether “windows” is now a generic term. We are contesting Microsoft’s appeal. The court has ruled that we can continue to use our marks throughout the course of the litigation.

      On November 28, 2003, Microsoft initiated an action against us in the Helsinki District Court of Finland. The action asserted that our use of the Lindows name violated Finland’s trademark law. Microsoft sought injunctive relief to prevent us from using the Lindows name in connection with our software or other computer products or services distributed in Finland. Microsoft also sought monetary damages in the form of attorneys’ fees and costs.

      Microsoft initiated similar actions against us in the Stockholm City Court in Sweden on December 8, 2003, the District Court in Amsterdam on December 11, 2003, the Tribunal de Grande Instance de Paris, or Paris Civil Court, on December 4, 2003, the Federal Court in Canada on February 11, 2004, and the Madrid First Instance Court in Spain on February 3, 2004. Microsoft included trademark violation claims against our French distributor, Hermitage Solutions, Inc., in the France lawsuit and our Canadian channel partner, South West Shore Development Authority, in the Canada lawsuit. Microsoft has threatened to bring trademark infringement actions against our distributors in South Africa and has indicated in legal papers filed in the U.S. action that it has filed suit in Mexico. As of the date of this prospectus, however, we have not received notice from Microsoft that actions have been initiated in South Africa.

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      All of the foreign lawsuits Microsoft has initiated seek monetary damages in the form of attorneys’ fees and costs. We expect that Microsoft will pursue additional monetary damages in each of these lawsuits and has already done so in France and Sweden. For instance, in the France lawsuit, Microsoft seeks compensation for damages allegedly sustained by reason of “acts of illegal imitation.” In Sweden, Microsoft alleges that it has been damaged in the form of reduced value of its goodwill and the dilution of the value of its trademark.

      Microsoft did not provide us with notice of the Finland and Sweden lawsuits until after the courts in those countries ruled in favor of Microsoft on its motions for injunctive relief. Accordingly, we had no opportunity to present a defense. We are now appealing these rulings. While the appeals are pending, we are prohibited from selling products with the Lindows name in Finland and Sweden. The Netherlands court also ruled in favor of Microsoft. The Netherlands court’s ruling prohibits us from selling products with the Lindows name in the Netherlands, Belgium and Luxembourg. The ruling also requires us to prohibit visitors from these countries from accessing our website to extent it uses the Lindows name. We are appealing this ruling by the Netherlands court. However, in order to comply with the ruling pending our appeal, we have adopted “Linspire” as an alternative name for our commerce website and our products and services.

      Our litigation with Microsoft is likely to continue well into the future. We intend to defend these lawsuits vigorously, but cannot assure you that they will be resolved in our favor. If the litigation is resolved in favor of Microsoft, Microsoft may be entitled to receive significant monetary damages from us, and we could be required to permanently drop our use of the Lindows name, which may result in a loss in goodwill associated with our Lindows brand name, customer confusion and a loss of sales. Furthermore, we may have to indemnify channel partners for losses they may suffer as a result of the Microsoft litigation.

     St. Paul Fire and Marine Insurance Company Litigation

      On February 3, 2002, our commercial general liability insurer, St. Paul Fire and Marine Insurance Company, or St. Paul, initiated a civil action against us in the U.S. District Court for the Central District of California. In this lawsuit, St. Paul sought declaratory relief that it had no duty to defend or indemnify us in connection with our litigation with Microsoft currently pending in the U.S. District Court for the Western District of Washington. Please see “Business — Legal Proceedings — Microsoft Litigation” for a description of our litigation with Microsoft. In support of this claim, St. Paul asserted that our insurance policy excludes litigation relating to the Lindows name because we used the Lindows name before the policy went into effect. St. Paul also asserted that it was entitled to deny coverage because we allegedly knew that using the Lindows name would result in a lawsuit by Microsoft.

      We asserted several defenses and a counterclaim in this lawsuit. We asserted that St. Paul has breached its contract with us and has acted in bad faith. We asked the court to give us monetary damages, including punitive damages, as well as a declaratory order by the court that St. Paul must defend and indemnify us in connection with the U.S. Microsoft litigation.

      Both parties filed motions for partial summary judgment. The court granted our motion and denied St. Paul’s motion. The court ruled that St. Paul had an obligation to defend us and had breached its contract by denying coverage. Based on this decision, the only remaining issues to be decided by the court are issues related to damages for St. Paul’s breach of contract, our bad faith claim against St. Paul for its failure to defend and St. Paul’s obligation to pay any liability that we may have to Microsoft. After the court granted our motion for partial summary judgment, St. Paul agreed to defend us in the U.S. Microsoft litigation, but reserved its right to appeal the court’s order after a final adjudication of the remaining issues in the lawsuit. The court then stayed the proceedings pending a final outcome in the U.S. Microsoft litigation.

      On January 6, 2004, we initiated a separate civil action against St. Paul in the U.S. District Court for the Central District of California. In this lawsuit, we assert that St. Paul has wrongfully

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denied us coverage in connection with the lawsuits Microsoft brought against us in Finland, Sweden, the Netherlands, and France. We are seeking monetary damages, including punitive damages, as well as a declaratory order by the court that St. Paul must fully defend and indemnify us in connection with the Microsoft litigation pending in Finland, Sweden, the Netherlands, and France.

      In response to our lawsuit, St. Paul sent us letters agreeing to pay partial defense costs for the lawsuits in Finland, Sweden, the Netherlands and France, subject to St. Paul’s reservation of its rights to deny coverage. In response to these letters we amended our complaint to address St. Paul’s refusal to pay complete defense costs and its reservation of rights. In addition, St. Paul recently sent us another letter stating that it will agree to pay defense costs for another lawsuit filed against us in Canada, on the same terms as set forth above with respect to the lawsuits in Finland, Sweden, the Netherlands and France, and has indicated that it also will agree to defend us against a lawsuit filed by Microsoft in Spain, on the same conditions. We intend to amend our complaint to add the Canada and Spain lawsuits.

      St. Paul has filed an answer to our amended complaint and a counterclaim. St. Paul seeks a declaratory order that it has no duty to defend or indemnify us in connection with the lawsuits in Finland, Sweden, the Netherlands and France. It also seeks a declaratory order that any attorneys’ fees it is obligated to pay be at a reduced hourly rate.

      Both of our lawsuits with St. Paul may proceed for an extended period of time. We intend to pursue our rights in the lawsuits vigorously, but cannot assure you that they will be resolved in our favor. If St. Paul appeals the decision relating to its obligations to us with respect to Microsoft’s U.S. litigation and is successful, we may be forced to reimburse St. Paul for some or all of the legal fees and costs it has paid to us, and continues to pay to us, in the Microsoft U.S. litigation. Additionally, although we believe our carrier is contractually bound to indemnify us for damages or other amounts we may be forced to pay Microsoft as a result of the U.S. litigation, up to the applicable policy limits, the court has not ruled on this point. Even if we are successful on an appeal by our carrier relating to its obligation to bear the cost of our legal defense, our carrier might have no obligation to reimburse us for any damages or other amounts we may be forced to pay Microsoft as a result of the U.S. litigation.

      If we are unsuccessful in our lawsuit with St. Paul relating to the foreign litigation, we also may be forced to reimburse St. Paul for some or all legal fees and costs it has paid to us, and continues to pay to us, relating to the foreign litigation, and St. Paul might have no obligation to reimburse us for any amounts we may be forced to pay Microsoft as a result of the foreign litigation.

     Xandros Litigation

      On December 13, 2002, we initiated a civil action against Xandros, Inc., Linux Global Partners, Inc., Michael Bego, and William Jay Roseman in U.S. District Court for the Southern District of California. Our action asserts that Xandros, Inc., Linux Global Partners, Inc., Michael Bego, and William Jay Roseman fraudulently induced us to loan Xandros, Inc. $750,000 in exchange for convertible promissory notes. Xandros, Inc. then failed to repay the promissory notes when they became due. We are seeking $750,000, plus interest, attorneys’ fees and punitive damages. This lawsuit is in the discovery phase, and may proceed for an extended period of time. We intend to pursue the lawsuit vigorously, but cannot assure you that it will be resolved in our favor. Additionally, even if the court rules in our favor, we cannot assure you that we will be able to collect the amounts owed.

      Other than the immediately preceding discussion, we are not currently a party to any material legal proceedings.

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MANAGEMENT

Executive Officers and Directors

      The following table sets forth certain information concerning our executive officers and directors:

             
Name Age Position(s)



Michael L. Robertson
    36     Chairman and Chief Executive Officer
Kevin B. Carmony
    44     President, Chief Operating Officer and Director
Chad H. Olson
    45     Chief Financial Officer
Thomas C. Welch
    41     Chief Technology Officer
Rex E. Bosen(1)(2)(3)
    45     Director
David S. Buzby(1)(2)(3)
    44     Director
Robin D. Richards(1)(2)(3)
    47     Director


(1)  Member of the nominating and corporate governance committee
 
(2)  Member of the compensation committee
 
(3)  Member of the audit committee

      Michael L. Robertson is our founder and has served as our Chairman and Chief Executive Officer since September 2001. Prior to founding us, Mr. Robertson founded MP3.com, a publicly-traded company which focused on storage, management, promotion, and delivery of digital music. Mr. Robertson served as MP3.com’s Chief Executive Officer and Chairman of the Board from March 1998 to August 2001, when it was acquired by Vivendi Universal. From September 1995 to March 1998, Mr. Robertson operated several websites that focused on merging search technologies with commerce. From September 1995 to September 1996, Mr. Robertson was President and Chief Executive Officer of Media Minds, Inc., a developer of digital picture software. From January 1994 to August 1995, Mr. Robertson was President and Chief Executive Officer of MR Mac Software, a developer of networking and security tools. From July 2003 to the present, Mr. Robertson has served as the founder and Chief Executive Officer of SIPphone, Inc., a company that uses the Internet to allow customers to make free long distance phone calls. From January 2002 to July 2003, Mr. Robertson served as Chairman of Gamespy, now IGN/ Gamespy, an Internet gaming and entertainment company. Mr. Robertson holds a B.A. in cognitive science from the University of California, San Diego.

      Kevin B. Carmony has served as our President and Chief Operating Officer since September 2001 and has served as a member of our board of directors since April 2004. Prior to joining us in July 2001, Mr. Carmony served as a Project Director for MP3.com from April 2001 to July 2001. From March 2000 to March 2001, Mr. Carmony served as President of NewVox Records, a record company for independent musicians. From August 1998 to March 2000, Mr. Carmony served as founder and Chief Executive Officer of TrueVerse Management, a music management firm for recording artists. From August 1995 to August 1998, Mr. Carmony was a co-founder and Vice President of Franchise Sales for I.N.V.U. Portraits, a chain of children’s vintage photography franchises. From January 1994 to August 1995, Mr. Carmony was President of I.N.V.U., Inc., an apparel manufacturing company. Mr. Carmony served as Vice President of Technology of Franklin Covey Co., an international learning and performance solutions company, from March 1992 to January 1994. From July 1989 to March 1992, Mr. Carmony served as founder and Chief Executive Officer of NewQuest Technologies, Inc., developer of the personal information management software Ascend, which was acquired by Franklin Covey in March 1992. From January 1983 to July 1989, Mr. Carmony served as founder and Chief Executive Officer of Streamlined Information Systems, Inc., a company that specialized in point-of-sale automation systems for retail operations. Mr. Carmony is also a co-founder and current director of Sadie’s, LLC, a national chain of mall-based children’s digital photography stores, as well as a board member of Awake Community, a

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not-for-profit organization. Mr. Carmony holds a B.A. in business administration from Weber State University.

      Chad H. Olson has served as our Chief Financial Officer since April 2003. From August 2000 to April 2003, Mr. Olson was the co-founder, Chief Executive Officer and a director of Sadie’s, LLC, a national chain of mall-based children’s digital photography stores. Mr. Olson continues to serve as a director of Sadie’s. From August 1995 to July 2000, Mr. Olson was a co-founder, Chief Executive Officer and President of I.N.V.U. Portraits, a chain of children’s vintage photography franchises. In October 1993, Mr. Olson founded I.N.V.U., Inc., an apparel manufacturing company, for which Mr. Olson served as Chief Executive Officer until August 1995. Mr. Olson was also the co-founder, Chairman and Chief Executive Officer of The Pro Image, Inc. from its inception in September 1985 until October 1993 when the company was sold. The Pro Image was a franchise chain of over 202 sports fan gift and apparel stores located in regional shopping malls in 46 states, Canada, Germany, Puerto Rico and Japan. Mr. Olson holds a B.S. in accounting from Weber State University. Mr. Olson is the brother-in-law of Thomas C. Welch, our Chief Technology Officer.

      Thomas C. Welch has served as our Chief Technology Officer since January 2002. From August 2001 to December 2001, Mr. Welch was a partner with QRQ Technologies, a professional services firm specializing in consultation and development of customized applications for various clients. From December 1999 until August 2001, Mr. Welch served as President of KnowledgeTrack Professional Services. From January 1994 to December 1999, Mr. Welch served as the founder, President and Chief Executive Officer of Axiom Technologies Ltd., which specialized in commercial quality software development and professional services for clients such as Franklin Covey Co., Rexall Corporation and Shaklee Corporation. Axiom Technologies was purchased by KnowledgeTrack Corporation in December 1999. From March 1992 to December 1993, Mr. Welch served as Director of Software Development at Franklin Covey Co., an international learning and performance solutions company. From July 1989 to March 1992 Mr. Welch served as Director of Software Development for NewQuest Technologies, Inc., where he developed the personal information management software, Ascend. Mr. Welch attended Brigham Young University and Weber State University. Mr. Welch is the brother-in-law of Chad H. Olson, our Chief Financial Officer.

      Rex E. Bosen has served as a member of our board of directors since April 2004. Since September 2002, Mr. Bosen has been Vice President, Finance and Accounting of Provide Commerce, Inc., a publicly-traded company that operates an e-commerce marketplace of websites for perishable goods. Prior to joining Provide Commerce, Mr. Bosen was a self-employed tax accountant from January 2001 through September 2002. From September 1999 through January 2001, Mr. Bosen co-founded and served as Chief Financial Officer at PhatPipe, Inc., a start-up company involved with the provision of high speed Internet access and e-commerce. From September 1992 through October 1999, Mr. Bosen served as the Controller at E/ G Electro-graph, Inc., a manufacturing company. From August 1984 to September 1992, Mr. Bosen was an accountant with Price Waterhouse. Mr. Bosen holds an MACC and B.S. in accounting from Brigham Young University.

      David S. Buzby has served as a member of our board of directors since April 2004. Since January 1992, Mr. Buzby has been a private equity investor investing in and managing early stage technology and environmental companies. From June 1999 to September 2000, Mr. Buzby was the Chief Operating Officer and a founding investor of Internet Barter, Inc., an international business-to-business e-commerce barter exchange. From August 1994 to January 1999, Mr. Buzby worked with Best Internet, a web hosting company. Mr. Buzby held various positions at Best Internet, including Chief Financial Officer and Vice Chairman of the board and was a founding investor. Since May 1999, Mr. Buzby has been a director of ValueClick, Inc., a publicly-traded company that provides a range of products and services relating to online marketing. Mr. Buzby also serves on the boards of several private companies. Mr. Buzby holds a B.A. in political science from Middlebury College and an M.B.A. from Harvard Business School.

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      Robin D. Richards has served as a member of our board of directors since April 2004. Mr. Richards is currently the Chairman and Chief Executive Officer of Notification Technologies, Inc., which does business under the name Partnership for Academic and Community Excellence, or PACE. PACE provides Internet-to-phone-based communication among schools, parents, students, and faculty. From December 2002 to June 2003, Mr. Richards was the President and Chief Operating Officer of the Prostate Cancer Foundation, for which he continues to serve as a director. From January 1999 to August 2001, Mr. Richards served as the President and a director of MP3.com, a publicly-traded company which focused on storage, management, promotion and delivery of digital music. He also served as the Chief Operating Officer of MP3.com from January 1999 to January 2001. After Vivendi Universal acquired MP3.com in August 2001, Mr. Richards served as the Chief Executive Officer of Vivendi Universal Net USA, a company created to oversee the U.S. Internet-related companies owned by Vivendi Universal. From October 1998 to January 1999 Mr. Richards served as Managing Director of Tickets.com, Inc., an Internet ticketing company. Prior to Tickets.com, Mr. Richards served as the founder, President and Chief Executive Officer of Lexi International, a teleservices and database management company. Mr. Richards also currently serves as the President of the Chase Foundation, an organization that provides funds to terminally ill children who have been hospitalized in the Los Angeles area. Mr. Richards holds a B.S. in political science from Michigan State University and attended Whittier College School of Law.

Classified Board of Directors

      Our board of directors currently has five members. Our restated certificate of incorporation and restated bylaws provide for a classified board of directors consisting of three classes of directors, each serving staggered three-year terms. As a result, stockholders will elect a portion of our board of directors each year. Class I directors’ terms will expire at the first annual meeting of stockholders following the completion of this offering, Class II directors’ terms will expire at the second annual meeting of stockholders following the completion of this offering, and Class III directors’ terms will expire at the third annual meeting of stockholders following the completion of this offering. The Class I directors are                     and                     , the Class II directors are  and                     and the Class III director is                     . At each annual meeting of stockholders held after the initial classification, the successors to directors whose terms will then expire will be elected to serve from the time of election until the third annual meeting following election. The division of our board of directors into three classes with staggered terms may delay or prevent a change of our management or a change in control.

      In addition, our restated bylaws provide that the authorized number of directors which shall constitute the whole board of directors may be changed by a resolution duly adopted by the board of directors or by the holders of at least 66 2/3% of our outstanding voting stock. Any additional directorships resulting from an increase in the number of directors will be distributed among the three classes so that, as nearly as possible, each class will consist of one-third of the total number of directors.

Board Committees

      Our board of directors has an audit committee, a compensation committee and a nominating and corporate governance committee.

      Audit Committee. Our audit committee currently consists of Messrs. Bosen, Buzby and Richards, each of whom is a non-management member of our board of directors. The functions of this committee include:

  •  meeting with our management periodically to consider the adequacy of our internal controls and the objectivity of our financial reporting;
 
  •  meeting with our independent auditors and with internal financial personnel regarding these matters;

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  •  recommending to our board of directors the engagement of our independent auditors;
 
  •  reviewing our audited financial statements and reports and discussing the statements and reports with our management and our independent auditors, including any significant adjustments, management judgments and estimates, new accounting policies and disagreements with management; and
 
  •  reviewing our financial plans and reporting recommendations to our full board for approval and to authorize action.

      Both our independent auditors and internal financial personnel regularly meet privately with our audit committee and have unrestricted access to this committee. We believe that the composition of our audit committee meets the criteria for independence under, and the functioning of our audit committee complies with the applicable requirements of, the Sarbanes-Oxley Act of 2002, the current rules of the Nasdaq Stock Market and Securities and Exchange Commission rules and regulations. We intend to comply with future audit committee requirements as they become applicable to us.

      Compensation Committee. Our compensation committee currently consists of Messrs. Bosen, Buzby and Richards, each of whom is a non-management member of our board of directors. The functions of this committee include:

  •  reviewing and, as it deems appropriate, recommending to our board of directors, policies, practices and procedures relating to the compensation of our directors, officers and other managerial employees and the establishment and administration of our employee benefit plans;
 
  •  exercising authority under our employee benefit plans; and
 
  •  advising and consulting with our officers regarding managerial personnel and development.

      Nominating and Corporate Governance Committee. Our nominating and corporate governance committee currently consists of Messrs. Bosen, Buzby and Richards, each of whom is a non-management member of our board of directors. The functions of this committee include:

  •  reviewing and recommending nominees for election as directors;
 
  •  assessing the performance of the board of directors;
 
  •  developing guidelines for board composition; and
 
  •  reviewing and administering our corporate governance guidelines and considering other issues relating to corporate governance.

Director Compensation

      In April 2004, we established a non-employee director compensation program. We currently do not pay any cash compensation to our directors for their service as directors. Directors are reimbursed for reasonable out-of-pocket expenses in connection with attending meetings of our board of directors and committees of the board of directors. In connection with each non-employee director’s election to our board of directors, we grant to the director an option to purchase 100,000 shares of common stock at an exercise price per share equal to the fair market value of our common stock at the date of grant. These options vest and become exercisable on a monthly basis over four years, and they become fully vested and exercisable if we experience a change of control. In addition, each non-employee director who is re-elected to the board of directors at an annual meeting of our stockholders will be granted a fully-vested option to purchase 20,000 shares of common stock at an exercise price per share equal to the fair market value of our common stock at the date of grant. Each year the chairman of our audit committee will receive an additional fully-vested option to purchase 30,000 shares of common stock and the chairman of each of our

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compensation committee and our nominating and corporate governance committee will receive an additional fully-vested option to purchase 20,000 shares of common stock.

      Pursuant to our non-employee director compensation program, in April 2004 our initial non-employee directors, Messrs. Bosen, Buzby and Richards, each received their initial option to purchase 100,000 shares of common stock and we also granted to Messrs. Bosen, Buzby and Richard their annual option grants under the program. These annual grants included options to purchase 50,000 shares of common stock in the case of Mr. Bosen and options to purchase 40,000 shares of common stock in the case of Messrs. Buzby and Richards.

Compensation Committee Interlocks and Insider Participation

      None of our executive officers serves as a member of the board of directors or compensation committee of any other company that has one or more executive officers serving as a member of our board of directors or compensation committee. Our full board of directors made all compensation decisions prior to the creation of our compensation committee.

Executive Compensation

      The following table summarizes information concerning the compensation awarded to, earned by or paid for services rendered to us in all capacities during the fiscal year ended December 31, 2003 by our Chief Executive Officer and our three other most highly compensated executive officers whose salary and bonus for fiscal 2003 exceeded $100,000. We refer to these executives as our named executive officers elsewhere in this prospectus. No other individuals served as our executive officers during 2003.

Summary Compensation Table

                                           
Long term
compensation
Annual compensation

Securities
Other annual underlying All other
Name and principal position Salary Bonus compensation options compensation






Michael L. Robertson
  $ 14,040     $                    
  Chief Executive Officer                                        
Kevin B. Carmony
    99,000       25,000                    
  President and Chief Operating Officer                                        
Chad H. Olson(1)
    65,100       5,000             1,000,000        
  Chief Financial Officer                                        
Thomas C. Welch
    140,000       10,000                    
  Chief Technology Officer                                        


(1)  Mr. Olson began his employment with us in April 2003.

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Stock Option Grants in Last Fiscal Year

      The following table summarizes the stock options granted to each named executive officer during the fiscal year ended December 31, 2003. No stock appreciation rights were granted during the year. All options were granted under the 2001 stock incentive plan.

                                                 
Potential
Option grants in last fiscal year realizable value

at assumed
Percent of annual rates of
Number of total options stock price
securities granted to appreciation for
underlying employees Exercise options terms(1)
options in fiscal price per Expiration
Name granted year share date 5% 10%







Michael L. Robertson
                                   
Kevin B. Carmony
                                   
Chad H. Olson
    1,000,000       59 %   $ 0.0095       04/01/2013     $       $    
Thomas C. Welch
                                   


(1)  Potential realizable value is based upon the assumed initial public offering price of our common stock of $                    , which is the midpoint of the range listed on the cover of this prospectus. Potential realizable values are net of exercise price, but before taxes associated with exercise. Amounts per share representing hypothetical gains are those that could be achieved if options are exercised at the end of the option term. The assumed 5% and 10% rates of stock price appreciation are provided in accordance with the rules of the Securities and Exchange Commission based on the assumed initial public offering price of $                     per share and do not represent our estimate or projection of the future common stock price.

Option Exercises in Last Fiscal Year and Fiscal Year-End Option Values

      The following table sets forth certain information regarding exercised stock options during the fiscal year ended December 31, 2003 and unexercised options held as of December 31, 2003, by each of the named executive officers. There was no public trading market for our common stock as of December 31, 2003. Accordingly, these values have been calculated on the basis of the initial public offering price of $                    , less the applicable exercise price per share, multiplied by the number of shares issued or issuable, as the case may be, on the exercise of the option. All options were granted under our 2001 stock incentive plan.

                                                 
Number of securities
underlying unexercised Value of unexercised
options at in-the-money options at
Shares December 31, 2003 December 31, 2003
acquired Value

Name on exercise realized Exercisable Unexercisable Exercisable Unexercisable







Michael L. Robertson
                                   
Kevin B. Carmony
                                   
Chad H. Olson
                250,000       750,000     $       $    
Thomas C. Welch
                500,000       500,000     $       $    

Employment Agreements

      Employment Agreement with Michael L. Robertson. In April 2004, we entered into an employment agreement with Michael L. Robertson, our Chairman and Chief Executive Officer. The agreement provides for a base salary of $410,000 per year, to be reviewed and adjusted from time to time in accordance with our procedures for adjusting salaries for senior executives. The agreement also provides that Mr. Robertson is eligible to receive an annual bonus of up to 25% of his annual base salary, subject to his attainment of reasonable corporate goals and objectives to be

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established annually by our board of directors (or compensation committee) with the assistance and agreement of Mr. Robertson. In addition, pursuant to the agreement, we granted to Mr. Robertson options to purchase 1,500,000 shares of our common stock, at an exercise price of $2.50 per share, which our board of directors determined to be the fair market value per share of our common stock at the date of grant. These options vest on a monthly basis over four years. The agreement also provides that, if we experience a change in control, then all non-vested options to purchase shares of our common stock granted to Mr. Robertson may immediately become vested, in the discretion of the administrator of the plans under which the options are granted.

      The agreement provides that Mr. Robertson is an at will employee, which means he or we can terminate his employment at any time, with or without cause. If we terminate Mr. Robertson’s employment without cause (as defined in the agreement), Mr. Robertson terminates his employment for good reason (as defined in the agreement) or if Mr. Robertson dies or becomes disabled as a direct result of business-related activities within nine months of the date of the agreement, then:

  •  Mr. Robertson is entitled to receive severance equal to the amount of the annual base salary and bonus that he would have earned during the severance period if he had remained employed with us;
 
  •  we will continue to make available to Mr. Robertson the benefits made generally available to our employees, to the extent permitted under applicable law and the terms of the benefit plans; and
 
  •  all non-vested options to purchase shares of our common stock granted to Mr. Robertson will immediately become vested.

The agreement provides that, if Mr. Robertson’s employment is terminated on or before the first anniversary of the date of the agreement, then the severance period will be the period beginning on the date of his termination and ending on the third anniversary of the date of the agreement. Otherwise, the severance period will be the 24-month period immediately following the date of his termination.

      Employment Agreement with Kevin B. Carmony. In April 2004, we entered into an employment agreement with Kevin B. Carmony, our President and Chief Operating Officer. The agreement provides for a base salary of $275,000 per year, to be reviewed and adjusted from time to time in accordance with our procedures for adjusting salaries for senior executives. The agreement also provides that Mr. Carmony is eligible to receive an annual bonus of up to 25% of his annual base salary, subject to his attainment of reasonable corporate goals and objectives to be established annually by our Chief Executive Officer (or compensation committee) with the assistance and agreement of Mr. Carmony. In addition, pursuant to the agreement, we granted to Mr. Carmony options to purchase 1,000,000 shares of our common stock, at an exercise price of $2.50 per share, which our board of directors determined to be the fair market value per share of our common stock at the date of grant. These options vest on a monthly basis over four years. The agreement also provides that, if we experience a change in control, then all non-vested options to purchase shares of our common stock granted to Mr. Carmony may immediately become vested, in the discretion of the administrator of the plans under which the options are granted.

      The agreement provides that Mr. Carmony is an at will employee, which means he or we can terminate his employment at any time, with or without cause. If we terminate Mr. Carmony’s employment without cause (as defined in the agreement), Mr. Carmony terminates his employment for good reason (as defined in the agreement) or if Mr. Carmony dies or becomes disabled as a direct result of business-related activities within nine months of the date of the agreement, then:

  •  Mr. Carmony is entitled to receive severance equal to the amount of the annual base salary and bonus that he would have earned during the severance period if he had remained employed with us;

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  •  we will continue to make available to Mr. Carmony the benefits made generally available to our employees, to the extent permitted under applicable law and the terms of the benefit plans; and
 
  •  all non-vested options to purchase shares of our common stock granted to Mr. Carmony will immediately become vested.

      The agreement provides that, if Mr. Carmony’s employment is terminated on or before the first anniversary of the date of the agreement, then the severance period will be the period beginning on the date of his termination and ending on the third anniversary of the date of the agreement. Otherwise, the severance period will be the 24-month period immediately following the date of his termination.

      Employment Agreement with Chad H. Olson. In April 2004, we entered into an employment agreement with Chad H. Olson, our Chief Financial Officer. The agreement provides for a base salary of $240,000 per year, to be reviewed and adjusted from time to time in accordance with our procedures for adjusting salaries for senior executives. The agreement also provides that Mr. Olson is eligible to receive an annual bonus of up to 25% of his annual base salary, subject to his attainment of reasonable corporate goals and objectives to be established annually by our Chief Operating Officer and President (or compensation committee) with the assistance and agreement of Mr. Olson. In addition, pursuant to the agreement, we granted to Mr. Olson options to purchase 750,000 shares of our common stock, at an exercise price of $2.50 per share, which our board of directors determined to be the fair market value per share of our common stock at the date of grant. These options vest on a monthly basis over four years. The agreement also provides that, if we experience a change in control, then all non-vested options to purchase shares of our common stock granted to Mr. Olson may immediately become vested, in the discretion of the administrator of the plans under which the options are granted.

      The agreement provides that Mr. Olson is an at will employee, which means he or we can terminate his employment at any time, with or without cause. If we terminate Mr. Olson’s employment without cause (as defined in the agreement), Mr. Olson terminates his employment for good reason (as defined in the agreement) or if Mr. Olson dies or becomes disabled as a direct result of business-related activities within nine months of the date of the agreement, then:

  •  Mr. Olson is entitled to receive severance equal to the amount of the annual base salary and bonus that he would have earned during the severance period if he had remained employed with us;
 
  •  we will continue to make available to Mr. Olson the benefits made generally available to our employees, to the extent permitted under applicable law and the terms of the benefit plans; and
 
  •  all non-vested options to purchase shares of our common stock granted to Mr. Olson will immediately become vested.

      The agreement provides that, if Mr. Olson’s employment is terminated on or before the first anniversary of the date of the agreement, then the severance period will be the period beginning on the date of his termination and ending on the third anniversary of the date of the agreement. Otherwise, the severance period will be the 24-month period immediately following the date of his termination.

      Employment Agreement with Thomas C. Welch. In April 2004, we entered into an employment agreement with Thomas C. Welch, our Chief Technology Officer. The agreement provides for a base salary of $200,000 per year, to be reviewed and adjusted from time to time in accordance with our procedures for adjusting salaries for senior executives. The agreement also provides that Mr. Welch is eligible to receive an annual bonus of up to 25% of his annual base salary, subject to his attainment of reasonable corporate goals and objectives to be established annually by our Chief

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Operating Officer and President (or compensation committee) with the assistance and agreement of Mr. Welch. In addition, pursuant to the agreement, we granted to Mr. Welch options to purchase 750,000 shares of our common stock, at an exercise price of $2.50 per share, which our board of directors determined to be the fair market value per share of our common stock at the date of grant. These options vest on a monthly basis over four years. The agreement also provides that, if we experience a change in control, then all non-vested options to purchase shares of our common stock granted to Mr. Welch may immediately become vested, in the discretion of the administrator of the plans under which the options are granted.

      The agreement provides that Mr. Welch is an at will employee, which means he or we can terminate his employment at any time, with or without cause. If we terminate Mr. Welch’s employment without cause (as defined in the agreement), Mr. Welch terminates his employment for good reason (as defined in the agreement) or if Mr. Welch dies or becomes disabled as a direct result of business-related activities within nine months of the date of the agreement, then:

  •  Mr. Welch is entitled to receive severance equal to the amount of the annual base salary and bonus that he would have earned during the severance period if he had remained employed with us;
 
  •  we will continue to make available to Mr. Welch the benefits made generally available to our employees, to the extent permitted under applicable law and the terms of the benefit plans; and
 
  •  all non-vested options to purchase shares of our common stock granted to Mr. Welch will immediately become vested.

      The agreement provides that, if Mr. Welch’s employment is terminated on or before the first anniversary of the date of the agreement, then the severance period will be the period beginning on the date of his termination and ending on the third anniversary of the date of the agreement. Otherwise, the severance period will be the 24-month period immediately following the date of his termination.

Benefit Plans

      2004 Stock Incentive Plan. Our board of directors and our stockholders approved our 2004 stock incentive plan in  2004. We have reserved                      shares of our common stock for issuance under our 2004 stock incentive plan, subject to adjustment for a stock split, or any future stock dividend or other similar change in our common stock or our capital structure. The number of shares initially reserved under the 2004 stock incentive plan will be increased by any shares (up to a maximum of                      shares) represented by awards under our 2001 stock incentive plan that are forfeited, expire or are cancelled on or after the effective date of the registration statement relating to this offering. Commencing on the first business day of each calendar year beginning in 2005, the number of shares of stock reserved for issuance under the 2004 stock incentive plan (including issuance as incentive stock options) will be increased annually by a number equal to the lesser of (a)                     % of the total number of shares outstanding as of that date, (b)                      shares, or (c) a lesser number of shares determined by the board. No awards have yet been granted under the 2004 stock incentive plan and therefore                      shares of common stock remain available for grant.

      Our 2004 stock incentive plan provides for the grant of stock options, restricted stock, restricted stock units, stock appreciation rights and dividend equivalent rights, collectively referred to as “awards.” Stock options granted under the 2004 stock incentive plan may be either incentive stock options under the provisions of Section 422 of the Internal Revenue Code, or non-qualified stock options. Incentive stock options may be granted only to employees. Awards other than incentive stock options may be granted to employees, directors and consultants.

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      The board of directors or a committee designated by the board, referred to as the “plan administrator”, will administer our 2004 stock incentive plan, including selecting the optionees, determining the number of shares to be subject to each award, determining the exercise or purchase price of each award and determining the vesting and exercise periods of each award.

      The exercise price of all incentive stock options granted under our 2004 stock incentive plan must be at least equal to 100% of the fair market value of the common stock on the date of grant. If, however, incentive stock options are granted to an employee who owns stock possessing more than 10% of the voting power of all classes of our stock or the stock of any parent or subsidiary of us, the exercise price of any incentive stock option granted must equal at least 110% of the fair market value of the common stock at the date of grant and the maximum term of these incentive stock options must not exceed five years. The maximum term of an incentive stock option granted to any other participant must not exceed ten years. The plan administrator will determine the term and exercise or purchase price of all other awards granted under our 2004 stock incentive plan.

      Under the 2004 stock incentive plan, incentive stock options may not be sold, pledged, assigned, hypothecated, transferred or disposed of in any manner other than by will or by the laws of descent or distribution and may be exercised during the lifetime of the participant only by the participant. Other awards are transferable by will or by the laws of descent or distribution and to the extent provided in the award agreement. The 2004 stock incentive plan permits the designation of beneficiaries by holders of awards, including incentive stock options.

      In the event a participant in our 2004 stock incentive plan terminates service or is terminated by us without cause, any options which have become exercisable prior to the time of termination will remain exercisable for three months from the date of termination (unless a shorter or longer period of time is determined by the plan administrator). In the event a participant in our 2004 stock incentive plan is terminated by us for cause, any options which have become exercisable prior to the time of termination will immediately terminate. If termination was caused by death or disability, any options which have become exercisable prior to the time of termination, will remain exercisable for twelve months from the date of termination (unless a shorter or longer period of time is determined by the plan administrator). In no event may a participant exercise the option after the expiration date of the option.

      In the event of a corporate transaction where the acquiror assumes or replaces awards granted under the 2004 stock incentive plan, none of these awards will be subject to accelerated vesting. However, assumed or replaced awards will automatically become fully vested if the grantee is terminated by the acquiror without cause or terminates employment for good reason within 24 months after a corporate transaction. In the event of a corporate transaction where the acquiror does not assume or replace awards granted under the 2004 stock incentive plan, all of these awards become fully vested immediately prior to the consummation of the corporate transaction. Under our 2004 stock incentive plan, a corporate transaction is generally defined as:

  •  acquisition of 40% or more of our stock by any individual or entity including by tender offer or a reverse merger;
 
  •  a sale, transfer or other disposition of all or substantially all of the assets of our company;
 
  •  a merger or consolidation in which our company is not the surviving entity; or
 
  •  a complete liquidation or dissolution.

      Unless terminated sooner, our 2004 stock incentive plan will automatically terminate in 2014. Our board of directors will have the authority to amend or terminate our 2004 stock incentive plan. No amendment or termination of the 2004 stock incentive plan may adversely affect any rights under awards already granted to a participant unless agreed to by the affected participant. To the extent necessary to comply with applicable provisions of federal securities laws, state corporate and securities laws, the Internal Revenue Code, the rules of any applicable stock exchange or national

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market system, and the rules of any non-U.S. jurisdiction applicable to awards granted to residents therein, we must obtain stockholder approval of any such amendment to the 2004 stock incentive plan in such a manner and to such a degree as required.

      2004 Non-Employee Director Stock Option Program. Our 2004 non-employee director stock option program will be adopted as part of to the 2004 stock incentive plan and will be subject to the terms and conditions of the 2004 stock incentive plan. Our 2004 non-employee director stock option program was approved by our board of directors in                     2004. The 2004 non-employee director stock option program will become effective as of the effective date of this prospectus, and no awards will be made under this program until that time.

      The purpose of the 2004 non-employee director stock option program is to enhance our ability to attract and retain the best available non-employee directors, to provide them additional incentives and, therefore, to promote the success of our business.

      The 2004 non-employee director stock option program will establish an automatic option grant program for the grant of awards to non-employee directors, which will be consistent with the terms and conditions of the non-employee director compensation program that we established in April 2004, as described above under “Management — Director Compensation.” Under the 2004 non-employee director stock option program, in connection with each non-employee director’s election to our board of directors, we grant to the director an option to purchase 100,000 shares of common stock at an exercise price per share equal to the fair market value of our common stock at the date of grant. These options vest and become exercisable on a monthly basis over four years, and they become fully vested and exercisable if we experience a change of control. In addition, each non-employee director who is re-elected to the board of directors at an annual meeting of our stockholders will be granted a fully-vested option to purchase 20,000 shares of common stock at an exercise price per share equal to the fair market value of our common stock at the date of grant. Each year the chairman of our audit committee will receive an additional fully-vested option to purchase 30,000 shares of common stock and the chairman of each of our compensation committee and our nominating and corporate governance committee will receive an additional fully-vested option to purchase 20,000 shares of common stock. The term of each automatic option grant and the extent to which it will be transferable will be provided in the agreement evidencing the option.

      The 2004 non-employee director stock option program will be administered by the board or a committee designated by the board made up of two or more non-employee directors so that such awards would be exempt from Section 16(b) of the Exchange Act, referred to as the “program administrator.” The program administrator determines the terms and conditions of awards, and construe and interpret the terms of the program and awards granted under the program. Non-employee directors may also be granted additional awards under the 2004 stock incentive plan, subject to the discretion of the board or the committee.

      Unless terminated sooner, the 2004 non-employee director stock option program will terminate automatically in 2014 when the 2004 stock incentive plan terminates. Our board of directors will have the authority to amend, suspend or terminate the 2004 non-employee director stock option program. No amendment or termination of the 2004 non-employee director stock option program may adversely affect any rights under options already granted to a non-employee director unless agreed to by the affected non-employee director. The 2004 non-employee director stock option program was adopted by the board pursuant to its discretionary authority under the 2004 stock incentive plan to make option grants to non-employee directors. Accordingly, stockholder approval is not required for the adoption or any amendment of the 2004 non-employee director stock option program.

      2001 Stock Incentive Plan. The 2001 stock incentive plan was approved by our board of directors and our stockholders in December 2001. As of the date of this prospectus, we have a total of 10,625,000 shares of common stock reserved for issuance under the 2001 stock incentive plan, subject to adjustment for a stock split, or any future stock dividend or other similar change in our common stock or our capital structure. As of December 31, 2003, options to purchase 329,912

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shares of common stock had been exercised, options to purchase 4,309,938 shares of common stock were outstanding and 1,985,150 shares of common stock remained available for grant. As of December 31, 2003, the outstanding options were exercisable at a weighted average exercise price of approximately $0.0095 per share. In April 2004, we amended and restated the 2001 stock incentive plan to increase the number of shares of common stock reserved for issuance under the 2001 stock incentive plan from 6,625,000 shares to 10,625,000 shares.

      After the completion of this offering, no additional options will be granted under the 2001 stock incentive plan and all options granted under the 2001 stock incentive plan that expire without having been exercised or are cancelled will become available for grant under the 2004 stock incentive plan.

      Awards under the 2001 stock incentive plan may consist of incentive stock options (which are stock options that qualify under Section 422 of the Internal Revenue Code), non-qualified stock options and direct issuances of common stock.

      Under the 2001 stock incentive plan, the board may grant incentive stock options to employees, including officers and employee directors. Non-qualified stock options and stock issuances may be granted to employees, directors and consultants. The board of directors or a committee designated by the board (referred to as the “administrator”) administers our 2001 stock incentive plan, including selecting the award recipients, determining the number of shares to be subject to each award, determining the exercise or purchase price of each award and determining the vesting and exercise periods of each award.

      The exercise price of all incentive stock options granted under our 2001 stock incentive plan must be at least equal to 100% of the fair market value of the common stock on the date of grant. The exercise price of all non-qualified stock options granted under our 2001 stock incentive plan are determined by the administrator, but in no event may be less than 85% of the fair market value of the common stock on the date of grant. With respect to any optionee who owns stock possessing more than 10% of the voting power of all our classes of stock or the stock of any parent or subsidiary of ours, the exercise price of any option must equal at least 110% of the fair market value of the common stock at the date of grant. The maximum term of an incentive stock option or non-qualified stock option must not exceed ten years. With respect to any optionee who owns stock possessing more than 10% of the voting power of all our classes of stock or the stock of any parent or subsidiary of us, the maximum term of an incentive stock option must not exceed five years. The purchase price per share for direct stock issuances cannot be less than 85% of the fair market value of the common stock on the date of issuance. With respect to any participant who owns stock possessing more than 10% of the voting power of all our classes of stock or the stock of any parent or subsidiary of us, the purchase price per share for direct stock issuances cannot be less than 100% of the fair market value of the common stock on the date of issuance.

      Under the 2001 stock incentive plan, incentive stock options may not be sold, pledged, assigned, hypothecated, transferred or disposed of in any manner other than by will or by the laws of descent or distribution and may be exercised during the lifetime of the optionee only by the optionee. Non-qualified stock options are transferable by will or by the laws of descent or distribution and to members of the optionee’s immediate family to the extent permitted by the administrator.

      If an optionee’s continuous service terminates without cause for any reason other than death or disability, the optionee may exercise his or her vested options within the period specified in the applicable option agreement, which period will not be less than the 60-day period following the termination date. If we terminate an optionee’s continuous service for cause, any options which have become exercisable prior to the time of termination will immediately terminate, except as otherwise determined by the administrator. If an optionee’s continuous service terminates as a result of death, the options vested as of the date of death may be exercised prior to the earlier of their expiration date or 12 months from the date of the optionee’s death. If an optionee’s continuous service terminates as a result of disability, the options vested as of the date of disability may be exercised prior to the earlier of their expiration date or 6 months from the date of the optionee’s disability.

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      The administrator has discretion to provide for acceleration of vesting in connection with a corporate transaction. Under our 2001 stock incentive plan, a corporate transaction is generally defined as:

  •  the acquisition of more than 50% of our stock by any individual or entity including by a reverse merger;
 
  •  a sale, transfer or other disposition of all or substantially all of the assets of our company;
 
  •  a merger or consolidation in which our company is not the surviving entity; or
 
  •  a complete liquidation or dissolution.

      The 2001 stock incentive plan will terminate automatically in 2011 unless terminated earlier by our board of directors. The board of directors has the authority to amend or terminate the 2001 stock incentive plan. No amendment or termination of the 2001 stock incentive plan may adversely affect any rights under awards already granted to a participant unless agreed to by the affected participant. To the extent necessary to comply with applicable provisions of federal securities laws, state corporate and securities laws, the Internal Revenue Code, the rules of any applicable stock exchange or national market system, and the rules of any non-U.S. jurisdiction applicable to awards granted to residents therein, we must obtain stockholder approval of any such amendment to the 2001 stock incentive plan in such a manner and to such a degree as required.

Limitations on Directors’ Liability and Indemnification Agreements

      As permitted by Section 102 of the Delaware General Corporation Law, we have adopted provisions in our restated certificate of incorporation and restated bylaws that limit or eliminate the personal liability of our directors for a breach of their fiduciary duty of care as a director. The duty of care generally requires that, when acting on behalf of the corporation, directors exercise an informed business judgment based on all material information reasonably available to them. Consequently, a director will not be personally liable to us or our stockholders for monetary damages or breach of fiduciary duty as a director, except for liability for:

  •  any breach of the director’s duty of loyalty to us or our stockholders;
 
  •  any act or omission not in good faith or that involves intentional misconduct or a knowing violation of law;
 
  •  any act related to unlawful stock repurchases, redemptions or other distributions or payment of dividends; or
 
  •  any transaction from which the director derived an improper personal benefit.

      These limitations of liability do not affect the availability of equitable remedies such as injunctive relief or rescission. Our restated certificate of incorporation also authorizes us to indemnify our officers, directors and other agents to the fullest extent permitted under Delaware law.

      As permitted by Section 145 of the Delaware General Corporation Law, our amended and restated bylaws provide that:

  •  we may indemnify our directors, officers and employees to the fullest extent permitted by the Delaware General Corporation Law, subject to limited exceptions;
 
  •  we may advance expenses to our directors, officers and employees in connection with a legal proceeding to the fullest extent permitted by the Delaware General Corporation Law, subject to limited exceptions; and
 
  •  the rights provided in our bylaws are not exclusive.

      We have entered, and intend to continue to enter, into separate indemnification agreements with each of our directors, officers and key employees which may be broader than the specific

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indemnification provisions contained in the Delaware General Corporation Law. These indemnification agreements may require us, among other things, to indemnify our officers and directors against liabilities that may arise by reason of their status or service as directors, officers and key employees other than liabilities arising from willful misconduct. These indemnification agreements also may require us to advance any expenses incurred by the directors, officers or key employees as a result of any proceeding against them as to which they could be indemnified.

      At present, we are not aware of any pending or threatened litigation or proceeding involving a director, officer, employee or agent in which indemnification would be required or permitted. We are not aware of any threatened litigation or proceeding that might result in a claim for such indemnification.

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CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

      In September 2001, we issued an aggregate of 1,000,000 shares of our common stock to Michael L. Robertson, our Chairman, Chief Executive Officer and majority stockholder, for an aggregate purchase price of $9,500, and in October 2001, we issued an aggregate of 47,474,626 shares of our Series A preferred stock to Mr. Robertson, for an aggregate purchase price of $4,499,645.

      In September 2001, we issued to Kevin B. Carmony, our President and Chief Operating Officer, 4,125,000 shares of our common stock valued at $39,187, in lieu of a like amount of compensation otherwise due to him for services rendered.

      In October 2001, we issued an aggregate of 5,275,374 shares of Series A preferred stock to the Burcham Community Property Trust dated May 23, 1990, for an aggregate purchase price of $500,000. The trustees of the Burcham Community Property Trust are the parents of Mr. Robertson’s wife.

      In July 2002, we entered into a revolving line-of-credit agreement with Mr. Robertson. Pursuant to this agreement, Mr. Robertson provided to us a line of credit of up to a total of $5,000,000, bearing simple interest at a rate of 10% per year, with interest payments due monthly and all outstanding principal amounts due on December 31, 2003. In February 2004, the credit agreement was amended to increase the maximum amount available under the line of credit to $10,000,000 and to extend the maturity date for both principal and accrued interest to June 30, 2005. The credit agreement was further amended to remove the requirement to make monthly interest payments. As of March 31, 2004, we owed Mr. Robertson approximately $10,400,000 in principal and accrued interest under the credit agreement. As discussed above under “Use of Proceeds,” we intend to use a portion of the proceeds of this offering to pay to Mr. Robertson all amounts that we owe to him under the credit agreement.

      In 2003 through March 2004, we had an arrangement with SIPphone, Inc., a company of which Mr. Robertson is the founder and Chief Executive Officer, under which we provided office space and administrative support to SIPphone, including the handling of payments from third parties for its products, for which we are reimbursed at cost. In 2003, the aggregate amounts paid to us by SIPphone under this arrangement were $91,916 and the aggregate amounts paid by us to SIPphone were $100,141. In April 2004, we entered into a written sublease with SIPphone memorializing the terms of our agreement to provide office space to SIPphone through 2006. SIPphone’s sublease payments are calculated based on the percentage of our total square footage subleased to SIPphone and a corresponding percentage of any overage from operating expenses. Given that SIPphone subleases 6% of our total square footage, these sublease payments have equaled 6% of our monthly lease obligation plus a percentage of any overage from operating expenses.

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PRINCIPAL STOCKHOLDERS

      The following table sets forth information regarding the beneficial ownership of our common stock as of March 31, 2004 for:

  •  each executive officer named in the Summary Compensation Table;
 
  •  each of our directors;
 
  •  each person known by us to beneficially own more than 5% of our common stock; and
 
  •  all of our executive officers and directors as a group.

      Beneficial ownership is determined in accordance with the rules of the Securities and Exchange Commission and includes voting and investment power with respect to the securities. Except as indicated by footnote, and subject to applicable community property laws, the persons named in the table have sole voting and investment power with respect to all shares of common stock shown as beneficially owned by them. The number of shares of common stock used to calculate the percentage ownership of each listed person includes the shares of common stock underlying options or warrants held by such persons that are exercisable within 60 days of March 31, 2004.

      Percentage of beneficial ownership before the offering is based on 59,257,287 shares, consisting of 6,507,287 shares of common stock outstanding as of March 31, 2004, and 52,750,000 shares issuable upon the conversion of the preferred stock. Percentage of beneficial ownership after the offering is based on                      shares, including                      shares sold in this offering.

      Unless otherwise indicated, the address for the following stockholders is c/o Lindows, Inc., 9333 Genesee Ave., 3rd Floor, San Diego, California 92121.

                         
Percentage beneficially owned
Name and address
of beneficial owner Shares beneficially owned Before offering After offering




Executive Officers and Directors:
                       
Michael L. Robertson(1)
    48,174,626       81.3 %           %
Kevin B. Carmony(2)
    3,087,600       5.2          
Chad H. Olson(3)
    1,000,000       1.7       *  
Thomas C. Welch(4)
    1,000,000       1.7       *  
Rex E. Bosen(5)
                 
David S. Buzby(6)
                 
Robin D. Richards(7)
                 
5% Stockholders:
                       
Burcham Community Property Trust dated May 23, 1990(8)
    5,075,374       8.6          
Executive officers and directors as a group (seven persons)(9)
    53,262,226       87.2 %           %


  * less than one percent of the outstanding shares of common stock.

(1)  Includes (a) 39,474,626 shares owned by The SKL Trust dated May 19, 2000, of which Mr. Robertson is a trustee and (b) 8,700,000 shares owned by The Robertson Descendants Irrevocable Trust dated July 15, 1999, of which Mr. Robertson is a trustee. In April 2004, we entered into an employment agreement with Mr. Robertson pursuant to which we granted to Mr. Robertson an option to purchase 1,500,000 shares of our common stock.
 
(2)  In April 2004, we entered into an employment agreement with Mr. Carmony pursuant to which we granted to Mr. Carmony an option to purchase 1,000,000 shares of our common stock.

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(3)  Includes options to purchase up to 950,000 shares of our common stock. In April 2004, we entered into an employment agreement with Mr. Olson pursuant to which we granted to Mr. Olson an additional option to purchase 750,000 shares of our common stock.
 
(4)  Includes options to purchase up to 1,000,000 shares of our common stock. In April 2004, we entered into an employment agreement with Mr. Welch pursuant to which we granted to Mr. Welch an additional option to purchase 750,000 shares of our common stock.
 
(5)  In April 2004, we granted to Mr. Bosen an option to purchase 150,000 shares of our common stock pursuant to our non-employee director compensation program.
 
(6)  In April 2004, we granted to Mr. Buzby an option to purchase 140,000 shares of our common stock pursuant to our non-employee director compensation program.
 
(7)  In April 2004, we granted to Mr. Richards an option to purchase 140,000 shares of our common stock pursuant to our non-employee director compensation program.
 
(8)  Keith Burcham and Audra Lee Burcham are co-trustees of Burcham Community Property Trust dated May 23, 1990. The Burcham Community Property Trust’s address is P.O. Box 3445, Rancho Santa Fe, California 92067.
 
(9)  Includes options to purchase up to 1,850,000 shares of our common stock.

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DESCRIPTION OF CAPITAL STOCK

      Upon completion of this offering, our authorized capital stock will consist of 100,000,000 shares of common stock, $0.0001 par value per share, and 10,000,000 shares of preferred stock, $0.0001 par value per share.

      The following summary of the rights of our common stock and preferred stock is not complete and is qualified in its entirety by reference to our amended and restated certificate of incorporation and amended and restated bylaws to be in effect upon completion of this offering, copies of which are filed as exhibits to the registration statement of which this prospectus is a part.

Common Stock

      Based on 6,582,599 shares of common stock outstanding as of March 31, 2004, the issuance of                      shares of common stock in this offering, the issuance of 52,750,000 shares of common stock upon conversion of all outstanding shares of our preferred stock, and no exercise of outstanding options or warrants, there will be                      shares of common stock outstanding upon completion of this offering. As of the same date, there were options outstanding to purchase 3,917,376 shares of common stock and no warrants outstanding. As of March 31, 2004, we had approximately 39 record holders of our common stock.

 
Voting Rights

      Holders of our common stock are entitled to one vote per share on all matters to be voted upon by the stockholders. The holders of common stock are not entitled to cumulate voting rights with respect to the election of directors, which means that the holders of a majority of the shares voted can elect all of the directors then standing for election.

 
Dividends

      Subject to limitations under Delaware law and preferences that may apply to any outstanding shares of preferred stock, holders of our common stock are entitled to receive ratably such dividends or other distribution, if any, as may be declared by our board of directors out of funds legally available therefor.

 
Liquidation

      In the event of our liquidation, dissolution or winding up, holders of our common stock are entitled to share ratably in all assets remaining after payment of liabilities, subject to the liquidation preference of any outstanding preferred stock.

 
Rights and Preferences

      The common stock has no preemptive, conversion or other rights to subscribe for additional securities. There are no redemption or sinking fund provisions applicable to our common stock. The rights, preferences and privileges of holders of common stock are subject to, and may be adversely affected by, the rights of the holders of shares of any series of preferred stock that we may designate and issue in the future.

 
Fully Paid and Nonassessable

      All outstanding shares of our common stock are, and all shares of common stock to be outstanding upon completion of the offering will be, validly issued, fully paid and nonassessable.

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Preferred Stock

      As of March 31, 2004, there were 52,750,000 shares of preferred stock outstanding. Upon the closing of this offering, all outstanding shares of preferred stock will automatically convert into 52,750,000 shares of common stock.

      Following the offering, our board of directors will have the authority, without further action by the stockholders and subject to the limits imposed by the Delaware General Corporation Law, to issue up to 10,000,000 shares of preferred stock in one or more series and to designate the rights, preferences, privileges and restrictions of each such series. The issuance of preferred stock could have the effect of restricting dividends on the common stock, diluting the voting power for the common stock, impairing the liquidation rights of the common stock or delaying or preventing a change in control without further action by the stockholders. At present, we have no plans to issue any shares of preferred stock after completion of this offering.

Anti-takeover Effects of Delaware Law and Provisions of Our Certificate of Incorporation and Bylaws

 
Delaware Takeover Statute

      We are subject to Section 203 of the Delaware General Corporation Law. This statute regulating corporate takeovers prohibits a Delaware corporation from engaging in any business combination with any interested stockholder for three years following the date that the stockholder became an interested stockholder, unless:

  •  prior to the date of the transaction, the board of directors of the corporation approved either the business combination or the transaction which resulted in the stockholder becoming an interested stockholder;
 
  •  the interested stockholder owned at least 85% of the voting stock of the corporation outstanding at the time the transaction commenced, excluding for purposes of determining the number of shares outstanding (a) shares owned by persons who are directors and also officers and (b) shares owned by employee stock plans in which employee participants do not have the right to determine confidentially whether shares held subject to the plan will be tendered in a tender or exchange offer; or
 
  •  on or subsequent to the date of the transaction, the business combination is approved by the board and authorized at an annual or special meeting of stockholders, and not by written consent, by the affirmative vote of at least 66 2/3% of the outstanding voting stock which is not owned by the interested stockholder.

      Section 203 defines a business combination to include:

  •  any merger or consolidation involving the corporation and the interested stockholder;
 
  •  any sale, transfer, pledge or other disposition involving the interested stockholder of 10% or more of the assets of the corporation;
 
  •  subject to exceptions, any transaction that results in the issuance or transfer by the corporation of any stock of the corporation to the interested stockholder; or
 
  •  the receipt by the interested stockholder of the benefit of any loans, advances, guarantees, pledges or other financial benefits provided by or through the corporation.

      In general, Section 203 defines an interested stockholder as any entity or person beneficially owning 15% or more of the outstanding voting stock of the corporation and any entity or person affiliated with or controlling or controlled by the entity or person.

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Certificate of Incorporation and Bylaw Provisions

      Provisions of our restated certificate of incorporation and restated bylaws, which will become effective upon the closing of this offering, may have the effect of making it more difficult for a third party to acquire, or discourage a third party from attempting to acquire, control of our company by means of a tender offer, a proxy contest or otherwise. These provisions may also make the removal of incumbent officers and directors more difficult. These provisions are intended to discourage certain types of coercive takeover practices and inadequate takeover bids and to encourage persons seeking to acquire control of us to first negotiate with us. These provisions could also limit the price that investors might be willing to pay in the future for shares of our common stock. These provisions may make it more difficult for stockholders to take specific corporate actions and could have the effect of delaying or preventing a change in our control. The amendment of any of these anti-takeover provisions would require approval by holders of at least 66 2/3% of our outstanding common stock entitled to vote.

      In particular, our certificate of incorporation and bylaws provide for the following:

 
Staggered Board of Directors

      Our board of directors is divided into three classes of the same or nearly the same number of directors, each serving staggered three-year terms, which means that only one class of directors may be elected at each annual meeting or special meeting in lieu of such annual meeting. These provisions may make the removal of incumbent directors difficult and may discourage third parties from attempting to circumvent the anti-takeover effects of our certificate of incorporation and bylaws by removing our incumbent directors.

 
No Written Consent of Stockholders

      Any action to be taken by our stockholders must be effected at a duly called annual or special meeting and may not be effected by written consent.

 
Special Meetings of Stockholders

      Special meetings of our stockholders may be called only by the chairman of the board of directors or a majority of the members of the board of directors.

 
Advance Notice Requirement

      Stockholder proposals to be brought before an annual meeting of our stockholders must comply with advance notice procedures. These advance notice procedures require timely notice and apply in several situations, including stockholder proposals relating to the nominations of persons for election to the board of directors. Generally, to be timely, notice must be received at our principal executive offices not less than 90 days nor more than 120 days prior to the first anniversary date of the annual meeting for the preceding year.

 
Amendment of Bylaws and Certificate of Incorporation

      The approval of not less that 66 2/3% of the outstanding shares of our capital stock entitled to vote is required to amend the provisions of our amended and restated bylaws by stockholder action, or to amend the provisions of our amended and restated certificate of incorporation that are described in this section or that are described under “Management — Limitation of Liability and Indemnification of Officers and Directors” above. These provisions will make it more difficult to circumvent the anti-takeover provisions of our certificate of incorporation and our bylaws.

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Issuance of Undesignated Preferred Stock

      Our board of directors is authorized to issue, without further action by the stockholders, up to 10,000,000 shares of undesignated preferred stock with rights and preferences, including voting rights, designated from time to time by the board of directors. The existence of authorized but unissued shares of preferred stock enables our board of directors to render more difficult or to discourage an attempt to obtain control of us by means of a merger, tender offer, proxy contest or otherwise.

Transfer Agent and Registrar

      The transfer agent and registrar for our common stock is                     .

Inclusion for Quotation on Nasdaq

      We have applied for approval for trading and quotation of our common stock on the Nasdaq National Market under the symbol “LINE.”

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MATERIAL U.S. FEDERAL INCOME TAX CONSEQUENCES TO NON-U.S. HOLDERS

      The following is a summary of certain U.S. federal income and estate tax consequences of the acquisition, ownership and disposition of our common stock purchased pursuant to this offering by a holder that, for U.S. federal income tax purposes, is not a “U.S. person,” as we define that term below. A beneficial owner of our common stock who is not a U.S. person is referred to below as a “non-U.S. holder.” This summary is based upon current provisions of the U.S. Internal Revenue Code, U.S. Treasury regulations promulgated thereunder, judicial opinions, administrative pronouncements and published rulings of the U.S. Internal Revenue Service all as in effect as of the date hereof. These authorities may be changed, possibly retroactively, resulting in U.S. federal tax consequences different from those set forth below. We have not sought, and will not seek, any ruling from the U.S. Internal Revenue Service or opinion of counsel with respect to the statements made in the following summary, and there can be no assurance that the U.S. Internal Revenue Service will not take a position contrary to such statements or that any such contrary position taken by the U.S. Internal Revenue Service would not be sustained.

      This summary is limited to non-U.S. holders who purchase our common stock issued pursuant to this offering and who hold our common stock as a capital asset, which generally is property held for investment. This summary also does not address the tax considerations arising under the laws of any foreign, state or local jurisdiction, or under U.S. federal estate or gift tax laws, except as specifically described below. In addition, this summary does not address tax considerations that may be applicable to an investor’s particular circumstances or to investors that may be subject to special tax rules, including, without limitation:

  •  banks, insurance companies or other financial institutions;
 
  •  partnerships;
 
  •  entities that are “controlled foreign corporations,” “passive foreign investment companies” or “foreign personal holding companies” for U.S. federal income tax purposes;
 
  •  U.S. expatriates;
 
  •  tax-exempt organizations;
 
  •  tax-qualified retirement plans;
 
  •  dealers in securities or currencies;
 
  •  traders in securities that elect to use a mark-to-market method of accounting for their securities holdings; or
 
  •  persons that will hold common stock as a position in a hedging transaction, “straddle” or “conversion transaction” for tax purposes.

      If a partnership, including any entity treated as a partnership for U.S. federal income tax purposes, is a holder, the tax treatment of a partner in the partnership will generally depend upon the status of the partner and the activities of the partnership. A holder that is a partnership, and partners in such partnership, should consult their own tax advisors regarding the tax consequences of the purchase, ownership and disposition of our common stock.

      For purposes of this discussion, a U.S. person means any one of the following:

  •  a citizen or resident of the United States;
 
  •  a corporation, including any entity treated as a corporation for U.S. federal income tax purposes, or partnership, including any entity treated as a partnership for U.S. federal income tax purposes, created or organized under the laws of the United States or of any political subdivision of the United States;

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  •  an estate the income of which is subject to U.S. federal income taxation regardless of its source; or
 
  •  a trust, the administration of which is subject to the primary supervision of a U.S. court and one or more U.S. persons have the authority to control all substantial decisions of the trust, or other trusts considered U.S. persons for U.S. federal income tax purposes.

      Generally, an individual may be treated as a resident of the United States in any calendar year for U.S. federal income tax purposes, instead of a nonresident, by, among other ways, being present in the United States for at least 31 days in that calendar year and for an aggregate of at least 183 days during a three-year period ending in the current calendar year. For purposes of this calculation, you would count all of the days present in the current year, one-third of the days present in the immediately preceding year and one-sixth of the days present in the second preceding year. Residents are taxed for U.S. federal income tax purposes as if they were U.S. citizens.

      YOU ARE URGED TO CONSULT YOUR TAX ADVISOR WITH RESPECT TO THE APPLICATION OF THE UNITED STATES FEDERAL INCOME TAX LAWS TO YOUR PARTICULAR SITUATION AS WELL AS ANY TAX CONSEQUENCES ARISING UNDER THE UNITED STATES FEDERAL ESTATE OR GIFT TAX RULES OR UNDER THE LAWS OF ANY STATE, LOCAL, FOREIGN OR OTHER TAXING JURISDICTION OR UNDER ANY APPLICABLE TAX TREATY.

Dividends

      If distributions are made with respect to shares of our common stock, such distributions will constitute dividends for U.S. federal income tax purposes to the extent paid from our current or accumulated earnings and profits, as determined under U.S. federal income tax principles. If a distribution exceeds our current and accumulated earnings and profits, it will constitute a return of capital that is applied against and reduces, but not below zero, your adjusted tax basis in our common stock. Any remainder will be treated as gain on the disposition of the common stock, as discussed below. Dividends paid to a non-U.S. holder generally will be subject to withholding of U.S. federal income tax at the rate of 30% or such lower rate as may be specified by an applicable income tax treaty.

      If the dividend is effectively connected with the non-U.S. holder’s conduct of a trade or business in the United States or, if an income tax treaty applies, attributable to a U.S. permanent establishment maintained by such non-U.S. holder, the dividend will not be subject to any U.S. federal income tax withholding, provided certain certification requirements are met, as described below, but will be subject to U.S. federal income tax imposed on net income on the same basis that applies to U.S. persons generally. A corporate holder under certain circumstances also may be subject to a U.S. federal “branch profits tax” equal to 30%, or such lower rate as may be specified by an applicable income tax treaty, of a portion of its effectively connected earnings and profits for the taxable year.

      In order to claim the benefit of a tax treaty or to claim exemption from withholding because the income is effectively connected with the conduct of a trade or business in the United States, a non-U.S. holder must provide a properly executed U.S. Internal Revenue Service Form W-8BEN for treaty benefits or W-8ECI for effectively connected income, or such successor forms as the U.S. Internal Revenue Service designates, prior to the payment of dividends. These forms must be periodically updated. Non-U.S. holders may obtain a refund of any excess amounts withheld by timely filing an appropriate claim for refund.

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Gain on Disposition

      A non-U.S. holder generally will not be subject to U.S. federal income tax on gain recognized on a disposition of our common stock unless:

  •  the gain is effectively connected with the non-U.S. holder’s conduct of a trade or business in the United States or, alternatively, if an income tax treaty applies, is attributable to a permanent establishment maintained by the non-U.S. holder in the United States; in these cases, the gain will be taxed on a net income basis at the regular graduated rates and generally in the manner applicable to U.S. persons and, if the non-U.S. holder is a foreign corporation, the “branch profits tax” described above may also apply;
 
  •  the non-U.S. holder is an individual who holds our common stock as a capital asset, is present in the United States for 183 days or more in the taxable year of the disposition and meets other requirements; or
 
  •  we are or have been a “U.S. real property holding corporation” for U.S. federal income tax purposes at any time during the shorter of the five-year period ending on the date of disposition or the period that the non-U.S. holder held our common stock.

      Generally, a corporation is a “U.S. real property holding corporation” if the fair market value of its “U.S. real property interests” equals or exceeds 50% of the sum of the fair market value of its worldwide real property interests plus its other assets used or held for use in a trade or business. The tax relating to stock in a “U.S. real property holding corporation” generally will not apply to a non-U.S. holder whose holdings, direct and indirect, at all times during the applicable period, constituted 5% or less of our common stock, provided that our common stock was regularly traded on an established securities market. We believe that we have not been and are not currently, and we do not anticipate becoming in the future, a “U.S. real property holding corporation” for U.S. federal income tax purposes.

U.S. Federal Estate Taxes

      Our common stock owned or treated as owned by an individual who at the time of death is a non-U.S. holder will be included in his or her estate for U.S. federal estate tax purposes, unless an applicable estate tax treaty provides otherwise.

U.S. Information Reporting and Backup Withholding

      Under U.S. Treasury regulations, we must report annually to the U.S. Internal Revenue Service and to each non-U.S. holder the amount of dividends paid to such non-U.S. holder and the tax withheld with respect to those dividends. These information reporting requirements apply even if withholding was not required because the dividends were effectively connected dividends or withholding was reduced or eliminated by an applicable income tax treaty. Pursuant to an applicable income tax treaty, that information may also be made available to the tax authorities in the country in which the non-U.S. holder resides.

      U.S. federal backup withholding, currently at a 28% rate of tax, generally will not apply to payments of dividends made by us or our paying agents, in their capacities as such, to a non-U.S. holder of our common stock if either the holder has properly certified that it is not a U.S. person on U.S. Internal Revenue Services Form W-8BEN (or other appropriate form) or certain other requirements are met. Notwithstanding the foregoing, backup withholding may apply if either we or our paying agent has actual knowledge, or reason to know, that the holder is a U.S. person.

      Payments of the proceeds from a disposition or a redemption effected outside the United States by a non-U.S. holder of our common stock made by or through a foreign office of a broker generally will not be subject to information reporting or backup withholding. However, information reporting, but not backup withholding, generally will apply to such a payment if the broker has certain

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connections with the United States, unless the broker has documentary evidence in its records that the beneficial owner is a non-U.S. holder and specified conditions are met or an exemption is otherwise established.

      Payment of the proceeds from a disposition by a non-U.S. holder of common stock made by or through the U.S. office of a broker generally is subject to information reporting and backup withholding unless the non-U.S. holder certifies that it is not a U.S. person under penalties of perjury (and we and our paying agent do not have actual knowledge, or reason to know, that the holder is a U.S. person) or otherwise establishes an exemption from information reporting and backup withholding.

      Backup withholding is not an additional tax. Any amounts that are withheld under the backup withholding rules will be refunded or credited against the non-U.S. holder’s U.S. federal income tax liability if certain required information is furnished to the U.S. Internal Revenue Service. Non-U.S. holders should consult their own tax advisors regarding application of backup withholding in their particular circumstance and the availability of, and procedure for, obtaining an exemption from backup withholding under current U.S. Treasury regulations.

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SHARES ELIGIBLE FOR FUTURE SALE

      Immediately prior to this offering, there has been no public market for our common stock. Possible or actual sales by our stockholders of substantial amounts of our common stock in the public market following this offering could cause the prevailing market price of our common stock to decline and could make it difficult or impossible for us to sell equity or equity-related securities in the future at a time and price we deem appropriate.

      Upon completion of this offering, we will have                      shares of common stock outstanding, assuming no exercise of currently outstanding options or warrants. Of these shares, the                      shares sold in this offering, plus any additional shares sold upon exercise of the underwriters’ over-allotment option, will be freely transferable without restriction under the Securities Act, unless they are held by our “affiliates” as that term is used under the Securities Act and the rules and regulations promulgated thereunder. The remaining                      shares of common stock held by existing stockholders are restricted shares. Restricted shares may be sold in the public market only if registered or if they qualify for an exemption from registration such as the exemptions under Rules 144 or 701 promulgated under the Securities Act, which rules are summarized below.

      As a result of lock-up agreements, the provisions of Rules 144 and 701 and a registration statement on Form S-8 that we expect to file after the effective date of this offering, additional shares will be available for sale in the public market, subject to certain volume and other restrictions, as follows:

  •                      restricted shares will be eligible for immediate sale on the effective date of this offering;
 
  •                      restricted shares will be eligible for sale approximately 30 days after the date of this prospectus, pursuant to a registration statement on Form S-8 that we expect to file, as described below;
 
  •                      restricted shares will be eligible for sale 90 days after the date of this prospectus;
 
  •                      restricted shares will be eligible for sale upon expiration of the lock-up agreements, which will occur 180 days after the date of this prospectus; and
 
  •  the remaining                     restricted shares will be eligible for sale from time to time thereafter upon expiration of their respective one-year holding periods.

Lock-Up Agreements

      The holders of approximately 95% of our capital stock outstanding as of December 31, 2003 have entered into lock-up agreements pursuant to which they have agreed, subject to specified exceptions, that, without prior written consent of WR Hambrecht + Co, they will not offer, sell, contract to sell, pledge, grant any option to sell, or otherwise dispose of, directly or indirectly, any shares of our common stock or securities convertible into or exercisable for shares of our common stock, or warrants or other rights to purchase our common stock during the 180-day period following the effective date of the registration statement. However, notwithstanding the foregoing restrictions, the lock-up agreements permit sales to be made in accordance with applicable securities rules and regulations, subject only to the Rule 144 volume limitations described below (to which the stockholders that have entered into the lock-up agreements have agreed to be subject during the term of such agreements, regardless of whether the Rule 144 volume limitations would otherwise restrict sales made by those stockholders). Additionally, WR Hambrecht + Co, at its discretion, can waive the restrictions of the lock-up agreements at an earlier time without prior notice or announcement and allow all of our stockholders to sell their shares of our common stock in the public market subject only to applicable securities rules and regulations. In considering any request to release shares subject to a lock-up agreement WR Hambrecht + Co will consider the possible impact of the release of the shares on the trading price of the stock sold in the offering.

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WR Hambrecht + Co does not have any present intention or any understandings, implicit or explicit, to release any of the shares subject to the lock-up agreements prior to the expiration of the lock-up period.

Rule 144

      In general, under Rule 144 as currently in effect, beginning 90 days after the date of this prospectus, a person who has beneficially owned shares of our common stock for at least one year, including the holding period of certain prior owners other than affiliates, is entitled to sell within any three-month period a number of shares that does not exceed the greater of (a) 1% of the number of shares of our common stock then outstanding, which will equal approximately                      shares immediately after the offering, or (b) the average weekly trading volume of our common stock on the Nasdaq National Market during the four calendar weeks preceding the filing of a notice on Form 144 with respect to that sale. Sales under Rule 144 are also subject to certain manner-of-sale provisions, notice requirements and the availability of current public information about us.

Rule 144(k)

      Under Rule 144(k), a person who is not deemed to have been one of our affiliates at any time during the three months preceding a sale and who has beneficially owned shares for at least two years, including the holding period of certain prior owners other than affiliates, is entitled to sell those shares without complying with the volume limitations, manner-of-sale provisions, notice requirements and public information provisions of Rule 144. Therefore, unless restricted under the 180-day lock-up arrangement or otherwise, Rule 144(k) shares may be sold immediately upon the closing of this offering.

Rule 701

      In general, under Rule 701 of the Securities Act as currently in effect, each of our directors, officers, employees, consultants or advisors who purchased shares from us before the date of this prospectus in connection with a compensatory stock plan or other written compensatory agreement is eligible to resell such shares 90 days after the effective date of this offering in reliance on Rule 144, but without compliance with certain restrictions, including the holding period, contained in Rule 144.

Employee Benefit Plans

      We intend to file with the Securities and Exchange Commission a registration statement on Form S-8 under the Securities Act covering the shares of common stock issued or reserved for issuance under our 2001 stock incentive plan and 2004 stock incentive plan, as well as 3,081,800 shares of common stock held by our President. The registration statement is expected to be filed and become effective approximately 30 days after the date of this prospectus. Accordingly, shares registered under the registration statement will be available for sale in the open market, subject to Rule 144 volume limitations applicable to affiliates and to shares that we issued prior to the filing of the registration statement, and subject to any vesting restrictions and lock-up agreements applicable to these shares.

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PLAN OF DISTRIBUTION

      In accordance with the terms of the underwriting agreement between WR Hambrecht + Co, LLC, and Roth Capital Partners, LLC, as representatives of the underwriters, and us, the underwriters have agreed to purchase from us that number of shares of common stock set forth opposite the underwriter’s name below at the public offering price less the underwriting discounts and commissions described on the cover page of this prospectus.

         
Underwriters Number of shares


WR Hambrecht + Co, LLC
       
Roth Capital Partners, LLC
       
     
 
Total
       
     
 

      The underwriting agreement provides that the obligations of the underwriters are subject to conditions, including:

  •  the absence of any material misstatements or omissions in this prospectus or the registration statement, including any related amendments or supplements;
 
  •  the absence of any current or prospective material adverse change in our business;
 
  •  the continuing accuracy of representations and warranties made to the underwriters by us; and
 
  •  the receipt of certificates, opinions and letters from us, counsel and independent accountants, including a letter from our independent accountants stating the results of their review of the our internal accounting controls, which letter shall not disclose any material weakness in such internal controls.

      Subject to those conditions, the underwriters are committed to purchase all of the shares of our common stock offered by this prospectus if any of the shares are purchased.

      The underwriters propose to offer the shares of our common stock directly to the public at the offering price set forth on the cover page of this prospectus, as this price is determined by the OpenIPO process described below, and to certain dealers at this price less a concession not in excess of $           per share. The underwriters may allow, and dealers may reallow, a concession not to exceed $           per share on sales to other dealers. Any dealers that participate in the distribution of our common stock may be deemed to be underwriters within the meaning of the Securities Act, and any discount, commission or concession received by them and any provided by the sale of the shares by them may be deemed to be underwriting discounts and commissions under the Securities Act. After completion of the initial public offering of the shares, the public offering price and other selling terms may be changed by the underwriters.

      The following table shows the per share and total underwriting discount to be paid to the underwriters by us in connection with this offering. The underwriting discount has been determined through negotiations between us and the underwriters, and has been calculated as a percentage of the offering price. These amounts are shown assuming both no exercise and full exercise of the over-allotment option.

                         
Per share No exercise Full exercise



Public Offering Price
                       
Underwriting Discounts
                       
Proceeds, before expenses, to us
                       

      The expenses of the offering, exclusive of the underwriting discounts, will be approximately $          . These fees and expenses are payable entirely by us. These fees include, among other things, our legal and accounting fees, printing expenses, expenses incurred in connection with meetings

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with potential investors, filing fees of the Securities and Exchange Commission and the National Association of Securities Dealers, Inc., fees of our transfer agent and registrar and the listing fees of the Nasdaq National Market.

      An electronic prospectus is available on the website maintained by WR Hambrecht + Co, and may also be made available on websites maintained by other underwriters, selected dealers and selling group members participating in this offering. Other than the prospectus in electronic format, the information on these websites is not part of this prospectus.

The OpenIPO Auction Process

      The distribution method being used in this offering is known as the OpenIPO auction, which differs from methods traditionally used in underwritten public offerings. In particular, the public offering price and the allocation of shares are determined primarily by an auction conducted by the underwriters. All qualified individual and institutional investors may place bids in an OpenIPO auction and investors submitting valid bids have an equal opportunity to receive an allocation of shares.

      The following describes how the underwriters and some selected dealers conduct the auction process and confirm bids from prospective investors:

  •  Before the registration statement relating to this offering becomes effective, the underwriters and participating dealers solicit bids from prospective investors through the Internet and by telephone and facsimile. The bids specify the number of shares of our common stock the potential investor proposes to purchase and the price the potential investor is willing to pay for the shares. These bids may be above or below the range set forth on the cover page of the prospectus. The minimum size of any bid is 100 shares.
 
  •  The shares offered by this prospectus may not be sold, nor may offers to buy be accepted, prior to the time that the registration statement filed with the Securities and Exchange Commission becomes effective. A bid received by the underwriters or a dealer involves no obligation or commitment of any kind prior to the closing of the auction. Bids can be modified or revoked at any time prior to the closing of the auction.
 
  •  Approximately two business days prior to the registration statement being declared effective, prospective investors receive, by email, telephone or facsimile, a notice indicating the proposed effective date.
 
  •  After the registration statement relating to this offering has become effective, potential investors who have submitted bids to the underwriters or a dealer are contacted by email, telephone or facsimile. Potential investors are advised that the registration statement has been declared effective and are requested to confirm their bids.
 
  •  The auction will close after the registration statement becomes effective at a time agreed to by us and WR Hambrecht + Co, which we anticipate will be immediately after the close of trading on the Nasdaq National Market on the same day on which the registration statement is declared effective. However, the date on which the auction will close cannot currently be predicted and will be determined by us and WR Hambrecht + Co based on general market conditions during the period after the registration statement is declared effective. If we are unable to determine a public offering price, close the auction and file a final prospectus with the Securities and Exchange Commission within 15 days after the registration statement is initially declared effective, we will be required to file with the Commission and have declared effective a post- effective amendment to the registration statement before the auction may be closed and before any bids may be accepted. If we are unable to close the auction within 15 days after the registration statement is initially declared effective, the underwriters or dealers will reconfirm all bids by either telephone or email following the filing and effectiveness of the post-effective amendment. After the registration statement has been

85


 

  declared effective, the public offering price of the common stock may be set at a price that is within or outside the range set forth on the cover of the prospectus.
 
  •  All bids that are not confirmed before the time specified by WR Hambrecht + Co, or if the time is not specified, by the close of the auction, are deemed withdrawn.
 
  •  Once a potential investor affirmatively confirms its previous bid, the confirmation remains valid unless subsequently withdrawn by the potential investor. Potential investors are able to withdraw their bids at any time before the close of the auction by notifying the underwriters or a participating dealer.
 
  •  If the public offering price range is changed before or after a potential investor affirmatively confirms a bid, or if the public offering price is outside the public offering range previously provided to the potential investor in the prospectus, the underwriters and participating dealers notify potential investors of the change and that offers will not be accepted until the potential investor has again reconfirmed its bid regardless of whether the potential investor’s initial bid was above, below or at the public offering price.
 
  •  Following the closing of the auction, the underwriters determine the highest price at which all of the shares offered, including shares that may be purchased by the underwriter to cover any over-allotments, may be sold to potential investors. This price, which is called the “clearing price,” is determined based on the results of all valid bids at the time the auction is closed. The clearing price is not necessarily the public offering price, which is set as described in “Determination of Public Offering Price” below. The public offering price determines the allocation of shares to potential investors, with all bids submitted at or above the public offering price receiving a pro rata portion of the shares bid for.
 
  •  Once the auction closes and a clearing price is set as described below, the underwriters or a participating dealer accept the bids from those bidders whose bid is at or above the public offering price but may allocate to a prospective investor fewer shares than the number included in the investor’s bid.
 
  •  Bidders receiving a pro rata portion of the shares bid receive an allocation of shares on a round lot basis, rounded to multiples of 100 or 1000 shares, depending on the size of the bid. No bids are rounded to a round lot higher than the original bid size. Because bids may be rounded down to round lots in multiples of 100 or 1000 shares, some bidders may receive allocations of shares that reflect a greater percentage decrease in their original bid than the average pro rata decrease. Thus, for example, if a bidder has confirmed a bid for 200 shares, and there is an average pro rata decrease of all bids of 30%, the bidder may receive an allocation of 100 shares (a 50% decrease from 200 shares) rather than receiving an allocation of 140 shares (a 30% decrease from 200 shares). In addition, some bidders may receive allocations of shares that reflect a lesser percentage decrease in their original bid than the average pro rata decrease. For example, if a bidder has confirmed a bid for 100 shares, and there is an average pro rata decrease of all bids of 30%, the bidder may receive an allocation of all 100 shares to avoid having the bid rounded down to zero.
 
  •  The underwriters or a participating dealer notifies successful bidders by email, telephone or facsimile or mail that the auction has closed and that their confirmed bids have been accepted. Other bidders are notified that their bids have not been accepted.
 
  •  Potential investors may at any time expressly request that all, or any specific, communications between them and the underwriter and participating dealers be made by specific means of communication, including email, telephone and facsimile.

      The underwriters and selected dealers that participate in this offering may request prospective investors to confirm their bids prior to the effective date of the registration statement, if that practice is used by these institutions in connection with initial public offerings that are not conducted using

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the OpenIPO process. Bidders should carefully review the procedures of, and communications from, the institution through which they bid to purchase our shares. In general, approximately two business days before the registration statement is declared effective, the underwriters and dealers will request potential investors to reconfirm the bids that they have submitted. If a bid is not reconfirmed prior to the close of the auction, it is rejected. If a bid is reconfirmed, it may still be modified or revoked prior to the auction closing; however, if the reconfirmed bid is not revoked prior to the effectiveness of the registration statement and the closing of the auction, it is considered a firm bid and may be accepted at the closing of the auction. The underwriters and these dealers will also seek reconfirmation of bids in the event that the price range of the offering is changed, the initial public offering price is set at a price that is outside the range that has previously been provided to potential investors, or we are otherwise required to recirculate the prospectus.

Determination of Public Offering Price

      The public offering price for this offering is ultimately determined by negotiation between the underwriters and us after the auction closes and does not necessarily bear any direct relationship to our assets, current earnings or book value or to any other established criteria of value, although these factors are considered in establishing the initial public offering price. Prior to the offering, there has been no public market for our common stock. The principal factor in establishing the public offering price is the clearing price resulting from the auction.

      The clearing price is the highest price at which all of the shares offered, including the shares that may be purchased by the underwriters to cover any over-allotments, may be sold to potential investors, based on the valid bids at the time the auction is run. The shares subject to the underwriters’ over-allotment option are used to calculate the clearing price whether or not the option is actually exercised.

      Factors considered in determining the initial public offering price include an assessment of our management, operating results, capital structure and business potential and the demand for similar securities of comparable companies. Changes, if any, in the public offering price are based primarily on the bids received.

      The public offering price may be lower, but will not be higher, than the clearing price based on negotiations between the underwriters and us. The public offering price always determines the allocation of shares to potential investors. Therefore, if the public offering price is below the clearing price, all bids that are at or above the public offering price receive a pro rata portion of the shares bid for. If sufficient bids are not received, or if we do not consider the clearing price to be adequate, or if we and the underwriters are not able to reach agreement on the public offering price, then we and the underwriters will either postpone or cancel this offering. Alternatively, we may file a post-effective amendment to the registration statement in order to conduct a new auction.

      The following simplified example illustrates how the public offering price is determined through the auction process:

      Company X offers to sell 1,000 shares in its public offering through the auction process. The underwriters, on behalf of Company X, receive five bids to purchase, all of which are kept confidential until the auction closes.

      The first bid is to pay $10.00 per share for 200 shares. The second bid is to pay $9.00 per share for 300 shares. The third bid is to pay $8.00 per share for 600 shares. The fourth bid is to pay $7.00 per share for 400 shares. The fifth bid is to pay $6.00 per share for 800 shares.

      Assuming that all of these bids are confirmed and not withdrawn or modified before the auction closes, and assuming that no additional bids are received, the clearing price used to determine the public offering price would be $8.00 per share, which is the highest price at which all 1,000 shares offered may be sold to potential investors who have submitted valid bids. However, the shares may

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be sold at a price below $8.00 per share based on negotiations between Company X and the underwriters.

      If the public offering price is the same as the $8.00 per share clearing price, the underwriters would confirm bids at or above $8.00 per share. Because 1,100 shares were bid for at or above the clearing price, each of the three potential investors who bid $8.00 per share or more would receive approximately 90% of the shares for which bids were made. The two potential investors whose bids were below $8.00 per share would not receive any shares in this example.

      If the public offering price is $7.00 per share, the underwriters would confirm bids that were made at or above $7.00 per share. No bids made at a price of less than $7.00 per share would be accepted. The four potential investors with the highest bids would receive a pro rata portion of the 1,000 shares offered, based on the 1,500 shares they requested, or two-thirds of the shares for which bids were made. The potential investor with the lowest bid would not receive any shares in this example.

      Because bids that are reduced on a pro rata basis may be rounded down to round lots, a potential investor may be allocated less than two-thirds of the shares bid for. Thus, the potential investor who bid for 200 shares may receive a pro rata allocation of 100 shares (one-half of the shares bid for), rather than receiving a pro rata allocation of 133 shares (two-thirds of the shares bid for).

      The following table illustrates the example described above, before rounding down any bids to the nearest round lot, assuming that the initial public offering price is set at $8.00 per share. The table also assumes that these bids are the final bids, and that they reflect any modifications that have been made to reflect any prior changes to the offering range, and to avoid the issuance of fractional shares.

                                                         
Initial Public Offering of Company X

Bid information Auction results


Approximate
Cumulative allocated
Shares shares Shares requested Clearing Amount
requested requested Bid price allocated shares price raised







      200       200     $ 10.00       180       90 %   $ 8.00     $ 1,440  
      300       500       9.00       270       90     $ 8.00       2,160  
Clearing Price
    600       1,100       8.00       550       90     $ 8.00       4,400  
      400       1,500       7.00                          
      800       2,300       6.00                          
Total
                            1,000                     $ 8,000  

Requirements for Valid Bids

      Valid bids are those that meet the requirements, including eligibility, account status and size, established by the underwriters or participating dealers. In order to open a brokerage account with WR Hambrecht + Co, a potential investor must deposit $2,000 in its account. This brokerage account will be a general account subject to WR Hambrecht + Co’s customary rules, and will not be limited to this offering. In addition, once the registration statement becomes effective and the auction closes, a prospective investor submitting a bid through a WR Hambrecht + Co brokerage account must have an account balance equal to or in excess of the amount of its bid or its bid is not accepted by WR Hambrecht + Co. However, other than the $2,000 described above, prospective investors are not required to deposit any money into their accounts until after the registration statement becomes effective. No funds will be transferred to WR Hambrecht + Co, and any amounts in excess of $2,000 may be withdrawn at any time until the acceptance of the bid and the subsequent closing of this offering. Conditions for valid bids, including eligibility standards and

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account funding requirements of other participating dealers other than WR Hambrecht + Co, may vary.

The Closing of the Auction and Allocation of Shares

      The auction closes on a date estimated and publicly disclosed in advance by the underwriters on the website of WR Hambrecht + Co at www.wrhambrecht.com and www.openipo.com. The                      shares offered by this prospectus, or                      shares if the underwriters’ over-allotment option is exercised in full, will be purchased from us by the underwriters and sold through the underwriters and participating dealers to investors who have submitted valid bids at or higher than the public offering price. These investors are notified by email, telephone, voice mail, facsimile or mail as soon as practicable following the closing of the auction that their bids have been accepted.

      Each participating dealer has agreed with the underwriters to sell the shares it purchases from the underwriters in accordance with the auction process described above, unless the underwriters otherwise consent. The underwriters reserve the right to reject bids that the underwriters deem manipulative or disruptive in order to facilitate the orderly completion of this offering, and the underwriters reserve the right, in exceptional circumstances, to alter this method of allocation as the underwriters deem necessary to ensure a fair and orderly distribution of the shares of our common stock. For example, large orders may be reduced to ensure a public distribution and bids may be rejected or reduced by the underwriters or participating dealers based on eligibility or creditworthiness criteria. In addition, the underwriters or the participating dealers may reject or reduce a bid by a prospective investor who has engaged in practices that could have a manipulative, disruptive or otherwise adverse effect on the offering.

      Some dealers participating in the selling group may submit firm bids that reflect indications of interest from their customers that they have received at prices within the initial public offering price range. In these cases, the dealer submitting the bid is treated as the bidder for the purposes of determining the clearing price and allocation of shares.

      Price and volume volatility in the market for our common stock may result from the somewhat unique nature of the proposed plan of distribution. Price and volume volatility in the market for our common stock after the completion of this offering may adversely affect the market price of our common stock.

      We have granted to the underwriters an option, exercisable no later than 30 days after the date of this prospectus, to purchase up to an aggregate of                     additional shares of our common stock from us at the offering price, less the underwriting discounts and commissions set forth on the cover page of this prospectus. To the extent that the underwriters exercise this option, they will have a firm commitment to purchase the additional shares and we will be obligated to sell the additional shares to the underwriters. The underwriters may exercise the option only to cover over-allotments made in connection with the sale of shares offered. The underwriting agreement provides that we will indemnify the underwriters against specified liabilities, including liabilities under the Securities Act, or contribute to payments that the underwriters may be required to make.

      We have agreed not to offer, sell, contract to sell, pledge, grant any option to purchase, make any short sale or otherwise dispose of any shares of common stock, or any options or warrants to purchase common stock other than the shares of common stock or options to acquire common stock issued under our stock plans, for a period of 180 days after the date of this prospectus, except with the prior written consent of WR Hambrecht + Co. In addition, the holders of approximately 95% of our capital stock outstanding as of December 31, 2003 have entered into lock-up agreements pursuant to which they have agreed, subject to specified exceptions, that, without prior written consent of WR Hambrecht + Co, they will not offer, sell, contract to sell, pledge, grant any option to sell, or otherwise dispose of, directly or indirectly, any shares of our common stock or securities convertible into or exercisable for shares of our common stock, or warrants or other rights to purchase our common stock during the 180-day period following the effective date of the registration

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statement. However, notwithstanding the foregoing restrictions, the lock-up agreements permit sales to be made in accordance with applicable securities rules and regulations, subject only to the Rule 144 volume limitations described in “Shares Eligible for Future Sale” (to which the stockholders that have entered into the lock-up agreements have agreed to be subject during the term of such agreements, regardless of whether the Rule 144 volume limitations would otherwise restrict sales made by those stockholders). WR Hambrecht + Co, at its discretion, can waive the restrictions of the lock-up agreements at an earlier time without prior notice or announcement and allow all of our stockholders to sell their shares of our common stock in the public market subject only to applicable securities rules and regulations. In considering any request to release shares subject to a lock-up agreement WR Hambrecht + Co will consider the possible impact of the release of the shares on the trading price of the stock sold in the offering. WR Hambrecht + Co does not have any present intention or any understandings, implicit or explicit, to release any of the shares subject to the lock-up agreements prior to the expiration of these lock-up periods.

      In connection with the offering, the underwriters may purchase and sell shares of common stock in the open market. These transactions may include short sales, stabilizing transactions and purchases to cover positions created by short sales. Short sales involve the sale by the underwriters of a greater number of shares than they are required to purchase in the offering. “Covered” short sales are sales made in an amount not greater than the underwriters’ option to purchase additional shares from us in the offering. The underwriters may close out any covered short position by either exercising their option to purchase additional shares or purchasing shares in the open market. In determining the source of shares to close out the covered short position, the underwriters will consider, among other things, the price of shares available for purchase in the open market as compared to the price at which they may purchase shares through the over-allotment option. “Naked” short sales are any sales in excess of such option. The underwriters must close out any naked short position by purchasing shares in the open market. A naked short position is more likely to be created if the underwriters are concerned that there may be downward pressure on the price of the common stock in the open market after pricing that could adversely affect investors who purchase in the offering. Stabilizing transactions consist of various bids for or purchases of common stock made by the underwriters in the open market prior to the completion of the offering.

      These activities by the underwriters may stabilize, maintain or otherwise affect the market price of the common stock. As a result, the price of the common stock may be higher than the price that otherwise might exist in the open market. If these activities are commenced, they may be discontinued by the underwriters at any time. These transactions may be effected on the Nasdaq National Market, in the over-the-counter market or otherwise.

      WR Hambrecht + Co and Roth Capital Partners, LLC currently intend to act as market makers for the common stock following this offering. However, they are not obligated to do so and may discontinue any market making at any time.

Indemnity

      The underwriting agreement contains covenants of indemnity between the underwriters and us against certain civil liabilities, including liabilities under the Securities Act, and liabilities arising from breaches of representations and warranties contained in the underwriting agreement.

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LEGAL MATTERS

      The validity of the shares of common stock offered by this prospectus will be passed upon for us by Morrison & Foerster LLP, San Diego, California. Certain legal matters in connection with this offering will be passed upon for the underwriters by Wilson Sonsini Goodrich & Rosati, Professional Corporation, Palo Alto, California.

EXPERTS

      The financial statements as of December 31, 2002 and 2003 and for each of the two years in the period ended December 31, 2003 and for the period from July 24, 2001 (inception) to December 31, 2001 included in this prospectus have been so included in reliance on the report (which contains an explanatory paragraph relating to our ability to continue as a going concern as described in Note 1 to the financial statements) of PricewaterhouseCoopers LLP, independent accountants, given on the authority of said firm as experts in auditing and accounting.

WHERE YOU CAN FIND MORE INFORMATION

      We have filed with the Securities and Exchange Commission a registration statement on Form S-1 under the Securities Act with respect to the shares of common stock being offered by this prospectus. This prospectus does not contain all of the information in the registration statement and its exhibits. For further information about us and the common stock offered by this prospectus, we refer you to the registration statement and its exhibits. Statements contained in this prospectus as to the contents of any contract or any other document referred to are not necessarily complete, and in each instance where such contract or other document is filed as an exhibit to the registration statement, we refer you to the copy of the contract or other document filed as an exhibit to the registration statement. Each of these statements is qualified in all respects by the filed exhibit.

      You can read our Securities and Exchange Commission filings, including the registration statement of which this prospectus is a part, over the Internet at the Securities and Exchange Commission’s website at www.sec.gov. You may also read and copy any document we file with the Securities and Exchange Commission at its public reference facilities at 450 Fifth Street, N.W., Washington, D.C. 20549. You may also obtain copies of the document at prescribed rates by writing to the Public Reference Section of the Securities and Exchange Commission at 450 Fifth Street, N.W., Washington, D.C. 20549. Please call the Securities and Exchange Commission at 1-800-SEC-0330 for further information on the operation of the public reference facilities.

      Upon completion of this offering, we will be subject to the information reporting requirements of the Exchange Act and we will file reports, proxy statements and other information with the Securities and Exchange Commission. We also intend to furnish our stockholders with annual reports containing our financial statements audited by an independent public accounting firm and quarterly reports containing our unaudited financial information. We maintain a website at www.linspire.com. Upon completion of this offering, you may access our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act with the Securities and Exchange Commission free of charge at our website as soon as reasonably practicable after such material is electronically filed with, or furnished to, the Securities and Exchange Commission. The reference to our web address does not constitute an incorporation by reference of the information contained at this site into the registration statement or this prospectus.

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INDEX TO FINANCIAL STATEMENTS

         
Page

Report of Independent Auditors
    F-2  
Balance Sheets at December 31, 2002 and 2003
    F-3  
Statements of Operations for the period from July 24, 2001 (inception) to December 31, 2001 and for the years ended December 31, 2002 and 2003
    F-4  
Statements of Changes in Stockholders’ Equity (Deficit) for the period from July 24, 2001 (inception) to December 31, 2001 and for the years ended December 31, 2002 and 2003
    F-5  
Statements of Cash Flows for the period from July 24, 2001 (inception) to December 31, 2001 and for the years ended December 31, 2002 and 2003
    F-6  
Notes to Financial Statements
    F-7  

F-1


 

REPORT OF INDEPENDENT AUDITORS

To the Board of Directors and Stockholders

Lindows, Inc.

      In our opinion, the accompanying balance sheets and the related statements of operations, stockholders’ equity (deficit) and cash flows present fairly, in all material respects, the financial position of Lindows, Inc. at December 31, 2002 and 2003, and the results of its operations and its cash flows for the years then ended and for the period from July 24, 2001 (inception) to December 31, 2001, in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule listed in the index appearing under Item 16(b)(2) presents fairly, in all material respects, the information set forth therein when read in conjunction with the related financial statements. These financial statements and financial statement schedule are the responsibility of the Company’s management; our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States of America, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

      The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 1 to the financial statements, the Company has suffered recurring losses from operations and has negative working capital and an accumulated deficit. These conditions raise substantial doubt about the Company’s ability to continue as a going concern. Management’s plans in regard to these matters are also described in Note 1. These financial statements do not include any adjustments that might result from the outcome of this uncertainty.

/s/ PricewaterhouseCoopers LLP

San Diego, California

April 19, 2004

F-2


 

LINDOWS, INC.

BALANCE SHEETS

                               
Pro forma
stockholders’
December 31, equity (deficit) at

December 31,
2002 2003 2003



(unaudited –
note 1)
ASSETS
Current Assets:
                       
 
Cash and cash equivalents
  $ 113,318     $ 250,720          
 
Prepaid and other current assets
    256,040       36,414          
     
     
         
Total current assets
    369,358       287,134          
Property and equipment, net
    658,641       646,603          
     
     
         
Total assets
  $ 1,027,999     $ 933,737          
     
     
         
LIABILITIES & STOCKHOLDERS’ EQUITY (DEFICIT)
 
Current Liabilities:
                       
 
Accounts payable
  $ 142,609     $ 102,642          
 
Accrued expenses
    307,197       302,301          
 
Accrued compensation
    114,583       212,626          
 
Deferred revenue
    850,037       1,446,120          
     
     
         
Total current liabilities
    1,414,426       2,063,689          
Deferred revenue — non-current
    572,111       260,719          
Note payable to stockholder, including accrued interest of $19,540 and $303,181 at December 31, 2002 and 2003, respectively
    1,499,261       4,703,181          
     
     
         
Total liabilities
    3,485,798       7,027,589          
Commitments & Contingencies (Notes 7 and 8)
                       
Stockholders’ Equity (Deficit):
                       
   
Series A Convertible Preferred stock: $.0001 par value; 80,000,000 shares authorized; 52,750,000 shares issued and outstanding at December 31, 2002 and 2003, respectively; liquidation preference of $5,000,000 at December 31, 2003; no shares issued and outstanding on a pro forma basis (unaudited)
    5,275       5,275     $  
   
Common stock, $.0001 par value; 70,000,000 shares authorized; 5,456,250 and 5,995,537, shares issued and outstanding at December 31, 2002 and 2003, respectively; 58,745,537 shares issued and outstanding on a pro forma basis (unaudited)
    546       600       5,875  
     
Additional paid-in capital
    5,440,011       6,016,466       6,016,466  
     
Deferred compensation
    (110,883 )     (248,243 )     (248,243 )
     
Stock subscription receivable
    (9,145 )     (9,145 )     (9,145 )
     
Accumulated deficit
    (7,783,603 )     (11,858,805 )     (11,858,805 )
     
     
     
 
Total stockholders’ equity (deficit)
    (2,457,799 )     (6,093,852 )   $ (6,093,852 )
     
     
     
 
Total liabilities and stockholders’ equity (deficit)
  $ 1,027,999     $ 933,737          
     
     
         

See accompanying notes to financial statements.

F-3


 

LINDOWS, INC.

STATEMENTS OF OPERATIONS

                             
Period from
July 24, 2001 Years ended
(inception) to December 31
December 31,
2001 2002 2003



Revenues
  $     $ 63,131     $ 2,074,002  
Cost of revenues
          415,077       605,567  
     
     
     
 
 
Gross profit (loss)
          (351,946 )     1,468,435  
Operating expenses:
                       
   
Research and development
    779,524       2,453,126       3,272,109  
   
Sales and marketing
    67,059       843,772       1,044,040  
   
General and administrative
    299,555       3,002,823       945,473  
     
     
     
 
 
Total operating expenses
    1,146,138       6,299,721       5,261,622  
     
     
     
 
Operating loss
    (1,146,138 )     (6,651,667 )     (3,793,187 )
   
Interest income
    18,747       15,018       1,770  
   
Interest expense (related party)
          (19,563 )     (283,785 )
     
     
     
 
      18,747       (4,545 )     (282,015 )
     
     
     
 
Net loss
  $ (1,127,391 )   $ (6,656,212 )   $ (4,075,202 )
     
     
     
 
Weighted average common shares outstanding, basic and diluted
    1,185,850       2,808,112       5,239,163  
     
     
     
 
Net loss per common share, basic and diluted
  $ (0.95 )   $ (2.37 )   $ (0.78 )
     
     
     
 
Pro forma weighted average common shares outstanding (unaudited)
                    57,989,163  
                     
 
Pro forma net loss per common share, basic and diluted (unaudited)
                  $ (0.07 )
                     
 

See accompanying notes to financial statements.

F-4


 

LINDOWS, INC.

STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY (DEFICIT)

For the Period from July 24, 2001 (Inception) to December 31, 2001 and for the
Years ended December 31, 2002 and 2003
                                                                           
Series A convertible Total
preferred stock Common stock Additional Stock stockholders’


paid-in Deferred subscription Accumulated equity
Shares Par value Shares Par value capital compensation receivable deficit (deficit)









Balance at July 24, 2001 (inception)
        $           $     $     $     $     $     $  
Issuance of restricted common stock
                4,125,000       413       38,774       (39,187 )                  
Issuance of common stock
                1,000,000       100       9,400                         9,500  
Issuance of Series A Convertible Preferred stock
    52,750,000       5,275                   4,994,370             (9,145 )           4,990,500  
Stock-based compensation related to options issued to employees
                            63,025       (63,025 )                  
Amortization of deferred compensation
                                  9,796                   9,796  
 
Net loss
                                              (1,127,391 )     (1,127,391 )
     
     
     
     
     
     
     
     
     
 
Balance at December 31, 2001
    52,750,000       5,275       5,125,000       513       5,105,569       (92,416 )     (9,145 )     (1,127,391 )     3,882,405  
Exercise of stock options
                331,250       33       3,115                         3,148  
Stock-based compensation related to options issued to employees
                            194,944       (194,944 )                  
Reversal of deferred compensation related to stock option cancellations
                            (2,170 )     2,170                    
Amortization of deferred compensation
                                  174,307                   174,307  
Stock-based expense related to options issued to consultants
                            138,553                         138,553  
 
Net loss
                                              (6,656,212 )     (6,656,212 )
     
     
     
     
     
     
     
     
     
 
Balance at December 31, 2002
    52,750,000       5,275       5,456,250       546     $ 5,440,011       (110,883 )     (9,145 )     (7,783,603 )     (2,457,799 )
Exercise of stock options
                539,287       54       5,069                         5,123  
Stock-based compensation related to options issued to employees
                            490,835       (490,835 )                  
Reversal of deferred compensation related to stock option cancellations
                            (11,535 )     11,535                    
Amortization of deferred compensation
                                  341,940                   341,940  
Stock-based expense related to options issued to consultants
                            92,086                         92,086  
 
Net loss
                                              (4,075,202 )     (4,075,202 )
     
     
     
     
     
     
     
     
     
 
Balance at December 31, 2003
    52,750,000     $ 5,275       5,995,537     $ 600     $ 6,016,466     $ (248,243 )   $ (9,145 )   $ (11,858,805 )   $ (6,093,852 )
     
     
     
     
     
     
     
     
     
 

See accompanying notes to financial statements.

F-5


 

LINDOWS, INC.

STATEMENTS OF CASH FLOWS

                               
Period from
July 24, 2001 Years ended
(inception) to December 31
December 31,
2001 2002 2003



Operating activities:
                       
 
Net loss
  $ (1,127,391 )   $ (6,656,212 )   $ (4,075,202 )
 
Adjustments to reconcile net loss to net cash used in operating activities:
                       
   
Bad debt expense
          661,366        
   
Depreciation and amortization
    13,212       256,710       337,462  
   
Stock-based expense related to options issued to consultants
          138,553       92,086  
   
Amortization of deferred compensation
    9,796       174,307       341,940  
   
Changes in operating assets and liabilities:
                       
     
Prepaid and other current assets
    (26,975 )     (229,065 )     219,626  
     
Accounts payable
    197,799       (55,190 )     (39,967 )
     
Accrued expenses
    37,846       357,985       (4,896 )
     
Accrued interest
          19,540       283,641  
     
Deferred revenue
          1,422,148       284,691  
     
Accrued compensation
    65,685       48,898       98,043  
     
     
     
 
Net cash used in operating activities
    (830,028 )     (3,860,960 )     (2,462,576 )
Investing activities:
                       
 
Issuance of note receivable to third party
    (750,000 )            
 
Purchases of property and equipment
    (513,779 )     (414,784 )     (325,424 )
     
     
     
 
Net cash used in investing activities
    (1,263,779 )     (414,784 )     (325,424 )
Financing activities:
                       
 
Proceeds from issuance of common stock
    9,500              
 
Proceeds from issuance of preferred stock
    4,990,500              
 
Proceeds from exercise of stock options
          3,148       5,123  
 
Draws on line of credit obligation
          1,479,721       2,920,279  
     
     
     
 
Net cash provided by financing activities
    5,000,000       1,482,869       2,925,402  
     
     
     
 
Increase (decrease) in cash and cash equivalents
    2,906,193       (2,792,875 )     137,402  
Cash and cash equivalents, beginning of year
          2,906,193       113,318  
     
     
     
 
Cash and cash equivalents, end of year
  $ 2,906,193     $ 113,318     $ 250,720  
     
     
     
 
Supplemental cash flow information:
                       
 
Interest received
  $ 18,747     $ 15,018     $ 1,770  
Non-cash transactions:
                       
 
Common stock issued in exchange for future services
  $ 39,187     $     $  
 
Stock subscription receivable from stockholder
  $ 9,145     $     $  

See accompanying notes to financial statements.

F-6


 

LINDOWS, INC.

NOTES TO FINANCIAL STATEMENTS

 
1. Organization and Significant Accounting Policies
 
Description of Business

      Lindows, Inc. (the “Company”) was incorporated in the state of Delaware on July 24, 2001. The Company is a developer and vendor of Linux-based operating systems, application software and services designed specifically for desktop and laptop computers in homes, schools and businesses. The cornerstone of the Company’s product line is the Linspire operating system. The Company also offers Linux application software and services developed by the Company and others. The Company sells and distributes its products and services both through the Internet using its CNR technology and through hardware manufacturers, systems builders, and software and hardware resellers. The Company’s CNR technology reduces the complexity of installing, managing and updating Linux application software.

 
Basis of Presentation

      The accompanying financial statements have been prepared assuming the Company will recover its assets and satisfy its liabilities in the normal course of business. As of December 31, 2003, the Company has a working capital deficit of $1.8 million, long-term debt of $4.7 million and an accumulated deficit of $11.9 million. The Company’s ability to fund its operations during 2004 is dependent upon obtaining additional debt or equity financing adequate to fulfill its development and marketing activities, and achieving a level of revenues adequate to support the Company’s cost structure. The Company intends to raise the proceeds necessary to fund its operations during 2004 through a combination of financings, including an offering of equity securities. Should the Company be unsuccessful in obtaining the funds necessary to fund its operations from third parties, one of the Company’s principal stockholders has committed to continue to provide an available line of credit up to $10.0 million through June 30, 2005 (See Notes 4 and 10). While management believes that its existing working capital, its plans to raise proceeds through equity or debt financings and the line of credit from one of its principal stockholders are sufficient to fund its operations for at least the next twelve months, there can be no assurance that the Company will be able to obtain additional financing on commercially reasonable terms or at all.

 
Unaudited Pro Forma Stockholders’ Equity

      The Company’s Board of Directors has authorized the filing of a registration statement with the Securities and Exchange Commission to register shares of its common stock in an initial public offering (IPO). If the IPO is consummated as presently anticipated, all of the outstanding shares of Series A Convertible Preferred stock will convert into 52,750,000 shares of common stock. Unaudited pro forma stockholders’ equity at December 31, 2003 reflects the assumed automatic conversion of all outstanding shares of Series A Convertible Preferred Stock into shares of common stock as if such conversion had occurred at December 31, 2003.

 
Use of Estimates

      The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from these estimates.

F-7


 

LINDOWS, INC.

NOTES TO FINANCIAL STATEMENTS — (Continued)

 
Cash and Cash Equivalents

      The Company considers all highly liquid investments with an original or remaining maturity of three months or less when purchased to be cash equivalents.

 
Concentration of Credit Risk and Significant Customers

      Financial instruments, which potentially subject the Company to concentrations of credit risk, consist primarily of cash and cash equivalents and accounts and notes receivable. The Company limits its exposure to credit loss by placing its cash and cash equivalents and short-term investments with high credit quality financial institutions. The Company does not require collateral on its arrangements with customers. In general, the Company requires most of its customers to pay by credit card at the time of purchase. As is necessary, the Company provides reserves against accounts receivable for estimated losses that may result from customers’ inability to pay. The amount of the reserve is determined by analyzing known uncollectible accounts, aged receivables, economic conditions in the customers’ industry, historical losses and changes in customer creditworthiness. Write-offs of trade receivables to date have not been material. Also see reserve for note receivable discussed in Note 8.

      The Company had one customer that comprised approximately 11% of revenues for the year ended December 31, 2003. No single customer comprised more than 10% of revenues for the year ended December 31, 2002.

 
Fair Value of Financial Instruments

      The carrying amounts shown for the Company’s cash and cash equivalents, notes receivable and accounts and notes payable approximate their fair value due to the short-term maturities of these instruments.

 
Property and Equipment

      Property and equipment is stated at cost and depreciated using the straight-line method over the estimated useful lives of the related assets: computer hardware and software — 3 years; office furniture and equipment — 5 years. Leasehold improvements are amortized using the straight-line method over the shorter of the estimated useful lives of the assets or the terms of the related leases.

 
Impairment of Long-Lived Assets

      In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 144, “Accounting for the Impairment of or Disposal of Long-Lived Assets,” the Company records impairment losses on long-lived assets used in operations when events and circumstances indicate that assets might be impaired and the undiscounted cash flows estimated to be generated by those assets are less than the carrying amount of those assets. To date, the Company has not experienced any impairment losses on its long-lived assets used in operations.

 
Revenue Recognition

      The Company generates its revenue from the sale of desktop operating systems, application software and services for desktop and laptop computers. The Company licenses and distributes Linux software applications, developed by the Company and others, through the Internet using the Company’s CNR technology and through hardware manufacturers, system builders and software and hardware resellers. The Company recognizes revenue in accordance with Statement of Position No. 97-2, “Software Revenue Recognition” (“SOP 97-2”), as amended by SOP 98-4 and SOP 98-9.

F-8


 

LINDOWS, INC.

NOTES TO FINANCIAL STATEMENTS — (Continued)

The Company recognizes revenues when all of the following criteria are met: (1) persuasive evidence of an arrangement exists (upon contract signing or receipt of an authorized purchase order from the customer); (2) delivery has occurred (upon delivery of the software product or performance of services in accordance with contract specifications); (3) the sales price is deemed fixed and determinable (free of contingencies or significant uncertainties such as refund/adjustment provisions or extended payment terms); and (4) collection is probable (there are no indicators of non-payment based upon history with the customer and/or upon completion of applicable credit review procedures). Billings made or payments received in advance of delivery are deferred until the period these services are provided. As of December 31, 2002 and 2003, the Company had deferred revenue amounts of $1,422,148 and $1,706,839, respectively, of which approximately $1,446,120 will be recognized as revenue during 2004.

      The Company’s product revenues consist of several key categories:

     The Linspire operating system and other desktop products

      The Company’s primary products, the Linspire operating system software and other application software (spreadsheet, presentation, word processing, games, etc.) are sold directly to end users through the Company’s internet website. Customers can download the purchased software directly from the website or request shipment of the software product on CD. Most of the Company’s customers pay for their purchases using a credit card. The Company offers a 15-day right of return; as a result, revenues are not recorded until after such return privileges expire. Purchasers of Linspire and other desktop products are not entitled to upgrade rights under the terms of the software license agreement; however, when the release of a new version of a software product is imminent and the Company expects that the new version will be provided to a customer due to the customer’s purchase of the current version of the product, revenue is deferred until the new version has been delivered to the customer. Post-contract customer support (PCS) is provided online primarily through databases of frequently asked questions (FAQs) which may be accessed on the Company’s website and secondarily through responses to email queries. The cost of providing such PCS is insignificant.

     Reseller agreements

      Revenues from agreements with resellers and distributors are recognized based upon the terms of the agreement. In general, revenues are recognized when all goods and services have been delivered, return obligations have been fulfilled and service obligations have lapsed. The Company provides technical support as part of most of its agreements with resellers (including when-and-if available upgrades); to the extent this is the case, revenue is recognized ratably over the term of the reseller arrangement which generally ranges from 12 to 24 months.

     Subscription services

      Several of the Company’s software products, including the LinspirePlus service (which allows users to install available software titles from the Company’s Warehouse at no additional charge or at a discounted price) and customer support services, are sold as annual subscription services, with access to these services over a certain period included in the software price. The Company’s virus protection, Internet security and access to the Warehouse are generally sold as annual subscription services. Revenues associated with such services are deferred and recognized as subscriptions on a straight-line basis over the entire term of the service period, which in general is a year in duration. For subscription services sold on a lifetime basis, revenues are recognized ratably over the estimated life of the underlying technology, generally ranging from 3 to 5 years in duration.

F-9


 

LINDOWS, INC.

NOTES TO FINANCIAL STATEMENTS — (Continued)

     Builder and Manufacturers Programs

      Builders of computer systems and manufacturers of computer hardware pay monthly or annual program fees or per-unit licensing fees for each unit of the Company’s product which they install. Builders and manufacturers are entitled to technical support relating to the builder’s specific hardware. High-volume builders may participate in revenue sharing programs for products and services that their customers buy from the Company’s Warehouse. Revenue sharing payments are accounted for as reductions in revenue in the period they are earned.

      Revenue associated with monthly and annual builder and manufacturer programs are deferred and recognized on a straight-line basis over the term of the contract, which in general ranges from one month to one year. Per unit license fees are recognized as revenue as the builder or manufacturer sells the products.

     Bundled Software

      The Company offers certain bundled packages of software for its customers. For such arrangements with multiple elements, the Company allocates revenue to each element of the transaction based upon the sales price of the products and services when sold by the Company on a stand-alone basis to other customers. When the fair value of an undelivered element has not been established and the only undelivered element is a subscription, revenue for the entire package is deferred and recognized on a straight-line basis over the term of the service period, generally ranging from 12 — 36 months.

     Shipping and handling

      The fees for shipping and handling paid by the customer are recognized as revenues. The costs associated with shipping and handling the Company’s products are expensed as cost of revenues.

 
Cost of revenues

      Cost of revenues are expensed as incurred and consist primarily of royalties, product costs, third party credit verification services, merchant transaction charges and bandwidth charges associated with the delivery of the Company’s software products to the consumer.

 
Research and development expenses

      Research and development expenses, including payroll, employee benefits, allocated overhead and other headcount-related costs associated with product development are charged to expense as incurred.

 
Internal Use Software

      In accordance with Statement of Position No. 98-1, “Accounting for the Costs of Computer Software Developed or Obtained for Internal Use” (“SOP 98-1”), the Company capitalized $280,450 in costs related to the development of internal use software for its website and e-commerce systems during the period from July 24, 2001 (inception) to December 31, 2001. Such costs represent software purchased from external third parties for use in the Company’s internal operations. No costs were capitalized during the years ended December 31, 2002 and 2003. The Company amortizes the costs of computer software developed for internal use on a straight-line basis over its estimated useful life of 3 years. The carrying value of internal use software is included in property and equipment at December 31, 2002 and 2003.

F-10


 

LINDOWS, INC.

NOTES TO FINANCIAL STATEMENTS — (Continued)

 
Capitalized Software Costs

      Capitalization of software development costs for products to be sold to third parties begins upon the establishment of technological feasibility and ceases when the product is available for general release. Technological feasibility is established upon the development of a working model of the software program. On a regular basis, the Company releases the source code underlying its software products as well as the beta versions of its software. As the time period between establishment of technological feasibility and when the software is available for general release is short and the related development costs are not material, the Company has not capitalized any software development costs since its inception.

 
Sales and Marketing Costs

      Sales and marketing expenses consist primarily of salaries, benefits and related expenses, including travel of personnel engaged in selling, marketing and customer support functions as well as public relations, promotional costs and allocated overhead costs and advertising. The Company expenses all advertising costs when incurred. For the year ended December 31, 2003, such costs were $7,549. There were no advertising costs incurred during the period from July 24, 2001 (inception) through December 31, 2001 and for the year ended December 31, 2002.

 
Stock-Based Compensation

      As permitted by SFAS No. 123, “Accounting for Stock-Based Compensation,” the Company has elected to apply Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”), and related interpretations in accounting for its employee stock options. Under APB 25, when the exercise price of the Company’s employee stock options is equal to or greater than the estimated fair value of the underlying stock on the date of grant, no compensation expense is recognized. With respect to stock options granted with exercise prices below the fair value of the Company’s common stock as estimated by the Company’s management for financial reporting purposes, the Company has recorded deferred stock-based compensation for the difference between the exercise prices of these stock options and the related estimated fair values. This deferred compensation is being amortized to expense on an accelerated basis over the stock option’s vesting period in accordance with Financial Accounting Standards Board (“FASB”) Interpretation No. 28 (“FIN 28”), “Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans, an Interpretation of APB Opinion Nos. 15 and 25.”

      Compensation for equity instruments issued to non-employees has been determined in accordance with SFAS No. 123, FASB Interpretation No. 44, “Accounting for Certain Transactions involving Stock Compensation,” and the EITF consensus on Issue 96-18, “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring or in Conjunction with Selling Goods or Services,” as the fair value of the consideration received or the fair value of the equity instruments issued, whichever is more reliably measured.

      Pro forma information regarding net loss is required by SFAS No. 123 and SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure,” and has been determined as if the Company had accounted for its employee stock options under the fair value method. The

F-11


 

LINDOWS, INC.

NOTES TO FINANCIAL STATEMENTS — (Continued)

fair value for these options was estimated at the grant date using the Black-Scholes method for option pricing with the following assumptions:

                         
Period from
July 24, 2001 Years ended
(inception) to December 31,
December 31,
2001 2002 2003



Weighted average risk-free interest rate
    4.6 %     4.1 %     3.0 %
Expected option life
    5 years       5 years       5 years  
Expected stock price volatility
    120 %     102 %     92 %
Expected dividend yield
    0.0 %     0.0 %     0.0 %
Weighted average fair value of options granted with exercise price less than fair value on date of grant
  $ 0.05     $ 0.14     $ 0.30  

      Future pro forma results of operations under SFAS No. 123 may be materially different from actual amounts reported. For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense on an accelerated basis in accordance with FIN 28 over the vesting period. The Company has used the Black-Scholes method to determine the fair value of options granted prior to its initial filing in a registration statement under the Securities Act of 1933 relating to an initial public offering of the Company’s common stock. While, as a non-public company, there has not been an observable market for the Company’s common stock, the Company has used an estimated volatility factor for grants issued since inception based upon stock price volatility factors of comparable public companies.

      The following table illustrates the effect on net losses if the Company had applied the fair value recognition provisions of SFAS No. 123 to record stock-based compensation:

                           
Period from
July 24, 2001 Years ended
(inception) to December 31,
December 31,
2001 2002 2003



Net loss — as reported
  $ (1,127,391 )   $ (6,656,212 )   $ (4,075,202 )
Add: Stock-based employee compensation expense included in reported net loss
    9,796       174,307       341,940  
Less: Total stock-based employee compensation expense determined under the fair value method for all awards
    (9,796 )     (185,285 )     (359,412 )
     
     
     
 
Pro forma net loss
  $ (1,127,391 )   $ (6,667,190 )   $ (4,092,674 )
     
     
     
 
Net loss per share:
                       
 
Basic and diluted — as reported
  $ (.95 )   $ (2.37 )   $ (.78 )
     
     
     
 
 
Basic and diluted — pro forma
  $ (.95 )   $ (2.37 )   $ (.78 )
     
     
     
 
 
Income Taxes

      Deferred income taxes result primarily from temporary differences between financial and tax reporting. Deferred tax assets and liabilities are determined based on the difference between the financial statement basis and the tax basis of assets and liabilities using enacted tax rates. Valuation

F-12


 

LINDOWS, INC.

NOTES TO FINANCIAL STATEMENTS — (Continued)

allowances are established to reduce deferred tax assets to the amount that is expected to more likely than not be realized in the future.

 
Comprehensive Loss

      Comprehensive loss is the total of net loss and all other non-owner changes in stockholders’ equity. Such amounts are excluded from net loss and are reported in accumulated other comprehensive loss in the accompanying financial statements. For the period from July 24, 2001 (inception) through December 31, 2003, the Company had no items of other comprehensive loss.

 
Net Loss Per Share

      In accordance with SFAS No. 128, “Earnings Per Share,” basic net loss per common share is computed by dividing the net loss for the period by the weighted average number of common shares outstanding during the period. Potentially dilutive securities are not considered in the calculation of net loss per common share as their inclusion would be anti-dilutive.

      In accordance with SAB No. 98, common shares issued for nominal consideration, if any, would be included in the per share calculations as if they were outstanding for all periods presented. No common shares have been issued for nominal consideration.

      A reconciliation of the numerator and denominator used in the calculation of basic and diluted net loss per share is as follows:

                           
Period from
July 24, 2001 Years ended
(inception) to December 31,
December 31,
2001 2002 2003



Numerator:
                       
Net loss
  $ (1,127,391 )   $ (6,656,212 )   $ (4,075,202 )
     
     
     
 
Denominator:
                       
Basic and diluted:
                       
 
Weighted average common shares outstanding
    1,185,850       2,808,112       5,239,163  
     
     
     
 
Basic and diluted net loss per share
  $ (0.95 )   $ (2.37 )   $ (0.78 )
     
     
     
 

      The following table summarizes securities as of December 31, 2001, 2002 and 2003 that could potentially dilute basic EPS in the future that are not included in the denominator used in the diluted net loss per share calculation because to do so would be antidilutive:

                         
December 31,

2001 2002 2003



Options to purchase common stock
    1,637,000       3,741,750       4,309,938  
Restricted shares subject to repurchase
    3,093,750       1,031,250        
Series A Convertible Preferred stock
    52,750,000       52,750,000       52,750,000  
     
     
     
 
      57,480,750       57,523,000       57,059,938  
     
     
     
 

F-13


 

LINDOWS, INC.

NOTES TO FINANCIAL STATEMENTS — (Continued)

 
Pro Forma Net Loss Per Share (Unaudited)

      Unaudited pro forma basic and diluted net loss per share for the year ended December 31, 2003 is computed using the weighted average number of common shares outstanding, including the pro forma effect, on an as-if converted basis, of the conversion of 52,750,000 shares of Series A Convertible Preferred stock into an equal number of shares of common stock, as if such conversion had occurred on January 1, 2003. Pro forma diluted net loss per share is computed using the pro forma weighted average number of shares of common stock and common stock equivalents outstanding. Common stock equivalent shares, composed of shares of common stock issuable upon the exercise of stock options, are not included in pro forma diluted net loss per share because to do so would be antidilutive.

 
Segment Information

      The provisions of SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information,” require public companies to report financial and descriptive information about their reportable operating segments. The Company identifies its operating segments based on how management internally evaluates separate financial information, business activities and management responsibility. On that basis, the Company believes it operates in a single business segment.

      International sales totaled $13,146 and $727,161 in the years ended December 31, 2002 and 2003, respectively and were received principally from customers in Europe and Japan.

 
Recently Issued Accounting Standards

      In December 2003, the Securities and Exchange Commission released Staff Accounting Bulletin No. 104, “Revenue Recognition,” (“SAB 104”). SAB 104 revises or rescinds portions of the interpretative guidance related to revenue recognition included in Topic 13 of the codification of the staff accounting bulletins. We have assessed the impact of SAB 104 and concluded that the adoption of SAB 104 did not have a material impact on our financial statements.

      In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity,” (“SFAS 150”). SFAS 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). Many of those instruments were previously classified as equity. SFAS 150 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. The adoption of SFAS 150 has had no effect on the Company’s financial position or results of operations.

      In April 2003, the FASB issued SFAS No. 149, “Amendment of Statement No. 133 on Derivative Instruments and Hedging Activities,” (“SFAS 149”). SFAS 149 amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts. SFAS 149 clarifies under what circumstances a contract with an initial net investment meets the characteristic of a derivative, clarifies when a derivative contains a financing component, amends the definition of an underlying to conform it to language used in FASB Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others” (“FIN 45”) and amends certain other existing pronouncements. SFAS 149 is effective for contracts entered into or modified after June 30, 2003 and for hedging relationships designated after June 30, 2003. All provisions of SFAS 149, except those related to forward purchases or sales of “when-issued” securities, should be applied

F-14


 

LINDOWS, INC.

NOTES TO FINANCIAL STATEMENTS — (Continued)

prospectively. The adoption of SFAS 149 has had no effect on the Company’s financial position or results of operations.

      In December 2003, the FASB issued additional guidance clarifying the provisions of FASB Interpretation No. 46, “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51,” or (“FIN 46-R”). FIN 46-R provides a deferral of FIN 46 for certain entities. FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. The adoption of this standard is not expected to have a material impact on the Company’s financial statements.

      FASB Interpretation No. 45 was issued in November 2002. FIN 45 requires that upon issuance of a guarantee, the guarantor must disclose and recognize a liability for the fair value of the obligation it assumes under that guarantee. The initial recognition and measurement requirement of FIN 45 is effective for guarantees issued or modified after December 31, 2002. The disclosure requirements of FIN 45 are effective for interim and annual periods ending after December 15, 2002, and are applicable to certain guarantees issued by the Company before December 31, 2002. The Company adopted FIN 45 disclosure requirements as of December 31, 2002. The adoption of the provisions for recognition and initial measurement did not have a material impact on the Company’s financial position, results of operations or cash flows.

      In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure.” SFAS No. 148 is an amendment to SFAS No. 123 providing alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation and also provides additional disclosures about the method of accounting for stock-based employee compensation. Amendments are effective for financial statements for fiscal years ending after December 15, 2002. The Company has currently chosen to not adopt the voluntary change to the fair value based method of accounting for stock based employee compensation, pursuant to SFAS No. 148, which, if adopted, could have a material impact on its financial position or results of operations.

 
2. Balance Sheet Details

      Prepaid and other current assets consist of the following:

                 
December 31,

2002 2003


Deposits
  $ 31,673     $ 16,084  
Prepaid insurance
    10,829       10,043  
Prepaid service contract
    36,369       7,482  
Prepaid royalties
    29,117       2,805  
Prepaid rent and lease deposit
    148,052        
     
     
 
Prepaid and other current assets
  $ 256,040     $ 36,414  
     
     
 

F-15


 

LINDOWS, INC.

NOTES TO FINANCIAL STATEMENTS — (Continued)

      Property and equipment, net consists of the following:

                 
December 31,

2002 2003


Computer hardware and software
  $ 615,290     $ 890,052  
Capitalized internal use software
    280,450       280,450  
Furniture, fixtures and office equipment
    30,581       81,243  
Leasehold improvements
    2,242       2,242  
     
     
 
      928,563       1,253,987  
Less: accumulated depreciation and amortization
    (269,922 )     (607,384 )
     
     
 
Property and equipment, net
  $ 658,641     $ 646,603  
     
     
 

      Depreciation and amortization expense was $13,212, $256,710 and $337,462, for the period from July 24, 2001 (inception) to December 31, 2001 and for the years ended December 31, 2002 and 2003, respectively.

      Accrued expenses consist of the following:

                 
December 31,

2002 2003


Accrued legal expense
  $ 260,178     $ 224,368  
Accrued other
    47,019       77,933  
     
     
 
Accrued expenses
  $ 307,197     $ 302,301  
     
     
 
 
3. Related Party Transactions

      The Company leases space on a month-to-month basis to and performs certain administrative, support and operational services for an entity, which is controlled by the Company’s CEO and majority stockholder, for which the Company is reimbursed based upon the actual cost of the space and services provided. During the year ended December 31, 2003, the Company received approximately $66,000 for reimbursement of such general and administrative costs.

 
4. Note Payable and Line of Credit — Stockholder

      In July 2002, the Company entered into a Revolving Line of Credit Agreement (“the Loan Agreement”) with the Company’s Chief Executive Officer and majority stockholder. The Loan Agreement, as amended, provided the Company a $5 million line of credit through December 31, 2003, bearing an interest rate of 10% per year, with interest payments due monthly. As of December 31, 2003, borrowings under the line of credit totaled $4,400,000, and accrued but unpaid interest totaled $303,181.

      In February 2004, the Loan Agreement was amended to increase the amount available under the line of credit to $10 million and to extend the maturity date for both principal and accrued interest to June 30, 2005. The amendment also removed the requirement to make monthly interest payments and waived all prior events of default under the Loan Agreement. To date, no interest payments have been made. As a result of the change in credit terms, the entire Loan balance of $4,400,000 plus accrued interest of $303,181 is due on June 30, 2005; accordingly, these amounts have been classified as a non-current liability at December 31, 2003.

F-16


 

LINDOWS, INC.

NOTES TO FINANCIAL STATEMENTS — (Continued)

      Interest expense related to the note payable was $0, $19,540, and $283,641 for the period from July 24, 2001 (inception) to December 31, 2001 and for the years ended December 31, 2002 and 2003, respectively.

 
5. Stockholders’ Equity
 
Common Stock

      In August 2001, the Company issued 1,000,000 shares of common stock to one of its founders at $0.0095 per share for proceeds of $9,500. In October 2001, the Company issued 4,125,000 shares of restricted common stock valued at $39,187 ($0.0095 per share) to the Company’s President. The estimated fair value of the common stock of $39,187 was recorded as deferred compensation upon issuance and was amortized to compensation expense over the 2-year vesting period of the restricted stock award. As of December 31, 2003, such common stock was fully vested and the restrictions had lapsed.

 
Convertible Preferred Stock

      The Company has authorized the issuance of 80,000,000 shares of preferred stock, of which 52,750,000 were issued during 2001 in the form of Series A Convertible Preferred stock with a liquidation value of $5,000,000. All shares of Series A Convertible Preferred stock remained issued and outstanding as at December 31, 2002 and 2003. The preferred stock is convertible on a one-to-one basis, subject to anti-dilution adjustments, into shares of common stock at the option of the stockholder. The preferred stock will automatically convert upon the occurrence of certain events including the closing of an initial public offering of at least $10,000,000, or by the written consent of a majority of the preferred stockholders of the consenting series.

      The outstanding shares of Series A Convertible Preferred stock are held by two stockholders, with approximately 90% of the Series A Convertible Preferred stock held by a single stockholder who controls the majority of the Company’s voting rights. The Series A Convertible Preferred stock has a non-cumulative cash dividend per share in an amount to be determined by the Board of Directors when and if declared. Each Series A Convertible Preferred stockholder has the right to vote as if their shares of preferred stock had been converted to common stock at the then-current conversion rate. The terms of the Series A Convertible Preferred stock provide for preferences upon liquidation and other rights. In general, the Series A Convertible Preferred stockholders have a preference at liquidation equal to the issuance price, plus any declared and unpaid dividends. The remaining assets, if any, would be distributed ratably to the common stockholders. No dividends were declared through December 31, 2003. The Series A Convertible Preferred stock is not subject to redemption.

 
Stock Options

      In December 2001, the Company adopted the Lindows.com, Inc. 2001 Stock Incentive Plan (the “Plan”). As amended, under the Plan the Company may grant options for up to 6,625,000 shares of the Company’s common stock. The Plan is administered by the Board of Directors or by a committee designated by the Board. The Board may fix the terms and vesting of all options; however, in no event will the contractual term exceed 10 years. Generally, options vest 25% one year from the grant date and  1/16th (6.25%) per quarter thereafter until the options are fully vested.

F-17


 

LINDOWS, INC.

NOTES TO FINANCIAL STATEMENTS — (Continued)

      Stock option activity is as follows:

                           
Common stock
options
available for Number of Weighted average
issuance shares exercise price



Balance at July 24, 2001 (inception)
              $  
 
Authorized
    4,625,000              
 
Granted
    (1,637,000 )     1,637,000     $ 0.0095  
     
     
         
Balance at December 31, 2001
    2,988,000       1,637,000     $ 0.0095  
 
Granted
    (1,429,500 )     2,454,500     $ 0.0095  
 
Exercised
          (331,250 )   $ 0.0095  
 
Expired or cancelled
    18,500       (18,500 )   $ 0.0095  
     
     
         
Balance at December 31, 2002
    1,577,000       3,741,750     $ 0.0095  
 
Authorized
    2,000,000              
 
Granted
    (1,699,000 )     1,699,000     $ 0.0095  
 
Exercised
          (539,287 )   $ 0.0095  
 
Expired or cancelled
    107,150       (591,525 )   $ 0.0095  
     
     
         
Balance at December 31, 2003
    1,985,150       4,309,938     $ 0.0095  
     
     
         
Weighted average contractual life (years) at December 31, 2003
            8.77          
             
         
Options exercisable at December 31, 2003
            1,726,854          
             
         

      The Company recorded deferred stock compensation totaling $63,025, $194,944 and $490,835 for the period from July 24, 2001 (inception) to December 31, 2001 and for the years ended December 31, 2002 and 2003, respectively, in connection with the grant of various stock options and restricted stock to employees. The deferred stock compensation represents the difference between the exercise or grant price and the estimated fair value of the Company’s common stock for financial reporting purposes as determined by the Company’s board of directors. Deferred compensation is included as a reduction of stockholders’ equity and is being amortized to expense over the vesting period of the options on an accelerated basis in accordance with FIN 28. Amortization of deferred compensation expense was $9,796, $174,307 and $341,940 for the period from July 24, 2001 (inception) to December 31, 2001 and for the years ended December 31, 2002 and 2003, respectively. Deferred compensation was reduced by $0, $2,170 and $11,535 for the period from July 24, 2001 (inception) to December 31, 2001 and for the years ended December 31, 2002 and 2003 to reflect the cancellation of certain unvested stock options upon the respective individual’s termination. As of December 31, 2003, the total charges to be recognized in future periods from amortization of deferred stock compensation are anticipated to be approximately $166,555, $67,268, $13,359 and $1,061 for the years ended December 31, 2004, 2005, 2006 and 2007, respectively.

      The above tables include certain options granted to consultants with terms similar to options issued to employees, including options granted in 2002 outside the Plan to purchase 1,025,000 shares (none of which were outstanding at December 31, 2003) and outstanding options granted under the Plan in 2003 to purchase 15,000 shares of common stock.

      Expense recorded related to awards granted to consultants was $0, $138,553 and $92,086 for the period from July 24, 2001 (inception) to December 31, 2001 and for the years ended

F-18


 

LINDOWS, INC.

NOTES TO FINANCIAL STATEMENTS — (Continued)

December 31, 2002 and 2003, respectively. The fair value for these options was estimated at the grant date using the Black-Scholes method for option pricing with the following assumptions:

                 
December 31,

2002 2003


Expected option life in years
    10       10  
Weighted average interest rate
    4.1 %     3.0 %
Expected stock price volatility
    102 %     92 %
Expected dividend yield
    0.0 %     0.0 %
Grant date weighted average fair value of options granted
  $ 0.11     $ 0.28  

      The fair value of stock options granted to consultants is periodically remeasured until the options are exercised or the service period is completed at which time a final remeasurement of the value of the options is determined.

 
Shares Reserved for Future Issuance

      Common stock is reserved for future issuance as follows:

         
December 31,
2003

Conversion of preferred stock
    52,750,000  
Stock options issued and outstanding
    4,309,938  
Authorized for future option grants
    1,985,150  
     
 
      59,045,088  
     
 
 
6. Income Taxes

      Since inception, the Company has incurred losses for both book and tax purposes; accordingly, the Company has not recorded any tax expense for the period from July 24, 2001 (inception) to December 31, 2001 and for the years ended December 31, 2002 and 2003. Significant components of the Company’s deferred tax assets as of December 31, 2002 and 2003 are shown below. A valuation allowance has been recognized to offset the deferred tax assets as realization of such assets is not considered to be more likely than not.

                 
December 31,

2002 2003


Deferred tax assets:
               
Net operating loss carryforwards
  $ 2,139,451     $ 3,369,258  
Research and development tax credits
    234,895       324,495  
Start-up costs capitalized for tax purposes
    95,671       105,127  
Bad debt expense
    298,758       298,758  
Deferred revenue
    558,497       663,896  
Other
    82,318       291,283  
     
     
 
Total deferred tax assets
    3,409,590       5,052,817  
Less: Valuation allowance for deferred tax assets
    (3,409,590 )     (5,052,817 )
     
     
 
Net deferred tax assets
  $     $  
     
     
 

F-19


 

LINDOWS, INC.

NOTES TO FINANCIAL STATEMENTS — (Continued)

      At December 31, 2003, the Company had federal and California tax net operating loss carryforwards of approximately $8,076,000 and $7,050,473, respectively. The federal and California tax loss carryforwards will begin to expire in 2021 and 2013, respectively, unless previously utilized. The Company also has federal and California research and development tax credits of approximately $173,000 and $192,000, respectively, and California manufacturers’ investment credit carryforwards of approximately $37,000. The federal research and development tax credit carryforwards will expire beginning in 2020, unless previously utilized. The California credits begin to expire in 2011.

      Pursuant to Code Sections 382 and 383, use of the Company’s net operating loss carryforwards may be limited in the event of a cumulative change in ownership of more than 50% within a three-year period.

 
7. Commitments
 
Lease Obligations

      The Company leases its corporate office space under a non-cancelable operating lease agreement. The lease contains escalation clauses and requires the Company to pay a share of any increases in operating expenses.

      Future minimum lease payments under non-cancelable operating lease arrangements as of December 31, 2003 are as follows:

         
2004
  $ 506,698  
2005
    528,774  
2006
    409,984  
     
 
    $ 1,445,456  
     
 

      Rent expense was $60,796, $371,672, and $368,557 for the period from July 24, 2001 (inception) to December 31, 2001 and for the years ended December 31, 2002 and 2003, respectively.

 
8. Litigation and Contingencies
 
Legal Proceedings
 
Microsoft Litigation

      On December 20, 2001, Microsoft initiated an action against the Company asserting that the Company’s use of the Lindows mark violates U.S. trademark law and U.S. and Washington state unfair competition laws. Microsoft seeks injunctive relief preventing the Company from using the name Lindows in connection with the Company’s software or other computer products or services. Microsoft also seeks monetary damages, including treble damages, attorney’s fees and costs.

      The Company has asserted several defenses and a counterclaim in this lawsuit. The Company asserts that Microsoft’s WINDOWS trademarks are unenforceable and invalid because the Company believes the term “windows” is generic, and a generic term can never be subject to trademark protection. The Company also asserts that Microsoft committed fraud on the U.S. Patent and Trademark Office and is pursuing this action for anti-competitive purposes. Finally, the Company asserts that the use of the Lindows name does not result in confusion with Microsoft’s WINDOWS trademark.

F-20


 

LINDOWS, INC.

NOTES TO FINANCIAL STATEMENTS — (Continued)

      In its ruling on February 10, 2004, the court determined that it would instruct the jury to consider whether “windows” was a generic term before Microsoft introduced software with that name in November 1985. Microsoft had argued that the jury should consider whether “windows” is now a generic term. Microsoft has appealed this ruling and the Company is contesting Microsoft’s appeal. While the court has postponed trial indefinitely pending Microsoft’s appeal of the court’s February 10, 2004 ruling, the court has ruled that the Company can continue to use the Company’s marks throughout the course of the litigation.

      During the period from November 28, 2003 through February 11, 2004, Microsoft initiated various separate trademark violation claims against the Company in certain foreign jurisdictions including Finland, Sweden, the Netherlands, France, Spain, Mexico and Canada. These claims seek injunctive relief to prevent the Company from using the Lindows name in connection with the Company’s software or other computer products or services distributed in the respective countries. Each of the foreign Microsoft lawsuits seeks monetary damages, including attorneys’ fees and other damages allegedly sustained by Microsoft. In addition to these actions, Microsoft has threatened to bring similar trademark infringement actions in other countries.

      Microsoft did not provide the Company with notice of the Finland and Sweden lawsuits until after the courts in those countries ruled in favor of Microsoft on its motions for injunctive relief. Accordingly, the Company had no opportunity to present a defense and is now appealing these rulings. While the appeals are pending, the Company is prohibited from selling products with the Lindows name in Finland and Sweden. The Netherlands court has also ruled in favor of Microsoft. The court’s ruling prohibits the Company from selling products with the Lindows name in the Netherlands, Belgium and Luxembourg. The ruling also requires the Company to prohibit visitors from these countries from accessing the Company’s website to the extent it uses the Lindows name. The Company has appealed this ruling; however, in order to comply with the ruling pending the appeal, the Company has adopted “Linspire” as an alternative name for its commerce website and its products and services.

      The litigation with Microsoft may continue well into the future. If the litigation is resolved in favor of Microsoft, Microsoft may be entitled to receive significant monetary damages from the Company, and the Company could be required to permanently drop the use of the Lindows name. Furthermore, the Company may have to indemnify channel partners for losses they may suffer as a result of the Microsoft litigation. Although there can be no assurance that an unfavorable outcome of the dispute would not have a material adverse effect on the Company’s operating results, liquidity and/or financial position, the Company believes the Microsoft claims are without merit and intends to vigorously defend the action.

 
Microsoft Litigation — Insurance Coverage

      On February 3, 2002, the Company’s commercial general liability insurer initiated a civil action against the Company whereby the insurance carrier sought declaratory relief that it had no duty to defend or indemnify the Company in connection with the Company’s U.S. litigation with Microsoft. As part of the Company’s defense and counterclaim in this lawsuit, the Company sought a declaratory order by the court that the insurance carrier must defend and indemnify the Company in connection with the U.S. Microsoft litigation. In March 2003, the court ruled that the insurance carrier had an obligation to defend the Company and had breached its contract by denying coverage. Thereafter, the insurance carrier agreed to defend the Company in the U.S. Microsoft litigation, but reserved its right to appeal the court’s order.

      During 2002, the Company incurred legal expenses related to the Microsoft litigation of $1,080,513 which were charged to general and administrative expenses without regard to the

F-21


 

LINDOWS, INC.

NOTES TO FINANCIAL STATEMENTS — (Continued)

potential for recovery of these expenses from the Company’s insurance carrier due to the litigation in process at the time whereby the insurance carrier had denied coverage. Following the March 2003 court ruling whereby the court ruled that the insurance carrier had a duty to defend the Company in the U.S. Microsoft litigation, the insurance carrier reimbursed the Company for 2002 legal expenses associated with the U.S. Microsoft litigation as well as 2003 legal expenses in the amount of $360,666. This reimbursement is included as a reduction in general and administrative expense in 2003. Subsequent to the March 2003 court ruling, the insurance carrier has assumed direct responsibility for legal fees associated with the defense of the U.S. Microsoft litigation and legal expenses incurred associated with this litigation are currently being paid directly by the insurance carrier. Including the $1,441,179 reimbursement received by the Company in 2003, the insurance carrier has paid approximately $3.29 million of the Company’s U.S. Microsoft legal defense costs through December 31, 2003. Although there can be no assurance that the insurance carrier will not appeal the March 2003 court ruling or that they will not be successful in such an appeal or that this would not have a material adverse effect on the Company’s operating results, liquidity and/or financial position, the Company believes that such an appeal would be without merit and intends to vigorously defend any such action.

      During 2004 the Company initiated a separate civil action against the same insurance carrier asserting that the insurance carrier has wrongfully denied coverage in connection with the lawsuits Microsoft had brought against the Company in Finland, Sweden, the Netherlands and France. The Company is seeking monetary damages, including punitive damages, as well as a declaratory order by the court that the insurance carrier must fully defend and indemnify the Company in connection with the Microsoft litigation pending in Finland, Sweden, the Netherlands and France. In response to this lawsuit, the insurance carrier agreed to pay partial defense costs for the lawsuits in Finland, Sweden, the Netherlands and France, subject to the reservation of its rights to deny coverage. In response, the Company amended the complaint to address the insurance carrier’s refusal to pay complete defense costs and its reservation of rights. The insurance carrier has filed an answer to the amended complaint and a counterclaim whereby it seeks a declaratory order that it has no duty to defend or indemnify the Company in connection with the lawsuits in Finland, Sweden, the Netherlands and France. It also seeks a declaratory order that any attorneys’ fees it is obligated to pay be at a reduced hourly rate. Although there can be no assurance that an unfavorable outcome of the dispute with the Company’s insurance carrier regarding coverage of the Microsoft lawsuits would not have a material adverse effect on the Company’s operating results, liquidity and/or financial position, the Company believes the insurance carrier’s claims are without merit and intends to vigorously defend the action.

 
Litigation Against a Debtor

      During 2002, the Company initiated a civil action against a Debtor Company and certain of its investors and executives with respect to the Company’s $750,000 loan to this Debtor Company in the form of convertible promissory notes which were expected to be converted into preferred stock of the Debtor Company. The Debtor Company has failed to repay the promissory notes when they became due and the Company is seeking $750,000, plus interest, attorneys’ fees and punitive damages. This lawsuit is in the discovery phase, and may proceed for an extended period of time. The Company intends to pursue the lawsuit vigorously, but there cannot be any assurance that it will be resolved in the Company’s favor. Additionally, even if the court rules in the Company’s favor, there can be no assurance that the Company will be able to collect the amounts owed. As a result, in 2002 the Company provided a bad debt reserve of $661,366 against the note receivable included in general and administrative expenses. During 2002, the Company also recorded $88,634 of royalties payable to the Debtor Company. In accordance with the terms of the royalty agreement, the

F-22


 

LINDOWS, INC.

NOTES TO FINANCIAL STATEMENTS — (Continued)

Company has offset the amount of royalties payable ($88,634 at December 31, 2002 and 2003) against the notes receivable balance of $750,000, resulting in a net balance due from the Debtor Company of $661,366, which is fully reserved at December 31, 2002 and 2003.

      The Company has not accrued any contingent liability associated with the legal proceedings described above based on the Company’s belief that a liability, while possible, is not probable. Further, any possible range of loss cannot be estimated at this time.

 
Indemnification

      From time to time, the Company enters into contracts with customers in which the Company provides certain indemnification to the customer in the event of claims of intellectual property infringement resulting from the customer’s use of the Company’s products. The Company has not recorded a liability for potential obligations under these indemnification provisions based on the Company’s belief that a liability, while possible, is not probable.

 
9. Employee Benefits

      In 2001, the Company established a defined contribution 401(k) plan for employees. Under the terms of the plan, employees may make voluntary contributions to the plan. The Company’s contributions to the plan are discretionary. The Company has made no discretionary contributions to the plan since its inception.

 
10. Subsequent Events

      In February 2004, the Company’s Loan Agreement was amended to (i) increase the amount available under the line to $10 million, (ii) extend the maturity date for both principal and interest to June 30, 2005, (iii) remove the requirement to make monthly interest payments, and (iv) waive all prior events of default, including those relating to the Company’s failure to make interest payments on a monthly basis. As a result of the change in credit terms, the outstanding note payable balance has been classified as a non-current liability at December 31, 2003. Through March 2004, the Company has utilized the remaining borrowing capacity under the line by borrowing an additional $5.6 million, which is repayable on June 30, 2005 under the terms of the Loan Agreement, as amended.

      In April 2004 the Company reserved an additional 4,000,000 shares for issuance under the 2001 Stock Incentive Plan. During 2004, the Company has granted options to purchase 4,333,000 shares of common stock with exercise prices ranging from $.0095 to $2.50 per share.

      Subsequent to December 31, 2003, the Company modified the terms of an employee option award for the purchase of 1,000,000 shares of common stock to include a provision for accelerated vesting in the event of a change in control of the Company, as defined. Subsequent to the modification, the change in control event occurred. The difference between the intrinsic value at the original grant date and the modification date was approximately $1,500,000. To the extent the employee terminates prior to the date at which the related options would have vested based on the original terms, allowing the employee to exercise (or vest in) option awards that otherwise would have expired unexercisable/unvested, a portion of this amount may be recognized as compensation expense in the period of termination.

F-23


 

Linspire Hard Drives Pre-installed


 

(LINDOWS, INC. CORPORATION LOGO)

                       Shares

Lindows, Inc.

Common Stock

Dealer Prospectus Delivery Obligation

      Until                     , 2004 (25 days after the date of this offering), all dealers that effect transactions in these securities, whether or not participating in this offering, may be required to deliver a prospectus. This is in addition to the dealers’ obligation to deliver a prospectus when acting as underwriters and with respect to their unsold allotments or subscriptions.


 

PART II

INFORMATION NOT REQUIRED IN PROSPECTUS

 
Item 13. Other Expenses of Issuance and Distribution

      The following table sets forth the costs and expenses, other than underwriting discounts and commissions, payable by us in connection with the sale of common stock being registered. All amounts are estimates except the SEC registration fee, the NASD filing fee and the Nasdaq National Market listing fee.

           
Amount
to be paid

SEC registration fee
  $ 7,286  
NASD filing fee
    6,250  
Nasdaq National Market listing fee
    100,000  
Printing and engraving expenses
    *  
Legal fees and expenses
    *  
Accounting fees and expenses
    *  
Blue Sky fees and expenses
    *  
Transfer Agent and Registrar fees
    *  
Miscellaneous fees and expenses
    *  
     
 
 
Total
  $ *  
     
 


To be completed by amendment

 
Item 14. Indemnification of Directors and Officers

      As permitted by Section 102 of the Delaware General Corporation Law, we have adopted provisions in our restated certificate of incorporation and restated bylaws that limit or eliminate the personal liability of our directors for a breach of their fiduciary duty of care as a director. The duty of care generally requires that, when acting on behalf of the corporation, directors exercise an informed business judgment based on all material information reasonably available to them. Consequently, a director will not be personally liable to us or our stockholders for monetary damages or breach of fiduciary duty as a director, except for liability for:

  •  any breach of the director’s duty of loyalty to us or our stockholders;
 
  •  any act or omission not in good faith or that involves intentional misconduct or a knowing violation of law;
 
  •  any act related to unlawful stock repurchases, redemptions or other distributions or payment of dividends; or
 
  •  any transaction from which the director derived an improper personal benefit.

      These limitations of liability do not affect the availability of equitable remedies such as injunctive relief or rescission. Our restated certificate of incorporation also authorizes us to indemnify our officers, directors and other agents to the fullest extent permitted under Delaware law.

      As permitted by Section 145 of the Delaware General Corporation Law, our bylaws provide that:

  •  we may indemnify our directors, officers, and employees to the fullest extent permitted by the Delaware General Corporation Law, subject to limited exceptions;

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  •  we may advance expenses to our directors, officers and employees in connection with a legal proceeding to the fullest extent permitted by the Delaware General Corporation Law, subject to limited exceptions; and
 
  •  the rights provided in our bylaws are not exclusive.

      Our restated certificate of incorporation, attached as Exhibit 3.1 hereto, and our restated bylaws, attached as Exhibit 3.2 hereto, provide for the indemnification provisions described above and elsewhere herein. In addition, we have entered into separate indemnification agreements, a form of which is attached as Exhibit 10.1 hereto, with our directors and officers which may be broader than the specific indemnification provisions contained in the Delaware General Corporation Law. These indemnification agreements may require us, among other things, to indemnify our officers and directors against liabilities that may arise by reason of their status or service as directors or officers, other than liabilities arising from willful misconduct. These indemnification agreements also may require us to advance any expenses incurred by the directors or officers as a result of any proceeding against them as to which they could be indemnified. In addition, we have purchased a policy of directors’ and officers’ liability insurance that insures our directors and officers against the cost of defense, settlement or payment of a judgment in some circumstances. These indemnification provisions and the indemnification agreements may be sufficiently broad to permit indemnification of our officers and directors for liabilities, including reimbursement of expenses incurred, arising under the Securities Act.

      The form of Underwriting Agreement, attached as Exhibit 1.1 hereto, provides for indemnification by the underwriters of us and our officers and directors for specified liabilities, including matters arising under the Securities Act.

 
Item 15. Recent Sales of Unregistered Securities

      During the last three years, we have issued unregistered securities to a limited number of persons, as described below.

        (a) On September 25, 2001, we issued 1,000,000 shares of our common stock at a price of $0.0095 per share to an accredited investor for an aggregate price of $9,500, and we issued 4,125,000 shares of our common stock to another accredited investor, in lieu of $39,187.50 of compensation otherwise due to him for services rendered.
 
        (b) On October 16, 2001, we issued 52,750,000 shares of our Series A preferred stock at a price of $.0948 per share to two accredited investors for an aggregate price of $4,999,645. Upon completion of this offering, these shares of Series A preferred stock will convert into 52,750,000 shares of our common stock.
 
        (c) On February 27, 2002, we granted options to purchase an aggregate of 750,000 shares of our common stock at an exercise price of $0.10 per share, to a consultant. On July 15, 2002, we granted options to purchase an aggregate of 275,000 shares of our common stock at an exercise price of $0.10 per share, to the same consultant. On December 12, 2002, we reduced the exercise price of these options to $0.0095 per share.
 
        (d) From December 30, 2001 through December 31, 2003, we granted options to purchase 4,765,500 shares of common stock to employees, directors and consultants under our 2001 stock incentive plan at an exercise price of $0.0095 per share. As of December 31, 2003, of the 4,765,500 options granted, 4,309,938 remain outstanding, 329,912 shares of common stock have been purchased pursuant to the exercise of stock options for aggregate consideration of $3,134 and 125,650 shares have been cancelled and returned to the 2001 stock incentive plan option pool.

      The offers, sales and issuances of the securities described in paragraphs (a), (b) and (c) were deemed to be exempt from registration under the Securities Act in reliance on Section 4(2) of the

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Securities Act in that the issuance of securities to the recipients did not involve a public offering. The recipients of securities in each such transaction represented to us their intention to acquire the securities for investment only and not with a view to or for sale in connection with any distribution thereof and appropriate legends were affixed to the share certificates and warrants issued in such transactions. Each of the recipients of securities in the transactions described in paragraphs (a), (b) and (c) were accredited or sophisticated persons and had adequate access, through employment, business or other relationships, to information about us.

      The offers, sales and issuances of the options and common stock described in paragraph (d) were deemed to be exempt from registration under the Securities Act in reliance on Rule 701 in that the transactions were under compensatory benefit plans and contracts relating to compensation as provided under such rule. The recipients of such options and common stock were our employees, directors or bona fide consultants and received the securities under our 2001 stock incentive plan. Appropriate legends were affixed to the securities issued in these transactions. Each of the recipients of securities in these transactions had adequate access, through employment, business or other relationships, to information about us.

 
Item 16. Exhibits and Financial Statement Schedules

  (a) Exhibits

         
Number Description


  1 .1*   Form of Underwriting Agreement.
  3 .1   Restated Certificate of Incorporation to be in effect upon the closing of this offering.
  3 .2   Restated Bylaws to be in effect upon the closing of this offering.
  4 .1*   Form of Common Stock Certificate.
  5 .1*   Opinion of Morrison & Foerster LLP.
  10 .1*#   Form of Indemnification Agreement between us and each of our directors and officers.
  10 .2#   2001 Stock Incentive Plan.
  10 .3*#   2004 Stock Incentive Plan.
  10 .4   GNU General Public License.
  10 .5†   StarOffice Software OEM License and Distribution Agreement, dated as of June 29, 2002, by and between Lindows, Inc. and Sun Microsystems, Inc.
  10 .6†   Revolving Line of Credit Agreement, dated as of July 29, 2002, by and between Lindows, Inc. and Michael Robertson, as amended on February 12, 2004.
  10 .7†   Software Distribution Agreement, dated as of March 17, 2003, by and between Lindows, Inc. and Livin’ On The Edge, Co., Ltd., d/b/a livedoor Co., Ltd.
  10 .8†   StarSuite Software OEM License and Distribution Agreement, dated as of June 17, 2003, by and between Lindows, Inc. and Sun Microsystems, Inc.
  10 .9†   Lindows Partnership License Agreement, dated as of September 21, 2003, by and between Lindows, Inc. and Seagate Technology LLC.
  10 .10†   Standard Office Lease, dated as of September 30, 2003, by and between Lindows, Inc. and Arden Realty Finance V, LLC.
  10 .11   Lindows License Agreement, dated as of November 25, 2003, by and among Lindows, Inc., Synnex Corporation and Synnex Canada Limited.
  10 .12†   Lindows CD Bundling and Distribution Agreement, dated as of January 1, 2004, by and between Lindows, Inc. and Albatron Technology Co., Ltd.
  10 .13†   Territorial Software Distribution Agreement, dated as of April 12, 2004, by and between Lindows, Inc. and Questar Srl.
  10 .14†   Territorial Software Distribution Agreement, dated as of April 14, 2004, by and between Lindows, Inc. and livedoor Co., Ltd.
  10 .15†   Addendum to Partnership License Agreement, dated as of April 15, 2004, by and between Lindows, Inc. and Seagate Technology LLC.

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Number Description


  10 .16#†   Employment Agreement, dated as of April 19, 2004, by and between Lindows, Inc. and Michael L. Robertson.
  10 .17#†   Employment Agreement, dated as of April 19, 2004, by and between Lindows, Inc. and Kevin B. Carmony.
  10 .18#†   Employment Agreement, dated as of April 19, 2004, by and between Lindows, Inc. and Chad H. Olson.
  10 .19#†   Employment Agreement, dated as of April 19, 2004, by and between Lindows, Inc. and Thomas C. Welch.
  23 .1   Consent of PricewaterhouseCoopers LLP, independent accountants.
  23 .2*   Consent of Morrison & Foerster LLP (included in Exhibit 5.1).
  24 .1   Powers of attorney (See Signature Page on Page II-5).


To be included by amendment.

Indicates management contract or compensatory plan.

†  Application has been made to the Securities and Exchange Commission to seek confidential treatment of certain provisions. Omitted material for which confidential treatment has been requested has been filed separately with the Securities and Exchange Commission.

      (b) Financial Statement Schedules

      Schedule II Valuation and Qualifying Accounts and Reserves

                                 
Year ended December 31, 2003

Beginning Charged to costs Ending
balance and expenses Deductions balance




Allowance for doubtful accounts
  $ 661,366     $     $     $ 661,366  
     
     
     
     
 
Valuation allowance on deferred tax assets
  $ 3,409,590     $ 1,643,227     $     $ 5,052,817  
     
     
     
     
 
                                 
Year ended December 31, 2002

Beginning Charged to costs Ending
balance and expenses Deductions balance




Allowance for doubtful accounts
  $     $ 661,366     $     $ 661,366  
     
     
     
     
 
Valuation allowance on deferred tax assets
  $ 516,773     $ 2,892,817     $     $ 3,409,590  
     
     
     
     
 
                                 
For the period July 24, 2001 (inception) to
December 31, 2001

Beginning Charged to costs Ending
balance and expenses Deductions balance




Allowance for doubtful accounts
  $     $     $     $  
     
     
     
     
 
Valuation allowance on deferred tax assets
  $     $ 516,773     $     $ 516,773  
     
     
     
     
 

      All other schedules of which provision is made in the applicable regulation of the Securities and Exchange Commission have been omitted because the information is disclosed in the Consolidated Financial Statements or because such schedules are not required or are not applicable.

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Item 17. Undertakings

      The undersigned hereby undertakes to provide to the underwriters, at the closing specified in the underwriting agreement, certificates in such denominations and registered in such names as required by the underwriters to permit prompt delivery to each purchaser.

      Insofar as indemnification for liabilities arising under the Securities Act may be permitted to our directors, officers and controlling persons pursuant to the Delaware General Corporation Law, our Certificate of Incorporation or our Bylaws, the underwriting agreement or otherwise, we have been advised that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the Securities Act, and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by us of expenses incurred or paid by one of our directors, officers, or controlling persons in the successful defense of any action, suit or proceeding) is asserted by such director, officer or controlling person in connection with the securities being registered hereunder, we will, unless in the opinion of our counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question of whether such indemnification by it is against public policy as expressed in the Securities Act and will be governed by the final adjudication of such issue.

      We hereby undertake that:

        1. For purposes of determining any liability under the Securities Act, the information omitted from the form of prospectus filed as part of this registration statement in reliance upon Rule 430A and contained in a form of prospectus filed by us pursuant to Rule 424(b)(1) or (4) or 497(h) under the Securities Act shall be deemed to be part of this Registration Statement as of the time it was declared effective.
 
        2. For the purpose of determining any liability under the Securities Act, each post-effective amendment that contains a form of prospectus shall be deemed to be a new registration statement relating to the securities offered therein, and this offering of such securities at that time shall be deemed to be the initial bona fide offering thereof.

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SIGNATURES

      Pursuant to the requirements of the Securities Act of 1933, as amended, we have duly caused this registration statement to be signed on our behalf by the undersigned, thereunto duly authorized, in San Diego, California, on April 20, 2004.

  LINDOWS, INC.

  By:  /s/ MICHAEL L. ROBERTSON
 
  Michael L. Robertson
  Chief Executive Officer

POWER OF ATTORNEY

      KNOW ALL PERSONS BY THESE PRESENTS, that each individual whose signature appears below constitutes and appoints Michael L. Robertson and Chad H. Olson, and each of them, his or her true and lawful attorneys-in-fact and agents, with full power of substitution, for him or her and in his or her name, place and stead, in any and all capacities, to sign any and all amendments (including post-effective amendments) to this registration statement, and to sign any registration statement for the same offering covered by this registration statement that is to be effective upon filing pursuant to Rule 462(b) promulgated under the Securities Act of 1933, and all post-effective amendments thereto, and to file the same, with all exhibits thereto and all documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents, or his or their substitute or substitutes, may lawfully do or cause to be done by virtue hereof.

      Pursuant to the requirements of the Securities Act of 1933, as amended, this Registration Statement has been signed by the following persons in the capacities and on the dates indicated:

             
Signature Title Date



 
/s/ MICHAEL L. ROBERTSON

Michael L. Robertson
  Chief Executive Officer & Chairman (Principal Executive Officer)   April 20, 2004
 
/s/ KEVIN B. CARMONY

Kevin B. Carmony
  President, Chief Operating Officer and Director   April 20, 2004
 
/s/ CHAD H. OLSON

Chad H. Olson
  Chief Financial Officer (Principal Financial and Accounting Officer)   April 20, 2004
 
/s/ REX E. BOSEN

Rex E. Bosen
  Director   April 20, 2004
 
/s/ DAVID S. BUZBY

David S. Buzby
  Director   April 20, 2004
 
/s/ ROBIN D. RICHARDS

Robin D. Richards
  Director   April 20, 2004

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EXHIBIT INDEX

         
Number Description


  1 .1*   Form of Underwriting Agreement.
  3 .1   Restated Certificate of Incorporation to be in effect upon the closing of this offering.
  3 .2   Restated Bylaws to be in effect upon the closing of this offering.
  4 .1*   Form of Common Stock Certificate.
  5 .1*   Opinion of Morrison & Foerster LLP.
  10 .1*#   Form of Indemnification Agreement between us and each of our directors and officers.
  10 .2#   2001 Stock Incentive Plan.
  10 .3*#   2004 Stock Incentive Plan.
  10 .4   GNU General Public License.
  10 .5†   StarOffice Software OEM License and Distribution Agreement, dated as of June 29, 2002, by and between Lindows, Inc. and Sun Microsystems, Inc.
  10 .6†   Revolving Line of Credit Agreement, dated as of July 29, 2002, by and between Lindows, Inc. and Michael Robertson, as amended on February 12, 2004.
  10 .7†   Software Distribution Agreement, dated as of March 17, 2003, by and between Lindows, Inc. and Livin’ On The Edge, Co., Ltd., d/b/a livedoor Co., Ltd.
  10 .8†   StarSuite Software OEM License and Distribution Agreement, dated as of June 17, 2003, by and between Lindows, Inc. and Sun Microsystems, Inc.
  10 .9†   Lindows Partnership License Agreement, dated as of September 21, 2003, by and between Lindows, Inc. and Seagate Technology LLC.
  10 .10†   Standard Office Lease, dated as of September 30, 2003, by and between Lindows, Inc. and Arden Realty Finance V, LLC.
  10 .11   Lindows License Agreement, dated as of November 25, 2003, by and among Lindows, Inc., Synnex Corporation and Synnex Canada Limited.
  10 .12†   Lindows CD Bundling and Distribution Agreement, dated as of January 1, 2004, by and between Lindows, Inc. and Albatron Technology Co., Ltd.
  10 .13†   Territorial Software Distribution Agreement, dated as of April 12, 2004, by and between Lindows, Inc. and Questar Srl.
  10 .14†