20-F 1 h01298e20vf.htm GRAVITY CO., LTD. GRAVITY CO., LTD.
Table of Contents

As filed with the Securities and Exchange Commission on June 29, 2007
 
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
 
 
 
Form 20-F
 
     
(Mark One)    
 
o
  REGISTRATION STATEMENT PURSUANT TO SECTION 12(b) OR (g) OF THE SECURITIES EXCHANGE ACT OF 1934
or
þ
  ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
    For the fiscal year ended December 31, 2006
or
o
  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
or
o
  SHELL COMPANY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
    For the transition period from          to          
 
Commission file number: 000-51138
 
GRAVITY CO., LTD.
(Exact name of registrant as specified in its charter)
 
     
N/A   The Republic of Korea
(Translation of registrant’s name into English)   (Jurisdiction of incorporation or organization)
 
 
 
 
Meritz Tower 14F, 825-2 Yeoksam-Dong, Gangnam-Gu
Seoul 135-934 Korea
(Address of principal executive offices)
 
 
 
 
Securities registered or to be registered pursuant to Section 12(b) of the Act:
 
         
Title of Each Class
 
Name of Each Exchange on Which Registered
 
Common stock, par value Won 500 per share*     Nasdaq Global Market  
American depositary shares, each representing
one-fourth of a share of common stock
       
 
Not for trading, but only in connection with the listing of American depositary shares on the Nasdaq Global Market pursuant to the requirements of the Securities and Exchange Commission.
 
Securities registered or to be registered pursuant to Section 12(g) of the Act:
None
 
Securities for which there is a reporting obligation pursuant to Section 15(d) of the Act:
None
 
Indicate the number of outstanding shares of each of the issuer’s classes of capital or common stock as of the close of the last full fiscal year covered by this annual report: 6,948,900 shares of common stock, par value of Won 500 per share
 
Indicated by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o     No þ
 
If this report is an annual or transition report, indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934.  Yes o     No þ
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days:  Yes þ     No o
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.
Large Accelerated filer  o     Accelerated filer  þ     Non-accelerated-filer  o
 
Indicate by check mark which financial statement item the registrant has elected to follow: Item 17  o     Item 18  þ
 
If this is an annual report, indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o     No þ
 


Table of Contents

 
TABLE OF CONTENTS
 
                     
  4
  4
  5
  IDENTITY OF DIRECTORS, SENIOR MANAGEMENT AND ADVISERS   5
    1.A.   Directors and Senior Management   5
    1.B.   Advisers   5
    1.C.   Auditors   5
  OFFER STATISTICS AND EXPECTED TIMETABLE   5
  KEY INFORMATION   5
    3.A.   Selected Financial Data   5
    3.B.   Capitalization and Indebtedness   8
    3.C.   Reasons for the Offer and Use of Proceeds   8
    3.D.   Risk Factors   8
  INFORMATION ON THE COMPANY   27
    4.A.   History and Development of the Company   27
    4.B.   Business Overview   27
    4.C.   Organizational Structure   54
    4.D.   Property, Plants and Equipment   54
  OPERATING AND FINANCIAL REVIEW AND PROSPECTS   55
    5.A.   Operating Results   55
    5.B.   Liquidity and Capital Resources   69
    5.C.   Research and Development, Patents and Licenses, etc   71
    5.D.   Trend Information   71
    5.E.   Off-Balance Sheet Arrangements   71
    5.F.   Contractual Obligations   71
  DIRECTORS, SENIOR MANAGEMENT AND EMPLOYEES   72
    6.A.   Directors and Senior Management   72
    6.B.   Compensation   73
    6.C.   Board Practices   74
    6.D.   Employees   75
    6.E.   Share Ownership   76
  MAJOR SHAREHOLDERS AND RELATED PARTY TRANSACTIONS   77
    7.A.   Major Shareholders   77
    7.B.   Related Party Transactions   78
    7.C.   Interests of Experts and Counsel   80
  FINANCIAL INFORMATION   80
    8.A.   Consolidated Statements and Other Financial Information   80
    8.B.   Significant Changes   81
  THE OFFER AND LISTING   81
    9.A.   Offer and Listing Details   81
    9.B.   Plan of Distribution   83
    9.C.   Markets   83
    9.D.   Selling Shareholders   83
    9.E.   Dilution   83
    9.F.   Expenses of the Issue   83


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  ADDITIONAL INFORMATION   83
    10.A.   Share Capital   83
    10.B.   Articles of Incorporation   83
    10.C.   Material Contracts   88
    10.D.   Exchange Controls   89
    10.E.   Taxation   91
    10.F.   Dividends and Paying Agents   98
    10.G.   Statement by Experts   99
    10.H.   Documents on Display   99
    10.I.   Subsidiary Information   99
  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK   99
    11.A.   Quantitative Information about Market Risk   99
    11.B.   Qualitative Information about Market Risk   100
    11.C.   Interim Periods   100
  DESCRIPTION OF SECURITIES OTHER THAN EQUITY SECURITIES   100
    12.A.   Debt Securities   100
    12.B.   Warrants and Rights   100
    12.C.   Other Securities   100
    12.D.   American Depositary Shares   100
  105
  DEFAULTS, DIVIDEND ARREARAGES AND DELINQUENCIES   105
  MATERIAL MODIFICATIONS TO THE RIGHTS OF SECURITY HOLDERS AND USE OF PROCEEDS   105
  CONTROLS AND PROCEDURES   106
  108
    16.A.   Audit Committee Financial Expert   108
    16.B.   Code of Ethics   108
    16.C.   Principal Accountant Fees and Services   109
    16.D.   Exemptions from the Listing Standards for Audit Committee   109
    16.E.   Purchases of Equity Securities by the Issuer and Affiliated Purchasers   109
  110
  FINANCIAL STATEMENTS   110
  FINANCIAL STATEMENTS   110
  EXHIBITS   110
  F-1
 EX-1.1 ARTICLES OF INCORPORATION
 EX-4.41 FOURTH AMENDMENT
 EX-4.42 FIFTH AMENDMENT
 EX-4.43 EXCLUSIVE RAGNAROK ONLINE SOFTWARE LICENSE
 EX-4.44 THIRD AMENDMENT
 EX-4.45 SECOND RENEWAL
 EX-4.46 AGREEMENT DATED OCTOBER 9, 2006
 EX-4.47 DISTRIBUTION AGREEMENT
 EX-4.48 AGREEMENT ON CHANGES OF THE LEASE CONTRACT
 EX-8.1 LIST OF REGISTRANT'S SUBSIDIARIES
 EX-12.1 CEO CERTIFICATION PURSUANT TO SECTION 302
 EX-12.2 CFO CERTIFICATION PURSUANT TO SECTION 302
 EX-13.1 CEO CERTIFICATION PURSUANT TO SECTION 906
 EX-13.2 CFO CERTIFICATION PURSUANT TO SECTION 906


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CERTAIN DEFINED TERMS
 
Unless the context otherwise requires, references in this annual report to:
 
  •  “China” or the “PRC” are to the People’s Republic of China;
 
  •  “Government” is to the government of The Republic of Korea;
 
  •  “GRAVITY,” “the Company,” “we,” “us,” “our,” or “our company” are to GRAVITY Co., Ltd. and its subsidiaries.
 
  •  “Japanese Yen” or “JPY” are to the currency of Japan;
 
  •  “Korea” or the “Republic” are to The Republic of Korea;
 
  •  “Taiwan” or the “ROC” are to Taiwan, the Republic of China;
 
  •  “US$,” “U.S. dollar” and “U.S. dollars” are to the currency of the United States; and
 
  •  “Won” or “W” are to the currency of the Republic of Korea.
 
For your convenience, this annual report contains translations of certain Won amounts into U.S. dollars at the noon buying rates of the Federal Reserve Bank of New York for Won in effect on December 31, 2006, which was Won 930.0 to US$1.00.
 
Discrepancies in tables between totals and sums of the amounts listed are due to rounding.
 
FORWARD-LOOKING STATEMENTS
 
This annual report on Form 20-F for the year ended December 31, 2006 contains “forward-looking statements,” as defined in Section 27A of the U.S. Securities Act of 1933, as amended (“Securities Act”), and Section 21E of the U.S. Securities Exchange Act of 1934, as amended (“Exchange Act”). All statements, other than statements of historical facts, included in this annual report that address activities, events or developments which we expect or anticipate will or may occur in the future are forward-looking statements. The words “believe,” “intend,” “expect,” “anticipate,” “project,” “estimate,” “predict,” “considering,” “depends,” “may,” “could,” “should” or “could” and similar expressions are also intended to identify forward-looking statements.
 
These forward-looking statements address, among others, such issues as:
 
  •  future prices of and demand for our products;
 
  •  future earnings and cash flow;
 
  •  expansion and growth of our business and operations; and
 
  •  our prospective operational and financial information.
 
These statements are based on assumptions and analyses made by us in light of our experience and our perception of historical trends, current conditions and expected future developments, as well as other factors we believe are appropriate in particular circumstances. However, whether actual results and developments will meet our expectations and predictions depends on a number of risks and uncertainties which could cause actual results to differ materially from our expectations, including the risks set forth in Item 3. “Key Information — Risk Factors” and the following:
 
  •  fluctuations in prices of our products;
 
  •  potential acquisitions and other business opportunities;
 
  •  general economic, market and business conditions; and
 
  •  other risks and factors beyond our control.
 
Consequently, all of the forward-looking statements made in this annual report are qualified by these cautionary statements. We cannot assure you that the actual results or developments anticipated by us will be realized or, even if substantially realized, that they will have the expected effect on us or our business or operations.


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PART I
 
ITEM 1.   IDENTITY OF DIRECTORS, SENIOR MANAGEMENT AND ADVISERS
 
1.A.   Directors and Senior Management
 
Not applicable.
 
1.B.   Advisers
 
Not applicable.
 
1.C.   Auditors
 
Not applicable.
 
ITEM 2.   OFFER STATISTICS AND EXPECTED TIMETABLE
 
Not applicable.
 
ITEM 3.   KEY INFORMATION
 
3.A.   Selected Financial Data
 
The following selected consolidated financial information is derived from our consolidated financial statements as of each of the dates and for each of the periods indicated below. This information should be read in conjunction with our audited consolidated financial statements and the related notes thereto, included in this annual report. Our consolidated financial statements and related notes thereto have been prepared in accordance with accounting principles generally accepted in the United States (“US GAAP”).
 
The consolidated statement of income data for the years ended December 31, 2002, 2003, 2004, 2005 and 2006 are derived from our audited consolidated financial statements. The consolidated balance sheet data as of December 31, 2003, 2004, 2005 and 2006 are derived from our audited consolidated financial statements.
 
                                                 
    As of and for the Years Ended December 31,  
    2002     2003     2004     2005     2006     2006(1)  
                                  (Unaudited)  
    (In millions of Won and thousands of US$, except share and per share data, operating data
 
    and percentage)  
 
Statement of operations:
                                               
Revenues:
                                               
Online games — subscription revenue
  W 7,310     W 18,560     W 16,253     W 11,249     W 8,420     US$ 9,054  
Online games — royalties and license fees
    2,330       29,727       45,101       37,375       26,123       28,089  
Mobile games
          43       376       1,664       3,840       4,129  
Character merchandising, animation and other revenue
    427       1,185       2,696       3,096       2,580       2,774  
                                                 
Total revenues
    10,067       49,515       64,426       53,384       40,963       44,046  
Cost of revenues
    1,738       6,958       10,116       16,038       17,746       19,082  
                                                 
Gross profit
    8,329       42,557       54,310       37,346       23,217       24,964  
Operating expenses:
                                               
Selling, general and administrative
    4,870       11,360       13,660       30,795       27,555       29,629  
Research and development
    815       1,597       2,029       9,219       9,239       9,934  


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    As of and for the Years Ended December 31,  
    2002     2003     2004     2005     2006     2006(1)  
                                  (Unaudited)  
    (In millions of Won and thousands of US$, except share and per share data, operating data
 
    and percentage)  
 
Litigation charges
                            4,648       4,998  
Proceeds from the former chairman due to fraud
                            (4,947 )     (5,319 )
Gain in disposal of assets held for sale
                            (1,081 )     (1,162 )
                                                 
Operating income (loss)
    2,644       29,600       38,621       (2,668 )     (12,197 )     (13,116 )
Other income (expense), net
    (2,424 )     (6,210 )     (4,879 )     (787 )     2,265       2,435  
                                                 
Income (loss) before income tax expenses, minority interest, and equity in loss of related joint venture and partnership
    220       23,390       33,742       (3,455 )     (9,932 )     (10,681 )
Income tax expenses (benefit)
    542       4,250       5,406       (817 )     12,069       12,977  
                                                 
Income (loss) before minority interest and equity in loss of related joint venture and partnership
    (322 )     19,140       28,336       (2,638 )     (22,001 )     (23,658 )
                                                 
Minority interest
                (17 )     (2 )     7       8  
Equity in loss of related joint venture and partnership
                296       394       1,106       1,189  
Income (loss) before cumulative effect of change in accounting principle
    (322 )     19,140       28,057       (3,030 )     (23,114 )     (24,855 )
Cumulative effect of change in accounting principle, net of tax
                            849       913  
                                                 
Net income (loss)
  W (322 )   W 19,140     W 28,057     W (3,030 )   W (22,265 )   US$ (23,942 )
                                                 
Earnings (loss) per share:
                                               
Before cumulative effect of change in accounting principle
  W (96 )   W 3,730     W 5,056     W (445 )   W (3,326 )   US$ (3.58 )
Cumulative effect of change in accounting principle
                            122       0.13  
Basic and diluted per share
  W (96 )   W 3,730     W 5,056     W (445 )   W (3,204 )   US$ (3.45 )
Basic and diluted per ADS
                      (111 )     (801 )     (0.86 )
Weighted average number of shares outstanding (basic and diluted)
    3,355,616       5,130,895       5,548,900       6,803,147       6,948,900       6,948,900  
Balance sheet data:
    (Unaudited )                                        
Cash and cash equivalents
  W 560     W 5,405     W 16,405     W 25,874     W 35,314     US $ 37,972  
Total current assets
    7,916       17,824       46,868       109,428       88,203       94,842  
Property and equipment, net
    2,254       5,417       14,760       11,863       8,472       9,110  
Total assets
    13,617       36,424       68,644       144,857       122,561       131,786  
Total current liabilities
    8,251       10,575       12,221       19,448       16,192       17,411  

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    As of and for the Years Ended December 31,  
    2002     2003     2004     2005     2006     2006(1)  
                                  (Unaudited)  
    (In millions of Won and thousands of US$, except share and per share data, operating data
 
    and percentage)  
 
Total liabilities
    13,707       13,960       18,209       24,073       24,419       26,257  
Total shareholders’ equity
    (90 )     22,464       50,435       120,762       98,113       105,498  
Selected operating data and financial ratios:
                                               
Gross profit margin(2)
    82.7 %     85.9 %     84.3 %     70.0 %     56.7 %     56.7 %
Operating profit margin(3)
    26.3       59.8       59.9       (5.0 )     (29.8 )     (29.8 )
Net profit margin(4)
    (3.2 )     38.7       43.5       (5.7 )     (54.4 )     (54.4 )
 
 
Notes:
 
(1) For convenience, the Won amounts are expressed in U.S. dollars at the rate of Won 930.0 to US$1.00.
 
(2) Gross profit margin for each period is calculated by dividing gross profit by total revenues for each such period.
 
(3) Operating profit margin for each period is calculated by dividing operating income (loss) by total revenues for each such period.
 
(4) Net profit margin for each period is calculated by dividing net income (loss) by total revenues for each such period.
 
Exchange Rates
 
Fluctuations in the exchange rate between Won and U.S. dollar may affect the market price of our ADSs. These fluctuations will also affect the U.S. dollar conversion by the depositary of any cash dividends paid in Won and the Won proceeds received by the depositary from any sale of our common shares represented by our ADSs.
 
In certain parts of this annual report, we have translated Won amounts into U.S. dollars for convenience purposes only. The “noon buying rate” is the rate in The City of New York used for cable transfers in foreign currencies as certified for customs purposes by the Federal Reserve Bank of New York. Unless otherwise stated, all translations from Won to U.S. dollars were made at Won 930.0 to US$1.00, which was the noon buying rate in effect on December 31, 2006. The translation is not a representation that the Won or U.S. dollar amounts referred to herein could have been or could be converted into U.S. dollars or Won, as the case may be, at any particular rate, or at all. The table below sets forth, for the periods indicated, information provided by the Federal Reserve Bank of New York concerning the noon buying rate for Won, expressed in Won per one U.S. dollar.
 
                                 
Period
  At End of Period     Average(1)     High     Low  
 
2002
    1,186.3       1,250.4       1,332.0       1,160.6  
2003
    1,192.0       1,192.1       1,262.0       1,146.0  
2004
    1,035.1       1,139.3       1,195.1       1,035.1  
2005
    1,010.0       1,023.8       1,059.8       997.0  
2006
    930.0       954.3       1,002.9       913.7  
December, 2006
    930.0       925.0       931.6       913.7  
January, 2007
    941.0       936.8       942.2       925.4  
February, 2007
    942.3       936.9       942.3       932.5  
March, 2007
    941.1       942.9       949.1       937.2  
April, 2007
    931.0       930.7       937.0       926.1  
May, 2007
    927.4       925.0       934.0       922.3  
 
 
Note:
 
(1) Annual and monthly averages are calculated using the average of the daily rates during the relevant period.

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3.B.  Capitalization and Indebtedness
 
Not applicable.
 
3.C.  Reasons for the Offer and Use of Proceeds
 
Not applicable.
 
3.D.  Risk Factors
 
Risks Relating to Our Business
 
We currently depend on one product, Ragnarok Online, for most of our revenues.
 
Most of our revenues have been and are currently derived from a single product, Ragnarok Online, which was commercially introduced in August 2002. In 2006, we derived Won 32,086 million (US$34,501 thousand) in revenues from Ragnarok Online, representing approximately 78.3% of our total revenues. We expect to continue to derive a substantial portion of our revenues from Ragnarok Online for at least the next one year. Our failure to maintain, improve, update or enhance Ragnarok Online in a timely manner or successfully enter new markets could reduce Ragnarok Online’s user base, decrease its popularity, and reduce our revenues, which would materially and adversely affect our business, financial condition and results of operations. In addition, as Ragnarok Online has been in the market for close to five years and we believe that this game has reached a relative maturity in our principal markets, its user base, popularity and revenues could continue to decline despite our efforts to improve, update and enhance it, which would materially and adversely affect our business, financial condition and results of operations.
 
For example, in 2006 and 2005, our total revenues and net income decreased significantly, primarily as a result of the declining revenues from Ragnarok Online. Our total revenues decreased by 23.3% to Won 40,963 million (US$44,046 thousand) in 2006 from Won 53,384 million in 2005 and decreased by 17.1% to Won 53,384 million in 2005 from Won 64,426 million in 2004. We recorded a net loss of Won 22,265 million (US$23,942 thousand) in 2006 as compared to a net loss of Won 3,030 million and net income of Won 28,057 million in 2005 and 2004, respectively. The decrease in revenues in 2006 and 2005 was primarily attributed to a declining user base of Ragnarok Online and the continued decline in the subscription revenues and royalties from Ragnarok Online.
 
If we are unable to consistently develop, acquire, license, launch, market or operate commercially successful online games in addition to Ragnarok Online, our business, financial condition and results of operations may be materially and adversely affected.
 
In order to improve our growth and profitability, we must continually develop or publish commercially successful online games in addition to Ragnarok Online that will retain our existing users and attract new users. In addition to Ragnarok Online, we currently offer two other massively multiplayer online role playing games, R.O.S.E. Online and Time N Tales, and two casual online games, Love Forty and TV Boyz, through our casual online portal site, STYLIA. We are currently developing two new massively multiplayer online role playing games, Ragnarok Online II and Requiem, as well as three new casual games, Pucca Racing, W Baseball and Bodycheck Online. We have also entered into a license agreement with a third party for the right to publish Emil Chronicle Online, a massively multiplayer online role playing game, worldwide, except for Japan. A game’s commercial success largely depends on appealing to the tastes and preferences of a critical mass of users as well as the willingness of such users to continue as paying subscribers, all of which are difficult to predict prior to a game’s development and introduction. No assurance can be given that Ragnarok Online II, Requiem or any of the other games we develop or purchase licensing rights to, will gain popularity with the market or that we will generate sufficient revenues from such games to justify the costs of development and/or payment of licensing fees for such games.
 
Developing games internally requires substantial development costs, including the costs of employing skilled developers and acquiring or developing game engines which enable the creation of products with the latest technological features. In order to succeed, we must acquire, license or develop promising games at an acceptable cost and ensure technical support for the successful operation of such games. The online game publishing market is highly competitive. And in order to successfully distribute and operate a game, we also need a sizable game management and support staff, continued investment in technology and a substantial marketing budget. If we are


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not able to consistently develop, acquire, license, launch, market or operate commercially successful online games, we may not be able to generate enough revenues to offset our initial development, acquisition, licensing or marketing costs, and our future business, financial condition and results of operations will be materially and adversely affected.
 
For example, we are currently developing Ragnarok Online II, the successor game to Ragnarok Online. Although we have indicated our plan to introduce Ragnarok Online II at various times in the past, the launch of this game has been delayed for various reasons, including as a result of technical difficulties. We currently intend to launch Ragnarok Online II in the third quarter of 2007, although no assurance can be given that we will be able to meet our current anticipated launch date for this game. In addition, no assurance can be given that when launched, Ragnarok Online II will gain market acceptance and popularity. The success of Ragnarok Online II will be subject to many factors, including the quality, uniqueness and playability of the game and the launch by our competitors of other games that may gain more market acceptance than Ragnarok Online II. Our inability to launch Ragnarok Online II, and if launched, the lack of popularity or market acceptance of it, is likely to have a materially adverse effect on our business, prospects, reputation, financial condition and results of operations.
 
We face the risks of changing consumer preferences and uncertainty of market acceptance of our new games.
 
Online games are a new and evolving entertainment concept. The level of demand and market acceptance of online games in general, and of any one online game in particular, is subject to a high degree of uncertainty. This uncertainty is particularly relevant to our current situation, because we are currently relying on one online game for most of our revenues. As the consumer preferences and trends evolve, there is a high degree of uncertainty about whether users will continue to value some or all of the key features of our games, thereby encouraging them to continue to play our games and pay subscription fees. Further, entertainment from other sources, including movies, cable TV and IPTV, among others, could erode the growth of the online game industry. A decline in the popularity of online games in general, and/or the online games we develop or publish in particular, will likely have a materially adverse affect on our business and prospects.
 
As we introduce new games, we face the risk that a significant number of users of our existing games may migrate to our new games without any net gains in the overall user base
 
We expect that as we introduce new games, certain number of our existing users will migrate to the new games from our old games. If the level of migration by our users from our existing games to such new games is significantly higher than our expectations, and the net gains in new users is significantly lower than our expectations, then we may have to adjust our marketing, pricing and other business plans and, as a result, our growth and profitability could be materially and adversely affected.
 
In particular, there is a high degree of uncertainty about the potential impact of the commercial launch of Ragnarok Online II on the user base of Ragnarok Online. While we believe that the game environment and the overall game experience of Ragnarok Online II are meaningfully different from that of Ragnarok Online such that it would attract a significant number of new users in addition to a certain number of Ragnarok users, we cannot provide assurances that the overall user base will grow and that the net migration away from Ragnarok Online will not be significant.
 
Our inability to adequately address the operational, network and system infrastructure and human resources challenges of managing our business may have a negative impact on our ability to implement our strategic initiatives.
 
Our growth to date has placed, and the anticipated further expansion of our operations will continue to place, a significant strain on our management, systems and resources. In order to properly manage our business, we must improve our operational systems, expand our network and system infrastructure, retain, hire and train qualified


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personnel and enhance the effectiveness of our operational controls and procedures. We cannot assure you that we will be able to efficiently or effectively manage our business, including the growth of our operations, and any failure


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to do so may limit our future growth and materially and adversely affect our business, financial condition and results of operations.
 
We depend on license fees and royalty payments from our overseas licensees for a substantial portion of our revenues.
 
In markets other than Korea, the United States, Canada, Russia, France and Belgium, we license our games to overseas operators or distributors from whom we receive license fees and royalty payments based on a percentage of such operators’ revenues from our games. Such overseas license fees and royalty payments represented 63.8% of our total revenues in 2006. In particular, we are heavily dependent on two licensees for a significant portion of our revenues, as we derived 37.7% of our total revenues from GungHo Online Entertainment, Inc., our licensee in Japan, and 10.0% of our total revenues from Soft-World International Corporation, our licensee in Taiwan. Deterioration in our relationship with our licensees, or material changes in the terms of our license with such licensees, will likely have a material adverse affect on our business, prospects, financial condition and results of operations. In addition, as we are heavily dependent on certain licensees, deterioration or any adverse developments in the operations, including changes in senior management, of our overseas licensees may materially and adversely affect our business, financial conditions and results of operations.
 
Our overseas licensees are responsible for remitting royalty payments to us based on a percentage of sales from our games, after deducting certain expenses. We generally receive royalties earned by us from such licensee within 20 to 30 days following the end of each month (except Europe, Chile and China, where such payments are received up to 60 days after the record date). Online payment systems in China and certain other countries are still in a developmental stage and are not as widely available or used. Payment for online game services in these countries generally take the form of prepaid cards sold in Internet cafés, convenience stores and other distribution channels. Some of our overseas licensees rely heavily on a multilayer distribution and payment network composed of third party distributors for sales to, and collection of payments from, users. Failure by our licensees to maintain a stable and efficient billing, recording, distribution and payment collection network in these markets may result in inaccurate recording of sales or insufficient collection of payments from these markets and may materially and adversely affect our financial condition and results of operations. In addition, although we have, pursuant to our license agreements, audit rights to the database of our licensees to ensure that proper payment amounts are being recorded and remitted, such activities can be disruptive and time consuming and, as a result, to date, we have not exercised such rights. Certain of our licensees in the past have failed to accurately report amounts due to us and have diverted certain payables to us to our former chairman, in contravention of our license agreements.
 
In many of our markets, we rely on our licensees to distribute, market and operate our games.
 
Our reliance on third parties that we do not control exposes us to certain risks that we would not encounter if we were to operate or distribute directly in such markets. If our overseas licensees fail to perform their contractual obligations or suffer from management or other problems in their businesses, our business operations in overseas markets and our ability to collect royalty payments from such markets may be materially and adversely affected. We may not be able to easily terminate our license agreements with our overseas licensees as these agreements do not specify particular financial or performance criteria that need to be met by our licensees. As our overseas licensees generally have the exclusive right to distribute our games in their respective markets generally for a term of two years, we may not be able to enter into a new license agreement in a particular country for the term of the agreement unless it is terminated earlier. Under the license arrangements, our overseas licensees may operate or publish other online games developed or offered by our competitors. Therefore, our overseas licensees may devote greater time and resources to marketing their proprietary games or those of our competitors than to ours. In general, we may not unilaterally terminate our license agreements. Furthermore, as a part of our license agreement with our licensees, we must provide technical and other consulting services to our licensees in order for them to offer our games in their markets. Our inability to provide such technical and other assistance may hinder our licensees’ efforts to gain market share in their markets and affect users’ satisfaction and loyalty as well as impact the number of users in these markets for our games, which may lead to modifications in the terms and conditions of our licensing agreements with our licensees and, in certain circumstances, result in our licensees terminating their relationship with us.


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We operate in a highly competitive industry and compete against many large companies.
 
Many companies worldwide, including over 100 companies in Korea alone, are dedicated to developing and/or operating online games. We expect more companies to enter the online game industry and a wider range of online games to be introduced in our current and future markets. Our competitors in the massively multiplayer online role playing game industry vary in size from small companies to very large companies with dominant market shares such as NCsoft of Korea and Shanda of China. We also compete with online casual game and game portal companies such as NHN, Nexon, Neowiz and CJ Internet, all from Korea. In addition, we may face stronger competition from console game companies, such as Sony, Microsoft, Electronic Arts, Nintendo and Sega, many of which have announced their intention to expand their game services and offerings over the Internet. For example, Electronic Arts co-developed and launched “FIFA online,” a sports online game based on its best-selling package sports game franchise “FIFA” series, with Neowiz in 2006 and recently announced its investment in Neowiz and further co-development plan for a series of online games. Many of our competitors have significantly greater financial, marketing and game development resources than we have. As a result, we may not be able to devote adequate resources to develop, acquire or license new games, undertake extensive marketing campaigns, adopt aggressive pricing policies or adequately compensate our or third-party game developers to the same degree as certain of our competitors.
 
As the online game industry in many of our markets is relatively new and rapidly evolving, our current or future competitors may compete more successfully as the industry matures. In particular, any of our competitors may offer products and services that have significant performance, price, creativity or other advantages over those offered by us. These products and services may weaken the market strength of our brand name and achieve greater market acceptance than ours. In addition, any of our current or future competitors may be acquired by, receive investments from or enter into other strategic relationships with larger, longer-established and better-financed companies and therefore obtain significantly greater financial, marketing and game licensing and development resources than we have. Increased competition in the online game industry in our markets could make it difficult for us to retain existing users and attract new users, and could reduce the number of hours users spend playing our current or future games or cause us and our licensees to reduce the fees charged to play our current or future games. In some of the countries in which our games are distributed, such as Korea and Taiwan, growth of the market for online games has slowed while competition continues to be strong. If we are unable to compete effectively in our principal markets, our business, financial condition and results of operations could be materially and adversely affected. See Item 4.B. “Business Overview — Competition.”
 
Our management has a limited operating experience in our relatively new industry, which may make it difficult for you to evaluate our business prospects.
 
Our senior management and employees have worked together at our company for a relatively short period of time, including as a result of frequent changes in senior management to date. In addition, the online game industry is a relatively new industry. The world’s first massively multiplayer online role playing game to be introduced commercially was developed and distributed by one of our competitors in 1996. Since then, only a limited number of companies have successfully commercialized such online games on an international scale. You must consider our business prospects in light of the risks and difficulties we have encountered and may encounter in the future in a new and rapidly evolving industry. We may not be able to successfully address these risks and difficulties, which could materially harm our business prospects, financial condition and results of operations.
 
Rapid technological change may adversely affect our future revenues and profitability.
 
The online game industry is subject to rapid technological change in such areas as hardware, software and content programming. We need to anticipate the emergence of new technologies and games, assess their likely market acceptance, and make substantial game development and related investments. In addition, new technologies in online game programming or operations could render our current or future games obsolete or unattractive to our users, thereby limiting our ability to recover game-related development, acquisition or licensing costs and potentially materially and adversely affecting our business, financial condition and results of operations.


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If we fail to retain and hire skilled and experienced game developers or other key personnel in order to design and develop new online games and additional game features, we may be unable to achieve our business objectives.
 
In order to meet our business objectives and maintain our competitiveness in the future, we will need to attract and retain qualified employees, including skilled and experienced online game developers. We compete to attract and retain these key personnel with other companies in our industry, some of which may offer superior compensation arrangements and career opportunities. In addition, our ability to train and integrate new employees into our operations may not meet the growing demands of our business. We cannot assure you that we will be able to attract or retain qualified game developers or other key personnel, or successfully train and integrate them to achieve our business objectives.
 
Undetected programming errors or flaws in our games could harm our reputation or decrease market acceptance of our games, which would materially and adversely affect our business prospects, reputation, financial condition and results of operations.
 
Our current and future games may contain programming errors or flaws, which may become apparent only after their release. In addition, our online games are developed using programs and engines developed by and licensed from third party vendors, which may include programming errors or flaws over which we have no control. If our users have a negative experience with our games related to or caused by undetected programming errors or flaws, they may be less inclined to continue or resume subscriptions for our games or recommend our games to other potential users. Undetected programming errors and game defects can also harm our reputation, cause our users to cease playing our games, divert our resources or delay market acceptance of our games, any of which could materially and adversely affect our business, financial condition and results of operations.
 
Unexpected network interruptions, security breaches or computer virus attacks could harm our business.
 
Any failure to maintain satisfactory performance, reliability, security and availability of our network infrastructure, whether maintained by us or by our overseas licensees, may cause significant harm to our reputation and our ability to attract and maintain users. Major risks relating to our network infrastructure include:
 
  •  any breakdowns or system failures, including from fire, flood, earthquake, typhoon or other natural disasters, power loss or telecommunications failure, resulting in a sustained shutdown of all or a material portion of our servers;
 
  •  any disruption or failure in the national or international backbone telecommunications network, which would prevent users in certain countries in which our games are distributed from logging onto or playing our games for which the game servers are all located in other countries; and
 
  •  any security breach caused by hacking, loss or corruption of data or malfunctions of software, hardware or other computer equipment, and the inadvertent transmission of computer viruses.
 
From time to time, we detect users that gain an unfair advantage by modifying our games execution files saved on the users’ computers to facilitate the progression of their game characters. Unauthorized character manipulation may negatively impact the image and users’ perception of our games and could limit the popularity of our games and damage our reputation.
 
Any of the foregoing factors could reduce our users’ satisfaction, harm our business and reputation and have a material adverse effect on our financial condition and results of operations.
 
Unauthorized use of our intellectual property by third parties, and the expenses incurred in protecting our intellectual property rights, may adversely affect our business.
 
We regard our copyrights, service marks, trademarks, trade secrets and other intellectual property as critical to our success. Unauthorized use of the intellectual property used in our business, whether owned by us or licensed to us, may materially and adversely affect our business and reputation.


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We rely on trademark and copyright law, trade secret protection and confidentiality agreements with our employees, customers, business partners and others to protect our intellectual property rights. Despite certain precautions taken by us, it may be possible for third parties to obtain and use our intellectual property without authorization. For example, in April 2003, we discovered that the server-end software of Ragnarok Online was unlawfully released in Korea, China and the United States. This enabled unauthorized third parties to set up local server networks to operate Ragnarok Online, which may have resulted in a diversion of a significant number of paying users. Since then, we have designated certain employees to be responsible for detecting these illegal servers and reporting them to the relevant enforcement authority in Korea in charge of crimes on the Internet. In overseas markets, we cooperate with and rely on our overseas licensees to seek enforcement actions against operators of illegal free servers. We may incur considerable costs in the future to remedy software piracy and to enforce our rights against the operators of unauthorized server networks.
 
The validity, enforceability, enforcement mechanisms and scope of protection of intellectual property in Internet-related industries are uncertain and evolving. In particular, the laws and enforcement regime of Korea, Japan, Taiwan, Thailand, China and certain other countries in which our games are distributed are uncertain or do not protect intellectual property rights to the same extent as do the laws and enforcement procedures of the United States and other developed countries. Moreover, litigation may be necessary in the future to enforce our intellectual property rights. Such litigation could result in substantial costs and diversion of our resources, including diverting the time and effort of our senior management, and could disrupt our business, as well as have a material adverse effect on our business, prospects, financial condition and results of operations.
 
We may be subject to claims with respect to the infringement of intellectual property rights of others, which could result in substantial costs and diversion of our financial and management resources.
 
We cannot be certain that our online games do not or will not infringe upon patents, copyrights or other intellectual property rights held by third parties. We may become subject to legal proceedings and claims from time to time relating to the intellectual property of others in the ordinary course of our business. If we are found to have violated the intellectual property rights of others, we may be enjoined from using such intellectual property, and we may incur licensing fees or be forced to develop alternative technology or obtain other licenses. In addition, we may incur substantial expenses in defending against these third party infringement claims, regardless of their merit. In addition, certain of our employees were recruited from other online game developers, including certain of our current or potential competitors. To the extent these employees have been and are involved in the development of our games similar to the development in which they have been involved at their former employers, we may become subject to claims that such employees or we have improperly used or disclosed trade secrets or other proprietary information. Although we are not aware of any pending or threatened claims of this type, if any such claims were to arise in the future, litigation or other dispute resolution procedures might be necessary to retain our ability to offer our current and future games, which could result in substantial costs and diversion of our financial and management resources.
 
Successful infringement or licensing claims against us may result in substantial monetary damages, which may materially disrupt the conduct of our business and have a material adverse effect on our reputation, business, financial condition and results of operations.
 
The discontinuation of any of the preferential tax treatments currently available to us in Korea could materially and adversely affect our business, financial condition and results of operations.
 
Under Korean law and regulations, small- and medium-sized venture companies may be entitled to enjoy a preferential tax treatment from the Korean government in the form of a 50% reduction in corporate income tax rates for the year in which it first generates taxable income and the following five years if such company satisfies a number of financial and non-financial criteria, including the maintenance of its status as a designated venture company. In 2002, when we first generated taxable income, we qualified for the preferential tax treatment and enjoyed the 50% reduction in corporate income tax rates. In 2005, we also qualified for this preferential treatment and our applicable corporate income tax rate (including resident surtax) was 13.75% after the 50% reduction. A company that engages in data processing or computer related businesses, including us, may qualify as a small-and medium-sized enterprise under the Framework Act on Small- and Medium-Sized Enterprises if, among other


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things, (i) we hire less than three hundred full-time employees or (ii) our total revenue does not exceed Won 30 billion (US$32 million). In 2004, we failed to satisfy both of these tests. However, even if a company fails to satisfy both of the preceding requirements, it may continue to enjoy its status as a small- and medium-sized enterprise for the following three years so long as that company neither (x) merges into, nor consolidates with, another company nor (y) becomes an affiliate of certain large enterprises. Accordingly, we believe that we qualify as a small- and medium-sized company through September 2007 as long as we satisfy such conditions. We will renew in the period from July 23, 2007 to October 23, 2007 as the termination date is September 23, 2007. However, after 2006, we may not be able to qualify for the preferential tax treatment because our status as a designated venture company is subject to renewal in 2007 and there is no guarantee that we will so qualify based on the non-financial criteria, which involve a relatively subjective determination by the regulatory authority. A designated venture company, including us, must qualify every one year based on the evaluation described above. Accordingly, our tax rate may increase substantially. The discontinuation of this preferential tax treatment could materially and adversely affect our net income. In addition, if the National Tax Service were to audit us and determine that we were not entitled to such tax benefit, we may be required to pay back-taxes and statutory interest. See Item 5.A. “Operating Results — Overview — Income tax expenses.”
 
We may not be able to successfully implement our growth strategies.
 
We are pursuing a number of growth strategies, including the following
 
  •  distributing games developed in-house;
 
  •  publishing games acquired from third parties or developed by third parties through licensing arrangements;
 
  •  offering our games in countries where we currently have little or no presence;
 
  •  taking advantage of our popular online games to strengthen our other lines of businesses, such as mobile games, animation and character merchandising;
 
  •  selectively pursuing acquisitions of, investments in, or joint ventures with, game development companies, technologies and personnel that are complementary to our existing business; and
 
  •  investing our capital in investment funds which target online game industry, with the goal, among others, of increasing our knowledge of, as well as building relationship with, potential third party developers of online games.
 
In addition, we have formulated a strategic vision to promote our role as a hub for all things related to the online game industry. As the hub for the online game industry, we will endeavor to bring together in one place the capital, human resources, technology and distribution channels necessary to create online games and establish a system to facilitate the publishing of online games. To this end, we will continue to (i) strengthen our efforts to develop online games, (ii) identify and implement opportunities for overseas publishing of our games, (iii) establish strategic alliances with major players in the online game industry in Korea, (iv) enhance brand recognition for our key online games and facilitate cross-selling of other products and (v) promote our mobile games.
 
We cannot assure you that we will be successful in implementing any of these strategies. Some of these strategies relate to new services or products for which there are no established markets, or in which we lack experience and expertise. If we are unable to successfully implement our growth strategies, our revenues, profitability and competitiveness may be materially and adversely affected. Our growth potential in many of the markets in which our games are currently distributed or which we intend to enter may be limited since the penetration rate for personal computers is relatively low and the cost of Internet access relative to the per capita income is higher in such markets when compared to some of our principal markets such as Korea and Japan. If we decide to pursue acquisitions, investments or joint ventures to achieve growth, the success of such acquisitions, investments or joint ventures will depend on the availability of suitable acquisition and investment candidates at an acceptable cost, our ability to compete effectively to attract and reach agreement with acquisition candidates or joint venture partners on commercially reasonable terms, and the availability of financing to complete such acquisitions, joint ventures or investments. For example, in May 2006, we entered into a contract to invest US$9 million in Perpetual Entertainment, Inc., an online game developer based in the United States. In December 2005, we


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completed an acquisition of a controlling interest in NEOCYON, Inc., a mobile Internet solutions provider in Korea. In December 2005, we also entered into an agreement with Movida Investment Inc., SOFTBANK CORP. and eight other companies to invest in “Online Game Revolution Fund No. 1,” with a total capital commitment in the amount of Japanese Yen 1 billion (US$9,096 thousand), which represented 10% of the aggregate size of the fund, and which currently represents 14.49% of the fund due to the withdrawal of some co-participants in 2006. As of the date hereof, we have invested Japanese Yen 250 million (US$2,274 thousand), which represents 25% of our total capital commitment. We cannot be certain that any particular acquisition, investment or joint venture will produce the intended benefits on a timely basis, or at all.
 
Mr. Il Young Ryu, our chairman, chief executive officer and representative director and also the representative director of EZER Inc., our largest shareholder, has substantial control over us and can delay or prevent a change in corporate control.
 
Mr. Il Young Ryu, our chairman, chief executive officer and representative director and also the representative director of EZER Inc., our largest shareholder, beneficially owns approximately 52.4% of our outstanding common shares. As a result, Mr. Ryu exerts significant control over all matters requiring shareholder approval, including the election of directors and approval of significant corporate transactions, including acquisitions, divestures, strategic relationships and other matters. Mr. Ryu also has the power to prevent or cause a change in control. In addition, the rights and responsibilities of our shareholders and members of our board of directors under Korean law may be different from those that apply to shareholders and directors of a corporation incorporated in the United States. While the facts and circumstances of each case will differ, the duty of care required of a director under Korean law may not be the same as the fiduciary duty of a director of a corporation incorporated in the United States. Holders of our ADSs may have more difficulty protecting their interests against actions of our management, members of our board of directors or controlling shareholder than they would as shareholders of a corporation incorporated in the United States.
 
We have limited business insurance coverage in Korea.
 
The insurance industry in Korea is still at an early stage of development. In particular, Korean insurance companies offer limited business insurance products. As a result, we do not have any business liability or disruption insurance coverage for our operations in Korea. In 2005 and 2006, we derived 18.9% and 24.8% of our total revenues from Korea, respectively. Any business disruption, litigation or natural disaster might result in our incurring substantial costs and the diversion of our resources.
 
Slow growth or contractions in the Internet café industry in Korea may affect our ability to target a core group of potential users.
 
According to the 2005 report issued by the Korean Game Development and Promotion Institute, which has recently changed its name to Korea Game Industry Agency, the growth in the number of active Internet cafés in Korea has stabilized since 2000 and the number of such cafés actually declined in 2003, with no significant change to the number of active Internet cafés from 2003 to 2005. We believe that there was no significant change in the number of active Internet cafés in 2006. Intensifying competition for users of online games, as well as a more widespread availability of personal computers, or PCs, and broadband Internet access in homes in Korea could trigger further declines in the number of Internet cafés. Future reductions in the number of Internet cafés operating in Korea could adversely affect our ability to target a core group of potential users, who tend to prefer playing online games, in particular, massively multiplayer online role playing games, at Internet cafés.


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We may be required to take significant actions that are contrary to our business objectives in order to avoid being deemed an investment company as defined under the Investment Company Act of 1940, as amended.
 
Generally, the Investment Company Act of 1940, or the 1940 Act, provides that a company is not an investment company and is not required to register under the 1940 Act as an investment company if:
 
  •  the company is primarily engaged, directly or through a wholly-owned subsidiary or subsidiaries, in a business or businesses other than that of investing, reinvesting, owning, holding or trading in securities; and
 
  •  40% or less of the value of the company’s assets (exclusive of cash items and U.S. government securities) is represented by “investment securities” as defined by the 1940 Act.
 
We believe that we are engaged primarily and directly in the businesses of providing online game services, that less than 40% of the fair market value of our assets (exclusive of our cash items) is represented by investment securities and, consequently, that we are not an investment company as that term is defined under the 1940 Act. For this purpose, we treat a bank deposit that may be withdrawn earlier than on its maturity date upon demand without penalty against the principal amount of the deposit as cash items even though such holdings may be categorized, for financial reporting purposes, as short-term financial instruments. In the future we may be required to take actions to avoid the requirement to register as an investment company, such as shifting a significant portion of our long- and short-term investment portfolio into low-yielding bank deposits or other short-term securities which are not considered to be investment securities due to their liquidity and certain other characteristics. These types of investments may reduce the amount of interest on other income that we could otherwise generate from our investment activities. In addition, we may need to acquire additional income or loss generating assets that we might not otherwise have acquired or forego opportunities to acquire minority interests in companies that could be important to our strategy.
 
The 1940 Act also contains regulations with respect to investment companies, including restrictions on their capital structure, operations, transactions with affiliates and other matters which would be incompatible with our operations. If we were to be deemed an investment company in the future, we would, among other things, effectively be precluded from making public offerings in the United States. We could also be subject to administrative or legal proceedings and, among other things, contracts to which we are a party might be rendered unenforceable or subject to rescission.
 
We may have been since our initial public offering, and may be in subsequent years, a passive foreign investment company, which could result in adverse U.S. tax consequences to you.
 
In light of the nature of our business activities and our holding of a significant amount of cash, short-term investments and other passive assets after our initial public offering, we may have been since our initial public offering, a passive foreign investment company for U.S. federal income tax purposes. If we are a passive foreign investment company for any taxable year during which you hold our ADSs or common shares, you could be subject to adverse U.S. federal income tax consequences. You are urged to consult your tax advisors concerning the U.S. federal income tax consequences of holding our ADSs or common shares if we are considered a passive foreign investment company in any taxable year. See Item 10.E. “Taxation — U.S. federal income tax considerations — Passive foreign investment companies.”
 
We have identified certain material weaknesses in our internal controls over financial reporting. If we fail to achieve and maintain an effective system of internal controls over financial reporting, we may be unable to accurately report our financial results on a timely basis or reduce our ability to prevent or detect fraud, and investor confidence and the market price of our ADSs may be adversely affected.
 
In connection with the audit of our financial statements prepared under US GAAP for the year ended December 31, 2006, we have identified certain material weaknesses (as defined under Standards of the Public Company Accounting Oversight Board (United States)) in our system of internal controls over financial reporting. In addition, our management assessed the effectiveness of our internal controls over financial reporting as of December 31, 2006 pursuant to section 404 of the Sarbanes-Oxley Act of 2002 (“Sarbanes-Oxley Act”) and related


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SEC rules and concluded that our internal control over financial reporting was not effective as of December 31, 2006. Specifically, management identified four material weaknesses set forth in our internal control over financial reporting as defined under Standards of the Public Accounting Oversight Standard Board (United States) as of December 31, 2006.
 
These material weaknesses could result in misstatements of any of our financial statements that are not prevented or detected which could result in a material misstatement to our annual consolidated financial statements. After considering these material weaknesses, among other matters, our chief executive officer and chief financial officer have also concluded, most recently as at December 31, 2006, that our disclosure controls and procedures were not effective to provide reasonable assurance that information required to be disclosed in the reports we file and submit under the Exchange Act is recorded, processed, summarized and reported as and when required.
 
Our management, in particular, our chief executive officer and chief financial officer, along with the Audit Committee, is in the process of addressing the material weaknesses and will seek to put in place a system of internal control over financial reporting which will remediate such material weaknesses as expeditiously as possible. All disclosure controls and procedures, no matter how well designed, however, have inherent limitations including the possibility of human error and the circumvention or overriding of the controls and procedures. A company’s internal control over financial reporting is a process designed to provide reasonable, not absolute, assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company, (ii) provide reasonable assurance that transactions are recorded as necessary to permit the preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Company’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect all misstatements. In addition, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changed conditions, or that the degree of compliance with the policies or procedures may deteriorate.
 
Furthermore, we are subject to the Sarbanes-Oxley Act, which requires us to, among other things, maintain an effective system of internal controls over financial reporting, and requires our management to provide a certification on the effectiveness of our internal controls on an annual basis. Additionally, our independent accountants must provide an independent attestation report on our internal control over financial reporting beginning from the fiscal year ending December 31, 2007. We have not yet fully completed the establishment of a system of internal controls appropriate for our anticipated reporting requirements. No assurance can be given that we will be able to establish such system in a timely manner and even if we do, that our internal controls system will not fail in the future.
 
If we fail to create an effective system of internal controls over financial reporting, we may be unable to accurately report our financial results in a timely manner or prevent errors or fraud, and investor confidence and the market price of our ADSs may be adversely affected. See Item 15. “Controls and Procedures” for additional discussion concerning our material weaknesses.
 
Risks Relating to Recent Developments at GRAVITY
 
Harm from continued regulatory scrutiny and securities litigation
 
We have received and continue to receive requests and inquiries from the staff of the Securities and Exchange Commission, the officials of Nasdaq, shareholders and others seeking information regarding our financial condition and results of operations, accounting and related internal controls over financial reporting and details related to the investigation and the restated financial statements arising from the embezzlement of company funds by Mr. Jung Ryool Kim, our former Chairman. We cannot predict if such inquiries will ultimately lead to formal investigations and enforcement actions by the Securities and Exchange Commission or Nasdaq, or other government agencies or lead to lawsuits filed by our shareholders. If such formal investigations or enforcement actions occur or lawsuits are brought, we may be required to pay fines, consent to injunctions on future conduct, be subject to other penalties or


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be required to expend time and resources on defending against such litigation, each of which could have a material adverse effect on our business, financial condition and results of operations.
 
In May 2005, a number of class action complaints were filed against the Company and other defendants for alleged violation of the United States federal securities law in the United States District Court for the Southern District of New York (the “Court”) in connection with the initial public offering of the Company’s ADSs in February 2005. The actions were consolidated by an order of the Court entered on December 12, 2005 as In Re Gravity Co., Ltd. Securities Litigation, No. 1:05-CV-4804-LAP to be prosecuted on behalf of a class of those who purchased ADSs between February 7, 2005 and November 10, 2005. On July 10, 2006, the lead plaintiff filed a Consolidated Amended Complaint (the “CAC”) which identifies the Company and certain of its former individual directors and officers as defendants, and claims that the Company’s registration statement on Form F-1 and the prospectus which constitutes a part of the registration statement used in connection with its initial public offering contained material misstatements and omissions. On October 17, 2006, the Company and certain other defendants filed motions to dismiss the CAC. Pursuant to a mediation session held in New York on April 25, 2007, the Company, one other defendant and the plaintiffs agreed in principle to settle the class action litigation for US$10 million. The Company’s share of the settlement is anticipated to be US$5 million. Upon completion of this settlement, the Company, its current and former directors and officers as well as other third parties will be released from liability for the claims asserted by the class. Costs associated with administering the settlement, including the plaintiffs’ attorneys’ fees and expenses will be paid out of the US$10 million settlement amount before distributions are made to the class members. While the parties have informed the Court by written correspondence of their intention to settle the dispute, the parties have not yet filed a stipulation with the Court. The parties are expected to file such stipulation in July 2007. The proposed settlement is conditioned, among other things, on various conditions being met and final approval by the Court after notice to the plaintiff class and expiration of the time for appeal from any order of the Court approving the settlement.
 
In addition, certain of our minority shareholders in Korea and outside of Korea have recently made various demands on our management, including with respect to our corporate governance practices. For example, certain of our minority shareholders have formed a committee named The Gravity Committee for the Fair Treatment of Minority Shareholders, or the Minority Shareholders Committee, in March 2006 and have since made a number of requests, including a request to inspect our financial documents and review decisions made by our management concerning transactions entered into with certain parties, and to pursue legal action if the committee views such transactions to have been entered into improperly. Our management may be required to expend substantial time, effort and resources to respond to such requests from our minority shareholders, including the Minority Shareholders Committee, in the future, which may negatively impact the ability of our management to address business challenges and operational requirements facing us, and adversely affect our business, financial condition and results of operation.
 
Risks Relating to Our Regulatory Environment
 
Our operations are subject to the regulation of the Internet in certain of the countries in which our games are distributed, such as Korea, China, Taiwan, Japan and Thailand, the impact of which is difficult to predict.
 
The regulatory and legal regimes in nearly all of the countries in which our games are distributed have yet to establish a sophisticated set of laws, rules or regulations designed to regulate, among other things, the social, political and financial risks relating to the online game industry. However, in many of our principal markets, such as Korea, China, Taiwan and Thailand, the legislators and regulators have, either through public announcements or press releases, indicated their intention to implement laws, rules or regulations regulating and restricting this industry, which include laws or regulations relating to issues such as user privacy, defamation, pricing, advertising, taxation, promotions, financial market regulation, consumer protection, content regulation, quality of products and services, and intellectual property ownership and infringement that may directly or indirectly impact our activities. In some of these countries, distribution of information over the Internet and electronic commerce are currently under legal and regulatory review. Other countries in which our games are distributed or which we intend to enter may adopt similar laws and regulations. The impact of such laws and regulations on our business and results of operations is difficult to predict. However, as we might unintentionally violate such laws or such laws may be


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modified and new laws may be enacted in the future, any such developments, or developments stemming from enactment or modification of other laws, could increase the costs of regulatory compliance, force changes in business practices or otherwise have a material adverse effect on our business and results of operations.
 
Our online games may be subject to governmental restrictions or rating systems, which could delay or prohibit the release of new games or reduce the existing and potential range of our user base.
 
Legislation is periodically introduced in many of the countries in which our games are distributed to establish a system for protecting consumers from the influence of graphic violence and sexually explicit materials contained in various types of games. For instance, Korean law requires online game companies to obtain rating classifications and implement procedures to restrict the distribution of online games to certain age groups. Similar mandatory rating systems and other regulations affecting the content and distribution of our games have also been adopted or are under review in Taiwan, China, the United States and other markets for our online games. In the future, we may be required to modify our games or alter our marketing strategies to comply with new governmental regulations or new ratings assigned to our current or future games that may call for restrictions or modifications to our game content or features, which could delay or prohibit the release of new games or upgrades and reduce the existing and potential range of our user base. Moreover, uncertainties regarding governmental restrictions or rating systems applicable to our business could give rise to market confusion, thereby materially and adversely affecting our business.
 
The legal systems in some of the countries where our games are distributed have uncertainties which could limit the legal protections available to us.
 
The laws, regulations and legal requirements in many of the countries in which our games are distributed are constantly changing, and their interpretation and enforcement involve uncertainties. These uncertainties could limit the legal protections available to us. We cannot predict the effect of future developments in the legal systems in these countries, particularly with regard to the Internet, including the promulgation of new laws, changes to existing laws or the interpretation or enforcement thereof, or the preemption of local regulations by national laws. If the cost of regulatory compliance increases for our licensees as a result of regulatory changes, our licensees may in the future seek to reduce royalties and license fees payable to us, which may materially and adversely affect our business, results of operations and financial condition.
 
If our licensee in Taiwan adopts the model consumer contract promulgated by the ROC Ministry of Economic Affairs or the ROC Ministry of Economic Affairs imposes additional regulatory burdens on our licensee in Taiwan, our licensee in Taiwan may require us to reduce the license fee or royalties, or share the cost of regulatory compliance.
 
In 2005 and 2006, we derived 19.8% and 10.0%, respectively, of our total revenues from our licensee in Taiwan. As a result of increasing disputes between the online game companies and consumers in Taiwan, on February 17, 2006, the ROC Ministry of Economic Affairs of the Executive Yuan (the “ROC MOEA”) has promulgated a model consumer contract that online game companies are encouraged to adopt. In addition, the ROC MOEA may, within its authority, further consider promulgating certain standard provisions that must be included in a consumer contract that online game companies must use in order to operate in the future when necessary. If our licensee in Taiwan adopts the above model consumer contract or these standard provisions are implemented, the cost of regulatory compliance may significantly increase for our Taiwanese licensee. Our Taiwanese licensee may in the future seek to reduce royalties and license fees, which may materially and adversely affect our licensee’s business and our results of operations and financial condition.


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Our business may be adversely affected by complexities, uncertainties and changes in law and regulations of China and Taiwan regulating Internet companies and businesses operating in China and Taiwan, including those related to online games.
 
In 2005 and 2006, we derived 2.2% and 1.3%, respectively, of our total revenues from our licensee in China. The Chinese government, through various regulatory authorities, heavily regulates the Internet sector, which includes the online game industry. These laws and regulations include the following:
 
  •  restrictions on content on the Internet, including restriction on distribution of online games containing content that purports to propagate obscenity, gambling or violence, instigate crime, undermine public morality or the cultural traditions of China, or compromise state security or secrets;
 
  •  license and permit requirements for companies in the Internet industry, including for importing and operating online games, from various regulatory authorities; and
 
  •  restrictions on and supervision of Internet cafés, including closing of unlicensed Internet cafés and requiring installation of security software to prevent access to subversive sites.
 
In addition, there are uncertainties in the interpretation and application of existing Chinese laws, regulations and policies regarding the businesses and activities of Internet companies and businesses in China, including those related to our online games. Any violations of the foregoing laws and regulations as well as other laws and regulations to be introduced in the future could materially and adversely affect the business and results of operations of our Chinese licensee and us.
 
The Taiwanese government has recently proposed a draft Statutes of Information-Entertainment Industry legislation and, according to local press, alternatively, is considering amending the Electronic Game Arcade Business Regulation Act, which may limit the total number of Internet cafés and require government approvals before their operation of business.
 
Restrictions on currency exchange in certain of the countries in which our games are distributed may limit our ability to receive and remit revenues effectively.
 
The governments in certain countries, including Taiwan, Thailand and China, in which our games are distributed, impose controls on the convertibility of the local currency into foreign currencies and, in some cases, the remittance of currency outside of their countries. Under current foreign exchange control regulations, shortages in the availability of foreign currency may restrict the ability of our overseas licensees to pay license fees and royalties to us in U.S. dollars. Restrictions on our ability to receive license fees, royalties and other payments from our overseas licensees would adversely affect our financial condition and liquidity.
 
In many of our markets, we rely heavily on our overseas licensees to operate and distribute our games and to comply with applicable laws and government regulations.
 
We rely on our overseas licensees for substantially all aspects of our overseas operations, including:
 
  •  holding the required government licenses for the operation and distribution of our games;
 
  •  publishing, advertising and marketing our games;
 
  •  establishing the pricing of our games after consultation with us;
 
  •  owning and operating the server network and other aspects of game management and maintenance;
 
  •  providing customer service and trouble-shooting;
 
  •  maintaining network security and providing back-up for game data and software; and
 
  •  billing and collecting subscription fees from users and remitting royalty payments to us.
 
Our overseas licensees are responsible for complying with local laws, including obtaining and maintaining the requisite government licenses and permits. Failure by our overseas licensees to do so may have a material adverse effect on our business, financial condition and results of operations.


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Restrictions on currency exchange in Korea in certain emergency circumstances may limit our ability to utilize effectively revenues generated in Won to fund our business activities outside Korea or expenditures denominated in foreign currencies.
 
The existing and any future restrictions on currency exchange in Korea, including Korean exchange control regulations, may restrict our ability to convert Won into foreign currencies under certain emergency circumstances, such as an outbreak of natural calamities, wars, conflict of arms or grave and sudden changes in domestic or foreign economic circumstances, difficulties in Korea’s international balance of payments and international finance and obstacles in carrying out currency policies, exchange rate policies and other macroeconomic policies of Korea. Such restrictions may limit our ability to utilize effectively revenues generated in the Won to fund our business activities outside Korea or expenditures denominated in foreign currencies.
 
Adverse changes in the withholding tax rates in the countries from which we receive license fees and royalties could adversely affect our net income.
 
We may be subject to income withholding in countries where we derive revenues. Such withholding is made by our overseas licensees at the current withholding rates in such countries. To the extent Korea has a tax treaty with any such country, the withholding rate prescribed by such tax treaty will apply. Under the Corporation Tax Law of Korea, we are entitled to, and recognize, a tax credit computed based on the amount of income withheld overseas when filing our income tax return in Korea, up to a limited amount. Accordingly, the amount of taxes withheld overseas may be offset against tax payable in Korea. Adverse changes in tax treaties between Korea and the countries from which we receive license fees and royalties, in the rate of withholding tax in the countries in which our games are distributed or in Korean tax law enabling us to recognize tax credits for taxes withheld overseas could adversely affect our net income.
 
Risks Relating to Our Market Environment
 
Our businesses may be adversely affected by developments affecting the economies of the countries in which our games are distributed.
 
Our future performance will depend in large part on the future economic growth of our principal markets. Our top markets in terms of revenues generated were Japan, Korea, Taiwan, U.S. and Thailand, representing 41.3%, 24.8%, 10.0%, 7.0% and 6.2%, respectively, of our total revenues in 2006. Accordingly, our business, financial condition, results of operations and prospects are subject to the economic, political, legal and regulatory conditions and developments in these countries. Adverse developments in such markets may have an adverse effect on the number of our subscribers and results of operations, which could have a material adverse effect on our business.
 
A deterioration in the economies of the countries in which our games are distributed can also occur as a result of deterioration in global economic conditions. The worldwide economy has experienced periods of economic weakness since the beginning of 2001, which has been exacerbated by the terrorist attacks in the United States on September 11, 2001, recent developments in the Middle East, including the war in Iraq and terrorist attacks and threats across the globe and rising oil prices. In addition, if investors perceive that there is a crisis in Asia, such as due to economic difficulties similar to those that Asian economies experienced in the late 1990s, companies and economies in that region may be adversely affected irrespective of their economic soundness.
 
Any future deterioration in global economic conditions, or a significant adverse change in politics and economies in Asia or a loss of investor confidence in the financial systems of emerging and other markets could have a material adverse effect on our business, financial condition and results of operations.
 
Fluctuations in exchange rates could result in foreign currency exchange losses.
 
In 2006, approximately 75.2% of our revenues were denominated in foreign currencies, primarily in the U.S. dollar and the Japanese Yen. In most of the countries in which our games are distributed, other than the United States, Japan and Europe, the revenues generated by our licensees in those markets are denominated in local currencies, which include the NT dollar, the Baht and the Renminbi. Depreciation of these local currencies against


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the U.S. dollar will result in reduced license fees and monthly royalty payments in U.S. dollar terms and may materially and adversely affect our financial condition and results of operations.
 
While we receive our monthly royalty revenues from our overseas licensees in foreign currencies, primarily the U.S. dollar, the Japanese Yen and the Euro, substantially all of our costs are denominated in Won. Our financial statements are also prepared and presented in the Won. We receive monthly royalty payments from our overseas licensees based on a percentage of revenues confirmed and recorded at the end of each month applying the foreign exchange rate applicable on such date. We generally receive these royalty payments 20 to 30 days after such record date (except in Europe, Chile and China, where such payments are received up to 60 days after the record date). Appreciation of the Won against these foreign currencies during this period will result in foreign currency losses that may materially and adversely affect our financial condition and results of operations.
 
As of December 31, 2006, there is no outstanding foreign currency forward exchange contract entered into by us. We may enter into hedging transactions in the future to mitigate our exposure to foreign currency exchange risks, but we may not be able to do so in a timely or cost-effective manner, or at all.
 
Increased tensions with North Korea could adversely affect us and the price of our ADSs.
 
Relations between Korea and North Korea have been tense over most of Korea’s history. The level of tension between Korea and North Korea has fluctuated and may increase or change abruptly as a result of current and future events, including ongoing contacts at the highest levels of the governments of Korea and North Korea and increased hostility between North Korea and the United States. In December 2002, North Korea removed the seals and surveillance equipment from its Yongbyon nuclear power plant and evicted inspectors from the United Nations International Atomic Energy Agency, and has reportedly resumed activity at its Yongbyon power plant. In January 2003, North Korea announced its intention to withdraw from the Nuclear Non-Proliferation Treaty, demanding that the United States sign a non-aggression pact as a condition to North Korea dismantling its nuclear program. In August 2003, representatives of Korea, the United States, North Korea, China, Japan and Russia held multilateral talks in an effort to resolve issues relating to the nuclear weapons program of North Korea. In February 2005, North Korea announced that it possessed nuclear weapons. In September 2005, North Korea agreed to end its nuclear weapons program, and the six participating nations signed a draft preliminary accord pursuant to which North Korea agreed to dismantle its existing nuclear weapons, abandon efforts to produce new future weapons and readmit international inspectors to its nuclear facilities. In return, the other five nations participating in the talks, China, Japan, Korea, Russia and the United States, expressed willingness to provide North Korea with energy assistance and other economic support. The six parties agreed to hold further talks in November 2005. However, one day after the joint statement was released, North Korea announced that it would not dismantle its nuclear weapons program unless the United States agreed to provide civilian nuclear reactors in return, a demand that the United States rejected.
 
In July 2006, North Korea conducted several missile tests, which increased tensions in the region and raised strong objections from Japan and the United States. In response, the United Nations Security Council passed a resolution condemning such missile tests and banning any United Nations member state from conducting transactions with North Korea in connection with material or technology related to missile development or weapons of mass destruction. On October 9, 2006, North Korea announced that it had successfully conducted a nuclear test, which increased tensions in the region and raised strong objections from Korea, the United States, Japan, China and other nations worldwide. In response, the United Nations Security Council passed a resolution which prohibits any United Nations member state from conducting transactions with North Korea in connection with any large-scale arms and material or technology related to missile development or weapons of mass destruction, providing luxury goods to North Korea, and imposes freezing of assets and an international travel ban on persons associated with North Korea’s weapons programs, and calls upon all United Nations member states to take cooperative action, including through inspection of cargo to or from North Korea.
 
In February 2007, the six parties entered a new accord whereby North Korea would begin to disable its nuclear facilities in return for fuel oil and aid. After several months of alleged non-compliance by North Korea and other related disputes among the parties, North Korea announced in June 2007 that it has agreed to begin disabling its nuclear facilities in the subsequent several weeks. We cannot assure you that these recent events constitute a final


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agreement on North Korea’s nuclear program, including critical details such as implementation, timing and verification, or that North Korea will fulfill its obligations under such accord.
 
In addition, in October 2004, the United States proposed plans to withdraw approximately one-third of the 37,500 troops stationed in Korea by the end of 2008. However, details regarding the timing and other aspects of the proposed reduction in U.S. troops are not yet finalized and talks between the governments of the United States and Korea are ongoing.
 
Any further increase in tensions, resulting for example from a break-down in contacts, test of long-range nuclear missiles, coupled with continuing nuclear programs by North Korea or an outbreak in military hostilities, could adversely affect our business, prospects, financial condition and results of operations and could lead to a decline in the market value of our ADSs.
 
Disruptions in Taiwan’s political environment could seriously harm our business and operations in Taiwan.
 
The government of China asserts sovereignty over mainland China and Taiwan and does not recognize the legitimacy of the government of Taiwan. The government of China has indicated that it may use military force to gain control over Taiwan if Taiwan declares independence or a foreign power interferes in Taiwan’s internal affairs. On the other hand, the government of Taiwan promulgated the Referendum Law on December 31, 2003 and as last amended on May 30, 2006 allowing referenda on a range of issues to be proposed and voted upon. The law allows a referendum on key constitutional issues in the event that Taiwan comes under military attack from a foreign power and its sovereignty is threatened. In 2005 and 2006, we derived 19.8% and 10.0% of our total revenues from our licensee in Taiwan, respectively. Deteriorations in the relationship between Taiwan and China and other factors affecting Taiwan’s political environment may materially and adversely affect our Taiwanese licensee’s business and our results of operations.
 
The economic, political and social conditions, as well as government policies in China, could adversely affect our operations in China.
 
In 2005 and 2006, we derived 2.2% and 1.3% of our total revenues from our licensee in China, respectively. While the Chinese economy has experienced significant growth in the past twenty years, growth has been uneven, both geographically and among various sectors of the economy. The Chinese government has implemented various measures to encourage economic growth and guide the allocation of resources. Some of these measures benefit the overall Chinese economy, but may also have a negative effect on us. For example, our financial condition and results of operations may be adversely affected by government control over capital investments or changes in tax regulations that are applicable to us or our licensees.
 
The Chinese economy has been transitioning from a planned economy to a more market-oriented economy. Although the Chinese government has implemented measures since the late 1970s emphasizing the utilization of market forces for economic reform, the reduction of state ownership of productive assets and the establishment of sound corporate governance in business enterprises, a substantial portion of productive assets in China is still owned by the Chinese government. In addition, the Chinese government continues to play a significant role in regulating industry development by imposing industrial policies. The Chinese government also exercises significant control over China’s economic growth through the allocation of resources, controlling payment of foreign currency-denominated obligations, setting monetary policy and providing preferential treatment to particular industries or companies.
 
Risks Relating to Our American Depositary Shares
 
The public shareholders of our ADSs may have more difficulty protecting their interests than they would as shareholders of a U.S. corporation.
 
Our corporate affairs are governed by our articles of incorporation and by the laws and regulations governing Korean corporations. The rights and responsibilities of our shareholders and members of our board of directors under Korean law may be different from those that apply to shareholders and directors of a U.S. corporation. For


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example, minority shareholder rights afforded under Korean law often require the minority shareholder to meet minimum shareholding requirements in order to exercise certain rights. Under applicable Korean law, a shareholder must own at least (i) one percent of the total issued shares to bring a shareholders’ derivative lawsuit, (ii) three percent to demand an extraordinary meeting of shareholders, demand removal of directors or inspect the books and related documents of a company, (iii) 10 percent to apply to the court for dissolution if there is gross improper management or a deadlock in corporate affairs likely to result in a significant and irreparable injury to the company or to apply to the court for a reorganization in the case of an insolvency and (iv) 20 percent to block a small-scale share exchange that may be approved only by a board resolution. In addition, while the facts and circumstances of each case will differ, the duty of care required of a director under Korean law may not be the same as the fiduciary duty of a director of a U.S. corporation. Although the concept of “business judgment rule” exists in Korea, there is insufficient case law or precedent to provide guidance to the management and shareholders as to how it should be applied or interpreted in a particular circumstance. Holders of our ADSs may have more difficulty protecting their interests against actions of our management, members of our board of directors or controlling shareholder than they would as shareholders of a U.S. corporation.
 
Any dividends paid on our common shares will be in the Won and fluctuations in the exchange rate between the Won and the U.S. dollar may affect the amount received by you.
 
If and when we declare cash dividends, the dividends will be paid to the depositary for the ADSs in Won and then converted by the depositary into U.S. dollars in connection with the deposit agreement. Fluctuations in the exchange rate between the Won and the U.S. dollar will affect, among other things, the U.S. dollar amounts you will receive from the depositary as dividends. Holders of ADSs may not receive dividends if the depositary does not believe it is reasonable or practicable to do so. In addition, the depositary may collect certain fees and expenses, at the sole discretion of the depositary, by billing the holders of ADSs for such charges or by deducting such charges from one or more cash dividends or other cash distributions from us to be distributed to the holders of ADSs.
 
Your ability to deposit or withdraw common shares underlying the ADSs into and from the depositary facility may be limited, which may adversely affect the value of your investment.
 
Under the terms of our deposit agreement, holders of our common shares may deposit such shares with the depositary’s custodian in Korea and obtain ADSs, and holders of our ADSs may surrender the ADSs to the depositary and receive our common shares. However, to the extent that a deposit of common shares exceeds the difference between:
 
  •  the aggregate number of common shares we have consented to be deposited for the issuance of ADSs (including deposits in connection with offerings of ADSs and stock dividends or other distributions relating to ADSs); and
 
  •  the number of common shares on deposit with the custodian for the benefit of the depositary at the time of such proposed deposit
 
such common shares will not be accepted for deposit unless (i) our consent with respect to such deposit has been obtained or (ii) such consent is no longer required under Korean laws and regulations or under the terms of the deposit agreement.
 
Under the terms of the deposit agreement, no consent is required if the common shares are obtained through a dividend, free distribution, rights offering or reclassification of such shares. Under the terms of the deposit agreement, we have consented to any deposit to the extent that, after the deposit, the aggregate number of deposited common shares does not exceed 3,552,229 common shares or any greater number of common shares we determine from time to time (i.e., as a result of a subsequent offering, stock dividend or rights offer), unless the deposit is prohibited by applicable laws or violates our articles of incorporation; provided, however, that in the case of any subsequent offer by us or our affiliates, the limit on the number of common shares on deposit shall not apply to such offer and the number of common shares issued, delivered or sold pursuant to the offer (including common shares in the form of ADSs) shall be eligible for deposit under the deposit agreement, except to the extent such deposit is prohibited by applicable laws or violates our articles of incorporation, or, in the case of any subsequent offer by us or our affiliates, we determine with the depositary to limit the number of common shares so offered that would be


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eligible for deposit under the deposit agreement in order to maintain liquidity of the shares in Korea as may be requested by the relevant Korean authorities. We might not consent to the deposit of any additional common shares. As a result, if a holder surrenders ADSs and withdraws common shares, it may not be able to deposit the common shares again to obtain ADSs.
 
You may not be able to exercise preemptive rights or participate in rights offerings and may experience dilution of your holdings.
 
The Korean Commercial Code and our articles of incorporation require us to offer shareholders the right to subscribe for new common shares in proportion to their existing ownership percentages whenever new common shares are issued, except under certain circumstances as provided in our articles of incorporation. See Item 10.B. “Articles of Incorporation — Preemptive rights and issuance of additional shares.”
 
Such exceptions include offering of new shares:
 
  •  through a general public offering;
 
  •  to the members of the employee stock ownership association;
 
  •  upon exercise of a stock option;
 
  •  in the form of depositary receipts;
 
  •  to induce foreign direct investment necessary for business in accordance with the Foreign Investment Promotion Act of Korea;
 
  •  for the purpose of raising funds on an emergency basis;
 
  •  as necessary for the inducement of technology to certain companies under an alliance arrangement with us; or
 
  •  by a public offering or subscribed for by the underwriters for the purpose of listing on the Korean public stock markets.
 
Accordingly, if we issue new shares to non-shareholders based on such exception, a holder of our ADSs will be diluted. If none of the above exemptions is available under Korean law, we may be required to grant subscription rights when issuing additional common shares. However, under U.S. law, we would not be able to make those rights available in the United States unless we register the securities to which the rights relate or an exemption from the registration requirements of the Securities Act is available. Under the deposit agreement governing the ADSs, if we offer rights to subscribe for additional common shares, the depositary under the deposit agreement, after consultation with us, may make such rights available to you or dispose of such rights on behalf of you and make the net proceeds available to you or, if the depositary is unable to take such actions, it may allow the rights to lapse with no consideration to be received by you. The depositary is generally not required to make available any rights under any circumstances. We are under no obligation to file a registration statement under the Securities Act to enable you to exercise preemptive rights in respect of the common shares underlying the ADSs, and we cannot assure you that any registration statement would be filed or that an exemption from the registration requirement under the Securities Act would be available. Accordingly, you may not be entitled to exercise preemptive rights and may thereby suffer dilution of your interests in us.
 
You will not be treated as our shareholder and you will not have shareholder rights such as the voting rights of a holder of common shares.
 
As an ADS holder, we will not treat you as one of our shareholders and you will not have the rights of a shareholder. Korean law governs shareholder rights. The depositary will be the shareholder of the common shares underlying your ADSs. As a holder of ADSs, you will have ADS holder rights. A deposit agreement among us, the depositary and you, as an ADS holder, sets out ADS holder rights as well as the rights and obligations of the depositary. New York law governs the deposit agreement and the ADSs. Upon receipt of the necessary voting materials, you may instruct the depositary to vote the number of shares your ADSs represent. The depositary will notify you of shareholders’ meetings and arrange to deliver our voting materials to you only when we deliver them


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to the depositary with sufficient time under the terms of the deposit agreement. If there is a delay, we cannot ensure that you will receive voting materials or otherwise learn of an upcoming shareholders’ meeting in time to ensure that you may instruct the depositary to vote your shares. In addition, the depositary and its agents are not responsible for failing to carry out voting instructions or for the manner of carrying out voting instructions.
 
You would not be able to exercise dissent and appraisal rights unless you have withdrawn the underlying common shares from the depositary facility and become our direct shareholders.
 
In some limited circumstances, including the transfer of the whole or any significant part of our business, our acquisition of a part of the business of any other company having a material effect on our business, our merger or consolidation with another company, dissenting shareholders have the right to require us to purchase their shares under Korean law. However, if you hold our ADSs, you will not be able to exercise such dissent and appraisal rights unless you have withdrawn the underlying common shares from the depositary facility and become our direct shareholder prior to the record date for the shareholders’ meeting at which the relevant transaction is to be approved.
 
We may amend the deposit agreement and the ADRs without your consent for any reason and, if you disagree, your option will be limited to selling the ADSs or withdrawing the underlying securities.
 
We may agree with the depositary to amend the deposit agreement and the American depositary receipts, or ADRs, without your consent for any reason. If an amendment adds or increases fees or charges, except for taxes and other governmental charges or expenses of the depositary, for registration fees, facsimile costs, delivery charges or similar items, or prejudices a substantial right of ADS holders, it will not become effective for outstanding ADRs until 30 days after the depositary notifies ADS holders of the amendment. At the time an amendment becomes effective, you are considered, by continuing to hold your ADSs, to agree to the amendment and to be bound by the ADRs and the deposit agreement as amended. If you do not agree with an amendment to the deposit agreement or the ADRs, your option is limited to selling the ADSs or withdrawing the underlying securities. No assurance can be given that the sale of ADSs would be made at a price satisfactory to you in such circumstances. In addition, the common shares underlying the ADSs are not listed on any stock exchange in Korea. Your ability to sell the underlying common shares following withdrawal and the liquidity of the common shares may be limited.
 
You may be subject to Korean withholding tax.
 
Under Korean tax law, if you are a U.S. investor, you may be subject to Korean withholding taxes on capital gains and dividends in respect of the ADSs unless an exemption or a reduction under the income tax treaty between the United States and Korea is available. Under the Korea-United States tax treaty, capital gains realized by holders that are residents of the United States eligible for treaty benefits will not be subject to Korean taxation upon the disposition of the ADSs. However, under the Korea-United States tax treaty, the following holders are not eligible for such tax treaty benefits: (i) in case the holder is a United States corporation, if by reason of any special measures, the tax imposed on such holder by the United States with respect to such capital gains is substantially less than the tax generally imposed by the United States on corporate profits, and 25% or more of the holder’s capital is held of record or is otherwise determined, after consultation between competent authorities of the United States and Korea, to be owned directly or indirectly by one or more persons who are not individual residents of the United States and (ii) in case the holder is an individual, if such holder maintains a fixed base in Korea for a period or periods aggregating 183 days or more during the taxable year and the holder’s ADSs or common shares giving rise to capital gains are effectively connected with such fixed base or such holder is present in Korea for a period or periods of 183 days or more during the taxable year.
 
You may have difficulty bringing an original action or enforcing any judgment obtained outside Korea against us, our directors and officers who are not U.S. persons.
 
We are organized under the law of Korea, and all of our directors and officers reside in Korea. All or a significant portion of our assets and the assets of such persons are located outside of the United States. As a result, it may not be possible for you to effect service of process within the United States upon these persons or to enforce against them or us court judgments obtained in the United States that are predicated upon the civil liability provisions of the federal securities laws of the United States or of the securities laws of any state of the United


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States. We have, however, irrevocably appointed an agent in New York to receive service of process in any proceedings in the State of New York relating to our ADSs. Notwithstanding the foregoing, there is doubt as to the enforceability in Korea, either in original actions or in actions for enforcement of judgments of United States courts, of civil liabilities predicated on the federal securities laws of the United States or the securities laws of any state of the United States.
 
ITEM 4.   INFORMATION ON THE COMPANY
 
4.A.  History and Development of the Company
 
History and Development of the Company
 
We were incorporated as a company with limited liability under Korean law on April 4, 2000 under the legal name of GRAVITY Co., Ltd. In March 2003, we established GRAVITY Interactive, LLC, our wholly-owned subsidiary in the United States. The name of GRAVITY Interactive, LLC was changed on January 1, 2006 to GRAVITY Interactive, Inc. In January 2004, we acquired 50% of the voting shares of GRAVITY Entertainment Corporation, formerly RO Production Co., Ltd., our subsidiary in Japan. In October 2004, we obtained from GungHo Online Entertainment, Inc., then the other 50% shareholder of RO Production Co., Ltd, their ownership interest in RO Production Co., Ltd., which made GRAVITY Entertainment our wholly-owned subsidiary. RO Production changed its corporate name to GRAVITY Entertainment Corporation on February 5, 2005. In April and May 2005, we acquired an aggregate of 88.15% equity interest in TriggerSoft Corporation, which developed our R.O.S.E. Online game. In November and December 2005, we acquired an aggregate of 96.11% of the total shares of NEOCYON, Inc., which provides mobile multimedia and online game distribution services in Korea and Russia. In August 2006, the Company founded Gravity EU SASU, a wholly owned Europe-based subsidiary, and in September 2006, the Company acquired 100% of the voting shares of Gravity CIS, Inc., formerly Mados, Inc., from Cybermedia International, Inc. a subsidiary of NEOCYON, Inc. In May 2007, the Company established Gravity Middle East & Africa FZ-LLC, a wholly owned subsidiary in Dubai.
 
Our registered office is located at Meritz Tower 14F, 825-2 Yeoksam-Dong, Gangnam-Gu, Seoul 135-934 Korea. Our telephone number is (822) 2019-6000. Our address for service of process in the United States is Gravity Interactive, Inc., located at 4505 Glencoe Ave, 2nd Floor, Marina Del Ray, California.
 
For the year ended December 31, 2004, 2005 and 2006, we expended Won 12,324 million, Won 8,459 million and Won 2,858 million (US$3,073 thousand) for capital expenditures (including capitalized interest) in connection with purchase of property and equipment.
 
4.B.  Business Overview
 
Overview
 
We are a leading developer and publisher of online games in Japan, Thailand, the Philippines, Indonesia, Malaysia and Singapore based on the number of peak concurrent users. We are based in Korea and our principal product, Ragnarok Online, is commercially offered in 20 countries. R.O.S.E. Online is commercially offered in the Philippines, the United States and Canada. STYLIA and Time N Tales are commercially offered in Korea. We also offer a number of mobile games and license the merchandizing rights of character-related products based on our online games. We intend to diversify our online game offering by developing online games internally as well as publishing additional online games developed by third parties. We have produced a televised animation series and intend to create other animation products for international distribution in the future.
 
In all the countries in which our games are serviced, our overseas licensees are responsible for the marketing, operation, billing and customer service in their respective markets in close cooperation with us, except in Korea, the United States, Canada, Russia, France and Belgium. Our license agreements generally have two years for the initial term and subject to renewal every year once the initial term expires. We rely, as a significant portion of our revenue, on the initial license fees and the ongoing royalties from our overseas licensees. The ongoing royalties are based on a percentage of revenues generated by our overseas licensees from the subscription to Ragnarok Online in their respective markets. In Korea, we directly manage game operations, while in the United States and Canada, our wholly-owned subsidiary, GRAVITY Interactive, Inc., is responsible for all aspects of the operation in such


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countries. We also have Gravity CIS, Inc. and Gravity EU SASU, our wholly-owned subsidiaries, for the game operations in Russia and CIS countries and in France and Belgium, respectively.
 
The table below provides for the periods indicated, the peak concurrent users and average concurrent users of Ragnarok Online since August 1, 2002, in each of our principal markets.
 
                                                                                                 
    Taiwan & Hong Kong     Thailand     Japan     China     Korea     USA & Canada  
    PCU(1)     ACU(2)     PCU     ACU     PCU     ACU     PCU     ACU     PCU     ACU     PCU     ACU  
 
3Q 2002
    73,274       31,338                                           24,966       13,880              
4Q 2002
    112,823       53,134       40,807       25,451       56,033       33,875                   31,294       14,930              
1Q 2003
    158,695       79,410       65,100       22,519       58,785       34,076                   28,598       15,758              
2Q 2003
    184,436       83,762       60,600       37,025       75,582       32,146       112,844       73,100       29,103       14,687              
3Q 2003
    206,904       91,620       66,700       36,048       75,026       40,634       125,183       87,577       33,491       17,554       9,000        
4Q 2003
    250,030       168,913       72,200       31,757       83,880       47,086       118,257       81,725       27,931       14,430       7,484       5,641  
1Q 2004
    342,228       220,448       82,385       43,609       89,111       50,306       147,059       97,547       30,059       15,439       9,456       6,995  
2Q 2004
    339,843       176,976       86,133       56,465       101,983       50,132       116,208       81,240       22,051       11,236       11,230       8,477  
3Q 2004
    352,592       193,132       107,798       64,935       100,503       50,699       100,002       78,509       26,508       13,023       12,965       8,919  
4Q 2004
    325,351       241,170       130,148       81,312       104,559       56,091       78,302       63,767       20,597       10,179       10,011       7,108  
1Q 2005
    344,534       283,553       116,672       88,475       106,195       59,345       76,993       62,006       22,403       10,569       9,190       6,457  
2Q 2005
    326,848       231,980       111,959       74,087       96,119       50,253       64,970       46,840       15,784       7,153       8,997       5,378  
3Q 2005
    213,006       146,467       102,716       71,097       93,954       52,213       58,253       41,756       16,516       8,124       8,219       5,426  
4Q 2005
    134,869       104,702       75,373       57,948       95,706       49,647       35,336       23,734       13,520       6,401       7,433       4,922  
1Q 2006
    132,539       107,141       69,997       52,404       75,302       36,362       28,248       21,909       13,145       6,342       8,338       5,222  
2Q 2006
    115,261       90,536       58,502       42,780       80,800       37,208       24,530       19,275       9,627       4,653       8,495       5,518  
3Q 2006
    122,978       86,985       116,331       36,361       83,632       35,551       36,290       17,220       9,796       4,837       8,128       5,381  
4Q 2006
    80,226       55,216       48,514       28,276       105,350       34,057       13,620       9,673       10,296       5,042       8,033       4,569  
1Q 2007
    78,516       45,993       27,491       19,061       78,053       34,504       25,419       8,526       10,338       5,177       6,538       4,042  
 
 
Notes:
 
(1) PCU, or peak concurrent users, represents the highest number of users of Ragnarok Online during the specified time period as recorded on the servers for the various countries.
 
(2) ACU, or average concurrent users, represents the average number of concurrent users of Ragnarok Online during the specified time period as recorded on the servers for the various countries.
 
(3) We believe that the number of users as measured by PCU or ACU (i) is reflective of our active user base and (ii) is co-related to revenues as revenues from an online game depend on the numbers of users as well as the time spend playing the game. However, PCU and ACU are not measures under accounting principles generally accepted in Korea (“K-GAAP”) or US GAAP and should not be construed as an alternative to operating income or another measure of performance determined in accordance with K-GAAP or US GAAP . Other companies may determine PCU or ACU differently than we do.


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The following table sets forth a summary of our consolidated statement of operations as a percentage of total revenues for the periods indicated.
 
                                                         
    Year Ended December 31,  
    2004     2005     2006(1)  
                            (Unaudited)  
    (In millions of Won and thousands of US$, except percentages)  
 
Ragnarok Online, R.O.S.E. Online and Time N Tales revenues(2):
                                                       
Subscriptions:
                                                       
Korea
  W 12,725       19.7 %   W 8,548       16.0 %   W 5,650     US$ 6,075       13.8 %
United States/Canada
    3,528       5.5       2,701       5.1       2,770       2,979       6.7  
Royalties and license fees:
                                                       
Japan
    17,009       26.4       15,447       28.9       15,388       16,546       37.6  
Taiwan/Hong Kong
    14,350       22.3       9,770       18.3       4,050       4,355       9.9  
Thailand
    5,335       8.3       4,817       9.0       2,505       2,694       6.1  
Others
    8,407       13.0       7,341       13.8       4,180       4,494       10.2  
                                                         
Sub-total
    45,101       70.0       37,375       70.0       26,123       28,089       63.8  
                                                         
Mobile games
    376       0.6       1,664       3.1       3,840       4,129       9.4  
Character merchandising and other revenue
    2,696       4.2       3,096       5.8       2,580       2,774       6.3  
                                                         
Total revenues
  W 64,426       100.0 %   W 53,384       100.0 %   W 40,963     US$ 44,046       100.0 %
                                                         
 
 
Notes:
 
(1) For convenience, the Won amounts are expressed in U.S. dollars at the rate of Won 930.0 to US$1.00.
 
(2) Revenues from STYLIA represented a nominal amount of the total revenues in 2006.
 
Our products
 
We currently have four product lines: massively multiplayer online role playing games, casual online games, mobile games, and animation and character-based merchandise. Revenues from our principal product, Ragnarok Online, accounted for 88.3% of our revenue in 2005 and 78.3% of our revenue in 2006. We are seeking to diversify our revenue sources by offering additional massively multiplayer online role playing games, casual online games, and other products and services, including mobile games.
 
Massively multiplayer online role playing games
 
Currently, we commercially offer three massively multiplayer online role playing games, Ragnarok Online, R.O.S.E. Online and Time N Tales. In addition, we are currently in the process of developing two additional massively multiplayer online role playing games, Ragnarok Online II and Requiem, and intend to publish Emil Chronicle Online which is licensed from a third party developer.


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The following table summarizes the massively multiplayer online role playing games that we are either currently offering or in the process of developing, as well as publishing games licensed from third parties we are planning to offer in the near future.
 
             
            Date of Commercial
Title
 
Description
 
Game source
 
Launch/Testing(2)
 
Ragnarok Online
  Action adventure with 99 levels of skill upgrades, which features two- dimensional characters in three-dimensional backgrounds(1)   Developed in-house   Launched in August 2002
Ragnarok Online II
  Three-dimensional sequel to Ragnarok Online   Developed in-house   Currently in development with open beta testing since May 2007 and expect to commercially launch in the third quarter 2007
Requiem
  Three-dimensional action adventure   Developed in-house   Currently in development with open beta testing scheduled for the third quarter 2007 and expect to commercially launch in the fourth quarter 2007
R.O.S.E. Online
  Three-dimensional action adventure with seven independent storylines   Licensed from third party developer   Launched in January 2005
Time N Tales
  Two-dimensional real- time tactical game   Licensed from third party developer   Launched in July 2006
Emil Chronicle Online
  Three-dimensional action adventure   Licensed from third party developer   Currently in open beta testing and expect to commercially launch in the third quarter 2007
 
 
Notes:
 
(1) A game with such features is generally referred to as a 2.5 dimensional game.
 
(2) The actual date of commercial launch of games are dependent on a variety of factors, including technical viability and durability, availability of in-house development capability, market conditions, beta testing results and availability of licensing partners in various jurisdictions, among others.
 
Massively multiplayer online role playing games currently offered
 
Ragnarok Online
 
Ragnarok Online represented 78.3% of our total revenues or Won 32,086 million (US$34,501 thousand) in 2006, compared with 88.3% of our total revenues or Won 47,151 million in 2005. Ragnarok Online is offered commercially in 20 markets.


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Revenues of Ragnarok Online
 
                                     
        Year Ended December 31,  
Revenues
 
Countries
  2004     2005     2006     2006(1)  
                          (Unaudited)  
        (In millions of Won and thousands of US$, except percentages)  
 
Online game-subscription revenue
  Korea   W 12,725     W 7,913     W 5,339     US $ 5,741  
    United States/Canada     3,528       2,665       2,163       2,326  
                                     
         Subtotal     16,253       10,578       7,502       8,067  
                                     
Online game-royalties and license fees
  Taiwan/Hong Kong     14,350       9,770       4,050       4,355  
    Japan     17,009       14,874       14,099       15,160  
    Thailand     5,335       4,817       2,505       2,693  
    Philippines     2,639       2,297       1,020       1,096  
    China     2,840       1,178       516       555  
    Indonesia     1,350       1,107       594       639  
    Europe     441       650       534       574  
    Singapore/Malaysia     1,103       894       224       241  
    Australia/New Zealand     34       214       155       167  
    Brazil           772       749       805  
    India                 118       127  
    Chile                 20       22  
                                     
         Subtotal     45,101       36,573       24,584       26,434  
                                     
         Total   W 61,354     W 47,151     W 32,086     US $ 34,501  
                                     
 
 
Notes:
 
(1) For convenience, the Won amounts are expressed in U.S. dollars at the rate of Won 930.0 to US$1.00.
 
In developing Ragnarok Online, we obtained an exclusive license from Mr. Myoung-Jin Lee to use the storyline and characters from his cartoon titled “Ragnarok” for the production of online games, animation and character merchandising. We paid Mr. Lee an initial license fee of Won 40 million and are required to pay royalties based on a percentage of adjusted revenues (net of value-added taxes and certain other expenses) or net income generated from the use of the Ragnarok brand, including the operation or licensing of Ragnarok Online through January 2033.
 
Ragnarok Online is an action adventure-based massively multiplayer online role playing game that combines cartoon-like characters, community-oriented themes and combat features in a virtual world within which thousands of players can interact with one another. Furthermore, we believe that the highly interactive and community-oriented nature of Ragnarok Online, such as marriages and organization of guilds, are important to users who appreciate social interaction in a virtual setting.
 
Other key features of Ragnarok Online include the following:
 
  •  players may assume an ongoing role, or alter-ego, of a particular game character, each with different strengths and weaknesses. In Ragnarok Online, the user starts as a “novice” and undergoes training in a specialized mapped game zone to become familiar with the game features. Once that stage is completed, the user can choose from six basic characters, each with a distinct combination of different traits;
 
  •  as each game character advances in challenge levels, the character can enter into a greater range of mapped game zones and morph into a more sophisticated game character in terms of game attributes and special powers;


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  •  Ragnarok Online characters may visually express the users’ mood and emotions by using emotive icons that appear within a bubble above the characters’ heads. We believe that this feature significantly expands the interface for user interaction and elevates the level of social reality of the game;
 
  •  game features may be traded or sold within the game, and game characters may simulate real-life experiences such as marriage, group fights and joining a guild. In addition, players may communicate with each other through in-game chatting or instant messaging;
 
  •  special events are held from time to time to stimulate community formations. For example, we periodically host “fortress raids” for which players are encouraged to organize themselves into a team to compete against other teams to capture a fortress within a set time; and
 
  •  the game has no preordained ending and is designed to continuously evolve in terms of plots, mapped game zones and character attributes through enhancements from time to time.
 
We believe that the personal computer, or PC, configurations required to run Ragnarok Online are lower than or on par with many other competing massively multiplayer online role playing games, which we believe has facilitated our successful entry into and continued expansion of Ragnarok Online in many of the developing countries in which Ragnarok Online is distributed. As we were developing and preparing to launch Ragnarok Online in Korea and overseas markets, we carefully balanced perceived demand for sophisticated three-dimensional graphics with prevailing computer processing and graphics capabilities in such markets. Based on these considerations, we opted to launch Ragnarok Online based on a combination of two-dimensional characters with a three-dimensional background, which would require lower PC configurations than three-dimensional massively multiplayer online role playing games. The recommended minimum PC configuration for Ragnarok Online is Pentium III 1.6 GHz, 256 MB RAM and 32 MB graphic card. Ragnarok Online can be accessed through a dial-up modem as well as broadband Internet.
 
R.O.S.E. Online
 
R.O.S.E. Online, which was commercially launched in January 2005, represented 5.4% of our total revenues or Won 2,198 million (US$2,363 thousand) in 2006.
 
Revenues of R.O.S.E. Online
 
                             
        Year Ended December 31,  
Revenues
 
Countries
  2005     2006     2006(1)  
                    (Unaudited)  
        (In millions of Won and thousands of US$, except percentages)  
 
Online game-subscription revenue
  Korea   W 635     W 52     US$ 56  
    United States/Canada     36       607       652  
                             
         Subtotal     671       659       708  
                             
Online game-royalties and license fees
  Japan     573       1,289       1,386  
    Europe     101              
    Philippines     128       250       269  
                             
         Subtotal     802       1,539       1,655  
                             
         Total   W 1,473     W 2,198     US$ 2,363  
                             
 
 
Notes:
 
(1) For convenience, the Won amounts are expressed in U.S. dollars at the rate of Won 930.0 to US$1.00.
 
R.O.S.E. Online, a three-dimensional game, is the first online game developed by a third party that we published pursuant to an exclusive publishing license agreement. R.O.S.E. Online was developed by TriggerSoft


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Corporation, in close coordination with our in-house game development team. In May 2005, we acquired control of TriggerSoft to enhance our ability to update and improve R.O.S.E. Online more effectively and on a timelier basis. In January and February 2005, we entered into arrangements with three licensees to distribute R.O.S.E. Online in Japan, Taiwan, Hong Kong, Macao and the Philippines. In June 2005 we commenced open beta testing of R.O.S.E. Online in Taiwan, Hong Kong and Macao, and in March 2007 we chose to terminate and no longer commercialize the game in these markets. We have been offering commercial service of R.O.S.E. Online in the Philippines, the United States and Canada since 2005. In March 2007, we terminated the publishing business of R.O.S.E. Online in Japan and transferred all the rights of R.O.S.E. Online to Faith, Inc. in Japan. We terminated its service in Korea in April 2007.
 
Time N Tales
 
We commercially launched Time N Tales in July 2006 under a publishing agreement entered into with Ndoors Corp., a Korean online game developer, in November 2005. Time N Tales allows gamers to embark on exciting time travel through numerous scenarios and game systems with a wide variety of characters. Game users will bring up their characters by solving individually composed omnibus type episodes one after another. Time N Tales allows gamers to get involved in real-time battles between large number of characters by formulating parties comprised of up to five or six heroes and mercenaries. The amount of revenues from Time N Tales in 2006 represented less than 1% of our total revenues.
 
Expected future release of massively multiplayer online role playing games
 
Ragnarok Online II
 
We expect that Ragnarok Online II will offer substantially the same gaming experience as Ragnarok Online with respect to storyline and other central features of the game, but in a more dynamic three-dimensional format. We currently have 40 designers, 12 programmers and 10 game planners dedicated to the development of Ragnarok Online II.
 
Requiem
 
Unlike Ragnarok Online, which we believe did not emphasize violent themes, we are designing Requiem to prominently feature user-to-user combat. In addition, we are using advanced game development engines for enhanced graphics and to capture the game’s speedy and streamlined action movements. We currently have 43 designers, 10 programmers and 11 game planners dedicated to the development of Requiem.
 
Emil Chronicle Online
 
Emil Chronicle Online is the first online game developed by GungHo Online Entertainment, Inc., the publisher of Ragnarok Online in Japan. Emil Chronicle Online has been commercially offered for service in Japan since 2005 and has maintained a very steady pool of players in Japan. We have entered into a software licensing agreement for the right to publish Emil Chronicle Online worldwide, except for Japan. We entered into license and distribution agreements for Emil Chronicle Online in the Southeast Asian and Oceania market with Infocomm Asia Holdings Pte Ltd. in November 2006 and in China with a wholly owned subsidiary of The9 Limited in January 2007. We are planning to commence commercialization of Emil Chronicle Online outside of Japan in the third quarter of 2007. Thailand is the first of Southeast Asia countries where the open beta testing started in June 2007.
 
Casual online games
 
Currently, we commercially offer two casual online games, Love Forty and TV Boys, through our casual online game portal site, STYLIA. In addition, we are currently in the process of developing three additional casual games, Pucca Racing, W Baseball and Bodycheck Online.


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The following table summarizes the casual online games that we are either currently offering or in the process of developing or are planning to offer in the near future.
 
             
            Date of Commercial
Title
 
Description
 
Game source
 
Launch/Testing
 
STYLIA
  Casual online game portal site   Licensed from third party developer   Launched in June 2006
Pucca Racing
  Casual online racing game   Developed in-house   Currently in development with open beta testing scheduled for the third quarter 2007 and expect to commercially launch in the fourth quarter 2007
W Baseball
  Casual online baseball game   Developed in-house   Currently in development with open beta testing scheduled for the third quarter 2007 and expect to commercially launch in the fourth quarter 2007
Bodycheck Online
  Casual online ice hockey game   Developed in-house   Currently in development with open beta testing scheduled for the third quarter 2007 and expect to commercially launch in the fourth quarter 2007
 
Casual games currently offered
 
STYLIA
 
Through STYLIA, we are currently offering two casual games, Love Forty, an online tennis game and TV Boyz, a three-dimensional action game. The amount of revenues from STYLIA in 2006 represented less than 1% of our total revenues.
 
Expected future release of casual online games
 
Pucca Racing
 
Pucca Racing is being co-developed by us and Vooz Co., Ltd. which originally designed Pucca characters. The most distinguishing characteristic of the game is its simple game play based on classic bike racing, allowing players of all age groups to freely enjoy the game. Players can apply various control techniques to achieve fast acceleration and lively movements based on performance differences across a wide selection of bikes. Furthermore, we believe the use of famous race tracks from countries around the world makes the game even more fun to play.
 
W Baseball
 
With W baseball, gamers can obtain lively batting experience using a simple mouse-based control as well as realistic scenery of the world’s famous baseball stadiums through dynamic camera effects and support for a 16:9 wide screen setting. Gamers can also decorate their own unique characters by applying a variety of casual uniforms and accessories on up to seven types of male/female characters. W Baseball adopted a motion-based character development system allowing gamers to select from over 200 famous baseball players’ styles and develop them based on the styles chosen.


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Bodycheck Online
 
Bodycheck Online boasts its futuristic settings and highlights upgraded equipments and daring actions based on crashing, smashing and speeding rather than adopting the complex rules and fixed uniforms associated with real life ice hockey games. Bodycheck Online, the first online ice hockey game, paves a new ground in the online sports game industry by combining realistic environments with the movements of a real hockey game, one of the fastest and most intense sports.
 
Mobile games currently offered
 
As compared to massively multiplayer online role playing games, mobile games, which are played using mobile phones and other mobile devices, have shorter game playtime and less complex user-game interaction. We believe that mobile games, due to such characteristics, provide less-experienced users with a means to become familiar with both game playing and the game culture without making a substantial commitment in time and resources. As a result, we believe that mobile games allow us to target a broader audience of users, help us to expand the online game culture beyond Internet cafés and users’ homes and act as an effective marketing tool to attract new users to our massively multiplayer online role playing games.
 
Revenues from our mobile business
 
                                         
    Year Ended December 31,  
Countries
  2004     2005     2006     2006(1)        
                      (Unaudited)        
    (In millions of Won and thousands of US$, except percentages)  
 
Korea
    W363       W1,237       W3,722     US$ 4,002       96.9 %
Japan
    11       67       59       63       1.5  
United States/Canada
                39       42       1.0  
Others
             2              360               20       22       0.6  
                                         
Total
    W376       W1,664       W3,840     US$ 4,129       100.0 %
                                         
 
 
Notes:
 
(1) For convenience, the Won amounts are expressed in U.S. dollars at the rate of Won 930.0 to US$1.00.
 
Our game-related products and services
 
Animation
 
GRAVITY Entertainment, our Japanese subsidiary, entered into an agreement with G&G Entertainment Inc. and three other Japanese media and entertainment companies for the production and distribution of 26 half-hour episode animation series based on the storyline and characters of Ragnarok Online. The series was broadcasted on television in Korea, Japan, the Philippines, Indonesia, Taiwan, Hong Kong, Malaysia and Brazil. We have also entered into agreement to broadcast such series in China, Thailand and Singapore. We intend to expand the distribution of Ragnarok animation to other countries in North and South America, Europe and elsewhere in which Ragnarok Online is in service and create other animation products for international distribution. In addition to the potential revenue generated from the sale of broadcasting rights, videos, DVDs and Internet viewing, we believe that our animation products will enhance the brand recognition of Ragnarok Online and facilitate cross-selling of other products. Our revenues from our animation business was Won 24 million (US$26 thousand) in 2006 and Won 614 million in 2005.
 
Game character merchandising
 
In order to take advantage of the commercial opportunities presented by the popularity generated by our games and game characters, we and our licensees have been marketing dolls, stationery and other character-based merchandise, as well as game manuals, monthly magazines and other publications, based on Ragnarok Online characters. We market the merchandise mostly through convenience stores where, in China and many Southeast Asian countries, prepaid game cards for our games are sold.


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We have entered into arrangements with seven Korean vendors and five overseas vendors to license Ragnarok’s animation characters in Korea, Japan, Taiwan, Hong Kong, China, Thailand, the Philippines, Indonesia, Singapore, Malaysia and Brazil. In 2006, the total amount of licensing fees from our contracts with Korean vendors was approximately Won 201 million (US$216 thousand) and the total amount of licensing fees from our contracts with overseas vendors was approximately Won 1,182 million (US$1,271 thousand). We intend to expand our character marketing to other countries in Asia, North and South America and Europe.
 
Revenues of game character merchandising
 
                                         
    Year Ended December 31,  
Countries
  2004     2005     2006     2006(1)        
                      (Unaudited)        
    (In millions of Won and thousands of US$, except percentages)  
 
Korea
  W 230     W 204     W 201     US$ 216       14.5 %
Japan
    1,175       1,430       1,075       1,156       77.7  
Taiwan/Hong Kong
    216       198       34       37       2.5  
Others
    186       19       73       78       5.3  
                                         
Total
  W 1,807     W 1,851     W 1,383     US$ 1,487       100.0 %
                                         
 
 
Notes:
 
(1) For convenience, the Won amounts are expressed in U.S. dollars at the rate of Won 930.0 to US$1.00.
 
Our markets
 
In terms of revenue, Japan, Korea, Taiwan, the United States and Thailand were our biggest markets in 2006.
 
Operations by geographic area
 
                                         
    Year Ended December 31,  
Countries
  2004     2005     2006     2006(1)        
                      (Unaudited)        
    (In millions of Won and thousands of US$, except percentages)  
 
Japan
  W 18,372     W 17,246     W 16,913     US$ 18,186       41.3 %
Korea
    13,524       10,093       10,155       10,919       24.8  
Taiwan/Hong Kong
    14,643       10,582       4,092       4,400       10.0  
United States/Canada
    3,528       2,701       2,868       3,084       7.0  
Thailand
    5,504       4,933       2,545       2,737       6.2  
Others
    8,855       7,829       4,390       4,720       10.7  
                                         
Total
  W 64,426     W 53,384     W 40,963     US$ 44,046       100.00 %
                                         
 
 
Notes:
 
(1) For convenience, the Won amounts are expressed in U.S. dollars at the rate of Won 930.0 to US$1.00.
 
Korea
 
In Korea, we commercially launched Ragnarok Online and began to charge subscribers in August 2002. Ragnarok Online subscribers in Korea consist of individual PC account subscribers and Internet café subscribers. Individual PC account subscribers are individuals who log on to our game servers from places other than Internet cafés, such as from home or work, whereas Internet café subscribers are commercial businesses operating Internet café outlets equipped with multiple PCs that provide broadband Internet access to their customers who typically prefer to play the most up-to-date versions of online games. Most Internet cafés charge their customers PC usage and Internet access fees that generally range from Won 500 to Won 1,500 per hour and subscribe to various online games. As of May 31, 2007, over 10,000 Internet cafés offered Ragnarok Online in Korea according to our internal


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data. In order to offer our games, including Ragnarok Online, an Internet café typically purchases from us minimum game hours. In 2006, the subscription collected from Internet cafés accounted for 10.1% of our subscription revenues in Korea.
 
We commercially launched STYLIA in June 2006 and Time N Tales in July 2006 in Korea.
 
Overseas markets
 
Ragnarok Online is commercially offered in 19 overseas markets: Taiwan, Japan, China, United States, Canada, Singapore, Malaysia, Thailand, the Philippines, Indonesia, Germany, Austria, Switzerland, Italy, Turkey, Brazil, India, Russia and Vietnam. We are currently conducting open beta testing for Ragnarok Online in France and Belgium. In addition, we currently plan to conduct closed beta testing of Ragnarok Online in the following 12 countries: United Arab Emirates, Saudi Arabia, Kuwait, Qatar, Bahrain, Oman, Yemen, Iraq, Egypt, Israel, Lebanon and Jordan. Except in the United States, Canada, Russia, France and Belgium, Ragnarok Online is distributed through local game operators and distributors.
 
The following table lists the overseas countries in which Ragnarok Online is commercially offered through our licensees, names of our licensees, where applicable, the dates of license agreements, commercial launch and expiry of the license agreements.
 
                 
        Date of
  Date of
   
        License
  Commercial
   
Country
 
Licensee
 
Agreement
 
Launch
 
Date of Expiry
 
Japan
  GungHo Online Entertainment, Inc.   July 2002   December 2002   August 2009(1)
Taiwan/Hong Kong(2)
  Soft-World International Corporation   May 2002   October 2002   October 2007(3)
Thailand
  Asiasoft International Company Ltd.   June 2002   March 2003   March 2007(4)
China
  Shengqu Information Technology (Shanghai) Co., Ltd(5)   August 2005   May 2003   July 2008
Singapore/Malaysia(2)
  Game Flier (Malaysia) Sdn. Bhd.(6)   May 2003   April 2004   October 2007(7)
Philippines
  Level Up! Inc.   March 2003   September 2003   August 2008(8)
Indonesia
  PT. Lyto Datarindo Fortuna(9)   February 2003   November 2003   February 2007(10)
Europe(11)
  Burda Interactive Communities GmbH   November 2003   April 2004   April 2007(12)
Brazil
  Level Up! Interactive S.A.   August 2004   February 2005   February 2007(13)
India
  Level Up! Network India Pvt. Ltd.   May 2004   March 2006   March 2008
Spain and 25 countries(14)
  Gamer Pro SA   September 2005   December 2006   December 2008
Vietnam
  VinaGame Software Service JSC(15)   December 2004   April 2007   April 2009
 
 
Notes:
 
(1) Renewed in August 2006.
 
(2) Governed under a single license agreement covering both markets.
 
(3) Renewed in October 2006.
 
(4) License Agreement with Asiasoft International expired in March 2007. We are considering extending the term of the expired license agreement with Asiasoft International. Although there is no license agreement in effect, Asiasoft currently continues to service our game in Thailand.


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(5) Shengqu is a wholly owned subsidiary of Shanda Interactive Entertainment Ltd., previously with different licensee.
 
(6) Game Flier (Malaysia) Sdn. Bhd. is a wholly-owned subsidiary of Soft-World International Corporation.
 
(7) Renewed in April 2006.
 
(8) Renewed in March 2006.
 
(9) Previously with a different licensee.
 
(10) License Agreement with PT. Lyto Datarindo Fortuna expired in February 2007. We are considering extending the term of the expired license agreement with PT. Lyto Datarindo Fortuna. Although there is no license agreement in effect, PT. Lyto Datarindo Fortuna currently continues to service our game in Indonesia.
 
(11) Represents massively multiplayer online role playing game operations in Germany, Austria, Switzerland, Italy and Turkey. A single operator services these five countries under one license agreement.
 
(12) License Agreement with Burda Holdings International GmbH expired in April 2007. We currently contemplate extending the term of the expired license agreement with Burda through April 2008. Although there is no license agreement in effect, Burda currently continues to service our game in Europe.
 
(13) License Agreement with Level Up! Interactive expired in February 2007. We are considering extending the term of the expired license agreement with Level Up! Interactive. Although there is no license agreement in effect, Level Up! Interactive Fortuna currently continues to service our game in Brazil.
 
(14) 25 countries are Mexico, Guatemala, El Salvador, Nicaragua, Panama, Honduras, Belize, Cuba, Jamaica, Haiti, the Dominican Republic, Costa Rica, Puerto Rico, Ecuador, Colombia, Peru, Venezuela, Guyana, Surinam, French Guiana, Chile, Bolivia, Paraguay, Argentina and Uruguay. Through our licensee, we commercially launched Ragnarok Online in these 25 markets in December 2006, but terminated such services in May 2007. Despite such termination, the license agreement with Gamer Pro SA remains valid. We are currently pursuing various other options in these markets and expect to find an alternative licensee in the near future.
 
(15) Previously with a different licensee.
 
R.O.S.E. Online is currently commercially offered in the Philippines, the United States and Canada. In the Philippines R.O.S.E is commercially offered under a license agreement with Level UP! Inc. We entered a license agreement with Level UP! Inc. in February 2005 for 2 years after commercialization.
 
Our licensees pay us:
 
  •  an initial license fee for initial set-up costs, technical support and advisory services that we provide until commercial launch; and
 
  •  ongoing royalty payments based on a percentage of revenues generated from subscription of the game they service in the respective overseas markets.
 
In addition, if the license agreement is renewed, we typically negotiate a renewal license fee. The license agreements may be terminated in the event of bankruptcy or a material breach by either party, including by us, the licensee fails to pay royalty fees in a timely manner.
 
Pricing
 
Our overseas licensees generally develop, after consultation with us, a retail pricing structure for the users of the game they service in their respective markets. Pricing structures are determined primarily based on the cost of publishing and operating the game, the playing and payment patterns of the users, the pricing of competing games in a given market and the purchase power parity of consumers in that market. Since the launch of Ragnarok Online in August 2002, we have tracked and accumulated user data generated from our user base, which provide us with an extensive database to analyze user patterns and establish pricing for other markets. The pricing for Ragnarok Online has remained generally stable in each of our markets since the respective date of Ragnarok Online’s commercial launch in those markets. In December 2006, we started to apply micro-transaction system, or sale of virtual in-game items model, as an additional business model, by providing virtual item shops in the games where players can


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purchase a wide array of items to customize, personalize and enhance their characters and game playing experiences. It started in Japan followed by Taiwan, Hong Kong, China, Thailand and Korea. In these countries, we offer our game services with two pricing models together — subscription and micro-transaction models. We intend to extend our micro-transaction model to other markets.
 
Korea
 
Individual PC subscribers in Korea can choose from a number of alternative payment options, including charges made through mobile or fixed telephone service provider payment systems, prepaid cards, gift certificates, online credit card payments and bank transfers. We pay a commission in the range of 8% to 15% to third parties to process payments. These third parties bear the delinquency risk associated with payments from subscribers.
 
Subscription-based fee model
 
We determine the pricing plan for Ragnarok Online in Korea. We offer separate pricing plans to Internet cafés and individual PC account subscribers. Our subscribers have an option to pay an hourly fee or a flat monthly fee. The following table sets forth our published pricing plans in Korea for Ragnarok Online access as of December 31, 2006, although we provide discounts based on the volume of business generated.
 
             
    Subscription Fees  
 
Individual PC users
           
Flat-fee rate
  1 month   W 22,000  
    2 months     41,800  
    3 months     59,400  
    6 months     112,200  
Hourly-fee rate
  5 hours     3,300  
    20 hours     8,800  
 
             
        Flat Fee per
 
    Number of PCs   PC  
 
Internet cafés(1)
           
Monthly flat-fee
  1-4 PCs   W 33,000  
    5-10 PCs     31,350  
    11-20 PCs     30,250  
    21-30 PCs     29,700  
    over 30 PCs     28,700  
Hourly-fee rate
  300 hours     77,000  
    600 hours     154,000  
    1,000 hours     238,700  
    2,000 hours     455,400  
 
Approximately 89.9% of our revenues from Ragnarok Online in Korea in 2006 were derived from subscriptions by individual PC users and the remaining 10.1% was derived from Internet cafés.
 
Micro-transaction model
 
We applied a micro-transaction model in Korea since April 2007. Game users buy RO Cash, the currency of the money used in Ragnarok Online which enables them to buy game items. The price range of the game items is between Won 500 and 4,500.
 
 
Note:
 
(1) Actual monthly and hourly-rate fees may vary depending on volume of use by the subscriber.


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Overseas markets
 
The pricing for Ragnarok Online in our principal overseas markets, Japan, Taiwan, China, Thailand and the United States, is as follows:
 
Japan
 
Users in Japan typically pay for access to Ragnarok Online with credit cards or cyber money, which is increasingly becoming a popular payment method in Japan.
 
Subscription-based fee model
 
Our licensee in Japan, GungHo Online Entertainment, offers only one rate for Ragnarok Online and charges Japanese Yen 1,500 per 30 days of unlimited use.
 
Micro-transaction model
 
We applied a micro-transaction model in Japan since December 2006. Game users buy Points which enables them to buy game items. The range of the game items is between JPY 100 and 2,000(1).
 
         
Points
  Retail Price(1)  
 
10,000 points
    JPY 1,000  
21,000 points
    2,000  
32,500 points
    3,000  
55,000 points
    5,000  
112,000 points.
    10,000  
 
 
Note:
 
(1) As of December 31, 2006, the noon buying rate of Japanese yens to U.S. dollars quoted by the Federal Reserve Bank of New York was JPY119.02 to US$1.00.
 
Taiwan
 
In Taiwan, most users purchase prepaid debit point cards to access Ragnarok Online. The prepaid cards can be purchased online, by mobile phones or at convenience stores, Internet cafés and at other locations. Taiwan also has websites dedicated to selling prepaid cards for various uses, including online game payments.
 
Subscription-based fee model
 
Our licensee in Taiwan, Soft-World International, typically does not offer a separate subscription plan for Internet café outlets. Our licensee in Taiwan currently offers approximately 200 different rates for Ragnarok Online. The following table sets forth our licensee’s published basic pricing for Ragnarok Online access in Taiwan as of December 31, 2006:
 
         
Points(1) or Days
  Retail Price(2)  
 
150 points
  NT$ 150  
350 points
    350  
400 points
    400  
450 points
    450  
500 points
    500  
1,000 points
    1,000  
30 days
    350  


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Micro-transaction model
 
We applied a micro-transaction model in Taiwan since December 2006. Game users buy Points which enables them to buy game items. The range of the game items is between NT$100 and 2,000.
 
 
Notes:
 
(1) Each time a user logs onto Ragnarok Online, 20 points are deducted. After a user’s playtime exceeds 12 hours, additional 20 points are deducted for every 12 hours of use.
 
(2) As of December 31, 2006, the noon buying rate of NT dollars to U.S. dollars quoted by the Federal Reserve Bank of New York was NT$32.59 to US$1.00.
 
China
 
Our licensee in China, Shanda Interactive Entertainment Limited, operates and offers Ragnarok Online through Shengqu Information Technology (Shanghai) Co., Ltd, its wholly-owned subsidiary. In China, Ragnarok Online can be accessed through prepaid cards. The prepaid card system was introduced to take account of the limited availability of online and credit card payment systems in China. A majority of Ragnarok Online players purchase prepaid debit point cards at Internet cafés or retail game outlets or purchase prepaid online credits by directly paying at Internet cafés, which in turn purchase online credits from our China licensee. Each prepaid card contains a network access password to access Ragnarok Online from a PC at home or at an Internet café.
 
Subscription-based fee model
 
Ragnarok Online access prices were set significantly lower in China than in Korea to take into account the prevailing pricing structure of other online games in the Chinese market as well as relatively low consumer spending levels. Our licensee in China currently offers approximately 200 different rates for Ragnarok Online. The following table sets forth our licensee’s published basic pricing for Ragnarok Online access in China as of December 31, 2006:
 
         
Points(1)
  Retail Price(2)  
 
500 points
    CNY 5  
1,000 points
    10  
3,000 points
    30  
4,500 points
    45  
10,000 points
    100  
50,000 points
    500  
 
Micro-transaction model
 
We applied a micro-transaction model in China since January 2007. Game users buy Points which enables them to buy game items. The range of the game items is between CNY 100 and 2,000(2).
 
 
Notes:
 
(1) Six points are deducted for every hour of use.
 
(2) As of December 31, 2006, the noon buying rate of Chinese Yuan to U.S. dollars quoted by the Federal Reserve Bank of New York was CNY 7.80 to US$1.00.
 
Thailand
 
Our licensee in Thailand, Asiasoft International, permits users to access Ragnarok Online through prepaid cards. Each prepaid card has a specified maximum number of hours or days of use. Users can purchase prepaid cards from automated teller machines, Internet cafés or convenience stores.


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Subscription-based fee model
 
The following table sets forth our licensee’s published basic pricing for Ragnarok Online access in Thailand as of December 31, 2006:
 
                 
Hours or Days
  Points     Retail Price(1)  
 
2 hours
    2,800       THB 28  
20 hours
    5,500       55  
40 hours
    8,900       89  
15 days
    15,900       159  
20 days
    18,900       189  
30 days
    34,900       349  
3 months
    88,800       888  
 
Micro-transaction model
 
We applied a micro-transaction model in Thailand since February 2007. Game users buy Points which enables them to buy game items. The range of the game items is between THB 300 and 34,900(1).
 
 
Note:
 
(1) As of December 31, 2006, the noon buying rate of the Thai Bahts to U.S. dollars quoted by the Federal Reserve Bank of New York was THB 36.10 to US$1.00.
 
The United States
 
GRAVITY Interactive, Inc., our wholly-owned subsidiary in the United States, permits users to access Ragnarok Online through credit cards, money orders, and wire and/or bank transfers. The following table sets forth our licensee’s published basic pricing for Ragnarok Online access in the United States as of December 31, 2006:
 
                         
    Retail Price  
Hours or Month
  Money Order     Wire/Bank Transfer     Credit Card/Debit Card  
 
30 hours
  US$ 9.99     US$ 8.99     US$ 7.99  
1 month
    13.99       12.99       12.00  
3 months
    35.98       33.99       32.00  
6 months
    63.48       59.99       57.00  
 
Game development and publishing
 
We expect the online game industry to be characterized by increasing demand for sophisticated or original games with the most up-to-date technologies and/or innovative game design. In response, we intend to expand our game offerings by continuing to develop in-house additional high quality games with the latest technologies and/or innovative game design and by publishing such new games developed by us or licensed or acquired from renowned third party developers.
 
To prepare for the commercial launch of a new game, we conduct “closed beta testing” for the game to eliminate technical problems, which is followed by “open beta testing” in which we allow registered users to play the game free of charge. During these testing periods, users provide us with feedback and our technical team seeks to address any technical problems and programming flaws that may compromise a stable and consistent game environment.
 
In-house game development
 
We developed Ragnarok Online in-house. In order to remain competitive, we are focusing our in-house game development efforts on enhancing the Ragnarok Online experience and on developing new massively multiplayer online role playing games incorporating the latest technologies. Also, as casual online games are becoming popular


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among the younger generations and female users, we have been developing a casual online game line-up. We currently have two massively multiplayer online role playing games, Ragnarok Online II and Requiem, and several casual online games under in-house development. Our game development department is divided into four development teams: two of them are dedicated to the massively multiplayer online role playing games and the other two are dedicated to the casual online games in operation or under development. As of May 31, 2007, we employed a total of 254 game developers.
 
Publishing
 
In line with our product diversification strategy, we intend to publish more games developed by third parties. For details concerning new games to be offered by us in the future, see “— Our products.”
 
Our publishing and licensing process includes the following:
 
  •  Preliminary screening.  Our preliminary screening process for a game typically includes our preliminary review and testing of the game and discussions with the game developer regarding technological and operational questions.
 
  •  In-depth examination, analysis and commercial negotiation.  Once a game passes the preliminary screening, we thoroughly review and test the game, conduct a cost analysis, develop operational and financial projections and formulate a preliminary game operating plan. We then begin commercial negotiations with the developer.
 
  •  Game rating and regulatory registration and approval.  Once a license agreement for a game is signed, we submit an application to the Game Rating Board to obtain a game rating. This process generally takes approximately 15 days. We also typically register our intellectual property rights with respect to our license agreements with the relevant Korean government agency. We or our licensees follow similar procedures in the respective markets where our games are commercially offered.
 
  •  Testing and marketing.  Once the required registration and approvals are obtained, we conduct closed beta testing and open beta testing of the new game and assist the licensor with the development of the game. Closed beta testing usually takes 6-12 months for massively multiplayer online role playing games but may take significantly more time if material problems are detected. Open beta testing of massively multiplayer online role playing games usually takes three to six months before commercial launch. We generally commence our other marketing activities for the game during the open beta testing stage. For overseas markets, we also localize the language and content of our games to tailor to the local cultural preferences.
 
Marketing
 
We employ a variety of traditional and online marketing programs and promotional activities, including in-game events, in-game marketing and offline events. Due to the close-knit nature of the online game community, we believe that word-of-mouth is an important medium for the promotion of our games.
 
In Korea, seven independent promotional agents currently promote our online games to Internet cafés pursuant to agency agreements. Under these agreements, each promotional agent is granted non-exclusive promotion rights within a specified geographical area. The agent is generally paid a monthly base commission of 30% of revenues received from Internet cafés in the allocated area.
 
We conduct a variety of marketing programs and online and offline events to target potential subscribers accessing the Internet from home. Our main marketing efforts include advertising on website portals and in online game magazines, conducting online promotional events, participating in trade shows and entering into promotional alliances with Internet service providers. We spent Won 4,614 million in 2004, Won 6,273 million in 2005 and Won 3,744 million (US$4,026 thousand) in 2006 on advertising and promotions.
 
We frequently organize in-game events, such as “fortress raids” for our users, which we believe encourages the development of virtual communities among our users and increases user interest in our games. We also host from time to time in-game tournaments in which users can compete against each other either as a team or individually. In addition, we use in-game events to introduce users to new features of our games. We organized 18 in-game events


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for Ragnarok Online users in 2005 and 17 in-game events in 2006. In August 2006, we hosted in Korea “Gravity Festival’’, the advanced form of “Ragnarok Festival”, an offline event for the Ragnarok Online users who have played the game for four years or more, at which about 70 users and licensees from 14 countries were invited. The event was visited by approximately 35,000 visitors and was broadcasted over one of Korea’s cable television channels.
 
In most of our overseas markets, marketing activities are principally conducted by our overseas licensees and typically consist of advertising on website game portals and online game magazines and through television commercials, as well as hosting online and offline promotional events. The licensees are responsible for the costs associated with such advertising and promotional activities. From time to time our licensees also market our games through sponsoring promotional events jointly with other local game publishers in order to reach a broader local audience.
 
Our licensees are selected in part on the basis of their marketing capabilities, including the size and scope of their distribution networks. In regions where we have a limited network or presence, we believe that conducting marketing through our licensees is more effective and cost-efficient than direct marketing by us in light of the established brand recognition and marketing networks of our licensees and their comparative advantage in identifying and taking advantage of the cultural and other local preferences of overseas users. However, in more strategic markets where we anticipate considerable growth, we also believe that it is important to enhance our own direct publishing network for online game services.
 
Game support and customer service
 
We are committed to providing superior customer service to our users directly and through our licensees. As of May 31, 2007, 54 employees were game masters, or persons who are in charge of testing, updating and providing server maintenance for online games, as well as dealing with customer complaints, 48 employees were members of our domestic customer service team and 84 employees were members of our overseas customer support team. With the diversification of our game offering and in order to better serve our users, we expect to continue to expand the size of our customer service team.
 
In Korea, we provide customer service for our online games through in-game bulletin boards, call centers, email and facsimile and at our walk-in customer service center. Our in-game bulletin boards allow our customers to post questions to, and receive responses from, other users and our support staff. In our overseas markets, our licensees administer customer service through varying combinations of in-game bulletin boards, call centers, email and facsimile, with assistance, from time to time, from our overseas customer support staff.
 
In addition to providing customer service to our users, our customer service staff also collect user comments with respect to our games and generate daily and weekly reports for our management and operations that summarize important issues raised by users as well as how such issues have been addressed.
 
Network and technology infrastructure
 
We have designed and assembled a game server network and information management system in Korea to allow centralized game management on a global basis. Our system network is designed to speedily accommodate a growing subscriber base and demand for faster game performance. Our game server architecture runs multiple servers on a parallel basis to readily accommodate increased user traffic through deployment of connection to servers, which permits us to route users in the same country to servers with less user traffic. Each of these servers is linked to our information systems network to ensure rapid implementation of game upgrades and to facilitate game monitoring and supervision.
 
We maintain our server hardware in a single climate-controlled facility at Korea Internet Data Center in Yeoksam-Dong, Gangnam-Gu, Seoul, Korea and our other system hardware in our offices in Seoul. As of May 31, 2007, our server network for our game operations in Korea consisted of a total of 680 servers.
 
In overseas markets, our overseas licensees own or lease the servers necessary to establish the server network for the online games and we assist our overseas licensees with initial assembly and installation of operating game servers and optimizing their systems network for game operations in their respective markets. While the overseas


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system architectures are modeled on our system architecture in Korea, they are also tailored to meet the specific needs of each market. When we install and initialize a game in an overseas market, we generally dispatch network engineers and database technicians from Korea to assist with assembly and operation of the system network and game servers. Following installation, we typically station two to five of our technicians and customer support staff in that market to assist with on-site game operation and technical support. Our overseas licensees are responsible for providing database and other game information backup.
 
Our game management software can program the game content to include localized features such as virtual map zones specific to each market. These features can be updated at the host country level in order to encourage development of a communal spirit among the users from the same country.
 
Competition
 
We compete primarily with other massively multiplayer online role playing game developers and distributors in each of our markets. In addition, we compete against providers of games on various platforms, such as console games, handheld games, arcade games and mobile games. We compete primarily on the basis of the quality of the online game experience offered by us to our users, which depends on a number of factors, including our ability to do the following:
 
  •  hire and retain creative personnel to develop games that appeal to our users;
 
  •  maintain online game platform that is stable and is not prone to server shutdowns, connection problems or other technical difficulties;
 
  •  provide timely and responsive customer service; and
 
  •  establish payment systems that are secure and efficient.
 
Competition in Korea
 
The online game market in Korea is comprised of the massively multiplayer online game market, the casual online games market, which includes casual sports games, and the portal-based online games market, which includes online card games. Currently, the leading providers of massively multiplayer online games in Korea are NCsoft Corporation, Neowiz and CJ Internet Corporation based on the number of peak concurrent users. NCsoft released Lineage II, a sequel to the original Lineage in July 2003. Lineage II is an enhanced version of the original Lineage game released in 1998, which gained dominant popularity in Korea. Neowiz released Special Force, a massively multiplayer online first person shooter, in July 2004 and FIFA Online, which was co-developed with Electronic Arts, in 2006. CJ Internet commercially launched Sudden Attack, a very popular massively multiplayer online first person shooter, in July 2006. In the market for casual online games, Nexon, which is renowned for Kart Rider, an extremely popular online racing game and Yedang Online, whose online dance game Audition has gained a large user base, are among the leading companies. The leading providers of portal-based online games in Korea are NHN Corporation, operating under the brand portal of Hangame, CJ Internet, operating under the brand portal of NetMarble and Neowiz Corporation, operating under the brand portal of Pmang. Many of our competitors have significantly greater financial, marketing and game development resources than we have.
 
While the number of domestic massively multiplayer online game developers in Korea may increase in the future, we expect the online game industry will consolidate into a small number of leading massively multiplayer online role playing game companies as the high cost of game development, marketing and distribution networks drives a greater number of unsuccessful massively multiplayer online role playing game providers to go out of business or be acquired.
 
Competition in overseas markets
 
In each of the overseas markets in which Ragnarok Online is distributed, we face strong competitive pressures. For example, Japan’s large game market is primarily driven by console games although online games are gaining popularity among Japanese game users. Our major competitors in Japan are Square Enix Co., Ltd., well-known for its Final Fantasy games, and Nexon Corporation. Taiwan’s online game industry has demonstrated significant


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growth in recent years with the market dominated by games developed in Korea. Our principal competitors in Taiwan include Blizzard Entertainment, NCsoft Corporation and Nexon Corporation. Thailand is also a fast growing online game market in Asia, where we believe that Ragnarok Online is the dominant online game based on the number of peak concurrent users. There are many online game developers and distributors in China such as The9 Limited, which publishes the World of Warcraft, and Shanda Interactive Entertainment.
 
Competition from other game platforms
 
We also compete against PC- and console-based game developers that produce popular package games, such as Electronic Arts, Sony Computer Entertainment, Blizzard Entertainment and Namco, and game console manufacturers such as Microsoft, Sony Computer Entertainment and Nintendo. In 2002, Microsoft and Sony introduced Internet-enabled video consoles and we believe that they plan to enhance their respective game platforms to provide online games. For example, Sony Computer Entertainment started distributing the PlayStation 2 game consoles, equipped with a network adapter to enable online game beginning in May 2002, and Microsoft started an online game service on Xbox Live consoles beginning in November 2002. Several PC-based game developers are introducing online features to their PC-packaged games, such as team plays or users-to-users combat features. In 2005 and 2006, they launched enhanced version of their console platforms. Microsoft’s Xbox360 was launched in November 2005, followed by Sony Computer Entertainment’s PlayStation 3 and Nintendo’s Wii in November 2006. Moreover, handheld game console is also getting popular among game users. In November 2004, Nintendo launched Nintendo DS, a sequel to Gameboy Advance, and Sony Computer Entertainment’s PlayStation Portable was released in December 2004.
 
Competition in the online game market is and is expected to remain intense as established game companies with significant financial resources seek to enter the industry. For a discussion of risks relating to competition, see Item 3.D. “Risk Factors — Risks Relating to Our Business — We operate in a highly competitive industry and compete against many large companies.”
 
Insurance
 
We maintain medical and accident insurance for our employees to the extent required under Korean law, and we also maintain fire and general commercial insurance with respect to our facilities. We do not have any business liability or disruption insurance coverage for our operations in Korea. We maintain a directors’ and officers’ liability insurance policy covering certain potential liabilities of our directors and officers.
 
Intellectual property
 
Our intellectual property is an essential element of our business operations. We rely on copyright, trademark, trade secret and other intellectual property law, as well as non-competition, confidentiality and license agreements with our employees, suppliers, licensees, business partners and others to protect our intellectual property rights. Our employees are generally required to sign agreements acknowledging that all inventions, trade secrets, works of authorship, developments and other processes generated by them on our behalf are our property, and assigning to us any ownership rights that they may claim in those works. With respect to copyrights and computer program rights created by our employees within their employment scope and which are made public bearing our name, we are not required to pay any additional compensation to our employees.
 
In developing Ragnarok Online, we obtained an exclusive license from Mr. Myoung-Jin Lee to use the storyline and characters from his cartoon titled Ragnarok for the production of online games, animation and character merchandising. See Item 4.B. “Business Overview — Our products — Massively multiplayer online role playing games — Massively multiplayer online role playing games currently offered — Ragnarok Online” above.
 
We are the registered owner of six registered software copyrights to six games: Ragnarok Online, Ragnarok Online II, R.O.S.E. Online, Pucca Racing Requiem and Arcturus, each of which has been registered with the Program Deliberation and Mediation Committee of Korea. We no longer commercially offer Arcturus, a PC-based, stand-alone game. As of December 31, 2006, we owned over 93 registered domain names, including our official website and domain names registered in connection with each of the games we offer. We also had registered trademarks and trademark pending at patent and trademark offices in 42 countries covering 22 discrete trademarks,


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three design patents and two analogous design patents, which are variations of the 11 design patents, registered with the Korea Intellectual Property Office, and registered copyrights covering 11 game characters, in each case as of December 31, 2006.
 
Seasonality
 
Usage of our online games has typically increased around the New Year’s holiday and other Korean holidays, in particular during winter and summer school holidays.
 
Laws and Regulations
 
Korea
 
The Korean game industry and online game companies operating in Korea are subject to the following law and regulations:
 
The Act on Promotion of the Game Industry
 
In January 2007, the National Assembly amended the Act on Promotion of the Game Industry (the “Promotion Act”), which became effective on April 20, 2007. Under the amended Article 21 of the Promotion Act, online games are classified into four categories: “suitable for users of all ages,” “suitable for users 12 years of age or older,” “suitable for users 15 years or older” and “suitable for users 18 years of age or older.” Ragnarok Online, R.O.S.E. Online and TV Boyz, a game offered through our casual online game portal site, STYLIA, have been classified as “suitable for users 12 years of age or older.” Time N Tales and Love Forty, a game offered through STYLIA, has been classified as “suitable for users of all ages.” The amendment includes for the first time the definition of the term “speculative game.” A speculative game refers to a game that offers monetary loss or profit, the purpose of which is betting or allocating money and the result of which is determined by chance. A game provider shall report any modification in the content of a game to the Game Rating Board, which may require the game to be reclassified depending on the scope of the modification. If the Game Rating Board determines that the game is speculative, it can deny any classification, in which case the game will be prohibited. This amendment may adversely affect our business in the sense that it could delay or even bar the release of new games or upgrades and that it may reduce the existing and potential range of our user base.
 
The Telecommunications Business Act
 
Report of business operation.  Under this Act we are classified as a value-added communications service provider. A person who intends to run a value-added communications business shall report to the relevant Commissioner of Communications Office to which the Minister of Information and Communication, or MIC, has delegated its authority to accept and monitor such reports.
 
Report of operation status.  We, as a value-added communications service provider, are required to prepare and submit statistical reports regarding, among others, the current status of facilities by telecommunications service, subscription records, current status of users, etc., to the MIC upon its request. The MIC is responsible for information and telecommunications policies under this Act. In addition, we are required to report any transfer, takeover, suspension or closing of our business activities to the MIC. The MIC may cancel our registration or order us to suspend our business for a period of up to one year if we fail to comply with its rules and regulations.
 
The Act on Consumer Protection for Transactions through Electronic Commerce
 
Protection of consumer information for electronic settlement services.  Under this Act, we are required to take necessary measures to maintain the security of consumer information related to our electronic settlement services. We are also required to notify consumers when electronic payments are made and to indemnify consumers for damages resulting from misappropriation of consumer information by third parties.
 
We believe that we have instituted appropriate safety measures to protect consumers against data misappropriation. To date, we have not experienced material disputes or claims in this area.


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The Act on Promotion of Information and Communications Network Utilization and Information Protection
 
Protection of personal information for users of information and communications services.  Under this Act, we are permitted to gather personal information relating to our subscribers within the scope of their consent. We are, however, generally prohibited from using personal information or providing it to third parties beyond the purposes disclosed in our subscriber agreements. Disclosure of personal information without consent from a subscriber is permitted if:
 
  •  it is necessary for the settlement of information and communication service charges;
 
  •  it involves personal information necessary for the implementation of the agreement on the provision of information and communication services, and it is significantly difficult to obtain the subscriber’s consent due to economic or technological reasons; or
 
  •  it is expressly permitted by this or any other statute.
 
We are required to indemnify users for damages occurring as a result of our violation of the foregoing restrictions, unless we can prove the absence of willful misconduct or negligence on our part. We believe that we have instituted appropriate measures and are in compliance with all material restrictions regarding internal mishandling of personal information.
 
The Korean Civil Code and the Telecommunication Framework Act
 
Protection of interests of online game users under 20 years of age.  Pursuant to the Korean Civil Code, contracts entered into with persons under 20 years of age without parental consent may be invalidated. Under the Telecommunication Framework Act, the Korea Communications Commission, or KCC, a regulatory agency of the MIC, was established for, among others, deliberating issues related to fair competition and consumer protection with respect to telecommunication services and arbitrating disputes involving telecommunication service carriers and their users. As a result, telecommunication service contracts and online game user agreements are required to specifically set forth procedures for rescinding service contracts, which may be entered into by persons under 20 years of age without parental consent.
 
In November 2003, the KCC issued an order addressed to 15 major online game companies in Korea, including us, to regulate certain business practices relating to the settlement of service charges involving persons under 20 years of age. The KCC raised concerns about the ability of persons under 20 years of age to subscribe to online game services without parental consent by settling charges payable to online game companies through settlement systems operated by fixed-line or broadband service providers. The order required online game companies to implement more specific and effective procedures to ensure, where relevant, that parental consent has been specifically obtained.
 
Although only a small number of our current subscribers are using the settlement options mentioned in the KCC order, we are enhancing our age verification and parental consent procedures for players using the relevant settlement options. We do not expect compliance with the KCC order to be burdensome.
 
The Special Tax Treatment Control Law
 
Taxation.  We are currently entitled to a reduced corporate income tax rate of 13.75%, which is 50% of the statutory tax rate, under this Law. This reduced tax rate applies to certain designated small- and medium- sized venture companies operating in Korea for six years. We are entitled to such reduced tax rate for the fiscal year ended December 31, 2006. We also believe that we will continue to be entitled to this reduced tax rate in 2007. See Item 5.A. “Operating Results — Overview — Income tax expenses.”
 
Other related laws and regulations
 
Even though there are no mandatory filing or reporting obligations, since online games generally consist of animation based on computer program software, the Copyright Act and the Computer Programs Protection Act also apply to online games.


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Taiwan
 
Consumer protection
 
As a result of increasing disputes between online game companies and consumers in Taiwan, on February 17, 2006, the ROC MOEA promulgated a model consumer contract that online game companies are encouraged to adopt and the ROC MOEA may, within its authority, further consider promulgating certain standard provisions that must be included in a consumer contract, which governs the relationship between a consumer and an online game company in the future when necessary. In general, the above model contract and these standard provisions, once adopted by or applied to online game companies, as the case may be, will impose more responsibilities and liabilities on the online game companies. Deviations from this model contract or these standard provisions may cause certain clauses to be invalidated.
 
Regulations of Internet content and game software
 
Pursuant to the Children and Juvenile Welfare Act, it is illegal to transmit or provide children under 18 years of age with, among other things, computer software, Internet, electronic signal, DVD and compact disk, that contain content which propagates violence, obscenity or similar material that may undermine the mental health of a minor. Any person or entity violating this Act may be subject to a fine and/or the enterprise may be forced to cease to operate for up to one year. In addition, according to this Act and the Regulations for the Rating of Internet Content, or the Regulations, promulgated on April 26, 2004 and last amended on October 17, 2005, under this Act, Internet content shall not violate any mandatory law and shall be classified as “restricted” and therefore shall not be viewed by the children and juvenile under age 18, if such content meets, among others, any of the following circumstances and harms the physical or mental development of children or juvenile:
 
  •  Excessive depiction of gambling, drug abuse, drug trafficking, robbery, burglary, kidnapping, homicide, or other criminal offenses;
 
  •  Excessive depiction of the process of suicide;
 
  •  Plot involving terror, bloodshed, cruelty, or perversion, which is presented in an intense manner, yet is still acceptable to adults in general; or
 
  •  Depiction of sexual acts or sexual obscenity, or exposure of genitals, through action, image, language, text, dialogue, sound, picture, photograph, or any other form, yet which does not embarrass or disgust adults in general.
 
In addition, the Regulations suggest that the Internet content that is not rated as restricted is better to be viewed by children under the guidance of the parents, guardians, or others taking care of them. Internet content rated as restricted shall be labeled in accordance with the Regulations.
 
Internet café regulation
 
Currently, there is no mandatory national legislation specifically covering the operation of Internet cafés. However, several municipalities and counties such as Taipei City and Taipei County have promulgated specific ordinances imposing restrictions on Internet cafés, which relate to the location, building structure, facilities, business hours, age limit of customers and the classification of Internet content.
 
Currently, an Internet cafés may be set up by registering with the competent authority. However, according to the latest public news, the ROC MOEA is considering to amend the Electronic Game Arcade Business Regulation Act so that the Internet cafés may be set up only after obtaining the approval of the authority in the future. Furthermore, according to the public news, the ROC MOEA is considering limiting the total numbers of the Internet cafés. Alternatively, the ROC MOEA has also proposed draft Statutes of Information-Entertainment Industry legislation that, if implemented, would regulate all Internet cafés located in the ROC. It is unclear, however, whether or when the above Act and draft legislation will be amended or passed by the Legislative Yuan. In addition, pursuant to the Public Order Maintenance Act, Internet cafés may be subject to a fine and/or a business suspension or shut-down if minors are found at Internet cafés during late hours.


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Privacy protection
 
The ROC government has promulgated the Computer-Processed Personal Data Protection Act to regulate the collection processing, usage and transmission of computer-processed personal data. Generally, an Internet content provider, or ICP, will not be subject to this Act if it does not collect or process the personal data through the computer as its main business activity. However, an ICP may become liable for the loss of any data so collected.
 
Japan
 
Online game companies in Japan are not currently subject to any national government regulations targeted specifically at the industry.
 
Protection of personal information.
 
Businesses in Japan are subject to certain statutory requirements with respect to personal information acquired during the course of business. Pursuant to these statutory requirements, businesses must set up procedures to appropriately protect personal information from use for any purpose other than the initial purpose.
 
Regulations on sound upbringing of minors
 
In Japan, Internet and game software content is generally regulated at the local, rather than the national, level. Many local governments have ordinances for sound upbringing of minors, which, among other things, empower competent authorities to designate game software as detrimental to the sound upbringing of minors and prohibit the sale or distribution to minors of such designated game software. In addition, the Computer Entertainment Rating Organization, or CERO, a nonprofit organization, offers rating services for home-use games, including online games. Game developers may request a rating for their game software from CERO, which will then review such software and assign one of the following five ratings: “suitable for users of all ages,” “suitable for users 12 years old or older,” “suitable for users 15 years old or older,” “suitable for users 17 years old or older,” and “suitable only for users 18 years old or older.” The rating is based on, among others, the degree of sex, violence and anti-social expression in the game software content. Once a rating is assigned, the relevant game software must prominently display such rating.
 
Thailand
 
There is no specific law or regulation that directly governs online games, online game companies or the industry. The online game industry in Thailand operates under a legal regime that generally regulates vendors of Internet cafés and game shops rather than online game operators. Several of the governmental agencies in Thailand work in cooperation with one another in regulating the industry. The Thai government, principally through the ICT Ministry with the cooperation of the Ministry of Culture, is making efforts to regulate the fast-growing Internet business, in particular the online game industry. The Thai government has, since 2004, proposed measures that would affect the online game industry, including the restriction on the playing time of game users under 18 years of age to three hours per day, prohibition of gambling, lottery or game item trading via online games and mandatory Internet café registration. These measures are pending legislative approval. The Ministry of Commerce in Thailand is also responsible for regulating online businesses by requiring registration.
 
Registration of Internet cafés and online game operators
 
There is no specific legislation that regulates online game operators, Internet cafés or online game shops. The Ministry of Commerce in Thailand, however, requires that online game operators that offer online games over websites or Internet portals to register for e-business registration and also requires Internet cafés and online game shops to register under the Commercial Registration Act.
 
Regulation of business hours
 
Under the Control of Business Relating to Tape Cassette and Television Material Act, computer game vendors and shops are required to obtain a license to broadcast tape cassette and television material, which includes


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CD-ROMS or digital videodiscs. A condition to this license restricts the business hours of game shops to generally from 10:00 a.m. to 10:00 p.m. In addition, game users under 18 years of age would be restricted from playing for more than three hours a day under the pending legislative proposals. The Ministry of Culture is responsible for granting licenses. The Act is currently applicable to only offline game shops that use CD-ROMs, hard discs or digital videodiscs.
 
Restriction on access by children
 
Under the Child Protection Act, the Royal Thai Police has the authority to set restricted hours for children at game shops to limit their time spent at such shops. Under this Act, the Royal Thai Police also prohibits any person from forcing, threatening, inducing, advocating, causing or permitting children to misbehave or engage in misconduct. In addition, under this Act, the ICT Minister requests online game operators to close access to its game server after curfew hours. Users over 18 years of age, however, are permitted password protected access to certain online game servers even during curfew hours by obtaining a password available at the post office. The ICT Minister has also implemented the Goodnet project, which recommends that members of the computer and Internet service provider community cooperate in restricting their business hours to prevent children under the age of 18 from entering their place of business during curfew hours.
 
Intellectual property
 
Under the Copyright Act, online games are classified as copyrightable work in the category of computer program or software, and, therefore, automatically protected in Thailand without requiring further registration with or notification to any governmental agency. Despite the lack of mandatory registration or notification requirements, it is recommended that copyright owners of online games notify the Department of Intellectual Property, the Ministry of Commerce of their online games to ensure that their names officially and publicly appear in the listing of copyrighted computer software. The copyright owner has the exclusive right to copy, modify and publish its copyrighted work.
 
China
 
The online game industry in China operates under a legal regime that consists of the State Council, which is the highest authority of the executive branch of the PRC central government, and various ministries and agencies under its leadership. These ministries and agencies include:
 
  •  the Ministry of Information Industry;
 
  •  the Ministry of Culture;
 
  •  the State Press and Publications Administration;
 
  •  the State Copyright Bureau;
 
  •  the Ministry of Public Security; and
 
  •  the Bureau of State Secrecy.
 
The State Council and these ministries and agencies have issued a series of rules that regulate a number of different substantive areas of our business, which are discussed below.
 
Licenses.  Online game companies are required to obtain licenses from a variety of PRC regulatory authorities.
 
As an ICP business, online game companies are required to hold a value-added telecommunications business operation license, or ICP license, issued by the Ministry of Information Industry or its local offices. Moreover, ICP operators providing ICP services in multiple provinces, autonomous regions and centrally administered municipalities may be required to obtain an inter-regional ICP license.
 
Each ICP license holder that engages in the supply and servicing of Internet cultural products, which include online games, must obtain an additional Internet culture business operations license from the Ministry of Culture.


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The State Press and Publications Administration and the Ministry of Information Industry jointly impose a license requirement for any company that intends to engage in Internet publishing, defined as any act by an Internet information service provider to select, edit and process content or programs and to make such content or programs publicly available on the Internet.
 
Furthermore, the Ministry of Information Industry has promulgated rules requiring ICP license holders that provide online bulletin board services to register with, and obtain an approval from, the relevant telecommunications authorities.
 
Regulation of Internet content.  The PRC government has promulgated measures relating to Internet content through a number of ministries and agencies, including the Ministry of Information Industry, the Ministry of Culture and the State Press and Publications Administration. These measures specifically prohibit Internet activities, which includes the operation of online games, that result in the publication of any content which is found to, among other things, propagate obscenity, gambling or violence, instigate crimes, undermine public morality or the cultural traditions of the PRC, or compromise State security or secrets. If an ICP license holder violates these measures, the PRC government may revoke its ICP license and shut down its websites.
 
Regulation of information security.  Internet content in China is also regulated and restricted from a State security standpoint. The National People’s Congress, China’s national legislative body, has enacted a law that may subject to criminal punishment in China any effort to: (i) gain improper entry into a computer or system of strategic importance; (ii) disseminate politically disruptive information; (iii) leak State secrets; (iv) spread false commercial information or (v) infringe intellectual property rights.
 
The Ministry of Public Security has promulgated measures that prohibit use of the Internet in ways which, among other things, result in a leakage of State secrets or a spread of socially destabilizing content. The Ministry of Public Security has supervision and inspection rights in this regard. If an ICP license holder violates these measures, the PRC government may revoke its ICP license and shut down its websites.
 
Import regulation.  Licensing online games from abroad and importing them into China is regulated in several ways. Any license agreement with a foreign licensor that involves import of technologies, including online game software into China, is required to be registered with the Ministry of Commerce. Without that registration, a licensee cannot remit licensing fees out of China to any foreign game licensor. In addition, the Ministry of Culture requires the licensee to submit for its content review and approval any online games to be imported. If a licensee imports games without that approval, the Ministry of Culture may impose penalties, including revoking the Internet culture business operations license required for the operation of online games in China. Moreover, imported online games are required to be registered with the Ministry of Information Industry or its designated agencies pursuant to the Measures Concerning Administration of Software Products before they can be operated in China. Furthermore, the State Copyright Bureau requires the licensee to register copyright license agreements relating to imported software. Without the State Copyright Bureau registration, a licensee cannot remit licensing fees out of China to any foreign game licensor and is not allowed to publish or reproduce the imported game software in China.
 
Intellectual property rights.  The State Council and the State Copyright Bureau have promulgated various regulations and rules relating to protection of software in China. Under these regulations and rules, software owners, licensees and transferees may register their rights in software with the State Copyright Bureau or its local branches and obtain software copyright registration certificates. Although such registration is not mandatory under PRC law, software owners, licensees and transferees are encouraged to go through the registration process and registered software rights may receive better protection.
 
Internet café and online game regulation.  Internet cafés are required to obtain a license from the Ministry of Culture and the State Administration of Industry and Commerce, and are subject to requirements and regulations with respect to minimum registered capital, location, size, number of computers, age limit of customers and business hours. The PRC government has published a series of rules in recent years to intensify its regulation of Internet cafés. In February 2007, 14 PRC governmental agencies, including the Ministry of Information Industry, the State Press and Publications Administration and Ministry of Public Security jointly promulgated a notice regarding further strengthening the administration work on Internet cafes and online games. According to the notice, no new Internet café should be approved in 2007 and the regulation of existing cafes should be strengthened.


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In April 2007, eight PRC governmental agencies, including the Ministry of Education, the Ministry of Information Industry, the State Press and Publications Administration and the Ministry of Public Security jointly promulgated a notice regarding the implementation of online game anti-addiction system to protect the physical and psychological health of minors. According to the notice, online game operators are required to develop and implement anti-addiction system to all online games from July 16, 2007, and the corresponding identity authentication scheme of the anti-addiction system shall be put into operation at the same time. Otherwise, the online games may not be approved by or filed with the relevant authorities or may not carry out “open beta” testing for operational purposes.
 
Privacy protection.  PRC law does not prohibit Internet content providers from collecting and analyzing personal information from their users. PRC law prohibits Internet content providers from disclosing to any third parties any information transmitted by users through their networks unless otherwise permitted by law. If an Internet content provider violates these regulations, the Ministry of Information Industry or its local bureaus may impose penalties and the Internet content provider may be liable for damages caused to its users.
 
While we believe that our licensee is in compliance with the applicable laws and regulations governing the online game industry in China, we cannot assure you that our operation of our games in China will not be found to be in violation of any current or future Chinese laws and regulations. Failure by our overseas licensees to comply with laws and regulations in China, including obtaining and maintaining the requisite government licenses and permits, may have a material adverse effect on our business, financial condition and results of operations. See Item 3.D. “Risk Factors — Risks Relating to Our Business — In many of our markets, we rely on our licensees to distribute, market and operate our games.”
 
United States
 
The content of video game software is not subject to federal regulation in the United States. However, many video game software publishers comply with the standardized rating system established by the Entertainment Software Rating Board, or ESRB, a non-profit, self-regulatory body established in 1994 by the Entertainment Software Association (ESA). ESRB rates video games, websites and online games submitted by video game publishers. It also monitors the content of advertisements and the demographics the advertisements target. Although submitting a game to the ESRB is voluntary, many retailers will not sell games without an ESRB rating. Once a game has been submitted for rating, game producers are required to disclose the entirety of the gaming code to the ESRB, including code not meant for play; a failure to disclose can be sanctioned by the ESRB. ESRB ratings must be displayed on both the front and back of game packaging in compliance with ESRB requirements and must also contain both a symbol for age appropriateness (e.g., “E” for Everyone or “M” for Mature) and content descriptors (e.g., “Blood and Gore” or “Intense Violence”). The ESRB may sanction game producers for failing to properly label their product. In addition, the Federal Trade Commission may conclude that a failure to disclose to the public the contents of a video game may be a deceptive trade practice.
 
Several bills are pending in Congress to regulate the interactive entertainment software industry, including one that would forbid the ESRB to rate a game without viewing all of its content. State laws that would regulate game industry content and marketing have, to date, been declared unconstitutional. The Federal Trade Commission has issued reports with respect to the marketing of “M” rated games to minors. Consumer advocacy groups have also opposed sales of interactive entertainment software containing graphic violence, profanity or sexually explicit material by pressing for legislation in these areas (including legislation prohibiting the sale of certain “M” rated video games to minors) and by engaging in public demonstrations and media campaigns. If any groups (including international, national and local political and regulatory bodies) were to target “M” rated titles, or if any legislation regulating the sale of such titles were to be enacted into law and survive constitutional challenge, sales practices regarding such titles could be affected or producers might be required to alter their contents.


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4.C.  Organizational Structure
 
The following is our organizational structure as of May 31, 2007:
 
 
4.D.  Property, Plants and Equipment
 
As of December 31, 2006, our property and equipment mainly consisted of (i) game engines, (ii) network servers and (iii) personal computers. As of December 31, 2006, the net book value of our property and equipment was Won 8,472 million (US$9,110 thousand). Because our main business is to develop and distribute online game services, we do not own any factories or facilities that manufacture products. There are no factories currently under construction, and we have no plans to build any factories in the future.
 
Korea
 
Our principal executive and administrative offices are located at Meritz Tower 14F, 825-2 Yeoksam-Dong, Gangnam-Gu, Seoul 135-934 Korea. We currently occupy 97,767 square feet of office space, which we lease from Meritz Fire and Marine Insurance Co., Ltd., pursuant to a lease that will expire on December 4, 2007 and which is renewable for one additional year. The annual lease payment amounts to Won 3,123 million (US$3,358 thousand).
 
We believe that our existing facilities are adequate for our current requirements and that additional space can be obtained on commercially reasonable terms to meet our future requirements.
 
United States
 
The offices of GRAVITY Interactive, Inc., our wholly-owned subsidiary in the United States, are located at 4505 Glencoe Ave, 2nd Floor, Marina Del Ray, California. GRAVITY Interactive currently occupies 5,815 square feet of office space, leased from a third party. The annual lease payment amounts to US$80.4 thousand. We believe that the existing facilities of GRAVITY Interactive are adequate for its current requirements and that additional space can be obtained on commercially reasonable terms to meet its future requirements.
 
France
 
The offices of GRAVITY EU SASU, our wholly-owned subsidiary in France, are located at 1 Place de la Coupole, Tour Areva 30 Floor, Paris La Defense. GRAVITY EU currently occupies 581 square feet of office space, leased from a third party. The annual lease payment amounts to EUR 64.8 thousand (US$85.3 thousand)(1). We believe that the existing facilities of GRAVITY EU are adequate for its current requirements and that additional space can be obtained on commercially reasonable terms to meet its future requirements.
 
 
Note:
 
(1) As of December 31, 2006, the noon buying rate of EMU euros to U.S. dollars quoted by the Federal Reserve Bank of New York was EUR 0.76 to US$1.00.
 
Russia
 
The offices of GRAVITY CIS, Inc., our wholly-owned subsidiary in Russia, are located at 1275549 Altufevskoe shosse build. 64, Moscow. GRAVITY CIS currently occupies 1,163 square feet of office space, leased from a third party. The annual lease payment amounts to Russian ruble 1,914 million (US$73 thousand)(1). We believe that the existing facilities of GRAVITY CIS are adequate for its current requirements and that additional space can be obtained on commercially reasonable terms to meet its future requirements.
 
 
Note:
 
(1) As of December 31, 2006, the rate of Russian rubles to U.S. dollars quoted by Russian Central Bank was Russian ruble 26.3 to US$1.00.


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Dubai
 
The offices of GRAVITY Middle East & Africa FZ-LLC, our wholly-owned subsidiary in Dubai are located at Dubai Internet City Office No. 6, Building No. 11, Ground Floor, Dubai, United Arab Emirates. GRAVITY Middle East & Africa currently occupies 552 square feet of office space, leased from a third party. The annual lease payment amounts to AED 80 thousand (US$22 thousand)(1). We believe that the existing facilities of GRAVITY Middle East & Africa are adequate for its current requirements and that additional space can be obtained on commercially reasonable terms to meet its future requirements.
 
 
Note:
 
(1) The United Arab Emirates Dirham is tied to the U.S. dollar at a steady exchange rate of AED 3.671 to US$1.00.
 
ITEM 5.   OPERATING AND FINANCIAL REVIEW AND PROSPECTS
 
You should read the following discussion together with our consolidated financial statements and the related notes which appear elsewhere in this report. The following discussion is based on our consolidated financial statements, which have been prepared in accordance with US GAAP. Our historic performance may not be indicative of our future results of operations and capital requirements and resources.
 
5.A.  Operating Results
 
Overview
 
We are based in Korea and are a leading developer and distributor of online games in Japan, Thailand, the Philippines, Indonesia, Malaysia and Singapore based on the number of peak concurrent users. From our inception in April 2000 to the commercialization of our first online game, Ragnarok Online in August 2002, our operating activities were limited primarily to developing Ragnarok Online and rolling out a free test, or beta-test, version of Ragnarok Online in November 2001.
 
Since Ragnarok Online’s initial commercial launch in August 2002, we have experienced significant growth in revenues and net income until 2004. However, in 2006 and 2005, revenues and net income decreased significantly. Our revenues decreased by 23.3% to Won 40,963 million (US$44,046 thousand) in 2006 from Won 53,384 million in 2005 and decreased by 17.1% to Won 53,384 million in 2005 from Won 64,426 million in 2004. We recorded a net loss of Won 22,265 million (US$23,942 thousand) in 2006 as compared to a net loss of Won 3,030 million and net income of Won 28,057 million in 2005 and 2004, respectively. Our gross profit margin also decreased from 84.3% in 2004 to 70.0% in 2005 and to 56.7% in 2006, and our operating margin decreased from negative 5.0% in 2005 to negative 29.8% in 2006. We attribute our revenue growth until 2004 largely to our early entry into additional markets since Ragnarok Online’s commercial launch and the continuing popularity of Ragnarok Online among users in the existing markets. Once a game is launched and the initial development and marketing costs have been expensed, relatively low marginal costs are incurred to expand into additional markets through licensing arrangements. The decrease in revenues in 2006 and 2005 was primarily due to the continuing decline in subscription revenues and royalties from Ragnarok Online arising from it reaching a relative maturity in our principal markets. Our operating expenses for 2006 decreased as compared to 2005 primarily as a result of (i) the expenses related to the investigation into accounting irregularities committed by the former Chairman in 2005 did not recur, (ii) the reimbursement by the former Chairman for certain of the costs and expenses incurred by the Company in connection with the investigation of the former Chairman’s diversion of revenues otherwise due to the Company and (iii) gain on disposal of asset from the sale of the Company’s building in May 2006. Our revenue trend may be adversely affected in the future by the popularity of online games introduced by our competitors. Our future success depends largely on our ability to develop or publish commercially successful new online games.
 
In June 2006, we commercially launched STYLIA, our casual online game portal site, followed by Time N Tales, a massively multi player online role playing game, in July 2006. Revenues of STYLIA and Time N Tales were Won 2 million (US$2 thousand) and Won 257 million (US$276 thousand) in 2006, respectively. Despite our commercial launch of these games, our revenues and net income declined in 2006 as compared to 2005.


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Our income tax rate in 2006 was 13.75%. As we were designated as a venture company and were entitled to a 50% reduction in corporate income tax in September 2005, we enjoyed such income tax rate reduction for the fiscal year ended December 31, 2006.
 
Revenues
 
We derive, and expect to continue to generate, most of our revenues from online game subscription fees paid by users in Korea, the United States and Canada, and royalties and license fees paid by our licensees in our overseas markets. Our revenues can be classified into the following four categories:
 
  •  online games — subscription revenue;
 
  •  online games — royalties and license fees;
 
  •  mobile games; and
 
  •  character merchandising, animation and other revenue.
 
Online games — subscription revenue
 
Prepaid online game subscription fees are deferred and recognized as revenue on a monthly basis in proportion to the number of days lapsed or based on actual hours used.
 
Online games — royalties and license fees
 
We license the right to market and distribute our games in various countries for a license fee and receive monthly royalties based on a percentage of the licensees’ revenues from our games. We generally are advised by each of our licensees as to the amount of royalties earned by us from such licensee within 15 to 25 days following the end of each month.
 
The initial license fees are deferred and recognized ratably as revenue over the license period, which generally does not exceed two years. The guaranteed minimum royalty payments are deferred and recognized as the relevant royalty is earned. For a table setting forth details of each license agreement, see Item 4.B. “Business Overview — Our markets — Overseas markets.” In addition, if the license agreements are renewed upon the expiration of their terms, we generally receive renewal license fees, which are deferred and recognized ratably over the new license period.
 
We also receive royalty revenues from our licensees based on an agreed percentage of the licensee’s revenues from our games. Royalty revenues are recognized on a monthly basis after the licensee confirms its revenues based on the licensees’ sales from our games during the month.
 
Mobile games revenue
 
Mobile games are played using mobile phones and other mobile devices. Mobile game revenues are derived from contract prices and a percentage of the per-download fees that users pay. Contract prices are recognized when the products or services have been delivered or rendered and the customers can begin its exploitation or sale in accordance with the contractual terms, and per-download fees are recognized in a monthly basis as they are earned by the licensee.
 
Character merchandising, animation and other revenue
 
We license the right to commercialize or distribute our games characters or animation in exchange for contract prices. These contract prices are recognized when the products or services have been delivered or rendered and the customers can begin its exploitation or sale in accordance with the contractual terms. In addition, we receive royalty payment based on a specified percentage of the licensees’ sales.


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Breakdown of revenues
 
                                                 
    Year Ended December 31,  
    2004     2005     2006  
    (In millions of Korean Won and percentages)  
 
Online games-subscription revenue
  W 16,253       25.2 %   W 11,249       21.1 %   W 8,420       20.6 %
Online games-royalties and license fees
    45,101       70.0       37,375       70.0       26,123       63.8  
Mobile games
    376       0.6       1,664       3.1       3,840       9.4  
Character merchandising, animation and other revenue
    2,696       4.2       3,096       5.8       2,580       6.2  
                                                 
Total
  W 64,426       100.0 %   W 53,384       100.0 %   W 40,963       100.0 %
                                                 
 
Cost of revenues
 
Our cost of revenues consists principally of the following:
 
  •  operational expenses, server depreciation expenses, server maintenance costs and related personnel costs and amortization of development-related costs as described in “— Critical accounting policies — Capitalized software development costs”; and
 
  •  royalty payments to Mr. Myoung-Jin Lee, on whose cartoon series our game Ragnarok Online is based.
 
In developing Ragnarok Online, we obtained an exclusive license from Mr. Myoung-Jin Lee to use the storyline and characters from his cartoon titled Ragnarok for the production of online games, animation and character merchandising. In return, we paid Mr. Lee an initial license fee of 40 million and are required to pay royalties based on 1.0% or 1.5% of adjusted revenues (net of value-added taxes and certain other expenses) or 2.5%, 5% or 10% of net income generated from the use of the Ragnarok brand, depending on the type of revenues received from the operation or licensing of Ragnarok Online.
 
The cost of revenues from the payments to Mr. Myoung-Jin Lee was Won 542 million for 2005 and Won 361 million for 2006. This agreement expires in January 2033.
 
Selling, general and administrative expenses
 
Selling, general and administrative expenses consist of sales commissions paid to independent promotional agents that distribute our online games to our Internet café subscribers in Korea, commissions paid to payment settlement providers, administrative expenses and related personnel expenses of executive and administrative staff, and marketing and promotional expenses and related personnel expenses.
 
Research and development expenses
 
Research and development expenses consist primarily of payroll and other overhead expenses which are all expensed as incurred until technological feasibility of a game is reached. Once technological feasibility of a game is reached, these costs are capitalized and, once commercial operation commences, amortized as cost of revenues. See “— Critical accounting policies — Capitalized software development costs.”
 
Interest expense
 
In February and April 2002, we entered into agreements with YNK Korea, an online game publisher in Korea, pursuant to which we granted it the exclusive right to distribute Ragnarok Online for a contractual period of three years from the date Ragnarok Online was first commercialized. In consideration, we received a lump sum payment in the amount of Won 7,000 million at the inception of these agreements, which we recorded as debt on our balance sheets beginning from such year. As there is no interest rate stated in the agreement with YNK Korea, the interest is imputed based on the difference between the principal amount of the loan and the total payments expected to be made pursuant to the agreement. Accordingly, the repayment of principal balance to YNK Korea is variable each year in accordance with the amount of annual revenues generated from distribution of Ragnarok Online and deduction of annual interest expense allocated using the interest rate method. As of December 31, 2005, the outstanding balance of our debt payable to YNK Korea was nil as our agreement with YNK Korea expired in July


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2005. Pursuant to the expiration of our agreement with YNK Korea in July 2005, we are no longer obligated to make payments to YNK Korea for the period subsequent to the date of expiration for revenues attributable to Ragnarok Online. In accordance with such agreement, we recognized payments in the amount of Won 7,037 million and Won 3,406 million for years 2004 and 2005, respectively, to YNK Korea. Of such payments, Won 2,391 million and Won 1,150 million were allocated to principal, and Won 4,646 million and Won 2,256 million were allocated to interest, respectively.
 
We recorded interest expense of Won 4,732 million, Won 2,158 million and Won 95 million (US$102 thousand) in 2004, 2005 and 2006, respectively.
 
Foreign currency effects
 
In 2006, 75.2% of our revenues were denominated in foreign currencies, primarily in U.S. dollars and Japanese Yen. In most of the countries in which our games are distributed, other than the United States, Japan and European countries, the revenues generated by our licensees are denominated in local currencies, which include the NT dollar, the Thai Baht and the Renminbi, and converted into the U.S. dollar for remittance of monthly royalty payments to us. Depreciation of these local currencies against the U.S. dollar will result in reduced monthly royalty payments in U.S. dollar terms, thereby having a negative impact on our revenues.
 
Although we receive our monthly royalty revenues from our overseas licensees in foreign currencies, primarily in U.S. dollar and Japanese Yen, in the case of the U.S. and Japan and other local currencies, such as the NT dollar, the Thai Baht and the Renminbi in our other principal markets, substantially all of our costs are denominated in Won. We receive monthly royalty payments from our overseas licensees based on a percentage of revenues confirmed and recorded at the end of each month applying the foreign exchange rate applicable on such date. We generally receive these royalty payments 20 to 30 days after such record date (except in Europe, Chile and China, where such payment could be received up to 60 days after the record date). Appreciation or depreciation of the Won against these foreign currencies during this period will result in foreign currency losses or gains and affect our net income in dollar terms.
 
In 2005, we began entering into derivatives arrangements to hedge against the risk of foreign currency fluctuations. As of December 31, 2005 and 2006, we had no foreign currency forward contracts outstanding. See Item 11. “Quantitative and Qualitative Disclosures about Market Risk.”
 
Income tax expenses
 
Income tax expenses in 2004 was Won 5,406 million. In 2005, we had income tax benefit, which amounted to Won 817 million. In 2006, income tax expenses was Won 12,069 million (US$12,977 thousand).
 
Recent Accounting Changes
 
No material change.
 
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 United States. The preparation of these financial statements requires us to make estimates, judgments and assumptions that affect the reported amounts of assets and liabilities, contingent liabilities, and revenue and expenses during the reporting period. We evaluate our estimates on an ongoing basis based on historical experience and other assumptions we believe are 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. The policies discussed below are considered by our management to be critical because they are not only important to the portrayal of our financial condition and results of operations but also because application and interpretation of these policies require both judgment and estimates of matters that are inherently uncertain and unknown. As a result, actual results may differ materially from our estimates.


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Revenue recognition
 
We derive, and expect to continue to generate, most of our revenues from online game subscription fees paid by users in Korea, and royalties and license fees paid by our licensees in overseas markets. Our revenues can be classified into the following four categories: (i) online games — subscription revenue; (ii) online games — royalties and license fees; (iii) mobile games; and (iv) character merchandising, animation and other revenue. For details, see “— Overview — Revenue recognition.”
 
We recognize revenue in accordance with accounting principles generally accepted in the United States, as set forth in Securities and Exchange Commission Staff Accounting Bulletin No. 104, Revenue Recognition, Statement of Position 97-2, Software Revenue Recognition and other related pronouncements.
 
Allowances for doubtful accounts
 
We maintain allowances for doubtful accounts receivable for estimated losses that result from the inability of our customers to make required payments. We base our allowances on the likelihood of recoverability of accounts receivable based on past experience and current collection trends. We record allowances for doubtful accounts based on historical payment patterns of our customers and increase our allowances as the length of time such receivables become past due increases.
 
Subsequent to June 2003, pursuant to agreements with various payment gateway providers, the payment gateway providers are responsible for remitting to us the full subscription revenues generated in Korea after deducting their fixed service fees and charges, which range from approximately 8% to 15% and risk of loss or delinquencies are borne by such payment gateway providers so that we no longer assume any collection risk.
 
Capitalized software development costs
 
We account for capitalized software development costs in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 86, Accounting for the Costs of Computer Software to be Sold, Leased, or Otherwise Marketed. Software development costs incurred prior to the establishment of technological feasibility are expensed when incurred and treated as research and development, or R&D, expenses. Once the game has reached technological feasibility, all subsequent software development costs for that product are capitalized until it is released for sale. Technological feasibility is evaluated on a product-by-product basis, but generally occurs once the online game has a proven ability to operate on a massively multi-player level. After the game is commercially released, the capitalized product development costs are amortized and expensed over the game’s estimated useful life, which is deemed to be three years. This expense is recorded as a component of cost of revenues.
 
We evaluate the recoverability of capitalized software development costs on a product-by product basis. Capitalized costs for those products whose further development or sale is terminated are expensed in the period of cancellation. In addition, a charge to cost of revenues is recorded when management’s forecast for a particular game indicates that unamortized capitalized costs exceed the net realizable value of that asset.
 
Significant management judgments and estimates are required to assess the timing of technological feasibility as well as the ongoing recoverability of capitalized costs.
 
Impairment of goodwill and other intangible assets
 
Goodwill represents the excess of the purchase price over the fair value of the identifiable net assets acquired in our acquisition of TriggerSoft and NEOCYON. As of December 31, 2006, residual goodwill reflected on our balance sheet was Won 1,451 million (US$1,560 thousand). At the time of such acquisition, we estimated that Won 8,505 million (US$9,145 thousand) of intangible assets were acquired from TriggerSoft and NEOCYON, comprising of contract-based intangible assets. We evaluate goodwill on an annual basis for possible impairment, in accordance with SFAS No. 142, Goodwill and Other Intangible Assets (“SFAS 142”), using fair value techniques and market comparables. We assess impairment of our definite-lived other intangible assets in accordance with the provisions of SFAS No. 144, Accounting for the Impairment or Disposal of Long-lived Assets (“SFAS 144”), whenever events or changes in circumstance indicate the carrying amount may not be recoverable.


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The assessment of impairments under SFAS 142 and 144 requires significant judgment and requires estimates to assess fair values. A percentage difference in cash flow projections or discount rate used would not likely result in an impairment write-down.
 
Impairment of Investments
 
Our investments are comprised of equity securities accounted for under both the cost and equity method of accounting. If it has been determined that an investment has sustained an other-than-temporary decline in its value, the investment is written down to its fair value by a charge to earnings. We regularly evaluate our investments to identify other-than-temporary impairments of individual securities. Factors that are considered by us in determining whether an other-than-temporary decline in value has occurred include: the length of time and extent to which the market value of the security has been less than its original cost, the financial condition, operating results, business plans, milestones and estimated future cash flows of investee, other specific factors affecting the market value. We have evaluated our investment in Online Game Revolution Fund No. 1 and Perpetual Entertainment Inc. as of December 31, 2006 and concluded that the investments were not impaired based on the investees’ business plan, milestone activities, near term prospects and other third party financing information. Significant management judgment is involved in the evaluation. Any changes in assumptions could significantly affect the valuation and timing of recognition of valuation losses.
 
Income taxes
 
We account for income taxes under the provisions of SFAS No. 109, Accounting for Income Taxes. Under SFAS No. 109, income taxes are accounted for under the asset and liability method.
 
Management judgment is required in determining our provision for income taxes, deferred tax assets and liabilities and the extent to which deferred tax assets can be recognized. A valuation allowance is provided for deferred tax assets to the extent that it is more likely than not that such deferred tax assets will not be realized. Realization of future tax benefits related to the deferred tax assets is dependent on many factors, including our ability to generate taxable income within the period during which the temporary differences reverse, the outlook for the economic environment in which the business operates, and the overall future industry outlook. As of December 31, 2006, we have concluded that a full valuation allowance on our deferred tax assets will be required based on our historical and projected net and taxable income.
 
As described in “— Overview — Income tax expenses,” we enjoyed in 2006 a reduced tax rate of 13.75%, which is 50% of the statutory tax rate and applied to certain designated venture companies. In 2007, while we will reapply for our designation as a venture company (as the reduced tax rate is valid until 2006), it is uncertain as to whether we will obtain this designation. However, even if we cease to enjoy the 50% reduction in corporate income tax rate in 2007, we will instead be entitled to a special tax exemption of 10% of the statutory corporate income tax rate for the fiscal year 2007 by virtue of being a small- and medium-sized company. Accordingly, deferred income taxes as of December 31, 2006 were calculated based on the rate of 24.75% and 27.50% for the amounts expected to be realized during the fiscal year 2007 and 2008, respectively.


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Results of Operations
 
2006 Compared to 2005
 
The following table summarizes our results of operations for the periods indicated.
 
                                 
    Year Ended December 31,  
    2005     2006     2006(1)     % Change  
                (Unaudited)        
    (In millions of Won and thousands of US$)  
 
Revenues:
                               
Online games — subscription revenue
  W 11,249     W 8,420     US$ 9,054       (25.1 )%
Online games — royalties and license fees
    37,375       26,123       28,089       (30.1 )
Mobile games
    1,664       3,840       4,129       130.8  
Character merchandising, animation and other revenue
    3,096       2,580       2,774       (16.7 )
                                 
Total net revenue
    53,384       40,963       44,046       (23.3 )
Cost of revenue
    16,038       17,746       19,082       10.6  
                                 
Gross profit
    37,346       23,217       24,964       (37.8 )
Gross profit margin(2)
    70.0 %     56.7 %     56.7 %        
Operating expenses:
                               
Selling, general and administrative
    30,795       27,555       29,629       (10.5 )
Research and development
    9,219       9,239       9,934       0.2  
Litigation charges
          4,648       4,998       N/M  
Proceeds from the former chairman due to fraud
          (4,947 )     (5,319 )     N/M  
Gain on disposal of assets held for sale
          (1,081 )     (1,162 )     N/M  
                                 
Total operating expenses
    40,014       35,414       38,080       (11.5 )
Operating income (loss)
    (2,668 )     (12,197 )     (13,116 )     357.2  
Operating profit margin(3)
    (5.0 )%     (29.8 )%     (29.8 )%        
Other income (expenses):
                               
Interest income
    2,850       2,973       3,197       4.3  
Interest expense
    (2,158 )     (95 )     (102 )     (95.6 )
Foreign currency losses, net
    (614 )     (728 )     (783 )     18.6  
Gain (Loss) on Foreign currency forward transaction
    (853 )     151       162       117.7  
Others, net
    (12 )     (36 )     (39 )     N/M  
                                 
Total net other expense
    (787 )     2,265       2,435       (387.8 )
Income (loss) before income tax expenses (benefit), minority interest, and equity loss of joint venture
    (3,455 )     (9,932 )     (10,681 )     187.5  
Income tax expenses (benefit)
    (817 )     12,069       12,977       (1,577.2 )
                                 
Income (loss) before minority interest and equity in loss of related joint venture and partnership
    (2,638 )     (22,001 )     (23,658 )     734.0  
Minority interest(4)
    (2 )     7       8       N/M  
Equity loss of joint venture and partnership(5)
    394       1,106       1,189       180.7  
                                 
Income (loss) before cumulative effect of change in accounting principle
    (3,030 )     (23,114 )     (24,855 )     662.8  
Cumulative effect of change in accounting principle, net of tax
          849       913       N/M  
                                 
Net income (loss)
  W (3,030 )   W (22,265 )   US$ (23,942 )     634.8 %
                                 


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N/M = not meaningful
 
Notes:
 
(1) For convenience, the Won amounts are expressed in U.S. dollars at the rate of Won 930.0 to US$1.00.
 
(2) Gross profit margin for each period is calculated by dividing gross profit by total revenues for each period.
 
(3) Operating profit margin for each period is calculated by dividing operating income (loss) by total revenues for each period.
 
(4) In 2005 and 2006, represents the minority interest in NEOCYON, Inc., a 96.11% held subsidiary purchased in December 2005.
 
(5) In 2005, represents the losses from our 30% equity investment in Animation Production Committee, a Japanese joint venture formed in order to produce and market Ragnarok the Animation through GRAVITY Entertainment Corporation, our Japanese subsidiary. In 2006, represents the losses from our 30% equity investment in Animation Production Committee and 14.49% equity investment in “Online Game Revolution Fund No. 1”, a limited liability partnership (“Revolution Fund”), formed in order to invest online game. These investments were accounted for using the equity method of accounting.
 
Revenues
 
Our total revenues decreased by 23.3% to Won 40,963 million (US$44,046 thousand) in 2006 from Won 53,384 million in 2005, primarily due to:
 
  •  a 30.1% decrease in royalties and license fees to Won 26,123 million (US$28,089 thousand) in 2006 from Won 37,375 million in 2005, which primarily resulted from a decrease in royalties and license fees attributable to our Ragnarok Online game resulting from increasing competition and as a result of the relative maturity of such game in our principal overseas markets. Royalties and license fees from Ragnarok Online decreased from Won 36,573 million in 2005 to Won 24,584 million (US$26,434 thousand) in 2006;
 
  •  a 25.1% decrease in subscription revenue to Won 8,420 million (US$9,054 thousand) in 2006 from Won 11,249 million in 2005. This 25.1% decrease resulted primarily from a 32.5% decrease in subscription revenue in Korea from Ragnarok Online to Won 5,339 million (US$5,741 thousand) in 2006 from Won 7,913 million in 2005, and a 18.8% decrease in the subscription revenue for Ragnarok Online in the United States and Canada to Won 2,163 million (US$2,326 thousand) in 2006 from Won 2,665 million in 2005, due to a decrease in playing time by our users of Ragnarok Online resulting from increasing competition and as a result of the relative maturity of such game; and
 
  •  a 16.7% decrease in character merchandising, animation and other revenue to Won 2,580 million (US$2,774 thousand) in 2006 from Won 3,096 million in 2005, which resulted primarily from a 25.3% decrease in technical support revenue to Won 349 million (US$375 thousand) in 2006 from Won 467 million in 2005 and 96.1% decrease in animation revenue to Won 24 million (US$26 thousand) in 2006 from Won 614 million in 2005.
 
Such decreases in revenues were partially offset by:
 
  •  a 130.8% increase in mobile games revenue to Won 3,840 million (US$4,129 thousand) in 2006 from Won 1,664 million in 2005. This 130.8% increase resulted primarily from acquisition of NEOCYON, which was made in November and December in 2005, and thereby in 2005, the revenue of NEOCYON are reflected only for the period after the acquisition whereas in 2006, the full year. Mobile revenues of NEOCYON were Won 429 million and Won 3,359 million in 2005 and 2006.


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Cost of revenues
 
Our cost of revenues increased by 10.6% to Won 17,746 million (US$19,082 thousand) in 2006 from Won 16,038 million in 2005, primarily due to:
 
  •  a 151.8% increase in amortization on intangible assets to Won 2,437 million (US$2,620 thousand) in 2006 from Won 968 million in 2005. Acquisition of NEOCYON was made in November and December in 2005, and for intangible assets recognized then, amortization expense only for the period after the acquisition is reflected in 2005 whereas in 2006, such expense is reflected for the full year; and
 
  •  a 141.9% increase in outsourcing fee to Won 958 million (US$1,030 thousand) in 2006 from Won 396 million in 2005 primarily resulted from the effect of the acquisition of NEOCYON, which was made in November and December in 2005, and thereby in 2005, outsourcing fee of NEOCYON are reflected only for the period after the acquisition whereas in 2006, such fee is reflected for the full year.
 
Such increases in cost of revenues were partially offset by:
 
  •  a 60.3% decrease in stock option plan compensation expense to Won 320 million (US$344 thousand) in 2006 from Won 806 million in 2005, as a result of a decrease of personnel in 2006.
 
Gross profit and margin
 
As a result of the foregoing, our gross profit decreased by 37.8% to Won 23,217 million (US$24,964 thousand) in 2006 from Won 37,346 million in 2005. Our gross profit margin decreased to 56.7% in 2006 from 70.0% in 2005.
 
Operating expenses
 
Selling, general and administrative expenses.  Our selling, general and administrative expenses decreased by 10.5% to Won 27,555 million (US$29,629 thousand) in 2006 from Won 30,795 million in 2005, primarily due to:
 
  •  a 45.4% decrease in fee payments to Won 5,229 million (US$5,623 thousand) in 2006 from Won 9,570 million in 2005, for fees and expenses incurred in connection with the investigation and subsequent restatement of the financial statements in 2005;
 
  •  a 40.3% decrease in advertising expenses to Won 3,744 million (US$4,026 thousand) in 2006 from Won 6,273 million in 2005, as a result of our participation in the Tokyo Game Show in September 2005, our participation in the G-star Game Show in November 2005, advertising for Ragnarok Online II and increase in marketing expenses related to the introduction of STYLIA in 2005, which did not recur in 2006; and
 
  •  a 28.7% decrease in taxes and dues to Won 997 million (US$1,072 thousand) in 2006 from Won 1,398 million in 2005, resulting from back-taxes in the amount of Won 1,060 million, representing the amount of tax benefits granted to us in respect of the building and land at Shinsa-Dong in July 2004 for research and development purposes, which did not recur in 2006.
 
Such decreases in selling, general and administrative expenses were partially offset by:
 
  •  a 216.3% increase in rent to Won 2,461 million (US$2,646 thousand) in 2006 from Won 778 million in 2005, primarily as a result of an increase in rent fee due to moving the head office in 2005; and
 
  •  a 41.4% increase in salaries to Won 8,054 million (US$8,660 thousand) in 2006 from Won 5,694 million in 2005, primarily as a result of an increase in the number of employees for administrative and other support functions.
 
Research and development expenses.  Our research and development expenses increased 0.2% to Won 9,239 million (US$9,934 thousand) in 2006 from Won 9,219 million in 2005.
 
Litigation charges.  Our litigation charges increased to Won 4,648 million (US$4,998 thousand) in 2006 from nil in 2005. See Item 8.A “Financial Information — Legal Proceedings.”
 
Proceeds from the former chairman due to fraud.  Our proceeds from the former chairman due to fraud increased to Won 4,947 million (US$5,319 thousand) in 2006 from nil in 2005.


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Gain on disposal of assets held for sale.  Our gain on disposal of assets held for sale increased to Won 1,081 million (US$1,162 thousand) in 2006 from nil in 2005.
 
Operating income and operating margin
 
As a result of the cumulative effects of the reasons stated above, we recorded an operating loss of Won 12,197 million (US$13,116 thousand) in 2006 compared to operating loss of Won 2,668 million in 2005.
 
Net other income (expense)
 
Our net other expense decreased 387.8% to other income of Won 2,265 million (US$2,435 thousand) in 2006 from other expense Won 787 million in 2005 primarily due to:
 
  •  a 95.6% decrease in interest expense from Won 2,158 million in 2005 to Won 95 million (US$102 thousand) in 2006 as a result of reduction in payments in connection with the loan from YNK Korea, due to the expiration of the term of the contract with YNK Korea in July 2005; and
 
  •  an increase in gain on foreign currency forward transaction from loss of Won 853 million in 2005, to gain of Won 151 million (US$162 thousand) in 2006.
 
Income tax expenses (benefit)
 
We recorded income tax expense of Won 12,069 million (US$12,977 thousand) in 2006, as compared to income tax benefit of Won 817 million in 2005 primarily due to recognizing a full valuation on allowances from deferred tax assets. In assessing the realizability of deferred tax assets, we considered whether it was more likely than not some portion or all of the deferred tax assets would not be realized. However, it is possible that these income tax expenses could be treated as income tax benefit if any taxable income becomes realizable in the future. For the year ended December 31, 2006, we recorded a full valuation allowance on our deferred tax assets, as we determined that it was more likely than not that none of the deferred tax assets were realizable in the near future.
 
Minority interest
 
Minority interest represents the net income (loss) from NEOCYON, our 96.11%-held subsidiary acquired in December 2005, attributable to third-party minority interest holders. We acquired 96.11% of voting equity of NEOCYON in 2005.
 
Equity loss of joint venture and partnership
 
Equity loss of joint venture and partnership represents the 30% of the net loss incurred from our 30% equity investment in Animation Production Committee, a Japanese animation joint venture which we invested through GRAVITY Entertainment Corporation, our Japanese subsidiary and 14.49% of the net loss incurred from 14.49% partnership interest in Revolution Fund. These investments were accounted for using the equity method of accounting.
 
Net income (loss)
 
As a result of the cumulative effects of the reasons stated above, our net income recorded net loss of Won 22,265 million (US$23,942 thousand) in 2006 as compared to net loss of Won 3,030 million in 2005.


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2005 Compared to 2004
 
The following table summarizes our results of operations for the periods indicated.
 
                                 
    Year Ended December 31,  
    2004     2005     2005(1)     % Change  
                (Unaudited)        
    (In millions of Won and thousands of US$)  
 
Revenues:
                               
Online games — subscription revenue
  W 16,253     W 11,249     US$ 11,138       (30.8 )%
Online games — royalties and license fees
    45,101       37,375       37,005       (17.1 )
Mobile games
    376       1,664       1,648       342.6  
Character merchandising, animation and other revenue
    2,696       3,096       3,065       14.8  
                                 
Total revenues
    64,426       53,384       52,856       (17.1 )
Cost of revenues
    10,116       16,038       15,879       58.5  
                                 
Gross profit
    54,310       37,346       36,977       (31.2 )
Gross profit margin(2)
    84.3 %     70.0 %     70.0 %        
Operating expenses:
                               
Selling, general and administrative
    13,660       30,795       30,490       125.4  
Research and development
    2,029       9,219       9,128       354.4  
                                 
Total operating expenses
    15,689       40,014       39,618       155.0  
Operating income (loss)
    38,621       (2,668 )     (2,641 )     (106.9 )
Operating profit margin(3)
    59.9 %     (5.0 )%     (5.0 )%        
Other income (expense):
                               
Interest income
    479       2,850       2,822       495.0  
Interest expense
    (4,732 )     (2,158 )     (2,137 )     (54.4 )
Foreign currency gains (losses), net
    (625 )     (614 )     (608 )     (1.8 )
Foreign currency forward transaction, net
          (853 )     (845 )     N/M  
Others, net
    (1 )     (12 )     (12 )     N/M  
                                 
Total net other expense
    (4,879 )     (787 )     (780 )     (83.9 )
Income (loss) before income tax expenses, minority interest, and equity in loss of related joint venture
    33,742       (3,455 )     (3,421 )     (110.2 )
Income tax expenses (benefit)
    5,406       (817 )     (809 )     (115.1 )
                                 
Income (loss) before minority interest and equity in loss of related joint venture
    28,336       (2,638 )     (2,612 )     (109.3 )
Minority interest(4)
    (17 )     (2 )     (2 )     N/M  
Equity in loss of related joint venture(5)
    296       394       390       33.1  
                                 
Net income (loss)
  W 28,057     W (3,030 )   US$ (3,000 )     (110.8 )%
                                 
 
 
N/M = not meaningful
 
Notes:
 
(1) For convenience, the Won amounts are expressed in U.S. dollars at the rate of Won 1,010.0 to US$1.00.
 
(2) Gross profit margin for each period is calculated by dividing gross profit by total revenues for each period.
 
(3) Operating profit margin for each period is calculated by dividing operating income (loss) by total revenues for each period.
 
(4) In 2004, represents the minority interest in GRAVITY Entertainment Corporation, our Japanese subsidiary. We acquired the remaining 50% of voting equity interest in RO Production (the predecessor name of


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GRAVITY Entertainment Corporation) in October 2004, resulting in RO Production becoming our wholly-owned subsidiary. In 2005, represents the minority interest in NEOCYON, Inc., a 96.11% held subsidiary purchased in December 2005.
 
(5) Represents the losses from our 30% equity investment in Animation Production Committee, a Japanese joint venture formed in order to produce and market Ragnarok the Animation through GRAVITY Entertainment Corporation, our Japanese subsidiary. This investment was accounted for using the equity method of accounting.
 
Revenues
 
Our total revenues decreased by 17.1% to Won 53,384 million (US$52,856 thousand) in 2005 from Won 64,426 million in 2004, primarily due to:
 
  •  a 17.1% decrease in royalties and license fees to Won 37,375 million (US$37,005 thousand) in 2005 from Won 45,101 million in 2004, which primarily resulted from a decrease in royalties and license fees attributable to our Ragnarok Online game resulting from increasing competition and as a result of the relative maturity of such game in our principal overseas markets. Royalties and license fees from Ragnarok Online decreased from Won 45,101 million in 2004 to Won 36,574 million (US$36,212 thousand) in 2005; and
 
  •  a 30.8% decrease in subscription revenue to Won 11,249 million (US$11,138 thousand) in 2005 from Won 16,253 million in 2004. This 30.8% decrease resulted primarily from a 37.8% decrease in subscription revenue in Korea from Ragnarok Online to Won 7,913 million (US$7,835 thousand) in 2005 from Won 12,724 million in 2004, and a 24.5% decrease in the subscription revenue for Ragnarok Online in the United States and Canada to Won 2,665 million (US$2,639 thousand) in 2005 from Won 3,528 million in 2004, due to a decrease in playing time by our users of Ragnarok Online resulting from increasing competition and as a result of the relative maturity of such game.
 
Such decreases in revenues were partially offset by:
 
  •  an increase in the subscription revenue from R.O.S.E Online to Won 671 million (US$664 thousand) in 2005, as such game was commercially launched in January 2005;
 
  •  a 14.8% increase in character merchandising, animation and other revenue to Won 3,096 million (US$3,065 thousand) in 2005 from Won 2,696 million in 2004, which resulted primarily from a 47.78% increase in technical support revenue to Won 467 million (US$462 thousand) from Won 316 million in 2004 and 148.58% increase in animation revenue to Won 614 million (US$608 thousand) from Won 247 million in 2004; and
 
  •  a 342.6% increase in mobile games revenue to Won 1,664 million (US$1,648 thousand) in 2005 from Won 376 million in 2004, which resulted primarily from increase in sales of mobile games in Taiwan, Japan, the Philippines, Singapore, Malaysia and Thailand and sales of Won 429 million resulting from the acquisition of NEOCYON, Inc. in November and December 2005.
 
Cost of revenues
 
Our cost of revenues increased by 58.5% to Won 16,038 million (US$15,879 thousand) in 2005 from Won 10,116 million in 2004, primarily due to:
 
  •  a 53.5% increase in salaries and wages to Won 6,759 million (US$6,692 thousand) in 2005 from Won 4,403 million in 2004, as a result of increased hiring of game developers and overseas support staff from 174 as of December 31, 2004 to 193 as of December 31, 2005 and payment of incentives for the success of Ragnarok Online and 16% increase in average salaries paid to our employees which became effective as of June 2005;
 
  •  a 18.9% increase in fee payments to Won 2,250 million (US$2,228 thousand) in 2005 from Won 1,893 million in 2004, as a result of an increase in fees we pay to Korea Internet Data Center for server housing fees due to the commercial launch of R.O.S.E. Online in January 2005;


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  •  a 55.4% increase in depreciation to Won 2,422 million (US$2,398 thousand) in 2005 from Won 1,559 million in 2004, as a result of the addition of servers and software in 2005 to better service Ragnarok Online and the addition of servers and software for the introduction of R.O.S.E Online; and
 
  •  a 2,778.6% increase in stock option plan compensation expense to Won 806 million (US$798 thousand) in 2005 from Won 28 million in 2004, which resulted from the increased amortization period to full year from 8 days in 2004.
 
Gross profit and margin
 
As a result of the foregoing, our gross profit decreased by 31.2% to Won 37,346 million (US$36,977 thousand) in 2005 from Won 54,310 million in 2004. Our gross profit margin decreased to 70.0% in 2005 from 84.3% in 2004.
 
Operating expenses
 
Selling, general and administrative expenses.  Our selling, general and administrative expenses increased by 125.4% to Won 30,795 million (US$30,490 thousand) in 2005 from Won 13,660 million in 2004, primarily due to:
 
  •  a 261.4% increase in fee payments to Won 9,570 million (US$9,475 thousand) in 2005 from Won 2,648 million in 2004, for fees and expenses incurred in connection with the investigation and subsequent restatement of the financial statements;
 
  •  a 36.0% increase in advertising expenses to Won 6,273 million (US$6,211 thousand) in 2005 from Won 4,614 million in 2004, as a result of our participation in the Tokyo Game Show in September 2005, our participation in the G-star Game Show in November 2005, advertising for Ragnarok Online II and increase in marketing expenses related to the introduction of STYLIA;
 
  •  a 80.4% increase in salaries and wages to Won 5,694 million (US$5,638 thousand) in 2005 from Won 3,156 million in 2004, primarily as a result of an increase in the number of employees for administrative and other support functions from 148 in 2004 to 161 in 2005 and 16% increase in average salaries paid to our employees which became effective as of June 2005;
 
  •  an increase in impairment on intangible assets to Won 1,547 million (US$1,532 thousand) in 2005 from nil in 2004, as a result of recognition of impairment losses for the remaining balance of intangible assets recognized in connection with the business combination with TriggerSoft in 2005; and
 
  •  a 779.2% increase in tax and dues to Won 1,398 million (US$1,384 thousand) in 2005 from Won 159 million in 2004, as a result of having to pay back-taxes in the amount of Won 1,060 million, representing the amount of tax benefits granted to us in respect of the building and land at Shinsa-Dong in July 2004 for research and development purposes.
 
Research and development expenses.  Our research and development expenses increased 354.4% to Won 9,219 million (US$9,128 thousand) in 2005 from Won 2,029 million in 2004, primarily due to the payment of the consideration for the right to publish STYLIA and Time N Tales upon completion of game development, including salaries and wages, and provision for severance indemnities, relating to the development of Requiem and Ragnarok Online II, as such games were in the pre-commercialization stage and not yet considered to be technologically feasible.
 
Operating income and operating margin
 
As a result of the cumulative effects of the reasons stated above, we recorded an operating loss of Won 2,668 million (US$2,641 thousand) in 2005 compared to operating income of Won 38,621 million in 2004, and our operating margin recorded to 59.9% in 2004 but we recorded operating loss in 2005.


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Net other income (expense)
 
Our net other expense decreased 83.9% to Won 787 million (US$780 thousand) in 2005 from Won 4,879 million in 2004 primarily due to:
 
  •  a 54.4% decrease in interest expense from Won 4,732 million in 2004 to Won 2,158 million (US$2,137 thousand) in 2005 as a result of reduction in payments in connection with the loan from YNK Korea, due to the significant decrease in Ragnarok Online revenues and the expiration of the term of the contract with YNK Korea in July 2005; and
 
  •  an increase in interest income from Won 479 million in 2004, to Won 2,850 million (US$2,822 thousand) in 2005 resulting from an increase in short-term financial instruments in 2005;
 
which was partially offset by
 
  •  an increase in net loss on foreign currency forward transactions of Won 853 million (US$845 thousand) in 2005 from nil in 2004.
 
Income tax expenses (benefit)
 
We recorded income tax benefit of Won 817 million (US$809 thousand) in 2005, as compared to income tax expense of Won 5,406 million in 2004. Income tax benefit in 2005 was due to increase in deferred income tax assets, which resulted from foreign tax credit carryforwards in the amount of Won 4,275 million and tax credit carryforwards for research and human resource development in the amount of Won 1,286 million in connection with decrease in our taxable income, in particular, subscription revenue and royalties and license fees.
 
Minority interest
 
Minority interest represents the net loss from GRAVITY Entertainment Corporation, our Japanese subsidiary, and NEOCYON, our 96.11%-held subsidiary acquired in December 2005, attributable to third-party minority interest holders. We acquired the remaining minority interest in GRAVITY Entertainment Corporation in October 2004 and acquired 96.11% of voting equity of NEOCYON in 2005.
 
Equity in loss of related joint venture
 
Equity in loss of related joint venture represents the 30% of the net loss incurred from our 30% equity investment in Animation Production Committee, a Japanese animation joint venture which we invested through GRAVITY Entertainment Corporation, our Japanese subsidiary. This investment was accounted for using the equity method of accounting.
 
Net income
 
As a result of the cumulative effects of the reasons stated above, our net income recorded net loss of Won 3,030 million (US$3,000 thousand) in 2005 as compared to net income of Won 28,057 million in 2004.
 
Impact of inflation
 
We believe that inflation in Korea and our other principal markets has not had a material impact on our results of operations. Inflation in Korea was 3.6% in 2004, 2.7% in 2005 and 2.1% in 2006.
 
Impact of foreign currency fluctuations
 
See Item 11. “Quantitative and Qualitative Disclosures about Market Risk.”
 
Government, Economic, Fiscal, Monetary or Political Policies or Factors
 
See Item 3.D. “Risk Factors — Risks Relating to our Regulatory Environment and Risks Relating to our Market Environment,” Item 4.B. “Business Overview — Laws and Regulations” and Item 10.E. “Taxation.”


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5.B.  Liquidity and Capital Resources
 
Liquidity
 
The following table sets forth the summary of our cash flows for the periods indicated:
 
                                 
    Year Ended December 31,  
    2004     2005     2006     2006(1)  
                      (Unaudited)  
    (In millions of Won and thousands of US$)  
 
Cash and cash equivalents at beginning of period
  W 5,405     W 16,405     W 25,874     US$ 27,821  
                                 
Net cash provided by (used in) operating activities
    32,642       17,928       (830 )     (892 )
Net cash provided by (used in) investing activities
    (19,007 )     (79,046 )     11,031       11,861  
Net cash provided by (used in) financing activities
    (2,635 )     70,587       (761 )     (818 )
                                 
Net increase in cash and cash equivalents
    11,000       9,469       9,440       10,151  
                                 
Cash and cash equivalents at end of period
  W 16,405     W 25,874     W 35,314     US$ 37,972  
                                 
 
 
Note:
 
(1) For convenience, the Won amounts are expressed in U.S. dollars at the rate of Won 930.0 to US$1.00.
 
Prior to the commercial launch of Ragnarok Online in August 2002, our principal sources of liquidity were cash from equity financing and incurrence of debt, including the debt we incurred from YNK Korea. Following the commercial launch of Ragnarok Online, our principal sources of liquidity have been cash flows from our operating activities and equity financing and, to a lesser extent, short-term borrowings. Net cash used in investing activities have consisted primarily of investments in acquisition of interests in companies which develop online games or which provide related products and services. See Note 6 to the notes to our consolidated financial statements included in this annual report. However, our net property and equipment decreased from Won 11,863 million as of December 31, 2005 to Won 8,472 million (US$9,110 thousand) as of December 31, 2006 due to the impairment of machinery and software of total Won 788 million (US$847 thousand).
 
Our cash investment policy emphasizes liquidity and preservation of principal over other portfolio considerations. We deposit our cash in demand deposits, short-term financial instruments, which primarily consist of time deposits with maturity of one year or less, and money market funds with a rolling maturity of 90 days or less. Our short-term financial instruments increased from Won 8,900 million as of December 31, 2004 to Won 59,900 million as of December 31, 2005. But short-term financial instruments decreased to Won 45,835 million (US$49,285 thousand) as of December 31, 2006 as compared 2005, primarily as a result of use of such proceeds in connection with working capital requirements and other expenses.
 
Cash received in the form of initial license fees are recognized as revenues on a monthly basis over the life of our license agreements as described in Item 5.A. “— Overview — Revenue recognition.” The portion of initial license fees not yet recognized as revenues are reflected in our balance sheet as deferred income. Our total deferred income, both short-term and long-term, increased from Won 7,597 million as of December 31, 2004 to Won 8,227 million as of December 31, 2005 and to Won 11,909 million (US$12,805 thousand) as of December 31, 2006 primarily due to our recognizing an increased portion of initial license fees that we received in 2004, 2005 and 2006, respectively.
 
Cash flows from operating activities.  The decrease in net cash provided by our operating activities from 2004 to 2006 were primarily the result of our recording net income in 2004 compared to net losses in 2005 and 2006. Our decrease in net cash provided by our operating activities in 2005 as compared to 2004 reflected an adjustment of (i) Won 6,232 million for deferred income taxes and (ii) Won 2,288 million for payment of severance benefits. This decrease was partially offset by Won 7,482 million in misappropriated funds receivable, Won 7,349 million in accounts payable and Won 5,370 million in depreciation and amortization that we recorded in 2005. Our decrease in net cash provided by operating activities in 2006 as compared to 2005 reflected an adjustment of (i) Won 6,811 million (US$7,324 thousand) in account payable and (ii) Won 1,081 million (US$1,162 thousand) in gain on disposal of assets held for sale. This decrease was partially offset by (i) Won 8,366 million (US$8,996 thousand) for


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deferred income taxes and (ii) Won 7,457 million (US$8,018 thousand) in depreciation and amortization that we recorded in 2006.
 
Cash flows from investing activities.  Our decrease in net cash provided by investing activities from 2004 to 2005 reflected purchases of property and equipment in these years in connection with the general growth of our businesses and the increase in payment of leasehold deposits. Our increase in net cash provided by investing activities in 2006 reflected (i) Won 14,118 million (US$15,181 thousand) for maturity of short-term financial instruments and (ii) Won 9,559 million (US$10,278 thousand) for disposal of property and equipment in 2006. Our net cash (used in) provided by investing activities in 2005 and 2006 also reflected the following:
 
  •  our investment in short-term financial instruments in the amount of Won 7,300 million in 2004 and Won 50,969 million in 2005;
 
  •  our investment in Perpetual Entertainment of Won 8,619 million (US$9,000 thousand) in 2006;
 
  •  our investment in TriggerSoft Corporation and NEOCYON, Inc. of Won 9,193 million in 2005; and
 
  •  our purchase of Emil Chronicle Online for Won 6,073 million in 2005.
 
Cash flows from financing activities.  Our net cash provided by financing activities has been primarily affected by the issuance of common shares in connection with our initial public offering in February 2005 in which we received net proceeds of Won 71,837 million from the sale of 1,400,000 common shares at US$13.50 per ADS (four ADSs are equivalent to one share of our common stock).
 
Capital resources
 
As our overseas operations are conducted primarily through our subsidiaries and our overseas licensees, our ability to finance our operations and any debt that we or our subsidiaries may incur depends, in part, on the payment of royalties and other fees by our overseas licensees and, to a lesser extent, the flow of dividends from our subsidiaries.
 
As of December 31, 2006, our primary source of liquidity was Won 35,314 million (US$37,972 thousand) of cash and cash equivalents. We believe that our available cash and cash equivalents and net cash provided by operating activities, will be sufficient to meet our capital needs through at least the first quarter of 2008. However, we cannot assure you that our business or operations will not change in a manner that would consume available capital resources more rapidly than anticipated. We may require additional cash resources due to changed business conditions or other future developments, including any significant investments or acquisitions. If these sources are insufficient to satisfy our cash requirements, we may seek to sell additional securities either in the form of equity or debt. In the past, we raised cash resources through the issuance of common shares. See note 11 to our audited consolidated financial statements as of December 31, 2005 and 2006 and for the years ended December 31, 2004, 2005 and 2006. The sale of additional equity securities or convertible debt securities could result in additional dilution to our shareholders. In the past, we also raised cash by entering into indebtedness arrangements such as the transaction entered into with YNK Korea as described in Item 5.A. “— Overview — Interest expense.” In addition, we may seek to incur indebtedness through the issuance of debt securities or by obtaining a credit facility. The incurrence of indebtedness would result in increased debt service obligations and could result in operating and financial covenants that would restrict operations. As of December 31, 2006, we have general borrowing facilities with a limit of Won 949 million and have an outstanding balance of borrowing amounting to Won 683 million (US$734 thousand).
 
We expect to have capital expenditure requirements for the ongoing expansion into other markets, including hardware expenditures for continuous expansions and upgrades to our existing server equipment, and also for game development, acquiring and publishing third party game developers or games developed by them and continuing to invest in enhancing our technological, marketing, distribution and service capabilities. We believe that our internal cash flow from operations, together with our proceeds from our initial public offering in February 2005 will be sufficient to satisfy our working capital requirements through at least the first quarter of 2008, including our new game development expenditures for Requiem and Ragnarok Online II.


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5.C.  Research and Development, Patents and Licenses, etc.
 
To remain competitive, we have continued to focus on our research and development efforts. For the past three years, our research and development efforts and plans have consisted of the following:
 
  •  Strategy and planning — overall game design and review of technical feasibility, market feasibility and the game development process.
 
  •  Graphics — designing game characters and game environments, with the objective of optimizing the overall gaming experience;
 
  •  Server programming — server design and development, handling interconnections, validation, security, character data and game process coordination and facilitating online communication among players;
 
  •  Client programming — enhancing the visual and sound experience and movement simulation of game characters; and
 
Our research and development expenditures were Won 2,029 million, Won 9,219 million, and Won 9,239 million (US$9,934 thousand) in 2004, 2005 and 2006, respectively.
 
See Item 4.B. “Business Overview — Game development and publishing” for our research and development and Item 4.B. Business Overview — Intellectual property” for our intellectual property.
 
5.D.  Trend Information
 
Trends, uncertainties and events which could have a material impact on our sales, operating revenues and liquidity and capital resources are discussed above in Item 5.A. “— Operating Results” and Item 5.B. “— Liquidity and Capital Resources.”
 
5.E.  Off-Balance Sheet Arrangements
 
There are no off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditure or capital resources that is material to investors.
 
5.F.  Contractual Obligations
 
The following table sets forth a summary of our contractual cash obligations due by period as of December 31, 2006.
 
                                         
    Payments Due by Period  
          Between 1
    Between 3
    Beyond
       
    Up to 1 Year     and 3 Years     and 5 Years     5 Years     Total  
    (In millions of Won)  
 
Long-term debt obligations
  W 81     W 286     W 273     W 68     W 708  
Operating lease obligations
    3,306       12                   3,318  
Purchase obligations
    1,600                         1,600  
                                         
Total
  W 4,987     W 298     W 273     W 68     W 5,626  
                                         
 
Long-term debt obligations.  We have financed our operations primarily through incurrence of debt from financial institutions, cash flows from operations as well as equity investments by our founder and current shareholders.
 
Operating lease obligations.  With respect to our operating lease obligations, the lease payments due by December 31, 2007 are Won 3,156 million, Won 48 million, Won 63 million and Won 39 million for our principal offices in Seoul, offices for our subsidiary in the United States, offices for our subsidiary in France and offices for our subsidiary in Russia, respectively. The lease terms expire in December 2007, April 2007, December 2007 and July 2007, respectively, for our principal offices in Seoul, offices for our subsidiary in the United States, offices for


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our subsidiary in France and offices for our subsidiary in Russia, respectively. The renewal terms in all of the leases are subject to market conditions.
 
Purchase obligations.  Our purchase obligations consist of acquiring exclusive distribution rights of the online games. In 2005, we entered into publishing agreements to acquire exclusive distribution rights of the online games, STYLIA and Time N Tales which were under development by Sonnori Co., Ltd. and Ndoors Corp., respectively. The purchase obligations due by December 31, 2006 are Won 500 million and Won 1,100 million for STYLIA and Time N Tales, respectively.
 
In December 2005, we entered into an agreement with Movida Investment Inc., SOFTBANK CORP. and other eight companies to invest in “Online Game Revolution Fund No. 1” amounting to Japanese Yen 1,000 million as a limited partner with 10% interest of the total fund and paid initial payment of Japanese Yen 100 million and Yen 150 million in 2005 and 2006, respectively. In 2006, some of the co-participants of “Online Game Revolution Fund No. 1” withdrew and our interest of the total fund rose from 10% to 14.49% of the aggregate size of the fund. However, it does not imply that our total capital commitment changed. Upon 30 days’ prior written notice by general partner, Movida Investment Inc., we shall pay the outstanding portion of contribution. At December 31, 2006, we do not estimate the time of notice. Therefore, the above table does not include the investment obligation of Japanese Yen 750 million due as of December 31, 2006. In accordance with the agreement, the investment term is five years from the effective date, which is January 1, 2006.
 
For a description of our commercial commitments and contingent liabilities, see note 10 of the Notes to our consolidated financial statements included elsewhere in this annual report.
 
For a description of our legal proceedings, see Item 8.A. “Financial Information — Legal Proceedings.”
 
ITEM 6.   DIRECTORS, SENIOR MANAGEMENT AND EMPLOYEES
 
6.A.  Directors and Senior Management
 
The following table sets forth certain information relating to our directors and executive officers as of May 31, 2007. The business address of all of our directors and executive officers is our registered office at Meritz Tower 14F, 825-2 Yeoksam-Dong, Gangnam-Gu, Seoul 135-934 Korea.
 
     
Name
 
Position
 
Il Young Ryu
  Chairman, President, Representative Director and Chief Executive Officer
Seung Taik Baik
  Executive Director and Chief Operating Officer
William Woojae Hahn
  Independent Director and Audit Committee member
Jungil Lee
  Independent Director and Audit Committee member
Kwangsuk Lee
  Independent Director and Audit Committee member
Kyu Hyeong Lee
  Senior Executive Vice President of Human Resources and Chief Compliance Officer
Jonathan J. Lee
  Chief Financial Officer and Investor Relations Officer
 
Il Young Ryu, our chairman of the board of directors and president, has served as our chief executive officer since September 21, 2005. Mr. Il Young Ryu is also currently the chief executive officer of EZER Inc, our largest shareholder. In 2004, he founded CJ Internet Japan and served as its chief executive officer. In 2003, Mr. Ryu held “Online Game Fantasy Star” event with the Softbank group. In 2002, Mr. Ryu formed an alliance between Techno Blood Inc. and Dasan Venture and managed Techno Blood & Dasan, the first Korea-Japan IT Fund. In 2001, he organized a Korea/Japan Bridging Business for Cultural Exchange between Korea & Japan. In 1999, Mr. Ryu founded Techno Blood Inc.


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Seung Taik Baik, our chief operating officer, has served as a director since December 2005 and executive director since March 31, 2006. Mr. Baik has also served as the chief executive officer of NEOCYON, Inc. from 2000. Mr. Baik served as the local representative for Northeast Asia of Entrepreneurs Organization in 2004, and has served as the president of the Korea branch of Entrepreneurs Organization since 2005.
 
William Woojae Hahn was elected as our independent director and member of the audit committee at our shareholders’ meeting in March 2007. Mr. Hahn currently serves as Managing Director of the Investment Banking Group at Bookook Securities Co., Ltd. Mr. Hahn was a Managing Director of the Investment Banking Group at Meritz Securities Co., Ltd. from 2004 to 2006. In 2002, Mr. Hahn was the Executive Vice President and Chief Financial Officer of TG Ubase, Inc. He was the President and Chief Executive Officer of Littauer Technologies, Inc. from 2000 to 2001 and the Co-Founder and Chief Investment Officer of AsiaNet Corporation, Ltd. from 1998 to 2000. Mr. Hahn worked as an Analyst in Corporate Strategy at AXA Equitable from 1994 to 1998.
 
Jungil Lee was elected as our independent director and member of the audit committee at our shareholders’ meeting in March 2006. Mr. Lee is currently the managing attorney of Daesung International Law Office. Mr. Lee is a member of both the Korean and New York bar associations. Mr. Lee is a member of Committee to review the Citizens’ Request for Audit based on Article 40 of Anti-Corruption Act at the Board of Audit and Inspection of Korea since February 2006. Mr. Lee was an outside director of Pyeong Hwa Automotive Co., Ltd. from March 2002 to March 2005.
 
Kwangsuk Lee was elected as our independent director and member of the audit committee at our shareholders’ meeting in March 2007. Mr. Lee currently serves as the Chief Executive Officer of Incruit Corporation, a company he founded in 1998. Mr. Lee created one of the first on-line recruiting systems in Korea and Incruit Corporation is now one of the leading recruiting companies in Korea.
 
Kyu Hyeong Lee has served as our senior executive vice president of human resources since April 2005 and chief compliance officer since February 2006. Mr. Lee worked as a human resources consultant for the Interim Management Service, a management consulting company, from August 2004 to April 2005 and as a director of human resources at Cisco Systems Corp./Korea from June 2002 to August 2004. Mr. Lee also worked at Tyco International Ltd./Asia Region from June 1999 to April 2002.
 
Jonathan J. Lee has served as our chief financial officer since March 2007. Before joining us, Mr. Lee was head of the Alternative Investments Division (Investment Banking) at Meritz Securities Co., Ltd. from 2004 to 2006. Mr. Lee was a Vice President of Investments at Littauer Technologies Co., Ltd. from 2000 to 2001, Vice President at AsiaNet Corporation, Ltd. from 1999 to 2000, and was also associated with the M&A Group at Dresdner Kleinwort Wasserstein.
 
6.B.  Compensation
 
We have not extended any loans or credit to any of our directors or executive officers, and we have not provided guarantees for borrowings by any of these persons. For the year ended December 31, 2006, the aggregate amount of compensation paid by us to all directors and executive officers was Won 996 million (US$1,071 thousand), which excludes Won 189 million (US$203 thousand) set aside or accrued to provide for retirement or similar benefits to our executive officers. At our general meeting of shareholders held on March 31, 2007, our shareholders approved an aggregate amount of up to Won 1.4 billion as compensation for our directors for 2007.
 
Under the Labor Standard Act and the Employee Retirement Benefit Security Act, we are required to pay a severance amount to eligible employees, who voluntarily or involuntarily terminate their employment with us, including through retirement. The severance amount for our officers and directors equals the monthly salary at the time of his or her departure, multiplied by the number of continuous years of service, and further multiplied by a discretionary number set forth in our severance payment regulation, which depending on the position of the officer or director ranges from two to three. As of December 31, 2006, we provided Won 649 million (US$698 thousand), being 100% of our severance liability as of such date.
 
We maintain a directors’ and officers’ liability insurance policy covering certain potential liabilities of our directors and officers.


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6.C.  Board Practices
 
Board of directors
 
Our board of directors has the ultimate responsibility for the administration of our affairs. Our articles of incorporation, as currently in effect, provide for a board of directors comprised of not less than three directors and also provide for an audit committee, a compensation committee and a director nomination committee. We currently have five members serving as members of our board of directors. The directors are elected at a shareholders’ meeting by a majority vote of the shareholders present or represented, which majority is not less than one-fourth of all issued and outstanding shares with voting rights, so long as not less than one third of all issued and outstanding shares with voting rights are present at the shareholders’ meeting.
 
Each of our directors is elected for a term of three years, which may be extended until the close of the annual general meeting of shareholders convened in respect to the last fiscal year of such director’s term. However, directors may serve any number of consecutive terms and may be removed from office at any time by a special resolution adopted at a general meeting of shareholders.
 
The terms of Il Young Ryu expire on September 20, 2008, those of Seung Taik Baik and Jung Il Lee on March 30, 2009, and those of William Woojae Hahn and Kwangsuk Lee on March 21, 2010, respectively.
 
The board of directors elects one or more representative directors from its members. A representative director is authorized to represent and act on behalf of such company and has the authority to bind such company. A company may have (i) one sole representative director, (ii) two or more co-representative directors or (iii) two or more joint representative directors. The powers and authorities of a sole representative director and any co-representative directors are exactly the same while the only distinction for joint representative directors is that they must act jointly (i.e., all of the joint representative directors must act together in order to bind the company while co-representative directors may act independently). Currently our board of directors has elected Il Young Ryu as our representative director. Under the Korean Commercial Code and our articles of incorporation, any director with special interest in an agenda of a board meeting may not exercise his voting rights in such board meeting.
 
Independent directors
 
Our ADSs are listed on Nasdaq and we are subject to the Nasdaq listing requirements applicable to non-U.S. companies. Under the Nasdaq listing requirements, we are required to appoint a minimum of three independent directors, unless we receive an exemption from Nasdaq to appoint a lesser number. Our board of directors has determined that Messrs. William Woojae Hahn, Jungil Lee and Kwangsuk Lee are independent directors under Nasdaq Marketplace Rule 4200.
 
Committees of the board of directors
 
Under our articles of incorporation, we currently have three committees that serve under our board of directors:
 
  •  the audit committee;
 
  •  the director nomination committee; and
 
  •  the compensation committee.
 
Audit committee
 
To comply with the Securities and Exchange Commission rules and regulations and the Nasdaq listing requirements regarding the need for, and composition of, an audit committee, we established an audit committee at our extraordinary shareholders meeting in December 2004.
 
The audit committee currently consists of the following directors: William Woojae Hahn, Jungil Lee and Kwangsuk Lee, all of whom are independent directors within the meaning of Nasdaq Marketplace Rule 4200 and meet the criteria for independence as set forth in Rule 10A-3(b)(1) of the Securities and Exchange Act of 1934. All of our independent directors are financially literate and have accounting or related financial management expertise. Our board of directors has determined that William Woojae Hahn is an “audit committee financial expert,” as such


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term is defined by the regulations of the Securities and Exchange Commission issued pursuant to Section 407 of the Sarbanes-Oxley Act. The audit committee is responsible for examining internal transactions and potential conflicts of interest and reviewing accounting and other relevant matters. Under the Korean Commercial Code, if a company establishes an audit committee, such company is not permitted to have a statutory auditor. The audit committee is chaired by William Woojae Hahn.
 
Director nomination committee
 
The Director nomination committee consists of the following three directors, Jungil Lee, William Woojae Hahn and Kwangsuk Lee, all of whom are independent as set forth in the Nasdaq listing requirements. This committee will be responsible for recommending and nominating candidates for our director positions and related matters. The committee is currently chaired by Jungil Lee.
 
Compensation committee
 
The Compensation committee consists of following three directors, Kwangsuk Lee, William Woojae Hahn and Jungil Lee, all of whom are independent as set forth in the Nasdaq listing requirements. This committee is responsible for reviewing and approving the management’s evaluation and compensation programs. The committee is currently chaired by Kwangsuk Lee.
 
6.D.  Employees
 
As of May 31, 2007, we had 536 full-time employees, of whom 515 were located in Korea and 21 were stationed overseas, either working with our subsidiaries or supporting our overseas licensees. The following table sets forth the number of our employees by department as of the dates indicated.
 
                                         
    December 31,     May 31,
 
    2003     2004     2005     2006     2007  
 
Senior management
    4       7       8       5       5  
Finance
    4       8       13       15       13  
Marketing
    18       27       43       25       49  
Game development and support
    225       357       443       470       469  
                                         
Total
    251       399       507       515       536  
                                         
 
We do not have a labor union and none of our employees are covered by collective bargaining agreements. We have a labor-management council as required under the Act on the Promotion of Workers’ Participation and Cooperation. We believe that we maintain a good working relationship with our employees and we have not experienced any significant labor disputes or work stoppages.
 
As of May 31, 2007, GRAVITY Interactive, Inc. employed 20 employees in the United States (including three employees seconded from us), NEOCYON employed 37 employees, Gravity CIS employed 20 employees (including two employees seconded from us) and Gravity EU employed 6 employees. None of the employees of GRAVITY Interactive, NEOCYON, Gravity CIS or Gravity EU are represented by a labor union or covered by a collective bargaining agreement.
 
We have entered into a standard annual employment contract with most of our officers, managers and employees. These contracts include a covenant that prohibits the officer, manager or employee from engaging in any activities that compete with our business during, and for six months after, the period of their employment with our company.
 
Under the Labor Standard Act and the Employee Retirement Benefit Security Act, employees with more than one year of service with us are entitled to receive a lump sum payment upon voluntary or involuntary termination of their employment. The amount of the benefit equals the employee’s monthly salary, calculated by averaging the employee’s daily salary for the three months prior to the date of the employee’s departure, multiplied by the number of continuous years of employment. In addition, we provide our registered directors with a lump sum payment upon


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voluntary or involuntary termination of their employment in the amount of two to three times the monthly salary of the departing registered directors at the time of termination of employment.
 
Pursuant to the Korean National Pension Law, we are required to pay 4.5% of each employee’s annual wages to the National Pension Corporation. Our employees are also required to pay 4.5% of their annual wages to the National Pension Corporation. Our employees are entitled to receive an annuity in the event they lose, in whole or in part, their wage earning capability. The total amount of contributions we made to the National Pension Corporation in 2004, 2005 and 2006 was Won 537 million, Won 910 million and Won 1,205 million (US$1,296 thousand), respectively.
 
6.E.  Share Ownership
 
Some of our current directors and officers beneficially own our common shares. See Item 7.A. “Major Shareholders.”
 
Stock option plan
 
Under our articles of incorporation and the Act on Special Measures for the Promotion of the Venture Business, we may grant options for the purchase of our shares to certain qualified directors, officers, employees and third parties. Set forth below are the details of our stock option plan as currently contained in our articles of incorporation.
 
  •  Stock options may be granted to our officers and employees who have contributed or are qualified to contribute to our establishment, management, overseas business and technical innovation. Notwithstanding the foregoing, no stock options may be granted to any executive officer or employee who is (i) our largest shareholder, (ii) a holder of 10% or more of our shares outstanding, (iii) certain specially related persons of the person set forth in (i) and (ii) above, or (iv) a shareholder who would own 10% or more of our shares upon exercise of options granted under the stock option plan.
 
  •  Stock options may be granted by a special resolution of our shareholders with the aggregate number of shares issuable not to exceed 50% of the total number of our then issued and outstanding common shares.
 
  •  Upon exercise of stock options, we deliver our common shares or pay in cash the difference between the market price of our shares and the option exercise price.
 
  •  Stock option granted under the stock option plan, in case new shares are issued, have a minimum exercise price equal to the higher of (i) the market price of our shares calculated pursuant to the method under the Inheritance and Gift Tax Law and (ii) the par value of our shares, and in other cases, have a minimum exercise price equal to or higher than the market price of our shares calculated pursuant to the method under the Inheritance and Gift Tax Law.
 
  •  Stock options can vest after two years from the stock option grant date and can be exercised up to five years from the vesting date. The stock option may be cancelled by a resolution of our board of directors if (i) the officer or employee who holds the option voluntarily resigns or is discharged from office prior to the vesting date; (ii) the officer or employee who holds the option causes material damage to us by willful misconduct or negligence; (iii) we are unable to deliver our shares or pay the prescribed amount due to bankruptcy or dissolution, or (iv) the occurrence of any cause for cancellation of stock options specified in the stock option agreement.
 
On December 24, 2004, our shareholders approved the implementation of our employee stock option plan and the granting of stock options under this plan to our directors, officers and employees.
 
Each stock option confers the right on the grantee to purchase one share of our common stock at the exercise price. The exercise price for these stock options is, in the case of some senior employees, Won 55,431 per share, representing the price per share of our common shares (or ADS equivalent) offered to the public in our initial public offering of February 2005, and in the case of all other eligible employees, Won 45,431 per share, representing the price per share offered to the public less Won 10,000 per share. A total of 122,670 shares of stock options were outstanding, representing 1.77% of our total number of shares issued as of December 31, 2006, consisting of (i) 9,000 shares issued to directors and officers and (ii) 113,670 shares issued to a total of 145 eligible employees.


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None of our current directors or executive officers has options to purchase our common shares.
 
ITEM 7.   MAJOR SHAREHOLDERS AND RELATED PARTY TRANSACTIONS
 
7.A.  Major Shareholders
 
The following table sets forth information known to us with respect to the beneficial ownership of our common shares as of May 31, 2007, by each person known to us to own beneficially 5% or more of our common shares based on 6,948,000 of our common shares outstanding. None of our common shares entitles the holder to any preferential voting rights. Beneficial ownership is determined in accordance with the rules of the Securities Exchange Commission, and includes the power to direct the voting or the disposition of the securities or to receive the economic benefit of the ownership of the securities.
 
                 
    Number of
       
    Shares
    Percentage
 
    Beneficially
    Beneficially
 
Name
  Owned     Owned  
 
EZER, Inc.(1)
    3,640,619       52.4 %
Ramius Capital Group, L.L.C.(2)
    642,772       9.2 %
Moon Capital Master Fund Ltd.(3)
    590,896       8.5 %
Government of Singapore Investment Corporation Pte Ltd(4)
    416,541       6.0 %
LaGrange Capital Administration, L.L.C.(5)
    349,770       5.0 %
 
 
Notes:
 
(1) On August 30, 2005, Mr. Jung Ryool Kim, our former controlling shareholder and Chairman, sold all of our shares that Mr. Kim and his family members owned to EZER Inc., a Japanese Company (“EZER”), pursuant to a stock purchase agreement by and among Jung Ryool Kim, Ji Young Kim, Young Joon Kim, Ji Yoon Kim and EZER dated August 30, 2005. Pursuant to the share sale transaction, EZER became our largest shareholder. EZER, which is 100% owned by our Chairman and CEO, Il Young Ryu, is the operator of an investment fund established pursuant to a contractual relationship known in Japan as a “tokumei kumiai” (“TK Relationship”) with Techno Groove, Inc. a Japanese company and a wholly-owned subsidiary of Asian Groove, Inc., a Japanese company (“Asian Groove”). The TK Relationship, which is governed by the Commercial Code of Japan, is used in Japan as a means of making and managing investments, and under the investment fund agreement for the TK Relationship (the “TK Agreement”), EZER acts as the operator of a fund, established in Japan under the name of “Asian Star Fund,” using the capital contribution made by Techno Groove as an investor in the fund. Asian Star Fund was established for the sole purpose of investing in our shares.
 
In accordance with a Schedule 13/D filed by Techno Grove, among others, their investment in the Asian Star Fund was financed through a loan from Son Assets Management Inc. (“SAM”), a Japanese company, in the amount of Japanese Yen 40 billion. In exchange, Asian Groove, a Japanese company and the parent company of Techno Groove, pledged all of its shares of GungHo Entertainment Online, Inc. (“GungHo”) in custody with Techno Groove, which in turn pledged such shares to SAM.
 
Under the terms of the TK Agreement, EZER, as the operator of Asian Star Fund, exercises the sole right, with respect to ownership and voting right of common shares of companies invested in by the Asian Star Fund. Asian Star Fund’s sole investment is in our shares. Techno Groove has no voting or investment power with respect to the securities held by Asian Star Fund. The term of the TK is one year, subject to automatic one-year renewals, unless terminated by either party upon three months prior notice. Upon such termination, the assets of Asian Star Fund must be distributed to Techno Groove by EZER.
 
We have in the ordinary course of business, entered into various contracts with GungHo. See Item 4.B. “Information on the Company — Business Overview — Our markets — Overseas markets” and Item 10.C. “Additional Information — Material Contracts.”
 
(2) As reported in Schedule 13D/A filed on November 20, 2006. Consists of shares beneficially owned by Starboard Value and Opportunity Master Fund Ltd., Parche LLC, RCG Ambrose Master Fund, Ltd., RCG Halifax Fund, Ltd., Ramius Master Fund, Ltd., Admiral Advisors, LLC, Ramius Advisors, LLC, Safe Harbor


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Master Fund, L.P., Safe Harbor Investment Ltd., Ramius Capital Group, L.L.C., C4S & Co., L.L.C.,Peter A. Cohen, Morgan B. Stark, Thomas W. Strauss and Jeffrey M. Solomon.
 
(3) As reported in a Schedule 13D/A filed on November 20, 2006. Consists of shares beneficially owned by Moon Capital Master Fund Ltd., Moon Capital Leveraged Master Fund Ltd., Moon Capital Management LP, JWM Capital LLC and John W. Moon.
 
(4) As reported in Schedule 13G/A filed on January 18, 2006. Consists of shares beneficially owned by Government of Singapore Investment Corporation Pte Ltd., Government of Singapore and Monetary Authority of Singapore.
 
(5) As reported in Schedule 13G filed on February 5, 2007. Consists of shares beneficially owned by LaGrange Capital Partners, L.P., LaGrange Capital Partners Offshore Fund, Ltd., LaGrange Capital Administration, L.L.C. and Frank LaGrange Johnson.
 
To the best of our knowledge, as of December 31, 2006, approximately 42.4% of our common shares were held in the United States (in the form of common shares or ADSs). Also to the best of our knowledge, we had approximately 1,000 beneficial holders of our shares (in the form of ADSs) in the United States as of December 31, 2006.
 
7.B.  Related Party Transactions
 
Until December 31, 2005, we leased our headquarters space from Mr. Jung Ryool Kim, our former largest shareholder and chairman, at a monthly rent of Won 33 million and a monthly management fee of approximately Won 20 million, together with a security deposit of Won 3.8 billion. Under customary practice in Korea, the security deposit refers to a lump-sum refundable deposit, which essentially has the economics of an interest-free loan, that the lessee gives to the lessor at the beginning of the lease term in exchange for an elimination or reduction of periodic rental payments. At the end of the lease term, the security deposit is returned to the lessee. Normally, the amount of the security deposit is significantly greater than the monthly rent and therefore is entitled to protection under Korean law in order for the lessee to secure refund of the security deposit from the lessor. In order to secure the return of the security deposit, we have obtained and registered a security interest in the leased building under Korean law. This lease was entered into on August 1, 2004 and terminated on December 31, 2005.
 
Upon EZER’s purchase of our shares owned by the former Chairman and his family on August 30, 2005, we no longer consider the former Chairman to be a related party of Gravity. We have not, in any event, entered into any material agreements with the former Chairman or his family members subsequent to such change of control.
 
Relationship with GRAVITY Interactive, Inc.
 
In April 2003, we entered into an agreement with GRAVITY Interactive, Inc., formerly known as Gravity Interactive, LLC, for the service and distribution of Ragnarok Online in the United States and Canada pursuant to which GRAVITY Interactive, Inc. agreed to remit dividends to us based on a percentage of earnings. After Gravity Interactive changed their form as incorporated company in January 2006, GRAVITY Interactive, Inc. agreed to remit royalty to us instead of dividends.
 
Relationship with GRAVITY Entertainment Corporation and the Animation Production Committee