S-1 1 ds1.htm FORM S-1 Form S-1
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As filed with the Securities and Exchange Commission on January 28, 2011

Registration No. 333-            

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM S-1

REGISTRATION STATEMENT

UNDER

THE SECURITIES ACT OF 1933

 

 

SKULLCANDY, INC.

(Exact name of registrant as specified in its charter)

 

Delaware   3651   56-2362196
(State or other jurisdiction of incorporation or organization)   (Primary Standard Industrial Classification Code Number)  

(I.R.S. Employer

Identification No.)

1441 West Ute Boulevard, Suite 250

Park City, Utah 84098

(435) 940-1545

(Address, including zip code, and telephone number, including area code, of the registrant’s principal executive offices)

Mitch Edwards

Chief Financial Officer and General Counsel

Skullcandy, Inc.

1441 West Ute Boulevard, Suite 250

Park City, Utah 84098

(435) 940-1545

(Name, address, including zip code, and telephone number, including area code, of agent for service)

Copies to:

 

Cary K. Hyden

B. Shayne Kennedy

Latham & Watkins LLP

650 Town Center Drive, 20th Floor

Costa Mesa, California 92626

(714) 540-1235

 

John D. Wilson

Shearman & Sterling LLP

525 Market Street, 15th Floor

San Francisco, California 94105

(415) 616-1100

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

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

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

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

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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

¨  Large accelerated filer

   ¨  Accelerated filer      x   Non-accelerated filer       ¨   Smaller reporting company   

CALCULATION OF REGISTRATION FEE

 

 

Title of each Class of

Securities to be Registered

 

Proposed Maximum
Aggregate

Offering Price(a)

  Amount of
Registration Fee

Common stock, $0.0001 par value

  $125,000,000   $14,513
 
 
(a) Estimated solely for the purpose of calculating the registration fee in accordance with Rule 457(o) promulgated under the Securities Act of 1933.

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

 

 

 


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

 

SUBJECT TO COMPLETION, DATED JANUARY 28, 2011

PROSPECTUS

             Shares

LOGO

This is the initial public offering of Skullcandy, Inc. common stock. We are selling              shares of our common stock and the selling stockholders identified in this prospectus are selling an additional              shares of common stock. We will not receive any proceeds from the sale of shares by the selling stockholders.

We expect the public offering price to be between $             and $             per share. After the pricing of the offering, we expect that the shares will trade on The Nasdaq Global Market under the symbol “SKUL.”

Investing in our common stock involves risks. See “Risk Factors” beginning on page 8.

 

 

 

       Per Share        Total  

Public offering price

   $                    $                

Underwriting discount

   $         $     

Proceeds, before expenses, to us

   $         $     

Proceeds, before expenses, to selling stockholders

   $         $     

Certain of the selling stockholders have granted the underwriters a 30-day option to purchase up to an additional              shares at the public offering price less the underwriting discounts and commissions.

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

The shares will be ready for delivery on or about                     , 2011.

 

 

 

BofA Merrill Lynch    Morgan Stanley

 

 

                    , 2011


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TABLE OF CONTENTS

 

     Page  

Prospectus Summary

     1   

Risk Factors

     8   

Special Note Regarding Forward-Looking Statements

     22   

Use of Proceeds

     23   

Dividend Policy

     24   

Capitalization

     25   

Dilution

     27   

Selected Consolidated Financial Data

     29   

Management’s Discussion and Analysis of Financial Condition and Results of Operations

     31   

Business

     44   

Management

     55   

Compensation Discussion and Analysis

     59   

Principal and Selling Stockholders

     81   

Certain Relationships and Related Party Transactions

     83   

Description of Capital Stock

     89   

Description of Certain Indebtedness

     93   

Shares Eligible for Future Sale

     95   

Material U.S. Federal Tax Considerations for Non-U.S. Holders of our Common Stock

     97   

Underwriting

     101   

Validity of Common Stock

     108   

Experts

     108   

Where You Can Find More Information

     108   

Index to Consolidated Financial Statements

     F-1   

 

 

You should rely only on the information contained in this prospectus and any free writing prospectus prepared by or on behalf of us that we have referred to you. We and the selling stockholders have not, and the underwriters have not, authorized anyone to provide you with additional or different information from that contained in this prospectus. If anyone provides you with additional, different or inconsistent information, you should not rely on it. We and the selling stockholders are offering to sell, and seeking offers to buy, shares of our common stock only in jurisdictions where offers and sales are permitted.

 

 

 

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PROSPECTUS SUMMARY

This summary highlights information contained elsewhere in this prospectus. Because this is only a summary, it does not contain all of the information that may be important to you. You should read this entire prospectus and should consider, among other things, the matters set forth under “Risk Factors,” “Selected Consolidated Financial Data,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and related notes thereto appearing elsewhere in this prospectus before making your investment decision.

LOGO

Our Company

Skullcandy is a leading audio brand that reflects the collision of the music, fashion and action sports lifestyles. Our brand symbolizes youth and rebellion, and embodies our motto, “Every revolution needs a soundtrack.” We believe we have revolutionized the headphone market by stylizing a previously-commoditized product and capitalizing on the increasing pervasiveness, portability and personalization of music. The Skullcandy name and distinctive logo have rapidly become icons and contributed to our leading market position, robust net sales growth and strong profitability and return on our invested capital. We increased our net sales from $9.1 million in 2006 to $118.3 million in 2009, representing a compound annual growth rate of approximately 135%.

We are a company founded on innovation. After our 2003 introduction of Link Technology, a revolutionary product that integrated mobile phones and personal media devices, we began offering headphones with cutting-edge technology by introducing the Skullcrusher, an amplified subwoofer-enhanced headphone. We redefined the headphone market by fusing bold color schemes, loud patterns, unique materials and creative packaging with the latest audio technologies and innovative functionalities. We offer a wide array of styles and price points and are expanding into complementary audio products and accessories.

We pioneered the distribution of headphones in specialty retailers focused on action sports and the youth lifestyle. Through this channel we have reached influencers, core consumers who helped establish the credibility and authenticity of our brand. Building on this foundation, we have successfully expanded our distribution to select consumer electronics, mass, sporting goods and mobile phone retailers. Skullcandy products are sold in the United States, as well as in more than 70 other countries around the world and through our website.

Rick Alden, the creator of several successful action sports companies and a lifelong industry enthusiast, founded Skullcandy in 2003. Rick has recruited a talented management team that shares his passion for the Skullcandy lifestyle. Our principal offices are located in Park City, Utah and San Clemente, California, which are at the epicenters of some of the best snow peaks, skate parks and surf breaks in the world. We believe these close connections to the Skullcandy lifestyle strengthen the authenticity of our brand and increase the loyalty of our consumers.

Market Opportunity

We believe the increasing use of portable media devices and smartphones, and the growing popularity of action sports, support our anticipated long-term sales growth.

The advent of portable media devices, such as Apple’s iPod, transformed the consumer electronics industry by dramatically increasing the portability and personalization of music, fueling an increased pervasiveness of

 

 

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these devices and their associated accessories, such as headphones. This transformation has continued as mobile phones have evolved into smartphones, capable of playing music and videos. IDC Research estimates that the total number of smartphones available worldwide will increase by a compound annual growth rate of 24% from 2010 through 2014, and that in 2010 alone, the total number of smartphones increased by 69% over 2009. This rapid growth is dramatically expanding the demand for headphones, especially ones with added functionality such as in-line microphones and volume controls. In addition, we believe consumers tend to own multiple sets of headphones and replace them frequently.

Our brand also benefits from the increasing popularity of action sports, particularly within the youth culture. Our core consumers, teens and young adults that associate themselves with snowboarding, skateboarding, surfing and other action sports, influence a broader consumer base that identifies with authentic action sports lifestyle brands. In addition, music is an integral part of the action sports lifestyle and headphones have become an accessory worn to express individuality.

Our Competitive Strengths

We believe that the following strengths differentiate us from our competitors, allow us to take advantage of the large and growing market we participate in and enable us to generate a strong return on our invested capital:

Leading, Authentic Lifestyle Brand. Skullcandy fuses music, fashion and action sports, all of which permeate youth culture. We believe the power of our brand has driven our strong market share. According to The NPD Group’s Retail Tracking Service, we held the #2 position domestically in headphones based on unit and dollar sales in 2010, behind only Sony.

Brand Authenticity Reinforced Through High Impact Sponsorships. We believe we were the first headphone brand to sponsor leading athletes, DJs, musicians, artists and events within action sports and the indie and hip-hop music genres. We believe this has increased our brand awareness and reinforced our credibility with our target consumers.

Track Record of Innovative Product Design. Our company was founded on innovation, and we employ innovative materials, technologies and processes in the design and development of our products. In addition, we leverage our relationships with sponsored athletes, DJs, musicians and artists to incorporate their ideas into our designs to enhance our products.

Targeted Distribution Model. We control the distribution and mix of our products to protect our brand and enhance its authenticity. We pioneered the distribution of headphones in specialty retailers focused on action sports and the youth lifestyle. Building on this foundation, we have successfully expanded our distribution to select consumer electronics, mass, sporting goods and mobile phone retailers.

Proven Management Team and Deep-Rooted Company Culture. Rick Alden, our founder and chief executive officer, has over 20 years of experience as a successful entrepreneur in the action sports industry. Rick has recruited a talented management team that shares his passion for action sports and music, and that possesses substantial experience in product development, marketing, merchandising, operations and finance. Our culture and brand image enable us to successfully attract and retain highly talented employees who share our passion for action sports and music and understand our target market in an authentic and credible way.

Growth Strategy

We intend to build upon our brand authenticity and product offering to continue to increase our net sales and profitability. Key elements of our growth strategy are to:

Further Penetrate Domestic Retail Channel. We plan to increase shelf space with our existing retailers and add select new specialty, consumer electronics, mass, sporting goods and mobile phone retailers to our customer

 

 

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base. In addition, we intend to increase the number of innovative in-store product displays and brand-building fixtures to emphasize our association with the action sports and the indie and hip-hop music lifestyles, and expand our online and in-store sales force training programs.

Accelerate Our International Growth. We currently sell our products internationally through third party distributors and believe that international expansion represents a substantial growth opportunity. We plan to replicate elements of our successful domestic marketing model by sponsoring internationally-based athletes, DJs, musicians, artists and events, and by creating localized marketing content to drive sales.

Grow Our Premium Product Offering. To date, the vast majority of our products have been priced in the $10 to $70 range. With our recently introduced $150 Aviator headphones and $250 Mix Master headphones, we have begun to expand our premium headphone offering and believe we can increase our share of this growing market. By offering premium products, we believe we can further strengthen our brand and broaden our reach to consumers with greater discretionary income.

Expand Complementary Product Categories. We have successfully tested and now plan to build more robust product assortments in certain complementary categories. For example, we plan to launch two new speaker dock models in the summer of 2011, increase our offering of protective cases for mobile devices, and introduce several gaming and mobile phone headphones that are currently in various stages of development.

Increase Our Online Sales. We plan to further engage our consumers and drive sales by adding, optimizing and broadening the content we offer through our interactive platforms. We believe our new content will allow us to dynamically interact with our loyal fan base, provide customized shopping experiences and drive our online sales. In addition, we plan to launch select international websites with localized content and e-commerce functionality.

Risks Related to Our Business

Investing in our common stock involves substantial risk. You should carefully consider all of the information in this prospectus prior to investing in our common stock. There are important risks related to our business that are described under “Risk Factors” elsewhere in this prospectus. Among these risks are the following:

 

   

If our design and marketing efforts do not effectively extend the recognition and reputation of our brand, we may not be able to successfully implement our growth strategy;

 

   

If we are unable to continue to develop innovative and popular products, our brand image may be harmed and demand for our products may decrease;

 

   

Our manufacturing is concentrated with two key manufacturers, and if our relationship with either or both of them terminates or is otherwise impaired, we would likely experience increased costs, disruptions in the manufacture and shipment of our products and a material loss of net sales;

 

   

We may be unable to sustain our past growth or manage our future growth, which may have a material adverse effect on our future operating results;

 

   

If we are unable to maintain and expand our network of sponsored athletes, DJs, musicians and artists, our ability to market and sell our products may be harmed; and

 

   

Our plans to grow our international business may require significant operating expenditures, but such expenditures may not result in increased net sales.

 

 

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Corporate Information

We were incorporated in Delaware in 2003. Our principal executive offices are located at 1441 West Ute Boulevard, Suite 250, Park City, Utah 84098, and our telephone number is (435) 940-1545. Our principal website address is www.skullcandy.com. Information contained on our website does not constitute part of, and is not incorporated by reference into, this prospectus.

This prospectus contains references to our trademarks Skullcandy®, Ink’d®, 2XL® and our skull logo LOGO . All other trademarks or tradenames referred to in this prospectus are the property of their respective owners.

 

 

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The Offering

 

Common stock offered by us

            shares

 

Common stock offered by selling stockholders

            shares

 

Common stock outstanding after this offering

            shares

 

Over-allotment option

The underwriters have a 30-day option to purchase up to an additional             shares from certain selling stockholders at the initial public offering price less the underwriting discounts and commissions.

 

Use of proceeds

We intend to use the net proceeds from the sale of shares by us to repay certain indebtedness and for working capital and other general corporate purposes. We will not receive any proceeds from shares sold by the selling stockholders. See “Use of Proceeds.”

 

Proposed Nasdaq ticker symbol

“SKUL”

Unless otherwise noted, the number of shares of our common stock to be outstanding after consummation of this offering is based on 1,610,932 shares outstanding as of December 31, 2010, and excludes:

 

   

239,875 shares of common stock issuable upon the exercise of options outstanding as of December 31, 2010 at a weighted average exercise price of $113.04 per share;

 

   

1,833 shares of restricted stock that were subject to a right of repurchase by us as of December 31, 2010; and

 

   

            shares of common stock reserved for future issuance under our employee benefit plans, plus annual scheduled increases in the number of shares reserved for issuance under our 2011 incentive award plan.

Unless we specifically state otherwise, all information in this prospectus assumes:

 

   

no exercise of the underwriters’ over-allotment option;

 

   

the automatic conversion of all of our outstanding shares of preferred stock into 321,980 shares of common stock upon the consummation of this offering;

 

   

the conversion of our convertible note into 275,866 shares of common stock upon the consummation of this offering; and

 

   

a         -for-         stock split of our outstanding common stock and preferred stock, which we intend to effect prior to the consummation of this offering.

 

 

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Summary Consolidated Financial Data

The following table sets forth a summary of our historical consolidated financial data for the periods ended or as of the dates indicated. We have derived the consolidated statements of operations data for the years ended December 31, 2007, 2008 and 2009 from our audited consolidated financial statements appearing elsewhere in this prospectus. We have derived the consolidated statements of operations data for the nine months ended September 30, 2009 and 2010 and the balance sheet data as of September 30, 2010 from our unaudited interim financial statements appearing elsewhere in this prospectus. This unaudited interim financial information has been prepared on the same basis as our audited annual consolidated financial statements and, in our opinion, reflects all adjustments, consisting only of normal recurring adjustments, that we consider necessary for a fair presentation of our financial position as of September 30, 2010 and operating results for the periods ended September 30, 2009 and 2010. The summary consolidated financial data in this section is not intended to replace our consolidated financial statements and the accompanying notes. Our historical results are not necessarily indicative of our future results. You should read this table together with our consolidated financial statements and the related notes thereto, “Selected Consolidated Financial Data” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” appearing elsewhere in this prospectus.

 

     Year ended December 31,     Nine months ended
September 30,
 
     2007     2008     2009     2009     2010  
     (in thousands, except share and per share data)  

Consolidated Statements of Operations Data:

          

Net sales

   $ 35,346      $ 80,380      $ 118,312      $ 70,712      $ 95,940   

Cost of goods sold

     18,162        41,120        60,847        36,654        46,629   
                                        

Gross profit

     17,184        39,260        57,465        34,058        49,311   

Selling, general and administrative expenses

     7,350        18,040        27,042        18,701        30,206   
                                        

Income from operations

     9,834        21,220        30,423        15,357        19,105   

Other (income) expense

     (13     (54     (111     (113     14   

Interest expense

     91        586        8,874        6,534        6,559   
                                        

Income before income taxes

     9,756        20,688        21,660        8,936        12,532   

Income taxes

     3,498        7,669        8,120        3,368        4,887   
                                        

Net income

     6,258        13,019        13,540        5,568        7,645   

Deemed dividend on redemption of Series A and Series B redeemable convertible preferred stock

                   (9,993     (9,993       
                                        

Net income (loss) available to common stockholders

   $ 6,258      $ 13,019      $ 3,547      $ (4,425   $ 7,645   
                                        

Net income (loss) per share:

          

Basic

   $ 5.65      $ 10.75      $ 3.57      $ (4.43   $ 7.67   

Diluted

     3.97        7.36        2.54        (4.43     5.57   

Weighted average shares outstanding

          

Basic

     1,106,610        1,211,074        993,444        998,191        996,731   

Diluted

     1,575,710        1,769,050        1,398,919        998,191        1,372,501   

Pro forma net income per share (unaudited):(1)

          

Basic

       $
10.63
  
    $
6.36
  

Diluted

         10.10          6.15   

Pro forma weighted average common shares outstanding (unaudited):

          

Basic

         1,597,918          1,594,577   

Diluted

         1,681,414          1,648,367   

 

 

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     As of September 30, 2010  
     Actual     Pro forma(2),(3)      Pro forma as
adjusted(4)
 
     (in thousands)  

Consolidated Balance Sheet Data:

  

Cash and cash equivalents

   $ 2,271      $ —         $                

Working capital

     25,750        22,999      

Total assets

     61,987        57,128      

Total debt

     49,661        18,582      

Series A and B redeemable convertible preferred stock

     2,388        —        

Total stockholders’ equity (deficit)

     (8,931     19,197      

 

(1) Please see note 2 to our audited consolidated financial statements included elsewhere in this prospectus for an explanation of the method used to calculate basic and diluted pro forma net income per share for the year ended December 31, 2009. Please see note 2 to our interim condensed consolidated financial statements included elsewhere in this prospectus for an explanation of the method used to calculate basic and diluted pro forma net income per share for nine months ended September 30, 2010.

 

(2) Our convertible note bears interest at 15% per annum, 5% of which is paid in cash and 10% of which is accrued and added to the principal balance on a quarterly basis. Upon conversion, the portion of the principal balance attributable to accrued interest must be paid in cash. The pro forma columns reflect our payment of $2.8 million accrued and unpaid cash interest as of September 30, 2010 and the reduction of deferred debt issuance costs and debt discounts related to the convertible note.

 

(3) The pro forma balance sheet data gives effect to the conversion of (i) all of our outstanding shares of preferred stock into 321,980 shares of common stock and (ii) the conversion of the convertible note into 275,866 shares of common stock.

 

(4) The pro forma as adjusted balance sheet data gives effect to the conversion of preferred stock and the convertible note, the sale of             shares of common stock in this offering at an assumed initial public offering price of $             per share, which is the midpoint of the price range set forth on the cover page of this prospectus, and the application of the net proceeds as described in “Use of Proceeds,” after deducting underwriting discounts and commissions and estimated offering expenses payable by us. A $1.00 increase (decrease) in the assumed initial public offering price of $             per share, which is the midpoint of the price range set forth on the cover page of this prospectus, would increase (decrease), as applicable, our pro forma as adjusted cash and cash equivalents, working capital, total assets and stockholders’ equity by approximately $             million, assuming that the number of shares offered by us, as set forth on the cover page of this prospectus, remains the same and after deducting the underwriting discounts and commissions and estimated offering expenses payable by us. A 1.0 million increase (decrease) in the number of shares offered by us would increase (decrease) our pro forma as adjusted cash and cash equivalents, working capital, total assets and stockholders’ equity by approximately $             million, assuming an initial public offering price of $                 per share, which is the midpoint of the price range set forth on the cover of this prospectus, and after deducting the underwriting discounts and commissions and estimated offering expenses payable by us. The pro forma as adjusted information discussed above is illustrative only and will be adjusted based on the actual public offering price and terms of this offering determined at pricing.

 

 

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RISK FACTORS

An investment in our common stock involves a high degree of risk. You should consider carefully the following risks and other information contained in this prospectus before you decide whether to buy our common stock. If any of the events contemplated by the following discussion of risks should occur, our business, results of operations and financial condition could suffer significantly. As a result, the market price of our common stock could decline, and you may lose all or part of your investment in our common stock.

Risks Related to Our Business

If our design and marketing efforts do not effectively extend the recognition and reputation of our brand, we may not be able to successfully implement our growth strategy.

We believe that our ability to extend the recognition and favorable perception of our brand is critical to implement our growth strategy, which includes further penetrating our domestic retail channel, accelerating our international growth, growing our premium product offering, expanding complementary product categories and increasing our online sales. To extend the reach of our brand, we believe we must devote significant time and resources to product design, marketing and promotions. These expenditures, however, may not result in a sufficient increase in net sales to cover such expenses.

Furthermore, we must balance our growth with the effect it has on the authenticity of our brand. For example, our credibility and brand image could be weakened if our core consumers perceive our distribution channels to be too broad or our retailers to not fit with our lifestyle image. Similarly, the introduction of new, low cost product lines, such as our 2XL headphones, may cause our consumers to perceive a decrease in the authenticity or quality of our products. If any of these events occur, our consumer base and our net sales may decline and we may not be able to successfully implement our growth strategy.

If we are unable to continue to develop innovative and popular products, our brand image may be harmed and demand for our products may decrease.

The consumer electronics and action sports lifestyle are subject to constantly and rapidly changing consumer preferences based on industry trends and performance features. Our success depends largely on our ability to anticipate, gauge and respond to these changing consumer preferences and trends in a timely manner, while preserving and strengthening the perception and authenticity of our brand. We must continue to develop innovative, trend-setting and stylish products that provide better design and performance attributes than the products of our competitors. Market acceptance of new designs and products is subject to uncertainty and we cannot assure you that our efforts will be successful. For example, our growth strategy includes growing our premium product offering, which may not achieve broad market acceptance. The inability of new product designs or new product lines to gain market acceptance could adversely affect our brand image, our business and financial condition. Achieving market acceptance for new products may also require substantial marketing efforts and expenditures to increase consumer demand, which could constrain our management, financial and operational resources. If new products we introduce do not experience broad market acceptance, our net sales and market share could decline.

Our manufacturing is concentrated with two key manufacturers, and if our relationship with either or both of them terminates or is otherwise impaired, we would likely experience increased costs, disruptions in the manufacture and shipment of our products and a material loss of net sales.

We have no long-term contracts with our manufacturers and as a result, our manufacturers could cease to provide products to us with little or no notice. Two of our manufacturers together accounted for 72% of our cost of goods sold in 2009 and 73% of our cost of goods sold for the nine months ended September 30, 2010. Each of these manufacturers is the sole source supplier for the products that it produces. A loss of either or both of these

 

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manufacturers or other key manufacturers would result in delayed deliveries to our retailers and distributors, would adversely impact our net sales and may require the establishment of new manufacturing relationships. Additionally, we cannot be certain that we will not experience operational difficulties with our manufacturers, including reductions in the availability of production capacity, errors in complying with product specifications, insufficient quality control, failures to meet production deadlines, increases in manufacturing costs and increased lead times. For example, during the first half of 2010, we experienced increased lead times from a majority of our manufacturers in China.

We have recently created a manufacturer selection and qualification program and are actively looking for new manufacturing sources in other countries and other regions of China. Qualifying new manufacturing sources may result in increased costs, disruptions and delays in the manufacture and shipment of our products while seeking alternative manufacturing sources, and a corresponding loss of net sales. In addition, any new manufacturer may not perform to our expectations or produce quality products in a timely, cost-efficient manner, either of which could make it difficult for us to meet our retailers’ and distributors’ orders on satisfactory commercial terms.

Moreover, certain natural disasters or outbreaks of illnesses could halt or disrupt production at the affected facilities, delay the completion of orders, cause the cancellation of orders, delay the introduction of new products or cause us to miss a selling season applicable to some of our products. The failure of any manufacturer to perform to our expectations could result in supply shortages or delivery delays, either of which could harm our business.

We may be unable to sustain our past growth or manage our future growth, which may have a material adverse effect on our future operating results.

We have experienced rapid growth since our inception in 2003. We increased our net sales from $9.1 million in 2006 to $118.3 million in 2009, and from $70.7 million for the nine months ended September 30, 2009 to $95.9 million for the nine months ended September 30, 2010. Our future success will depend upon various factors, including the strength of our brand image, broad market acceptance of our current and future products, competitive conditions, our ability to manage increased net sales, if any, the implementation of our growth strategy and our ability to manage our anticipated growth. We intend to finance our anticipated growth through cash flows generated from sales to our existing retailers and distributors, borrowings under our credit facility and the net proceeds from this offering. However, if our net sales decline, we may not have the cash flow necessary to pursue our growth strategy.

We anticipate significantly expanding our infrastructure and adding personnel, particularly in our legal and finance departments, which will cause our selling, general and administrative expenses to increase in absolute dollars and which may cause our selling, general and administrative expenses to increase as a percentage of net sales. Because these expenses are generally fixed, particularly in the short-term, if we do not achieve our anticipated growth, our operating results may be adversely impacted. If we continue to experience growth in our operations, our operational, administrative, financial and legal procedures and controls may need to be expanded. As a result, we may need to train and manage an increasing number of employees, which could distract our management team from our business plan. Our future success will depend substantially on our ability to manage our anticipated growth. If we are unable to anticipate or manage our growth effectively, our operating results could be adversely affected.

If we are unable to maintain and expand our network of sponsored athletes, DJs, musicians and artists, our ability to market and sell our products may be harmed.

A key element of our marketing strategy has been to sponsor best-in-class athletes, DJs, musicians and artists, which we believe contributes to our authenticity and brand image. We do not have contractual relationships with the majority of our sponsored athletes, DJs, musicians and artists, and we cannot assure you that they will continue to support our brand or that they will not support one of our competitors.

 

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We compensate the sponsored athletes, DJs, musicians and artists that we do have contracts with for promoting our products. Sponsorship arrangements are typically structured to give our sponsored team members financial incentives to maintain a highly visible profile with our products. Our contracts typically have a one year term, with some providing for a two year term, and grant us an unlimited license for the use of their names and likenesses, and typically require them to maintain exclusive association with our headphones. In turn, we agree to make cash payments to our sponsored team members for wearing our products during various public appearances, in magazine shoots and on the podium after certain competitive victories. In addition to cash payments, we also generally provide limited free products for their use, and reimburse certain travel expenses incurred in conjunction with promoting our products.

We cannot assure you that we will be able to maintain our existing relationships with any of our sponsored team members in the future or that we will be able to attract new athletes, DJs, musicians or artists to endorse our products. Additionally, certain competitors with greater access to capital may increase the cost for these relationships to levels we may choose not to match. If this were to occur, our sponsored team members may terminate their relationships with us and endorse our competitors’ products, and we may be unable to obtain endorsements from other comparable individuals.

We may also select individuals who are unable to perform at expected levels or who do not maintain the level of recognition we expect. Negative publicity concerning any of our athletes, DJs, musicians or artists could harm our brand and adversely impact our net sales. If we are unable to secure prominent athletes, DJs, musicians and artists and arrange endorsements of our products on terms we deem to be reasonable, we may be required to modify our marketing platform and to rely more heavily on other forms of marketing and promotion, which may not prove to be as effective.

Our plans to grow our international business may require significant operating expenditures, but such expenditures may not result in increased net sales.

We believe that our success in international markets is partially dependent on being “locally” relevant, but we have limited experience with the action sports and youth lifestyle in Europe and Asia. We plan to identify the best-in-class internationally-based athletes, DJs, musicians and artists that will best represent our lifestyle brand and arrange for such persons to endorse our products. We also plan to launch websites in Europe and Asia which will be available in the local language with local content and expect that our products will have region-specific packaging that we believe will help sell through of our products. Each of these efforts will require significant management time and resources, and we cannot assure you that we will be successful in expanding our brand in international markets.

In addition, our European distribution is controlled by a third party over which we have limited control. Our distribution relationship is governed by an exclusive agreement with 57 North which terminates in 2013. For the nine months ended September 30, 2010, 57 North accounted for more than 10% of our net sales. In September 2009, we entered into an arbitration proceeding with 57 North as a result of certain disputes regarding the terms governing our distribution agreement. During the arbitration process, sales to Europe declined as a result of the uncertainty surrounding our relationship with 57 North. The arbitration process was resolved in the third quarter of 2010, and we are working aggressively with 57 North to expand our European sales. We cannot assure you these efforts will be successful. Moreover, an unanticipated termination of our agreement with 57 North or further disputes with 57 North or any other current or future distributor may have an adverse effect on our international growth.

Over time, we plan to assume direct control of certain international markets, which will require increased operating expenditures to establish the infrastructure. We have limited experience with international distribution and we cannot assure you that we will manage it successfully. If we are not able to manage our international distribution efficiently, our international retailers and distributors may experience delays in receipt of our products and we may have to find alternate distribution arrangements, which could result in increased expenditures and a reduction in margins.

 

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Two of our retailers account for a significant amount of our net sales, and the loss of, or reduced purchases from, these or other retailers could have a material adverse effect on our operating results.

Target and Best Buy each accounted for more than 10% of our net sales in 2009. We do not have long-term contracts with any of our retailers, including Target and Best Buy, and all of our retailers generally purchase from us on a purchase order basis. As a result, these retailers generally may, with little or no notice or penalty, cease ordering and selling our products, or materially reduce their orders. If certain retailers, including Target or Best Buy, individually or in the aggregate, choose to no longer sell our products, to slow their rate of purchase of our products or to decrease the number of products they purchase, our results of operations would be adversely affected.

We may not be able to compete effectively, which could cause our net sales and market share to decline.

The consumer electronics industry is highly competitive and includes many new competitors as well as increased competition from established companies expanding their product portfolio. We face competition from large consumer electronics brands that have historically dominated the stereo headphone market. These include large companies with strong worldwide brand recognition, such as Sony, JVC and Bose. These competitors have significant competitive advantages, including greater financial, distribution, marketing and other resources, longer operating histories, better brand recognition among certain groups of consumers, and greater economies of scale. In addition, these competitors have long-term relationships with many of our larger retailers that are potentially more important to those retailers. As a result, these competitors may be better equipped to influence consumer preferences or otherwise increase their market share by:

 

   

quickly adapting to changes in consumer preferences;

 

   

readily taking advantage of acquisition and other opportunities;

 

   

discounting excess inventory that has been written down or written off;

 

   

devoting greater resources to the marketing and sale of their products, including significant advertising, media placement and product endorsement;

 

   

adopting aggressive pricing policies; and

 

   

engaging in lengthy and costly intellectual property and other disputes.

Well established sports brand companies, such as adidas and Nike, have also recently introduced headphone products. Similar to the large electronic companies we compete with, these sport brand companies have significant competitive advantages, including greater financial, distribution, marketing and other resources, longer operating histories, better brand recognition among certain groups of consumers, and greater economies of scale.

We also face competition from smaller lifestyle brand companies, such as Beats by Dr. Dre and Nixon. These smaller companies have recently introduced products that compete directly with our headphones, while also portraying themselves as a lifestyle brand within the action sports and the indie and hip-hop music markets.

Recently, retailers have begun to introduce their own private label headphones. If any of our retailers introduce such headphones, it could reduce the volume of product they buy from us, as well as decrease the shelf space they allocate to our products. The introduction of private label headphones could decrease the demand for our products and have an adverse effect on our net sales and results of operations.

The industry in which we compete generally has low barriers to entry that allow the introduction of new products or new competitors at a fast pace. If we are unable to protect our brand image and authenticity, while carefully balancing our growth, we may be unable to effectively compete with these new market entrants or new products. The inability to compete effectively against new and existing competitors could have an adverse effect on our net sales and results of operations.

 

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We may be adversely affected by the financial condition of our retailers and distributors.

Some of our retailers and distributors have experienced financial difficulties in the past. A retailer or distributor experiencing such difficulties will generally not purchase and sell as many of our products as it would under normal circumstances and may cancel orders. In addition, a retailer or distributor experiencing financial difficulties generally increases our exposure to uncollectible receivables. We extend credit to our retailers and distributors based on our assessment of their financial condition, generally without requiring collateral. While such credit losses have historically been within our reserves, we cannot assure you that this will continue to be the case. Financial difficulties on the part of our retailers or distributors could have a material adverse effect on our results of operations and financial condition.

Changes in the mix of retailers to whom we distribute our products could impact our gross margin and brand image, which could have a material adverse effect on our results of operations.

We sell our products through a mix of retailers, including specialty, consumer electronics, mass, sporting goods and mobile phone retailers. Any changes to our current mix of retailers could adversely affect our gross margin and could negatively affect both our brand image and our reputation. In addition, we sell certain products at higher margins and any significant changes to our product mix made available to our retailers could adversely affect our gross margin. We generally realize lower gross margins when we sell through our distributors, and therefore our gross margins may be adversely impacted if we increase product sales made through our distributors as opposed to through our retailers. A negative change in our gross margin or our brand image could have a material adverse effect on our results of operations and financial condition.

We face business, political, operational, financial and economic risks because a portion of our net sales are generated internationally and substantially all of our products are manufactured outside of the United States.

In 2009 and the nine months ended September 30, 2010, international sales were $21.1 million, or 29.9% of net sales, and $18.1 million, or 18.9% of net sales, respectively. In addition, substantially all of our products are manufactured in China. As a result, we face business, political, operational, financial and economic risks inherent in international business, many of which are beyond our control, including:

 

   

difficulties obtaining domestic and foreign export, import and other governmental approvals, permits and licenses, and compliance with foreign laws, which could halt, interrupt or delay our operations if we cannot obtain such approvals, permits and licenses, and that could have a material adverse effect on our results of operations;

 

   

difficulties encountered by our international distributors or us in staffing and managing foreign operations or international sales, including higher labor costs, which could increase our expenses and decrease our net sales and profitability;

 

   

transportation delays and difficulties of managing international distribution channels, which could halt, interrupt or delay our operations;

 

   

longer payment cycles for, and greater difficulty collecting, accounts receivable, which could reduce our net sales and harm our financial results;

 

   

trade restrictions, higher tariffs, currency fluctuations or the imposition of additional regulations relating to import or export of our products, especially in China, where substantially all of our products are manufactured, which could force us to seek alternate manufacturing sources or increase our expenses, either of which could have a material adverse effect on our results of operations;

 

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political and economic instability, including wars, terrorism, political unrest, boycotts, curtailment of trade and other business restrictions, any of which could materially and adversely affect our net sales and results of operations; and

 

   

natural disasters, which could have a material adverse effect on our results of operations.

Any of these factors could reduce our net sales, decrease our gross margin or increase our expenses. Should we establish our own operations in international territories where we currently utilize a distributor, we will become subject to greater risks associated with operating outside of the United States.

Any shortage of raw materials or components could impair our ability to ship orders of our products in a cost-efficient manner or could cause us to miss the delivery requirements of our retailers or distributors, which could harm our business.

The ability of our manufacturers to supply our products is dependent, in part, upon the availability of raw materials and certain components. Our manufacturers may experience shortages in the availability of raw materials or components, which could result in delayed delivery of products to us or in increased costs to us. For example, we are dependent on the supply of certain components for our production of iPhone compatible headphones. These components are in high demand and we have experienced supply shortages in the past. Any shortage of raw materials or components or inability to control costs associated with manufacturing could increase the costs for our products or impair our ability to ship orders in a timely cost-efficient manner. As a result, we could experience cancellation of orders, refusal to accept deliveries or a reduction in our prices and margins, any of which could harm our financial performance and results of operations.

Our business could suffer if any of our manufacturers fail to use acceptable labor practices.

We do not control our manufacturers or their labor practices. The violation of labor or other laws by a manufacturer utilized by us, or the divergence of an independent manufacturer’s labor practices from those generally accepted as ethical or legal in the United States, could damage our reputation or disrupt the shipment of finished products to us if such manufacturer is ordered to cease its manufacturing operations due to violations of laws or if such manufacturer’s operations are adversely affected by such failure to use acceptable labor practices. If this were to occur, it could have a material adverse effect on our financial condition and results of operations.

If we experience problems with our distribution network for domestic retailers, our ability to deliver our products to the market could be adversely affected.

We rely on our newly contracted distribution facility in Auburn, Washington, operated by UPS Supply Chain Solutions, for the majority of our domestic product distribution. Our distribution facility utilizes computer controlled and automated equipment, which means the operations are complicated and may be subject to a number of risks related to security or computer viruses, the proper operation of software and hardware, power interruptions or other system failures. In 2011, we expect to contract with UPS Supply Chain Solutions to open additional facilities in Louisville, Kentucky and Shenzhen, China that would utilize the same equipment and would be subject to the same risks. Furthermore, we have a limited history of order fulfillment and inventory management from the Auburn facility and could encounter problems that disrupt our distribution. We maintain business interruption insurance, but it may not adequately protect us from the adverse effects that could be caused by significant disruptions in our distribution facility, such as the long-term loss of retailers or an erosion of our brand image. In addition, our distribution capacity is dependent on the timely performance of services by third parties, including the shipping of product to and from the Auburn facility. If we encounter problems with the Auburn facility, our ability to meet retailer expectations, manage inventory, complete sales and achieve objectives for operating efficiencies could be materially adversely affected.

 

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If we are unable to obtain intellectual property rights and/or enforce those rights against third parties who are violating those rights, our business could suffer.

We rely on various intellectual property rights, including patents, trademarks, trade secrets and trade dress to protect our brand name, reputation, product appearance and technology. If we fail to obtain, maintain, or in some cases enforce our intellectual property rights, our competitors may be able to copy our designs, or use our brand name, trademarks or technology. As a result, if we are unable to successfully protect our intellectual property rights, or resolve any conflicts effectively, our results of operations may be harmed.

We are susceptible to counterfeiting of our products, which may harm our reputation for producing high-quality products and force us to incur expenses in enforcing our intellectual property rights. Such claims and lawsuits can be expensive to resolve, require substantial management time and resources, and may not provide a satisfactory or timely result, any of which would harm our results of operations. It can be particularly difficult and expensive to detect and stop counterfeiting, whether in the United States or abroad. Despite our efforts to enforce our intellectual property, counterfeiters may continue to violate our intellectual property rights by using our trademarks or imitating or copying our products, which could harm our brand, reputation and financial condition. Since our products are sold internationally, we are also dependent on the laws of a range of countries to protect and enforce our intellectual property rights. These laws may not protect intellectual property rights to the same extent or in the same manner as the laws of the United States.

We also face competition from competitors in the United States and abroad that are not “counterfeiters” but that may be using our patented technology, using confusingly similar trademarks, or copying the “look-and-feel” of our products. We may have to engage in expensive and distracting litigation to enforce and defend our patents, trademarks, trade dress, or other intellectual property rights. Our enforcement of our intellectual property rights also places such assets at risk. For example, it is common for a competitor that is accused of infringing a patent, trademark, or other intellectual property right to challenge the validity of that intellectual property right. If that intellectual property right is invalidated, it is no longer available to assert against other competitors. Finally, competitors may also circumvent a patent by designing around the patent.

Further, we are a party to licenses that grant us rights to intellectual property, including trademarks, that are necessary or useful to our business. For example, we license the right to market certain products with the tradenames and imagery of brands such as Paul Frank, the NBA, RocNation and Snoop Dogg. One or more of our licensors may allege that we have breached our license agreement with them, and accordingly seek to terminate our license. If successful, this could result in our loss of the right to use the licensed intellectual property, which could adversely affect our ability to commercialize our technologies or products, as well as harm our competitive business position and our business prospects.

Claims that we violate a third party’s intellectual property rights may give rise to burdensome litigation, result in potential liability for damages or impede our development efforts.

We cannot assure you that our products or activities do not violate the patents or other intellectual property rights of third parties. Patent infringement, trade secret misappropriation and other intellectual property claims and proceedings brought against us, whether successful or not, could result in substantial costs and harm our reputation. Such claims and proceedings can also distract and divert management and key personnel from other tasks important to the success of our business. Examples of such claims include a recently filed action asserting that our speaker docks infringe another company’s design patent and another recently filed action asserting that the hiring and employment of one of our new employees constitutes misappropriation of another company’s trade secrets. In addition, intellectual property litigation could force us to do one or more of the following:

 

   

cease developing, manufacturing, or selling products that incorporate the challenged intellectual property;

 

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obtain and pay for licenses from the holder of the infringed intellectual property right, which licenses may not be available on reasonable terms, or at all;

 

   

redesign or reengineer products;

 

   

change our business processes; and

 

   

pay substantial damages, court costs and attorneys’ fees, including potentially increased damages for any infringement or violation found to be willful.

In the event of an adverse determination in an intellectual property suit or proceeding, or our failure to license essential technology, our sales could be harmed and/or our costs could increase, which could harm our financial condition.

Our current executive officers are critical to our success and the loss of any of these individuals, or other key personnel, could harm our business and brand image.

We are heavily dependent upon the contributions, talent and leadership of our current executive officers, particularly Rick Alden, our founder and chief executive officer, and Jeremy Andrus, our president and chief operating officer. Rick remains a driving force behind our brand image and philosophy and his services would be very difficult to replace. The loss of any executive officers or the inability to attract or retain qualified executive officers could delay the development and introduction of, and harm our ability to sell, our products and damage our brand, which could have a material adverse effect on our results of operations. Our future success also depends on our ability to attract and retain additional qualified design and marketing personnel. We face significant competition for these individuals worldwide and we may not be able to attract or retain these employees.

Our credit facility provides our lenders with a first-priority lien against substantially all of our assets and contains financial covenants and other restrictions on our actions and it could therefore limit our operational flexibility.

Our credit facility contains certain financial covenants and other restrictions that limit our ability, among other things, to:

 

   

undergo a merger or consolidation;

 

   

sell certain assets;

 

   

create liens;

 

   

guarantee certain obligations of third parties;

 

   

make certain investments or capital expenditures;

 

   

materially change our line of business;

 

   

declare dividends or make certain distributions;

 

   

make advances, loans or extensions of credit; and

 

   

incur additional indebtedness or prepay existing indebtedness.

 

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In addition, we have granted the lenders a first-priority lien against substantially all of our assets. Failure to comply with the operating restrictions or financial covenants in the credit facility could result in a default which could cause the lender to accelerate the timing of payments and exercise its lien on substantially all of our assets. This could cause us to cease operations and result in a complete loss of your investment in our common stock.

If the popularity or growth of the portable media device and smartphone markets stagnates, our business and financial condition may be negatively affected.

We have experienced rapid growth in the past due in part to the popularity of, and increase in demand for, portable media devices and smartphones. We expect that sales of such products will continue to drive a substantial portion of our net sales in the future. The markets for portable media devices and smartphones continue to evolve rapidly and are dominated by several large companies. Increased competition in the headphones market from established portable media device companies or a decline in demand or popularity for such products due to technological change or otherwise, our business and financial condition may be negatively affected.

Our online operations are subject to numerous risks that could have an adverse effect on our results of operations.

Although online sales through our website constitute a small portion of our total net sales, our online operations subject us to certain risks that could have an adverse effect on our results of operations. These risks include, negatively impacting our relationships with our retailers and distributors, liability for online content, and risks related to the computer systems that operate our website and related support systems, such as computer viruses and electronic break-ins or similar disruptions. In addition, certain risks beyond our control, such as governmental regulation of the Internet, additional companies competing with us for online sales, online security breaches and general economic conditions specific to the Internet and online commerce could have an adverse effect on our results of operations. We can provide no assurance that our online operations will meet our sales and profitability plans and the failure to do so could negatively impact our results of operations.

Our net sales and operating income fluctuate on a seasonal basis and decreases in sales or margins during our peak seasons could have a disproportionate effect on our overall financial condition and results of operations.

Historically, we have experienced greater net sales in the second half of the year relative to those in the first half, due to a concentration of shopping around the fall and holiday seasons. As a result, our net sales and gross margins are typically higher in the third and fourth quarters and lower in the first and second quarters, as fixed operating costs are spread over the differing levels of sales volume. Given the strong seasonal nature of our sales, appropriate forecasting is critical to our operations. We anticipate that this seasonal impact on our net sales is likely to continue and any shortfall in expected third and fourth quarter net sales would cause our annual results of operations to suffer significantly.

Our results of operations could be materially harmed if we are unable to accurately forecast demand for our products.

To ensure adequate inventory supply, we must forecast inventory needs and place orders with our manufacturers before firm orders are placed by our retailers and distributors. In addition, a portion of our net sales are generated by orders for immediate delivery, particularly during our historical peak season from August through December. If we fail to accurately forecast retailer and distributor demand we may experience excess inventory levels or a shortage of product to deliver to our retailers or distributors.

Factors that could affect our ability to accurately forecast demand for our products include:

 

   

changes in consumer demand for our products;

 

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lack of consumer acceptance for our new products;

 

   

product introductions by competitors;

 

   

changes in general market conditions or other factors, which may result in cancellations of advance orders or a reduction or increase in the rate of reorders;

 

   

weakening of economic conditions or consumer confidence in future economic conditions, which could reduce demand for discretionary items; and

 

   

terrorism or acts of war, or the threat thereof, which could adversely affect consumer confidence and spending or interrupt production and distribution of product and raw materials.

Inventory levels in excess of retailer and distributor demand may result in inventory write-downs or write-offs and the sale of excess inventory at discounted prices, which would have an adverse effect on our gross margin. In addition, if we underestimate the demand for our products, our manufacturers may not be able to produce a sufficient number of products to meet such unanticipated demand, and this could result in delays in the shipment of our products and damage to our reputation and retailer or distributor relationships.

The difficulty in forecasting demand also makes it difficult to estimate our future results of operations and financial condition from period to period. A failure to accurately predict the level of demand for our products could adversely impact our profitability.

We may be subject to product liability or warranty claims that could result in significant direct or indirect costs, or we could experience greater returns from retailers than expected, which could harm our net sales.

We generally provide a limited lifetime warranty on all of our products. In addition, if a consumer breaks his or her headphones, we generally offer such consumer the option to buy another pair of headphones at a 50% discount to the retail price. The occurrence of any quality problems due to defects in our products could make us liable for damages and warranty claims in excess of our current reserves. In addition to the risk of direct costs to correct any defects, warranty claims or other problems, any negative publicity related to the perceived quality of our products could also affect our brand image, decrease retailer and distributor demand and our operating results and financial condition could be adversely affected.

We have entered into contracts with various customers granting a conditional right of return allowance with respect to defective products. We have also executed an open return program with a major retailer allowing for an unlimited amount of returns. Estimates for these items are based on actual experience and are recorded at the time net sales are recognized. If we experience a greater number of returns than expected, our net sales could be harmed.

We expect to incur significant expenses as a result of being a public company, which may negatively impact our financial performance.

We expect to incur significant legal, accounting, insurance and other expenses as a result of becoming a public company. The Sarbanes-Oxley Act of 2002, or SOX, as well as related rules implemented by the Securities and Exchange Commission, or SEC, and The Nasdaq Stock Market, have required changes in corporate governance practices of public companies. Compliance with these laws, rules and regulations, including compliance with Section 404 of SOX and the recently enacted Dodd-Frank Wall Street Reform and Consumer Protection Act, will increase our expenses, including our legal and accounting costs, and make some activities more time-consuming and costly. We also believe these laws, rules and regulations will make it more expensive for us to obtain director and officer liability insurance, and in the future we may be required to accept reduced policy limits and coverage or incur substantially higher costs to obtain the same or similar coverage. As

 

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a result, it may be more difficult for us to attract and retain qualified persons to serve on our board of directors or as officers. Furthermore, any additional increases in legal, accounting, insurance and certain other expenses that we may experience in the future could negatively impact our financial performance and have a material adverse effect on our results of operations and financial condition.

If we fail to implement effective internal controls, our ability to produce accurate financial statements could be impaired, which could adversely affect our operating results and our ability to operate our business.

Ensuring that we have adequate internal financial and accounting controls and procedures in place to enable us to produce accurate financial statements on a timely basis is a costly and time-consuming effort that needs to be re-evaluated frequently. We have begun the process of documenting, reviewing and improving our internal controls and procedures in order to meet the requirements of Section 404 of SOX. Section 404 of SOX requires annual management assessments of the effectiveness of our internal controls over financial reporting and a report by our independent auditors addressing these assessments beginning with our Annual Report for the year ending December 31, 2012. Both our independent auditors and we will be testing our internal controls pursuant to the requirements of Section 404 of SOX and could, as part of that documentation and testing, identify areas for further attention or improvement. Implementing any appropriate changes to our internal controls may require additional personnel, specific compliance training of our directors, officers and employees, entail substantial costs in order to modify our existing accounting systems and require a significant period of time to complete. These changes may not, however, be effective in maintaining the adequacy of our internal controls, and any failure to maintain such adequacy, or the consequent inability to produce accurate financial statements on a timely basis, could increase our operating costs and could harm our ability to operate our business. In addition, investor perception that our internal controls are inadequate or that we are unable to produce accurate financial statements on a consistent basis may adversely affect our stock price.

Risks Related to our Common Stock

There is no existing market for our common stock, and we do not know if one will develop to provide you with adequate liquidity to sell our common stock at prices equal to or greater than the price you paid in this offering.

Prior to this offering, there has not been a public market for our common stock. We cannot predict the extent to which investor interest in our company will lead to the development of an active trading market on a stock exchange or otherwise or how liquid that market might become. If an active trading market does not develop, you may have difficulty selling any of our common stock that you purchase in this offering. The initial public offering price for our common stock will be determined by negotiations between us and the representatives of the underwriters and may not be indicative of prices that will prevail in the open market following this offering. Consequently, you may not be able to sell our common stock at prices equal to or greater than the price you paid in this offering, or at all.

The price of our common stock may fluctuate significantly, and you could lose all or part of your investment.

Volatility in the market price of our common stock may prevent you from being able to sell your common stock at or above the price you paid for your common stock. The market price of our common stock could fluctuate significantly for various reasons, including:

 

   

our operating and financial performance and prospects, including seasonal fluctuations in our financial performance;

 

   

our quarterly or annual earnings or those of other companies in our industry;

 

   

the public’s reaction to our press releases and our other public announcements;

 

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changes in, or failure to meet, earnings estimates or recommendations by research analysts;

 

   

strategic actions by us or our competitors, such as acquisitions or restructurings;

 

   

new laws or regulations or new interpretations of existing laws or regulations applicable to our business;

 

   

changes in accounting standards, policies, guidance, interpretations or principles;

 

   

material litigations or government investigations;

 

   

changes in general conditions in the U.S. and global economies or financial markets, including those resulting from war, incidents of terrorism or responses to such events;

 

   

changes in key personnel;

 

   

sales of common stock by us or members of our management team;

 

   

termination of lock-up agreements with our management team;

 

   

the granting or exercise of employee stock options;

 

   

volume of trading in our common stock; and

 

   

the realization of any risks described under “Risk Factors.”

In addition, in the past few years, the stock market has experienced significant price and volume fluctuations. This volatility has had a significant impact on the market price of securities issued by many companies, including companies in our industry. The changes frequently appear to occur without regard to the operating performance of the affected companies. As a result, the price of our common stock could fluctuate based upon factors that have little or nothing to do with our company, and these fluctuations could materially reduce our stock price and cause you to lose all or part of your investment. Furthermore, in the past, market fluctuations and price declines in a company’s stock have led to securities class action litigations. If such a suit were to arise, it could have a substantial cost and divert our resources regardless of the outcome.

If securities analysts do not publish research reports about our business or if they downgrade our stock, the price of our stock could decline.

The trading market for our common stock will depend in part on the research reports that securities or industry analysts publish about us or our business. Securities and industry analysts do not currently, and may never, publish research on our company. If no securities or industry analysts commence coverage of our company, the trading price for our stock would be negatively impacted. In the event securities or industry analysts initiate coverage, and if one or more of the analysts who cover us downgrade our stock or publish inaccurate or unfavorable research about our business, our stock price would likely decline. If one or more of these analysts cease coverage of our company or fail to publish research reports about us regularly, demand for our stock could decrease, which might cause our stock price and trading volume to decline.

Directors, executive officers and principal stockholders own a significant percentage of our capital stock, and they may make decisions that you do not consider to be in the best interests of our stockholders.

As of December 31, 2010, our directors, executive officers and principal stockholders beneficially owned, in the aggregate, approximately 75% of our outstanding voting securities, including approximately 34% beneficially

 

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owned by Ptarmigan, an affiliate of Jeff Kearl, our chairman. As a result, if some or all of them acted together, they would have the ability to exert substantial influence over the election of our board of directors and the outcome of issues requiring approval by our stockholders. We also plan to reserve up to              shares offered by us in this offering for a directed share program in which our directors, officers, distributors, retailers, business associates and related persons may be able to purchase shares at the initial public offering price. This program may further increase the percentage of stock held by persons whose interests are aligned with our directors, executives officers and principal stockholders. This concentration of ownership also may have the effect of delaying or preventing a change in control of our company that may be favored by other stockholders. This could prevent transactions in which stockholders might otherwise recover a premium for their shares over current market prices.

We have no plans to pay regular dividends on our common stock, so you may not receive funds without selling your common stock.

We have no plans to pay regular dividends on our common stock. We generally intend to invest our future earnings, if any, to fund our growth. Any payment of future dividends will be at the discretion of our board of directors and will depend on, among other things, our earnings, financial condition, capital requirements, level of indebtedness, statutory and contractual restrictions applying to the payment of dividends and other considerations that our board of directors deems relevant. Accordingly, you may have to sell some or all of your common stock in order to generate cash flow from your investment. You may not receive a gain on your investment when you sell your common stock and you may lose the entire amount of the investment.

Our management will have broad discretion over the use of the proceeds from this offering and might not apply the proceeds of this offering in ways that increase the value of your investment.

Our management will have broad discretion to use the net proceeds from this offering. We expect to use the net proceeds from this offering to repay certain indebtedness and for working capital and other general corporate purposes. We may also use net proceeds for other purposes, including for possible acquisitions of other businesses, products or technologies, although we have no agreements or commitments for any specific acquisitions at this time. We may fail to use these funds effectively to yield an adequate return, or any return, on any investment of these net proceeds, and we cannot assure you the proceeds will be used in a manner in which you would approve.

You will suffer immediate and substantial dilution.

The initial public offering price per share of our common stock is substantially higher than our net tangible book value per common share immediately after the offering. As a result, you will pay a price per share that substantially exceeds the tangible book value of our assets after subtracting our liabilities. At an initial public offering price of $             per share, which is the midpoint of the price range set forth on the cover page of this prospectus, you will incur immediate and substantial dilution in the amount of $             per share based on our net tangible book value at September 30, 2010. As of September 30, 2010, we also have outstanding stock options to purchase 184,947 shares of our common stock at a weighted average exercise price of $91.40 per share. To the extent these options are exercised, there will be further dilution.

Future sales of our common stock in the public market could lower our stock price, and any additional capital raised by us through the sale of equity or convertible debt securities may dilute your ownership in us and may adversely affect the market price of our common stock.

We and substantially all of our stockholders may sell additional shares of common stock in subsequent public offerings. We may also issue additional shares of common stock or convertible debt securities to finance future acquisitions or for other purposes. After the consummation of this offering, we will have             shares of common stock authorized and              shares of common stock outstanding. This number includes              shares

 

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that we are selling in this offering, which may be resold immediately in the public market, excluding any shares purchased through the directed share program. Of the remaining shares,                     , or     % of our total outstanding shares, are restricted from immediate resale pursuant to the lock-up agreements described in “Underwriting.” These shares will become available for sale following the expiration of the lock-up agreements under Rule 144 of the Securities Act of 1933, or the Securities Act, as described in “Underwriting.”

We cannot predict the size of future issuances of our common stock or the effect, if any, that future issuances and sales of our common stock will have on the market price of our common stock. Sales of substantial amounts of our common stock (including shares issued in connection with an acquisition), or the perception that such sales could occur, may adversely affect prevailing market prices for our common stock.

Certain provisions in our charter documents and Delaware law could discourage takeover attempts and lead to management entrenchment.

Our amended and restated certificate of incorporation and bylaws that will be in effect immediately prior to the closing of this offering will contain provisions that could have the effect of delaying or preventing changes in control or changes in our management without the consent of our board of directors. These provisions will include:

 

   

a classified board of directors with three-year staggered terms, which may delay the ability of stockholders to change the membership of a majority of our board of directors;

 

   

no cumulative voting in the election of directors, which limits the ability of minority stockholders to elect director candidates;

 

   

the exclusive right of our board of directors to elect a director to fill a vacancy created by the expansion of the board of directors or the resignation, death or removal of a director, which prevents stockholders from being able to fill vacancies on our board of directors;

 

   

the ability of our board of directors to determine to issue shares of preferred stock and to determine the price and other terms of those shares, including preferences and voting rights, without stockholder approval, which could be used to significantly dilute the ownership of a hostile acquirer;

 

   

a prohibition on stockholder action by written consent, which forces stockholder action to be taken at an annual or special meeting of our stockholders;

 

   

the requirement that a special meeting of stockholders may be called only by the chairman of the board of directors, the chief executive officer, the president (in the absence of a chief executive officer) or the board of directors, which may delay the ability of our stockholders to force consideration of a proposal or to take action, including the removal of directors; and

 

   

notice procedures that stockholders must comply with in order to nominate candidates to our board of directors or to propose matters to be acted upon at a stockholders’ meeting, which may discourage or deter a potential acquiror from conducting a solicitation of proxies to elect the acquiror’s own slate of directors or otherwise attempting to obtain control of us.

We are also subject to certain anti-takeover provisions under Delaware law. Under Delaware law, a corporation may not, in general, engage in a business combination with any holder of 15% or more of its capital stock unless the holder has held the stock for three years or, among other things, the board of directors has approved the transaction. See “Description of Capital Stock—Anti-Takeover Provisions.”

 

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SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

This prospectus contains forward-looking statements. The words “may,” “will,” “plan,” “believe,” “expect,” “anticipate,” “intend,” “estimate” and other expressions that are predictions of or indicate future events and trends and that do not relate to historical matters identify forward-looking statements. Although forward-looking statements reflect our current views, reliance should not be placed on forward-looking statements because they involve known and unknown risks, uncertainties and other factors, which may cause the actual results, performance or achievements to differ materially from anticipated future results, performance or achievements expressed or implied by such forward-looking statements. Forward-looking statements speak only as of the date the statements are made. We undertake no obligation to publicly update or revise any forward-looking statement, whether as a result of new information, future events, changed circumstances or otherwise. These forward-looking statements are subject to numerous risks and uncertainties, including the risks and uncertainties described under “Risk Factors,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and elsewhere in this prospectus. Moreover, we operate in an evolving environment. New risk factors and uncertainties emerge from time to time and it is not possible for our management to predict all risk factors and uncertainties, nor can we assess the impact of all factors on our business or the extent to which any factor, or combination of factors may cause actual results to differ materially from those contained in any forward-looking statement. We qualify all of our forward-looking statements by these cautionary statements.

 

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USE OF PROCEEDS

We estimate that the net proceeds from the sale of shares by us in this offering will be approximately $             million, after deducting underwriting discounts and commissions and estimated expenses, based upon an assumed initial public offering price of $             per share, which is the midpoint of the price range set forth on the cover of this prospectus. We will not receive any proceeds from the sale of common stock by the selling stockholders. A $1.00 increase (decrease) in the assumed initial public offering price of $             per share would increase (decrease) the net proceeds to us of this offering by $             million, assuming the sale by us of              shares of our common stock and after deducting underwriting discounts and commissions and estimated expenses. A 1.0 million increase (decrease) in the number of shares offered by us, assuming an initial public offering price of $                 per share, which is the midpoint of the price range set forth on the cover of this prospectus, would increase (decrease) the net proceeds to us by $             million, after deducting underwriting discounts and commissions and estimated expenses.

We intend to use the net proceeds received by us from this offering:

 

   

to repay the outstanding balance on our unsecured subordinated promissory notes, which was approximately $23.8 million as of December 31, 2010;

 

   

to pay the additional consideration of $17.5 million pursuant to our securities purchase and redemption agreement;

 

   

to pay approximately $3.6 million, which represents the portion of the principal balance attributable to accrued interest that must be paid in cash upon conversion of our convertible note; and

 

   

for working capital and other general corporate purposes.

Our unsecured subordinated promissory notes consist of two tranches. The first tranche, our 2009 note, was issued in February 2009 and bears interest at 11% per annum, which interest is payable quarterly until the 2009 note is repaid or until its maturity on February 3, 2013. As of December 31, 2010, $7.3 million was outstanding under the 2009 note.

The second tranche, our 2010 notes, was issued in December 2010 and bears interest at 3.3% per annum, which interest is due and payable, together with any outstanding principal amount, at maturity. The 2010 notes mature on the earlier of December 31, 2012, ten business days following the consummation of this offering, ten business days following a sale of a majority ownership interest in us, or upon certain events of default. As of December 31, 2010, $16.5 million was outstanding under the 2010 notes.

Our securities purchase and redemption agreement provides that we will pay an aggregate of $17.5 million as additional consideration to stockholders that redeemed certain of their shares in February 2009. The additional consideration amount is due on the earlier of December 31, 2013, ten business days following the consummation of this offering or ten business days following a sale of a majority ownership interest in us.

A portion of the net proceeds used to repay the unsecured subordinated promissory notes and to pay the additional consideration will be received by certain of our officers, directors and their affiliates. See “Certain Relationships and Related Party Transactions.”

In November 2008, we issued a convertible note in the amount of $29.8 million to Goode Skullcandy Holdings. The convertible note is secured by a second lien on substantially all of our assets and bears interest at 15% per annum, 5% of which is paid in cash and 10% of which is accrued and added to the principal balance of the convertible note on a quarterly basis. As of December 31, 2010, the outstanding balance totaled $33.4 million and the portion attributable to accrued interest that must be paid in cash upon conversion was $3.6 million.

We may also use a portion of the net proceeds to acquire other businesses, products or technologies. However, we do not have any agreements or commitments for any specific acquisitions at this time. Pending the uses described above, we intend to invest the net proceeds in short-term, investment grade, interest bearing securities.

 

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DIVIDEND POLICY

We plan to retain any earnings for the foreseeable future for our operations. We have never paid any dividends on our common stock and do not anticipate paying any cash dividends in the foreseeable future. Any future determination to pay cash dividends will be at the discretion of our board of directors and will depend on our financial condition, operating results, capital requirements and such other factors as our board of directors deems relevant. In addition, our credit facility restricts our ability to pay dividends.

 

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CAPITALIZATION

The following table sets forth our cash and cash equivalents and capitalization as of September 30, 2010 on:

 

   

an actual basis;

 

   

a pro forma basis to reflect conversion of all of our outstanding shares of preferred stock into 321,980 shares of common stock, the conversion of our convertible note into 275,866 shares of common stock, our issuance of $16.5 million of 2010 notes and the filing of our amended and restated certificate of incorporation; and

 

   

a pro forma as adjusted basis to also give effect to the items described above, the sale by us of             shares of our common stock in this offering at an assumed initial public offering price of $             per share, which is the midpoint of the price range set forth on the cover of this prospectus, and the application of the net proceeds as described in “Use of Proceeds,” after deducting underwriting discounts and commissions and estimated offering expenses payable by us.

The information in this table should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and related notes thereto included elsewhere in this prospectus.

 

    September 30, 2010  
    Actual     Pro Forma     Pro Forma
as Adjusted(2)
 
    (in thousands)  

Cash and cash equivalents

  $ 2,271      $ —        $                
                       

Total debt(1)

  $ 49,661      $ 18,582      $                
                       

Series A and B redeemable convertible preferred stock, $0.0001 par value, 401,379 shares authorized, 399,896 shares issued and 320,352 shares outstanding, actual; no shares authorized, issued or outstanding, pro forma and pro forma as adjusted

    2,388        —       

Stockholders’ equity (deficit):

     

Series C convertible preferred stock, $0.0001 par value, 10,000 shares authorized, 1,628 shares issued and outstanding, actual; no shares authorized, issued or outstanding, pro forma and pro forma as adjusted

    146        —       

Common stock, $0.0001 par value, 10,000,000 shares authorized, 1,006,391 shares issued and outstanding, actual; 200,000,000 shares authorized, 1,604,237 shares issued and outstanding, pro forma; 200,000,000 shares authorized,                  shares issued and outstanding, pro forma as adjusted

    —          —       

Preferred stock, $0.0001 par value, no shares authorized, issued or outstanding, actual; 10,000,000 shares authorized, no shares issued and outstanding, pro forma and pro forma as adjusted

    —          —       

Treasury stock

    (44,826     (44,826  

Additional paid-in capital

    5,467        37,825     

Retained earnings

    30,282        26,198     
                       

Total stockholders’ equity (deficit)

    (8,931         19,197     
                       

Total capitalization

  $ 43,118      $ 37,779      $                
                       

 

(1) Our convertible note bears interest at 15% per annum, 5% of which is paid in cash and 10% of which is accrued and added to the principal balance on a quarterly basis. Upon conversion, the portion of the principal balance attributable to accrued interest must be paid in cash. The pro forma columns reflect our payment of $2.8 million of accrued and unpaid cash interest as of September 30, 2010.

 

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(2) A $1.00 increase (decrease) in the assumed initial public offering price of $             per share, which is the midpoint of the price range set forth on the cover page of this prospectus, would increase (decrease) each of cash and cash equivalents, additional paid-in capital, total stockholders’ equity (deficit) and total capitalization by $             million, assuming that the number of shares offered by us, as set forth on the cover page of this prospectus, remains the same. A 1.0 million increase (decrease) in the number of shares offered by us would increase (decrease) each of cash and cash equivalents, additional paid-in capital, total stockholders’ equity and total capitalization by $             million, assuming an initial public offering price of $                 per share, which is the midpoint of the price range set forth on the cover of this prospectus, and after deducting the underwriting discounts and commissions and estimated offering expenses payable by us. The pro forma as adjusted information discussed above is illustrative only and will be adjusted based on the actual public offering price and terms of this offering determined at pricing.

The information in the above table excludes, as of September 30, 2010:

 

   

184,947 shares of common stock issuable upon the exercise of options outstanding as of September 30, 2010 at a weighted average exercise price of $91.49 per share;

 

   

2,271 shares of restricted stock that were subject to a right of repurchase by us as of September 30, 2010; and

 

   

             shares of common stock reserved for future issuance under our employee benefit plans, plus annual scheduled increases in the number of shares reserved for issuance under our 2011 incentive award plan.

 

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DILUTION

If you invest in our common stock, your ownership interest will be diluted to the extent of the difference between the offering price per share and the pro forma as adjusted net tangible book value per share after this offering. Net tangible book value per share represents the amount of our total tangible assets less total liabilities, divided by the number of shares of common stock outstanding. Dilution in pro forma net tangible book value per share represents the difference between the amount per share paid by purchasers of our common stock in this offering and the pro forma as adjusted net tangible book value per share of common stock immediately after the consummation of this offering.

Our historical net tangible book value as of September 30, 2010 was a deficit of $(9.2) million, or $(9.16) per share, not taking into account the conversion of our outstanding preferred stock or the conversion of the convertible note. Our pro forma net tangible book value as of September 30, 2010 was approximately $18.9 million, or $11.79 per share, after giving effect to the conversion of all outstanding shares of our preferred stock and convertible note into 597,846 shares of our common stock.

After giving effect to the conversion of all of our preferred stock and convertible note and the sale by us of the              shares of our common stock in this offering at an assumed initial public offering price of $             per share, which is the midpoint of the price range on the cover page of this prospectus, less underwriting discounts and commissions and estimated offering expenses payable by us, our pro forma as adjusted net tangible book value as of September 30, 2010 would have been approximately $             million, or approximately $             per share. This represents an immediate increase in net tangible book value of $             per share to existing stockholders and an immediate dilution in net tangible book value of $             per share to new investors of common stock in this offering. The following table illustrates this per share dilution:

 

Assumed initial public offering price per share

     $                

Historical net tangible book value per share as of September 30, 2010

   $ (9.16  

Pro forma increase in net tangible book value per share attributable to conversion of preferred stock and convertible note

     20.95     

Pro forma net tangible book value per share as of September 30, 2010

     11.79     

Increase in pro forma net tangible book value per share attributable to this offering

    
          

Pro forma as adjusted net tangible book value per share after this offering

     $     
          

Dilution per share to new investors

     $     
          

A $1.00 increase (decrease) in the assumed initial public offering price of $             per share, which is the midpoint of the price range set forth on the cover page of this prospectus, would increase (decrease) our pro forma as adjusted net tangible book value by approximately $             million, or $             per share, and the dilution per share to investors in this offering by approximately $             per share, assuming no change to the number of shares offered by us as set forth on the cover page of this prospectus, and after deducting underwriting discounts and commissions and estimated offering expenses payable by us. We may also increase or decrease the number of shares we are offering. A 1.0 million increase (decrease) in the number of shares offered by us would increase (decrease) our pro forma as adjusted net tangible book value by approximately $             million, or $             per share, assuming an initial public offering price of $                 per share, which is the midpoint of the price range set forth on the cover of this prospectus, and the dilution per share to investors in this offering by approximately $             per share after deducting underwriting discounts and commissions and estimated offering expenses payable by us. The pro forma as adjusted information discussed above is illustrative only.

If the underwriters exercise their option to purchase up to              additional shares in this offering from certain of the selling stockholders, our pro forma as adjusted net tangible book value as of September 30, 2010 and dilution per share to new investors will not change.

 

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The following table sets forth, on a pro forma as adjusted basis, as of September 30, 2010, the differences between the number of shares of common stock purchased from us, the total consideration paid, and the weighted average price per share paid by existing stockholders and new investors purchasing shares of our common stock in this offering, before deducting underwriting discounts and commissions and estimated expenses payable by us at an assumed initial public offering price of $             per share, which is the midpoint of the price range set forth on the cover page of this prospectus.

 

     Shares Purchased     Total Consideration     Weighted
Average
Price Per
Share
 
     Number      Percent     Amount      Percent    

Existing stockholders

               $                             $                

New investors

            

Total

               $                  $     

A $1.00 increase (or decrease) in the assumed public offering price of $             per share, which is the midpoint of the price range set forth on the cover page of this prospectus, would increase (decrease), respectively, total consideration paid by new investors and total consideration paid by all stockholders by approximately $             million, assuming that the number of shares offered by us, as set forth on the cover page of this prospectus, remains the same and after deducting the underwriting discounts and commissions.

The discussion and tables above assume the conversion of all our outstanding shares of preferred stock into 321,980 shares of common stock upon the consummation of this offering and the conversion of the convertible note into 275,866 shares of common stock upon the consummation of this offering and excludes, as of September 30, 2010:

 

   

184,947 shares of common stock issuable upon the exercise of options outstanding as of September 30, 2010 at a weighted average exercise price of $91.49 per share; and

 

   

2,271 shares of restricted stock that were subject to a right of repurchase by us as of September 30, 2010; and

 

   

             shares of common stock reserved for future issuance under our employee benefit plans, plus annual scheduled increases in the number of shares reserved for issuance under our 2011 incentive award plan.

Because the exercise prices of the outstanding options are significantly below the assumed initial offering price of $             per share, which is the midpoint of the price range on the cover page of this prospectus, investors purchasing common stock in this offering will suffer additional dilution when and if these options are exercised. Assuming the exercise in full of the 184,947 outstanding options, pro forma net tangible book value before this offering at September 30, 2010 would be $             per share, representing an immediate increase of $             per share to our existing stockholders, and, after giving effect to the sale of              shares of common stock in this offering, there would be an immediate dilution of $             per share to new investors in this offering.

 

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SELECTED CONSOLIDATED FINANCIAL DATA

The selected consolidated statements of operations data for the years ended December 31, 2007, 2008 and 2009 and the consolidated balance sheet data as of December 31, 2008 and 2009 have been derived from our audited consolidated financial statements included elsewhere in this prospectus, which have been audited by Ernst & Young LLP, independent registered public accounting firm. The consolidated balance sheet data as of December 31, 2007 has been derived from our audited financial statements that do not appear in this prospectus and which have been audited by Ernst & Young LLP. The consolidated statements of operations data for the years ended December 31, 2005 and 2006 and the consolidated balance sheet data as of December 31, 2005 have not been audited. The balance sheet data as of December 31, 2006 have been derived from our audited financial statements that do not appear in this prospectus and which have been audited by Wisan, Smith, Racker & Prescott, LLP. The consolidated statements of operations data for the nine months ended September 30, 2009 and 2010 and the consolidated balance sheet data as of September 30, 2010 have been derived from our unaudited condensed consolidated financial statements included elsewhere in this prospectus. This unaudited interim financial information has been prepared on the same basis as our audited annual consolidated financial statements and, in our opinion, reflects all adjustments, consisting only of normal recurring adjustments, that we consider necessary for a fair presentation of our financial position as of September 30, 2010 and operating results for the periods ended September 30, 2009 and 2010. The historical results are not necessarily indicative of the results to be expected for any future periods and the results for the nine months ended September 30, 2010 should not be considered indicative of results expected for the fiscal year 2010. You should read the following financial information together with the information under “Management’s Discussions and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and the notes included elsewhere in this prospectus.

 

     Year ended December 31,     Nine months ended
September 30,
 
     2005     2006      2007     2008     2009     2009     2010  
     (in thousands, except share and per share data)  

Consolidated Statements of Operations Data:

               

Net sales

   $ 1,330      $ 9,105       $ 35,346      $ 80,380      $ 118,312      $ 70,712      $ 95,940   

Cost of goods sold

     747        5,493         18,162        41,120        60,847        36,654        46,629   
                                                         

Gross profit

     583        3,612         17,184        39,260        57,465        34,058        49,311   

Selling, general and administrative expenses

     857        2,658         7,350        18,040        27,042        18,701        30,206   
                                                         

Income (loss) from operations

     (274     954         9,834        21,220        30,423        15,357        19,105   

Other (income) expense

                    (13     (54     (111     (113     14   

Interest expense

     166        142         91        586        8,874        6,534        6,559   
                                                         

Income (loss) before income taxes

     (440     812         9,756        20,688        21,660        8,936        12,532   

Income taxes

     2        180         3,498        7,669        8,120        3,368        4,887   
                                                         

Net income (loss)

     (442     632         6,258        13,019        13,540        5,568        7,645   

Deemed dividend on redemption of Series A and Series B redeemable convertible preferred stock

                                  (9,993     (9,993       
                                                         

Net income (loss) available to common stockholders

   $ (442   $ 632       $ 6,258      $ 13,019      $ 3,547      $ (4,425   $ 7,645   
                                                         

Net income (loss) per share:

               

Basic

   $ (0.44   $ 0.62       $ 5.65      $ 10.75      $ 3.57      $ (4.43   $ 7.67   

Diluted

     (0.44     0.55         3.97        7.36        2.54        (4.43     5.57   

Weighted average shares outstanding:

               

Basic

     1,000,000        1,022,246         1,106,610        1,211,074        993,444        998,191        996,731   

Diluted

     1,000,000        1,151,340         1,575,710        1,769,050        1,398,919        998,191        1,372,501   

Pro forma net income per share (unaudited):(1)

               

Basic

            $ 10.63        $ 6.36   

Diluted

              10.10          6.15   

Pro forma weighted average common shares outstanding (unaudited):

               

Basic

              1,597,918          1,594,577   

Diluted

              1,681,414          1,648,367   

 

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     As of December 31,     As of
September 30,

2010
 
     2005     2006      2007      2008      2009    
     (in thousands)  

Consolidated Balance Sheet Data:

               

Cash and cash equivalents

   $      $ 10       $ 590       $  19,363       $ 1,732      $ 2,271   

Working capital

     (317     1,173         8,950         46,086         35,019        25,750   

Total assets

     572        3,271         18,546         63,039         57,115        61,987   

Total debt

            709                 27,628         56,401        49,661   

Series A and B redeemable convertible preferred stock

                    2,737         2,737         2,388        2,388   

Total stockholders’ equity (deficit)

     (591     145         6,790         20,760         (18,625     (8,931

 

(1) Please see note 2 to our audited consolidated financial statements included elsewhere in this prospectus for an explanation of the method used to calculate basic and diluted pro forma net income per share for the year ended December 31, 2009. Please see note 2 to our interim condensed consolidated financial statements included elsewhere in this prospectus for an explanation of the method used to calculate basic and diluted pro forma net income per share for nine months ended September 30, 2010.

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion contains forward-looking statements that involve risks and uncertainties. Our actual results may differ materially from those discussed in the forward-looking statements as a result of various factors, including, without limitation, those set forth in “Risk Factors,” “Special Note Regarding Forward-Looking Statements” and other matters included elsewhere in this prospectus. The following discussion of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and the related notes thereto included elsewhere in this prospectus, as well as the information presented under “Selected Consolidated Financial Data.”

Overview

Skullcandy is a leading audio brand that reflects the collision of the music, fashion and action sports lifestyles. Our brand symbolizes youth and rebellion and embodies our motto, “Every revolution needs a soundtrack.” We believe we have revolutionized the headphone market by stylizing a previously-commoditized product and capitalizing on the increasing pervasiveness, portability and personalization of music. The Skullcandy name and distinctive logo have rapidly become icons and contributed to our leading market position, robust net sales growth and strong profitability and return on our invested capital.

Our net sales are derived primarily from the sale of headphones and audio accessories. We pioneered the distribution of headphones in specialty retailers focused on action sports and the youth lifestyle, such as Zumiez, Tilly’s and hundreds of independent snow, skate and surf retailers. Through this channel we have reached influencers, core consumers who helped establish the credibility and authenticity of our brand. Building on this foundation, we have successfully expanded our distribution to select consumer electronics, mass, sporting goods and mobile phone retailers such as Best Buy, Target, Dick’s Sporting Goods and AT&T Wireless. Skullcandy products are sold in the United States and in more than 70 other countries around the world, with international sales representing approximately 28% of our net sales in 2009. We also offer products through our website, with online sales representing approximately 4% of our net sales in 2009.

A number of industry trends have facilitated our growth to date, and we expect these trends to continue. The increasing use of portable media devices, such as Apple’s iPod, and smartphones with integrated music and video capabilities, such as Apple’s iPhone and third-party Android-based phones, has driven growth in the headphones and audio accessories markets. Our brand also benefits from the increasing popularity of action sports, particularly within the youth culture. Our core consumers are teens and young adults that associate themselves with snowboarding, skateboarding, surfing and other action sports. These consumers influence a broader consumer base that identifies with authentic action sports lifestyle brands. In addition, music is an integral part of the youth action sports lifestyle, and headphones have become an accessory worn to express individuality. We believe these trends provide us with an expanding consumer base for our products. Furthermore, we believe that these trends in preferences and lifestyles are not unique to the United States and are prevalent in a number of markets around the world.

We face potential challenges that could limit our ability to take advantage of these opportunities, including, among others, the risk that we may not be able to effectively extend the recognition and reputation of our brand or continue to develop innovative and popular products. We also face the risk that we may not be able to sustain our past growth or manage our anticipated future growth. In addition, we rely on two key retailers for a significant portion of our net sales. Moreover, we expect to experience growth internationally, which will require significant additional operating expenditures and increase our exposure to the risks inherent in international operations. We rely primarily on two key manufacturers in China for substantially all of our products. Each of these manufacturers is the sole source for the products it supplies. Furthermore, our industry is very competitive and we cannot assure you that we will be able to compete effectively. For a more complete discussion of the risks facing our business, see “Risk Factors.”

 

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Basis of Presentation

Our net sales are derived primarily from the sale of headphones and audio accessories under the Skullcandy brand name. Amounts billed to retailers for shipping and handling are included in net sales. Sales are reported net of estimated product returns and pricing adjustments. Domestic net sales are derived primarily from sales to our retailers, while our international net sales are primarily attributable to sales to our distributors.

Gross profit is influenced by cost of goods sold, which consists primarily of product costs, packaging, freight, duties and warehousing. We are experiencing higher product costs due to increasing labor and other costs in China. If we are unable to pass along these costs to our retailers and distributors or shift our sales mix to higher margin products, our gross profit as a percentage of net sales, or gross margin, may decrease.

Our selling, general and administrative expenses consist primarily of marketing and advertising expenses, wages, related payroll and employee benefit expenses, including stock-based compensation, commissions to outside sales representatives, legal and professional fees, travel expenses, utilities, other facility related costs, such as rent and depreciation, and consulting expenses. The primary components of our marketing and advertising expenses include in-store advertising, brand building fixtures, sponsorship of trade shows and events, promotional products and sponsorships for athletes, DJs, musicians and artists. We expect our selling, general and administrative expenses to increase in absolute dollars as we hire additional personnel and incur increased costs related to the growth of our business and our operation as a public company.

Results of Operations

The following table sets forth selected items in our statements of operations in dollars and as a percentage of net sales for the periods presented:

 

    Year ended December 31,     Nine months ended September 30,  
    2007     2008     2009     2009     2010  
    (in thousands)  

Net sales

  $ 35,346        100.0   $ 80,380        100.0   $ 118,312        100.0   $ 70,712        100.0   $ 95,940        100.0

Cost of goods sold

    18,162        51.4        41,120        51.2        60,847        51.4        36,654        51.8        46,629        48.6   
                                                                               

Gross profit

    17,184        48.6        39,260        48.8        57,465        48.6        34,058        48.2        49,311        51.4   

Selling, general and administrative expenses

    7,350        20.8        18,040        22.4        27,042        22.9        18,701        26.4        30,206        31.5   
                                                                               

Income from operations

    9,834        27.8        21,220        26.4        30,423        25.7        15,357        21.7        19,105        19.9   

Other (income) expense

    (13     0.0        (54     (0.1     (111     (0.1     (113     (0.2     14        0.0   

Interest expense

    91        0.3        586        0.7        8,874        7.5        6,534        9.2        6,559        6.8   
                                                                               

Income before income taxes

    9,756        27.6        20,688        25.7        21,660        18.3        8,936        12.6        12,532        13.1   

Income taxes

    3,498        9.9        7,669        9.5        8,120        6.9        3,368        4.8        4,887        5.1   
                                                                               

Net income

  $ 6,258        17.7   $ 13,019        16.2   $ 13,540        11.4   $ 5,568        7.9   $ 7,645        8.0
                                                                               

Nine Months Ended September 30, 2010 Compared to Nine Months Ended September 30, 2009

Net Sales

Net sales increased $25.2 million, or 35.7%, to $95.9 million for the nine months ended September 30, 2010, from $70.7 million for the nine months ended September 30, 2009. This increase primarily reflects a $23.0 million increase in net sales to large national retailers, driven by increased volumes to existing retailers and the addition of new retailers. Online net sales increased $0.9 million compared to the prior period.

 

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Domestic net sales increased $28.2 million, or 57.0%, to $77.8 million, or 81.1% of our net sales, for the nine months ended September 30, 2010, from $49.6 million, or 70.1% of our net sales, for the nine months ended September 30, 2009. This increase primarily reflects a $23.0 million increase in net sales to large national retailers as noted above.

International net sales, which consist primarily of net sales in Europe and Canada, decreased $3.0 million, or 14.4%, to $18.1 million, or 18.9% of our net sales, for the nine months ended September 30, 2010, from $21.1 million, or 29.9% of our net sales, for the nine months ended September 30, 2009. This decrease was primarily attributable to a 20% decrease in net sales in Europe attributable to a legal dispute and accompanying arbitration proceeding with our exclusive European distributor. The arbitration was resolved in the third quarter of 2010. Following the arbitration proceeding, our agreement with this distributor will continue until 2013. We are currently working aggressively with this distributor to expand our European sales.

Gross Profit

Gross profit increased $15.2 million, or 44.8%, to $49.3 million for the nine months ended September 30, 2010, from $34.1 million for the nine months ended September 30, 2009. Gross profit as a percentage of net sales, or gross margin, increased 3.2 percentage points to 51.4% for the nine months ended September 30, 2010, from 48.2% for the nine months ended September 30, 2009. The increase in gross margin was largely a result of an increase in domestic net sales, where our margins are generally higher relative to international net sales because we sell direct to retailers rather than through distributors. In addition, the higher gross margin was the result of a shift in sales mix to higher margin products and more favorable pricing with certain retailers.

Selling, General and Administrative Expenses

Selling, general and administrative expenses increased $11.5 million, or 61.5%, to $30.2 million for the nine months ended September 30, 2010, from $18.7 million for the nine months ended September 30, 2009. This increase was due primarily to a $4.1 million increase in advertising and marketing expenses, driven by increased marketing spend on in-store advertising and in-store displays, as well as costs associated with attending and sponsoring a higher number of trade shows and events. This increase was also a result of a $2.6 million increase in wages and salary expense, driven by growing our employee base during the year to support our growth, and increased sales commission expenses resulting from increased net sales. Selling, general and administrative expenses for the nine months ended September 30, 2010 included $0.6 million of outside legal fees related to the arbitration proceeding as noted above. As a percentage of net sales, selling, general and administrative expenses increased 5.1 percentage points to 31.5% for the nine months ended September 30, 2010, from 26.4% for the nine months ended September 30, 2009.

Income from Operations

As a result of the factors above, income from operations increased $3.7 million, or 24.4%, to $19.1 million for the nine months ended September 30, 2010, from $15.4 million for the nine months ended September 30, 2009. Income from operations as a percentage of net sales decreased 1.8 percentage points to 19.9% for the nine months ended September 30, 2010, from 21.7% for the nine months ended September 30, 2009.

Interest Expense

Interest expense for the nine months ended September 30, 2010 increased slightly to $6.6 million from $6.5 million for the nine months ended September 30, 2009. The consistent expense in 2010 when compared to 2009 was a result of lower expense associated with paying down unsecured debt, offset by greater use of our credit facility.

Income Taxes

Income taxes were $4.9 million for the nine months ended September 30, 2010 compared to $3.4 million for the nine months ended September 30, 2009. Our effective tax rate for the nine months ended September 30, 2010 and 2009 was 39.0% and 37.7%, respectively.

 

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Net Income

As a result of the factors above, net income increased $2.0 million, or 37.3%, to $7.6 million for the nine months ended September 30, 2010 from $5.6 million for the nine months ended September 30, 2009.

Year Ended December 31, 2009 Compared to Year Ended December 31, 2008

Net Sales

Net sales increased $37.9 million, or 47.2%, to $118.3 million in 2009 compared to $80.4 million in 2008. This increase primarily reflects a $23.3 million increase in net sales to large national retailers, driven by increased volumes to existing retailers and the addition of new retailers, a $7.5 million increase in net sales to international distributors and a $4.7 million increase in net sales to specialty retailers. Online net sales increased $2.1 million compared to the prior period.

Domestic net sales increased $30.4 million, or 55.0%, to $85.8 million, or 72.5% of our net sales, in 2009 from $55.3 million, or 68.8% of our net sales, in 2008. This increase primarily reflects the increases in net sales to large national retailers and specialty retailers as noted above.

International net sales increased $7.5 million, or 29.9%, to $32.5 million, or 27.5% of our net sales in 2009 from $25.1 million, or 31.2%, of our net sales in 2008. The increase in international net sales was primarily attributable to sales growth with our European and Canadian distributors.

Gross Profit

Gross profit increased $18.2 million, or 46.4%, to $57.5 million in 2009 from $39.3 million in 2008. Gross margin was 48.6% for 2009 and remained relatively unchanged from 2008. The consistent gross margin was a result of similar year over year domestic and international revenue mix and comparable product costs in 2009 compared with 2008.

Selling, General and Administrative Expenses

Selling, general and administrative expenses increased $9.0 million, or 49.9%, to $27.0 million in 2009 from $18.0 million in 2008. This increase was due primarily to a $3.8 million increase in marketing and advertising expenses, driven by increased marketing spend on in-store displays, as well as costs associated with attending and sponsoring a higher number of trade shows and events. This increase was also a result of a $2.5 million increase in wages and salary expense, driven by growing our employee base during the year to support our growth, and increased sales commission expenses resulting from increased net sales. As a percentage of net sales, selling, general and administrative expenses increased 0.5 percentage points to 22.9% in 2009 from 22.4% in 2008.

Income from Operations

As a result of the factors above, income from operations increased $9.2 million, or 43.4%, to $30.4 million in 2009 from $21.2 million in 2008. Income from operations as a percentage of net sales decreased 0.7 percentage points to 25.7% in 2009 from 26.4% in 2008.

Interest Expense

Interest expense increased $8.3 million to $8.9 million in 2009 from $0.6 million in 2008. The increase in interest expense was primarily due to interest on the convertible note and 2009 note, as well as increased borrowings under our credit facility in 2009.

 

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Income Taxes

Income taxes were $8.1 million in 2009 compared to $7.7 million in 2008. Our effective tax rate for 2009 and 2008 was 37.5% and 37.1%, respectively.

Net Income

As a result of the factors above, net income increased $0.5 million, or 4.0%, to $13.5 million in 2009 compared to $13.0 million in 2008.

Year Ended December 31, 2008 Compared to Year Ended December 31, 2007

Net Sales

Net sales increased $45.1 million, or 127.4%, to $80.4 million in 2008 from $35.3 million in 2007. The increase primarily reflects a $21.9 million increase in net sales to large national retailers, driven by increased volumes to existing retailers and the addition of new retailers, a $16.6 million increase in net sales to international distributors, a $4.4 million increase in net sales to specialty retailers. Online net sales increased $2.1 million compared to the prior period.

Domestic net sales increased $27.4 million, or 97.9%, to $55.3 million, or 68.8% of our net sales, in 2008 from $27.9 million, or 79.1% of our net sales, in 2007. This increase primarily reflects the increases in net sales to large national retailers and specialty retailers as noted above.

International net sales increased $17.7 million, or 239.1%, to $25.1 million, or 31.2% of our net sales for 2008 from $7.4 million, or 20.9%, of our net sales in 2007. The increase in international net sales was primarily attributable to sales growth with our European and Canadian distributors.

Gross Profit

Gross profit increased $22.1 million, or 128.5%, to $39.3 million in 2008 from $17.2 million in 2007. Gross margin was 48.8% for 2008 and remained relatively unchanged from 2007. A higher percentage of international net sales at lower margins compared with domestic net sales was partially offset by a higher percentage of online net sales at higher margins in 2008 compared with 2007.

Selling, General and Administrative Expenses

Selling, general and administrative expenses increased $10.6 million, or 145.4%, to $18.0 million in 2008 from $7.4 million in 2007. This increase was due primarily to a $4.0 million increase in marketing and advertising expenses, driven by increased marketing spend on in-store advertising, as well as costs associated with new athlete and team sponsorships. This increase was also a result of a $3.5 million increase in wages and salary expense, driven by growing our employee base during the year to support our growth, and increased sales commission expenses resulting from increased net sales. As a percentage of net sales, selling, general and administrative expenses increased 1.6 percentage points to 22.4% in 2008 from 20.8% in 2007.

Income from Operations

As a result of the factors above, income from operations increased $11.4 million, or 115.8%, to $21.2 million in 2008 compared to $9.8 million in 2007. Income from operations as a percentage of net sales decreased 1.4 percentage points to 26.4% in 2008 from 27.8% in 2007.

Interest Expense

Interest expense in 2008 was $0.6 million compared to $0.1 million in 2007, driven by increased borrowings under our credit facility in 2008.

 

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Income Taxes

Income taxes were $7.7 million in 2008 compared to $3.5 million in 2007. Our effective tax rate for 2008 and 2007 was 37.1% and 35.9% respectively.

Net Income

As a result of the factors above, net income increased $6.7 million, or 108.0%, to $13.0 million in 2008 from $6.3 million in 2007.

Quarterly Results

The following table sets forth our unaudited quarterly consolidated statement of operations data for the seven quarters ended September 30, 2010. The information for each quarter is derived from our unaudited interim consolidated financial statements, which we have prepared on the same basis as the audited consolidated financial statements appearing elsewhere in this prospectus. This information includes all adjustments that management considers necessary for the fair presentation of such data. The quarterly data should be read together with our consolidated financial statements and related notes appearing elsewhere in this prospectus.

 

     Quarter Ended  
     Mar. 31,
2009
    Jun. 30,
2009
    Sept. 30,
2009
     Dec. 31,
2009
     Mar. 31,
2010
     Jun. 30,
2010
     Sept. 30,
2010
 
     (in thousands)  

Net sales

   $ 14,262      $ 24,012      $ 32,438       $ 47,600       $ 21,658       $ 35,789       $ 38,493   

Cost of goods sold

     7,261        11,880        17,513         24,193         10,660         17,482         18,487   
                                                            

Gross profit

     7,001        12,132        14,925         23,407         10,998         18,307         20,006   

Selling, general and administrative expenses

     6,205        5,778        6,718         8,341         7,572         9,346         13,288   
                                                            

Income from operations

     796        6,354        8,207         15,066         3,426         8,961         6,718   

Other (income) expense

     (22     (91             2         5                 9   

Interest expense

     1,886        2,296        2,352         2,340         2,189         1,920         2,450   
                                                            

Income (loss) before income taxes

     (1,068     4,149        5,855         12,724         1,232         7,041         4,259   

Income tax (benefit) expense

     (354     1,549        2,173         4,752         512         2,692         1,683   
                                                            

Net income (loss)

   $ (714   $ 2,600      $ 3,682       $ 7,972       $ 720       $ 4,349       $ 2,576   
                                                            

Historically, we have experienced greater net sales in the second half of the year than those in the first half due to a concentration of shopping during the fall and holiday seasons. We anticipate that this seasonal impact on our net sales is likely to continue. In 2009, approximately 67.6% of our net sales, 66.7% of our gross profit and 76.5% of our operating income were generated in the second half of the year. Accordingly, our results of operations for any particular quarter are not indicative of the results we expect for the full year.

As a result of the effects of seasonality, particularly in preparation for the fall and holiday shopping seasons, our inventory levels and other working capital requirements generally begin to increase during the second quarter and into the third quarter of each year. During these peak periods, we have historically borrowed under our credit facility.

Liquidity and Capital Resources

Our primary cash needs are working capital and capital expenditures. Historically, we have generally financed these needs with operating cash flows and borrowings under our credit facility. These sources of liquidity may be impacted by fluctuations in demand for our products, ongoing investments in our infrastructure and expenditures on marketing and advertising.

 

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The following table sets forth, for the periods indicated, our beginning balance of cash, net cash flows provided by and used in operating, investing and financing activities and our ending balance of cash:

 

     Year ended December 31,     Nine months ended
September 30,
 
     2007     2008     2009     2009     2010  
     (in thousands)  

Cash and cash equivalents at beginning of period

   $ 10      $ 590      $ 19,363      $ 19,363      $ 1,732   

Net cash provided by (used in) operating activities

     (111     (4,514     13,291        5,499        11,498   

Net cash provided by (used in) investing activities

     (596     (932     (1,308     (792     (1,725

Net cash provided by (used in) financing activities

     1,287        24,219        (29,614     (21,110     (9,234
                                        

Cash and cash equivalents at end of period

   $ 590      $ 19,363      $ 1,732      $ 2,960      $ 2,271   
                                        

Net Cash Provided by (Used in) Operating Activities. Cash from operating activities consists primarily of net income adjusted for certain non-cash items including depreciation, provision for doubtful accounts, benefit from deferred income taxes, non-cash interest expense, stock-based compensation expense and the effect of changes in working capital and other activities.

For the nine months ended September 30, 2010, net cash provided by operating activities was $11.5 million and consisted of net income of $7.6 million plus $6.5 million for non-cash items, less $2.6 million for working capital and other activities. Working capital and other activities consisted primarily of increases in accounts payable of $4.4 million, in prepaid expenses and other of $3.7 million and in inventory of $1.7 million, partially offset by decreases in income taxes payable of $2.8 million and accounts receivable of $0.6 million.

For the nine months ended September 30, 2009, net cash used in operating activities was $5.5 million and consisted of net income of $5.6 million plus $4.5 million for non-cash items, less $4.6 million for working capital and other activities. Working capital and other activities consisted primarily of increases in inventory of $13.6 million and accounts payable of $6.8 million, partially offset by decreases in restricted cash of $2.3 million, in income taxes payable of $2.4 million and in accrued liabilities and other current liabilities of $1.5 million.

In 2009, net cash provided by operating activities was $13.3 million and consisted of net income of $13.5 million, plus $5.9 million for non-cash items, which included $4.7 million of non-cash interest expense, less $6.2 million for working capital and other activities. Working capital and other activities consisted primarily of increases in accounts receivable of $5.3 million and in inventory of $8.4 million, partially offset by decreases in accounts payable of $2.4 million and in restricted cash of $2.3 million.

In 2008, net cash used in operating activities was $4.5 million and consisted of net income of $13.0 million, plus $1.5 million for non-cash items, less $19.1 million for working capital and other activities. Working capital and other activities consisted primarily of increases in accounts receivable of $15.2 million and in inventory of $3.3 million, partially offset by decreases in accrued liabilities and other current liabilities of $3.2 million and in accounts payable of $1.0 million.

In 2007, net cash used in operating activities was $0.1 million and consisted of net income of $6.3 million, less $0.4 million for non-cash items and $6.0 million for working capital and other activities. Working capital and other activities consisted primarily of increases in accounts receivable of $8.3 million and in inventory of $5.1 million, partially offset by decreases in accounts payable of $1.4 million and income taxes payable of $3.7 million.

Net Cash Provided by (Used in) Investing Activities. Net cash used in investing activities relates almost entirely to capital expenditure. Net cash used in investing activities was $1.7 million and $0.8 million for the nine months ended September 30, 2010 and 2009, respectively. Net cash used in investing activities was $1.3 million, $0.9 million and $0.6 million in 2009, 2008 and 2007, respectively.

 

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Net Cash Provided by (Used in) Financing Activities. Net cash used in financing activities was $9.2 million and $21.1 million for the nine months ended September 30, 2010 and 2009, respectively, which primarily resulted from payments made to stockholders. Net cash used in financing activities was $29.6 million in 2009, and net cash provided by financing activities was $24.2 million and $1.3 million in 2008 and 2007, respectively. Net cash used in financing activities during 2009 consisted primarily of $30.2 million paid to repurchase shares of our common stock. Net cash provided by financing activities during 2008 consisted primarily of proceeds from the issuance of long- term debt. Net cash provided by financing activities during 2007 consisted primarily of proceeds from the issuance of shares of our common and preferred stock.

We believe that our cash, cash flow from operating activities, available borrowings under our credit facility and net proceeds from this offering will be sufficient to meet our capital requirements for at least the next twelve months.

Indebtedness

In December 2010, in recognition of the likelihood that the bonus pool under our previously existing management incentive plan would ultimately be funded at the maximum level based on this offering, our board of directors determined to pay out the bonus pool on December 31, 2010 and to recognize the associated compensation expense at that time. Accordingly, on December 31, 2010, we issued subordinated promissory notes, which we refer to as the 2010 notes, to each of the participants in the management incentive plan in an aggregate principal amount of $16.5 million. Upon issuance of the 2010 notes, each recipient was entitled to an immediate payment in an amount sufficient to satisfy all tax obligations of the recipient arising in connection with the issuance of the 2010 notes. The 2010 notes bear interest at a rate of 3.3% per annum, with all unpaid principal and interest amounts payable on the earlier of December 31, 2012, the tenth business day following a qualified initial public offering, the tenth business day following a sale of a majority ownership interest in us or upon the occurrence of certain events of default. In connection with the issuance of the 2010 notes, the management incentive plan was terminated. Concurrent with the issuance of the 2010 notes, we also amended our securities purchase and redemption agreement.

On August 31, 2010, we entered into a revolving credit and security agreement, or the credit facility, with PNC Bank and UPS Capital Corporation, as lenders. The credit facility provides for revolving loans and letters of credit of up to $28.8 million (which may be increased to up to $50.0 million upon our request subject to certain conditions) and expires on August 31, 2013. The credit facility is secured by substantially all of our assets. The total amount of available borrowings is subject to limitations based on specified percentages of the value of eligible receivables and inventory. At September 30, 2010, total borrowings were $11.2 million and we had $12.7 million of additional availability under the credit facility. We may request up to two increases in the total maximum available amount of the credit facility from the existing lenders, each in an amount not to exceed $10.6 million, such that the aggregate amount of the facility does not exceed $50.0 million. We may select from two interest rate options for borrowings under the credit facility: (i) Alternate Base Rate (as defined in the credit facility) plus 1.50% or (ii) Eurodollar Rate (as defined in the credit facility) plus 3.0%. We are required to pay a commitment fee on any unused credit facility commitments at a per annum rate of 0.50%. The credit facility includes restrictions on, among other things, our ability to incur additional indebtedness, pay dividends or make other distributions, make investments, make loans and make capital expenditures, and requires that we maintain a Fixed Charge Coverage Ratio (as defined in the credit facility) of not less than 1.15 to 1.0, measured on a trailing 12-month basis. At December 31, 2010, we were in compliance with all financial covenants.

In February 2009, we issued an unsecured subordinated promissory note, which we refer to as the 2009 note, in aggregate principal amount of $25.0 million to certain of our stockholders. The note bears interest at 11% per annum and matures on February 3, 2013. At December 31, 2010, the principal balance outstanding on the 2009 note was $7.3 million.

 

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In November 2008, we issued a convertible note in the amount of $29.8 million to Goode Skullcandy Holdings, or Goode. Goode has the option to convert the note, subject to certain adjustments, into 275,866 shares of our common stock at any time before the maturity of the convertible note on November 28, 2013. Upon the consummation of a qualified initial public offering, we have the option to require Goode to exercise its conversion right or, in the alternative, accept the principal amount plus all accrued and unpaid interest in full. In connection with this offering we intend to cause Goode to convert the convertible note into shares of our common stock.

Contractual Obligations and Commitments

The following table summarizes, as of December 31, 2009, the total amount of future payments due in various future periods:

 

     Payments Due by Period  
     Total      Less Than
One Year
     1-3
Years
     3-5
Years
     More Than
Five Years
 
     (in thousands)  

Operating lease obligations

   $ 1,570       $ 370       $ 1,118       $ 83       $   

Debt repayments

     69,532         2         69,530                   

Interest payments

     10,053         2,749         7,304                   
                                            

Total

   $ 81,155       $ 3,121       $ 77,952       $     83       $     –   
                                            

We lease office space under non-cancelable operating leases. The leases expire at various dates through 2014, excluding extensions at our option, and contain provisions for rental adjustments, including in certain cases, adjustments based on increases in the Consumer Price Index. The leases generally contain renewal provisions for varying periods of time.

We have contractual relationships with certain of our sponsored athletes, DJs, musicians and artists, whereby we compensate them for promoting our products or pay them a royalty on sales of their signature headphones. Sponsorship arrangements are typically structured to give our sponsored team members financial incentives to maintain a highly visible profile with our products. Our contracts typically have a one year term, with some providing for a two year term, and grant us an unlimited license for the use of their names and likenesses, and typically require them to maintain exclusive association with our headphones. In turn, we agree to make cash payments to our sponsored team members for wearing our products during various public appearances, in magazine shoots and on the podium after certain competitive victories. In addition to cash payments, we also generally provide limited free products for their use, and reimburse certain travel expenses incurred in conjunction with promoting our products.

In November 2008, we entered into a securities purchase and redemption agreement with Goode to sell, in a private placement, 1,628 shares of our Series C convertible preferred stock. We used a portion of the consideration obtained in that transaction to redeem shares of our capital stock, options and warrants from certain security holders, including Ptarmigan, Mercato Partners, Rick Alden, our chief executive officer, Jeremy Andrus, our president and chief operating officer, and an affiliate of Jeremy. The securities purchase and redemption agreement provided that, in certain circumstances, we would pay the security holders that redeemed their securities additional consideration for the securities sold. In December 2010, in connection with our issuance of the 2010 notes and termination of the management incentive plan, we amended the securities purchase and redemption agreement to set the additional consideration amount at $17.5 million and to provide that such amount would be paid to the selling security holders on the earlier of December 31, 2013, ten business days following the consummation of this offering and ten business days following a sale of a majority ownership interest in us. See “Compensation Discussion and Analysis—Executive Compensation Program Components—Long-Term Incentives—Long-Term Cash Incentives” and “Certain Relationships and Related Party Transactions—Series C Convertible Preferred Stock Financing and Stock Redemption.”

 

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Stock Repurchase

In February 2009, we repurchased 344,743 shares of common stock, 73,289 shares of Series A preferred stock and 6,255 shares of Series B preferred stock from existing stockholders for an aggregate purchase price of $55.2 million. The purchase price consisted of $30 million in cash, which funds were primarily obtained from the convertible note issued in November 2008, $168,000 in proceeds from exercise of options on common stock, and $25 million in the form of unsecured subordinated promissory notes. Amounts paid in excess of the stated value on the Series A and B preferred stock are reflected as a deemed preferred dividend in arriving at net income available to common stockholders during 2009.

Off-Balance Sheet Arrangements

We currently do not have any off-balance sheet arrangements or financing activities with special-purpose entities.

Quantitative and Qualitative Disclosure about Market Risk

Interest Rate Risk

We maintain a credit facility that provides for revolving loans and letters of credit of up to $28.8 million (which may be increased to up to $50.0 million upon our request subject to certain conditions). At September 30, 2010, total borrowings were $11.2 million and we had $12.7 million of additional availability under the credit facility. We currently do not engage in any interest rate hedging activity and currently have no intention to do so in the foreseeable future. Based on the average interest rate on the credit facility during 2009, and to the extent that borrowings were outstanding, we do not believe that a 10% change in the interest rate would have a material effect on our results of operations or financial condition.

Inflation

Inflationary factors, such as increases in the cost of our product and overhead costs, may adversely affect our operating results. Although we do not believe that inflation has had a material impact on our financial position or results of operations to date, a high rate of inflation in the future may have an adverse effect on our ability to maintain current levels of gross margin and selling, general and administrative expenses as a percentage of net sales if the selling prices of our products do not increase with these increased costs.

Outstanding Orders

We typically receive the bulk of our orders from retailers about three weeks prior to the date the products are to be shipped and from distributors approximately six weeks prior to the date the products are to be shipped. Generally, these orders are not subject to cancellation prior to the date of shipment. As of September 30, 2010, our order backlog was $18.4 million, compared to $9.4 million at September 30, 2009. Retailers regularly request reduced order lead-time, which puts pressure on our supply chain. Our open order book varies by season, with the highest level occurring during the fourth quarter.

Critical Accounting Policies

Our consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States. To prepare these financial statements, we must make estimates and assumptions that affect the reported amounts of assets and liabilities. These estimates also affect our reported net sales and expenses. Judgments must also be made about the disclosure of contingent liabilities. Actual results could be significantly different from these estimates. We believe that the following discussion addresses the accounting policies that are necessary to understand and evaluate our reported financial results.

 

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Revenue Recognition and Sales Returns and Allowances

Net sales are recognized when title and risk of loss pass to the retailer or distributor and when collectability is reasonably assured. Generally, we extend credit to our retailers and distributors and do not require collateral. Our payment terms are typically net-30 with terms up to net-90 for certain international distributors. We recognize revenue net of estimated product returns and pricing adjustments. Further, we provide for product warranties in accordance with the contract terms given to various retailers and end users by accruing estimated warranty costs at the time of revenue recognition. We have entered into contracts with various retailers granting a conditional right of return allowance with respect to defective products. The contracts with each retailer specify the defective allowance percentage of gross sales. We have executed an open return program with a major retailer allowing for an unlimited amount of returns. Estimates for these items are based on actual experience and are recorded as a reduction of revenue at the time of recognition or when circumstances change resulting in a change in estimated returns.

Accounts Receivable

Throughout the year, we perform credit evaluations of our retailers and distributors, and we adjust credit limits based on payment history and the retailer’s or distributor’s current creditworthiness. We continuously monitor our collections and maintain an allowance for doubtful accounts based on our historical experience and any specific customer collection issues that have been identified. Bad debt expense is reported as a component of selling, general and administrative expenses. Historically, our losses associated with uncollectible accounts have been consistent with our estimates, but there can be no assurance that we will continue to experience the same credit loss rates that we have experienced in the past. Unforeseen, material financial difficulties of our retailers or distributors could have an adverse impact on our profits.

Inventories

We value inventories at the lower of the cost or the current estimated market value of the inventory. We regularly review our inventory quantities on hand and adjust inventory values for excess and obsolete inventory based primarily on estimated forecasts of product demand and market value. Demand for our products could fluctuate significantly. The demand for our products could be negatively affected by many factors, including the following:

 

   

unanticipated changes in consumer preferences;

 

   

weakening economic conditions;

 

   

terrorist acts or threats;

 

   

reduced consumer confidence in the retail market; and

 

   

unseasonable weather.

Some of these factors could also interrupt the production and importation of our products or otherwise increase the cost of our products. As a result, our operations and financial performance could be negatively affected. Additionally, our estimates of product demand and market value could be inaccurate, which could result in excess and obsolete inventory.

Stock-Based Compensation

We account for all stock-based compensation awards to employees using a fair-value method and recognize the fair value of each award as an expense over the requisite service period. Option awards issued to

 

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non-employees (excluding non-employee directors) are recorded at their fair value as determined in accordance with authoritative guidance, are periodically revalued at each reporting date, and are recognized as expense over the related service period.

For purposes of calculating stock-based compensation, we estimate the fair value of stock options using a Black-Scholes-Merton valuation model, which requires the use of certain subjective assumptions including expected term, volatility, expected dividend, risk-free interest rate, forfeiture rate and the fair value of our common stock. These assumptions generally require significant judgment.

We estimate the expected term of employee options using the average of the time-to-vesting and the contractual term. We derive our expected volatility from the historical volatilities of several unrelated public companies within our industry because we have little information on the volatility of the price of our common stock since we have no trading history. When making the selections of our industry peer companies to be used in the volatility calculation, we also considered the stage of development, size and financial leverage of potential comparable companies. These historical volatilities are weighted based on certain qualitative factors and combined to produce a single volatility factor. Our expected dividend rate is zero, as we have never paid any dividends on our common stock and do not anticipate any dividends in the foreseeable future. We base the risk-free interest rate on the U.S. Treasury yield in effect at the time of grant for zero coupon U.S. Treasury notes with maturities approximately equal to each grant’s expected life.

We estimate our forfeiture rate based on an analysis of our actual forfeitures and will continue to evaluate the appropriateness of the forfeiture rate based on actual forfeiture experience, analysis of employee turnover behavior and other factors. Quarterly changes in the estimated forfeiture rate can have a significant effect on reported stock-based compensation expense, as the cumulative effect of adjusting the rate for all expense amortization is recognized in the period the forfeiture estimate is changed. If a revised forfeiture rate is higher than the previously estimated forfeiture rate, an adjustment is made that will result in a decrease to the stock-based compensation expense recognized in the consolidated financial statements. If a revised forfeiture rate is lower than the previously estimated forfeiture rate, an adjustment is made that will result in an increase to the stock-based compensation expense recognized in the consolidated financial statements.

The following table summarizes the amount of stock-based compensation expense recognized in our statements of operations:

 

     Year ended
December 31,
     Nine months  ended
September 30,
 
     2007      2008      2009          2009          2010  
     (in thousands)  

Total stock-based compensation

   $ 101       $ 595       $ 871         $511       $ 1,831   

If factors change and we employ different assumptions, stock-based compensation expense may differ significantly from what we have recorded in the past. If there is a difference between the assumptions used in determining stock-based compensation expense and the actual factors which become known over time, we may change the input factors used in determining stock-based compensation costs for future grants. These changes, if any, may materially impact our results of operations in the period such changes are made. We expect to continue to grant stock options in the future, and to the extent that we do, our actual stock-based compensation expense recognized in future periods will likely increase.

 

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Significant Factors Used in Determining Fair Value of Our Common Stock

The fair value of the common stock that underlies our stock options has historically been determined by our board of directors based upon information available to it at the time of grant. The following table summarizes, by grant date, the number of stock options granted since January 1, 2010 and the associated per share exercise price, which was not less than the fair value of our common stock for each of these grants.

 

Grant Date

   Number of
Options
Granted
     Exercise
Price Per
Share of
Common
Stock
     Estimated
Fair Value
Per Share of
Common
Stock
 

January 21, 2010

     34,666       $ 134.69       $ 134.69   

March 31, 2010

     8,800         134.69         134.69   

May 27, 2010

     26,321         144.37         144.37   

November 4, 2010

     61,185         167.90         167.90   

Because there has been no public market for our common stock, our board of directors has determined the fair value of our common stock based on an analysis of relevant metrics, including the following:

 

   

the rights, privileges and preferences of our convertible preferred stock;

 

   

our operating and financial performance;

 

   

the hiring of key personnel;

 

   

the introduction of new products;

 

   

the risks inherent in the development and expansion of our products;

 

   

the fact that the option grants involve illiquid securities in a private company;

 

   

the likelihood of achieving a liquidity event, such as an initial public offering or sale of our company; and

 

   

an estimated enterprise value determined by applying a consistent multiple to our earnings before interest, taxes, depreciation and amortization, or EBITDA.

In addition, our board of directors has obtained periodic valuation studies from an independent third-party valuation firm. In performing its valuation analysis, the valuation firm engaged in discussions with management, analyzed historical and forecasted financial statements and reviewed our corporate documents. In addition, these valuation studies were based on a number of assumptions, including industry, general economic, market and other conditions that could reasonably be evaluated at the time of the valuation. Third-party valuations were performed on each of January 15, 2010, and October 8, 2010 using generally accepted valuation methodologies.

Income Taxes

We estimate what our effective tax rate will be for the full year and record a quarterly income tax provision in accordance with the anticipated effective annual tax rate. As the year progresses, we continually refine our estimate based upon actual events and earnings by jurisdiction during the year. This continual process periodically results in a change to our expected effective tax rate for the year. When this occurs, we adjust the income tax provision during the quarter in which the change in estimate occurs so that the year-to-date provision equals the expected annual rate.

Recent Accounting Pronouncements

We have evaluated recent accounting pronouncements and their adoption has not had or is not expected to have a material impact on our financial statements.

 

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BUSINESS

 

LOGO

Our Company

Skullcandy is a leading audio brand that reflects the collision of the music, fashion and action sports lifestyles. Our brand symbolizes youth and rebellion, and embodies our motto, “Every revolution needs a soundtrack.” We believe we have revolutionized the headphone market by stylizing a previously-commoditized product and capitalizing on the increasing pervasiveness, portability and personalization of music. The Skullcandy name and distinctive logo have rapidly become icons and contributed to our leading market position, robust net sales growth and strong profitability and return on our invested capital. We increased our net sales from $9.1 million in 2006 to $118.3 million in 2009, representing a compound annual growth rate of approximately 135%. During the same period, we increased operating income from $1.0 million to $30.4 million, representing a compound annual growth rate of approximately 217%.

We are a company founded on innovation. After our 2003 introduction of Link Technology, a revolutionary product that integrated mobile phones and personal media devices, we began offering headphones with cutting- edge technology by introducing the Skullcrusher, an amplified subwoofer-enhanced headphone. We redefined the headphone market by fusing bold color schemes, loud patterns, unique materials and creative packaging with the latest audio technologies and innovative functionalities. While our design team identifies and tracks trends in the market, our goal is to establish market trends rather than to follow them. Our headphones feature our distinctive Skullcandy sound and leading-edge design. We offer a wide array of styles and price points and are expanding our brand into complementary audio products and accessories.

We pioneered the distribution of headphones in specialty retailers focused on action sports and the youth lifestyle, such as Zumiez, Tilly’s and hundreds of independent snow, skate and surf retailers. Through this channel we have reached influencers, core consumers who have established the credibility and authenticity of our brand. Building on this foundation, we have successfully expanded our distribution to select consumer electronics, mass, sporting goods and mobile phone retailers such as Best Buy, Target, Dick’s Sporting Goods and AT&T Wireless. Skullcandy products are sold in the United States and in more than 70 other countries around the world, with international sales representing approximately 28% of our net sales in 2009. We also offer products through our website, with online sales representing approximately 3% of our net sales in 2009.

Rick Alden, the creator of several successful action sports companies and a lifelong industry enthusiast, founded Skullcandy in 2003. He developed his inspiration for Skullcandy while listening to a portable music player on a chairlift in Park City, Utah. Rick has recruited a talented management team that shares his passion for the Skullcandy lifestyle. Our principal offices are located in Park City, Utah and San Clemente, California, which are at the epicenters of some of the best snow peaks, skate parks and surf breaks in the world. We believe these close connections to the Skullcandy lifestyle strengthen the authenticity of our brand and increase the loyalty of our consumers.

Market Opportunity

We believe the increasing use of portable media devices and smartphones, and the growing popularity of action sports, support our anticipated long-term sales growth.

The advent of portable media devices, such as Apple’s iPod, transformed the consumer electronics industry by dramatically increasing the portability and personalization of music, fueling an increased pervasiveness of

 

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these devices and their associated accessories, such as headphones. This transformation has continued as mobile phones have evolved into smartphones, capable of playing music and videos. IDC Research estimates that the total number of smartphones available worldwide will increase by a compound annual growth rate of 24% from 2010 through 2014, and that in 2010 alone, the total number of smartphones increased by 69% over 2009. This rapid growth is dramatically expanding the demand for headphones, especially ones with added functionality such as in-line microphones and volume controls. In addition, we believe consumers tend to own multiple sets of headphones and replace them frequently.

Our brand also benefits from the increasing popularity of action sports, particularly within the youth culture. Our core consumers, teens and young adults that associate themselves with snowboarding, skateboarding, surfing and other action sports, influence a broader consumer base that identifies with authentic action sports lifestyle brands. In addition, music is an integral part of the action sports lifestyle and headphones have become an accessory worn to express individuality.

Our Competitive Strengths

We believe that the following strengths differentiate us from our competitors, allow us to take advantage of the large and growing market we participate in and enable us to generate a strong return on our invested capital:

Leading, Authentic Lifestyle Brand. Skullcandy fuses music, fashion and action sports, all of which permeate youth culture. Our brand symbolizes youth and rebellion, and embodies our motto, “Every revolution needs a soundtrack.” The Skullcandy name, distinct skull logo and signature design aesthetic enable our consumers to express their individuality and go against the grain. We believe the power of our brand has driven our strong market share. According to The NPD Group’s Retail Tracking Service, we held the #2 position domestically in headphones based on unit and dollar sales in 2010, behind only Sony.

Brand Authenticity Reinforced Through High Impact Sponsorships. We believe we were the first headphone brand to sponsor leading athletes, DJs, musicians, artists and events within action sports and the indie and hip-hop music genres. We believe associating our name with leading athletes such as snowboarder Danny Kass and surfer Mick Fanning, music artists and DJs such as Snoop Dogg and Mix Master Mike of the Beastie Boys, major professional sports organizations such as the NBA and events such as the Warped Tour, Maloof Money Cup and U.S. Open of Surfing, increases our brand awareness and reinforces our credibility with our consumers.

Track Record of Innovative Product Design. Our company was founded on innovation. Our first headphone, the Skullcrusher, incorporated a subwoofer into the ear-piece, delivering an extreme level of bass. We employ innovative materials, technologies and processes in the design and development of our products. We leverage our relationships with sponsored athletes, DJs, musicians and artists to incorporate their ideas into our designs. We recently released our Aviator headphones, a high performance, over-the-ear headphone inspired by aviator sunglasses, and our Mix Master headphones, which were developed in collaboration with Mix Master Mike to offer performance and functionality demanded by professional DJs.

Targeted Distribution Model. We control the distribution and mix of our products to protect our brand and enhance its authenticity. We pioneered the distribution of headphones in specialty retailers focused on action sports and the youth lifestyle. Building on this foundation, we have successfully expanded our distribution to select consumer electronics, mass, sporting goods and mobile phone retailers. While we collaborate with all our retailers, we focus in particular on specialty retailers. One way we support these retailers is to offer them an exclusive collection of headphones called the Decibel, or dB, Collection. In addition, we provide our specialty retailers unique fixtures and product displays to enhance the presentation of our brand.

Proven Management Team and Deep-Rooted Company Culture. Rick Alden, our founder and chief executive officer, is a lifelong action sports enthusiast, and has over 20 years of experience as a successful

 

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entrepreneur in the action sports industry. Rick has recruited a talented management team that shares his passion for action sports and music, and that possesses substantial experience in product development, marketing, merchandising, operations and finance. Our culture and brand image enable us to successfully attract and retain highly talented employees who share our passion for action sports and music. We believe our employees represent the best version of our target consumers, which allows us to connect with and understand our target market in an authentic and credible way.

Growth Strategy

We intend to build upon our brand authenticity and product offering to continue to increase our net sales and profitability. Key elements of our growth strategy are to:

Further Penetrate Domestic Retail Channel. We plan to increase shelf space with our existing retailers in response to the growing demand for our products. We plan to increase the number of innovative in-store product displays and brand-building fixtures to emphasize our association with the action sports and indie and hip-hop music lifestyles. We are expanding our online and in-store sales force training programs, which we believe will strengthen our retailer relationships and better connect our brand with existing and new retailers. We also plan to increase sales by adding select new specialty, consumer electronics, mass, sporting goods and mobile phone retailers.

Accelerate Our International Growth. We currently sell our products internationally through third party distributors and believe that international expansion represents a substantial growth opportunity. To date, our international marketing and brand development efforts have been limited. We recently hired a vice president of international sales to manage the growth of our international operations and partner with our local distributors on sales and marketing efforts. We plan to replicate elements of our successful domestic marketing model by sponsoring internationally-based athletes, DJs, musicians, artists and events, and by creating localized marketing content to drive sales. We also plan to transition to a direct sales model in select international markets over time to leverage our brand building and marketing expertise to increase penetration of our products.

Grow Our Premium Product Offering. To date, the vast majority of our products have been priced in the $10 to $70 range. We have begun to extend our product offering to premium headphones and believe we can increase our market share in this growing market. Two recent premium additions to our product offering include our $150 Aviator headphones and our $250 Mix Master headphones. By offering premium products, we believe we can further strengthen our brand and broaden our reach to consumers with greater discretionary income.

Expand Complementary Product Categories. We have successfully tested and now plan to build more robust product assortments in certain complementary categories. For example, we plan to launch two new speaker dock models in the summer of 2011, we have recently hired a category manager to help increase our offering of protective cases for mobile devices, and we have several gaming and mobile phone headphones that are currently in various stages of development.

Increase Our Online Sales. We believe our consumers are heavy users of the internet. Our websites, including skullcandy.com and skullcandy.tv, and our mobile phone applications provide our consumers with compelling, entertaining action sports and music content, in addition to an engaging online shopping experience. We plan to further engage our consumers and drive sales by adding, optimizing and broadening the content we offer through these interactive platforms. We believe our new content will allow us to dynamically interact with our loyal fan base and provide customized shopping experiences. In addition, we plan to launch select international websites with localized content and e-commerce functionality.

 

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Our Products

Overview

We redefined the headphone market by fusing bold color schemes, loud patterns, unique materials and creative packaging with the latest audio technologies and innovative functionalities. Our headphones feature our distinctive Skullcandy sound and leading-edge design. We offer a wide array of styles and price points and are expanding our brand into complementary audio products and accessories.

Our product offering has evolved from one SKU in 2003 to over 1,200 SKUs across a broad range of categories as of September 30, 2010, including headphones as well as speaker docks, mobile device cases, apparel and other accessories. Headphones represented 90% and 87% of our gross sales for the year ended December 31, 2009 and the nine months September 30, 2010, respectively. Many of our headphone models include in-line microphones and volume control buttons compatible with the latest generation of smartphones, including Apple’s iPhone. We continually incorporate the latest technology into our product offerings to enhance performance and functionality.

Our range of headphone products includes:

 

Product

  In Ear   On Ear   Over Ear   Gaming
  LOGO   LOGO   LOGO   LOGO
         

Price Range

          $10-100 MSRP           $20-40 MSRP           $50-250 MSRP           $50-90 MSRP

Models

 

•    Jib

•    Ink’d

•    Riot

•    Chops

•    Smokin’ Buds

•    Titan

•    ASYM

•    50/50

•    Full Metal Jacket

•    Heavy Metal

•    Holua

 

•    Icon

•    Icon 2

•    Uprock

•    Icon Soft

•    Lowrider

 

•    Hesh

•    Agent

•    G.I.

•    Skullcrusher

•    SK Pro

•    Aviator

•    Mix Master

 

•    Lowrider Xbox

•    G.I. PS3

•    G.I. Xbox

Our Product Differentiation Strategy

We launched our initial products under the Skullcandy brand and logo. As we have expanded our distribution channels from independent action sports retailers to consumer electronics and other large national and regional chains, we have developed differentiated product lines designed to appeal specifically to consumers in the targeted channel while protecting our brand image. These product lines include:

dB Collection—The dB Collection is identified by the gold dB badge and features state-of-the-art functionality, exclusive designs and distinct packaging that appeal to the individual fashion interests of our target consumers. Products in the dB Collection are available exclusively from our core independent specialty retailers and our website.

 

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Mobility Collection—The mobility collection features our franchise ear bud styles available exclusively with an in-line microphone. The collection is targeted at the mobile channel with product features designed to work on cell phones and smartphones, such as the Apple iPhone.

2XL—The 2XL brand represents a lifestyle rooted in traditional sports, motor sports and rock & roll music. 2XL brand products are available in fewer styles and colors and incorporate simpler designs and technology than our Skullcandy branded or dB Collection products. We developed the 2XL brand to create a product line that could be sold at a lower price point at retailers that do not carry the Skullcandy brand.

Product Design and Development

We are a company founded on innovation. We believe that our success is uniquely tied to our ability to consistently introduce new product ideation concepts and combine them with bold color schemes, unique materials and creative packaging. We launched our first headphones in 2003 and have grown our product offering to over 20 different models of headphones today.

Our product design efforts are led by Rick Alden, our chief executive officer, and Dan Levine, our chief merchandising officer, who work closely with the category managers in each of our product categories and with our in-house team of engineers, designers and artists to develop and iterate design ideas. We believe our creative team is unique to our market since it is comprised of individuals dedicated to the Skullcandy culture and lifestyle.

We strive to develop and employ innovative materials, technologies and processes in the design of our product. While our design team identifies and tracks trends in the market, our goal is not to follow market trends but rather to establish them. In addition to product design and development, our design team is also responsible for developing the packaging for our various products. We believe packaging is a critical component in developing and maintaining brand image and authenticity and contributes directly to point of sale purchase decisions.

We leverage our relationships with sponsored athletes, DJs, musicians and artists in the product development process. We incorporate their ideas into our designs at the product ideation phase, enhancing our authenticity with consumers.

Our product development process is designed to facilitate speed-to-market while adhering to a strategic milestone-based engineering timeline. Our in-house industrial design team performs the majority of the initial conceptualization while external industrial design firms are contracted to design the remaining portion. Our in-house industrial design team enables designs to be rapidly created, prototyped and reviewed before being turned over to our project engineering managers to begin the development of the product. This collaborative interaction helps accelerate the concept-to-market timeline while preserving the brand image, authenticity, quality and performance.

We utilize third-party manufacturers to facilitate the commercialization of our products from the computer aided design stage to mass production, which includes tool making, decorating, materialization, acoustic tuning and performance and compliance testing.

We are typically able to bring new products from concept to market in approximately 10 to 24 months depending on the technology integration and complexity of the product. In situations where we are launching new products that are based on existing designs and do not require tooling, we can accelerate the concept-to-market process to approximately 6 to 12 months.

Marketing

Our marketing and art departments employ a multi-pronged marketing strategy, including sponsorship of athletes, DJs, musicians, artists and athletic and music events, interactive media and traditional print and television advertising. We believe that our marketing strategy strengthens our brand authenticity in our core markets by integrating our brand with the activities and interests of our loyal fan base.

 

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Athlete and Musician Sponsorships

We believe we were the first headphone brand to sponsor leading athletes, DJs, musicians, artists and events within all areas of action sports and the indie and hip-hop music genres. Our sponsored athletes, DJs, musicians and artists generally display our logo on their equipment prior to and during competition or performances and concerts, as well as during daily activities and media appearances. We believe associating our name with leading athletes, DJs, musicians, artists and major professional sports organizations increases our brand awareness and reinforces our credibility with our consumers.

Our sponsored athletes, DJs, musicians and artists include:

 

LOGO

  The Skullcandy Snow Team   The Skullcandy Ski Team
 

•  Pat Milbery

•  Marc Frank Montoya

•  Aaron Biittner

•  Devun Walsh

•  Stevie Bell

•  Kimmy Fasani

•  Justin Bennee

•  Drew Fuller

•  Tim Humphreys

•  Tyler Flanagan

•  Jamie Anderson

 

•  Mikey Rencz

•  Eero Ettala

•  Eiki Helgason

•  Halldor Helgason

•  Benny Hernriech

•  Bode Merrill

•  Cooper Hoffmeister

•  Scott Stevens

•  Mark Edlund

•  Zak Hale

•  Johnny Lazzareschi

 

•  Andy Mahre

•  Julian Carr

•  Jen Hudak

•  Justin Dorey

•  Peter Olenick

•  Kaya Turski

•  Tanner Rainville

•  TJ Schiller

 

•  Tom Wallisch

•  Mike Riddle

•  John Spriggs

•  Jossi Wells

•  Roz Groenewoud

•  Sammy Carlson

•  Tanner Hall

  The Skullcandy Skate Team   The Skullcandy Surf Team
 

•  Adam Dyet

•  PLG

•  Greg Lutzka

•  Lauren Perkins

•  Lizard King

 

•  Corey Duffel

•  Theotis Beasley

•  Steve Caballero

•  Christian Hosoi

 

•  Owen Wright

•  Mick Fanning

•  Kolohe Andino

•  Dane Gudauskas

•  Patrick Gudauskas

•  Tanner Gudauskas

 

•  Kai Otton

•  Clay Marzo

•  Balaram Stack

•  Dylan Graves

•  Sam Hammer

  The Skullcandy Moto Team   The Skullcandy Wake Team
 

•  Adam Jones

•  Mike Mason

•  Brian Foster

•  Tarah Geiger

 

•  Justin Brayton

•  Nick Paluzzi

•  Cooper Webb

 

•  Scott Byerly

•  Brandon Thomas

•  Melissa Marquardt

•  Ben Greenwood

 

•  Jeff McKee

•  Pat Panakos

•  Rob Jacques

•  Shawn Watson

  The Skullcandy BMX Team   The Skullcandy Mountain Bike Team
 

•  Ryan Guettler

•  TJ Ellis

•  Mike “Hucker” Clark

•  Rob Wise

 

•  Brandon Dosch

•  Matt Beringer

•  Josh Harrington

 

•  Kirt Voreis

•  Jamie Goldman

 

•  Chris Van Dine

•  Andrew Taylor

LOGO

  The Skullcandy NBA Crew
 

•  Kevin Durant

•  Andre Iguodala

•  Deron Williams

   

•  James Harden

•  Derrick Rose

   

LOGO

  The Skullcandy Music Family   The Skullcandy DJ Family
 

•  Snoop Dogg

•  Slightly Stoopid

•  Thrice

•  Molotov

•  Othello

•  The Bouncing Souls

•  Dirty Heads

•  Murs

•  Del

•  Ozomatli

•  Chali 2na

•  Super Nat

 

•  RocNation: Jay-Z, The Ting Tings and several other artists and producers

•  Metallica

•  Hyper Crush

•  Forever the Sickest Kids

•  Gift of Gab

•  Rita J

•  Pepper

•  Passafire

•  Ugly Duckling

•  The Bronx

 

•  Mix Master Mike

•  Mike Relm

•  NASA

•  The Crystal Method

•  Skeet Skeet

•  DJ Irie

•  MFM

•  DJ Tina T

•  Amp Live

•  DJ Poet Name Life

•  Ohmega Watts

•  Waajeed

•  DJ House Shoes

 

•  DJ Z-Trip

•  DJ Crime

•  DJ Juggy

•  Risk One

•  DJ Drez

•  DJ Miner

•  Einstein

•  Le Castle Vania

•  DJ Vinroc

•  DJ Rampage

•  The Pinkertones

•  DJ Ashley Anderson

•  DJ Unite

MUSIC NBA ACTION SPORTS

 

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The majority of the individuals and groups listed above do not have contractual relationships with us but support our brand by wearing our products and participating in Skullcandy events and marketing activities. We compensate the sponsored athletes that we do have contractual relationships with for promoting our products. Sponsorship arrangements are typically structured to give our sponsored team members financial incentives to maintain a highly visible profile with our products. Our contracts typically have a one year term, with some providing for a two year term, and grant us an unlimited license for the use of their names and likenesses, and typically require them to maintain exclusive association with our headphones. In turn, we agree to make cash payments to our sponsored team members for wearing our products during various public appearances, in magazine shoots and on the podium after certain competitive victories. In addition to cash payments, we also generally provide limited free products for their use, and reimburse certain travel expenses incurred in conjunction with promoting our products.

Event Sponsorship

Action Sports Event Sponsorship. We participate in grassroots and major national events that support our commitment to snowboarding, skateboarding and surfing. Spectators and athletes at these events are exposed to and experience our brand through an interactive environment that includes music listening stations, DJ booths and promotional product giveaways.

Our sponsored action sports events include:

 

Action Sports Events

•   U.S. Open of Surfing

•   Maloof Money Cup

•   East Coast Surfing Championship

•   Zumiez Coach Tour

  

•   Triple Crown of Surfing

•   X Games China

•   SLC Dew Tour

•   World Ski and Snowboard Festival

Music Event Sponsorship. We support several national music events and tours. At these events, we engage attendees through music acts on a branded stage, music listening stations and interactive media stations. In addition to various music events and tours, we sponsor a stage at the Hard Rock Hotel & Casino in Las Vegas, where concert attendees can see iconic and rising music stars on a stage emblazoned with our name and logo.

Our sponsored music events and tours include:

 

Music Events

•   Warped Tour

•   Afro-punk Festival

•   SXSW Music Festival

  

•   Candlelight Serenade Acoustic Festival

•   Sessions at Sundance Film Festival

•   Hard Rock Hotel and Casino Las Vegas concert  stage

Interactive Media

Websites. Our websites, skullcandy.com and skullcandy.tv, are part of our interactive media strategy and our e-commerce business strategy, where visitors can view videos, listen to music by our sponsored artists, read blog updates on events, athletes, DJs, musicians and artists, and shop for Skullcandy products.

Social Media. We utilize social media, such as Facebook and Twitter, to enable a direct conversation and connection with our target consumers. We communicate local and national event participation, provide and solicit product feedback, launch brand contests and discuss news about our sponsored athletes, DJs, musicians and artists. Similarly, some of our sponsored athletes, DJs, musicians and artists use their respective Facebook and Twitter accounts to provide announcements about our products and engage our target consumers with insights as to how they use our products to enhance their sports or art.

 

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Mobile Phone Applications. We offer a free iOS app through the Apple App Store. The app allows users to find snow reports for all North American and international ski resorts, search for current surf reports for all major international surf spots, locate a skate park anywhere in the United States, employ any of our fan generated wallpaper designs, find a local Skullcandy dealer and connect to our website to purchase Skullcandy products. As of September 30, 2010, our app had been downloaded approximately 250,000 times. We recently launched an Android application with similar functionality.

Print and Television Advertising

Print Advertising. Our in-house creative media team focuses on print media placement into endemic magazines that support the lifestyles that we believe are important to our target consumers. These magazines include Surfing, Transworld Surf, Transworld Skate, Transworld Snowboarding, Nylon, Alternative Press, Freeskier and Fader.

TV Sponsorship. We are the presenting sponsor of the highest rated show on Fuel TV, “Built To Shred.” Built To Shred is a reality-style TV show featuring host Jeff King building skateparks and skate features. In addition, Built To Shred regularly features skateboarders riding while prominently displaying Skullcandy products and logos.

Distribution and Sales

Domestic. As we have grown our retailer base from independent action sports retailers to large regional and national retailers, we have sought to protect and enhance our brand image by carefully controlling the distribution of our products as well as the product mix we offer to each retailer.

Our core retailers are independent specialty retailers focused on action sports and the youth lifestyle. In addition, we sell to a number of national and regional retailers with an action sports orientation, such as Zumiez, Tilly’s, Jack’s Surfboards, Blades, Ron Jon Surf Shop and Karmaloop. Our specialty retailers provide a direct connection to our target consumer and serve as the platform upon which we develop, reinforce and maintain our reputation as an authentic lifestyle brand. We rely on independent sales representatives to establish and maintain our relationship with these specialty retailers. Our independent sales representatives collaborate with these retailers to develop appropriate product mix and in-store marketing displays that promote our products and brand image. As of September 30, 2010 we utilized 30 independent, commission-based sales representatives that we manage with an in-house team of five regional sales managers. To further help protect our brand image, we developed our dB Collection, which features state-of-the-art functionality, exclusive designs and distinct packaging. The dB Collection is available exclusively through our specialty retailers and online at our website, allowing specialty retailers to differentiate their product offerings from other Skullcandy products offered by large retailers.

We have leveraged the brand authenticity built with our specialty retailers to launch products with various large national retailers, including those focused on consumer electronics, such as Best Buy and Radio Shack, mass retailers, such as Target and Fred Meyer, and those focused on sporting goods, such as Dick’s Sporting Goods and The Sports Authority. We are selective about the national retailers we sell through as well as with the product mix we offer to these retailers in order to protect our brand image and authenticity. Historically, we have managed our relationships with these large retailers through independent commission-based sales representatives. More recently we hired a national sales manager, who is located in Minneapolis and works directly with our two largest retailers, Target and Best Buy. Our national sales manager enables us to improve the frequency and level of interaction with these retailers. Our other large retailers will continue to be managed by our regional sales managers through independent sales representatives; however, we expect to continue to seek opportunities to transition large retailers into a direct relationship.

Domestic sales of our products represented 72.5% and 81.1% of net sales for the year ended December 31, 2009 and the nine months ended September 30, 2010, respectively. During these periods, each of Target and Best

 

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Buy accounted for more than 10% of our net sales. We have entered into vendor program agreements with both Target and Best Buy and many of our other large retailers that govern the terms of sale, rebates and obligations of each party, but each purchase is typically made on a purchase order basis. None of our retailers have minimum or long term purchase obligations. If either of these retailers chooses to slow its rate of purchases of our products, decrease its purchases of our products, or no longer purchase our products, our net sales and results of operations could be adversely affected.

International. Outside the United States, we sell our products through third party distributors. We currently have relationships with 26 distributors serving more than 70 countries. Sales to our European distributor, 57 North, represented more than 10% of our net sales for the year ended December 31, 2009 and the nine months ended September 30, 2010. With the exception of 57 North, we generally do not have distribution agreements with any of our international distributors. Our distribution agreement with 57 North provides for exclusivity in Europe. In September 2009, we entered into an arbitration proceeding with 57 North associated with a legal dispute. The arbitration process was resolved in the third quarter of 2010. Following the arbitration proceeding, our agreement with 57 North will continue until 2013. We are currently working aggressively with 57 North to expand our European sales. We sell to our other distributors on a purchase order basis and generally limit ourselves to one distributor in any particular region. Our international distributors can slow or stop their rate of purchase at any time at their sole discretion. If any of these distributors, including, in particular, 57 North, were to stop selling our products or slow their rate of purchase, our net sales could be adversely affected. Additionally, we cannot make assurances that we would be able to locate substitute distributors in a timely manner, if at all, if any of these international distributors stopped purchasing our products. International sales of our products represented 27.5% and 18.9% of net sales for the year ended December 31, 2009 and the nine months ended September 30, 2010, respectively.

Online. Nearly all of our products are available for purchase on our website and we plan to launch select international websites with localized content and e-commerce functionality. For the year ended December 31, 2009 and the nine months ended September 30, 2010, sales through our website represented 4% of net sales in each period.

Manufacturing and Sourcing

Nearly all of our products are manufactured outside of the United States. We do not own any manufacturing facilities and utilize third party manufacturing for all of our products. We do not have any long-term contracts with our existing manufacturers and no manufacturer is required to produce our products in the long-term. We procure finished and packaged products from our manufacturers so that we require no subassembly. In 2010, substantially all of our products were manufactured in China.

We utilized 19 independent manufacturers in 2010. Two of our manufacturers together accounted for 72% of our cost of goods sold in 2009 and 73% of our cost of goods sold for the nine months ended September 30, 2010. Currently, each of these manufacturers is the sole source supplier of the products that it produces. In order to mitigate the risk associated with having single source manufacturers, we have made diversification of our manufacturing base a high priority. We recently created a manufacturer selection and qualification process to help facilitate our diversification needs. Furthermore, we are actively looking for sourcing opportunities in other regions of China as well as new countries to further diversify our manufacturing sources geographically.

In order to better manage our manufacturers, we recently opened an office in Southern China. This office is tasked with quality compliance, component sourcing and production control for our manufacturers. Our Asia operations group evaluates all manufacturers for quality, delivery, costs, quality systems and social compliance. We expect that the increased oversight provided by this team will enable us to increase quality and enhance delivery performance.

 

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Order Fulfillment and Inventory Management

In August 2010, we entered into a three-year contract with UPS Supply Chain Solutions, a third party supply chain provider, for use of their distribution facility in Auburn, Washington. We store and ship all products for North American retailers and distributors and some products for international distributors from this facility. We believe we have sufficient capacity at this facility for existing and expected needs.

In order to further reduce costs and facilitate order fulfillment to our retailers, in 2011 we plan to contract with UPS Supply Chain Solutions to open a second domestic distribution facility near Louisville, Kentucky. In addition, we expect to expand our international distribution network with other UPS facilities around the world in order to reduce costs and decrease order lead-time. We are looking at options to serve international retailers and distributors from UPS facilities in Europe, Canada and Japan. We currently have a third-party warehouse near Shenzhen, China to handle most international orders outside of North America and expect to transition the inventory from this warehouse to a UPS facility near Shenzhen in 2011. All UPS facilities utilize the same technology and systems as the UPS facility we currently use in Auburn, Washington, which will greatly reduce the cost and time of implementation.

During the first half of 2010, we experienced increased lead-time from a majority of our manufacturers in China. We believe we will be able to compensate for potential inventory shortages with improved supply management and dual sourcing for certain products. Changing economic conditions in China may cause further issues with lead-time. Because we operate on a build-to-forecast model, extended lead-time can cause unexpected inventory shortages or excesses which may reduce our net sales.

Management Information Systems

In October 2008, we implemented an integrated information system called SAP Business ByDesign. This Enterprise Resource Planning, or ERP, software manages purchasing, planning, inventory tracking, financial information, and retailer or distributor ordering. SAP Business ByDesign is a hosted solution. All data resides on SAP servers and is accessed over secure internet connections. We were an early adopter of this system, and we have benefited from a close development and marketing relationship with SAP. In August 2010, we began to work with SAP and UPS on a customized gateway to our third party logistics partner, UPS Supply Chain Solutions. This project will extend our ERP system into the UPS Warehouse Management System for complete location accuracy, wireless functionality and full visibility into the receiving, storage and shipment of our goods. The gateway connection between the SAP and UPS systems is repeatable as we expand into new UPS distribution centers.

Competition

The consumer electronics product market in which we operate is highly competitive and includes large, well-established companies. We face competition from consumer electronics brands that have historically dominated the stereo headphone market, including Sony, JVC and Bose. These companies have significant competitive advantages, including greater financial, distribution, marketing and other resources, longer operating histories, better brand recognition among certain groups of consumers, and greater economies of scale. In addition, these competitors have long-term relationships with many of our larger retailers.

Well established sports and lifestyle brands have also recently entered the headphone market, such as adidas and Nike. Similar to the large electronic companies we compete with, these sports brand competitors have significant competitive advantages, including greater financial, distribution, marketing and other resources, longer operating histories, better brand recognition among certain groups of consumers, and greater economies of scale. For example, adidas and Nike have partnered with established consumer electronics brands (Sennheiser and Phillips, respectively) to release lifestyle-branded headphones.

 

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In addition, we face competition from other lifestyle brand companies, such as Beats by Dr. Dre and Nixon. These companies have recently introduced products that compete directly with our headphones and market their lifestyle-branded consumer electronics within the action sports and indie and hip-hop markets. If we are unable to protect our brand image and authenticity, while carefully balancing our growth and maintaining quality, we may be unable to effectively compete with these new market entrants.

Recently, some retailers have begun to introduce their own private label headphones. If any of our retailers introduce such headphones, it could reduce the volume of product they buy from us as well as decrease the shelf space they allow for our products. The introduction of private label headphones could decrease the demand for our product and have an adverse effect on our net sales and results of operations.

The inability to compete effectively against new and existing competitors could have an adverse effect on our net sales and results of operations. We believe our brand image authenticity, innovative products, product quality and selective distributions policies are important aspects of competition and are among our primary competitive advantages.

Intellectual Property

We utilize the trade name “Skullcandy” and the Skullcandy logo and trademark on nearly all of our products. We believe that having distinctive marks that are registered and readily identifiable is an important factor in identifying our brand and in distinguishing our products from those of our competitors. We consider the Skullcandy trademark and our skull logo trademark and copyrighted design to be among our most valuable assets and we have registered these trademarks in more than 30 countries. Each trademark registered with the U.S. Patent and Trademark Office has a duration of ten years and trademarks registered outside of the United States normally have a duration of ten years depending upon the jurisdiction. Trademarks are generally subject to an indefinite number of renewals for a like period upon appropriate application.

We also have utility patents on certain features and technologies used in some of our products, and have filed for additional utility and design patents. These applications are in various stages. We cannot assure you that any pending future patent applications held by us will result in an issued patent, or that if patents are issued to us, that such patents will provide meaningful protection against competitors or against competitive technologies.

Properties

Our executive and administrative offices are located in Park City, Utah, where we lease approximately 16,500 square feet of space pursuant to a lease that expires in February 2013 with an option to extend through February 2018. Our marketing offices are located in San Clemente, California, where we lease approximately 5,200 square feet of space pursuant to a lease that expires in November 2014 with an option to extend through November 2016. Our Asia operations offices are located in the Nanshan District of Shenzen, China, where we lease approximately 9,300 square feet pursuant to a lease that expires in September 2013.

Employees

As of December 31, 2010, we had 132 full-time employees. In the United States, we had 110 full-time employees, including 50 in sales and marketing, 23 in design and development and 15 in supply chain. In China, we had 22 full-time employees. None of our employees are currently covered by a collective bargaining agreement. We consider our relationship with our employees to be excellent and have never experienced a labor-related work stoppage.

Legal Proceedings

We are subject to various claims, complaints and legal actions in the normal course of business from time to time. We do not believe we have any currently pending litigation of which the outcome will have a material adverse effect on our operations or financial position.

 

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MANAGEMENT

The following table sets forth certain information regarding our executive officers and directors, as of the date of this prospectus:

 

Name

   Age     

Position

Rick Alden

     46       Chief Executive Officer and Director

Jeremy Andrus

     39       President and Chief Operating Officer

Mitch Edwards

     52       Chief Financial Officer and General Counsel

Dan Levine

     41       Chief Merchandising Officer

Clarke Miyasaki

     33       Global Vice President, Business Development and Marketing

Aaron Behle

     39       Vice President, International Sales

Mike Carter

     39       Vice President, Global Marketing: Boardsports

Richard Sargente

     43       Vice President, North America Sales

Jeff Kearl(1)

     38       Chairman of the Board

Joe Ferreira, Jr.(1)(2)

     54       Director

David Oddi(2)

     40       Director

Greg Warnock(1)(2)

     50       Director

 

(1) Member of compensation committee.
(2) Member of audit committee.

Executive Officer Biographies

Rick Alden founded Skullcandy in January 2003 and currently serves on our board of directors and as our chief executive officer. Prior to founding Skullcandy, Rick co-founded Device Manufacturing, a snowboard boot and binding company, in 1995 and later served as its chief operating officer until it was purchased by Atomic Ski Company in 1999. In 1986, Rick co-founded National Snowboard, a snowboard events and marketing company, which was acquired by the American Ski Association in 1991. Rick holds a B.S. from the University of Colorado.

Jeremy Andrus joined us in March 2005 and currently serves as our president and chief operating officer. Prior to joining us, Jeremy served as a strategic planner for Kimpton Hotel & Restaurant Group from 2003 to 2005 and developed Marriott hotel properties from 1998 to 2000. Jeremy worked as a consultant for Monitor Company from 1996 to 1998. Jeremy holds a B.A. from Brigham Young University and an M.B.A. from Harvard Business School.

Mitch Edwards joined us in May 2010 and currently serves as our chief financial officer and general counsel. From December 2007 to June 2010, Mitch served as chief financial officer and general counsel of BitTorrent, a leading global provider of Internet software. Prior to that, Mitch served as chief financial officer of several hi-tech and entertainment companies from 2004 to 2007, including Groxis, Ikano Communications and Digital Courier Technologies. From 1992 to 1996, Mitch was a partner at Brobeck, Phelger & Harrison LLP. Mitch holds a B.A. from Brigham Young University, a B.A. and M.A. from Oxford University and a J.D. from Stanford Law School.

Dan Levine joined us in September 2008 and currently serves as our chief merchandising officer. From September 2007 to September 2008, Dan was president of RVCA, a lifestyle apparel brand based in Orange County. From July 2003 to September 2007, Dan was vice president of merchandising design and business development for Hurley International, a youth lifestyle brand, and a division of Nike. Dan holds a B.A. from Tufts University.

Clarke Miyasaki joined us in April 2008 and currently serves as our global vice president, business development and marketing. From August 2004 to April 2008, Clarke served as vice president of business development at Logoworks, which was acquired by Hewlett-Packard in April 2007. From 2002 to 2004, Clarke was an associate at vSpring Capital, an early stage venture capital fund. Clarke holds a B.S. from Brigham Young University.

 

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Aaron Behle joined us in September 2010 and currently serves as our vice president, international sales. From January 2006 to September 2010 Aaron served as global general manager and chief operating officer of Dragon Alliance, a premium eyewear company that separated from Oakley in June 2008. Aaron continues to serve on the board of directors of Dragon Alliance. From 2001 to 2005, Aaron was vice president of international for Reef, an action sports and surf-inspired footwear brand. He was also an international brand manager for Oakley from 1996 to 1999. Aaron is a licensed CPA in California and holds a B.A. from the University of California, Los Angeles.

Mike Carter joined us in September 2009 and currently serves as our vice president, global marketing: boardsports. Prior to joining us, from January 2000 to September 2009, Mike was a co-founder and global marketing director of Electric Visual, a premium eyewear company that was acquired by Volcom in 2008. From January 1997 to December 1999, Mike served as sports marketing manager for Arnette Optical Illusions, a sunglasses company. Prior to that, Mike served in various sales positions in the action sports industry. Since January 2010, Mike has served as a member of the advisory board of Surf Industry Manufacturers Association (SIMA). Mike holds a B.A. from San Diego State University.

Richard Sargente joined us in December 2009 and serves as our vice president, North America sales. From March 2009 to December 2009, Richard served as vice president of sales for the consumer electronics division of Panasonic. From 2004 to March 2009, Richard served as vice president of sales, North America accessories and peripherals division for Philips Electronics. Richard holds a B.S. and M.B.A. from St. Thomas Aquinas College.

Director Biographies

Jeff Kearl has served as a member of our board of directors since March 2005 and currently serves as our chairman and as a member of our compensation committee. Jeff is the chief executive officer and chairman of the board of Stance, an action sports-inspired men’s hosiery company. From April 2007 to April 2008, Jeff was director of strategy and new ventures for Hewlett Packard. From June 2004, Jeff was executive vice president and a member of the board of Logoworks until it was acquired by Hewlett-Packard in April 2007. Jeff was previously an associate at vSpring Capital, an early stage venture capital fund. Jeff currently serves on the board of directors at Needle, Stance and Connect SDSI. Jeff holds a B.A. from Brigham Young University.

Rick Alden. See above.

Joe Ferreira, Jr. has served as a member of our board of directors since November 2008 and currently serves as chairman of our compensation committee and a member of our audit committee. Joe is a co-founder and partner at Goode Partners, a private equity firm. Prior to the founding of Goode Partners, Joe founded and was president and chief executive officer of Woodclyffe Group, an international business consulting and interim management firm. Prior to founding Woodclyffe Group in 2001, Joe was co-chief operating officer, president of international and a member of the board of directors of Avon Products. Joe has served on the board of directors of various companies, public and private, and currently sits on the board of directors of Chuy’s Holdings, Rosa Mexicano, Bowlmor Lanes and Princess House. Joe holds a B.S. from Central Connecticut State University and an M.B.A. from Fordham University.

David Oddi has served as a member of our board of directors since November 2008 and currently serves as a member of our audit committee. David is a co-founder and partner at Goode Partners, a private equity firm. Prior to the founding of Goode Partners, David was a partner of Saunders Karp & Megrue, a private equity firm. David previously served as an analyst in the leveraged finance group of Salomon Brothers. David has served on the board of directors of various companies, public and private, and currently sits on the board of Chuy’s Holdings, Intermix, Rosa Mexicano, Luxury Optical Holdings and Bowlmor Lanes. David holds a B.S. from the Wharton School at the University of Pennsylvania.

Greg Warnock has served as a member of our board of directors since August 2006 and currently serves as chairman of the audit committee and as a member of our compensation committee. Greg is a co-founder and

 

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managing director of Mercato Partners, a private equity firm. Prior to the founding of Mercato Partners, Greg co-founded vSpring Capital, an early stage venture capital fund. Greg is also the founder of Junto Partners, an entrepreneurship education initiative that trains and mentors aspiring entrepreneurs. Greg holds a B.S., an M.B.A. and a Ph.D. from the University of Utah.

Board of Directors

Our board of directors currently consists of five directors. Joe Ferreira, Jr., David Oddi and Greg Warnock were elected as directors pursuant to a security holders agreement. The provisions of the agreement regarding the right of our preferred stockholders to nominate and elect members of the board will terminate upon the consummation of the offering. See “Certain Relationships and Related Party Transactions—Series C Convertible Preferred Stock Financing and Stockholder Redemption—Security Holders Agreement.” Additionally, Joe and David have agreed to resign from our board of directors upon consummation of this offering. We are actively searching for additional board members whom we expect to join our board of directors prior to the consummation of this offering.

Upon consummation of this offering, our bylaws will be amended and restated to provide that the authorized number of directors may be changed only by resolution of the board of directors, and our amended and restated certificate of incorporation will divide our board into three classes with staggered three-year terms. At each annual meeting of stockholders, the successors to directors whose terms then expire will be elected to serve from the time of election and qualification until the third annual meeting following election or until their earlier death, resignation or removal.

This classification of the board of directors, together with the ability of the stockholders to remove our directors only for cause and the inability of stockholders to call special meetings, may have the effect of delaying or preventing a change in control or management. See “Description of Capital Stock—Anti-Takeover Provisions” for a discussion of other anti-takeover provisions found in our amended and restated certificate of incorporation.

Commencing in fiscal year 2011, our board of directors will review at least annually the independence of each director. During these reviews, the board will consider transactions and relationships between each director (and his or her immediate family and affiliates) and our company and its management to determine whether any such transactions or relationships are inconsistent with a determination that the director is independent. This review will be based primarily on responses of the directors to questions in a directors’ and officers’ questionnaire regarding employment, business, familial, compensation and other relationships with Skullcandy and our management. Prior to the consummation of this offering, our board will meet to formally assess the independence of each of our directors.

As required by The Nasdaq Global Market, we anticipate that our independent directors will meet in regularly scheduled executive sessions at which only independent directors are present. We intend to comply with future governance requirements to the extent they become applicable to us.

Corporate Governance

We believe that good corporate governance is important to ensure that, as a public company, we will be managed for the long-term benefit of our stockholders. In preparation for the offering being made by this prospectus, we and our board of directors have been reviewing the corporate governance policies and practices of other public companies, as well as those suggested by various authorities in corporate governance. We have also considered the provisions of the Sarbanes-Oxley Act and the rules of the SEC and The Nasdaq Global Market.

Based on this review, we intend to establish and adopt charters for the audit committee, compensation committee and nominating and corporate governance committee, as well as a code of business conduct and ethics applicable to all of our directors, officers and employees.

 

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Board Committees

Upon consummation of this offering, our board of directors will have three standing committees: an audit committee, a compensation committee and a nominating and corporate governance committee.

Audit Committee

Our audit committee is a standing committee of our board of directors. The functions of our audit committee include appointing and determining the compensation for our independent auditors, establishing procedures for the receipt, retention and treatment of complaints regarding internal accounting controls and reviewing and overseeing our independent registered public accounting firm. The composition of the audit committee will be in compliance with the standards established by The Nasdaq Global Market and SEC rules upon the consummation of this offering.

Compensation Committee

Our compensation committee is a standing committee of our board of directors. The compensation committee reviews and recommends to our board of directors the salaries and benefits for our executive officers and recommends overall employee compensation policies. The compensation committee also administers our equity compensation plans. The composition of the compensation committee will be in compliance with the standards established by The Nasdaq Global Market and SEC rules upon the consummation of this offering.

Nominating and Corporate Governance Committee

We currently do not have a nominating and corporate governance committee. Prior to the consummation of this offering we will establish a standing nominating and corporate governance committee which will operate under a written charter adopted by our board of directors. The nominating and corporate governance committee will indentify individuals qualified to serve as members of our board of directors, recommend to our board nominees for our annual meetings of stockholders, evaluate our board’s performance, develop and recommend to our board corporate governance guidelines and provide oversight with respect to corporate governance and ethical conduct. The composition of the nominating and corporate governance committee will be in compliance with the standards established by The Nasdaq Global Market and SEC rules upon the consummation of this offering.

Other Committees

Our board of directors may establish other committees as it deems necessary or appropriate from time to time.

Compensation Committee Interlocks and Insider Participation

None of our executive officers have served as a member of the board of directors or compensation committee of any related entity that has one or more executive officers serving on our board of directors or compensation committee.

 

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COMPENSATION DISCUSSION AND ANALYSIS

This Compensation Discussion and Analysis section discusses the compensation programs and policies for our executive officers and the compensation committee’s role in the design and administration of these programs and policies and in making specific compensation decisions for our executive officers, including our “named executive officers” for 2010 who consist of Rick Alden, chief executive officer; Jeremy Andrus, president and chief operating officer; Mitch Edwards, chief financial officer and general counsel; Dan Levine, chief merchandising officer; and Aaron Behle, vice president, international sales.

Executive Compensation Philosophy and Objectives

We are a leading audio brand company. To succeed in our industry, we must continuously develop and refine new and existing products, and demonstrate an ability to quickly identify and capitalize on new business opportunities. To achieve these objectives, we need a highly talented and seasoned team of technical, sales, marketing, design, operations, financial and other business professionals.

We recognize that our ability to attract and retain these professionals, as well as to grow our organization, largely depends on how we compensate and reward our employees. We strive to create an environment that is responsive to the needs of our employees, is open towards employee communication and continual performance feedback, encourages teamwork and rewards commitment and performance. The principles and objectives of our compensation and benefits programs for our executive officers and other employees are to:

 

   

attract, engage and retain the best executives to work for us, with experience and managerial talent enabling us to be an employer of choice in highly competitive and dynamic industries;

 

   

align compensation incentives with our business and financial objectives and the long-term interests of our stockholders;

 

   

motivate and reward executives whose knowledge, skills and performance ensure our continued success; and

 

   

ensure that our total compensation is fair, reasonable and competitive.

We compete with many other companies in seeking to attract and retain experienced and skilled executives. To meet this challenge, we have embraced a compensation philosophy of offering our executive officers competitive compensation and benefits packages that are focused on long-term value creation and that reward our executive officers for achieving our financial and strategic objectives.

Roles of Our Board of Directors, Compensation Committee and Chief Executive Officer in Compensation Decisions

Historically, the initial compensation arrangements with our executive officers, including the named executive officers, have been determined in arm’s-length negotiations with each individual executive. For each of the named executive officers, these compensation arrangements have been memorialized in formal employment agreements or offer letters, described in “—Narrative Disclosure to Summary Compensation Table and Grants of Plan-Based Awards Table—Current Employment Agreement and Offer Letters” below. Typically, our chief executive officer has been responsible for negotiating these arrangements, except with respect to his own compensation, with the oversight of our board of directors and, since April 2009, with the oversight of our compensation committee. The compensation arrangements have been influenced by a variety of factors, including, but not limited to:

 

   

our financial condition and available resources;

 

   

our need to fill a particular position;

 

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an evaluation of the competitive market, based on the collective experience of the members of the compensation committee;

 

   

the length of service of an individual; and

 

   

the compensation levels of our other executive officers;

each as of the time of the applicable compensation decision. Generally, the focus of these arrangements has been to (i) recruit skilled individuals to help us meet our product development, retailer and distributor acquisition and growth objectives, while continuing to achieve our financial growth and profitability goals, and (ii) to maintain the level of talent and experience needed to further our growth.

Our board of directors and, since April 2009, our compensation committee have been responsible for overseeing our executive compensation program, including the compensation arrangements for our chief executive officer and the other named executive officers. Determinations regarding the named executive officers’ compensation for 2010 were made by the compensation committee after consideration of the recommendations made by Rick and Jeremy (with respect to the named executive officers other than themselves).

To control expenditures and effectively allocate our limited resources, we have not historically engaged compensation consultants or established formal benchmark processes against any set of peer-group companies. The current compensation levels of our executive officers, including the named executive officers, primarily reflect the varying roles and responsibilities of each individual, as well as the length of time each executive officer has been employed by us.

Compensation Philosophy

We design the principal components of our executive compensation program to fulfill one or more of the principles and objectives described above. Compensation of our named executive officers for 2010 consisted of the following elements:

 

   

base salary;

 

   

annual performance-based bonuses;

 

   

long-term cash incentives;

 

   

stock options;

 

   

certain severance benefits;

 

   

a retirement savings (401(k)) plan; and

 

   

health and welfare benefits and certain limited perquisites and other personal benefits.

We view each component of our executive compensation program as related but distinct, and we also regularly reassess the total compensation of our executive officers, including our named executive officers, to ensure that our overall compensation objectives are met. Historically, not all of the enumerated components have been provided to all executive officers. In addition, we have considered, in determining the appropriate level for each compensation component, but not relied on exclusively, our understanding of the competitive market based

 

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on the collective experience of members of our compensation committee, our recruiting and retention goals, our view of internal equity and consistency, the length of service of our executive officers, our overall performance and other considerations the compensation committee considers relevant.

We offer cash compensation in the form of base salaries and annual performance-based bonuses that we believe appropriately reward our executive officers for their individual contributions to our business. When making bonus decisions, the compensation committee has considered our financial and operational performance, and in some cases, an executive officer’s individual contributions during the year. We also provide equity compensation in the form of stock options to incentivize our executive officers to focus on the growth of our overall enterprise value and, correspondingly, the creation of value for our stockholders. Historically, we have not granted equity awards to Rick, as he is our founder and holds equity interests in us that provide him with long-term incentives. In addition, we have awarded long-term cash incentive awards as described more fully below under “—Executive Compensation Program Components—Long-Term Incentives—Long-Term Cash Incentives.”

We have not adopted any formal or informal policy or guidelines for allocating compensation between currently-paid and long-term compensation, between cash and non-cash compensation, or among different forms of non-cash compensation. However, in accordance with our philosophy of incentivizing performance and linking the interests of our executive officers to those of our stockholders, we have historically placed a greater emphasis on cash and equity performance-based compensation while keeping base salaries to a nominally competitive level.

Each of the components of our executive compensation program is discussed in more detail below. While each element of executive compensation serves particular compensation objectives, as identified below, our compensation programs are designed to be flexible and complementary and to collectively serve all of the executive compensation objectives described above. Accordingly, whether or not specifically mentioned below, we believe that, as a part of our overall executive compensation policy, each individual element, to a greater or lesser extent, serves each of our compensation objectives.

Executive Compensation Program Components

The following describes the primary components of our executive compensation program for each of our named executive officers, the rationale for that component, and how compensation amounts are determined.

Base Salary

To obtain executives with the skills and experience that we believe are necessary to lead our growth, we established our named executive officers’ initial base salaries through arm’s-length negotiations at the time the individual was hired, taking into account his qualifications, experience and prior salary level.

Since the formation of our compensation committee in April 2009, the base salaries of our executive officers, including the named executive officers, have been reviewed periodically by the compensation committee. Adjustments have been made as deemed appropriate based on such factors as the scope of an executive officer’s responsibilities, individual contribution, prior experience and sustained performance. Decisions regarding base salary adjustments may also take into account the executive officer’s current base salary, equity ownership and the amounts paid to the executive’s peers inside our company. Base salaries are also customarily reviewed annually and at the time of a promotion or other significant change in an executive officer’s role or responsibilities.

In January 2010, the compensation committee approved base salary increases of 5% for Rick, Jeremy and Dan. These salary increases were based on each executive’s level of responsibility and the compensation committee’s subjective evaluation of each executive’s contributions to our sales and profitability results for the prior year. Aaron and Mitch were hired during 2010 and their base salaries for 2010 were set through negotiations of the terms of their new-hire offer letters.

 

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Annual Performance-Based Bonuses

We provide annual cash bonus opportunities to our executive officers to motivate them to achieve our short-term financial objectives while making progress towards our longer-term growth and other goals. In 2010, Rick, Jeremy, Mitch and Dan were each eligible to receive an annual bonus ranging from 25% to 150% of their respective base salaries based on our attainment of (i) revenue ranging from $151.0 million (referred to below as the revenue threshold) to $183.0 million (referred to below as the revenue maximum) and (ii) earnings before interest, taxes and depreciation and amortization, or EBITDA, as a percentage of revenue, or EBITDA margin, of no less than 25% (referred to below as the EBITDA threshold). Bonus payouts were determined on a linear basis between 25% and 150% of applicable base salary for attainment of company revenue between the revenue threshold and revenue maximum, subject to attainment of the EBITDA threshold. Each named executive officer’s target bonus opportunity was set at 50% of base salary and was payable upon achievement of revenue of $157.0 million and EBITDA margin of 25%.

Aaron was eligible to receive an annual bonus ranging from 33% to 100% of his base salary based on attainment of the same revenue and EBITDA margin goals. His bonus payout was determined on a linear basis between 33% and 100% of his base salary for attainment of revenue between the same revenue threshold and same revenue maximum as is noted above for Rick, Jeremy, Mitch and Dan, subject to attainment of the same EBITDA threshold, as described above. Aaron’s target bonus opportunity was set at 33% of his base salary and was payable upon achievement of revenue of $157.0 million and EBITDA margin of 25%.

The compensation committee has not yet made determinations with respect to 2010 bonuses, but anticipates that such determinations will be made in the first quarter of 2011.

Long-Term Incentives

The goals of our long-term equity incentive awards are to incentivize and reward our executive officers, including our named executive officers, for long-term corporate performance based on the value of our common stock and, thereby, to align the interests of our executive officers with those of our stockholders.

Equity Awards

As discussed below, we currently maintain the 2008 Equity Incentive Plan. We anticipate that, prior to the consummation of this offering, our board of directors will adopt, and our stockholders will approve, our 2011 Incentive Award Plan. Assuming that the 2011 Incentive Award Plan is adopted and approved by our stockholders, we expect that no further grants will be made under the 2008 Equity Incentive Plan following the closing of this offering. The 2011 Incentive Award Plan and the 2008 Equity Incentive Plan are described below under the caption “Equity Incentive Plans.”

To reward our executive officers in a manner that best aligns their interests with the interests of our stockholders, we have in the past used stock options as our equity incentive vehicle. Because our executive officers are able to benefit from stock options only if the market price of our common stock increases relative to the option’s exercise price, we believe stock options provide meaningful incentives to our executive officers to achieve increases in the value of our stock over time. Accordingly, we believe that stock options are an effective tool for meeting our compensation goal of increasing long-term stockholder value by tying the value of these incentive awards to our future performance. We further believe that our long-term equity compensation encourages the retention of our named executive officers because the vesting of these equity awards is generally linked to continued employment.

Historically, the size and form of the initial equity awards for our named executive officers have been established through arm’s-length negotiation at the time the individual was hired. In making these awards, we considered, among other things, the prospective role and responsibility of the individual, competitive factors, the

 

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amount of equity-based compensation held by the executive officer at his or her former employer, our compensation committee’s collective experience with compensation paid in respect of similar roles and in companies in similar stages of growth and industries as us at the time the executive officer was hired, the cash compensation received by the executive officer and the need to create a meaningful opportunity for reward predicated on the creation of long-term stockholder value. We have also in the past made subsequent “refresher” stock option grants to certain employees from time to time, including our named executive officers, to ensure that these individuals remained properly incentivized.

Historically, we have not granted compensatory equity to Rick, as he is our founder and holds equity interests in us that provide him with long-term incentives. During 2010, the only named executive officers who received awards were Mitch, Dan and Aaron.

On May 27, 2010, Mitch was granted new-hire options to purchase 17,621 shares of our common stock in connection with the terms of his offer letter based on negotiations in connection with his hiring and Dan was granted options to purchase 2,500 shares of our common stock. In approving these awards, the compensation committee considered the need to provide new retention incentives to Dan based on his substantial value to us and the fact that he had not been granted an award since September 2008. These options have an exercise price of $144.37 per share, which was determined to be the fair market value of our common stock on the date of grant, and vest over four years, with 25% of the shares vesting on the first anniversary of the date of grant and the remaining shares vesting monthly in equal installments over the next 36 months.

On November 4, 2010, Mitch and Dan were granted additional option awards for 1,285 shares and 5,000 shares, respectively. These options have an exercise price of $167.90 per share, which was determined to be the fair market value of our common stock on the date of grant, and vest over four years, with 25% of the shares vesting on the first anniversary of the date of grant and the remaining shares vesting monthly in equal installments over the next 36 months. In approving these awards, the compensation committee exercised its judgment and discretion and considered the role and responsibility of each named executive officer, including expected future roles and responsibilities and our specific need to retain and properly incentivize each such executive. The compensation committee drew on its collective experience in determining grant levels that were appropriate based on these considerations.

In addition, on November 4, 2010, Aaron was granted 6,000 options and an additional 2,500 performance-vesting options based on negotiations with Aaron in connection with his hiring. The time-vesting options vest with respect to 25% of the shares vesting on the first anniversary of the date of grant and the remaining shares vesting monthly in equal installments over the next 36 months. The performance-vesting options will vest in full if our annual international gross sales (excluding Canada) reach $100 million by December 31, 2013. If this metric has not been reached by December 31, 2013, the options will be forfeited.

As a privately-held company, there has been no market for shares of our common stock. Accordingly, we have had no program, plan or practice pertaining to the timing of stock option grants to our executive officers coinciding with the release of material non-public information about us. We intend to adopt a formal policy regarding the timing of stock option grants and other equity awards in connection with this offering.

Long-Term Cash Incentives

Our board of directors adopted a management incentive plan on November 28, 2008 in which certain employees, including our current named executive officers, other than Rick, participate. Under the original terms of the management incentive plan, upon the occurrence of either: (i) a sale or transfer of the convertible notes and shares held by Goode Skullcandy Holdings, or Goode, with at least 75% of such notes and shares being sold or transferred in exchange for liquid assets, or (ii) the six-month anniversary of our initial public offering, a bonus pool would be established based on the compound annual internal rate of return, or IRR, realized by Goode from its investment. The bonus pool amount under the original terms of the management incentive plan ranged from $2.5 million to $17.5 million based on Goode’s IRR in either transaction ranging from 17.5% to 32.5%. See

 

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“Certain Relationships and Related Party Transactions—Series C Convertible Preferred Stock Financing and Stock Redemption” for more information.

Each participant in the management incentive plan was allocated a percentage of the bonus pool. The percentage allocations were initially based on an allocation of a fraction of the bonus pool and were increased proportionately by our board of directors in December 2010 to a total allocation of 100% of the bonus pool in recognition of the fact that the appropriate employees were participating in the pool. Jeremy, Mitch, Dan and Aaron were finally allocated approximately 12%, 7%, 10% and 5%, respectively, of the bonus pool. The original percentages for Mitch and Aaron were set based on negotiations with these executives in connection with their hiring. The percentages for Jeremy and Dan were determined based on each executive’s level of responsibility and the compensation committee’s subjective assessment, based on their collective experience, of the amounts that would be necessary to retain and incentivize these executives. In addition, Jeremy’s employment agreement provided that his percentage allocation would be at a level equal to or greater than that provided to any other participants in the management incentive plan. Under the original terms of the plan, in order to be eligible to receive a payout, the participant was required to be employed through the date of determination of the payout amount and could not be terminated for cause prior to the date the payouts are made.

In December 2010, in recognition of the likelihood that the bonus pool would ultimately be funded at the maximum level based on this anticipated offering, our board of directors determined to pay out the bonus pool on December 31, 2010 and to recognize the associated compensation expense at that time. Accordingly, on December 31, 2010, we amended the management incentive plan to set the maximum pool funding level at $16.5 million and issued subordinated promissory notes to the participants in our management incentive plan with a face value equal to the payout to which each such participant would be entitled, assuming funding of the pool at $16.5 million. Our board of directors determined to retain $1.0 million of the previously allocated $17.5 million bonus pool to pay bonuses to certain employees that were not participants in the management incentive plan. Under their respective promissory notes, each participant was entitled to an immediate payment upon issuance of the note in an amount sufficient to satisfy all tax obligations of the participant arising in connection with the issuance of such note (which amounts were withheld by us and remitted to the appropriate tax authorities). The notes bear interest at a rate of 3.3% per annum, with all unpaid principal and interest amounts payable on the first to occur of (i) the tenth business day following any qualified initial public offering, (ii) the tenth business day following the sale of a majority ownership interest in us, (iii) an enumerated event of default under the note or (iv) December 31, 2012.

Retirement Savings and Other Benefits

We have established a 401(k) retirement savings plan for our employees, including our named executive officers, who satisfy certain eligibility requirements. Our named executive officers are eligible to participate in the 401(k) plan on the same terms as other salaried employees. Under the 401(k) plan, eligible employees may elect to contribute pre-tax amounts to the plan up to a statutorily prescribed limit. Currently, we match contributions made by participants in the plan up to 4% of compensation. We believe that providing a vehicle for tax-deferred retirement savings through our 401(k) plan adds to the overall desirability of our executive compensation package and further incentivizes our employees, including our named executive officers, in accordance with our compensation policies.

Employee Benefits and Perquisites

Additional benefits received by our employees, including the named executive officers, include medical, dental, and vision benefits, and medical and dependent care flexible spending accounts. These benefits are provided to our named executive officers on the same general terms as they are provided to all of our full-time U.S. employees.

We design our employee benefits programs to be affordable and competitive in relation to the market, as well as compliant with applicable laws and practices. We adjust our employee benefits programs as needed based upon regular monitoring of applicable laws and practices in the competitive market.

 

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In order to prevent geographic restrictions on our recruitment and hiring opportunities, we occasionally provide new hires with limited relocation benefits. Our executives, including our named executive officers, are eligible to receive these relocation benefits when we determine that relocation is desirable and/or required due to the specific circumstances of the assignment. We agreed to pay the relocation expenses of Mitch and Dan, up to $15,000 and $50,000, respectively, in connection with their respective relocations upon the commencement of their employment with us. In addition, we provide Rick with a company car to perform his duties as chief executive officer, which involve extensive regional travel. We believe that providing these benefits is a relatively inexpensive way to enhance the competitiveness of the executives’ compensation packages.

Historically, we have not provided any other perquisites to our named executive officers and we generally do not view perquisites or other personal benefits as a material component of our executive compensation program. In the future, we may provide perquisites or other personal benefits in limited circumstances, where we believe such perquisites are appropriate to assist an individual executive officer in the performance of his duties, to make our executive officers more efficient and effective and for recruitment, motivation and/or retention purposes. Future practices with respect to perquisites or other personal benefits for our named executive officers will be subject to periodic review by the compensation committee.

Severance and Change in Control Benefits

As more fully described below under the caption “—Narrative Disclosure to Summary Compensation Table and Grants of Plan-Based Awards Table—Current Employment Agreements and Offer Letters” and “—Potential Payments Upon Termination or Change-in-Control,” (i) each of Rick’s and Jeremy’s employment agreement provides for salary continuation for three years following termination if the executive resigns for “good reason” or is terminated by us without “cause” (each as defined in the agreements), (ii) Mitch’s offer letter provides for up to twenty-four months’ base salary if we terminate him without cause and (iii) Aaron’s offer letter provides for severance in the amount of six months base salary if we terminate him without cause. Dan is not contractually entitled to a severance payment under his employment agreement. We believe that job security is a cause of significant concern and uncertainty for senior executives and that providing protections to these executives in these contexts is therefore appropriate in order to alleviate these concerns and allow the executives to remain focused on their duties and responsibilities in all situations. For a discussion of the material terms of these agreements, see “—Narrative Disclosure to Summary Compensation Table and Grants of Plan-Based Awards Table” below.

Tax and Accounting Considerations

Section 162(m) of the Internal Revenue Code

Generally, Section 162(m) of the Internal Revenue Code disallows a tax deduction to any publicly-held corporation for any individual remuneration in excess of $1.0 million paid in any taxable year to its chief executive officer and each of its other named executive officers, other than its chief financial officer. However, remuneration in excess of $1.0 million may be deducted if, among other things, it qualifies as “performance-based compensation” within the meaning of the Internal Revenue Code.

As we are not currently publicly-traded, the compensation committee has not previously taken the deductibility limit imposed by Section 162(m) of the Internal Revenue Code into consideration in setting compensation. Following this offering, we expect that, where reasonably practicable, the compensation committee may seek to qualify the variable compensation paid to our named executive officers for the “performance-based compensation” exemption from the deductibility limitations of Section 162(m) of the Internal Revenue Code. As such, in approving the amount and form of compensation for our named executive officers in the future, the compensation committee will consider all elements of the cost to us of providing such compensation, including the potential impact of Section 162(m) of the Internal Revenue Code. The compensation committee may, in its judgment, authorize compensation payments that do not comply with this exemption from

 

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the deductibility limit in Section 162(m) of the Internal Revenue Code when it believes that such payments are appropriate to attract and retain executive talent.

Furthermore, we do not expect Section 162(m) of the Internal Revenue Code to apply to awards under the 2011 Incentive Award Plan until the earliest to occur of our annual stockholders’ meeting in 2015, a material modification of the 2011 Incentive Award Plan or exhaustion of the share supply under the 2011 Incentive Award Plan. However, qualified performance-based compensation performance criteria may be used with respect to performance awards that are not intended to constitute qualified performance-based compensation under Section 162(m) of the Internal Revenue Code.

Section 280G of the Internal Revenue Code

Section 280G of the Internal Revenue Code disallows a tax deduction with respect to excess parachute payments to certain executives of companies which undergo a change in control. In addition, Section 4999 of the Internal Revenue Code imposes a 20% excise tax on the individual with respect to the excess parachute payment. Parachute payments are compensation linked to or triggered by a change in control and may include, but are not limited to, bonus payments, severance payments, certain fringe benefits, and payments and acceleration of vesting from long-term incentive plans including stock options and other equity-based compensation. Excess parachute payments are parachute payments that exceed a threshold determined under Section 280G of the Internal Revenue Code based on the executive’s prior compensation. In approving the compensation arrangements for our named executive officers in the future, our compensation committee will consider all elements of the cost to us of providing such compensation, including the potential impact of Section 280G of the Internal Revenue Code. However, our compensation committee may, in its judgment, authorize compensation arrangements that could give rise to loss of deductibility under Section 280G of the Internal Revenue Code and the imposition of excise taxes under Section 4999 of the Internal Revenue Code when it believes that such arrangements are appropriate to attract and retain executive talent.

Section 409A of the Internal Revenue Code

Section 409A of the Internal Revenue Code requires that “nonqualified deferred compensation” be deferred and paid under plans or arrangements that satisfy the requirements of the statute with respect to the timing of deferral elections, timing of payments and certain other matters. Failure to satisfy these requirements can expose employees and other service providers to accelerated income tax liabilities, penalty taxes and interest on their vested compensation under such plans. Accordingly, as a general matter, it is our intention to design and administer our compensation and benefits plans and arrangements for all of our employees and other service providers, including our named executive officers, so that they are either exempt from, or satisfy the requirements of, Section 409A.

Accounting for Stock-Based Compensation

We follow Financial Accounting Standards Board Accounting Standards Codification Topic 718, or ASC Topic 718, for our stock-based compensation awards. ASC Topic 718 requires companies to calculate the grant date “fair value” of their stock-based awards using a variety of assumptions. ASC Topic 718 also requires companies to recognize the compensation cost of their stock-based awards in their income statements over the period that an employee is required to render service in exchange for the award. Grants of stock options, restricted stock, restricted stock units and other equity-based awards under our equity incentive award plans will be accounted for under ASC Topic 718. Our compensation committee will regularly consider the accounting implications of significant compensation decisions, especially in connection with decisions that relate to our equity incentive award plans and programs. As accounting standards change, we may revise certain programs to appropriately align accounting expenses of our equity awards with our overall executive compensation philosophy and objectives.

 

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Executive Compensation Tables

Summary Compensation Table for the Twelve Months Ended December 31, 2010

The following table sets forth all of the compensation awarded to, earned by or paid to our named executive officers during the year ended December 31, 2010.

 

Name and Principal Position

  Year     Salary
($)
    Option
Awards
($)(1)
    Non-Equity
Incentive Plan
Compensation
($)(2)
    All Other
Compensation
($)(3)
    Total
($)
 

Rick Alden

Chief Executive Officer

    2010      $ 262,500      $      $      $ 22,812      $ 285,312   

Jeremy Andrus

President and Chief Operating Officer

    2010        210,000               1,987,952        9,800        2,207,752   

Mitch Edwards

Chief Financial Officer and General Counsel

    2010        153,425 (4)      1,394,785        1,192,771        20,769        2,761,750   

Dan Levine

Chief Merchandising Officer

    2010        210,000        583,996        1,590,361        25,247        2,409,604   

Aaron Behle

Vice President, International Sales

    2010        55,452 (5)      681,224        795,181        2,223        1,534,080   

 

(1) Amounts reflect the full grant-date fair value of stock options granted during 2010, computed in accordance with ASC Topic 718, rather than the amounts paid to or realized by the named individual. We provide information regarding the assumptions used to calculate the value of all stock option awards made to executive officers in note 10 to our consolidated financial statements included in this prospectus. There can be no assurance that awards will vest or will be exercised (if they are not exercised, no value will be realized by the individual), or that the value upon exercise will approximate the aggregate grant date fair value determined under ASC Topic 718.

 

(2) Amounts shown in the table above represent the issuance of subordinated promissory notes to management incentive plan participants. On December 31, 2010, we issued subordinated promissory notes to the participants in our management incentive plan with a face value equal to the payout to which each such participant would be entitled, assuming funding of the pool at $16.5 million. For a description of the promissory notes refer to the discussion under the caption “Executive Compensation Program Components—Long-Term Incentives—Long-Term Cash Incentives.” Our 2010 bonus program is an annual plan and bonuses are payable following the end of the fiscal year based upon achievement of pre-established company financial objectives for 2010. The compensation committee has not yet made determinations related to 2010 bonuses, but anticipates that such determinations will be made in the first quarter of 2011. For a description of the 2010 bonus program, refer to the discussion under the caption “—Executive Compensation Program Components—Annual Performance-Based Bonuses” above.

 

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(3) Amounts under the “All Other Compensation” column for the twelve months ended December 31, 2010 consist of 401(k) company matching contributions, payments of Mitch’s and Dan’s relocation expenses and the incremental cost of providing Rick a company car as shown in the table below.

 

Name

   401(k) Plan
Company
Contributions
     Relocation
Benefit
     Incremental
Cost of
Company
Car(a)
 

Rick Alden

   $ 9,800       $       $ 13,012   

Jeremy Andrus

     9,800                   

Mitch Edwards

     5,769         15,000           

Dan Levine

             25,247           

Aaron Behle

     2,123                   

 

  (a) The incremental cost of the company car to us has been calculated based on the depreciation value of the vehicle.

 

(4) Mitch was hired in May 2010. This table reflects his base salary earned beginning on his hire date. Mitch has an annual base salary of $250,000.

 

(5) Aaron was hired in October 2010. This table reflects his base salary earned beginning on his hire date. Aaron has an annual base salary of $230,000.

Grants of Plan-Based Awards in 2010

The following table sets forth certain information with respect to grants of plan-based awards to our named executive officers for the year ended December 31, 2010.

 

Name

  Grant
Date
    Estimated Payouts Under Non-Equity
Incentive Plan Awards
    All Other
Option
Awards:
Number of
Securities
Underlying
Options

(# shares)
    Exercise
or Base
Price of
Option
Awards
Per Share

($)
    Grant Date
Fair Value
of Stock and
Options

Awards
($)
(1)
 
    Threshold
($)
    Target
($)
    Maximum
($)
       

Rick Alden

    $ 65,625 (2)    $ 131,250 (2)    $ 393,750 (2)       

Jeremy Andrus

      52,500 (2)      105,000 (2)      315,000 (2)       
      301,205 (3)      1,987,952 (3)      1,987,952 (3)       

Mitch Edwards

      62,500 (2)      125,000 (2)      376,000 (2)       
      180,723 (3)      1,192,771 (3)      1,192,771 (3)       
    May 27, 2010              17,621      $ 144.37      $ 1,291,800   
    November 4, 2010              1,285        167.90        102,985   

Dan Levine

      52,500 (2)      105,000 (2)      315,000 (2)       
      240,964 (3)      1,590,361 (3)      1,590,361 (3)       
    May 27, 2010              2,500        144.37        183,276   
    November 4, 2010              5,000        167.90        400,720   

Aaron Behle

      18,216 (2)      18,216 (2)      55,200 (2)       
      120,482 (3)      795,181 (3)      795,181 (3)       
    November 4, 2010              6,000        167.90        520,936   
    November 4, 2010              2,500        167.90        160,288   

 

(1) The amounts shown in the this column represent the aggregate grant date fair value of option awards granted during 2010, computed in accordance with ASC Topic 718. See note 10 to our consolidated financial statements included in this prospectus for a discussion of valuation assumptions used in determining aggregate grant date fair values.

 

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(2) The amounts shown represent the estimated payouts under our 2010 bonus program. For Rick, Jeremy, Mitch and Dan, (i) the “Threshold” amounts shown represent 25% of each named executive officer’s base salary payable under the bonus program upon achievement of the plan’s minimum or threshold revenue and threshold EBITDA margin; (ii) the “Target” amounts shown represent 50% of each named executive officer’s base salary payable under the bonus program upon achievement of the plan’s target revenue and threshold EBITDA margin and (iii) the “Maximum” amounts shown represent 150% of each named executive officer’s base salary payable under the bonus program upon achievement of the plan’s maximum revenue and threshold EBITDA margin. For Aaron, the “Threshold” and “Target” amounts shown represents 33% of his base salary payable under the bonus program upon achievement of the plan’s target revenue and threshold EBITDA margin and the “Maximum” amount shown represents 100% of his base salary payable under the bonus program upon achievement of the plan’s maximum revenue and threshold EBITDA margin. The value for Aaron has been pro-rated to reflect his hire date in 2010. See “—Executive Compensation Program Components—Annual Performance-Based Bonuses” for a discussion of our 2010 bonus program.

 

(3) The amounts shown represent the estimated payouts under the amended terms of our management incentive plan described more fully under “Compensation Discussion and Analysis—Long-Term Incentives—Long-Term Cash Incentives.” The “Threshold” amounts shown represent each named executive officer’s payout upon achievement by Goode of an IRR of 17.5% resulting in the bonus pool funding at $2.5 million. The “Maximum” amounts shown represent each named executive officer’s payout upon achievement by Goode of an IRR of 32.5% resulting in the bonus pool funding at $16.5 million under the amended terms of our management incentive plan. The “Maximum” payout amounts have also been used as the Target amounts as the IRR at December 31, 2010 was above 32.5%. In December 2010, we issued subordinated promissory notes to the participants in the management incentive plan with a face value equal to the payout to which each such participant would be entitled, assuming funding of the pool at $16.5 million, in full satisfaction of our obligations under the management incentive plan. See “—Executive Compensation Program Components—Long-Term Incentives—Long-Term Cash Incentives.” In connection with the issuance of the 2010 notes, the management incentive plan was terminated.

Narrative Disclosure to Summary Compensation Table and Grants of Plan-Based Awards Table

Current Employment Agreements and Offer Letters

We have entered into employment agreements and offer letters with each of our named executive officers. The principal elements of these employment letters are summarized below.

Rick Alden. In November 2008, we entered into an employment and non-compete agreement with Rick, pursuant to which Rick serves as our chief executive officer. The agreement will remain in effect through November 28, 2011 and will extend for additional one-year periods thereafter unless either party elects not to extend the term. Under the agreement, Rick’s annual base salary was set at $250,000, subject to annual increases in an amount not less than the increase in the Consumer Price Index for Urban Customers issued by the Department of Labor for the preceding calendar year. Rick’s 2010 annual base salary was $262,500. The agreement provides that Rick is eligible to receive an annual cash bonus based upon the achievement of performance goals set in good faith by the board of directors and consistent with the bonus plan in place for senior management. The agreement also provides that, during the term of the agreement, Rick is (i) entitled to four weeks of vacation and use of a company-owned vehicle with all related expenses paid by us, and (ii) eligible to participate in any of our employee benefit plans generally available to our senior executives. Rick is also eligible to receive discretionary equity awards under his agreement.

If Rick’s employment is terminated by Rick for “good reason” or by us without “cause” (each as defined in his agreement), Rick will be entitled to severance pay equal to three times his base salary in effect at the time of termination, payable in accordance with our regular payroll practices over a period of three years following

 

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termination. These severance benefits are conditioned on Rick delivering a general release to us within 45 days following his termination of employment. If Rick’s employment terminates due to his death, we will pay the cost of “COBRA” continuation healthcare benefits to Rick’s dependents for one year following such termination (but will not make any salary continuation payments).

Rick’s agreement requires him to comply with non-compete, non-solicitation, assignment of inventions and copyrightable works, confidentiality and non-disparagement covenants during and for specified periods after his employment. If Rick fails to comply with these covenants, he will forfeit his right to continuation of cash severance (if applicable). In addition, at our election, we may choose to pay additional salary continuation severance in exchange for Rick’s extended compliance with these covenants.

Jeremy Andrus. In November 2008, we entered into an employment and non-compete agreement with Jeremy, pursuant to which Jeremy serves as our president and chief operating officer. The agreement will remain in effect through November 28, 2011 and will extend for additional one-year periods thereafter unless either party elects not to extend the term. Under the agreement, Jeremy’s annual base salary was set at $200,000, subject to annual increases in an amount not less than the increase in the Consumer Price Index for Urban Customers issued by the Department of Labor for the preceding calendar year. Jeremy’s 2010 annual base salary was $210,000. The agreement provides that Jeremy is eligible to participate in any executive bonus plan in which the chief executive officer or other senior executive officers participate on equal terms. In addition, the agreement provides that Jeremy is entitled to participate in the management incentive plan adopted in November of 2008 and discussed more fully under “—Executive Compensation Program Components—Long-Term Incentives—Long-Term Cash Incentives” at a level equal to or greater than that provided to any other participants in that management incentive plan as long as he is employed by us on the date that the management incentive plan is paid. The agreement also provides that, during the term of the agreement, Jeremy is entitled to four weeks of vacation and is eligible to participate in any of our employee benefit plans generally available to our senior executives. Pursuant to the agreement, Jeremy was granted stock options covering 17,000 shares of common stock with an exercise price of $103.82 on April 3, 2009, vesting over a four-year period with 25% of the shares vesting on the first anniversary of the vesting commencement date and the remaining shares vesting monthly in equal installments thereafter over 36 months.

If Jeremy’s employment is terminated by Jeremy for “good reason” or by us without “cause” (each as defined in his agreement), Jeremy will be entitled to severance pay equal to three times his base salary in effect at the time of termination, payable in accordance with our regular payroll practices for a period of three years following termination. These severance benefits are conditioned on Jeremy delivering to us a general release within 45 days following his termination of employment. In addition, Jeremy’s agreement requires him to comply with non-compete, non-solicitation, assignment of inventions and copyrightable works, confidentiality and non-disparagement covenants of the agreement during and for specified periods after his employment. If Jeremy fails to comply with these covenants, he will forfeit his right to continuation of cash severance (if applicable). In addition, at our election, we may choose to pay additional salary continuation severance in exchange for Jeremy’s extended compliance with these covenants.

Mitch Edwards. In June 2010, we entered into an offer letter with Mitch Edwards. Under the offer letter, Mitch’s annual base salary was set at $250,000. The offer letter provides that Mitch is eligible to receive an annual cash bonus for 2010 based upon the achievement of revenue and EBITDA margin performance goals, as more fully discussed under “—Executive Compensation Program Components—Annual Performance-Based Bonuses.” The offer letter also provides that Mitch may participate in the management incentive plan and would be allocated 6% of the bonus pool, which amount was subsequently increased to 7% of the bonus pool, as more fully discussed under “—Executive Compensation Program Components—Long-Term Incentives—Long-Term Cash Incentives.” Pursuant to the offer letter, Mitch was granted stock options covering an aggregate of 17,621 shares of common stock with an exercise price of $144.37 per share, vesting over four years with accelerated vesting upon a change of control or a termination without cause within the first 24 months of employment. The offer letter also provided for $15,000 in relocation benefits. Under the offer letter, Mitch is also entitled to

 

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participate in our 401(k) plan and receive a 4% matching contribution from us in accordance with the terms of the plan, in addition to which, Mitch is entitled to three weeks of vacation and participation in our health plans while employed. As required by his offer letter, Mitch has also entered into an Employment, Confidential Information, Invention Assignment and Arbitration Agreement. Under his offer letter, in the event of a termination without “cause,” Mitch’s first 24 months of base salary will be guaranteed up to his 18th month of employment. Beginning with the 19th month, he will receive 6 months’ base salary as severance.

Dan Levine. In August 2008, we entered into an offer letter with Dan Levine. Under the offer letter, Dan’s annual base salary was initially set at $200,000. Dan’s 2010 annual base salary was $210,000. The offer letter provides that Dan is eligible to receive an annual cash bonus based upon the achievement of revenue and other performance goals to be established by the board of directors. Pursuant to the offer letter, Dan was granted stock options covering an aggregate of 7,000 shares of common stock. The offer letter also provided for reimbursement of up to $50,000 in relocation and related travel expenses. Under the offer letter, Dan is entitled to participate in our 401(k) plan and receive a 4% matching contribution from us in accordance with the terms of the plan, in addition to which, Dan is entitled to three weeks of vacation and participation in our health plans while employed. As required by his offer letter, Dan has also entered into an Employment, Confidential Information, Invention Assignment and Arbitration Agreement.

Aaron Behle. In September 2010, we entered into an offer letter with Aaron. Under the offer letter, Aaron’s annual base salary was set at $230,000. The offer letter provides that Aaron may participate in the management incentive plan at an allocation of 4% of the bonus pool, which amount was subsequently increased to 5% of the bonus pool, as more fully discussed under “—Executive Compensation Program Components—Long-Term Incentives—Long-Term Cash Incentives.” Pursuant to the offer letter, Aaron was granted stock options covering 6,000 shares of common stock and 2,500 performance-vesting stock options, as described more fully under “—Executive Compensation Program Components—Long-Term Incentives—Equity Awards.” Under the offer letter, Aaron is also entitled to participate in our 401(k) plan and receive a 4% matching contribution from us in accordance with the terms of the plan, in addition to which, Aaron is entitled to three weeks of vacation and participation in our health plans while employed. As required by his offer letter, Aaron has also entered into an Employment, Confidential Information, Invention Assignment and Arbitration Agreement. Under his offer letter, in the event of a termination without “cause,” Aaron will be entitled to continuation of his annual base salary plus benefits for a period of six months following termination of employment.

 

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Outstanding Equity Awards at December 31, 2010

The following table lists all outstanding equity awards held by our named executive officers as of December 31, 2010.

 

     Vesting
Commencement
Date
     Option Awards  

Name

      Number
of Securities
Underlying
Unexercised
Options
(Exercisable)
     Number
of Securities
Underlying
Unexercised
Options
(Unexercisable)(1)
    Option
Exercise
Price
($)
     Option
Expiration
Date
 

Rick Alden

                                      

Jeremy Andrus

     1/1/2009         8,146         8,854      $ 103.82         4/3/2019   

Mitch Edwards

     5/21/2010                 17,621 (2)      144.37         5/27/2020   
     11/4/2010                 1,285 (2)      167.90         11/4/2020   

Dan Levine

     5/28/2008         2,769         1,594        38.24         5/28/2018   
     9/2/2008         1,381         1,094        73.60         9/5/2018   
     5/27/2010                 2,500        144.37         5/27/2020   
     11/4/2010                 5,000        167.90         11/4/2020   

Aaron Behle

     9/27/2010                 6,000        167.90         11/4/2020   
     9/27/2010                 2,500 (3)      167.90         11/4/2020   

 

(1) Except as specified in footnotes (2) and (3) below, these options vest as to 25% of the shares on the first anniversary of the vesting commencement date and as to the remaining shares monthly in equal installments over the next 36 months.

 

(2) These options vest as to 25% of the shares on the first anniversary of the vesting commencement date and as to the remaining shares monthly in equal installments over the next 36 months, subject to accelerated vesting upon a change of control or a termination without cause within the first 24 months of employment.

 

(3) These performance-vesting options will vest in full if our international gross sales (excluding Canada) reach $100 million by December 31, 2013. If this metric has not been reached by December 31, 2013, the options are forfeited.

Option Exercises and Stock Vested

None of our named executive officers exercised any options or had any stock vest during the year ended December 31, 2010.

Pension Benefits

None of our named executive officers participate in or have account balances in qualified or non-qualified defined benefit plans sponsored by us.

Nonqualified Deferred Compensation

None of our named executive officers participate in or have account balances in non-qualified defined contribution plans or other deferred compensation plans maintained by us.

 

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Potential Payments upon Termination or Change-in-Control

The information below describes and quantifies certain compensation and benefits that would have become payable to our named executive officers (other than Dan) in the event of a qualifying change in control and/or a qualifying termination of the named executive officers’ employment, in either case, on December 31, 2010 under applicable agreements or letters in effect as of that date. Dan is not contractually entitled to any severance or other benefits in the event of a change in control and/or termination. The information below does not generally reflect compensation and benefits available to all salaried employees upon termination of employment with us under similar circumstances. Amounts shown in the table below do not include payouts under our management incentive plan, which was terminated outside of the context of a change in control on December 31, 2010 and paid in full through the issuance of subordinated promissory notes to the participants in the management incentive plan. Such amounts have been included in the Summary Compensation Table above.

 

Named Executive Officer

  

Scenario

  Severance(1)     COBRA
continuation(2)
    Option
Acceleration(3)
    Total  

Rick Alden

   Termination without Cause or for Good Reason   $ 787,500      $      $      $ 787,500   
          
          
   Death            8,363               8,363   

Jeremy Andrus

   Termination without Cause or for Good Reason     630,000                      630,000   
          
          

Mitch Edwards

   Termination without Cause     375,000               729,974 (4)      1,104,974   
          
   Change in Control                   729,974 (4)      729,974   

Aaron Behle

   Termination without Cause     115,000                      115,000   
          

 

(1) In the event of a termination without “cause” or for “good reason,” Rick’s and Jeremy’s employment agreements provide that we will continue to provide them with severance pay in the amount of their base salary at the time of termination for a period of three years following termination. Mitch’s offer letter provides that in the event a termination without “cause,” Mitch’s first 24 months of base salary will be guaranteed up to his 18th month of employment. Beginning with the 19th month, he will receive 6 months severance. Aaron’s offer letter provides for severance in the amount of six months base salary if we terminate him without “cause.”

 

(2) In the event of death, Rick is entitled to COBRA continuation healthcare for his dependents for one year following the event.

 

(3) Under our 2005 Stock Plan and 2008 Equity Incentive Plan, in the event of a change in control, if the outstanding options are not assumed or substituted, outstanding unvested awards will accelerate. See “—Equity Incentive Plans—2005 Stock Plan” and “—Equity Incentive Plans—2008 Equity Incentive Plan” below for additional information on the treatment of these awards in the event of a change in control. Amounts in this table do not reflect such acceleration as the options do not automatically accelerate upon a change in control and only accelerate if they are not assumed or substituted.

 

(4) Pursuant to Mitch’s offer letter, his initial option award for 17,621 shares of our common stock granted in connection with his hiring in May 2010 and the additional option award for 1,285 shares of our common stock granted in November 2010 will accelerate upon a change of control or a termination without cause within the first 24 months of employment.

 

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Equity Incentive Plans

2005 Stock Plan

In May 2005 we adopted, and our stockholders approved, the 2005 Stock Plan to attract, retain and provide incentives to the best available personnel for positions of substantial responsibility with us. The 2005 Stock Plan was amended and restated on August 10, 2006 and further amended on August 27, 2007 and December 19, 2007. We refer to this plan, as amended, as the 2005 Plan. Following our adoption of the 2008 Equity Incentive Plan (discussed below), we have not made any further awards under the 2005 Plan. The material terms of the 2005 Plan are summarized below.

Eligibility. Our employees, directors and consultants, as well as employees, directors and consultants of certain of our parent and subsidiary entities, are eligible to receive awards under the 2005 Plan.

Administration. The 2005 Plan is administered by our board of directors. Our board may also delegate its administrative powers to a committee of the board (referred to collectively as the plan administrator). After the closing of this offering, certain limitations as to the composition of the plan administrator may be imposed under Section 162(m) of the Internal Revenue Code, Section 16 of the Exchange Act and/or stock exchange rules, as applicable. The plan administrator has broad authority to make determinations and interpretations under, prescribe forms for use with, and adopt rules for the administration of, the 2005 Plan, subject to its express terms and conditions. The plan administrator also sets the terms and conditions of all awards under the 2005 Plan, including any vesting and acceleration conditions.

Limitation on Awards and Shares Available. The aggregate number of shares of our common stock authorized for issuance pursuant to the 2005 Plan is 277,328 shares. The following types of shares will be added back to the 2005 Plan’s share reserve: shares subject to options or stock purchase rights that expire or become unexercisable (to the extent of such expiration or non-exercise); and shares of restricted stock that are repurchased by us at their original purchase price.

Awards. The 2005 Plan provides for the grant of stock options, including incentive stock options, or ISOs, and nonqualified stock options, or NSOs, and stock purchase rights. ISOs may be granted to our employees and employees of our qualifying parent and subsidiary corporations. NSOs may be granted to our employees, consultants and directors and the employees, consultants and directors of certain of our parent and subsidiary entities. Awards under the 2005 Plan are set forth in award agreements, which detail the terms and conditions of the awards, including any applicable vesting and payment terms and post-termination exercise limitations. Awards are settled in shares of our common stock. A brief description of each award type follows.

 

   

Stock Options. Stock options provide for the purchase of shares of our common stock in the future at an exercise price set on the grant date. ISOs, by contrast to NSOs, may provide tax deferral beyond exercise and favorable capital gains tax treatment to their holders if certain holding period and other Internal Revenue Code requirements are satisfied. The exercise price of an ISO may not be less than 100% of the fair market value of the underlying share on the date of grant (or 110% in the case of ISOs granted to certain significant stockholders), except with respect to certain substitute options granted in connection with a corporate transaction. The exercise price of NSOs shall be determined by the plan administrator. The term of a stock option may not be longer than ten years (or five years in the case of ISOs granted to certain significant stockholders). Vesting conditions determined by the plan administrator may apply to stock options and may include continued service, performance and/or other conditions.

 

   

Stock Purchase Rights. Stock purchase rights represent rights to acquire restricted stock, which is an award of nontransferable shares of our common stock that remain forfeitable unless and until specified vesting conditions are met, and which may be subject to a purchase price. Vesting conditions applicable to stock purchase rights may be based on continuing service with us or our affiliates, the attainment of performance goals and/or such other conditions as the plan administrator may determine.

 

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Certain Transactions. The plan administrator has broad discretion to equitably adjust the provisions of the 2005 Plan, as well as the terms and conditions of existing and future awards, to prevent the dilution or enlargement of intended benefits and facilitate necessary or desirable changes in the event of certain transactions and events affecting our common stock, such as stock dividends, stock splits, mergers, consolidations, reorganizations, asset sales and other corporate transactions. In the event we merge into another corporation or undergo a change in control (as defined in the 2005 Plan), each outstanding option and stock purchase right shall be assumed or substituted with an equivalent award. Where the acquirer does not assume or replace awards granted under the 2005 Plan, awards issued under the 2005 Plan will be subject to accelerated vesting such that 100% of such awards will become vested and exercisable or payable, as applicable. The plan administrator shall notify the holders that the awards are fully exercisable for a 15-day period following the date of such notice and the awards will terminate upon expiration of the period. Individual award agreements may provide for additional accelerated vesting and payment provisions.

Nontransferability. Generally, awards granted under the 2005 Plan are not transferable by a participant other than by will or by the laws of descent and distribution.

Plan Amendment and Termination. Our board of directors may amend or terminate the 2005 Plan at any time subject to obtaining stockholder approval to the extent necessary under applicable laws; provided that no amendment or termination may impair the rights of a participant without the affected participant’s consent.

2008 Equity Incentive Plan

In November 2008, we adopted, and our stockholders approved, the 2008 Equity Incentive Plan, referred to as the 2008 Plan, to attract, retain and provide incentives to the best available personnel for positions of substantial responsibility with our company. Assuming that the 2011 Incentive Award Plan is adopted and approved by our board and stockholders (as discussed below), we expect that no further grants will be made under the 2008 Plan. The material terms of the 2008 Plan are summarized below.

Eligibility. Our employees, directors and consultants, as well as employees, directors and consultants of certain of our parent and subsidiary entities, are eligible to receive awards under the 2008 Plan.

Administration. The 2008 Plan is administered by our board of directors. Our board may also delegate its administrative powers to the compensation committee and/or to other subcommittees of the board consisting of no less than two directors appointed by the board (referred to collectively as the plan administrator). After the closing of this offering, certain limitations as to the composition of the plan administrator may be imposed under Section 162(m) of the Internal Revenue Code, Section 16 of the Exchange Act and/or stock exchange rules, as applicable. The plan administrator has broad authority to make determinations and interpretations under, prescribe forms for use with, and adopt rules for the administration of, the 2008 Plan, subject to its express terms and conditions. The plan administrator also sets the terms and conditions of all awards under the 2008 Plan, including any vesting and acceleration conditions.

Limitation on Awards and Shares Available. The aggregate number of shares of our common stock authorized for issuance pursuant to the 2008 Plan may not exceed a maximum of 337,300 shares, comprised of (i) 184,751 shares initially authorized under the 2008 Plan and (ii) 152,549 shares that were reserved for awards which were not granted under the 2005 Plan as of the date of stockholder approval of the 2008 Plan. The following types of shares will be added back to the 2008 Plan’s share reserve: shares tendered or withheld to satisfy grant or exercise price or tax withholding obligations associated with an award granted under the 2008 Plan; shares subject to awards that expire or become unexercisable (to the extent of such expiration or non-exercise); shares that are surrendered pursuant to an exchange program; shares of restricted stock issued pursuant to the early exercise of an option that fail to vest; and shares covered by stock appreciation rights that are not delivered upon settlement of the stock appreciation rights.

 

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Awards. The 2008 Plan provides for the grant of stock options, including ISOs or NSOs, and stock appreciation rights. ISOs may be granted to our employees and employees of our qualifying parent and subsidiary corporations. NSOs and stock appreciation rights may be granted to our employees, consultants and directors and the employees, consultants and directors of certain of our parent and subsidiary entities. Stock options granted under the 2008 Plan may permit early exercise prior to vesting, in which case restricted shares that are subject to the vesting schedule applicable to the underlying stock option will be delivered upon exercise. Awards under the 2008 Plan are set forth in award agreements, which detail the terms and conditions of the awards, including any applicable vesting and payment terms and post-termination exercise limitations. Awards are generally settled in shares of our common stock. A brief description of each award type follows.

 

   

Stock Options. Stock options provide for the purchase of shares of our common stock in the future at an exercise price set on the grant date. ISOs, by contrast to NSOs, may provide tax deferral beyond exercise and favorable capital gains tax treatment to their holders if certain holding period and other Internal Revenue Code requirements are satisfied. The exercise price of a stock option may not be less than 100% of the fair market value of the underlying share on the date of grant (or 110% in the case of ISOs granted to certain significant stockholders), except with respect to certain substitute options granted in connection with a corporate transaction. The term of a stock option may not be longer than ten years (or five years in the case of ISOs granted to certain significant stockholders). Vesting conditions determined by the plan administrator may apply to stock options and may include continued service, performance and/or other conditions. A stock option may provide for “early exercise” prior to vesting in exchange for shares of restricted shares that vest on the option’s vesting schedule.

 

   

Stock Appreciation Rights. Stock appreciation rights, or SARs, entitle their holder, upon exercise, to receive from us an amount equal to the appreciation of the shares subject to the award between the grant date and the exercise date. The exercise price of a SAR may not be less than 100% of the fair market value of the underlying share on the date of grant and the term of a SAR may not be longer than ten years. Vesting conditions determined by the plan administrator may apply to SARs and may include continued service, performance and/or other conditions.

 

   

Restricted Stock. Restricted stock may be issued pursuant to the early exercise of options and may be forfeited for no consideration if the conditions or restrictions on vesting are not met. In general, restricted stock may not be sold or otherwise transferred until restrictions are removed or expire. Holders of restricted stock will have voting rights and will have the right to receive dividends, if any, prior to the time when the restrictions lapse.

Certain Transactions. The plan administrator has broad discretion to equitably adjust the provisions of the 2008 Plan, as well as the terms and conditions of existing and future awards, to prevent the dilution or enlargement of intended benefits and facilitate necessary or desirable changes in the event of certain transactions and events affecting our common stock, such as stock dividends, stock splits, mergers, consolidations, reorganizations, asset sales and other corporate transactions. The plan administrator has discretion, upon the occurrence of a change in control (as defined in the 2008 Plan), to provide that awards outstanding under the 2008 Plan will be assumed, substituted with equivalent awards, accelerated and terminated, cashed out or any combination of the foregoing, except that if awards will not be assumed, cashed out or substituted with equivalent awards, the awards will be subject to accelerated vesting such that 100% of such awards will become vested and exercisable or payable, as applicable, prior to the consummation of such transaction. Individual award agreements may provide for additional accelerated vesting and payment provisions.

Nontransferability. Generally, awards granted under the 2008 Plan are not transferable by a participant other than by will or by the laws of descent and distribution.

Plan Amendment and Termination. Our board of directors may amend or terminate the 2008 Plan at any time subject to obtaining stockholder approval to the extent necessary under applicable laws; provided that no amendment or termination may impair the rights of a participant without the affected participant’s consent.

 

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2011 Incentive Award Plan

Prior to this offering, we expect our board of directors to adopt and for our stockholders to approve the 2011 Incentive Award Plan, referred to as the 2011 Plan, under which we expect to grant cash and equity incentive awards to eligible service providers in order to attract, motivate and retain the talent for which we compete. We expect that the material terms of the 2011 Plan will be as summarized below.

Eligibility and Administration. We expect that our employees, consultants and directors will be eligible to receive awards under the 2011 Plan. We expect that the 2011 Plan will be administered by our board of directors, which may delegate its duties and responsibilities to committees of our directors and/or officers (referred to collectively as the plan administrator), subject to certain limitations that may be imposed under Section 162(m) of the Internal Revenue Code, Section 16 of the Exchange Act and/or stock exchange rules, as applicable. The plan administrator will have the authority to make all determinations and interpretations under, prescribe all forms for use with, and adopt rules for the administration of, the 2011 Plan, subject to its express terms and conditions. The plan administrator is also expected to set the terms and conditions of all awards under the 2011 Plan, including any vesting and vesting acceleration conditions.

Limitation on Awards and Shares Available. The aggregate number of shares of our common stock that will be available for issuance under awards granted pursuant to the 2011 Plan is expected to be equal to the sum of (i)             shares, (ii) any shares of our common stock subject to awards under the 2008 Plan or the 2005 Plan that terminate, expire or lapse for any reason and (iii) an annual increase in shares on the first day of each year beginning in 2012 and ending in 2021. The annual increase is expected to be equal to the lesser of (A)             shares, (B)     % of our common stock outstanding on the last day of the prior year or (C) such smaller number of shares as may be determined by our board. Upon effectiveness of the 2011 Plan, we do not expect to grant any additional awards under the 2008 Plan. Shares granted under the 2011 Plan may be treasury shares, authorized but unissued shares, or shares purchased in the open market. We expect that shares tendered or withheld to satisfy grant or exercise price or tax withholding obligations associated with an award granted under the 2011 Plan, and shares subject to an award that is granted under the 2011 Plan that is forfeited, expires or is settled for cash, may be used again for new grants under the 2011 Plan. However, we expect that the following shares may not be used again for grant under the 2011 Plan: (i) shares subject to a stock appreciation right, or SAR, that are not issued in connection with the stock settlement of the SAR on its exercise, and (ii) shares purchased on the open market with the cash proceeds from the exercise of options.

We expect that awards granted under the 2011 Plan upon the assumption of, or in substitution for, awards authorized or outstanding under a qualifying equity plan maintained by an entity with which we enter into a merger or similar corporate transaction will not reduce the shares available for grant under the 2011 Plan. After a transition period that may apply following the effective date of the offering, the maximum number of shares of our common stock that may be subject to one or more awards granted to any one participant pursuant to the 2011 Plan during any calendar year is expected to be             and the maximum amount that may be paid in cash pursuant to the 2011 Plan to any one participant during any calendar year period is expected to be $            .

Awards. We expect that the 2011 Plan will provide for the grant of stock options, including ISOs and NSOs, restricted stock, dividend equivalents, stock payments, restricted stock units, or RSUs, performance shares, other incentive awards, SARs and cash awards. Certain awards under the 2011 Plan may constitute or provide for a deferral of compensation, subject to Section 409A of the Internal Revenue Code, which may impose additional requirements on the terms and conditions of such awards. We expect that all awards under the 2011 Plan will be set forth in award agreements, which will detail the terms and conditions of the awards, including any applicable vesting and payment terms and post-termination exercise limitations. We expect that awards other than cash awards will generally be settled in shares of our common stock, but the plan administrator may provide for cash settlement of any award. A brief description of each award type follows.

 

   

Stock Options. Stock options provide for the purchase of shares of our common stock in the future at an exercise price set on the grant date. ISOs, by contrast to NSOs, may provide tax deferral beyond

 

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exercise and favorable capital gains tax treatment to their holders if certain holding period and other requirements of the Internal Revenue Code are satisfied. The exercise price of a stock option may not be less than 100% of the fair market value of the underlying share on the date of grant (or 110% in the case of ISOs granted to certain significant stockholders), except with respect to certain substitute options granted in connection with a corporate transaction. The term of a stock option may not be longer than ten years (or five years in the case of ISOs granted to certain significant stockholders). Vesting conditions determined by the plan administrator may apply to stock options and may include continued service, performance and/or other conditions.

 

   

Stock Appreciation Rights. SARs entitle their holder, upon exercise, to receive from us an amount equal to the appreciation of the shares subject to the award between the grant date and the exercise date. The exercise price of a SAR may not be less than 100% of the fair market value of the underlying share on the date of grant (except with respect to certain substitute SARs granted in connection with a corporate transaction) and the term of a SAR may not be longer than ten years. Vesting conditions determined by the plan administrator may apply to SARs and may include continued service, performance and/or other conditions.

 

   

Restricted Stock, Deferred Stock, Restricted Stock Units and Performance Shares. Restricted stock is an award of nontransferable shares of our common stock that remain forfeitable unless and until specified conditions are met, and which may be subject to a purchase price. Deferred stock and RSUs are contractual promises to deliver shares of our common stock in the future, which may also remain forfeitable unless and until specified conditions are met. Delivery of the shares underlying these awards may be deferred under the terms of the award or at the election of the participant if the plan administrator permits such a deferral. Performance shares are contractual rights to receive a range of shares of our common stock in the future based on the attainment of specified performance goals, in addition to other conditions which may apply to these awards. Conditions applicable to restricted stock, deferred stock, RSUs and performance shares may be based on continuing service with us or our affiliates, the attainment of performance goals and/or such other conditions as the plan administrator may determine.

 

   

Stock Payments, Other Incentive Awards and Cash Awards. Stock payments are awards of fully vested shares of our common stock that may, but need not, be made in lieu of base salary, bonus, fees or other cash compensation otherwise payable to any individual who is eligible to receive awards. Other incentive awards are awards other than those enumerated in this summary that are denominated in, linked to or derived from shares of our common stock or value metrics related to our shares, and may remain forfeitable unless and until specified conditions are met. Cash awards are cash incentive bonuses subject to performance goals.

 

   

Dividend Equivalents. Dividend equivalents represent the right to receive the equivalent value of dividends paid on shares of our common stock and may be granted alone or in tandem with awards. Dividend equivalents are credited as of dividend payments dates during the period between the date an award is granted and the date such award vests, is exercised, is distributed or expires, as determined by the plan administrator. Dividend equivalents may not be paid on awards granted under the 2011 Plan unless and until such awards have vested.

Performance Awards. Performance awards include any of the awards that are granted subject to vesting and/or payment based on the attainment of specified performance goals. The plan administrator will determine whether performance awards are intended to constitute “qualified performance-based compensation,” or QPBC, within the meaning of Section 162(m) of the Internal Revenue Code, in which case the applicable performance criteria will be selected from the list below in accordance with the requirements of Section 162(m) of the Internal Revenue Code.

 

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Section 162(m) of the Internal Revenue Code imposes a $1,000,000 cap on the compensation deduction that we may take in respect of compensation paid to our “covered employees” (which should include our chief executive officer and our next three most highly compensated employees other than our chief financial officer), but excludes from the calculation of amounts subject to this limitation any amounts that constitute QPBC. We do not expect Section 162(m) of the Internal Revenue Code to apply to awards under the 2011 Plan until the earliest to occur of our annual stockholders’ meeting in 2015, a material modification of the 2011 Plan or exhaustion of the share supply under the 2011 Plan. However, QPBC performance criteria may be used with respect to performance awards that are not intended to constitute QPBC.

In order to constitute QPBC under Section 162(m) of the Internal Revenue Code, in addition to certain other requirements, the relevant amounts must be payable only upon the attainment of pre-established, objective performance goals set by our compensation committee and linked to stockholder-approved performance criteria. For purposes of the 2011 Plan, we expect that one or more of the following performance criteria will be used in setting performance goals applicable to QPBC, and may be used in setting performance goals applicable to other performance awards: (i) net earnings (either before or after one or more of the following: (a) interest, (b) taxes, (c) depreciation, (d) amortization and (e) non-cash equity-based compensation); (ii) gross or net sales or revenue; (iii) net income (either before or after taxes); (iv) adjusted net income; (v) operating earnings or profit; (vi) cash flow (including, but not limited to, operating cash flow and free cash flow); (vii) return on assets; (viii) return on capital; (ix) return on stockholders’ equity; (x) total stockholder return; (xi) return on sales; (xii) gross or net profit or operating margin; (xiii) costs; (xiv) funds from operations; (xv) expenses; (xvi) working capital; (xvii) earnings per share; (xviii) adjusted earnings per share; (xix) price per share of common stock; (xx) market share; and (xxi) economic value, any of which may be measured either in absolute terms for us or any operating unit of our company or as compared to any incremental increase or decrease or as compared to results of a peer group or to market performance indicators or indices. We expect that the 2011 Plan will also permit the plan administrator to provide for objectively determinable adjustments to the applicable performance criteria in setting performance goals for QPBC awards.

Certain Transactions. The plan administrator will have broad discretion to equitably adjust the provisions of the 2011 Plan, as well as the terms and conditions of existing and future awards, to prevent the dilution or enlargement of intended benefits and facilitate necessary or desirable changes in the event of certain transactions and events affecting our common stock, such as stock dividends, stock splits, mergers, acquisitions, consolidations and other corporate transactions. In addition, in the event of certain non-reciprocal transactions with our stockholders known as “equity restructurings,” the plan administrator will be able to make equitable adjustments to the 2011 Plan and outstanding awards. We expect that in the event of a change in control of our company (as defined in the 2011 Plan), the surviving entity must assume outstanding awards or substitute economically equivalent awards for such outstanding awards; however, if the surviving entity declines to assume or substitute for some or all outstanding awards, then we expect all such awards will vest in full and be deemed exercised (as applicable) upon the transaction. Individual award agreements may provide for additional accelerated vesting and payment provisions.

Foreign Participants, Transferability, Repricing and Participant Payments. The plan administrator may modify award terms, establish subplans and/or adjust other terms and conditions of awards, subject to the share limits described above, in order to facilitate grants of awards subject to the laws and/or stock exchange rules of countries outside of the United States. With limited exceptions for estate planning, domestic relations orders, certain beneficiary designations and the laws of descent and distribution, awards under the 2011 Plan are expected to generally be non-transferable prior to vesting and exercisable only by the participant. Subject to applicable limitations of the Internal Revenue Code, the plan administrator is expected to be able to increase or reduce the applicable price per share of an award, or cancel and replace an award with another award. With regard to tax withholding, exercise price and purchase price obligations arising in connection with awards under the 2011 Plan, the plan administrator is expected to be able to, in its discretion, accept cash or check, shares of our common stock that meet specified conditions, a “market sell order” or such other consideration as it deems suitable.

 

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Plan Amendment and Termination. Our board of directors is expected to be able to amend or terminate the 2011 Plan at any time; however, except in connection with certain changes in our capital structure, stockholder approval will be required for any amendment that increases the number of shares available under the 2011 Plan or cancels any stock option or SAR in exchange for cash or another award when the option or SAR price per share exceeds the fair market value of the underlying shares. After the tenth anniversary of the date on which we adopt the 2011 Plan, no automatic annual increases to the 2011 Plan’s share limit will occur and no incentive stock options may be granted; however, the 2011 Plan will not have a specified expiration and will otherwise continue in effect until terminated by us.

Director Compensation Table

The following table sets forth information regarding compensation earned by our non-employee directors during the year ended December 31, 2010.

 

Name

   Fees Earned or
Paid in
Cash($)
     Total
($)
 

Joe Ferreira, Jr.(1)

   $       $   

Jeff Kearl(2)

     25,000         25,000   

David Oddi(1)

               

Greg Warnock(3)

               

 

(1) Both Joe and David are co-founders of and partners at Goode Partners LLC, which receives annual fees totaling $150,000 under the terms of an advisory agreement with us. Please see “Certain Relationships and Related Party Transactions—Series C Convertible Preferred Stock Financing and Stock Redemption—Advisory Agreement.” Neither Joe nor David directly received any compensation for their services as a director on our board.

 

(2) Jeff receives an annual fee of $25,000 for his services as a director on our board.

 

(3) Greg is the co-founder and managing director of Mercato Partners. No management fees or compensation were paid to Mercato Partners or Greg in connection with his service as a director on the board.

Jeff indirectly held 6,257 shares of common stock and 13,532 stock options as of December 31, 2010. None of our directors, other than Jeff, held any stock options or stock awards at December 31, 2010.

 

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PRINCIPAL AND SELLING STOCKHOLDERS

We have 1,610,932 shares of common stock outstanding as of December 31, 2010. The following table sets forth information with respect to the beneficial ownership of our common stock as of December 31, 2010 by:

 

   

each person or group known to own beneficially more than 5% of our common stock;

 

   

each of our directors;

 

   

each of our executive officers named in the summary compensation table;

 

   

all of our directors and executive officers as a group; and

 

   

each selling stockholder.

The amounts and percentages of shares beneficially owned are reported on the basis of SEC regulations governing the determination of beneficial ownership of securities. Applicable percentage ownership is based on shares of common stock outstanding on December 31, 2010, which assumes the conversion of all outstanding shares of our preferred stock into an aggregate of 321,980 shares of our common stock and conversion of the convertible note into 275,866 shares of common stock. In computing the number of shares beneficially owned by a person and the percentage ownership of that person, we have included the shares the person has the right to acquire within 60 days of the date above, including through the exercise of any option, warrant or other right or conversion of any security. The shares that a stockholder has the right to acquire within 60 days, however, are not included in the computation of the percentage ownership of any other stockholder.

Except as otherwise indicated in these footnotes, each of the beneficial owners listed has, to our knowledge, sole voting and investment power with respect to the shares of capital stock and the business address of each such beneficial owner is c/o Skullcandy, Inc., 1441 West Ute Boulevard, Suite 250, Park City, Utah 84098.

 

                            Shares Beneficially
Owned After the Offering
 

Name of Beneficial Owner

  Number of
Shares
    Percentage  of
Outstanding
Capital Stock
    Shares
Being
Offered
    Shares
Subject
to Over-
Allotment
    Excluding
Exercise of
Over-Allotment
    Including
Exercise of
Over-Allotment
 
          Number     Percent     Number     Percent  

5% Stockholders:

               

Ptarmigan, LLC(1)

    552,538        34.3            

Goode Skullcandy Holdings LLC(2)

    277,494        17.2            

JA Cropston, LLC(3)

    135,731        8.4            

Mercato Partners(4)

    111,674        7.0            

Officers and Directors:

               

Rick Alden(5)

    75,921        4.7            

Jeremy Andrus(6)

    162,772        10.1            

Aaron Behle

           *               

Mitch Edwards

           *               

Joe Ferreira, Jr.(2)

    277,494        17.2            

Jeff Kearl(1)(7)

    568,214        35.3            

Dan Levine(8)

    4,442        *               

David Oddi(2)

    277,494        17.2            

Greg Warnock(4)(9)

    134,284        8.3            

All executive officers and directors as a group (12 persons)(10)

    1,232,063        75.0            

Other Selling Stockholders:

               

 

* Denotes less than 1.0% of beneficial ownership.

 

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(1) Jeff Kearl is the manager of Ptarmigan, LLC, or Ptarmigan, and holds voting and dispositive power of these shares. The sole member of Ptarmigan is The Alden Irrevocable Trust, for which Jeff Kearl serves as the trustee. Rick Alden’s spouse and his children are the beneficiaries of the trust. Jeff may be deemed to indirectly beneficially own the shares held by Ptarmigan. Jeff disclaims beneficial ownership of the shares held by Ptarmigan. The address of Ptarmigan is 38 Via Divertirse, San Clemente, California 92673.

 

(2) Joe Ferreira, Jr. and David Oddi, two of our current directors, are members of Goode Partners I, LLC, or GP I, which is the general partner of Goode Partners Consumer Fund I, L.P., or GPCF I, which is the managing director of Goode Skullcandy Holdings LLC. Both Joe and David are also managing directors and members of Goode Partners, LLC, which manages GP I and GPFC I, collectively referred to as the “Goode Entities.” Joe and David may each be deemed to indirectly beneficially own the shares held by Goode Skullcandy Holdings LLC because of their affiliation with the Goode Entities. Both Joe and David disclaim beneficial ownership of the shares held by Goode Skullcandy Holdings LLC except to the extent of their pecuniary interests therein. The address of Goode Skullcandy Holdings LLC is c/o Goode Partners, LLC, 767 Third Avenue, New York, New York 10017.

 

(3) Jeremy Andrus and his father, Brent Andrus, are the managers of JA Cropston, LLC and hold voting and dispositive power over these shares. The address of JA Cropston, LLC is 2681 Chadwick Street, Salt Lake City, Utah 84106.

 

(4) Consists of 39,695 shares of common stock, held by Mercato Partners QP, L.P, or Mercato QP, and 71,979 shares of common stock held by Mercato Partners, L.P, or Mercato LP. Greg Warnock, one of our directors, and Alan Hall are managing directors of Mercato LP and Mercato QP, and have voting and dispositive power of the shares held by these entities. Both Greg Warnock and Alan Hall disclaim beneficial ownership of the shares held by Mercato LP and Mercato QP except to the extent of their pecuniary interests therein. The address of Mercato LP and Mercato QP is 6550 South Millrock Drive, Suite 125, Salt Lake City, Utah 84121.

 

(5) Consists of 75,921 shares of common stock held directly by Rick Alden.

 

(6) Consists of 135,731 shares of common stock identified in footnote 3, 17,832 shares of common stock and 9,208 shares of common stock subject to options exercisable within 60 days of December 31, 2010 held directly by Jeremy Andrus.

 

(7) Consists of (i) 552,538 shares of common stock held by Ptarmigan as identified in footnote 1, and (ii) 6,257 shares of common stock and 9,419 shares of common stock subject to options exercisable within 60 days of December 31, 2010, held by Pura Vida Investment Capital, or Pura Vida. Jeff is the manager of Ptarmigan and Pura Vida and holds voting and dispositive power of the shares held by Ptarmigan and Pura Vida. Jeff may be deemed to indirectly beneficially own the shares held by Ptarmigan and Pura Vida. Jeff disclaims beneficial ownership of the shares held by the Ptarmigan and Pura Vida except, with respect to Pura Vida, to the extent of his pecuniary interest therein. The address of Pura Vida is 38 Via Divertirse, San Clemente, California 92673.

 

(8) Consists of 4,442 shares of common stock subject to options exercisable within 60 days of December 31, 2010 held directly by Dan Levine.

 

(9) Consists of (i) 111,674 shares of common stock identified in footnote 4, (ii) 15,636 shares of common stock held by Gazelle Investments LLC and (iii) 6,974 shares of common stock held directly by Greg Warnock. Greg Warnock, one of our directors, is the managing member of Gazelle Investments LLC and holds voting and dispositive power of these shares. Greg Warnock disclaims beneficial ownership of the shares held by Gazelle Investments LLC except to the extent of his proportionate pecuniary interest therein. The address of Gazelle Investments LLC is 8548 Mivu Circle, Sandy, Utah 84093.

 

(10) Includes 32,006 shares of common stock subject to options exercisable within 60 days of December 31, 2010.

 

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CERTAIN RELATIONSHIPS AND RELATED PARTY TRANSACTIONS

We describe below transactions and series of similar transactions that have occurred since January 1, 2008 to which we were a party or will be a party in which:

 

   

the amounts involved exceeded or will exceed $120,000; and

 

   

a director, executive officer, holder of more than 5% of our outstanding common stock or any member of their immediate family had or will have a direct or indirect material interest.

Series C Convertible Preferred Stock Financing and Stock Redemption

Securities Purchase and Redemption Agreement

On November 28, 2008, we entered into a securities purchase and redemption agreement with Goode Skullcandy Holdings LLC, or Goode, to sell, in a private placement, 1,628 shares of our Series C convertible preferred stock for $108.11 per share. The total aggregate offering price for these shares was $176,074. We expect that all shares of Series C convertible preferred stock will convert into 1,628 shares of our common stock upon the consummation of this offering.

The securities purchase and redemption agreement also provided that we would repurchase certain securities from our existing security holders in an aggregate amount of $55.2 million. The repurchase price was funded primarily from the issuance of the convertible note and the 2009 note, each of which is discussed below. The offer to repurchase shares was offered to all of our then existing stockholders. Those who agreed to sell securities to us became parties to the securities purchase and redemption agreement. As part of this redemption, we purchased securities from certain of our officers, directors and stockholders in the amounts set forth in the table below.

The securities purchase and redemption agreement also provided for an additional payment amount to be calculated following, among other events, a closing of a qualified initial public offering of our common stock. The amount of the payment was contingent upon the internal rate of return realized by Goode in the transaction and ranged from $5.0 million to $35.0 million. Following calculation of the payment amount, half of the amount would be paid to the selling security holders as additional consideration for their securities. The other half would be used to fund a bonus pool that would be distributed pursuant to a management incentive plan that was established concurrently with the execution of the securities purchase and redemption agreement.

In December 2010, in recognition of the likelihood that the additional payment amount would ultimately be calculated at the maximum level based on this offering, our board of directors determined to pay out the bonus pool amount on December 31, 2010 and to recognize the associated compensation expense at that time. To that end, we entered into a modification agreement with Goode, the selling security holders and the management incentive plan participants, pursuant to which we amended the securities purchase and redemption agreement to establish the bonus pool amount and to pay it out under the management incentive plan on December 31, 2010. To satisfy the payment of the bonus pool, we issued subordinated promissory notes, which we refer to as the 2010 notes, to each of the participants in the management incentive plan in an aggregate principal amount of $16.5 million. Our board of directors determined to retain $1.0 million of the amount initially allocated to the management incentive plan to be allocated in the future to various non-participating employees. The 2010 notes were issued in full satisfaction of our obligations under the management incentive plan. Under the 2010 notes, each participant was entitled to an immediate payment upon the issuance of the 2010 note in an amount sufficient to satisfy all tax obligations of the participant arising in connection with the issuance of the 2010 notes. The 2010 notes bear interest at a rate of 3.3% per annum, with all unpaid principal and interest amounts payable on the first to occur of (i) the tenth business day following any qualified initial public offering, (ii) the tenth business day following the sale of a majority ownership interest in us, (iii) an enumerated event of default or

 

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(iv) December 31, 2012. In connection with the issuance of the 2010 notes, the management incentive plan was terminated. The following table indicates the amount of 2010 notes issued to our executive officers, directors and 5% or greater stockholders:

 

Note Holder

   2010 Note
Amount
($)
 

Jeremy Andrus

   $ 1,987,952   

Dan Levine

     1,590,361   

Clarke Miyasaki

     993,976   

Mitch Edwards

     1,192,771   

Aaron Behle

     795,181   

In addition, we also established the additional consideration amount at $17.5 million and agreed to pay each selling security holder its pro rata portion of the additional consideration. The additional consideration will be paid to the selling security holders upon the earlier of December 31, 2013, the tenth day following the consummation of this offering, and the tenth day following the sale of a majority ownership interest in us. The following table identifies, for each of our executive officers, directors and 5% or greater stockholders, the number of shares repurchased, the repurchase price, the additional consideration and the total purchase price.

 

Note Holder

   Shares
Repurchased
     Repurchase
Price

($)
     Additional
Consideration
($)
     Total
($)
 

Rick Alden

     27,395       $ 3,551,300       $ 977,970       $ 4,529,270   

Jeremy Andrus(1)

     4,327         560,869         237,283         798,152   

Dan Levine

     152         19,674         66,308         85,982   

Clarke Miyasaki

     955         123,827         85,243         108,070   

Greg Warnock

     1,206         156,332         76,545         232,877   

JA Cropston, LLC(1)

     52,250         7,400,000         2,072,525         9,472,525   

Ptarmigan, LLC(2)

     199,417         28,851,198         7,119,000         35,970,198   

Pura Vida Investment Capital, LLC(2)

     6,225         807,010         312,095         1,119,105   

Monarch Partners(2)

     455         58,921         16,223         75,144   

Mercato Partners, L.P.(3)

     27,064         3,508,407         966,158         4,474,565   

Mercato Partners QP, L.P.(3)

     14,927         1,934,768         532,805         2,467,573   

Gazelle Investments LLC(3)

     11,673         1,513,273         416,728         1,930,001   

 

(1) JA Cropston, LLC is an affiliate of Jeremy Andrus, our president and chief operating officer.
(2) Ptarmigan, LLC, Pura Vida Investment Capital, LLC and Monarch Partners are affiliates of Jeff Kearl, our chairman. The sole member of Ptarmigan, LLC is The Alden Irrevocable Trust, for which Jeff Kearl serves as the trustee. Rick Alden’s spouse and his children are the beneficiaries of the trust.
(3) Mercato Partners L.P., Mercato Partners QP, L.P. and Gazelle Investments LLC, are affiliates of Greg Warnock, a member of our board of directors.

Security Holders Agreement

On November 28, 2008, we entered into a security holders agreement with the holders of our capital stock. The security holders agreement provides for the following:

Right of First Refusal. If Rick, Ptarmigan, LLC or any holder of our Series A or Series B preferred stock proposes to transfer any of our capital stock then held by such proposed transferor, the holder will be required to deliver a notice of such proposed transfer to us, Goode and any other security holder that holds at least 30,000 shares of our common stock (on an as-converted basis) containing the terms of such proposed transfer. Following delivery of such notice, Goode and the other security holders receiving such notice will have the right to purchase their pro rata share of all, or a portion of, the securities set forth in the notice on the terms set forth therein. The

 

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right of first refusal will expire upon the consummation of a qualified initial public offering and will not apply with respect to any such offering.

Right of First Offer. Prior to the consummation of a qualified initial public offering, if Goode proposes to sell or transfer any of our capital stock held by it or the convertible note to a third party, it will be required to give to us, Mercato Partners (and certain of its affiliates), Rick Alden and Jeremy Andrus, collectively the ROFR Holders, notice of such transfer. Each ROFR holder will have 15 days from the date of the notice to offer to purchase all (but not less than all) of the securities proposed to be sold or transferred. If Goode chooses not to accept any such offer within 30 days, it may transfer or sell the securities to the third party, subject to the Tag-Along Rights described below. This right will expire upon the consummation of a qualified initial public offering and will not apply with respect to any such offering.

Tag-Along Rights. Prior to the consummation of a qualified initial public offering, and subject to the transfer restrictions set forth in the security holders agreement, if a Security Holder (as defined in the security holders agreement) proposes to transfer any of our capital stock held by such Security Holder (other than to permitted transferees designated in the security holders agreement), such transferor will be required to notify us, Goode and any other Security Holder that holds at least 30,000 shares of our common stock (on an as-converted basis) of the proposed transfer and the terms of the proposed transfer. Following delivery of such notice, we, Goode and the other Security Holders receiving such notice will have the right to participate in such sale in accordance with their pro rata share (as calculated in the security holders agreement). This right will expire upon the consummation of a qualified initial public offering and will not apply with respect to any such offering.

Drag-Along Rights. If our board of directors approves an offer from any person (other than an affiliate or our security holders) to effect the sale of our company, we will have the right to cause all Security Holders to vote their shares in favor of such proposed sale. The drag-along rights will expire upon the consummation of a qualified initial public offering and will not apply to any such offering.

Rights to Purchase. In the event that we issue new securities, we are generally required to provide notice to holders of our preferred stock of such issuance and allow them to participate in the offering on a pro rata basis. This right will expire upon the consummation of a qualified initial public offering and will not apply with respect to any such offering.

Registration Rights. At any time and from time to time at least 180 days following the consummation of a qualified initial public offering, each of (i) Goode, so long as it holds at least 50% of the common stock issued or issuable upon conversion of the Series C convertible preferred stock and convertible note, and (ii) holders who own at least 50% of the common stock issued or issuable upon conversion of the Series A and Series B preferred stock, together the Registration Rights Holders, will be able to require us to use our reasonable best efforts to register their Registrable Securities (as defined in the security holders agreement) under the Securities Act (subject to certain exceptions) on a Form S-1, if the total proceeds of the offering are expected to be at least $25 million, or on Form S-3, if the total proceeds of the offering are expected to be at least $500,000, in which case the percentage holdings requirement will be 20%, rather than 50%. The aggregate proceeds dollar thresholds will not need to be satisfied if the Registration Right Holders exercising the right propose to sell all of their securities in the offering. We will not be obligated to effect more than one demand right in any 12 month period. Furthermore, if we propose to register any of our own securities under the Securities Act for a qualified initial public offering, we will be required to provide notice to Goode and the holders of the Series A and Series B preferred stock relating to such registration and provide them with the right to include their shares in such registration statement. The piggy-back rights described in the preceding sentence are subject to certain exceptions set forth in the security holders agreement.

Election of Directors. So long as Goode remains the holder of shares of Series C convertible preferred stock outstanding and the convertible note, it is entitled to elect two directors to our board of directors. In the event Goode’s aggregate investment in the convertible note and Series C convertible preferred stock exceeds $85 million,

 

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it will be entitled to elect a total of three directors. The Series C convertible preferred stock will automatically convert into our common stock immediately prior to the closing of an initial public offering in which the initial public offering price per share is equal to or greater than 150% of the then current conversion price of the Series C convertible preferred stock. Assuming such condition is met in this offering, there will be no shares of Series C convertible preferred stock outstanding and Goode will no longer be entitled to elect any directors to our board of directors. In addition, pursuant to the modification agreement, the two directors currently designated by Goode, David Oddi and Joe Ferreira, Jr., have agreed to voluntarily resign from the board of directors upon the effective date of a qualified initial public offering or other specified liquidity events.

The Series A and Series B preferred stock holders identified in the security holders agreement are entitled to elect two directors to our board of directors. So long as Mercato Partners holds at least 10,000 shares of our common stock (on an as-converted basis), the holders of Series A and Series B preferred stock will be required to vote in favor of the director nominees designated by Mercato Partners. One independent director will be designated jointly by (i) Goode (so long as it holds at least 50% of our common stock issued or issuable upon conversion of the Series C convertible preferred stock and convertible note) and (ii) the majority of other security holders, excluding Goode.

Board Observer Rights. For so long as Goode holds at least 25% of the common stock acquired by it upon conversion of the convertible note and Series C convertible preferred stock, it is entitled to have two representatives present at all board meetings. For so long as Mercato Partners holds at least 10,000 shares of our Series B preferred stock, it is entitled to have one representative present at all board meetings. Pursuant to the modification agreement, so long as Goode continues to own at least 25% of the common stock into which the convertible note and Series C convertible preferred stock are converted upon a qualified initial public offering, it is entitled to have one representative present at all meetings of our board of directors.

Put Rights/Compelled Sale. If we have not consummated a qualified initial public offering by May 28, 2012, Goode will have the right, but not the obligation, to require us to purchase all (but not less than all) of its common stock following conversion of the Series C convertible preferred stock and convertible note held by it. If the put right is exercised but not consummated by us, Goode can require us to use our reasonable best efforts to complete a sale of our company.

Prior to consummation of this offering, we will obtain waivers from the security holders waiving their respective piggy-back registration rights.

Convertible Promissory Note

On November 28, 2008, we issued the convertible note to Goode in the initial principal amount of $29.8 million. See “Description of Certain Indebtedness—Convertible Note.”

Advisory Agreement

On November 28, 2008, we entered into an advisory agreement with Goode Partners, an affiliate of Goode. Pursuant to the advisory agreement, we agreed to pay Goode Partners an annual fee of $150,000 (subject to adjustment) in return for certain financial advisory services. The advisory agreement terminates upon the earlier of (i) the date on which Goode and all of its affiliates own less than 35% of the equity securities that such parties owned on the Initial Closing Date (as defined in the advisory agreement) or (ii) a qualified initial public offering.

2009 Note

On February 3,