-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, Qoa5kBjwdRdcuMt8/6LW4EKwDd0ThC1jRG1vecWR9INGUJFrdwoN8wjv6iYCTh8E BI/+RmJdSXmOFH5zqf8PgA== 0000950147-00-000487.txt : 20000331 0000950147-00-000487.hdr.sgml : 20000331 ACCESSION NUMBER: 0000950147-00-000487 CONFORMED SUBMISSION TYPE: 10-K405 PUBLIC DOCUMENT COUNT: 4 CONFORMED PERIOD OF REPORT: 19991231 FILED AS OF DATE: 20000330 FILER: COMPANY DATA: COMPANY CONFORMED NAME: SILICON GAMING INC CENTRAL INDEX KEY: 0001013170 STANDARD INDUSTRIAL CLASSIFICATION: SERVICES-PREPACKAGED SOFTWARE [7372] IRS NUMBER: 770357939 STATE OF INCORPORATION: CA FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K405 SEC ACT: SEC FILE NUMBER: 000-28294 FILM NUMBER: 586884 BUSINESS ADDRESS: STREET 1: 2800 W BAYSHORE CITY: PALO ALTO STATE: CA ZIP: 94303 BUSINESS PHONE: 6508429000 MAIL ADDRESS: STREET 1: 2800 WEST BAYSHORE ROAD CITY: PALO ALTO STATE: CA ZIP: 94303 10-K405 1 ANNUAL REPORT FOR THE YEAR ENDED 12/31/99 ================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, DC 20549 FORM 10-K Mark One [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 1999 [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from _______________ to ______________ Commission File Number 000-28294 SILICON GAMING, INC. (Exact Name of Registrant as Specified in Its Charter) California 77-0357939 (State or Other Jurisdiction (I.R.S. Employer of Incorporation or Organization) Identification No.) 2800 W. Bayshore Road, Palo Alto, CA 94303 (Address of Principal Executive Offices) (Zip Code) (Registrant's Telephone Number, Including Area Code) 650-842-9000 Securities Registered Pursuant to Section 12(b) of the Act: Title of Class Name of Each Exchange on Which Registered - -------------- ----------------------------------------- None None Securities Registered Pursuant to Section 12(g) of the Act: Common Stock, $.001 par value Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ]. Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [X] Aggregate market value of the registrant's Common Stock held by non-affiliates as of February 29, 2000: $5,013,226 Number of shares outstanding of the issuer's Common Stock, $.001 par value, as of February 29, 2000: 30,949,273 DOCUMENTS INCORPORATED BY REFERENCE: Portions of the definitive Proxy Statement for the Registrant's Annual Meeting of Shareholders to be held on May 25, 2000, are incorporated by reference into Part III of this Form 10-K. ================================================================================ PART I ITEM 1: BUSINESS Silicon Gaming, Inc. ("SGI" or the "Company") is engaged in the design, development, production, marketing and sale of interactive, software-based products for the gaming industry. To date it has deployed its product in video-based slot machines that it has designed and developed for use in casinos and other gaming establishments. These machines combine a multimedia gaming platform with the software-based games. The Company believes its products are more engaging and entertaining than other gaming products currently available and will, as a result, generate increased gaming revenue per device ("win per machine") for the casino operator. The Company's games feature high-quality animation, video clips, digital sound and a level of visual appeal and interactivity that the Company believes is not met by the current generation of slot machines. To take advantage of these features, the Company's initial products were deployed in a product that featured high resolution video presented across the full surface of a distinctive, large touchscreen display. The Company is attempting to maximize the entertainment value offered on the video screen by providing multiple levels of achievement within certain games so that, through successful play over a period of time, a player may advance to a bonusing sequence and win additional jackpots. SGI believes that, by utilizing these features, its products will encourage longer and more frequent periods of play by existing slot machine customers and attract new gaming customers who are seeking greater entertainment value than that offered by the current generation of slot machines. The Company has also designed its machines with a number of unique player features, such as play stoppage entertainmentTM. In addition, the product's modular components and Machine Management SystemTM software provide easy-to-use diagnostics designed to minimize player inconvenience and machine down time. The Company currently offers several platforms for its games, including ODYSSEYTM, a multi-game machine that can play up to six different games on the same machine, QUEST, a single-game upright machine, and a traditional slant top machine. The Company was granted product approval for ODYSSEY from the Nevada Gaming Commission in March 1997, allowing the Company to commence commercial distribution of its products. The Company typically places machines in casinos for an evaluation period prior to sale, consistent with industry practice. The Company sells machines outright to casinos and also places machines in casinos and receives a predetermined percentage of the net win per machine. The Company also sells new game titles periodically to existing customers which allows customers to update their products. As of December 31, 1999, the Company had 4,050 machines installed in approximately 200 properties throughout Connecticut, Iowa, Louisiana, Michigan, Mississippi, Missouri, Nevada, New Mexico, certain Canadian provinces and Uruguay. Of these machines, 3,702 have been sold outright or placed on a revenue-sharing basis. After returns, 348 machines remain installed on a trial basis and the casino operators will be required to purchase the machine outright, participate in SGI's revenue sharing plan or return the machine to the Company within a defined trial period. INDUSTRY BACKGROUND According to industry sources, casino gaming revenue in the United States in 1993, 1994, 1995, 1996, 1997 and 1998 was approximately $12.6 billion, $14.0 billion, $18.0 billion, $22.4 billion, $25.8 billion and $28.1 billion, respectively, and continued growth was forecast for 1999 and 2000. Slot machines, video gaming machines and similar devices are the dominant source of gaming revenue for casino operators in most U.S. markets. Slot revenue as a percentage of total gaming revenue in 1999 was 64 in Nevada and 71 in Atlantic City. Jurisdictions where gaming has been legalized more recently have reported similar statistics. For example, in 1999 slot machines accounted for 76 of casino revenue in Indiana. In addition to constituting the largest portion of gaming revenue, slot revenue is more profitable than table games for casino operators, since slot machines require much lower labor costs. The Company believes that slot machines offer their owners an attractive return on investment. In 1998, the average win per machine per day, defined as the average amount of money wagered on a machine less the average jackpot payoffs, on the Las Vegas Strip was $101. A new slot machine from a major manufacturer, equipped with player tracking and slot accounting software, costs approximately $8,000 and generally has a useful life that can exceed five years. At this price, a new slot machine earning the Las Vegas Strip average would recoup its purchase price in 79 days. While certain markets have lower average wins per day than the Las Vegas Strip, many other markets have win per day figures that are significantly higher. For example, in 1998, Harrahs Marina Hotel & Casino in Atlantic City reported win per machine per day of $255 and Harrah's riverboat casino in Joliet, Illinois reported win per machine per day 2 of $371. Many of the native American gaming establishments often have daily win per machine numbers much higher than these levels, as evidenced by the two native American casinos in Connecticut reporting win per machine per day during December 1999 of $394. All casino games offer the same underlying proposition: the opportunity to win money in varying amounts and with varying frequency, but with the statistical certainty of losing money to the casino operator over an extended period of time. With slot machines, the prospect of winning can be varied across the spectrum from many small jackpots won frequently to one very large jackpot won very rarely. Players' risk/reward appetites will determine what type of machine they will want to play, and the nature of the payoffs can be deduced from the "pay table," a chart that graphically shows how much can be won based on various outcomes and various amounts of money wagered. Notwithstanding the differences in jackpot frequency and size, however, all slot machines retain a net amount of the money wagered through them over time. This amount is referred to as the "hold" and is generally expressed as a percentage of the amount of money wagered on a machine, which is called the "handle." The hold percentage in any given machine is preset by the manufacturer based on specifications from the casino, subject to legal parameters in some jurisdictions, and may differ from machine to machine on a casino floor. The U.S. gaming machine market has traditionally been dominated by reel-based slot machines. These were broadly introduced in the 1960s, when the free-spinning reel was made possible by advances in electro-mechanical circuitry. The free-spinning reel enabled manufacturers to create different versions of the same product by varying such things as the number of reels, the number of stops on each reel and the number and variety of payoff combinations. The 1980s saw the introduction of virtual reel "stepper" technology which allowed for a greater number of stops, or outcomes, on a reel, enabling casino operators to offer larger jackpots due to the lower likelihood of their being hit. Another significant development was the installation of electronic memory in machines, allowing players to keep an "account" of credits on the machine consisting of the initial amount inserted plus winnings minus losses. Since the player did not have to reinsert coins for every pull of the handle, the number of pulls per hour was increased significantly, and players tended to rewager much of the amounts won, raising the total win per machine. Except for the addition of features such as bill acceptors and player tracking systems, the technology employed by slot machines in the 1970s and 1980s still predominates in current-generation, reel-based slot machines. In the 1980s, hardware and software advances allowed for application of video graphics to gaming devices. Using these techniques, International Game Technology, Inc. ("IGT") was the first company to introduce video poker. Video poker offered slot players two important advantages. First, the game is interactive, since the player has to decide which cards to hold or discard during the hand. This feature allows the outcome to be influenced somewhat by the player, an attribute unavailable on reel-based machines. Second, the use of a video screen allows machine manufacturers to develop more interesting and attractive graphics than are available on reel-based slot machines. Since the mid-1990s, a number of slot machine manufacturers have introduced video-based products that have expanded the capabilities of video-based devices, including machines that offer the player a choice of up to twelve different games on a single machine. Now video-based products actually constitute a majority of new machines sales in the slot machine industry. The Company believes that the increasing popularity of video poker and multi-game machines suggests that customers may be receptive to a more complex and interactive slot experience. In the mid 1980s, a category of slot machine games called "progressives" was introduced and became very popular. The progressive configuration generally consists of traditional reel-based machines linked together by a computer network that allows them to share a common jackpot which is usually much larger than the jackpot that a single, unlinked machine could support. Progressives now include video based products as well. Progressive jackpots are typically several million dollars, and recently have exceeded $35 million. Progressives may be linked locally within a bank of a few machines, across an entire casino, or across an entire state. IGT is the dominant competitor in the progressives market. Growth in demand for slot machines has historically been driven by the opening of new casinos, including casinos in jurisdictions where gaming has recently been legalized. However, in recent years, the number of new jurisdictions that have legalized gaming has significantly declined; therefore, demand based on new openings will be largely limited to new projects in existing markets. Several new projects are under construction or have been announced in Las Vegas, Atlantic City, on the Gulf Coast and in the Midwest. While the physical useful life of a slot machine can be up to a decade or more, casino operators have tended to replace machines on a cycle closer to every five years. Also, the development of certain new features which offer the prospect of significantly increased slot earnings, such as the advent of bill acceptors in the early 1990s, or more recent developments such as tokenization or cashless operating systems, can encourage operators to replace machines even more rapidly. 3 STRATEGY Although the gaming industry as a whole has enjoyed significant growth over the past decade, the Company believes that there has been very little growth in the slot machine manufacturing segment. The Company believes that most of the growth and new investment in the gaming industry over this period has come from the investment made in assets such as large hotels and themed attractions, or from the consolidation of property ownership, and that comparatively little has been invested in further developing the actual casino games which, in the aggregate, account for a majority of the average casino's revenue and profits. In contrast, SGI has focused its resources primarily on developing what it believes will be more rewarding and entertaining casino games. It has also developed what it believes to be a new generation of interactive slot machines on which to run its games. Since its inception, in addition to its game development, the Company has developed and refined a gaming platform that takes advantage of personal computer-based technology to offer a more visually appealing and complex gaming experience. The Company believes that its games and its machines will encourage casino patrons to play more frequently and for longer periods of time and will also attract new gaming customers, particularly younger patrons who typically are not attracted to current generation slot machines. The Company believes that, as a result, its machines will outperform most existing machines in win per machine and thus motivate casino operators to supplement or replace existing slot machines with SGI products. The market for slot machines has become increasingly competitive since the Company was formed, and the number of new game and product introductions has increased significantly from historical levels. The proliferation of new product offerings has benefitted casino operators who are able to leverage their position with slot machine manufacturers and who have demanded higher levels of perfomance from new products. The casino operators are willing to try new products or new games for existing products that offer the prospect of higher win per machine per day. At the same time, operators are also much quicker to remove or replace a slot machine whose performance is less than that of other competing products. Casino operators have also been able to benefit from the level of competition to keep the average selling price of new slot machines from increasing significantly, despite the higher cost and complexity of new-generation products. As a result, the slot machine manufacturing industry can now be characterized by high competition and low levels of profitability. Certain slot machine manufacturers have responded to this pressure from the casino operators by placing machines in casinos and participating in the revenue stream generated from the product, either by participating in the net win per machine or in the gross amount wagered on the machine. This has allowed manufacturers to achieve a higher revenue per machine than an outright sale to the casino operator. Casino operators are increasingly reluctant to place machines in their casinos on a participation basis in the belief that this represents a profit shift from the casino operator to the manufacturer. Manufacturers have responded by selling their newest and most successful games, or games that they think will be highly successful, on a participation basis only. Casino operators have only tolerated this where the game is highly successful, as the net win to the casino is still attractive. This has also contributed to the casino operators' willingness to remove non-performing slot machines from their floors. The Company believes that it is uniquely placed among slot machine manufacturers because of the potential to leverage the technology that is inherent in its products. The Company believes its products and platforms are significantly more complex than competing products but at the same time are more flexible so that new and innovative game types can be deployed on its game platforms. This will allow the Company to develop game types and game themes that can offer play characteristics that cannot be easily imitated by its competitors and that take full advantage of the underlying technology of the product. By doing so, the Company hopes to offer a richer, more entertaining gaming experience for the casino customer and thereby generate a higher win per day per machine. The Company believes that this will also assist it in placing machines with casino operators on a participation basis, which should prove more profitable for the Company than a one-time sale of the machine. The flexibility of the Company's products allow it to customize or develop new game content much quicker than its competitors. The Company believes that this will allow it to partner directly with casino operators to develop games for the exclusive use of that operator, affording the operator a competitive advantage given the lack of product differentiation between most casinos. Working directly with operators to develop products may also help the Company overcome the operators concerns about participation games, as it aligns the operator and the manufacturer to the benefits of product success. The Company believes that there is greater profit potential in this type of collaborative relationship than in the more traditional "build and sell" model of the typical slot machine manufacturer. 4 The Company believes that new slot machine sales in the replacement category will surpass sales for new installations in the near future, due to the slowing in demand from new casino projects, and because the large number of machines installed during the high growth period of the early 1990s will soon be reaching their normal replacement time. The market for slot machines outside of North America is relatively small, with the exception of Australia, and it is generally difficult to forecast. In addition, international markets have often served as an outlet for used machines for most slot machine operators. SGI is currently focussed on establishing and solidifying its market position in North America. Given the relatively small size of the Company compared to certain of its competitors, the Company does not believe it has adequate resources to simultaneously develop products for both the North American and international markets. As a result, SGI does not currently contemplate entering any international markets with the exception of certain Canadian provinces. SGI remains open to taking advantage of opportunities in international markets, but only if this can be accomplished without any adverse impact on its domestic business. SGI currently sells its products outright to casino operators and other potential purchasers offering several pricing programs. For the ODYSSEY this consists of either (i) the sale of the hardware unit bundled with a single game or a suite of games and other software for a fixed price, or (ii) the sale of the hardware unit alone combined with a renewable one-year software license, including access to the entire ODYSSEY game library for the term of the license. The Company's single game upright machine, QUEST, and its slant top machine are sold as a bundled package of the hardware unit and a single game for a fixed price. The Company also offers a participation program where it will place its product on a casino floor in exchange for a share in the aggregate win generated by the machine. Typically, under this program 20% of the aggregate win, subject to a predetermined minimum, or a fixed daily rental fee, goes to the Company. SGI believes that with the ODYSSEY, it has achieved a leadership position within the multi-game segment of the video slot machine market. Since 1997, the Company has made a great deal of progress in defining and developing what the industry refers to as a "successful game". The Company believes that it has been able to improve its game content as a result of this experience, and now it has one of the most successful blackjack games with TOP HAT 21, a successful poker game with LUCKY DRAW POKER, and some of the more successful multi-line, multi-coin games with EUREKA and BANANA RAMA. At the same time the Company believes that it currently has not yet fully exploited the technological potential of its game platform and that many of its game offerings are in fact similar to competing products. The introduction of QUEST during 1998 was designed to allow the Company to increase its penetration of the casino floor by offering a wider array of product and price points to the casino operator. The introduction of the wide-area progressive products in December 1998 further increased the Company's product offerings. In 1999 the Company also introduced a more traditional, slant-top machine that is physically similar to competitors' products. The Company intends to offer additional platform choices such as a new upright machines during 2000 to further diversify its product offering. The Company believes that its ultimate success will come not from the breadth of platform offerings, but from the quality of play characteristics of the individual games offered on those platforms, and from the total gaming experience that it can provide to patrons playing its products. Developing pricing models that will allow the Company to maximize the revenue from each of its games will also be critical to the Company's future success. PRODUCTS The Company has developed a family of games and platforms that it believes represents the next generation of interactive gaming devices for use in casinos and other gaming establishments in the United States and worldwide. The Company's products utilize multimedia technologies to present casino games that it believes will be more engaging and entertaining than other gaming devices currently available. The Company's games feature high-resolution video presented across the full surface of a large touchscreen display. The touchscreen displays used by the Company are larger and more distinctive than those on competitive products, which has helped make the Company's platforms distinctive and easily recognizable within a casino environment. The games themselves feature 5 high-quality animation, video clips, digital sound and a level of game attractiveness and interaction that the Company believes is unavailable from and unachievable by current-generation slot machines. Unlike traditional "hardware-dominant" slot machines, the Company's products run games that are software based, allowing SGI to offer casino operators the benefit of flexibility to adapt their game offerings to evolving technologies and changing consumer tastes without structural change to, or replacement of, the gaming platform. GAMES AND OTHER SOFTWARE While SGI believes that the design of its machines and its hardware components are important to its operation and its ability to foster initial and extended play, it believes that the most important factor affecting the success of its platforms will be the games themselves and the software that controls those games. The majority of the Company's development efforts to date have been devoted to hardware, system software and game development, and the Company expects that, in the future, game development will be its principal development activity. The Company's games have been designed to present traditional casino games with the benefit of video and audio enhancements that are afforded by the Company's use of high-end multimedia hardware. While the underlying game may consist of a traditional casino game such as poker, keno or a reel-based slot machine, the game itself is only one aspect of the entertainment experience. The development cycle for the Company's games has been reduced significantly since the Company's initial introduction of games in 1997. The Company developed a standard "engine" for each game type that it introduced such as video-reels, keno, poker, blackjack and multi-line, multi-coin. In addition, for every game that is introduced the Company develops a number of different percentaging models that each have a different hold percentage. The percentaging models are developed to meet jurisdictional regulatory requirements, local market conditions and to offer flexibility to the casino operators. The number of percentaging models vary by game type. For example, ARABIAN RICHES, a reel-based game introduced during 1998 has 38 different percentaging variations and PHANTOM BELLE, a poker-based game, has 29 different percentaging variations. The choice of gaming platform can also affect the development cycle for games; however, to date the Company has used a common gaming platform for all of its hardware products. Development of a new game engine is a lengthy process but one that can be leveraged and used on subsequent game offerings. The ability to leverage existing game engines and percentaging models allows the Company to develop new game themes and to introduce these new game titles much faster than if it had to develop a brand new game engine with unique percentaging requirements. This has been reflected in the increase in the number of new game titles that the Company introduced in 1999 as compared to 1998. All of SGI's games embed an engaging and entertaining theme story to help attract patrons to the Company's machines. Some of the games developed and introduced during 1999 include the following: EUREKA - This multi-line, multi-coin wagering experience takes players deep inside a derelict coal mine on the way to hidden fortune. Featuring two separate bonuses embedded in the basic 4 X 4 playing field, players can follow a coal cart as it speeds its way into a long-sealed mine shaft on their way to discovering riches. This game was named one of Casino Journal's Top 20 Most Innovative Games of the Year in 1999. HOT REELS - A new game type developed and patented by Silicon Gaming during 1999, Hot Reels introduces the player-decision characteristics of video poker into a 3-reel traditional game set to an engaging auto racing theme. Players can select or hold game symbols from one reel across all of the reels being played (up to 5 reels simultaneously), and then re-spin for a second chance at a match, increasing their opportunities to win. STRIKE-IT-RICH - A multi-line, multi-coin game based on the popular pasttime of 10-pin bowling, this game offers players an unusual twist. The opportunity to actually bowl a bowling ball for cash. Incorporating a track ball, when bonus time comes around, the player can use the track ball to go bowling for dollars. Also named one of Casino Journal's Top 20 Most Innovative Games of the Year in 1999, this game is sold and distributed on the Company's behlf by Anchor Gaming. BANANA-RAMA DELUXE- A multi-line, multi-coin version of the Company's traditional three-reel game BANANA RAMA, this game utilizes the same infectious jungle rhythms and the on-screen antics of the game's two animated host monkeys, Banana and Clyde. The characters interact with each other and with the player and celebrate jackpots with the player. A bonus feature takes the player to the Oyster Bar for a pick-till-you-win bonus 6 game where players can select up to twelve oysters and collect the awards lying inside each of the oysters. The players continue doing this until the collect symbol appears at which time they return to the game. CASH CRUISE - This multi-line, multi-coin game set to a cruise ship theme takes the player across the oceans to either of a tropical or artic destination to see the sights and win some cash. Cash Cruise is a nickel game that allows the player to wager up to 50 coins a play. This game features two instant bonuses that hit with varying frequencies. Players select one of a selection of different destinations and collect prizes based upon the amount wagered and then return to the game. The Company believes that the combination of its attractive machines, high-level graphics and sound, bonusing features and the pursuit of an interesting and entertaining story will make SGI's product outperform conventional slot machines. During the last few years, a number of the Company's competitors have developed games based upon well known licensed brands that the manufacturers have licensed from the holders of the brands. This has helped in the "attract" stage of the wagering experience in bringing customers to a machine as customers can readily identify with these brands. Many of these games have been participation games, and have been highly successful for both the casino operator and the slot machine manufacturer. The abilty to use licensed brands as themes for slot games has to date been limited to the larger competitors in the slot machine industry who have the necessary financial resources to acquire those brands. Competition for well known and established brands has intensified, which has increased the price that a manufacturer must pay to acquire the licensed brand. The Company believes that opportunities exist for it to partner with one or several of the larger casino operators to aquire licensed brands during 2000 that will allow it to compete in this new, but growing segment of the gaming industry. The Company believes that the physical appearance of its machines is more attractive than conventional machines and will entice customers to play. In addition to the physical attributes of its machines, the Company has included a suite of video images that run when the machine is not being played. These include short, animated vignettes from the Company's games and "help" screens, as well as a menu page identifying all of the games available on that particular machine. Information regarding any game can be viewed through the push of a "Help" button. These merchandising segments feature the same quality of graphics, sound, video and animation that distinguish all of SGI's games. In the initial play period, SGI believes it is necessary to quickly engage the customer in the story line and to avoid any confusion, unfamiliarity or negative experience which might cause the customer to discontinue play. For this reason, many of the Company's game offerings to date consist of enhanced versions of traditional casino games, including reel-based slot games, so that the rules of the game will be well known. SGI intends to present these games using enhanced graphics and sound to enrich the play experience, but will not change the fundamental characteristics or objective of the game. In addition, the machine will offer traditional game controls for those players unfamiliar or uncomfortable with the touchscreen interface. The Company believes that the enhancements it has made to traditional casino games by the addition of high level graphics, sound, animation and storyline will encourage extended play, as well as more frequent play, and thereby generate greater win per machine than the unenhanced versions of these games available in conventional machines. A significant feature which the Company believes will contribute significantly to extended play is the introduction of advanced play levels in which a player, by virtue of having played a certain amount of time or achieved a certain number of jackpots at one level, gains access to a bonus sequence in which larger jackpots become available. The Company believes that the principal events that lead to completion of play include the player's running out of money, running out of time or achieving a targeted jackpot level. The Company believes that the unique features and entertainment value of its games will entice players to remain in the extended play phase for longer periods of time than are generally fostered by current generation slot machines. Moreover, the design of the Company's platform and games is intended to provide an entertainment experience that will encourage repeated play. In addition to features that are designed to enhance the entertainment value of SGI's machines and its ability to generate incremental revenue for the casino, SGI's platform incorporates proprietary features that are designed to overcome certain hurdles that may be involved in the licensing of a slot machine design, as well as to facilitate easy maintenance and supervision by casino personnel. These features are as follows: RANDOM NUMBER GENERATOR. At the core of every gaming machine is a random number generator that determines the outcome of every gaming proposition. To eliminate what the Company believes are some of the 7 impediments to randomness that characterize random number generators, SGI engaged Dr. Evangelos A. Yfantis, a recognized authority in the field of random number algorithms, to develop a proprietary random number generator algorithm for the Company. The Company has filed and received a U.S. patent with respect to its algorithm. SOFTWARE AUTHENTICATION. A critical element of all gaming machines is an authentication mechanism to determine that the software being used is identical to the software that has been approved by regulatory authorities and is operating correctly. This is necessary to ensure that the game being played corresponds exactly to that designed by the manufacturer and approved by regulatory authorities. Traditional slot machines need to be authenticated manually, a process usually performed only after a sizable jackpot award. The infrequency of checks offer greater opportunities to breach the security of traditional machines. The Company has developed a proprietary authentication process which leverages the advanced capabilities of the Company's machine to verify the integrity of a game each time it is selected for play. This process combines sophisticated authentication routines developed by RSA Data Security, Inc. with a proprietary methodology developed by the Company. The Company's authentication process provides continual checking of the machine's software for both accidental corruptions or malicious attempts to cheat the machine. Any detected anomalies will cause the machine to signal the loss of integrity immediately. The Company has filed for and received patent protection for certain aspects of its authentication methodology. MACHINE MANAGEMENT SYSTEM. The Company's Machine Management System is designed to provide easy access to the configuration, accounting, and diagnostic capabilities of the machine. The Machine Management System's accounting functions are designed to provide a rapid, easy-to-interpret report of all key machine metering data, as well as detailed accounting and statistics, on a game-by-game basis. The Machine Management System uses the full benefit of the machine's touchscreen to make installation and setup of the machine easier than traditional slot machines. The diagnostic programs comprise a user-friendly maintenance and troubleshooting system that allows casino floor personnel to quickly and effectively assess the cause of a play stoppage or other malfunctions or to examine transaction history where the validity of a jackpot or other transaction must be verified. For example, if a player asserts that the machine has not given full credit for a jackpot or has not properly recorded a cash input, a floor manager, using the touchscreen and a key, can access comprehensive data to review transaction and event history. With this information, the floor manager can rapidly evaluate the merit of the player's claim and take appropriate action. In this way, disputes can be quickly resolved at the machine's location without the operator having to consult back office records or review surveillance videotape. PLATFORM, HARDWARE AND OTHER PHYSICAL ATTRIBUTES SGI's gaming platforms so far have been designed to resemble a traditional slot machine in many respects. Its machines occupy the same footprint as a traditional slot machine and are of roughly the same general size and shape, enabling casino operators to replace traditional slot machines with SGI's machines without any reconfiguration of the casino floor. The most distinctive attribute of the upright products the Company has introduced so far are their vertically-oriented, 26-inch-diagonal touchscreen video monitor. A player's sense of interactivity is heightened by the ability to make all the required decisions on the screen, within the game itself. However, for players who are uncomfortable or unfamiliar with touchscreen devices, all of the traditional slot machine controls have been included as well. Thus, a player can control the game by using the touchscreen, by pushing a series of buttons similar to those found on current slot or video poker machines, or by pulling a handle as on traditional slot machines. Coin handling mechanisms, bill acceptors, card readers and other devices related to cash deposit, credit and win payout are similar to those used in current gaming machines. The music, voice and other audible features of the Company's games are played on a digital sound system. The products that the Company has introduced all share a common gaming platform. The principal electronic hardware used in the SGI gaming platform consists of multimedia and personal computer ("PC") components. The central processing unit is an Intel 200-MHz Pentium chip. This processor is accompanied by a variety of video and auxiliary controllers, some of which have been developed exclusively for use with the Company's products. To achieve a high level of multimedia performance from its system, the Company's machines use 64 megabytes of random access memory. Storage for the audio and visual media elements of the games, as well as the product software itself, is provided by a high-density 4 gigabyte hard disk drive for the multi-game machines and by a smaller 2-gigabyte hard disk drive for single game machines. All of these components are connected internally by a high-speed PCI bus. SGI's reliance on sophisticated full-motion video and high-quality audio presentations requires the use of state-of-the-art technology, and SGI expects to upgrade the performance of its platform periodically as higher-performance components become available. SGI machines are intended to be easily reconfigurable in the field 8 through the replacement of hardware components such as computer motherboards and video and auxiliary controllers, allowing casino operators to upgrade hardware in a cost-effective manner. SGI's gaming platforms employ modular construction at almost every level, facilitating upgrades and minimizing machine down-time. Such modularity permits the rapid exchange of components for upgrades or to replace defective parts. Using SGI's proprietary Machine Management System, casino personnel can run a variety of diagnostic programs or review detailed performance data directly from the gaming platform itself. In the case of a malfunctioning component, a casino technician can quickly restore play simply by swapping out the failed component with a new one. The modularity of SGI's platform will also facilitate upgrades of hardware components such as card readers and bill validators as new components become available. The Company believes that these features may allow casino operators to reduce platform down-time and shorten the time required to fix any malfunction, thereby increasing the time the platform is available for play and reducing the risk that a player will elect to terminate a gaming session as a result of play stoppage. The Company's gaming platforms are assembled almost entirely from off-the-shelf hardware, which the Company anticipates will reduce the chance of a parts shortage and will enable the Company to continue to manufacture its devices using state-of-the-art components as PC and multimedia technologies advance. The different platforms share many common components, making it easier for the Company's games to be played on different platforms and for customer technical staff to work on the Company's different product offerings. There can be no assurance, however, that the Company will continue to use common components or enjoy a reliable supply of hardware components. Moreover, certain components such as the touchscreen display and monitor are manufactured by single sources and may be particularly susceptible to interruptions in supply. Although SGI does develop proprietary components in order to meet certain specialized requirements of its platform, the Company intends to primarily use commercially available computer hardware components as a regular part of its product development process. SGI's machines were designed to accept future hardware upgrades to take advantage of networking capabilities. When networked, two or more machines can be linked, facilitating activities such as group play, tournaments and progressives. For example, a particular group of platforms can be configured to announce to players that a tournament will begin at a particular time and allow each player the option to participate. Similarly, platforms can be configured so that when one machine hits a jackpot, a player at another machine can win a bonus award; the two affected platforms can then display a coordinated audio/video simulation of a coin flying out of one tray and into the other. The Company believes that features of this kind will promote interaction among players at adjacent platforms and thereby maintain player interest for longer periods of time. The Company introduced its first product into the Nevada market in December 1998, THE BIG WIN, that incorporated this networking capability in a wide-area progressive system. The Company anticipates introducing products into the market during 2000 that will incorporate group play and tournament capabilities. SGI has incorporated numerous features into its gaming platform that are designed both to attract the player and to maintain his or her interest over an extended period of time. For example, SGI's gaming platform can be programmed to allow for a free spin following a specified number of unsuccessful attempts in order to ensure a minimum level of reward to the player. Similarly, SGI's machines are capable of running promotional or entertainment video programs during play stoppages such as those caused by a hopper refill, malfunction or request for change. These features have been designed to reduce the likelihood that a player will leave the machine during a play stoppage event. These features may also provide an additional revenue or promotional source to the operator by providing a medium for commercial messages. PRODUCT DEVELOPMENT The Company's product development efforts, particularly its game development and customization efforts, will be critical to its success in the gaming market. Research and development (R&D) expenses have increased significantly since inception. However, given the maturity of the game platform, the development tools and the software code base, the Company anticipate higher levels of productivity that will result in increased product output and an overall reduction in the level of development expenses. Development efforts will also likely be focussed on new or custom game development during 2000. During the years ended December 31, 1999, 1998 and 1997, the Company's research and development expenses were $4,410,000, $11,853,000 and $9,283,000, respectively. The reductions in the Company's headcount in late 1998 and early 1999, driven by efforts to reduce costs in light of continued losses, contributed to the lower levels of R&D expense during 1999. At December 31, 1999, 23 of the Company's 90 full-time employees were engaged in research and development. 9 Ideas for new games are derived from customer preferences as perceived by the Company or ascertained through the Company's market research and direct feedback from slot machine operators. The initial designs for the Company's games are conceived by a design team, which outlines the appearance and features of each game. A prototype is developed by a production team that includes a producer, product manager, artists, computer graphics engineers and entertainment software engineers. The game is then evaluated by SGI's marketing and sales staff, after which it is modified into its final form. The Company estimates that the development of a typical game takes approximately two to six months and costs approximately $150,000 to $400,000. SGI is seeking to develop a variety of specific games which management believes will appeal to casino operators and their customers. Currently, the Company is engaged in the development of games based on traditional slot machine games such as animated reel slots and video poker, as well as developing its first brand based products. The Company is also creating variations of the multi-coin, multi-line, Australian type games which have proved popular and successful in all of the US gaming markets since 1998. Some of the games currently under development include the following: HITSVILLE - The hits keep coming in this Motown inspired multi-line, multi-coin game. Stylized characters and soulful sounds come together in this nod to Barry Gordy `s "hit factory". The game features two unique bonuses and stunning graphics, making it a pleasure to play. KING PUTTT - Golf and gambling have long gone together and now players can test their skills in a true "putt for money" contest. This five-reel, nine-line payout game brings high hit frequency and a seemingly skill based bonus game incorporating the animated antics of mini-golf with an entertaining wagering experience. 3-REEL HOLDUP - This comic-book caper set to a 20's gangster theme, complete with wise -cracking "tough guys", car chases, armored car heists and a swinging soundtrack, is the Company's second unique "multi-spin" reel based game. Targetted to be a quarter denomination game, success sees the lucky particpant choosing a bag of loot from the back of an armored truck. STOCK CARDS - This high-speed, single hand poker game has been set to an auto racing theme and is designed to remind you how popular traditional draw poker still is. Stock cards offers the added challenge of accelerated play and experienced players can rev up the proposition rate to keep pace with their thirst for action. Completion of the games under development is subject to various risks and uncertainties. Such games may be subject to further creative decisions that could alter the game implementation or marketing considerations that could result in a shift of the Company's development focus to different types of games altogether. Successful completion of any game will also be subject to risks typically associated with the creative process, such as the risk that the Company's creative team will be unable to achieve the desired results in terms of the game's entertainment quality. The product development strategy to date has focussed on enhancing traditional gaming experiences by offering variations of existing casino-type games. Familiarity with these game types attracts customers to these games. The company has also taken this strategy a step further by introducing games based on familiar brands or activities, such as the EUREKA mining game. The next phase in the Company's product development strategy , which it commenced in 1999 is to introduce completely new types of wagering experiences such as the multi-spin games offered with HOT REELS or the interactive bowling in STRIKE IT RICH. The Company intends to introduce new game types that reflect a broader kind of wagering experiences during 2000. Over time, SGI expects to introduce additional games that offer a wider range of gaming experiences as players become more familiar with the capabilities of advanced video gaming platforms. For example, the Company may introduce games that utilize new digital camera technology to transform the player into the game during a bonus event, to enable the player to "participate" in the game, rather than merely being a spectator to a predetermined random outcome. The Company also anticipates developing more of its games for progressive formats in which the Company's machines would be networked to support a common jackpot that is significantly larger than that which a stand-alone machine could offer, or to support additional networked features such as tournaments and peer-to-peer play. 10 As internet technolgies continue to evolve, the Company will continue to monitor the changes in the legal environment surrounding on-line gaming. To the extent that it will not jeopardize is existing gaming licenses, the Company will look at leveraging its software content in the internet domain, either through licensing its content to third parties, developing or operating its own internet gaming site for cash or for prize, developing gaming sites for other third parties, or any combination of the above. The Company believes that its software-based games would translate easily into the internet world, and continues to monitor the evolution of this online gaming market. SALES AND MARKETING The ultimate success of SGI's games and its gaming platforms depends on its acceptance by casino operators and casino patrons. The Company believes that, from the point of view of casino operators, the attractiveness of any game or gaming platform depends on win per machine, ease of upgrade, maintenance and game change and information management. The Company believes that, from the casino patron's perspective, the attractiveness of a platform is a function of entertainment value and the perceived likelihood of the customer winning. SGI's sales and marketing strategy is to generate product sales by highlighting the advantages presented by its gaming platform to casino operators, such as potential for increased win per machine; and by developing processes focused on key operator values. SGI's marketing strategy also targets casino players and will focus on developing brand recognition for SGI's games, which the Company believes can be accomplished through the development of proprietary games that deliver greater entertainment value for the gaming dollar. SGI intends to position itself as a partner with either casino operators or other slot manufacturers in establishing the next generation of wagering entertainment. The Company recognizes that it is a small player in the gaming industry at this point and that it may have to leverage the skills and experience of these third parties to help in the development or deployment of new products. During 1999 the Company worked with Anchor Gaming to jointly develop and introduce a new game, STRIKE-IT-RICH. Anchor is responsible for the sale and support of the product which is manufactured by the Company. Because SGI's games are software-based, SGI believes that there will be a significant opportunity for game customization and the development of games for the exclusive use of one or more casino customers. It is already commonplace for casinos to ask that conventional slot machines be customized with the casino's logo or theme. SGI believes that it can significantly exceed this level of customization by inserting the casino's logo or theme right in the game, by presenting images of the casino's other games and amenities, or by creating a new game entirely based on the casino's theme. The Company expects that it would charge fees for any customization or development work that it performs for any other parties. The Company announced in February 2000 that it had entered into a joint-development agreement with a Nevada-based casino operator to develop a licensed brand into an exclusive game for that operator. The Company expects to announce more of these type of arrangements in the future as a way to help defray the cost and risks of new game development and to facilitate distribution of its products. The Company currently sells product through a direct sales force that is based in Nevada, Mississippi and the mid-west. The Company is planning to distribute product through third parties including other slot machine manufacturers or casino operators to help in the penetration of new markets without the need for additional hiring. As at December 31, 1999, 19 of the Company's 90 full-time employees were engaged in sales and marketing. The successful introduction of the Company's product is subject to substantial risks and uncertainties, including the risk of technical or manufacturing difficulties, the possibility that the SGI platform will not receive the anticipated market acceptance and possible delays or hurdles associated with licensing of the Company's product in various jurisdictions. The Company is required to be licensed in each jurisdiction in which it expects to sell product. As of December 31, 1999, the Company has received both corporate approval and approval to sell its product in Colorado, Illinois, Indiana, Iowa, Nevada, New Jersey, Missouri, Mississippi, and certain native American jurisdictions in Connecticut, Louisiana, Michigan, Minnesota and New Mexico. See "Gaming Regulation and Licensing." Although the Company plans to file applications in other jurisdictions, there can be no assurance that the Company will be ready to file future applications or that any licenses will be granted on a timely basis, or at all. PRICING The Company sells its products to casino operators and other potential purchasers offering several pricing programs. For the ODYSSEY this consists of either (i) the sale of the hardware unit bundled with a single game or a suite 11 of games and other software for a fixed price, or (ii) the sale of the hardware unit alone combined with a renewable one-year software license, including access to the entire game library for the term of the license. QUEST and the slant-top product are sold as a bundled package of the hardware unit and a single game for a fixed price. Similar to several of its competitors, the Company also offers a revenue sharing plan as an alternative to the above purchase pricing options. Under this plan, the casino operator is not required to make an upfront capital investment; rather, in exchange for placing the machines on the floor, the casino operator agrees to share with the Company the aggregate win generated by the machines. Under this plan, 20% of the aggregate win goes to the Company, subject to a predetermined minimum. In certain jurisdictions where this type of arrangement is not permitted, the operator agrees to pay a fixed daily fee for the use of the machine. The Company's plan is unique because the Company also offers the casino operator a buyout option at any point after the 90 day minimum evaluation period, something not currently offered in the industry. Under the buyout option, the operator receives a credit towards the purchase of the hardware and must purchase its choice of software at list price. The Company believes that licensing revenue from game software may eventually constitute a substantial portion of its revenue. COMPETITION The current slot machine market is highly competitive and is dominated by a small number of manufacturers, many of whom have significantly greater financial and other resources than the Company. The Company believes that the principal competitive factors in this market are the appeal of the machine to players, knowledge of customer requirements and player preferences, price, ease of use, service, support and training, distribution, and name and product recognition. The principal competitors in the slot machine market are IGT and Williams Industries. IGT may be viewed as a dominant competitor, with a 1999 market share estimated at 70%; William Industries 1999 market share is estimated at 15%. Additional competitors or potential competitors include Bally/Alliance Gaming, Inc., Anchor Gaming, Inc., Aristocrat Leisure Industries, Universal Distributing, Sigma Games, Casino Data Systems, Mikohn Systems, Inc. and Acres Gaming Inc. There can be no assurance that other companies in the video game or multimedia market will not successfully enter the market for video slot machines, nor can there be any assurance that the manufacturers of traditional slot machines will not develop products that are superior to, or that achieve greater market acceptance than, the Company's product. A number of the Company's larger customers who operate multiple casinos have also indicated that they may become involved in the design, development and manufacture of slot machines, although to date few have actually done so. In general, the Company's existing competitors, as well as many potential new competitors, have significantly greater financial and technical resources than the Company, as well as more established customer bases and distribution channels, any of which could afford them a competitive advantage. If any of the Company's products or specific game titles display potential to capture a significant share of the gaming machine market, the Company's competitors can be expected to employ a variety of tactics to limit erosion of their market shares, including price reductions, acceleration of technical development or acquisition of new, competitive technologies. Any success the Company might have may benefit existing competitors and induce new competitors to enter the market. There can be no assurance that the Company will be a successful competitor in the gaming machine industry. PROPRIETARY RIGHTS AND LICENSES The Company's computer programs and technical know-how are both novel and proprietary, and management believes that they can best be protected by use of technical devices to protect the computer programs and by enforcement of contracts and covenants not to compete with certain employees and others with respect to the use of the Company's proprietary information and trade secrets. The Company has registered copyrights with respect to various aspects of its games, and has filed several U.S. patent applications for protection of certain technology it has created or licensed. These patent applications cover various aspects of the gaming machine hardware and software. Although the Company has received certain patents and trademarks with respect to its intellectual property, no assurance can be given that the remaining pending applications will be granted, nor can there be any assurance that the patents will not be infringed or that others will not develop technology that does not violate such patents. SGI has developed a proprietary method of authentication for disk drive-based gaming machines, for which it has submitted a patent application. Since modern gaming technology requires the handling and processing of large amounts of on-line data, establishing a method for storing and retrieving data that meets the approval requirements of the regulatory authorities while meeting adequate standards of internal performance requires use of a comprehensive authentication system to assure both the casino operator and requisite gaming authorities that the software is an exact copy of what was generated by SGI and approved by such gaming authorities. 12 In addition, SGI owns exclusive rights to the algorithm for its random number generator, the key component of the Company's gaming machine that determines the outcome of each proposition. SGI's algorithm, which may have uses outside the gaming industry, was developed by Dr. Evangelos A. Yfantis, a professor of Computer Science at the University of Nevada, Las Vegas. In developing its games, the Company relies on certain software that it licenses from Duck Corporation ("Duck") on a nonexclusive basis. This license may be terminated by Duck only in the event of a material breach of its terms by the Company or in the event of a bankruptcy petition with respect to the Company. The Company believes that alternative products exist that accomplish the same functionality as that licensed from Duck. EMPLOYEES As of December 31, 1999, the Company had 90 full-time employees, including 23 in research and development. The Company also retains independent contractors to provide certain services, primarily in connection with its product development activities. The Company and its full-time employees are not subject to any collective bargaining agreements and the Company believes that its relations with its employees are good. From time to time the Company has retained actors and/or "voice over" talent to perform in certain of the Company's games and expects to continue this practice in the future. The Company's future success depends in large part on its ability to attract and retain management and other key personnel. MANUFACTURING The Company's manufacturing process consists primarily of assembly of components obtained from third-party suppliers and testing of software systems and applications. This activity now takes place at the Company's Las Vegas, Nevada facility. As the Company has introduced new product platforms, it has increased its use of subcontractors and third party vendors to supply completed sub-assemblies and components, which has decreased its need for direct manufacturing labor. As of December 31, 1999, the Company had 30 full-time employees engaged in manufacturing and support-related activities. GAMING REGULATION AND LICENSING GENERAL REGULATION OF SHAREHOLDERS OF PUBLICLY TRADED CORPORATIONS. In most jurisdictions, any beneficial owner of the Company's Common Stock is subject on a discretionary basis to being required to file applications with gaming regulatory authorities, be investigated and found suitable or qualified as such. In addition, shareholders whose holdings of Common Stock exceed certain designated percentages are subject to certain reporting and qualification requirements imposed by state and federal gaming regulators and, any shareholder, if found to be unsuitable, may be required to immediately dispose of its holdings of Common Stock. NEVADA REGULATORY MATTERS. The Company must obtain a registration, license, approval or finding of suitability, and equipment approval in all jurisdictions before it can offer gaming devices for sale to licensed gaming operations within those jurisdictions. The licensing process usually involves the licensing or approval of certain officers, directors, and shareholders of the corporation, and approval of the specific product that the Company wants to offer for sale. On June 19, 1996 the Nevada Commission registered SGI as a publicly traded corporation and licensed Silicon Gaming-Nevada ("SGI-Nevada"), a wholly-owned subsidiary of SGI, as a manufacturer, distributor and operator of a slot machine route. The Company's initial public offering was also approved by the Nevada Commission on June 19, 1996. On March 20, 1997, the Nevada Commission granted final approval of the Company's product for sale to licensed casinos in Nevada. The manufacture, sale and distribution of gaming devices for use or play in Nevada or for distribution outside of Nevada, the manufacture and distribution of associated equipment for use in Nevada, and the ownership and operation of slot machine routes in Nevada are subject to: (i) the Nevada Gaming Control Act and the regulations promulgated thereunder (collectively, "Nevada Act"); and (ii) various local ordinances and regulations. Such activities are subject to the licensing and regulatory control of the Nevada Commission, the Nevada Board, and various local, city and county regulatory agencies (collectively referred to as the "Nevada Gaming Authorities"). The laws, regulations and supervisory procedures of the Nevada Gaming Authorities are based upon declarations of public policy which are concerned with, among other things: (i) the prevention of unsavory or unsuitable persons from having a direct or indirect involvement with gaming, or manufacturing or distribution of gaming devices at any time or in any capacity; (ii) the strict regulation of all persons, locations, practices, associations and activities related to the operation of licensed gaming establishments and the manufacture or distribution of gaming devices and equipment; (iii) the establishment and 13 maintenance of responsible accounting practices and procedures; (iv) the maintenance of effective controls over the financial practices of licensees, including the establishment of minimum procedures for internal fiscal affairs and the safeguarding of assets and revenue, providing reliable record keeping and requiring the filing of periodic reports with the Nevada Gaming Authorities; (v) the prevention of cheating and fraudulent practices; and (vi) the provision of a source of state and local revenue through taxation and licensing fees. Change in such laws, regulations and procedures could have an adverse effect on the Company's operations. On June 19, 1996 the Company was registered by the Nevada Commission as a publicly-traded corporation (a "Registered Corporation"), and SGI-Nevada was approved as a manufacturer, distributor and operator of a slot machine route. On March 20, 1997, the Nevada Commission granted final approval of the Company's product. Such gaming approvals require the periodic payment of fees and taxes and are not transferable. As a Registered Corporation, the Company is required periodically to submit detailed financial and operating reports to the Nevada Commission and furnish any other information which the Nevada Commission may require. No person may become a shareholder of, or receive any profit from SGI-Nevada without first obtaining licenses and approvals from the Nevada Gaming Authorities. The Company and SGI-Nevada have applied for, and in some cases received, the various registrations, approvals, permits and licenses in order to engage in manufacturing, distribution and slot route activities in Nevada. All gaming devices that are manufactured, sold or distributed for use or play in Nevada, or for distribution outside of Nevada, must be manufactured by licensed manufacturers and distributed or sold by licensed distributors. All gaming devices manufactured for use or play in Nevada must be approved by the Nevada Commission before distribution or exposure for play. The approval process for gaming devices includes rigorous testing by the Nevada Board, a field trial and a determination as to whether the gaming device meets strict technical standards that are set forth in the regulations of the Nevada Commission. Associated equipment must be administratively approved by the Chairman of the Nevada Board before it is distributed for use in Nevada. The Nevada Gaming Authorities may investigate any individual who has a material relationship to, or material involvement with, a Registered Corporation or its subsidiaries in order to determine whether such individual is suitable or should be licensed as a business associate of a gaming licensee. Officers, directors and certain key employees of the Company and SGI-Nevada are required to file applications with the Nevada Gaming Authorities and may be required to be licensed or found suitable by the Nevada Gaming Authorities. The Nevada Gaming Authorities may deny an application for licensing for any cause which they deem reasonable. A finding of suitability is comparable to licensing, and both require submission of detailed personal and financial information followed by a thorough investigation. The applicant for licensing or a finding of suitability must pay all the costs of the investigation. Changes in licensed positions must be reported to the Nevada Gaming Authorities and in addition to their authority to deny an application for a finding of suitability or licensure, the Nevada Gaming Authorities have jurisdiction to disapprove a change in a corporate position. On June 19, 1996 SGI's Chief Executive Officer, Chief Financial Officer, the required directors and SGI-Nevada's sole officer and director were found suitable by the Nevada Commission. If the Nevada Gaming Authorities were to find an officer, director or key employee unsuitable for licensing or unsuitable to continue having a relationship with SGI or SGI-Nevada, the Company would have to sever all relationships with such person. In addition, the Nevada Commission may require the Company or SGI-Nevada to terminate the employment of any person who refuses to file appropriate applications. Determination of suitability or of questions pertaining to licensing are not subject to judicial review in Nevada. The Company and SGI-Nevada will be required to submit detailed financial and operating reports to the Nevada Commission. Substantially all material loans, leases, sales of securities and similar financing transactions by the Company will be required to be reported to or approved by the Nevada Commission. If it were determined that the Nevada Act was violated by the Company or SGI-Nevada, the registration and gaming licenses it holds could be limited, conditioned, suspended or revoked, subject to compliance with certain statutory and regulatory procedures. In addition, the Company, SGI-Nevada and the persons involved could be subject to substantial fines for each separate violation of the Nevada Act at the discretion of the Nevada Commission. Limitation, conditioning or suspension of any gaming license could (and revocation of any gaming license would) materially adversely affect the Company's gaming operations. 14 Any beneficial holder of a Registered Corporation's voting securities, regardless of the number of shares owned, may be required to file an application, be investigated, and have his suitability determined as a beneficial holder of the Registered Corporation's voting securities if the Nevada Commission has reason to believe that such ownership would otherwise be inconsistent with the declared policies of the State of Nevada. The applicant must pay all costs of investigation incurred by the Nevada Gaming Authorities in conducting any such investigation. The Nevada Act requires any person who acquires beneficial ownership of more than 5% of a Registered Corporation's voting securities to report the acquisition to the Nevada Commission. The Nevada Act requires that beneficial owners of more than 10% of a Registered Corporation's voting securities apply to the Nevada Commission for a finding of suitability within thirty days after the Chairman of the Nevada Board mails the written notice requiring such filing. Under certain circumstances, an "institutional investor," as defined in the Nevada Act, which acquires more than 10% but not more than 15%, of the Registered Corporation's voting securities may apply to the Nevada Commission for a waiver of such finding of suitability if such institutional investor holds the voting securities for investment purposes only. An institutional investor shall not be deemed to hold voting securities for investment purposes unless the voting securities were acquired and are held in the ordinary course of business as an institutional investor and not for the purpose of causing, directly or indirectly, the election of a majority of the members of the board of directors of the Registered Corporation, any change in the Registered Corporation's corporate charter, bylaws, management, policies or operations of the Registered Corporation, or any of its gaming affiliates, or any other action which the Nevada Commission finds to be inconsistent with holding the Registered Corporation's voting securities for investment purposes only. Activities which are not deemed to be inconsistent with holding voting securities for investment purposes only include: (i) voting on all matters voted on by shareholders; (ii) making financial and other inquiries of management of the type normally made by securities analysts for informational purposes and not to cause a change in its management, policies or operations; and (iii) such other activities as the Nevada Commission may determine to be consistent with such investment intent. If the beneficial holder of voting securities who must be found suitable is a corporation, partnership or trust, it must submit detailed business and financial information including a list of beneficial owners. The applicant is required to pay all costs of investigation. Any person who fails or refuses to apply for a finding of suitability or a license within thirty days after being ordered to do so by the Nevada Commission or the Chairman of the Nevada Board, may be found unsuitable. The same restrictions apply to a record owner if the record owner, after request, fails to identify the beneficial owner. Any shareholder found unsuitable and who holds, directly or indirectly, any beneficial ownership of the Common Stock beyond such period of time as may be prescribed by the Nevada Commission may be guilty of a criminal offense. The Company will be subject to disciplinary action if, after it receives notice that a person is unsuitable to be a shareholder or to have any other relationship with the Company or SGI-Nevada, the Company (i) pays that person any dividend or interest upon voting securities of the Company, (ii) allows that person to exercise, directly or indirectly, any voting right conferred through securities held by that person, (iii) pays remuneration in any form to that person for services rendered or otherwise, or (iv) fails to pursue all lawful efforts to require such unsuitable person to relinquish his voting securities including, if necessary, the immediate purchase of said voting securities for cash at fair market value. The Nevada Commission may, in its discretion, require the holder of any debt security of a Registered Corporation to file applications, be investigated and be found suitable to own the debt security of a Registered Corporation. If the Nevada Commission determines that a person is unsuitable to own such security, then pursuant to the Nevada Act, the Registered Corporation can be sanctioned, including the loss of its approvals, if without the prior approval of the Nevada Commission, it: (i) pays to the unsuitable person any dividend, interest, or any distribution whatsoever; (ii) recognizes any voting right by such unsuitable person in connection with such securities; (iii) pays the unsuitable person remuneration in any form; or (iv) makes any payment to the unsuitable person by way of principal, redemption, conversion, exchange, liquidation, or similar transaction. The Company will be required to maintain a current stock ledger in Nevada which may be examined by the Nevada Gaming Authorities at any time. If any securities are held in trust by an agent or by a nominee, the record holder may be required to disclose the identity of the beneficial owner to the Nevada Gaming Authorities. Failure to make such disclosure may be grounds for finding the record holder unsuitable. The Company will also be required to render maximum assistance in determining the identity of the beneficial owner. The Nevada Commission has the power to require the stock certificates of the Company to bear a legend indicating that the securities are subject to the Nevada Act. However, the Nevada Commission has not imposed such a requirement on the Company to date, but it is unknown whether the Nevada Commission will impose such a requirement on the Company in the future. 15 As a Registered Corporation, the Company may not make a public offering of its securities, such as an IPO or follow-on offering, without the prior approval of the Nevada Commission if the securities or proceeds therefrom are intended to be used to construct, acquire or finance gaming facilities in Nevada, or to retire or extend obligations incurred for such purposes. Approval of a public offering, if given, does not constitute a finding, recommendation or approval by the Nevada Commission or the Nevada Board as to the accuracy or adequacy of the Offering Memorandum or the investment merits of the securities offered. Any representation to the contrary is unlawful. Changes in control of a Registered Corporation through merger, consolidation, stock or asset acquisitions, management or consulting agreements, or any act or conduct by a person whereby he obtains control, may not occur without the prior approval of the Nevada Commission. Entities seeking to acquire control of a Registered Corporation must satisfy the Nevada Board and the Nevada Commission in a variety of stringent standards prior to assuming control of such Registered Corporation. The Nevada Commission may also require controlling shareholders, officers, directors and other persons having a material relationship or involvement with the entity proposing to acquire control, to be investigated and licensed as part of the approval process relating to the transaction. The Nevada legislature has declared that some corporate acquisitions opposed by management, repurchases of voting securities and corporate defense tactics affecting Nevada corporate gaming licensees, and Registered Corporations that are affiliated with those operations, may be injurious to stable and productive corporate gaming. The Nevada Commission has established a regulatory scheme to ameliorate the potentially adverse effects of these business practices upon Nevada's gaming industry and to further Nevada's policy to: (i) assure the financial stability of corporate gaming licensees and their affiliates; (ii) preserve the beneficial aspects of conducting business in the corporate form; and (iii) promote a neutral environment for the orderly governance of corporate affairs. Approvals are, in certain circumstances, required from the Nevada Commission before the Registered Corporation can make exceptional repurchases of voting securities above the current market price thereof and before a corporate acquisition opposed by management can be consummated. The Nevada Act also requires prior approval of a plan of recapitalization proposed by the Registered Corporation's Board of Directors in response to a tender offer made directly to the Registered Corporation's shareholders for the purposes of acquiring control of the Registered Corporation. License fees and taxes, computed in various ways depending on the type of gaming or activity involved, are payable to the State of Nevada and to the counties and cities in which gaming operations are to be conducted. Depending upon the particular fee or tax involved, these fees and taxes are payable either monthly, quarterly or annually and are based upon either: (i) a percentage of the gross revenue received; or (ii) the number of gaming devices operated. Annual fees are also payable to the State of Nevada for renewal of licenses as a manufacturer, distributor and operator of a slot machine route. Any person who is licensed, required to be licensed, registered, required to be registered, or is under common control with such persons (collectively, "Licensees"), and who proposes to become involved in a gaming venture outside of Nevada, is required to deposit with the Nevada Board, and thereafter maintain, a revolving fund in the amount of $10,000 to pay the expenses of investigation by the Nevada Board of their participation in such foreign gaming. The revolving fund is subject to increase or decrease in the discretion of the Nevada Commission. Thereafter, Licensees are required to comply with certain reporting requirements imposed by the Nevada Act. Licensees are also subject to disciplinary action by the Nevada Commission if they knowingly violate any laws of the foreign jurisdiction pertaining to the foreign gaming operation, fail to conduct the foreign gaming operation in accordance with the standards of honesty and integrity required of Nevada gaming operations, engage in activities that are harmful to the state of Nevada or its ability to collect gaming taxes and fees, or employ a person in the foreign operation who has been denied a license or finding of suitability in Nevada on the ground of personal unsuitability. In the future, SGI intends to seek the necessary registrations, licenses, approvals, and findings of suitability for the Company, its product and its personnel in other jurisdictions throughout the world. However, there can be no assurances that such registrations, licenses, approvals or findings of suitability will be obtained. Many other jurisdictions in which the Company wishes to do business require various licenses, permits, and approvals in connection with the manufacture and/or distribution of gaming devices, typically involving restrictions similar in most respects to those of Nevada. 16 MISSOURI REGULATORY MATTERS. Gaming was originally authorized in the state of Missouri in November 1992. On April 29, 1993, new legislation (the "Missouri Act") was enacted which replaced the 1992 legislation. In January 1994 the Missouri Supreme Court handed down a decision which held that the operation of certain games of chance such as traditional slot machines was prohibited by the constitution of the state of Missouri. On November 8, 1994, the people of Missouri voted in favor of an amendment to the Missouri constitution to allow slot machine gaming in the state. The Missouri Act provides for the licensing and regulation of excursion gambling boat operations on the Mississippi and Missouri Rivers in the state of Missouri and the licensing and regulation of persons who distribute gaming equipment and supplies to gaming licensees. An excursion gambling boat is a boat, ferry or other floating facility on which gaming is allowed. The Missouri Act limits the loss per individual on each excursion to $500, but does not otherwise limit the amount which may be wagered on any bet or the amount of space in the vessel which may be utilized for gaming. The Missouri Act is to be implemented and enforced by a five-member Missouri Commission. The Missouri Commission is empowered to issue such number of riverboat gaming licenses as it determines to be appropriate. A gaming license cannot be granted to any gaming operator unless the voters in such operator's "home dock" city or county have authorized gaming activities on gaming riverboats. On September 1, 1993, the Missouri Commission adopted rules and regulations (the "Missouri Regulations") governing the licensing, operation and administration of riverboat gaming in the state of Missouri and the form of application for such licensure. The Missouri Regulations generally provide for four types of licenses--a Class A owner's license; a Class B operator's license; a supplier's license; and an occupational license. In addition, the Missouri Regulations remain subject to amendment and interpretation, and may further limit or otherwise adversely affect the Company and its Missouri gaming operations. Directors and certain officers and key persons of the Company and Silicon Gaming-Missouri ("SGI-Missouri"), a wholly-owned subsidiary of SGI, must file personal disclosure forms with the gaming license application and must be found suitable by the Missouri Commission. Further, the Missouri Regulations require that all employees of SGI-Missouri who are involved in gaming operations and who are employed on the licensed premises must file applications for and receive Missouri gaming occupational licenses. The Missouri regulations require disclosure by the Company and SGI-Missouri of any person or entity holding any direct or indirect ownership interest in SGI-Missouri. SGI-Missouri is also required to disclose the names of the holders of all of the Company's and SGI-Missouri's debt including a description of the nature and terms of such debt. The Missouri Commission may, in its sole discretion, request additional information with respect to such holders. Missouri suppliers' gaming licenses must be renewed annually for a fee of $5,000 or such greater amount as may be determined by the Commission. On November 8, 1996, SGI-Missouri was granted a temporary supplier's license by the Missouri Commission. Under Missouri law, gaming licenses are not transferable, and under the Missouri Regulations the transfer of (i) any ownership interest in a privately held business entity or (ii) a 5% or greater interest in a publicly traded company directly or indirectly holding a Missouri gaming license is prohibited without the approval of the Missouri Commission. Further, without the prior approval of the Missouri Commission, the Missouri Regulations prohibit withdrawals of capital, loans, advances or distribution of any assets in excess of 5% of accumulated earnings by a license holder to anyone with an ownership interest in the license holder. The Missouri Regulations specifically provide that any action of the Missouri Commission shall not indicate or suggest that the Missouri Commission has considered or passed in any way on the marketability of the applicant or licensee's securities, or on any other matter, other than the applicant or licensee's suitability for licensure under Missouri law. A Missouri gaming license holder can be disciplined in Missouri for gaming-related acts occurring in another jurisdiction which result in disciplinary action in the other jurisdiction. The Missouri Commission has broad powers to require additional disclosure by an applicant during the processing of a gaming application, to deny gaming licensure and to administratively fine, suspend or revoke a gaming license for failure to comply with or for violation of the Missouri Act or Missouri Regulations. 17 NEW JERSEY REGULATORY MATTERS. Casino gaming in New Jersey, including the manufacture, distribution and operation of gaming devices, is subject to strict regulation by the New Jersey Casino Control Commission (the "New Jersey Commission") pursuant to the New Jersey Casino Control Act and the regulations of the New Jersey Commission promulgated thereunder (collectively, the "New Jersey Act"). The New Jersey Commission is authorized to decide all applications for licensure or other approvals and to promulgate regulations. The New Jersey Act also established the New Jersey Division of Gaming Enforcement (the "New Jersey Division"), which is responsible for investigating all applications for licensure or approval and for prosecuting violations of the New Jersey Act. Under the New Jersey Act, a company must be licensed as a gaming related casino service industry ("CSI") in order to manufacture or distribute gaming devices to New Jersey casinos. In January of 1997, the applications of the Company and its wholly-owned subsidiary, Silicon Gaming-New Jersey, Inc. ("SGI-NJ"), for CSI licensure were deemed complete and accepted for filling by the New Jersey Commission. These applications consisted of extensive disclosure forms by the Company, SGI-NJ, and certain of their officers, directors, principal employees and security holders. The New Jersey Commission has broad discretion regarding the issuance, renewal, suspension or revocation of CSI licenses. In order to obtain a CSI license, the Company and SGI-NJ must demonstrate to the New Jersey Commission by clear and convincing evidence that they, any five percent or greater security holders, certain officers, directors, and principal employees, and anyone else whom the New Jersey Commission deems appropriate in its discretion, possess good character, honesty and integrity, and financial stability and responsibility. If a person who is required to be found qualified is found disqualified by the New Jersey Commission, the license applications may be denied. With respect to security holders, the New Jersey Commission may waive the qualification requirement for "institutional investors," as defined in the New Jersey Act, of the Company in the absence of a prima facie showing by the Director of the New Jersey Division that there is any cause to believe that the institutional investor may be unqualified, if the institutional investor holds less than ten percent of the outstanding securities, provided the securities were acquired for investment purposes only and the holder has no intention of influencing the affairs of the Company, other than voting its securities. The New Jersey Act defines an "institutional investor" as (i) any retirement fund administered by a public agency for the exclusive benefit of federal, state or local public employees, (ii) an investment company registered under the Investment Company Act of 1940, (iii) a collective investment trust organized by banks under Part Nine of the Rules of the Comptroller of the Currency, (iv) a closed end investment trust, (v) a chartered or licensed life insurance company or property and casualty insurance company, (vi) banking or other licensed or chartered lending institutions, (vii) an investment advisor registered under the Investment Advisors Act of 1940, or (viii) such other persons as the New Jersey Commission may determine for reasons consistent with the policies of the New Jersey Act. The applications of the Company and SGI-NJ will be investigated by the New Jersey Division. During the course of the investigation, the Company and SGI-NJ are required to provide additional information to the New Jersey Division. At the conclusion of its investigation, the New Jersey Division will file a report with the New Jersey Commission stating its position on the license applications. After receipt of the report of the New Jersey Division, the New Jersey Commission will hold a public hearing on the license applications. No assurances can be given as to the timing of the completion of the investigation by the New Jersey Division and the public hearing by the New Jersey Commission on the license applications or that the licenses will be obtained. In its discretion, the New Jersey Commission may permit the Company and SGI-NJ to transact business with New Jersey casinos prior to their licensure. In order to do so, the Company and SGI-NJ must continue to have complete applications for CSI licensure on file with the New Jersey Commission, petition the New Jersey Commission for permission for each transaction, demonstrate that good cause exists for granting the petition and the New Jersey Division must not object to the petition. The fee for a CSI license is a minimum of $5,000 and a maximum of $15,000, with the actual cost depending upon the amount of time spent by the New Jersey Commission and New Jersey Division in investigating an processing the applications, plus the out of pocket expenses of the New Jersey Commission and New Jersey Division. 18 A CSI license is issued for an initial period of two years and, upon proper application and satisfaction of the same standards applicable to the initial issuance of a CSI license, is renewable for four year periods. The New Jersey Commission may impose conditions on the issuance of a license. In addition, the New Jersey Commission has the authority to impose fines or suspend or revoke a license for violations of the New Jersey Act, including the failure to satisfy the licensure requirements. In addition, gaming devices manufactured or distributed by the Company or SGI-NJ must be approved by the New Jersey Commission based on, at a minimum, their quality, design, integrity, fairness, honesty and suitability in order to be used in New Jersey casinos. The approval process includes the submission of a model of the gaming device and relevant documentation to the New Jersey Division for testing, examination and analysis. Only a licensed CSI or an applicant for CSI licensure can submit a gaming device for approval. All costs of such testing, examination and analysis are borne by the Company. Prior to deciding to approve a particular model of gaming device, the New Jersey Commission may require a test of up to 60 days of the gaming device in a licensed casino. During the test period, the manufacturer or distributor of the gaming device shall not be entitled to receive revenue of any kind whatsoever. Once a gaming device is approved by the New Jersey Commission, all gaming devices of that model placed in operation in licensed casinos shall operate in conformity with the model approved by the New Jersey Commission. Any changes in the design, function or operation of an approved gaming device are subject to prior approval by the New Jersey Commission, after testing by the New Jersey Division. In March of 1997, ODYSSEY was submitted to the New Jersey Division and New Jersey Commission for testing and approval and approval was received in March, 1999, at which time SGI-NJ commenced sales of its product. MISSISSIPPI REGULATORY MATTERS. The manufacture, sale and distribution of gaming devices for use or play in Mississippi are subject to the Mississippi Gaming Control Act and the regulations promulgated thereunder (collectively, the "Mississippi Act"). Such activities are subject to the licensing and regulatory control of the Mississippi Gaming Commission (the "Mississippi Commission") and the Mississippi State Tax Commission (collectively referred to as the "Mississippi Gaming Authorities"). Although not identical, the Mississippi Act is similar to the Nevada Gaming Control Act and regulations promulgated thereunder. On June 20, 1996 the Company was registered by the Mississippi Commission as a publicly traded corporation (a "Registered Corporation") and the holding company of Silicon Gaming-Mississippi, Inc. (the "Mississippi Subsidiary"). Also on June 20, 1996 the Mississippi Subsidiary was licensed as a manufacturer and distributor. SGI and the Mississippi Subsidiary are required to periodically submit detailed financial and operating reports to the Mississippi Commission and furnish any other information which the Mississippi Commission may require. The Company and the Mississippi Subsidiary have received the various registrations, approvals, permits and licenses in order to engage in manufacturing, distribution and gaming activities as presently conducted in Mississippi. Such licenses, registrations and approvals are not transferable, are initially issued for a two-year period and must be renewed periodically thereafter. Similar to Nevada, the Mississippi Commission may investigate and find suitable any individual who has a material relationship to, or material involvement with, the Company or the Mississippi Subsidiary, including record or beneficial holders of any of the voting securities of the Company, holders of debt obligations, and officers, directors and employees of the Company and the Mississippi Subsidiary. The Company and the Mississippi Subsidiary are required to maintain a current stock ledger in Mississippi which may be examined by the Mississippi Commission at any time. The Company believes that all required findings of suitability currently required have been applied for or obtained. Any application for a finding of suitability must pay all investigative fees and costs of the Mississippi Commission in connection with such an investigation. The Mississippi Act requires any person who acquires beneficial ownership of more than 5% of a Registered Corporation's voting securities to report the acquisition to the Mississippi Commission and such person may be required to be found suitable. The Mississippi Act requires that beneficial owners of more than 10% of a Registered Corporation's voting securities apply to the Mississippi Commission for a finding of suitability. The Mississippi Commission has generally exercised its discretion to require a finding of suitability of any beneficial owner of more than 5% of a Registered Corporation's Common Stock. Under certain circumstances, an "institutional investor," as defined by Mississippi Commission policy, which acquires more than 5%, but not more than 10%, of the Registered Corporation's voting securities may apply to the Mississippi Commission for a waiver of such finding of suitability if such institutional investor holds the voting securities for investment purposes only. 19 The Company may not make a public offering of its securities without the approval of the Mississippi Commission if the securities or proceeds therefrom are intended to be used to construct, acquire or finance gaming facilities in Mississippi, or to retire or extend obligations incurred for such purposes. If it were determined that the Mississippi Act was violated by the Mississippi Subsidiary, the licenses it holds could be limited, conditioned, suspended or revoked, subject to compliance with certain statutory and regulatory procedures, which action, if taken, could materially adversely affect the Company's manufacturing and distribution. FEDERAL REGULATION. The Federal Gambling Devices Act of 1962 (the "Federal Act") makes it unlawful, in general, for a person to manufacture, deliver, or receive gaming machines, gaming machine type devices and components across state lines or to operate gaming machines unless that person has first registered with the Attorney General of the United States. The Company is required to register and renew its registration annually. The Company has complied with such registration requirements. In addition, various record keeping equipment identification requirements are imposed by the Federal Act. Violation of the Federal Act may result in seizure and forfeiture of the equipment, as well as other penalties. NATIVE AMERICAN GAMING. Gaming on Native American lands, including the terms and conditions under which gaming equipment can be sold or leased to Native American tribes, is or may be subject to regulation under the laws of the tribes, the laws of the host state, the Indian Gaming Regulatory Act or 1988 ("IGRA"), which is administered by the National Indian Gaming Commission (the "NIGC") and the Security of the U.S. Department of the Interior (the "Secretary"), and also may be subject to the provisions of certain statutes relating to contracts with Native American tribes, which are administered by the Secretary. As a precondition to gaming involving gaming machines, IGRA requires that the tribe and the state have entered into a written agreement (a "tribal-state compact") that specifically authorizes such gaming, and that has been approved by the Secretary, with notice of such approval published in the Federal Registrar. Tribal-state compacts vary from state to state. Many require that equipment suppliers meet ongoing registration and licensing requirements of the state and/or the tribe and some impose background check requirements on the officers, directors, and shareholders of gaming equipment supplies. Under IGRA, tribes are required to regulate all commercial gaming under ordinances approved by the NIGC. Such ordinances may impose standards and technical requirements on gaming hardware and software, and may impose registration, licensing and background check requirements to gaming equipment suppliers and their officers, directors, and shareholders. APPLICATION OF FUTURE OR ADDITIONAL REGULATORY REQUIREMENTS. In the future, the Company intends to seek the necessary registrations, licenses, approvals and findings of suitability for the Company, its product and its personnel in other U.S. and foreign jurisdictions in which the Company identifies significant sales potential for its product. However, there can be no assurance that such registrations, licenses, approvals or findings of suitability will be obtained and will not be revoked, suspended or conditioned or that the Company will be able to obtain the necessary approvals for its future products as they are developed in a timely manner, or at all. If a registration, license, approval or finding of suitability is required by a regulatory authority and the Company fails to seek or does not receive the necessary registration, license, approval or finding of suitability, the Company may be prohibited from selling its product for use in the respective jurisdiction or may be required to sell its product through other licensed entities at a reduced profit to the Company. 20 ITEM 2: PROPERTIES The Company leases a 28,000 square foot facility in Palo Alto, California. The Company subleases approximately 16,000 square feet of this facility and uses the remainder for its development, marketing, sales and administrative personnel. The lease expires in January 2006. The Company also leases a 27,000 square foot facility in Las Vegas, Nevada that houses its sales and support organization, and a 4,000 square foot facility in Reno, Nevada that houses a sales and support organization. ITEM 3: LEGAL PROCEEDINGS In March 2000 the Company was served papers in connection with a patent infringement lawsuit filed against it and another slot machine manufacturer by International Game Technology, Inc. (IGT). As disclosed in November 1999, IGT is alleging infringement of a patent issued to IGT in September 1999 entitled "Game Machine and Method Using Touch Screen". The Company has not yet responded to the lawsuit and the Company's management denies the assertions of infringement. The Company is presently unable to determine the financial impact, if any, of this litigation. In March 2000, a former distributor of the Company's products, filed suit against the Company in the United States District Court for the District of South Carolina. The distributor seeks repayment of $1 million, plus damages, in connection with machines previously shipped to the distributor in 1998. The Company is in the process of arbitration as required by the Distribution Agreement, seeking to recover outstanding receivables from the distributor when it received this lawsuit. The Company is in the preliminary stages of investigating the allegations contained in the suit and has not yet responded to the complaint. ITEM 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Inapplicable. EXECUTIVE OFFICERS The executive officers of the Company are as follows: Name Age Position ---- --- -------- Andrew S. Pascal........ 34 Chief Executive Officer, Chief Financial Officer Charles R. Berg......... 47 Vice President - Engineering Michael R. Fields....... 39 Vice President - Sales Paul D. Mathews......... 35 Vice President - Corporate Development & Government Affairs Paul D. Miltenberger.... 34 Vice President - Development Betsy B. Sutter......... 39 Vice President - Human Resources ANDREW S. PASCAL has served as Chief Executive Officer of the Company since February, 1999 and as acting Chief Financial Officer since March, 1999. He had previously held the title of Executive Vice President - Marketing and Game Development since October 1994. He has over 14 years of gaming industry experience with an emphasis in slot marketing, slot merchandising and slot operations. He joined SGI in October 1994 from Mirage Resorts, Incorporated , where he worked from June 1985 to October 1994. Mr. Pascal held the position of Director of Slot Operations and Marketing at The Mirage Hotel and Casino, managing a division consisting of 350 employees and annual revenue in excess of $110 million. Mr. Pascal served on The Mirage's eight-member Operating Committee, which set operating policy and established the strategic direction for The Mirage and its 7,300 employees, from September 1992 to October 1994. Prior to the opening of The Mirage Hotel and Casino, Mr. Pascal served as the Director of Slot Marketing for the Golden Nugget Casino-Hotel. 21 CHARLES R. BERG joined SGI in August 1999 from as Vice president of Engineering. Prior to joining SGI he was the founder of The Software Studio, Inc., a designer of engineering based software applications where for seven years he was the Director of Development. Prior to his work at the Software Studio, Inc., Mr. Berg spent two years at Document Technologies, Inc. as Software Development Manager, and prior to that three years at Anray, Inc., where he was founder and Vice President of Engineering. MICHAEL R. FIELDS joined SGI in September 1999 as Vice President of Sales from Mikohn Gaming, a diversified designer and manufacturer of casino products and gaming devices, where he had worked for three years, most recently as the Director of Western US sales. Prior to joining Mikohn, Mr. Fields was Vice President and General Manager for Genasys USA, and prior to that, Director of North American Sales for Spectravision, Inc. Both companies were involved in the sale of entertainment products to hotels. PAUL D. MATHEWS joined SGI in November 1995 from Casino Data Systems ("CDS"), a designer and manufacturer of casino management information systems and gaming devices, where from March 1995 to November 1995 he was Director of Regulatory Compliance responsible for corporate and product licensing in all gaming jurisdictions. Prior to joining CDS, Mr. Mathews spent five years with the Nevada State Gaming Control Board in the Corporate Securities and Investigation Divisions. Mr Mathews now manages the Company's product sales operations in addition to his duties with Corporate Development and Government Affairs. PAUL D. MILTENBERGER joined SGI in April, 1996 as Business Planning Manager and in April 1997 became Director of Sales Planning, a position he held until September 1998 when he was promoted to Vice President of Sales. Mr. Miltenberger became Vice President - Development in August 1999. Prior to joining SGI, Mr. Miltenberger worked at Tektronics, a high-technology manufacturer of color printers and test equipment, where from June 1995 to April 1996 he held the position of Strategic Analysis Manager. Prior to Tektronics, Mr. Miltenberger worked at Conner Peripherals, Inc. between August 1990 and June 1995 as Manager of Strategic Reporting. BETSY B. SUTTER joined SGI in March 1997 from Digital Equipment Corporation, where from 1989 she had been the Human Resources Manager for their Research and Advanced Technology Division in Palo Alto. Between 1985 and 1989, Ms. Sutter had been the Human Resources Manager at Aehr Test Systems. Prior to this she had human resources experience with other high technology companies including Hitachi America Ltd. and General Electric Corporation. Ms. Sutter was promoted to Vice President -Human Resources in April, 1998. PART II ITEM 5: MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS STOCK PRICE HISTORY (Fiscal Year) 1999 1998 ------------------- ------------------- High Low High Low ---- --- ---- --- FIRST QUARTER 1 11/16 7/16 11 3/16 8 1/4 SECOND QUARTER 13/16 5/16 10 3/8 7 1/2 THIRD QUARTER 19/32 3/16 9 15/16 3 1/8 FOURTH QUARTER 11/32 5/64 3 7/8 1 3/8 ======= ==== ======== ===== The preceding table sets forth the high and low closing sale prices as reported for the Company during each of the quarters in 1999 and 1998. Until February 1999 the Company's common stock was listed on the Nasdaq Stock Market under the symbol `SGIC'. In February 1999 the Company's Common Stock was delisted from the Nasdaq National Market and the Company's stock now trades on the NASD Over-The-Counter (OTC) bulletin board system under the symbol `SGIC'. 22 DIVIDEND POLICY The Company has never paid cash dividends on its Common stock. The Company presently intends to retain all cash for use in the operation and expansion of the Company's business and does not anticipate paying any cash dividends in the near future. ITEM 6: SELECTED CONSOLIDATED FINANCIAL DATA
Nine Years Ended December 31, Months Ended -------------------------------------------- December 31, (in thousands except per share amounts) 1999 1998 1997 1996 1995 (1) ---- ---- ---- ---- -------- Statement of Operations Data: Net sales .................................. $17,115 $22,281 $ 9,550 $ -- $ -- Loss from operations ....................... 16,436 32,009 22,984 14,533 4,059 Loss before extraordinary gain ............. 24,081 -- -- -- -- Net loss ................................... 11,765 37,670 22,986 13,634 3,974 Basic and diluted net loss per share ....... $ 0.70 $ 2.75 $ 2.16 $ 2.54 $ 2.34 Loss before extraordinary gain per share ... $ 1.42 -- -- -- -- Shares used in computation ................. 16,906 13,696 10,666 5,364 1,695 December 31 --------------------------------------------------------- (in thousands) 1999 1998 1997 1996 1995 ---- ---- ---- ---- ---- Balance Sheet Data: Cash and equivalents ....................... $ 877 $ 8,399 $16,352 $25,583 $ 2,399 Short-term investments ..................... 1,000 -- 4,705 9,683 -- Working capital ............................ 6,394 10,772 25,087 34,203 2,027 Total assets ............................... 15,581 41,744 49,038 39,646 3,486 Long-term obligations ...................... 16,260 39,809 22,637 778 272 Redeemable Convertible Preferred Stock ..... -- 1,666 3,065 6,455 8,496 Total shareholders' equity (deficiency) .... (7,361) (18,452) 14,432 30,061 (5,946)
- ---------- (1) Effective April 1, 1995, the Company changed its fiscal year end from March 31 to December 31. 23 ITEM 7: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW The Company was incorporated on July 27, 1993 to design, develop, manufacture and distribute interactive gaming devices that implement advanced multimedia technologies using state-of-the-art, off-the-shelf components. In 1997 the Company successfully introduced its first product, ODYSSEYTM, a multi-game, video-based slot machine, into the Nevada market. Since that time the Company has rolled out ODYSSEY into other jurisdictions including Connecticut, Illinois, Indiana, Iowa, Kansas, Louisiana, Michigan, Minnesota, Mississippi, Missouri, New Jersey, New Mexico, certain Canadian provinces and Uruguay. In 1998 the Company introduced QUEST, a single-game platform that utilizes many of the same components as the ODYSSEY, and in 1999 the Company introduced a slant-top, single-game platform, to increase its penetration of the casino floor. As of December 31, 1999, the Company has 4,050 machines installed in approximately 200 properties. Of these machines, 3,702 have been sold outright or placed on a revenue-sharing basis. After returns, 348 machines remain installed on a trial basis and the casino operators are required to purchase the machine outright, participate in SGI's revenue sharing plan or return the machine to the Company within a defined trial period. At December 31, 1999 the Company had cash and equivalents and short-term investments of $1.9 million. The Company has incurred operating losses each year since inception, and as of December 31, 1999 had an accumulated deficit of $92.0 million and a deficiency of shareholders' equity of $7.4 million. The Company has been required to obtain additional financing each year to be able to fund its ongoing operations. Based on historical levels of cash usage, the above factors raise substantial doubt about the Company's ability to continue as a going concern. In late 1998 and early 1999 the Company took steps to reduce the level of operating expenses and made a number of management decisions which resulted in total reductions of the Company's work force by approximately 70% and made significant cuts in expenditures across the Company. Management also announced the relocation of its manufacturing to its Las Vegas, Nevada facility and the closure of its Mountain View, California manufacturing facility. In November 1999, the Company, with the consent of the holders of its Senior Discount Notes, was able to convert approximately $40 million principal amount of debt plus $8.3 million in accrued interest into a 57% equity stake in the Company, and to obtain commitments for additional financing from the debt holders. The aforementioned actions resulted in the Company reducing its operating expenses by approximately 40%, its interest obligations by approximately 80%, and reduced the cash used in operations by approximately 80% from the levels of the prior year. Management has recently renewed the terms of a line of credit with a new bank on more favorable terms so that this financing source remains available to the Company. Management is also reviewing financing alternatives available to the Company such as additional share or debt offerings in the Company or certain of its subsidiaries, joint ventures, alternative distribution channels and sale of all or a portion of the Company's assets, to improve the Company's liquidity position. Management believes that these steps, plus sales related to new product introductions will provide sufficient cash and working capital for the Company to meet its ongoing obligations and to allow it to continue operating as a going concern through at least the end of 2000. See Note 1 of Notes to Consolidated Financial Statements. The Company spent much of 1999 addressing its poor liquidity position, restructuring its balance sheet, retaining its key personnel and taking such actions necessary to enable the Company to continue operating. The uncertainty surrounding the Company's future, along with the reductions in the Company's workforce, negatively impacted its ability to retain some senior management and some key employees, especially in its engineering and sales organizations. These factors also negatively impacted the Company's sales performance, especially in the second half of 1999 as the Company was forced to rebuild its sales 24 organization. Through these difficult times, and with less resources, the Company has continued to introduce new game titles into the marketplace during 1999. Prior to March 1997 the Company was in the development stage and its primary activities were focussed on product development, including system hardware and software, game concept development and software coding. Towards the end of 1996 the Company began manufacturing slot machines for commercial distribution. The Company sold its first product in May 1997 following completion of a customer evaluation period. Prior to this time the Company did not generate any revenue from product sales. Silicon Gaming is headquartered in Palo Alto, California and has sales offices in Reno and Las Vegas, Nevada, and in Gulfport, Mississippi. Product is manufactured at the Company's location in Mountain View, California. At December 31, 1999 the Company had 90 employees. RESULTS OF OPERATIONS The Company had a net loss of $24.1 million for the year ended December 31, 1999 before the $12.3 million extraordinary gain recorded on the conversion of debt in conjunction with a financial restructuring of the Company in November 1999 . This compared to net losses of $37.7 million and $23.0 million for the years ended December 31, 1998 and 1997, respectively. The significant decrease in net loss in 1999 was achieved on lower revenues largely due to the Company's efforts at reducing its level of operating expenses in early 1999. REVENUES The Company generates hardware revenue from the sale of its products and related parts and accessories. All products are sold with licensed software and customers have the choice of either a paid-up or renewable annual license. The Company places products in casinos under a participation program where it receives 20% of the net win generated by the product as revenue. Total revenue units include machines sold outright as well as machines placed under the participation programs. The Company generated revenues as follows: Years Ended December 31, (in $'000, except for ----------------------------------------------- machine numbers) 1999 1998 1997 -------------- -------------- ------------- Hardware sales $10,370 61% $14,126 63% $7,636 80% Software sales 4,288 25% 4,657 21% 567 6% Participation revenue 2,457 14% 3,498 16% 1,347 14% ------- --- ------- --- ------ --- Total revenue $17,115 100% $22,281 100% $9,550 100% ======= ======= ====== Total revenue units 926 1,622 1,298 As can be seen from the above table, the Company had total revenue of $17,115,000 for the year ended December 31, 1999. This was a decrease of $5,166,000 or 23% from the $22,281,000 recorded in 1998. The decrease in revenue was in part due to a 43% decrease in the total revenue units compared to 1998. This was largely attributable to uncertainty surrounding the Company's future due to its liquidity situation through much of 1999, which saw customers deferring product purchases until the financial position of the Company became clearer. The loss of the majority of the Company's sales organization during 1999 also exacerbated the decrease in sales and the Company spent much of the second half of 1999 in rebuilding its sales organization. The average selling price on machines sold outright decreased from $10,230 in 1998 to $8,343 in 1999, reflecting a higher level of sales of used machines, as well as the impact of higher competition in the gaming-machine industry than in the previous year. SGI sells its products outright to casino operators and other potential purchasers offering several pricing programs. For the ODYSSEY this consists of either (i) the sale of the hardware unit bundled with a single game or a suite of games and other software for a fixed price, or (ii) the sale of the hardware 25 unit alone combined with a renewable one-year software license, including access to the entire ODYSSEY game library for the term of the license. The Company's slant-top machine and the QUEST are sold as a bundled package of the hardware unit and a single game for a fixed price. The Company also offers a participation program where it will place its products on a casino floor in exchange for a share in the aggregate win generated by the machine. Typically, under this program, 20% of the aggregate win goes to the Company, subject to a predetermined minimum. In December 1998, the Company introduced its first wide-area progressive product, THE BIG WIN. Machines placed in casinos on the progressive system are priced such that the Company receives a predetermined share of the gross amount wagered on the machine. During 1999 the Company modified the game in an attempt to improve the performance of the game, before deciding in the fourth quarter of 1999 to remove all progressive machines from casinos due to unsatisfactory product performance. Revenues generated from the participation program and from the wide-area progressive product are included as `Participation revenues' in the above table. The decreases in participation revenue and in software revenue in 1999 compared to 1998 reflect decisions made by management during 1999 to remove poor performing machines from the participation programs, which reduced the number of machines on participation by almost 50%, and by a program in 1998 to convert customers from the renewable annual license program, which caused a decrease in software renewal revenues in 1999. Management believes that eliminating the annual license program will bring the Company more into line with its competitors and will result in increased future revenue opportunities as customers will now purchase new game titles from the Company. The Company believes that in the future participation revenues will increase in absolute as well as relative terms as it places more of its new products on a participation basis, and that in relative terms, hardware and software revenues will decrease from current levels. The Company was able to increase revenue during the year ended December 31, 1998 by 133% to $22,281,000 from the $9,550,000 recorded in the year ended December 31, 1997. A large portion of this increase represents the increase in volume in the number of machines sold or generating revenue for the Company, which increased by 25%, or 324 units, from 1,298 in 1997 to 1,622 in 1998. The average selling price on machines sold outright decreased from $11,050 in 1997 to $10,230 in 1998 reflecting the increased levels of competition in the industry and a resulting higher level of discounts given to strategic corporate customers during 1998. The increases in participation revenue and in software revenue in 1998 compared to 1997 reflect the full year impact in 1998 of machines in the participation programs, which were first offered in June 1997, and the larger installed base from which the Company derives software license revenue. Software revenue increased by $4,090,000 or 721% in 1998 as a result of these factors. During 1999, one customer accounted for 16% of revenues. During 1998, two different customers accounted for 11% and 10% of revenues. In 1997 three different customers accounted for 27%, 12% and 12% of revenue. The Company expects that a significant portion of its revenue will remain concentrated within a limited number of strategic customers within the gaming industry due to the increasing consolidation that is taking place among casino operators. As an equipment vendor to the gaming industry, the Company sells infrequently to many customers and the volume of sales to any particular customer may vary significantly from period to period. As a result, there can be no assurance that the above strategic customers will continue to account for a significant percentage of the Company's revenue in the future. The loss of any strategic customer could have a material adverse affect on the Company's business and results of operations. 26 COST OF SALES Cost of sales includes the direct cost of product sales as well as the unabsorbed costs of the Company's manufacturing operations. Cost of sales also includes license fees and royalties paid to third parties, depreciation on machines placed on the participation programs as well as the costs directly associated with running the wide-area progressive system, including payments of jackpot awards. Cost of sales were $13,213,000, $24,062,000, and $10,421,000 for the years ended December 31, 1999, 1998, and 1997, respectively. The decrease in cost of sales in 1999 of $10,849,000 or 45% from 1998 reflects a $3.5 million reduction in manufacturing expenses as a result of closing the Company's California manufacturing facility during 1999, the lower number of machines sold , and significantly lower royalty expenses to third parties compared to the prior year. This was offset partially by the higher costs of operating the progressive system and a $2.5 million expense related to excess and obsolete inventories in the fourth quarter of 1999 following certain product configuration decisions by management which affected the salability of certain parts. The year-to-year increases in cost of sales between 1998 and 1997 was largely driven by the higher number of machines sold or placed on one of the Company's participation programs, the absence of product sales prior to May 1997, royalties of $2,200,000 paid to a third party in 1998 in connection with a new game offering, as well as the cost of operating the wide-area progressive system that was introduced in the fourth quarter of 1998. The Company also recorded $5,200,000 in expense during 1998 related to lower of cost or market and excess and obsolete inventories. Cost of sales represented 77%, 108% and 109% of revenues in 1999, 1998 and 1997, respectively. The improvement in 1999 reflects the lower operating costs of the Company and the absence of large one-time expenses such as those recorded during 1998. The marginal decrease in cost of sales as a percentage of revenues between 1998 and 1997 was a reflection of the charges that the Company booked related to inventory write-offs and due to the royalty payments that the Company agreed to pay to a third party during 1998. These charges offset the benefits of efficiencies gained as manufacturing volumes increased, reflecting the fixed cost of the manufacturing facility. The per-unit manufacturing cost has decreased as the Company began to realize benefits from the tooling of certain of its hardware components, and from cost reductions in many of the components included in its machines. Through the end of 1998 the Company was able to reduce the per-unit material cost of its products by approximately 50% from the first products it produced in 1996. Due to significant levels of finished goods inventory, the Company manufactured minimal product during 1999 and this has prevented it from obtaining further cost reductions in its products. The Company anticipates that as it introduces more unique, fully integrated specialty products, per-unit costs may increase in future periods. RESEARCH AND DEVELOPMENT Research and development ("R&D") expenses include payroll and related costs of employees engaged in the ongoing design and development activities of the Company, costs paid to outside contractors and specialists, prototype development expenses, overhead costs, equipment depreciation and costs of supplies. To date, the Company has expensed all costs associated with the research, design and development of its products. R&D expenses were $4,410,000, $11,853,000 and $9,283,000 for the years ended December 31, 1999, 1998 and 1997, respectively. The significant decrease in R&D expenses in 1999 is primarily due to lower salary expense as a direct result of the reductions in the Company's workforce during 1999, and because of higher development costs in 1998 related to the development of the wide-area progressive system that were not incurred in 1999. The increase between 1998 and 1997 was largely the result of incremental hiring of personnel, increased use of engineering consultants and license fees and similar costs associated with the acquisition of outside technologies. Prior to 1997 the focus of R&D activities was in the successful development of the Company's initial product, ODYSSEY, and the initial suite of games that the Company offered. Since that time, R&D activities have focused on new game development, the introduction of new product platforms, and in the development of new game types such as the wide-area progressive system. The Company is 27 focussed on ensuring that it can offer additional features into its products that will fully capitalize the underlying technology used. This is expected to require significant R&D resources to continue the development of the product platform to facilitate the elaborate requirements of the game development process and to enable it to introduce new game types into the slot machine market. SELLING, GENERAL & ADMINISTRATIVE Selling, general and administrative ("SG&A") expenses include payroll and related costs for executive and administrative personnel, sales and customer-support organization personnel, and marketing and licensing personnel, corporate overhead costs, legal and associated costs, costs associated with obtaining and retaining corporate and product licenses in various jurisdictions, and fees for professional services. Approximately 50% of SG&A expenses are headcount related. SG&A expenses were $12,651,000, $18,375,000 and $12,830,000 for the years ended December 31, 1999, 1998 and 1997, respectively. The decrease in SG&A expenses in 1999 reflects the lower number of employees following the reductions in the Company's workforce in the first quarter of 1999 and lower commissions reflecting the lower revenues. These savings were offset by higher legal fees in connection with a number of patent infringement cases that the Company was party to during 1999. Increases in SG&A expenses between 1998 and 1997 were largely attributable to the hiring of additional personnel and in costs associated with applying for corporate and product licenses as the Company began selling product into new jurisdictions. The Company also incurred costs as it created and established a customer-support organization to support the rollout of its product, and as it established a marketing organization upon the commercial distribution of its products in 1997. A significant portion of these increases occurred during 1997 when the Company commenced sales of the ODYSSEY and built its infrastructure in the Nevada and Mississippi markets. Additional increases in SG&A expenses in 1998 were due to severance payments made to senior management and increases in bad debt provisions of $1,600,000 due to problems with customer collections. The Company intends to restrict the growth in SG&A expenses as much as possible in future periods and expects SG&A expenses in absolute dollars and as a percentage of revenue to decline. RESTRUCTURING The Company recorded restructuring expenses of $3,277,000, in the first quarter of 1999, following management decisions to reduce the size of the Company's workforce and to close its California manufacturing facility and relocate all of its manufacturing and production operations to its Las Vegas, Nevada facility. This was done as the Company sought to reduce its operating expenses to a level more appropriate to its revenue levels. Restructuring expenses include employee severance costs of $595,000, costs of $2,424,000 relating to scrapping and abandonment of assets, and $258,000 for lease-associated expenses. All costs were incurred prior to June 30, 1999. INTEREST INCOME AND EXPENSE Interest income was $99,000, $618,000 and $1,238,000 for the years ended December 31, 1999, 1998 and 1997, respectively. Fluctuations in the level of interest income are directly attributable to fluctuations in the level of average cash and investment balances that the Company holds. The timing of share offerings, issuance of Senior Discount Notes, and the rate of spending on operations have impacted the average level of cash and investments held. Interest expense was $7,241,000, $6,261,000 and $1,240,000 for the years ended December 31, 1999, 1998 and 1997, respectively. The increases in interest expense are due to increases in the Company's level of long-term indebtedness over the period. The Company raised $25 million in September 1997 from the issuance of Senior Discount Notes (the 1997 Notes) and raised an additional $15 million in June 1998 from the issuance of additional Senior Discount Notes (the 1998 Notes). The Company also raised approximately $3.6 million from equipment financing borrowing during 1998. Interest expense was higher in 1999 due to the full-year impact of interest expense on amounts borrowed during 1998. The increase in interest expense in 1998 reflects the full year interest cost of the 1997 notes as well as the interest costs associated with the 1998 Notes, the repricing of stock warrants and the equipment financing. 28 GAIN ON CANCELLATION OF DEBT In November 1999 the Company completed a restructuring of its balance sheet with the cooperation of the holders of its Senior Discount Notes. The holders of the Senior Discount Notes exchanged $39.75 million principal notes and accrued interest of $8.3 million for Preferred Stock that is convertible into a 57% voting interest in the Company. Concurrent with this conversion, the holders of the Senior Discount Notes invested an additional $2 million of New Senior Discount Notes in the Company. After accruing future interest payments on the restructured debt (which will result in no interest expense being recorded for these payments in future periods), recording certain expenses related to issuance of warrants to the existing equity holders of the Company and the costs of the restructuring, the Company recorded a gain of $12.3 million upon the cancellation of the underlying debt. INCOME TAXES The Company has not been required to pay income taxes due to the fact that it has had net operating losses in each period since the Company's inception. The Tax Reform Act of 1986 and the California Act of 1987 impose restrictions on the utilization of net operating loss and tax credit carryforwards in the event of an "ownership change" as defined by the Internal Revenue Code. The Company' ability to utilize its net operating loss and tax credit carryforwards is subject to limitation pursuant to these restrictions. The Company underwent an ownership change as of the date of the debt restructuring in November, 1999. As a result, the Company lost the potential tax benefits of the net operating loss carryforwards and the tax credit carryfowards that existed at that time. A valuation allowance has been recorded for any deferred tax assets due to uncertainty regarding the ultimate realization of these assets resulting from the lack of earnings history of the Company. LIQUIDITY & FINANCIAL CONDITION The Company was able to significantly reduce its level of debt as a result of the debt restructuring completed in November 1999, but has continued to operate under very tight liquidity constraints. Cash and equivalents and short-term investments decreased by $6,522,000 and were $1,877,000 as at December 31, 1999 compared to $8,399,000 at December 31, 1998. This decrease in resources is primarily due to the ongoing losses from operations that the Company has incurred and the need to repay outstanding borrowings that the Company had previously incurred. As of December 31, 1999 the Company had an accumulated deficit of $92,035,000, a shareholder's deficiency of $7,361,000 and has had operating losses every year since its inception. The Company has been required to obtain additional financing each year to be able to fund its ongoing operations. Based on historical levels of cash usage, the above factors raise substantial doubt about the Company's ability to continue as a going concern. In late 1998 and early 1999 the Company took steps to reduce the level of operating expenses and made a number of management decisions which resulted in total reductions of the Company's work force by approximately 70% and made significant cuts in expenditures across the Company. Management also announced the relocation of its manufacturing to its Las Vegas, Nevada facility and the closure of its Mountain View, California manufacturing facility. In November 1999, the Company, with the consent of the holders of its Senior Discount Notes, was able to convert approximately $40 million principal amount of debt plus $8.3 million in accrued interest into a 57% equity stake in the Company, and to obtain additional financing from the debt holders. The aforementioned actions resulted in the Company reducing its operating expenses by approximately 40% compared to the prior year, its future interest obligations by approximately 80%, and reduced the cash used in operations by approximately 80% from the levels of the prior year. Management has recently entered into a $ 2 million accounts receivable based line of credit with a new bank on more favorable terms than it previously had. Management is also reviewing financing alternatives available to the Company such as additional share or debt offerings in the Company or certain of its subsidiaries, joint ventures, alternative distribution channels and sale of all or a portion of the Company's assets, to improve the Company's liquidity position. Management believes that these steps, plus sales related to new 29 product introductions will provide sufficient cash and working capital for the Company to meet its ongoing obligations and to allow it to continue operating as a going concern through at least the end of 2000. However, the success of any new product introductions is subject to various risks and uncertainties, and there is no assurance that such new products will generate the amount of revenue hoped for by the Company. In the event it is unable to generate sufficient cash from operations or identify new sources of capital, the Company will be required to significantly limit or shut down all or some of its operations. The net cash used in operating activities was $3,836,000, $32,110,000 and $29,909,000 for the years ended December 31, 1999, 1998 and 1997, respectively. The large decrease in cash used during 1999 was due to the reduction in the Company's operating losses and through improved management of the Company's working capital. The Company reduced its level of inventories and receivables by $8,845,000 in 1999 which helped provide cash for the ongoing daily operations of the Company. The increase in cash used in operating activities in 1998 from 1997 was due to the increase in net operating losses and due to increases in the Company's working capital requirements, predominantly in inventory and receivables during 1998. This increase was offset partially by increases in depreciation, amortization, bad debt provisions, and accrued interest. Inventory levels, particularly raw materials and finished goods, increased significantly in 1998. This increase occurred as the Company ramped up its level of operations in anticipation of sales demand, and was unable to reduce these levels once the anticipated sales levels did not materialize. The increase in receivables was largely due to problems in collections from several customers, which also resulted in the Company having to increase its bad debt reserves during 1998 by approximately $1,600,000. The Company anticipates that in 2000 it will continue to need to reduce its level of inventory and convert such inventory into cash to be used for operations, if it is to have sufficient cash resources. Net cash used in investing activities was $1,109,000 for the year ended December 31, 1999 largely due to the timing of investment of the Company's surplus operating cash, with $1 million being held in short-term investment as at December 31, 1999. This was offset by the Company's investment in new capital equipment. The Company has significantly reduced its investment in new equipment because of the liquidity constraints that the Company was forced to operate under for most of 1999. Net cash provided by investing activities of $1,245,000 for the year ended December 31, 1998 was due largely to the redemption of short-term investments, offset by the amount of money spent on capital expenditure. Net cash used in investing activities was $3,077,000 for the year ended December 31, 1997. The decrease in 1998 from 1997 is due to the sale and maturity of the Company's short-term investments that were redeemed during 1998. This offset the Company's increased investment in fixed assets in 1998, particularly in relation to the introduction of the Company's wide-area progressive system. The Company anticipates continued investment in fixed assets during 2000 as it continues to develop new delivery systems and channels for its software based products. Net cash used in financing activities was $2,577,000 for the year ended December 31, 1999 compared to net cash provided by financing activities of $22,912,000 and $23,755,000 for the years ended December 31, 1998 and 1997, respectively. In 1999 the Company was required to repay borrowings under its bank line of credit and its equipment financing of approximately $4.7 million. This was offset by the $2 million received in New Senior Discount Notes in November 1999 in connection with the restructuring of the Company's long-term debt. Fluctuations in net cash provided by financing activities in 1998 and 1997 are due to the timing of the company's various share and debt offerings. In 1998 the Company raised net proceeds of $14,950,000 from the issuance of Senior Discount Notes and $3,586,000 from the proceeds of new equipment financing arrangements. In 1997 the Company financed its operations primarily through the proceeds of $23,055,000 from the issuance of Senior Discount Notes plus detachable warrants. In November, 1999 the Company along with three other slot machine manufacturers was named in a lawsuit filed by International Game Technology (IGT) alleging infringement of a particular patent relating to the use of electronic buttons on the game play field. The lawsuit has not been served upon the Company by IGT. The Company, along with the other defendants, has provided certain information to IGT that it believes invalidates IGT's patent claim. If the patent is not served upon the Company in a timely manner it will lapse and no further action will be required. The costs of defending such lawsuits may be substantial and may require significant amounts of senior management time, and an adverse result in any such litigation could materially and adversely affect the Company's liquidity and capital resources. 30 In March 2000 the Company received notification that it has been sued in the Federal Court in the District of South Carolina by a former distributor of the Company's products. The distributor seeks repayment of $1 million, plus damages, in connection with machines previously shipped to the distributor in 1998. The Company was in the process of arbitration as required by the Distribution Agreement, seeking to recover outstanding receivables from the distributor. The Company has not yet responded to this lawsuit and the Company's management vehemently deny the allegations of the lawsuit. The Company is not yet able to determine the likely outcome of this litigation and the financial impact, if any, on the Company's results of operations or liquidity position. RECENTLY ISSUED ACCOUNTING STANDARDS In June 1998, the FASB issued Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities". This statement requires companies to record derivatives on the balance sheet as assets or liabilities measured at fair value. Adoption of this standard has no impact upon the Company's consolidated financial position, results of operations or cash flows as the Company does not currently have any derivative financial instruments covered by this standard. OUTLOOK This outlook section and other sections in this Annual Report on Form 10-K contain a number of forward-looking statements that reflect the Company's current views with respect to future events and future financial performances. Because they relate to future activities, there is a high degree of risk that such events will not materialize and readers should not place undue influence upon them as actual results may differ materially. To date the Company has focussed many of its resources on creating a business based on high-volume manufacturing and placement of slot machines with a goal of capturing market share. The Company has struggled in its endeavors against many competitors who are significantly larger and who have much greater resources than the Company. The Company has historically emphasized selling game platforms and strived to penetrate the market through frequent software releases of new game titles. Changes in the competitive landscape since the Company was formed have forced the Company to reevaluate its basic business strategy. The Company has incurred significant expenses in developing a fully integrated, high overhead business that assumed a much higher level of unit sales than the Company has been able to achieve, resulting in unacceptable levels of profitability for the Company. Since the completion of the restructuring of its balance sheet in November 1999, management has spent time reviewing the basic business strategy of the Company and intends to reorganize the business around the different product and market opportunities that it has identified. Management also intends to simplify the business and focus resources so that it can continue to reduce the level of corporate overhead, minimize the level of cash usage, transition the business to one that takes advantage of revenue-sharing opportunities and focus on achieving profitability. 31 The Company has sold over 3,700 machines to date and understands the need to continue to support its products and the needs of its existing customers. At the same time, the Company needs to focus on how to best exploit the technology inherent in its game platforms and the development capabilities of its development organization. This will allow it to provide game experiences and game features that are unique to the Company that cannot be easily exploited or imitated by its competitors. By emphasizing the quality of the wagering attraction, including the game itself, rather than the volume of new game titles, the Company hopes to be able to command premium floor locations in its customers' casinos, and as a result achieve a premium level of performance and revenue. The Company intends to partner with outside parties, including casino operators, other slot manufacturers, and other intellectual property and brand-based content holders, to accomplish these goals. By partnering with outside parties the Company believes it can offset its development risk and costs, achieve higher revenues and increase the likelihood of product success. In 1999 the Company entered into a joint-product development and marketing agreement with Anchor Gaming. This is the first example of where the Company will seek external skills to complement its own resources. The Company anticipates announcing more similar arrangement during 2000. In February 2000 the Company announced that it had entered into a product development arrangement with a Nevada-based casino operator whereby the Company will develop an exclusive, brand-based product for the operator. The Company expects to introduce this product into the market in the Summer of 2000. The Company also intends to continue its program of improving and solidifying its financial position. This will require that the Company continue to sell through its existing inventory to provide adequate working capital for the Company to use in its day to day operations. The Company is also considering raising additional capital in either the parent company or directly into certain of its subsidiaries, in order to fund new product and system development. The Company will continue to introduce new game title releases for sale and to refresh the game offerings on its installed base of ODYSSEY, QUEST and slant-top machines during 2000. The Company intends to change its focus from one of frequent game releases to one that emphasizes the quality and feature content of new game titles. It will also offer product extensions and variations of existing successful game titles. The Company also understands that it must emphasize more than selling a platform that has a variety of game applications upon it. The Company hopes to partner with casino operators to provide a unique, fully integrated gaming experience which encompasses packaging, merchandising, signage systems and, in some cases, unique platform packaging as well. By doing this, the Company aims to provide a more complete and feature rich experience for the gaming patron that is unique to the Company. By partnering with casino operators the Company hopes to achieve premium placement of its product. The Company's future results of operations and the other forward-looking statements contained in this outlook - in particular the statements regarding potential partnerships with casino operators or other third parties, and possible raising of additional capital- involve a number of risks and uncertainties. In addition to the factors discussed above, among the other factors that could cause actual results to differ materially are the following: the success of the Company's game titles that it introduces into the market, changes in customer order patterns, competitive factors such as new competitor product or game introductions or changes in pricing strategies, reluctance of casino operators to use participation-based products or to partner with the Company in product development, the Company's level of financial resources and adequate cash flows, the stability of the Company's management team and workforce, and the ability of the Company to meet all initial and ongoing licensing requirements in the jurisdictions in which it sells products. The Company believes that it has the product offerings, facilities, personnel, and competitive resources needed for business success, but future revenue, costs, margins and profits are all influenced by a number of factors, including those discussed above and the need for the Company to raise additional funds, all of which are inherently difficult to predict. 32 FACTORS AFFECTING FUTURE RESULTS MANAGEMENT OF CHANGING BUSINESS - The Company has spent the last year trying to shift its business strategy from one of high-volume manufacturing and placement of slot machines with a goal of capturing market share, to a strategy that emphasizes the quality and feature content of new game titles and takes advantage of revenue-sharing opportunities. The Company plans on offering product extensions and variations of successful existing games in 2000, however the emphasis will shift from volume-based to one of providing a unique, fully-integrated gaming experience. This transition represents a significant challenge for the Company and its management and employees, and places increased demand on its systems and controls. The Company's ability to manage this change will require the Company to continue to change, expand and improve its operational, management and financial systems and controls to manage any outsourcing or relocation of existing activities. Key to effecting this change in business is the ability of the Company to sell its existing inventory of ODYSSEY and QUEST products in a timely manner and to resolve outstanding collections issues with customers to provide sufficient working capital during this transition process. If the Company is not able to generate adequate funds from its working capital in a timely manner, the Company's business, operating results and financial condition will be materially and adversely affected. LIQUIDITY - The Company has funded its operations to date primarily through private and public offerings of its equity securities, the issuance of Senior Discount Notes, term and equipment loans and from bank borrowings. At December 31, 1999 the Company had an accumulated deficit of $92,035,000 and a deficiency of shareholders' equity of $7,361,000 and was not in compliance with the terms of its line of credit that expired in January 2000. The Company subsequently repaid all amounts due under the line of credit and has negotiated a new line of credit with a different financial institution on better terms. Management is also reviewing financing alternatives available to the Company such as additional share or debt offerings in the Company or certain of its subsidiaries, joint ventures, alternative distribution channels and sale of all or a portion of the Company's assets. If the plans that management has undertaken to improve the Company's liquidity position are not successfully completed in a timely manner it is probable that insufficient funds will exist to satisfy the Company's operating requirements. The Company will be required to make adjustments to its operating activities to operate within the restrictions of its liquidity and this could have a material adverse affect upon the Company's business, operating results and financial condition. To the extent that the Company sells additional shares or issues any convertible debt securities, this could result in additional dilution to existing shareholders. There can be no assurance that the Company will be able to successfully renegotiate its existing credit facility or be able to raise additional funds when and if needed. VOLATILITY OF STOCK - The market price of the Company's stock has been highly volatile and subject to large fluctuations. The Company's stock price may be affected by factors such as actual or unanticipated fluctuations in the Company's results of operations, new product or technical introductions by the Company or any of its competitors, developments with respect to patents, copyrights or proprietary rights, conditions or trends in the gaming industry, changes in or failure by the Company to meet securities analysts' expectations, general market conditions and other factors. The Company's stock now trades on the Over The Counter (OTC) Bulletin Board. This may affect the level of trading activity in the Company's stock, result in higher bid/ask spreads, and increase the cost of raising additional equity for the Company, as well as result in higher levels of volatility in the price of the Company's stock. RETENTION OF PERSONNEL - The operations of the Company depend to a great extent on the management efforts of its officers and other key personnel, and on the ability to attract new key personnel and retain existing key personnel. The Company has experienced high turnover among its senior management during 1998 and 1999. In February 1999 the Company announced the appointment of a new Chief Executive Officer. The Company also reduced its workforce by approximately 20% in December 1998 and by a further 40% in March 1999. These factors, combined with the Company's poor operating results and the significant decrease in the price of the Company's Common Stock may have an adverse affect on the Company's ability to retain and motivate its key employees. Competition is intense for 33 highly skilled product development employees in particular. In addition, the Company's officers and key employees are not bound by non-competition agreements that extend beyond their employment at the Company, and there can be no assurance that employees will leave the Company or compete against the Company. The Company's failure to attract additional qualified employees or to retain its existing employees could have a material adverse affect on the Company's operating results and financial condition. Should the Company offer additional stock option grants to its existing employees to encourage them to continue their employment at the Company, this may result in additional dilution to existing shareholders. CUSTOMER RETENTION - The Company's ability to sell product may be hampered due to the financial position of the Company which presents risks to customers that the Company may not be able to fulfill its obligations under license agreements or be available to provide warranty, repair or upgrade services on products that it has already sold. The Company experienced negative reaction from customers who held these views during 1999 and who have indicated that they may not purchase additional product from the Company. Completion of the Company's debt restructuring in November 1999 mitigates these risks however the Company continues to experience these negative sentiments from its customers. Certain of the Company's competitors who have significantly greater financial and marketing resources than the Company are also trying to take advantage of the Company's financial position and are fueling the speculation about the Company's financial position. To the extent that this results in the loss of any of the Company's strategic customers or results in a loss of sales opportunities, the Company's business, operating results and financial condition may be adversely affected. INTELLECTUAL PROPERTY RIGHTS - The Company regards its product as proprietary and relies primarily on a combination of patent, trademark, copyright and trade secret laws and employee and third-party nondisclosure agreements to protect its proprietary rights. Defense of intellectual property rights can be costly, and there can be no assurance that the Company will be able to effectively protect its technology from misappropriation by competitors. As the number of software products in the gaming industry increases and the functionality of these products further overlaps, software developers and publishers or competitors may increasingly become subject to infringement claims. The Company may also become subject to infringement claims, with or without merit, that are brought by competitors who are motivated with a desire to disrupt the Company's business. The Company and three of its competitors were notified by one of its competitors, IGT, of a potential infringement claim during November 1999. This required senior management to work with the other defendants to provide information to IGT that it believes repudiates the claims alleged by IGT. The Company has not been served with the actual lawsuit so it is unable to ascertain the future impact, if any, of this claim. Any such claims or litigation can be costly and result in a diversion of management's attention, which could have a material adverse effect on the Company's business and financial condition. Any settlement of such claims or adverse determinations in such litigation could also have a material adverse effect on the Company's business, operating results and financial condition. CHANGING LEGISLATIVE ENVIRONMENT -The opening of new casinos, including casinos in jurisdictions where gaming has recently been legalized historically has driven growth for demand in slot machines. However, in recent years, the legalization of gaming in new jurisdictions has been significantly reduced; therefore demand based on new openings will be largely limited to new projects in existing markets. Certain markets, which currently permit gaming, are contemplating legislation to limit, reduce or eliminate gaming. If successful such legislation could limit growth opportunities for the Company. As a result of these factors, there can be no assurance that the slot machine market will sustain the rate of growth that was possible in the first half of this decade. 34 RAPIDLY CHANGING TECHNOLOGY - The Company's products utilize hardware components that have been developed primarily for the personal computer and multimedia industries. These industries are characterized by rapid technological change and product enhancements. The Company's ability to remain competitive and retain any technological lead may depend in part upon its ability to continually develop new slot machine games that take full advantage of the technological possibilities of state-of-the-art hardware. The Company has not updated its product offering to take advantage of enhanced hardware components since 1998. Should any current or potential competitor of the Company succeed in developing a competing software-based gaming platform, such competitor could be in a position to outperform the Company in its ability to exploit developments in microprocessor, video or other multimedia technology. The emergence of a suite of slot machine games that is superior to the Company's in any respect could substantially diminish the Company's product sales and thereby have a material adverse effect on the Company's operating results. DEPENDENCE ON SINGLE-SOURCE SUPPLIERS - The Company currently obtains certain systems components from single-source suppliers. In particular the touchscreen and picture tube that comprise the video display are supplied by MircoTouch Systems, Inc. and Philips Display Components Company, respectively. The Company does not have long-term supply contracts with these suppliers but rather obtains these components on a purchase order basis. Although the design of these components is not unique or proprietary and the Company believes that it could identify alternative sources of supply, if necessary, there can be no assurance that the Company would be able to procure, substitute or produce such components without a significant interruption in its assembly process in the event that these single sources were unable to supply these components. Even where the Company has multiple sources of supply for a component, industry-wide component shortages, such as those that have occurred with various computer components, could significantly delay productivity, increase costs or both. The Company is also considering exclusive outsourcing arrangements whereby a single third party contract manufacturer will assemble all or a significant portion of new products that the Company is planning to introduce. The failure or delay by any supplier to furnish the Company with the required components or products would have a material adverse effect on the Company's business, financial condition and results of operations. ITEM 7A MARKET RISK DISCLOSURES: The following discussion about the Company's market risk disclosures involves forward-looking statements. Actual results could differ materially from those projected in the forward-looking statements. The Company is exposed to market risk related to changes in interest rates and equity security price risk. The Company does not have derivative financial instruments for speculative or trading purposes. The Company has fixed rate long-term debt of approximately $9.5 million outstanding at December 31, 1999 and a hypothetical ten percent increase or decrease in interest rates would not have a material impact on the fair market value of this debt. The fair value of the Company's Senior Discount Notes may be lower than the recorded value, but the Company is unable to estimate the fair value at this time. The Company does not hedge any interest rate exposures. 35 FINANCIAL INFORMATION BY QUARTER (UNAUDITED)
(in thousands, Three Months Ended except per share amounts) ----------------------------------------- March 31 June 30 Sept. 30 Dec. 31 Total Year -------- ------- -------- ------- ---------- 1999: Sales ........................ $ 5,661 $ 5,928 $ 1,999 $ 3,527 $ 17,115 Operating loss ............... $(7,114) $(1,273) $ (3,005) $ (5,044) $(16,436) Net income (loss) ............ $(9,040) $(3,199) $ (4,980) $ 5,454 $(11,765) Basic and diluted net income (loss) per share(1)... $ (0.64) $ (0.22) $ (0.34) $ 0.24 $ (0.70) ------- ------- -------- -------- -------- 1998: Sales ....................... $ 4,026 $ 8,261 $ 4,989 $ 5,005 $ 22,281 Net loss .................... $(6,764) $(5,428) $(14,702) $(10,776) $(37,670) Basic and diluted net loss per share(1) ............... $ (0.51) $ (0.39) $ (1.06) $ (0.77) $ (2.75) ------- ------- -------- -------- --------
- ---------- (1) See Note 1 of Notes to Consolidated Financial Statements for an explanation of the method used to determine the number of shares used in the computation of basic and diluted net loss per share ITEM 8: FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Index to Financial Statements and Supplementary Data Financial Statements: Page ---- Consolidated Balance Sheets at December 31, 1999 and 1998 40 Consolidated Statements of Operations for the years ended December 31, 1999, 1998 and 1997 41 Consolidated Statements of Shareholders's Deficiency for the years ended December 31, 1999, 1998 and 1997 42 Consolidated Statements of Cash Flows for the years ended December 31, 1999, 1998 and 1997 43 Notes to Consolidated Financial Statements 44 Independent Auditors' Report 56 ITEM 9: CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. 36 PART III Portions of the information required by Part III of Form 10-K are incorporated by reference to portions of the Company's definitive Proxy Statement to be filed with the Commission in connection with the 2000 Annual Meeting of Shareholders (the "Proxy Statement"), which the Company intends to file not more than 120 days after the end of the fiscal year covered by this Report. ITEM 10: DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information set forth in the Proxy Statement under the captions "Proposal One--Election of Directors-Nominees" and "Section 16(a) Beneficial Ownership Reporting Compliance" in the Company's Proxy Statement to be filed in connection with its 2000 annual meeting of shareholders (the "Proxy Statement") and the information set forth in Item I of this Report under the caption "Executive Officers" is incorporated herein by reference. ITEM 11: EXECUTIVE COMPENSATION The information set forth in the Proxy Statement under the caption "Executive Compensation" is incorporated herein by reference. ITEM 12: SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information set forth in the Proxy Statement under the caption "Security Ownership of Certain Beneficial Owners and Management" is incorporated herein by reference. ITEM 13: CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information set forth in the Proxy Statement under the caption "Certain Relationships and Related Transactions" is incorporated herein by reference. PART IV ITEM 14: EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) The following documents are filed as part of this Form 10-K: (1) Consolidated Financial Statements. See the Index to Consolidated Financial Statements and Supplementary data at page 38 of this Form 10-K. (2) Financial Statement Schedule. Schedule II - Valuation and Qualifying Accounts and Reserves (3) Exhibits. The exhibits listed in the accompanying Exhibit Index are filed as part of, or incorporated by reference into, this Report. (b) Reports on Form 8-K: During the quarter ended December 31, 1999 the Company filed a report on Form 8-K that outlined the terms of a financial restructuring that the Company completed with the holders of the $47.25 million principal outstanding Senior Discount Notes. As a result of the restructuring, $39.75 37 million of Notes and accrued interest thereon were exchanged for 39,750 shares of Series D Preferred Stock that is convertible into a 57% common equity interest in the Company. The terms of the remaining $7.5 million of outstanding Notes were modified to reduce the interest rate from 12.5% to 10% per annum (effective July 15, 1999) and to provide for interest to be payable in-kind at the Company's option and subject to certain coverage tests. The Notes will mature 5 years from the date of the restructuring. Accrued and unpaid interest on the $7.5 million of Notes outstanding following the restructuring was forgiven through July 15, 1999. As a part of the restructuring, the holders of the Notes have agreed to make an additional investment in the Company of up to $5 million in the form of Senior Secured Notes (the New Notes). The New Notes are not convertible and bear cash interest at 10% per annum and in-kind interest at the rate of 3% per annum. The New Notes mature in five years and are issuable in tranches. The first $2.0 million was issued at the closing of the restructuring. To the extent required by the Company, the remaining $3.0 million of New Notes will be issued upon the achievement of certain operating and financial milestones as determined by the holders of the Notes. Effective upon the closing of the restructuring, a majority of the members of the Company's Board of Directors resigned and two new members were appointed. In addition, the Company intends to conduct an Exchange Offer whereby holders of common stock as of November 24, 1999 who elect to participate, may exchange their shares of common stock for units consisting of a share of common stock and a warrant to purchase 3.59662 additional shares of common stock. The exercise price of the warrants will be at a premium to fair market value and will be based on an enterprise value for the Company of $70 million. In addition, the warrants would only be exercisable after the first anniversary of issuance and would terminate four years after their issuance. The warrants could terminate prior to their scheduled expiration if the Company's enterprise value, as measured on the Nasdaq national market or a national securities exchange, exceeds $100 million. Holders of the warrants would have 180 days to exercise prior to such termination. The Company has allocated 38% of its equity (calculated prior to the issuance of the out-of-the-money warrants described above) as of the effective date of the restructuring to be issued as incentive compensation to employees. Of the 116,190,084 shares of common stock issuable as incentive, 15,657,490 shares were authorized for issuance on November 24, 1999. 38 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, in the City of Palo Alto, County of Santa Clara, State of California, on the 30th day of March, 2000. SILICON GAMING, INC. By: /s/ Andrew S. Pascal ------------------------------------ Andrew S. Pascal President, Chief Executive Officer, Acting Chief Financial Officer (Principal Financial and Chief Accounting Officer) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Signature Title Date - --------- ----- ---- /s/ Andrew S. Pascal President ,Chief Executive March 30, 2000 - ---------------------------- Officer, Chief Financial Officer Andrew S. Pascal (Principal Financial and Accounting Officer) and director /s/ Stanford Springel Director March 30, 2000 - ---------------------------- Stanford Springel /s/ Robert Reis Director March 30, 2000 - ---------------------------- Robert Reis 39 SILICON GAMING, INC. CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT SHARE DATA) December 31, ---------------------- 1999 1998 -------- -------- ASSETS CURRENT ASSETS: Cash and equivalents ................................ $ 877 $ 8,399 Short-term investments .............................. 1,000 -- Accounts receivable (net of allowances of $1,169 in 1999 and $1,650 in 1998) ................. 1,188 5,340 Inventories ......................................... 7,331 12,024 Prepaids and other .................................. 1,069 1,698 -------- -------- Total current assets ........................... 11,465 27,461 PROPERTY AND EQUIPMENT, NET .......................... 3,795 12,922 OTHER ASSETS, NET .................................... 321 1,361 -------- -------- $ 15,581 $ 41,744 ======== ======== LIABILITIES AND SHAREHOLDERS' DEFICIENCY CURRENT LIABILITIES: Accounts payable .................................... $ 1,389 $ 1,480 Accrued liabilities ................................. 1,655 8,154 Deferred revenue .................................... 240 1,766 Line of credit ...................................... 622 4,000 Current portion of long-term obligations ............ 1,165 1,289 -------- -------- Total current liabilities ...................... 5,071 16,689 OTHER LONG-TERM LIABILITIES .......................... 1,611 2,032 LONG-TERM OBLIGATIONS ................................ 10,428 39,809 LONG-TERM ACCRUED INTEREST ........................... 5,832 -- REDEEMABLE CONVERTIBLE PREFERRED STOCK -- shares outstanding: December 31, 1999 -- 0; December 31, 1998--1,474,641 ........................ -- 1,666 SHAREHOLDERS' DEFICIENCY: Preferred Stock, $.001 par value; 6,884,473 shares authorized; 39,750 shares outstanding at December 31, 1999; (liquidation preference up to $39.75 million) ................... 20,000 -- Common Stock, $.001 par value; 750,000,000 shares authorized; shares outstanding: December 31, 1999 -- 30,949,273; December 31, 1998 -- 14,242,313 ........ 64,123 57,398 Warrants ............................................ 5,542 4,548 Notes receivable from shareholders .................. (345) (128) Deferred stock compensation ......................... (4,646) -- Accumulated deficit ................................. (92,035) (80,270) Accumulated other comprehensive income .............. -- -- -------- -------- Total shareholders' equity (deficiency) ........... (7,361) (18,452) -------- -------- $ 15,581 $ 41,744 ======== ======== See Notes to Consolidated Financial Statements. 40 SILICON GAMING, INC. CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT PER SHARE DATA) Year Ended December 31, -------------------------------- 1999 1998 1997 -------- -------- -------- REVENUE: Hardware .................................. $ 10,370 $ 14,126 $ 7,636 Software .................................. 4,288 4,657 567 Participation ............................. 2,457 3,498 1,347 -------- -------- -------- Total revenue ........................ 17,115 22,281 9,550 OPERATING EXPENSES: Cost of sales and related manufacturing expenses ................................. 13,213 24,062 10,421 Research and development .................. 4,410 11,853 9,283 Selling, general and administrative ....... 12,651 18,375 12,830 Restructuring ............................. 3,277 -- -- -------- -------- -------- Total costs and expenses ............. 33,551 54,290 32,534 -------- -------- -------- Loss from operations ................. 16,436 32,009 22,984 Interest income ........................... (99) (618) (1,238) Interest expense .......................... 7,241 6,261 1,240 Other expense, net ........................ 503 18 -- -------- -------- -------- LOSS BEFORE EXTRAORDINARY ITEMS ............ 24,081 37,670 22,986 Extraordinary gain upon conversion of debt (Note 7) ............................ (12,316) -- -- ======== ======== ======== NET LOSS ................................... $ 11,765 $ 37,670 $ 22,986 ======== ======== ======== BASIC AND DILUTED NET LOSS PER SHARE: Loss before extraodinary items ............ $ 1.42 $ 2.75 $ 2.16 ======== ======== ======== Net loss .................................. $ 0.70 $ 2.75 $ 2.16 ======== ======== ======== SHARES USED IN COMPUTATION ................. 16,906 13,696 10,666 ======== ======== ======== See Notes to Consolidated Financial Statements. 41 SILICON GAMING, INC. CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (DEFICIENCY) (IN THOUSANDS, EXCEPT SHARE AMOUNTS)
Preferred Stock Common Stock ------------------- --------------------- Shares Amount Shares Amount Warrants ------ ------ ------ ------ -------- BALANCES, January 1, 1997 ........ -- -- 10,608,105 49,848 25 Options exercised for cash ....... 49,083 200 Collection of notes receivable ... Employee stock purchase plan issuances ....................... 99,894 696 Repurchase of Common Stock ....... (17,377) (3) Conversion of Series A1 Redeemable Preferred Stock ...... 1,219,032 1,371 Conversion of Series B1 Redeemable Preferred Stock ...... 1,191,000 2,019 Warrants issued in conjunction with Senior Notes ............... 3,082 Other comprehensive income (loss) .......................... Net loss & comprehensive net loss ............................ ------ ------- ---------- -------- ------- BALANCES, December 31, 1997 ...... -- $ -- 13,149,737 $ 54,131 $ 3,107 Options exercised for cash ....... 97,400 217 Collection of notes receivable ... Employee stock purchase plan issuances ....................... 151,808 935 Repurchase of Common Stock ....... (54,130) (6) Net exercise of warrants ......... 34,309 25 (25) Conversion of Series A1 Redeemable Preferred Stock ...... 113,189 128 Conversion of Series B1 Redeemable Preferred Stock ...... 750,000 1,271 Warrants issued in conjunction with Senior Notes ............... 1,466 Stock compensation arrangements... 697 Net loss ......................... Other comprehensive income (loss) .......................... Comprehensive loss ............... ------ ------- ---------- -------- ------- BALANCES, December 31, 1998 ...... -- $ -- 14,242,313 $ 57,398 $ 4,548 Debt restructuring transactions: Conversion of Series B1 Preferred Stock ................ 983,093 468 Issuance of preferred stock 39,750 20,000 Issuance of warrants ............ 994 Options exercised for cash and notes receivable ................ 15,722,830 6,202 Amortization of deferred stock compensation .................... Collection of notes receivable ... Employee stock purchase plan issuances ....................... 48,815 62 Repurchase of Common Stock ....... (47,778) (7) Net loss and comprehensive loss... ------ ------- ---------- -------- ------- BALANCES, December 31, 1999 ...... 39,750 $20,000 30,949,273 $ 64,123 $ 5,542 ====== ======= ========== ======== ======= Notes Accumulated Receivable Deferred Other From Stock Accumulated Comprehensive Shareholders Compensation Deficit Income Total ------------ ------------ ------- ------ ----- BALANCES, January 1, 1997 ........ (221) -- (19,614) 23 30,061 Options exercised for cash ....... 200 Collection of notes receivable ... 14 14 Employee stock purchase plan issuances ....................... 696 Repurchase of Common Stock ....... (3) Conversion of Series A1 Redeemable Preferred Stock ...... 1,371 Conversion of Series B1 Redeemable Preferred Stock ...... 2,019 Warrants issued in conjunction with Senior Notes ............... 3,082 Other comprehensive income (loss) .......................... (22) Net loss & comprehensive net loss ............................ (22,986) (23,008) ---- ------- -------- ---- -------- BALANCES, December 31, 1997 ...... $(207) $ -- $(42,600) $ 1 $ 14,432 Options exercised for cash ....... 217 Collection of notes receivable ... 75 75 Employee stock purchase plan issuances ....................... 935 Repurchase of Common Stock ....... 4 (2) Net exercise of warrants ......... -- Conversion of Series A1 Redeemable Preferred Stock ...... 128 Conversion of Series B1 Redeemable Preferred Stock ...... 1,271 Warrants issued in conjunction with Senior Notes ............... 1,466 Stock compensation arrangements... 697 Net loss ......................... (37,670) Other comprehensive income (loss) .......................... (1) Comprehensive loss ............... (37,671) ---- ------- -------- ---- -------- BALANCES, December 31, 1998 ...... $(128) $ -- $(80,270) $ -- (18,452) Debt restructuring transactions: Conversion of Series B1 Preferred Stock ................ 468 Issuance of preferred stock 20,000 Issuance of warrants ............ 994 Options exercised for cash and notes receivable ................ (235) (5,807) 160 Amortization of deferred stock compensation .................... 1,161 1,161 Collection of notes receivable ... 11 11 Employee stock purchase plan issuances ....................... 62 Repurchase of Common Stock ....... 7 -- Net loss and comprehensive loss... (11,765) (11,765) ---- ------- -------- ---- -------- BALANCES, December 31, 1999 ...... (345) $(4,646) $(92,035) $ -- $ (7,361) ==== ======= ======== ==== ========
See Notes to Consolidated Financial Statements. 42 SILICON GAMING, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS)
Year Ended December 31, -------------------------------------- 1999 1998 1997 -------- -------- -------- CASH FLOWS FROM OPERATING ACTIVITIES: Net loss .......................................... $(11,765) $(37,670) $(22,986) Reconciliation to net cash used in operating activities: Gain on debt conversion ......................... (12,316) -- -- Depreciation and amortization ................... 4,775 4,700 2,623 Accrued interest ................................ 4,405 3,594 672 Accretion of debt discount ...................... 2,206 1,905 359 Deferred rent ................................... (98) 213 202 Restructuring expenses .......................... 3,277 -- -- Stock compensation .............................. 1,161 697 -- Loss (gain) on disposal of property ............. 131 (35) -- Changes in assets and liabilities: Accounts receivable ............................. 4,152 (410) (4,930) Inventory ....................................... 4,693 (5,689) (5,858) Prepaids and other .............................. (146) (64) (133) Participation units ............................. 2,252 (361) (5,325) Accounts payable ................................ (591) (1,671) 1,993 Deferred revenue ................................ (1,526) 288 1,478 Accrued and other liabilities ................... (4,446) 2,389 1,996 -------- -------- -------- Net cash used in operating activities ........ (3,836) (32,110) (29,909) -------- -------- -------- CASH FLOWS FROM INVESTING ACTIVITIES: Acquisition of property and equipment ............. (397) (3,271) (7,817) Proceeds from sale of assets ...................... -- 127 -- Purchases of short-term investments ............... (1,000) -- (6,725) Sales and maturities of short-term investments ...................................... -- 4,704 11,681 Other assets, net ................................. 288 (315) (216) -------- -------- -------- Net cash provided by (used in) investing activities ........................ (1,109) 1,245 (3,077) -------- -------- -------- CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from debt financing and issuance of warrants, net of costs ............... 2,000 14,950 23,055 Sale of Common Stock, net ......................... 80 1,146 893 Collection of note receivable ..................... 11 79 14 Proceeds from notes payable ....................... -- 3,586 -- Repayment of notes payable ........................ (985) (564) -- Proceeds (repayment) from line of credi ........... (3,378) 4,000 -- Repayment of capital lease obligation ............. (305) (285) (207) -------- -------- -------- Net cash provided by (used in) financing activities ........................ (2,577) 22,912 23,755 -------- -------- -------- NET DECREASE IN CASH AND EQUIVALENTS ................ (7,522) (9,231) (7,953) CASH AND EQUIVALENTS: Beginning of period ............................... 8,399 16,352 25,583 -------- -------- -------- End of period ..................................... $ 877 $ 8,399 $ 16,352 ======== ======== ======== SUPPLEMENTARY DISCLOSURES OF CASH FLOW INFORMATION-- Cash paid during the period for interest .......... $ 602 $ 360 $ 106 ======== ======== ======== NONCASH INVESTING AND FINANCING ACTIVITIES: Issuance of Common Stock for notes receivable...... $ 235 $ -- $ -- ======== ======== ======== Issuance of Common Stock warrants ................. $ 994 $ 1,466 $ 3,082 ======== ======== ======== Conversion of Preferred Stock to Common Stock...... $ 468 $ 1,399 $ 3,390 ======== ======== ========
See Notes to Consolidated Financial Statements. 43 SILICON GAMING, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. BUSINESS AND SIGNIFICANT ACCOUNTING POLICIES BUSINESS--Silicon Gaming, Inc. (the "Company") was incorporated on July 27, 1993 to develop and market innovative gaming devices through the use of advanced multimedia and interactive technologies. BASIS OF PRESENTATION - The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. The Company has incurred operating losses every year since its inception and at December 31, 1999 had an accumulated deficit of $92,035,000 and a shareholders' deficiency of $7,361,000. The Company has been required to obtain additional financing every year to be able to fund its ongoing operations. Based on historical levels of cash useage, the above factors raise substantial doubt about the Company's ability to continue as a going concern. In the fourth quarter of 1999 the Company completed a substantial restructuring of its capitalization whereby $39.75 million of Senior Discount Notes and approximately $8.3 million of accrued interest were converted into Preferred Stock, and the remaining terms of the Senior Discount Notes were modified to reduce the interest rate thereon and extend the payment terms. Concurrent with the restructuring, the Company borrowed $2 million under new Senior Discount Notes and established a facility whereby up to an additional $3 million of new Senior Discount Notes may be issued upon meeting certain financial and operational milestones. Management continues to review financing and other strategic alternatives available to the Company such as additional equity or debt offerings in the Company or certain of its subsidiaries, joint ventures, alternative distribution channels, direct investment by third parties into several of the Company's strategic business opportunities and sale of all or part of the Company's assets to improve the Company's liquidity position. Management believes that these steps, plus sales related to proposed new product introductions, will provide sufficient cash and working capital for the Company to meet its ongoing obligations and to allow it to continue operating as a going concern through at least the end of 2000. The accompanying consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty. CONSOLIDATION--The consolidated financial statements include the Company and its wholly-owned subsidiaries after elimination of intercompany accounts and transactions. ESTIMATES--The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. CASH EQUIVALENTS--The Company considers all highly liquid debt instruments purchased with an original maturity of three months or less to be cash equivalents. SHORT-TERM INVESTMENTS - Short-term investments represent debt securities which are stated at fair value. To the extent there is a difference between amortized cost (cost adjusted for amortization of premiums and accretion of discounts which are recognized as adjustments to interest income) and fair value representing the unrealized holding gains or losses, these will will be recorded as a separate component of shareholders' equity until realized. While the Company's intent is to hold debt securities to maturity, they are classified as available-for-sale securities because the sale of such securities my be required prior to maturity. Any gains or losses on the sale of debt securities are determined on a specific identification basis. FAIR VALUE OF FINANCIAL INSTRUMENTS--The estimated fair value of the Company's financial instruments, which include cash equivalents and short-term investments approximate their carrying value. The fair value of the Company's Senior Discount Notes may be lower than the recorded value but the Company is unable to estimate the fair value at this time. 44 INVENTORIES--Inventories consist of raw materials, work-in-process and finished goods and are stated at the lower of cost or market on a first-in, first-out basis. PROPERTY AND EQUIPMENT--Property and equipment are stated at cost. Depreciation and amortization are computed using the straight-line method over estimated useful lives between eighteen months and seven years. Leasehold improvements are amortized using the straight-line method over the shorter of the lease term or the asset's useful life. The Company places gaming machines and related equipment in customer locations on its participation program and receives a portion of the net win from each machine. Depreciation of units under such arrangements is the greater of the ratio that current gross revenue bears to total anticipated revenue for such unit or straight-line over three years. Ancillary gaming equipment such as signs and chairs are depreciated over an eighteen-month period. REVENUE RECOGNITION--Revenue from hardware units and non-renewable software licenses is recognized upon acceptance by the customer after completion of a trial period, if applicable, or otherwise upon shipment of the unit. Renewable software licenses are recognized ratably over the license period. Amounts due the Company under revenue participation plans with its customers are recognized ratably based on the Company's share of gaming machine play. CONCENTRATION OF CREDIT RISK-- Financial instruments which potentially subject the Company to concentrations of credit risk consist primarily of cash equivalents, short-term investmements and trade accounts receivable. The Company performs ongoing credit evaluations of its customers' financial condition and limits the amount of credit extended when deemed necessary but generally requires no collateral. The Company maintains reserves for estimated potential credit losses. At December 31, 1999, one customer accounted for 19% of accounts receivable. A significant portion of the Company's revenues are concentrated with a small number of strategic customers. For the year ended December 31, 1999 one customer accounted for 16% of revenue and the Company's top 10 customers represented 52% of revenue. For the year ended December 31, 1998, two customers accounted for 11% and 10% of revenue and the Company's top 10 customers represented 67% of revenue. In 1997 three different customers accounted for 27%, 12% and 12% of revenue. RESEARCH AND DEVELOPMENT EXPENSES--Research and development expenses are charged to operations as incurred. In connection with the Company's product development efforts, it develops software applications which are integral to the operation of the product. The costs to develop such software have not been capitalized as the Company believes its current software development process is essentially completed concurrent with the establishment of technological feasibility and/or development of the related hardware. INCOME TAXES--The Company accounts for income taxes in accordance with Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes, which requires an asset and liability approach for financial reporting of income taxes. STOCK-BASED COMPENSATION--The Company accounts for stock-based awards to employees using the intrinsic value method in accordance with APB No. 25 Accounting for Stock Issued to Employees ("APB 25"). The Company adopted the disclosure requirements of Statement of Financial Accounting Standards No.123, Accounting for Stock-Based Compensation, ("SFAS 123"), which require the disclosure of pro forma net income and earnings per share as if the Company adopted the fair value-based method in measuring compensation expense as of the beginning of fiscal 1995. NET LOSS PER SHARE--Basic EPS excludes dilution and is computed by dividing net income by the weighted average of common shares outstanding for the period. Diluted EPS reflects the potential dilution that would occur if securities or other contracts to issue Common Stock were exercised or converted into Common Stock. Common share equivalents including stock options, warrants and Preferred Stock have been excluded for all periods presented, as their effect would be antidilutive. 45 The following is a reconciliation of the numerators and denominators of the basic and diluted net loss per share computations (in thousands except per share amounts): Year Ended December 31, --------------------------- 1999 1998 1997 ------- ------- ------- Net Loss (Numerator): Net loss, basic and diluted ...................... $11,765 $37,670 $22,986 ======= ======= ======= Shares (Denominator): Weighted average common shares outstanding ....... 16,965 14,047 11,418 Weighted average common shares outstanding subject to repurchase .......................... 59 351 752 ------- ------- ------- Shares used in computation, basic and diluted .... 16,906 13,696 10,666 ======= ======= ======= Net Loss Per Share, Basic and Diluted ............ $ 0.70 $ 2.75 $ 2.16 ======= ======= ======= SEGMENT DISCLOSURES - Effective January 1, 1999 the Company adopted SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information". The Company organizes and manages its products and services as a single product family, and accordingly, the required disclosures under SFAS No. 131 regarding the Company's products and services are made to the face of the financial statements. The adoption of SFAS No. 131 had no effect on the financial position of the Company. RECLASSIFICATIONS-- Certain prior year amounts have been reclassified to conform to the current year presentation. 2. SHORT-TERM INVESTMENTS Short-term investments consist of the following debt securities as of December 31, 1999: Amortized Market Unrealized Unrealized (In Thousands) Cost Value Holding Gains Holding Losses ---- ----- ------------- -------------- Available-for-sale corporate securities .... $1,000 $1,000 $ -- $ -- ====== ====== ==== ==== 3. INVENTORIES Inventories are stated at the lower of cost (first-in, first-out) or market and consist of the following : December 31, --------------------- (In Thousands) 1999 1998 ------- ------- Raw materials .................................. $ 849 $ 4,294 Work in process ................................ 111 93 Finished goods ................................. 6,371 7,637 ------- ------- $ 7,331 $12,024 ======= ======= Finished goods includes units on trial of $ 2,397 and $ 3,462 at December 31, 1999 and 1998, respectively. 46 4. PROPERTY AND EQUIPMENT Property and equipment consists of: December 31, -------------------- (In Thousands) 1999 1998 -------- -------- Furniture, fixtures and office equipment .............. $ 453 $ 1,586 Computer equipment .................................... 6,876 9,292 Manufacturing equipment ............................... 69 1,954 Gaming machines & equipment ........................... 3,125 6,230 Leasehold improvements ................................ 737 1,445 ------- ------- 11,260 20,507 Accumulated depreciation and amortization (7,465) (7,585) ------- ------- $ 3,795 $12,922 ======= ======= Included in property and equipment at December 31, 1999 and 1998 are assets leased under capital leases of $1,000,000 net of accumulated depreciation of $1,000,000 and $792,000 as of December 31, 1999 and 1998, respectively. 5. ACCRUED LIABILITIES AND RESTRUCTURING ACCRUAL Accrued liabilities consists of: December 31, ------------------- (In Thousands) 1999 1998 ------ ------ Accrued compensation benefits.......................... $ 363 $ 958 Accrued purchase arrangements.......................... 160 1,100 Accrued royalties ..................................... 60 1,811 Accrued tax obligations ............................... 550 -- Accrued interest expense .............................. 20 2,782 Other accrued liabilities ............................. 502 1,503 ------ ------ $1,655 $8,154 ====== ====== In March 1999 the Company announced the closure of its Mountain View, California manufacturing facility and the relocation of all of its manufacturing operations to its Las Vegas, Nevada facility. At the same time the Company announced a reduction in size of its employee workforce by approximately 35%. The Company recorded restructuring charges of $3,312,000 in the three-month period ended March 31, 1999. The restructuring charges include severance costs, lease related costs of excess facilities and the write down of specific fixed assets associated with these facilities and assets rendered surplus as a result of the reduction in force. Details of the restructuring charges are as follows (in thousands): Accrued severance, Facility Write down benefits & lease of other costs obligations fixed assets Total ----------- ----------- ------------ ----- Restructuring provision ........ $ 595 $ 293 $ 2,424 $ 3,312 Adjustment to amounts recorded ..................... -- (35) -- (35) Non-cash items ................. -- -- (2,424) (2,424) Amounts paid ................... (595) (258) -- (853) ----- ----- ------- ------- Balance at September 30, 1999 .. $ -- $ -- $ -- $ -- ===== ===== ======= ======= Termination benefits were paid to 55 employees and all benefits were paid prior to May 31, 1999. The Company completed all remaining restructuring activities, including disposal of assets, before the end of 1999. 47 6. LEASES The Company leases its facilities under noncancellable operating lease agreements. The accompanying statements of operations reflect rent expense on a straight-line basis over the term of the leases. The difference between straight-line rent expense and actual cash payments is recorded as deferred rent. Future minimum operating commitments at December 31, 1999 are as follows: Operating Leases ------- (in thousands) 2000........................................................ $ 1,059 2001........................................................ 961 2002........................................................ 926 2003........................................................ 567 2004........................................................ 549 Thereafter.................................................. 566 ------- Total minimum lease payments................................ $ 4,628 ======= During 1999 the Company entered into a sublease with respect to a portion of its Palo Alto facility. Pursuant to this agreement, which expires in 2005, the Company will receive sublease income approximating $3,912,000. Rent expense (including prorated common area maintenance charges and utilities) for the years ended December 31, 1999, 1998 and 1997 was $859,000, $1,310,000 and $975,000, respectively. The 1999 rent expense was net of sublease income received of $279,000. 7. LONG-TERM BORROWING OBLIGATIONS The Company had a $4 million secured revolving line of credit agreement based on the Company's eligible accounts receivable, which expired on December 31, 1999. As of December 31, 1999 the Company had $622,000 outstanding under this agreement. As of December 31, 1999 the Company was not in compliance with the minimum net worth covenants of the agreement, however the Company subsequently repaid all outstanding balances under this agreement in February 2000. Borrowing arrangements consist of the following (in thousands): December 31, ---------------------- 1999 1998 -------- -------- Senior Discount Notes ($9.5 million and $47.25 million principal obligation, respectively) ....... $ 9,500 $ 37,716 Capital lease obligations .......................... 55 360 Other long-term obligations ........................ 2,038 3,022 -------- -------- 11,593 41,098 Current obligation ................................. (1,165) (1,289) -------- -------- Long-term portion .................................. $ 10,428 $ 39,809 ======== ======== 48 Future minimum debt commitments at December 31, 1999 are as follows (in thousands):
Senior Other Discount Capital Long Term Total Notes Leases Obligations Debt -------- -------- -------- -------- 2000 ............................................. $ 1,037 $ 56 $ 1,315 $ 2,408 2001 ............................................. 1,063 -- 788 1,851 2002 ............................................. 1,072 -- 230 1,302 2003 ............................................. 1,082 -- -- 1,082 2004 ............................................. 10,887 -- -- 10,887 Thereafter ....................................... -- -- -- -- -------- ----- ------- -------- Total minimum payments ........................ 15,141 56 2,333 17,530 Amount representing interest or future discount... (5,641) (1) (295) (5,937) -------- ----- ------- -------- Present value of debt payments ................... 9,500 55 2,038 11,593 Current portion .................................. -- 55 1,110 1,165 -------- ----- ------- -------- Long-term portion ................................ $ 9,500 $ -- $ 928 $ 10,428 ======== ===== ======= ========
In November 1999 the Company completed a restructuring of its then outstanding Senior Discount Notes whereby $39.75 million of principal plus approximately $8.3 million of accrued interest was exchanged for 39,750 shares of Series D Preferred Stock (see Note 8) which is convertible into 57% of the fully diluted equity of the Company and warrants to purchase up to 60,807.7 shares of Series E Preferred Stock at $0.01 per share. The terms of the remaining $7.5 million of Senior Discount Notes were modified to reduce the interest rate from 12.5% to 10% per annum (effective July 15, 1999) and to provide for interest to be payable in-kind through the issuance of additional notes at the Company's option and subject to certain coverage ratio tests. The maturity date of the remaining notes was extended to November 2004. Accrued and unpaid interest on the $7.5 million of notes remaining outstanding following the restructuring was forgiven through July 15, 1999. As a part of the debt restructuring, the holders of the Senior Discount Notes agreed to make an additional investment in the Company of up to $5 million in the form of senior secured notes (the New Notes). The New Notes are not convertible and bear cash interest at the rate of 10% per annum and in-kind interest at the rate of 3% per annum. The New Notes mature in five years and are issuable in tranches. The first $2 million was issued at the closing of the restructuring on November 24, 1999. To the extent, required by the Company, the additional $3 million of New Notes will be issued upon the achievement of certain financial and operating milestones, as determined by the holders of the Notes. Also, as part of the debt restructuring, the Company entered into certain other equity transactions: Holders of the outstanding Series B1 Redeemable Preferred Stock were required to convert their shares into Common Stock. Holders of outstanding shares of Common Stock (subject to the increase in authorized common stock which was approved by the shareholders in February 2000) are to be granted warrants to purchase additional shares of Common Stock for $0.1528 per share, at a rate of 3.59662 additional shares for each share of Common Stock held as of November 24, 1999 (54.9 million additional shares in total). See additional information regarding these equity securities in Notes 8 and 9. In accordance with Statement of Financial Accouting Standard No. 15, "Accounting by Debtors and Creditors for Troubled Debt Restructurings", the gain on cancellation of debt reflects these related equity transactions was reduced to reflect all future cash payments due to the holders of the Senior Discount Notes, as well as, future interest payments on these Notes and estimated amounts under the New Notes. All such future interest payments have been recorded as a liability as of the date of the Company's debt restructuring and are shown as Long-Term Accrued Interest on the accompanying balance sheet. As a result, in the future the Company will not record interest expense on its Senior Discount Notes. 49 The components of the gain on conversion of debt consist of (in thousands): Carrying value of debt and related accrued interest ......... $ 39,098 Fair value of Series D Preferred Stock and Series E Preferred Stock warrants issued ............................ (20,000) Future expected interest on modified debt and New Notes ..... (5,832) Gain on conversion of preferred stock to common stock ....... 1,198 Fair value of warrants issued to common stockholders ........ (994) Legal and other costs of restructuring ...................... (1,154) -------- Net gain .................................................... $ 12,316 ======== In June 1998, the Company entered into a secured equipment loan. Borrowings bear interest at 14% per annum for a term of 42 months. As of December 31, 1999, the Company had borrowed $1,562,000 under this agreement. The agreement requires the Company to comply with certain financial covenants, with which the Company was in compliance as of December 31, 1999. In March 1998, the Company entered into a secured equipment term. Borrowings bear interest at 11% per annum for a term of 36 months. As of December 31, 1999 the Company had borrowed $1,698,000 under this agreement. The agreement requires the Company to comply with certain financial covenants, with which the Company was not in in compliance as of December 31, 1999. 8. PREFERRED STOCK At December 31, 1999, the Company had 39,750 shares of Series D Preferred Stock and warrants to purchase up to 60,807.731 shares of Series E Preferred Stock outstanding. In connection with the increase in authorized shares of Common Stock approved by the shareholders in February 2000, the terms of the preferred stock was amended. The significant terms of the Series D and E Preferred Stock, as amended, are as follows: * Each share of Series D Preferred Stock is convertible into 4,384.53 shares of Common Stock (subject to adjustment for anti-dilution) and each share of Series E Preferred Stock is convertible into 1,000 shares of Common Stock (subject to adjustment for anti-dilution). * The holders of the Series D and E Preferred Stock will have the right to vote the number of shares of Common Stock into which all of such holder's shares are convertible, only if such holder has first received all prior approvals required under applicable gaming laws for conversion of all of the shares of Series D held by such holder * Dividends may be paid at the discretion of the Board of Directors, however, cash dividends must be paid in an amount equal to the as-converted rate based on any cash dividends paid on common stock. * In the event of liquidation, the holders of the Series D are first entitled to receive varying amounts based upon the aggregate transaction proceeds. If such proceeds are less than $20 million, the Series D holders are entitled to 100% of the proceeds. If such transaction proceeds exceed $30 million, the Series D holders would be entitled to the amount that would be paid if such Series D stock were converted into Common Stock immediately prior to the liquidation event. For aggregate transaction proceeds between $20 and $30 million, a pro rata fomula applies. Notwithstanding this, the holders of the Series D Preferred Stock shall not receive more than $1,000 per share as a result of a liquidation event. Series E holders will then receive an amount equal to the as-converted amount to be received for each share of Common Stock. * The Company may redeem the outstanding shares of Series D, in whole or in part, at any time for cash at a redemption price equal to the greater of $1,000 per share or the amount which is equal to the fair market value of the Common Stock into which a share of Series D could be converted. * In the event of a Change in Control (as defined), the holders of a majority of the Series D Preferred Stock may require the Company to redeem the outstanding shares of Series D Preferred Stock at a redemption price equal to the greater of $1,000 per share or the amount which is equal to the fair market value of the Common Stock into which a share of Series D Preferred Stock could be converted. 50 * So long as at least 100 shares of Series D or 200 shares of Series E remain outstanding, the prior written consent of the holders of the Series D and Series E will be required prior to certain corporate actions including, but not limited to, issuing additional capital stock or debt with a preference to or equal to the Series D or E in the Company or any of its subsidiaries, payment of dividends, incurring additional indebtedness (excluding refinancing and the Company's bank borrowings), entering into transactions with affiliates, issuing or disposing of the capital stock of its subsidiaries, disposing of assets of the Company or its subsidiaries, and merging or consolidating with any other entity or entering into any transaction which would have the effect of a change in control. The warrants to purchase up to 60,807.731 shares of Series E Preferred Stock at $0.01 per share are to be issued in connection with the debt restructuring and are directly related to the common stock warrants issued to the Common Shareholders of record as of November 24, 1999 (see Note 7). The Series E warrants become exercisable in proportion to the number of Common Stock warrants exercised. The warrants expire in May 2004. 9. COMMON STOCK In February 2000 the Company's shareholders approved an increase in the authorized capital of the Company to 750,000,000 shares. This will provide suffficient shares for the conversion of the Preferred Shares into Common Stock, the issuance of warrants to the existing equity holders, and the granting of stock options to management and employees of the Company as contemplated in the November 1999 debt restructuring. At the same time the Board of Directors increased the number of shares authorized in the 1999 Long-Term Compensation Plan from 15,657,490 to 116,190,084. At December 31, 1999, Common Stock (including the effect of the February 2000 increases noted above) was reserved for issuance as follows: Conversion of outstanding shares of Series D Preferred Stock ..... 174,285,127 Conversion upon exercise of Series E Preferred Stock warrants .... 60,807,731 Common stock warrants issued to shareholders of record as of November 24, 1999 in connection with the debt restructuring .... 54,985,667 Issuable under other stock purchase warrants ..................... 919,443 Stock Option Plans ............................................... 105,904,165 Employee Stock Purchase Plans .................................... 449,483 ----------- 397,351,616 =========== WARRANTS Holders of outstanding shares of Common Stock (subject to the increase in authorized common stock which was approved by the shareholders in February 2000) are to be granted warrants to purchase additional shares of Common Stock for $0.1528 per share, at a rate of 3.59662 additional shares for each share of Common Stock held as of November 24, 1999. These warrants become exercisable beginning in February 2001 and expire in February 2004. In the event that the Company's stock price exceeds $0.2346 per share for twenty consecutive days, the expiration date of the warrant is accelerated to a date 180 days after that event. During 1998, the Company issued warrants to purchase 250,000 shares of Common Stock at $8.00 per share in conjunction with the issuance and sale of the Company's 1998 Senior Discount Notes. These warrants expire on September 30, 2002. During 1997, the Company issued warrants to purchase 375,000 shares of Common Stock at $15.4375 per share in conjunction with the issuance and sale of the Company's 1997 Senior Discount Notes. These warrants were repriced to $8.00 per share in connection with the issuance of the Company's 1998 Senior Discount Notes. The warrants expire on September 30, 2002. During 1996, the Company issued warrants to certain financial advisors in connection with its Series C Redeemable Convertible Preferred Stock financing. These warrants are exercisable for 116,666 shares of Common Stock at an exercise price of $7.50 per share and expire in 2001. In connection with the initial public offering in 1996, the Company issued 5-year warrants to purchase an aggregate of 177,777 shares of Common Stock to other financial advisors at an exercise price of $12.60 per share. All warrants remain outstanding after the debt restructuring that occurred during the fourth quarter of 1999. 51 STOCK OPTION PLANS Under the 1994 Stock Option Plan (the "1994 Option Plan"), the Company may grant incentive or nonstatutory stock options up to 4,563,077 shares of Common Stock to employees, directors and consultants at prices not less than fair market value for incentive stock options and not less than 85% of fair market value for nonstatutory stock options. These options generally expire five to ten years from the date of grant. Options normally vest at a rate of 25% on the first anniversary of the grant date and 1/48 per month thereafter and may be exercised at any time, subject to the Company's right to repurchase unvested shares at the original exercise price upon termination. In 1996, the Board of Directors adopted the 1996 Outside Directors Stock Option Plan (the "Directors Plan"). Under this plan, non-employee directors of the Company are automatically granted initial options to purchase 15,000 shares of Common Stock and additional options to purchase 5,000 shares of Common Stock in each subsequent year that such person remains a director of the Company. Options under the Directors Plan have an exercise price equal to fair market value at the grant date, vest ratably over three years and expire ten years from the date of grant. The number of shares authorized under this plan is 200,000. In 1997, the Board of Directors adopted the 1997 Nonstatutory Stock Option Plan (the "1997 Option Plan"). Under this plan, the Company may grant nonstatutory stock options for up to 2,350,000 shares of Common Stock to employees and consultants at prices not less than 85% of fair market value on the effective date of the grant. These options generally expire ten years from the date of grant and are immediately exercisable. In 1999, the Board of Directors adopted the 1999 Long-Term Compensation Plan (the "1999 Plan") as a part of the debt restructuring. A total of 15,657,490 shares were authorized for issuance under this plan and 15,657,490 shares were sold to officers in the year ended December 31, 1999. Under the terms of the restricted stock purchase agreement, the Company has the right to repurchase up to 80% of these shares at the original sale price; this right lapses over a four-year period based on continued employment. Under this plan, the Company may grant options or restricted shares of Common Stock to employees, and directors at prices not less than 85% of fair market value on the effective date of the grant. The terms of the options may vary but generally expire ten years from the date of grant and are immediately exercisable. In February 2000 the authorized number of shares in the 1999 Plan was increased to 116,190,094 shares following the increase in the Company's authorized capital. Also in February, 2000 the Company issued an additional 85,090,492 shares to employees and directors. Option activity under the Company's option plans is as follows: Weighted Number Average of Exercise Shares Price ---------- ------- Outstanding, January 1, 1997 ...................... 835,403 $ 6.35 Granted (weighted average fair value of $7.49) .... 1,150,385 15.02 Exercised ......................................... (49,083) 4.13 Cancelled ......................................... (39,529) 12.01 ----------- ------ Outstanding, December 31, 1997 .................... 1,897,176 11.36 Granted (weighted average fair value of $4.29) .... 3,759,563 5.85 Exercised ......................................... (97,400) 2.23 Cancelled ......................................... (3,605,166) 9.84 ----------- ------ Outstanding, December 31, 1998 .................... 1,954,173 4.09 Granted at market value (weighted average fair value of $0.13) .................................. 3,437,751 0.58 Granted below market value (weighted average fair value of $0.01) .................................. 15,657,490 0.02 Exercised ......................................... (15,722,830) 0.45 Cancelled ......................................... (1,920,039) 2.69 ----------- ------ Outstanding, December 31, 1999 .................... 3,406,545 $ 1.58 =========== ====== 52 Additional information regarding options outstanding as of December 31, 1999, is as follows: Options Outstanding Options Exercisable ---------------------------------- --------------------- Weighted Number Average Weighted Number Weighted Outstanding Remaining Average Exercisable Average Range of as of Contractual Exercise as of Exercise Exercise Prices 12/31/99 Life (yrs) Price 12/31/99 Price --------------- -------- ---------- ----- -------- ----- $ 0.105 - $ 0.452 176,512 8.77 $ 0.43 176,512 $ 0.43 $ 0.500 - $ 0.500 1,337,375 2.98 0.50 1,337,375 0.50 $ 0.562 - $ 0.719 139,128 4.41 0.62 139,128 0.62 $ 0.750 - $ 0.750 804,500 9.2 0.75 804,500 0.75 $ 1.500 - $ 3.750 268,819 8.31 1.84 268,819 1.90 $ 4.000 - $ 4.000 576,445 7.57 4.00 576,445 4.00 $ 4.250 - $10.500 72,666 7.10 9.55 63,218 9.58 $11.750 - $11.750 1,100 7.38 11.75 1,100 11.75 $12.250 - $12.250 15,000 7.39 12.25 12,915 12.25 $18.750 - $18.750 15,000 7.18 18.75 13,750 18.75 ----------------- ------ ---- ----- ------ ----- $ 0.105 - $18.750 3,406,545 6.13 $ 1.58 3,393,762 $ 1.55 ================= ========= ==== ======= ========= ======= At December 31, 1999, 1,111,317, 105,000, and 748,699 shares were available for future grants under the 1994 Option Plan, Directors Plan, and 1997 Option Plan respectively. At December 31, 1999, 13,212 shares exercised were subject to repurchase. As of December 31, 1998 and 1997, 1,915,974 and 1,826,896 shares respectively were exercisable with a weighted average exercise price of $3.94 and $11.27, respectively. EMPLOYEE STOCK PURCHASE PLAN Under the 1998 Purchase Plan, eligible employees are permitted to purchase shares of Common Stock through salary withholding at a price equal to 85% of the lower of the market value of the stock at the beginning or the end of the 6-month offering period, subject to certain limitations. At December 31, 1999, 300,517 shares had been issued under both of the Purchase Plans and 449,483 shares were reserved for further issuance. The weighted average fair value of those purchase rights granted in 1999, 1998 and 1997 was $1.28, $3.73 and $3.52, respectively. The Company's calculations were made using the Black-Scholes option pricing model with the following weighted average assumptions: expected life of one year for all years; expected interest rate of 6.0%, 5.7% and 6.2% for 1999, 1998 and 1997, respectively; expected volatility of 115% in 1999, 75% in 1998 and 65% in 1997; and no dividends during the expected term. ADDITIONAL STOCK PLAN INFORMATION As discussed in Note 1, the Company continues to account for its stock-based awards using the intrinsic value method in accordance with APB No. 25 and its related interpretations. Accordingly, no compensation expense has been recognized in the financial statements for employee stock arrangements. SFAS 123 requires the disclosure of pro forma net income and earnings per share had the Company adopted the fair value method as of the beginning of fiscal 1995. Under SFAS 123, the fair value of stock-based awards to employees is calculated through the use of the minimum value method for all periods prior to the initial public offering, and subsequently through the use of option pricing models, even though such models were developed to estimate the fair value of freely tradable, fully transferable options without vesting restrictions, which significantly differ from the Company's stock option awards. These models also require subjective assumptions, including future stock price volatility and expected time to exercise, which greatly affect the calculated values. The Company's stock option calculations were made using the Black-Scholes option pricing model with the following weighted average assumptions: expected life, 12 months following vesting; stock volatility, 115% 53 in 1999, 75% in 1998 and 65% in 1997; risk-free interest rates, 6.0% in 1999, 5.7% in 1998, and 6.2% in 1997; and no dividends during the expected term. The Company's calculations are based on a multiple option valuation approach and forfeitures are recognized as they occur. If the computed fair values of the stock-based awards (including awards under the Purchase Plan) had been amortized to expense over the vesting period of the awards, pro forma net loss would have been $13,763,000 ($0.81 loss per share) in 1999, $44,673,000 ($3.15 loss per share) in 1998, and $26,815,000 ($2.51 loss per share) in 1997. 10. INCOME TAXES The Company has had losses since inception and therefore has not provided for income taxes. Deferred income taxes reflect the net tax effects of temporary differences between the carrying amount of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes, as well as operating loss and tax credit carryforwards. Significant components of the Company's deferred income tax assets as of December 31, 1999 and 1998 are as follows: December 31, ---------------------- (in thousands) 1999 1998 -------- -------- Net deferred tax assets: Net operating losses ............................. $ -- $ 25,596 Research and development credits ................. -- 1,140 Capitalized research and development costs ....... -- 895 Accruals deductible in different periods ......... 6,160 4,204 Depreciation and amortization .................... 258 (250) -------- -------- 6,418 31,585 Valuation allowance ................................ (6,418) (31,585) -------- -------- Total $ -- $ -- ======== ======== Due to the uncertainty surrounding the realization of the benefits of its favorable tax attributes in future tax returns, the Company has fully reserved its net deferred tax assets as of December 31, 1999 and 1998, respectively. The Tax Reform Act of 1986 and the California Act of 1987 impose restrictions on the utilization of net operating loss and tax credit carryforwards in the event of an "ownership change" as defined by the Internal Revenue Code. The Company's ability to utilize its net operating loss and tax credit carryforwards is subject to limitation pursuant to these restrictions. The Company underwent an ownership change as of the date of the debt restructuring in November, 1999. As a result, the Company lost the potential tax benefits of the net operating loss carryforwards and tax credit carryforwards tha existed at that time. 11. SUBSEQUENT EVENTS In March 2000 the Company entered into a secured revolving line of credit with a new bank based upon eligible accounts receivable. Under the terms of this borrowing arrangement which will expire in March 2001, the Company may borrow up to $2 million. Borrowings will bear interest at the bank's prime rate plus 1.50%. The Company will issue the bank warrants to acquire 100,000 shares of Common Stock at a per share price of $0.30 which may be exercised over a five-year period. 54 In March 2000 the Company was served papers in connection with a patent infringement lawsuit filed against it and one other slot machine manufacturer by International Game Technology, Inc. (IGT). As disclosed in November 1999, IGT is alleging infringement of a patent issued to IGT in September 1999 entitled "Game Machine and Method Using Touch Screen". The Company has not yet responded to the lawsuit and the Company's management denies the assertions of infringement. The Company is presently unable to determine the financial impact, if any, of this litigation. The costs of defending this lawsuit may be substantial and may require significant amounts of senior management time. Any adverse result from such litigation could materially and adversely affect the Company's liquidity and capital resources. No adjustments have been made in the accompanying consolidated financial statements relating to this litigation. In March 2000, a former distributor of the Company's products, filed suit against the Company in the United States District Court for the District of South Carolina. The distributor seeks repayment of $1 million, plus damages, in connection with machines previously shipped to the distributor in 1998. The Company is in the process of arbitration as required by the Distribution Agreement, seeking to recover outstanding receivables from the distributor when it received this lawsuit. The Company is in the preliminary stages of investigating the allegations contained in the suit and has not yet responded to the complaint. 55 INDEPENDENT AUDITORS' REPORT To the Board of Directors and Shareholders of Silicon Gaming, Inc.: We have audited the accompanying consolidated balance sheets of Silicon Gaming, Inc. and subsidiaries as of December 31, 1999 and 1998, and the related consolidated statements of operations, shareholders' equity (deficiency) and cash flows for each of the three years in the period ended December 31, 1999. Our audits also included the consolidated financial statement schedule listed in Item 14(a)2. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Silicon Gaming, Inc. and subsidiaries at December 31, 1999 and 1998, and the results of their operations and their cash flows for each of the years in the period ended December 31, 1999 in conformity with generally accepted accounting principles. The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 1 to the consolidated financial statements, the Company's recurring losses from operations and shareholders' deficiency raise substantial doubt about its ability to continue as a going concern. Management's plans concerning these matters are also described in Note 1. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. /s/ Deloitte & Touche LLP San Jose, California February 15, 2000 (March 22, 2000 as to Note 11) 56 SCHEDULE II VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEARS ENDED DECEMBER 31, (DOLLARS IN THOUSANDS) Additions Balance at charged to Balance at Beginning costs and end of Description of period expenses Deductions period ----------- --------- -------- ---------- ------ YEAR ENDED DECEMBER 31, 1999: Allowance for doubtful accounts $1,650 $ 200 $681 $1,169 YEAR ENDED DECEMBER 31, 1998: Allowance for doubtful accounts $ 50 $1,600 $ -- $1,650 YEAR ENDED DECEMBER 31, 1997: Allowance for doubtful accounts $ -- $ 50 $ -- $ 50 INDEX TO EXHIBITS Exhibit Description - ------- ----------- 3.1 (1) Amended and Restated Articles of Incorporation of the Registrant. 3.2 (2) Bylaws of the Registrant. 4.1 (4) Amendment No. 2 to Securities Purchase Agreement, by and between the Company and B III Capital Partners L.P., a Delaware partnership dated as of September 30, 1997 4.2 (4) Form of Certificate of Determination for Series D Preferred Stock dated as of November 24, 1999 4.3 (4) Form of Certificate of Determination for Series E Preferred Stock dated as of November 24, 1999 4.4 (4) Series E Warrant Agreement dated November 24, 1999 4.5 (4) Securities Purchase Agreement by and between the Company and BIII Capital Partners L.P., a Delaware partnership dated as of November 24, 1999 4.6 (4) Form of Senior Discount Notes due November 24, 2004 dated as of November 24, 1999 10.1 (2) Amended and Restated 1994 Stock Option Plan, as amended. 10.2 (2) Lease Agreement dated September 14, 1995, between the Registrant and Demmon Family Partnership. 10.7 (2) Second Amended and Restated Rights Agreement dated as of March 21, 1996. 10.8 (3) Master Equipment Lease Agreement dated October 6, 1995, between the Registrant and Lighthouse Capital Partners, L.P. 10.10 (2) Side Letter Agreement dated March 21, 1996, between the Registrant and the Interpublic Group of Companies, Inc. 10.11 (2) Side Letter Agreement dated March 21, 1996, between the Registrant and Station Casinos, Inc. 10.15 (2) OEM Master License Agreement dated April 17, 1996, between the Registrant and RSA Data Security, Inc. 10.19 (2) 1996 Employee Stock Purchase Plan. 10.20 (2) 1996 Outside Directors Stock Option Plan. 10.21 (3) Software License Agreement dated June 20, 1996 between the Registrant and Duck Corporation. 10.22 (5) Lease Agreement dated August 14, 1996, between the Registrant and Interactive Technologies, Inc. 10.24 (5) Lease Agreement dated January 23, 1997, between the Registrant and Johnny Ribeiro 10.25 (5) Lease Agreement dated January 23, 1997, between the Registrant and The Ribeiro Corporation 10.26 (6) Lease Agreement dated October 7, 1997 between the Registrant and Battle Born Development, LLC. 10.27 (6) 1997 Nonstatutory Stock Option Plan 10.41 (4) Restructuring Agreement by and between the Registrant and BIII Capital Partners, L.P., a Delaware partnership, dated November 24, 1999 10.42 (4) 1999 Long-Term Compensation Plan 10.43 (4) Stockholders Agreement by and between the Registrant, management stockholders and BIII Capital Partners, L.P., a Delaware partnership, dated November 24, 1999 21.1 Subsidiaries of the registrant. 23.1 Consent of Deloitte & Touche LLP. 27 Financial Data Schedule. - ---------- (1) Incorporated by reference to Exhibit 3.3 to Registrant's Registration Statement on Form S-1 (no.333-4793) which became effective on July 30, 1996 (the "Form S-1"). (2) Incoporated by reference to identically numbered exhibit to Registrant's Registration Statement on Form 10 (No.0-28294) filed with the Commission on April 24, 1996 (the "Form 10"). (3) Incorporated by reference to identically numbered exhibit to the Form S-1. (4) Incoporated by reference to exhibits in the Registrants Form 8-K filed with the Commision on November 24, 1999. (5) Incorporated by reference to identically numbered exhibits to Registrant's Annual Report on Form 10-K for the year ended December 31, 1996. (6) Incorporated by reference to identically numbered exhibits to the Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 1998. EX-21.1 2 SUBSIDIARIES SILICON GAMING, INC. LIST OF SUBSIDIARIES Subsidiary Jurisdiction ---------- ------------ Silicon Gaming-Colorado, Inc. Colorado Silicon Gaming-Louisiana Louisiana Silicon Gaming-Michigan Michigan Silicon Gaming-Minnesota Minnesota Silicon Gaming-Mississippi, Inc. Mississippi Silicon Gaming-Missouri, Inc. Missouri Silicon Gaming-Nevada Nevada Silicon Gaming-New Jersey, Inc. New Jersey Silicon Gaming-Indiana, Inc. Indiana Silicon Gaming-Illinois Illinois Silicon Gaming-Iowa Iowa Silicon Gaming-New Jersey, Inc. New Jersey UBet.com., Inc. Delaware EX-23.1 3 CONSENT OF DELOITTE & TOUCHE LLP INDEPENDENT AUDITORS' CONSENT We consent to the incorporation by reference in Registration Statements (333-30482, 333-92359, 333-80519 and 333-60309) on Form S-8 and Registration Statements (333-69369 and 333-48393) on Form S-3 of our report dated February 15, 2000 (March 22, 2000 as to Note 11) (which expresses an unqualified opinion and includes an explanatory paragraph relating to an uncertainty concerning the Company's ability to continue as a going concern) included in the Annual Report on Form 10-K of Silicon Gaming, Inc. for the year ended December 31, 1999. /s/ DELOITTE & TOUCHE LLP San Jose, California March 29, 2000 EX-27 4 FINANCIAL DATA SCHEDULE
5 1,000 YEAR DEC-31-1999 JAN-01-1999 DEC-31-1999 877 1,000 1,188 1,169 7,331 11,465 11,260 7,465 15,581 5,071 10,428 0 20,000 69,665 (97,026) 15,581 17,115 17,115 13,323 33,661 18 0 7,212 (24,081) 0 (24,081) 0 12,316 0 (11,765) (0.70) (0.70)
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