-----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, FVBwX5kEVgQbc27PFf9AvtT4ftA00wjrrZax0avLqFfJsmXCW/Kv5hI6daQQmDVl g8Wwyfu49c34cBp2QMpuKg== 0000891020-97-001338.txt : 19971103 0000891020-97-001338.hdr.sgml : 19971103 ACCESSION NUMBER: 0000891020-97-001338 CONFORMED SUBMISSION TYPE: S-1/A PUBLIC DOCUMENT COUNT: 8 FILED AS OF DATE: 19971031 SROS: NONE FILER: COMPANY DATA: COMPANY CONFORMED NAME: REALNETWORKS INC CENTRAL INDEX KEY: 0001046327 STANDARD INDUSTRIAL CLASSIFICATION: SERVICES-COMPUTER PROGRAMMING SERVICES [7371] IRS NUMBER: 911628146 STATE OF INCORPORATION: WA FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: S-1/A SEC ACT: SEC FILE NUMBER: 333-36553 FILM NUMBER: 97706096 BUSINESS ADDRESS: STREET 1: 1111 THIRD AVE STREET 2: STE 2900 CITY: SEATTLE STATE: WA ZIP: 98101 BUSINESS PHONE: 2066742700 MAIL ADDRESS: STREET 1: 1111 THIRD AVE STREET 2: STE 2900 CITY: SEATTLE STATE: WA ZIP: 98101 S-1/A 1 AMENDMENT NO. 2 TO FORM S-1 1 AS FILED WITH THE SECURITIES AND EXCHANGE COMMISSION ON OCTOBER 31, 1997 REGISTRATION NO. 333-36553 ================================================================================ SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 ------------------------ AMENDMENT NO. 2 TO FORM S-1 REGISTRATION STATEMENT UNDER THE SECURITIES ACT OF 1933 ------------------------ REALNETWORKS, INC. (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) WASHINGTON 7371 91-1628146 (STATE OR OTHER JURISDICTION OF (PRIMARY STANDARD INDUSTRIAL (I.R.S. EMPLOYER INCORPORATION OR ORGANIZATION) CLASSIFICATION CODE NUMBER) IDENTIFICATION NO.)
1111 THIRD AVENUE, SUITE 2900 SEATTLE, WASHINGTON 98101 (206) 674-2700 (ADDRESS, INCLUDING ZIP CODE, AND TELEPHONE NUMBER, INCLUDING AREA CODE, OF REGISTRANT'S PRINCIPAL EXECUTIVE OFFICES) ------------------------ ROBERT GLASER, CHIEF EXECUTIVE OFFICER 1111 THIRD AVENUE, SUITE 2900 SEATTLE, WASHINGTON 98101 (206) 674-2700 (NAME, ADDRESS, INCLUDING ZIP CODE, AND TELEPHONE NUMBER, INCLUDING AREA CODE, OF AGENT FOR SERVICE) ------------------------ COPIES TO: LAURA T. PUCKETT CHARLES J. KATZ, JR. JOHN M. STEEL SCOTT L. GELBAND ALAN KOSLOW ELIZABETH W. KORRELL GRAHAM & JAMES LLP/RIDDELL WILLIAMS P.S. PERKINS COIE 1001 FOURTH AVENUE PLAZA, SUITE 4500 1201 THIRD AVENUE, 40TH FLOOR SEATTLE, WASHINGTON 98154 SEATTLE, WASHINGTON 98101-3099
------------------------ Approximate date of commencement of proposed sale to public: AS SOON AS PRACTICABLE AFTER THIS REGISTRATION STATEMENT BECOMES EFFECTIVE. If any of the securities being registered on this form are to be offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act of 1933, check the following box: [ ] If this form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, please check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering: [ ] - ------------------ If this form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering: [ ] - ------------------ If this form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering: [ ] - ------------------ If delivery of the prospectus is expected to be made pursuant to Rule 434, please check the following box: [ ] ------------------------ THE REGISTRANT HEREBY AMENDS THIS REGISTRATION STATEMENT ON SUCH DATE OR DATES AS MAY BE NECESSARY TO DELAY ITS EFFECTIVE DATE UNTIL THE REGISTRANT SHALL FILE A FURTHER AMENDMENT WHICH SPECIFICALLY STATES THAT THIS REGISTRATION STATEMENT SHALL THEREAFTER BECOME EFFECTIVE IN ACCORDANCE WITH SECTION 8(A) OF THE SECURITIES ACT OF 1933 OR UNTIL THIS REGISTRATION STATEMENT SHALL BECOME EFFECTIVE ON SUCH DATE AS THE COMMISSION, ACTING PURSUANT TO SAID SECTION 8(A), MAY DETERMINE. ================================================================================ 2 INFORMATION CONTAINED HEREIN IS SUBJECT TO COMPLETION OR AMENDMENT. A REGISTRATION STATEMENT RELATING TO THESE SECURITIES HAS BEEN FILED WITH THE SECURITIES AND EXCHANGE COMMISSION. THESE SECURITIES MAY NOT BE SOLD NOR MAY OFFERS TO BUY BE ACCEPTED PRIOR TO THE TIME THE REGISTRATION STATEMENT BECOMES EFFECTIVE. THIS PROSPECTUS SHALL NOT CONSTITUTE AN OFFER TO SELL OR THE SOLICITATION OF AN OFFER TO BUY NOR SHALL THERE BE ANY SALE OF THESE SECURITIES IN ANY STATE IN WHICH SUCH OFFER, SOLICITATION OR SALE WOULD BE UNLAWFUL PRIOR TO REGISTRATION OR QUALIFICATION UNDER THE SECURITIES LAWS OF ANY SUCH STATE. SUBJECT TO COMPLETION, DATED OCTOBER 31, 1997 3,000,000 SHARES [REALNETWORKS LOGO] REALNETWORKS, INC. (FORMERLY "PROGRESSIVE NETWORKS, INC.") COMMON STOCK (PAR VALUE $.001 PER SHARE) ------------------------ All of the 3,000,000 shares of Common Stock offered hereby are being sold by RealNetworks, Inc. Prior to the offering, there has been no public market for the Common Stock. It is currently estimated that the initial public offering price will be between $9.00 and $11.00 per share. For factors considered in determining the initial public offering price, see "Underwriting". THE COMMON STOCK OFFERED HEREBY INVOLVES A HIGH DEGREE OF RISK. SEE "RISK FACTORS" BEGINNING ON PAGE 6. Application has been made for quotation of the Common Stock on the Nasdaq National Market under the symbol "RNWK". ------------------------ THESE SECURITIES HAVE NOT BEEN APPROVED OR DISAPPROVED BY THE SECURITIES AND EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION NOR HAS THE SECURITIES AND EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION PASSED UPON THE ACCURACY OR ADEQUACY OF THIS PROSPECTUS. ANY REPRESENTATION TO THE CONTRARY IS A CRIMINAL OFFENSE. ------------------------
INITIAL PUBLIC UNDERWRITING PROCEEDS TO OFFERING PRICE(1) DISCOUNT(2) COMPANY(3) ------------------ ------------- ----------- Per Share.......................... $ $ $ Total(4)........................... $ $ $
- --------------- (1) In connection with the offering, the Underwriters have reserved up to 300,000 shares of Common Stock for sale at the initial public offering price to employees and friends of the Company. (2) The Company has agreed to indemnify the Underwriters against certain liabilities, including liabilities under the Securities Act of 1933, as amended. See "Underwriting". (3) Before deducting estimated expenses of $950,000 payable by the Company. (4) The Company has granted the Underwriters an option for 30 days to purchase up to an additional 450,000 shares at the initial public offering price per share, less the underwriting discount, solely to cover over-allotments. If such option is exercised in full, the total initial public offering price, underwriting discount and proceeds to Company will be $ , $ and $ , respectively. See "Underwriting". ------------------------ The shares offered hereby are offered severally by the Underwriters, as specified herein, subject to receipt and acceptance by them and subject to their right to reject any order in whole or in part. It is expected that certificates for the shares will be ready for delivery in New York, New York on or about , 1997, against payment therefor in immediately available funds. GOLDMAN, SACHS & CO. BANCAMERICA ROBERTSON STEPHENS NATIONSBANC MONTGOMERY SECURITIES, INC. ------------------------ The date of this Prospectus is , 1997. 3 [SCREEN-SHOTS OF WEB PAGES SUPERIMPOSED OVER COMPANY LOGO] CERTAIN PERSONS PARTICIPATING IN THE OFFERING MAY ENGAGE IN TRANSACTIONS THAT STABILIZE, MAINTAIN, OR OTHERWISE AFFECT THE PRICE OF THE COMMON STOCK OF THE COMPANY, INCLUDING OVER-ALLOTMENT, STABILIZING AND SHORT-COVERING TRANSACTIONS IN SUCH SECURITIES, AND THE IMPOSITION OF A PENALTY BID, IN CONNECTION WITH THE OFFERING. FOR A DESCRIPTION OF THESE ACTIVITIES, SEE "UNDERWRITING". 2 4 PROSPECTUS SUMMARY The following summary is qualified in its entirety by the more detailed information and Consolidated Financial Statements and Notes thereto appearing elsewhere in this Prospectus, including the information under "Risk Factors." Unless otherwise indicated, all information in this Prospectus (i) assumes that the Underwriters' over-allotment option will not be exercised; (ii) reflects an amendment to the Company's Amended and Restated Articles of Incorporation (the "Articles") to change the Company's authorized capital stock to common stock (the "Common Stock"), nonvoting special common stock (the "Special Common Stock") and preferred stock effective on the closing of the offering; (iii) reflects the conversion of each outstanding share of the Company's Series A Common Stock, Series B Common Stock, Series C Common Stock, Series A Preferred Stock, Series B Preferred Stock, Series C Preferred Stock and Series D Preferred Stock into one share of Common Stock effective on closing of the offering; (iv) reflects the conversion of each outstanding share of the Company's Series E Preferred Stock into one share of Special Common Stock effective on closing of the offering; and (v) assumes the issuance of 998,058 shares of Common Stock, reflecting exercise of outstanding warrants at a weighted average exercise price of $6.97 per share, on closing of the offering, except as noted hereinafter. See "Description of Capital Stock." THE COMPANY RealNetworks, Inc. is a leading provider of branded software products and services that enable the delivery of streaming media content over the Internet and intranets. Streaming technology enables the transmission and playback of continuous "streams" of multimedia content, such as audio and video, over the Internet and intranets and represents a significant advancement over earlier technologies. The Company's products and services include its RealSystem, a streaming media solution that includes RealAudio and RealVideo technology, an electronic commerce Web site designed to promote the proliferation of streaming media products and a network of advertising-supported content aggregation Web sites. The Company believes that the emergence of rich multimedia capabilities, such as streaming audio and video, has significantly enhanced the effectiveness of the Web as a global mass communications medium. These enhanced multimedia capabilities, combined with the unique interactive properties of the Internet, are attracting a large and expanding audience, a growing number of advertisers and an increasing breadth and depth of content and online commercial applications. As the Web continues to evolve as a mass communications medium, the Company believes that certain types of content currently delivered through traditional media, such as radio and television, increasingly will be delivered over the Internet. The Company believes that streaming media technology is essential to this evolution because it provides a more compelling user experience, allowing the Internet to compete more effectively with traditional media for audience share. From its inception, the Company has strategically chosen to offer its RealPlayer software to individual users free of charge to promote the widespread adoption of its client software and to speed the acceptance of Internet multimedia. The Company believes that more than 28 million copies of its RealPlayer software have been downloaded electronically. Over 200,000 copies of its premium client product, RealPlayer Plus, have been sold electronically in its first year of distribution. In addition, the Company believes that more than 100,000 hours per week of live audio and video content are broadcast over the Web using RealAudio and RealVideo technology, and that more than 150,000 Web pages use the Company's software. As a result of these activities and the Company's aggressive promotional programs, the Company believes that its "Real" brand has become one of the most widely recognized brands on the Internet. The Company's customers, including ABC Radio Net, Bloomberg L.P., The Boeing Company, Dow Jones & Company, Inc., NBC Desktop, The News Corporation Limited, Starwave Corporation and 3Com Corporation, use its software products and services to deliver a broad range of streaming audio and video news, sports, entertainment and corporate information over the Internet and intranets. 3 5 The Company's objective is to be the leading streaming media company, providing software and services that enable the delivery of a broad range of multimedia content over the Internet and intranets, thereby facilitating the evolution of the Internet into a mass communications and commerce medium. The key elements of this strategy include the extension of the Company's technology leadership, a continued focus on product ubiquity and brand leadership, the continued development of its electronic commerce and content aggregation businesses, a focus on providing cross-platform product solutions that operate in a wide variety of bandwidth environments, and the strengthening and expansion of strategic relationships. The Company was incorporated in Washington in February 1994, and therefore has a limited operating history. Unless the context otherwise requires, the term "Company" or "RealNetworks" refers to RealNetworks, Inc. and its subsidiaries: RealNetworks, SARL, RealNetworks, Limited and RealNetworks Kabushiki Kaisha. Prior to September 26, 1997, the Company's name was "Progressive Networks, Inc." The Company's principal executive offices are located at 1111 Third Avenue, Suite 2900, Seattle, Washington 98101, and its telephone number is (206) 674-2700. Information contained on the Company's Web sites will not be deemed to be part of this Prospectus. RealSystem(TM), RealAudio(R), RealVideo(R), RealPlayer(TM), RealPlayer Plus(TM), RealPublisher(TM), RealServer(TM), RealEncoder(TM), Basic Server(TM), RealNetworks(TM), Real(TM), the Real logo, RealStore(TM), Film.com(TM), Daily Briefing(TM) and Timecast(TM) are registered and unregistered trademarks, service marks and trade names of the Company. This Prospectus also includes trademarks, service marks and trade names other than those identified in this paragraph, all of which are the property of their respective holders. THE OFFERING Common Stock offered by the Company........... 3,000,000 shares Common stock to be outstanding after the offering: Common Stock................................ 27,626,705 shares(1) Special Common Stock........................ 3,338,374 shares(1) Use of proceeds............................... Working capital requirements and other general corporate purposes. See "Use of Proceeds." Proposed Nasdaq National Market symbol........ "RNWK"
- --------------- (1) Excludes (i) 6,390,014 shares of Common Stock issuable at a weighted average exercise price of $1.80 per share upon exercise of stock options outstanding at October 9, 1997, (ii) 4,446,992 shares of Common Stock reserved for future issuance under the Company's stock option plans and (iii) 1,000,000 shares of Common Stock reserved for issuance under the 1998 Employee Stock Purchase Plan. See "Management -- Benefit Plans." Also excludes up to 3,709,305 shares of Special Common Stock issuable on exercise of a warrant to purchase Series E Preferred Stock at an exercise price of $13.48 per share (the "Series E Warrant") that terminates on the closing of the offering. See "Description of Capital Stock." 4 6 SUMMARY CONSOLIDATED FINANCIAL DATA The following summary consolidated financial data should be read in conjunction with the Company's Consolidated Financial Statements and Notes thereto and "Management's Discussion and Analysis of Financial Condition and Results of Operations," included elsewhere in this Prospectus. The summary consolidated financial data for the period from February 9, 1994 (inception) to December 31, 1994, for the years ended December 31, 1995 and 1996, and for the nine months ended September 30, 1997, and as of December 31, 1996 and September 30, 1997, are derived from the Consolidated Financial Statements of the Company audited by KPMG Peat Marwick LLP, independent accountants. The summary consolidated financial data for the nine months ended September 30, 1996 are derived from unaudited consolidated financial statements prepared by the Company on a basis consistent with the Company's audited Consolidated Financial Statements and, in the opinion of management, include all adjustments, consisting only of normal recurring accruals, necessary for a fair presentation of the results for such periods. Operating results for the nine months ended September 30, 1997 are not necessarily indicative of the results that may be expected for any other interim period or for the year ending December 31, 1997.
PERIOD FROM FEBRUARY 9, 1994 YEAR ENDED NINE MONTHS ENDED (INCEPTION) TO DECEMBER 31, SEPTEMBER 30, DECEMBER 31, ------------------- ------------------- 1994 1995 1996 1996 1997 ---------------- ------- ------- ------- ------- (IN THOUSANDS, EXCEPT PER SHARE DATA) STATEMENT OF OPERATIONS DATA: Total net revenues................... $ -- $ 1,812 $14,012 $ 8,274 $22,417 Total cost of revenues............... -- 62 2,185 969 4,609 Gross profit......................... -- 1,750 11,827 7,305 17,808 Operating loss....................... (545) (1,595) (4,016) (2,475) (9,759) Net loss............................. (545) (1,501) (3,789) (2,315) (8,575) Pro forma net loss per share(1)...... $ (0.14) $ (0.32) Shares used to compute pro forma net 27,779 28,315 loss per share(1)..................
SEPTEMBER 30, 1997 DECEMBER 31, -------------------------- 1996 ACTUAL AS ADJUSTED(2) ------------ ------- -------------- (IN THOUSANDS) BALANCE SHEET DATA: Cash, cash equivalents and short-term investments..... $ 19,595 $67,648 $101,554 Working capital....................................... 16,893 50,762 84,668 Total assets.......................................... 26,468 84,372 118,278 Redeemable, convertible preferred stock............... 23,153 49,278 -- Shareholders' equity (deficit)........................ (3,320) (8,089) 75,095
- --------------- (1) For an explanation of pro forma net loss per share and the number of shares used to compute pro forma net loss per share, see Note 1 of Notes to Consolidated Financial Statements. (2) As adjusted to give effect to the (i) conversion of all outstanding shares of Series A Common Stock, Series B Common Stock, Series C Common Stock, Series A Preferred Stock, Series B Preferred Stock, Series C Preferred Stock and Series D Preferred Stock into Common Stock and Series E Preferred Stock into Special Common Stock, in each case on closing of the offering; (ii) sale by the Company of the 3,000,000 shares of Common Stock offered hereby at an assumed initial public offering price of $10.00 per share (after deducting the underwriting discount and estimated expenses of the offering); (iii) application of the estimated net proceeds of the offering; and (iv) issuance of 998,058 shares of Common Stock issuable upon exercise of outstanding warrants at an average exercise price of $6.97 per share (for an aggregate of $6,956,000). Excludes up to 3,709,305 shares of Special Common Stock (representing additional cash and shareholders' equity of up to $50,001,431) issuable on exercise of the Series E Warrant. See "Use of Proceeds," "Capitalization" and "Description of Capital Stock." 5 7 RISK FACTORS In addition to the other information contained in this Prospectus, investors should consider carefully the following risk factors before making an investment decision concerning the Common Stock. This Prospectus contains forward-looking statements that involve risks and uncertainties. The Company's actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors, including those set forth in this "Risk Factors" section and elsewhere in this Prospectus. LIMITED OPERATING HISTORY; ACCUMULATED DEFICIT AND ANTICIPATED FUTURE LOSSES The Company was incorporated in February 1994 and did not recognize any revenue until July 1995, when the Company began delivery of the commercial version of RealAudio Version 1.0. Accordingly, the Company has a limited operating history on which an evaluation of the Company and its prospects can be based. The Company's prospects must be considered in light of the risks, expenses and difficulties frequently encountered by companies in early stages of development, particularly companies in rapidly evolving markets such as media delivery and electronic commerce over the Internet and intranets. The Company has incurred significant losses since its inception and expects to continue to incur substantial operating losses for the foreseeable future. As of September 30, 1997, the Company had an accumulated deficit of $14.8 million. As a result of taxable income generated from a license agreement with Microsoft Corporation ("Microsoft"), the Company has recognized deferred tax assets to the extent of its accrued taxes. The Company believes it is more likely than not that its net deferred tax assets as of September 30, 1997 will be realized through the reversal of temporary differences in 1998 and 1999. To achieve and sustain profitability, the Company must, among other things, establish widespread market acceptance of its existing products and services, successfully develop new products and services, respond quickly and effectively to competitive, market and technological developments, expand sales and marketing operations, broaden customer support capabilities, control expenses and continue to attract, train and retain qualified personnel. In addition, market prices for the Company's products must attain a level at which the Company can generate revenues in excess of its anticipated operating and other expenses. There can be no assurance that the Company will achieve or sustain profitability. See "-- Unpredictability of Future Revenues; Potential Fluctuation in Quarterly Operating Results," "-- Competition; Relationship With Microsoft" and "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Overview." UNPREDICTABILITY OF FUTURE REVENUES; POTENTIAL FLUCTUATION IN QUARTERLY OPERATING RESULTS As a result of the Company's limited operating history and the emerging nature of the markets in which it competes, the Company is unable to forecast its revenues accurately. The Company expects to experience significant fluctuations in its future quarterly operating results due to a variety of factors, many of which are outside the Company's control, including (i) demand for the Company's products and services, (ii) introduction or enhancement of products and services by the Company and its competitors, (iii) market acceptance of new products and services of the Company and its competitors, (iv) price reductions by the Company or its competitors or changes in how products and services are priced (such as the Company's recent decision to offer for download free of charge a version of its Basic Server, which previously sold for $295 to $995), (v) the mix of products and services sold by the Company and its competitors, (vi) the mix of distribution channels through which the Company's products are licensed and sold, (vii) the mix of international and U.S. revenues, (viii) costs of litigation and intellectual property protection, (ix) growth in the use of the Internet, (x) the Company's ability to attract, train and retain qualified personnel, (xi) the amount and timing of operating costs and capital expenditures related to expansion of the Company's business, operations and infrastructure, (xii) technical difficulties with respect to the use of the Company's products, (xiii) governmental regulations and (xiv) general economic conditions and economic conditions specifically related to the Internet. It often is difficult to forecast the effect such factors, or any combination thereof, would have on the Company's results of operations for any given fiscal quarter. There can be no assurance that the Company will be able to 6 8 achieve historical revenue levels or maintain its historical growth rate. The Company has used, and expects to continue to use, price promotions to increase trial, purchase and use of its products, as well as to increase the overall recognition of its brands. The effect of such promotions on revenues in a particular period may be significant and extremely difficult to forecast. Based on the foregoing, the Company believes that its quarterly revenues, expenses and operating results could vary significantly in the future, and that period-to-period comparisons should not be relied on as indications of future performance. Historically, the Company has received a significant portion of its revenues from a limited number of sales and license agreements. The Company believes that a customer's decision to purchase its server products or license its technology is relatively discretionary and, for large-scale users, generally involves a significant commitment of capital resources. Therefore, any downturn in the economy or in the business of potential customers could have a material adverse effect on the Company's revenues and quarterly results of operations. The Company generally distributes its software products in "beta" form to the public prior to finalizing product features, functionality and operability. This may cause certain customers to delay purchasing decisions until commercial versions of the products are available, which could have a material adverse effect on the Company's revenues and quarterly results of operations. The Company derives a significant portion of its revenues from the sale of technical support services and software upgrades to its installed customer base. There can be no assurance that a sufficient number of the Company's customers will continue to enter into support and upgrade contracts or will renew existing support and upgrade contracts, or that revenues therefrom will continue to be significant. The loss of a material portion of such revenues would likely have a material adverse effect on the Company's business, financial condition and results of operations. Management has observed that revenues from advertising sales have tended to be higher in the second and fourth quarters, and retail sales have tended to be highest in the fourth quarter. The Company typically operates with no backlog. As a result, quarterly sales and operating results depend primarily on the volume and timing of orders received in the quarter, both of which are difficult to forecast. The Company typically recognizes a substantial portion of its revenues in the last month of each quarter. As a result of its limited operating history, the Company does not have relevant historical financial data for a significant number of periods on which to base planned operating expenses. The Company's expense levels are based in part on its expectations with regard to future revenues, which also are difficult to forecast. The Company may be unable to adjust spending in a timely manner to compensate for any unexpected revenue shortfall. As a result, any significant shortfall in demand for the Company's products and services relative to the Company's expectations would have an immediate material adverse effect on the Company's business, financial condition and results of operations. Due to the foregoing factors, it is likely that in some future quarters the Company's operating results will fall below the expectations of securities analysts and investors, which would likely have a material adverse effect on the trading price of the Common Stock. See "Management's Discussion and Analysis of Financial Condition and Results of Operations." COMPETITION; RELATIONSHIP WITH MICROSOFT The market for software and services for the Internet and intranets is relatively new, constantly evolving and intensely competitive. The Company expects that competition will intensify in the future. Many of the Company's current and potential competitors have longer operating histories, greater name recognition and significantly greater financial, technical and marketing resources than the Company. The Company engages primarily in the sale and licensing of audio and video streaming products and services, electronic commerce and Internet advertising. The Company's principal competitors in the development and distribution of audio and video streaming solutions include Microsoft, VXtreme, Inc. ("VXtreme"), VDOnet Corporation ("VDOnet"), Xing Technology Corporation ("Xing"), Precept Software, Inc. ("Precept"), Cubic VideoComm, Inc. ("Cubic"), Motorola, Inc. ("Motorola"), Vivo 7 9 Software, Inc. ("Vivo"), Vosaic LLC ("Vosaic") and Oracle Corporation ("Oracle"). The Company's RealSystem also competes to a lesser degree with non-streaming audio and video delivery technologies such as AVI and Quicktime, and indirectly with delivery systems for multimedia content other than audio and video, such as Flash by Macromedia Inc. ("Macromedia") and Enliven by Narrative Communications Corp. ("Narrative"). Competitive factors in this market include the quality and reliability of software; features for creating, editing and adapting content; ease of use and interactive user features; scaleability and cost per user; and compatibility with the user's existing network components and software systems. To expand its user base and further enhance the user experience, the Company must continue to innovate and improve the performance of its RealSystem. The Company is committed to the continued market penetration of its brand, products and services, which, as a strategic response to changes in the competitive environment, may require pricing, licensing, service or marketing changes intended to extend its current brand and technology franchise. For example, the Company recently made its Basic Server, which had previously sold for $295 to $995, available for download free of charge. Continued price concessions or the emergence of other pricing or distribution strategies by competitors may have a material adverse effect on the Company's business, financial condition and results of operations. See "Business -- Competition." The Company derives significant revenues from sales of RealPlayer Plus, an enhanced version of its free RealPlayer product. The Company's ability to continue to generate revenues from sales of RealPlayer Plus is in large part dependent on its ability to differentiate the features and functionality of RealPlayer Plus from its own and competitors' free and for sale player products. In addition, the demand for RealPlayer Plus is in part contingent on the demand for and the volume of free player products in the market. The Company's failure to continue to differentiate RealPlayer Plus, or to stimulate demand for its free player or RealPlayer Plus, may have a material adverse effect on the Company's business, financial condition and results of operations. See "Business -- Products and Services." The Company anticipates that the consolidation that has occurred in the streaming media industry and related industries, such as computer software, media and communications, will continue. Consequently, competitors may be acquired by, receive investments from, or enter into other commercial relationships with, larger, well-established and well-financed companies. For instance, Microsoft recently acquired VXtreme, a direct competitor of the Company in the market for streaming media software. Microsoft also owns a minority interest in VDOnet, a direct competitor of the Company in the market for streaming video software. In addition, in June 1997 the Company and Microsoft entered into a strategic agreement pursuant to which Microsoft purchased a minority interest in the Company. See "-- Department of Justice Subpoena," "Business -- Microsoft Relationship" and "Certain Transactions -- Microsoft Corporation." In connection with the Microsoft agreement, the Company granted Microsoft a nonexclusive license to certain substantial elements of the source code of the Company's RealAudio/RealVideo Version 4.0 technology included in its basic RealPlayer and substantial elements of its EasyStart Server (currently known as the Basic Server), and related Company trademarks. Under the agreement, Microsoft may sublicense its rights to the licensed technology to third parties under certain circumstances. On two occasions during the first two years following delivery under the agreement, Microsoft may acquire for $25 million and $35 million, respectively, a nonexclusive license to subsequently developed versions of the core audio and video technology, which currently is distributed to end-users at no charge. Under prescribed circumstances that are solely within the Company's control, the agreement provides for a full refund of each license fee during the first year, declining to 0% over the following two years. The Company may not assign its obligations under the agreement without Microsoft's consent, and a merger, the sale of substantially all of the Company's assets and certain other events will be deemed to be an assignment under the agreement. Microsoft is obligated to distribute the Company's RealPlayer Version 4.0 for a defined term as long as the Company's player supports certain Microsoft architectures. The Company also agreed to work with Microsoft and several other companies to author and promote the Active Streaming Format ("ASF") as a standard file format for streaming media. The agreement also requires the Company to provide Microsoft with engineering consultation services, certain error correc- 8 10 tions and certain technical support over a defined term. As a result of Microsoft's agreement with the Company, its acquisition of VXtreme and its investment in VDOnet, Microsoft will be able to augment substantially the functionality of NetShow, its streaming media product, which could have a material adverse effect on the competitiveness of the Company's products. See "-- Impact of Evolving Standards," "-- Uncertain Protection of Intellectual Property; Risks Associated With Licensed Third-Party Technology" and "Business -- Microsoft Relationship." Microsoft currently competes with the Company in the market for streaming media server and player software. The Company believes that Microsoft will compete more directly with the Company in the future. The Company also believes that Microsoft's commitment to and presence in the streaming media industry will dramatically increase competitive pressure in the overall market for streaming media software, leading to, among other things, increased pricing pressure and longer sales cycles. Such pressures may result in further price reductions in the Company's products and may also materially reduce the Company's market share. The Company believes that Microsoft will incorporate streaming media technology in its Web browser software and certain of its server software offerings, possibly at no additional cost to the user. In addition, notwithstanding the Company's cooperation with Microsoft regarding ASF, Microsoft may promote technologies and standards not compatible with the Company's technology. Microsoft has a longer operating history, a larger installed base of customers and dramatically greater financial, distribution, marketing and technical resources than the Company. As a result, there can be no assurance that the Company will be able to compete effectively with Microsoft now or in the future, or that the Company's business, financial condition and results of operations will not be materially adversely affected by increased competition in the streaming media industry. In addition, if considerable industry consolidation occurs, there can be no assurance that the Company will be able to compete effectively. See "Business -- Sales, Marketing and Distribution" and "-- Microsoft Relationship." The Company currently derives significant revenues from the electronic distribution of certain of its products. The Company recently opened its RealStore Web site, an online store for the sale of the Company's products, third-party streaming media tools and utilities, and intranet-based training products. The Company competes with a variety of Web sites, such as Buydirect.Com and Software.Net, which also offer software products for download. To compete successfully in the electronic commerce market, the Company must attract sufficient commercial traffic to its RealStore Web site by offering high-quality, competitively priced merchandise in a compelling, easy-to-purchase format. There can be no assurance that the Company will be able to compete successfully in this market, and any failure to do so could have a material adverse effect on the Company's business, financial condition and results of operations. See "Business -- Products and Services" and "-- Competition." In the Internet advertising segment, the Company competes for Internet advertising revenues with a wide variety of Web sites and Internet service providers. While Internet advertising revenues across the industry continue to grow, the number of Web sites competing for such revenue also is growing rapidly. The Company's advertising sales force and infrastructure are still in early stages of development relative to the Company's competitors. There can be no assurance that advertisers will place advertising with the Company or that revenues derived from such advertising will be material. In addition, if the Company loses advertising customers, fails to attract new customers, is forced to reduce advertising rates or otherwise modify its rate structure to retain or attract customers, or loses Web site traffic, the Company's business, financial condition and results of operations may be materially adversely affected. See "Business -- Products and Services" and "-- Competition." DEPARTMENT OF JUSTICE SUBPOENA Shortly after the Company entered into the license agreement with Microsoft, Microsoft acquired VXtreme and announced that it would incorporate VXtreme technology, which competes with the Company's technology licensed to Microsoft, into its NetShow product. In addition, Microsoft owns a minority interest in VDOnet, a direct competitor of the Company, and has selected VDOnet as a Microsoft Solution Provider for NetShow-based products. Microsoft's acquisitions, investments and agreements in 9 11 the streaming media industry prompted a U.S. Department of Justice investigation into horizontal merger activities within the industry. In August 1997, the Department of Justice served several companies, including the Company and Microsoft, with subpoenas to produce certain documents. The investigation, including interviews of Company officers by Department of Justice personnel and document production requests, is ongoing. The Company is cooperating fully with the Department of Justice's investigation. See "-- Competition; Relationship With Microsoft" and "Business -- Microsoft Relationship" and "-- Legal Proceedings." As a result of the investigation, it is possible that the Department of Justice will require certain actions by the Company, Microsoft or other companies in the streaming media industry that could have a material adverse effect on the Company's business, financial condition and results of operations. The Department of Justice could decide to take actions that could materially and adversely affect the Company's current relationship with Microsoft or other companies, affect Microsoft's obligations with respect to the distribution of the Company's products, result in certain penalties, require the Company to refund all or a portion of the license fee paid by Microsoft to the Company, require Microsoft to limit or divest certain of its acquisitions or investments in the streaming media industry, including its investment in the Company, and, if Microsoft were forced to rescind its agreement with the Company, place the Company at a significant competitive disadvantage within the industry. There can be no assurance that any such outcome would not have an immediate material adverse effect on the Company's business, financial condition and results of operations. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Liquidity and Capital Resources." DEVELOPING MARKET; DEPENDENCE ON THE INTERNET AND INTRANETS AS MEDIUMS OF COMMERCE AND COMMUNICATIONS The market for the Company's streaming media products and services, especially the market for the Company's intranet products and services, has begun only recently to develop and is evolving rapidly, with continuing new developments in technology, product distribution methods and marketing and licensing relationships. The development of a market for the Company's streaming media products also depends on increased use of the Internet and intranets for information, publication, distribution and commerce. Continued growth in the use of the Internet may depend on potential increases in available bandwidth or transmission speeds or on other technological improvements. In particular, the Company believes that continued growth in market acceptance of streaming media, especially streaming video, depends on such developments. Changes in network infrastructure, transmission and content delivery methods and underlying software platforms, and the emergence of new Internet access devices, such as TV set-top boxes, could dramatically change the structure and competitive dynamic of the market for streaming media solutions. In particular, technological developments or strategic partnerships that accelerate the adoption of "high bandwidth" access technologies such as cable modems may have a material adverse effect on the Company's business. Critical issues concerning use of the Internet and intranets (including security, reliability, cost, ease of use and quality of service) remain unresolved and may affect the growth of and the degree to which business is conducted over the Internet and intranets. If the market for the Company's products and services fails to grow, develops more slowly than expected or becomes saturated with competing products or services, the Company's business, financial condition and results of operations will be materially adversely affected. See "-- Availability and Quality of Content" and "-- Online Commerce Security Risks." Because electronic commerce over the Internet is relatively new and evolving, it is difficult to predict whether the Internet will be a viable commercial marketplace or whether the Internet or intranets will be viable mediums of communication. Sales of the Company's products will continue to depend in large part on the emergence of the Internet as a viable commercial marketplace with a strong and reliable infrastructure. The Internet has experienced substantial growth in the number of users and amount of traffic, and there can be no assurance that its technological infrastructure will be able to support the demands placed on it by continued growth. Delays in the development or adoption of new technological standards and protocols, or increased governmental regulation, could also affect the degree of use of the 10 12 Internet. In addition, developments in Internet infrastructure such as broadband Internet access may significantly affect the market for streaming media products. There can be no assurance that the infrastructure or complementary services necessary to make the Internet a viable commercial medium will be developed or, if developed, that the Internet will become a viable commercial medium for products and services such as those offered by the Company. See "Business -- Industry Background." EVOLVING BUSINESS MODEL; DEVELOPMENT OF NEW PRODUCTS AND OTHER REVENUE SOURCES The Company's success depends in part on its ability to develop new products in a timely manner and provide new services that achieve rapid and broad market acceptance. There can be no assurance that the Company can identify new product and service opportunities successfully and develop and bring to market new products and services in a timely manner or that any such product innovations will achieve the market penetration or price stability necessary for profitability. As the online medium continues to evolve, the Company plans to leverage its technology by developing complementary products and services as additional sources of revenue. Accordingly, the Company may change its business model to take advantage of new business opportunities, including business areas in which the Company does not have extensive experience. For example, the Company recently focused on, and will continue to devote significant resources to, the development of its electronic commerce business, as well as its advertising-supported content aggregation business, as extensions of its business model. There can be no assurance that the Company will develop these or other business models successfully. In addition, the Company must continue to innovate and develop new versions of its software to remain competitive in the market for streaming media solutions. The Company's product and software development efforts inherently are difficult to manage and keep on schedule. The Company on occasion has experienced development delays and related cost overruns, and there can be no assurance that it will not encounter such problems in the future. In addition, products as complex as those offered by the Company may contain undetected errors when first introduced or when new versions are released. There can be no assurance that errors will not occur in current or new products, the result of which may be adverse publicity, loss of or delay in market acceptance, or claims by customers against the Company, any of which could have a material adverse effect on the Company's business, financial condition and results of operations. Expansion of the Company's operations to take advantage of new opportunities and to sustain a leadership position in the market for streaming media software may require significant additional expenditures and may strain the Company's management, financial and operational resources. A lack of market acceptance of new products or services or the Company's inability to generate satisfactory revenues from such new products and services to offset their cost could have a material adverse effect on the Company's business, financial condition and results of operations. "Business -- Strategy." DEPENDENCE ON KEY PERSONNEL; NEED FOR ADDITIONAL PERSONNEL The Company's performance depends substantially on the continued services of its executive officers and key employees, and in particular on Mr. Glaser, the Company's Chairman of the Board and Chief Executive Officer. The loss of the services of Mr. Glaser or any of its other executive officers or key employees could have a material adverse effect on the Company's business, financial condition and results of operations. None of the Company's executive officers has a contract that guarantees employment. Other than a $2,000,000 insurance policy on the life of Mr. Glaser, the Company does not maintain "key person" life insurance policies. Given the Company's early stage of development, the Company depends on its ability to attract, train and retain qualified personnel, specifically those with management, technical and product development skills. Competition for such personnel is intense, particularly in geographic areas recognized as high technology centers such as the Pacific Northwest. There can be no assurance that the Company will be able to attract, train or retain additional highly 11 13 qualified technical and managerial personnel in the future, which failure could have a material adverse effect on the Company's business, financial condition and results of operations. See "Management." CONTROL BY MR. GLASER; ANTITAKEOVER PROVISIONS Immediately after the closing of the offering, Mr. Glaser, the Company's founder, will own of record 14,089,919 shares of the outstanding Common Stock, which will represent approximately 51.0% of the outstanding voting rights (approximately 50.2% if the Underwriters' over-allotment option is exercised in full). Following the closing of the offering, Mr. Glaser intends to donate approximately 700,000 shares of Common Stock to various charitable organizations. Mr. Glaser will have significant influence over the election of directors and other matters submitted to a vote of the Company's shareholders. Control by Mr. Glaser may discourage certain types of transactions involving an actual or potential change of control of the Company, including transactions in which the holders of Common Stock might receive a premium for their shares over prevailing market prices. See "Principal Shareholders." The Articles provide that on closing of the offering, a Strategic Transactions Committee of the Board of Directors shall be created, which Committee shall be comprised of three directors. Without the prior approval of such Committee, and subject to certain limited exceptions, the Board of Directors will not have the authority to (i) adopt a plan of merger, (ii) authorize the sale, lease, exchange or mortgage of (A) assets representing more than 50% of the book value of the Company's assets prior to the transaction or (B) any other asset or assets on which the long-term business strategy of the Company is substantially dependent, (iii) authorize the Company's voluntary dissolution or (iv) take any action that has the effect of clauses (i) through (iii). In connection therewith, the Company entered into an agreement (the "Strategic Transactions Agreement") providing Mr. Glaser with a direct contractual right to require the Company to abide by and perform all terms of the Articles with respect to the Strategic Transactions Committee. The Strategic Transactions Agreement also provides that so long as Mr. Glaser owns a specified number of shares, the Company shall use its best efforts to cause him to be nominated to, elected to, and not removed from, the Board of Directors. In addition, the Articles provide that on closing of the offering, Mr. Glaser shall serve, or shall appoint another officer of the Company to serve, as the Company's Policy Ombudsman, with the exclusive authority to adopt or change the editorial policies of the Company as reflected on the Company's Web sites or other communications or media in which the Company has a significant editorial or media voice. The provisions with respect to the authority of the Strategic Transactions Committee and the Policy Ombudsman may be amended only with the approval of 90% of the shares entitled to vote on an amendment to the Articles. The foregoing provisions, as well as those relating to a classified Board of Directors, the availability of "blank check" preferred stock and certain provisions of Washington corporate law, the Microsoft agreement and the shareholder rights plan that the Company intends to adopt prior to closing of the offering, could have the effect of making it more difficult or more expensive for a third party to acquire, or of discouraging a third party from attempting to acquire, control of the Company. These provisions may also have the effect of limiting the price that investors might be willing to pay in the future for the Common Stock. See "Management" and "Description of Capital Stock." UNCERTAIN PROTECTION OF INTELLECTUAL PROPERTY; RISKS ASSOCIATED WITH LICENSED THIRD-PARTY TECHNOLOGY The Company's success depends in part on its ability to protect its proprietary software and other intellectual property. To protect its proprietary rights, the Company relies generally on patent, copyright, trademark and trade secret laws, confidentiality agreements with employees and third parties, and license agreements with consultants, vendors and customers, although the Company has not signed such agreements in every case. Despite such protections, a third party could, without authorization, copy or otherwise obtain and use the Company's products or technology, or develop similar technology. There can be no assurance that the Company's agreements with employees, consultants and others who participate in product development activities will not be breached, that the Company will have adequate 12 14 remedies for any breach, or that the Company's trade secrets will not otherwise become known or independently developed by competitors. The Company currently has two patents pending in the U.S. relating to its product architecture and technology and holds one patent entitled "Method and Apparatus for Recommending Selections Based on Preferences in a Multi-User System." There can be no assurance that any pending or future patent applications will be granted, that any existing or future patent will not be challenged, invalidated or circumvented, or that the rights granted under any patent that has issued or may issue will provide competitive advantages to the Company. Many of the Company's current and potential competitors dedicate substantially greater resources to protection and enforcement of intellectual property rights, especially patents. If a blocking patent has issued or issues in the future, the Company would need to either obtain a license or design around the patent. There can be no assurance that the Company would be able to obtain such a license on acceptable terms, if at all, or to design around the patent. The Company pursues the registration of certain of its trademarks and service marks in the U.S. and in certain other countries, although it has not secured registration of all its marks. A significant portion of the Company's marks begin with the word "Real" (such as RealSystem, RealAudio and RealVideo). The Company is aware of other companies that use "Real" in their marks alone or in combination with other words, and the Company does not expect to be able to prevent all third-party uses of the word "Real" for all goods and services. In addition, the laws of some foreign countries do not protect the Company's proprietary rights to the same extent as do the laws of the U.S., and effective patent, copyright, trademark and trade secret protection may not be available in such jurisdictions. The Company licenses certain of its proprietary rights to third parties, and there can be no assurance that such licensees will abide by compliance and quality control guidelines with respect to such proprietary rights or that such licensees will not take actions that would materially adversely affect the Company's business, financial condition and results of operations. To license many of its products, the Company relies in part on "shrinkwrap" and "clickwrap" licenses that are not signed by the end user and, therefore, may be unenforceable under the laws of certain jurisdictions. As with other software products, the Company's products are susceptible to unauthorized copying and uses that may go undetected, and policing such unauthorized use is difficult. In general, there can be no assurance that the Company's efforts to protect its intellectual property rights through patent, copyright, trademark and trade secret laws will be effective to prevent misappropriation of its technology, or to prevent the development and design by others of products or technologies similar to or competitive with those developed by the Company, and the Company's failure or inability to protect its proprietary rights could materially adversely affect its business, financial condition and results of operations. The computer software market is characterized by frequent and substantial intellectual property litigation that often is complex and expensive, and involves a significant diversion of resources and uncertainty of outcome. In the future, the Company may need to pursue litigation to enforce and protect its intellectual property and trade secrets or to defend against a claim of infringement or invalidity. The Company has been and expects to continue to be subject to legal proceedings and claims from time to time in the ordinary course of its business, including claims of alleged infringement of third-party proprietary rights by the Company and its licensees. The Company attempts to avoid infringing known proprietary rights of third parties in its product development efforts. However, the Company has not conducted and does not conduct comprehensive patent searches to determine whether the technology used in its products infringes patents held by third parties. In addition, it is difficult to proceed with certainty in a rapidly evolving technological environment in which there may be numerous patent applications pending, many of which are confidential when filed, with regard to similar technologies. If the Company were to discover that its products violate third-party proprietary rights, there can be no assurance that it would be able to obtain licenses to continue offering such products without substantial reengineering or that any effort to undertake such reengineering would be successful, that any such licenses would be available on commercially reasonable terms, if at all, or that litigation regarding alleged infringement could be avoided or settled without substantial expense and damage awards. Any claims 13 15 against the Company relating to the infringement of third-party proprietary rights, even if not meritorious, could result in the expenditure of significant financial and managerial resources and in injunctions preventing the Company from distributing certain products. Such claims could materially adversely affect the Company's business, financial condition and results of operations. The Company also relies on certain technology that it licenses from third parties, including software that is integrated with the Company's internally developed software and used in the Company's products, to perform key functions. There can be no assurance that such third-party technology licenses will continue to be available to the Company on commercially reasonable terms. The loss of any of these technologies could have a material adverse effect on the Company's business, financial condition and results of operations. Moreover, although the Company is generally indemnified against claims that such third-party technology infringes the proprietary rights of others, such indemnification is not always available for all types of intellectual property rights (for example, patents may be excluded), and in some cases the scope of such indemnification is limited. Even if the Company receives broad indemnification, third-party indemnitors are not always well capitalized and may not be able to indemnify the Company in the event of infringement, resulting in substantial exposure to the Company. There can be no assurance that infringement or invalidity claims arising from the incorporation of third-party technology, and claims for indemnification from the Company's customers resulting from such claims, will not be asserted or prosecuted against the Company. Such claims, even if not meritorious, could result in the expenditure of significant financial and managerial resources in addition to potential product redevelopment costs and delays, all of which could materially adversely affect the Company's business, financial condition and results of operations. See "Business -- Intellectual Property." AVAILABILITY AND QUALITY OF CONTENT The availability of compelling content for the Internet and intranets is critical to the continued and increasing use and sales of the Company's RealSystem software. The willingness of content providers to offer and license content that appeals to end users and attracts advertisers is an important factor in promoting the continued and increasing use of the Company's products and services. There can be no assurance that such content will continue to be available on acceptable terms, if at all. Historically, the Company has recognized increased revenues from sales of RealPlayer Plus in months in which the Company bundled compelling content with its products. If the Company were unable to bundle compelling content with its products, license desirable content on favorable terms, or otherwise offer content that is widely accepted by a broad market audience, the Company's business, financial condition and results of operations would likely be materially adversely affected. It is possible that associations that represent collectives of content owners will seek to and successfully establish minimum royalties or other conditions that apply to the licensing or distribution of content over the Internet, which may limit the availability of such content or increase the cost to the Company to use such content. The imposition of any such mandatory royalty payments may increase the Company's cost of revenues significantly, which would have a material adverse effect on the Company's business, financial condition and results of operations. See "Business -- Products and Services -- Media Publishing Products and Services." MANAGEMENT OF GROWTH; ACQUISITION RISKS The Company's rapid growth has placed, and is expected to continue to place, a significant strain on the Company's managerial, technical, operational and financial resources. None of the Company's executive officers has had senior management experience in a public company in the position he or she currently holds. From September 30, 1996 to September 30, 1997, the Company grew from 157 employees to 297 employees, which rapid growth the Company expects to continue for the foreseeable future. To manage its growth, the Company must implement and improve its operational and financial systems and expand, train and manage its workforce. The Company will also need to manage an increasing number of complex relationships with customers, marketing partners and other third parties. In addition, the Company may pursue the acquisition of new or complementary businesses, products or technologies, although it has no present understandings, commitments or agreements with respect to 14 16 any material acquisitions or investments in third parties. Any such future acquisitions would be accompanied by the risks commonly encountered in acquisitions of companies. Such risks include, among other things, the difficulty of assimilating the operations and personnel of the acquired companies, the potential disruption of the Company's ongoing business, the inability of management to succeed in incorporating acquired technology and rights into the Company's products, services and media offerings, additional expense associated with amortization of acquired intangible assets, the difficulty of maintaining uniform standards, controls, procedures and policies, and the potential impairment of relationships with employees, customers and strategic partners. There can be no assurance that the Company's systems, procedures or controls will be adequate to support its current or future operations or that the Company's management will be able to manage the expansion and still achieve the rapid execution necessary to exploit fully the market for the Company's products and services. The Company's future operating results will also depend on its ability to expand its sales and marketing organizations, implement and manage new distribution channels to penetrate different and broader markets, including the market for intranet software products, and expand its support organization accordingly. If the Company were to fail to manage its growth effectively, its business, financial condition and results of operations would be materially adversely affected. See "-- Dependence on Key Personnel; Need for Additional Personnel" and "-- Risk of Capacity Constraints; Reliance on Internally Developed Systems; System Development Risks." IMPACT OF EVOLVING STANDARDS The Company's current streaming media products are based on protocols designed around certain standards, and the Company's business, financial condition and results of operations would be materially adversely affected if any of the Company's competitors were to establish a competing technology as the de facto industry standard for streaming audio and video transmission. The Company and Netscape Communications Corporation co-authored the Real Time Streaming Protocol ("RTSP"), a proposed protocol for standardizing the control and delivery of streaming media over the Internet. RTSP is a unified standard for a broad range of media data types and is intended to promote a greater level of interoperability among various streaming media solutions by providing a standard way for clients and servers from multiple vendors to stream multimedia content. RTSP is built on top of a number of other Internet standard protocols and is complementary with ASF, a file format for streaming media that does not specify a method of client-server interaction. RTSP provides the client-server specification necessary to stream ASF files (and many other file types) on the Internet. There can be no assurance that RTSP will be established as the de facto industry standard or, if so accepted, that existing competitors and new entrants would not be able to compete more effectively with the Company's products. See "-- Competition; Relationship With Microsoft" and "Business -- Technology." RISK OF CAPACITY CONSTRAINTS; RELIANCE ON INTERNALLY DEVELOPED SYSTEMS; SYSTEM DEVELOPMENT RISKS The satisfactory performance, reliability and availability of the Company's Web sites, transaction-processing systems and network infrastructure are critical to the Company's reputation and ability to attract and retain customers and maintain adequate customer service. Any system interruptions that result in the unavailability of the Company's Web sites would adversely affect the Company's ability to conduct business. The Company's Web sites are complex and require considerable technical expertise to maintain. Personnel with technological expertise in this area are in great demand, and there can be no assurance that the Company can attract, train or retain such personnel. Many of the software systems used to support the Company's Web sites, including its electronic commerce operations, were developed internally. These systems will need to be enhanced over time or replaced with equivalent commercial products, either of which could entail considerable effort and expense. The Company's ability to provide a consistent level of high-quality customer service depends in part on the efficient and uninterrupted operation of its computer and communications hardware systems. Substantially all of the Company's computer and communications hardware is located at a single leased 15 17 facility in Seattle, Washington. The Company's systems and operations are vulnerable to damage or interruption from fire, flood, power loss, telecommunications failure, break-ins, earthquake and similar events. Because the Company does not presently have fully redundant systems or a formal disaster recovery plan, there can be no assurance that a system failure would not have a material adverse effect on the Company's business, financial condition and results of operations. The Company's servers are vulnerable to computer viruses, physical or electronic break-ins and similar disruptions, which could lead to interruptions, delays, loss of data or the inability to accept and fulfill customer orders. The occurrence of any of the foregoing risks could have a material adverse effect on the Company's business, financial condition and results of operations. See "Business -- Technology." ONLINE COMMERCE SECURITY RISKS Online commerce and communications depend to a significant extent on the ability to conduct secure transmission of confidential information over public networks. The Company relies on encryption and authentication technology licensed from third parties to provide the security and authentication intended to effect secure transmission of confidential information, such as customer credit card numbers. There can be no assurance that the Company's efforts in this area or advances in computer capabilities, new discoveries in the field of cryptography, or other events or developments will not result in a compromise or breach of the algorithms used by the Company to protect customer transaction data. Any compromise of the Company's security could have a material adverse effect on the Company's business, financial condition and results of operations. A party who is able to circumvent the Company's security measures could misappropriate proprietary information or cause interruptions in the Company's operations. The Company may be required to expend significant capital and other resources to protect against such security breaches or to alleviate problems caused by such breaches. In addition, there can be no assurance that credit card companies will not restrict online credit card transactions in the future for reasons such as fraudulent credit card transactions or other risks associated with online commerce transactions, which restrictions could have a material adverse effect on the Company's business, financial condition and results of operations. To the extent that activities of the Company or third-party contractors involve the storage and transmission of proprietary information, security breaches could damage the Company's reputation and expose the Company to a risk of litigation and possible liability. There can be no assurance that the Company's security measures will prevent security breaches or that the failure to prevent such security breaches will not have a material adverse effect on the Company's business, financial condition and results of operations. RISKS ASSOCIATED WITH INTERNATIONAL EXPANSION For the year ended December 31, 1996 and the nine months ended September 30, 1997, approximately 22% and 27%, respectively, of the Company's total net revenues were generated from sources outside the U.S. As a result, the Company is subject to the risks of doing business abroad, including unexpected changes in regulatory requirements, export and import restrictions, tariffs and other trade barriers, difficulties in staffing and managing foreign operations, longer payment cycles, problems in collecting accounts receivable, potential adverse tax consequences, exchange rate fluctuations, increased risks of piracy, limits on the Company's ability to enforce its intellectual property rights, discontinuity of network infrastructures, limits on repatriation of funds and political risks that may limit or disrupt international sales. Such limitations and interruptions could have a material adverse effect on the Company's business, financial condition and results of operations. In addition, operations of the Company's foreign subsidiaries are translated from local currency into U.S. dollars based on average monthly exchange rates. The Company currently does not hedge its foreign currency transactions and is therefore subject to the risk of changes in exchange rates. See "Management's Discussion and Analysis of Financial Condition and Results of Operations" and "Business -- Sales, Marketing and Distribution." 16 18 GOVERNMENTAL REGULATION AND LEGAL UNCERTAINTIES The Company currently is not subject to direct regulation by any governmental agency, other than laws and regulations generally applicable to businesses, although certain U.S. export controls and import controls of other countries, including controls on the use of encryption technologies, may apply to the Company's products. Due to the increasing popularity and use of the Internet, it is possible that a number of laws and regulations may be adopted in the U.S. and abroad with particular applicability to the Internet. It is possible that governments will enact legislation that may be applicable to the Company in areas such as content, network security, encryption and the use of key escrow, data and privacy protection, electronic authentication or "digital" signatures, illegal and harmful content, access charges and retransmission activities. Moreover, the applicability to the Internet of existing laws governing issues such as property ownership, content, taxation, defamation and personal privacy is uncertain. The majority of such laws were adopted before the widespread use and commercialization of the Internet and, as a result, do not contemplate or address the unique issues of the Internet and related technologies. Any such export or import restrictions, new legislation or regulation or governmental enforcement of existing regulations may limit the growth of the Internet, increase the Company's cost of doing business or increase the Company's legal exposure, which could have a material adverse effect on the Company's business, financial condition and results of operations. The Company faces potential liability for claims based on the nature and content of the materials that it distributes over the Internet, including claims for defamation, negligence or copyright, patent or trademark infringement, which claims have been brought, and sometimes successfully litigated, against Internet companies. The Company's general liability insurance may not cover claims of this type or may not be adequate to indemnify the Company for any liability that may be imposed. Any liability not covered by insurance or in excess of insurance coverage could have a material adverse effect on the Company's business, financial condition and results of operations. Although sections of the Communications Decency Act of 1996 (the "CDA") that, among other things, proposed to impose criminal penalties on anyone distributing "indecent" material to minors over the Internet, were held to be unconstitutional by the U.S. Supreme Court, there can be no assurance that similar laws will not be proposed and adopted. While the Company does not distribute the types of materials that the CDA may have deemed illegal, the nature of such similar legislation and the manner in which it may be interpreted and enforced cannot be fully determined and, therefore, legislation similar to the CDA could subject the Company to potential liability, which in turn could have an adverse effect on the Company's business, financial condition and results of operations. Such laws also could damage the growth of the Internet generally and decrease the demand for the Company's products and services, which could adversely affect the Company's business, financial condition and results of operations. See "Business -- Governmental Regulation" and "-- Intellectual Property." VOLATILITY OF STOCK PRICE The Company believes that factors such as announcements of developments related to the Company's business, announcements of technological innovations or new products or enhancements by the Company or its competitors, sales by competitors (including sales to the Company's customers), sales of the Common Stock into the public market (including sales by members of management), exercise of, or failure to exercise, warrants to purchase shares of the Company's common stock (including the Series E Warrant), developments in the Company's relationships with its customers, partners, distributors and suppliers, shortfalls or changes in revenues, gross margins, earnings or losses or other financial results from analysts' expectations, regulatory developments, fluctuations in results of operations and conditions in the Company's market or the markets served by the Company's customers or the economy could cause the price of the Common Stock to fluctuate, perhaps substantially. In addition, in recent years the stock market in general, and the market for shares of small capitalization and technology stocks in particular, have experienced extreme price fluctuations, which have often been unrelated to the operating performance of affected companies. There can be no assurance that the market price of the Common Stock will not experience significant fluctuations in the future, including 17 19 fluctuations unrelated to the Company's performance. Such fluctuations could materially adversely affect the market price of the Common Stock. SALES AND OTHER TAXES The Company currently does not collect sales or similar taxes with respect to the sale of products, license of technology, or provision of services in states and countries other than states in which the Company has offices. However, one or more states or foreign countries may seek to impose sales or other tax obligations on companies that engage in online commerce within their jurisdictions. A successful assertion by one or more states or any foreign country that the Company should collect sales or other taxes on the sale of products, license of technology or provision of services, or remit payment of sales or other taxes for prior periods, could have a material adverse effect on the Company's business, financial condition and results of operations. IMPACT OF EXERCISE OF THE SERIES E WARRANT In connection with Microsoft's investment in the Company in July 1997, the Company issued the Series E Warrant. If it is not exercised, the Series E Warrant will terminate on the closing of the offering. If the Series E Warrant is exercised in full, Microsoft will own of record approximately 20.3% of the Company's outstanding capital stock immediately after the offering. There can be no assurance that Microsoft will exercise any or all of the Series E Warrant. Because the Series E Warrant may be exercised at any time until the closing of the offering, it is impossible to predict the impact that the exercise thereof will have on the market price of the Common Stock. See "-- Volatility of Stock Price" and "Principal Shareholders." NO SPECIFIC USE OF PROCEEDS The Company has not designated any specific use for the net proceeds from the sale of the Common Stock offered hereby. The Company intends to use the net proceeds primarily for general corporate purposes, including working capital to fund anticipated operating losses and capital expenditures. Accordingly, management will have significant flexibility in applying the net proceeds of the offering. The failure of management to apply such funds effectively could have a material adverse effect on the Company's business, financial condition and results of operations. See "Use of Proceeds." NO PRIOR MARKET FOR COMMON STOCK Prior to the offering, there has been no public market for the Common Stock. The initial public offering price of the Common Stock will be determined by negotiations between the Company and the representatives of the Underwriters and may not be indicative of the market price of the Common Stock in the future. There can be no assurance that an active trading market will develop or be sustained after the offering. See "Underwriting" for a discussion of the factors considered in determining the initial public offering price. BENEFITS OF THE OFFERING TO CURRENT SHAREHOLDERS The offering will provide benefits to the current shareholders of the Company, including the creation of a public market for the Common Stock and the unrealized gain of approximately $215,683,000 in the value of the total equity interest of all current shareholders in the Company. POSSIBLE ADVERSE EFFECT ON MARKET PRICE OF COMMON STOCK OF SHARES ELIGIBLE FOR FUTURE SALE AFTER THE OFFERING On the closing of the offering, the Company will have outstanding 30,965,079 shares of Common Stock and Special Common Stock (31,415,079 shares if the Underwriters' over-allotment option is exercised in full), of which the 3,000,000 shares offered hereby (3,450,000 shares if the Underwriters' over-allotment option is exercised in full) will be freely transferable in the public market without restriction or further registration under the Securities Act of 1933, as amended (the "Securities Act"), except to the extent such shares are held by affiliates of the Company. The remaining 27,965,079 shares of Common Stock and Special Common Stock (the "Restricted Shares") outstanding on completion of the offering 18 20 (assuming no exercise of options after October 9, 1997) were issued by the Company in reliance on exemptions from registration under the Securities Act, and public sale thereof is restricted except to the extent they are registered under the Securities Act or sold in accordance with an exemption from such registration. Of these Restricted Shares, 3,338,374 are shares of Special Common Stock that are convertible into the same number of shares of Common Stock on a bona fide sale to a purchaser who is not an affiliate of the holder. The Company and certain holders of these Restricted Shares have entered into lock-up agreements (the "Lock-Up Agreements") with the Underwriters not to sell, offer to sell or otherwise dispose of any shares of Common Stock owned of record or beneficially as of the date of this Prospectus, including securities convertible into or exercisable or exchangeable for shares of Common Stock as of such date, as well as any shares of Common Stock later acquired by reason of the conversion, exercise or exchange of such securities, for a period of 180 days after the date of this Prospectus without the prior written consent of Goldman, Sachs & Co., on behalf of the Underwriters, except that persons other than officers, directors and holders of 1% or more of the capital stock of the Company will be free to sell or otherwise dispose of up to 5,000 shares of Common Stock to the extent permissible under Rule 144 or Rule 701 under the Securities Act. On closing of the offering, 27,670,989 of the Restricted Shares will be subject to restriction pursuant to the Lock-Up Agreements. Of the remaining 294,090 Restricted Shares, 11,947 shares will be eligible for immediate public sale under Rule 144(k) under the Securities Act as currently in effect, 281,143 shares will be eligible for public sale 90 days after the date of this Prospectus pursuant to Rule 701 under the Securities Act, and the remaining 1,000 shares will be eligible for public sale subject to compliance with the holding period and volume and manner of sale restrictions of Rule 144, unless earlier registered under the Securities Act. At October 9, 1997, options for 6,390,014 shares of Common Stock were outstanding, of which options for 1,673,755 shares may be exercised during the 180 days following the date of this Prospectus and potentially will be eligible for public sale 90 days after the date of this Prospectus pursuant to Rule 701 under the Securities Act; of these shares, 1,301,463 will be subject to Lock-Up Agreements. Warrants to purchase an additional 4,707,363 shares of Common Stock, including the Series E Warrant to purchase up to 3,709,305 shares of Special Common Stock, will be exercisable prior to closing of the offering, and the shares issued upon exercise thereof will be eligible for public sale, subject to compliance with Rule 144. All of these shares are subject to Lock-Up Agreements. The holders of an aggregate of 16,390,753 shares of common stock (including shares of Common Stock and Special Common Stock issuable upon exercise of outstanding warrants) have the right to require the Company to register their shares for sale under the Securities Act beginning six months after the closing of the offering. Sales of substantial numbers of shares of Common Stock in the public market following the offering could have a material adverse effect on the market price for the Common Stock. See "Shares Eligible for Future Sale." DONATION OF NET INCOME TO CHARITY The Company's philosophy includes a commitment to charitable responsibility. If sustained profitability is achieved, the Company intends to donate approximately 5% of its annual net income to charitable organizations. The Company's net income will be reduced by the amount of any such charitable donations. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Donation of Net Income to Charity" and "Business -- Position on Charitable Responsibility." ABSENCE OF DIVIDENDS The Company has never declared or paid cash dividends on its capital stock and does not anticipate paying any cash dividends in the foreseeable future. See "Dividend Policy." DILUTION Investors in Common Stock in the offering will experience immediate and substantial dilution in the net tangible book value of their shares. Assuming an initial public offering price of $10.00 per share, dilution to new investors would be $7.57 per share. Additional dilution will occur upon exercise of outstanding stock options. See "Dilution." 19 21 USE OF PROCEEDS The net proceeds to the Company from the sale of the 3,000,000 shares of Common Stock offered hereby at an assumed initial public offering price of $10.00 per share, after deducting the underwriting discount and estimated offering expenses payable by the Company, are estimated to be $26,950,000 ($31,135,000 if the Underwriters' over-allotment option is exercised in full). The principal purposes of the offering are to increase the Company's working capital, to create a public market for the Common Stock, to increase the visibility of the Company in the marketplace and to facilitate future access by the Company to public equity markets. The Company has no specific plans for the net proceeds. The Company intends to use the net proceeds primarily for general corporate purposes, including working capital to fund anticipated operating losses and capital expenditures. The Company may, when and if the opportunity arises, use an unspecified portion of the net proceeds to acquire or invest in complementary businesses, products and technologies. The Company has no present understandings, commitments or agreements with respect to any material acquisition or investment in third parties. Pending use of the net proceeds for the above purposes, the Company intends to invest such funds in interest-bearing, investment-grade securities. DIVIDEND POLICY The Company has never declared or paid cash dividends on its capital stock. The Company currently anticipates that it will retain all of its future earnings, if any, for use in the expansion and operations of its business and, therefore, does not anticipate paying any cash dividends in the foreseeable future. 20 22 CAPITALIZATION The following table sets forth the capitalization of the Company at September 30, 1997 and as adjusted to give effect to the (i) conversion of all outstanding shares of Series A Common Stock, Series B Common Stock, Series C Common Stock, Series A Preferred Stock, Series B Preferred Stock, Series C Preferred Stock and Series D Preferred Stock into Common Stock and Series E Preferred Stock into Special Common Stock, in each case on closing of the offering; (ii) sale by the Company of the 3,000,000 shares of Common Stock offered hereby at an assumed initial public offering price of $10.00 per share (after deducting the underwriting discount and estimated expenses of the offering); and (iii) issuance of 998,058 shares of Common Stock reflecting exercise of outstanding warrants at an average exercise price of $6.97 per share on the closing of the offering, except as noted below. See "Use of Proceeds" and Note 7 of Notes to Consolidated Financial Statements. The information set forth below is unaudited and should be read in conjunction with the Company's Consolidated Financial Statements and Notes thereto.
SEPTEMBER 30, 1997 ------------------------ ACTUAL AS ADJUSTED -------- ----------- (IN THOUSANDS) Note payable........................................................ $ 959 $ 959 Redeemable, convertible preferred stock, par value $0.001 per share: 16,206,998 shares authorized; 11,683,390 shares issued and outstanding, actual; no shares authorized, issued and outstanding, as adjusted(1).................................................... 49,278 -- Shareholders' equity (deficit): Convertible preferred stock, par value $0.001 per share: 13,713,439 shares authorized; 13,713,439 issued and outstanding, actual; no shares authorized, issued and outstanding, as adjusted(1).................................... 14 -- Preferred stock, undesignated, par value $0.001 per share: 30,079,563 shares authorized; no shares issued and outstanding(1)................................................. -- -- Common stock, par value $0.001 per share: 300,000,000 shares authorized; 1,543,292 shares issued and outstanding, actual; 27,599,805 shares issued and outstanding, as adjusted(2)....... 1 28 Special Common Stock, par value $0.001 per share: no shares authorized; no shares issued and outstanding, actual; 3,338,374 shares issued and outstanding, as adjusted(2).................. -- 3 Additional paid-in capital........................................ 6,755 89,923 Foreign currency translation adjustment........................... (72) (72) Accumulated deficit............................................... (14,787) (14,787) -------- -------- Total shareholders' equity (deficit)........................... (8,089) 75,095 -------- -------- Total capitalization...................................... $ 42,148 $ 76,054 ======== ========
- --------------- (1) At September 30, 1997, the Company had 60,000,000 shares of preferred stock authorized, of which 13,713,439 shares were designated Series A Preferred Stock, 3,059,701 shares were designated Series B Preferred Stock, 3,004,305 shares were designated Series C Preferred Stock, 3,095,313 shares were designated Series D Preferred Stock and 7,047,679 shares were designated Series E Preferred Stock. (2) Excludes (i) 6,442,714 shares of Common Stock issuable at a weighted average exercise price of $1.80 per share upon exercise of stock options outstanding at September 30, 1997, (ii) 4,421,192 shares of Common Stock reserved for future issuance under the Company's stock option plans, (iii) 1,000,000 shares of Common Stock reserved for issuance under the 1998 Employee Stock Purchase Plan and (iv) up to 3,709,305 shares of Special Common Stock (representing additional cash and shareholders' equity of up to $50,001,431) issuable on exercise of the Series E Warrant. See "Management -- Benefit Plans," "Certain Transactions -- Microsoft Corporation," "Description of Capital Stock -- Warrants to Purchase Preferred Stock and Common Stock" and Note 7 of Notes to Consolidated Financial Statements. 21 23 DILUTION The pro forma net tangible book value of the Company at September 30, 1997 is $48,145,000, or $1.72 per share, as adjusted to give effect to the (i) conversion of all outstanding shares of Series A Common Stock, Series B Common Stock, Series C Common Stock, Series A Preferred Stock, Series B Preferred Stock, Series C Preferred Stock and Series D Preferred Stock into Common Stock and Series E Preferred Stock into Special Common Stock, in each case on closing of the offering; (ii) exclusion of up to 3,709,305 shares of Special Common Stock (representing additional cash and shareholders' equity of up to $50,001,431 and an increase to tangible book value per share of $1.58) issuable on exercise of the Series E Warrant; and (iii) issuance of 998,058 shares of Common Stock, reflecting exercise of outstanding warrants at an average exercise price of $6.97 per share on closing of the offering. Pro forma net tangible book value per share represents total tangible assets of the Company less total liabilities divided by the aggregate number of shares of Common Stock and Special Common Stock outstanding. After giving effect to the application of the estimated net proceeds from the sale of 3,000,000 shares of Common Stock offered by the Company at an assumed initial public offering price of $10.00 per share, the adjusted pro forma net tangible book value of the Company at September 30, 1997 would have been approximately $75,095,000, or $2.43 per share of Common Stock and Special Common Stock. This represents an immediate increase in the pro forma net tangible book value of $0.71 per share of Common Stock and Special Common Stock to existing shareholders and an immediate dilution of $7.57 per share to new investors. The following table illustrates this per share dilution: Assumed initial public offering price per share............................... $10.00 Pro forma net tangible book value per share at September 30, 1997............. $1.72 Increase per share attributable to new investors.............................. 0.71 ------- Adjusted pro forma net tangible book value per share after the offering....... 2.43 ------- Dilution per share to new investors........................................... $ 7.57 =======
The following table summarizes on a pro forma basis at September 30, 1997, after giving effect to the offering, the difference between existing shareholders and investors in the offering with respect to the number of shares of Common Stock and Special Common Stock purchased from the Company, the total consideration paid and the average price paid per share.
SHARES PURCHASED(1)(2) TOTAL CONSIDERATION ---------------------- ----------------------- AVERAGE PRICE NUMBER PERCENT AMOUNT PERCENT PER SHARE ----------- ------- ------------ ------- ------------- Existing shareholders............ 27,938,179 90.3% $ 63,767,800 68.0% $ 2.28 New investors.................... 3,000,000 9.7 30,000,000 32.0 10.00 ---------- ----- ---------- ----- Total................... 30,938,179 100.0% $ 93,767,800 100.0% ========== ===== ========== =====
- --------------- (1) The table assumes no exercise of the Underwriters' over-allotment option. Exercise of the over-allotment option in full would (i) reduce the proportion of shares held by existing shareholders to 89.0% of the total number of shares outstanding after the offering and (ii) increase the number of shares held by investors in the offering to 3,450,000 shares, or 11.0% of the total number of shares. (2) Excludes (i) 6,442,714 shares of Common Stock issuable at a weighted average exercise price of $1.80 per share upon exercise of stock options outstanding at September 30, 1997, (ii) 4,421,192 shares of Common Stock reserved for future issuance under the Company's stock option plans, (iii) 1,000,000 shares of Common Stock reserved for issuance under the 1998 Employee Stock Purchase Plan and (iv) up to 3,709,305 shares of Special Common Stock (representing additional cash and shareholders' equity of up to $50,001,431) issuable on exercise of the Series E Warrant. See "Management -- Benefit Plans," "Certain Transactions -- Microsoft Corporation," "Description of Capital Stock -- Warrants to Purchase Preferred Stock and Common Stock" and Note 7 of Notes to Consolidated Financial Statements. 22 24 SELECTED CONSOLIDATED FINANCIAL DATA The following selected consolidated financial data should be read in conjunction with the Company's Consolidated Financial Statements and Notes thereto and "Management's Discussion and Analysis of Financial Condition and Results of Operations," included elsewhere in this Prospectus. The selected consolidated financial data as of December 31, 1994, and for the period from February 9, 1994 (inception) to December 31, 1994, as of and for the years ended December 31, 1995 and 1996 and as of and for the nine months ended September 30, 1997 are derived from the Consolidated Financial Statements of the Company audited by KPMG Peat Marwick LLP, independent accountants. The selected consolidated financial data for the nine months ended September 30, 1996 are derived from unaudited consolidated financial statements prepared by the Company on a basis consistent with the Company's audited Consolidated Financial Statements and, in the opinion of management, include all adjustments, consisting only of normal recurring accruals, necessary for a fair presentation of the results for such periods. Operating results for the nine months ended September 30, 1997 are not necessarily indicative of the results that may be expected for any other interim period or for the year ending December 31, 1997.
PERIOD FROM FEBRUARY 9, 1994 YEAR ENDED NINE MONTHS ENDED (INCEPTION) TO DECEMBER 31, SEPTEMBER 30, DECEMBER 31, --------------------- ----------------------- 1994 1995 1996 1996 1997 ---------------- ------- ------- ----------- ------- (IN THOUSANDS, EXCEPT PER SHARE DATA) STATEMENT OF OPERATIONS DATA: Net revenues: Software license fees....................... $ -- $ 1,782 $11,876 $ 7,213 $17,550 Advertising................................. -- -- 1,016 426 1,557 Service revenues............................ -- 30 1,120 635 3,310 ----- ------- ------- ------- ------- Total net revenues................... -- 1,812 14,012 8,274 22,417 Cost of revenues: Software license fees....................... -- 29 1,343 470 2,080 Advertising................................. -- -- 288 187 572 Service revenues............................ -- 33 554 312 1,957 ----- ------- ------- ------- ------- Total cost of revenues............... -- 62 2,185 969 4,609 ----- ------- ------- ------- ------- Gross profit.............................. -- 1,750 11,827 7,305 17,808 Operating expenses: Research and development.................... 202 1,380 4,812 3,073 9,130 Selling and marketing....................... 47 1,218 7,540 4,389 14,024 General and administrative.................. 296 747 3,491 2,318 4,413 ----- ------- ------- ------- ------- Total operating expenses............. 545 3,345 15,843 9,780 27,567 ----- ------- ------- ------- ------- Operating loss............................ (545) (1,595) (4,016) (2,475) (9,759) Net other income.............................. -- 94 227 160 1,184 ----- ------- ------- ------- ------- Net loss...................................... $ (545) $(1,501) $(3,789) $ (2,315) $(8,575) ===== ======= ======= ======= ======= Pro forma net loss per share(1)............... $ (0.14) $ (0.32) Shares used to compute pro forma net loss per share(1).................................... 27,779 28,315
DECEMBER 31, --------------------------------- SEPTEMBER 30, 1994 1995 1996 1997 ------- ------- ------- ------------- (IN THOUSANDS) BALANCE SHEET DATA: Cash, cash equivalents and short-term investments............. $ -- $ 6,116 $19,595 $67,648 Working capital (deficit)..................................... (49) 5,948 16,893 50,762 Total assets.................................................. 64 7,574 26,468 84,372 Redeemable, convertible preferred stock....................... -- 7,655 23,153 49,278 Shareholders' equity (deficit)................................ 15 (1,111) (3,320) (8,089)
- --------------- (1) For an explanation of pro forma net loss per share and the number of shares used to compute pro forma net loss per share, see Note 1 of Notes to Consolidated Financial Statements. 23 25 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion of the financial condition and results of operations of the Company should be read in conjunction with the Consolidated Financial Statements and Notes thereto included elsewhere in this Prospectus. This discussion contains forward-looking statements that involve risks and uncertainties. The Company's actual results may differ materially from those anticipated in these forward-looking statements as a result of certain factors, including, but not limited to, those set forth under "Risk Factors" and elsewhere in this Prospectus. OVERVIEW RealNetworks is a leading provider of branded software products and services that enable the delivery of streaming media content over the Internet and intranets. The Company's products and services include its RealSystem, a streaming media solution that includes RealAudio and RealVideo technology, an electronic commerce Web site designed to promote the proliferation of streaming media products and a network of advertising-supported content aggregation Web sites. The Company was incorporated in February 1994 and did not recognize any revenue until July 1995, when the Company began delivery of the commercial version of RealAudio Version 1.0. From inception through December 31, 1995, the Company's operating activities related primarily to recruiting personnel, raising capital, purchasing operating assets, conducting research and development, building the RealAudio brand and establishing the market for streaming audio. During 1996, the Company continued to invest heavily in research and development, marketing, building domestic and international sales channels and general and administrative infrastructure. In August 1996, the Company began selling RealPlayer Plus, a premium version of its RealPlayer product. RealPlayer continues to be available for download free of charge from the Company's Web sites. In February 1997, the Company released a "beta" version of its RealVideo product and, in June 1997, it released the commercial version of RealVideo Version 4.0. In October 1997, the Company released a "beta" version of its RealSystem Version 5.0, a streaming media solution that includes RealAudio and RealVideo technology. The Company has a limited operating history on which an evaluation of the Company and its prospects can be based. The Company's prospects must be considered in light of the risks, expenses and difficulties frequently encountered by companies in early stages of development, particularly companies in rapidly evolving markets such as media delivery and electronic commerce over the Internet and intranets. To achieve and sustain profitability, the Company must, among other things, establish widespread market acceptance of its existing products and services, successfully develop new products and services, respond quickly and effectively to competitive, market and technological developments, expand sales and marketing operations, broaden customer support capabilities, control expenses and continue to attract, train and retain qualified personnel. There can be no assurance that the Company will achieve or sustain profitability. The Company has incurred significant losses since its inception, and as of September 30, 1997 had an accumulated deficit of $14,787,000. The Company believes that its success will depend largely on its ability to extend its technological leadership and continue to build its brand position. Accordingly, the Company intends to invest heavily in research and development and sales and marketing. The Company expects to continue to incur substantial operating losses for the foreseeable future. In view of the rapidly evolving nature of the Company's business and its limited operating history, the Company believes that period-to-period comparisons of its revenues and operating results, including its gross profit margin and operating expenses as a percentage of total net revenues, are not necessarily meaningful and should not be relied upon as indications of future performance. Although the Company has experienced significant percentage growth in total net revenues, it does not believe that its historical growth rates are sustainable or indicative of future growth. The Company has used, and expects to continue to use, price promotions to increase trial, purchase and use of its products, as well as to increase overall recognition of its brands. 24 26 The effect of such promotions on revenues in a particular period may be significant and extremely difficult to forecast. The following table sets forth certain financial data for the periods indicated as a percentage of total net revenues:
YEAR ENDED NINE MONTHS ENDED DECEMBER 31, SEPTEMBER 30, ------------------ ------------------ 1995 1996 1996 1997 ------ ------ ------ ------ Net revenues: Software license fees............ 98.4% 84.8% 87.2% 78.3% Advertising...................... -- 7.2 5.1 6.9 Service revenues................. 1.6 8.0 7.7 14.8 ----- ----- ----- ----- Total net revenues....... 100.0 100.0 100.0 100.0 ----- ----- ----- ----- Cost of revenues: Software license fees............ 1.6 9.6 5.7 9.3 Advertising...................... -- 2.0 2.2 2.6 Service revenues................. 1.8 4.0 3.8 8.7 ----- ----- ----- ----- Total cost of revenues... 3.4 15.6 11.7 20.6 ----- ----- ----- ----- Gross profit.................. 96.6 84.4 88.3 79.4 Operating expenses: Research and development......... 76.2 34.3 37.1 40.7 Selling and marketing............ 67.2 53.8 53.1 62.6 General and administrative....... 41.2 24.9 28.0 19.7 ----- ----- ----- ----- Total operating expenses............... 184.6 113.0 118.2 123.0 ----- ----- ----- ----- Operating loss................ (88.0) (28.6) (29.9) (43.6) Other income (expense): Interest income, net............. 5.2 2.1 2.3 5.4 Other expense.................... -- (0.5) (0.4) (0.1) ----- ----- ----- ----- Net other income................... 5.2 1.6 1.9 5.3 ----- ----- ----- ----- Net loss........................... (82.8)% (27.0)% (28.0)% (38.3)% ===== ===== ===== =====
RESULTS OF OPERATIONS -- NINE MONTHS ENDED SEPTEMBER 30, 1996 AND 1997 REVENUES The Company generates revenues primarily from three sources: software license fees, advertising and services. Software license fees are recognized upon delivery, net of allowances for estimated future returns, provided that no significant obligations of the Company remain and collection of the resulting receivable is deemed probable. Revenues from software license agreements with original equipment manufacturers ("OEM") are recognized when the OEM delivers its product incorporating the Company's software to the end user. In the case of prepayments from an OEM, the Company generally recognizes revenues based on the actual products sold by the OEM. If the Company anticipates providing ongoing support to the OEM in the form of future upgrades, enhancements or other services over the term of the contract, revenue generally is recognized on the straight-line method over the term of the contract. The Company recognizes revenues from software license agreements with value-added resellers ("VAR"), provided the following conditions are met: the software product has been delivered to the VAR, the fee to the Company is fixed or determinable, and collectibility is probable. Advertising revenues are recognized over the period in which the advertisement is displayed on one of the Company's Web pages. The Company guarantees to certain advertising customers a minimum number of page impressions to be delivered to users of its Web sites for a particular period. To the extent minimum guaranteed page impression deliveries are not met, the Company defers recognition of the corresponding advertising 25 27 revenues until guaranteed page impression delivery levels are achieved. Service revenues include payments under support and upgrade contracts, commissions from electronic sales of third-party products, and fees from consulting, content hosting and user conferences. Support and upgrade revenues are recognized ratably over the term of the contract, which typically is 12 months. Payments for support and upgrade contracts generally are made in advance and are nonrefundable. Other service revenues are recognized when the service is performed. Software License Fees. Software license fees were $7,213,000 and $17,550,000 for the nine months ended September 30, 1996 and 1997, respectively. The increase was due primarily to a greater volume of products sold as a result of growing market acceptance of the Company's server and player products, including the introduction of RealPlayer Plus in August 1996 and RealVideo in February 1997, successful product promotions and diversification of the Company's sales channels, including electronic distribution. Server product sales were $5,799,000 and $10,379,000 for the nine months ended September 30, 1996 and 1997, respectively. In June 1997, the Company entered into a $30,000,000 license agreement with Microsoft. The agreement requires the Company to provide Microsoft with engineering consultation services, certain error corrections and certain technical support over a defined term. The Company recognizes revenue from the agreement over the three-year term of the Company's ongoing obligations. Included in server product sales for the nine months ended September 30, 1997 was $2,417,000 related to the Microsoft license agreement. Player product sales were $1,414,000 and $7,171,000 over the same respective periods. The Company began selling products electronically from its Web site in August 1996. Electronic sales of both server and player products for the nine months ended September 30, 1996 and 1997 were $650,000 and $6,038,000, respectively, or 9% and 34%, respectively, of software license fees in the period. The Company has used price promotions to increase the trial, purchase and use of its software products. In February 1997, the Company reduced the prices of its server products. In July 1997, the Company made its Basic Server available for download free of charge. Advertising Revenues. Advertising revenues were $426,000 and $1,557,000 for the nine months ended September 30, 1996 and 1997, respectively. The Company began selling advertising space on its Web sites in March 1996. Increased revenues in 1997 were due in part to a full period of advertising sales and the Company's success in attracting a greater number of advertisers. Service Revenues. Service revenues were $635,000 and $3,310,000 for the nine months ended September 30, 1996 and 1997, respectively. Revenues from upgrade and support contracts were $630,000 and $2,453,000 for the nine months ended September 30, 1996 and 1997, respectively. This increase was primarily due to a greater installed base of the Company's products. Service revenues for the nine months ended September 30, 1997 also included fees of $498,000 related to the Company's first RealMedia conference. International Revenues. International revenues were 21% and 27% of total net revenues for the nine months ended September 30, 1996 and 1997, respectively. The increase in international revenues was due in part to the creation of the Company's three foreign subsidiaries. The Company incorporated its French and Japanese subsidiaries in November 1996 and its U.K. subsidiary in February 1997. Substantially all of the Company's international revenues were generated in Europe and Asia. The functional currency of the Company's foreign subsidiaries is the local currency in the country in which the subsidiary is incorporated. Operations of the Company's foreign subsidiaries are translated from local currency into U.S. dollars based on average monthly exchange rates. The Company currently does not hedge its foreign currency transactions and therefore is subject to the risk of changes in exchange rates. The Company expects that international revenues will continue to increase. The cost structures of both domestic and international revenues are substantially the same. 26 28 COST OF REVENUES Cost of Software License Fees. Cost of software license fees includes cost of product media, duplication, manuals, packaging materials, amounts paid for licensed technology and fees paid to third-party vendors for order fulfillment. Cost of software license fees was $470,000 and $2,080,000 for the nine months ended September 30, 1996 and 1997, respectively, and 7% and 12%, respectively, of software license fees. The increase in absolute dollars was due primarily to higher sales volume. The increase in percentage terms was due to a shift in product mix toward lower-margin player products, a greater percentage of sales through indirect channels, and the utilization of a third-party order fulfillment agency. Cost of Advertising Revenues. Cost of advertising revenues includes personnel associated with content creation and bandwidth expenses related to the Company's Web sites. Cost of advertising revenues was $187,000 and $572,000 for the nine months ended September 30, 1996 and 1997, respectively, and 44% and 37%, respectively, of advertising revenues. The increase in absolute dollars was due primarily to increased head count associated with content creation and higher bandwidth expenses. The decrease in percentage terms was due to revenues growing at a faster rate than expenses. Cost of Service Revenues. Cost of service revenues includes the cost of in-house and contract personnel providing services, bandwidth expenses for hosting services and user conference expenses. Cost of service revenues was $312,000 and $1,957,000 for the nine months ended September 30, 1996 and 1997, respectively, and 49% and 59%, respectively, of service revenues. The increase in absolute dollars was primarily due to increased staff and other costs associated with providing these services to a greater number of customers, and, in March 1997, the Company incurred $1,000,000 of costs associated with its RealMedia conference. No such costs were incurred in the comparable period in 1996. Excluding the effects of the RealMedia conference, cost of service revenues was 49% and 34% of service revenues for the nine months ended September 30, 1996 and 1997, respectively. This decrease was attributable primarily to better utilization of service personnel associated with an increased customer base. Gross margins may be affected by the mix of distribution channels used by the Company, the mix of products sold, the mix of product revenues versus service revenues and the mix of international versus U.S. revenues. The Company typically realizes higher gross margins on direct channel sales relative to indirect channels and higher gross margins on software license fees relative to service revenues. If sales through indirect channels increase as a percentage of total net revenues, or if, as the Company anticipates, service revenues increase as a percentage of total net revenues, the Company's gross margins will be adversely affected. OPERATING EXPENSES Research and Development. Research and development expenses consist primarily of salaries and consulting fees to support product development and costs of technology acquired from third parties to incorporate into products currently under development. To date, all research and development costs have been expensed as incurred because technological feasibility of the Company's products is established upon completion of a working model. To date, costs incurred between completion of a working model and general release of products have been insignificant. The Company believes that continued investment in research and development is critical to attaining its strategic objectives and, as a result, expects research and development expenses to increase significantly. Research and development expenses were $3,073,000 and $9,130,000 for the nine months ended September 30, 1996 and 1997, respectively, and 37% and 41%, respectively, of total net revenues. The increase was due primarily to increases in internal development personnel, travel, and consulting expenses. In addition, during the nine months ended September 30, 1997, the Company expensed approximately $998,000 related to the cost of technology purchased from third parties. The Company expects to incur similar types of expenditures in future periods. Research and development expenses incurred for the nine months ended Septem- 27 29 ber 30, 1997 were primarily related to enhancements made to existing products and development of new technology and products. Selling and Marketing. Selling and marketing expenses consist primarily of salaries, commissions, consulting fees paid, trade show expenses, advertising and cost of marketing collateral. The Company intends to continue its aggressive branding and marketing campaign and therefore expects selling and marketing expenses to increase significantly. Selling and marketing expenses were $4,389,000 and $14,024,000 for the nine months ended September 30, 1996 and 1997, respectively, and 53% and 63%, respectively, of total net revenues. The increases were due in large part to growth in sales personnel, commissions and costs related to the continued development and implementation of the Company's branding and marketing campaigns. During the nine months ended September 30, 1997, the Company also incurred approximately $694,000 in marketing expenses related to the launch of RealVideo. General and Administrative. General and administrative expenses consist primarily of salaries and fees for professional services. The Company expects general and administrative expenses to increase as the Company expands its staff, incurs additional costs related to growth of its business, and becomes a publicly traded company. General and administrative expenses were $2,318,000 and $4,413,000 for the nine months ended September 30, 1996 and 1997, respectively, and 28% and 20%, respectively, of total net revenues. The increase in absolute dollars was primarily a result of increased personnel and facility expenses necessary to support the Company's growth. The decrease in percentage terms was a result of revenues growing at a faster rate than expenses. NET OTHER INCOME Net other income consists primarily of earnings on the Company's cash and cash equivalents and short-term investments. Net other income was $160,000 and $1,184,000 for the nine months ended September 30, 1996 and 1997, respectively. The increase was due primarily to interest income resulting from additional invested cash and cash equivalents and short-term investments. INCOME TAXES The Company had a net operating loss for each period from inception through December 31, 1996. As of September 30, 1997, the Company anticipates fully utilizing its net operating loss and other credit carryforwards by December 31, 1997 as a result of taxable income generated from a license agreement with Microsoft. For financial reporting purposes, those license fees are recognized over the three-year term of the Company's ongoing obligations. As a result, the Company has recognized deferred tax assets to the extent of its accrued income taxes. See Note 4 of Notes to Consolidated Financial Statements. RESULTS OF OPERATIONS -- YEARS ENDED DECEMBER 31, 1995 AND 1996 REVENUES Software License Fees. Software license fees were $1,782,000 and $11,876,000 for 1995 and 1996, respectively. The Company first began recognizing revenues from software license fees in July 1995. The increase in software license fees in 1996 was due primarily to a greater volume of products sold as a result of a full period of sales, growing market acceptance of the Company's products, the introduction of RealPlayer Plus in August 1996 and diversification of sales channels, including electronic distribution. All of the Company's software license fees in 1995 were from the sale of its server software. In 1996, server product sales were $8,188,000 and player product sales were $3,688,000. Advertising Revenues. Advertising revenues were $1,016,000 for 1996. The Company began selling advertising space on its Web sites in March 1996, and, as a result, no advertising revenues were generated in 1995. Service Revenues. Service revenues were $30,000 and $1,120,000 for 1995 and 1996, respectively. The increase in service revenues in 1996 was due primarily to additional support and upgrade 28 30 contracts associated with a larger installed base of the Company's products. Consulting, content hosting and user conference revenues were not significant in either period. International Revenues. International revenues as a percentage of total net revenues were 17% and 22% for 1995 and 1996, respectively. Substantially all international revenues were generated in Europe and Asia. COST OF REVENUES Cost of Software License Fees. Cost of software license fees was $29,000 and $1,343,000 for 1995 and 1996, respectively, and 2% and 11%, respectively, of software license fees. The increase in absolute dollars was primarily due to higher sales volume. The increase in percentage terms was due to a shift in product mix toward lower-margin player products, a greater percentage of sales through indirect channels, and the utilization of a third-party order fulfillment agency. Cost of Advertising Revenues. Cost of advertising revenues was $288,000 for 1996, and was 28% of advertising revenues. Since the Company did not begin selling advertising until 1996, all content creation costs in 1995 were charged to research and development and selling and marketing expenses. Cost of Service Revenues. Cost of service revenues was $33,000 and $554,000 for 1995 and 1996, respectively, and was 110% and 49%, respectively, of service revenues. The increase in absolute dollars was due primarily to increased staff and other costs associated with providing these services to a greater number of customers. The decrease in percentage terms was due to better utilization of service personnel associated with an increased customer base. OPERATING EXPENSES Research and Development. Research and development expenses were $1,380,000 and $4,812,000 for 1995 and 1996, respectively, and 76% and 34%, respectively, of total net revenues. The increase in absolute dollars was attributable primarily to increased personnel and related costs associated with enhancement of existing products and development of new products. The decrease in percentage terms was a result of revenues growing at a faster rate than research and development expenses. Selling and Marketing. Selling and marketing expenses were $1,218,000 and $7,540,000 for 1995 and 1996, respectively, and 67% and 54%, respectively, of total net revenues. The increase in absolute dollars was due primarily to increased salaries, direct sales personnel, commissions, costs associated with international expansion and promotional expenses. The decrease in percentage terms was a result of revenues growing at a faster rate than selling and marketing expenses. General and Administrative. General and administrative expenses were $747,000 and $3,491,000 for 1995 and 1996, respectively, and 41% and 25%, respectively of total net revenues. The increase in absolute dollars was primarily a result of increased salaries and related expenses associated with the hiring of additional personnel and increased facilities expenses. The decrease in percentage terms was a result of revenues growing at a faster rate than general and administrative expenses. NET OTHER INCOME Net other income was $94,000 and $227,000 for 1995 and 1996, respectively. The increase was due primarily to interest income resulting from higher invested cash and cash equivalents and short-term investments. INCOME TAXES As of December 31, 1996, the Company had approximately $2,802,000 of net operating loss and other credit carryforwards for federal income tax purposes that will expire in 2010 and 2011 if not utilized. See Note 4 of Notes to Consolidated Financial Statements. 29 31 QUARTERLY RESULTS OF OPERATIONS The following table sets forth certain unaudited quarterly statement of operations data for the five quarters ended September 30, 1997. In the opinion of management, this information has been prepared substantially on the same basis as the audited Consolidated Financial Statements appearing elsewhere in this Prospectus, and all necessary adjustments, consisting only of normal recurring adjustments, have been included in the amounts stated below to present fairly the unaudited quarterly results of operations. The quarterly data should be read in conjunction with the audited Consolidated Financial Statements of the Company and the Notes thereto appearing elsewhere in this Prospectus. The operating results for any quarter are not necessarily indicative of the operating results for any future period.
QUARTER ENDED ------------------------------------------------------ SEPT. SEPT. 30, DEC. 31, MARCH 31, JUNE 30, 30, 1996 1996 1997 1997 1997 --------- -------- --------- -------- -------- (IN THOUSANDS) Total net revenues........................ $ 4,030 $ 5,738 $ 6,356 $ 7,010 $ 9,051 Total cost of revenues.................... 575 1,216 2,021 1,033 1,555 ---- ------ ------- ------- ------- Gross profit......................... 3,455 4,522 4,335 5,977 7,496 Operating expenses: Research and development................. 1,334 1,739 2,725 2,738 3,667 Selling and marketing.................... 2,125 3,151 4,350 4,811 4,863 General and administrative............... 906 1,173 1,171 1,325 1,917 ---- ------ ------- ------- ------- Total operating expenses........ 4,365 6,063 8,246 8,874 10,447 ---- ------ ------- ------- ------- Operating loss....................... (910) (1,541) (3,911) (2,897) (2,951) Net other income.......................... 43 67 205 231 748 ---- ------ ------- ------- ------- Net loss.................................. $ (867) $(1,474) $(3,706) $(2,666) $(2,203) ==== ====== ======= ======= =======
QUARTER ENDED ------------------------------------------------------ SEPT. SEPT. 30, DEC. 31, MARCH 31, JUNE 30, 30, 1996 1996 1997 1997 1997 --------- -------- --------- -------- -------- (AS A PERCENTAGE OF TOTAL NET REVENUES) Total net revenues........................ 100.0 % 100.0 % 100.0 % 100.0 % 100.0 % Total cost of revenues.................... 14.3 21.2 31.8 14.7 17.2 ----- ----- ----- ----- ----- Gross profit......................... 85.7 78.8 68.2 85.3 82.8 Operating expenses: Research and development................ 33.1 30.3 42.9 39.1 40.5 Selling and marketing................... 52.7 54.9 68.4 68.6 53.7 General and administrative.............. 22.5 20.5 18.4 18.9 21.2 ----- ----- ----- ----- ----- Total operating expenses........ 108.3 105.7 129.7 126.6 115.4 ----- ----- ----- ----- ----- Operating loss....................... (22.6) (26.9) (61.5) (41.3) (32.6) Net other income.......................... 1.1 1.2 3.2 3.3 8.3 ----- ----- ----- ----- ----- Net loss.................................. (21.5)% (25.7)% (58.3)% (38.0)% (24.3)% ===== ===== ===== ===== =====
The Company's total net revenues have increased in all quarters presented as a result of increasing market acceptance of the Company's products, diversification of the Company's sales channels, including electronic distribution, expansion of the Company's direct sales efforts and continued increases in its installed customer base. In the third quarter of 1996, the Company released RealPlayer Plus. During the first quarter of 1997, the Company released a "beta" version of RealVideo and began recognizing revenues on the commercial release of RealVideo in the second quarter of 1997. In the third quarter of 1997, the Company recognized $2,417,000 related to a license agreement with Microsoft. The Company recognizes revenues from the agreement over the three-year term of the Company's ongoing obligations. The increases in total cost of revenues as a percentage of total net revenues in the third and fourth 30 32 quarters of 1996 were due to a shift in product mix toward RealPlayer Plus products, a greater percentage of sales through indirect channels and the utilization of a third-party order fulfillment agency. In the first quarter of 1997, the Company held its first RealMedia conference and recognized revenues and cost of revenues of $498,000 and $1,000,000, respectively, which increased total cost of revenues as a percentage of total net revenues. Operating expenses increased in each quarter, reflecting increased spending on developing, selling, marketing and supporting the Company's products, as well as building the Company's market presence. Research and development expenses have increased as a result of continued enhancements to existing products and development of new products. Selling and marketing expenses increased as a result of increased sales personnel and commissions. In the first and second quarters of 1997, the Company increased marketing activities associated with the release of RealVideo. The trend of increasing general and administrative expenses is due primarily to additional personnel and facilities costs. In the third quarter of 1997, general and administrative expenses increased due in part to costs incurred in responding to the Department of Justice subpoena. FACTORS AFFECTING OPERATING RESULTS As a result of the Company's limited operating history and the emerging nature of the markets in which it competes, the Company is unable to forecast accurately its revenues. The Company's expense levels are based in part on its expectations with regard to future revenues. The Company may be unable to adjust spending in a timely manner to compensate for any unexpected revenue shortfall. As a result, any significant shortfall in demand for the Company's products and services relative to the Company's expectations would have an immediate material adverse effect on the Company's business, financial condition and results of operations. Further, as a strategic response to changes in the competitive environment, the Company may from time to time implement pricing, service or marketing changes that could have a material adverse effect on its business, financial condition and results of operations. See "Risk Factors -- Unpredictability of Future Revenues; Potential Fluctuation in Quarterly Operating Results," "-- Competition; Relationship With Microsoft" and "Business -- Competition." The Company expects to experience significant fluctuations in its future quarterly operating results due to a variety of factors, many of which are outside the Company's control, including (i) demand for the Company's products and services, (ii) introduction or enhancement of products and services by the Company and its competitors, (iii) market acceptance of new products and services of the Company and its competitors, (iv) price reductions by the Company or its competitors or changes in how products and services are priced (such as the Company's recent decision to offer for download free of charge a version of its Basic Server, which previously sold for $295 to $995), (v) the mix of products and services sold by the Company and its competitors, (vi) the mix of distribution channels through which the Company's products are licensed and sold, (vii) the mix of international and U.S. revenues, (viii) costs of litigation and intellectual property protection, (ix) growth in the use of the Internet, (x) the Company's ability to attract, train and retain qualified personnel, (xi) the amount and timing of operating costs and capital expenditures related to expansion of the Company's business, operations and infrastructure, (xii) technical difficulties with respect to the use of the Company's products, (xiii) governmental regulations and (xiv) general economic conditions and economic conditions specifically related to the Internet. It often is difficult to forecast the effect such factors, or any combination thereof, would have on the Company's results of operations for any given fiscal quarter. The Company has used, and expects to continue to use, price promotions to increase trial, purchase and use of its products, as well as to increase the overall recognition of its brands. The effect of such promotions on revenues in a particular period may be significant and extremely difficult to forecast. Based on the foregoing, the Company believes that its quarterly revenues, expenses and operating results could vary significantly in the future, and that period-to-period comparisons should not be relied upon as indications of future performance. Historically, the Company has received a significant portion of its revenues from a limited number of sales and license agreements. The Company believes that a customer's decision to purchase its server products or license its technology is relatively discretionary and, for large-scale users, generally involves a 31 33 significant commitment of capital resources. Therefore, any downturn in the economy or in the business of potential customers could have a material adverse effect on the Company's revenues and quarterly results of operations. The Company generally distributes its software products in "beta" form to the public prior to finalizing product features, functionality and operability. This may cause certain customers to delay purchasing decisions until commercial versions of the products are available, which could have a material adverse effect on the Company's revenues and quarterly results of operations. The Company derives a significant portion of its revenues from the sale of technical support services and software upgrades to its installed customer base. There can be no assurance that a sufficient number of the Company's customers will continue to enter into support and upgrade contracts or will renew existing support and upgrade contracts, or that revenues therefrom will continue to be significant. The loss of a material portion of such revenues would likely have a material adverse effect on the Company's business, financial condition and results of operations. Management has observed that revenues from advertising sales have tended to be higher in the second and fourth quarters, and retail sales have tended to be highest in the fourth quarter. The Company typically operates with no backlog. As a result, quarterly sales and operating results depend primarily on the volume and timing of orders received in the quarter, both of which are difficult to forecast. The Company typically recognizes a substantial portion of its revenues in the last month of each quarter. Due to the foregoing factors, it is likely that in some future quarters the Company's operating results will fall below the expectations of securities analysts and investors, which would likely have a material adverse affect on the trading price of the Common Stock. DONATION OF NET INCOME TO CHARITY The Company's philosophy includes a commitment to charitable responsibility. If sustained profitability is achieved, the Company intends to donate approximately 5% of its annual net income to charitable organizations. The Company's net income will be reduced by the amount of any such charitable donations. See "Business -- Position on Charitable Responsibility." LIQUIDITY AND CAPITAL RESOURCES Since its inception, the Company has financed its operations primarily through private sales of preferred stock and common stock and contributions of capital by the Company's founder. Net proceeds from these sales and contributions totaled $55,480,000. Net cash used in operating activities was $1,240,000 and $635,000 in 1995 and 1996, respectively. Cash used in operating activities in 1995 was due primarily to a net loss of $1,501,000. For 1996, cash used in operating activities resulted primarily from a net loss of $3,789,000 and an increase of $2,608,000 in trade accounts receivable, largely offset by increases of $2,267,000 in deferred revenue, $2,220,000 in accounts payable and $822,000 in other accrued expenses. Net cash provided by operating activities was $21,870,000 for the nine months ended September 30, 1997. This was primarily attributable to a net loss of $8,575,000, an increase of $1,079,000 in trade accounts receivable, and an increase of $29,406,000 in deferred revenue related primarily to the Microsoft license agreement. See "Recent Developments." Net cash used in investing activities of $3,660,000, $4,837,000, and $22,785,000 for the years ended December 31, 1995 and 1996 and the nine months ended September 30, 1997, respectively, was primarily related to purchases of property and equipment and increases in short-term investments. Cash provided by financing activities of $8,029,000 in 1995 consisted primarily of $7,405,000 in net proceeds from the issuance of Series B and C Preferred Stock and a capital contribution by the founder of $372,000. Cash provided by financing activities of $17,091,000 in 1996 was primarily from net proceeds of $17,047,000 from the issuance of Series D Preferred Stock. Cash flows provided by financing activities 32 34 of $30,980,000 for the nine months ended September 30, 1997 were primarily from net proceeds of $29,869,000 from the issuance of Series E Preferred Stock and $991,000 of proceeds from the issuance of a note payable. In connection with the Series E Preferred Stock financing, the Company issued a warrant to purchase up to 3,709,305 shares of Series E Preferred Stock at an exercise price of $13.48 per share. As of September 30, 1997, the Company had $44,751,000 of cash and cash equivalents and $22,897,000 in short-term investments. As of September 30, 1997, the Company's principal commitments consisted of obligations outstanding under operating leases and a $959,000 note payable. The note is denominated in Japanese yen and bears interest at a rate not to exceed the Japanese Short Term Prime Rate (1.63% at September 30, 1997). Interest on the note is payable monthly, and the principal is due in May 2000. The terms of the note contain no restrictions or covenants. The note is secured by the Company's shares in its Japanese joint venture. See "Certain Transactions -- Japanese Joint Venture." Although the Company has no material commitments for capital expenditures, management anticipates a substantial increase in its capital expenditures and lease commitments consistent with anticipated growth in operations, infrastructure and personnel. The Company conducts its operations using primarily three currencies: the United States dollar, the Japanese yen, and the British pound. Historically, neither fluctuations in foreign exchange rates nor changes in foreign economic conditions has had a significant impact on the Company's financial condition or results of operations. As a result, the Company currently does not hedge its foreign currency transactions and is therefore subject to the risk of exchange rates. The Company monitors its foreign exchange exposure and in the future may choose to hedge foreign currency transactions, enter into currency contracts, or take other such actions as deemed necessary to mitigate exchange rate risks. The Company is unaware of any existing foreign government policies that would significantly impact the Company's operations. In August 1997, the Department of Justice commenced an investigation into horizontal merger activities within the streaming media industry. The Department of Justice served several companies, including the Company and Microsoft, with subpoenas to produce certain documents. As a result of the investigation, it is possible that the Department of Justice will require certain actions by the Company, Microsoft or other companies in the streaming media industry that could have a material adverse effect on the Company's business, financial condition and results of operations. The Department of Justice could decide to take actions that could materially and adversely affect the Company's current relationship with Microsoft or other companies, affect Microsoft's obligations with respect to the distribution of the Company's products, result in certain penalties, require the Company to refund all or a portion of the license fee paid by Microsoft to the Company, require Microsoft to limit or divest certain of its acquisitions or investments in the streaming media industry, including its investment in the Company, and, if Microsoft were forced to rescind its agreement with the Company, place the Company at a significant competitive disadvantage within the industry. There can be no assurance that any such outcome would not have an immediate material adverse effect on the Company's business, financial condition and results of operations. See "Risk Factors -- Department of Justice Subpoena." Since its inception, the Company has significantly increased its operating expenses. The Company currently anticipates that it will continue to experience significant growth in its operating expenses for the foreseeable future and that its operating expenses will be a material use of the Company's cash resources. The Company believes that the net proceeds from the offering, together with its current cash, cash equivalents and short-term investments, will be sufficient to meet its anticipated cash needs for working capital and capital expenditures for at least the next 12 months. RECENT DEVELOPMENTS In June 1997, the Company entered into the license agreement with Microsoft. The terms of the agreement provide that a $30,000,000 software license fee will be paid to the Company in two installments. The first installment of $20,000,000 was due within 30 days of the signing of the software license agreement, and the remaining $10,000,000 is due within 30 days of the earlier of (i) the 33 35 Company's completion of six "man months" of consulting services and (ii) six months after delivery of the specified source code to Microsoft. In July 1997, the Company delivered the specified source code and subsequently received from Microsoft a payment of $30,000,000 representing Microsoft's payment of both installments under the agreement although payment of the second installment of $10,000,000 was not due at that time. In October 1997, Microsoft requested that the Company return the $10,000,000 installment that Microsoft had paid prior to its due date. Although not legally required to do so, the Company refunded the $10,000,000 to Microsoft. The Company expects Microsoft to make this second installment payment in accordance with the terms of the agreement. NEW ACCOUNTING PRONOUNCEMENTS In February 1997, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 128, Earnings Per Share ("Statement 128"). Statement 128 establishes standards for the computation, presentation and disclosure of earnings per share ("EPS"), replacing the presentation of the currently required Primary EPS with a presentation of Basic EPS. It also requires dual presentation of Basic EPS and Diluted EPS on the face of the income statement for entities with complex capital structures. Basic EPS is based on the weighted average number of common shares outstanding during the period. Diluted EPS is based on the potential dilution that would occur on exercise or conversion of securities into common stock using the treasury stock method. Statement 128 is effective for financial statements for periods ending after December 15, 1997, including interim periods; earlier application is not permitted. When adopted, the Company will be required to restate its EPS data for all prior periods presented. The Company does not expect the impact of the adoption of Statement 128 to be material to its reported EPS amounts. In June 1997, the FASB issued SFAS No. 130, Reporting Comprehensive Income ("Statement 130"). Statement 130 establishes standards for reporting and disclosure of comprehensive income and its components (revenues, expenses, gains and losses) in a full set of general-purpose financial statements. Statement 130, which is effective for fiscal years beginning after December 15, 1997, requires reclassification of financial statements for earlier periods to be provided for comparative purposes. The Company anticipates that implementing the provisions of Statement 130 will not have a significant impact on the Company's existing disclosures. The Company has not determined the manner in which it will present the information required by Statement 130. In June 1997, the FASB issued SFAS No. 131, Disclosure About Segments of an Enterprise and Related Information("Statement 131"). Statement 131 establishes standards for the way that public business enterprises report information about operating segments. It also establishes standards for related disclosures about products and services, geographic areas and major customers. Statement 131 is effective for financial statements for periods beginning after December 15, 1997. In the initial year of application, comparative information for earlier years must be restated. The Company anticipates that implementing the provisions of Statement 131 will not have a significant impact on the Company's existing disclosures. The Company has not determined the manner in which it will present the information required by Statement 131. 34 36 BUSINESS THE COMPANY RealNetworks is a leading provider of branded software products and services that enable the delivery of streaming media content over the Internet and intranets. The Company's products and services include its RealSystem, a streaming media solution that includes RealAudio and RealVideo technology, an electronic commerce Web site designed to promote the proliferation of streaming media products and a network of advertising-supported content aggregation Web sites. As the Web continues to evolve as a mass communications medium, the Company believes that certain types of content currently delivered through traditional media, such as radio and television, increasingly will be delivered over the Internet. The Company believes that streaming media technology is essential to this evolution because it enables a more compelling user experience, allowing the Internet to compete more effectively with traditional media for audience share. From its inception, the Company has strategically chosen to offer its RealPlayer software to individual users free of charge to promote the widespread adoption of its client software and to speed the acceptance of Internet multimedia. The Company believes that more than 28 million copies of its RealPlayer software have been downloaded. Over 200,000 copies of its premium client product, RealPlayer Plus, have been sold electronically in the product's first year of distribution. In addition, the Company believes that more than 100,000 hours per week of live audio and video content are broadcast over the Web using RealAudio and RealVideo technology, and that more than 150,000 Web pages use the Company's software. The Company's customers, including ABC Radio Net, Bloomberg L.P., The Boeing Company, Dow Jones & Company, Inc. ("Dow Jones"), NBC Desktop, The News Corporation Limited ("News Corp."), Starwave Corporation ("Starwave") and 3Com Corporation ("3Com"), use its software products and services to deliver a broad range of streaming audio and video news, sports, entertainment and corporate information over the Internet and intranets. INDUSTRY BACKGROUND The Internet has grown rapidly in recent years, driven by the development of the Web and graphically intuitive Web browsers, the proliferation of multimedia PCs, increasingly robust network architectures and the emergence of compelling Web-based content and commerce applications. The broad acceptance of the standard Internet Protocol ("IP") has also led to the emergence of intranets and the development of a wide range of non-PC devices that allow users to access the Internet and intranets. International Data Corporation ("IDC") estimates that the number of Web users worldwide will continue to grow rapidly from 28 million in 1996 to 175 million in 2001. In addition, users are spending an increasing amount of time on the Web. A recent study by the Georgia Institute of Technology indicates that 51% of total Internet users access the Internet for 10 or more hours per week as of April 1997, compared with 29% as of April 1995. The development of the Web has contributed to the transition of the Internet from a text and e-mail-focused data-sharing network to a richer environment, capable of delivering graphical and interactive content. The Web has a number of features unavailable in traditional media and commerce channels that attract online users, content providers, advertisers and merchants. The relatively low barriers to publishing content on the Web have led to an explosion of Web-based content and the development of a large and diverse group of Web-based communication channels. As an interactive, searchable, user-controlled medium, the Web provides a highly engaging user experience and allows users to access this broad range of online content on demand and at their convenience. The narrow-casting capabilities of the Web enable content providers and advertisers to establish customized, personalized interactions with consumers. The development of streaming media technology has further enhanced the graphical capabilities of the Internet and intranets. Streaming technology enables the transmission and playback of continuous "streams" of multimedia content, such as audio and video, over the Internet and intranets, and represents a significant advancement over earlier technologies. Prior to the advent of streaming technology, users could not initiate the playback of audio or video clips until such content was 35 37 downloaded in its entirety, resulting in significant waiting times. As a result, live broadcasts of audio and video content over the Internet or intranets were not possible. MARKET OPPORTUNITY The Company believes that the emergence of rich multimedia capabilities, such as streaming audio and video, has significantly enhanced the effectiveness of the Web as a global mass communications medium and has accelerated the adoption of corporate intranets as a means to improve communications within enterprises. Many businesses and content providers now offer interactive audio, video and other multimedia content as a means of enriching and differentiating their Web sites. The Company believes that more than 100,000 hours per week of live audio and video content are broadcast over the Web using RealAudio and RealVideo technology, with a substantially greater amount of recorded media available on demand. These enhanced multimedia capabilities, combined with the unique interactive properties of the Internet, are attracting a large and expanding audience, a growing number of advertisers and an increasing breadth and depth of content and online commercial applications. The market for Web advertising revenues is expected to grow from $180 million in 1996 to $2.9 billion in 2000, according to IDC. Overall usage growth, together with the Internet's unique interactive properties, has also led to a rapidly evolving online commerce opportunity. IDC estimates that worldwide revenues generated by Web-based commerce will grow from $2.6 billion in 1996 to $223 billion in 2001. As a result of the growth in business opportunities on the Internet, the market for software solutions that focus on the Internet and intranets is also growing rapidly. IDC estimates that Internet-focused software revenues will grow from $359 million in 1995 to $4.3 billion in 2000. As the Web continues to evolve as a mass communications medium, the Company believes that certain types of content currently delivered through traditional media, such as radio and television, increasingly will be delivered over the Internet. The Company believes that streaming media technology is essential to this evolution because it provides a more compelling user experience, allowing the Internet to compete more effectively with traditional media for audience share. The Company believes that to successfully capitalize on this opportunity, streaming media providers must address the following challenges: DELIVER COMPELLING STREAMING MEDIA CONTENT IN BANDWIDTH CONSTRAINED ENVIRONMENTS. The Internet was designed to transmit discrete packets of data and is not inherently well suited to the delivery of continuous streams of multimedia data without additional software. In addition, bandwidth is limited in Internet and intranet environments, posing significant technological challenges for delivery of high-quality streaming audio and video content. ENABLE BROAD-BASED ACCESS TO STREAMING MEDIA TECHNOLOGY. Online content providers, advertisers and merchants must make a significant investment to create and deliver streaming media content and need to reach a sufficiently large audience to generate an adequate return on such investment. As a result, content providers must consider the popularity and quality of a particular streaming media solution before committing resources to delivering content using that solution. DRIVE CONSUMER USAGE. The Company believes that consumer interest in streaming media content is driven in large part by the ability to locate and experience such content easily. As a result, the Company believes that the development of well-marketed, compelling Web sites that aggregate streaming media content is central to the continued growth of multimedia content on the Web. The Company believes that a substantial opportunity exists to provide software solutions and content aggregation and delivery services that address these challenges and support the development of large and growing advertising and electronic commerce markets on the Web. 36 38 THE REALNETWORKS SOLUTION RealNetworks enables and promotes the transmission of real-time streaming media content over the Internet and intranets. The Company provides branded streaming media software products and services, including its RealSystem, a streaming media solution that includes RealAudio and RealVideo technology, an electronic commerce Web site designed to promote the proliferation of streaming media products and a network of advertising-supported content aggregation Web sites. Each of the Company's products and services has been designed to address the technological and market development challenges that confront streaming media content providers. STREAMING MEDIA TECHNOLOGY. RealNetworks has been a pioneer in the development of streaming media technology and continues to offer leading streaming media software solutions. The Company's products use advanced compression and error-correction technologies to deliver acceptable performance even in bandwidth-constrained environments. The Company has won numerous awards for its technology, including PC Magazine Editor's Choice award for streaming video in October 1997. The Company's recent "beta" release of its RealSystem Version 5.0 offers software products with streaming animation capabilities and improved audio and video quality, including full-screen video at higher bandwidths. RealSystem Version 5.0 also enables incorporation of seamless in-stream advertising into existing broadcasts or on-demand clips. The Company believes in-stream advertising offers increased revenue opportunities for its RealSystem Server customers. In addition, RealSystem Version 5.0 enables password-protected access to content, allowing content providers to incorporate subscription-based or "pay-per-view" streaming media content access over the Internet. The Company's software runs on a broad range of operating systems and hardware platforms, enabling content providers to reach a broad audience and enterprises to deliver intranet content in heterogeneous computing environments. REALPLAYER UBIQUITY AND BRAND STRENGTH. From its inception, the Company has strategically chosen to offer its RealPlayer software to individual users free of charge to promote the widespread adoption of its client software and speed the acceptance of Internet multimedia. The Company estimates that more than 28 million copies of its RealPlayer software have been downloaded and that more than 150,000 Web pages use the Company's software. In addition, over 1,200 third-party developers have joined the Company's Real Developer Program. To continue the broad market adoption of its server products, the Company now offers its Basic Server free of charge. As a result of these activities and the Company's aggressive promotional programs, the Company believes that the "Real" brand has become one of the most widely recognized brands on the Internet. ELECTRONIC COMMERCE DISTRIBUTION CHANNEL. The Company has pursued an electronic commerce distribution strategy designed to further accelerate product adoption and drive upgrade and cross-selling opportunities among its existing installed user base. The Company's online distribution efforts have resulted in electronic sales of over 200,000 copies of the Company's RealPlayer Plus in its first year of distribution and the collection of a database of information that includes over 7 million names. Recently, the Company opened its RealStore Web site, an online store for the sale of the Company's products, third-party multimedia tools and utilities, and intranet-based training products. The Company believes that it will be able to continue to facilitate the adoption and growth of streaming media content by providing a concentrated marketplace and a low-cost distribution mechanism for emerging streaming media tools and their developers. STREAMING MEDIA CONTENT AND AGGREGATION. The Company's advertising-supported Web sites, including Timecast, LiveConcerts.com and Film.com, aggregate, organize and provide streaming media programming in order to build consumer awareness and Web site traffic for streaming media content. According to I/Pro, Inc., the Company's network of Web sites attracted an average of 380,000 visitors and generated over 2 million page impressions per day. The Company's Daily Briefing and Destination Button services provide one-click access to a range of third-party programming. In addition to generating advertising revenues, the Company believes these sites and services stimulate demand for and creation of streaming media content using the Company's RealSystem. 37 39 STRATEGY The Company's objective is to be the leading streaming media company, providing software and services that enable the delivery of a broad range of multimedia content over the Internet and intranets, thereby facilitating the evolution of the Internet into a mass communications and commerce medium. To achieve this objective, the Company's strategy includes the following key elements: EXTEND TECHNOLOGY LEADERSHIP. The Company has established a reputation as a leader in streaming media technology and intends to continue to maintain its reputation for quality and innovation by expanding the features and breadth of its audio and video product offerings. The Company recently introduced streaming animation, in-stream advertising and password-protected access to content as part of the "beta" release of its RealSystem Version 5.0. The Company believes that the fundamental architecture of its products also can be expanded to support synchronized streaming of a wide variety of other time-based data types, such as MIDI, images and multimedia presentations. As part of its strategy, the Company has devoted and will continue to commit significant resources to the development of technologies that increase the scaleability of streaming media solutions. MAXIMIZE MARKET PENETRATION AND BRAND NAME RECOGNITION. The Company believes that it is a recognized leader in the streaming media technology and that its "Real" brand is one of the most widely recognized brand names on the Internet. Since its inception, the Company has sought to achieve rapid and broad adoption of its technologies and strong brand recognition. This strategy has been pursued through various means, such as offering the Company's RealPlayer to individual users free of charge over the Internet, bundling the Company's products with those of other major vendors and using multiple distribution channels, including both direct sales and indirect OEM and retail relationships. The Company recently has intensified its efforts to proliferate its streaming technology by offering its Basic Server free of charge and entering into a licensing and distribution agreement with Microsoft. The Company also intends to continue to promote the adoption of industry standards that are either based on or compatible with its technologies. For example, the Company is one of the principal co-authors of RTSP, a proposed industry standard for the control and delivery of streaming media. LEVERAGE MARKET POSITION TO EXPAND BUSINESS MODEL. Management believes that the Company's technology leadership, market position and brand name are significant assets that the Company can leverage to maintain and increase its market share and diversify its revenue base. The Company intends to leverage these assets as follows: - GROW STREAMING MEDIA SOFTWARE BUSINESS. The Company intends to capitalize on the growth in demand for streaming media software by continuing to develop, market and support industry-leading products and services. The Company also plans to strengthen its marketing, sales and customer support efforts as the size of its market opportunity and customer base increases. - EXPAND INTERNET COMMERCE BUSINESS. The Company's Web sites provide product information and fulfillment resources for streaming media content users and developers. The Company recently opened its RealStore Web site, an online store for the sale of the Company's products, third-party streaming media tools and utilities, and intranet-based training products. The Company believes that it will be able to continue to facilitate the adoption and growth of streaming media content by providing a concentrated marketplace and a low-cost distribution mechanism for emerging streaming media tools and their developers. - OFFER LEADING CONTENT AGGREGATION SITES FOR STREAMING MEDIA. The Company has developed a network of Web sites that aggregate links to third-party streaming media programming. The Company plans to continue building Web site traffic with these activities to increase Web site advertising revenues, increase visibility and sales of the Company's products, promote the use of streaming media content on the Internet or intranets and promote the Company's Internet commerce platform. DEVELOP AND MARKET STREAMING MEDIA SOLUTIONS FOR A VARIETY OF PLATFORMS AND BANDWIDTHS. The Company's rapid growth is attributable in part to the wide acceptance of the 38 40 streaming media solutions it has developed for PCs networked in low-bandwidth environments. However, significant efforts are underway to make the Internet available on a wider range of platforms, including non-PC Internet appliances, and over higher-speed connections, including cable modems. Accordingly, the Company seeks to design its solutions to add value in a range of bandwidth environments and to be flexible enough to port easily to new platforms. As a result, management believes that the Company is positioned to capitalize on possibly significant platform and bandwidth changes. STRENGTHEN STRATEGIC RELATIONSHIPS. The Company has established strategic relationships with a variety of industry participants, including software and hardware vendors, entertainment companies, content publishers and broadcast media companies. The Company's relationship with Microsoft enables wider distribution of the Company's products and promotes interoperability among numerous streaming media technologies. In addition to its relationship with Microsoft, the Company has formed strategic distribution relationships with several other companies, including Starlight Networks Incorporated and Macromedia, has formed a joint venture in Japan with NTT PC Communications, Inc. ("NTT"), Kokusai Denshin Denwa Co., Ltd. ("KDD") and Trans Cosmos, Inc. ("Trans Cosmos") and has entered into a pilot program with MCI Communications Corporation ("MCI") to distribute the RealNetwork broadcast service. The Company pursues strategic relationships for a variety of purposes, such as maximizing rapid penetration, validation and adoption of its technologies; aiding the development of compelling content to build consumer demand for streaming media over the Internet; and expanding the range of commercial activities based on its technology and brand name. The Company has also collaborated with other industry leaders for the purpose of developing software protocols for proposed adoption as industry standards. Although the Company has not engaged in significant joint technology development relationships to date, it anticipates that it may form third-party development relationships in the future as it seeks to expand the fundamental architecture of its technology and influence the direction of technological developments in the industry. PRODUCTS AND SERVICES The Company develops and markets software products and services that enable the delivery of streaming audio and video content over the Internet and intranets. The Company also conducts electronic commerce and sells advertising through its Web sites, provides audio and video broadcast services to third parties, and provides various other services designed to promote widespread usage of the Company's technology. MEDIA SYSTEM The Company's streaming media system allows content providers to encode content such as audio, video or other multimedia programming into discrete data packets that can be broadcast to large numbers of simultaneous users. BASIC SERVER. The Company offers a Basic Server free of charge from its Web sites. This product enables content providers to stream both audio and video to as many as 60 simultaneous users. BASIC SERVER PLUS. The Basic Server Plus is an enhanced server that can be downloaded from the Company's Web sites for $695. In addition to the Basic Server functions, Basic Server Plus supports streaming animation and enhanced administration capabilities and includes RealPublisher, technical support and upgrades. REALSERVER INTERNET SOLUTION. The Internet Solution is designed for use by commercial Web sites, including media content providers that distribute audio, video or animation content over the Internet to a broad base of consumers. The Internet Solution includes the RealServer, which offers the Basic Server Plus functions as well as advanced administrative features, the ability to reach a larger audience and in-stream advertising insertion and rotation. The Internet Solution also includes the RealPublisher and the RealEncoder. Internet Solution licenses start at $4,995 and are priced based on the number of streams licensed. 39 41 REALSERVER INTRANET SOLUTION. The Intranet Solution is a RealServer designed specifically for use in intranet applications. The Intranet Solution includes the RealPublisher, the RealEncoder and a site license for the RealPlayer. A 10-user Intranet Solution is available free of charge from the Company's Web sites. Larger system licenses start at $6,995 and are priced according to the number of licensed users. COMMERCE SOLUTION. The Commerce Solution is an integrated system that can be used with the Internet or Intranet Solution to provide secure, selective access to streaming media content. The Commerce Solution is comprised of the Commerce RealServer, which includes all the functions of the RealServer as well as user and workstation authentication, encrypted challenge/response systems and broad database and Web-based commerce systems compatibility. Commerce Solution licenses are priced based on the number of streams licensed. REALPUBLISHER. The RealPublisher is a software tool that enables users to create and publish RealAudio and RealVideo content-enabled Web pages without having to program in HTML. The RealPublisher can be downloaded from the Company's Web sites for $49.95. REALENCODERS. The Company's RealEncoders enable content providers to compress live or recorded audio and video programming into the Company's file format. This highly compressed file format increases the efficiency of limited-bandwidth transmissions and is readable by the Company's players. The RealEncoder can be downloaded free of charge from the Company's Web site. REALNETWORK BROADCAST SERVICE. The Company operates the RealNetwork broadcast service, which uses the Company's splitter technology to broadcast content to thousands of simultaneous users through IP multicasting or traditional unicasting. In August 1997, the Company and MCI commenced a pilot program in which the Company's technology will be incorporated into MCI's Internet backbone. The RealNetwork broadcast service enables broadcasters to reach up to 50,000 users simultaneously by combining MCI's nationwide network of datalines and computer centers with the Company's streaming media and splitter technologies. Current content providers using the RealNetwork broadcast service include ABC News, Inc., Atlantic Recording Corporation, ESPN, Inc., and Major League Baseball teams, including the Los Angeles Dodgers and the Seattle Mariners. The Company often uses the RealNetwork broadcast service to host its own content. In select cases, the Company has and will continue to enter into relationships with content providers in which the providers' content is hosted on the RealNetwork broadcast service at the Company's expense in exchange for a share of the advertising or other revenue generated. In May 1997, the Company entered into a joint venture with NTT, KDD and Trans Cosmos in Japan to establish J-Stream Co. Inc. ("J-Stream"), which, like the Company's RealNetwork broadcast service, streams audio and video content to users through IP multicasting or traditional unicasting. The Company supplies its RealAudio and RealVideo system and technical support for the operation of the J-Stream broadcast network. The Company holds a 24% interest in J-Stream. See "Certain Transactions -- Japanese Joint Venture." CONSULTING. The Company provides a range of consulting services that principally relate to the creation and maintenance of streaming media networks based on the Company's technology. Commonly provided services include sound editing, video production assistance and network design. CONSUMER PRODUCTS AND ELECTRONIC COMMERCE The Company's player enables a user to listen to or view content from Web sites that use the Company's server products. The player decompresses and decodes audio, video or animation packets transmitted by the server, reassembles them in the correct order, identifies and requests retransmission of any missing data packets, and then plays back the reassembled audio, video or animation content for the user in real-time. The players can be easily installed and used by nontechnical computer users, even using dial-up modems over standard voice-grade telephone lines. REALPLAYER. RealPlayer, the Company's standard player, can be downloaded free of charge from the Company's Web site and currently is distributed by a number of third parties in combination with their own products. RealPlayer offers basic functions such as play, stop, fast-forward, rewind and volume 40 42 adjustment, as well as the ability to program six Destination Buttons, which provide one-click access to preprogrammed audio, video or animation content. REALPLAYER PLUS. The RealPlayer Plus is an enhanced player that can be downloaded from the Company's Web site or purchased in a retail store for a suggested price of $29.95. RealPlayer Plus not only offers basic RealPlayer functions, but also features a scan function and 40 programmable buttons that allow users to preset favorite content. Customers who purchase a RealPlayer Plus also have access to special content available only to RealPlayer Plus users. ELECTRONIC COMMERCE AND REALSTORE. Since August 1996, the Company has sold its products electronically. On September 8, 1997, it opened its RealStore Web site, an online store for the sale of the Company's products, third-party streaming media tools and utilities, and intranet-based training products. Through this distribution channel, the Company is able to offer a broad selection of products with little inventory risk or merchandising expense. MEDIA PUBLISHING PRODUCTS AND SERVICES The Company's network of Web sites aggregates, organizes and provides streaming media programming through a variety of navigational and theme-oriented content sites. These sites derive revenues from the sale of advertising to third parties such as General Motors Corporation, International Business Machines Corporation, AT&T Corp. and Microsoft. The Company has been instrumental in pioneering new forms of Internet advertising, including in-stream advertising, in which streamed audio and video advertisements are inserted into selected programming. In addition to its main Web site, the Company's network of Web sites includes: Timecast, a guide to RealAudio and RealVideo content that offers programming information from and links to over 2,500 Web sites, including over 500 radio and television stations; LiveConcerts.com, which, in cooperation with House of Blues, offers live streamed music concerts using the Company's products as well as access to services, including up-to-date concert schedules; Film.com, which the Company began hosting in September 1997, provides in-depth information about, and streaming media clips of, movies, including reviews and previews; and Daily Briefing, which allows customers to design their own custom streaming media newscasts from over 35 short programs in the areas of news, sports, entertainment, weather and business/technology, and to receive the custom newscasts daily. Daily Briefing providers include NBC News, The Weather Channel, CBS/SportsLine and Warner Bros. Inc. TECHNOLOGY The Company's client/server software system is designed to optimize the delivery of streaming media over the Internet, intranets or any IP-based network. The system is based on open industry standards and works with a broad range of operating systems, hardware platforms and media types. CODECS The Company's system uses multiple compression/decompression algorithms (or "codecs") to translate time-based data-intensive content such as audio, video or animation data into discrete data packets and then broadcast (or "stream") the packets to the client (or "player"). The player then reassembles the packets in the correct order and plays back the streaming media content in real time. The compression process enables the data to be streamed to the player even in very low bandwidth (14.4 kbps) or congested network environments by reducing the amount of data to be streamed. 41 43 TRANSMISSION TECHNOLOGY AND PROTOCOLS Neither of the two basic Internet transport protocols, User Datagram Protocol ("UDP") and Transport Control Protocol ("TCP"), was originally designed to handle the transmission of real-time content. UDP is able to transmit data packets efficiently and without delays, but is not generally robust enough to ensure delivery of all data packets. TCP generates robust and reliable transmissions, but is not designed for efficient and continuous real-time delivery of content. Higher level Internet protocols, such as File Transfer Protocol ("FTP") and Hypertext Transfer Protocol ("HTTP"), were designed originally for one-way continuous transmissions and as such do not efficiently allow the player to communicate back to the server to activate functions such as fast forward, pause and rewind or to select a particular portion of a clip for playing. To address the inherent limitations of the Internet with respect to multimedia delivery, the Company has developed its own client/server software architecture based on advanced transmission technologies and protocols. Key elements of the Company's technology solution include: - BUFFERING: Because the streaming of continuous, time-based content such as audio or video must occur in real-time and with minimal transmission loss, the Company's technology incorporates a time delay (or "buffering") feature that allows the player extra time to accumulate data packets and, if any are missing, request retransmission of particular packets. As a result, transmission and playback quality can be optimized, even in highly congested transmission environments. - BIDIRECTIONAL COMMUNICATION: The Company's server and player communicate during transmission regarding the bandwidth and quality of the user's connection to optimize the transmission by using the system's bandwidth negotiation and dynamic connection management capabilities. For example, the system is able to detect the available bandwidth and the extent of packet loss and performance degradation. - ERROR-MITIGATION: To the extent that buffering and packet retransmission efforts are insufficient to maintain acceptable quality of user experience, the Company's system draws on several techniques designed to mitigate performance degradation, including interpolation methods that "reconstruct" lost data packets based on approximations regarding adjacent or closely related data packets, UDP-based retransmission of lost packets and forward error correction. - SMART NETWORKING: This feature allows a server to stream content to the player via unicasting or IP multicasting and automatically select the appropriate transmission protocol (UDP, TCP or HTTP) depending on current network conditions and the presence of firewalls or proxies. - VIDEO-OPTIMIZED TRANSMISSION: Because video transmissions are more data-intensive than audio transmissions, the encoding of video streams for low bandwidth requires a higher compression ratio. In addition to standard compression techniques, the Company uses a technique known as interframe compression, which reduces unnecessary repetition of redundant background data in neighboring video frames, thereby reducing the number of data packets being transmitted. The system also incorporates "stream thinning" technology that responds to episodes of performance degradation by dynamically reducing the amount of video content being streamed to the user, thereby preserving bandwidth for audio packets to maintain the continuity of the audio stream, which is often more central to the user experience than video. In addition to its core client/server technology, the Company has adopted RTSP, a proposed protocol for standardizing the control and delivery of streaming media over the Internet. RTSP is a unified standard for a broad range of media data types and is intended to promote a greater level of interoperability among various streaming media solutions. RTSP is built on top of a number of other Internet standard protocols such as HTTP, TCP/IP and Real Transport Protocol, and is complementary with ASF, a file format for streaming media that does not specify a method of client-server interaction. RTSP provides the client-server specification necessary to stream ASF files (and many other file types) 42 44 on the Internet. RTSP was submitted to the IETF in October 1996 with the support of over 40 companies. See "-- Microsoft Relationship" and "Risk Factors -- Impact of Evolving Standards." NETWORKED MULTIMEDIA FOR LARGE-SCALE DELIVERY The Company's splitter technology allows broadcasters to transmit large numbers of simultaneous streams. Traditionally, a stand-alone server sends a separate signal to each individual user, which is an inefficient use of network bandwidth because the same signal often is distributed through many of the same links on the network. The Company's splitter technology enables one "central" server to broadcast a signal to a set of servers distributed around a network, which servers then transmit the signal to the end user, thereby minimizing the use of the network backbone and improving signal quality. The Company uses this technology in its RealNetwork broadcasting service, as well as in its J-Stream joint venture in Japan. See "-- Strategy -- Strengthen Strategic Relationships" and "-- Products and Services -- Media System." RESEARCH AND DEVELOPMENT The Company devotes a substantial portion of its resources to developing new products and product features, expanding and improving its fundamental streaming technology, and strengthening its technological expertise. During the fiscal year ended December 31, 1996, and the nine months ended September 30, 1997, the Company expended approximately 34% and 41%, respectively, of its total net revenues on research and development activities. The Company intends to continue to devote substantial resources toward research and development for the next several years. As of September 30, 1997, the Company had 93 employees, or approximately 31% of its workforce, engaged in research and development activities. The Company must hire additional skilled software engineers to further its research and development efforts. The Company's business, financial condition and results of operations could be adversely affected if it is not able to hire and retain the required number of engineers. SALES, MARKETING AND DISTRIBUTION The Company believes that any individual or company that desires to transmit or receive streaming media content over the Internet or intranets is a potential Company customer. To reach as many customer segments as possible, the Company markets its products and services through several direct and indirect distribution channels, including over the Internet, through a direct sales force, through OEMs and VARs, and internationally through distributors and the J-Stream joint venture. As of September 30, 1997, the Company had 103 employees, or approximately 35% of its workforce, engaged in sales and marketing activities. ELECTRONIC COMMERCE. The Company's Consumer and E-Commerce Divisions are responsible for electronic commerce sales and marketing of the Company's products as well as third-party multimedia development products sold on the Company's RealStore Web site. Substantially all of the Company's products may be downloaded directly from the Company's Web sites, with over 18 million product downloads to date. The Company sells third-party products on its RealStore Web site on a consignment basis and, accordingly, incurs no inventory risk with respect to such products. Electronic distribution provides the Company with a low-cost, globally accessible, 24-hour sales channel. DIRECT SALES FORCE. The Company's direct sales force markets the Company's products and services primarily to corporate customers worldwide. The direct sales force is comprised of the Major Accounts, National Accounts and Telesales groups of the Company's Media Systems Division. The Major Accounts and National Accounts groups market and sell to corporate customers primarily interested in server products for commercial Internet Web sites or intranets. The Telesales group develops and pursues leads generated from inquiries on the Company's Web sites and from downloads of its EasyStart Server. 43 45 OEMS AND VARS. The Strategic Channels, OEM and Consulting groups of the Company's Media Systems Division market and establish indirect distribution agreements. The Company has entered into various distribution relationships with third parties pursuant to which the Company's products are incorporated into, or bundled with, the third party's products for delivery by the third party to end users. Such third parties include Creative Labs, Inc., Apple Computer, Inc., Network Computer, Inc., WebTV Networks, Inc. and Microsoft. ADVERTISING SALES. The Company's Advertising Sales group markets and sells advertising on the Company's Web sites and within media streams that the Company hosts on behalf of its corporate customers. INTERNATIONAL SALES. The Company has three international subsidiaries that market and sell the Company's products outside the U.S. The Company distributes its products internationally through a direct sales force and distribution arrangements. MARKETING PROGRAMS. The Company participates in trade shows, conferences and seminars, provides product information through the Company's Web sites, promotes and co-promotes special events, places advertising for the Company's products and services in print and electronic media, and sponsors special programs for software developers, including its own conference. The Company's marketing programs are aimed at informing distributors and end users about the capabilities and benefits of the Company's products and services, increasing brand name awareness, stimulating demand across all market segments and encouraging independent software developers to develop products and applications that are compatible with the Company's products and technology. MICROSOFT RELATIONSHIP In June 1997, the Company entered into a strategic agreement with Microsoft pursuant to which the Company granted Microsoft a nonexclusive license to certain substantial elements of the source code of the Company's RealAudio/RealVideo Version 4.0 technology included in its basic RealPlayer and substantial elements of its EasyStart Server (currently known as the Basic Server), and related Company trademarks. Under the agreement, Microsoft may sublicense its rights to the licensed technology to third parties under certain circumstances. On two occasions during the first two years following delivery under the agreement, Microsoft may acquire for $25 million and $35 million, respectively, a nonexclusive license to subsequently developed versions of the core audio and video technology, which currently is distributed to end-users at no charge. Under prescribed circumstances that are solely within the Company's control, the agreement provides for a full refund of each license fee during the first year, declining to 0% over the following two years. The Company may not assign its obligations under the agreement without Microsoft's consent, and a merger, the sale of substantially all of the Company's assets and certain other events will be deemed to be an assignment under the agreement. Microsoft is obligated to distribute the Company's RealPlayer Version 4.0 for a defined term as long as the Company's player supports certain Microsoft architectures. The Company also agreed to work with Microsoft and several other companies to author and promote ASF as a standard file format for streaming media. The agreement also requires the Company to provide Microsoft with engineering consultation services, certain error corrections and certain technical support over a defined term. In connection with the agreement, Microsoft also purchased a minority interest in the Company. Microsoft currently offers its own streaming media product, NetShow. In addition, Microsoft recently acquired VXtreme, a direct competitor of the Company in the market for streaming media software. Microsoft also owns a minority interest in VDOnet, a direct competitor of the Company in the market for streaming video software. As a result of Microsoft's agreement with the Company, its acquisition of VXtreme and its investment in VDOnet, Microsoft will be able to augment substantially the functionality of NetShow, its streaming media product, which could have a material adverse effect on the competitiveness of the Company's products. See "Risk Factors -- Department of Justice Subpoena." Microsoft currently competes with the Company in the market for streaming media server and player software. The Company believes that Microsoft will compete more directly with the Company in the 44 46 future. The Company also believes that Microsoft's commitment to and presence in the streaming media industry will dramatically increase competitive pressure in the overall market for streaming media software, leading to, among other things, increased pricing pressure and longer sales cycles. Such pressures may result in further price reductions in the Company's products and may also materially reduce the Company's market share. The Company believes that Microsoft will incorporate streaming media technology in its Web browser software and certain of its server software offerings, possibly at no additional cost to the user. In addition, notwithstanding the Company's cooperation with Microsoft regarding ASF, Microsoft may promote technologies and standards not compatible with the Company's technology. Microsoft has a longer operating history, a larger installed base of customers and dramatically greater financial, distribution, marketing and technical resources than the Company. As a result, there can be no assurance that the Company will be able to compete effectively with Microsoft now or in the future, or that the Company's business, financial condition and results of operations will not be materially adversely affected by increased competition in the streaming media industry. In addition, if considerable industry consolidation occurs, there can be no assurance that the Company will be able to continue to compete effectively. CUSTOMERS Since the Company's inception, the following companies have paid $45,000 or more to the Company for the purchase of products or services or the license of technology: ABC Radio Net, Apple Computer, Inc., Bandai Digital Entertainment Corporation, Bloomberg L.P., Boeing-Inform, Cisco Systems, Inc., Creative Labs, Inc., Dow Jones, Forefront Graphics Corporation, Internet Canada Corporation, Merrill Lynch & Co. Inc, Microsoft, Multiple Zones International, Inc., Muzak Limited Partners, Navio Communications, Inc., NBC Desktop, NetRadio Network, Network Computer Inc., News Corp., Prodigy Inc., Starwave, Tele2 Danmark A/S, Teledanmark In, Telia AB, 3Com, United Technologies Corporation, WavePhore, Inc. and WebTV Networks, Inc. The Company's customers consist primarily of resellers and users located in the U.S. and various foreign countries. Sales to customers outside the U.S., primarily in Asia and Europe, were approximately 17%, 22% and 27% of total net revenues in the years ended December 31, 1995 and 1996 and the nine months ended September 30, 1997, respectively. Software license fees under a license agreement with Microsoft accounted for approximately 11% of total net revenues for the nine months ended September 30, 1997. CUSTOMER SUPPORT The Company's customers have a choice of support options depending on the level of service desired. The Company maintains a technical support hotline to answer inquiries and provides an online database of technical information. The Company's support staff also responds to e-mail inquiries. The Company tracks all support requests through a series of customer databases, including current status reports and historical customer interaction logs. The Company uses customer feedback as a source of ideas for product improvements and enhancements. As of September 30, 1997, the Company employed 8 technical representatives to respond to customer requests for support. COMPETITION The market for software and services for the Internet and intranets is relatively new, constantly evolving and intensely competitive. The Company expects that competition will intensify in the future. Many of the Company's current and potential competitors have longer operating histories, greater name recognition and significantly greater financial, technical and marketing resources than the Company. The Company's principal competitors in the development and distribution of audio and video streaming solutions include Microsoft, VXtreme, VDOnet, Xing, Precept, Cubic, Motorola, Vivo, Vosaic and Oracle. The Company's RealSystem also competes to a lesser degree with non-streaming audio and video delivery technologies such as AVI and Quicktime, and indirectly with delivery systems for multimedia content other than audio and video, such as Flash by Macromedia and Enliven by Narrative. Competitive factors in this market include the quality and reliability of software; features for creating, editing and 45 47 adapting content; ease of use and interactive user features; scaleability and cost per user; and compatibility with the user's existing network components and software systems. To expand its user base and further enhance the user experience, the Company must continue to innovate and improve the performance of its RealSystem. The Company anticipates that consolidation will continue in the streaming media industry and related industries such as computer software, media and communications. Consequently, competitors may be acquired by, receive investments from or enter into other commercial relationships with, larger, well-established and well-financed companies. There can be no assurance that the Company can establish or sustain a leadership position in this market segment. See "-- Microsoft Relationship." The Company is committed to the continued market penetration of its brand, products and services, which, as a strategic response to changes in the competitive environment, may require pricing, licensing, service or marketing changes intended to extend its current brand and technology franchise. For example, the Company recently made its Basic Server, which had previously sold for $295 to $995, available for download free of charge. Continued price concessions or the emergence of other pricing or distribution strategies by competitors may have a material adverse effect on the Company's business, financial condition and results of operations. The Company currently derives significant revenues from the electronic distribution of certain of its products. The Company recently opened its RealStore Web site, an online store for the sale of the Company's products, third-party streaming media tools and utilities, and intranet-based training products. The Company competes with a variety of Web sites, such as Buydirect.Com and Sofware.Net, which also offer software products for download. To compete successfully in the electronic commerce market, the Company must attract sufficient commercial traffic to its RealStore Web site by offering high-quality merchandise in a compelling, easy-to-purchase format. There can be no assurance that the Company will be able to compete successfully in this market, and any failure to do so could have a material adverse effect on the Company's business, financial condition and results of operations. In the Internet advertising segment, the Company competes for Internet advertising revenues with a wide variety of Web sites and Internet service providers. While Internet advertising revenues across the industry continue to grow, the number of Web sites competing for such revenue is also growing rapidly. The Company's advertising sales force and infrastructure are still in early stages of development relative to the Company's competitors. There can be no assurance that advertisers will place advertising with the Company or that revenues derived from such advertising will be material. In addition, if the Company loses advertising customers, fails to attract new customers, is forced to reduce advertising rates or otherwise modify its rate structure to retain or attract customers, or loses Web site traffic, the Company's business, financial condition and results of operations may be materially adversely affected. POSITION ON CHARITABLE RESPONSIBILITY Following closing of the offering, Mr. Glaser will contribute 5%, or approximately 700,000 shares, of his Common Stock to charitable organizations. In addition, Mr. Jacobsen intends to contribute approximately 60,000 shares of his Common Stock to charitable organizations. The Company is strongly committed to charitable responsibility, as evidenced by its donations of software to charitable organizations. If sustained profitability is achieved, the Company intends to donate approximately 5% of its annual net income to charitable organizations. The Company hopes to encourage employee giving by using a portion of its intended contribution to match charitable donations made by employees. See "Risk Factors -- Donation of Net Income to Charity." GOVERNMENTAL REGULATION The Company currently is not subject to direct regulation by any governmental agency, other than laws and regulations generally applicable to businesses, although certain U.S. export controls and import controls of other countries, including controls on the use of encryption technologies, may apply to the Company's products. Due to the increasing popularity and use of the Internet, it is possible that a number 46 48 of laws and regulations may be adopted in the U.S. and abroad with particular applicability to the Internet. It is possible that governments will enact legislation that may be applicable to the Company in areas such as content, network security, encryption and the use of key escrow, data and privacy protection, electronic authentication or "digital" signatures, illegal and harmful content, access charges and retransmission activities. Moreover, the applicability to the Internet of existing laws governing issues such as property ownership, content, taxation, defamation and personal privacy is uncertain. The majority of such laws were adopted before the widespread use and commercialization of the Internet and, as a result, do not contemplate or address the unique issues of the Internet and related technologies. Any such export or import restrictions, new legislation or regulation or governmental enforcement of existing regulations may limit the growth of the Internet, increase the Company's cost of doing business or increase the Company's legal exposure, which could have a material adverse effect on the Company's business, financial condition and results of operations. The Company faces potential liability for claims based on the nature and content of the materials that it distributes over the Internet, including claims for defamation, negligence or copyright, patent or trademark infringement, which claims have been brought, and sometimes successfully litigated, against Internet companies. The Company's general liability insurance may not cover claims of this type or may not be adequate to indemnify the Company for any liability that may be imposed. Any liability not covered by insurance or in excess of insurance coverage could have a material adverse effect on the Company's business, financial condition and results of operations. Although sections of the CDA that, among other things, proposed to impose criminal penalties on anyone distributing "indecent" material to minors over the Internet, were held to be unconstitutional by the U.S. Supreme Court, there can be no assurance that similar laws will not be proposed and adopted. While the Company does not distribute the types of materials that the CDA may have deemed illegal, the nature of such similar legislation and the manner in which it may be interpreted and enforced cannot be fully determined and, therefore, legislation similar to the CDA could subject the Company to potential liability, which in turn could have an adverse effect on the Company's business, financial condition and results of operations. Such laws also could damage the growth of the Internet generally and decrease the demand for the Company's products and services, which could adversely affect the Company's business, financial condition and results of operations. INTELLECTUAL PROPERTY The Company's success depends in part on its ability to protect its proprietary software and other intellectual property. To protect its proprietary rights, the Company relies generally on patent, copyright, trademark and trade secret laws, confidentiality agreements with employees and third parties, and license agreements with consultants, vendors and customers, although the Company has not signed such agreements in every case. Despite such protections, a third party could, without authorization, copy or otherwise obtain and use the Company's products or technology, or develop similar technology. There can be no assurance that the Company's agreements with employees, consultants and others who participate in product development activities will not be breached, that the Company will have adequate remedies for any breach, or that the Company's trade secrets will not otherwise become known or independently developed by competitors. The Company currently has two patents pending in the U.S. relating to its product architecture and technology and holds one patent entitled "Method and Apparatus for Recommending Selections Based on Preferences in a Multi-User System." There can be no assurance that any pending or future patent applications will be granted, that any existing or future patent will not be challenged, invalidated or circumvented, or that the rights granted under any patent that has issued or may issue will provide competitive advantages to the Company. Many of the Company's current and potential competitors dedicate substantially greater resources to protection and enforcement of intellectual property rights, especially patents. If a blocking patent has issued or issues in the future, the Company would need to either obtain a license or design around the patent. There can be no assurance that the Company would be able to obtain such a license on acceptable terms, if at all, or to design around the patent. The Company pursues the registration of certain of its trademarks and service marks in the U.S. and in certain 47 49 other countries, although it has not secured registration of all its marks. As of September 30, 1997, the Company had nine registered U.S. trademarks or service marks, and had applications pending for an additional 27 U.S. trademarks. A significant portion of the Company's marks begin with the word "Real" (such as RealSystem, RealAudio and RealVideo). The Company is aware of other companies that use "Real" in their marks alone or in combination with other words, and the Company does not expect to be able to prevent all third-party uses of the word "Real" for all goods and services. In addition, the laws of some foreign countries do not protect the Company's proprietary rights to the same extent as do the laws of the U.S., and effective patent, copyright, trademark and trade secret protection may not be available in such jurisdictions. The Company licenses certain of its proprietary rights to third parties, and there can be no assurance that such licensees will abide by compliance and quality control guidelines with respect to such proprietary rights or that such licensees will not take actions that would materially adversely affect the Company's business, financial condition and results of operations. To license many of its products, the Company relies in part on "shrinkwrap" and "clickwrap" licenses that are not signed by the end user and, therefore, may be unenforceable under the laws of certain jurisdictions. As with other software products, the Company's products are susceptible to unauthorized copying and uses that may go undetected, and policing such unauthorized use is difficult. In general, there can be no assurance that the Company's efforts to protect its intellectual property rights through patent, copyright, trademark and trade secret laws will be effective to prevent misappropriation of its technology, or to prevent the development and design by others of products or technologies similar to or competitive with those developed by the Company, and the Company's failure or inability to protect its proprietary rights could materially adversely affect its business, financial condition and results of operations. The computer software market is characterized by frequent and substantial intellectual property litigation that often is complex and expensive and involves a significant diversion of resources and uncertainty of outcome. In the future, the Company may need to pursue litigation to enforce and protect its intellectual property and trade secrets or to defend against a claim of infringement or invalidity. The Company has been and expects to continue to be subject to legal proceedings and claims from time to time in the ordinary course of its business, including claims of alleged infringement of third-party proprietary rights by the Company and its licensees. The Company attempts to avoid infringing known proprietary rights of third parties in its product development efforts. However, the Company has not conducted and does not conduct comprehensive patent searches to determine whether the technology used in its products infringes patents held by third parties. In addition, it is difficult to proceed with certainty in a rapidly evolving technological environment in which there may be numerous patent applications pending, many of which are confidential when filed, with regard to similar technologies. If the Company were to discover that its products violate third-party proprietary rights, there can be no assurance that it would be able to obtain licenses to continue offering such products without substantial reengineering or that any effort to undertake such reengineering would be successful, that any such licenses would be available on commercially reasonable terms, if at all, or that litigation regarding alleged infringement could be avoided or settled without substantial expense and damage awards. Any claims against the Company relating to the infringement of third-party proprietary rights, even if not meritorious, could result in the expenditure of significant financial and managerial resources and in injunctions preventing the Company from distributing certain products. Such claims could materially adversely affect the Company's business, financial condition and results of operations. The Company also relies on certain technology that it licenses from third parties, including software that is integrated with the Company's internally developed software and used in the Company's products, to perform key functions. There can be no assurance that such third-party technology licenses will continue to be available to the Company on commercially reasonable terms. The loss of any of these technologies could have a material adverse effect on the Company's business, financial condition and results of operations. Moreover, although the Company is generally indemnified against claims that such third-party technology infringes the proprietary rights of others, such indemnification is not always available for all types of intellectual property rights (for example, patents may be excluded), and in some 48 50 cases the scope of such indemnification is limited. Even if the Company receives broad indemnification, third-party indemnitors are not always well capitalized and may not be able to indemnify the Company in the event of infringement, resulting in substantial exposure to the Company. There can be no assurance that infringement or invalidity claims arising from the incorporation of third-party technology, and claims for indemnification from the Company's customers resulting from such claims, will not be asserted or prosecuted against the Company. Such claims, even if not meritorious, could result in the expenditure of significant financial and managerial resources in addition to potential product redevelopment costs and delays, all of which could materially adversely affect the Company's business, financial condition and results of operations. See "Risk Factors -- Uncertain Protection of Intellectual Property; Risks Associated with Licensed Third-Party Technology." EMPLOYEES As of September 30, 1997, the Company had 296 full-time employees and one part-time employee, 268 of whom were based at the Company's executive offices in Seattle, Washington, 24 of whom were based at the Company's offices in Japan, England or France and five of whom were salespersons based at other locations. None of the Company's employees is subject to a collective bargaining agreement, and the Company believes that its relations with its employees are good. FACILITIES The Company's executive offices are located in downtown Seattle, Washington in an office building in which, as of September 30, 1997, the Company leases an aggregate of 80,345 square feet at a current monthly rental of $122,411. The lease agreement terminates on April 30, 2001. The Company has an option to extend the lease agreement for two additional five-year terms. The Company anticipates that it will require additional space within the next 12 months, but that suitable additional space will be available on commercially reasonable terms, although there can be no assurance in this regard. The Company does not own any real estate. LEGAL PROCEEDINGS From time to time the Company has been, and expects to continue to be, subject to legal proceedings and claims in the ordinary course of its business, including claims of alleged infringement of third-party trademarks and other intellectual property rights by the Company and its licensees. Such claims, even if not meritorious, could result in the expenditure of significant financial and managerial resources. In August 1997, the Company was served with a subpoena by the U.S. Department of Justice in connection with its investigation into horizontal merger activity within the streaming media industry. The investigation, including interviews of Company officers by Department of Justice personnel and document production requests, is ongoing. As a result of the investigation, it is possible that the Department of Justice will require certain actions by the Company or other companies in the streaming media industry, which could have a material adverse effect on the Company's competitive position and on its business, financial condition and results of operations. The Company is cooperating fully with the investigation. The Company is not aware of any other legal proceedings or claims that it believes will have, individually or in the aggregate, a material adverse effect on its business, financial condition and results of operations. See "Risk Factors -- Department of Justice Subpoena" and "-- Uncertain Protection of Intellectual Property; Risks Associated With Licensed Third-Party Technology." 49 51 MANAGEMENT DIRECTORS AND EXECUTIVE OFFICERS The directors and executive officers of the Company as of October 24, 1997 are as follows:
NAME AGE POSITION - -------------------------- --- --------------------------------------------------------------- Robert Glaser(1).......... 35 Chairman of the Board, Chief Executive Officer, Secretary and Treasurer Bruce Jacobsen(2)......... 37 President, Chief Operating Officer and Director Mark Klebanoff............ 35 Chief Financial Officer Len Jordan................ 31 Senior Vice President -- Media Systems Phillip Barrett........... 44 Senior Vice President -- Media Systems Maria Cantwell............ 39 Senior Vice President -- Consumer and E-Commerce James Higa................ 39 Vice President -- Asia/Rest of World ("ROW") John Atcheson............. 38 Vice President -- Media Publishing James Wells............... 50 Vice President -- Sales Kelly Jo MacArthur........ 33 Vice President and General Counsel Erik Moris................ 38 Vice President -- Marketing Jeff Lehman............... 40 Vice President -- Advertising Sales Philip Rosedale........... 29 Vice President -- Media Systems James Breyer(1)(2)........ 36 Director Mitchell Kapor(1)(2)...... 46 Director
- --------------- (1) Member of the Compensation Committee. (2) Member of the Audit Committee. Set forth below is certain information regarding the business experience during the past five years for each of the above-named persons. ROBERT GLASER has served as Chairman of the Board, Chief Executive Officer and Treasurer of the Company since its inception in February 1994, and as Secretary since March 1995. On closing of the offering, he will also serve as the Company's Policy Ombudsman, with the exclusive authority to adopt or change the editorial policies of the Company as reflected on the Company's Web sites or in other communications or media in which the Company has a significant editorial or media voice. See "Risk Factors -- Control by Mr. Glaser; Antitakeover Provisions" and "Description of Capital Stock -- Certain Voting and Other Matters." From 1983 to 1993, Mr. Glaser was employed at Microsoft, most recently as Vice President of multimedia and consumer systems, where he focused on the development of new businesses related to the convergence of the computer, consumer electronics and media industries. Mr. Glaser holds a B.A. and an M.A. in Economics and a B.S. in Computer Science from Yale University. Mr. Glaser has been elected as a Class 3 director. BRUCE JACOBSEN has served as President and Chief Operating Officer of the Company since February 1996 and as a Director since August 1997. From April 1995 to February 1996, Mr. Jacobsen was Chief Operating Officer of Dreamworks Interactive, a joint venture between Microsoft and Dreamworks SKG, a partnership among Steven Spielberg, Jeffery Katzenberg and David Geffen. From August 1986 to April 1995, Mr. Jacobsen was employed at Microsoft in a number of capacities, including General Manager of the Kids/Games business unit. Mr. Jacobsen graduated summa cum laude with Honors from Yale University and holds an M.B.A. from Stanford University. Mr. Jacobsen has been elected as a Class 2 director. MARK KLEBANOFF has served as Chief Financial Officer of the Company since June 1996. From May 1992 to June 1996, Mr. Klebanoff was Vice President of Finance and Operations of Industrial Systems, Inc., a client/server process information management software vendor that merged with Aspen 50 52 Technology, Inc. in 1995. From 1989 to 1992, Mr. Klebanoff worked in a number of general management capacities for the Japanese trading company Itochu Corporation. Mr. Klebanoff holds a B.A. from Yale University and a Masters degree from the Yale School of Management. LEN JORDAN has served as Senior Vice President -- Media Systems of the Company since January 1997. From November 1993 to November 1996, Mr. Jordan was employed at Creative Multimedia, Inc., a developer and publisher of CD-ROM/Internet products in a number of capacities, most recently as President. From September 1989 to November 1993, Mr. Jordan was employed at Central Point Software, Inc., a utility software publisher. Mr. Jordan graduated magna cum laude from the Eccles School of Business at the University of Utah with B.S. degrees in Finance and Economics. PHILLIP BARRETT has served as Senior Vice President -- Media Systems of the Company since January 1997, and from November 1994 to January 1997 as Vice President -- Software Development. From March 1986 to October 1994, Mr. Barrett was a Development Group Manager at Microsoft, where he led development efforts for Windows 386, Windows 3.0 and Windows 3.1. Mr. Barrett holds an A.B. in Mathematics from Rutgers University and an M.S. in Computer Sciences from the University of Wisconsin, Madison. MARIA CANTWELL has served as Senior Vice President -- Consumer and E-Commerce of the Company since July 1997. From April 1995 to July 1997, Ms. Cantwell served as Vice President -- Marketing of the Company. From February 1995 to April 1995, Ms. Cantwell was a consultant to the Company. From 1992 to January 1995, Ms. Cantwell served as a member of the 103rd Congress. Ms. Cantwell holds a B.A. in Public Administration from Miami University. JAMES HIGA has served as Vice President -- Asia/ROW of the Company since September 1996. From January 1989 to August 1996, Mr. Higa was the Director for Asia/Pacific for NeXT Software, Inc. From 1986 to 1989, Mr. Higa served as Director of Product Marketing at Apple Computer Japan, Inc. Mr. Higa holds a B.A. in Political Science from Stanford University. JOHN ATCHESON has served as Vice President -- Media Publishing of the Company since January 1997. From March 1990 to May 1996, Mr. Atcheson was President and Chief Executive Officer of MNI Interactive, Inc., a developer and distributor of consumer interactive services. Mr. Atcheson holds a B.A. from Brown University and an M.B.A. from the Stanford Graduate School of Business. JAMES WELLS has served as Vice President -- Sales of the Company since May 1995. From March 1994 to April 1995, Mr. Wells served as a consultant in sales, marketing and product strategy at Aldus Corporation, a developer and marketer of publishing software. From January 1991 to February 1994, Mr. Wells served in various senior sales and marketing positions with Apple Computer, Inc. Mr. Wells holds a B.S. in Engineering from Lamar University and an M.B.A. from the University of Delaware. KELLY JO MACARTHUR has served as Vice President and General Counsel of the Company since October 1996. From January 1995 to March 1996, Ms. MacArthur served as General Counsel and Director of Business Affairs for Compton's NewMedia, Inc., which was acquired by Learning Co., Inc. in 1996. From July 1989 to December 1994, Ms. MacArthur was an attorney at Sidley & Austin. Ms. MacArthur graduated summa cum laude from the University of Illinois at Champaign-Urbana and holds a J.D. from Harvard Law School. ERIK MORIS has served as Vice President -- Marketing of the Company since August 1997. From April 1997 to July 1997, Mr. Moris served in various marketing capacities as an employee of the Company. From September 1996 to April 1997, Mr. Moris was a consultant to the Company. From April 1995 to August 1996, Mr. Moris worked at Microsoft, first as a consultant and later as an employee, where he managed advertising for the Windows 95 launch and was Group Manager for the Internet Platform and Tools Division. From 1985 to 1994, Mr. Moris was a Senior Vice President at McCann-Erickson Advertising. Mr. Moris holds a B.A. in Communications and Business from Western Washington University. 51 53 JEFF LEHMAN has served as Vice President -- Advertising Sales of the Company since October 1997. From September 1985 to September 1997 Mr. Lehman was employed by Ziff-Davis/Softbank in a number of Vice President, Director, and other publishing positions. Mr. Lehman graduated cum laude from The University of Central Florida with a B.S.B.A. and an M.B.A. with Honors. PHILIP ROSEDALE has served as Vice President -- Media Systems of the Company since October 1997. From February 1996 to October 1997, Mr. Rosedale served as General Manager, Software Development of the Company. From June 1986 to February 1996, Mr. Rosedale was President and Chief Executive Officer of Automated Management Systems, a developer and marketer of software applications. Mr. Rosedale holds a B.S. in Physics from the University of California, San Diego. JAMES BREYER has been a Director of the Company since October 1995. Mr. Breyer has served as a Managing Partner of Accel Partners L.P. in Palo Alto/San Francisco since November 1995 and as a general partner from 1990 to 1995. At Accel Partners L.P., Mr. Breyer has sponsored investments in over a dozen companies that have completed public offerings or successful mergers. Previously, Mr. Breyer was a management consultant at McKinsey & Company, Inc., and worked in product management and marketing at Apple Computer, Inc. and Hewlett-Packard Corporation. Mr. Breyer holds a B.S. from Stanford University and an M.B.A. from Harvard University, where he was named a Baker Scholar. Mr. Breyer has been elected as a Class 2 director. MITCHELL KAPOR has been a Director of the Company since October 1995. From 1990 to 1993, Mr. Kapor was President, from 1993 to 1995 he was Chairman and from 1995 to 1996 he was a director, of the Electronic Frontier Foundation, a nonprofit public Internet organization that he co-founded in 1990. Mr. Kapor designed Lotus 1-2-3, and founded Lotus Development Corporation in 1982 and served as its President and Chief Executive Officer from April 1982 to July 1986. Mr. Kapor holds a B.A. in Cybernetics from Yale University and an M.A. in Psychology from Beacon College. Mr. Kapor has been elected as a Class 1 director. NUMBER, TERM AND ELECTION OF DIRECTORS The Articles provide that the number of directors shall be determined in the manner provided by the Company's Bylaws. The Bylaws provide that the number of directors shall not be less than one or more than seven, with the precise number to be determined by resolution of the Board of Directors. The Board of Directors has determined that the number of directors shall be seven. Four directors currently serve on the Board, with three vacancies currently existing. Prior to October 1997, each director was elected to serve until the next annual meeting of shareholders or until the election and qualification of his or her successor or his or her earlier resignation or removal. In October 1997, the Company established a classified Board of Directors with three classes (Class 1, Class 2 and Class 3), each class as nearly equal in number of directors as possible. Each of the current directors was elected in October 1997 to one of these three classes. Mr. Kapor was elected to Class 1 with a term expiring at the annual shareholders meeting in 1998; Messrs. Breyer and Jacobsen were elected to Class 2 with terms expiring at the annual shareholders meeting in 1999; and Mr. Glaser was elected to Class 3 with a term expiring at the annual shareholders meeting in 2000. Commencing with the annual shareholders meeting in 1998 and thereafter, each newly elected director shall serve for a term ending at the third annual meeting of shareholders following such director's election. CONTRACTUAL ARRANGEMENTS Pursuant to the terms of a Second Amended and Restated Investors' Rights Agreement (the "Investors' Rights Agreement"), the holders of Series B Preferred Stock are entitled to nominate one member to the Board of Directors, the holders of Series C Preferred Stock are entitled to nominate one member to the Board of Directors, and the holders of Series E Preferred Stock are entitled to nominate one member to the Board of Directors. Mr. Kapor was nominated by the holders of the Series B Preferred Stock, Mr. Breyer was nominated by the holders of the Series C Preferred Stock, and the holder of the 52 54 Series E Preferred Stock currently has not nominated a director. The right to nominate directors pursuant to the Investors' Rights Agreement will terminate on closing of the offering. Under a voting agreement (the "Voting Agreement") entered into in September 1997 among the Company, Accel IV L.P. ("Accel IV") and Messrs. Jacobsen, Kapor and Glaser, each of Accel IV and Messrs. Jacobsen and Kapor have agreed, effective on closing of the offering, to vote all shares of stock of the Company owned by them to elect Mr. Glaser to the Board of Directors of the Company in each election in which he is a nominee. The obligations under the Voting Agreement terminate with respect to shares transferred by the parties thereto. The Voting Agreement terminates on the death of Mr. Glaser. Pursuant to the terms of the Strategic Transactions Agreement, the Company granted Mr. Glaser a direct contractual right to require the Company to abide by and perform all terms of the Articles with respect to the Strategic Transactions Committee. The Strategic Transactions Agreement also provides that, so long as Mr. Glaser owns a specified number of shares, the Company shall use its best efforts to cause Mr. Glaser to be nominated to, elected to, and not removed from, the Board of Directors. COMPENSATION OF DIRECTORS Directors of the Company do not receive cash compensation for their services as directors or members of committees of the Board of Directors, but are reimbursed for their reasonable expenses incurred in attending Board of Directors or Committee meetings. The Company has not made option grants to outside directors, but intends to make such grants to outside directors in the future. BOARD COMMITTEES The Company has established an Audit Committee, a Compensation Committee and a Strategy Committee. In addition, the Articles provide that, following the closing of the offering, the Company will establish a Strategic Transactions Committee. Following the closing of the offering, the Company also intends to establish a Nominating Committee. The Audit Committee consists of Messrs. Breyer, Jacobsen and Kapor. The functions of the Audit Committee are to make recommendations to the Board of Directors regarding the selection of independent auditors, review the results and scope of the audit and other services provided by the Company's independent auditors and evaluate the Company's internal controls. The Compensation Committee consists of Messrs. Breyer, Glaser and Kapor. The functions of the Compensation Committee are to review and approve the compensation and benefits for the Company's executive officers, administer the Company's stock option and stock purchase plans and make recommendations to the Board of Directors regarding such matters. The Strategy Committee consists of Messrs. Breyer, Glaser, Jacobsen and Kapor. The functions of the Strategy Committee are to make recommendations to the Board of Directors regarding the overall strategic goals of the Company and review significant business transactions that affect the future strategic direction of the Company. The Strategic Transactions Committee shall be comprised of three directors, who initially will be Messrs. Glaser, Breyer and Kapor. Without the prior approval of such Committee, and subject to certain limited exceptions, the Board of Directors shall not have the authority to (i) adopt a plan of merger, (ii) authorize the sale, lease, exchange or mortgage of (A) assets representing more than 50% of the book value of the Company's assets prior to the transaction or (B) any other asset or assets on which the long-term business strategy of the Company is substantially dependent, (iii) authorize the Company's voluntary dissolution or (iv) take any action that has the effect of clauses (i) through (iii). Any vacancy on the Committee will be filled by the remaining members of the Committee. If two members of the Committee remain and are unable to agree on an individual to fill the vacancy, such vacancy may be filled by the member who holds or controls, directly or indirectly, the larger percentage of the outstanding shares of the Company's capital stock. The Committee, by vote of the Chairman of the Committee and one additional member, may limit the powers of the Committee or may terminate the Committee. The 53 55 existence and powers of the Committee will terminate when the members in the aggregate cease to hold or control, directly or indirectly, at least 10% of the outstanding shares of the Company's capital stock. See "Risk Factors -- Control by Mr. Glaser; Antitakeover Provisions" and "Description of Capital Stock." COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION As of the end of the Company's last fiscal year, the Company did not have a Compensation Committee, and all decisions regarding compensation of the Company's executive officers were made by the Board of Directors. During fiscal year 1996, Mr. Glaser participated in deliberations of the Board of Directors concerning executive officer compensation. No executive officer of the Company serves as a member of the board of directors or compensation committee of any entity that has one or more executive officers serving as a member of the Company's Board of Directors or Compensation Committee, which was established during fiscal year 1997. POLICY OMBUDSMAN The Articles provide that Mr. Glaser will serve, or will appoint another officer of the Company to serve, as the Company's Policy Ombudsman, with the exclusive authority to adopt or change the editorial policies of the Company as reflected on the Company's Web sites or in other communications or media in which the Company has a significant editorial or media voice. On the death, resignation or removal of Mr. Glaser as the Policy Ombudsman, the Chief Executive Officer will serve or appoint another officer of the Company to serve as Mr. Glaser's successor. See "Risk Factors -- Control by Mr. Glaser; Antitakeover Provisions" and "Certain Transactions." EXECUTIVE COMPENSATION The following table sets forth information concerning the compensation received by the Company's Chief Executive Officer and by the other three executive officers of the Company whose salary and bonus exceeded $100,000 in 1996 (the "Named Executive Officers") for services rendered to the Company in all capacities during the year ended December 31, 1996. SUMMARY COMPENSATION TABLE
LONG-TERM COMPENSATION AWARDS ------------- ANNUAL COMPENSATION SECURITIES -------------------------- UNDERLYING NAME AND PRINCIPAL POSITION SALARY($)(1) BONUS($) OPTIONS(#) - ------------------------------------------------ ------------ -------- ------------- Robert Glaser................................... $100,000 $ -- -- Chairman, Chief Executive Officer, Secretary and Treasurer Bruce Jacobsen.................................. 118,158 -- 1,176,367 President and Chief Operating Officer James Wells..................................... 90,000 23,625 -- Vice President -- Sales Andrew Sharpless................................ 102,295 -- 125,000(2) Senior Vice President
- --------------- (1) The current annual salaries for Messrs. Glaser, Jacobsen and Wells are $100,000, $135,000 and $90,000, respectively. (2) Mr. Sharpless resigned as a Senior Vice President of the Company effective August 2, 1996; however, he continued to serve as a Vice President of the Company until February 1997, when he terminated his employment with the Company. Mr. Sharpless exercised this option with respect to 12,500 shares on April 8, 1997, after terminating his employment with the Company. The remainder 54 56 of the shares subject to this option were unvested as of his termination date and therefore were canceled. The following table sets forth information concerning stock options granted to the Named Executive Officers in 1996 and reflects the conversion of Series B Common Stock and Series C Common Stock underlying such options into an equal number of shares of Common Stock on closing of the offering. OPTION GRANTS IN 1996
INDIVIDUAL GRANTS POTENTIAL REALIZABLE ------------------------------------------------------- VALUE NUMBER OF % OF TOTAL AT ASSUMED ANNUAL RATES SECURITIES OPTIONS OF STOCK APPRECIATION UNDERLYING GRANTED TO EXERCISE FOR OPTION TERM(3) OPTIONS EMPLOYEES PRICE EXPIRATION ------------------------ NAME GRANTED(#)(1) IN 1996 ($/SHARE)(2) DATE 5%($) 10%($) - -------------------- ------------- ---------- ------------ ----------- -------- ---------- Robert Glaser....... -- -- -- -- $ -- $ -- Bruce Jacobsen...... 1,176,367 31.2% $ 0.20 2/16/2016 388,977 1,347,528 James Wells......... -- -- -- -- -- -- Andrew Sharpless.... 125,000 3.3% $ 0.20 5/29/1997(4) 41,332 143,187
- --------------- (1) All options granted to the Named Executive Officers in 1996 were nonqualified stock options that vest with respect to 20% of the shares on the first anniversary of the date of grant and thereafter at a rate of 10% for each six months of service rendered by the optionee to the Company, except for one option granted to Mr. Jacobsen on February 16, 1996 for the purchase of 470,544 shares of Common Stock, of which 50% vests one year from date of grant and 25% vests every six months thereafter. (2) The exercise price of each option is the estimated fair market value of the underlying securities on the date of grant, as determined by the Company's Board of Directors. (3) Based on the estimated fair market value of the underlying securities on the date of grant and assumed appreciation over the original 20-year option term at the respective annual rates of stock appreciation shown. Potential gains are net of the exercise price but before taxes associated with the exercise. The 5% and 10% assumed annual rates of compounded stock price appreciation are mandated by the rules of the Securities and Exchange Commission (the "Commission") and do not represent the Company's estimate of the future price of the Common Stock. Actual gains, if any, on stock option exercises depend on the future financial performance of the Company and overall market conditions. The actual value realized may be greater or less than the potential realizable value set forth in the table. (4) Mr. Sharpless exercised this option with respect to 12,500 shares on April 8, 1997, after terminating his employment with the Company. The remainder of the shares subject to this option were unvested as of his termination date and therefore were canceled. 55 57 The following table sets forth information regarding option exercises, and the fiscal year-end values of stock options held, by each of the Named Executive Officers during the year ended December 31, 1996. The table reflects the conversion of Series B Common Stock and Series C Common Stock underlying such options into an equal number of shares of Common Stock on closing of the offering. AGGREGATED OPTION EXERCISES IN 1996 AND YEAR-END OPTION VALUES
NUMBER OF SECURITIES VALUE OF UNEXERCISED UNDERLYING UNEXERCISED IN-THE-MONEY OPTIONS OPTIONS AT AT DECEMBER 31, SHARES VALUE REALIZED($) DECEMBER 31, 1996(#) 1996($) ACQUIRED (MARKET PRICE AT ---------------------- -------------------- ON EXERCISE LESS EXERCISABLE/ EXERCISABLE/ NAME EXERCISE(#) EXERCISE PRICE) UNEXERCISABLE UNEXERCISABLE(1) - ------------------------- ----------- -------------------- ---------------------- -------------------- Robert Glaser............ -- $ -- --/-- $ --/-- Bruce Jacobsen........... -- -- --/1,176,367 --/941,094 James Wells.............. -- -- 82,500/192,500 76,725/179,025 Andrew Sharpless(2)...... 300,000 87,750 12,500/112,500(3) 10,000/90,000
- --------------- (1) The fair market value of the underlying securities at the close of business on December 31, 1996 was estimated to be approximately $1.00 per share, as determined by the Company's Board of Directors. (2) The fair market value of the underlying securities at the close of business on the dates of exercise of Mr. Sharpless' options to purchase 225,000 shares and 75,000 shares were estimated to be approximately $0.20 and $0.85 per share, respectively, as determined by the Company's Board of Directors. (3) Mr. Sharpless exercised this option with respect to 12,500 shares on April 8, 1997, after terminating his employment with the Company. The remainder of the shares subject to this option were unvested as of his termination date and therefore were canceled. LIMITATION OF LIABILITY AND INDEMNIFICATION MATTERS The Articles limit the liability of the Company's directors to the fullest extent permitted by Washington law. The Washington Business Corporation Act (the "Washington Act") provides that a corporation's articles of incorporation may contain a provision eliminating or limiting the personal liability of directors for monetary damages for breach of their fiduciary duty as directors, except for liability for (i) acts or omissions that involve intentional misconduct or a knowing violation of law, (ii) unlawful payments of dividends or unlawful stock repurchases or redemptions as provided in Section 23B.08.310 of the Washington Act or (iii) any transaction from which the director derived an improper personal benefit. The Articles provide that the Company shall indemnify its directors and officers, and may indemnify its employees and agents, to the fullest extent permitted by law. The Company has entered into agreements with its directors and executive officers that, among other things, indemnify them for certain expenses (including attorneys' fees), judgments, fines and settlement amounts incurred by such persons in any action or proceeding, including any action by or in the right of the Company, arising out of such person's services as a director or officer of the Company, any subsidiary of the Company or any other company or enterprise to which the person provides services at the request of the Company. The Company believes that these provisions and agreements are necessary to attract and retain qualified directors and officers. These agreements also provide officers with the same limitation of liability for monetary damages that the Washington Act and the Articles provide to directors. BENEFIT PLANS 1995 STOCK OPTION PLAN. The Company's 1995 Stock Option Plan (the "1995 Plan") was adopted by the Board of Directors, and approved by the Company's shareholders, in March 1995. The 1995 Plan 56 58 provides for the grant of incentive and nonqualified options to purchase up to an aggregate of 3,600,000 shares of Common Stock to employees, officers, directors, consultants and independent contractors of the Company. As of October 9, 1997, options to purchase 1,521,173 shares of Common Stock were outstanding under the 1995 Plan, with exercise prices ranging from $0.07 to $1.00 per share and options to purchase 1,177,091 shares had been exercised. The Company has resolved not to grant any additional options under the 1995 Plan, and has amended its Amended and Restated 1996 Stock Option Plan to provide for a corresponding increase in the number of shares reserved for issuance thereunder. See "-- Amended and Restated 1996 Stock Option Plan." The provisions of the 1995 Plan with respect to the administration of the 1995 Plan and options granted thereunder, and the term and termination of options granted, including any provision regarding the acceleration of exercisability thereof, are as set forth below with respect to the Amended and Restated 1996 Stock Option Plan. AMENDED AND RESTATED 1996 STOCK OPTION PLAN. The Company's Amended and Restated 1996 Stock Option Plan (the "1996 Plan") was originally adopted by the Board of Directors in February 1996, and was approved by the Company's shareholders in September 1997. The 1996 Plan provides for the grant of incentive and nonqualified options to purchase up to an aggregate of 9,701,736 shares of Common Stock to employees, officers, directors, consultants and independent contractors of the Company or any of its affiliates (the "Initial Option Amount"). The Initial Option Amount can be increased to up to 11,222,909 shares after taking into account 1,521,173 shares of Common Stock subject to options outstanding under the 1995 Plan on October 9, 1997, to the extent that such options terminate without having been exercised in full. As of October 9, 1997, options to purchase 4,868,841 shares of Common Stock were outstanding under the 1996 Plan, with exercise prices ranging from $0.20 to $8.50 per share, options to purchase 4,446,992 shares of Common Stock were available for grant, and options to purchase 385,903 shares of Common Stock had been exercised. The 1996 Plan is administered by the Board of Directors, which has the authority to grant options and to specify the terms and conditions of each option so granted, including the number of shares covered by the option, the type of option, the exercise price and the vesting provisions. Options granted under the 1996 Plan must be exercised within three months following termination of the optionee's employment with, or service to, the Company, or within one year after the optionee's termination due to death or disability, but in no event later than the expiration of the option term. Options granted under the 1996 Plan are not transferable by the optionee except by will or the laws of descent and distribution and generally are exercisable during the optionee's lifetime only by the optionee. In the event of a sale of all or substantially all of the Company's assets, a merger or reorganization in which the Company is not the surviving corporation, or the sale or other transfer of shares representing more than 50% of the combined voting power of the then outstanding securities of the Company (each, a "Terminating Event"), the Board may determine whether provision will be made for assumption of, or substitution for, the stock options granted under the 1996 Plan by the successor corporation. If, with respect to a Terminating Event that has been approved by the Board, the Board determines that no such assumption or substitution will be made, then all options will become fully vested, and each optionee will have the right to exercise any unexercised options prior to closing of the Terminating Event. All options not so exercised will expire upon closing of the Terminating Event. 1998 EMPLOYEE STOCK PURCHASE PLAN. The Company's 1998 Employee Stock Purchase Plan (the "ESPP"), which was adopted by the Board of Directors and approved by the Company's shareholders in September 1997, will become effective on January 1, 1998. The Company has reserved 1,000,000 shares of Common Stock for issuance under the ESPP. The ESPP is intended to qualify for favorable tax treatment under Section 423 of the Internal Revenue Code of 1986, as amended. The ESPP will be implemented through a series of offering periods of six months' duration, with new offering periods commencing on January 1 and July 1 of each year. The ESPP will be administered by the Compensation Committee of the Board of Directors of the Company. Each employee of the Company or of any majority- owned subsidiary of the Company who has been employed by the Company or such majority-owned 57 59 subsidiary of the Company for at least 90 days and for more than 20 hours per week and more than five months per year will be eligible to participate in the ESPP. The ESPP permits an eligible employee to purchase Common Stock through payroll deductions, which may not exceed 10% of his or her compensation, at a price equal to 85% of the lower of the fair market value of the Common Stock at the beginning or end of the offering period. Employees may terminate their participation in the ESPP any time during the offering period; provided, however, that employees may not change their level of participation in the ESPP at any time during the offering period. Participation in the ESPP terminates automatically on the participant's termination of employment with the Company. 401(K) PLAN. The Company maintains a 401(k) plan that covers all employees who satisfy certain eligibility requirements relating to minimum age, length of service and hours worked. Under the profit-sharing portion of the plan, the Company may make an annual contribution for the benefit of eligible employees in an amount determined by the Board of Directors. The Company has not made any such contribution to date and currently has no plans to do so. Under the 401(k) portion of the plan, eligible employees may make pretax elective contributions of up to 20% of their compensation, subject to maximum limits on contributions prescribed by law. 58 60 CERTAIN TRANSACTIONS SALES OF PREFERRED STOCK Since the Company's inception in February 1994, the Company has issued, in private placement transactions, shares of Preferred Stock as follows: (i) in April 1995, an aggregate of 2,686,567 shares of Series B Preferred Stock at $0.67 per share, (ii) in October 1995, an aggregate of 2,904,305 shares of Series C Preferred Stock at approximately $1.96 per share, (iii) in November 1996, an aggregate of 2,381,010 shares of Series D Preferred Stock at $7.53 per share and (iv) in July 1997, an aggregate of 3,338,374 shares of Series E Preferred Stock at $8.99 per share. In addition, in connection with these private placements, the Company issued warrants as follows: (i) in April 1995, a warrant to purchase up to 373,134 shares of Series B Preferred Stock at an exercise price of $0.67 per share, which warrant was exercised in October 1995, (ii) in October 1995, warrants to purchase up to 100,000 shares of Series C Preferred Stock at an exercise price of approximately $1.96 per share and warrants to purchase up to 183,755 shares of Series B Common Stock at an exercise price of approximately $0.20 per share, (iii) in November 1996, warrants to purchase up to 714,303 shares of Series D Preferred Stock at an exercise price of approximately $9.41 per share and (iv) in July 1997, the Series E Warrant to purchase up to 3,709,305 shares of Series E Preferred Stock at an exercise price of $13.48 per share. In April 1995, in connection with the Company's Series B Preferred Stock financing, Mr. Glaser exchanged 10,000 shares of the capital stock of the Company for one share of Series A Common Stock and 13,713,439 shares of Series A Preferred Stock to reflect capital contributions made by Mr. Glaser of approximately $0.07 per share. The purchasers of record of the Series B Preferred Stock, Series C Preferred Stock, Series D Preferred Stock and Series E Preferred Stock and the accompanying warrants to purchase Series B Common Stock and Series C, Series D and Series E Preferred Stock included, among others, the following 5% shareholders, executive officers, directors and entities associated with directors:
PREFERRED STOCK --------------------------------------------------------------------------------- NAME SERIES B SERIES C SERIES D SERIES E - ---------------------- --------------- ------------------ --------------- ------------------ Robert Glaser......... 287,313 50,825 39,841 Mitchell Kapor........ 1,492,537 656,172 66,401 Accel Entities(1)..... 2,037,282 66,401 Microsoft Corporation......... 3,338,374 Phillip Barrett....... 373,134
WARRANTS --------------------------------------------------------------------------------- SERIES B SERIES C SERIES D SERIES E NAME COMMON STOCK(2) PREFERRED STOCK(2) PREFERRED STOCK PREFERRED STOCK(2) - ---------------------- --------------- ------------------ --------------- ------------------ Robert Glaser......... 11,952 Mitchell Kapor........ 33,755 19,920 Accel Entities(1)..... 150,000 100,000 19,921 Microsoft Corporation......... 3,709,305
- --------------- (1) The "Accel Entities" include Accel IV, Accel Investors '95 L.P., Accel Keiretsu L.P. and Ellmore C. Patterson Partners. James Breyer, a director of the Company, is affiliated with the Accel Entities. See "Principal Shareholders." (2) These warrants terminate automatically on closing of the offering. In addition, members of Mr. Glaser's immediate family purchased an aggregate of 223,881 shares of Series B Preferred Stock in April 1995, and an aggregate of 39,498 shares of Series C Preferred Stock in October 1995, in each case on the same terms as the other investors. In addition, Trans Cosmos and Encompass Group, Inc., an affiliate of Trans Cosmos, purchased 796,813 and 265,604 shares of Series D Preferred Stock, respectively, in November 1996 on the same terms as the other investors. In connection with those purchases, Trans Cosmos and Encompass received warrants to acquire 239,043 and 79,682 shares of Series D Preferred Stock, respectively. 59 61 Pursuant to the terms of the Investors' Rights Agreement, the holders of Series B Preferred Stock are entitled to nominate one member to the Board of Directors, the holders of Series C Preferred Stock are entitled to nominate one member to the Board of Directors and the holders of Series E Preferred Stock are entitled to nominate one member to the Board of Directors. In addition, all holders of preferred stock hold preemptive rights to purchase their pro rata share of new securities issued by the Company. The rights to nominate directors and the preemptive rights will terminate on closing of the offering. In addition, the Investors' Rights Agreement grants to the investors certain registration rights that obligate the Company, under certain circumstances, to effect a registration under the Securities Act of any common stock issued upon conversion of the Preferred Stock, and any Common Stock issued pursuant to the exercise of the Series B Common Stock warrants. See "Shares Eligible for Future Sale -- Registration Rights." All shares of Preferred Stock will be converted into an equivalent number of shares of Common Stock or Special Common Stock, as applicable, on closing of the offering. The Company has entered into indemnification agreements with each of its executive officers and directors. See "Management -- Limitation of Liability and Indemnification Matters." MICROSOFT CORPORATION The Company and Microsoft entered into an agreement in June 1997 pursuant to which the Company granted Microsoft a nonexclusive license to certain substantial elements of the source code of the Company's RealAudio/RealVideo Version 4.0 technology included in its basic RealPlayer and substantial elements of its EasyStart Server (currently known as the Basic Server), and related Company trademarks. Under the agreement, Microsoft may sublicense its rights to the licensed technology to third parties under certain circumstances. On two occasions during the first two years following delivery under the agreement, Microsoft may acquire for $25 million and $35 million, respectively, a nonexclusive license to subsequently developed versions of the core audio and video technology, which currently is distributed to end-users at no charge. Under prescribed circumstances that are solely within the Company's control, the agreement provides for a full refund of each license fee during the first year, declining to 0% over the following two years. The Company may not assign its obligations under the agreement without Microsoft's consent, and a merger, the sale of substantially all of the Company's assets and certain other events will be deemed to be an assignment under the agreement. Microsoft is obligated to distribute the Company's RealPlayer Version 4.0 for a defined term as long as the Company's player supports certain Microsoft architectures. The Company also agreed to work with Microsoft and several other companies to author and promote ASF as a standard file format for streaming media. The agreement also requires the Company to provide Microsoft with engineering consultation services, certain error corrections and certain technical support over a defined term. In connection with the agreement, Microsoft purchased 3,338,374 shares of nonvoting Series E Preferred Stock at $8.99 per share for approximately $30,000,000. Pursuant to the Articles, each share of Series E Preferred Stock is convertible at the option of Microsoft into either one share of Common Stock or one share of Special Common Stock. Microsoft also received a warrant to purchase 3,709,305 shares of Series E Preferred Stock at an exercise price of $13.48 per share. If exercised, each share of Series E Preferred Stock acquired upon exercise will be automatically converted, at the election of the holder, into either one share of Common Stock or one share of Special Common Stock. This warrant terminates on closing of the offering. Subsequent to the investment, at Microsoft's request, the Board of Directors agreed to adopt, and recommend to the shareholders, an amendment to the Articles providing for the automatic conversion of shares of Special Common Stock into shares of Common Stock on a bona fide sale to a purchaser who is not an affiliate of the holder. In consideration of the foregoing, Microsoft gave notice to the Company of its election to receive only Special Common Stock in connection with any conversion of shares of Series E Preferred Stock. In connection with its equity investment, Microsoft also granted a limited proxy to the Company. See "Risk Factors -- Competition; Relationship With Microsoft," "-- Department of Justice Subpoena," "Business -- Microsoft Relationship" and "Description of Capital Stock -- Certain Voting and Other Matters." 60 62 JAPANESE JOINT VENTURE Trans Cosmos is the beneficial owner of 1,381,142 shares of Common Stock of the Company. In May 1997, Trans Cosmos, the Company, NTT and KDD entered into a joint venture agreement with respect to the establishment and management of J-Stream to operate an Internet streaming business in Japan. Trans Cosmos owns 28% of J-Stream, and each of the Company and the other two parties own 24%. Trans Cosmos is responsible for managing J-Stream, and the Company supplies J-Stream with software and technology for streaming on Internet networks. Trans Cosmos contributed approximately $1,165,000 for its 28% interest, and the Company contributed approximately $998,000 for its 24% interest in J-Stream. Trans Cosmos loaned the Company the amount of the Company's contribution. The note is denominated in Japanese yen and bears interest at a rate not to exceed the Japanese Short Term Prime Rate (1.63% at September 30, 1997). Interest on the note is payable monthly, and the principal is due in May 2000. The terms of the note contain no restrictions or covenants. The note is secured by the Company's shares in J-Stream, and the Company may, under certain circumstances, tender its 24% interest to Trans Cosmos as repayment of the loan. See "Principal Shareholders." TRANS COSMOS RELATIONSHIP The Company and Trans Cosmos are parties to a Master Distribution Agreement pursuant to which the Company granted Trans Cosmos a nonexclusive, nontransferable license to reproduce and distribute RealPlayer and RealPlayer Plus, and to distribute the Company's server products, in Japan. Under the distribution agreement, Trans Cosmos must comply with certain marketing requirements, personnel commitments and specified minimum distribution requirements. Trans Cosmos paid the Company $820,000 in 1996, and approximately $469,000 from January 1, 1997 through September 30, 1997 pursuant to the distribution agreement. The distribution agreement became effective on July 22, 1996 and terminated in accordance with its terms on July 22, 1997. The Company and Trans Cosmos have continued to adhere to the terms of the agreement and are currently renegotiating the agreement. The Company believes that all of the transactions set forth above were made on terms no less favorable to the Company than could have been obtained from unaffiliated third parties. CHANGES TO CAPITAL STRUCTURE In connection with the offering, the Board recommended, and the Company's shareholders approved, amendments to the Articles that, among other things, will reduce the number of series of authorized Common Stock from five to two (Common Stock and Special Common Stock), establish the Strategic Transactions Committee and provide for a Policy Ombudsman with authority to determine certain matters related to editorial policies of the Company. These amendments will become effective on closing of the offering. See "Management -- Policy Ombudsman" and "Description of Capital Stock -- Certain Voting and Other Matters." VOTING AGREEMENT Under the Voting Agreement, each of Accel IV and Messrs. Jacobsen and Kapor have agreed, effective on closing of the offering, to vote all shares of stock of the Company owned by them to elect Mr. Glaser to the Board of Directors of the Company in each election in which he is a nominee. The obligations under the Voting Agreement terminate with respect to shares transferred by the parties thereto. The Voting Agreement terminates on the death of Mr. Glaser. STRATEGIC TRANSACTIONS AGREEMENT Pursuant to the terms of the Strategic Transactions Agreement, the Company granted Mr. Glaser a direct contractual right to require the Company to abide by and perform all terms of the Articles with respect to the Strategic Transactions Committee. The Strategic Transactions Agreement also provides that so long as Mr. Glaser owns a specified number of shares, the Company shall use its best efforts to cause Mr. Glaser to be nominated to, elected to, and not removed from, the Board of Directors. See "Management -- Contractual Arrangements." 61 63 PRINCIPAL SHAREHOLDERS The following table sets forth certain information regarding the beneficial ownership of the Common Stock as of October 24, 1997, assuming the conversion of all shares of Series A Common Stock, Series B Common Stock, Series C Common Stock, Series A Preferred Stock, Series B Preferred Stock, Series C Preferred Stock, Series D Preferred Stock into Common Stock and Series E Preferred Stock into Special Common Stock, and as adjusted to reflect the sale of 3,000,000 shares of Common Stock in the offering for (i) each person known to the Company to own beneficially more than 5% of the Common Stock, (ii) each of the Company's directors, (iii) each of the Named Executive Officers and (iv) all executive officers and directors as a group. See footnote (1) below regarding share ownership by Microsoft.
COMMON STOCK(1) ------------------------------------------- NUMBER OF PERCENT OWNERSHIP SHARES ------------------------ BENEFICIALLY BEFORE AFTER NAME OWNED(2) OFFERING OFFERING(3) - ------------------------------------------------------ ------------ -------- ----------- Robert Glaser......................................... 14,101,871(4) 59.5% 52.8% c/o RealNetworks, Inc. 1111 Third Avenue Suite 2900 Seattle, WA 98101 Accel IV L.P.......................................... 2,373,604(5) 9.9 8.8 c/o Accel Partners L.P. 428 University Ave. Palo Alto, CA 94301 James W. Breyer....................................... 2,373,604(6) 9.9 8.8 Mitchell Kapor........................................ 2,258,785(7) 9.5 8.5 Kapor Enterprises, Inc. 238 Main Street Cambridge, MA 02142 Trans Cosmos USA, Inc................................. 1,381,142(8) 5.8 5.1 4040 Lake Washington Blvd. N.E. Suite 205 Kirkland, WA 98033 Bruce Jacobsen........................................ 562,665(9) 2.3 2.1 Andrew Sharpless...................................... 312,500 1.3 1.2 James Wells........................................... 137,500(10) * * All directors and executive officers as a group (15 persons)(11)........................................ 20,472,204 83.2% 74.1%
- --------------- * Less than 1%. (1) Excludes (i) 3,338,374 shares of Special Common Stock to be issued to Microsoft on the closing of the offering upon conversion of an equal number of shares of Series E Preferred Stock and (ii) up to 3,709,305 shares of Special Common Stock issuable upon exercise of the Series E Warrant. If not exercised, the Series E Warrant will terminate on closing of the offering. Pursuant to the Articles, the holder of Series E Preferred Stock may elect to convert such shares into Common Stock or Special Common Stock. Microsoft has given notice of its intention and has agreed to receive only Special Common Stock in connection with any conversion of shares of Series E Preferred Stock (including those shares issuable upon exercise of the Series E Warrant). Upon such conversion, Microsoft will own 100% of the outstanding Special Common Stock. Shares of Special Common Stock have rights identical to the Common Stock, except that shares of Special Common Stock do not have the right to vote, unless required by applicable law. The Special Common Stock converts automatically into Common Stock on a bona fide sale to a purchaser who is not an affiliate of the holder. See "Description of Capital Stock." 62 64 (2) Beneficial ownership is determined in accordance with rules of the Commission and includes shares over which the beneficial owner exercises voting or investment power. Shares of Common Stock subject to options or warrants currently exercisable or exercisable within 60 days of October 24, 1997 are deemed outstanding for the purpose of computing the percentage ownership of the person holding the options or warrants, but are not deemed outstanding for the purpose of computing the percentage ownership of any other person. Except as indicated, and subject to community property laws where applicable, the Company believes, based on information provided by such persons, that the persons named in the table above have sole voting and investment power with respect to all shares of Common Stock shown as beneficially owned by them. (3) Microsoft has entered into a Lock-Up Agreement with the Underwriters, pursuant to which Microsoft has agreed not to sell, offer to sell or otherwise dispose of any shares of capital stock owned of record or beneficially as of the date of this Prospectus for a period of 180 days after the date of the Prospectus without the prior written consent of Goldman, Sachs & Co. on behalf of the Underwriters. After the expiration of such period, Microsoft may sell shares of Special Common Stock, which shares will convert automatically into Common Stock as noted in footnote (1) above. Assuming the exercise in full of the Series E Warrant and the resale of all shares of Special Common Stock (and no changes in beneficial ownership of the persons listed below), the resulting ownership percentages for the other shareholders listed in the table would be as follows: Mr. Glaser -- 41.8%; Accel IV -- 7.0%; Mr. Breyer -- 7.0%; Mr. Kapor -- 6.7%; Trans Cosmos -- 4.1%; Mr. Jacobsen -- 1.7%; Mr. Sharpless -- .9%; Mr. Wells -- .4%; and all directors and executive officers as a group -- 59.1%. (4) Includes 11,952 shares of Common Stock issuable on exercise of a warrant. Following closing of the offering, Mr. Glaser intends to donate approximately 700,000 shares of Common Stock to various charitable organizations. These gifts will reduce the percentage of Common Stock that he owns following closing of the offering to approximately 50.2%. (5) Includes 1,926,973 shares owned by Accel IV, 39,970 shares owned by Accel Keiretsu L.P., 90,459 shares owned by Accel Investors '95 L.P. and 46,281 shares owned by Ellmore C. Patterson Partners. Also includes 247,247 shares, 5,129 shares, 11,607 shares, and 5,938 shares of Common Stock issuable on exercise of warrants owned by Accel IV, Accel Keiretsu L.P., Accel Investors '95 L.P. and Ellmore C. Patterson Partners, respectively. (6) Mr. Breyer may be deemed to be the beneficial owner of the 2,373,604 shares of Common Stock beneficially owned by the Accel Entities because he is a general partner of Accel Partners L.P., which is the general partner of Accel IV. Mr. Breyer disclaims beneficial ownership of these shares except to the extent of his pecuniary interest therein. See footnote (5) above. (7) Includes 53,675 shares of Common Stock issuable on exercise of warrants. (8) Includes 796,813 shares of Common Stock owned by Trans Cosmos and 265,604 shares of Common Stock owned by Encompass Group, Inc., an affiliate of Trans Cosmos ("Encompass"). Also includes 239,043 and 79,682 shares of Common Stock issuable on exercise of warrants owned by Trans Cosmos and Encompass, respectively. (9) Includes 362,655 shares of Common Stock issuable on exercise of options. Following closing of the offering, Mr. Jacobsen intends to donate approximately 60,000 shares of Common Stock to various charitable organizations. (10) Includes 27,500 shares of Common Stock issuable on exercise of options. (11) Does not include shares owned by Mr. Sharpless, who terminated his employment with the Company in February 1997. Includes an aggregate of 611,810 shares and 335,548 shares, respectively, of Common Stock issuable upon exercise of options and warrants. 63 65 DESCRIPTION OF CAPITAL STOCK The following description of the capital stock of the Company and certain provisions of the Articles and the Bylaws is a summary and is qualified by reference to the Articles and the Bylaws, copies of which have been filed with the Commission as exhibits to the Company's Registration Statement, of which this Prospectus forms a part. The descriptions of the common stock and preferred stock reflect changes to the Company's capital structure that will occur on closing of the offering in accordance with the terms of the Articles. The authorized capital stock of the Company consists of 300,000,000 shares of common stock, par value $0.001 per share, which is divided into Common Stock and Special Common Stock, and 60,000,000 shares of preferred stock, par value $0.001 per share. COMMON STOCK As of October 9, 1997, 23,628,647 shares of Common Stock were outstanding and held of record by 166 shareholders, assuming no exercise after October 9, 1997 of outstanding options or warrants. Each holder of Common Stock is entitled to one vote per share. Subject to the rights of the holders of any preferred stock that may be outstanding, holders of Common Stock on the applicable record date are entitled to receive such dividends as may be declared by the Board of Directors out of funds legally available therefor and, in the event of liquidation, to share pro rata in any distribution of the Company's assets after payment or providing for the payment of liabilities and the liquidation preference of any outstanding preferred stock. Holders of Common Stock have no cumulative voting rights or preemptive rights to purchase or subscribe for any shares of Common Stock or other securities of the Company. SPECIAL COMMON STOCK The Company has 7,047,679 authorized shares of Special Common Stock that have rights identical to the Common Stock, except that they do not have the right to vote unless required by applicable law. The Special Common Stock converts automatically into Common Stock on a bona fide sale to a purchaser who is not an affiliate of the holder. As of October 9, 1997, 3,338,374 shares of Special Common Stock were outstanding and held of record by one holder. PREFERRED STOCK The Company's Board of Directors has the authority to issue shares of preferred stock in one or more series and to fix and determine the relative rights and preferences of the shares constituting any series to be established without any further vote or action by the shareholders. Any shares of preferred stock so issued may have priority over the common stock with respect to dividend or liquidation rights or both. On closing of the offering, no shares of preferred stock will be outstanding. The Company has no current intention to issue any shares of preferred stock, except with respect to the proposed Shareholder Rights Plan. See " -- Shareholder Rights Plan." WARRANTS TO PURCHASE PREFERRED STOCK AND COMMON STOCK As of October 9, 1997 the Company had outstanding warrants to purchase 183,755 shares of Series B Common Stock at an exercise price of approximately $0.20 per share, warrants to purchase 100,000 shares of Series C Preferred Stock at an exercise price of approximately $1.96 per share, warrants to purchase 714,303 shares of Series D Preferred Stock at an exercise price of approximately $9.41 per share and a warrant to purchase 3,709,305 shares of Series E Preferred Stock at an exercise price of $13.48 per share. The warrants to purchase shares of Series B Common Stock, Series C Preferred Stock and Series E Preferred Stock will terminate on closing of the offering. The warrants to purchase shares of Series D Preferred Stock expire on November 27, 1998 and, following the offering, will be exercisable for an equivalent number of shares of Common Stock. All of the Company's outstanding warrants currently are exercisable. 64 66 CERTAIN VOTING AND OTHER MATTERS Holders of preferred stock or other capital stock hereafter issued by the Company may be entitled to vote in connection with certain mergers and share exchanges, certain proposals to sell substantially all of the Company's assets or certain other actions, and separate approval of each class of the Company's capital stock may be required to the extent class voting rights are accorded to the holders of other capital stock of the Company. Amendments to the Articles must be approved by the Board of Directors and the holders of at least a majority of the outstanding shares of Common Stock in most instances. ARTICLES AND BYLAWS The Articles provide that Mr. Glaser will serve, or will appoint another officer of the Company to serve, as the Company's Policy Ombudsman, with the exclusive authority to adopt or change the editorial policies of the Company as reflected on the Company's Web sites or in other communications or media in which the Company has a significant editorial or media voice. On the death, resignation or removal of Mr. Glaser as the Policy Ombudsman, the Chief Executive Officer will serve or appoint another officer of the Company to serve as Mr. Glaser's successor. The provisions delineating the authority of the Policy Ombudsman may be amended only with the approval of 90% of the shares entitled to vote on an amendment to the Articles. In addition, the Articles provide for a Strategic Transactions Committee comprised of three directors, who initially will be Messrs. Glaser, Breyer and Kapor. Without the prior approval of such Committee, and subject to certain limited exceptions, the Board of Directors will not have the authority to (i) adopt a plan of merger, (ii) authorize the sale, lease, exchange or mortgage of (A) assets representing more than 50% of the book value of the Company's assets prior to the transaction or (B) any other asset or assets on which the long-term business strategy of the Company is substantially dependent, (iii) authorize the Company's voluntary dissolution or (iv) take any action that has the effect of clauses (i) through (iii). Any vacancy on the Committee will be filled by the remaining members of the Committee. If two members of the Committee remain and are unable to agree on an individual to fill the vacancy, such vacancy may be filled by the member who holds or controls, directly or indirectly, the larger percentage of the outstanding shares of the Company's capital stock. The Committee, by vote of the Chairman of the Committee and one additional member, may limit the powers of the Committee or may terminate the Committee. The existence and powers of the Committee will terminate when the members in the aggregate cease to hold or control, directly or indirectly, at least 10% of the outstanding shares of the Company's capital stock. The provisions with respect to the authority of the Strategic Transactions Committee may be amended only with the approval of 90% of the shares entitled to vote on an amendment to the Articles. Special meetings of the shareholders may be called only by the Board of Directors, the Chairman of the Board, the President or the holders of at least 25% of all votes entitled to be cast on any issue proposed to be considered at such special meeting. The Company's Bylaws provide that shareholders seeking to bring business before, or to nominate directors at, any meeting of shareholders must provide timely notice thereof in writing. To be timely, a shareholder's notice must be delivered to, or mailed and received at, the principal executive offices of the Company not less than 70 days prior to the date of the meeting, or the tenth day after notice of the meeting is first given to shareholders, whichever is later, if the meeting is an annual meeting or a special meeting at which directors are to be elected. The Bylaws also contain specific requirements for the form of a shareholder's notice. These provisions may preclude or deter some shareholders from bringing matters before the shareholders or from making nominations of directors. CONTRACTUAL AGREEMENTS On July 21, 1997, the Company and Microsoft entered into a Limited Proxy and Voting Agreement (the "Proxy Agreement") that gives Mr. Glaser, or Mr. Jacobsen if Mr. Glaser is unable to act, an irrevocable proxy with respect to the limited voting rights of Microsoft's shares of Special Common Stock. 65 67 The Proxy Agreement does not apply to voting with respect to certain matters, such as any amendment to the Articles in which the class of shares held by Microsoft is treated adversely or disproportionately relative to other classes. The Proxy Agreement terminates upon the earliest of (i) the date on which Microsoft no longer holds any nonvoting shares, (ii) the conversion of the Series E Preferred Stock into Common Stock and (iii) July 21, 2007. Under the Voting Agreement entered into in September 1997 among the Company, Accel IV and Messrs. Jacobsen, Kapor and Glaser, each of Accel IV and Messrs. Jacobsen and Kapor have agreed, effective on closing of the offering, to vote all shares of stock of the Company owned by such shareholders to elect Mr. Glaser to the Board of Directors of the Company in each election in which he is a nominee. The obligations under the Voting Agreement terminate with respect to shares transferred by the parties thereto. The Voting Agreement terminates on the death of Mr. Glaser. The Company, Mr. Glaser and certain holders of Series B Common Stock and Series C Common Stock (together, the "Shares") have entered into a Shareholders' Buy-Sell Agreement dated March 31, 1995 (the "Buy-Sell Agreement") that restricts the free transferability of the Shares held by parties to the Buy-Sell Agreement. The Buy-Sell Agreement gives the Company and other parties to the Buy-Sell Agreement a right of first refusal with respect to a party's proposed transfer of Shares, other than transfers to the Company, to certain family members and to trusts that are created and administered for the exclusive benefit of certain family members. The Buy-Sell Agreement is terminable upon the written agreement of the Company and the holders of two-thirds of the Shares in the event of dissolution, bankruptcy or insolvency of the Company, or at such time as there is only one remaining party to the Buy-Sell Agreement. The Company and the requisite holders have entered into an agreement to terminate the Buy-Sell Agreement, effective immediately prior to effectiveness of the offering. WASHINGTON ANTITAKEOVER STATUTE Washington law contains certain provisions that may have the effect of delaying, deterring or preventing a takeover or change in control of the Company. Chapter 23B.19 of the Washington Act prohibits the Company, with certain exceptions, from engaging in certain significant business transactions with an "acquiring person" (defined as a person who acquires 10% or more of the Company's voting securities without the prior approval of the Company's Board of Directors) for a period of five years after such acquisition. The prohibited transactions include, among others, a merger with, disposition of assets to, or issuance or redemption of stock to or from, the acquiring person, or otherwise allowing the acquiring person to receive any disproportionate benefit as a shareholder. After the five-year period, the Company may engage in otherwise proscribed transactions, so long as the transaction complies with certain fair price provisions of the statute or is approved by a majority of disinterested shareholders within each voting group entitled to vote separately. The Company may not exempt itself from coverage of this statute. These statutory provisions may have the effect of delaying, deterring or preventing a change in control of the Company. SHAREHOLDER RIGHTS PLAN The Company plans to enter into a Shareholder Rights Plan (the "Rights Plan") by and between the Company and a rights agent to be selected by the Company that would be adopted prior to the closing of the offering. Under the proposed Rights Plan, the Board would declare and distribute to the shareholders of record of the Company as of the date selected by the Board a dividend of one right ("Right") for each outstanding share of Common Stock. Shares of Common Stock issued in the offering (assuming no triggering event) automatically would receive the Rights. The Rights would not be exercisable or transferable separately from shares of Common Stock and Special Common Stock, if any, until the earlier of: (i) 10 days following a public announcement that a person or group has acquired, or obtained the right to acquire, beneficial ownership of a designated percentage of the outstanding shares of the Common Stock and (ii) 10 days following the commencement or announcement of an intention to make a tender or exchange offer that would result in an acquiring person or group beneficially owning a designated percentage of outstanding shares of Common Stock, unless the Board sets a later date (the earlier of such dates, the "Distribution Date"). The Board would have the option to redeem the Rights at 66 68 a nominal cost or prevent the Rights from being triggered by designating offers for all outstanding Common Stock as a permitted offer. Prior to the Distribution Date, the Company would be able to amend or supplement the Rights Plan without the consent of any of the holders of the Rights. Following the Distribution Date, the Rights Plan could be amended to cure any ambiguity, to correct or supplement any inconsistent provision or any other provision so long as such amendment or supplement would not adversely affect the holders of the Rights (other than an acquiring person or group). The Rights would expire 10 years after the date of adoption of the Rights Plan by the Board unless earlier redeemed by the Company. The Rights (other than those Rights held by an acquiring person or group), when exercisable, would entitle their holders to purchase a specified fraction of a share of preferred stock (subject to adjustment) or, in certain instances, other securities of the Company. In certain circumstances, if the Company, in a merger or consolidation, is not the surviving entity or disposes of more than 50% of the Company's assets or earnings power, the Rights would entitle their holders (other than an acquiring person or group) to purchase the highest priority voting shares in the surviving entity or its affiliates having a market value of two times the exercise price of the Rights. The Rights Plan, which is intended to encourage a potential acquiring person or group to negotiate directly with the Board, may have certain antitakeover effects. The Rights Plan, if adopted, could significantly dilute the interests in the Company of an acquiring person or group. The Rights Plan could therefore have the effect of delaying, deterring or preventing a change in control of the Company. TRANSFER AGENT AND REGISTRAR The transfer agent and registrar for the Common Stock is ChaseMellon Shareholder Services, Ridgefield Park, New Jersey. SHARES ELIGIBLE FOR FUTURE SALE Prior to the offering, there has been no public market for the Common Stock, and there can be no assurance that a significant public market for the Common Stock will be developed or be sustained after the offering. Sales of substantial amounts of Common Stock in the public market after the offering, or the possibility of such sales occurring, could adversely affect prevailing market prices for the Common Stock or the future ability of the Company to raise capital through an offering of equity securities. On closing of the offering, the Company will have outstanding 30,965,079 shares of Common Stock and Special Common Stock (31,415,079 shares if the Underwriters' over-allotment option is exercised in full), of which 3,000,000 shares offered hereby (3,450,000 shares if the Underwriters' over-allotment option is exercised in full) will be freely transferable in the public market without restriction or further registration under the Securities Act unless purchased by "affiliates" of the Company as that term is defined in Rule 144 under the Securities Act (an "Affiliate"), which shares will be subject to the resale limitations of Rule 144. The remaining 27,965,079 Restricted Shares outstanding on completion of the offering (assuming no exercise of options after October 9, 1997) and held by existing shareholders will be "Restricted Securities" as that term is defined under Rule 144. The Restricted Shares were issued in private transactions in reliance on exemptions from registration under the Securities Act. Restricted Shares may be sold in the public market only if registered or if they qualify for an exemption from registration under Rule 144 or 701 of the Securities Act, which rules are summarized below. Of these Restricted Shares, 3,338,374 are shares of Special Common Stock that convert automatically into the same number of shares of Common Stock on a bona fide sale to a purchaser who is not an affiliate of the holder. Pursuant to the Lock-Up Agreements, certain holders of Restricted Shares, including all officers and directors of the Company, have agreed with the representatives of the Underwriters that, for a period of 180 days following the date of this Prospectus, they will not sell, offer to sell or otherwise dispose of any shares of Common Stock owned of record or beneficially by such persons as of the date of this 67 69 Prospectus, including securities convertible into or exercisable or exchangeable for shares of Common Stock as of said date, as well as any shares of Common Stock later acquired by reason of the conversion, exercise or exchange of such securities, except that persons other than officers, directors and holders of 1% or more of the capital stock of the Company each will be free to sell or otherwise dispose of up to 5,000 shares of Common Stock to the extent permissible under Rule 144 or Rule 701. On closing of the offering, 27,670,989 of the Restricted Shares will be subject to restriction pursuant to Lock-Up Agreements. The Lock-Up Agreements may be released at any time as to all or any portion of the shares subject to such agreements at the sole discretion of Goldman, Sachs & Co. on behalf of the Underwriters. Based on the provisions of the Lock-Up Agreements and the provisions of Rules 144 and 701 of the Securities Act, additional shares will be available for sale in the public market as follows: (i) 11,947 shares will be eligible for immediate sale in the public market on the date of this Prospectus pursuant to Rule 144(k) under the Securities Act, (ii) 281,143 shares issued upon exercise of options prior to October 9, 1997 not subject to Lock-Up Agreements will be eligible for sale in the public market in accordance with Rule 701 as soon as 90 days after the date of this Prospectus, (iii) 1,000 shares will be eligible for public sale subject to compliance with the holding period and volume and manner of sale restrictions of Rule 144, (iv) 4,707,363 shares issuable upon the exercise of warrants (assuming all outstanding warrants are exercised) will not be available for sale until expiration of the applicable holding period under Rule 144 and (v) 27,670,989 currently outstanding shares will be eligible for sale upon expiration of Lock-Up Agreements. At October 9, 1997, options for 6,390,014 shares of Common Stock were outstanding, of which options for 1,673,755 shares may be exercised during the 180 days following the date of this Prospectus, which shares potentially will be eligible for public sale 90 days after the date of this Prospectus pursuant to Rule 701 under the Securities Act; of the shares exercisable within 180 days, 1,301,463 will be subject to Lock-Up Agreements. In general, Rule 144 provides that any person who has beneficially owned shares for at least one year, including an Affiliate, is generally entitled to sell, within any three-month period, a number of shares that does not exceed the greater of 1% of the shares of Common Stock then outstanding (approximately 276,267 shares immediately after the offering) or the reported average weekly trading volume of the Common Stock during the four calendar weeks immediately preceding the date on which notice of the sale is sent to the Commission. Sales under Rule 144 are subject to certain manner of sale restrictions, notice requirements and availability of current public information concerning the Company. A person who is not an Affiliate of the Company, and who has not been an Affiliate within three months prior to the sale, generally may sell shares without regard to the limitations of Rule 144 provided that the person has held such shares for at least two years. Any employee, director or officer of, or consultant to, the Company holding shares purchased pursuant to a written compensatory plan or contract (including options) entered into prior to the offering is entitled to rely on the resale provisions of Rule 701, which permit nonaffiliates to sell such shares without having to comply with the public information, holding period, volume limitation or notice requirements of Rule 144 and permit Affiliates to sell their Rule 701 shares without having to comply with the holding period restrictions of Rule 144, in each case beginning 90 days after the date of this Prospectus. REGISTRATION RIGHTS Pursuant to the Investors' Rights Agreement, which provides registration rights to certain holders of shares of the Company's capital stock, holders of 16,390,753 shares of common stock or their permitted transferees (collectively, the "Registrable Shares") (assuming exercise of all outstanding warrants) have certain rights with respect to the registration of the Registrable Shares under the Securities Act. Under the terms of the Investors' Rights Agreement, if the Company proposes to register any of its securities under the Securities Act for its own account or for the account of others (including pursuant to this offering), Registrable Shares may be included, subject to any limitation set by the underwriters on the number of shares included in such registration. The Company and the holders of the requisite number of shares have waived the rights of the holders of Registrable Securities to have their shares registered in 68 70 connection with this offering. Holders of not less than 30% of the Registrable Shares may also require the Company, not more than twice, to file a registration statement under the Securities Act, at the Company's expense, with respect to any Registrable Shares holders desire to include. In addition, Holders of Registrable Shares may require the Company to file up to three registration statements on Form S-3, at the expense of the holders, for public offerings of Registrable Shares, provided that the aggregate offering price for such registration is not less than $250,000. The Company is required to use its best efforts to effect all such registrations, subject to certain conditions and limitations. LEGAL MATTERS The validity of the Common Stock being offered hereby will be passed upon for the Company by Graham & James LLP/Riddell Williams P.S., Seattle, Washington. Certain legal matters in connection with the offering will be passed upon for the Underwriters by Perkins Coie, Seattle, Washington. EXPERTS The consolidated balance sheets at December 31, 1995 and 1996 and September 30, 1997, and the consolidated statements of operations, shareholders' equity (deficit) and cash flows for the period from February 9, 1994 (inception) to December 31, 1994, the years ended December 31, 1995 and 1996, and the nine months ended September 30, 1997 included in this Prospectus and in the Registration Statement of which this Prospectus forms a part have been included herein in reliance on the report of KPMG Peat Marwick LLP, independent accountants, appearing elsewhere herein, and upon the authority of said firm as experts in accounting and auditing. ADDITIONAL INFORMATION The Company has filed with the Commission a Registration Statement on Form S-1 (together with all amendments and exhibits thereto, the "Registration Statement") under the Securities Act with respect to the offer and sale of Common Stock pursuant to this Prospectus. This Prospectus, filed as a part of the Registration Statement, does not contain all the information set forth in the Registration Statement or the exhibits thereto in accordance with the rules and regulations of the Commission, and reference is hereby made to such omitted information. Statements made in this Prospectus concerning the contents of any contract, agreement or other document filed as an exhibit to the Registration Statement are summaries of the terms of such contracts, agreements or documents and are not necessarily complete. Reference is made to each such exhibit for a more complete description of the matters involved, and such statements shall be deemed qualified by such reference. The Registration Statement and the exhibits thereto filed with the Commission may be inspected, without charge, and copies may be obtained at prescribed rates, at the public reference facility maintained by the Commission at Judiciary Plaza, 450 Fifth Street, N.W., Washington, D.C. 20549 and at the regional offices of the Commission located at 7 World Trade Center, 13th Floor, New York, New York 10048 and Citicorp Center, 500 West Madison Street, Suite 1400, Chicago, Illinois 60661-2511. The Registration Statement and other information filed by the Company with the Commission also are available at the Web site maintained by the Commission on the World Wide Web at http://www.sec.gov. For further information pertaining to the Company and the Common Stock offered by this Prospectus, reference is hereby made to the Registration Statement. The Company intends to furnish its shareholders with annual reports containing consolidated financial statements audited by its independent accountants and quarterly reports for the first three quarters of each fiscal year containing unaudited consolidated financial statements. 69 71 REALNETWORKS, INC. AND SUBSIDIARIES INDEX TO CONSOLIDATED FINANCIAL STATEMENTS Report of KPMG Peat Marwick LLP, Independent Accountants.............................. F-2 Consolidated Balance Sheets as of December 31, 1995 and 1996 and September 30, 1997... F-3 Consolidated Statements of Operations for the period from February 9, 1994 (inception) to December 31, 1994, the years ended December 31, 1995 and 1996, and the nine months ended September 30, 1996 (unaudited) and 1997................................ F-4 Consolidated Statements of Shareholders' Equity (Deficit) for the period from February 9, 1994 (inception) to December 31, 1994, the years ended December 31, 1995 and 1996, and the nine months ended September 30, 1997.................................. F-5 Consolidated Statements of Cash Flows for the period from February 9, 1994 (inception) to December 31, 1994, the years ended December 31, 1995 and 1996, and the nine months ended September 30, 1996 (unaudited) and 1997................................ F-6 Notes to Consolidated Financial Statements............................................ F-7
F-1 72 INDEPENDENT AUDITORS' REPORT The Board of Directors RealNetworks, Inc.: We have audited the accompanying consolidated balance sheets of RealNetworks, Inc. (formerly Progressive Networks, Inc.) and subsidiaries as of December 31, 1995 and 1996 and September 30, 1997, and the related consolidated statements of operations, shareholders' equity (deficit) and cash flows for the period from February 9, 1994 (inception) to December 31, 1994, the years ended December 31, 1995 and 1996 and the nine months ended September 30, 1997. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated 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, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of RealNetworks, Inc. and subsidiaries as of December 31, 1995 and 1996 and September 30, 1997, and the results of their operations and their cash flows for the period from February 9, 1994 (inception) to December 31, 1994, the years ended December 31, 1995 and 1996 and the nine months ended September 30, 1997 in conformity with generally accepted accounting principles. KPMG Peat Marwick LLP October 10, 1997, except as to Note 9, which is as of October 30, 1997 Seattle, Washington F-2 73 REALNETWORKS, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS ASSETS
PRO FORMA SHAREHOLDERS' DECEMBER 31, SEPTEMBER EQUITY AT --------------------------- 30, SEPTEMBER 30, 1995 1996 1997 1997 ----------- ----------- ------------ ------------- CURRENT ASSETS: Cash and cash equivalents..................................... $ 3,129,394 $14,737,806 $ 44,751,298 Short-term investments........................................ 2,986,493 4,857,163 22,897,196 Trade accounts receivable, net of allowance for doubtful 667,847 3,275,518 4,350,464 accounts and sales returns of $129,869 in 1995, $383,350 in 1996 and $688,572 in 1997................................... Other receivables............................................. 48,568 105,888 474,691 Inventory..................................................... 3,218 60,543 66,029 Prepaid expenses and other current assets..................... 143,328 491,348 319,188 Deferred income taxes......................................... -- -- 2,210,000 ----------- ----------- ------------ Total current assets.................................... 6,978,848 23,528,266 75,068,866 Property and equipment, net.................................... 594,042 2,678,798 4,773,480 Investment in joint venture.................................... -- -- 924,917 Deferred income taxes.......................................... -- -- 2,990,000 Other assets................................................... 836 261,094 614,371 ----------- ----------- ------------ $ 7,573,726 $26,468,158 $ 84,371,634 =========== =========== ============ LIABILITIES AND SHAREHOLDERS' EQUITY (DEFICIT) CURRENT LIABILITIES: Accounts payable.............................................. $ 185,368 $ 2,405,490 $ 1,193,543 Accrued compensation.......................................... 49,981 346,011 769,215 Other accrued expenses........................................ 149,909 971,499 2,745,782 Accrued income taxes.......................................... -- -- 5,200,000 Deferred revenue.............................................. 645,416 2,911,922 14,398,509 ----------- ----------- ------------ Total current liabilities............................... 1,030,674 6,634,922 24,307,049 ----------- ----------- ------------ Deferred revenue.............................................. -- -- 17,916,660 Note payable.................................................. -- -- 959,380 Redeemable, convertible preferred stock, $0.001 par value. Authorized 16,206,998 shares; issued and outstanding 7,654,528 23,153,494 49,277,652 5,964,006 shares at December 31, 1995, 8,345,016 shares at December 31, 1996 and 11,683,390 shares at September 30, 1997 (none pro forma) (aggregate liquidation preference of $7,752,312 at December 31, 1995, $34,645,820 at December 31, 1996 and $64,657,802 at September 30, 1997 and aggregate redemption value of $7,752,312 at December 31, 1995, $25,681,317 at December 31, 1996 and $55,693,300 at September 30, 1997)....................................... $ -- SHAREHOLDERS' EQUITY (DEFICIT): Convertible preferred stock, $0.001 par value. Authorized, issued and outstanding; 13,713,439 shares at 13,713 13,713 13,713 December 31, 1995 and 1996, and September 30, 1997 (none pro forma) (aggregate liquidation preference of $999,710 at December 31, 1995 and 1996, and September 30, 1997).... -- Preferred stock, undesignated series, $0.001 par value. Authorized 30,079,563 shares; no shares issued and -- -- -- outstanding............................................... -- Common stock, $0.001 par value. Authorized 300,000,000 shares; issued and outstanding; 37 535 1,543 36,948 shares at December 31, 1995, 535,491 shares at December 31, 1996 and 1,543,292 shares at September 30, 1997 (23,601,747 pro forma)............................... 23,602 Special common stock, $0.001 par value Authorized, issued and outstanding; no shares (3,338,374 pro forma)..................................... -- -- -- 3,338 Additional paid-in capital.................................... 921,315 2,543,587 6,755,080 56,021,048 Cumulative translation adjustment............................. -- (11,307) (72,041) (72,041) Accumulated deficit........................................... (2,046,541) (5,866,786) (14,787,402) (14,787,402) ----------- ----------- ------------ ------------- Total shareholders' equity (deficit).................... (1,111,476) (3,320,258) (8,089,107) $ 41,188,545 ============= Commitments and contingencies ----------- ----------- ------------ $ 7,573,726 $26,468,158 $ 84,371,634 =========== =========== ============
See accompanying notes to consolidated financial statements. F-3 74 REALNETWORKS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS
PERIOD FROM FEBRUARY 9, 1994 NINE MONTHS ENDED SEPTEMBER (INCEPTION) TO YEAR ENDED DECEMBER 31, 30, DECEMBER 31, --------------------------- --------------------------- 1994 1995 1996 1996 1997 -------------- ----------- ----------- ----------- ----------- (UNAUDITED) NET REVENUES: Software license fees.......... $ -- $ 1,781,763 $11,875,945 $ 7,213,357 $17,550,387 Advertising.................... -- -- 1,015,964 426,035 1,556,540 Service revenues............... -- 29,835 1,120,479 634,787 3,309,877 --------- ---------- ---------- ---------- ---------- Total net revenues...... -- 1,811,598 14,012,388 8,274,179 22,416,804 COST OF REVENUES: Software license fees.......... -- 29,194 1,342,942 470,440 2,080,167 Advertising.................... -- -- 288,024 186,909 571,595 Service revenues............... -- 32,940 554,558 311,916 1,956,899 --------- ---------- ---------- ---------- ---------- Total cost of -- 62,134 2,185,524 969,265 4,608,661 revenues.............. --------- ---------- ---------- ---------- ---------- Gross profit................. -- 1,749,464 11,826,864 7,304,914 17,808,143 OPERATING EXPENSES: Research and development....... 201,847 1,379,727 4,812,188 3,073,031 9,129,668 Selling and marketing.......... 47,181 1,217,900 7,539,924 4,389,030 14,024,617 General and administrative..... 296,211 746,645 3,491,296 2,318,173 4,412,831 --------- ---------- ---------- ---------- ---------- Total operating 545,239 3,344,272 15,843,408 9,780,234 27,567,116 expenses.............. --------- ---------- ---------- ---------- ---------- Operating loss............... (545,239) (1,594,808) (4,016,544) (2,475,320) (9,758,973) OTHER INCOME (EXPENSE): Interest income, net........... -- 93,506 296,427 189,320 1,220,374 Other income (expense)......... -- -- (69,128) (28,977) 37,174 Equity in net losses of joint -- -- -- -- (73,291) venture...................... --------- ---------- ---------- ---------- ---------- Net other income............. -- 93,506 227,299 160,343 1,184,257 --------- ---------- ---------- ---------- ---------- Net loss..................... $ (545,239) $(1,501,302) $(3,789,245) $(2,314,977) $(8,574,716) ========= ========== ========== ========== ========== Pro forma net loss per share... $ (0.14) $ (0.32) Shares used to compute pro 27,779,321 28,315,053 forma net loss per share.....
See accompanying notes to consolidated financial statements. F-4 75 REALNETWORKS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (DEFICIT)
TOTAL PREFERRED STOCK COMMON STOCK ADDITIONAL CUMULATIVE SHAREHOLDERS' -------------------- ------------------ PAID-IN TRANSLATION ACCUMULATED EQUITY SHARES AMOUNT SHARES AMOUNT CAPITAL ADJUSTMENT DEFICIT (DEFICIT) ---------- ------- --------- ------ ---------- ----------- ------------- ------------- Sale of common stock....... -- $ -- 10,000 $ 10 $ 72,828 $ -- $ -- $ 72,838 Contribution of capital by founder.................. -- -- -- -- 487,357 -- -- 487,357 Net loss................. -- -- -- -- -- -- (545,239) (545,239) ---------- -------- -------- --------- --------- -------- ----------- ----------- Balances at December 31, 1994..................... -- -- 10,000 10 560,185 -- (545,239) 14,956 Contribution of capital by founder.................. -- -- -- -- 372,283 -- -- 372,283 Exchange of common stock for Series A preferred stock.................... 13,713,439 13,713 (9,999) (10) (13,703) -- -- -- Exercise of common stock options.................. -- -- 30,750 31 2,122 -- -- 2,153 Issuance of common stock in exchange for services.... -- -- 6,197 6 428 -- -- 434 Net loss................. -- -- -- -- -- -- (1,501,302) (1,501,302) ---------- -------- -------- --------- --------- -------- ----------- ----------- Balances at December 31, 1995..................... 13,713,439 13,713 36,948 37 921,315 -- (2,046,541) (1,111,476) Exercise of common stock options.................. -- -- 498,543 498 43,272 -- -- 43,770 Issuance of preferred stock warrants................. -- -- -- -- 1,579,000 -- -- 1,579,000 Translation adjustment..... -- -- -- -- -- (11,307) -- (11,307) Accretion of redemption value of redeemable, convertible preferred stock.................... -- -- -- -- -- -- (31,000) (31,000) Net loss................. -- -- -- -- -- -- (3,789,245) (3,789,245) ---------- -------- -------- --------- --------- -------- ----------- ----------- Balances at December 31, 1996..................... 13,713,439 13,713 535,491 535 2,543,587 (11,307) (5,866,786) (3,320,258) Exercise of common stock options.................. -- -- 1,006,801 1,007 141,494 -- -- 142,501 Issuance of common stock in exchange for services.... -- -- 1,000 1 1,999 -- -- 2,000 Issuance of preferred stock warrants................. -- -- -- -- 4,068,000 -- -- 4,068,000 Translation adjustment..... -- -- -- -- -- (60,734) -- (60,734) Accretion of redemption value of redeemable, convertible preferred stock.................... -- -- -- -- -- -- (345,900) (345,900) Net loss................. -- -- -- -- -- -- (8,574,716) (8,574,716) ---------- -------- -------- --------- --------- -------- ----------- ----------- Balances at September 30, 1997..................... 13,713,439 $13,713 1,543,292 $1,543 $6,755,080 $ (72,041) $ (14,787,402) $(8,089,107) ========== ======== ======== ========= ========= ======== =========== ===========
See accompanying notes to consolidated financial statements. F-5 76 REALNETWORKS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS
PERIOD FROM FEBRUARY 9, 1994 YEAR ENDED NINE MONTHS ENDED (INCEPTION) TO DECEMBER 31, SEPTEMBER 30, DECEMBER 31, --------------------------- ---------------------------- 1994 1995 1996 1996 1997 ---------------- ----------- ------------ ------------ ------------ (UNAUDITED) Cash flows from operating activities: Net loss..................................... $ (545,239) $(1,501,302) $ (3,789,245) $ (2,314,977) $ (8,574,716) Adjustments to reconcile net loss to net cash provided by (used in) operating activities: Depreciation and amortization.............. 5,295 93,265 699,087 333,242 1,397,108 Common stock issued in exchange for services................................. -- 434 -- -- 2,000 Equity in net losses of joint venture...... -- -- -- -- 73,291 Foreign currency transaction gain.......... -- -- -- -- (31,888) Deferred income tax benefit................ -- -- -- -- (5,200,000) Change in certain assets and liabilities: Trade accounts receivable................ -- (667,847) (2,607,671) (1,536,816) (1,079,435) Other receivables........................ -- -- (57,320) (246,591) (368,803) Inventory................................ -- (3,218) (57,325) (65,875) (5,486) Prepaid expenses and other current assets................................. -- (143,328) (348,723) (342,262) 168,876 Other assets............................. -- -- (78,298) 355 (104,858) Accounts payable......................... -- 185,368 2,220,292 842,186 (1,210,809) Accrued compensation..................... 15,817 34,164 296,030 217,119 423,951 Other accrued expenses................... 33,217 116,692 821,590 333,622 1,774,984 Accrued income taxes..................... -- -- -- -- 5,200,000 Deferred revenue......................... -- 645,416 2,266,506 1,338,432 29,405,712 -------- ---------- ---------- ---------- ---------- Net cash provided by (used in) operating activities................. (490,910) (1,240,356) (635,077) (1,441,565) 21,869,927 -------- ---------- ---------- ---------- ---------- Cash flows from investing activities: Purchases of property and equipment.......... (67,542) (624,503) (2,783,994) (1,705,783) (3,496,171) Purchases of short-term investments.......... -- (3,035,061) (30,514,885) (11,836,281) (189,419,284) Proceeds from sales and maturities of short-term investments..................... -- -- 28,644,215 13,279,604 171,379,251 Investment in joint venture.................. -- -- -- -- (998,208) Increase in other assets..................... (1,393) -- (181,960) (237,708) (250,575) -------- ---------- ---------- ---------- ---------- Net cash used in investing activities........................... (68,935) (3,659,564) (4,836,624) (500,168) (22,784,987) -------- ---------- ---------- ---------- ---------- Cash flows from financing activities: Proceeds from issuance of note payable....... -- -- -- -- 991,268 Proceeds from sale of preferred stock and stock warrants, net........................ -- 7,404,528 17,046,966 -- 29,846,258 Proceeds from exercise of preferred stock warrant.................................... -- 250,000 -- -- -- Proceeds from exercise of common stock options.................................... -- 2,153 43,770 42,749 142,501 Proceeds from sale of common stock........... 72,838 -- -- -- -- Contribution of capital by founder........... 487,357 372,283 -- -- -- -------- ---------- ---------- ---------- ---------- Net cash provided by financing activities........................... 560,195 8,028,964 17,090,736 42,749 30,980,027 -------- ---------- ---------- ---------- ---------- Effect of exchange rate changes on cash........ -- -- (10,623) -- (51,475) -------- ---------- ---------- ---------- ---------- Net increase (decrease) in cash and cash equivalents..................... 350 3,129,044 11,608,412 (1,898,984) 30,013,492 Cash and cash equivalents at beginning of period....................................... -- 350 3,129,394 3,129,394 14,737,806 -------- ---------- ---------- ---------- ---------- Cash and cash equivalents at end of period..... $ 350 $ 3,129,394 $ 14,737,806 $ 1,230,410 $ 44,751,298 ======== ========== ========== ========== ========== Supplemental disclosure of cash flow information -- cash paid during the period for interest................................. $ -- $ 1,853 $ 4,430 $ -- $ 26,633 Supplemental disclosure of noncash financing and investing activities: Exchange of common stock for Series A preferred stock............................ $ -- $ 932,385 $ -- $ -- $ -- Accretion of redemption value of redeemable, convertible preferred stock................ $ -- $ -- $ 31,000 $ -- $ 345,900
See accompanying notes to consolidated financial statements. F-6 77 REALNETWORKS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1994, 1995 AND 1996, AND SEPTEMBER 30, 1996 AND 1997 (INFORMATION FOR THE NINE MONTHS ENDED SEPTEMBER 30, 1996 IS UNAUDITED) (1) NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (a) Nature of Business RealNetworks, Inc. (formerly Progressive Networks, Inc.) and subsidiaries (Company) is a leading provider of branded software products and services that enable the delivery of streaming media content over the Internet and intranets. Streaming technology enables the transmission and playback of continuous "streams" of multimedia content, such as audio and video, over the Internet and intranets. The Company's products and services include its RealSystem, a streaming media solution that includes RealAudio and RealVideo technology, an electronic commerce Web site designed to promote the proliferation of streaming media products and a network of advertising-supported content aggregation Web sites. Inherent in the Company's business are various risks and uncertainties, including its limited operating history and the limited history of commerce on the Internet. The Company's success may depend in part upon the emergence of the Internet as a communications medium, the acceptance of the Company's technology by the marketplace and the Company's ability to generate license and advertising revenues from the use of its technology on the Internet. (b) Basis of Presentation The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation. (c) Cash and Cash Equivalents and Short-Term Investments The Company considers all short-term investments with a remaining contractual maturity at date of purchase of three months or less to be cash equivalents. The Company classifies its short-term investments as available-for-sale. Accordingly, these investments are carried at fair value. The fair value of such securities approximated cost, and there were no unrealized holding gains or losses at December 31, 1995 and 1996, and September 30, 1997. At September 30, 1997, all short-term investments had contractual maturities of two years or less. F-7 78 REALNETWORKS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) The Company's cash and cash equivalents and short-term investments as of December 31, 1995 and 1996 and September 30, 1997 consist of the following:
DECEMBER 31, --------------------------- SEPTEMBER 30, 1995 1996 1997 ---------- ----------- ------------- Cash and cash equivalents: Cash........................................ $1,104,358 $ 1,016,728 $ 1,538,598 Commercial paper............................ 2,025,036 13,721,078 35,648,430 U.S. Government agency securities........... -- -- 7,564,270 --------- ---------- ---------- Total cash and cash equivalents..... 3,129,394 14,737,806 44,751,298 Short-term investments: Corporate notes............................. 2,986,493 4,857,163 10,416,565 U.S. Government agency securities........... -- -- 9,980,935 Certificates of deposit..................... -- -- 2,499,696 --------- ---------- ---------- Total short-term investments........ 2,986,493 4,857,163 22,897,196 --------- ---------- ---------- Total cash and cash equivalents and short-term investments............ $6,115,887 $19,594,969 $67,648,494 ========= ========== ==========
(d) Inventory Inventory is stated at the lower of cost or market, with cost determined on the first-in, first-out basis. (e) Property and Equipment Property and equipment are stated at cost. Depreciation is computed using the straight-line method over the estimated useful lives of the assets, generally three years. Leasehold improvements are amortized over the lesser of the term of the lease or the estimated useful life of the asset. (f) Investment in Joint Venture The Company has a 24% interest in a Japanese limited liability company and accounts for this investment using the equity method. Accordingly, the initial investment is recorded at cost. Subsequently, the carrying amount of the investment is increased or decreased to reflect the Company's share of income or losses of the joint venture and is reduced to reflect dividends received from the joint venture. The Company's share of income or losses of the joint venture is included in the Company's consolidated statements of operations. The Company's investment in the joint venture was funded with proceeds from a loan from Trans Cosmos, Inc., one of the joint venture's partners (see note 6). The Company and Trans Cosmos, Inc. are parties to a Master Distribution Agreement pursuant to which the Company granted Trans Cosmos, Inc. a nonexclusive, nontransferable license to reproduce and distribute the Company's products in Japan. (g) Research and Development Research and development costs are charged to operations as incurred. Statement of Financial Accounting Standards (SFAS) No. 86, Accounting for the Costs of Computer Software to be Sold, Leased or Otherwise Marketed, requires capitalization of certain software development costs subsequent to the establishment of technological feasibility. F-8 79 REALNETWORKS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Based on the Company's product development process, technological feasibility is established upon completion of a working model. Costs incurred by the Company between completion of the working model and the point at which the product is ready for general release have been insignificant. (h) Revenue Recognition The Company recognizes revenue from software license fees upon delivery, net of an allowance for estimated returns, provided that no significant obligations of the Company remain and collection of the resulting receivable is deemed probable. Revenue from software license agreements with original equipment manufacturers (OEM) is recognized when the OEM delivers its product incorporating the Company's software to the end user. In the case of prepayments received from an OEM, the Company generally recognizes revenue based on the actual products sold by the OEM. If the Company anticipates providing ongoing support to the OEM in the form of future upgrades, enhancements or other services over the term of the contract, revenue generally is recognized on the straight-line method over the term of the contract. The Company recognizes revenue from software license agreements with value-added resellers (VAR), provided the following conditions are met: the software product has been delivered to the VAR, the fee to the Company is fixed or determinable, and collectibility is probable. Revenues from advertising appearing on the Company's World Wide Web (Web) sites are recognized on the straight-line method over the terms of the advertising contracts. The Company guarantees to certain advertising customers a minimum number of page impressions to be delivered to users of its Web sites for a specified period. To the extent guaranteed minimum page impression deliveries are not met, the Company defers recognition of the corresponding revenues until guaranteed page impression delivery levels are achieved. As of December 31, 1996 and September 30, 1997, no revenues had been deferred as a result of these guarantees. Service revenues include revenues from upgrade and support agreements, consulting, content hosting, and fees from user conferences. Service revenues from upgrade and support agreements are recognized ratably over the term of the related agreements. Other service revenues are recognized when the service is performed. (i) Financial Instruments and Concentrations of Risk The Company's financial instruments consist of cash and cash equivalents, short-term investments, trade accounts receivable, accounts payable, accrued expenses, and note payable. The fair value of these instruments approximates their financial statement carrying amount. Credit is extended to customers based on an evaluation of their financial condition, and collateral is not required. The Company performs ongoing credit evaluations of its customers and maintains an allowance for potential credit losses. Substantially all of the Company's accounts receivable are derived from domestic sales. The Company is subject to concentrations of credit and interest rate risk related to its short-term investments. The Company's credit risk is managed by limiting the amount of investments placed with any one issuer, investing in high-quality investment securities and securities of the U.S. government, and limiting the average maturity of the overall portfolio. F-9 80 REALNETWORKS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) The Company's customers consist primarily of resellers and end users located in the United States and various foreign countries. Revenues in the years ended December 31, 1995 and 1996 and the nine months ended September 30, 1996 and 1997 by geographic region, as a percent of total net revenues, are as follows:
DECEMBER 31, SEPTEMBER 30, ------------- ------------- 1995 1996 1996 1997 ---- ---- ---- ---- United States.................................. 83% 78% 79% 73% Asia........................................... 8% 7% 8% 11% Europe......................................... 5% 7% 7% 10% Canada......................................... 2% 3% 3% 3% Other.......................................... 2% 5% 3% 3%
One customer accounted for approximately 14% of total net revenues in 1995. No single customer accounted for more than 10% of total net revenues in 1996 or in the nine months ended September 30, 1996. Software license fees under a license agreement with Microsoft Corporation (Microsoft) (see note 8) accounted for approximately 11% of total net revenues for the nine months ended September 30, 1997. (j) Advertising Expenses The Company expenses the cost of advertising and promoting its products as incurred. Such costs are included in selling and marketing expense and totaled approximately $68,000 and $665,000 during the years ended December 31, 1995 and 1996, respectively, and $365,000 and $751,000 during the nine months ended September 30, 1996 and 1997, respectively. (k) Income Taxes The Company was an S corporation for federal income tax purposes from its inception through April 8, 1995. Consequently, taxable income or loss of the Company through April 8, 1995 was attributed to the Company's shareholders. Effective April 8, 1995, the Company changed its election to utilize the provisions of subchapter S of the Internal Revenue Code of 1986, as amended, and elected to be taxed as a subchapter C corporation. The Company uses the asset and liability method of accounting for income taxes. Under this method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and to operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in results of operations in the period that includes the enactment date. Pro forma income tax information has not been provided for the period from inception to April 8, 1995. As a result of the operating losses recognized prior to April 8, 1995, any income tax benefit would have been fully offset by the establishment of a valuation allowance for deferred tax assets had the Company been taxed as a subchapter C corporation. F-10 81 REALNETWORKS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (l) Foreign Currency Translation The functional currency of the Company's foreign subsidiaries is the local currency in the country in which the subsidiary is incorporated. Assets and liabilities of foreign operations are translated into U.S. dollars using rates of exchange in effect at the end of the reporting period. Income and expense accounts are translated into U.S. dollars using average rates of exchange. The net gain or loss resulting from translation is shown as a cumulative translation adjustment in shareholders' equity. Gains and losses from foreign currency transactions are included in the consolidated statement of operations. (m) Use of 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, 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. (n) Stock-Based Compensation The Company accounts for its stock option plans for employees in accordance with the provisions of Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations. As such, compensation expense related to employee stock options is recorded only if, on the date of grant, the fair value of the underlying stock exceeded the exercise price. On January 1, 1996, the Company adopted the disclosure-only requirements of SFAS No. 123, Accounting for Stock-Based Compensation, which allows entities to continue to apply the provisions of APB Opinion No. 25 for transactions with employees and provide pro forma net income and pro forma earnings per share disclosures for employee stock option grants made in 1995 and future years as if the fair-value-based method of accounting in SFAS No. 123 had been applied to these transactions. (o) Impairment of Long-Lived Assets The Company reviews its long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets held and used is measured by a comparison of the carrying amount of an asset to future net cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets. (p) Reclassifications Certain reclassifications have been made to the 1994, 1995 and 1996 consolidated financial statements to conform with the 1997 presentation. (q) Unaudited Interim Financial Statements In the opinion of the Company's management, the September 30, 1996 unaudited interim financial statements include all adjustments, consisting of normal recurring adjustments, necessary for a fair presentation. F-11 82 REALNETWORKS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (r) Pro Forma Net Loss Per Share Pro forma net loss per share is computed by dividing the sum of net loss plus accretion of redemption value of redeemable, convertible preferred stock by the weighted average number of shares of common stock and common stock equivalents outstanding during each period and the shares resulting from the conversion of all outstanding shares of preferred stock. Common stock equivalents include all warrants and stock options that would have a dilutive effect, applying the treasury stock method. Additionally, common and common equivalent shares issued during the twelve months immediately preceding the initial filing of a registration statement for the Company's initial public offering (IPO) have been included in the calculation of common and common equivalent shares as if they were outstanding for all periods presented, including loss years where the impact of the incremental shares is antidilutive, using the treasury stock method and an assumed initial public offering price of $10.00 per share. Due to the significant impact of the assumed conversion of the preferred stock upon closing of the IPO, historical net loss per share is not meaningful and, therefore, is not presented. (s) New Accounting Pronouncements In February 1997, the Financial Accounting Standards Board (FASB) issued SFAS No. 128, Earnings Per Share (Statement 128). Statement 128 establishes standards for the computation, presentation and disclosure of earnings per share (EPS), replacing the presentation of currently required Primary EPS with a presentation of Basic EPS. It also requires dual presentation of Basic EPS and Diluted EPS on the face of the income statement for entities with complex capital structures. Basic EPS is based on the weighted average number of common shares outstanding during the period. Diluted EPS is based on the potential dilution that would occur on exercise or conversion of securities into common stock using the treasury stock method. Statement 128 is effective for periods ending after December 15, 1997, including interim periods; earlier application is not permitted. When adopted, the Company will be required to restate its EPS data for all prior periods presented. The Company does not expect the impact of the adoption of Statement 128 to be material to its reported EPS amounts. In June 1997, the FASB issued SFAS No. 130, Reporting Comprehensive Income (Statement 130). Statement 130 establishes standards for reporting and disclosure of comprehensive income and its components (revenues, expenses, gains and losses) in a full set of general-purpose financial statements. Statement 130, which is effective for fiscal years beginning after December 15, 1997, requires reclassification of financial statements for earlier periods to be provided for comparative purposes. The Company anticipates that implementing the provisions of Statement 130 will not have a significant impact on the Company's existing disclosures. The Company has not determined the manner in which it will present the information required by Statement 130. In June 1997, the FASB issued SFAS No. 131, Disclosure About Segments of an Enterprise and Related Information (Statement 131). Statement 131 establishes standards for the way that public business enterprises report information about operating segments. It also establishes standards for related disclosures about products and services, geographic areas and major customers. Statement 131 is effective for fiscal years beginning after December 15, 1997. In the initial year of application, comparative information for earlier years must be restated. The Company anticipates that implementing the provisions of Statement 131 will not have a significant impact on the Company's existing disclosures. The Company has not determined the manner in which it will present the information required by Statement 131. F-12 83 REALNETWORKS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (2) PROPERTY AND EQUIPMENT Property and equipment consist of the following:
DECEMBER 31, ------------------------ SEPTEMBER 30, 1995 1996 1997 --------- ----------- ------------- Computer equipment and software... $ 529,705 $ 2,210,799 $ 4,255,153 Furniture, fixtures and leasehold improvements.................... 162,340 1,251,354 2,698,345 -------- ---------- ---------- 692,045 3,462,153 6,953,498 Less accumulated depreciation and amortization.................... 98,003 783,355 2,180,018 -------- ---------- ---------- $ 594,042 $ 2,678,798 $ 4,773,480 ======== ========== ==========
(3) COMMITMENTS (a) Leases The Company leases facilities under operating lease agreements expiring through April 2001. Future minimum lease payments under these leases are:
NET MINIMUM MINIMUM LEASE SUBLEASE LEASE YEARS ENDING SEPTEMBER 30: PAYMENTS RECEIPTS PAYMENTS ---------- --------- ---------- 1998....................................... $1,906,415 $(191,100) $1,715,315 1999....................................... 1,828,750 (95,500) 1,733,250 2000....................................... 1,646,251 -- 1,646,251 2001....................................... 946,933 -- 946,933 ---------- --------- ---------- Total minimum lease payments..... $6,328,349 $(286,600) $6,041,749 ========== ========= ==========
Rent expense totaled approximately $76,000 and $610,000 for the years ended December 31, 1995 and 1996, respectively, and $418,000 and $1,260,000 for the nine months ended September 30, 1996 and 1997, respectively. In April 1996, the Company entered into operating lease agreements for additional corporate office space, with the lease term extending through April 2001. These leases can be terminated beginning October 1998 with nine months' advance written notice and contain options for two five-year renewals. (b) Royalties The Company has arrangements with several Internet content providers pursuant to which it is committed to pay a percentage of certain advertising revenues generated from its Web sites. As of December 31, 1996 and September 30, 1997, royalties under these arrangements have not been significant. F-13 84 REALNETWORKS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (4) INCOME TAXES The components of income tax expense (benefit) are:
YEAR ENDED NINE MONTHS DECEMBER 31, ENDED ---------------------- SEPTEMBER 30, 1995 1996 1997 --------- --------- ------------- Current............................. $ -- $ -- $ 5,200,000 Deferred............................ -- -- (5,200,000) -------- -------- ----------- $ -- $ -- $ -- ======== ======== ===========
The expected U.S. federal income tax benefit determined by applying the statutory U.S. federal income tax rate of 34% to pretax loss for the period from February 9, 1994 (inception) to December 31, 1994, the years ended December 31, 1995 and 1996 and the nine months ended September 30, 1997 differs from the U.S. federal income tax benefit in the consolidated financial statements due primarily to the increase in the valuation allowance for deferred tax assets. The tax effects of temporary differences and tax loss and credit carryforwards that give rise to significant portions of federal deferred tax assets are comprised of the following:
DECEMBER 31, ------------------------ SEPTEMBER 30, 1995 1996 1997 --------- ----------- ------------- Deferred tax assets: Net operating loss carryforwards.......... $ 216,000 $ 918,000 $ -- Deferred revenue.......................... 112,000 530,000 10,154,000 Allowances for doubtful accounts and sales returns.......................... 44,000 130,000 232,000 Start-up costs capitalized for tax purposes............................... 84,000 70,000 48,000 Research and experimentation credit carryforwards.......................... 7,000 102,000 -- Other..................................... 30,000 78,000 276,000 -------- ---------- ---------- Gross deferred tax assets................... 493,000 1,828,000 10,710,000 Less valuation allowance.................. 493,000 1,828,000 5,510,000 -------- ---------- ---------- Net deferred tax assets..................... $ -- $ -- $ 5,200,000 ======== ========== ==========
The valuation allowance for deferred tax assets increased by $493,000, $1,335,000, and $3,682,000 for the years ended December 31, 1995 and 1996 and the nine months ended September 30, 1997, respectively. At December 31, 1996, the Company had net operating loss and other credit carryforwards of $2,802,000. As of September 30, 1997, the Company anticipates fully utilizing its net operating loss and other credit carryforwards by December 31, 1997 as a result of taxable income generated from a license agreement with Microsoft (see note 8). For financial reporting purposes, those license fees are recognized over the three-year term of the Company's ongoing obligations. As a result, the Company has recognized deferred tax assets to the extent of its accrued taxes. The Company believes it is more likely than not that its net deferred tax assets as of September 30, 1997 will be realized through the reversal of temporary differences in 1998 and 1999. F-14 85 REALNETWORKS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (5) 401(K) RETIREMENT SAVINGS PLAN The Company has a 401(k) Retirement Savings Plan that covers all employees who have met certain employment requirements. Employees can contribute a portion of their salary to the maximum allowed by the federal tax guidelines. (6) BANK LINE OF CREDIT AND TERM LOAN AND NOTE PAYABLE At December 31, 1996, the Company had available a $1,000,000 domestic bank line of credit and a $1,500,000 bank term loan. There were no borrowings outstanding under the line of credit or the term loan as of December 31, 1996, and the Company terminated the line of credit and term loan in September 1997. At September 30, 1997, the Company had outstanding a note payable to one of its joint venture partners. The note is denominated in Japanese yen, bears interest at a rate not to exceed the Japanese Short Term Prime Rate (1.63% at September 30, 1997) and is secured by the Company's shares in the joint venture. Interest on the note is payable monthly and the principal is due in May 2000. The principal amount of the note is 115,200,000 Japanese yen ($959,380 at September 30, 1997), and the Company may, under certain circumstances, tender its shares in the joint venture as repayment of the note. (7) SHAREHOLDERS' EQUITY (a) Authorized Capital In September 1997, the Company increased its authorized capital to 300,000,000 shares of common stock and 60,000,000 shares of preferred stock and established a par value of $0.001 for both common and preferred stock. The accompanying consolidated financial statements have been restated in all periods presented to reflect this action. (b) Preferred Stock The Company has authorized and issued convertible preferred stock and redeemable, convertible preferred stock as follows:
ISSUED AND OUTSTANDING SHARES ----------------------------------------- DECEMBER 31, SEPTEMBER AUTHORIZED -------------------------- 30, SERIES SHARES 1995 1996 1997 ------- ---------- ----------- ----------- ----------- Convertible preferred....... A 13,713,439 13,713,439 13,713,439 13,713,439 Redeemable, convertible preferred................. B 3,059,701 3,059,701 3,059,701 3,059,701 Redeemable, convertible preferred................. C 3,004,305 2,904,305 2,904,305 2,904,305 Redeemable, convertible preferred................. D 3,095,313 -- 2,381,010 2,381,010 Redeemable, convertible preferred................. E 7,047,679 -- -- 3,338,374
F-15 86 REALNETWORKS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) The following table summarizes activity of the Company's redeemable, convertible preferred stock for the years ended December 31, 1995 and 1996, and the nine months ended September 30, 1997:
PRICE DESCRIPTION PER SHARE SHARES AMOUNT - ----------------------------------------------------- --------- ---------- ----------- Balances at December 31, 1994........................ -- $ -- Sale of Series B preferred stock, net of issuance costs of $40,000................................... $0.67 2,686,567 1,760,000 Sale of Series C preferred stock, net of issuance costs of $57,784................................... 1.9634 2,904,305 5,644,528 Exercise of warrants for Series B preferred stock.... 0.67 373,134 250,000 --------- ----------- Balances at December 31, 1995........................ 5,964,006 7,654,528 Sale of Series D preferred stock, net of issuance costs and warrant value of $889,186 and $1,579,000, respectively....................................... 7.53 2,381,010 15,467,966 Accretion of redemption value........................ -- 31,000 --------- ----------- Balances at December 31, 1996........................ 8,345,016 23,153,494 Issuance costs related to sale of Series D preferred stock.............................................. -- (22,807) Sale of Series E preferred stock, net of issuance costs and warrant value of $130,935 and $4,068,000, respectively....................................... 8.99 3,338,374 25,801,065 Accretion of redemption value........................ -- 345,900 --------- ----------- Balances at September 30, 1997....................... 11,683,390 $49,277,652 ========= ===========
The rights, preferences and restrictions of the Series A, B, C, D and E Preferred Stock are as follows: - Each of the Series B, C, D and E Preferred Stock are redeemable by the holder, on, or at any time after, December 31, 2002 with the written consent of at least two-thirds of the respective outstanding Series B, C, D and E shareholders. The stated redemption prices at date of issuance were $0.67, $1.9634, $7.53 and $8.99 per share for the Series B, C, D and E Preferred Stock, respectively, and are to be adjusted for inflation from the issuance date to the redemption date. Redemption payments would be made in three equal installments commencing on the initial redemption request date, and each year thereafter, for a period of two years. The Company accounts for the difference between the carrying amount of redeemable preferred stock and the redemption amount by increasing the carrying amount for periodic accretion against accumulated deficit using the interest method, so that the carrying amount will equal the redemption amount at the redemption date. - Each share of Series A, B, C and D Preferred Stock is convertible at the option of the holder at any time into one share of Series A Common Stock, subject to certain antidilution provisions. The holders of Series A Preferred Stock have the right, under certain circumstances, to convert one share of Series A Preferred Stock to one share of Series D Common Stock. - Each share of Series E Preferred Stock is convertible at the option of the holder at any time into one share of either Series A Common Stock or Series E Common Stock. - Conversion of all Series A, B, C, D and E Preferred Stock is automatic upon the closing of a public offering of the Company's common stock if either (a) the price to the public in the offering is at least $13.554 per share and the aggregate proceeds of the offering are not less than $20,000,000, or (b) the holders of not less than two-thirds of the then outstanding shares of Series D Preferred Stock, by affirmative vote or written consent, have consented to the automatic conversion. F-16 87 REALNETWORKS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) - Series A, B, C, D and E Preferred Stock have a liquidation preference of $0.0729, $0.67, $1.9634, $11.295 and $8.99 per share, respectively, plus all declared but unpaid dividends, if any. No dividends have been declared through December 31, 1996 and September 30, 1997. - Series A, B, C and D Preferred Stock have the same voting rights as Series A Common Stock based upon the number of shares of Series A Common Stock into which they are convertible. Series E Preferred Stock is nonvoting except as otherwise required by law, in which case the holders of each share of Series E Preferred Stock shall be entitled to one vote per share. Series A, B, C, D and E Preferred Stock have preferential treatment over all common stock with respect to any payment of dividends when and if declared by the board of directors and any distributions of assets upon liquidation. Pursuant to the rules and regulations of the Securities and Exchange Commission (SEC), the Company has classified redeemable, convertible preferred stock outside of shareholders' deficit. In September 1997, the Board of Directors authorized the filing of a registration statement with the SEC to permit the Company to sell shares of its common stock to the public. In connection therewith, the Company received the approval of the holders of two-thirds of the Series D Preferred Stock to convert the Series A, B, C, D and E Preferred Stock into common stock on closing of the IPO. Unaudited pro forma shareholders' equity included on the face of the balance sheet reflects the assumed conversion of redeemable, convertible preferred stock and convertible preferred stock into Common Stock and Special Common Stock (see note 9(b)) as of September 30, 1997. (c) Common Stock Common stock at December 31, 1995 and 1996, and September 30, 1997, consisted of the following:
ISSUED AND OUTSTANDING SHARES ------------------------------------ DECEMBER 31, ------------------ SEPTEMBER 30, AUTHORIZED SHARES 1995 1996 1997 ----------------- ------ ------- ------------- Series A............................... 207,047,679 1 1 1 Series B............................... 30,000,000 2,400 463,018 1,044,649 Series C............................... 30,000,000 34,547 72,472 498,642 Series D............................... 1 -- -- -- Series E............................... 7,047,679 -- -- --
At January 1, 1995, 10,000 shares of common stock were issued and outstanding. In April 1995, these 10,000 shares of common stock were exchanged for 13,713,439 shares of Series A Preferred Stock and one share of Series A Common Stock. Series A, B and D Common Stock entitle the holder to fifteen votes for each share held. Each share of Series E Common Stock shall not be entitled to vote, except as required by law, in which case it shall entitle the holder to one vote. Series C Common Stock entitles the holder to one vote for each share held. Series B Common Stock is reserved for issuance to employees, directors or affiliates of directors. Each share of Series B Common Stock automatically converts to one share of Series C Common Stock upon termination of the holder's employment, or his or her status as a director or an affiliate of a director. On the closing of a Qualified Offering of the Company's stock, as defined in the Company's Amended and Restated Articles of Incorporation, the designations of Series A through D Common Stock terminate and Series A through D Common Stock convert into one class of common stock, with each share entitled to one vote; and the designation of Series E Common Stock terminates and Series E Common Stock converts at the option of the holder into either Common Stock, with each share entitled to F-17 88 REALNETWORKS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) one vote, or Special Common Stock, with no voting rights except as required by applicable law. The Special Common Stock has all other rights and privileges of the Common Stock. (d) Stock Warrants In connection with the sale of Series B Preferred Stock, the Company issued a warrant to purchase 373,134 additional shares of Series B Preferred Stock at an exercise price of $0.67 per share. No separate value was assigned to the warrant as the value was not significant at the date of issuance. This warrant was exercised in 1995. In connection with the sale of Series C Preferred Stock, the Company issued warrants to purchase up to 100,000 additional shares of Series C Preferred Stock at an exercise price of $1.9634 per share, and warrants to purchase up to 183,755 shares of Series B Common Stock at an exercise price of approximately $0.20 per share. No separate value has been assigned to the warrants as the values were not significant at the date of issuance. These warrants vest on the earlier of January 26, 1997 or, if certain conditions are met, upon the closing of an IPO of the Company's common stock. These warrants expire on the earlier of the closing of an IPO by the Company with aggregate proceeds of not less than $10,000,000 and at not less than $4.00 per share or October 26, 2000. No warrants to purchase Series C Preferred Stock or Series B Common Stock have been exercised as of December 31, 1996 and September 30, 1997. In connection with the sale of Series D Preferred Stock, the Company issued warrants to purchase up to 714,303 additional shares of Series D Preferred Stock at an exercise price of $9.4125 per share. The value of the warrants, $1,579,000, was recorded as additional paid-in capital. These warrants are exercisable at December 31, 1996, and expire on November 27, 1998. The value of these warrants was determined using a Black-Scholes valuation model with the following assumptions: expected life of two years, expected dividend yield of 0%, expected volatility of 60% and a risk-free interest rate of 6%. Upon a merger or consolidation in which the Company is not the survivor, the warrants are canceled and all rights granted shall terminate. If an event causing conversion of the Company's Series D Preferred Stock shall have occurred prior to the exercise of the warrants, then all warrants shall be exercisable for the number of shares of common stock of the Company into which the Series D Preferred Stock not purchased upon any prior exercise of the warrants would have been so converted. In connection with the sale of Series E Preferred Stock, the Company issued a warrant to purchase up to 3,709,305 additional shares of Series E Preferred Stock at an exercise price of $13.48 per share. The value of the warrant, $4,068,000, was recorded as additional paid-in capital. This warrant is exercisable at any time through January 21, 2000 and will terminate automatically upon either closing of an IPO by the Company, or completion of a merger or consolidation in which the Company is not a survivor. The value of the warrant was determined using a Black-Scholes valuation model with the following assumptions: expected life of one year, expected dividend yield of 0%, expected volatility of 60% and a risk-free interest rate of 6%. If an event causing conversion of the Company's Series E Preferred Stock shall have occurred prior to the exercise of the warrant, in whole or in part, then the warrant shall be exercisable for the number of shares of common stock of the Company into which the Series E Preferred Stock not purchased upon any prior exercise of the warrant would have been so converted. (e) Stock Option Plans Under the Company's 1995 Stock Option Plan (1995 Plan), 3,600,000 shares of Common Stock were reserved for the issuance of stock options. Under the Company's Amended and Restated 1996 Stock Option Plan (1996 Plan), 8,800,000 shares of Common Stock are reserved for the issuance of F-18 89 REALNETWORKS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) stock options. In September 1997, the Company discontinued granting stock options under the 1995 Plan. In accordance with the provisions of the 1996 Plan, in addition to the 8,800,000 shares of Common Stock reserved, shares of Common Stock previously available for grant under the 1995 Plan are available for grant under the 1996 Plan, and to the extent options outstanding under the 1995 Plan terminate without having been exercised in full, the terminated options become available under the 1996 Plan. Options granted under the 1996 Plan may be designated as qualified or nonqualified at the discretion of the Board of Directors, generally vest over a period of one to five years from the date of grant, expire 20 years from the date of grant and terminate, to the extent not exercised, three months after the termination of employment. A summary of stock option activity under the 1995 Plan and the 1996 Plan is as follows:
OUTSTANDING OPTIONS ----------------------------- SHARES WEIGHTED AVAILABLE NUMBER AVERAGE FOR GRANT OF SHARES EXERCISE PRICE ---------- ---------- -------------- Balances at December 31, 1994...... -- -- $ -- Plan introduction.................. 3,600,000 -- -- Options granted.................... (3,313,214) 3,313,214 0.07 Options exercised.................. -- (30,750) 0.07 Options canceled................... 450,000 (450,000) 0.07 ---------- --------- Balances at December 31, 1995...... 736,786 2,832,464 0.07 Plan introduction.................. 3,000,000 -- -- Options granted.................... (3,766,364) 3,766,364 0.34 Options exercised.................. -- (498,543) 0.09 Options canceled................... 765,250 (765,250) 0.10 ---------- --------- Balances at December 31, 1996...... 735,672 5,335,035 0.27 Plan amendment..................... 5,800,000 -- -- Options granted.................... (2,739,930) 2,739,930 3.94 Options exercised.................. -- (1,006,801) 0.14 Options canceled................... 625,450 (625,450) 0.71 ---------- --------- Balances at September 30, 1997..... 4,421,192 6,442,714 $ 1.80 ========== =========
The Company applies APB Opinion No. 25 in accounting for the 1995 Plan and the 1996 Plan, and no compensation cost has been recognized for its employee stock options in the consolidated financial statements. Had the Company determined compensation cost of employee stock options based on the fair value of the option at the grant date for its stock options under SFAS No. 123, the Company's net loss would have been increased to the pro forma amounts indicated below:
DECEMBER 31, --------------------------- SEPTEMBER 30, 1995 1996 1997 ----------- ----------- ------------- Net loss: As reported................... $(1,501,302) $(3,789,245) $ (8,574,716) Pro forma..................... (1,510,513) (3,865,415) (8,770,334) Net loss per share: As reported................... $ (0.14) $ (0.32) Pro forma..................... (0.14) (0.32)
F-19 90 REALNETWORKS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) The full impact of calculating compensation cost for stock options under SFAS No. 123 is not reflected in the pro forma net loss and net loss per share amounts presented above because compensation cost is recognized over the options' vesting period. The per share weighted-average fair value of stock options granted during the years ended December 31, 1995 and 1996 and the nine months ended September 30, 1997 was $.01, $.07 and $.70, respectively, on the date of grant using the minimum value method with the following weighted average assumptions:
DECEMBER 31, ----------------------- SEPTEMBER 30, 1995 1996 1997 --------- --------- ------------- Expected dividend yield............... 0% 0% 0% Risk-free interest rate............... 5.9% 6.1% 6.1% Expected life......................... 3.5 years 4.5 years 3.5 years
The following table summarizes information about stock options outstanding under the 1995 Plan and the 1996 Plan at September 30, 1997:
OPTIONS OUTSTANDING ----------------------------------------- OPTIONS EXERCISABLE WEIGHTED- ------------------------- AVERAGE WEIGHTED- WEIGHTED- REMAINING AVERAGE AVERAGE EXERCISE NUMBER CONTRACTUAL EXERCISE NUMBER EXERCISE PRICES OUTSTANDING LIFE PRICE EXERCISABLE PRICE - ---------- ----------- ----------- --------- ----------- --------- $ 0.07 1,193,473 17.58 years $0.07 123,873 $0.07 0.20 1,993,206 18.42 years 0.20 480,438 0.20 0.85-1.50 1,349,535 19.12 years 1.23 62,135 0.93 2.00-3.50 970,000 19.64 years 2.60 4,600 2.30 7.25-8.50 936,500 19.90 years 7.38 4,000 7.25 ----- ----- 6,442,714 18.81 years $1.80 675,046 $0.30 ----- -----
(f) Employee Stock Purchase Plan In September 1997, the Company adopted the 1998 Employee Stock Purchase Plan (ESPP) which will become effective January 1, 1998. The Company has reserved 1,000,000 shares of Common Stock for issuance under the ESPP. The ESPP will be implemented through a series of offering periods of six months' duration, with new offering periods commencing on January 1 and July 1 of each year. The ESPP permits eligible employees to purchase Common Stock at a price equal to 85% of the lower of the fair market value of the Common Stock at the beginning or end of the offering period. (8) LICENSE AGREEMENT In June 1997, the Company entered into a strategic agreement with Microsoft pursuant to which the Company granted Microsoft a nonexclusive license to certain substantial elements of the source code of the Company's RealAudio/RealVideo Version 4.0 technology included in its basic RealPlayer and substantial elements of its EasyStart Server (currently known as the Basic Server), and related Company trademarks. Under the agreement, Microsoft may sublicense its rights to the licensed technology to third parties under certain conditions. On two occasions during the first two years following delivery under the agreement, Microsoft may acquire for $25 million and $35 million, respectively, a nonexclusive license to subsequently developed versions of the core audio and video technology, which currently is distributed to end-users at no charge. Under prescribed circumstances that are solely within the Company's control, the agreement provides for a full refund of each license fee during the first year, declining to 0% over the following two years. The Company may not assign its obligations under the agreement without Microsoft's consent, and a merger, the sale of substantially all of the Company's assets and certain other F-20 91 REALNETWORKS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) events will be deemed to be an assignment under the agreement. Microsoft is obligated to distribute the Company's RealPlayer Version 4.0 for a defined term as long as the Company's player supports certain Microsoft architectures. The Company also agreed to work with Microsoft and several other companies to author and promote the Active Streaming Format as a standard file format for streaming media. The agreement also requires the Company to provide Microsoft with engineering consultation services, certain error corrections, and certain technical support over a defined term. In July 1997, the Company delivered the specified source code in exchange for a license fee of $30,000,000. The Company recognizes revenue, commencing with delivery of the source code, over the three-year term of its ongoing obligations. The portion of the license fee that has not yet been recognized as revenue is included in deferred revenue. In connection with the agreement, Microsoft purchased a minority interest in the Company in the form of 3,338,374 shares of Series E Preferred Stock at $8.99 per share. (9) SUBSEQUENT EVENTS (a) License Agreement The terms of the Company's strategic agreement with Microsoft provide that the $30,000,000 software license fee will be paid to the Company in two installments. The first installment of $20,000,000 was due within 30 days of the signing of the software license agreement, and the remaining $10,000,000 is due within 30 days of the earlier of (1) the Company's completion of six "man months" of consulting services, or (2) six months after delivery of the specified source code to Microsoft. In July 1997, the Company delivered the specified source code and subsequently received from Microsoft a payment of $30,000,000 representing Microsoft's payment of both installments under the agreement although payment of the second installment of $10,000,000 was not due at that time. In October 1997, Microsoft requested that the Company return the $10,000,000 installment that Microsoft had paid prior to its due date. Although not legally required to do so, the Company refunded the $10,000,000 to Microsoft. The Company expects Microsoft to make this second installment payment in accordance with the terms of the agreement. (b) Special Common Stock In October 1997, the Company's Board of Directors and shareholders approved an amendment to the Company's Amended and Restated Articles of Incorporation to provide that any shares of Special Common Stock held by Microsoft will convert automatically into Common Stock upon transfer by a purchaser who is not affiliated with the holder. In October 1997, Microsoft agreed in writing to accept Special Common Stock in connection with any conversion of shares of Series E Preferred Stock held by Microsoft. F-21 92 UNDERWRITING Subject to the terms and conditions of the Underwriting Agreement, the Company has agreed to sell to each of the Underwriters named below, and each of such Underwriters, for whom Goldman, Sachs & Co., BancAmerica Robertson Stephens and NationsBanc Montgomery Securities, Inc. are acting as representatives, has severally agreed to purchase from the Company, the respective number of shares of Common Stock set forth opposite its name below:
NUMBER OF SHARES OF COMMON UNDERWRITER STOCK -------------------------------------------------------------------- ---------- Goldman, Sachs & Co................................................. BancAmerica Robertson Stephens...................................... NationsBanc Montgomery Securities, Inc.............................. --------- Total............................................................. 3,000,000 =========
Under the terms and conditions of the Underwriting Agreement, the Underwriters are committed to take and pay for all of the shares offered hereby, if any are taken. The Underwriters propose to offer the shares of Common Stock in part directly to the public at the initial public offering price set forth on the cover page of this Prospectus and in part to certain securities dealers at such price less a concession of $ per share. The Underwriters may allow, and such dealers may reallow, a concession not in excess of $ per share to certain brokers and dealers. After the shares of Common Stock are released for sale to the public, the offering price and other selling terms may from time to time be varied by the representatives. The Company has granted the Underwriters an option exercisable for 30 days after the date of this Prospectus to purchase up to an aggregate of 450,000 additional shares of Common Stock at the initial public offering price per share, less the underwriting discount, solely to cover over-allotments, if any. If the Underwriters exercise their over-allotment option, the Underwriters have severally agreed, subject to certain conditions, to purchase approximately the same percentage thereof that the number of shares to be purchased by each of them, as shown in the foregoing table, bears to the 3,000,000 shares of Common Stock offered. As of the date of this Prospectus, The Goldman Sachs Group, L.P., an affiliate of Goldman, Sachs & Co., beneficially owns 66,401 shares, and a warrant to purchase 19,920 shares, of Series D Preferred Stock. These shares and the warrant were purchased on November 27, 1996 in reliance on the exemption from registration set forth in Section 4(2) of the Securities Act relating to sales by an issuer not involving a public offering. Goldman, Sachs & Co. acted as placement agent for the Company in connection with the Company's sale of 2,381,010 shares of Series D Preferred Stock and warrants to purchase 714,303 shares of Series D Preferred Stock in November 1996. In connection with its services as placement agent, Goldman, Sachs & Co. received total fees of $889,186. The Company has agreed that, during the period beginning from the date of this Prospectus and continuing to and including the date 180 days after the date of this Prospectus, it will not offer, sell, contract to sell or otherwise dispose of any securities of the Company (other than pursuant to employee stock option or stock purchase plans existing, or on the conversion or exchange of convertible or exchangeable securities outstanding, on the date of this Prospectus) which are substantially similar to the Common Stock or which are convertible into or exchangeable for securities which are substantially similar to the Common Stock without the prior written consent of the representatives, except for the shares of Common Stock offered in connection with the offering. In addition, the officers, directors and certain persons who prior to closing of the offering hold shares of capital stock of the Company (including but not limited to all holders of 1% or more of the Company's U-1 93 capital stock) have agreed that they will not offer, sell or otherwise dispose of any shares of Common Stock owned of record or beneficially as of the date of the Prospectus, including securities convertible into or exercisable or exchangeable for shares of Common Stock as of said date, as well as any shares of Common Stock later acquired by reason of the conversion, exercise or exchange of such securities, or enter into any swap or other transaction with respect to the shares that would transfer the economic consequences of ownership of the Common Stock to another person, for a period of 180 days following the date of this Prospectus, except that (i) persons other than officers, directors and holders of 1% or more of the capital stock of the Company each will be free to sell or otherwise dispose of up to 5,000 shares of Common Stock to the extent permissible under Rule 144 or Rule 701 and (ii) directors, officers and holders of 1% of the Company's capital stock may dispose of shares of Common Stock as bona fide gifts if the recipient of any such gift agrees in writing with the Underwriters to be bound by the terms of this 180-day transfer restriction. At the request of the Company, the Underwriters have reserved up to 300,000 shares of Common Stock for sale, at the initial public offering price, to employees and friends of the Company through a directed share program. The number of shares of Common Stock available for sale to the general public in the public offering will be reduced to the extent such persons purchase such reserved shares. The representatives of the Underwriters have informed the Company that they do not expect sales to accounts over which the Underwriters exercise discretionary authority to exceed 5% of the total number of shares of Common Stock offered by them. Prior to the offering, there has been no public market for the shares. The initial public offering price will be negotiated among the Company and the representatives. Among the factors to be considered in determining the initial public offering price of the Common Stock, in addition to prevailing market conditions, will be the Company's historical performance, estimates of the business potential and earnings prospects of the Company, an assessment of the Company's management and the consideration of the above factors in relation to market valuation of companies in related businesses. In connection with the offering, the Underwriters may purchase and sell the Common Stock in the open market. These transactions may include over-allotment and stabilizing transactions and purchases to cover syndicate short positions created by the Underwriters in connection with the offering. Stabilizing transactions consist of certain bids or purchases for the purpose of preventing or retarding a decline in the market price of the Common Stock; and syndicate short positions created by the Underwriters involve the sale by the Underwriters of a greater number of shares of Common Stock than they are required to purchase from the Company in the offering. The Underwriters also may impose a penalty bid, whereby selling concessions allowed to syndicate members or other broker-dealers in respect of the securities sold in the offering for their account may be reclaimed by the syndicate if such shares of Common Stock are repurchased by the syndicate in stabilizing or covering transactions. These activities may stabilize, maintain or otherwise affect the market price of the Common Stock which may be higher than the price that might otherwise prevail in the open market; and these activities, if commenced, may be discontinued at any time. These transactions may be effected on the Nasdaq National Market in the over-the-counter market or otherwise. Application has been made for quotation of the Common Stock on the Nasdaq National Market under the symbol "RNWK." The Company has agreed to indemnify the several Underwriters against certain liabilities, including liabilities under the Securities Act. U-2 94 [SCREEN-SHOTS OF WEB PAGES SUPERIMPOSED OVER COMPANY LOGO] 95 ============================================================ NO PERSON HAS BEEN AUTHORIZED TO GIVE ANY INFORMATION OR TO MAKE ANY REPRESENTATIONS OTHER THAN THOSE CONTAINED IN THIS PROSPECTUS, AND, IF GIVEN OR MADE, SUCH INFORMATION OR REPRESENTATIONS MUST NOT BE RELIED UPON AS HAVING BEEN AUTHORIZED. THIS PROSPECTUS DOES NOT CONSTITUTE AN OFFER TO SELL OR THE SOLICITATION OF AN OFFER TO BUY ANY SECURITIES OTHER THAN THE SECURITIES TO WHICH IT RELATES OR AN OFFER TO SELL OR THE SOLICITATION OF AN OFFER TO BUY SUCH SECURITIES IN ANY CIRCUMSTANCES IN WHICH SUCH OFFER OR SOLICITATION IS UNLAWFUL. NEITHER THE DELIVERY OF THIS PROSPECTUS NOR ANY SALE MADE HEREUNDER SHALL, UNDER ANY CIRCUMSTANCES, CREATE ANY IMPLICATION THAT THERE HAS BEEN NO CHANGE IN THE AFFAIRS OF THE COMPANY SINCE THE DATE HEREOF OR THAT THE INFORMATION CONTAINED HEREIN IS CORRECT AS OF ANY TIME SUBSEQUENT TO ITS DATE. ------------------------ TABLE OF CONTENTS
PAGE ----- Prospectus Summary........................ 3 Risk Factors.............................. 6 Use of Proceeds........................... 20 Dividend Policy........................... 20 Capitalization............................ 21 Dilution.................................. 22 Selected Consolidated Financial Data...... 23 Management's Discussion and Analysis of Financial Condition and Results of Operations.............................. 24 Business.................................. 35 Management................................ 50 Certain Transactions...................... 59 Principal Shareholders.................... 62 Description of Capital Stock.............. 64 Shares Eligible for Future Sale........... 67 Legal Matters............................. 69 Experts................................... 69 Additional Information.................... 69 Index to Consolidated Financial Statements.............................. F-1 Underwriting.............................. U-1 THROUGH AND INCLUDING , 1997 (THE 25TH DAY AFTER THE DATE OF THIS PROSPECTUS), ALL DEALERS EFFECTING TRANSACTIONS IN THE COMMON STOCK, WHETHER OR NOT PARTICIPATING IN THIS DISTRIBUTION, MAY BE REQUIRED TO DELIVER A PROSPECTUS. THIS IS IN ADDITION TO THE OBLIGATION OF DEALERS TO DELIVER A PROSPECTUS WHEN ACTING AS UNDERWRITERS AND WITH RESPECT TO THEIR UNSOLD ALLOTMENTS OR SUBSCRIPTIONS. =================================================
============================================================ 3,000,000 SHARES REALNETWORKS, INC. (FORMERLY "PROGRESSIVE NETWORKS, INC.") COMMON STOCK (PAR VALUE $.001 PER SHARE) [REALNETWORKS LOGO] GOLDMAN, SACHS & CO. BANCAMERICA ROBERTSON STEPHENS NATIONSBANC MONTGOMERY SECURITIES, INC. REPRESENTATIVES OF THE UNDERWRITERS ============================================================ 96 PART II INFORMATION NOT REQUIRED IN PROSPECTUS ITEM 13. OTHER EXPENSES OF ISSUANCE AND DISTRIBUTION* Securities and Exchange Commission Registration Fee.............. $ 11,500 NASD Filing Fee.................................................. 3,950 Nasdaq National Market Listing Fee............................... 50,000 Legal Fees and Expenses.......................................... 325,000 Accountants' Fees and Expenses................................... 225,000 Blue Sky Filing and Counsel Fees and Expenses.................... 5,000 Printing and Engraving Expenses.................................. 150,000 Transfer Agent and Registrar Fees................................ 10,000 Miscellaneous Expenses........................................... 169,550 -------- Total.................................................. $ 950,000 ========
- --------------- * All expenses other than the Securities and Exchange Commission Registration Fee, the NASD Filing Fee and the Nasdaq National Market Fee are estimated. ITEM 14. INDEMNIFICATION OF DIRECTORS AND OFFICERS Sections 23B.08.500 through 23B.08.600 of the Washington Business Corporation Act (the "Washington Act") authorize a court to award, or a corporation's board of directors to grant, indemnification to directors and officers on terms sufficiently broad to permit indemnification under certain circumstances for liabilities arising under the Securities Act of 1933, as amended (the "Securities Act"). Article VI, Section 6.5, of the Registrant's Amended and Restated Articles of Incorporation (Exhibit 3.1 hereto) and Article X of the Registrant' Restated Bylaws (Exhibit 3.2 hereto) provide for indemnification of the Registrant's directors, officers, employees and agents to the maximum extent permitted by Washington law. The Registrant has entered into agreements with all officers and directors to indemnify them against certain liabilities arising out of their service as officers and directors, as applicable, and to advance expenses to defend claims subject to indemnification. The directors and officers of the Registrant also may be indemnified against liability they may incur for serving in that capacity pursuant to a liability insurance policy maintained by the Registrant for such purpose. Section 23B.08.320 of the Washington Act authorizes a corporation to limit a director's liability to the corporation or its shareholders for monetary damages for acts or omissions as a director, except in certain circumstances involving intentional misconduct, self-dealing or illegal corporate loans or distributions, or any transaction from which the director personally receives a benefit in money, property or services to which the director is not legally entitled. Article VI, Section 6.6, of the Registrant's Amended and Restated Articles of Incorporation contains provisions implementing, to the fullest extent permitted by Washington law, such limitations on a director's liability to the Registrant and its shareholders. Reference is also made to the Form of Underwriting Agreement to be filed as Exhibit 1.1 to this Registration Statement for certain provisions regarding the indemnification of officers and directors of the Registrant by the Underwriters. ITEM 15. RECENT SALES OF UNREGISTERED SECURITIES Since September 1, 1994, the Registrant has issued and sold unregistered securities as follows: (1) An aggregate of 2,686,567 shares of Series B Preferred Stock was issued in a private placement in April 1995 to nine investors. The aggregate consideration received for such shares was $1,800,000. II-1 97 (2) A warrant for the purchase of an aggregate of 373,134 shares of Series B Preferred Stock was issued in a private placement in April 1995 to one investor. The consideration received by the Registrant in connection with the issuance of such warrant was part of the aggregate consideration received by the Registrant in connection with the private placement of Series B Preferred Stock noted above. (3) An aggregate of 2,600 shares of Series B Common Stock was issued in September 1995 to 26 employees in exchange for services, and 100 shares of Series C Common Stock were issued in September 1995 to one individual in exchange for services, in each case in connection with a product launch. (4) An aggregate of 373,134 shares of Series B Preferred Stock was issued to one investor upon the exercise of a warrant in October 1995. The aggregate consideration received for such shares was $250,000. (5) An aggregate of 3,497 shares of Series C Common Stock was issued in October 1995 to one individual in exchange for services. (6) An aggregate of 2,904,305 shares of Series C Preferred Stock was issued in a private placement in October 1995 to 12 investors. The aggregate consideration received for such shares was $5,702,312. (7) Warrants for the purchase of an aggregate of 183,755 shares of Series B Common Stock were issued in a private placement in October 1995 to five investors, and warrants for the purchase of an aggregate of 100,000 shares of Series C Preferred Stock were issued in a private placement in October 1995 to four investors. The consideration received by the Registrant in connection with the issuance of such warrants was part of the aggregate consideration received by the Registrant in connection with the private placement of Series C Preferred Stock noted above. (8) An aggregate of 2,381,010 shares of Series D Preferred Stock was issued in a private placement in November 1996 to 23 investors. The aggregate consideration received for such shares was $17,929,005. (9) Warrants for the purchase of an aggregate of 714,303 shares of Series D Preferred Stock were issued in connection with the Series D Preferred Stock private placement in November 1996 to 23 investors. The aggregate consideration received for such warrants was $7,143. (10) An aggregate of 1,000 shares of Series C Common Stock was issued in March 1997 to one individual in exchange for services. (11) An aggregate of 3,338,374 shares of Series E Preferred Stock was issued in a private placement in July 1997 to one investor. The aggregate consideration received for such shares was $30,000,000. (12) A warrant for the purchase of an aggregate of 3,709,305 shares of Series E Preferred Stock was issued in a private placement in July 1997 to one investor. The consideration received by the Registrant in connection with the issuance of such warrant was part of the aggregate consideration received by the Registrant in connection with the private placement of Series E Preferred Stock noted above. (13) As of October 9, 1997, an aggregate of 1,562,994 shares of Series B Common Stock and Series C Common Stock has been issued to employees and consultants upon the exercise of options. The aggregate consideration received for such shares was $211,374. (14) An aggregate of 15,000 shares of Series C Common Stock was issued in October 1997 to one entity in a private placement in connection with the acquisition of certain assets of that entity. Except in connection with the Series D Preferred Stock private placement, no underwriters were engaged in connection with these issuances and sales. Each of the transactions noted above was made II-2 98 in reliance upon the exemption from registration provided by either Section 3(b) or 4(2) of the Securities Act. ITEM 16. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES (a) EXHIBITS
NUMBER DESCRIPTION ------- ------------------------------------------------------------------------------- 1.1 Form of Underwriting Agreement 3.1 Form of Amended and Restated Articles of Incorporation 3.2** Bylaws (previously filed as Exhibit 3.4 to Amendment No. 1 filed on October 15, 1997) 4.1 Specimen Stock Certificate 5.1 Opinion of Graham & James LLP/Riddell Williams P.S. 10.1** RealNetworks, Inc. 1995 Stock Option Plan 10.2** RealNetworks, Inc. Amended and Restated 1996 Stock Option Plan 10.3** Form of Stock Option Agreement 10.4** 1998 Employee Stock Purchase Plan 10.5** Form of Warrant to Purchase Series D Preferred Stock 10.6** Warrant to Purchase Series E Preferred Stock dated July 21, 1997 between the Registrant and Microsoft Corporation 10.7** Lease Agreement dated March 4, 1996 by and between the Registrant as Lessee and Wright Runstad Properties L.P. as Lessor 10.8** Sublease Agreement dated March 1996 by and between the Registrant as Sublessee and Legent Corporation as Sublessor 10.9** Antenna Site License Agreement dated August 12, 1997 by and between the Registrant and Wright Runstad & Company 10.10** Agreement between Microsoft Corporation and the Registrant on Media Streaming Technology dated June 17, 1997 (confidential treatment requested) 10.11** Offer letter dated February 16, 1996 between the Registrant and Bruce Jacobsen 10.12** Offer letter dated May 2, 1995 between the Registrant and James Wells 10.13** Offer letter dated May 24, 1994 between the Registrant and Andrew Sharpless 10.14** Form of Director and Officer Indemnification Agreement 10.15** Limited Proxy and Voting Agreement dated July 21, 1997 by and between the Registrant and Microsoft Corporation 10.16** Shareholders' Buy-Sell Agreement dated March 31, 1995 by and among the Registrant, Robert Glaser and certain shareholders of the Registrant 10.17** Voting Agreement dated September 25, 1997 by and among the Registrant, Robert Glaser, Accel IV L.P., Mitchell Kapor and Bruce Jacobsen 10.18** Agreement dated September 26, 1997 by and between the Registrant and Robert Glaser 10.19** Second Amended and Restated Investors' Rights Agreement dated July 21, 1997 by and among the Registrant and certain shareholders of the Registrant 10.20 Agreement to Terminate Shareholders' Buy-Sell Agreement dated October 24, 1997 10.21 Representative License Agreement -- License Agreement for the RealPlayer Plus 11.1** Statement re: Computation of Pro Forma Net Loss Per Share 21.1** Subsidiaries of the Registrant
II-3 99
NUMBER DESCRIPTION ------- ------------------------------------------------------------------------------- 23.1 Consent of Graham & James LLP/Riddell Williams P.S. (included in its opinion to be filed as Exhibit 5.1 hereto) 23.2 Consent of KPMG Peat Marwick LLP 24.1** Power of Attorney 27.1** Financial Data Schedule
- --------------- ** Previously filed. (b) FINANCIAL STATEMENT SCHEDULE Schedule II -- Valuation and Qualifying Accounts II-4 100 ITEM 17. UNDERTAKINGS Insofar as indemnification for liabilities arising under the Securities Act may be permitted to directors, officers and controlling persons of the Registrant pursuant to the foregoing provisions, or otherwise, the Registrant has been advised that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the Securities Act and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by the Registrant of expenses incurred or paid by a director, officer or controlling person of the Registrant in the successful defense of any action, suit or proceeding) is asserted by such director, officer or controlling person in connection with the securities being registered, the Registrant will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the Securities Act and will be governed by the final adjudication of such issue. The undersigned Registrant hereby undertakes to provide to the Underwriters, at the closing specified in the Underwriting Agreement, certificates in such denominations and registered in such names as required by the Underwriters to permit prompt delivery to each purchaser. The undersigned Registrant hereby undertakes that: (1) For purposes of determining any liability under the Securities Act, the information omitted from the form of prospectus filed as part of this registration statement in reliance upon Rule 430A and contained in a form of prospectus filed by the Registrant pursuant to Rule 424(b)(1) or (4) or 497(h) under the Securities Act shall be deemed to be a part of this Registration Statement as of the time it was declared effective. (2) For the purpose of determining any liability under the Securities Act, each post-effective amendment that contains a form of prospectus shall be deemed to be a new registration statement relating to the securities offered therein, and the offering of such securities at that time shall be deemed to be the initial bona fide offering thereof. II-5 101 SIGNATURES Pursuant to the requirements of the Securities Act of 1933, the Registrant has duly caused this Amendment No. 2 to Registration Statement to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Seattle, State of Washington, on October 31, 1997. REALNETWORKS, INC. By: /s/ ROBERT GLASER ------------------------------------ Robert Glaser Chief Executive Officer Pursuant to the requirements of the Securities Act of 1933, this Amendment No. 2 to Registration Statement has been signed by the following persons in the capacities indicated below on October 31, 1997.
SIGNATURE TITLE - --------------------------------------------- ------------------------- /s/ ROBERT GLASER Chairman of the Board, - --------------------------------------------- Chief Executive Robert Glaser Officer, Secretary and Treasurer (Principal Executive Officer) * BRUCE JACOBSEN President, Chief - --------------------------------------------- Operating Officer and Bruce Jacobsen Director * MARK KLEBANOFF Chief Financial Officer - --------------------------------------------- (Principal Financial Mark Klebanoff and Accounting Officer) * JIM BREYER Director - --------------------------------------------- James Breyer * MITCHELL KAPOR Director - --------------------------------------------- Mitchell Kapor *By /s/ ROBERT GLASER - --------------------------------------------- Robert Glaser Attorney-in-fact
II-6 102 SCHEDULE II -- VALUATION AND QUALIFYING ACCOUNTS REALNETWORKS, INC. AND SUBSIDIARIES PERIOD FROM FEBRUARY 9, 1994 (INCEPTION) TO DECEMBER 31, 1994, THE YEARS ENDED DECEMBER 31, 1995 AND 1996 AND THE NINE MONTHS ENDED SEPTEMBER 30, 1997
BALANCE AT CHARGED TO BALANCE AT BEGINNING COSTS AND COSTS AND END OF DESCRIPTION OF PERIOD EXPENSES DEDUCTIONS(1) PERIOD - ------------------------------------ ---------- ---------- ------------- ---------- Nine months ended September 30, 1997: Valuation accounts deducted from assets: Allowance for doubtful accounts receivable and sales returns...................... $ 383,350 $1,502,273 $(1,197,051) $ 688,572 Valuation allowance for deferred tax assets.......... 1,828,000 3,682,000 -- 5,510,000 ========== ========== =========== ========== Year ended December 31, 1996: Valuation accounts deducted from assets: Allowance for doubtful accounts receivable and sales returns...................... 129,869 563,046 (309,565) 383,350 Valuation allowance for deferred tax assets.......... 493,000 1,335,000 -- 1,828,000 ========== ========== =========== ========== Year ended December 31, 1995: Valuation accounts deducted from assets: Allowance for doubtful accounts receivable and sales returns...................... -- 129,869 -- 129,869 Valuation allowance for deferred tax assets.......... -- 493,000 -- 493,000 ========== ========== =========== ========== Period from February 9, 1994 (inception) to December 31, 1994: Valuation accounts deducted from assets: Allowance for doubtful accounts receivable and sales returns...................... -- -- -- -- Valuation allowance for deferred tax assets.......... -- -- -- -- ========== ========== =========== ==========
- --------------- (1) Represents amounts written off. 103 EXHIBIT INDEX
EXHIBIT NUMBER DESCRIPTION - -------- ---------------------------------------------------------------------- 1.1 Form of Underwriting Agreement........................................ 3.1 Form of Amended and Restated Articles of Incorporation................ 3.2** Bylaws (previously filed as Exhibit 3.4 to Amendment No. 1 filed on October 15, 1997...................................................... 4.1 Specimen Stock Certificate............................................ 5.1 Opinion of Graham & James LLP/Riddell Williams P.S.................... 10.1** RealNetworks, Inc. 1995 Stock Option Plan............................. 10.2** RealNetworks, Inc. Amended and Restated 1996 Stock Option Plan........ 10.3** Form of Stock Option Agreement........................................ 10.4** 1998 Employee Stock Purchase Plan..................................... 10.5** Form of Warrant to Purchase Series D Preferred Stock.................. 10.6** Warrant to Purchase Series E Preferred Stock dated July 21, 1997 between the Registrant and Microsoft Corporation...................... 10.7** Lease Agreement dated March 4, 1996 by and between the Registrant as Lessee and Wright Runstad Properties L.P. as Lessor................... 10.8** Sublease Agreement dated March, 1996 by and between the Registrant as Sublessee and Legent Corporation as Sublessor......................... 10.9** Antenna Site License Agreement dated August 12, 1997 by and between the Registrant and Wright Runstad & Company........................... 10.10** Agreement between Microsoft Corporation and the Registrant on Media Streaming Technology dated June 17, 1997 (confidential treatment requested)............................................................ 10.11** Offer letter dated February 16, 1996 between the Registrant and Bruce Jacobsen.............................................................. 10.12** Offer letter dated May 2, 1995 between the Registrant and James Wells................................................................. 10.13** Offer letter dated May 24, 1994 between the Registrant and Andrew Sharpless............................................................. 10.14** Form of Director and Officer Indemnification Agreement................ 10.15** Limited Proxy and Voting Agreement dated July 21, 1997 by and between the Registrant and Microsoft Corporation.............................. 10.16** Shareholders' Buy-Sell Agreement dated March 31, 1995 by and among the Registrant, Robert Glaser and certain shareholders of the Registrant............................................................ 10.17** Voting Agreement dated September 25, 1997 by and among the Registrant, Robert Glaser, Accel IV L.P., Mitchell Kapor and Bruce Jacobsen....... 10.18** Agreement dated September 26, 1997 by and between the Registrant and Robert Glaser......................................................... 10.19** Second Amended and Restated Investors' Rights Agreement dated July 21, 1997 by and among the Registrant and certain shareholders of the Registrant............................................................ 10.20 Agreement to Terminate Shareholders' Buy-Sell Agreement dated October 24, 1997.............................................................. 10.21 Representative License Agreement -- License Agreement for the RealPlayer Plus 11.1** Statement re: Computation of Pro Forma Net Loss Per Share............. 21.1** Subsidiaries of the Registrant........................................ 23.1 Consent of Graham & James LLP/Riddell Williams P.S. (included in its opinion to be filed as Exhibit 5.1 hereto)............................ 23.2 Consent of KPMG Peat Marwick LLP...................................... 24.1** Power of Attorney..................................................... 27.1** Financial Data Schedule...............................................
- --------------- ** Previously filed. EX-1.1 2 FORM OF UNDERWRITING AGREEMENT 1 EXHIBIT 1.1 RealNetworks, Inc. Common Stock Underwriting Agreement November __, 1997 Goldman, Sachs & Co. NationsBanc Montgomery Securities, Inc. BancAmerica Robertson Stephens As representatives of the several Underwriters named in Schedule I hereto c/o Goldman, Sachs & Co. 85 Broad Street New York, New York 10004 Ladies and Gentlemen: RealNetworks, Inc., a Washington corporation (the "Company"), proposes, subject to the terms and conditions stated herein, to issue and sell to the Underwriters named in Schedule I hereto (the "Underwriters") an aggregate of 3,000,000 shares (the "Firm Shares") and, at the election of the Underwriters, up to 450,000 additional shares (the "Optional Shares") of Common Stock, par value $.001 per share (the "Stock"), of the Company (the Firm Shares and the Optional Shares that the Underwriters elect to purchase pursuant to Section 2 hereof being collectively called the "Shares"). 1. The Company represents and warrants to, and agrees with, each of the Underwriters that: (a) A registration statement on Form S-1 (File No. 333-36553) (the "Initial Registration Statement") in respect of the Shares has been filed with the Securities and Exchange Commission (the "Commission"); the Initial Registration Statement and any post-effective amendment thereto, each in the form heretofore delivered to you, and, excluding exhibits thereto, to you for each of the other Underwriters, have been declared effective by the Commission in such form; other than a registration statement, if any, increasing the size of the offering (the "Rule 462(b) Registration Statement") filed pursuant to Rule 462(b) under the Securities Act of 1933, as amended (the "Act"), which became effective upon filing, no other document with respect to the Initial Registration Statement has heretofore been filed with the Commission; and no stop order suspending the effectiveness of the Initial Registration Statement, any post-effective amendment thereto or the Rule 462(b) Registration Statement, if any, has been issued and no proceeding for that purpose has been initiated or threatened by the Commission (any preliminary prospectus included in the Initial Registration Statement and the Rule 462(b) Registration Statement, if any, or filed with the Commission pursuant to Rule 424(a) of the rules and regulations of the Commission under the Act is hereinafter called a "Preliminary Prospectus"; the various parts of the Initial Registration 2 Statement and the Rule 462(b) Registration Statement, if any, including all exhibits thereto and including the information contained in the form of final prospectus filed with the Commission pursuant to Rule 424(b) under the Act in accordance with Section 5(a) hereof and deemed by virtue of Rule 430A under the Act to be part of the Initial Registration Statement at the time it was declared effective or such part of the Rule 462(b) Registration Statement, if any, which became or hereafter becomes effective, each as amended at the time such part of the registration statement became effective, is hereinafter collectively called the "Registration Statement"; and such final prospectus, in the form first filed pursuant to Rule 424(b) under the Act, is hereinafter called the "Prospectus"); (b) No order preventing or suspending the use of any Preliminary Prospectus has been issued by the Commission, and each Preliminary Prospectus, at the time of filing thereof, conformed in all material respects to the requirements of the Act and the rules and regulations of the Commission thereunder, and did not contain an untrue statement of a material fact or omit to state a material fact required to be stated therein or necessary to make the statements therein, in the light of the circumstances under which they were made, not misleading; provided, however, that this representation and warranty shall not apply to any statements or omissions made in reliance upon and in conformity with information furnished in writing to the Company by an Underwriter through Goldman, Sachs & Co. expressly for use therein; (c) The Registration Statement conforms, and the Prospectus and any further amendments or supplements to the Registration Statement or the Prospectus will conform, in all material respects to the requirements of the Act and the rules and regulations of the Commission thereunder and do not and will not, as of the applicable effective date as to the Registration Statement and any amendment thereto and as of the applicable filing date as to the Prospectus and any amendment or supplement thereto, contain an untrue statement of a material fact or omit to state a material fact required to be stated therein or necessary to make the statements therein not misleading; provided, however, that this representation and warranty shall not apply to any statements or omissions made in reliance upon and in conformity with information furnished in writing to the Company by an Underwriter through Goldman, Sachs & Co. expressly for use therein; (d) Neither the Company nor any of its subsidiaries has sustained since the date of the latest audited financial statements included in the Prospectus any material loss or interference with its business from fire, explosion, flood or other calamity, whether or not covered by insurance, or from any labor dispute or court or governmental action, order or decree, otherwise than as set forth or contemplated in the Prospectus; and, since the respective dates as of which information is given in the Registration Statement and the Prospectus, there has not been any change in the capital stock (other than as a result of the exercise of options or warrants outstanding as of the date of this Agreement) or any increase in the long-term debt of the Company or any of its subsidiaries in excess of $____________ or any material adverse change, or any development that could reasonably be expected to result in a material adverse change, in or affecting the general affairs, management, financial position, shareholders' equity or results of operations of the Company and its subsidiaries, taken as a whole, otherwise than as set forth or contemplated in the Prospectus; -2- 3 (e) The Company and its subsidiaries have good and marketable title in fee simple to all real property and good and marketable title to all personal property owned by them, in each case free and clear of all liens, encumbrances and defects except such as are described in the Prospectus or such as do not and will not have a material adverse effect upon the assets, business, financial condition or results of operations of the Company and its subsidiaries, taken as a whole, or on the consummation of any of the transactions contemplated hereby (a "Material Adverse Effect"); and any real property and buildings held under lease by the Company and its subsidiaries are held by them under valid, subsisting and enforceable leases with such exceptions as are not material and do not interfere with the use made and proposed to be made of such property and buildings by the Company and its subsidiaries; (f) The Company has been duly incorporated and is duly authorized to transact business in the corporate form under the laws of the state of Washington, with power and authority (corporate and other) to own its properties and conduct its business as described in the Prospectus, and has been duly qualified as a foreign corporation for the transaction of business and is in good standing under the laws of each other jurisdiction in which it owns or leases properties or conducts any business so as to require such qualification, except where the failure to be so qualified in any such jurisdiction would not have a Material Adverse Effect; and each subsidiary of the Company has been duly incorporated and is validly existing as a corporation in good standing under the laws of its jurisdiction of incorporation; (g) The Company has an authorized capitalization as set forth in the Prospectus, and all of the issued shares of capital stock of the Company have been duly and validly authorized and issued, are fully paid and non-assessable and conform to the description of the various classes and series of capital stock contained in the Prospectus; and all of the issued shares of capital stock of each wholly owned subsidiary of the Company have been duly and validly authorized and issued, are fully paid and non-assessable and are owned directly by the Company, free and clear of all liens, encumbrances, equities or claims; (h) The Shares have been duly and validly authorized and, when issued and delivered against payment therefor as provided herein, will be duly and validly issued and fully paid and non-assessable and will conform to the description of the Stock contained in the Prospectus; (i) The issue and sale of the Shares by the Company hereunder and the compliance by the Company with all of the provisions of this Agreement and the consummation of the transactions herein contemplated will not conflict with or result in a breach or violation of any of the terms or provisions of, or constitute a default under, any indenture, mortgage, deed of trust, loan agreement or other agreement or instrument to which the Company or any of its subsidiaries is a party or by which the Company or any of its subsidiaries is bound or to which any of the property or assets of the Company or any of its subsidiaries is subject, nor will such action result in any violation of the provisions of the Amended and Restated Articles of Incorporation or Restated Bylaws of the Company or any statute or any order, rule or regulation of any court or governmental agency or body having jurisdiction over the Company or any of its subsidiaries or any of their properties; and no consent, approval, authorization, order, registration or qualification of or with any such court or governmental agency or -3- 4 body is required for the issue and sale of the Shares or the consummation by the Company of the transactions contemplated by this Agreement, except the registration under the Act of the Shares, and such consents, approvals, authorizations, registrations or qualifications as may be required under state securities or Blue Sky laws in connection with the purchase and distribution of the Shares by the Underwriters; (j) The Amended and Restated Articles of Incorporation and the Restated Bylaws of the Company are not in conflict with or in violation of the provisions of the Washington Business Corporation Act (the "WBCA"). Neither the Company nor any of its subsidiaries is in violation of its articles of incorporation or bylaws or in default in the performance or observance of any material obligation, agreement, covenant or condition contained in any indenture, mortgage, deed of trust, loan agreement, lease or other agreement or instrument to which it is a party or by which it or any of its properties may be bound; (k) The statements set forth in the Prospectus (i) under the caption "Description of Capital Stock," insofar as they purport to constitute a summary of the terms of the various classes and series of capital stock of the Company and (ii) under the caption "Underwriting," insofar as they purport to describe the provisions of the laws and documents referred to therein, are in each case accurate and complete; (l) Other than as set forth or contemplated in the Prospectus, there are no legal or governmental proceedings pending to which the Company or any of its subsidiaries is a party or of which any property of the Company or any of its subsidiaries is the subject that, if determined adversely to the Company or any of its subsidiaries, would individually or in the aggregate have a Material Adverse Effect; and, to the best of the Company's knowledge, no such proceedings are threatened or contemplated by governmental authorities or threatened by others; (m) The Company is not and, after giving effect to the offering and sale of the Shares, will not be an "investment company" or an entity "controlled" by an "investment company," as such terms are defined in the Investment Company Act of 1940, as amended (the "Investment Company Act"); (n) Neither the Company nor any of its affiliates does business with the government of Cuba or with any person or affiliate located in Cuba within the meaning of Section 517.075, Florida Statutes; (o) KPMG Peat Marwick LLP, who have certified certain financial statements of the Company and its subsidiaries, are independent public accountants as required by the Act and the rules and regulations of the Commission thereunder; (p) Except as described in the Prospectus, the Company and each of its subsidiaries own or possess adequate licenses or other rights to use all patents, patent applications, trademarks, trademark applications, service marks, service mark applications, trade names, copyrights, manufacturing or other processes, formulae, trade secrets, know-how, franchises and other material intangible property and assets (collectively, "Intellectual Property") that are necessary or material to the conduct of their businesses as conducted and as proposed to be conducted as described in the -4- 5 Prospectus. Except as described in the Prospectus, there are no facts that would preclude it from having rights to the patent and patent applications referenced in the Prospectus. Except as described in the Prospectus, the Company is not aware that it or any of its subsidiaries lacks or will be unable to obtain any rights or licenses to use any of the Intellectual Property necessary to conduct the business now conducted or proposed to be conducted by it as described in the Prospectus. The Prospectus fairly and accurately describes the Company's rights with respect to the Intellectual Property. The Company is not aware of any material violation or infringement by a third party of any of the Intellectual Property and, except as described in the Prospectus, no third party has an interest in or right to a license to use, or the right to license others to use, any of the Intellectual Property. No material claim is pending or, to the Company's knowledge, threatened to the effect that the operations of the Company infringe upon or conflict with the asserted rights of any other person or entity under any Intellectual Property, and there is no known basis for any such material claim (whether or not pending or threatened). No material claim is pending or, to the Company's knowledge, threatened to the effect that any such Intellectual Property owned or licensed by the Company, or which the Company otherwise has the right to use, is invalid or unenforceable by the Company, and there is no known basis for any such material claim (whether or not pending or threatened). To the Company's knowledge, all material proprietary trade secrets developed by or belonging to the Company that have not been patented have been kept confidential. Each current and prior employee (other than clerical staff and other employees without access to proprietary trade secrets) has executed an agreement regarding confidentiality, proprietary information and assignment of inventions to the Company and, to the Company's knowledge, no such person is in breach of any agreement or arrangement with employers relating to proprietary information or assignment of inventions. Except as described in the Prospectus, to the Company's knowledge, the business conducted or proposed to be conducted by the Company will not cause the Company to infringe or violate any of the patents, trademarks, service marks, trade names, copyrights, licenses, trade secrets or other proprietary rights of any other person or entity. Except as described in the Prospectus, to the Company's knowledge, no person or entity, including any prior or current employer of any prior or current employee, has any right to or interest in any material inventions, improvements, discoveries or other information assigned to the Company by such employee; (q) The Company and its subsidiaries possess all consents, licenses, certificates, authorizations and permits issued by the appropriate federal, state or foreign regulatory authorities necessary to conduct their respective businesses, and the Company is not aware of any proceedings relating to the revocation or modification of any such certificate, authorization or permit that, individually or in the aggregate, if the subject of an unfavorable decision, ruling or finding, would have a Material Adverse Effect, except as described in or contemplated by the Prospectus; (r) The Company and its subsidiaries maintain a system of internal accounting controls sufficient to provide reasonable assurances that (i) transactions are executed in accordance with management's general or specific authorizations, (ii) transactions are recorded as necessary to permit preparation of financial statements in conformity with generally accepted accounting principles and to maintain accountability for assets, and (iii) access to assets is permitted only in accordance with management's general or specific authorization; and -5- 6 (s) Except as set forth in the Prospectus, (i) no preemptive right, co-sale right, right of first refusal or other similar rights of securityholders exist with respect to any class or series of capital stock, including the issuance and sale of the Shares, other than those that have been expressly waived or terminated prior to the date hereof, (ii) no holder of securities of the Company has the right to cause the Company to include such holder's securities in the Registration Statement, (iii) no further approval or authorization of any securityholder, the Board of Directors or any duly appointed committee thereof or others is required under the Act, the Securities Exchange Act of 1934, as amended (the "Exchange Act"), or under state securities or Blue Sky laws and (iv) the Company does not have outstanding any options or warrants to purchase, or any preemptive rights or other rights to subscribe for or to purchase, any securities or obligations convertible into, or any contracts or commitments to issue or sell, shares of its capital stock or any such options, rights, convertible securities or obligations. 2. Subject to the terms and conditions herein set forth, (a) the Company agrees to issue and sell to each of the Underwriters, and each of the Underwriters agrees, severally and not jointly, to purchase from the Company, at a purchase price per share of $[_____], the number of Firm Shares set forth opposite the name of such Underwriter in Schedule I hereto and (b) in the event and to the extent that the Underwriters shall exercise the election to purchase Optional Shares as provided below, the Company agrees to issue and sell to each of the Underwriters, and each of the Underwriters agrees, severally and not jointly, to purchase from the Company, at the purchase price per share set forth in clause (a) of this Section 2, that portion of the number of Optional Shares as to which such election shall have been exercised (to be adjusted by you so as to eliminate fractional shares) determined by multiplying such number of Optional Shares by a fraction, the numerator of which is the maximum number of Optional Shares that such Underwriter is entitled to purchase as set forth opposite the name of such Underwriter in Schedule I hereto and the denominator of which is the maximum number of Optional Shares that all of the Underwriters are entitled to purchase hereunder. The Company hereby grants to the Underwriters the right to purchase at their election up to 450,000 Optional Shares, at the purchase price per share set forth in the paragraph above, for the sole purpose of covering overallotments in the sale of the Firm Shares. Any such election to purchase Optional Shares may be exercised only by written notice from you to the Company, given within a period of 30 calendar days after the date of this Agreement, setting forth the aggregate number of Optional Shares to be purchased and the date on which such Optional Shares are to be delivered, as determined by you but in no event earlier than the First Time of Delivery (as defined in Section 4 hereof) or, unless you and the Company otherwise agree in writing, earlier than two or later than ten business days after the date of such notice. 3. Upon the authorization by you of the release of the Firm Shares, the several Underwriters propose to offer the Firm Shares for sale upon the terms and conditions set forth in the Prospectus. 4. (a) The Shares to be purchased by each Underwriter hereunder, in definitive form and in such authorized denominations and registered in such names as Goldman, Sachs & Co. may request upon at least forty-eight hours' prior notice to the Company, shall be delivered by or on behalf of the Company to Goldman, Sachs & Co., for the account of such Underwriter, against payment by or on behalf of such Underwriter of the purchase price therefor by wire transfer, payable to the Company in Federal (same day) funds. The Company will cause the certificates representing the Shares to be made available for checking and packaging at least twenty-four hours prior to the Time of Delivery (as defined below) with respect thereto at the -6- 7 office of Goldman, Sachs & Co., 85 Broad Street, New York, New York 10004 (the "Designated Office"). The time and date of such delivery and payment shall be, with respect to the Firm Shares, 9:30 a.m., New York City time, on [_____], 1997 or such other time and date as Goldman, Sachs & Co. and the Company may agree upon in writing, and, with respect to the Optional Shares, 9:30 a.m., New York time, on the date specified by Goldman, Sachs & Co. in the written notice given by Goldman, Sachs & Co. of the Underwriters' election to purchase such Optional Shares, or such other time and date as Goldman, Sachs & Co. and the Company may agree upon in writing. Such time and date for delivery of the Firm Shares is herein called the "First Time of Delivery," such time and date for delivery of the Optional Shares, if not the First Time of Delivery, is herein called the "Second Time of Delivery," and each such time and date for delivery is herein called a "Time of Delivery." (b) The documents to be delivered at each Time of Delivery by or on behalf of the parties hereto pursuant to Section 7 hereof, including the cross receipt for the Shares and any additional documents requested by the Underwriters pursuant to Section 7(i) hereof, will be delivered at the offices of Perkins Coie, 1201 Third Avenue, Seattle, Washington 98101 (the "Closing Location"), and the Shares will be delivered at the Designated Office, all at such Time of Delivery. A meeting will be held at the Closing Location at [__] p.m., New York City time, on the New York Business Day next preceding such Time of Delivery, at which meeting the final drafts of the documents to be delivered pursuant to the preceding sentence will be available for review by the parties hereto. For the purposes of this Section 4, "New York Business Day" shall mean each Monday, Tuesday, Wednesday, Thursday and Friday that is not a day on which banking institutions in New York are generally authorized or obligated by law or executive order to close. 5. The Company agrees with each of the Underwriters: (a) To prepare the Prospectus in a form mutually approved by the Company and you and to file such Prospectus pursuant to Rule 424(b) under the Act not later than the Commission's close of business on the second business day following the execution and delivery of this Agreement, or, if applicable, such earlier time as may be required by Rule 430A(a)(3) under the Act; to make no further amendment or any supplement to the Registration Statement or Prospectus without your prior written approval; to advise you, promptly after it receives notice thereof, of the time when any amendment to the Registration Statement has been filed or becomes effective or any supplement to the Prospectus or any amended Prospectus has been filed and to furnish you with copies thereof; to advise you, promptly after it receives notice thereof, of the issuance by the Commission of any stop order or of any order preventing or suspending the use of any Preliminary Prospectus or prospectus, of the suspension of the qualification of the Shares for offering or sale in any jurisdiction, of the initiation or threatening of any proceeding for any such purpose, or of any request by the Commission for amending or supplementing the Registration Statement or Prospectus or for additional information; and, in the event of the issuance of any stop order or of any order preventing or suspending the use of any Preliminary Prospectus or prospectus or suspending any such qualification, promptly to use its best efforts to obtain the withdrawal of such order; (b) Promptly from time to time to take such action as you may reasonably request to qualify the Shares for offering and sale under the securities laws of such jurisdictions as you may request and to comply with such laws so as to permit the continuance of sales and dealings therein in such jurisdictions for as long as may be necessary to complete the -7- 8 distribution of the Shares, provided that in connection therewith the Company shall not be required to qualify as a foreign corporation or to file a general consent to service of process in any jurisdiction; (c) Prior to 10:00 a.m., New York City time, on the New York Business Day next succeeding the date of this Agreement and from time to time, to furnish the Underwriters with copies of the Prospectus in New York City in such quantities as you may from time to time reasonably request, and, if the delivery of a prospectus is required at any time prior to the expiration of nine months after the time of issue of the Prospectus in connection with the offering or sale of the Shares and if at such time any event shall have occurred as a result of which the Prospectus as then amended or supplemented would include an untrue statement of a material fact or omit to state any material fact necessary in order to make the statements therein, in the light of the circumstances under which they were made when such Prospectus is delivered, not misleading, or, if for any other reason it shall be necessary during such period to amend or supplement the Prospectus in order to comply with the Act, to notify you and upon your request to prepare and furnish without charge to each Underwriter and to any dealer in securities as many copies as you may from time to time reasonably request of an amended Prospectus or a supplement to the Prospectus that will correct such statement or omission or effect such compliance, and in case any Underwriter is required to deliver a prospectus in connection with sales of any of the Shares at any time nine months or more after the time of issue of the Prospectus, upon your request but at the expense of such Underwriter, to prepare and deliver to such Underwriter as many copies as you may request of an amended or supplemented Prospectus complying with Section 10(a)(3) of the Act; (d) To make generally available to its securityholders as soon as practicable, but in any event not later than eighteen months after the effective date of the Registration Statement (as defined in Rule 158(c) under the Act), an earnings statement of the Company and its subsidiaries (which need not be audited) complying with Section 11(a) of the Act and the rules and regulations thereunder (including, at the option of the Company, Rule 158); (e) During the period beginning from the date hereof and continuing to and including the date 180 days after the date of the Prospectus, not to offer, sell, contract to sell or otherwise dispose of, except as provided hereunder, any securities of the Company that are substantially similar to the Shares, including, but not limited to, any securities that are convertible into or exchangeable for, or that represent the right to receive, Stock or any such substantially similar securities (other than pursuant to employee stock option or employee stock purchase plans existing on, or upon the conversion or exchange of convertible or exchangeable securities outstanding as of, the date of this Agreement), without your prior written consent; (f) To furnish to its shareholders as soon as practicable after the end of each fiscal year an annual report (including a balance sheet and statements of income, shareholders' equity and cash flows of the Company and its consolidated subsidiaries certified by independent public accountants) and, as soon as practicable after the end of each of the first three quarters of each fiscal year (beginning with the fiscal quarter ending after the effective date of the Registration Statement), consolidated summary financial information of the Company and its subsidiaries for such quarter in reasonable detail; (g) During a period of five years from the effective date of the Registration Statement, to furnish to you copies of all reports or other communications (financial or other) -8- 9 furnished to shareholders, and to deliver to you (i) as soon as they are available, copies of any reports and financial statements furnished to or filed with the Commission or any national securities exchange on which any class of securities of the Company is listed and (ii) such additional information concerning the business and financial condition of the Company as you may from time to time reasonably request (such financial statements to be on a consolidated basis to the extent the accounts of the Company and its subsidiaries are consolidated in reports furnished to the Company's shareholders generally or to the Commission); (h) To use the net proceeds received by it from the sale of the Shares pursuant to this Agreement in the manner specified in the Prospectus under the caption "Use of Proceeds"; (i) To use its best efforts to list for quotation the Shares on the Nasdaq National Market ("Nasdaq"); and (j) If the Company elects to rely upon Rule 462(b), the Company shall file a Rule 462(b) Registration Statement with the Commission in compliance with Rule 462(b) by 10:00 p.m., Washington, D.C. time, on the date of this Agreement, and the Company shall at the time of filing either pay to the Commission the filing fee for the Rule 462(b) Registration Statement or give irrevocable instructions for the payment of such fee pursuant to Rule 111(b) under the Act. 6. The Company covenants and agrees with the several Underwriters that the Company will pay or cause to be paid the following: (i) the fees, disbursements and expenses of the Company's counsel and accountants in connection with the registration of the Shares under the Act and all other expenses in connection with the preparation, printing and filing of the Registration Statement, any Preliminary Prospectus and the Prospectus and amendments and supplements thereto and the mailing and delivering of copies thereof to the Underwriters and dealers; (ii) the cost of producing any Agreement Among Underwriters, this Agreement, the Blue Sky Memorandum, closing documents (including compilations thereof) and any other documents in connection with the offering, purchase, sale and delivery of the Shares; (iii) all expenses in connection with the qualification of the Shares for offering and sale under state securities laws as provided in Section 5(b) hereof, including the fees and disbursements of counsel for the Underwriters in connection with such qualification and in connection with the Blue Sky survey; (iv) all fees and expenses in connection with listing the Shares on Nasdaq; (v) the filing fees incident to, and the fees and disbursements of counsel for the Underwriters in connection with, securing any required review by the National Association of Securities Dealers, Inc. of the terms of the sale of the Shares; (vi) the cost of preparing stock certificates; (vii) the cost and charges of any transfer agent or registrar; and (viii) all other costs and expenses incident to the performance of its obligations hereunder that are not otherwise specifically provided for in this Section. It is understood, however, that, except as provided in this Section, and Sections 8 and 11 hereof, the Underwriters will pay all of their own costs and expenses, including the fees of their counsel, stock transfer taxes on resale of any of the Shares by them, and any advertising expenses connected with any offers they may make. 7. The obligations of the Underwriters hereunder, as to the Shares to be delivered at each Time of Delivery, shall be subject, in their discretion, to the condition that all representations and warranties and other statements of the Company herein are, at and as of such Time of Delivery, true and correct, the condition that the Company shall have performed all of its obligations hereunder theretofore to be performed, and the following additional conditions: -9- 10 (a) The Prospectus shall have been filed with the Commission pursuant to Rule 424(b) within the applicable time period prescribed for such filing by the rules and regulations under the Act and in accordance with Section 5(a) hereof; if the Company has elected to rely upon Rule 462(b), the Rule 462(b) Registration Statement shall have become effective by 10:00 p.m., Washington, D.C. time, on the date of this Agreement; no stop order suspending the effectiveness of the Registration Statement or any part thereof shall have been issued and no proceeding for that purpose shall have been initiated or threatened by the Commission; and all requests for additional information on the part of the Commission shall have been complied with to your reasonable satisfaction; (b) Perkins Coie, counsel for the Underwriters, shall have furnished to you such opinion or opinions, (a draft of each such opinion is attached as Annex II(a) hereto) dated such Time of Delivery, with respect to the matters covered in paragraphs (i), (ii), (vi), (x) and (xv) of subsection (c) below as well as such other related matters as you may reasonably request, and such counsel shall have received such papers and information as they may reasonably request to enable them to pass upon such matters; (c) Graham & James LLP/Riddell Williams P.S., counsel for the Company, shall have furnished to you their written opinion, dated such Time of Delivery, in form and substance satisfactory to you, to the effect that: (i) The Company has been duly incorporated and is duly authorized to transact business in the corporate form under the laws of the state of Washington, with power and authority (corporate and other) to own its properties and conduct its business as described in the Prospectus; (ii) The Company has an authorized capitalization as set forth in the Prospectus, and all of the issued shares of capital stock of the Company (including the Shares being delivered at such Time of Delivery) have been duly and validly authorized and issued and are fully paid and nonassessable; and the Shares conform to the description of the Stock contained in the Prospectus; (iii) The Company has been duly qualified as a foreign corporation for the transaction of business and is in good standing under the laws of each other jurisdiction in which it owns or leases properties or conducts any business so as to require such qualification, except where the reason for failure to be so qualified in any such jurisdiction does not have a Material Adverse Effect (such counsel being entitled to rely in respect of the opinion in this clause upon opinions of local counsel and in respect of matters of fact upon certificates of officers of the Company, provided that such counsel shall state that they believe that both you and they are justified in relying upon such opinions and certificates); (iv) Each wholly owned subsidiary of the Company has been duly incorporated and is validly existing as a corporation in good standing under the laws of its jurisdiction of incorporation; and all of the issued shares of capital stock of each such subsidiary have been duly and validly authorized and issued, are fully paid and non-assessable, and are owned directly by the Company, free and clear of all liens, encumbrances, equities or claims (such counsel being entitled to rely in respect of the opinion in this clause upon opinions of local counsel and in respect to matters of fact upon certificates of officers of the -10- 11 Company or its subsidiaries, provided that such counsel shall state that they believe that both you and they are justified in relying upon such opinions and certificates); (v) To the best of such counsel's knowledge and other than as set forth in the Prospectus, there are no legal or governmental proceedings pending to which the Company or any of its subsidiaries is a party or of which any property of the Company or any of its subsidiaries is the subject which, if determined adversely to the Company or any of its subsidiaries, would individually or in the aggregate have a material adverse effect on the current consolidated financial position, shareholders' equity or results of operations of the Company and its subsidiaries taken as a whole; and, to the best of such counsel's knowledge, no such proceedings are threatened or contemplated by governmental authorities or threatened by others; (vi) This Agreement has been duly authorized, executed and delivered by the Company; (vii) The issue and sale of the Shares being delivered at such Time of Delivery by the Company and the compliance by the Company with all of the provisions of this Agreement and the consummation of the transactions herein contemplated will not conflict with or result in a breach or violation of any of the terms or provisions of, or constitute a default under, any indenture, mortgage, deed of trust, loan agreement or other agreement or instrument known to such counsel to which the Company or any of its subsidiaries is a party or by which the Company or any of its subsidiaries is bound or to which any of the property or assets of the Company or any of its subsidiaries is subject, nor will such action result in any violation of the provisions of the Amended and Restated Articles of Incorporation or Restated Bylaws of the Company or any statute or any order, rule or regulation known to such counsel of any court or governmental agency or body having jurisdiction over the Company or any of its subsidiaries or any of their properties; (viii) No consent, approval, authorization, order, registration or qualification of or with any such court or governmental agency or body is required for the issue and sale of the Shares or the consummation by the Company of the transactions contemplated by this Agreement, except the registration under the Act of the Shares, and such consents, approvals, authorizations, registrations or qualifications as may be required under state securities or Blue Sky laws in connection with the purchase and distribution of the Shares by the Underwriters; (ix) The Amended and Restated Articles of Incorporation and the Bylaws of the Company are not in conflict with or in violation of the provisions of the WBCA. Neither the Company nor any of its subsidiaries is in violation of its articles of incorporation or bylaws or, to the best of such counsel's knowledge, in default in the performance or observance of any material obligation, agreement, covenant or condition contained in any indenture, mortgage, deed of trust, loan agreement, lease or other agreement or instrument to which it is a party or by which it or any of its properties may be bound; -11- 12 (x) The statements set forth in the Prospectus (i) under the caption "Description of Capital Stock," insofar as they purport to constitute a summary of the terms of the various classes and series of capital stock of the Company and (ii) under the caption "Underwriting," insofar as they purport to describe the provisions of the laws and documents referred to therein, are in each case accurate and fair summaries of such laws and documents; (xi) The Company is not an "investment company" or an entity "controlled" by an "investment company," as such terms are defined in the Investment Company Act; (xii) Except as described in the Prospectus, the Company and each of its subsidiaries own or possess adequate licenses or other rights to use the Intellectual Property that are necessary or material to the conduct of their businesses as conducted and as proposed to be conducted as described in the Prospectus. Except as described in the Prospectus, such counsel is not aware of any facts that would preclude the Company from having rights to its patent and patent applications referenced in the Prospectus. The Prospectus fairly and accurately describes the Company's rights with respect to the Intellectual Property. Such counsel is not aware of any material violation or infringement by a third party of any of the Intellectual Property and, except as described in the Prospectus, no third party has a material interest in or right to a license to use, or the right to license others to use any of the Intellectual Property. No material claim is pending or, to such counsel's knowledge, threatened to the effect that the operations of the Company infringe upon or conflict with the asserted rights of any other person or entity under any Intellectual Property. No material claim is pending or, to such counsel's knowledge, threatened to the effect that any such Intellectual Property owned or licensed by the Company, or which the Company otherwise has the right to use, is invalid or unenforceable by the Company. (xiii)The Company and its subsidiaries possess all material consents, licenses, certificates, authorizations and permits issued by the appropriate federal, state or foreign regulatory authorities necessary to conduct their respective businesses, and the Company has not received any notice of proceedings relating to the revocation or modification of any such certificate, authorization or permit that, individually or in the aggregate, if the subject of an unfavorable decision, ruling or finding, would have a materially adverse effect on the current or future consolidated financial position, shareholders' equity or results of operations of the Company and its subsidiaries, except as described in or contemplated by the Prospectus; (xiv) Except as set forth in the Prospectus, to the best of such counsel's knowledge, (A) no preemptive right, co-sale right, right of first refusal or other similar rights of securityholders exists with respect to any class or series of capital stock, including the issuance and sale of the Shares, other than those that have been expressly waived or terminated prior to the date hereof, (B) no holder of securities of the Company has the right to cause the Company to include such holder's securities in the Registration Statement, (C) no further approval or authorization of any securityholder, the Board of Directors or any -12- 13 duly appointed committee thereof or others is required under the Act, the Exchange Act or under state securities or Blue Sky laws and (D) the Company does not have outstanding any options or warrants to purchase, or any preemptive rights or other rights to subscribe for or to purchase, any securities or obligations convertible into, or any contracts or commitments to issue or sell, shares of its capital stock or any such options, rights, convertible securities or obligations; and (xv) The Registration Statement and the Prospectus and any further amendments and supplements thereto made by the Company prior to such Time of Delivery (other than the financial statements and related schedules therein, as to which such counsel need express no opinion) comply as to form in all material respects with the requirements of the Act and the rules and regulations thereunder, although they do not assume any responsibility for the accuracy, completeness or fairness of the statements contained in the Registration Statement or the Prospectus, except for those referred to in the opinion in subsection (x) of this Section 7(c). In addition, such counsel shall state that they have no reason to believe that, as of its effective date, the Registration Statement or any further amendment thereto made by the Company prior to such Time of Delivery (other than the financial statements and related statements and related schedules therein, as to which such counsel need express no opinion) contained an untrue statement of a material fact or omitted to state a material fact required to be stated therein or necessary to make the statements therein not misleading or that, as of its date, the Prospectus or any further amendment or supplement thereto made by the Company prior to such Time of Delivery (other than the financial statements and related schedules therein, as to which such counsel need express no opinion) contained an untrue statement of a material fact or omitted to state a material fact necessary to make the statements therein, in the light of the circumstances under which they were made, not misleading or that, as of such Time of Delivery, either the Registration Statement or the Prospectus or any further amendment or supplement thereto made by the Company prior to such Time of Delivery (other than the financial statements and related schedules therein, as to which such counsel need express no opinion) contains an untrue statement of a material fact or omits to state a material fact necessary to make the statements therein, in the light of the circumstances under which they were made, not misleading; and they do not know of any amendment to the Registration Statement required to be filed or of any contracts or other documents of a character required to be filed as an exhibit to the Registration Statement or required to be described in the Registration Statement or the Prospectus that are not filed or described as required. In rendering such opinion, such counsel may state that they express no opinion as to the laws of any jurisdiction outside the United States. (d) On the date of the Prospectus at a time prior to the execution of this Agreement, at 9:30 a.m., New York City time, on the effective date of any post-effective amendment to the Registration Statement filed subsequent to the date of this Agreement and also at each Time of Delivery, KPMG Peat Marwick LLP shall have furnished to you a letter or letters, dated the respective dates of delivery thereof, in -13- 14 form and substance satisfactory to you, to the effect set forth in Annex I hereto (the executed copy of the letter delivered prior to the execution of this Agreement is attached as Annex I(a) hereto and a draft of the form of letter to be delivered on the effective date of any post-effective amendment to the Registration Statement and as of each Time of Delivery is attached as Annex I(b) hereto); (e) (i) Neither the Company nor any of its subsidiaries shall have sustained since the date of the latest audited financial statements included in the Prospectus any loss or interference with its business from fire, explosion, flood or other calamity, whether or not covered by insurance, or from any labor dispute or court or governmental action, order or decree, otherwise than as set forth or contemplated in the Prospectus and (ii) since the respective dates as of which information is given in the Prospectus there shall not have been any change in the capital stock (other than as a result of the exercise of options or warrants outstanding as of the date of this Agreement) or any increase in the long-term debt of the Company or any of its subsidiaries in excess of $___________ or any change, or any development that could reasonably be expected to result in a change, in or affecting the general affairs, management, financial position, shareholders' equity or results of operations of the Company and its subsidiaries, otherwise than as set forth or contemplated in the Prospectus, the effect of which, in any such case described in Clause (i) or (ii), is in the judgment of the Representatives so material and adverse as to make it impracticable or inadvisable to proceed with the public offering or the delivery of the Shares being delivered at such Time of Delivery on the terms and in the manner contemplated in the Prospectus; (f) On or after the date hereof there shall not have occurred any of the following: (i) a suspension or material limitation in trading in securities generally on the New York Stock Exchange or on Nasdaq; (ii) a suspension or material limitation in trading in the Company's securities on Nasdaq; (iii) a general moratorium on commercial banking activities declared by either Federal or New York or Washington State authorities; or (iv) the outbreak or escalation of hostilities involving the United States or the declaration by the United States of a national emergency or war, if the effect of any such event specified in this Clause (iv) in the judgment of the Representatives makes it impracticable or inadvisable to proceed with the public offering or the delivery of the Shares being delivered at such Time of Delivery on the terms and in the manner contemplated in the Prospectus; (g) The Shares to be sold at such Time of Delivery shall have been duly listed for quotation on Nasdaq; (h) The Company has obtained and delivered to the Underwriters executed copies of an agreement from each of the Company's shareholders named in Schedule II hereto substantially to the effect set forth in Subsection 5(e) hereof in form and substance satisfactory to you; (i) The Company shall have complied with the provisions of Section 5(c) hereof with respect to the furnishing of prospectuses on the New York Business Day next succeeding the date of this Agreement; and -14- 15 (j) The Company shall have furnished or caused to be furnished to you at such Time of Delivery certificates of officers of the Company satisfactory to you as to the accuracy of the representations and warranties of the Company herein at and as of such Time of Delivery, as to the performance by the Company of all of its obligations hereunder to be performed at or prior to such Time of Delivery, as to the matters set forth in subsections (a) and (e) of this Section and as to such other matters as you may reasonably request. 8. (a) The Company will indemnify and hold harmless each Underwriter against any losses, claims, damages or liabilities, joint or several, to which such Underwriter may become subject, under the Act or otherwise, insofar as such losses, claims, damages or liabilities (or actions in respect thereof) arise out of or are based upon an untrue statement or alleged untrue statement of a material fact contained in any Preliminary Prospectus, the Registration Statement or the Prospectus, or any amendment or supplement thereto, or arise out of or are based upon the omission or alleged omission to state therein a material fact required to be stated therein or necessary to make the statements therein not misleading, and will reimburse each Underwriter for any legal or other expenses reasonably incurred by such Underwriter in connection with investigating or defending any such action or claim as such expenses are incurred; provided, however, that the Company shall not be liable in any such case to the extent that any such loss, claim, damage or liability arises out of or is based upon an untrue statement or alleged untrue statement or omission or alleged omission made in any Preliminary Prospectus, the Registration Statement or the Prospectus or any such amendment or supplement in reliance upon and in conformity with written information furnished to the Company by any Underwriter through Goldman, Sachs & Co. expressly for use therein. (b) Each Underwriter will indemnify and hold harmless the Company against any losses, claims, damages or liabilities to which the Company may become subject, under the Act or otherwise, insofar as such losses, claims, damages or liabilities (or actions in respect thereof) arise out of or are based upon an untrue statement or alleged untrue statement of a material fact contained in any Preliminary Prospectus, the Registration Statement or the Prospectus, or any amendment or supplement thereto, or arise out of or are based upon the omission or alleged omission to state therein a material fact required to be stated therein or necessary to make the statements therein not misleading, in each case to the extent, but only to the extent, that such untrue statement or alleged untrue statement or omission or alleged omission was made in any Preliminary Prospectus, the Registration Statement or the Prospectus or any such amendment or supplement in reliance upon and in conformity with written information furnished to the Company by such Underwriter through Goldman, Sachs & Co. expressly for use therein; and will reimburse the Company for any legal or other expenses reasonably incurred by the Company in connection with investigating or defending any such action or claim as such expenses are incurred. (c) Promptly after receipt by an indemnified party under subsection (a) or (b) above of notice of the commencement of any action, such indemnified party shall, if a claim in respect thereof is to be made against the indemnifying party under such subsection, notify the indemnifying party in writing of the commencement thereof; but the omission so to notify the indemnifying party shall not relieve it from any liability which it may have to any indemnified party otherwise than under such subsection. In -15- 16 case any such action shall be brought against any indemnified party and it shall notify the indemnifying party of the commencement thereof, the indemnifying party shall be entitled to participate therein and, to the extent that it shall wish, jointly with any other indemnifying party similarly notified, to assume the defense thereof, with counsel satisfactory to such indemnified party (who shall not, except with the consent of the indemnified party, be counsel to the indemnifying party), and, after notice from the indemnifying party to such indemnified party of its election so to assume the defense thereof, the indemnifying party shall not be liable to such indemnified party under such subsection for any legal expenses of other counsel or any other expenses, in each case subsequently incurred by such indemnified party, in connection with the defense thereof other than reasonable costs of investigation. No indemnifying party shall, without the written consent of the indemnified party, effect the settlement or compromise of, or consent to the entry of any judgment with respect to, any pending or threatened action or claim in respect of which indemnification or contribution may be sought hereunder (whether or not the indemnified party is an actual or potential party to such action or claim) unless such settlement, compromise or judgment (i) includes an unconditional release of the indemnified party from all liability arising out of such action or claim and (ii) does not include a statement as to or an admission of fault, culpability or a failure to act, by or on behalf of any indemnified party. (d) If the indemnification provided for in this Section 8 is unavailable to or insufficient to hold harmless an indemnified party under subsection (a) or (b) above in respect of any losses, claims, damages or liabilities (or actions in respect thereof) referred to therein, then each indemnifying party shall contribute to the amount paid or payable by such indemnified party as a result of such losses, claims, damages or liabilities (or actions in respect thereof) in such proportion as is appropriate to reflect the relative benefits received by the Company on the one hand and the Underwriters on the other from the offering of the Shares. If, however, the allocation provided by the immediately preceding sentence is not permitted by applicable law or if the indemnified party failed to give the notice required under subsection (c) above, then each indemnifying party shall contribute to such amount paid or payable by such indemnified party in such proportion as is appropriate to reflect not only such relative benefits but also the relative fault of the Company on the one hand and the Underwriters on the other in connection with the statements or omissions that resulted in such losses, claims, damages or liabilities (or actions in respect thereof), as well as any other relevant equitable considerations. The relative benefits received by the Company on the one hand and the Underwriters on the other shall be deemed to be in the same proportion as the total net proceeds from the offering of the Shares purchased under this Agreement (before deducting expenses) received by the Company bear to the total underwriting discounts and commissions received by the Underwriters with respect to the Shares purchased under this Agreement, in each case as set forth in the table on the cover page of the Prospectus. The relative fault shall be determined by reference to, among other things, whether the untrue or alleged untrue statement of a material fact or the omission or alleged omission to state a material fact relates to information supplied by the Company on the one hand or the Underwriters on the other and the parties' relative intent, knowledge, access to information and opportunity to correct or prevent such statement or omission. The Company and the Underwriters agree that it would not be just and equitable if contributions pursuant to this subsection (d) were determined by pro rata allocation (even if the Underwriters were treated as one entity for such purpose) or by any other method of allocation which does not take account of -16- 17 the equitable considerations referred to above in this subsection (d). The amount paid or payable by an indemnified party as a result of the losses, claims, damages or liabilities (or actions in respect thereof) referred to above in this subsection (d) shall be deemed to include any legal or other expenses reasonably incurred by such indemnified party in connection with investigating or defending any such action or claim. Notwithstanding the provisions of this subsection (d), no Underwriter shall be required to contribute any amount in excess of the amount by which the total price at which the Shares underwritten by it and distributed to the public were offered to the public exceeds the amount of any damages that such Underwriter has otherwise been required to pay by reason of such untrue or alleged untrue statement or omission or alleged omission. No person guilty of fraudulent misrepresentation (within the meaning of Section 11(f) of the Act) shall be entitled to contribution from any person who was not guilty of such fraudulent misrepresentation. The Underwriters' obligations in this subsection (d) to contribute are several in proportion to their respective underwriting obligations and not joint. (e) The obligations of the Company under this Section 8 shall be in addition to any liability that the Company may otherwise have and shall extend, upon the same terms and conditions, to each person, if any, who controls any Underwriter within the meaning of the Act; and the obligations of the Underwriters under this Section 8 shall be in addition to any liability that the respective Underwriters may otherwise have and shall extend, upon the same terms and conditions, to each officer and director of the Company and to each person, if any, who controls the Company within the meaning of the Act. 9. (a) If any Underwriter shall default in its obligation to purchase the Shares that it has agreed to purchase hereunder at a Time of Delivery, you may in your discretion arrange for you or another party or other parties to purchase such Shares on the terms contained herein. If within thirty-six hours after such default by any Underwriter you do not arrange for the purchase of such Shares, then the Company shall be entitled to a further period of thirty-six hours within which to procure another party or other parties satisfactory to you to purchase such Shares on such terms. In the event that, within the respective prescribed periods, you notify the Company that you have so arranged for the purchase of such Shares, or the Company notifies you that it has so arranged for the purchase of such Shares, you or the Company shall have the right to postpone such Time of Delivery for a period of not more than seven days in order to effect whatever changes may thereby be made necessary in the Registration Statement or the Prospectus, or in any other documents or arrangements, and the Company agrees to file promptly any amendments to the Registration Statement or the Prospectus that in your opinion may thereby be made necessary. The term "Underwriter" as used in this Agreement shall include any person substituted under this Section with like effect as if such person had originally been a party to this Agreement with respect to such Shares. (b) If, after giving effect to any arrangements for the purchase of the Shares of a defaulting Underwriter or Underwriters by you and the Company as provided in subsection (a) above, the aggregate number of such Shares that remains unpurchased does not exceed one-eleventh of the aggregate number of all the Shares to be purchased at such Time of Delivery, then the Company shall have the right to require each non-defaulting Underwriter to purchase the number of Shares that such Underwriter agreed to purchase hereunder at such Time of Delivery and, in addition, to require each non-defaulting Underwriter to purchase its pro rata share (based on the number of Shares that such Underwriter agreed to purchase hereunder) of the Shares of such defaulting Underwriter or Underwriters for which such -17- 18 arrangements have not been made; but nothing herein shall relieve a defaulting Underwriter from liability for its default. (c) If, after giving effect to any arrangements for the purchase of the Shares of a defaulting Underwriter or Underwriters by you and the Company as provided in subsection (a) above, the aggregate number of such Shares that remains unpurchased exceeds one-eleventh of the aggregate number of all the Shares to be purchased at such Time of Delivery, or if the Company shall not exercise the right described in subsection (b) above to require non-defaulting Underwriters to purchase Shares of a defaulting Underwriter or Underwriters, then this Agreement (or, with respect to the Second Time of Delivery, the obligations of the Underwriters to purchase and of the Company to sell the Optional Shares) shall thereupon terminate, without liability on the part of any non-defaulting Underwriter or the Company, except for the expenses to be borne by the Company and the Underwriters as provided in Section 6 hereof and the indemnity and contribution agreements in Section 8 hereof; but nothing herein shall relieve a defaulting Underwriter from liability for its default. 10. The respective indemnities, agreements, representations, warranties and other statements of the Company and the several Underwriters, as set forth in this Agreement or made by or on behalf of them, respectively, pursuant to this Agreement, shall remain in full force and effect, regardless of any investigation (or any statement as to the results thereof) made by or on behalf of any Underwriter or any controlling person of any Underwriter, or the Company, or any officer or director or controlling person of the Company, and shall survive delivery of and payment for the Shares. 11. If this Agreement shall be terminated pursuant to Section 9 hereof, the Company shall not then be under any liability to any Underwriter except as provided in Sections 6 and 8 hereof; but, if for any other reason, any Shares are not delivered by or on behalf of the Company as provided herein, the Company will reimburse the Underwriters through you for all out-of-pocket expenses approved in writing by you, including fees and disbursements of counsel, reasonably incurred by the Underwriters in making preparations for the purchase, sale and delivery of the Shares not so delivered, but the Company shall then be under no further liability to any Underwriter in respect of the Shares not so delivered except as provided in Sections 6 and 8 hereof. 12. In all dealings hereunder, you shall act on behalf of each of the Underwriters, and the parties hereto shall be entitled to act and rely upon any statement, request, notice or agreement on behalf of any Underwriter made or given by you jointly or by Goldman, Sachs & Co. on behalf of you as the representatives. All statements, requests, notices and agreements hereunder shall be in writing, and if to the Underwriters shall be delivered or sent by mail, telex or facsimile transmission to you as the representatives in care of Goldman, Sachs & Co., 85 Broad Street, New York, New York 10004, Attention: Registration Department; and if to the Company shall be delivered or sent by mail, telex or facsimile transmission to the address of the Company set forth in the Registration Statement, Attention: Secretary; provided, however, that any notice to an Underwriter pursuant to Section 8(c) hereof shall be delivered or sent by mail, telex or facsimile transmission to such Underwriter at its address set forth in its Underwriters' Questionnaire, or telex constituting such Questionnaire, which address will be supplied to the Company by you upon request. Any such statements, requests, notices or agreements shall take effect at the time of receipt thereof. 13. This Agreement shall be binding upon, and inure solely to the benefit of, the Underwriters, the Company and, to the extent provided in Sections 8 and 10 hereof, the officers and directors of the Company and each person who controls the Company or any -18- 19 Underwriter, and their respective heirs, executors, administrators, successors and assigns, and no other person shall acquire or have any right under or by virtue of this Agreement. No purchaser of any of the Shares from any Underwriter shall be deemed a successor or assign by reason merely of such purchase. 14. Time shall be of the essence of this Agreement. As used herein, the term "business day" shall mean any day when the Commission's office in Washington, D.C. is open for business. 15. This Agreement shall be governed by and construed in accordance with the laws of the state of New York. 16. This Agreement may be executed by any one or more of the parties hereto in any number of six (6) counterparts, each of which shall be deemed to be an original, but all such counterparts shall together constitute one and the same instrument. -19- 20 If the foregoing is in accordance with your understanding, please sign and return to us counterparts hereof, and upon the acceptance hereof by you, on behalf of each of the Underwriters, this letter and such acceptance hereof shall constitute a binding agreement between each of the Underwriters and the Company. It is understood that your acceptance of this letter on behalf of each of the Underwriters is pursuant to the authority set forth in a form of Agreement Among Underwriters the form of which shall be submitted to the Company for examination upon request, but without warranty on your part as to the authority of the signers thereof. Very truly yours, RealNetworks, Inc. By: ------------------------------- Name: Title: Accepted as of the date hereof: Goldman, Sachs & Co. NationsBanc Montgomery Securities, Inc. BancAmerica Robertson Stephens By:------------------------------- (Goldman, Sachs & Co.) On behalf of each of the Underwriters -20- 21 SCHEDULE I
Number of Optional Total Number Shares to Be of Purchased if Firm Shares Maximum Option Underwriter to Be Purchased Exercised ----------- --------------- --------- Goldman, Sachs & Co......................... NationsBanc Montgomery Securities, Inc...... BancAmerica Robertson Stephens.............. [Names of other Underwriters]............... --------------- --------- Total..................... =============== =========
-21- 22 ANNEX I [FORM OF COMFORT LETTER] Pursuant to Section 7(d) of the Underwriting Agreement, the accountants shall furnish letters to the Underwriters to the effect that: (i) They are independent certified public accountants with respect to the Company and its subsidiaries within the meaning of the Act and the applicable published rules and regulations thereunder; (ii) In their opinion, the financial statements and any supplementary financial information and schedules (and, if applicable, financial forecasts and/or pro forma financial information) examined by them and included in the Prospectus or the Registration Statement comply as to form in all material respects with the applicable accounting requirements of the Act and the related published rules and regulations thereunder; and, if applicable, they have made a review in accordance with standards established by the American Institute of Certified Public Accountants of the unaudited consolidated interim financial statements, selected financial data, pro forma financial information, financial forecasts and/or condensed financial statements derived from audited financial statements of the Company for the periods specified in such letter, as indicated in their reports thereon, copies of which have been furnished separately to the representatives of the Underwriters (the "Representatives"); (iii) They have made a review in accordance with standards established by the American Institute of Certified Public Accountants of the unaudited condensed consolidated statements of income, consolidated balance sheets and consolidated statements of cash flows included in the Prospectus as indicated in their reports thereon copies of which have been separately furnished to the Representatives, and on the basis of specified procedures including inquiries of officials of the Company who have responsibility for financial and accounting matters regarding whether the unaudited condensed consolidated financial statements referred to in paragraph (vi)(A)(i) below comply as to form in all material respects with the applicable accounting requirements of the Act and the related published rules and regulations, nothing came to their attention that caused them to believe that the unaudited condensed consolidated financial statements do not comply as to form in all material respects with the applicable accounting requirements of the Act and the related published rules and regulations; (iv) The unaudited selected financial information with respect to the consolidated results of operations and financial position of the Company for the period from February 4, 1994 through December 31, 1996 included in the Prospectus agrees with the corresponding amounts (after restatements where applicable) in the audited consolidated financial statements for such fiscal years; 23 (v) They have compared the information in the Prospectus under selected captions with the disclosure requirements of Regulation S-K and on the basis of limited procedures specified in such letter nothing came to their attention as a result of the foregoing procedures that caused them to believe that this information does not conform in all material respects with the disclosure requirements of Items 301, 302, 402 and 503(d), respectively, of Regulation S-K; (vi) On the basis of limited procedures, not constituting an examination in accordance with generally accepted auditing standards, consisting of a reading of the unaudited financial statements and other information referred to below, a reading of the latest available interim financial statements of the Company and its subsidiaries, inspection of the minute books of the Company and its subsidiaries since the date of the latest audited financial statements included in the Prospectus, inquiries of officials of the Company and its subsidiaries responsible for financial and accounting matters and such other inquiries and procedures as may be specified in such letter, nothing came to their attention that caused them to believe that: (A) (i) the unaudited consolidated statements of income, consolidated balance sheets and consolidated statements of cash flows included in the Prospectus do not comply as to form in all material respects with the applicable accounting requirements of the Act and the related published rules and regulations, or (ii) any material modifications should be made to the unaudited condensed consolidated statements of income, consolidated balance sheets and consolidated statements of cash flows included in the Prospectus for them to be in conformity with generally accepted accounting principles; (B) any other unaudited income statement data and balance sheet items included in the Prospectus do not agree with the corresponding items in the unaudited consolidated financial statements from which such data and items were derived, and any such unaudited data and items were not determined on a basis substantially consistent with the basis for the corresponding amounts in the audited consolidated financial statements included in the Prospectus; (C) the unaudited financial statements that were not included in the Prospectus but from which were derived any unaudited condensed financial statements referred to in Clause (A) and any unaudited income statement data and balance sheet items included in the Prospectus and referred to in Clause (B) were not determined on a basis substantially consistent with the basis for the audited consolidated financial statements included in the Prospectus; (D) any unaudited pro forma condensed consolidated financial statements included in the Prospectus do not comply as to form in all material respects with the applicable accounting requirements of the Act and the published rules and regulations thereunder or the pro forma adjustments -2- 24 have not been properly applied to the historical amounts in the compilation of those statements; (E) as of a specified date not more than five days prior to the date of such letter, there have been any changes in the consolidated capital stock (other than issuances of capital stock upon exercise of options and stock appreciation rights, upon earn-outs of performance shares and upon conversions of convertible securities, in each case that were outstanding on the date of the latest financial statements included in the Prospectus) or any increase in the consolidated long-term debt of the Company and its subsidiaries, or any decreases in consolidated net current assets or shareholders' equity or other items specified by the Representatives, or any increases in any items specified by the Representatives, in each case as compared with amounts shown in the latest balance sheet included in the Prospectus, except in each case for changes, increases or decreases that the Prospectus discloses have occurred or may occur or that are described in such letter; and (F) for the period from the date of the latest financial statements included in the Prospectus to the specified date referred to in Clause (E), there were any decreases (increases) in consolidated net revenues or operating profit (loss) or the total or per share amounts of consolidated net income (loss) or other items specified by the Representatives, or any increases in any items specified by the Representatives, in each case as compared with the comparable period of the preceding year and with any other period of corresponding length specified by the Representatives, except in each case for decreases or increases that the Prospectus discloses have occurred or may occur or that are described in such letter; and (vii) In addition to the examination referred to in their report(s) included in the Prospectus and the limited procedures, inspection of minute books, inquiries and other procedures referred to in paragraphs (iii) and (vi) above, they have carried out certain specified procedures, not constituting an examination in accordance with generally accepted auditing standards, with respect to certain amounts, percentages and financial information specified by the Representatives, which are derived from the general accounting records of the Company and its subsidiaries, which appear in the Prospectus, or in Part II of, or in exhibits and schedules to, the Registration Statement specified by the Representatives, and have compared certain of such amounts, percentages and financial information with the accounting records of the Company and its subsidiaries and have found them to be in agreement. -3- EX-3.1 3 FORM OF AMENDED/RESTATED ARTICLES OF INCORPORATION 1 EXHIBIT 3.1 AMENDED AND RESTATED ARTICLES OF INCORPORATION OF REALNETWORKS, INC. RealNetworks, Inc., a Washington corporation, by its Chief Financial Officer, hereby submits the following Amended and Restated Articles of Incorporation of said Corporation pursuant to the provisions of RCW 23B.10.070. These Amended and Restated Articles of Incorporation supersede the original Articles of Incorporation and all amendments and prior restatements thereto. ARTICLE I NAME The name of this Corporation is RealNetworks, Inc. ARTICLE II DURATION This Corporation is organized under the Washington Business Corporation Act (the "Act") and shall have perpetual existence. ARTICLE III PURPOSE AND POWERS The purpose and powers of this Corporation are as follows: (a) to engage in any lawful business; (b) to engage in any and all activities that, in the judgment of the Board of Directors, may at any time be incidental or conducive to the attainment of the foregoing purpose; and (c) to exercise any and all powers that a corporation formed under the Act, or any amendment thereto or substitute therefor, is entitled at the time to exercise. ARTICLE IV CAPITAL STOCK 4.1 AUTHORIZED CAPITAL. The aggregate number of shares of capital stock which this Corporation shall be authorized to issue shall be Three Hundred Sixty Million (360,000,000), divided into two classes as follows: Three Hundred Million (300,000,000) shares of common 2 stock, $.001 par value per share (the "Common Stock"), and Sixty Million (60,000,000) shares of preferred stock, $.001 par value per share (the "Preferred Stock"). 4.2 ISSUANCE OF COMMON STOCK IN SERIES. 4.2.1 AUTHORITY VESTED IN BOARD OF DIRECTORS. The Common Stock may be divided into and issued in series from time to time. Authority is vested in the Board of Directors, subject to the limitations and procedures prescribed by law, to divide any part or all of such Common Stock into any number of series, to fix and determine the relative rights and preferences of the shares of any series to be established, and to amend the rights and preferences of the shares of any series that has been established but is wholly unissued. 4.2.2 AMENDMENT TO SERIES DECREASING SHARES. Within any limits stated in these Articles of Incorporation or in the resolution of the Board of Directors establishing a series, the Board of Directors, after the issuance of shares of a series, may amend the resolution establishing the series to decrease (but not below the number of shares of such series then outstanding) the number of shares of that series, and the number of shares constituting the decrease shall thereafter constitute authorized but undesignated shares. 4.2.3 AUTHORITY LIMITED TO UNISSUED SHARES. The authority herein granted to the Board of Directors to determine the relative rights and preferences of the Common Stock shall be limited to unissued shares, and no power shall exist to alter or change the rights and preferences of any shares that have been issued. 4.3 DESIGNATION OF SERIES A COMMON STOCK, SERIES B COMMON STOCK, SERIES C COMMON STOCK, SERIES D COMMON STOCK AND SERIES E COMMON STOCK. The following series of Common Stock are hereby designated, and each such series shall have the following rights, preferences and limitations: 4.3.1 DESIGNATION. Two Hundred Seven Million Forty-Seven Thousand Six Hundred Seventy-Nine (207,047,679) shares of Common Stock shall be designated and known as "Series A Common Stock"; Thirty Million (30,000,000) shares of Common Stock shall be designated and known as "Series B Common Stock"; Thirty Million (30,000,000) shares of Common Stock shall be designated and known as "Series C Common Stock"; one (1) share shall be designated and known as "Series D Common Stock" and Seven Million Forty-Seven Thousand Six Hundred Seventy-Nine (7,047,679) shares of Common Stock shall be designated and known as "Series E Common Stock." Except as otherwise provided in these Articles of Incorporation, all shares of Series A Common Stock, Series B Common Stock, Series C Common Stock, Series D Common Stock and Series E Common Stock shall be identical and shall entitle the holders thereof to the same rights and privileges. The designations of the Series A Common Stock, Series B Common Stock, Series C Common Stock, Series D Common Stock and Series E Common Stock in this Article are expressly subject to the provisions of Section 4.3.6, Section 4.3.7, Section 4.3.8 and 4.3.9. 2 3 4.3.2 ISSUANCE. Shares of Series A Common Stock, Series B Common Stock, Series C Common Stock, Series D Common Stock and Series E Common Stock may be issued, upon authorization by the Board of Directors, to such persons and entities, and for such consideration permitted by the Act, as the Board of Directors shall determine; provided, that shares of Series B Common Stock shall be issued only to persons or entities who, at the time of issuance, are either (a) employees of the Corporation, or (b) directors, or affiliates of directors, of the Corporation. For purposes of this section, an "affiliate" shall be a person or entity that directly, or indirectly through one or more intermediaries, controls, or is controlled by, or is under common control with, a director; and provided further, that shares of Series D Common Stock shall be issued only in compliance with Section 4.3.7. 4.3.3 VOTING RIGHTS. Except as otherwise required by law and except as otherwise provided in these Articles of Incorporation, on all matters submitted to the Corporation's shareholders, each share of Series A Common Stock shall entitle the holder to fifteen (15) votes, each share of Series B Common Stock shall entitle the holder to fifteen (15) votes, each share of Series D Common Stock shall entitle the holder to fifteen (15) votes, each share of Series C Common Stock shall entitle the holder to one (1) vote, and each share of Series E Common Stock shall not be entitled to vote, except as required by law, in which case it shall entitle the holder to one (1) vote. Except with regard to those matters required by law to be voted on by one or more voting groups and except as otherwise provided in these Articles of Incorporation, all shares of Series A Common Stock, Series B Common Stock, Series C Common Stock and Series D Common Stock shall vote and be counted together and not separately as a voting group upon all matters submitted to a vote of shareholders. Where the Series E Common Stock is entitled to voting rights by law, all shares of Series E Common Stock shall vote and be counted together with the Series A Common Stock, the Series B Common Stock, the Series C Common Stock and the Series D Common Stock and not separately as a voting group, except as required by law. 4.3.4 DIVIDENDS. (a) IN CASH OR SECURITIES. Subject to any preferential rights granted for any series of Common Stock or Preferred Stock, the holders of Series A Common Stock, the holders of Series B Common Stock, the holders of Series C Common Stock, the holders of the Series D Common Stock and the holders of Series E Common Stock shall be entitled to receive dividends equally, share for share, if, when and as declared by the Board of Directors out of funds of this Corporation legally available for that purpose; provided, that if such dividends are declared, they will be payable at the same rate on each other series of Common Stock and payable in Common Stock of the series with respect to which it is declared or in Common Stock of one or more newly designated series with substantially similar rights to the series with respect to which it is declared, as determined by the Board of Directors in its sole discretion. (b) SUBDIVISIONS AND COMBINATIONS OF SHARES. Any increase or decrease in the number of shares of any series of Common Stock resulting from a subdivision or combination of shares or other capital reclassification shall not be permitted unless parallel action 3 4 is taken with respect to each other series of Common Stock, so that the number of shares of each series of Common Stock outstanding shall be increased or decreased proportionately. 4.3.5 AUTOMATIC CONVERSION OF SERIES B COMMON STOCK. (a) CONVERSION EVENT/CONVERSION DATE FOR EMPLOYEE HOLDERS. Each share of Series B Common Stock held by a holder who was an employee at the time of issuance shall automatically convert into one (1) share of Series C Common Stock upon the termination of the holder's employment with the Corporation for any reason, including but not limited to death, disability, retirement, resignation or involuntary termination by the Corporation. In addition, if any such holder, while an employee, makes or attempts to make any transfer of shares of Series B Common Stock to any person or entity, whether voluntary or involuntary, each such share that the holder has transferred or attempted to transfer shall automatically convert into one (1) share of Series C Common Stock simultaneously with such transfer or attempted transfer. If it is necessary for any reason to determine whether the holder's employment has terminated or the time thereof, or whether the holder has made or attempted to make any transfer of any shares of Series B Common Stock or the time thereof, the Board of Directors shall make such determination and it shall be binding on the holder and any other person having any interest therein. (b) CONVERSION EVENT/CONVERSION DATE FOR DIRECTOR OR AFFILIATE HOLDERS. Each share of Series B Common Stock held by a holder who was a director or an affiliate of a director (as defined above) at the time of issuance shall automatically convert into one (1) share of Series C Common Stock upon the termination of the holder's status as a director or an affiliate of a director for any reason, including but not limited to death, resignation or removal by the shareholders. In addition, if any such holder, while a director or an affiliate of a director, makes or attempts to make any transfer of shares of Series B Common Stock, whether voluntary or involuntary, each such share that the holder has transferred or attempted to transfer shall automatically convert into one (1) share of Series C Common Stock simultaneously with such transfer or attempted transfer. If it is necessary for any reason to determine whether the holder has made or attempted to make any transfer of any shares of Series B Common Stock or the time thereof, the Board of Directors shall make such determination and it shall be binding on the holder and any other person having any interest therein. (c) STATUS OF CERTIFICATES. If one or more shares of Series B Common Stock are so converted, the certificate(s) representing such share or shares shall, by virtue of the conversion and without any action on the part of the holder, thereafter represent, to the extent of the number of shares so converted, the corresponding number of shares of Series C Common Stock, and the share or shares of Series B Common Stock previously represented by such certificate(s) shall be canceled and revert to the status of authorized but unissued share(s) of Series B Common Stock. Upon surrender of any such certificate to the Corporation, the Corporation shall issue and deliver to the person entitled thereto a new certificate or certificates to represent the shares of Series C Common Stock (and, if applicable, any remaining shares of Series B Common Stock) represented by the surrendered certificate. 4 5 (d) RESERVATION AND ISSUANCE OF SERIES C COMMON STOCK. The Corporation shall reserve at all times, for so long as any shares of Series B Common Stock remain outstanding, free from preemptive rights, out of its authorized but unissued shares of Series C Common Stock, solely for the purpose of effecting the conversion of the shares of Series B Common Stock, sufficient shares of Series C Common Stock to provide for the conversion of all outstanding shares of Series B Common Stock. All shares of Series C Common Stock issued upon conversion of the shares of Series B Common Stock will be duly and validly issued, fully paid and nonassessable to the same extent as the shares of Series B Common Stock from which they were converted. 4.3.6 TERMINATION OF DESIGNATION OF SERIES A COMMON STOCK, SERIES B COMMON STOCK AND SERIES C COMMON STOCK. Upon the earlier of the following events (a "Designated Event"): (a) the written election delivered to the Corporation at any time by the holders of a majority of: (i) the then outstanding shares of Series A Preferred Stock, or (ii) the then outstanding shares of Series A Common Stock issued upon the conversion of Series A Preferred as provided in Article V; or (b) the closing of a Public Offering (as defined in Section 5.4(b)), provided: (i) immediately following the closing of the Public Offering, the persons who held shares of Series A Preferred prior to the Public Offering, or prior to the conversion of the Series A Preferred into Common Stock as provided in Article V, hold more than fifty percent (50%) of all of the outstanding shares of the Corporation, assuming the issuance and exercise of all options under the Corporation's 1995 -------- Stock Option Plan, 1996 Stock Option Plan or any other stock option, employee stock bonus or restricted stock plan designated and approved by the Board of Directors, (ii) in the opinion of the underwriters, delivered to the Corporation prior to the closing of the Public Offering, the existence of multiple classes of Common Stock will lower the price in the Public Offering by more than twenty-five percent (25%), and (iii) the Public Offering does not constitute a Qualified Public Offering (as defined in Section 4.3.9); the designation of the Series A Common Stock, Series B Common Stock and Series C Common Stock as separate series of Common Stock having the respective rights, preferences and limitations set forth in this Section 4.3, and the authority of the Board of Directors under Section 4.2 to divide the Common Stock into series and to fix and determine the relative rights and preferences therefor, shall automatically terminate. Effective immediately upon such termination (A) the number of authorized but undesignated shares of Common Stock of the Corporation shall be increased by the number of authorized shares of Series A Common Stock, Series B Common Stock, and Series C Common Stock, without any distinctions between any of such shares (except as provided in Section 4.3.7); (B) each share of Series A Common Stock, Series B Common Stock and Series C Common Stock then outstanding shall thereafter constitute one (1) share of Common Stock, the holder of which shall be entitled to one (1) vote upon all matters submitted to a vote of shareholders; and (C) each certificate representing shares of Series A Common Stock, Series B Common Stock or Series C Common Stock that were outstanding immediately prior to the termination shall, by virtue of the termination and without 5 6 any action on the part of the holder, thereafter represent the corresponding number of shares of Common Stock. Upon surrender of any such certificate to the Corporation, the Corporation shall issue and deliver to the person entitled thereto a new certificate to represent the shares of Common Stock represented by the surrendered certificate. 4.3.7 SERIES D COMMON STOCK. Following a Designated Event, notwithstanding anything in Section 4.3.6 to the contrary, one (1) share of Common Stock shall remain designated a share of Series D Common Stock, and, as provided in Section 5.4(a), the holders of Series A Preferred shall have the nontransferable right to convert one (1) share of Series A Preferred into one (1) share of Series D Common Stock provided the Corporation has received, in connection with the Designated Event, an opinion of a recognized investment banking firm that the existence of this class of stock will not impair the value of the Series A Common Stock. Upon the transfer of that one (1) share of Series D Common Stock, the one (1) share of Series D Common Stock shall automatically convert into one (1) share of Series A Common Stock or Conversion Stock (as defined in Section 5.4(a)). The one (1) share of Series D Common Stock, which shall be issued as described in Section 5.4(a), shall have the right (in addition to its right to vote with the Common Stock) to elect one (1) member of the Board of Directors of the Corporation (the "Policy Director") who shall have the rights and authority to adopt or change the editorial policies of the Corporation. 4.3.8 TERMINATION OF DESIGNATION OF SERIES E COMMON STOCK. If a holder of Series E Preferred elects to convert such shares into shares of Series A Common Stock, then, at any time following such conversion, the Board of Directors may amend the resolution establishing the Series E Common Stock to decrease (but not below the number of Series E Preferred then outstanding) the number of shares of Series E Common Stock, and the number of shares constituting the decrease shall thereafter constitute authorized but undesignated shares of Common Stock. In addition, if all of the Series E Preferred are converted into shares of Series A Common Stock, the designation of the Series E Common Stock as a separate series of Common Stock shall automatically terminate. Effective immediately upon such termination, the number of authorized but undesignated shares of Common Stock of the Corporation shall be increased by the number of authorized shares of Series E Common Stock. 4.3.9 QUALIFIED PUBLIC OFFERING. The provisions of this Section 4.3.9 shall apply in the event of the closing of a firm commitment underwritten public offering pursuant to an effective registration statement under the Securities Act of 1933, as amended (the "Securities Act"), covering the offer and sale of Common Stock for the account of the Corporation to the public with aggregate proceeds to the Corporation of not less than $20,000,000 (prior to deduction of underwriter commissions and offering expenses), provided, the holders of not less than Sixty-Six and Two-Thirds Percent (66_%) of the then outstanding shares of Series D Preferred, by affirmative vote or written consent, have consented to such offering ("Qualified Public Offering"). (a) TERMINATION OF DESIGNATION OF SERIES A COMMON STOCK, SERIES B COMMON STOCK, SERIES C COMMON STOCK AND SERIES D COMMON STOCK. Effective upon closing of a Qualified Public Offering, the designation of the Series A Common Stock, Series B 6 7 Common Stock, Series C Common Stock and Series D Common Stock as separate series of Common Stock having the respective rights, preferences and limitations set forth in this Section 4.3, and the authority of the Board of Directors under Section 4. to divide the Common Stock into series and to fix and determine the relative rights and preferences therefor, shall automatically terminate. Effective immediately upon such termination (i) the number of authorized but undesignated shares of Common Stock of the Corporation shall be increased by the number of authorized shares of Series A Common Stock, Series B Common Stock, Series C Common Stock and Series D Common Stock without any distinctions between any of such shares; (ii) each share of Series A Common Stock, Series B Common Stock, Series C Common Stock and Series D Common Stock then outstanding shall thereafter constitute one (1) share of Common Stock, the holder of which shall be entitled to one (1) vote upon all matters submitted to a vote of shareholders; and (iii) each certificate representing shares of Series A Common Stock, Series B Common Stock, Series C Common Stock or Series D Common Stock that were outstanding immediately prior to the termination shall, by virtue of the termination and without any action on the part of the holder, thereafter represent the corresponding number of shares of Common Stock. Upon surrender of any such certificate to the Corporation, the Corporation shall issue and deliver to the person entitled thereto a new certificate to represent the shares of Common Stock represented by the surrendered certificate. (b) DESIGNATION OF SPECIAL COMMON STOCK; RECLASSIFICATION OF SERIES E COMMON STOCK. Effective upon closing of a Qualified Public Offering (i) the designation of the Seven Million Forty-Seven Thousand Six Hundred Seventy-Nine (7,047,679) shares of Series E Common Stock shall automatically terminate and be replaced by the designation of a new series of Common Stock to be known as "Special Common Stock," consisting of the same number of shares, which series shall have the rights described in this Section 4.3.9, and (ii) each share of Series E Common Stock then outstanding shall automatically be reclassified as one (1) share of Special Common Stock; and (iii) each certificate representing shares of Series E Common Stock that were outstanding immediately prior to the reclassification shall, by virtue of the reclassification and without any action on the part of the holder, thereafter represent the corresponding number of shares of Special Common Stock. Upon surrender of any such certificate to the Corporation, the Corporation shall issue and deliver to the person entitled thereto a new certificate to represent the shares of Special Common Stock represented by the surrendered certificate. (c) RECLASSIFICATION OF SPECIAL COMMON STOCK OR SERIES E COMMON STOCK UPON QUALIFIED TRANSFER. (i) If any shares of Special Common Stock are sold in a Qualified Sale (as defined in Section 4.3.9(c)(iii)), then, effective immediately upon such sale (A) the number of authorized but undesignated shares of Common Stock of the Corporation shall be increased by the number of shares of Special Common Stock so sold; (B) each share of Special Common Stock so sold shall thereafter constitute one (1) share of Common Stock, the holder of which shall be entitled to one (1) vote upon all matters submitted to a vote of shareholders; (C) the certificate or certificates representing the shares of Special Common Stock that were outstanding immediately prior to such sale shall, by virtue of the sale and without any action on the part of 7 8 the holder, thereafter represent (I) to the extent of the number of shares of Special Common Stock so sold, the corresponding number of shares of Common Stock, and (II) the shares of Special Common Stock represented by such certificate or certificates immediately prior to such sale, if any, that have not been so sold; and (D) if no shares of Special Common Stock remain outstanding following the Qualified Sale, the designation of the Special Common Stock as a separate series of Common Stock having the respective rights, preferences and limitations set forth in this Section 4.3.9 shall automatically terminate. Upon surrender of any such certificate to the Corporation, the Corporation shall issue and deliver to the person entitled thereto a new certificate or certificates to represent the shares of Common Stock and Special Common Stock, if any, represented by the surrendered certificate. (ii) If any shares of Series E Common Stock are sold in a Qualified Sale, then, effective immediately upon such sale (A) the number of authorized shares of Series E Common Stock shall be decreased, and the number of authorized but undesignated shares of Common Stock of the Corporation shall be increased, by the number of shares of Series E Common Stock so sold; (B) each share of Series E Common Stock so sold shall automatically be converted into one (1) share of Series A Common Stock; (C) the certificate or certificates representing the shares of Series E Common Stock that were outstanding immediately prior to such sale shall, by virtue of the sale and without any action on the part of the holder, thereafter represent (I) to the extent of the number of shares of Series E Common Stock so sold, the corresponding number of shares of Common Stock, and (II) the shares of Series E Common Stock represented by such certificate or certificates immediately prior to such sale, if any, that have not been so sold; and (D) if no shares of Series E Common Stock remain outstanding following the Qualified Sale, the designation of the Series E Common Stock as a separate series of Common Stock having the respective rights, preferences and limitations set forth in this Section 4.3 shall automatically terminate. Upon surrender of any such certificate to the Corporation, the Corporation shall issue and deliver to the person entitled thereto a new certificate or certificates to represent the shares of Series A Common Stock and Series E Common Stock, if any, represented by the surrendered certificate. Nothing in the first sentence of this Section 4.3.9 shall limit the effectiveness of this Section 4.3.9(c)(ii), notwithstanding that a Qualified Public Offering has not occurred. (iii) For purposes of this Section 4.3.9(c), a "Qualified Sale" of shares of Special Common Stock or Series E Common Stock shall mean a bona fide sale of the shares by the holder thereof to a purchaser who is not directly, or acting on behalf of, an affiliate (as that term is defined in Rule 405 promulgated under the Securities Act) of the holder. (d) VOTING RIGHTS. Each share of Common Stock shall be entitled to one (1) vote on all matters submitted to the shareholders of the Corporation and each share of Special Common Stock shall not be entitled to vote, except as required by law, in which case each share of Special Common Stock shall be entitled to one (1) vote. (e) RANKING. The rights and preferences of the Common Stock and the Special Common Stock shall be in all respects identical, except as otherwise required by law or expressly provided in these Articles of Incorporation. 8 9 4.4 ISSUANCE OF PREFERRED STOCK IN SERIES. 4.4.1 AUTHORITY VESTED IN BOARD OF DIRECTORS. The Preferred Stock may be divided into and issued in series from time to time. Authority is vested in the Board of Directors, subject to the limitations and procedures set forth in these Articles of Incorporation or prescribed by law, to divide any part or all of such Preferred Stock into any number of series, to fix and determine the relative rights and preferences of the shares of any series to be established, and to amend the rights and preferences of the shares of any series that has been established but is wholly unissued. 4.4.2 DESIGNATION OF SERIES A PREFERRED STOCK, SERIES B PREFERRED STOCK, SERIES C PREFERRED STOCK, SERIES D PREFERRED STOCK AND SERIES E PREFERRED STOCK. The following series of Preferred Stock are hereby designated, and each such series shall have the following rights, preferences and limitations: 4.4.3 DESIGNATION. Thirteen Million Seven Hundred Thirteen Thousand Four Hundred Thirty Nine (13,713,439) shares of Preferred Stock shall be designated and known as "Series A Preferred Stock" or "Series A Preferred"; Three Million Fifty-Nine Thousand Seven Hundred One (3,059,701) shares of Preferred Stock shall be designated and known as "Series B Preferred Stock" or "Series B Preferred"; Three Million Four Thousand Three Hundred Five (3,004,305) shares of Preferred Stock shall be designated and known as "Series C Preferred Stock" or "Series C Preferred"; Three Million Ninety-Five Thousand Three Hundred Thirteen (3,095,313) shares of Preferred Stock shall be designated and known as "Series D Preferred Stock" or "Series D Preferred"; and Seven Million Forty-Seven Thousand Six Hundred Seventy-Nine (7,047,679) shares of Preferred Stock shall be designated as "Series E Preferred Stock" or "Series E Preferred." Except as otherwise provided in these Articles of Incorporation, all shares of Series A Preferred Stock, Series B Preferred Stock, Series C Preferred Stock, Series D Preferred Stock and Series E Preferred Stock shall be identical and shall entitle the holders thereof to the same rights and privileges. 4.4.4 AMENDMENT TO SERIES DECREASING SHARES. Within any limits stated in these Articles of Incorporation or in the resolution of the Board of Directors establishing a series, the Board of Directors, after the issuance of shares of a series, may amend the resolution establishing the series to decrease (but not below the number of shares of such series then outstanding or reserved for issuance pursuant to the exercise of any outstanding warrants) the number of shares of that series, and the number of shares constituting the decrease shall thereafter constitute authorized but undesignated shares. 4.4.5 AUTHORITY LIMITED TO UNISSUED SHARES. The authority herein granted to the Board of Directors to determine the relative rights and preferences of the Preferred Stock shall be limited to unissued shares, and no power shall exist to alter or change the rights and preferences of any shares that have been issued. 9 10 4.5 ISSUANCE OF CERTIFICATES. The Board of Directors shall have the authority to issue shares of the capital stock of this Corporation and the certificates therefor subject to such transfer restrictions and other limitations as it may deem necessary to promote compliance with applicable federal and state securities laws, and to regulate the transfer thereof in such manner as may be calculated to promote such compliance or to further any other reasonable purpose. 4.6 NO CUMULATIVE RIGHTS. Shareholders of this Corporation shall not have the right to cumulate votes for the election of directors. 4.7 NO PREEMPTIVE RIGHTS. No shareholder of this Corporation shall have, solely by reason of being a shareholder, any preemptive or preferential right or subscription right to any stock of this Corporation or to any obligations convertible into stock of this Corporation, or to any warrant or option for the purchase thereof, except to the extent provided by written agreement with this Corporation. 4.8 QUORUM FOR MEETING OF SHAREHOLDERS. A quorum shall exist at any meeting of shareholders if a majority of the votes entitled to be cast is represented in person or by proxy. In the case of any meeting of shareholders that is adjourned more than once because of the failure of a quorum to attend, those who attend the third convening of such meeting, although less than a quorum, shall nevertheless constitute a quorum for the purpose of electing directors, provided that the percentage of shares represented at the third convening of such meeting shall not be less than one-third of the shares entitled to vote. 4.9 CONTRACTS WITH INTERESTED SHAREHOLDERS. Subject to the limitations set forth in RCW 23B.19.040, to the extent applicable: 4.9.1 The Corporation may enter into contracts and otherwise transact business as vendor, purchaser, lender, borrower, or otherwise with its shareholders and with corporations, associations, firms, and entities in which they are or may be or become interested as directors, officers, shareholders, members, or otherwise. 4.9.2 Any such contract or transaction shall not be affected or invalidated or give rise to liability by reason of the shareholder's having an interest in the contract or transaction. 4.10 SHAREHOLDER VOTING REQUIREMENTS. Subject to the requirements of RCW 23B.08.730, and 23B.19.040, any contract, transaction, or act of the Corporation or of any director or officer of the Corporation that shall be authorized, approved, or ratified by a majority of the votes entitled to be cast at a meeting at which a quorum is present shall, insofar as permitted by law, be as valid and as binding as though ratified by every shareholder of the Corporation. 4.11 EXECUTION OF CONSENT OF SHAREHOLDERS BY LESS THAN UNANIMOUS CONSENT. To the extent permitted by the Act, the taking of action by shareholders without a meeting by less than unanimous written consent of all shareholders entitled to vote on the action shall be permitted. Before the date on which the action becomes effective, notice of the taking of such action shall 10 11 be given to those shareholders entitled to vote on the action who have not consented in writing (and, if the Act would otherwise require that notice of a meeting of shareholders to consider the action be given to nonvoting shareholders, to all nonvoting shareholders), in writing, describing with reasonable clarity and specifying the general nature of the action, and accompanied by the same material that, under the Act, would have been required to be sent to nonconsenting (or nonvoting) shareholders in a notice of meeting at which the action would have been submitted for shareholder action. Such notice shall be given as follows: (i) if mailed, by deposit in the U.S. mail at least seventy-two (72) hours prior to the specified effective time of such action, with first-class postage thereon prepaid, correctly addressed to each shareholder entitled thereto at the shareholder's address as it appears on the current record of shareholders of the Corporation; or (ii) if delivered by personal delivery, by courier service, by wire or wireless equipment, by telegraphic or other facsimile transmission, or by any other electronic means which transmits a facsimile of such communication correctly addressed to each shareholder entitled thereto at the shareholder's physical address, electronic mail address, or facsimile number, as it appears on the current record of shareholders of the Corporation, at least twenty-four (24) hours prior to the specified effective time of such action. 4.12 SPECIAL MEETINGS OF SHAREHOLDERS. Subsequent to the date of closing of a firm commitment underwritten public offering pursuant to an effective registration statement under the Securities Act covering the offer and sale of Common Stock for the account of the Corporation to the public, special meetings of the shareholders for any purpose or purposes may be called at any time only by a majority of the Board of Directors or the Chairman of the Board of Directors (if one be appointed) or the President or one or more shareholders holding not less than twenty-five percent (25%) of all the shares entitled to be cast on any issue proposed to be considered at that meeting. 4.13 MAJORITY VOTE REQUIRED. Unless otherwise provided in these Articles of Incorporation, subsequent to the date of closing of a firm commitment underwritten public offering pursuant to an effective registration statement under the Securities Act covering the offer and sale of Common Stock for the account of the Corporation to the public, pursuant to authority granted under Sections 23B.10.030, 23B.11.030, 23B.12.020, and 23B.14.020 of the Act, the vote of shareholders of the Corporation required in order to approve amendments to the Articles of Incorporation, a plan of merger or share exchange, the sale, lease, exchange, or other disposition of all or substantially all of the property of the Corporation not in the usual and regular course of business, or dissolution of the Corporation shall be a majority of all of the votes entitled to be cast by each voting group entitled to vote thereon, regardless of whether or not the Corporation is a "public company," as that term is defined in Section 23B.01.400 of the Act. 11 12 ARTICLE V ADDITIONAL TERMS OF CAPITAL STOCK In addition to the relative rights, preferences, privileges and restrictions granted to or imposed on the respective classes of the shares of capital stock or the holders thereof as set forth in Article IV, the relative rights, preferences, privileges and restrictions granted to or imposed on the respective classes of the shares of capital stock or the holders thereof are as follows: 5.1 DIVIDENDS. No dividends or other distributions shall be made with respect to the Common Stock, other than dividends payable solely in Common Stock, unless at the same time an equivalent dividend with respect to the Series A Preferred, Series B Preferred, Series C Preferred, Series D Preferred and Series E Preferred has been paid or set apart or such equivalent dividend has been waived by the affirmative vote or written consent of the holders of not less than Sixty-Six and Two-Thirds Percent (66_%) of the outstanding shares of each of Series A Preferred, Series B Preferred, Series C Preferred, Series D Preferred and Series E Preferred. Any declared but unpaid dividends on the shares of Series A Preferred, Series B Preferred, Series C Preferred, Series D Preferred and Series E Preferred shall be paid upon the conversion of such shares into Common Stock either (at the option of the Corporation) by payment of cash or by the issuance of additional shares of Common Stock based upon the fair market value of the Common Stock at the time of conversion, as determined by the Corporation's Board of Directors. 5.2 LIQUIDATION PREFERENCES. In the event of any liquidation, dissolution, or winding up of the Corporation, either voluntary or involuntary, distributions to the shareholders of the Corporation shall be made in the following manner: (a) The holders of each of the Series D Preferred and the Series E Preferred shall be entitled to receive, prior and in preference to any distribution of any of the assets or surplus funds of the Corporation to the holders of the Series A Preferred, the Series B Preferred, the Series C Preferred or the Common Stock by reason of their ownership of such stock, an amount equal to the greater of: (1) $11.295 per share, in the case of Series D Preferred, and $8.99 per share, in the case of Series E Preferred, adjusted for any combinations, consolidations, subdivisions, or stock dividends with respect to such shares and, in addition, an amount equal to all declared but unpaid dividends on such shares; or (2) the amount per share the holder would have received if he/she/it had converted his/her/its shares into Common Stock as provided in these Articles of Incorporation, provided, that the holders of Series D Preferred and the Series E Preferred shall receive such amounts simultaneously with the receipt by the holders of Common Stock of the amounts to which they are entitled, as described in Section 5.2(c). If the assets and funds thus distributed among the holders of the Series D Preferred and Series E Preferred shall be insufficient to permit the payment to such holders of the full aforesaid preferential amount, then the entire assets and funds of the Corporation legally available for distribution shall be distributed, first, pro rata among the holders of the Series E Preferred in proportion to the full preferential amount each such holder is otherwise entitled to receive under clause (1) above, and among the holders of the Series D Preferred in proportion to Sixty-Six and Two-Thirds Percent 12 13 (66_%) of the full preferential amount each such holder is otherwise entitled to receive under clause (1) above, and, second, among the holders of the Series D Preferred in proportion to the remaining full preferential amount each such holder is otherwise entitled to receive under clause (1) above. (b) After payment has thus been made to the holders of each of the Series D Preferred and the Series E Preferred of the full amounts to which they shall be entitled as aforesaid, the holders of each of the Series A Preferred, the Series B Preferred and the Series C Preferred shall be entitled to receive prior and in preference to any distribution of any of the assets or surplus funds of the Corporation to the holders of the Common Stock by reason of their ownership of such stock, an amount equal to the greater of: (1) $0.0729 per share, in the case of Series A Preferred, $0.67 per share, in the case of Series B Preferred, and $1.9634 per share, in the case of Series C Preferred, adjusted for any combinations, consolidations, subdivisions, or stock dividends with respect to such shares and, in addition, an amount equal to all declared but unpaid dividends on such shares; or (2) the amount per share the holder would have received if he/she/it had converted his/her/its shares into Common Stock as provided in these Articles of Incorporation, provided, that the holders of the Series A Preferred, the Series B Preferred and the Series C Preferred shall receive such amounts simultaneously with the receipt by the holders of Common Stock of the amounts to which they are entitled, as described in Section 5.2(c). If the assets and funds thus distributed among the holders of the Series A Preferred, the Series B Preferred and the Series C Preferred shall be insufficient to permit the payment to such holders of the full aforesaid preferential amount, then the entire assets and funds of the Corporation legally available for distribution shall be distributed among the holders of the Series A Preferred, the Series B Preferred and the Series C Preferred in proportion to the full preferential amount each such holder is otherwise entitled to receive under clause (1) above. (c) After payment has thus been made to the holders of each of the Series A Preferred, the Series B Preferred, the Series C Preferred, the Series D Preferred and the Series E Preferred of the full amounts to which they shall be entitled as aforesaid, the holders of the Common Stock shall be entitled to receive ratably on a per-share basis all the remaining assets. (d) For purposes of this Section 5.2, a merger or consolidation of the Corporation with or into any other corporation or corporations, or the merger of any other corporation or corporations into the Corporation, in which the shareholders of the Corporation receive distributions in cash or securities of another corporation or corporations as a result of such consolidation or merger, or a sale of all or substantially all of the assets of the Corporation, shall be treated as a liquidation, dissolution or winding up of the Corporation unless the Corporation's stockholders immediately prior to such an event hold, immediately after such event, at least 50% of the general voting power of the surviving or acquiring entity by virtue of their ownership of the Corporation's equity securities. 5.3 VOTING RIGHTS. Except as otherwise required by law or by Section 5.6, the holder of each share of Common Stock issued and outstanding shall have the votes set forth in Section 4.3.3, and the holder of each share of Series A Preferred, Series B Preferred, Series C Preferred and Series D Preferred shall be entitled to the number of votes equal to the number of 13 14 votes entitled to be cast by the number of shares of Common Stock into which such share of Series A Preferred, Series B Preferred, Series C Preferred or Series D Preferred could be converted at the record date for determination of the shareholders entitled to vote on such matters, such votes to be counted together with all other shares of the Corporation having general voting power and not separately as a class. Fractional votes by the holders of Series A Preferred, Series B Preferred, Series C Preferred and Series D Preferred shall not, however, be permitted and any fractional voting right shall (after aggregating all shares into which shares of Series A Preferred, Series B Preferred, Series C Preferred and Series D Preferred held by each holder could be converted) be rounded to the nearest whole number. Except as otherwise required by law, in which case the holder of each share of Series E Preferred shall be entitled to one (1) vote, the holders of Series E Preferred shall not be entitled to vote. Where the Series E Preferred is entitled to voting rights by law, all shares of Series E Preferred shall vote and be counted together with the Series A Preferred, the Series B Preferred, the Series C Preferred and Series D Preferred and not separately as a voting group, except as otherwise required by law. Holders of Common Stock and Series A Preferred, Series B Preferred, Series C Preferred, Series D Preferred and Series E Preferred shall be entitled to notice of any shareholders' meeting in accordance with the Bylaws of the Corporation. 5.4 CONVERSION. The holders of Series A Preferred, Series B Preferred, Series C Preferred, Series D Preferred and Series E Preferred shall have conversion rights as follows (the "Conversion Rights"): (a) RIGHT TO CONVERT. Each share of Series A Preferred, Series B Preferred, Series C Preferred, Series D Preferred and Series E Preferred shall be convertible, at the option of the holder thereof, at any time after the date of issuance of such share (including immediately prior to any liquidation, dissolution or winding up of the Corporation as set forth in Section 5.2 above) at the office of the Corporation or any transfer agent for each of the Series A Preferred, Series B Preferred, Series C Preferred, Series D Preferred or Series E Preferred (whichever is appropriate), into such number of fully paid and nonassessable shares of Series A Common Stock, or if, pursuant to Section 4.3.6 or Section 4.3.9, the Articles of Incorporation as amended from time to time do not, at the time of conversion, provide for Series A Common Stock, into shares of Common Stock, or for the Series E Preferred, into shares of Series E Common Stock, or if, pursuant to Section 4.3.9, the Articles of Incorporation as amended from time to time do not, at the time of conversion, provide for Series E Common Stock, into shares of Special Common Stock (such Series A Common Stock, Series E Common Stock, Common Stock or Special Common Stock, as the case may be, the "Conversion Stock"), as is determined by dividing $8.99, in the case of the Series E Preferred, $7.53, in the case of the Series D Preferred, $1.9634, in the case of the Series C Preferred, $0.67, in the case of the Series B Preferred, and $0.0729, in the case of the Series A Preferred, by the Conversion Price (determined as hereinafter provided) for such series in effect at the time of the conversion (the "Conversion Rate"). The price at which shares of Conversion Stock shall be deliverable upon conversion (the "Conversion Price") shall initially be $8.99, in the case of the Series E Preferred, $7.53, in the case of the Series D Preferred, $1.9634, in the case of the Series C Preferred, $0.67, in the case of the Series B Preferred, and $0.0729, in the case of the Series A Preferred. Such initial Conversion Price shall be subject to adjustment as hereinafter provided. 14 15 Notwithstanding anything in this Section 5.4(a) to the contrary, in the event of a Public Offering that is not a Qualified Public Offering, the holders of the Series A Preferred (including for this purpose any shares of Conversion Stock issued upon conversion of the Series A Preferred prior to a Public Offering) will have the-non-transferable right to convert one (1) such share, unless otherwise provided in Section 4.3.7, into one (1) share of Series D Common Stock with the rights provided in Section 4.3.7. (b) AUTOMATIC CONVERSION. Each share of Series A Preferred, Series B Preferred, Series C Preferred, Series D Preferred and Series E Preferred shall automatically be converted into the number and class of fully paid and nonassessable shares of Conversion Stock into which such share would then convert upon voluntary conversion under Section 5.4(a), effective upon the closing of a firm commitment underwritten public offering (a "Public Offering") pursuant to an effective registration statement under the Securities Act covering the offer and sale of Common Stock for the account of the Corporation to the public, if either (x) the price to the public in the offering is at least $13.554 per share (as adjusted to reflect subsequent stock dividends, stock splits, combinations and recapitalizations) and the aggregate proceeds of the offering are not less than $20,000,000 (prior to deduction of underwriter commissions and offering expenses), or (y) the holders of not less than Sixty-Six and Two-Thirds Percent (66_%) of the then outstanding shares of Series D Preferred, by affirmative vote or written consent, have consented to the automatic conversion. (c) MECHANICS OF CONVERSION. No fractional shares of Conversion Stock shall be issued upon conversion of Series A Preferred, Series B Preferred, Series C Preferred, Series D Preferred or Series E Preferred. In lieu of any fractional shares to which the holder would otherwise be entitled, the Corporation shall pay cash equal to such fraction multiplied by the then effective Conversion Price. Before any holder of Series A Preferred, Series B Preferred, Series C Preferred, Series D Preferred or Series E Preferred shall be entitled to convert the same into full shares of Conversion Stock and to receive certificates therefor, such holder shall surrender the certificate or certificates therefor, duly endorsed, at the office of the Corporation or of any transfer agent for the Series A Preferred, Series B Preferred, Series C Preferred, Series D Preferred or Series E Preferred (whichever is appropriate), and shall give written notice to the Corporation at such office that such holder elects to convert the same; provided, however, that in the event of an automatic conversion pursuant to Section 5.4(b), the outstanding shares of Series A Preferred, Series B Preferred, Series C Preferred, Series D Preferred and Series E Preferred shall be converted automatically without any further action by the holders of such shares and whether or not the certificates representing such shares are surrendered to the Corporation or its transfer agent, and provided further, that the Corporation shall not be obligated to issue certificates evidencing the shares of Conversion Stock issuable upon such automatic conversion unless the certificates evidencing such shares of Series A Preferred, Series B Preferred, Series C Preferred, Series D Preferred or Series E Preferred are either delivered to the Corporation or its transfer agent as provided above, or the holder notifies the Corporation or its transfer agent that such certificates have been lost, stolen or destroyed and executes an agreement satisfactory to the Corporation to indemnify the Corporation from any loss incurred by it in connection with such certificates. The Corporation shall, as soon as practicable after delivery of such certificate, or such agreement of indemnification in the case of 15 16 a lost certificate, issue and deliver at such office to such holder of Series A Preferred, Series B Preferred, Series C Preferred, Series D Preferred or Series E Preferred, a certificate or certificates for the number of shares of Conversion Stock to which such holder shall be entitled as aforesaid and a check payable to the holder in the amount of any cash amounts payable as the result of a conversion into fractional shares of Conversion Stock. Such conversion shall be deemed to have been made immediately prior to the close of business on the date of such surrender of the shares of Series A Preferred, Series B Preferred, Series C Preferred, Series D Preferred or Series E Preferred to be converted, or in the case of automatic conversion under Section 5.4(b), on the date of closing of the Public Offering, and the person or persons entitled to receive the shares of Conversion Stock issuable upon such conversion shall be treated for all purposes as the record holder or holders of such shares of Conversion Stock on such date. (d) ADJUSTMENTS TO CONVERSION PRICE FOR DILUTIVE ISSUES. (i) SPECIAL DEFINITIONS. For purposes of this Section 5.4(d), the following definitions shall apply: (1) "OPTIONS" shall mean rights, options or warrants to subscribe for, purchase or otherwise acquire either Common Stock or Convertible Securities. (2) "ORIGINAL ISSUE DATE" shall mean the date on which the first share of Series E Preferred was first issued. (3) "CONVERTIBLE SECURITIES" shall mean any evidence of indebtedness, shares of capital stock (other than the Common Stock) or other securities convertible into or exchangeable for Common Stock. (4) "ADDITIONAL SHARES OF COMMON STOCK" shall mean all shares of Common Stock issued (or, pursuant to Section 5.4(d)(ii), deemed to be issued) by the Corporation after the Original Issue Date, other than: (A) shares of Common Stock issued or issuable at any time upon conversion of the shares of Series A Preferred, Series B Preferred, Series C Preferred, Series D Preferred or Series E Preferred authorized herein; (B) shares of Common Stock issued or issuable at any time to officers, directors, and employees of, and consultants to, the Corporation pursuant to the Corporation's 1995 Stock Option Plan, 1996 Stock Option Plan or any other stock option, restricted stock plan or employee stock bonus program or grant designated and approved by the Board of Directors by unanimous vote if there are three or fewer directors then serving or, if there are greater than three directors then serving, by a two-thirds majority vote thereof (provided that any shares repurchased by the Corporation from employees, officers, directors and consultants pursuant to the terms of stock repurchase agreements approved by the Board of Directors shall not, unless reissued, be counted as issued for purposes of this calculation) other than shares issued to Rob Glaser, the Corporation's Founder, without the written consent of the 16 17 holders of a majority of the Series B Preferred, Series C Preferred, Series D Preferred and Series E Preferred (provided, for purposes of calculating the majority for purposes of this clause (B), the shares of Series E Preferred to be issued upon exercise, if ever, of the Series E Preferred Stock Purchase Warrant issued pursuant to the Series E Preferred Stock Purchase Agreement dated July 21, 1997, shall not be deemed to be outstanding, regardless of whether such Series E Preferred Stock Purchase Warrant has been exercised); (C) shares of Common Stock issued or issuable at any time as a dividend or distribution on Series A Preferred, Series B Preferred, Series C Preferred, Series D Preferred or Series E Preferred or any other event for which adjustment is made pursuant to Section 5.4(e)(i) hereof; (D) shares of Common Stock issued upon conversion of Series B Common Stock to Series C Common Stock pursuant to Section 4.3.5 of these Articles; (E) shares of Common Stock issued upon exercise of the Series B Common Stock Warrants which were issued pursuant to the Series C Preferred Stock Purchase Agreement by and among the Corporation and certain purchasers dated October 26, 1995; (F) shares of Common Stock issued or issuable in connection with: (i) the acquisition, by this Corporation or any subsidiary, of any assets, stock or other interest in any partnership, corporation or other entity approved by a majority of this Corporation's Board of Directors, or (ii) the formation of any research and development partnerships, licensing or collaborative agreements or other similar venture approved by a majority of this corporation's Board of Directors; provided, that the number of shares issued or issuable pursuant to this clause (F) shall not exceed 330,000 (as adjusted to reflect subsequent stock dividends, stock splits and recapitalizations) in any one transaction or series of related transactions and shall not exceed 990,000 (as adjusted to reflect subsequent stock dividends, stock splits and recapitalizations) in the aggregate; and (G) shares of Common Stock issued or issuable at any time by way of dividend or other distribution on shares of Common Stock (x) excluded from the definition of Additional Shares of Common Stock by the foregoing clauses (A), (B), (C), (D), (E), and (F) or this clause (G) or (y) on shares of Common Stock so excluded under Subsection (x). 17 18 (ii) DEEMED ISSUANCE OF ADDITIONAL SHARES OF COMMON STOCK. (1) OPTIONS AND CONVERTIBLE SECURITIES. In the event the Corporation at any time or from time to time after the Original Issue Date shall issue any Options or Convertible Securities, then the maximum number of shares (as set forth in the instrument relating thereto without regard to any provisions contained therein for a subsequent adjustment of such number) of Common Stock issuable upon the exercise of such Options or, in the case of Convertible Securities and Options therefor, the conversion or exchange of such Convertible Securities, shall, except as otherwise provided in Section 5.4(d)(i)(4), be deemed to be Additional Shares of Common Stock issued as of the time of such issuance, provided that, with respect to a particular series of Preferred Stock, Additional Shares of Common Stock shall not be deemed to have been issued unless the consideration per share (determined pursuant to Section 5.4(d)(iv) hereof) of such Additional Shares of Common Stock would be less than the Conversion Price in effect for such series on the date of and immediately prior to such issuance, and, provided further that in any such case in which Additional Shares of Common Stock are deemed to be issued (notwithstanding the foregoing): (A) no further adjustment in the Conversion Price for such series shall be made upon the subsequent issuance of Convertible Securities or shares of Common Stock upon the exercise of such Options or conversion or exchange of such Convertible Securities; (B) if such Options or Convertible Securities by their terms provide, with the passage of time or otherwise, except as provided in this Section 5.4(d), for any increase or decrease in the consideration payable to the Corporation, or in the number of shares of Common Stock issuable, upon the exercise, conversion or exchange thereof (a "Change Event"), the Conversion Price for any series of Preferred Stock recomputed upon the original issuance thereof, and any subsequent adjustments based thereon, shall, upon any such increase or decrease becoming effective, again be recomputed to reflect such increase or decrease insofar as it affects such Options or the rights of conversion or exchange under such Convertible Securities; provided, however, that anything to the contrary notwithstanding, if the Change Event is triggered or caused by a Dilutive Issue (as defined in Section 5.4(d)(iii)), this Section 5.4(d)(ii)(B) shall be inapplicable and no adjustment shall be made to any Conversion Price as a result of the Change Event; (C) upon the expiration of any such Options or any rights of conversion or exchange under such Convertible Securities which shall not have been exercised, the Conversion Price computed upon the original issuance thereof, and any subsequent adjustments based thereon, shall, upon such expiration, be recomputed as if, (I) in the case of Convertible Securities or Options for Common Stock, only the shares of Common Stock, if any, actually issued upon the exercise of such Options or the conversion or exchange of such Convertible Securities were issued at the 18 19 time of the issuance of such Convertible Securities or Options and the consideration received therefor was the consideration actually received by the Corporation for the issue of all such Options or Convertible Securities, whether or not exercised, converted, or exchanged, plus the consideration actually received by the Corporation upon such exercise, conversion or exchange, and (II) in the case of Options for Convertible Securities, only the Convertible Securities, if any, actually issued upon the exercise thereof were issued at the time of issue of such Options, and the consideration received by the Corporation for the Additional Shares of Common Stock deemed to have been then issued was the consideration actually received by the Corporation for the issue of all such Options, whether or not exercised, plus the consideration deemed to have been received by the Corporation upon the issue of the Convertible Securities with respect to which such Options were actually exercised; (D) no readjustment pursuant to clause (B) or (C) above shall have the effect of increasing the Conversion Price to an amount which exceeds the lower of (i) the Conversion Price on the original adjustment date, or (ii) the Conversion Price that would have resulted from any other issuance of Additional Shares of Common Stock between the original adjustment date and such readjustment date; and (E) in the case of any options which expire by their terms not more than 90 days after the date of issuance thereof, no adjustment of the Conversion Price shall be made until all such Options have either expired or been exercised. In the event that a record date is established for the purpose of determining the holders of the Corporation's securities who shall be entitled to receive Options or Convertible Securities as a dividend or a distribution, the Options or Convertible Securities to be so distributed or issued shall, for purposes of this Section 5.4(d), be deemed to have been issued as of such record date (provided that the Conversion Price so computed shall be recomputed if such Options or Convertible Securities are not so distributed or issued). (2) STOCK DIVIDENDS. In the event the Corporation at any time or from time to time after the Original Issue Date shall declare or pay any dividend on the Common Stock payable in Common Stock, then and in any such event, Additional Shares of Common Stock shall be deemed to have been issued immediately after the close of business on the record date for the determination of holders of any class of securities entitled to receive such dividend; provided, however, that if such record date is fixed and such dividend is not fully paid, the only Additional Shares of Common Stock deemed to have been issued will be the number of shares of Common Stock actually issued in such dividend, and such shares will be deemed to have been issued as of the close of business on such record date, and the Conversion Price shall be recomputed accordingly. 19 20 (iii) ADJUSTMENT OF CONVERSION PRICE UPON ISSUANCE OF ADDITIONAL SHARES OF COMMON STOCK. (1) If at any time or from time to time after the Original Issue Date this Corporation shall issue Additional Shares of Common Stock (including Additional Shares of Common Stock deemed to be issued pursuant to Section 5.4(d)(ii)) without consideration or for a consideration (as determined in Section 5.4(d)(iv)) per share issued or deemed to have been issued under Section 5.4(d)(ii), less than: (I) in the case of the Series A Preferred, the Conversion Price for the Series A Preferred in effect on the date of and immediately prior to such issuance, (II) in the case of the Series B Preferred, the Conversion Price for the Series B Preferred in effect on the date of and immediately prior to such issuance, (III) in the case of the Series C Preferred, the Conversion Price for the Series C Preferred in effect on the date of and immediately prior to such issuance, (IV) in the case of the Series D Preferred, the Conversion Price for the Series D Preferred in effect on the date of and immediately prior to such issuance, or (V) in the case of the Series E Preferred, the Conversion Price for the Series E Preferred in effect on the date of and immediately prior to such issuance, then and in such event (a "Dilutive Issue"), any one or all of such Conversion Prices shall be reduced, concurrently with such issuance, to a price determined by multiplying such Conversion Price by a fraction, the numerator of which shall be the number of shares of Common Stock outstanding immediately prior to such issuance on a fully diluted basis (including for such purpose Convertible Securities the conversion rights of which, are then exercisable but excluding all Options) plus the number of shares of Common Stock which the aggregate consideration received by the Corporation for the total number of Additional Shares of Common Stock so issued would purchase at such Conversion Price; and the denominator of which shall be the number of shares of Common Stock outstanding immediately prior to such issuance on a fully-diluted basis (including for such purpose Convertible Securities the conversion rights of which, are then exercisable but excluding all Options) plus the number of such Additional Shares of Common Stock so issued. (2) In addition to any adjustments to the Conversion Price for the Series E Preferred made pursuant to Section 5.4(d)(iii)(1), if this Corporation sells shares of Common Stock to the public in a Public Offering pursuant to Section 5.4(b)(y) at a price per share less than $8.99, (as adjusted to reflect subsequent stock dividends, stock splits and recapitalizations), the Conversion Price for the Series E Preferred in effect on the date of and immediately prior to such Public Offering, shall be reduced, immediately prior to but contingent upon the effectiveness of the Public Offering, to $7.53 (as adjusted to reflect subsequent stock dividends, stock splits and recapitalizations). (iv) DETERMINATION OF CONSIDERATION. For purposes of this Section 5.4(d), the consideration received by the Corporation for the issuance of any Additional Shares of Common Stock shall be computed as follows: (1) CASH AND PROPERTY: Such consideration shall: 20 21 (A) insofar as it consists of cash, be computed at the aggregate amount of cash received by the Corporation excluding amounts paid or payable for accrued interest or accrued dividends; (B) insofar as it consists of property other than cash, be computed at the fair value thereof at the time of such issuance, as determined in good faith by the Corporation's Board of Directors; and (C) in the event Additional Shares of Common Stock are issued together with other shares or securities or other assets of the Corporation for consideration which covers both, be the proportion of such consideration so received, computed as provided in clauses (A) and (B) above, as determined in good faith by the Corporation's Board of Directors. (2) OPTIONS AND CONVERTIBLE SECURITIES. The consideration per share received by the Corporation for Additional Shares of Common Stock deemed to have been issued pursuant to Section 5.4(d)(ii)(1), relating to Options and Convertible Securities, shall be determined by dividing: (x) the total amount, if any, received or receivable by the Corporation as consideration for the issue of such Options or Convertible Securities, plus the minimum aggregate amount of additional consideration (as set forth in the instruments relating thereto, without regard to any provision contained therein for a subsequent adjustment of such consideration) payable to the Corporation upon the exercise of such Options or the conversion or exchange of such Convertible Securities, or in the case of Options for Convertible Securities, the exercise of such Options for Convertible Securities and the conversion or exchange of such Convertible Securities; by (y) the maximum number of shares of Common Stock (as set forth in the instruments relating thereto, without regard to any provision contained therein for a subsequent adjustment of such number) issuable upon the exercise of such Options or the conversion or exchange of such Convertible Securities. (3) STOCK DIVIDENDS. Any Additional Shares of Common Stock relating to stock dividends shall be deemed to have been issued for no consideration. (e) ADDITIONAL ADJUSTMENTS TO CONVERSION PRICE. (i) ADJUSTMENTS FOR SUBDIVISIONS, COMBINATIONS OR CONSOLIDATION OF COMMON STOCK. In the event the outstanding shares of Common Stock (whether Series A Common Stock, Series E Common Stock or Common Stock) shall be subdivided, by stock split, or otherwise (but other than by stock dividend, which is addressed in Section 5.4(d)(ii)(2) of these Articles of Incorporation), into a greater number of shares of Common Stock, the Conversion Price for each series of Preferred Stock then in effect shall, concurrently with the effectiveness of such subdivision, be proportionately decreased. In the event the outstanding shares of Common Stock shall be combined or consolidated, by reclassification or otherwise, into a lesser number of shares of Common Stock, the Conversion Price for each series of Preferred Stock then in effect shall, concurrently with the effectiveness of such combination or consolidation, be proportionately increased. 21 22 (ii) ADJUSTMENTS FOR OTHER DISTRIBUTIONS. In the event the Corporation at any time or from time to time makes, or fixes a record date for the determination of holders of Common Stock entitled to receive, any distribution payable in securities of the Corporation other than shares of Common Stock and other than as otherwise adjusted in this Section 5.4, then and in each such event provision shall be made so that the holders of Series A Preferred, Series B Preferred, Series C Preferred, Series D Preferred and Series E Preferred shall receive upon conversion thereof, in addition to the number of shares of Common Stock (whether Series A Common Stock, Series E Common Stock or Common Stock) receivable thereupon, the amount of securities of the Corporation which they would have received had their Series A Preferred, Series B Preferred, Series C Preferred, Series D Preferred and Series E Preferred been converted into Common Stock on the date of such event and had then thereafter, during the period from the date of such event to and including the date of conversion, retained such securities receivable by them as aforesaid during such period, subject to all other adjustments called for during such period under this Section 5.4 with respect to the rights of the holders of the Series A Preferred, Series B Preferred, Series C Preferred, Series D Preferred and Series E Preferred. (iii) ADJUSTMENTS FOR RECLASSIFICATION, EXCHANGE AND SUBSTITUTION. If the Common Stock (whether Series A Common Stock, Series E Common Stock or Common Stock) issuable upon conversion of the Series A Preferred, Series B Preferred, Series C Preferred, Series D Preferred and Series E Preferred shall be changed into the same or a different number of shares of any other class or classes of stock, whether by capital reorganization, reclassification or otherwise (other than a subdivision or combination of shares provided for above), the terms of the Series A Preferred, Series B Preferred, Series C Preferred, Series D Preferred and Series E Preferred shall, concurrently with the effectiveness of such reorganization or reclassification, be modified such that the Series A Preferred, Series B Preferred, Series C Preferred, Series D Preferred and Series E Preferred, as the case may be, shall be convertible into, in lieu of the number of shares of Common Stock which the holders would otherwise have been entitled to receive, a number of shares of such other class or classes of stock equivalent to the number of shares of Common Stock that would have been subject to receipt by the holders upon conversion of the Series A Preferred, Series B Preferred, Series C Preferred, Series D Preferred and Series E Preferred immediately before that change. (f) NO IMPAIRMENT. Except as provided in Section 5.6, the Corporation will not, by amendment of its Articles of Incorporation or through any reorganization, transfer of assets, consolidation, merger, dissolution, issuance or sale of securities or any other voluntary action, avoid or seek to avoid the observance or performance of any of the terms to be observed or performed hereunder by the Corporation but will at all times in good faith assist in the carrying out of all the provisions of this Section 5.4 and in the taking of all such actions as may be necessary or appropriate in order to protect the Conversion Rights of the holders of the Series A Preferred, Series B Preferred, Series C Preferred, Series D Preferred and Series E Preferred against impairment. (g) CERTIFICATE AS TO ADJUSTMENTS. Upon the occurrence of each adjustment or readjustment of the Conversion Price for the Series A Preferred, Series B Preferred, Series C Preferred, Series D Preferred or Series E Preferred pursuant to this Section 5.4, the Corporation 22 23 at its expense shall promptly compute such adjustment or readjustment in accordance with the terms hereof and furnish to each holder of Series A Preferred, Series B Preferred, Series C Preferred, Series D Preferred or Series E Preferred a certificate setting forth such adjustment or readjustment and showing in detail the facts upon which such adjustment or readjustment is based. The Corporation shall, upon the written request at any time of any holder of Series A Preferred, Series B Preferred, Series C Preferred, Series D Preferred or Series E Preferred, furnish or cause to be furnished to such holder a like certificate setting forth (i) such adjustments and readjustments, (ii) the Conversion Price in effect at the time for such series, and (iii) the number of shares of Common Stock and the amount, if any, of other property which at the time would be received upon the conversion of such series of Preferred Stock. (h) NOTICES OF RECORD DATE. In the event that this Corporation shall propose at any time: (i) to declare any dividend or distribution upon its Common Stock, whether in cash, property, stock or other securities, whether or not a regular cash dividend and whether or not out of earnings or earned surplus; (ii) to offer for subscription, pro rata to the holders of any class or series of its stock, any additional shares of stock of any class or series or any other similar rights; (iii) to effect any reclassification or recapitalization of its Common Stock outstanding which results in a change in the Common Stock; or (iv) to merge or consolidate with or into any other corporation, or sell, lease or convey all or substantially all its property or business, or to liquidate, dissolve or wind up; then, in connection with each such event; this Corporation shall send to the holders of the Series A Preferred, Series B Preferred, Series C Preferred, Series D Preferred and Series E Preferred: (1) at least twenty (20) days prior written notice of (x) the record date for such dividend, distribution or subscription rights (and specifying the date on which the holders of Common Stock shall be entitled thereto) or (y) the record date at which the rights to vote on the matters referred to in (iii) and (iv) above will be determined; and (2) in the case of the matters referred to in (iii) and (iv) above, at least twenty (20) days prior written notice of the date when the same shall take place and specifying the date on which the holders of Common Stock shall be entitled to exchange their Common Stock for securities or other property deliverable upon the occurrence of such event or the record date for the determination of such holders if such record date is earlier. Each such written notice shall (x) be delivered personally; (y) given by certified or registered mail, postage prepaid; or (z) to the extent receipt is confirmed, by telecopy, telefax or other electronic transmission service; addressed to the holders of the Series A Preferred, Series B 23 24 Preferred, Series C Preferred, Series D Preferred and Series E Preferred at the address for each such holder as shown on the books of this Corporation. (i) ELECTION UPON CONVERSION OF SERIES E PREFERRED STOCK. In the event that a holder of Series E Preferred elects to convert its shares of Series E Preferred pursuant to Section 5.4(a) or there occurs an event requiring automatic conversion of the Series E Preferred pursuant to Section 5.4(b), such holder may elect to convert all of such shares into Series E Common Stock with the rights provided in these Articles of Incorporation. 5.5 REDEMPTION. (a) NO CALL. The Corporation shall not have the right to call for redemption all or any part of the Series B Preferred, Series C Preferred, Series D Preferred or Series E Preferred. (b) OPTION TO REQUIRE REDEMPTION. On or at any time after December 31, 2002, within sixty (60) days after the receipt by the Corporation of the written request (a "Redemption Notice") by one or more holders of shares of Series B Preferred, Series C Preferred, Series D Preferred or Series E Preferred (the "Requesting Holders"), together with the written approval of the holders of not less than two-thirds of the Series B Preferred then outstanding if any shares of Series B Preferred are to be redeemed, and with the written approval of not less than two-thirds of the Series C Preferred then outstanding if any shares of Series C Preferred are to be redeemed, and with the written approval of not less than two-thirds of the Series D Preferred then outstanding if any shares of Series D Preferred are to be redeemed, and with the written approval of not less than two-thirds of the Series E Preferred then outstanding if any shares of Series E Preferred are to be redeemed (each series for which such approval is granted being hereinafter referred to as an "Approved Series"), the Corporation shall, to the extent it may lawfully do so, redeem the number of whole shares of each Approved Series most nearly equal to one-third of the shares specified in the Redemption Notice by paying therefor in cash the Series B Redemption Price, Series C Redemption Price, Series D Redemption Price, or Series E Redemption Price (each as defined below), as appropriate. The date of this payment shall be referred to as an "Initial Redemption Date." The remaining shares of each Approved Series specified in the Redemption Notice shall be redeemed in two (2) additional equal installments (or, if such number of shares is not evenly divisible by two, then the first such installment shall be rounded to the nearest whole number of shares) on an annual basis in a similar manner, beginning one (1) year from the Initial Redemption Date, with all remaining shares of each Approved Series specified in the Redemption Notice being purchased on the second anniversary of the Initial Redemption Date (the "Initial Redemption Date" and each of the two following redemption dates shall be referred to as a "Redemption Date"). The Corporation shall effect any redemption pursuant to this Section 5.5 on a pro rata basis according to the aggregate amounts which would be received upon redemption by each Requesting Holder. (c) REDEMPTION PRICE. The redemption price to be paid by the Corporation shall be $0.67 per share, in the case of the Series B Preferred (as 24 25 adjusted to reflect subsequent stock dividends, stock splits or recapitalizations), $1.9634, in the case of the Series C Preferred (as adjusted to reflect subsequent stock dividends, stock splits or recapitalizations), $7.53 in the case of the Series D Preferred (as adjusted to reflect subsequent stock dividends, stock splits or recapitalizations) and $8.99, in the case of the Series E Preferred (as adjusted to reflect subsequent stock dividends, stock splits or recapitalizations) (in each case, the "Issue Price"), in each case plus: (i) all declared but unpaid dividends thereon as of the Initial Redemption Date, and (ii) an amount per share equal to the percentage increase (if any) in the Implicit Price Deflator for Gross Domestic Product, as published by the United States Department of Commerce, Economics and Statistics Administration, Bureau of Economic Analysis, or any successor thereto (1987 = 100), from the date of the original issuance of the share to the date of the Corporation's receipt of the Redemption Notice multiplied by the applicable Issue Price (such totals are referred to as the "Series B Redemption Price," the "Series C Redemption Price," the "Series D Redemption Price," and the "Series E Redemption Price," respectively). (d) NOTICE OF REDEMPTION. Within ten (10) days of the Corporation's receipt of a Redemption Notice and the related written approval of the holders of two-thirds of the then outstanding shares of each Approved Series, the Corporation shall deliver (by (i) personal delivery; (ii) certified or registered mail, postage prepaid; or (iii) to the extent receipt is confirmed, by telecopy, telefax or other electronic transmission service) written notice to each holder of Series B Preferred, Series C Preferred, Series D Preferred or Series E Preferred who did not approve the Redemption Notice, at the address of such holder last shown on the records of the Corporation for the purpose of notice or, if no such address appears or is given, at the place where the principal executive office of the Corporation is located, identifying each Requesting Holder and specifying the number of shares to be redeemed by such holder. If, within ten (10) days of receiving such notice, the holders of Series B Preferred, Series C Preferred, Series D Preferred or Series E Preferred who did not approve the Redemption Notice give written notice to the Corporation of their wish to have any of their shares of Series B Preferred, Series C Preferred, Series D Preferred or Series E Preferred redeemed simultaneously with the redemption of the Requesting Holders, such holders shall become Requesting Holders for purposes of such redemption. (e) SURRENDER OF CERTIFICATES. On the Initial Redemption Date, each Requesting Holder shall surrender to the Corporation the certificate or certificates representing the number of shares of Series B Preferred, Series C Preferred, Series D Preferred and Series E Preferred specified in the Redemption Notice or pursuant to Section 5.5(d). Simultaneously, the Corporation shall pay one-third of the Series B Redemption Price, the Series C Redemption Price, the Series D Redemption Price or the Series E Redemption Price (as applicable) of such shares to be redeemed on that date to the order of the person whose name appears on such certificate or certificates as the owner thereof and each surrendered certificate shall be canceled. In the event that less than all the shares represented by any such certificate are to be redeemed pursuant to the Redemption Notice, a new certificate shall be issued representing the shares not subject to redemption and delivered to the Requesting Holder. In the event that less than all the shares represented by any such certificate have been redeemed on a Redemption Date, a new certificate shall be issued representing the shares not redeemed and such certificate shall be retained by the Corporation for cancellation on the next Redemption Date(s). 25 26 (f) STATUS OF SHARES SPECIFIED IN THE REDEMPTION NOTICE. From and after the Initial Redemption Date, unless there has been a default in payment of the Series B Redemption Price, the Series C Redemption Price, the Series D Redemption Price or the Series E Redemption Price, all rights of the Requesting Holders with respect to the shares of Series B Preferred, Series C Preferred, Series D Preferred or Series E Preferred specified in the Redemption Notice (except the right to receive the Series B Redemption Price, the Series C Redemption Price, the Series D Redemption Price or the Series E Redemption Price) shall cease with respect to such shares, and such shares shall not thereafter be transferred on the books of the Corporation or be deemed to be outstanding for any purpose whatsoever. If the funds of the Corporation legally available for redemption of such shares on any Redemption Date are insufficient to redeem the total number of shares of Series B Preferred, Series C Preferred, Series D Preferred or Series E Preferred to be redeemed on such date, those funds which are legally available shall be used to redeem the maximum possible number of such shares, and the shares of Series B Preferred, Series C Preferred, Series D Preferred and Series E Preferred not redeemed shall be deemed to be outstanding and shall be entitled to all the rights and preferences provided herein. At any time thereafter when additional funds of the Corporation are legally available for the redemption of such shares, such funds will immediately be used to redeem the balance of the shares that the Corporation has become obligated to redeem on any Redemption Date but that it has not redeemed. (g) PARTIAL REVOCATION OF REDEMPTION NOTICE. Notwithstanding any provision in this Section 5.5 to the contrary, if, after the Initial Redemption Date, while a Requesting Holder has not yet received in full the Series B Redemption Price, the Series C Redemption Price, the Series D Redemption Price or the Series E Redemption Price, as applicable, for all shares specified in his/her/its Redemption Notice (the shares for which the applicable redemption price has not been received shall be referred to as the "Shares Being Redeemed"), the Corporation enters into any transaction described in Section 5.2(d) in which the Requesting Holder would have received an amount per share, in cash or securities of another corporation or corporations, greater than the Series B Redemption Price, the Series C Redemption Price, the Series D Redemption Price or the Series E Redemption Price, as applicable, for the Shares Being Redeemed had the shares not been the subject of the Redemption Notice, the Corporation shall notify the Requesting Holder in writing of such transaction, in accordance with Section 5.4(h), as if his/her/its rights with respect to the Shares Being Redeemed had not terminated in accordance with Section 5.5, and if, within seven (7) days of receipt of such notice, the Requesting Holder delivers written notice to the Corporation of his/her/its election to convert the Shares Being Redeemed into Common Stock, such shares shall be converted to Common Stock in accordance with Section 5.4 and simultaneously the Requesting Holder's right to receive the applicable redemption price for the Shares Being Redeemed shall terminate. 5.6 COVENANTS. (a) SERIES A PREFERRED, SERIES B PREFERRED, SERIES C PREFERRED AND SERIES D PREFERRED. In addition to any other rights provided by law, this Corporation shall not, without first obtaining the affirmative vote or written consent of the holders of not less than a majority of 26 27 the outstanding shares of Series A Preferred, Series B Preferred, Series C Preferred and Series D Preferred, voting as a single voting group: (i) amend or repeal any provision of, or add any provision to, the Corporation's Articles of Incorporation if such action would alter or change the preferences, rights, or privileges of the Series A Preferred, Series B Preferred, Series C Preferred or Series D Preferred; (ii) increase or decrease the authorized number of shares of Series A Preferred, Series B Preferred, Series C Preferred, Series D Preferred or Common Stock; (iii) authorize, create or issue any shares of (A) Preferred Stock or securities convertible into Common Stock equal or senior to the Series A Preferred, Series B Preferred, Series C Preferred or Series D Preferred as to dividends, conversion rights, redemption rights or liquidation preference or (B) Common Stock equal or senior to the Series D Preferred as to redemption rights or liquidation preference or senior to the Series D Preferred as to dividends or voting rights (other than shares issuable upon exercise of the Series C Preferred Stock Warrants issued pursuant to the Series C Preferred Stock Purchase Agreement dated October 25, 1995 or the Series D Preferred Stock Purchase Warrants issued pursuant to the Series D Preferred Stock Purchase Agreement dated November 19, 1996); (iv) merge or consolidate with one or more other corporations if, after such merger or consolidation, the stockholders of the Corporation would hold stock representing less than a majority of the voting power of the outstanding stock of the surviving corporation; or (v) declare or pay any dividend on the Common Stock. (b) SERIES D PREFERRED. In addition to any other rights provided by law, this Corporation shall not, without first obtaining the affirmative vote or written consent of the holders of not less than Sixty-Six and Two-Thirds Percent (66_%) of the outstanding shares of Series D Preferred: (i) amend or repeal any provision of, or add any provision to, the Corporation's Articles of Incorporation if such action would adversely alter or change the preferences, rights, or privileges of the Series D Preferred; (ii) increase the authorized number of shares of Series D Preferred; (iii) authorize, create or issue any shares of (A) Preferred Stock or securities convertible into Common Stock equal or senior to the Series D Preferred as to dividends, conversion rights, redemption rights or liquidation preference or (B) Common Stock equal or senior to the Series D Preferred as to redemption rights or liquidation preference or senior to the Series D Preferred as to dividends or voting rights (other than shares issuable upon exercise of the Series C Preferred Stock Warrants issued pursuant to the Series C Preferred Stock Purchase 27 28 Agreement dated October 25, 1995 or the Series D Preferred Stock Purchase Warrants issued pursuant to the Series D Preferred Stock Purchase Agreement dated November 19, 1996); or (iv) declare or pay any dividend. 28 29 ARTICLE VI DIRECTORS 6.1 NUMBER OF DIRECTORS. 6.1.1 The number of directors of the Corporation shall be fixed as provided in the Bylaws and may be changed from time to time by amending the Bylaws. 6.1.2 When the Board of Directors shall consist of four or more members, the directors shall be divided into three classes: Class 1, Class 2 and Class 3. Such classes shall be as nearly equal in number of directors as possible. Except as provided in Section 6.1.4, each director shall serve for a term ending at the third annual meeting of shareholders following the director's election; provided, that the director or directors first elected to Class 1 shall serve for a term ending at the first annual meeting of shareholders following such election, the director or directors first elected to Class 2 shall serve for a term ending at the second annual meeting of shareholders following such election, and the director or directors first elected to Class 3 shall serve for a term ending at the third annual meeting of shareholders following such election. 6.1.3 At each annual meeting of shareholders, the directors nominated to succeed those whose terms then expire shall be identified as being of the same class as the directors they succeed unless, by reason of any intervening changes in the authorized number of directors, the Board of Directors shall designate one or more directorships whose terms then expire as directorships of another class in order more nearly to achieve equality in the number of directors in the respective classes. When the Board of Directors fills a vacancy resulting from the death, resignation or removal of a director, the director chosen to fill that vacancy shall be of the same class as the director he succeeds. 6.1.4 Notwithstanding the foregoing provisions of this Section 6.1, in all cases, including upon any change in the authorized number of directors, each director then continuing to serve as such will nevertheless continue as a director of the class of which he is a member until the expiration of his or her term or his or her earlier death, resignation or removal. Any vacancy in any class resulting from the death, resignation or removal of a director or an increase in the number of authorized directors may be filled by the directors in any manner permitted by the Act; provided, if the term of the director or directors in that class is not scheduled to expire at the next annual meeting of shareholders, the term of the director chosen to fill such vacancy shall continue only until the next annual meeting of shareholders at which a successor shall be chosen for a term to expire at the scheduled date for expiration of the term of the director or directors in that class. 6.1.5 If a Qualified Public Offering does not occur on or prior to January 31, 1998, then the provisions of Sections 6.1.2 through 6.1.4 shall automatically cease to apply, and each director then in office shall continue in office, without class designation, until the next annual meeting of shareholders or until his or her earlier death, resignation or removal. 29 30 6.2 REMOVAL. 6.2.1 Any director or the entire Board of Directors may be removed with or without cause by the holders of not less than a majority of the shares then entitled to vote at an election of directors; provided, that, following a Qualified Public Offering, no director may be removed without "cause," as defined below. Action to remove a director may be taken at any annual or special meeting of the shareholders of this Corporation, provided that notice of the proposed removal, which shall include a statement of the charges alleged against the director in the event of removal for cause, shall have been duly given to the shareholders together with or as a part of the notice of the meeting. 6.2.2 Where a proposal to remove a director for cause is to be presented for shareholder consideration following a Qualified Public Offering, an opportunity shall be provided the director to present the director's defense to the shareholders in a statement to accompany or precede the notice of the meeting at which such proposal is to be presented. The director shall also be served with notice of the meeting at which such proposal is to be presented, together with a statement of the specific charges alleged against the director, and shall be given an opportunity to be present and to be heard at the meeting. 6.2.3 For purposes of this Section 6.2, "cause" for removal shall be limited to (a) action by a director involving willful malfeasance having a material adverse effect on the Corporation and (b) conviction of a director of a felony; provided, that action by a director shall not constitute "cause" if, in good faith, the director believed such action to be in or not opposed to the best interests of the Corporation, or if the director is entitled, under applicable law or the Articles of Incorporation or Bylaws of this Corporation, to be indemnified with respect to such action. 6.3 AUTHORITY OF BOARD OF DIRECTORS TO AMEND BYLAWS. Subject to the limitation(s) of RCW 23B.10.210, and subject to the power of the shareholders of the Corporation to change or repeal the Bylaws, the Board of Directors is expressly authorized to make, amend, or repeal the Bylaws of the Corporation unless the shareholders in amending or repealing a particular bylaw provide expressly that the Board of Directors may not amend or repeal that bylaw. 6.4 CONTRACTS WITH INTERESTED DIRECTORS. Subject to the limitations set forth in RCW 23B.08.700 through 23B.08.730: 6.4.1 The Corporation may enter into contracts and otherwise transact business as vendor, purchaser, lender, borrower, or otherwise with its directors and with corporations, associations, firms, and entities in which they are or may be or become interested as directors, officers, shareholders, members, or otherwise. 6.4.2 Any such contract or transaction shall not be affected or invalidated or give rise to liability by reason of the director's having an interest in the contract or transaction. 30 31 6.5 INDEMNIFICATION OF DIRECTORS, OFFICERS, EMPLOYEES AND AGENTS. 6.5.1 The capitalized terms in this Section 6.5 shall have the meanings set forth in RCW 23B.08.500. 6.5.2 The Corporation shall indemnify and hold harmless each individual who is or was serving as a Director or officer of the Corporation or who, while serving as a Director or officer of the Corporation, is or was serving at the request of the Corporation as a director, officer, partner, trustee, employee, or agent of another foreign or domestic corporation, partnership, joint venture, trust, employee benefit plan, or other enterprise, against any and all Liability incurred with respect to any Proceeding to which the individual is or is threatened to be made a Party because of such service, and shall make advances of reasonable Expenses with respect to such Proceeding, to the fullest extent permitted by law, without regard to the limitations in RCW 23B.08.510 through 23B.08.550; provided that no such indemnity shall indemnify any Director or officer from or on account of (1) acts or omissions of the Director or officer finally adjudged to be intentional misconduct or a knowing violation of law; (2) conduct of the Director or officer finally adjudged to be in violation of RCW 23B.08.310; or (3) any transaction with respect to which it was finally adjudged that such Director or officer personally received a benefit in money, property, or services to which the Director or officer was not legally entitled. 6.5.3 The Corporation may purchase and maintain insurance on behalf of an individual who is or was a Director, officer, employee, or agent of the Corporation or, who, while a Director, officer, employee, or agent of the Corporation, is or was serving at the request of the Corporation as a director, officer, partner, trustee, employee, or agent of another foreign or domestic corporation, partnership, joint venture, trust, employee benefit plan, or other enterprise against Liability asserted against or incurred by the individual in that capacity or arising from the individual's status as a Director, officer, employee, or agent, whether or not the Corporation would have power to indemnify the individual against such Liability under RCW 23B.08.510 or 23B.08.520. 6.5.4 If, after the effective date of this Section 6.5, the Act is amended to authorize further indemnification of Directors or officers, then Directors and officers of the Corporation shall be indemnified to the fullest extent permitted by the Act as so amended. 6.5.5 To the extent permitted by law, the rights to indemnification and advance of reasonable Expenses conferred in this Section 6.5 shall not be exclusive of any other right which any individual may have or hereafter acquire under any statute, provision of the Bylaws, agreement, vote of shareholders or disinterested Directors, or otherwise. The right to indemnification conferred in this Section 6.5 shall be a contract right upon which each Director or officer shall be presumed to have relied in determining to serve or to continue to serve as such. Any amendment to or repeal of this Section 6.5 shall not adversely affect any right or protection of a Director or officer of the Corporation for or with respect to any acts or omissions of such Director or officer occurring prior to such amendment or repeal. 31 32 6.5.6 If any provision of this Section 6.5 or any application thereof shall be invalid, unenforceable, or contrary to applicable law, the remainder of this Section 6.5, and the application of such provisions to individuals or circumstances other than those as to which it is held invalid, unenforceable, or contrary to applicable law, shall not be affected thereby. 6.6 LIMITATION OF DIRECTORS' LIABILITY. To the fullest extent permitted by the Act, as it exists on the date hereof or may hereafter be amended, a director of this Corporation shall not be personally liable to the Corporation or its shareholders for monetary damages for conduct as a director. Any amendment to or repeal of this Section 6.6 shall not adversely affect a director of this Corporation with respect to any conduct of such director occurring prior to such amendment or repeal. ARTICLE VII OTHER MATTERS 7.1 CERTAIN CORPORATE GOVERNANCE MATTERS. At all times following the closing of a Qualified Public Offering, the following provisions will apply: 7.1.1 STRATEGIC TRANSACTIONS COMMITTEE. (a) MEMBERS. There shall be a Strategic Transactions Committee (the "Committee") of the Board of Directors which shall consist of three (3) directors. The members of the initial Committee shall be Robert Glaser, the Corporation's Founder, James Breyer and Mitchell Kapor. A member of the Committee shall automatically cease to be a member of the Committee upon the earlier of: (i) his or her death, resignation or removal as a director, or (ii) at the option of the Chairman of the Committee, his or her ceasing to hold or control, directly or indirectly, at least five percent (5%) of the outstanding shares of capital stock of the Corporation. Neither the Board of Directors nor the shareholders shall have any authority to remove any member of the Committee or to otherwise reconstitute the Committee or its membership. (b) CHAIRMAN OF COMMITTEE. Mr. Glaser shall serve as Chairman of the Committee as long as he is a member of the Committee. At such time as Mr. Glaser is no longer a member of the Committee, the Committee shall select one of its members as Chairman. (c) POWER OF COMMITTEE. Without the prior approval of the Committee, the Board of Directors of the Corporation shall not have the power and authority to: (i) adopt a plan of merger, (ii) authorize the sale, lease, exchange or mortgage of (A) assets representing more than fifty percent (50%) of the book value of the Corporation's assets prior to the transaction, or (B) any other asset or assets on which the long-term business strategy of the Corporation is substantially dependent, (iii) authorize the voluntary dissolution of the Corporation, or (iv) take any action that has the effect of clauses (i) through (iii) of this Section 7.1.1(c). 32 33 (d) MEETINGS AND NOTICE. The Committee shall meet from time to time on the call of its Chairman or of the other two members. Each meeting of the Committee shall be held at the date, time and place as may be designated in the notice of the meeting given by the person or persons authorized to call the meeting. Notice of the date, time and place of each meeting of the Committee shall be given to each member of the Committee in any manner permitted by the Act not less than one (1) day prior to the meeting; such notice need not state the purpose or purposes of the meeting. The Committee shall keep regular minutes of its meetings and proceedings. (E) QUORUM. At any meeting of the Committee, presence of the Chairman and at least one other member thereof shall constitute a quorum. The act of at least two (2) members of the Committee at a meeting at which a quorum is present shall be the act of the Committee. All action of the Committee shall be taken at a meeting of the Committee or as otherwise provided or allowed by law. (F) VACANCIES. Any vacancy on the Committee shall be filled by the remaining member or members of the Committee, regardless of whether or not a quorum. If two members of the Committee remain and they are unable to agree on an individual to fill the vacancy, the vacancy may be filled by the member who holds or controls, directly or indirectly, the larger percentage of the outstanding shares of capital stock of the Corporation. (G) TERMINATION OF COMMITTEE. The Committee, by vote of the Chairman of the Committee and one additional member, may limit the powers of the Committee or may terminate the Committee. The existence and powers of the Committee shall terminate when the members in the aggregate cease to hold or control, directly or indirectly, at least ten percent (10%) of the outstanding shares of capital stock of the Corporation. The Board of Directors shall have and succeed to any and all power and authority of the Committee that have been limited or eliminated as a result of actions taken pursuant to this Section 7.1.1(g). 7.1.2 POLICY OMBUDSMAN. Mr. Glaser shall serve, or shall appoint another officer of the Corporation who shall serve, as the Corporation's Policy Ombudsman. The Policy Ombudsman shall have exclusive responsibility for adopting or changing the editorial policies of the Corporation as reflected on the Corporation's Web sites or in other communications or media where the Corporation has a significant editorial or media voice. The Policy Ombudsman may be removed only by the unanimous approval of all members of the Board of Directors. Upon the death, resignation or removal of Mr. Glaser as the Policy Ombudsman, the Chief Executive Officer or another officer of the Corporation appointed by the Chief Executive Officer, shall serve as his or her successor. 7.1.3 AUTHORITY FOR SECTION 7.1. The provisions of this Section 7.1 are intended to modify the authority of the Board of Directors in a manner permitted by RCW 23B.08.010(3) and shall be construed consistent with that provision of the Act. Except as otherwise provided in these Articles of Incorporation, as amended from time to time, the Committee shall have all of the powers and authority of a committee of the Board of Directors created pursuant to RCW 23B.08.250. 33 34 7.1.4 AMENDMENT OF SECTION 7.1. Notwithstanding any provision of these Articles of Incorporation or the Corporation's Bylaws, as either may be amended from time to time by the Board of Directors or the shareholders of the Corporation, this Section 7.1 cannot be amended without the approval of the holders of ninety percent (90%) of the shares entitled to be voted on such proposed amendment(s). 7.2 AMENDMENTS TO ARTICLES OF INCORPORATION. Except as otherwise provided in these Articles of Incorporation, as amended from time to time, the Corporation reserves the right to amend, alter, change, or repeal any provisions contained in these Articles of Incorporation in any manner now or hereafter prescribed or permitted by statute. All rights of shareholders of the Corporation are subject to this reservation. A shareholder of the Corporation does not have a vested property right resulting from any provision of these Articles of Incorporation. 7.3 CORRECTION OF CLERICAL ERRORS. The Corporation shall have authority to correct clerical errors in any documents filed with the Secretary of State of Washington, including these Articles of Incorporation or any amendments hereto, without the necessity of special shareholder approval of such corrections. Executed this ___ day of October, 1997. -------------------------------------------- Mark Klebanoff, Chief Financial Officer 34 EX-4.1 4 SPECIMEN STOCK CERTIFICATE 1 EXHIBIT 4.1
- ----------------------------------------------------------------------------------------------------------------------------------- [NUMBER] [RealNetworks Logo] [SHARES] RN INCORPORATED UNDER THE LAWS OF SEE REVERSE FOR THE STATE OF WASHINGTON CERTAIN DEFINITIONS CUSIP 75605L 10 4 THIS IS TO CERTIFY THAT IS THE OWNER OF FULLY-PAID AND NON-ASSESSABLE SHARES OF THE COMMON STOCK, $.001 PAR VALUE, OF ________________________________________________________ RealNetworks, Inc. _______________________________________________________ (hereinafter called the "Corporation") transferable on the books of the Corporation by said owner person or by duly authorized attorney, upon surrender of this certificate properly endorsed. This certificate and the shares represented hereby are issued and shall be held subject to all the provisions of the Articles of Incorporation and all amendments thereto, and the Bylaws of the Corporation, as amended, copies of which are on file at the office of the Transfer Agent, and the holder hereof, by acceptance of this certificate, consents and agrees to be bound by all of said provisions. This certificate is not valid unless countersigned and registered by the Transfer Agent and Registrar. WITNESS the facsimile seal of the Corporation and the signatures of its duly authorized officers. Dated: [ S E A L ] /s/ ROBERT GLASER /s/ BRUCE JACOBSEN CHAIRMAN OF THE BOARD, PRESIDENT AND CHIEF EXECUTIVE OFFICER AND SECRETARY CHIEF OPERATING OFFICER COUNTERSIGNED AND REGISTERED: CHASEMELLON SHAREHOLDER SERVICES, L.L.C. TRANSFER AGENT AND REGISTRAR BY AUTHORIZED SIGNATURE
2 The Corporation will furnish without charge to any shareholder upon written request a statement of the designations, relative rights, preferences, and limitations applicable to each class of stock which the Corporation is authorized to issue, the variations in the rights, preferences, and limitations of the shares of each series of each such class of stock insofar as the same may have been fixed and determined, and the authority of the Board of Directors to determine variations for future series. The following abbreviations, when used in the inscription on the face of this certificate, shall be construed as though they were written out in full according to applicable laws or regulations:
TEN COM -- as tenants in common UNIF GIFT MIN ACT -- ............ Custodian ............... TEN ENT -- as tenants by the entireties (Cust) (Minor) JT TEN -- as joint tenants with right of survivorship and not as tenants under Uniform Gifts to Minors in common Act .................................. (State)
Additional abbreviations may also be used though not in the above list. FOR VALUE RECEIVED,___________________________hereby sell, assign and transfer unto PLEASE INSERT SOCIAL SECURITY OR OTHER IDENTIFYING NUMBER OF ASSIGNEE - -------------------------------------- - -------------------------------------- _______________________________________________________________________________ (PLEASE PRINT OR TYPEWRITE NAME AND ADDRESS, INCLUDING ZIP CODE, OF ASSIGNEE) _______________________________________________________________________________ _______________________________________________________________________________ ________________________________________________________________________ Shares of the capital stock represented by the within Certificate, and do hereby irrevocably constitute and appoint ______________________________________________________________________ Attorney to transfer the said stock on the books of the within named Corporation with full power of substitution in the premises. Dated________________________ _______________________________________________ _______________________________________________ THE SIGNATURE(S) TO THIS ASSIGNMENT MUST CORRESPOND WITH THE NAME(S) AS WRITTEN UPON THE NOTICE: FACE OF THE CERTIFICATE IN EVERY PARTICULAR, WITHOUT ALTERATION OR ENLARGEMENT OR ANY CHANGE WHATEVER. SIGNATURE(S) GUARANTEED By___________________________________ THE SIGNATURE(S) MUST BE GUARANTEED BY AN ELIGIBLE GUARANTOR INSTITUTION (BANKS, STOCKBROKERS, SAVINGS AND LOAN ASSOCIATIONS AND CREDIT UNIONS WITH MEMBERSHIP IN AN APPROVED SIGNATURE GUARANTEE MEDALLION PROGRAM), PURSUANT TO S.E.C. RULE 17Ad-15. EX-5.1 5 OPINION OF GRAHAM & JAMES LLP/RIDDELL WILLIAMS PS 1 EXHIBIT 5.1 [GRAHAM & JAMES LLP/RIDDELL WILLIAMS P.S. LETTERHEAD] October 30, 1997 RealNetworks, Inc. 1111 Third Avenue, Suite 2900 Seattle, WA 98101 RE: 3,450,000 SHARES OF COMMON STOCK OF REALNETWORKS, INC. Ladies and Gentlemen: We have acted as counsel for RealNetworks, Inc. (the "Company"), a Washington corporation, in connection with (i) the authorization and issuance of 3,000,000 shares of common stock of the Company, $.001 par value per share (the "Issuer Shares"), (ii) the sale of up to an additional 450,000 shares of common stock of the Company by the Company pursuant to an over-allotment option granted to the underwriters (the "Option Shares"), and (iii) the preparation of a Registration Statement on Form S-1 (the "Registration Statement") under the Securities Act of 1933, as amended. We have examined the Registration Statement and such other documents as we deem necessary for the purpose of this opinion. Based on the foregoing, we are of the opinion that: 1. The Issuer Shares will, upon due execution by the Company and the registration by its registrar of the certificates for such shares and issuance thereof by the Company and receipt by the Company of the consideration from the sale of such shares as contemplated by the Registration Statement, be duly authorized, validly issued, fully paid and non-assessable. 2. The Option Shares will, upon due execution by the Company and the registration by its registrar of the certificates for such shares and issuance thereof by the Company and receipt by the Company of the consideration from the sale of such shares as contemplated by the Registration Statement, be duly authorized, validly issued, fully paid and non-assessable. 2 RealNetworks, Inc. October 30, 1997 Page 2 We hereby consent to the filing of this opinion as an exhibit to the Registration Statement and to the reference to our firm in the Registration Statement under the caption "Legal Matters." Very truly yours, GRAHAM & JAMES LLP/RIDDELL WILLIAMS P.S. EX-10.20 6 AGRMNT TO TERMINATE SHAREHOLDERS' BUY-SELL AGRMNT 1 EXHIBIT 10.20 REALNETWORKS, INC. AGREEMENT TO TERMINATE SHAREHOLDERS' BUY-SELL AGREEMENT THIS AGREEMENT TO TERMINATE SHAREHOLDERS' BUY-SELL AGREEMENT (the "Termination Agreement") is entered into as of October ___, 1997, by and among RealNetworks, Inc., a Washington corporation formerly known as Progressive Networks, Inc. (the "Company"), Robert Glaser (the "Founder"), and the holders of shares of common stock (the "Shares") of the Company who have agreed in writing to be bound by the Shareholders' Buy-Sell Agreement dated as of March 31, 1995 (the Founder and the holders of the Shares are collectively referred to herein as the "Shareholders"). RECITALS A. The Company, the Founder and the holders of the Shares have entered into a Shareholders' Buy-Sell Agreement dated as of March 31, 1995 (the "Buy-Sell Agreement"), which Buy-Sell Agreement restricts the free transferability of the Shares. B. The Company has filed a Registration Statement on Form S-1 with the Securities and Exchange Commission. C. The Buy Sell Agreement may be terminated upon the written agreement of the Company and the Shareholders holding two-thirds (2/3) of the outstanding Shares of Capital Stock (as defined in Section 3.3.4 of the Buy-Sell Agreement). D. The Company and the Shareholders holding at least two-thirds (2/3) of the outstanding Shares of Capital Stock desire to terminate the Agreement immediately prior to the Registration Statement being declared effective by the SEC. AGREEMENT 1. TERMINATION OF BUY-SELL AGREEMENT. Effective immediately prior to the effectiveness of a firm commitment underwritten public offering pursuant to an effective registration statement under the Securities Act of 1933, as amended, covering the offer and sale of the Company's capital stock for the account of the Company to the public with aggregate proceeds to the Company of not less than $20,000,000 (prior to deduction of underwriter commissions and offering expenses), the Buy-Sell Agreement shall be terminated in its entirety. 2. NOTICE. Within fifteen (15) days after the termination of the Buy-Sell Agreement, the Company shall give written notice of such termination to each of the Shareholders by delivering such notice in person, or by depositing such notice in the United States mail, first 2 class, postage prepaid, addressed to each Shareholder at the last address provided to the Company by each such Shareholder. IN WITNESS WHEREOF, the parties have executed this Agreement effective as of the date first written above. COMPANY: REALNETWORKS, INC. By________________________________________ Its_______________________________________ FOUNDER: __________________________________________ Robert Glaser EX-10.21 7 FORM OF LICENSE AGREEMENT FOR THE REALPLAYER PLUS 1 EXHIBIT 10.21 LICENSE AGREEMENT FOR THE REALPLAYER PLUS IMPORTANT -- READ CAREFULLY: By clicking on the "I Accept" button or by opening the sealed packet(s) to make and utilize copies of the RealPlayer Plus and accompanying software ("Software") Licensee agrees to be and is hereby bound by the terms of this License Agreement ("License Agreement"). If Licensee does not agree to the terms of this License Agreement, Licensee must promptly destroy all copies of the Software and accompanying documentation ("Documentation") and obtain a full refund of any fees paid from RealNetworks Inc. I. GRANT OF LICENSE: RealNetworks Inc. and it's suppliers and licensors (collectively "RN") hereby grants to Licensee a non-exclusive license to use the Software and Documentation subject to the following terms: Licensee may: (i) use the Software on any single computer; (ii) use the Software on a second computer so long as the first and second computers are not used simultaneously; (iii) copy the Software for back-up, archival purposes provided any copy must contain all of the original Software's proprietary notices. Licensee may not: (i) permit other individuals to use the Software except under the terms listed above; (ii) modify, translate, reverse engineer, decompile, disassemble (except to the extent that this restriction is expressly prohibited by law) or create derivative works based upon the Software or Documentation; (iii) copy the Software or Documentation (except for back-up purposes); (iv) rent, lease, transfer, or otherwise transfer rights to the Software or Documentation; or (v) remove any proprietary notices or labels on the Software or Documentation. II. SOFTWARE: If Licensee receives the first copy of the Software electronically and a second copy on media the second copy may be used for archival purposes only and may not be transferred to or used by any other person. This license does not grant Licensee any right to any enhancement or update. III. TITLE: Title, ownership, rights, and intellectual property rights in and to the Software and Documentation shall remain in RN and/or its suppliers. The Software is protected by the copyright laws of the United States and international copyright treaties. Title, ownership rights and intellectual property rights in and to the content accessed through the Software including the content contained in the Software media demonstration files shall be retained by the applicable content owner and may be protected by applicable copyright or other law. This license gives Licensee no rights to such content. IV. LIMITED WARRANTY: RN warrants that for a period of ninety (90) days from the date of acquisition the Software if operated as directed will substantially achieve the functionality described in the Documentation. RN does not warrant however that Licensee's use of the Software will be uninterrupted or that the operation of the Software will be error-free or secure. RN also warrants that the media containing the Software if provided by RN is free from defects in material and workmanship and will so remain for ninety (90) days from the date Licensee acquires the Software. NO OTHER WARRANTIES: TO THE MAXIMUM EXTENT PERMITTED BY APPLICABLE LAW RN AND ITS SUPPLIERS DISCLAIM ALL OTHER WARRANTIES EITHER EXPRESS OR IMPLIED INCLUDING BUT NOT LIMITED TO IMPLIED WARRANTIES OF MERCHANTIBILITY AND FITNESS FOR A PARTICULAR PURPOSE WITH REGARD TO THE SOFTWARE THE ACCOMPANYING WRITTEN MATERIALS AND ANY ACCOMPANYING HARDWARE. If any modifications are made to the Software by Licensee during the warranty period; if the media is subjected to accident abuse or improper use; or if Licensee violates the terms of this License Agreement, this warranty shall immediately terminate. This warranty shall not apply if the Software is used on or in conjunction with hardware or software other than the unmodified version of hardware and software with which the Software was designed to be used as described in the Documentation. THIS LIMITED WARRANTY GIVES LICENSEE SPECIFIC LEGAL RIGHTS. LICENSEE MAY HAVE OTHERS WHICH VARY FROM STATE/JURISDICTION TO STATE/JURISDICTION. V. CUSTOMER REMEDIES: RN's sole liability for any breach of this warranty shall be in RN's sole discretion: (i) to replace Licensee's defective media; or (ii) to advise Licensee how to achieve substantially the same functionality with the Software as described in the Documentation through a procedure different from that set forth in the Documentation; or (iii) if the above remedies are impracticable, to refund the license fee, if any, Licensee paid for the Software. RealPlayer Plus 5.0 License Pub. Date (10-6-97) 2 Repaired, corrected or replaced Software and Documentation shall be covered by this limited warranty for the period remaining under the warranty that covered the original Software or if longer for thirty (30) days after the date RN either shipped to Licensee the repaired or replaced Software or advised Licensee as to how to operate the Software so as to achieve the functionality described in the Documentation, whichever is applicable. Only if Licensee informs RN of the problem with the Software during the applicable warranty period and provides evidence of the date Licensee acquired the Software will RN be obligated to honor this warranty. VI. LIMITATION OF LIABILITY: UNDER NO CIRCUMSTANCES AND UNDER NO LEGAL THEORY WHETHER IN TORT CONTRACT OR OTHERWISE SHALL RN OR ITS SUPPLIERS OR RESELLERS BE LIABLE TO LICENSEE OR ANY OTHER PERSON FOR ANY INDIRECT, SPECIAL, INCIDENTAL OR CONSEQUENTIAL DAMAGES OF ANY CHARACTER INCLUDING WITHOUT LIMITATION DAMAGES FOR LOSS OF GOODWILL, WORK STOPPAGE, COMPUTER FAILURE OR MALFUNCTION OR ANY AND ALL OTHER COMMERCIAL DAMAGES OR LOSSES EVEN IF RN SHALL HAVE BEEN INFORMED OF THE POSSIBILITY OF SUCH DAMAGES OR FOR ANY CLAIM BY ANY OTHER PARTY. FURTHER, IN NO EVENT SHALL RN'S LIABILITY UNDER ANY PROVISION OF THIS AGREEMENT EXCEED THE LICENSE FEE PAID TO RN FOR THE SOFTWARE AND DOCUMENTATION. BECAUSE SOME STATES/JURISDICTIONS DO NOT ALLOW THE EXCLUSION OR LIMITATION OF LIABILITY FOR CONSEQUENTIAL OR INCIDENTAL DAMAGES, THE ABOVE LIMITATION MAY NOT APPLY TO LICENSEE. VII. INDEMNIFICATION Licensee represents and warrants that it will utilize the "Selective Record" feature only for data or content for which Licensee has obtained all necessary clearances and permissions, or for which the owner of such data or content has expressly granted permission to record in writing adjacent to such data or content on the owner's website. Licensee assumes the entire risk resulting from its breach of this warranty and agrees to hold harmless, indemnify, and defend RN its officers, directors, and employees from and against any losses, damages, fines and expenses (including attorneys' fees and costs) arising out of or relating to any claims that the Licensee has recorded and/or transmitted materials in violation of another party's rights. VIII. TERMINATION: This License Agreement shall terminate automatically if Licensee fails to comply with the limitations described in this license. No notice shall be required from RN to effectuate such termination. On termination Licensee must destroy all copies of the Software and Documentation. IX. U.S. GOVERNMENT RESTRICTED RIGHTS AND EXPORT RESTRICTIONS: The Software is provided with RESTRICTED RIGHTS. Use, duplication, or disclosure by the Government is subject to restrictions as set forth in subparagraph (c)(1)(ii) of The Rights in Technical Data and Computer Software clause of DFARS 252.227-7013 or subparagraphs (c)(i) and (2) of the Commercial Computer Software-Restricted Rights at 48 CFR 52.227-19, as applicable. Manufacturer is RealNetworks, 1111 Third Avenue, Suite 2900, Seattle, Washington 98101. Licensee acknowledges that none of the Software or underlying information or technology may be downloaded or otherwise exported or re-exported into (or to a national or resident of) Angola, Cuba, Iran, Iraq, Libya,North Korea, Sudan, Syria, or any other country to which the U.S. has embargoed goods; or anyone on the U.S. Treasury Department's list of Specially Designated Nationals or the U.S. Commerce Department's Table of Denial Orders. By using the Software, Licensee is agreeing to the foregoing, and is representing and warranting that it is not located in or under the control of a national or resident of any such country or on any such list. X. GOVERNING LAW: This License Agreement shall be governed by the laws of the State of Washington, without regard to conflicts of law provisions, and Recipient consents to the exclusive jurisdiction of the state and federal courts sitting in the State of Washington. Any and all unresolved disputes arising under this License Agreement shall be submitted to arbitration in the State of Washington. The arbitration shall be conducted under the rules then prevailing of the American Arbitration Association. The award of the arbitrator shall be binding and may be entered as a judgment in any court of competent jurisdiction. This License Agreement will not be governed by the United Nations Convention of Contracts for the International Sale of Goods, the application of which is hereby expressly excluded. XI. ENTIRE AGREEMENT: This License Agreement constitutes the complete and exclusive agreement between RN and Licensee with respect to the subject matter hereof and supersedes all prior oral or written understandings, communications or agreements not specifically incorporated herein. This License Agreement may not be modified except in a writing duly signed by an authorized representative of RN and Licensee. THE ACCEPTANCE OF ANY PURCHASE ORDER PLACED BY LICENSEE IS EXPRESSLY MADE CONDITIONAL ON THE CONSENT OFLICENSEE TO THE TERMS SET FORTH HEREIN. RealPlayer Plus 5.0 License Pub. Date (10-6-97) EX-23.2 8 CONSENT OF KPMG PEAT MARWICK LLP 1 EXHIBIT 23.2 REPORT AND CONSENT OF INDEPENDENT AUDITORS The Board of Directors RealNetworks, Inc.: The audits referred to in our report dated October 10, 1997, except as to Note 9, which is as of October 30, 1997, included the related financial statement schedule for the period from February 9, 1994 (inception) to December 31, 1994, the years ended December 31, 1995 and 1996, and the nine months ended September 30, 1997 included in the registration statement on Form S-1 of RealNetworks, Inc. This financial statement schedule is the responsibility of the Company's management. Our responsibility is to express an opinion on this financial statement schedule based on our audits. In our opinion, such financial statement schedule, when considered in relation to the consolidated financial statements taken as a whole, presents fairly in all material respects the information set forth therein. We consent to the use of our reports and to the reference of our firm under the headings "Summary Consolidated Financial Data", "Selected Consolidated Financial Data" and "Experts" in the prospectus. KPMG Peat Marwick LLP Seattle, Washington October 31, 1997 -----END PRIVACY-ENHANCED MESSAGE-----