20-F 1 a14-9009_120f.htm 20-F

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 


 

FORM 20-F

 


 

(Mark One)

 

o

REGISTRATION STATEMENT PURSUANT TO SECTION 12(b) OR (g) OF THE SECURITIES EXCHANGE ACT OF 1934

 

 

OR

 

 

x

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2013

 

 

OR

 

 

o

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

 

For the transition period from                       to                        .

 

OR

 

 

o

SHELL COMPANY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

Date of event requiring this shell company report . . . . . . . . . . . . . . . . . . .

 

Commission file number: 001-34225

 


 

VIMICRO INTERNATIONAL CORPORATION

(Exact name of Registrant as specified in its charter)

 

N/A

(Translation of Registrant’s name into English)

 


 

Cayman Islands

(Jurisdiction of incorporation or organization)

 

16/F Shining Tower

No. 35 Xueyuan Road, Haidian District

Beijing 100191, People’s Republic of China

(Address of principal executive offices)

 

Jinming (Jimmy) Dong

Vimicro International Corporation

16/F Shining Tower

No. 35 Xueyuan Road, Haidian District

Beijing 100191, People’s Republic of China

Phone: (8610) 6894-8888

Facsimile: (8610) 6894-4075

(Name, Telephone, E-mail and/or Facsimile number and Address of Company Contact Person)

 


 

Securities registered or to be registered pursuant to Section 12(b) of the Act:

 

Title of each class

 

Name of each exchange on which registered

American depositary shares, each

representing four ordinary shares, par value

$0.0001 per share

 

The NASDAQ Stock Market LLC

 

 

 

Ordinary shares, par value $0.0001 per share*

 

The NASDAQ Stock Market LLC

 

* Not for trading, but only in connection with the listing of the American depositary shares

 

Securities registered or to be registered pursuant to Section 12(g) of the Act.

 

None

(Title of Class)

 



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Securities for which there is a reporting obligation pursuant to Section 15(d) of the Act.

 

None

(Title of Class)

 

Indicate the number of outstanding shares of each of the issuer’s classes of capital or common stock as of the close of the period covered by the annual report: As of December 31, 2013, 104,014,754 ordinary shares were outstanding.

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.

o Yes   x No

 

If this report is an annual or transition report, indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934.

o Yes   x No

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

x Yes   o No

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or such shorter period that the registrant was required to submit and post such files).

x Yes   o No

 

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

 

Large accelerated filer o

 

Accelerated filer o

 

Non-accelerated filer x

 

Indicate by check mark which basis of accounting the registrant has used to prepare the financial statements included in this filing:

 

US GAAP x

 

International Financial Reporting Standards as issued
by the International Accounting Standards Board
o

 

Other o

 

If “Other” has been checked in response to the previous question indicate by check mark which financial statement item the registrant has elected to follow.

o Item 17   o Item 18

 

If this is an annual report, indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

o Yes   x No

 

(APPLICABLE ONLY TO ISSUERS INVOLVED IN BANKRUPTCY PROCEEDINGS DURING THE PAST FIVE YEARS)

 

Indicate by check mark whether the registrant has filed all documents and reports required to be filed by Sections 12, 13 or 15(d) of the Securities Exchange Act of 1934 subsequent to the distribution of securities under a plan confirmed by a court.

 

o Yes   o No

 



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TABLE OF CONTENTS

 

 

 

Page

 

 

INTRODUCTION

2

 

 

PART I

 

6

 

 

 

ITEM 1.

IDENTITY OF DIRECTORS, SENIOR MANAGEMENT AND ADVISERS

6

ITEM 2.

OFFER STATISTICS AND EXPECTED TIMETABLE

6

ITEM 3.

KEY INFORMATION

6

ITEM 4.

INFORMATION ON THE COMPANY

29

ITEM 4A.

UNRESOLVED STAFF COMMENTS

52

ITEM 5.

OPERATING AND FINANCIAL REVIEW AND PROSPECTS

52

ITEM 6.

DIRECTORS, SENIOR MANAGEMENT AND EMPLOYEES

71

ITEM 7.

MAJOR SHAREHOLDERS AND RELATED PARTY TRANSACTIONS

80

ITEM 8.

FINANCIAL INFORMATION

82

ITEM 9.

THE OFFER AND LISTING

82

ITEM 10.

ADDITIONAL INFORMATION

83

ITEM 11.

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

94

ITEM 12.

DESCRIPTION OF SECURITIES OTHER THAN EQUITY SECURITIES

94

 

 

 

PART II

 

96

 

 

 

ITEM 13.

DEFAULTS, DIVIDEND ARREARAGES AND DELINQUENCIES

96

ITEM 14.

MATERIAL MODIFICATIONS TO THE RIGHTS OF SECURITY HOLDERS AND USE OF PROCEEDS

96

ITEM 15.

CONTROLS AND PROCEDURES

96

ITEM 16A.

AUDIT COMMITTEE FINANCIAL EXPERT

97

ITEM 16B.

CODE OF ETHICS

97

ITEM 16C.

PRINCIPAL ACCOUNTANT FEES AND SERVICES

97

ITEM 16D.

EXEMPTIONS FROM THE LISTING STANDARDS FOR AUDIT COMMITTEES

98

ITEM 16E.

PURCHASES OF EQUITY SECURITIES BY THE ISSUER AND AFFILIATED PURCHASERS

98

ITEM 16F.

CHANGE IN REGISTRANT’S CERTIFYING ACCOUNTANT

98

ITEM 16G.

CORPORATE GOVERNANCE

98

ITEM 16H.

MINE SAFETY DISCLOSURE

99

 

 

 

PART III

 

99

 

 

 

ITEM 17.

FINANCIAL STATEMENTS

99

ITEM 18.

FINANCIAL STATEMENTS

99

ITEM 19.

EXHIBITS

99

 

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INTRODUCTION

 

Unless otherwise indicated, “we,” “us,” “our company,” “our,” and “Vimicro” refer to Vimicro International Corporation, its predecessor entities and subsidiaries. Unless otherwise indicated, references in this annual report on Form 20-F to,

 

·                                          “Viewtel” are to Viewtel Corporation, a wholly-owned subsidiary of Vimicro China;

 

·                                          “Vimicro Beijing” are to Vimicro Electronic Technology Corporation, a wholly-owned subsidiary of Vimicro China;

 

·                                          “Vimicro China” are to Vimicro Corporation, our wholly-owned subsidiary;

 

·                                          “Vimicro Guangdong” are to Vimicro Guangdong Corporation, a wholly-owned subsidiary of Vimicro China;

 

·                                          “Vimicro Fuzhou” are to Vimicro Fuzhou Corporation, a wholly-owned subsidiary of Vimicro China;

 

·                                          “Vimicro Guiyang” are to Vimicro Guiyang Corporation, a wholly-owned subsidiary of Vimicro Tianjin;

 

·                                          “Vimicro Hong Kong” are to Vimicro Electronics International Limited, a wholly-owned subsidiary of Vimicro China;

 

·                                          “Vimicro Jiangsu” are to Jiangsu Vimicro Electronics Corporation, a wholly-owned subsidiary of Vimicro Beijing;

 

·                                          “Vimicro Qingdao” are to Qingdao Vimicro Corporation, a company in which Vimicro China effectively holds a 18.03% equity interest;

 

·                                          “Vimicro Shanghai” are to Vimicro High-Tech Corporation, a wholly-owned subsidiary of Vimicro which we disposed of in 2012;

 

·                                          “Vimicro Shenzhen” are to Vimicro Technology Corporation, a wholly-owned subsidiary of Vimicro which we disposed of in 2013;

 

·                                          “Vimicro Sky-Vision” are to Vimicro Sky-Vision Technology Corporation, our variable interest entity, or VIE;

 

·                                          “Vimicro Tianjin” are to Vimicro Electronics Corporation, a company in which Vimicro China holds a 49.99% equity interest;

 

·                                          “Visiondigi” are to Shanghai Visiondigi Technology Co. Ltd, in which we beneficially own 12.03% of equity interest. See “Item 4. Information on the Company - A. History and Development of the Company - Our Recent Corporate Developments;” and

 

·                                          “Zhongtianxin” are to Zhongtianxin Science and Technology Co., Ltd., a company, in which Vimicro China beneficially owns a 51% equity interest. We do not control Zhongtianxin and our investment in Zhongtianxin is accounted for using the equity method. See “Item 4. Information on the Company - A. History and Development of the Company - Our Recent Corporate Developments.”

 

The following chart sets forth our corporate structure as of April 23, 2014.

 

 

 

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In addition, references in this annual report on Form 20-F to,

 

·                                          “ADRs” are to the American depositary receipts that evidence our ADSs;

 

·                                          “ADSs” are to our American depositary shares, each of which represents four ordinary shares;

 

·                                          “China” or the “PRC” are to the People’s Republic of China, excluding, for the purpose of this annual report on Form 20-F only, Hong Kong, Macau and Taiwan;

 

·                                          “ordinary shares” are to our ordinary shares, par value $0.0001 per share;

 

·                                          “RMB” and Renminbi are to the legal currency of China; and

 

·                                          “U.S. dollars,” “$,” and “dollars” are to the legal currency of the United States.

 

This annual report on Form 20-F includes our audited consolidated financial statements for the years ended December 31, 2011, 2012 and 2013, and as of December 31, 2012 and 2013.

 

This annual report contains translations of certain Renminbi amounts into U.S. dollars at the rate of RMB6.0537 to $1.00, the noon buying rate in effect on December 31, 2013 in New York City for cable transfers of Renminbi as certified for customs purposes by the H.10 weekly statistical release of the Federal Reserve Board. We make no representation that the Renminbi or U.S. dollar amounts referred to in this annual report could have been or could be converted into U.S. dollars or Renminbi, as the case may be, at any particular rate or at all. See “Item 3. Key Information—D. Risk Factors—Risks Related to Doing Business in China—Future movements in exchange rates between the U.S. dollar and the RMB may have a material adverse effect on your investment.” On April 18, 2014, the noon buying rate was RMB6.2240 to $1.00.

 

We and certain shareholders of the company completed our initial public offering of 8,697,063 ADSs, each representing four of our ordinary shares on November 18, 2005. On November 15, 2005, we listed our ADSs on the NASDAQ Global Market under the symbol “VIMC.”

 

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GLOSSARY OF TECHNICAL TERMS

 

 

3G

third generation wireless network.

 

 

4G

fourth generation wireless network.

 

 

AAC

Advanced Audio Coding, a standardized lossy compression and encoding scheme for digital audio.

 

 

CMOS

Complementary Metal Oxide Semiconductor, a technology for constructing integrated circuits.

 

 

D1

one of the following video resolutions for TV specification: (i) 704x576 (TV PAL), (ii) 704x480 (TV NTSC), (iii) 720x576 (DVD-Video PAL) and (iv) 720x480 (DVD-Video NTSC).

 

 

DSP

digital signal processing, which is concerned with the representation of discrete time signals by a sequence of numbers or symbols and the processing of these signals.

 

 

DVR

digital video recorder, a consumer electronics device or application software that records video in a digital format to a disk drive, USB flash drive, SD memory card or other local or networked mass storage device.

 

 

DVS

digital video server, a computer based device (also called a “host”) dedicated to delivering analog video signals.

 

 

fabless

a semiconductor company that uses third-party foundries for all of its wafer fabrication requirements.

 

 

firmware

software stored in read-only memory (ROM) or programmable ROM (PROM). Firmware is easier to modify than hardware but more difficult to modify than software stored on disk. Firmware is often responsible for the behavior of a system when it is first switched on. A typical example of firmware would be a “monitor” program in a microcomputer that loads the full operating system from disk or from a network and then passes control to it.

 

 

IC

integrated circuit.

 

 

IP

internet protocol, which is the principal communications protocol in the internet protocol suite for relaying datagrams across network boundaries.

 

 

memory

a device that can store information for later retrieval.

 

 

micron

a term for micrometer, which is a unit of linear measure that equals one one-millionth (1/1,000,000) of a meter; there are 25.4 microns in one one-thousandth of an inch.

 

 

MIDI

Musical Instrument Digital Interface, an industry-standard protocol that enables electronic musical instruments, such as keyboard controllers, computers, and other electronic equipment, to communicate, control and synchronize with each other.

 

 

MPEG2

a standard for the generic coding of moving pictures and associated audio information.

 

 

MPEG4

a method of defining compression of audio and visual (AV) digital data.

 

 

NTSC

the National Television System Committee, an analog television system that is used in North America, South America (except Brazil, Argentina, Uruguay, and French Guiana), Burma, South Korea, Taiwan, Japan, the Philippines, and some Pacific island countries and territories.

 

 

NVR

network video recorder.

 

 

QFN

Quad Flat No leads, a type of chip package with a lead frame and wire bonding.

 

 

PAL

Phase Alternate Line, the dominant television standard in Europe.

 

 

RISC

reduced instruction set computer.

 

 

SD

secure digital, or SD, is a non-volatile memory card format developed by Matsushita, SanDisk, and Toshiba.

 

 

SVAC

Surveillance Digital Video Audio Coding, a Chinese standard under development for the video surveillance solutions market employing advanced audio video coding technology. Vimicro China is a co- founder of the SVAC Working Group with Ministry of Public Security.

 

 

SVR

super digital video recorder.

 

 

system-on- chip or SoC

a chip that incorporates functions usually performed by several different devices and therefore generally offers better performance and lower cost.

 

 

UAC

Universal Audio Class, Universal Serial Bus Device Class, a definition for Audio Devices.

 

 

UVC

Universal Video Class, short-wave ultraviolet radiation, in the “C” band (200 to 280 nanometers), mainly support Windows XP (with Service Pack 2) and Vista.

 

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ViSS

Video Surveillance System, a video surveillance solution originally developed by Alcatel-Lucent Shanghai Bell Co., Ltd., or ASB, addressing the needs of telecom operators and local governments in China.

 

 

wafer

a thin, round, flat piece of silicon on which integrated circuits are etched.

 

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PART I

 

ITEM 1.                         IDENTITY OF DIRECTORS, SENIOR MANAGEMENT AND ADVISERS

 

Not Applicable.

 

ITEM 2.                         OFFER STATISTICS AND EXPECTED TIMETABLE

 

Not Applicable.

 

ITEM 3.                         KEY INFORMATION

 

A.                                    Selected Financial Data

 

Selected Consolidated Financial Data

 

The following selected consolidated statement of operations data for the three years ended December 31, 2011, 2012 and 2013 and the selected consolidated balance sheet data as of December 31, 2012 and 2013 have been derived from our audited consolidated financial statements, which are included in “Item 18. Financial Statements” in this annual report on Form 20-F. The selected consolidated financial data should be read in conjunction with our audited consolidated financial statements and related notes and “Item 5. Operating and Financial Review and Prospects” in this annual report on Form 20-F. Our consolidated financial statements are prepared and presented in accordance with generally accepted accounting principles in the United States, or U.S. GAAP.

 

Our selected consolidated statement of operations data for the years ended December 31, 2009 and 2010 and our consolidated balance sheet data as of December 31, 2009, 2010 and 2011 have been derived from our audited consolidated financial statements, which are not included in this annual report on Form 20-F.

 

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For the Year Ended December 31,

 

 

 

2009(1)

 

2010(1)

 

2011(1)

 

2012

 

2013

 

 

 

(in thousands of U.S. dollars, except per share and per ADS data)

 

Consolidated Statement of Operations Data

 

 

 

 

 

 

 

 

 

 

 

Net revenue

 

51,237

 

74,144

 

58,972

 

71,187

 

64,525

 

Cost of revenue

 

(34,822

)

(49,097

)

(38,459

)

(45,146

)

(42,141

)

Gross profit

 

16,415

 

25,047

 

20,513

 

26,041

 

22,384

 

Operating expenses

 

(29,538

)

(31,843

)

(49,134

)

(31,747

)

(33,258

)

—Research and development, net

 

(15,739

)

(17,707

)

(19,005

)

(8,881

)

(11,627

)

—Sales and marketing

 

(3,419

)

(5,369

)

(12,050

)

(9,174

)

(9,488

)

—General and administrative

 

(10,380

)

(8,767

)

(11,480

)

(12,244

)

(12,143

)

—Asset impairment

 

 

 

(6,599

)

(1,448

)

 

(Loss)/income from continuing operations attributable to Vimicro International Corporation

 

(8,048

)

(102

)

(13,264

)

1,383

 

(8,418

)

Loss from discontinued operations attributable to Vimicro International Corporation

 

(10,719

)

(18,542

)

(14,936

)

(2,002

)

 

Net loss attributable to Vimicro International Corporation

 

(18,767

)

(18,644

)

(28,200

)

(619

)

(8,418

)

(Loss)/income per ordinary share for continuing operations

 

 

 

 

 

 

 

 

 

 

 

—Basic

 

(0.06

)

(0.00

)

(0.09

)

0.01

 

(0.07

)

—Diluted

 

(0.06

)

(0.00

)

(0.09

)

0.01

 

(0.07

)

(Loss)/income per ADS for continuing operations

 

 

 

 

 

 

 

 

 

 

 

—Basic

 

(0.22

)

(0.00

)

(0.37

)

0.04

 

(0.29

)

—Diluted

 

(0.22

)

(0.00

)

(0.37

)

0.04

 

(0.29

)

Loss per ordinary share for discontinued operations

 

 

 

 

 

 

 

 

 

 

 

—Basic

 

(0.07

)

(0.13

)

(0.10

)

(0.02

)

 

—Diluted

 

(0.07

)

(0.13

)

(0.10

)

(0.02

)

 

Loss per ADS for discontinued operations

 

 

 

 

 

 

 

 

 

 

 

—Basic

 

(0.30

)

(0.50

)

(0.41

)

(0.06

)

 

—Diluted

 

(0.30

)

(0.50

)

(0.41

)

(0.06

)

 

Weighted -average number of shares used in (loss)/income per share calculations

 

 

 

 

 

 

 

 

 

 

 

—Basic

 

143,182

 

147,816

 

145,124

 

123,254

 

114,687

 

—Diluted

 

143,182

 

147,816

 

145,124

 

127,624

 

114,687

 

 


(1)              Figures in 2009 through 2011 were adjusted to reflect the restructuring in investments in, and the deconsolidation of, Visiondigi in 2012. Results of such disposed businesses are presented under “discontinued operations.” See “Item 4. Information on the Company - A. History and Development of the Company - Our Recent Corporate Developments.” In addition, (a) figures in 2009 were adjusted to reflect the disposal of our non-core IC businesses in December 2010 (results of such disposed businesses are presented under “discontinued operations,” except with respect to the entities to be disposed which holds certain related property interests), and (b) Figures in 2009 through 2010 were adjusted to reflect the disposal of our mobile phone multimedia processor business in December 2011 (results of such disposed businesses are presented under “discontinued operations”). See “Item 7. Major Shareholders and Related Party Transactions—B. Related Party Transactions.”

 

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As of December 31,

 

 

 

2009

 

2010

 

2011

 

2012

 

2013

 

 

 

(in thousands of U.S. dollars)

 

Consolidated Balance Sheet Data

 

 

 

 

 

 

 

 

 

 

 

Cash and cash equivalents

 

84,510

 

69,491

 

49,227

 

55,532

 

35,869

 

Total assets

 

178,275

 

171,925

 

137,297

 

144,494

 

158,232

 

Total liabilities

 

16,451

 

25,893

 

28,957

 

49,265

 

75,918

 

Number of ordinary shares

 

147,643

 

147,136

 

139,953

 

116,600

 

104,014

 

Additional paid-in capital

 

151,672

 

156,415

 

158,879

 

161,017

 

158,384

 

Total shareholders’ equity

 

161,824

 

146,032

 

108,340

 

95,229

 

82,314

 

 

B.                                Capitalization and Indebtedness

 

Not Applicable.

 

C.                                    Reasons for the Offer and Use of Proceeds

 

Not Applicable.

 

D.                                    Risk Factors

 

Risks Related to Our Business

 

We are exposed to risks related to general economic conditions in domestic and international markets.

 

The uncertainty arising out of domestic and global economic conditions, including the global financial crisis and the related credit crisis, poses a risk to the economies in which we operate. Such uncertainty has impacted demand for our products and services, and may impact our ability to manage normal relationships with our customers, suppliers and creditors. The markets for semiconductor products and video surveillance products significantly depend on consumer spending and available capital and other financial resources for spending. Economic uncertainty exacerbates negative trends in consumer spending and may cause certain customers to delay, cancel, or refrain from placing orders, which may affect our business and operating results. In addition, any tightening of liquidity in China and elsewhere in the world might also negatively influence market recovery.

 

The recent financial turmoil and related credit crisis affecting the financial markets and banking system may significantly restrict our ability to obtain financing in the capital markets or from financial institutions on commercially reasonable terms, or at all. In addition, difficulty in obtaining capital and market uncertainty may also prevent some customers from obtaining affordable financing, resulting in lower sales. Customers with liquidity issues may cause us to experience longer turnover days or incur additional bad debt expenses. These conditions may also similarly affect key suppliers, which could affect their ability to deliver parts thereby causing delays in our production. Further, these conditions and uncertainty about future economic conditions make it challenging for us to forecast our operating results, make business decisions, and identify the risks that may affect our business, financial condition and results of operations. If we are not able to timely and appropriately adapt to changes resulting from the uncertain macroeconomic environment, our business, financial condition or results of operations may be materially and adversely affected.

 

We may continue to incur net losses in the future.

 

Our financial condition and results of operation have been negatively affected by weakening global economic conditions and intense industry competition in recent years. Our net revenue increased from $59.0 million in 2011 to $71.2 million in 2012, and decreased to $64.5 million in 2013. Our gross profit increased from $20.5 million in 2011 to $26.0 million in 2012, and decreased to $22.4 million in 2013. We incurred a net loss attributable to Vimicro International Corporation of $28.2 million, $0.6 million and $8.4 million in 2011, 2012 and 2013, respectively. We had net cash used by operating activities of $26.8 million in 2011, net cash provided in operating activities of $7.1 million in 2012 and net cash used by operating activities of $14.8 million in 2013. There is no assurance that our revenues and gross profits will continue to increase, or that we will be able to generate net profit in the near future, or at all. Our financial condition and results of operations could also fluctuate significantly due to changes in our product mix and the industry environment. In addition, we may continue to grant options to employees and consultants in the future to retain and recruit key personnel and may therefore continue to incur share-based compensation expenses.

 

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The development and ramping-up plan of our video surveillance operations involves risks.

 

We plan to allocate additional resources to the development and ramping-up of our video surveillance operations. In particular, in May, 2013, Vimicro Tianjin completed the construction of a project for the research, development and production of digital high-definition video surveillance products and solutions. We may plan for additional development projects on this parcel of land based on our operational needs. See “Item 5. Operating and Financial Review and Prospects—B. Liquidity and Capital Resources—Capital Expenditures.” We are in the process of applying for the necessary governmental approvals to utilize this facility.There are risks associated with our planned expansion of business into the video surveillance market and the development project, including without limitation, our ability to:

 

·                                          successfully design and develop video surveillance products and solutions that can be applied for commercial production and meet market demands;

 

·                                          effectively sell and distribute our new products and solutions;

 

·                                          respond rapidly and timely to technological and other changes in the industry;

 

·                                          effectively manage the increase in costs and expenses in connection with our expansion into the relevant fields; and

 

·                                          compete effectively against other players in the market.

 

In addition, the loans provided by banks include covenants and restrictions that could limit our flexibility in planning for or reacting to market conditions or in meeting our capital needs or that may otherwise restrict our operations or corporate activities. We cannot assure you that we will be able to effectively manage our planned expansion. We may not have, or be able to raise, sufficient capital to service or refinance our indebtedness or to complete the project and our ability to raise additional capital depends on market and regulatory conditions which we cannot control. In addition, the gross margin from our video surveillance business has historically been less than that of our video processor business which could lead to overall lower gross margins as we increasingly rely on our video surveillance business. We may fail to generate revenue, profit or operating cash flow as expected. Furthermore, our efforts to allocate additional resources, managerial or financial, to the video surveillance business may adversely affect our ability to manage and grow our other business operations. As a result, our business, financial condition and results of operations may be materially and adversely affected.

 

Any changes in government policies on surveillance and safety system installation and operation may cause our revenues and profits to decrease.

 

We depend on state and local government policies mandating and funding surveillance and safety system installation and operation in China. For instance, our video surveillance business benefits from the government’s support of surveillance projects in China which promotes the installation of urban and suburban surveillance and monitoring networks to improve the safety-monitoring and alarm systems in cities. We expect that our video surveillance business will continue to rely on government policies in the foreseeable future. If such policies change, whether due to tightening budgets, shifting policy, or otherwise, initiatives promoting surveillance projects may be abandoned or cut back, and our financial condition and results of operations may suffer material adverse effects.

 

Our video surveillance products are subject to delivery acceptance, testing and approval.

 

We normally supply video surveillance products and services pursuant to agreements with general contractors or government agencies. The successful completion of our obligations under these contracts is often subject to delivery acceptance, satisfactory testing and approval of such products and services. Although we endeavor to satisfy the requirements of each of these contracts to which we are a party, no assurance can be given that the necessary approval of our products and services will be granted on a timely basis or at all, and that we will receive any payments due to us. In some cases, we may depend on others to complete these projects which may also delay payments to us. Any failure to obtain these approvals and payments may have a material adverse effect on our business and future financial performance.

 

We sometimes extend credit to our customers in the video surveillance projects. Failure or delay in collecting trade receivables from these customers could affect our liquidity.

 

We extend credit to some of our customers in the video surveillance projects without requiring collateral in most cases. As a result, our claims for payment would rank as unsecured claims, which would expose us to the credit risks of our customers in the event of their insolvency or bankruptcy. Generally, our customers in the video surveillance projects pay in installments, with a portion of the payment upfront upon signing the sales contracts, a portion of the payment upon receipt of our products but before installation and a portion of the payment after installation and upon satisfaction of our customers. Sometimes, a portion of the payment may not be paid until after a certain period following the installation.

 

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As of December 31, 2012 and 2013, accounts receivable due from ASB, a distributor of our video surveillance products, accounted for 48% and 33%, respectively, of our total accounts receivable. Net revenue generated from the same customer accounted for 11% and 7%, respectively, of our total net revenue in the same periods. We perform ongoing credit evaluations of our customers’ financial condition. Our provisions for doubtful accounts amounted to $2.2 million and $2.2 million as of December 31, 2012 and 2013, respectively. Our net working capital requirements could increase significantly if we offer longer payment terms to attract and retain large customers, including customers of our video surveillance products. We may encounter further issues with or material delay in collecting accounts receivable due from our customers, which could materially and adversely affect our financial condition and results of operations.

 

If our subcontractors fail to perform their contractual obligations, our ability to provide services and products to our customers, as well as our ability to obtain future video surveillance business, may be harmed.

 

We sometimes may enter into contracts with subcontractors who perform a portion of the video surveillance services that we provide to our customers. We may have disputes with our subcontractors, including disputes regarding quality and timeliness of the work performed by those subcontractors. Failure by one or more of our subcontractors to satisfactorily perform the agreed-upon services may materially and adversely impact our ability to fulfill our obligations to our customers, expose us to liability and cause a material adverse effect on our ability to compete for future business.

 

If the SVAC standard is not widely adopted, or if the deployment of the SVAC standard in China is slower than we expect, the growth of our video surveillance business will be adversely affected.

 

Reflecting our commitment to the video surveillance business, we are a co-founder and co-developer of the Surveillance Digital Video Audio Coding Standard Working Group, or SVAC Working Group. The goals of the SVAC Working Group are to develop standards for advanced audio video coding and safety systems and improve synchronization among various safety and alarm systems. In December 2010, the Standardization Administration of China released a national standard for SVAC, which was prepared by the SVAC Working Group. The SVAC standard has been approved by the national standardization committee in China and has been applied in industry use starting in May 2011.

 

We have invested substantial time and resources in developing and promoting the SVAC standard. The market for video surveillance products that adopt the SVAC standard is relatively new and its potential is uncertain. Our growth in video surveillance business depends in part upon the timely and broadly deployment of video surveillance products that adopt SVAC standards, which is affected by the extent that SVAC standard is adopted. The deployment of the SVAC standard depends upon many factors, for example: the promotion efforts and the incentives associated with government construction projects to adopt the SVAC standard; end-use customers’ awareness and acceptance of the SVAC standard; any favorable business benefit derived from the SVAC-based products and system applications to the end-use customers; the maturity and the degree of the serialization of the SVAC-based products and system applications; and the number of the suppliers and the suppliers’ capability to provide SVAC products to meet end-users’ demand. In addition, even if the video surveillance market for SVAC projects is fully developed, our success will still depend upon the selection by existing and potential customers of our products for use in their projects. If the SVAC standard is not broadly adopted in a timely manner or our products are not selected by customers, the growth and success of our video surveillance business will be adversely affected. As a result, our business, financial condition and results of operations may be materially and adversely affected.

 

Due to the nature of our business, we do not have significant amounts of recurring revenues from our existing customers, and we are highly dependent on new business development.

 

Most of our revenues are derived from the installation of video surveillance systems which are generally non-recurring. Our customers are primarily governmental entities and their affiliates such as cities, municipalities and provinces, non-profit organizations and commercial entities, such as airports, customs agencies, banks and theaters. We install video surveillance systems for these customers and generate revenues from the sale of these systems to our customers and, to a lesser extent, from maintenance of these systems for our customers. After we have installed a solution at any particular customer site, we have generated the majority of revenues from that particular customer. We do not expect to generate significant revenues from any existing customer in future years unless that customer has additional installation sites for which our services might be required. Therefore, in order to maintain a level of revenues each year that is at or in excess of the level of revenues we generated in prior years, we must identify and be retained by new customers or work on new projects for existing customers. If our business development, marketing and sales techniques do not result in an equal or greater number of projects of at least comparable size and value for us in a given year compared to the prior year, then we may be unable to increase our revenues and earnings or even sustain current levels in the future.

 

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Future government regulations or other standards could have an adverse effect on our operations.

 

Our operations are subject to a variety of laws, regulations and licensing requirements of state and local authorities in the PRC. In certain jurisdictions, we are required to obtain licenses or permits and to meet certain standards in the conduct of our business. The loss of such licenses, or the imposition of conditions to the granting or retention of such licenses, could have an adverse effect on us. In the event that these laws, regulations and/or licensing requirements change, we may be required to modify our operations or to utilize resources to maintain compliance with such rules and regulations. In addition, new regulations may be enacted that could have an adverse effect on us.

 

Our operating results are affected by peaks and troughs in our product delivery and project installation schedule and we may experience delays in our recognition of revenue.

 

We expect our results of operations to fluctuate significantly from period to period in the future. As we expand our video surveillance business, we expect the fluctuation to increase because the video surveillance business relies on a smaller number of large contracts. We generally recognize revenue from delivered hardware with bundled software when customer acceptance is obtained, which occurs when the customer acknowledges receipt of goods and the delivered hardware with bundled software meet vendor-specific criteria.  For installation services, we recognize revenue after obtaining acceptance of the related services. Our revenue and profit during any given period reflects the number of products shipped and projects installed during that period and are significantly affected by any peaks or troughs in our product delivery and project installation schedule. The fluctuation in revenue from our video surveillance business reflected the characteristics of our product delivery and project installation schedule. Our operating results may not be indicative of the actual demand for our products and installation services during the relevant period. In addition, because we do not recognize revenue from installation services until after obtaining acceptance from customers, we may experience delays in recognizing revenue for certain projects. As a result, it may be difficult for us to predict our performance quarterly or annually and our operating results for any period are not necessarily indicative of results that may be expected for any future period.

 

Our business is subject to a concentration of customers, and a significant portion of our video surveillance revenue comes from a small number of projects.

 

Our business is subject to a concentration of customers. Our top ten customers collectively accounted for approximately 89%, 91% and 82% of our revenue in 2011, 2012 and 2013, respectively. Richpower Co., Ltd., one of our major China-based distributors for our PC camera processor business, accounted for approximately 63% of our net revenue in 2012 and 26% of our net revenue in 2013. We expect to continue to rely on a concentration of China-based customers for our sales. We are especially dependent on a limited number of customers for our video surveillance business due to the project nature of such business, for which sales to our top five customers accounted for 72% of our total video surveillance revenue in 2013. In addition, our largest customers may change from time to time as we continue to expand our video surveillance market share. If a major customer ceases to order our products, or otherwise delays or reduces its order for our products, or if we fail to develop additional major customers, our business, operating results and financial condition could be materially and adversely affected. See “Item 4. Information on the Company—Business Overview—Customers.”

 

As we undertake a growing number of large-scale surveillance projects in our video surveillance business, we are also subject to certain concentration risks. Many of these large-scale surveillance projects are with government agencies and can take many months to complete. In order to successfully complete these projects, we need to ensure that we have sufficient cash to fund our working capital requirements and that we have sufficient technical and managerial resources to complete the projects in a timely manner and with acceptable quality. Any inability to complete the projects to the satisfaction of our customers, or any inability to receive payment upon completion, could materially and adversely affect our business, operating results and financial condition.

 

Future acquisitions, investments and divestitures may have an adverse effect on our ability to manage our business and may harm our operating results.

 

If we are presented with appropriate opportunities, we may acquire complementary technologies, businesses or assets. We may also consider divesting certain of our business operations to the extent our management deems it to be in the best interest of our shareholders and company. Future acquisitions, investments and divestitures would expose us to potential risks, including risks associated with the assimilation of new technologies, businesses and personnel, unforeseen or hidden liabilities, the diversion of management attention and resources from our existing business and the inability to generate sufficient revenue or cost savings associated with such acquisitions, investments or divestitures. Any difficulties encountered in the integration and divestiture process may have an adverse effect on our ability to manage our business. We have made and may continue to consider making strategic divestitures. To concentrate more on our video surveillance business and video surveillance processor business, we disposed of certain loss-making businesses, including our non-core IC businesses and our mobile phone multimedia processor businesses in 2010 and 2011. There is no assurance that the business divestiture may be completed as expected, or the projected cost savings and other benefits of such divestiture may be realized to our benefit, on a timely basis, or at all. We may also experience business interruptions in case the business divestiture was not executed successfully. We plan to allocate additional resources to the development of our video surveillance business. For example, we made investments and established Zhongtianxin in 2012. Any negative development in this regard may have a material and adverse impact upon our business, financial condition and results of operations.

 

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We may not be able to execute cost-control measures successfully which may adversely affect our financial condition and results of operations.

 

We have adopted significant measures to reduce our operating costs and expenses. These measures include adjusting staff and employee compensation and benefits and implementing general cost-control measures across our company. We expect to continue these measures. We may not achieve the expected savings on our operating costs and expenses, and we may otherwise experience significant increases in operating costs and expenses without any associated increase in revenue. A portion of our operating costs and expenses are fixed and do not change in line with the fluctuation in our revenues. As a result, our business, financial condition and results of operations may be materially and adversely affected. In addition, if our cost-reduction measures are not executed properly, the quality of our products may be affected and our ability to generate future revenue may deteriorate. Our adjustments in staff and employee compensation and benefits may also adversely affect our ability to attract and retain key employees.

 

Failure to obtain design wins could have a material adverse effect on our video processor business.

 

Our business significantly depends on our ability to obtain design wins whereby the product designers agree to incorporate our video processors into their new product designs. Once a video processor designed by a supplier has been incorporated into a product design, especially PC camera designs, the product designer tends to keep the same supplier for the life of the product as significant costs are generally required in association with qualifying a new supplier. This reluctance to change existing suppliers may be an entry barrier for new suppliers and there is no guarantee that we may qualify as suppliers to new customers we intend to sell our products to. On the other hand, the designers of PC camera and surveillance products constantly develop and introduce new products to the market, which requires suppliers, such as us, to continue to create innovative, highly integrated, low-power and cost-effective products and solutions in order to continue to achieve design wins from our current customers. Our failure to achieve design wins could have a material adverse effect on our business.

 

We face significant volatility in supply and demand conditions for our video processor products, and this volatility, as well as any failure by us to accurately forecast future supply and demand conditions, could materially and negatively impact our business.

 

The semiconductor industry has historically been characterized by significant fluctuations in the demand for, and supply of, semiconductor products. Demand for our products depends in large part on the continued growth of various electronics industries that use our products, including, but not limited to:

 

·                                          PC and computer-related peripherals;

 

·                                          security processor and surveillance products; and

 

·                                          wireless telecommunications equipment.

 

Any downturn or reduction in the growth of these industries could seriously harm our business, financial condition and results of operations. We order materials and build our products based primarily on our internal forecasts, customer forecasts and existing orders. Existing orders may be cancelled and our forecasted orders may not be realized. There is no guarantee that we may adjust our orders for raw materials and manufacturing activities on a timely basis to reflect such changes. Because the video processor market is volatile and subject to rapid technological and price changes, our forecasts may be inaccurate, causing us to incur significant costs and expenses, which could negatively affect our business, financial condition and results of operations.

 

Our video processor business is dependent on sales of our PC camera processors.

 

We derive a significant portion of our net revenue from sales of our PC camera processors. In 2011, 2012 and 2013, we generated approximately 80%, 75% and 32%, respectively, of our net revenue from sales of PC camera processors. Even though our sales of PC camera processors have significantly decreased in 2013, we expect that sales of our PC camera processors will continue to be a major source of revenue for our video processor business in the near future. However, we also anticipate that revenue from surveillance processors will continue to increase as a proportion of the revenue from our video processor business. The success of competing products, negative development or slow-down in the growth of the PC camera market or any other adverse developments could result in decreased demand or lower average prices for these products, which could in turn result in a decrease in the revenue from the sale of these products. Any such negative development, or any inability to generate an increasing portion of revenue from surveillance processors, could materially and adversely affect our business, financial condition and results of operations.

 

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Our video processor business depends on our ability to respond in a timely manner to the evolving video processor market and changing consumer preferences and industry standards.

 

Our business and future growth depends significantly on the development of the video processor market, which is evolving rapidly. The development of the video processor market depends on several factors, including changes in end user preferences and demand for multimedia functions and applications on end products. In addition, the video processor market is characterized by evolving industry standards, which are difficult for us to predict. If we do not respond to the evolving market, changing consumer preferences and industry standards in a timely manner, our business, financial condition and results of operations could be materially and adversely affected.

 

Our lengthy time-to-market makes it difficult for us to forecast revenue and increases the variability of our short-term results.

 

Our video processor products business is characterized by lengthy intervals between the product development stage and the volume sales stage. This interval, commonly referred to as time-to-market, typically ranges from three to six months for our video processors, and may be significantly longer for new customers. A number of factors contribute to the length of our time-to-market. After initially developing a product, we need to convince a customer to incorporate it into the design of the customer’s end product, which is referred to as a “design win.” Following the design win, we need to complete our product development and deliver our product to the customer, and the customer will then test and evaluate our product before completing the design of its own end product. Our customers may need one to two months or longer to test and evaluate our products and an additional three months or more to commence volume production of end products. Our lengthy time-to-market makes it difficult for us to forecast revenue and results in fluctuations in our short-term results. It also results in a lengthy interval from the time we incur research and development and other operating expenses in connection with a new product to the time that we can start to generate revenue from the product. In addition, there is no guarantee that a design win will result in volume production or sales of our product. We may not be able to generate sufficient revenue and profit from a new product to offset the operating expenses incurred in connection with the development and sale of that product.

 

We may be unable to accurately predict demand for our video processors, which may result in product shortages or excess inventory or obsolete inventory.

 

The lead time required by the foundries that we use to fabricate wafers and manufacture our video processors is generally longer than the lead time our customers may require for delivery of our products to them. Consequently, we must forecast our anticipated manufacturing needs and place binding manufacturing orders with these foundries before we receive purchase orders from our customers. This may result in shortages or excess inventory because we cannot easily adjust our orders or commitments. Obtaining additional supply in the event of inventory shortages may be costly or impossible, particularly in a short time frame, which could prevent us from fulfilling orders from our customers. In line with industry-wide increases in foundry lead times, the lead times the foundries require to manufacture our new video processors have grown longer, which has led to an increase in our inventory levels. These lead times may increase further, which may in turn cause us to increase our inventory levels. In addition, like most semiconductor products, our video processors are often susceptible to rapidly declining average selling prices or product obsolescence. Excess inventory levels, whether due to inaccurate forecasts, lengthening foundry lead times or other reasons, could result in unprofitable sales or write-offs of excess or obsolete inventory. Consequently, any such negative development could adversely affect our business, operating results and financial condition.

 

We depend on third-party foundries to manufacture our video processors. Failure to obtain sufficient foundry capacity could significantly delay our ability to ship our products, cause us to lose revenue and damage our customer relationships.

 

We rely on Taiwan Semiconductor Manufacturing Company, or TSMC, and Semiconductor Manufacturing International Corporation, or SMIC, to manufacture our video processors. We face several risks associated with our dependence on these third-party foundries, including:

 

·                                          failure to secure sufficient manufacturing capacity at a reasonable cost, or at all;

 

·                                          limited control over delivery schedules, quality assurance and control, manufacturing yields and production costs; and

 

·                                          the unavailability of, or potential delays in obtaining access to, key process technologies.

 

The ability of a foundry to manufacture our video processors is limited by its available production capacity. Neither of these third-party foundries has allocated a fixed level of production capacity to us. It is difficult for us to accurately forecast our capacity needs. We do not have any long-term agreement with any foundry and we typically place orders with them on a purchase order basis, depending on our own customers’ purchase orders and sales forecasts. These foundries can allocate their production capacities to their other customers and reduce deliveries to us on short notice. It is possible that other customers of these foundries are larger with more financial and other resources than we are, or have long-term agreements with these foundries. Foundries may allocate their production capacities to these customers on a preferential basis in the event that they experience shortage in production capacity. Any shortfall in available foundry capacity could significantly delay our ability to ship our products, cause us to lose revenue and damage our customer relationships.

 

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In addition, if either of these foundries experience financial difficulties, suffer damage to its facilities, or experience other disruption to their operations, we may not be able to qualify an alternative foundry in a timely manner, as the qualification process could take several months before we could place an order. Such a delay could damage our customer relationships and have a material adverse effect on our business, financial condition and results of operations.

 

If the foundries that we use do not achieve expected manufacturing yields, our product costs could increase and product availability could decrease.

 

The manufacture of semiconductors is a highly complex process. Minute impurities in a silicon wafer can cause a substantial number of wafers to be rejected or cause numerous die on a wafer to be nonfunctional. Foundries encounter difficulties from time to time in achieving acceptable manufacturing yields, which are measured by the percentage of dies produced on a fab line that pass all visual and process control monitoring tests. This often occurs during the production of new products or the installation and start-up of new process technologies. The foundries that we use may not be able to achieve acceptable manufacturing yields as we migrate our designs to smaller geometries. If these foundries do not achieve expected manufacturing yields, our product costs could increase and product availability could decrease.

 

Significant disruption in operations of the two independent assembly and testing houses we rely on could significantly disrupt our shipments, harm our customer relationships and reduce our sales.

 

We rely on independent assembly and testing houses to assemble and test substantially all of our current video processors either for the foundry or directly for us. As a result, we do not have direct control on our product delivery schedules, assembly and testing costs or quality assurance and control. We currently engage Advanced Semiconductor Engineering, Inc., or ASE, and Siliconware Precision Industries Co., Ltd., or SPIL, for our assembly and testing requirements. If either of these assembly and testing houses experiences capacity constraints or financial difficulties or suffers any damage to their facilities, or if there is any other disruption of operations, we may not be able to obtain alternative assembly and testing services in a timely manner. We do not have long-term agreements with either of our independent assembly and testing houses. We typically procure services from them on a per-order basis. Because of the lengthy period required to qualify third-party assembly and testing houses, we could experience significant delays in product shipments if we are required to qualify an alternative assembly and testing house for our products on short notice. Any issue we may experience in this regard could negatively affect our product delivery, product quality or result in increased operating costs and expenses, which could in turn damage our reputation and result in a loss of customers. Our business and results of operations could be materially and adversely affected as a result.

 

Our video processor business significantly depends on our customers’ ability to successfully sell their products incorporating our video processors.

 

Demand for our products significantly depends on the market demand for our customers’ products incorporating our products. In particular, even if a product designer decides to incorporate our products into its product or design, the designer may not be able to market and sell its product or design successfully. Even though the designer does not have the right to return the product purchased from us, the designer’s inability to market and sell its products, whether from lack of market acceptance or otherwise, could adversely affect our business as the designer may cease to order or otherwise reduce orders of our products. Our reputation may also be negatively affected. Accordingly, our business depends on our customers’ ability to successfully sell their products incorporating our products, and may be materially and adversely affected if they fail to do so.

 

One of the principal foundries and one of the assembly and testing houses that we use are both located in a region that is subject to earthquakes, typhoons and other natural disasters, as well as geopolitical risks and social upheaval.

 

Our business relies on certain foundries and assembly and testing houses in Taiwan. In particular, we currently rely on TSMC, one of our principal foundries, to manufacture a majority of our video processors. In addition, we also use ASE as one of our assembly and testing houses. These two entities are both located in Taiwan, which is susceptible to earthquakes, typhoons, floods and other natural disasters. Taiwan has historically experienced severe earthquakes that have caused significant casualties and property damage. In addition, TSMC and ASE are subject to risks associated with uncertain political, economic and other conditions in Taiwan and elsewhere in Asia, such as political turmoil in the region and the outbreak of communicable diseases. The occurrence of any of the foregoing could disrupt the operations of TSMC and ASE, resulting in significant delays in deliveries or substantial shortages in supply. As a result, our business, financial condition and results of operations could be materially and adversely affected.

 

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We are exposed to risks relating to our development of facilities on land held by Vimicro Jiangsu

 

Vimicro Jiangsu holds land use rights to a parcel of undeveloped land that we originally planned to use for our non-core IC businesses. We currently plan on using the property to develop offices, sales and research facilities. We will use a portion of these facilities for our own purposes and the remaining portion we will sell to third parties through the assistance of the local government. Such third party buyers and the terms of the relevant sales agreements will need to be approved by the local government. The sale of a portion of the units to qualified third parties is in line with the government policy of attracting investment to the local area. For a detailed discussion of our current plan with respect to the land held by Vimicro Jiangsu, see “Item 4. Information on the Company—D. Property, Plant and Equipment.” The construction of this project involves a number of risks including:

 

·                            our ability to sell completed units to purchasers at acceptable prices, or at all;

 

·                            our ability to reach agreements with, and obtain regulatory consents and approvals from, local regulators, for the conversion of the land use rights and issuance of ownership certificates to allow us to dispose of property units to be built on the land;

 

·                            our ability to use the completed units for our business needs;

 

·                            our ability to work effectively with partners in developing the property and selling units of the property;

 

·                            potential fines and penalties for delays in development of the property;

 

·                            our ability to obtain necessary cash and financial resources to complete the construction of this project; and

 

·                            our ability to apply for and acquire necessary governmental approvals in developing the property and selling units of the property.

 

Any such negative development could have a material and adverse effect on our business, financial condition and results of operations. In November 2013, we entered into an agreement with the Nanjing Bureau of Land and Resources, or the Bureau. Pursuant to this agreement, we agreed to pay a security deposit of RMB1.8 million ($0.3 million) to the Bureau. The Bureau has agreed to repay us half of this amount if we commence construction by May 15, 2014 and the other half if we complete construction by May 15, 2016. However, failure to meet these deadlines could cause us to lose the deposit that we have paid.

 

We are currently managing construction projects with significant capital expenditure requirements and may continue to manage such projects in the future, including the development of the property held by Vimicro Jiangsu. See “Item 4. Information on the Company—D. Property, Plant and Equipment.” We are required to obtain various governmental approvals at the different stages of our construction projects, and there is no assurance that we will be able to obtain such approvals on a timely basis. In addition, the relevant governmental authorities may require us to make material changes to our initial designs as conditions to issue certain approvals, which may significantly increase the costs and capital requirements of our construction projects. Government authorities could also impose penalties or fines for any non-compliance issues or significant construction delays. In addition, we rely on independent contractors for the construction of these projects. The contractors may experience financial or other difficulties which may affect their ability to carry out construction work and thus delay the completion of the projects or cause us to incur additional costs. In addition, construction delays and specific site conditions at any site could affect the final cost and completion date of the projects, which may in turn disrupt our growth strategy and materially and adversely affect our operating results. An increase in the estimated or actual construction costs may require a higher capital expenditure than we had anticipated. Any such negative development could materially affect the progress of our construction projects, which in turn could have a material and adverse effect on our business, financial condition and results of operations.

 

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We rely on third-party distributors for a significant portion of our revenue.

 

A significant portion of our revenue is derived from sales to distributors who resell our products to manufacturers of modules or end products, such as PC cameras into which our products are incorporated. Sales to distributors accounted for 67%, 72% and 37% of our net revenue in 2011, 2012 and 2013, respectively. In 2013, there were two distributors among our top ten customers. As a result, our ability to maintain good relationships with these distributors is important to the growth of our business and our results of operations. If our major distributors defer orders or fail to place additional orders with us, our business, financial condition and results of operations could be materially and adversely affected.

 

We do not have long-term purchase commitments from our customers, which may result in significant uncertainty and volatility with respect to our revenue from period to period.

 

We do not have long-term purchase commitments from our customers and our sales are made on the basis of individual purchase orders. Our customers may cancel or defer purchase orders. Our customers’ purchase orders may vary significantly from period to period, and it is difficult to forecast future order quantities. We cannot assure you that any of our customers will continue to place purchase orders with us in the future at the same level as in prior periods. We also cannot assure you that the volume of our customers’ purchase orders will be consistent with our expectations when we plan our expenditures. As a result, our results of operations may vary from period to period and may fluctuate significantly in the future.

 

If we are unable to obtain additional capital in future years, we may be unable to grow at the expected pace or proceed with our long-term business plan, and we may be forced to curtail or cease some of our projects.

 

We will require additional working capital to support our long-term business plan, which includes identifying suitable targets for horizontal or vertical mergers or acquisitions, fulfilling the agreements with general contractors or government agencies to provide the products and services for video surveillance projects, constructing additional projects for research, development, productions or office uses. Our working capital requirements and the cash flow provided by future operating activities, if any, will vary greatly from period to period, depending on the volume of business during the period and payment terms with our customers. We may not be able to obtain adequate levels of additional financing, whether through equity financing, debt financing or through other sources. Additional equity financings could result in significant dilution to our shareholders and debt financing could adversely affect our earnings. If we are unable to raise additional capital, we may be unable to implement our long-term business plan, develop or enhance our products and services, take advantage of future opportunities or respond to competition on a timely basis, if at all. In addition, lack of financing could force us to substantially curtail or cease some of our projects.

 

Defects in our products could result in a loss of customers and a decrease in revenue, unexpected expenses and a reduction in market share.

 

Our products are complex and must meet stringent quality requirements. Complex products, such as our highly integrated single-chip video processor products, may contain defects, errors or viruses when they are first introduced or as new versions are released. If any of our products have reliability, quality or compatibility problems, we may not be able to correct these problems on a timely basis. Consequently, our reputation may be damaged and we may fail to obtain design wins, which could harm our ability to retain existing customers and attract new customers. In addition, these defects, errors or viruses could interrupt or delay sales to our customers. Because we cannot test for all possible scenarios, our products may contain errors which are not discovered until after they are shipped. If any of these problems are not found until after we have delivered our products to our customers, we may be required to incur additional development costs and costs associated with product recalls, repairs or replacements. Product defects may also result in product liability claims against us.

 

Our operating results have fluctuated in the past and we expect our operating results to continue to fluctuate.

 

Our revenue and operating results are difficult to predict, and have in the past and may in the future fluctuate from period to period. We expect that our revenue will continue to vary from period to period, making it difficult to predict our future operating results. In particular, we experience seasonality and variability in the demand for our products as our customers manage their inventories. Our customers tend to increase their inventories of our products in anticipation of the peak fourth quarter buying season for PCs and other devices into which our products are incorporated, which often leads to sequentially lower sales of our products in the first and fourth quarters. In addition, business activities in China generally slows down during the Chinese New Year period in the first quarter of each year, which may adversely affect our sales and results of operations during that period. We base our planned operating expenses in part on our expectations of future revenue. If our revenue for a particular period is lower than what we expect, we may be unable to proportionately reduce our operating expenses for that period, which could harm our operating results for that quarter.

 

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Additional factors that could cause our results of operations to fluctuate include:

 

·                                          the timing and volume of purchase orders and cancellations from our customers;

 

·                                          changes in manufacturing costs, including wafer, testing and assembly costs, and changes in manufacturing yields, product quality and reliability;

 

·                                          the timing and availability of adequate manufacturing capacity of the foundries we use;

 

·                                          our ability to successfully design and introduce new products, including video surveillance products, in a timely manner that meet our customers’ needs;

 

·                                          the timing, performance and pricing of new products introduced by us and our competitors;

 

·                                          the timing and amount of operating expenses incurred by us, including cash bonuses to senior management;

 

·                                          the liquidity and cash flow of our company and our customers; and

 

·                                          changes in exchange rates, interest rates, tax rates and tax withholding.

 

Any fluctuations in our quarterly results of operations may affect the price of our ADSs. In future periods, the market price of our ADSs could decline if our revenue and results of operations are below the expectations of analysts and investors.

 

We may not be able to prevent others from the unauthorized use of our intellectual property, which could harm our business and competitive position.

 

We rely on a combination of patent, copyright, trademark and trade secret laws, as well as nondisclosure agreements and other methods to protect our intellectual property rights. As of December 31, 2013, we had 561 registered patents and 326 pending patent applications in China, 59 registered patents and 47 pending patent applications in the United States, one registered patent and six pending patent applications in Taiwan and four pending patent applications in South Korea. We cannot assure you that any patent will be issued as a result of our applications or, if issued, that it will sufficiently protect our intellectual property rights. Implementation of PRC intellectual property-related laws has historically been lacking, primarily because of ambiguities in the PRC laws and difficulties in enforcement. Accordingly, intellectual property rights and confidentiality protections in China may not be as effective as in the United States or other countries. Policing unauthorized use of proprietary technology is difficult and expensive. The steps we have taken may be inadequate to prevent the misappropriation of our proprietary technology. Reverse engineering, unauthorized copying or other misappropriation of our proprietary technologies could enable third parties to benefit from our technologies without paying us for doing so, which could harm our business and competitive position. Though we are not currently involved in any litigation with respect to intellectual property, we may need to enforce our intellectual property rights through litigation. Litigation relating to our intellectual property might result in substantial costs and diversion of resources and management attention. See “—Risks Related to Doing Business in China—Uncertainties with respect to the PRC legal system could adversely affect us.”

 

We may face intellectual property infringement claims that could be time-consuming and costly to defend and, if successful, result in our loss of significant rights and inability to continue providing our existing products.

 

Our business also depends in large part on our ability to use and develop our technology and know-how without infringing the intellectual property rights of third parties. Intellectual property litigation is expensive and time-consuming and could divert management’s attention from our business. If there is a successful claim of infringement against us, we may be required to pay substantial damages to the party claiming infringement, develop non-infringing technology or enter into royalty or license agreements that may not be available on acceptable terms, if at all. Our failure to develop non-infringing technologies or license the proprietary rights on a timely basis would harm our business. Protracted litigation could also result in our customers or potential customers deferring or limiting their purchase or use of our products until resolution of such litigation. Also, we may be unaware of filed patent applications that relate to our products. Parties making infringement claims may be able to obtain an injunction, which could prevent us from selling our products or using technology that contains the allegedly infringing intellectual property. Any intellectual property litigation could have a material adverse effect on our business, operating results or financial condition.

 

Our business depends substantially on the continuing efforts of our senior executives and other key personnel, and our business may be severely disrupted if we lose their services.

 

Our business and future growth depends heavily upon the continued services of our senior executives and other key employees. We rely on their expertise in research and development, business operations, sales and marketing and on their relationships with our shareholders and customers and relevant government authorities. We also rely on a number of experienced mixed-signal semiconductor designers who are difficult to find since it often requires years of experience to fully master mixed-signal design. We do not maintain key-man life insurance for any of our senior executives or other key employees. If one or more of our senior executives or key employees were unable or unwilling to continue in their present positions, we might not be able to replace them easily or at all. Our business may be severely disrupted, our financial conditions and results of operations may be materially and adversely affected, and we may incur additional expenses to recruit, train and retain personnel. Since our industry is characterized by high demand and intense competition for talent, we also may not be able to attract or retain additional highly skilled employees or other key personnel that we will need to achieve our strategic objectives. Our business has grown rapidly. Our ability to train and integrate new employees into our operations may not meet the growing demands of our business.

 

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If any of our senior executives or key employees joins a competitor or forms a competing company, we may lose customers, suppliers, know-how and key professionals and staff members. Each of our executive officers has entered into an employment agreement with us, which contains non-competition provisions. However, if any dispute arises between our executive officers and us, we cannot assure you the extent to which any of these agreements could be enforced in China, where these executive officers reside, in light of the uncertainties with China’s legal system. See “—Risks Related to Doing Business in China—Uncertainties with respect to the PRC legal system could adversely affect us.”

 

Our business success depends on our ability to retain our key employees or replace departing key employees in a timely manner.

 

All share options that we initially granted to certain key employees have become vested. While we periodically grant additional share options to certain employees upon their recruitments, the numbers of options that we may grant from time to time with respect to such new hires are generally smaller compared to our initial option grants to our key employees. Such key employees as well as our newly hired employees may leave us after the share options are fully vested, especially if the options are substantially exercised. If any member of our management team or any of our key employees leaves our company, our ability to operate our business and execute our strategy could be materially impaired. We may also incur significant costs in identifying, hiring, training and retaining replacements for departing employees. There is no assurance that we could do so at a timely manner, or at all.

 

There are unknown risks associated with our acquisitions.

 

Selective acquisitions form part of our strategic expansion plan. Failure to successfully integrate the acquired business may affect the expected synergies from this acquisition and impede our overall growth strategy. Although we have conducted due diligence in connection with this acquisition, we may not be aware of all of the risks associated with the acquired business. Discovery of adverse information concerning the acquired business could have a material adverse effect on our business, financial condition and results of operations. Although we are entitled to claiming indemnification in certain circumstances, asserting indemnification or enforcing such indemnification could be costly and time-consuming and may not be successful at all.

 

We are subject to risks relating to our relationships with minority shareholders of our non wholly-owned subsidiaries and joint venture partners of our associated companies.

 

We have one significant non wholly-owned subsidiary, Vimicro Tianjin. The constitutional documents of Vimicro Tianjin require an affirmative vote of a qualified majority of the shareholders to take certain actions, which could have the consequence of slowing down the decision-making process for the subsidiary. In addition, the other major shareholder of Zhongtianxin, a joint venture established in 2012 in which we beneficially own 51% of equity interest, may exercise substantive participating rights in accordance with the constitutional documents of Zhongtianxin. We cannot assure you that we will maintain sound relationships with the other shareholders of these entities, and we may be required to dispose of our interests in any of such entities in the future or to purchase such interests held by the other shareholders. Failure to maintain relationships with the other shareholders of our non wholly-owned subsidiaries and associated companies may result in material disputes or disruptions of the operations of these subsidiaries, any of which could have a material adverse effect on our financial condition and results of operations.

 

If we fail to maintain effective internal control over financial reporting in accordance with the Sarbanes-Oxley Act, we could suffer a loss of investor confidence in the reliability of our financial statements.

 

We are subject to reporting obligations under the U.S. securities laws. The Securities and Exchange Commission, or the SEC, as required by Section 404 of the Sarbanes-Oxley Act of 2002, or the Sarbanes-Oxley Act, adopted rules requiring every public company to include a management report on such company’s internal control over financial reporting in its annual report, which must also contain management’s assessment of the effectiveness of its internal control over financial reporting. Our management has conducted an evaluation of our internal control over financial reporting, and concludes that our internal control over financial reporting as of December 31, 2013 is effective.

 

We are continuously improving our internal control over financial reporting in line with the development of our business, including the recent expansion of our operations in the security and surveillance market. However, we cannot assure you that our efforts to improve and develop our internal control over financial reporting will be effective or any material weaknesses in our internal control over financial reporting will not be identified in the future. If we fail to maintain effective internal control over financial reporting in accordance with the Sarbanes-Oxley Act, we could suffer a loss of investor confidence in the reliability of our financial statements, which in turn could negatively impact the trading price of our ADSs, result in lawsuits being filed against us by our shareholders or otherwise harm our reputation. Furthermore, we have incurred and anticipate that we will continue to incur considerable costs and use significant management time and other resources in an effort to continue to comply with Section 404 and other requirements of the Sarbanes-Oxley Act.

 

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Contractual arrangements between Vimicro China and Vimicro Hong Kong may be subject to scrutiny by the Hong Kong tax authorities and a finding that Vimicro Hong Kong owes additional taxes could substantially reduce our financial performance and the value of your investment.

 

We use Vimicro Hong Kong, a wholly-owned subsidiary of Vimicro China incorporated in Hong Kong, to facilitate a substantial portion of our overseas sales activities, primarily due to Vimicro Hong Kong’s close proximity to our clients as well as foundries and assembly and testing houses located in Taiwan and Hong Kong. Vimicro Hong Kong and Vimicro China have entered into a contractual arrangement pursuant to which Vimicro Hong Kong makes royalty payments to Vimicro China for certain technologies licensed by Vimicro China. We could be subject to material and adverse tax liabilities if the Hong Kong tax authorities determine that such contractual arrangement for royalty payments were not entered into on an arm’s-length basis and adjust Vimicro Hong Kong’s taxable income in the form of a transfer pricing adjustment. In addition, the Hong Kong tax authorities may impose late payment fees and other penalties on Vimicro Hong Kong for underpaid or unpaid taxes. Our financial performance may be materially and adversely affected if Vimicro Hong Kong’s tax liabilities increase or if it is found to be subject to related fees or penalties. Any such negative development could have a material and adverse effect on our business, financial condition and results of operations.

 

Vimicro Hong Kong’s application for claims in the future may not be successful and as a result, the penalties to those underpaid taxes might be invoked and the royalty payments to Vimicro China could be subject to withholding tax.

 

In September 2006, Vimicro Hong Kong lodged offshore claims for all years since its commencement of operations in 2002. Based on the territorial source principle of taxation in Hong Kong, we believe that Vimicro Hong Kong has a reasonable basis to obtain the approval for such offshore claims. If the offshore claims are approved by the tax authorities in Hong Kong, Vimicro Hong Kong will not be subject to profits taxes on its operations or withholding taxes on its royalty payments to Vimicro China. In November 2012, Vimicro Hong Kong obtained a notice of no tax adjustment for the years from 2005/06 to 2008/09 and a Notice of Revised Assessment and Refund of Tax for 2004/05 and Notice of Provision Tax for 2005/06 from the Hong Kong Inland Revenue Department. As such, Vimicro Hong Kong’s offshore claims for such periods have been accepted by the tax authorities in Hong Kong. We believe that Vimicro Hong Kong is highly likely to obtain approval for its offshore claims and enjoy exemptions of profits taxes for 2010/11, 2011/12 and 2012/13 in Hong Kong, as there has been no change in its business model since 2009. However, we cannot assure you that Vimicro Hong Kong will be able to enjoy such favorable tax treatments. If the tax authorities in Hong Kong decline Vimicro Hong Kong’s offshore claims in the future, Vimicro Hong Kong could be required to pay unpaid or underpaid taxes and be subject to penalties, which could materially and adversely affect our business, financial condition and results of operations.

 

We may be exposed to liabilities under the Foreign Corrupt Practices Act and Chinese anti-corruption laws, and any determination that we violate any of these laws could have a material adverse effect on our business.

 

We are subject to the Foreign Corrupt Practice Act, or FCPA, and other laws that prohibit improper payments or offers of payments to foreign governments and their officials and political parties by U.S. persons and issuers as defined by the statute for the purpose of obtaining or retaining business. We are similarly subject to Chinese anti-corruption laws. Our activities in China create the risk of unauthorized payments or offers of payments by one of the employees, consultants, sales agents or distributors of our Company, even though these parties are not always subject to our control. We implement safeguard measures to prohibit these practices by our employees. Although we believe that we have adopted sufficient measures to control the related risks, our existing safeguard measures and any future improvements may not be effective in prohibiting related illegal conducts. The employees, consultants, sales agents or distributors of our Company may engage in conducts, without our knowledge, for which we might be held responsible. Violations of the FCPA or Chinese anti-corruption laws may result in severe criminal or civil sanctions, and we may be subject to other liabilities, which could negatively affect our business, operating results and financial condition. In addition, the U.S. government may seek to hold our Company liable for successor liability FCPA violations committed by companies in which we invest or that we acquire.

 

We have limited insurance coverage in China, and any business disruption or litigation we experience may result in our incurring substantial costs and the diversion of resources.

 

Insurance companies in China offer limited business insurance products and do not, to our knowledge, offer business liability insurance. While business disruption insurance is available to a limited extent in China, we have determined that the risks of disruption, cost of such insurance and the difficulties associated with acquiring such insurance on commercially reasonable terms make it impractical for us to have such insurance. As a result, except for fire insurance and our liability insurance for directors and officers, we do not have any business liability, disruption or litigation insurance coverage for our operations in China. Any business disruption or litigation may result in our incurring substantial costs and the diversion of resources. Any such negative development could have a material and adverse effect on our business, financial condition and results of operations.

 

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Risks Related to Our Industry

 

The markets in which we operate are highly competitive, and we cannot assure you that we will be able to compete successfully against our competitors.

 

The video processor market and video surveillance market are intensely competitive and are characterized by frequent technological changes and evolving industry standards. Our video processor business is comprised of two sub-product lines: PC camera processors and surveillance processors. In the PC camera processor market, we face competition primarily from ALi Corporation, EMPIA Technology Inc., Sonix Technology Co. Ltd. and Sunplus Technology Industrial Corp. In the surveillance processor market, we face competition primarily from Texas Instruments Incorporated, HiSilicon Technologies Co., Ltd. and Ambarella Incorporated.

 

A large number of companies in China also engage in the business of designing, manufacturing and installing video surveillance products. We also face competition from international companies since China’s entry into the World Trade Organization in 2001. In our video surveillance business, we face competitions from companies such as Sony, Samsung, Texas Instruments Incorporated, NXP Semiconductors N.V., Zhejiang Uniview Technologies Co., Ltd. and STMicroelectronics Dahua Technology, Axis, HiSilicon Technologies Co., Ltd. and Ambarella Incorporated.

 

We expect competition to increase in the markets in which we conduct our business. Increased competition may result in price reductions, reduced margins and market share and increased marketing and research and development expenditures. Many of our competitors have significantly greater financial, technical, manufacturing, marketing, sales and other resources than we do and may be able to respond to changing market conditions and customer requirements more quickly and effectively. We cannot assure you that we will be able to compete effectively and increase or maintain our revenue and market share in the video processor market and video surveillance market or compete successfully against our current or future competitors. If we are unable to successfully compete with existing and future competitors, our business, financial condition and results of operations could be materially adversely affected.

 

Our video surveillance product offerings involve a lengthy sales cycle and we may not anticipate sales levels appropriately, which could impair our profitability.

 

Some of our video surveillance products and services are designed for medium to large commercial, industrial and government facilities to protect valuable assets or prevent intrusion into high security facilities in China. Given the nature of our products and the customers that purchase them, sales cycles can be lengthy as customers conduct intensive investigations and deliberate between competing technologies and providers. For these and other reasons, the sales cycle associated with some of our products and services is typically lengthy and subject to a number of significant risks over which we have little or no control. If sales in any period fall significantly below anticipated levels, our financial condition and results of operations could suffer.

 

We are subject to rapidly declining average selling prices, which may harm our revenue and gross profit.

 

Semiconductor products and electronics products into which they are incorporated are typically sold in high volumes and are subject to rapid declines in average selling prices. We have reduced the prices of many of our video processor products in the past to meet market demand, and expect that we will continue to face market-driven pricing pressures on our products in the short term as a result of the industry downturn and uncertain market conditions. We expect to face more pricing pressures on our video processor products, which would require us to reduce the production costs of our existing products and develop new products with better prices in order to stay competitive. We will focus on promoting our production scale and reducing production costs in our video processor products. Our financial results will suffer if we are unable to offset any reductions in our average selling prices by developing new or enhanced products on a timely basis with higher selling prices or gross profit margins, increasing our sales volumes or reducing our costs.

 

We may be adversely affected by the cyclicality of the semiconductor industry.

 

The semiconductor industry is highly cyclical and is characterized by constant and rapid technological change, product obsolescence and price erosion, evolving standards, short product life cycles and wide fluctuations in product supply and demand. The semiconductor industry and our operations are characterized by high costs, such as those related to facility construction and equipment, research and development, and employment and training of a highly skilled workforce, that are either fixed or difficult to reduce in the short term. The industry has, from time to time, experienced significant downturns, often connected with, or in anticipation of, maturing product cycles of both semiconductor companies’ and their customers’ products and declines in general economic conditions. In addition, during these downturns some competitors may become more aggressive in their pricing practices, which would adversely impact our gross margin. Any downturns in the semiconductor industry may be severe and prolonged, and any failure of the industry to fully recover from downturns could seriously impact our revenue and harm our business, financial condition and results of operations in the short and long term. The semiconductor industry also periodically experiences increased demand and production capacity constraints, which may affect our ability to ship products.

 

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The recent global economic crisis has significantly impacted our industry and the downturn may occur again in the near to medium term. The recent downturn in our industry has led to sharply diminished product demand, production overcapacity, high inventory levels and accelerated erosion of average selling prices. Any future downturns may result in consolidations in our industry and changes in our competitive landscape. They may also reduce our revenue, cause excessive inventory, and result in material and adverse changes in our operating results.

 

Our business could be materially and adversely affected if we fail to anticipate changes in evolving industry standards and to develop and introduce new and enhanced products.

 

Our products are generally based on industry standards, which are continually evolving. Significant changes in customer requirements and preferences, introduction of new products and services embodying new technologies and the emergence of new industry standards and practices could render our products, services and systems obsolete, and may require us to incur substantial unanticipated costs to comply with any such new standards. We have in the past significantly relied on our ability to anticipate changes in technology and industry standards and to develop and introduce new and enhanced products. Our continued ability to adapt to such changes and anticipate future standards will be a significant factor in maintaining or improving our competitive position and our prospects for growth. We cannot assure you that we will be able to anticipate the evolving industry standards or that we will be able to successfully develop and introduce new products to meet the new standards. If we fail to anticipate technological change and introduce new products that achieve market acceptance, our business and results of operations could be materially and adversely affected.

 

Risks Related To Doing Business in China

 

Adverse changes in political and economic policies of the PRC government could have a material adverse effect on the overall economic growth of China, which could reduce the demand for our products and have a material adverse effect on our competitive position.

 

Most of our business operations are conducted in China and we believe that a significant portion of devices that our products are incorporated into are ultimately sold to end users in China. Accordingly, our business, financial condition, results of operations and prospects are affected significantly by economic, political and legal developments in China. The Chinese economy differs from the economies of most developed countries in many respects, including the amount of government involvement, the level of development, the growth rate, the control of foreign exchange and the allocation of resources.

 

While the Chinese economy has experienced significant growth in the past twenty years, growth has been uneven, both geographically and among various sectors of the economy. The PRC government has implemented various measures to encourage economic growth and guide the allocation of resources. Some of these measures benefit the overall Chinese economy, but may also have a negative effect on us. We cannot predict the future direction of economic reforms or the effects such measures may have on our business, financial position or results of operations. Any adverse change in the economic conditions in China, in the policies of the PRC government or in the laws and regulations in China, could have a material adverse effect on the overall economic growth of China or on the investment in the semiconductor industry. Such developments could lead to reduction in demand for our products and consequently materially and adversely affect our competitive position.

 

Because our business depends in part on the continuing expansion of the electronics supply chain in China, any slowdown in this expansion or a disruption of the supply chain could have a material adverse effect on our business and operating results.

 

Our continuing growth is based upon, among other factors, the continuing expansion of design, manufacturing and other elements of the electronics supply chain in China. This expansion depends on many factors, such as the sustained global demand for electronics products, China’s ability to continue to attract foreign investment, maintain low costs of operations and supply a well-educated labor force, as well as compete successfully against other countries which desire to establish themselves as preferred supply centers. Since 2008, the global downturn has put severe pressure on global demand for electronics product, and significant realignment may take place in the electronics supply chain in China as a result. Any slowdown in the expansion of the electronics supply chain in China or a disruption of the supply chain due to industry realignment could have a material adverse effect on our business and operating results.

 

Uncertainties with respect to the PRC legal system could adversely affect us.

 

We conduct our business primarily through Vimicro China, which is subject to PRC laws and regulations applicable to foreign investment in China and, in particular, laws applicable to wholly foreign owned companies. The PRC legal system is based on written statutes. Prior court decisions may be cited for reference but have limited precedential value. Since 1979, PRC legislation and regulations have significantly enhanced the protections afforded to various forms of foreign investments in China. However, since these laws and regulations are relatively new and the PRC legal system continues to rapidly evolve, the interpretations of many laws, regulations and rules are not always uniform and enforcement of these laws, regulations and rules involve uncertainties, which may limit the legal protections available to us. In addition, any litigation in China may be protracted and result in substantial costs and the diversion of resources and management attention.

 

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Our business benefits from certain tax incentives and government grants relating to research and development activities. Expiration or elimination of, or other adverse changes to, these tax incentives or reductions of these grants could have a material adverse effect on our results of operations.

 

The PRC government has provided various tax incentives to domestic companies in the semiconductor industry, including Vimicro China, in order to encourage development of the industry. Vimicro China has benefited from tax incentives provided by the PRC tax authorities in the form of preferential tax treatment, reduced tax rates and tax credits, and has also received government research grants and other incentives. However, the PRC tax authorities could reduce or eliminate any or all of these tax incentives at any time in the future.

 

In March 2007, the National People’s Congress adopted the New Enterprise Income Tax Law, or New EIT Law, which became effective as of January 1, 2008. Under the New EIT Law, the enterprise income tax rate for domestic and foreign enterprises is unified at 25%, and enterprises established prior to March 16, 2007 that were eligible for preferential tax treatment according to the then effective PRC EIT Law for Foreign Investment Enterprise and Foreign Enterprise, administrative regulations and circulars with equivalent effect are subject to transitional rules to gradually change their rates to 25%. Certain qualified “high and new technology companies” may be entitled to a 15% preferential tax rate if they meet the definition of “high and new technology enterprises” set out in the Implementation Rules of the New EIT Law. The Implementation Rules of the New EIT Law as well as a series of clarification rules were promulgated by the State Council and relevant local authorities. In accordance with the Implementation Rules of the New EIT Law, the preferential tax rates granted to PRC entities that previously qualified as “high and new technology enterprises” will not be automatically applicable under the new tax regime unless they qualify as “high and new technology enterprises” pursuant to the New EIT Law, its Implementation Rules, and relevant working guidance promulgated by the authorities. Vimicro China is currently recognized as a “high and new technology enterprise” under the New EIT Law which entitles Vimicro China to a preferential tax rate of 15% for three years starting from January 1, 2011. We cannot assure you that Vimicro China will continue to qualify for such status under governmental evaluations in the future. For example, in the past, we received certain preferential tax treatment as an integrated circuit design enterprises, or ICDE; however, we are no longer eligible for such preferential tax treatment. In the event the preferential tax treatment for Vimicro China is discontinued, it will become subject to the standard PRC enterprise income tax rate, which could materially increase our tax obligations.

 

In addition, under the New EIT Law, the worldwide income of a resident enterprise, which includes an enterprise established outside of China with effective management located in China, will be subject to PRC income tax. If the PRC tax authorities determine that our company or any of our subsidiaries registered outside the PRC is a resident enterprise, its worldwide income will be subject to PRC income tax at a tax rate of 25%. Furthermore, under the New EIT Law, dividends payable by a foreign investment enterprise to its foreign non-resident enterprise investors that were derived from income after January 1, 2008 are subject to a 10% withholding tax, unless such foreign investor’s jurisdiction of incorporation has signed a tax treaty or arrangement for the avoidance of double taxation and the prevention of tax evasion with China that provides for a reduced rate of withholding tax. The Cayman Islands, where we are incorporated, does not have such a tax treaty with the PRC. If we are considered a non-resident enterprise, the 10% withholding tax imposed on our dividend income received from Vimicro China, our PRC subsidiary, would reduce our net income and have an adverse effect on our operating results. The New EIT Law also provides that, if a resident enterprise directly invests in another resident enterprise, the dividends received by the investing resident enterprise from the invested enterprise are exempted from income tax, subject to certain conditions. Therefore, if we are classified as a resident enterprise, the dividends that we receive from Vimicro China may be exempted from income tax. However, it remains unclear how the PRC tax authorities will interpret the PRC tax resident treatment of an offshore company, like us.

 

The discontinuation of preferential tax treatment, the increase of the enterprise income tax rate applicable to Vimicro China, or the imposition of PRC income tax on our worldwide income could have a material adverse effect on our financial condition and results of operations.

 

Foreign holders of our ADSs or ordinary shares may be subject to PRC withholding tax on dividends payable by us and on gains realized on the sale of our ADSs or ordinary shares, if we are classified as a PRC “resident enterprise.”

 

Under the New EIT Law, withholding tax at a rate of 10% is applicable to dividends payable to investors that are “non-resident enterprises,” which do not have an establishment or place of business in the PRC, or which have such establishment or place of business but the relevant income is not effectively connected with the establishment or place of business, to the extent such interest or dividends have their sources within the PRC unless such non-resident enterprise can claim treaty protection. Similarly, any gain realized on the transfer of ADSs or ordinary shares by such investors is also subject to a 10% withholding tax if such gain is regarded as income derived from sources within the PRC. Since the New EIT Law is relatively new and ambiguous in certain aspects, there is uncertainty as to whether the dividends we pay with respect to our ADSs or ordinary shares, or the gain you may realize from the transfer of our ADSs or ordinary shares, would be treated as income derived from sources within the PRC and be subject to PRC withholding tax. If we are required under the New EIT Law to withhold PRC income tax on such dividends or your gains realized on the sales of our ADSs or ordinary shares, your investment in our ADSs or ordinary shares may be materially and adversely affected.

 

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Vimicro China is subject to restrictions on paying dividends or making other distributions to us.

 

We are a holding company and we rely on dividends paid by our subsidiaries, including Vimicro China, for our cash needs, such as the funds necessary to pay dividends and other cash distributions to our shareholders, to service any debt we may incur and to pay our operating expenses. Regulations in the PRC currently permit payment of dividends only out of accumulated profits as determined in accordance with accounting standards and regulations in China. Subsidiaries are required to set aside at least 10% of its accumulated profits each year, if any, to fund certain reserve funds, until the accumulated reserve fund exceeds 50% of its registered capital. These reserve funds are not distributable as cash dividends. If our subsidiary in China incurs debt on its own behalf in the future, the instruments governing the debt may restrict its ability to pay dividends or make other distributions to us.

 

Future movements in exchange rates between the U.S. dollar and the RMB may have a material adverse effect on your investment.

 

The value of the RMB against the U.S. dollar and other currencies may fluctuate and is affected by, among other things, changes in political and economic conditions and China’s foreign exchange policies. On July 21, 2005, the PRC government changed its decade-old policy of pegging the value of the RMB to the U.S. dollar. Under the new policy, the RMB is permitted to fluctuate within a managed band based on market supply and demand and by reference to a basket of certain foreign currencies. This change in policy has resulted in an approximately more than 30% appreciation of the RMB against the U.S. dollar since the introduction of new policy.

 

The majority of our revenue, cost of revenue and operating expenses are denominated in RMB, while a portion of non-operating expenses are denominated in U.S. dollars and Hong Kong dollars, which is pegged to the U.S. dollar. We use the U.S. dollar as the reporting currency for our financial statements. Fluctuations in exchange rates, primarily those involving the U.S. dollar, may affect our costs and operating margins as well as our net income and comprehensive income reported in U.S. dollars. Conversely, if we decide to convert our RMB into U.S. dollars for the purpose of making payments for dividends on our ordinary shares or ADSs or for other business purposes, appreciation of the U.S. dollar against the RMB would have a negative effect on the U.S. dollar amount available to us.

 

Restrictions on currency exchange may limit our ability to receive and use our revenue effectively.

 

The PRC government imposes controls on the convertibility of RMB into foreign currencies and, in certain cases, the remittance of currency out of China. We receive a portion of our revenue in RMB, which is currently not a freely convertible currency. Under our current structure, our income will be primarily derived from dividend payments from Vimicro China. Under existing PRC foreign exchange regulations, payments of current account items, including profit distributions, interest payments and expenditures from the transaction, can be made in foreign currencies without prior approval from the PRC State Administration of Foreign Exchange, or SAFE, by complying with certain procedural requirements. However, approval from appropriate governmental authorities is required where RMB is to be converted into foreign currency and remitted outside of China to pay capital expenses such as the repayment of bank loans denominated in foreign currencies. The PRC government may also, at its discretion, restrict access in the future to foreign currencies for current account transactions. If the foreign exchange control system prevents us from obtaining sufficient foreign currency to satisfy our currency demands, we may not be able to pay dividends in foreign currencies to our shareholders, including holders of our ADSs. In addition, we cannot be certain that the PRC regulatory authorities will not impose more stringent restrictions on RMB foreign exchange transactions.

 

PRC regulations relating to the establishment of offshore special purpose companies by PRC residents may subject our PRC resident shareholders to personal liability and limit our ability to inject capital into our PRC subsidiary, limit our subsidiary’s ability to distribute profits to us, or otherwise adversely affect us.

 

On October 21, 2005, SAFE issued the Circular on Relevant Issues Concerning Foreign Exchange Control on Domestic Residents’ Financing and Roundtrip Investment Through Offshore Special Purpose Vehicle, or Circular 75. On November 19, 2012, SAFE issued Notice on Further Improving and Adjusting Foreign Administration Policies in Respect of Foreign Direct Investment, or SAFE Circular 59, which became effective on December 17, 2012. SAFE Circular 59 provides, among other things, detailed implementing rules on initial registration procedures relating to incorporation of offshore special purpose vehicles owned by onshore residents and amendment registration procedures relating to changes to such offshore special purpose vehicles. Pursuant to Circular 75 and SAFE Circular 59, a PRC resident is required to complete the initial registration with the local SAFE counterpart before incorporating or acquiring control of an offshore special purpose vehicle, with assets or equity interests in an onshore company located in the PRC, for the purpose of offshore equity financing. The PRC resident is also required to amend the registration or handle a filing procedure upon (i) injection of the assets or equity interests in an onshore company or undertaking of offshore financing, and (ii) a material change that may affect the capital structure of the special purpose vehicle. Under Circular 75, the fulfillment of the initial and amended SAFE registrations is a prerequisite for other regulatory approvals and registrations required for relevant cross-border investment activities and capital flows, such as the offshore entity’s inbound capital contribution or provision of shareholder’s loans to the onshore entity and the onshore entity’s payment of dividends or repatriation of liquidation proceeds, equity interests disposal proceeds or capital reduction to the offshore entity.

 

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We have notified beneficial owners of our company who are PRC residents to register with the local SAFE branch as required under Circular 75. We understand that members of our senior management who are PRC residents have registered with the local SAFE branch. However, we may not at all times be fully aware or informed of the identities of all our beneficial owners who are PRC residents, and we may not always be able to compel our beneficial owners to comply with the Circular 75 requirements. As a result, we cannot assure you that all of our shareholders or beneficial owners who are PRC residents will at all times comply with, or in the future make or obtain any applicable registrations or approvals required by, Circular 75 or other related regulations. The failure or inability of beneficial owners of our company resident in the PRC to comply with the registration procedures set forth under Circular 75 could subject such beneficial owners to fines and legal sanctions and may also limit our ability to contribute additional capital into our PRC subsidiary, limit our PRC subsidiary’s ability to distribute profits to our company or otherwise adversely affect our business.

 

If the PRC government determines that the contractual arrangements that establish the structure for operating our wireless value-added telecommunications business do not comply with applicable PRC laws and regulations, we could be subject to penalties.

 

We are a Cayman Islands company and, as such, we are classified as a foreign enterprise under PRC laws, and our PRC subsidiaries, including Vimicro China, are foreign-invested enterprises. Various regulations in China restrict or prevent foreign-invested entities from holding certain licenses required to operate value-added telecommunications business, including wireless value-added telecommunications business. In light of these restrictions, we plan to rely on Vimicro Sky-Vision to hold and maintain the permits and licenses necessary to operate our wireless value-added telecommunications business in China. Vimicro Sky-Vision has had no substantive operations since its incorporation. We do not possess any equity interest in Vimicro Sky-Vision, but we receive certain economic benefits from it through various contractual arrangements and certain corporate governance and shareholder rights arrangements. In addition, we have entered into agreements with each of Vimicro Sky-Vision’s shareholders, which provide us with substantial control over Vimicro Sky-Vision. For a description of these contractual arrangements with Vimicro Sky-Vision and its shareholders, see “Item 7. Major Shareholders and Related Party Transactions—B. Related Party Transactions—Contractual Arrangements with Vimicro Sky-Vision and its Shareholders.”

 

The Circular on Strengthening the Administration of Foreign Investment in and Operation of Value-added Telecommunications Business, or the Circular, issued in July 2006 by the Ministry of Industry and Information Technology, or the MIIT, reiterated the regulations on foreign investment in telecommunications businesses, which requires foreign investors to set up foreign-invested enterprises and obtain a business operating license, or VT license, for conducting any value-added telecommunications business in China. Under the Circular, a domestic company that holds a VT license is prohibited from leasing, transferring or selling the license to foreign investors in any form. They are also prohibited from providing any assistance, including providing resources, sites or facilities, to foreign investors that conduct value-added telecommunications business illegally in China. Furthermore, the relevant trademarks and domain names that are used in the value-added telecommunications business must be owned by a VT license holder or its shareholder(s). The Circular further requires each VT license holder to have the necessary facilities for its approved business operations and to maintain such facilities in the regions covered by its license. In addition, all value-added telecommunications service providers are required to maintain network and information security in accordance with the standards set forth under relevant PRC regulations. Due to a lack of interpretative materials from the regulator, it is unclear what impact the Circular will have on us or other domestic providers of value-added telecommunications services that have adopted the same or similar corporate and contractual structures as ours.

 

If we are found to be in violation of any existing or future PRC laws or regulations, including the Circular, or if we fail to obtain or maintain any of the required permits or approvals, the relevant regulatory authorities would have broad discretion in dealing with such violation, including but not limited to imposing fines, issuing rectification orders, confiscating our income, revoking Vimicro China’s or Vimicro Sky-Vision’s business and operating licenses, requiring us to restructure the relevant ownership structure or operations or requiring us to discontinue all or any portion of our wireless value-added telecommunication business. We did not derive any revenues from our wireless value-added telecommunications business in 2013 and we currently do not have any plan to operate wireless value-added telecommunications business in the foreseeable future.

 

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Our contractual arrangements with Vimicro Sky-Vision and its shareholders, respectively, may not be as effective in providing control over Vimicro Sky-Vision as direct ownership.

 

We plan to conduct our wireless value-added telecommunication business in China through Vimicro Sky-Vision, which was set up in March 2010. There have been no substantive operations since its incorporation. Our contractual arrangements with Vimicro Sky-Vision and its shareholders provide us with effective control over Vimicro Sky-Vision. See “Item 7. Major Shareholders and Related Party Transactions—B. Related Party Transactions—Contractual Arrangements with Vimicro Sky-Vision and its Shareholders.” As a result of these contractual arrangements, we are considered to be the primary beneficiary of Vimicro Sky-Vision and Vimicro Sky-Vision becomes our VIE. Accordingly, we consolidate the results of operations, assets and liabilities of Vimicro Sky-Vision in our financial statements.

 

These contractual arrangements may not be as effective in providing us with control over Vimicro Sky-Vision as direct ownership. In addition, Vimicro Sky-Vision or its shareholders may breach the contractual arrangements. We cannot assure you that when conflicts of interest arise, Vimicro Sky-Vision and its shareholders will act completely in our interests or that conflicts of interest will be resolved in our favor. In any such event, we would have to rely on legal remedies under PRC law. These remedies may not always be effective, particularly in light of uncertainties in the PRC legal system. See “—Risks Related to Doing Business in China—Uncertainties with respect to the PRC legal system could adversely affect us.”

 

Contractual arrangements we have entered into may be subject to scrutiny by the PRC tax authorities, and a finding that we or Vimicro Sky-Vision owe additional taxes could reduce our net income and the value of your investment.

 

As required by applicable PRC laws and regulations, arrangements and transactions among related parties may be subject to audit or challenge by the PRC tax authorities. On January 8, 2009, the State Administration of Taxation, or SAT, issued the Implementation Measures of Special Tax Adjustments (Provisional), which reinforces its supervision on transfer pricing. We could face adverse tax consequences if the PRC tax authorities determine that the contractual arrangements between Vimicro China and Vimicro Sky-Vision, if any, do not represent an arm’s-length price, and adjust Vimicro Sky-Vision’s income in the form of a transfer pricing adjustment. A transfer pricing adjustment could, among other things, result in a reduction, for PRC tax purposes, of expense deductions recorded by Vimicro Sky-Vision, which could in turn increase its tax liabilities. In addition, the PRC tax authorities may impose late payment fees, fines, or revocation of business licenses and other penalties on Vimicro Sky-Vision for underpaid taxes. Our net income may be adversely affected if tax liabilities of Vimicro Sky-Vision increase or if Vimicro Sky-Vision is found to be subject to late payment fees or other penalties.

 

We face uncertainty with respect to the indirect transfer of equity interests in PRC on-shore entities.

 

Pursuant to the Circular on Strengthening the Administration of Enterprise Income Tax on Non-resident Enterprises’ Share Transfer, or Circular 698, issued by the SAT, effective as of January 1, 2008, any foreign investor indirectly transferring equity interests in a Chinese resident enterprise by selling the shares in an offshore holding company (which is located in a jurisdiction where the effective tax burden is less than 12.5% or where the offshore income of its residents is not taxable) must provide the PRC tax authority in charge of that Chinese resident enterprise with the relevant information within 30 days of the transfer. Where a foreign investor indirectly transfers equity interests in a Chinese resident enterprise through any “abusive use of organizational form” and there are no reasonable commercial purposes for such form with the result that the corporate income tax liability is avoided, the PRC tax authorities shall have the power to reassess the nature of the equity transfer in accordance with the “substance-over-form” principle and deny the existence of an offshore holding company that is used for abusive tax planning purposes. In that case, the indirect equity transfer will be viewed as a direct transfer. Therefore, the capital gain derived from the indirect transfer will be subject to PRC withholding tax at 10%. “Income derived from equity transfers” as mentioned in this circular refers to income derived by nonresident enterprises from direct or indirect transfers of equity interest in China resident enterprises, excluding shares in Chinese resident enterprises that are bought and sold openly on the stock exchange.

 

While the term “indirectly transfer” is not defined, we understand that the relevant PRC tax authorities have broad discretion in requesting for information over a wide range of foreign entities having no direct contact with China. Meanwhile, there have been no formal declarations with regard to the interpretation and implementation of rules relating to the “abusive use of organizational form” and “reasonable commercial purpose.” As a result, in the event that any transaction we engage is deemed as an “indirect transfer” that is subject to Circular 698, we may be subject to additional compliance requirements and tax burdens, which could have a material and adverse effect on our business, financial condition and results of operations.

 

We face risks related to health epidemics and other outbreaks.

 

Our business could be adversely affected by swine flu, avian flu, SARS or another epidemic or outbreak on the economic and business climate. In 2009, an outbreak of swine flu occurred in various countries, including China. Any outbreak of swine flu, avian flu, or another epidemic in China may have a material adverse effect on our business operations, financial condition and results of operations. For instance, health or other government regulations may require temporary closure of our offices, which will severely disrupt our business operations.

 

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Our auditor, like other independent registered public accounting firms operating in China, is not permitted to be subject to inspection by the Public Company Accounting Oversight Board and investors may be deprived of the benefits of such inspection.

 

Our independent registered public accounting firm that issues the audit reports included in our annual reports filed with the SEC, as an auditor of companies that are traded publicly in the United States and a firm registered with the Public Company Accounting Oversight Board (United States), or the PCAOB, is required by the laws of the United States to undergo regular inspections by the PCAOB to assess its compliance with the laws of the United States and professional standards. Because our auditor is located in China, a jurisdiction where the PCAOB is currently unable to conduct inspections without the approval of the PRC authorities, our auditor, like other independent registered public accounting firms operating in China, is currently not inspected by the PCAOB.

 

Inspections of other firms that the PCAOB has conducted outside China have identified deficiencies in those firms’ audit procedures and quality control procedures, which may be addressed as part of the inspection process to improve future audit quality. The inability of the PCAOB to conduct inspections of independent registered public accounting firms operating in China makes it more difficult to evaluate the effectiveness of our auditor’s audit procedures and quality control procedures. As a result, investors may be deprived of benefits of PCAOB inspections.

 

Proceedings instituted recently by the SEC against five PRC-based accounting firms, including our independent registered public accounting firm, could result in financial statements being determined to not be in compliance with the requirements of the Securities Exchange Act of 1934.

 

In December 2012, the SEC instituted proceedings under Rule 102(e)(1)(iii) of the SEC’s Rules of Practice against five PRC-based accounting firms, including our independent registered public accounting firm, alleging that these firms had violated U.S. securities laws and the SEC’s rules and regulations thereunder by failing to provide to the SEC the firms’ work papers related to their audits of certain PRC-based companies that are publicly traded in the United States. Rule 102(e)(1)(iii) grants the SEC the authority to deny to any person, temporarily or permanently, the ability to practice before the SEC who is found by the SEC, after notice and opportunity for a hearing, to have willfully violated any such laws or rules and regulations.  On January 22, 2014, an initial administrative law decision was issued, sanctioning four of these accounting firms and suspending them from practicing before the SEC for a period of six months. The sanction will not take effect until there is an order of effectiveness issued by the SEC. The accounting firms involved have the ability to appeal and if appealed, the sanction will not become effective until after a full appeal process is concluded and a final decision is issued by the SEC.  While we cannot predict the outcome of the SEC’s proceedings, if our independent registered public accounting firm is denied, temporarily or permanently, the ability to practice before the SEC, and we are unable to find in a timely manner another registered public accounting firm which can audit and issue a report on our financial statements, our financial statements could be determined to not be in compliance with the requirements for financial statements of public companies with a class of securities registered under the Securities Exchange Act of 1934, as amended, or the Exchange Act. Such a determination could ultimately lead to the delisting of our ADSs from the NASDAQ Global Market, which event would effectively terminate the trading market for our ADSs in the United States, and/or to the SEC’s revoking the registration of our ADSs under the Exchange Act pursuant to Section 12(j) thereof, in which event broker-dealers thereafter would be prohibited from effecting transactions in, or inducing the purchase or sale of, our ADSs in the United States.

 

Risks Related to the Shares and ADSs

 

We believe we were a passive foreign investment company for the taxable year ended December 31, 2013, which could result in adverse United States federal income tax consequences to United States Holders of our ADSs or ordinary shares.

 

Based on the market price of our ADSs and the value and composition of our assets, we believe we were a “passive foreign investment company,” or PFIC, for United States federal income tax purposes for the taxable year ended December 31, 2013. In addition, it is likely one or more of our subsidiaries were also PFICs for such year. A non-United States corporation will be a PFIC for any taxable year if either (1) at least 75% of its gross income for such year is passive income or (2) at least 50% of the value of its assets (based on an average of the quarterly values of the assets) during such year is attributable to assets that produce passive income or are held for the production of passive income. We must make a separate determination after the close of each taxable year as to whether we were a PFIC for that year. Because the value of our assets for purposes of the PFIC test will generally be determined by reference to the market price of our ADSs or ordinary shares, our PFIC status will depend in large part on the market price of the ADSs or ordinary shares, which may fluctuate significantly. Because we believe we were a PFIC for the taxable year ended December 31, 2013, certain adverse United States federal income tax consequences could apply to U.S. Holders (as defined in “Item 10. Additional Information—E. Taxation—United States Federal Income Taxation”) of our ADSs or ordinary shares with respect to any “excess distribution” received from us and any gain from a sale or other disposition of the ADSs or ordinary shares. See “Item 10. Additional Information—E. Taxation—United States Federal Income Taxation—Passive Foreign Investment Company.”

 

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The market price for our ADSs may be volatile.

 

The market price for our ADSs is likely to be highly volatile and subject to wide fluctuations in response to factors including the following:

 

·                                          actual or anticipated fluctuations in our quarterly operating results and changes or revisions of our expected results;

 

·                                          changes in financial estimates by securities research analysts;

 

·                                          conditions in the PC camera and video surveillance markets;

 

·                                          changes in the economic performance or market valuations of other semiconductor companies;

 

·                                          announcements by us or our competitors of new products, acquisitions, strategic relationships, joint ventures or capital commitments;

 

·                                          addition or departure of our key personnel;

 

·                                          fluctuations of exchange rates between the RMB, the U.S. dollar and the Hong Kong dollar;

 

·                                          litigation related to our intellectual property;

 

·                                          release or expiry of lock-up or other transfer restrictions on our outstanding ordinary shares or ADSs; and

 

·                                          sales or perceived potential sales of additional ordinary shares or ADSs.

 

In addition, the securities market has from time to time experienced significant price and volume fluctuations that are not related to the operating performance of particular companies. These market fluctuations may also have a material adverse effect on the market price of our ADSs.

 

In October 2012, we received a notification from the NASDAQ Stock Market, indicating that the minimum bid price of our ADS had been below $1.00 per ADS for 30 consecutive business days and as a result, we were not in compliance with the minimum bid price requirement for continued listing set forth in NASDAQ Listing Rule 5450(a)(1). Under NASDAQ Listing Rule 5810(c)(3)(A), we had a grace period of 180 calendar days, within which to regain compliance with the minimum bid price rule. We regained compliance on November 1, 2012 by meeting or exceeding $1.00 per ADS for a minimum of ten consecutive business days. We actively monitor the price of its ADSs and will consider available options, including, but not limited to, changing the ADS ratio, to regain compliance with the continued listing standards of the NASDAQ. If we are unable to comply with the continued listing standards of the NASDAQ Stock Market, we would not be able to remain listed on that stock exchange which would have a material adverse effect on the price of our ADSs.

 

We may need additional capital, and the sale of additional ADSs or other equity securities could result in additional dilution to our shareholders.

 

We may require additional cash resources due to changed business conditions or other future developments, including any investments or acquisitions we may decide to pursue, the performance of video surveillance projects and construction of office buildings. If our resources are insufficient to satisfy our cash requirements, we may seek to sell additional equity or debt securities or obtain a credit facility. The sale of additional equity securities could result in additional dilution to our shareholders. The incurrence of indebtedness would result in increased debt service obligations and could result in operating and financing covenants that would restrict our operations. We cannot assure our existing shareholders that financing will be available in amounts or on terms acceptable to us, if at all.

 

Substantial future sales of our ADSs or ordinary shares in the public market, or the perception that these sales could occur, could cause the price of our ADSs to decline.

 

Additional sales of our ADSs or ordinary shares in the public market, or the perception that these sales could occur, could cause the market price of our ADSs to decline. If our shareholders sell substantial amounts of our ADSs, including those issued upon the exercise of outstanding options, in the public market, the market price of our ADSs could fall. Such sales also might make it more difficult for us to sell equity or equity-related securities in the future at a time and price that we deem appropriate. If any existing shareholder or shareholders sell a substantial amount of ordinary shares, the prevailing market price for our ADSs could be adversely affected.

 

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Holders of our ADSs may not have the same voting rights as the holders of our ordinary shares and may not receive voting materials in time to be able to exercise their right to vote.

 

Except as described in this annual report on Form 20-F and in the deposit agreement, holders of our ADSs will not be able to exercise voting rights attaching to the shares evidenced by our ADSs on an individual basis. Holders of our ADSs will appoint the depositary or its nominee as their representative to exercise the voting rights attaching to the shares represented by the ADSs. You may not receive voting materials in time to instruct the depositary to vote, and it is possible that you, or persons who hold their ADSs through brokers, dealers or other third parties, will not have the opportunity to exercise a right to vote.

 

Your right to participate in any future rights offerings may be limited, which may cause dilution to your holdings and you may not receive cash dividends if it is impractical to make them available to you.

 

We may from time to time distribute rights to our shareholders, including rights to acquire our securities. However, we cannot make rights available to you in the United States unless we register the rights and the securities to which the rights relate under the Securities Act or an exemption from the registration requirements is available. Under the deposit agreement, the depositary bank will not make rights available to you unless both the rights and the underlying securities to be distributed to ADS holders are either registered under the Securities Act or exempt from registration under the Securities Act. We are under no obligation to file a registration statement with respect to any such rights or securities or to endeavor to cause such a registration statement to be declared effective and we may not be able to establish a necessary exemption from registration under the Securities Act. Accordingly, you may be unable to participate in our rights offerings and may experience dilution in your holdings.

 

The depositary of our ADSs has agreed to pay to you the cash dividends or other distributions it or the custodian receives on our ordinary shares or other deposited securities after deducting its fees and expenses. You will receive these distributions in proportion to the number of ordinary shares your ADSs represent. However, the depositary may, at its discretion, decide that it is inequitable or impractical to make a distribution available to any holders of ADSs. For example, the depositary may determine that it is not practicable to distribute certain property through the mail, or that the value of certain distributions may be less than the cost of mailing them. In these cases, the depositary may decide not to distribute such property and you will not receive such distribution.

 

You may be subject to limitations on transfer of your ADSs.

 

Your ADSs are transferable on the books of the depositary. However, the depositary may close its transfer books at any time or from time to time when it deems expedient in connection with the performance of its duties. In addition, the depositary may refuse to deliver, transfer or register transfers of ADSs generally when our books or the books of the depositary are closed, or at any time if we or the depositary deem it advisable to do so because of any requirement of law or of any government or governmental body, or under any provision of the deposit agreement, or for any other reason.

 

Your ability to protect your rights through the U.S. federal courts may be limited, because we are incorporated under Cayman Islands law, conduct a substantial portion of our operations in China and the majority of our directors and officers reside outside of the United States.

 

We are incorporated in the Cayman Islands, and conduct a substantial portion of our operations in China through Vimicro China. A majority of our directors and officers reside outside of the United States and a substantial portion of their assets are located outside of the United States. As a result, it may be difficult for you to effect service of process within the United States upon these persons. It may also be difficult for you to enforce in U.S. courts judgments obtained in U.S. courts based on the civil liability provisions of the U.S. federal securities laws against us and our officers and directors, most of whom are not residents in the United States and the substantial majority of whose assets are located outside of the United States. In addition, there is uncertainty as to whether the courts of the Cayman Islands or the PRC would recognize or enforce judgments of U.S. courts against us or such persons predicated upon the civil liability provisions of the securities laws of the United States or any state and it is uncertain whether such Cayman Islands or PRC courts would impose liabilities in original actions brought in the Cayman Islands or the PRC against us or such persons predicated upon the securities laws of the United States or any state.

 

You may face difficulties in protecting your interests as a shareholder, as Cayman Islands law provides significantly less protection to shareholders when compared to the laws of the U.S.

 

Our corporate affairs are governed by our memorandum and articles of association, as amended and restated from time to time, and by the Companies Law (2013 Revision) and common law of the Cayman Islands. The rights of shareholders to take legal action against our directors, actions by minority shareholders and the fiduciary responsibilities of our directors to us under Cayman Islands law are to a large extent governed by the common law of the Cayman Islands. The common law of the Cayman Islands is derived in part from comparatively limited judicial precedent in the Cayman Islands as well as from English common law, which has persuasive, but not binding, authority on a court in the Cayman Islands. The rights of our shareholders and the fiduciary responsibilities of our directors under Cayman Islands law are not as clearly established as they would be under statutes or judicial precedents in the United States. In particular, the Cayman Islands has a less developed body of securities laws as compared to the United States, and provides significantly less protection to investors. In addition, shareholders of Cayman Islands companies may not have standing to initiate a shareholder derivative action before the federal courts of the United States. As a result, our public shareholders may have more difficulty in protecting their interests in actions against the management, directors or our controlling shareholders than would shareholders of a corporation incorporated in a jurisdiction in the United States, and our ability to protect our interests if we are harmed in a manner that would otherwise enable us to sue in a United States federal court may be limited.

 

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Although publicly traded, the trading market in our common stock has been substantially less liquid than the average trading market for a stock quoted on the NASDAQ Global Market and this low trading volume may adversely affect the price of our common stock.

 

We completed our initial public offering on November 18, 2005. On November 15, 2005, we listed our ADSs on the NASDAQ Global Market under the symbol “VIMC.” The trading market in our common stock has been substantially less liquid than the average trading market for companies quoted on the NASDAQ Global Market. Limited trading volume will subject our shares of common stock to greater price volatility and may make it difficult for you to sell your shares of common stock at a price that is attractive to you.

 

Provisions of our stockholder rights plan could delay or prevent an acquisition of our company, even if the acquisition would be beneficial to our shareholders, and could make it more difficult for shareholders to change management.

 

In December 2008, we adopted a shareholder rights plan. Although the rights plan will not prevent a takeover, it is intended to encourage anyone seeking to acquire our company to negotiate with our board of directors prior to attempting a takeover by potentially diluting an acquirer’s ownership interest significantly in our outstanding capital stock. The existence of the rights plan may also discourage transactions that otherwise could involve payment of a premium over prevailing market prices for our ADSs.

 

We have incurred and will continue to incur increased costs as a result of being a public company.

 

As a public company, we have incurred and will continue to incur a significantly higher level of legal, accounting and other expenses than we did as a private company. We have incurred and will continue to incur costs associated with our public company reporting requirements. In addition, the Sarbanes-Oxley Act, as well as new rules subsequently implemented by the SEC and the NASDAQ Stock Market, have required changes in corporate governance practices of public companies. We expect these new rules and regulations to increase our legal and financial compliance costs and to make some activities more time-consuming and costly. We are currently evaluating and monitoring developments with respect to these new rules, and we cannot predict or estimate the amount of additional costs we may incur or the timing of such costs.

 

ITEM 4.                          INFORMATION ON THE COMPANY

 

A.                     History and Development of the Company

 

Our legal and commercial name is Vimicro International Corporation. We commenced operations in 1999 through Vimicro China, a company established in China. In February 2004, we incorporated Vimicro International Corporation in the Cayman Islands as an exempted company with limited liability under the Cayman Islands laws. In May 2004, we underwent a corporate reorganization whereby all former owners of Vimicro China transferred their ownership interests in Vimicro China to Vimicro International Corporation, and Vimicro China became a wholly-owned subsidiary of Vimicro International Corporation. Following the share transfer, each former owner of Vimicro China and/or its designated nominee subscribed for the shares of Vimicro International Corporation based on such former owner’s pro rata ownership interest in Vimicro China prior to the reorganization. We completed our initial public offering on November 18, 2005. On November 15, 2005, we listed our ADSs on the NASDAQ Global Market under the symbol “VIMC.”

 

Our principal executive offices are located at 16/F Shining Tower, No. 35 Xueyuan Road, Haidian District, Beijing 100191, People’s Republic of China. Our telephone number at this address is (8610) 6894-8888 and our fax number is (8610) 6874-4075. Our registered office in the Cayman Islands is located at the offices of Maples Corporate Services Limited, PO Box 309, Ugland House, Grand Cayman, KY1-1104 Cayman Islands. Our telephone number at this address is (1-345) 949-8066. In addition, we have regional offices in Shanghai, Shenzhen, Nanjing, Tianjin, Guiyang, Fuzhou, Hong Kong, Taiwan and Silicon Valley.

 

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The following descriptions set forth detailed information of our current significant subsidiaries and affiliated entities:

 

·                          Vimicro China, incorporated in China in October 1999 as a limited liability company with an approved operating period through May 2034. Vimicro China is our onshore holding subsidiary and we conduct substantially all of our headquarters functions through Vimicro China, including research and development, administration, sales and marketing at a headquarters level;

 

·                          Viewtel, incorporated in California, the United States, in June 1999 to keep abreast with the latest technology developments in the United States and to maintain a small team of engineers to conduct advanced research and development activities;

 

·                          Vimicro Hong Kong, established in Hong Kong in May 2002 to facilitate our sales activities and utilization of third-party foundries and assembly and testing houses located in China, Taiwan and Hong Kong;

 

·                          Vimicro Beijing, established in Beijing in April 2007 as a limited liability company with an approved operating period of 20 years. Vimicro Beijing primarily engages in research and development and sales and marketing activities;

 

·                          Vimicro Jiangsu, established in Jiangsu in December 2007 as limited liability company with an approved operating period of 20 years. Vimicro Jiangsu owns land use rights to a parcel of property on which it plans to develop office and research/manufacturing facilities, a portion of which we will use for our own purposes and a portion of which we will lease to third parties. See “Item 4. Information on the Company—D. Property, Plant and Equipment”;

 

·                          Vimicro Tianjin, established in Tianjin in December 2008 to focus on the design, manufacture and sales of video surveillance products. It is a limited stock corporation incorporated by (i) Vimicro China, (ii) the State-owned Asset Management Corporation of Tianjin Economic-Technological Development Area, or Tianjin SAMC, and (iii) the Vimicro Management Foundation, or VMF, a limited partnership with Zhonghan (John) Deng and Zhaowei (Kevin) Jin as limited partners who are members of our management team and managed by Dr. Xiaodong (Dave) Yang, the general partner of VMF, who acted as our director until May 2012, to provide investment and consulting services. Tianjin SAMC and Vimicro China each contributed RMB250 million in cash to Vimicro Tianjin as initial registered capital and each holds approximately 49.99% ownership interest in the company. VMF holds a nominal ownership interest. Pursuant to agreements between Vimicro China and VMF, we obtained the voting rights and economic interests associated with VMF’s current share ownership in Vimicro Tianjin, which provides us control of Vimicro Tianjin. VMF also granted us an exclusive right to acquire from VMF the beneficial ownership of Tianjin SAMC’s interest in Vimicro Tianjin for the same amount of consideration paid by VMF. It is necessary for VMF to receive our consent before it can exercise the option to acquire Tianjin SAMC’s interest in Vimicro Tianjin. If we exercise this exclusive right, approximately 15% of Vimicro Tianjin’s ownership interest will be reserved for an equity award scheme whereby we may make grants of equity awards at our discretion. In 2009, Vimicro Tianjin acquired the complete ViSS business from ASB, including all equipment, inventories, business contracts, intellectual property and employees in China for a total consideration of approximately RMB56.0 million. In addition, Vimicro and ASB agreed to continue to cooperate on the related fields in the future. Through Vimicro Tianjin, we are also constructing a new facility for the research, development and production of digital high-definition video surveillance products and solutions. For more information about this project, see “Item 5. Operating and Financial Review and Prospects—B. Liquidity and Capital Resources—Capital Expenditures;”

 

·                          Vimicro Guiyang, wholly owned and established by Vimicro Tianjin in Guiyang in January 2012 as a limited liability company with an approved unlimited operating period. Vimicro Guiyang focuses on the design, manufacture and sales of video surveillance products, as well as the execution and maintenance of local video surveillance projects;

 

·                          Vimicro Fuzhou, established in Fuzhou in July 2012 as a limited liability company with an approved long-term operating period. Vimicro Fuzhou focuses on producing and marketing SVAC-based security surveillance products in Fuzhou, the capital city of Fujian province in China;

 

·                          Vimicro Guangdong, established in Zhuhai, Guangdong in March 2014 as a limited liability company with an approved unlimited operating period. Vimicro Guangdong focuses on producing and marketing SVAC-based security surveillance products in Guangdong; and

 

·                          Vimicro Sky-Vision, established in March 2010 as a limited liability company. Zhonghan (John) Deng, our chairman and chief executive officer, and Zhaowei (Kevin) Jin, our president and chief operating officer, hold 67% and 33% of the equity interest in Vimicro Sky-Vision, respectively. We entered into a series of contractual arrangements with Vimicro Sky-Vision and its shareholders. As a result of these contractual arrangements, Vimicro Sky-Vision became a VIE of our company, and we are considered to be the primary beneficiary of Vimicro Sky-Vision. Accordingly, we consolidated the results of operations, assets and liabilities of Vimicro Sky-Vision in our financial statements. To comply with the PRC regulations that restrict foreign ownership in value-added telecommunications business in China, we conduct our wireless value-added telecommunication operations, particularly the mobile surveillance business, through Vimicro Sky-Vision. There have been no substantive operations since its incorporation.

 

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Contractual Arrangements with Vimicro Sky-Vision and its Shareholders

 

In order to comply with PRC laws restricting foreign ownership in the wireless value-added telecommunication business in China, we plan to conduct all of our wireless value-added telecommunication business through Vimicro Sky-Vision. We expect that Vimicro Sky-Vision will apply and hold the licenses and permits required to operate our wireless value-added telecommunication services. There have been no substantive operations since its incorporation. The equity interest in Vimicro Sky-Vision was owned 67% by Zhonghan (John) Deng, our chairman and chief executive officer, and 33% by Zhaowei (Kevin) Jin, our president and chief operating officers, upon its establishment in March 2010. Vimicro China, Vimicro Sky-Vision and the shareholders of Vimicro Sky-Vision entered into a series of agreements that became effective on March 5, 2010 through which we exercise effective control of Vimicro Sky-Vision and can receive economic benefits generated from its shareholders’ equity interests. The following is a summary of the agreements currently in effect:

 

·                          Loan Agreement, between Vimicro China and Vimicro Sky-Vision’s shareholders. These loan agreements provide for loans in the amount of RMB6.7 million ($1.0 million) to Mr. Deng and of RMB3.3 million ($0.5 million) to Mr. Jin for them to make contributions to the registered capital of Vimicro Sky-Vision in exchange for their 67% and 33% equity interests in Vimicro Sky-Vision. The loans are interest free and are repayable on demand, but the only means by which the shareholders can repay the loans is to transfer to Vimicro China or a third party designated by Vimicro China their respective equity interests in Vimicro Sky-Vision.

 

·                          Equity Interests Purchase Right Agreement, among Vimicro China, Vimicro Sky-Vision and Vimicro Sky-Vision’s shareholders. Pursuant to these agreements, Vimicro China and any third party designated by Vimicro China have the right, exercisable at any time during the term of the agreements, to the extent permitted under PRC law, to purchase from Mr. Deng or Mr. Jin, as the case may be, all or any part of their equity interests in Vimicro Sky-Vision at a purchase price equal to their respective initial contributions to the registered capital of Vimicro Sky-Vision or at a price determined by Vimicro China. Vimicro China also has the right to determine the type of purchase price payment and the means of rendering the purchase price when exercising all or part of the option to purchase the equity interest held by the shareholders of Vimicro Sky-Vision.

 

·                          Share Pledge Agreements, among Vimicro China, Vimicro Sky-Vision and the shareholders of Vimicro Sky-Vision. Pursuant to these agreements, Mr. Deng and Mr. Jin pledged to Vimicro China their equity interest in Vimicro Sky-Vision to secure the performance of their respective obligations and Vimicro Sky-Vision’s obligations under the various VIE-related agreements. If any of the shareholders of Vimicro Sky-Vision breaches his or her respective obligations under any VIE-related agreements (Vimicro Sky-Vision’s breach of any of its obligations under the various VIE-related agreements will be treated as its shareholders’ breach of their respective obligations), including the Share Pledge Agreement, Vimicro China is entitled to exercise its rights as the beneficiary under the Share Pledge Agreement, including all the rights such shareholder has as a shareholder of Vimicro Sky-Vision.

 

·                          Business Operations Agreement, among Vimicro China, Vimicro Sky-Vision and the shareholders of Vimicro Sky-Vision. This agreement sets forth the rights of Vimicro China to control the actions of the shareholders of Vimicro Sky-Vision.

 

·                          Powers of Attorney, executed by the shareholders of Vimicro Sky-Vision in favor of Vimicro China. These powers of attorney give Vimicro China the exclusive right to appoint nominees to act on behalf of each of the Vimicro Sky-Vision shareholders in connection with all actions to be taken by Vimicro Sky-Vision.

 

·                          Exclusive Technical and Consulting Services Agreement, between Vimicro China and Vimicro Sky-Vision. Pursuant to this agreement, Vimicro China has the exclusive right to provide product development and application services, technology support, intellectual property rights, marketing, staffing, business operation and maintenance services to Vimicro Sky-Vision for a fee, based on a predetermined operating margin of Vimicro Sky-Vision.

 

In the opinion of our PRC counsel, King & Wood Mallesons, (i) the ownership structure and the business and operation model of Vimicro China and Vimicro Sky-Vision comply with current PRC laws and regulations; and (ii) each contract under Vimicro China’s contractual arrangements with Vimicro Sky-Vision and each of Vimicro Sky-Vision’s shareholders is valid, binding and enforceable, and will not result in any violation of PRC laws or regulations currently in effect. There are, however, substantial uncertainties regarding the interpretation and application of current or future PRC laws and regulations. Accordingly, PRC governmental authorities may ultimately take a view that is inconsistent with the opinion of King & Wood Mallesons. See “Item 3. Key Information—D. Risk Factors—Risks Related To Doing Business in China—If the PRC government determines that the contractual arrangements that establish the structure for operating our wireless value-added telecommunications business do not comply with applicable PRC laws and regulations, we could be subject to penalties.”

 

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Our Recent Corporate Developments

 

Disposal of non-core IC businesses

 

In December 2010, we adopted the plan to dispose our loss-making non-core IC businesses and three entities holding related land use rights to VMF Consulting Company, a related party, for cash consideration. In December 2010, we completed the disposal of Wuxi Vimicro Corporation, or Vimicro Wuxi, the entity engaging in such business, to VMF Consulting Company by transferring 95% of the equity interest in Vimicro Wuxi. In 2012 and September 2013, we completed the transfer of 4.9% and the remaining 0.1% of the equity interest in Vimicro Wuxi to VMF Consulting Company, respectively.

 

In 2012, we disposed of our interest of Vimicro VMF Shanghai Corporation, the parent company of Vimicro Shanghai, to Vimicro Xingguang Corporation, an affiliate of VMF Consulting Company, for a total consideration of $10.4 million. In April 2013, we transferred our interest in Vimicro VMF Shenzhen Corporation, or VMF Shenzhen, the parent company of Vimicro Shenzhen, to Vimicro Management Zhongxing Tianshi Investment Corporation, or Vimicro Tianshi, an affiliate of VMF Consulting Company for a total consideration of US$10.0 million. The consideration was based on a valuation performed by a third party appraiser. We received $5.0 million of this amount in 2013, and $3.8 million and $1.2 million in January and April 2014, respectively.

 

We had also planned to dispose of Vimicro Jiangsu to divest the land use right associated with our non-core IC businesses. However, after discussions with the Administrative Committee of Nanjing Xuzhuang Software Industrial Base, we were informed that it would be difficult to obtain the necessary approvals to dispose Vimicro Jiangsu. We currently plan on using the property to develop offices, sales and research facilities. We will use a portion of these facilities for our own purposes and the remaining portion we will sell to third parties who are qualified and accepted by the local government. The sale of a portion of the units to qualified third parties is in line with the government policy of attracting investment to the local area. For a detailed discussion of our current plan with respect to the land held by Vimicro Jiangsu, see “Item 4. Information on the Company—D. Property, Plant and Equipment.”

 

Establishment of Zhongtianxin

 

In September 2012, we made investments to incorporate Zhongtianxin with Shanxi Guoxin Investment (Group) Corporation, or Guoxin Group, a financial holding group associated with the local government of Shanxi, and VMF Consulting Company to focus on security-surveillance investment, services and products, as well as developing relationships with security-surveillance customers initially in the local Shanxi market. In particular, Zhongtianxin will focus on the video surveillance business, particularly integrating, developing, producing and marketing SVAC-based security surveillance products and related video sensing and intelligence surveillance applications. Zhongtianxin will also focus on large-scale and capital-intensive projects, such as our projects in Taiyuan and Baoding Vimicro China and Vimicro Tianjin will continue to focus on surveillance processor products as well as video surveillance solutions. According to the terms of the agreement, the parties to the agreement would collectively (i) contribute RMB100 million for the registered capital of Zhongtianxin and (ii) contribute RMB100 million for a capital reserve for Zhongtianxin. In particular, Guoxin Group and VMF Consulting Company agreed to make cash contributions of RMB98 million and RMB4 million, respectively, to Zhongtianxin. In addition, Vimicro China agreed to make a cash contribution of RMB26 million and provide certain intellectual property, appraised at RMB72 million by an independent third-party valuation firm, as part of its investment in Zhongtianxin. As of December 31, 2013, these amounts had been paid in full.

 

Vimicro China, Guoxin Group and VMF Consulting Company each holds 49%, 49% and 2%, respectively, of the equity interests of Zhongtianxin. Pursuant to a nominee agreement between Vimicro China and VMF Consulting Company, VMF Consulting Company is holding the 2% of equity interest as nominee on behalf of Vimicro China. Our investment in Zhongtianxin is accounted for using the equity method as Guoxin Group may exercise substantive participating rights in accordance with the constitutional documents of Zhongtianxin. The establishment of Zhongtianxin reflects our efforts to expand our video surveillance business by cooperating with a state-owned enterprise and engaging in high cash demand video surveillance projects, such as build-transfer, or BT projects, and surveillance integration projects.

 

Beijing Zhongxing Tianshi Consulting Company, or VMF Consulting Company, is a related party controlled by Zhonghan (John) Deng and Zhaowei (Kevin) Jin, who are members of our management team and managed by Xiaodong (Dave) Yang, who acted as our director until May 2012.

 

Deconsolidation of Visiondigi

 

In 2012, we restructured our investments in and deconsolidated Visiondigi, an entity established in Shanghai in July 2009 to focus on research and development, production and sales of network video surveillance products and solutions. Visiondigi was incorporated as a limited liability company by Vimicro China and three DSP experts. In January 2010, Visiondigi introduced Ningbo Sunny Optoelectronic Information Co., Ltd., or Ningbo Sunny, a wholly-owned subsidiary of Sunny Optical Technology Co., Ltd., a company listed on the Hong Kong Stock Exchange, as a minority shareholder. In 2012, we restructured our investments in Visiondigi. In particular, (i) we transferred 35.26% of the equity interest in Visiondigi to an independent third party individual for a consideration of RMB0.3 million, and (ii) entered into a nominee arrangement with the other shareholders of Visiondigi to hold an aggregate of 5.97% of equity interest on behalf of such shareholders. After the restructuring, we beneficially owned 12.03% of equity interest in Visiondigi. As a result, in 2012, we deconsolidated Visiondigi in 2012 and its financial results were presented as “discontinued operations” on our consolidated financial statements.

 

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Repurchase of Shares held by General Atlantic

 

In December 2013 we entered into a purchase and sale agreement with General Atlantic investment funds to repurchase ordinary shares and ADSs held by General Atlantic. The securities owned by General Atlantic represented 19.6% of the Company’s outstanding shares as of the date of the Agreement. In December 2013, we repurchased 11,267,767 shares held by General Atlantic and in January 2014, we repurchased 11,267,755 shares held by General Atlantic. These two repurchases constituted all of the shares held by General Atlantic at that time. The total consideration for the transaction was approximately $11.1 million, which we funded from our working capital.

 

B.                     Business Overview

 

Overview

 

We are a leading video processor and video surveillance solution provider. Our video surveillance business comprises system-level solutions including surveillance cameras, system and management software, digital video decoders, recorders and servers. We believe the expansion of our video surveillance business will capitalize on China’s growing demand in this industry. Our video processor business comprises PC camera processors and surveillance processors that we design, develop and market. These mixed-signal semiconductor products are used in both PC/notebooks as well as surveillance products.

 

We have a growing video surveillance business which generated approximately 67.9% of our revenue in 2013 compared to 24.9% of our revenue in 2012. We aim to establish a leading position in the video surveillance market with our system-level solutions and semiconductor products. We intend to continue to identify and actively pursue additional markets which we believe have the potential for high volume sales of video semiconductor products and video surveillance products. To execute our strategy in relation to the video surveillance market, we co-founded the Surveillance Digital Video Audio Coding Standard Working Group, or SVAC Working Group. In December 2010, the Standardization Administration of China released a national standard for SVAC, which was prepared by the SVAC Working Group. The SVAC standard has been approved by the national standardization committee in China and has been applied in industry use starting in May 2011. The SVAC standard is the first national standard for the Chinese video surveillance industry and is considered crucial for the establishment of the public security and criminal prevention system in China. For further information relating to our recent efforts in developing video surveillance market, see “—Our Solutions and Competitive Strengths—Leading Role in Developing the SVAC Standard.”

 

With respect to our video processor business, we are one of the leading suppliers of PC camera processors in terms of the number of peripheral PC cameras shipped worldwide in 2013. Our PC camera processors are incorporated into the products of well-known notebook computer vendors, such as the largest notebook vendor in the world and the largest personal computer maker in China. We provide a broad range of surveillance processors for surveillance applications ranging from home surveillance to professional commercial surveillance applications. Our surveillance processors provide various features such as image signal processing, video compression, audio compression, video analytics, video storage and networking.

 

We conduct most of our operations in China and believe that we benefit from our access to high-quality design talent, a competitive cost environment, growing electronics design and manufacturing industries and increasingly significant domestic video surveillance markets in China. Founded in 1999, we began volume shipments of our mixed-signal PC camera processors in September 2001. We introduced our first mixed-signal video products in September 2001. Our net revenue increased from $59.0 million in 2011 to $71.2 million in 2012, and decreased to $64.5 million in 2013. We incurred net loss attributable to Vimicro International Corporation of $28.2 million, $0.6 million and $8.4 million in 2011, 2012 and 2013, respectively.

 

Our Solutions and Competitive Strengths

 

Our solutions consist of semiconductors, software and system-level reference designs. We have designed our solutions to support a broad range of standards, baseband platforms and components in order to facilitate our customers’ designs, assembly and supply chain management processes. We believe that our products and solutions, our location in China and our team of experienced managers and engineers provide us with a number of significant competitive strengths, including:

 

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·                          Leading Role in Developing the SVAC Standard. We aim to establish a leading position in the video surveillance market with system-level solutions and semiconductor products including surveillance processors, surveillance cameras, system and management software, digital video decoders, recorders and servers, among other things. We intend to continue to identify and actively pursue additional markets which we believe have the potential for high volume sales of video semiconductor products and video surveillance products. To execute our strategy in relation to video surveillance market. For more information and recent developments with respect to the SVAC standard, please see “Item 4. Information on the Company—B. Business Overview—Technology—Surveillance Video and Audio Coding (SVAC) standard.”

 

·                          Expertise in Mixed-Signal, System-on-Chip Design. Integrating analog and digital circuits in a single semiconductor product is inherently difficult due to noise interference and other technical challenges. Our experienced teams of mixed-signal design engineers are skilled in integrating a variety of multi-voltage, analog and digital functional building blocks in our SoC designs. The high level of integration of our single-chip products delivers several benefits to our customers, including low power consumption, small size and cost effectiveness. All of our products are implemented in standard CMOS processes and manufactured using leading-edge process technologies.

 

·                          Leading Design Capabilities in Audio, Imaging and Video Algorithms and Related Technologies. Our teams of designers have experience in multimedia systems and a variety of audio, imaging and video technologies. We are able to integrate multiple multimedia functions in a single semiconductor product. We have created sophisticated high performance signal processing algorithms for many stages of video processing, including sampling, filtering, coding, decoding, synthesis, compression, storage, playback, transmission and receiving (modulation/demodulation). Using these algorithms, our multimedia SoC solutions are able to perform image, video and audio DSP functions such as data recovery, signal quality enhancement, noise reduction, sample rate conversion, auto exposure, white-balance and focus control, and video and audio signal reconstruction. As a co-founder of SVAC Working Group, we initiated and participated in the establishment of the core algorithm for the SVAC standard. The proprietary intelligent video analysis algorithm can fulfill functions such as image quality diagnosis, overstepping analysis, face snapshot and recognition and calculation of the number of people within a camera’s view.

 

·                          Proprietary Technologies Enabling High Performance Signal Processing Capabilities. Our mixed-signal video processors enable high performance real-time processing of large volumes of audio, image and video signal data. Our adaptable processor architecture incorporates circuitry that can be modified by software commands to permit different types of tasks to be performed by the same processor. We believe that this architecture allows our products to achieve processing speed, signal quality and power consumption performance comparable to that obtained from competing fixed function hardware. However, unlike fixed function hardware, which is suitable for single applications such as video processing, our products can support a variety of multimedia applications such as audio, video and imaging using a single processor. Since our processors are designed solely for multimedia applications, rather than a broad spectrum of computing tasks, our processors avoid the need for the complex control software used by CPUs and baseband processors, and can therefore offer significantly better processing speed, signal quality and power consumption performance.

 

·                          Application-Level Software Development Capabilities. We seek to differentiate our products and speed our customers’ time-to-market through developing application-level software capabilities. We work closely with other technology leaders to enable innovative multimedia applications through the integration of value-added software features. We offer video management software, including a carrier-grade ViSS security platform that offers sophisticated centralized management of users, configurations and video monitoring, customized versions for various industries and diversified 3G, 4G terminal applications. Our video management software adopts SIP protocol, which is widely used in China’s telecom operator networks and tightly integrates with video analytics. It acts as a core piece that connects the hardware in a surveillance system and has a wide array of advanced features to cover customers’ surveillance needs. Our video management software also meets the requirement of GB/T.28181, the latest standard from the Ministry of Public Security of China.

 

·                          Extensive Network of Sales, Marketing and Customer Support Resources. We have an extensive network of sales, marketing and customer support resources, including offices in Mountain View California, Hong Kong, Taipei, Beijing, Shanghai, Shenzhen and Nanjing. We have entered into distribution and support agreements with partners whom we have trained to support our products to cover additional areas such as Japan and specific large customers in South Korea and elsewhere. We maintain an extensive technical support team in Beijing and in other cities in China to provide high-quality, low-cost support services for our global sales force.

 

·                          Proximity to the Growing Electronics Design and Manufacturing Industry and Electronics Markets in China. We market and sell our products and solutions to an increasing number of companies in the electronics industry that have established design, manufacturing and assembly facilities in China. Our close proximity to these facilitates provides opportunities for efficient cooperation, marketing, manufacturing improvements and after-sales support.

 

·                          Ability to Enter Local Public Purchase Programs and to Penetrate Certain Vertical Domestic Markets. We have won various awards and endorsements from local governments in China for technological innovation and self-developed intellectual properties. Our extensive industry experience allows us to enter public projects, government procurement programs and vertical industries that are dominated by state-owned enterprises. We collaborate closely with various national research institutions and leading domestic enterprises in China to develop products and solutions that are tailored to specific local requirements, in areas of security, surveillance and other multimedia applications.

 

·                          Ability to Benefit from Worldwide Sourcing of Semiconductor and System Design Talent. Our management and engineering team leaders have significant international experience that they have leveraged in guiding us to our current position. We believe that this has enabled us to attract skilled and experienced engineers in Silicon Valley and elsewhere with expertise in mixed-signal design to support our growth and continued technology innovation. In addition, we believe this position gives us a competitive advantage in recruiting candidates from China’s top universities. China has established a significant educational system for advanced semiconductor design, and graduates a large number of advanced degree holders in engineering each year, creating a large pool of motivated and qualified candidates. As a result, we have been consistently able to hire qualified engineering graduates at a competitive cost. Recruiting and retaining research and development talent comprises one of the most significant expenses for semiconductor design companies. Our access to high-quality, low-cost design talent in China provides us with a significant competitive advantage relative to semiconductor designers based in higher-cost areas.

 

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Products

 

We design, develop and market video surveillance solutions and mixed-signal video processors for PC cameras and surveillance products. We provide our customers with system-level solutions and comprehensive products that include highly integrated semiconductors, customizable firmware and software, software development tools, reference designs and applications support. Our products support a broad range of standards, platforms and components in order to facilitate our customers’ designs and their assembly and supply chain management processes.

 

Video Surveillance Business

 

The video surveillance market primarily consists of video capturing, compression, transmission, storage, processing, display and video analysis products. We provide complete hardware-software surveillance solutions for our customers, which are used in a variety of government, business, and industrial applications. Our solutions fully support the SVAC standard, China’s domestic standard for surveillance video.

 

Our main products in the video surveillance business include hardware and software. The hardware portion of this business is comprised of digital video recorders (DVRs), network video recorders (NVRs), video servers, digital high-definition camera, and other equipment. The hardware is based on our proprietary integrated chips, which offers functions such as image signal processing, audio and video compression, video analytics, video storage, real-time network monitoring and other functions. Our video intelligent surveillance system (ViSS) software comprises the centerpiece of our video surveillance systems and this software is integrated into the surveillance solutions that we sell. ViSS offers a platform for unified surveillance, storage and management solutions utilizing broadband network infrastructure to connect independent monitoring sites across a broad geographical area. ViSS can meet the monitoring needs of city roadways, airports, shopping centers, banks, schools, and other large facilities where surveillance is vital. ViSS also provides system management tools that enhance the visual and audio monitoring capabilities of multiple sites over telecommunication networks. ViSS represents one of the most stable carrier-class video surveillance platforms available in the industry.

 

The following table sets forth the features of our video recorder products (including DVR, NVR and SVR) from 2009 to the year end of 2013.

 

Product

 

Features

 

Month Introduced(1)

 

 

 

 

 

NVR 2100S

 

An intermediate level new generation network hard-drive-based, multi-functional all-in-one machine for high-definition video applications in security surveillance. It is a full-HD, high-capacity, hardware-based, multi-functional, and highly reliable integrated machine. NVR 2100S supports various resolutions, including: 5 Mega-pixels, 3 Mega-pixels, 1080P, 720P, D1, and CIF. It is suitable for various configurations of Megapixel HD network camera access and management. It supports up to 64-channels D1 stream, or 24-channels full HD (1080P) streaming.

 

December 2013

 

 

 

 

 

DCE1104

 

A multi-channels high definition video stream decoder. It supports up to 4-channels 1080P, or 8-channels 720P or 16-channels D1 resolution video decoding and display to high definition displays, through the miniDP display port. With two Ethernet ports support 10M/100M/1000M bandwidth, the DCE1104 can store the encoded video and audio stream, compressed in H.264, MPEG4, M-JPEG or SVAC format.

 

December 2013

 

 

 

 

 

NVR 2100C

 

An intermediate level new generation network hard-drive-based, multi-functional all-in-one machine for high-definition video applications in security surveillance. It is a full-HD, high-capacity, hardware-based, multi-functional, and highly reliable integrated machine. NVR 2100C supports various resolutions, including: 5 Mega-pixels, 3 Mega-pixels, 1080p, 1080i, 720p, D1, and CIF. It is suitable for various configurations of Megapixel HD network camera access and management. It has 64-channels equivalent D1 format video signaling access power.

 

November 2012

 

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Product

 

Features

 

Month Introduced(1)

 

 

 

 

 

SVR 3300

 

A high-end product in video surveillance hardware. It utilizes all-in-one management equipment that is tailored for mid- to small-sized security surveillance systems. It is a highly reliable, multi-functional, digital-analogue integrated management system that offers analogue video coding, digital video access, video hardware coding embedded, TV wall control, professional high hardware video storage, and a customized surveillance equipment platform. It integrates the analogue video encoding D1, a single device can achieve a 90-channel D1 encoding and 38-channel digital video access management.

 

December 2010

 

 

 

 

 

NVR 2100

 

An intermediate level new generation network hard-drive-based, multi-functional all-in-one machine for high-definition video applications in security surveillance. It is a full-HD, high-capacity, hardware-based, multi-functional, and highly reliable integrated machine. NVR 2100 supports various resolutions, including: 1080p, 1080i, 720p, D1, and CIF. It is suitable for various configurations of Megapixel HD network camera access and management. It has 64-channel equivalent D1 format video signaling access power.

 

November 2010

 

 

 

 

 

SVR 3100

 

A high-end product in video surveillance hardware. It utilizes all-in-one management equipment that is tailored for mid to small sized security surveillance systems. It is a highly reliable, multi-functional, digital-analogue integrated management system that offers analogue video coding, digital video access, video hardware coding embedded, TV wall control, professional high hardware video storage, and a customized surveillance equipment platform. It integrates the analogue video encoding D1, a single device can achieve a 30-channel D1 encoding and 64-channel digital video access management.

 

September 2010

 

 

 

 

 

NVR 2200

 

A high-end new generation network hard-drive-based, multi-functional all-in-one machine for high-definition video applications in security surveillance. It is a full-HD, high-capacity, hardware-based, multi-functional, and highly reliable integrated machine. NVR 2200 supports various resolutions, including: 1080p, 1080i, 720p, D1, and CIF. It is suitable for various configurations of Megapixel HD network camera access and management. NVR 2200 can support max 16-channel concurrent 1080p access and max 32 way 720p HD access. It has 128-channel equivalent D1 format video signaling access power and 200-channel equivalent D1 format video signaling transferring power.

 

June 2010

 


(1)                  “Month introduced” means the month during which we began shipments of the product.

 

The following table sets forth the features of our IP camera products, including IP camera, camera module and IP Dome, from 2009 to the year end of 2013.

 

Product

 

Features

 

Month
Introduced
(1)

 

 

 

 

 

VS-
IPC0096

 

A low light HD-SDI camera that uses a Star-Light sensor. The 1/1.1 inch star-light sensor provides higher performance in ultra-low-light environments. VS-IPC0096 supports 1080i resolution at 50frames per second. VS-IPC0096 supports linkage alarm, can head through the standard RS485and regular Ethernet interface access and is suitable for indoor surveillance applications.

 

October, 2013

 

 

 

 

 

VS-
MC6206

 

A super low light camera module targeting high performance security applications. It is a powerful combination of Vimicros proprietary image processing algorithms and flagship starlight sensor. VS-MC6206 comes in two versions: the VS-MC6206F module stacking with two boards (sensor board + FPGA board) capable of outputting 16-bit linear Bayer RGB data and the VS-MC6206T stacks with three boards (sensor board + FPGA board + Codec board) capable of outputting 8-bit H264 video data directly and supports advanced IR-Cut, auto-IRIS and auto-focus functions.

 

April, 2013

 

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VS-
IPC6221-
R

 

The first outdoor IP camera supporting the Chinese SVAC standard. It adopts 1/2.7 inch CMOS sensor and supports SVAC/H.264 video coding, up to the Full HD (1920x1080) resolution, at 25 frames per second. Its multi-stream transmission can be used for long distance PC access or mobile phone access. By configuring a high-performance image processor, VS-IPC6221-R can integrate the functions of video recording and monitoring with internet connectivity and scalability. VS-IPC6221-R integrates the embedded IR LED lights, thus record high performance video even at dark night. VS-IPC6221-R supports linkage alarm, remote user snapshots and storing video to a remote PC; supports two-way audio, front-end storage; can head through the standard RS485 interface access and is suitable for outdoor surveillance applications. VS-IPC6221-R adopts an open system, and its integrated alarm input/output interface can provide a flexible security system extended application platform that enables users to maximize the integration of its intelligent security solutions and have access to more comprehensive security protection.

 

August, 2013

 

 

 

 

 

VS-IPD6120-
R

 

The first outdoor IP Dome series supporting the Chinese SVAC standard. VS-IPD6120-R supports a 20x zoom lens, while VS-IPD6130-R supports a 30x zoom lens. These two models support SVAC/H.264 video coding, up to the Full HD (1920x1080) resolution, at 25 frames per second.

 

January, 2013

 

 

 

 

 

VS-
IPD6130-
R

 

The multi-streams transmission can be used for long distance PC access or mobile phone access. By configuring a high-performance image processor, these two models can integrate the functions of video recording and monitoring with internet connectivity and scalability. These two models integrate the embedded IR LED lights, thus record high performance video even at dark night. These two models integrate the speed dome, which can provide the Pan-Tile function, and support linkage alarm, remote user snapshots and storing video to a remote PC; support two-way audio, front-end storage; can head through the standard RS485 interface access and is suitable for outdoor surveillance applications. These two models adopt an open system, and their integrated alarm input/output interface can provide a flexible security system extended application platform that enables users to maximize the integration of its intelligent security solutions and have access to more comprehensive security protection.

 

September,
2013

 

 

 

 

 

VS-
IPC6096

 

The first IP camera that uses a Star-Light sensor. The 1/1.1 inch star-light sensor provides higher performance in ultra-low-light environments than our previous IP cameras. VS-IPC6096 supports H.264 video coding, with Full HD (1920x1080) resolution at 25 frames per second. Its multi-streams transmission can be used for long distance PC access or mobile phone access. By configuring a high-performance image processor, VS-IPC6096 can integrate the functions of video recording and monitoring with internet connectivity and scalability. VS-IPC6096 supports linkage alarm, remote user snapshots and storing video to a remote PC; supports two-way audio, front-end storage; can head through the standard RS485 interface access and is suitable for indoor surveillance applications. VS-IPC6096 adopts an open system, and its integrated alarm input / output interface can provide a flexible security system extended application platform that enables users to maximize the integration of its intelligent security solutions and have access to more comprehensive security protection.

 

November 
2012

 

 

 

 

 

VS-
IPD6118


 

The first IP Dome series supporting the Chinese SVAC standard. VS-IPD6118 supports an 18x zoom lens, while VS-IPD6120 supports a 20x zoom lens. These two models support SVAC/H.264 video coding, up to the Full HD (1920x1080) resolution (for VS-IPD6120) or HD (1280x720) resolution (for VS-IPD6118), at 25 frames per second.

 

July 2012

 

 

 

 

 

VS-
IPD6120

 

The multi-streams transmission can be used for long distance PC access or mobile phone access. By configuring a high-performance image processor, These two models can integrate the functions of video recording and monitoring with internet connectivity and scalability. These two models integrate the speed dome, which can provide the Pan-Tile function, and support linkage alarm, remote user snapshots and storing video to a remote PC; supports two-way audio, front-end storage; can head through the standard RS485 interface access and is suitable for indoor surveillance applications. These two models adopt an open system, and its integrated alarm input / output interface can provide a flexible security system extended application platform that enables users to maximize the integration of its intelligent security solutions and have access to more comprehensive security protection.

 

 

 

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VS-
IPC6094

 

A new generation High Definition IP camera. It adopts a 1.3 mega pixel CCD sensor and supports H.264 video coding, with up to HD (1280x720) resolution. Its multi-streams transmission can be used for long distance PC access or mobile phone access. By configuring a high-performance image processor, VS-IPC6094 can integrate the functions of video recording and monitoring with internet connectivity and scalability. VS-IPC6094 supports linkage alarm, remote user snapshots and storing video to a remote PC; supports two-way audio, front-end storage; can head through the standard RS485 interface access and is suitable for indoor surveillance applications. VS-IPC6094 adopts an open system, and its integrated alarm input / output interface can provide a flexible security system extended application platform that enables users to maximize the integration of its intelligent security solutions and have access to more comprehensive security protection.

 

May 2012

 

 

 

 

 

VS-
IPC6092

 

A new generation High Definition IP camera. It adopts a 1/2.7 inch CMOS sensor and supports H.264 video coding, with up to Full HD (1920x1080) resolution. Its dual-stream transmission can be used for long distance PC access or mobile phone access. By configuring a high-performance image processor, VS-IPC6092 can integrate the functions of video recording and monitoring with internet connectivity and scalability. VS-IPC6092 supports linkage alarm, remote user snapshots and storing video to a remote PC; supports two-way audio, front-end storage; can head through the standard RS485 interface access and is suitable for indoor surveillance applications. VS-IPC6092 adopts an open system, and its integrated alarm input / output interface can provide a flexible security system extended application platform that enables users to maximize the integration of its intelligent security solutions and have access to more comprehensive security protection.

 

July 2011

 

 

 

 

 

VS-
IPC6091

 

The first IP camera supporting the Chinese SVAC standard. It adopts 1/2.7 inch CMOS sensor and supports H.264/SVAC video coding. Its dual-stream transmission can be used for long distance PC access or mobile phone access. By configuring a high-performance image processor, VS-IPC6091 can integrate the functions of video recording and monitoring with internet connectivity and scalability. VS-IPC6091 supports linkage alarm, remote user snapshots and storing video to a remote PC; supports two-way audio, front-end storage; can head through the standard RS485 interface access, suitable for indoor surveillance applications. VS-IPC6091 adopts an open system, and its integrated alarm input / output interface can provide a flexible security system integration extended application platform that enables users to maximize the integration of its intelligent security solutions and have access to more comprehensive security protection.

 

June 2011

 

 

 

 

 

VS-
IPC6052

 

A new generation IP camera. It adopts 1/4 inch CMOS sensor and supports H.264 video coding. Its dual-stream transmission can be used for long distance PC access or mobile phone access. By configuring high-performance image processor, VS-IPC6052 can integrate the functions of video recording and monitoring with internet connectivity and scalability. VS-IPC6052 supports linkage alarm, remote user snapshots and storing video to a remote PC; supports two-way audio, front-end storage; can head through the standard RS485 interface access, suitable for indoor surveillance applications. VS-IPC6052 adopts an open system, and its integrated alarm input / output interface can provide a flexible security system integration extended application platform that enables users to maximize the integration of its intelligent security solutions and have access to more comprehensive security protection.

 

November
2010

 


(1)                  “Month introduced” means the month during which we began shipments of the product.

 

The following table sets forth the features of our security platform from 2009 to the year end of 2013.

 

Product

 

Features

 

Month Introduced(1)

 

 

 

 

 

ACME

 

ACME is an integrated application platform with a view to integrate various scattered subsystems at service level, interworking with video surveillance system, to meet the demands of different industries. For instance, we have already integrated many subsystems, such as video monitoring, record replaying, GPS, intelligent traffic, behavior analysis, and video investigation, in public security territory. Meanwhile, we are planning to integrate entrance guard, alarm server and VOIP for petroleum industry.

 

September, 2013

 

 

 

 

 

ViSS R3.3

 

ViSS R3.3 is the latest release of our video surveillance platform. It has a unified interface that lets users manage and control their intelligent DVRS, VideoEdge NVRs and associated IP and analog cameras. ViSS R3.3’s smart client is based on Microsoft’s WPF technology and lets user create customizable layouts that exactly match the tasks an operator performs each day. ViSS R3.3 is in full compliance with GB/T28181-2011 Security and protection video monitoring network system technical specification for information transport, switch and control, which is a latest Chinese national standard for security systems.

 

January, 2013

 

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ViSS R3.1

 

ViSS release 3.1 is the state-of-art IP video surveillance software, which offers video monitoring, sophisticated centralized management of users, configurations and alarm management. It adopts SIP protocol, which is widely used in China Mobile operator networks, and closely integrates with video analytics and NVR. ViSS R3.1 has a wide array of impressive features to cover customer surveillance needs. It acts as the core of a customer’s surveillance system, connecting all the hardware.

 

October 2011

 

 

 

 

 

ViSS R2.15

 

ViSS release 2.15 is a carrier-grade security platform that provides remote collection, transferring, storage, processing of images, sounds and other alarm signals for users based on Broad Band Network. R2.15 has scalable, redundancy architecture and can be used to construct key security applications and closely integrates with video analytics module. It also receives certifications from China Telecom and China Unicom for deployment in the Safe-City project.

 

July 2011

 

 

 

 

 

Intelligent
video
analysis
system

 

a network-based surveillance system that analyzes live digital video stream. Behavior analysis focuses on identifying and tracking the movements of objects. Behavior analysis has a great variety of applications, such as in detecting trespassing, theft and littering. Video quality analysis is to detect camera malfunctions by measuring the image quality. The centralized administration user interface display allows security to react swiftly to alarms.

 

April 2011

 

 

 

 

 

ViSS R3.0

 

ViSS release 3.0 is the state-of-art IP video surveillance software, which offers sophisticated centralized management of users, configurations and video monitoring. It adopts SIP protocol, which is widely used in China telecom operator networks, and closely integrates with video analytics. ViSS R3.0 has a wide array of impressive features to cover customer surveillance needs. It acts as the core of a customer’s surveillance system, connecting all the hardware

 

February 2010

 

 

 

 

 

ViSS R2.10

 

a carrier-grade security platform that provides remote collection, transferring, storage, processing of images, sounds and other alarm signals for users based on Broad Band Network. R2.10 has scalable, redundancy architecture and can be used to construct key security applications. It also has been certified by China Telecom and China Unicom for deployment in the Safe-City project.

 

November 2009

 


(1)                  “Month introduced” means the month during which we began shipments of the product.

 

Video Processors

 

We design different models of PC camera processors and surveillance processors based on the same core technology platform with modifications in successive models with improved performance and functionality. Our PC camera processors are fully compatible with sensors that are based on CMOS technology, the primary type of technology for sensors. We also provide a broad range of video processors for surveillance applications, ranging from home surveillance to professional commercial surveillance applications. Our surveillance processors offer various features such as image signal processing, video compression, audio compression, video analytic, video storage, and real-time network monitoring. All of our PC camera processors and surveillance processors are single-chip processors manufactured under our own brand name using our proprietary intellectual property. While our principal focus is on providing our customers with proprietary, high performance products, we also develop and sell a range of basic, complementary semiconductor products in order to provide more comprehensive solutions for our customers.

 

The following table sets forth major PC camera processors we have developed and shipped in volume from 2009 to the year end of 2013.

 

Product

 

Features

 

Month Introduced(1)

 

 

 

 

 

VC0338

 

Controller chip for USB 2.0 stand-alone or notebook PC embedded cameras with high resolution (up to 5 mega pixel); supports UVC and UAC; advanced ISP; small footprint QFN package and low power design; best fitted to embedded camera applications.

 

September 2009

 

 

 

 

 

VC0347

 

Controller chip for USB 2.0 stand-alone or notebook PC embedded cameras with HD resolution (up to 720P or 1080P); supports UVC and UAC; supports MJPG compression; small footprint QFN package and low power design; best fitted to embedded camera applications.

 

July 2009

 

 

 

 

 

VC0345

 

Controller chip for USB 2.0 notebook PC embedded cameras with high resolution (up to 2 mega pixel); supports UVC; small footprint QFN package and low power design; best fitted to embedded camera applications.

 

January 2009

 


(1)                 “Month introduced” means the month during which we began shipments of the product.

 

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The following table sets forth major surveillance processors we have developed and shipped in volume from 2009 to the year end of 2013.

 

Product

 

Features

 

Month Introduced(1)

 

 

 

 

 

VC0710

 

High performance Image Signal Processing chip for IP Camera applications. It supports CMOS/CCD image sensors up to 16 mega pixels with LVDS/SubLVDS/MIPI/Parallel sensor interface, with 16-bits width ISP and EIS (Electronic Image Stabilization), WDR (Wide Dynamic Range), 3D NR (Noise Reduction) and other image functions, such as de-fog, fisheye lens supporting. VC0710 is best suited to IP Camera, HD-SDI camera applications.

 

October, 2013

 

In 2011, 2012 and 2013, we shipped 44.4 million, 52.3 million and 22.1 million units, respectively, of PC camera processors. Our PC camera processors have been incorporated into PC cameras sold by leading PC camera vendors, including Logitech and other major global brands. We started to ship surveillance processors in 2013.

 

Technology

 

We have developed a broad portfolio of technologies to support multiple functions that are required for video processors and video surveillance solutions. Our products integrate multiple multimedia applications, numerous industry-standard formats, advanced input/output capabilities, analog functions, on-chip memory, and complex algorithms to provide high-quality still picture, video and audio and are designed to allow efficient use of silicon.

 

We provide multimedia signal processing products that exceed the quality levels required by multiple key industry standards, which enables our customers to offer products with superior quality and functions. We have established a rigorous design process to support the integration of numerous functional blocks into a low-cost single-chip product on a rapid time-to-market schedule. This process enables us to adapt to evolving industry standards and quickly improve features of our products to support our customers’ rapid product release cycles.

 

Leveraging our PC camera processor technologies, we have expanded our business into the video surveillance industry. With devoted resources such as support from our sophisticated research and development team, we are capable of providing end-to-end solution packages and key digital surveillance products to customers. We supply the full range of products with digital, networking, intelligentization and high-definition features, such as front-end IP Camera, back-end NVR, D1 and 1080P high-definition products. Our core technologies include the following:

 

Multimedia SoC Design and Video, Imaging, Audio and Graphic Technologies

 

Our team of designers has extensive experience in multimedia systems and a variety of audio, imaging and video technologies, including leading industry standards and compression technologies such as MIDI, MP3, MPEG2, MPEG4, H.264 SVAC and JPEG. This enables us to integrate multiple multimedia functions into a single semiconductor product. We have created sophisticated high performance signal processing algorithms for various stages of video processing, including sampling, filtering, coding and decoding, synthesis, compression, storage, playback, transmission and receiving (modulation/demodulation).

 

·                          Video. We possess a broad portfolio of video technologies to support leading industry standards and compression technologies, such as JPEG, MPEG2, MPEG4, AVS and H.264. In addition, we have developed a variety of technologies to provide high video quality and differentiated features, including interlaced to progressive and progressive to interlaced, audio video synchronization, noise reduction, resolution enhancement, sample rate conversion, scaling, auto focus, face tracking algorithms and signal reconstruction.

 

·                          Imaging. We have developed a number of image processing algorithm technologies to provide high-quality imaging capabilities in our products. Such technologies include color interpolation, color space conversion and correction, white balance, noise reduction, auto exposure, focus control, resolution enhancement, signal quality enhancement, wide dynamic range, contrast enhancement and dead pixel detection and correction technologies.

 

·                          Audio. We have developed a broad portfolio of audio technologies to support leading industry standards and compression technologies such as MIDI, MP3, WMA, AAC, AMR and our proprietary versatile multimedia data (VMD). We have developed several audio processing algorithms and other capabilities to provide a superior aural experience to end users and differentiate our customers’ products in the market, including wave engine, wave engine codec, surround sound audio, 3D audio, noise cancellation, echo cancellation and all-digital amplifier technologies.

 

·                          Graphics. To support graphics capabilities for user interface and other applications in video surveillance devices, we have developed a number of graphics signal processing capabilities, including support for low power 2D and 3D graphics such as drawing polygons, mobile flash and java.

 

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Embedded DSP and Multimedia Signal Processing Algorithms

 

To support the development of highly integrated multimedia SoC’s incorporating multiple multimedia capabilities, we have developed adaptable processor architecture. The processor can be modified by software commands to reconfigure it in an optimal manner for the processing of different types of tasks such as audio, video, imaging and graphics processing. We believe that this architecture allows our products to achieve processing speed, signal quality and power consumption performance comparable to that obtained from competing fixed function hardware that is suitable for a single application such as video processing. Since our processors are designed solely for multimedia applications, rather than a broad spectrum of computing tasks, our processors avoid the need for the complex and power inefficient control and processing software used by general purpose CPUs and baseband processors, and can therefore offer significantly better processing speed, signal quality and power consumption performance than those general-purpose processors.

 

Design Methodology

 

Multimedia SoC design usually requires integration of each of the aforementioned technological capabilities into a single chip on a rapid product design cycle. We use a number of industry leading standard and proprietary CAD and design methodologies to accomplish this. Our design methodologies in algorithms, software and hardware co-design enables integration of multimedia signal processing algorithms with mixed-signal design to ensure that our algorithms are optimized for efficient silicon implementation and high yield manufacturing. To meet stringent time-to-market requirements and rapid product cycles of multimedia semiconductor design, we have developed a methodology based on software simulation, hardware simulation, single and multi-FPGA emulation, software-hardware co-simulation, processor based software-hardware co-emulation and digital and analog co-simulation. In addition, we have developed proprietary multimedia mixed-signal development platforms for system-level integration at the customer site.

 

Surveillance Video and Audio Coding (SVAC) standard

 

We aim to establish a leading position in the video surveillance market with system-level solutions and semiconductor products including surveillance cameras, system and management software, digital video decoders, recorders and servers, among other things. We intend to continue to identify and actively pursue additional markets which we believe have the potential for high volume sales of multimedia semiconductor products and video surveillance products. To execute our strategy in relation to video surveillance market:

 

·                  We co-founded the SVAC Working Group. The goals of SVAC Working Group are to develop standards for advanced audio video coding and safety system and improve synchronization among various safety and alarm systems. In December 2010, Standardization Administration of China released a national standard for SVAC, which was prepared by the SVAC Working Group. The SVAC standard has been approved by the national standardization committee in China and has been applied in industry use starting in May 2011. The SVAC standard is the first national standard for the Chinese video surveillance industry and is considered crucial for the establishment of the public security and criminal prevention system in China.

 

·                  We, through Vimicro China and Vimicro Tianjin, participated as senior members in the Beijing Surveillance Video & Audio Coding Industry Alliance, or SVAC Alliance, a non-profit organization, in Beijing in August 2011. The purpose of SVAC Alliance is to (i) enhance the application and implementation of SVAC, (ii) promote the SVAC standard and its industrialization process, (iii) create a SVAC industrial cooperation platform, and (iv) enhance the technical level of video surveillance in China. SVAC Alliance attracted more than 40 research institutes, universities, companies and other industry participants.

 

·                  We entered into a framework agreement with the Fuzhou local municipal government to jointly develop, produce, and market SVAC-based security surveillance products in Fuzhou, the capital city of Fujian province in China. We also incorporated Vimicro Fuzhou which currently focuses on developing 4G standard SVAC-based IP cameras and also undertakes maintenance work for our surveillance products.

 

·                  We set up a joint venture with Guoxin Group in Shanxi province to develop, produce, and market surveillance video and audio coding SVAC-based surveillance security products and related video sensing and intelligence applications.

 

·                  We secured a government procurement contract from the Jinzhong City Public Security Bureau of Shanxi province to provide SVAC-based security surveillance products and services in 2012.

 

·                  The SVAC industry and technology alliance conference was held on July 23, 2013 in Beijing and was attended by representatives from the Ministry of Public Security (MPS), the Standardization Administration of the People’s Republic of China (SAC), the Ministry of Science and Technology, the Ministry of Industry and Information Technology (MIIT), the National Development and Reform Commission (NDRC), as well as the members of the SVAC Alliance. MPS and Vimicro together co-founded the SVAC Alliance, for the development, promotion, and commercialization of the SVAC standard. The SVAC Alliance now counts most major Chinese surveillance companies and research institutions as its members. Hikvision Digital Technology Co., Ltd. and Dahua Technology, the two largest video-surveillance companies in China, recently joined the SVAC Alliance. At the conference, the formation of a cross-ministry SVAC Promotion Office was announced, which will be directly led by the Chinese government. The SVAC Promotion Office has authorized MPS to draft a provision for security-technology management. As a result of these initiatives, it appears the SVAC standard has entered a new phasethe deployment phase in China.

 

·                  In July 2013, Zhongtianxin signed an agreement with the Public Security Bureau of Taiyuan, Shanxi province, valued at approximately $31 million, for the first phase of a major video-surveillance system, to be installed along highways, sidewalks, and at key public facilities. Vimicro Tianjin would receive approximately $20 million from selling surveillance products to Zhongtianxin under this agreement.

 

·                  In September 2013, Vimicro Tianjin received an order for a SVAC-based technology solution in Ziyang city in Sichuan province, valued at approximately $9 million. The system will be comprised of hundreds of video surveillance stations installed in the city. This project represents the first phase of a larger installation in Ziyang city and in the surrounding town.

 

·                  In December 2013, Zhongtianxin received an order for a SVAC-based technology solution, valued at nearly $41 million. In connection with this contract, Vimicro received purchase orders in the amount of approximately $20.3 million as of the date of this annual report. This order is from the Baoding Public Security Bureau for a city-wide SVAC-based surveillance network project in Baoding city in Hebei province. The network is being installed for security, surveillance, and traffic monitoring. The system will be comprised of several thousand video surveillance stations, and the project represents the first phase of a multiyear deployment and includes equipment and installation.

 

·                  In April 2014, we signed an agreement regarding SVAC-compliant chips with the First Research Institute of the Ministry of Public Security. We expect that cooperation with First Research Institute of the Ministry of Public Security will continue to develop future SVAC national standards with the respect to core chips, safety programs, promotions, and other system features.

 

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Scene-based Image Processing Technology

 

We have launched a scene-based, high-fidelity image processing technology for the surveillance market. This new technology has been adopted by the Chinese National Standard for Technical Specification of SVAC. Our SVAC-enabled digital video processor is designed with low-power and configurable multi-core architecture that substantially boosts the performance of video surveillance systems and improves security capabilities.

 

Core Chip Technology

 

Utilizing our digital-multimedia core chip technology, we have been focusing on development and innovation of our video surveillance business line. We have invested significant resources in the research and development of our video surveillance business, in order to quickly adapt to the evolving industry standards and respond to customers’ demand for intelligent high-definition digital-core video surveillance solutions. Our VC710X Series Multi-Media Image Processor Core Chip released in October 2013, which was designed specifically for both PC cameras and notebook cameras and that can be used in the video surveillance industry, has brought wide interest from many high definition digital camera vendors and IP surveillance camera vendorsConsidering the surveillance industry is moving into full HD, WDR (Wide Dynamic Range) applications, we have enhanced these image processing capabilities and implemented them into several of our new Multimedia SoC chip products. This core chip utilizes our self-developed intelligent visual calculation analysis technology, which provides a technological platform for facial recognition, behavioral analysis, high-definition facial image capture and single frame subject number calculation. Our advanced core chip technology is fully integrated with our IPC, DVS, HVR, SVR, NVR board designs and our ViSS software platform, creating a competitive advantage for our full range of products, from front end IP cameras to back end NVRs and from basic D1 to 1080P high-definition products.

 

Key Technology in Printed Circuit Board

 

We possess sophisticated printed circuit board design capabilities for IP camera, DVS, HVR, SVR and NVR. We are the first manufacturer in the industry to fulfill above 32-channel analog/digital mixed video recording and management technology in China.

 

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Video Management Software Technology

 

We offer video management software, including a carrier-grade ViSS security platform that offers sophisticated centralized management of users, configurations and video monitoring, customized versions for various industries and diversified 3G terminal applications. Our video management software adopts SIP protocol, which is widely used in China telecom operator networks, and closely integrates with video analytics. It acts as a core piece that connects the hardware in a surveillance system and has a wide array of advanced features to cover customers’ surveillance needs. Our video management software also meets the requirement of GB/T.28181, the latest standard from Ministry of Public Security of China.

 

Customers

 

Customers of our video surveillance business mainly include government entities, telecommunications operators and other entities in China, such as schools, banks, railway companies, supermarkets and theaters. We sell our video surveillance products primarily to distributors and system integrators. We expect our revenue of sales of video surveillance products to end-users as a percentage of our total video surveillance revenue to continue to increase.

 

Many of the leading brand owners in our PC camera processor markets use original design manufacturers, or ODMs, which are companies that specialize in the design and manufacture of products for brand owners. Accordingly, a significant portion of our revenue is derived from our sales to ODMs, who incorporate our video processors into end products that they supply to brand owners. Our major ODM customers include Akkord International Limited and Namuga Co. Ltd. We also sell our products to distributors, to original equipment manufacturers, or OEMs, who incorporate our video processors in their end products, and to design houses and module manufacturers. In most cases, we ship products to and receive payments directly from distributors and ODMs rather than brand owners for whom the ODMs design and manufacture products. As a result, we do not always have the ability to confirm directly with brand owners that our video processors are incorporated in their end products. Our representative customers and distributors in the PC camera markets in 2013 are Hanvision Electronics Co., Ltd., Richpower Co., Ltd., T-Link Technology Co., Ltd.

 

For our surveillance processors, we have not engaged design houses or ODMs. We currently manufacture modules incorporating our surveillance processors and supply the modules directly to brand owners, such as Zhejiang Dahua Technology Co., Ltd., Yaan Group, Jabsco Electronic Technology Co., Ltd. and Guangzhou Lilin Electronic Technology Co., Ltd. In the future, we may sell our surveillance processors directly to brand owners or to design houses, which will incorporate the surveillance processors into end products that they supply to brand owners.

 

Substantially all of our customers are based in Asia. We anticipate that most of our revenues will continue to be derived from sales to our customers in Asia. However, we believe that a significant number of PC cameras designed and manufactured by our customers are sold to end users outside of the Asia-Pacific region. The following table sets forth our net revenue by country of domicile of the customer for the periods indicated.

 

 

 

Years ended December 31,

 

 

 

2011

 

2012

 

2013

 

 

 

(in thousands of U.S. dollars)

 

Net revenue:

 

 

 

 

 

 

 

Mainland China

 

12,010

 

18,186

 

44,115

 

Hong Kong

 

46,962

 

53,001

 

20,410

 

Total net revenue

 

58,972

 

71,187

 

64,525

 

 

Net revenue from external customers amounted to $54.7 million, $70.3 million, $42.4 million for the years ended December 31, 2011, 2012 and, 2013, respectively. Third party transections took 93%, 99%, 66% of total revenue in 2011, 2012 and 2013.

 

Revenue from mainland China increased by $26.0 million, or 142.6%, from 2012 to 2013. This corresponded with a decrease in revenue from Hong Kong of $32.6 million, or 61.5%. These shifts reflected the increased revenue contribution from our video surveillance business for which the majority of customers are located within mainland China. The majority of our video processor customers are located outside mainland China.

 

A small number of customers have historically accounted for a substantial portion of our net revenue and accounts receivable balance. In 2013, sales to our top five and top ten customers (including related parties) collectively accounted for approximately 74% and 82%, respectively, of our net revenue for the year, and accounts receivable balance attributable to these customers amounted to 61% and 75%, respectively, of our total accounts receivable as of December 31, 2013. Richpower Co., Ltd., one of our major China-based distributors for our video processor business and one of our largest customers in 2013, accounted for approximately 63% and 26% of our net revenue in 2012 and 2013, respectively. As of December 31, 2013, accounts receivable balance attributable to top five and ten customers (in terms of accounts receivable balance) collectively represented approximately 58% and 70%, respectively, of our total accounts receivable balance, and revenue derived from these customers accounted for 15% and 46%, respectively, of our total revenues in 2013. As of December 31, 2012 and 2013, accounts receivable due from ASB, a distributor of our video surveillance products and one of our top five customers in 2013, accounted for 48% and 33%, respectively, of our total accounts receivable. We are exposed to risks relating to the concentration of sales to and accounts receivables due from a limited number of customers. See “Item 3. Key Information—D. Risk Factors—Risks Related to Our Business—We sometimes extend credit to our customers in the video surveillance projects. Failure or delay in collecting trade receivables from these customers could affect our liquidity.”

 

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Sales and Marketing

 

Our marketing staff works closely with our research and development staff and our customers to develop demand for our products. When designing products, we aim to anticipate our customers’ needs and to meet their increasingly complex and specific design requirements. We also strive to design products that will achieve broad market acceptance and generate widespread end user demand, including demand for follow-on and derivative products using our solutions.

 

Video surveillance business

 

We sell most of our video surveillance products and services through our extensive sales network in China. We have approximately 118 sales personnel in our video surveillance business. We divide our market by geographic regions and industries. Each region or industry is managed by a marketing manager who is responsible for technical support, management and client relations within the region or industry. In addition to our own sales and marketing force, we have established close relationships with a number of sales agents in order to take advantage of their regional resources and provide products and services that are tailored to the needs of our customers in those regions. We expect our revenue of sales of video surveillance solution products to end-users as a percentage of our total revenue to continue to increase. We also market and promote our products by attending industry exhibitions and advertising our products in industry magazines and periodicals.

 

We co-founded the SVAC Working Group. The goals of SVAC Working Group are to develop standards for advanced audio video coding and safety system and improve synchronization among various safety and alarm systems. In December 2010, Standardization Administration of China released a national standard for SVAC, which was prepared by the SVAC Working Group. The SVAC standard has been approved by the national standardization committee in China and has been applied in industry use starting in May 2011. The SVAC standard is the first national standard for the Chinese video surveillance industry and is considered crucial for the establishment of the public security and criminal prevention system in China;

 

In addition, in August 2011, we, through Vimicro China and Vimicro Tianjin, participated as senior members in the SVAC Alliance, a non-profit organization, in Beijing. The purpose of the SVAC Alliance is to (i) enhance the application and implementation of SVAC, (ii) promote the SVAC standard and its industrialization process, (iii) create a SVAC industrial cooperation platform, and (iv) enhance the technical level of video surveillance in China. In July 2013, there were 54 members of the SVAC Alliance, including Hikvision Digital Technology Co., Ltd. and Dahua Technology, the two largest video-surveillance companies in China.

 

Video processor business

 

We sell our products through both our direct sales staff and authorized sales representatives. Our direct sales staff is located in Beijing, Shenzhen, and Taipei, covering major regional markets in mainland China and Taiwan. Our direct sales staff includes trained field application engineers who assist our customers in designing, testing and qualifying their devices that incorporate our products. Our network of authorized sales representatives also play important roles in our sales, in particular in the Taiwan, South Korea, Japan and mainland China markets, where many of our principal customers are located. We intend to expand our sales and marketing network to develop new customers in Asia. Our sales are made primarily pursuant to individual purchase orders rather than long-term commitments. Because industry practice allows customers to reschedule or cancel orders on relatively short notice, we believe that our backlog is not a good indicator of our future sales. Our time-to-market typically ranges from three to six months for our PC processors and surveillance processors and may be significantly longer for first-time customers.

 

We engage in marketing activities such as attending conferences and exhibitions and participating in industry specific organizations to promote our products and brand name. We were a founding member of MultiMedia Telecommunications Association, or MMTA, which was established in October 2004 by leading participants in China’s telecommunications industry, such as China Mobile, China Unicom, China Telecom, China Netcom, Huawei Technologies Co., Ltd. and ZTE Corporation, to promote domestic and international technical innovation and standards and to promote 3G applications in China. MMTA has established a number of key working groups focusing on developing and promoting industry standards in areas such as streaming technology, mobile TV, DRM and mobile surveillance. We have also taken steps to promote our video surveillance processors. In particular, we have taken a leading role in the SVAC Working Group, the implementation of SVAC standard and the establishment of the SVAC Alliance. We believe these activities, in addition to our research and development activities with respect to surveillance processors, has helped us promote our SVAC-based surveillance processor business.

 

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We believe that the above activities have been instrumental in promoting our products and brand name in the video processor market.

 

Manufacturing

 

Video surveillance business

 

We have established assembly lines and a test centers in Tianjin, Fuzhou, and Taiyuan for our video surveillance business, which produce all of our video recorder products (including NVR, DVR and SVR) and some of our IP camera products. We also use OEMs, for example, Shenzhen Jabsco Electronic Technology Co. Ltd., when there is a large demand for our video surveillance solution products. In addition, in May 2013, Vimicro Tianjin completed the construction of a project for the research, development and production of digital high-definition video surveillance products and solutions. We are in the process of applying for the necessary governmental approvals to utilize this facility.

 

Video processor business

 

We develop our proprietary designs and provide them to third-party foundries to produce silicon wafers for our video processors. By utilizing third-party foundries to produce silicon wafers for our video processors, we are able to focus more of our resources on product design and eliminate the high cost of building and operating advanced semiconductor fabrication facilities. The bulk of our video processors are manufactured with 0.18 micron, 0.13 micron and 65 nanometer CMOS process technologies. We periodically negotiate with these third-party foundries to establish price, volume, timing and other terms.

 

We have historically purchased substantially all of our silicon wafers from TSMC in Taiwan, and SMIC, in China, both of which are leading foundries in the world. We usually order sufficient processors each quarter in advance to ensure that we have sufficient supply to support our current and planned sales growth. As the price of our raw materials has been stable in recent years and due to our long-term relationships with these foundries, we have enjoyed consistent pricing in the past. We have the ability to negotiate our price each quarter or every half year when we order our products for the subsequent quarter. We work closely with these foundries in order to achieve high manufacturing yields in the fabrication process, which is an important aspect of our cost containment efforts.

 

We have developed our own automatic testing process for mixed-signal semiconductors and outsource most of our assembly and testing requirements to independent assembly and testing houses. We engage ASE and SPIL for our assembly and testing requirements. We have also designed and incorporated on-chip test circuits into some of our video processor products. We use standard, readily available packages for all of our products. We currently meet our entire mixed-signal semiconductor testing requirements through the use of logic testing equipment. For cost reduction purposes, we continue to evaluate the relative costs and benefits of outsourcing the testing of our mixed-signal semiconductors.

 

Quality Assurance

 

For video processor products, we focus on product quality through all stages of the design and manufacturing process. Our designs are subject to extensive circuit simulation before being committed to test manufacture. In an effort to reduce production costs, we commit a new product to volume production only after sample wafers are fabricated and sample processors are manufactured, packaged and tested. We qualify each of the foundries and assembly and testing companies we use through a series of industry standard product stress tests, as well as an audit and an analysis of their quality assurance systems and, in the case of foundries, their manufacturing capability. We also monitor quality and reliability throughout the production cycle by reviewing electrical parametric data from these foundries and assembly and testing companies. We closely monitor foundry production for consistent quality and reliability. We have been certified with ISO 9001 for the quality system used in manufacturing our video processor products.

 

For product quality standardization and quality improvements of our video surveillance solution products, we closely monitor the production process through all stages of the design and manufacturing process. We monitor and test product functionality to ensure that the products will satisfy the customers’ demands. We have also developed a system to manage the documentation of the production cycle, including documentation from the suppliers’ management, documentation from raw material, manufacturing and assembly testing, documentation relating to product performance inspection, documentation relating to product aging evaluation, as well as documentation relating to the quality of finished products to be delivered. We are ISO 9001 certified for our quality system and CQC certified for product safety.

 

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Intellectual Property

 

We design substantially all of our video processors in-house and rely on a combination of patents, trademarks, employee and third-party nondisclosure agreements and licensing arrangements to protect our intellectual property. As of December 31, 2013, we had 561 registered patents and 326 pending patent applications in China, 59 registered patents and 47 pending patent applications in the United States, one registered patent and six pending patent applications in Taiwan and four pending patent applications in South Korea. Our issued patents and pending patent applications relate primarily to technology we developed for our video processors and video surveillance solutions. As of December 31, 2013, we registered 91 trademarks in China, including a trademark that incorporates our English name “Vimicro.” We have registered our domain name www.vimicro.com with ChinaDNS.

 

Competition

 

The video processor semiconductor industry is highly competitive and dynamic and is characterized by rapid technological changes, evolving industry standards, price reductions and rapid product obsolescence. Our ability to compete effectively depends on defining, designing and regularly introducing new products that meet or anticipate the design needs of our customers’ next generation products and applications. We face competition from various companies, including certain of our customers.

 

In the PC camera processor market, we face competition primarily from ALi Corporation, EMPIA Technology Inc., Sonix Technology Co., Ltd. and Sunplus Technology Industrial Corp. We also face competition from large, diversified semiconductor vendors such as Realtek and Ricoh. In the surveillance processor market, we mainly face competition from Texas Instruments Incorporated, Ambarella Incorporated and HiSilicon Technologies Co.

 

In the video surveillance solution market, competition is largely based on price, product quality, distribution capability and after-sales services. The video surveillance industry in China is highly competitive, with a large number of domestic players engaging in the business of designing, manufacturing and installing video surveillance products. We also face competition from international companies since China’s entry into the World Trade Organization in 2001. Due to the rapid growth of the market and increasing demand for customized products, we believe that the video surveillance market in China will remain competitive with a large number of companies offering differentiated products targeting different customers.

 

A significant part of the video surveillance solution market involves video capturing, compression, transmission, storage, processing, display and video analysis. Leveraging our video processor technologies, we have expanded our business into the video surveillance solution market, where we face competition mainly from companies such as Sony, Samsung, Texas Instruments Incorporated, Hikvision Digital Technology Co., Ltd, Zhejiang Uniview Technology Co., Dahua Technology, Axis, HiSilicon Technologies Co., Ltd. and Ambarella Incorporated.

 

The most significant factors that affect our competitiveness are:

 

·                          the performance and cost effectiveness of our products relative to those of our competitors’ products;

 

·                          the level of integration and power efficiency of our products;

 

·                          the quality and reliability of our products;

 

·                          our ability to deliver products in required volumes, on a timely basis and at competitive prices;

 

·                          our ability to rapidly introduce new products to market; and

 

·                          our customer support capabilities.

 

We believe we compete favorably on the basis of these factors. However, many of our existing and potential competitors have significantly greater financial, technical, manufacturing, marketing, sales and other resources than we do. We cannot assure you that we will be able to compete successfully against our current or future competitors.

 

REGULATION

 

The semiconductor industry in China is subject to substantial regulation. This section summarizes the most significant PRC regulations governing our business in China.

 

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Regulations and Policies that Encourage the Development of Semiconductor Design Companies

 

Preferential Taxation Policies

 

Promulgation of PRC New Income Tax Law. In March 2007, the National People’s Congress adopted the New EIT Law, which became effective as of January 1, 2008. Under the New EIT Law, the enterprise income tax rate for domestic and foreign enterprises is unified at 25%, and enterprises established prior to March 16, 2007 that were eligible for preferential tax treatment according to the then effective PRC EIT Law for Foreign Investment Enterprise and Foreign Enterprise, administrative regulations, and circulars with equivalent effect shall be subject to transitional rules to gradually change their rates to 25%. Certain qualified “high and new technology companies” may be entitled to a 15% preferential tax rate if they meet the definition of “high and new technology enterprise” set out in the Implementation Rules of the New EIT Law. The Implementation Rules of the New EIT Law as well as a series of clarification rules were promulgated by the State Council and the taxation authorities in December 2007 and early 2008. On April 14, 2008, the Measures on the Qualification of High and New Technology Enterprises were promulgated. In accordance with these laws and rules, the preferential tax rates granted to PRC entities that previously qualified as “high and new technology enterprises” will not automatically be applicable under the new tax regime unless they qualify as “high and new technology enterprises” pursuant to the New EIT Law, its Implementation Rules, and relevant working guidance promulgated by the authorities. Vimicro China was recognized as a “high and new technology enterprise” by the competent government authorities and under the New EIT Law, effective in 2008, it was entitled to a preferential tax rate of 15% for three years from January 1, 2008. Vimicro China’s application to renew its “high and new technology enterprise” status was duly approved and is currently enjoying a preferential tax rate of 15% for 2011 -2013.

 

Restriction on Foreign Investment in Value-Added Telecommunications Business

 

In July 2006, the MIIT issued the Circular on Strengthening the Administration of Foreign Investment in and Operation of Value-added Telecommunications Business, or the Circular. The Circular reiterated the regulations on foreign investment in telecommunications businesses, which requires foreign investors to set up foreign-invested enterprises and obtain a business operating license, or VT license, for conducting any value-added telecommunications business in China. Under the Circular, a domestic company that holds a VT license is prohibited from leasing, transferring or selling the license to foreign investors in any form, and from providing any assistance, including providing resources, sites or facilities, to foreign investors that conduct value-added telecommunications business illegally in China. Furthermore, the relevant trademarks and domain names that are used in the value-added telecommunications business must be owned by a VT license holder or its shareholder(s). The Circular further requires each VT license holder to have the necessary facilities for its approved business operations and to maintain such facilities in the regions covered by its license. In addition, all value-added telecommunications service providers are required to maintain network and information security in accordance with the standards set forth under relevant PRC regulations. Due to a lack of interpretative materials from the regulator, it is unclear what impact the Circular will have on us or other domestic providers of value-added telecommunications services that have adopted the same or similar corporate and contractual structures as ours.

 

Intellectual Property Protection for Semiconductors

 

China has adopted legislation related to intellectual property rights, including trademarks, patents and copyrights. China is a signatory to the main international conventions on intellectual property rights and became a member of the Agreement on Trade Related Aspects of Intellectual Property Rights upon its accession to the World Trade Organization, in December 2001. Set forth below are major PRC laws and international treaties effective in China protecting intellectual property rights in semiconductors:

 

·                          the Patent Law of the People’s Republic of China, or the Patent Law, revised at the seventh meeting of the Standing Committee of the Ninth National People’s Congress of the People’s Republic of China on August 25, 2000 and the revised implementing regulation of the Patent Law issued by the State Council on June 15, 2001, effective July 1, 2001; the third amendment of the Patent Law was adopted by the People’s Congress on December 27, 2008 and became effective on October 1, 2009 and the amended implementing regulation of the Patent Law was issued by the State Council on January 9, 2010, effective on February 1, 2010;

 

·                          the Paris Convention for the Protection of Industrial Property of the World Intellectual Property Organization, of which China became a member state on March 19, 1985;

 

·                          the Patent Cooperation Treaty, of which China became a member state on January 1, 1994;

 

·                          the General Principles of the Civil Law of the People’s Republic of China adopted at the fourth session of the Sixth National People’s Congress of the People’s Republic of China on April 12, 1986, effective January 1, 1987. In this legislation, intellectual property rights were defined in China’s basic civil law for the first time as a civil right of citizens and legal persons;

 

·                          the Regulations for the Protection of the Layout Design of Integrated Circuits, or the Layout Design Regulations, adopted March 28, 2001 at the 36th session of the executive meeting of the State Council, effective October 1,2001;

 

·                          the Washington Treaty on Intellectual Property in Respect of ICs of the World Intellectual Property Organization, of which China was among the first signatory states in 1990;

 

·                          the Law of the People’s Republic of China on Scientific and Technological Progress amended and adopted at the 31st session of the Standing Committee of the Tenth National People’s Congress of the People’s Republic of China on December 29, 2007. The amended Law of the People’s Republic of China on Scientific and Technological Progress became effective on July 1, 2008;

 

·                          the Property Law of the People’s Republic of China, which was adopted at the fifth session of the Tenth National People’s Congress of the People’s Republic of China on March 16, 2007 and became effective on October 1, 2007; and

 

·                          the Opinions of the Supreme People’s Court on Comprehensively Strengthening the Trial System Involving Intellectual Property Rights Litigation to Provide Judicial Protection for the Construction of an Innovative Country, which was circulated in January 11, 2007. The Supreme Court sought to provide powerful judicial protection of intellectual property rights such as patents, and integrated circuit lay-out designs in this circulation.

 

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Protection of Semiconductors under the Patent Law of the People’s Republic of China

 

In China, the semiconductor is the patentable subject matter and protected under Chinese patent laws.

 

Under the Patent Law, the holder of a patent has an exclusive right to the invention. The holder of a patent has the right to prevent a third party from infringement, including making, manufacturing, using, or selling the invention for the duration of the patent. The term of a patent on an invention is valid for 20 years from the day on which the application is filed under the Patent Law.

 

The State Intellectual Property Office in China accepts applications for the protections of invention, carries out examination of patent applications and grants patents.

 

Protection of Integrated Circuit Layout Design

 

Under the Layout Design Regulations, an integrated circuit layout design is defined as a three-dimensional configuration of a semiconductor circuit that has two or more components, at least one of which is an active component, and part or all of the interconnected circuitry or the three-dimensional configuration has been prepared for the production of semiconductor circuits.

 

The following persons and entities can hold proprietary rights in the layout designs that they create: (i)PRC natural persons, legal persons or other organizations; (ii)foreign persons or companies who are creators of integrated circuit layout design, and whose layout designs are first commercially used in China; and (iii)foreign persons or companies from a country that either has an agreement with China concerning the protection of layout designs or is a signatory to an international treaty concerning the protection of layout designs to which China is also a signatory.

 

A holder of proprietary rights in a layout design may:

 

·                          duplicate the entire protected layout design or any part of the original design; and

 

·                          use the protected layout design, the integrated circuit containing the layout design or products containing the integrated circuit commercially.

 

The proprietary rights are valid after the layout design is registered with the State Intellectual Property Office in China.

 

Proprietary rights in a layout design are granted for ten years, commencing from the earlier of the date of the application for registration of the layout design or the first date of its commercial use anywhere in the world. However, a layout design is not entitled to any protection beyond 15 years from the time of its creation, regardless of when the layout design is registered or put into commercial use. The holder of the proprietary rights may transfer those rights to another party or grant permission for use of the design.

 

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Registration of a Layout Design

 

The State Intellectual Property Office in China decides on applications for registration of layout designs. An application must be made within two years of the design being put in commercial use anywhere in the world, or the application will be rejected.

 

Compulsory Licenses for Exploitation of Patents in Respect of Semiconductor Technology

 

Under the third amendment of the Patent Law, which became effective on October 1, 2009, an individual or a company may request the patent regulatory body under the State Council to grant a compulsory license to use an invention patent or a utility model patent if: (i)three years has passed from the patent grant date and four years has passed from the patent application date by a patent applicant, and the patentee or the patent applicant has not used the patent or has not adequately used the patent without a good reason; or (ii)the patentee’s use of the patent has been recognized as monopolization under applicable laws and the grant of a compulsory license can eliminate or reduce the adverse effect on competition caused by the patentee’s use.

 

A compulsory license for the use of a semiconductor technology patent is restricted to public uses, or to uses that prevent anti-competitive actions, as determined by judicial or administrative procedures.

 

Under the Layout Design Regulations, the intellectual property administration department of the State Counsel may grant a non-voluntary license to use a layout design in the event of a national emergency or any extraordinary state of affairs, where public interest so requires, or where the holder is engaging in unfair competition, as determined by a court or the supervision and inspection against unfair competition department of the State Council. The scope and duration of the license will be determined in accordance with the reasons justifying the grant. The scope shall be limited to non-commercial use for public purposes, or to remedy the holder’s unfair competitive actions as determined by a court or the supervision and inspection against unfair competition department.

 

Regulations on Foreign Exchange

 

Foreign exchange regulation in China is primarily governed by the following rules:

 

·                          Foreign Currency Administration Rules (1996), which was amended on August 5, 2008, or the Exchange Rules; and

 

·                          Administration Rules of the Settlement, Sale and Payment of Foreign Exchange (1996), or the Administration Rules.

 

Under the Exchange Rules, the RMB is convertible for current account items, including the distribution of dividends, interest payments, trade and service-related foreign exchange transactions. Conversion of RMB for capital account items, such as direct investment, loan, security investment and repatriation of investment, however, is still subject to the approval of the SAFE or its local branch.

 

The amendments to the Exchange Rules, which was adopted on August 5, 2008, provided for the following: (i) domestic entities are no longer required to remit foreign currencies back to the PRC; (ii) international payment or remittance under current accounts is not restricted, and proceeds in foreign currencies are not required to be exchanged into RMB and (iii) the requirement that foreign currencies under capital accounts shall be deposited into designated banks was abolished. Instead, unless the laws provide otherwise, foreign currencies under capital accounts may be retained or exchanged into RMB upon approval by relevant authority, which approval may be waived under certain circumstances; (iv) the foreign currencies under capital accounts may in principle be purchased after the relevant transaction documents are submitted to the relevant financial institutions that sell foreign currencies; and (v) a simplified registration regime is adopted for direct offshore investment by domestic entities.

 

Under the Administration Rules, foreign-invested enterprises may only buy, sell or remit foreign currencies at those banks authorized to conduct foreign exchange business after providing valid commercial documents and, in the case of capital account item transactions, obtaining approval from the SAFE. Capital investments by foreign-invested enterprises outside of China are also subject to limitations, which include approvals by the Ministry of Commerce, the SAFE and the State Development and Reform Commission.

 

Regulations on Dividend Distribution

 

The principal regulations governing dividend distributions of wholly foreign-owned companies include:

 

·                          Wholly Foreign-Owned Enterprise Law (1986), as amended;

 

·                          Wholly Foreign-Owned Enterprise Law Implementing Rules (1990), as amended; and

 

·                          Company Law of the PRC (2005), as amended.

 

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Under these regulations, wholly foreign-owned companies in the PRC may pay dividends only out of their accumulated profits as determined in accordance with PRC accounting standards. In addition, these wholly foreign-owned companies are required to set aside at least 10% of their respective accumulated profits each year, if any, to fund certain reserve funds, until the accumulative amount of such fund reaches 50% of its registered capital. At the discretion of these wholly foreign-owned companies, they may allocate a portion of their after-tax profits based on PRC accounting standards to staff welfare and bonus funds. These reserve funds and staff welfare and bonus funds are not distributable as cash dividends.

 

In addition, under SAFE’s Circular 75, which became effective on November 1, 2005, PRC subsidiaries controlled by offshore special purpose companies beneficially owned by PRC shareholders may be prohibited from making distributions of profits to their offshore parent companies or paying the offshore parent companies proceeds from any reduction in capital, share transfer or liquidation, unless PRC shareholders with a direct or indirect stake in such offshore parent companies make the required SAFE registrations.

 

SAFE Registration Relating to the Establishment of Offshore Special Purpose Companies and Round-trip Investment by PRC Residents

 

On October 21, 2005, SAFE issued the Notice on Issues Relating to the Administration of Foreign Exchange in Fund-raising and Return Investment Activities of Domestic Residents Conducted via Offshore Special Purpose Companies, or Circular 75, which became effective as of November 1, 2005.

 

According to Circular 75, prior to establishing or assuming control of an offshore company for the purpose of financing that offshore company with assets or equity interests in an onshore enterprise in the PRC, each PRC resident, whether a natural or legal person, must complete the overseas investment foreign exchange registration procedures with the relevant local SAFE branch. Moreover, such PRC residents must also amend such registration form if there is a material event affecting the offshore company, such as, among other things, a change to the company’s share capital, a transfer of shares or if the company is involved in a merger, an acquisition or a spin-off transaction or provides guarantees to other entities.

 

On May 29, 2007, SAFE promulgated Circular 106, which serves as the implementing rules of Circular 75. Under Circular 106, PRC subsidiaries of an offshore enterprise governed by Circular 75 are required to coordinate and supervise the filing of SAFE registrations in a timely manner by the offshore holding company’s shareholders who are PRC residents. If these shareholders fail to comply, the PRC subsidiaries are required to report to the local SAFE authorities. If our shareholders who are PRC citizens or residents do not complete their registration with the local SAFE authorities, our PRC subsidiaries will be prohibited from distributing their profits and proceeds from any reduction in capital, share transfer or liquidation to us, and we may be restricted in our ability to contribute additional capital to our PRC subsidiaries.

 

On November 19, 2012, SAFE issued SAFE Circular 59, which became effective on December 17, 2012. SAFE Circular 59 provides, among other things, detailed implementing rules on initial registration procedures relating to incorporation of offshore special purpose vehicles owned by onshore residents and amendment registration procedures relating to changes to such offshore special purpose vehicles. On May 11, 2013, SAFE issued SAFE Circular 21. SAFE Circular 21 provides for and simplifies the operational steps and regulations on foreign exchange matters related to direct investment by foreign investors, including foreign exchange registration, account opening and use, receipt and payment of funds, and settlement and sales of foreign exchange.

 

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C.                     Organizational Structure

 

The following diagram illustrates our corporate structure, place of incorporation and ownership interest as of April 23, 2014:

 

GRAPHIC

 


(1)      We do not control Zhongtianxin and our investment in Zhongtianxin is accounted for using the equity method.

 

D.                     Property, Plant and Equipment

 

We are a leading video processor and video surveillance solution provider. For our video surveillance solution products, we have established assembly line and test centers in Tianjin and Fuzhou where we produce our video recorder products (including NVR, DVR and SVR) and some of our IP camera products. For video processors, including PC camera processors and surveillance processors, we develop our proprietary designs and provide them to third-party foundries to produce silicon wafers. Therefore, we do not have manufacturing facilities of our own for video processors.

 

In May 2009, Vimicro Tianjin obtained the land use right for a parcel of land with a gross land area of 34,418 square meters in the Tianjin Economic Technology Development Area from the local governmental authority in Tianjin. In May 2013, Vimicro Tianjin completed the construction of a project for the research, development and production of digital high-definition video surveillance products and solutions on the land. We are in the process of applying for the necessary governmental approvals to utilize this facility. We may plan for additional development projects on this parcel of land based on our operational needs.

 

Our principal executive offices are located on premises comprising approximately 4,483 square meters in Beijing, China. We have regional offices in Shanghai, Shenzhen, Nanjing, Tianjin, Fujian, Guiyang, Hong Kong, Taiwan, San Diego and Silicon Valley, California. We lease substantially all of our premises from unrelated third parties. We currently lease approximately 3,795 square meters of space in Tianjin as manufacturing facilities and office building for our video surveillance business. We believe that we will be able to obtain adequate facilities at research and development centers that are currently under construction to accommodate our future expansion plans.

 

Construction of new corporate headquarters

 

In February 2010, Vimicro China entered into an agreement with Beijing Municipal Bureau of Land and Resources to acquire the land use right for 5,046.52 square meters of land from Beijing local government, which we expect to use as Vimicro China’s new headquarters as well as for research and development activities. The aggregate consideration for the acquisition of the land use right is RMB39.1 million ($6.2 million). Pursuant to an agreement entered into in December 2006 between Vimicro China and Beijing Haidian Xinhua Agricultural Industrial & Commercial Co., or Xinhua Agricultural, the former holder of this land use right, Vimicro China shall transfer 35% of the total construction area of the same developed property to Xinhua Agricultural as compensation in kind for the expropriation of the land upon completion of the construction of the office building. The proposed project is subject to governmental approval. Should the governmental authorities request us to modify the project, the land and construction site areas, as well as the total cost for the project, may change. We expect to commence construction of the project upon receipt of the land use right certificates for the land.

 

Construction of property held by Vimicro Jiangsu

 

Vimicro Jiangsu holds certain land use rights originally planned for the construction of a property project relating to research and development activities for the non-core IC businesses. The construction was required to commence prior to December 31, 2010. However, Vimicro Jiangsu was not able to commence the construction on a timely basis and had sought to dispose of the land to VMF Consulting Company. However, after discussion with the Administrative Committee of Nanjing Xuzhuang Software Industrial Base, we were informed that it would be difficult to obtain the necessary approvals to sell Vimicro Jiangsu.

 

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In November 2013, Vimicro Jiangsu entered into a supplemental agreement with the Nanjing Bureau of Land and Resources, or the Bureau. Pursuant to this agreement, we agreed to commence construction before May 2014 and complete construction before May 2016. We also paid a security deposit of RMB1.8 million ($0.3 million) to the Bureau, RMB0.9 million ($0.15 million) of which we will receive upon timely commencement of the project and RMB0.9 million ($0.15 million) of which we will receive upon timely completion of the project.

 

In June 2012, Vimicro Jiangsu entered into an agreement with the Administrative Committee of Nanjing Xuzhuang Software Industrial Base, or the Committee, whereby the Committee agreed to (i) assist Vimicro Jiangsu in developing a facility on the land held by Vimicro Jiangsu, and (ii) guide and assist Vimicro Jiangsu in selling units of that facility that Vimicro Jiangsu does not need for its own purposes. This agreement was supplemented by an agreement in August 2013. Pursuant to this agreement the Committee pledged to use their best effort to secure qualified buyers for the property units to be built on the land. The Committee will be entitled to receive the excess from the disposition of the units over an amount specified in the contract. In addition, if the committee fails to complete the sale of the property by a certain date, we may require that they purchase the units at a price specified in the contract. We rely on the assistance of the Committee to search for potential qualified buyers, and the terms of the relevant sales agreements will need to be approved by the Committee. In addition, when we sell either entire buildings or units within buildings, we will need to obtain consent from the Bureau in order to complete the sale and for the purchaser to receive the necessary ownership certificate.

 

In December 2012, Vimicro Jiangsu entered into an agreement with Nanjing Xuanwu District State-owned Assets Investment & Management Holding (Group) Co., Ltd., or the Management Co., an entity affiliated with the Committee, whereby the Management Co. agreed to purchase an office building to be built on the land for a pre-agreed price upon the completion of construction. A purchase down payment of RMB5.0 million ($0.8 million) was made in April 2013, and another payment of RMB15 million ($2.5 million) was made in May 2013 by the Management Co., which can only be applied for the costs and expenses in relation to the construction project.

 

In March 2014, Vimicro Jiangsu entered into a construction contracting agreement with Jiangsu International Economic Technology Cooperation Group Co. Ltd., or the Contractor. Pursuant to this agreement, the Contractor agreed to construct the facility according to our specifications and procure our approval for any subcontracting. The total consideration under the contract is RMB259.6 million ($42.9 million) and contains customary provisions requiring the Contractor to compensate us for delays and damages. According to the agreement, we agreed to make progress payments at specific stages equivalent to 75% of the price for the then-completed portion of the construction project. We will make such payments upon (i) completion of the foundation, (ii) completion of building main structure and passing of quality check, (iii) completion of 50% of the finishing work and installation, and, (iv)completion of all construction work and passing of quality check. Within 14 days after filing of the completed construction and approval of the construction price, we will pay the difference between 95% of the approved construction price and the total amount we will have paid through progress payments. The remaining 5% of the construction price will be retained by us as a quality assurance fund, which we can keep for two years. The term of the contract is from March 2014 to November 2015.

 

To fully carry out the plan set out in these agreements, Vimicro Jiangsu needs to reach agreements with, and obtain regulatory consent and approvals from, the Bureau and other local regulators, including the conversion of the land use rights to allow such development activities and disposition of property units to be built on the land. The time and procedures for obtaining the above-mentioned consents and approvals by the PRC regulatory authority may be subject to significant uncertainty and there is no assurance that we may receive the approvals, develop the project or otherwise complete the disposal using other options on a timely basis, or at all. See “Item 3. Key Information—D. Risk Factors—Risks Related to Our Business—We are exposed to risks relating to our development of facilities on land held by Vimicro Jiangsu.”

 

ITEM 4A.                UNRESOLVED STAFF COMMENTS

 

There are no unresolved Staff comments.

 

ITEM 5.                         OPERATING AND FINANCIAL REVIEW AND PROSPECTS

 

You should read the following discussion and analysis of our financial condition and results of operations in conjunction with our consolidated financial statements and the related notes included elsewhere in this annual report on Form 20-F. This discussion may contain forward-looking statements based upon current expectations that involve risks and uncertainties. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of various factors, including those set forth under “Item 3. Key Information—D. Risk Factors” or in other parts of this annual report on Form 20-F.

 

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A.                     Operating Results

 

Overview

 

We are a leading video surveillance solution provider and manufacturer of video processors. Our video surveillance business comprises system-level solutions and semiconductor products including surveillance cameras, system and management software, digital video decoders, recorders and servers. We believe the expansion of our video surveillance business will capitalize on China’s growing demand in this industry. Our video processing business comprises the design, development and marketing of mixed-signal semiconductor products. These mixed-signal semiconductor products are used in both PC/notebooks as well as surveillance products.

 

We currently derive a majority of our revenue from video surveillance products and solutions based on core technologies we have developed in response to market demand. We generated net revenue of $59.0 million, $71.2 million and $64.5 million in 2011, 2012 and 2013, respectively. Our gross profit amounted to $20.5 million, $26.0 million and $22.4 million in 2011, 2012 and 2013, respectively. We incurred a net loss attributable to Vimicro International Corporation of $28.2 million, $0.6 million and $8.4 million in 2011, 2011 and 2013, respectively. Fluctuations in our operating results make the prediction of future operating results difficult. We believe that period-to-period comparisons of operating results should not be relied upon as indicative of future performance.

 

Factors Affecting Our Results of Operations

 

Our operating results are affected by general conditions in the PRC semiconductor industry, including China’s economic performance and the PRC regulatory environment governing the semiconductor industry. Our operating results are also affected by certain non-financial factors, such as our market penetration, the features and performance of our products, our number of design wins, the length of our product sales cycles and shipment volumes of our products. Specifically, our operating results are affected by the following company-specific factors:

 

Product Mix and Pricing. As part of our growth strategies and in order to continue our efforts to focus on our core business and align our resources and expenses with opportunities in our core businesses, we disposed of the loss-making IC business in 2010 and mobile phone multimedia processor business in 2011. We plan to allocate additional financial and other resources for the development of our video surveillance business. For example, in 2012, we invested in Zhongtianxin to invest in and develop our security-surveillance business initially in Shanxi local market. Such efforts could significantly change our product mix, which in turn could further affect our financial condition and results of operations. We expect revenues from the video surveillance business to grow in the near future. Our business and growth significantly depends on the demand for our products as well as our ability to sell our products to our customers, which in turn could be affected by, among other factors described below, the general conditions in the industry in which we operate.

 

In addition, our gross profit margins have historically fluctuated and are expected to continue to fluctuate due to several factors, including changes in our product mix, the per-unit cost and the average selling price for our products. We expect to continue to face price pressure for our products as average selling prices for semiconductor products generally decline over time. However, the price decline may be mitigated by our developing and marketing successive generations of products with lower unit costs than prior generations. In order to maintain or improve our gross profit margins, we need to continue to introduce new products, increase sales volumes and reduce unit costs.

 

Research and Development. In order to increase our sales and gross profit margin, we have invested significant resources in research and development to enhance our technology and improve and develop products. In 2011, 2012 and 2013, our research and development expenses amounted to $19.0 million, $8.9 million and $11.6 million, representing 32.2%, 12.5% and 18.0% of our net revenue, respectively. We expect our research and development expenses to continue to increase as we develop new products and recruit research and development staff for our business operations.

 

Time-to-market of Our Products. Video processors are characterized by a lengthy time-to-market, which is the interval between product development and initial volume sales. The time-to-market typically ranges from three to six months for our PC camera processors and may be significantly longer for first-time customers. Our lengthy time-to-market makes it difficult for us to forecast our revenue and increases the variability of our quarterly results. It also results in a lengthy interval from the time we incur research and development and other operating expenses in connection with a new product to the time that we can first generate revenue from that product.

 

Availability of Third-party Foundries and Assembly and Testing Houses. We use a limited number of third-party foundries to manufacture our video products, and rely on a limited number of independent assembly and testing houses to assemble and test substantially all of our video processors. We believe that this business model enables us to reduce our capital expenditures and fixed costs relative to semiconductor companies that manufacture, assemble and test their own products, while focusing our engineering and design resources on our core strengths. We do not have any long-term agreement with any foundry or assembly and testing house and we typically place orders with them on a purchase order basis, depending on our customers’ purchase orders and sales forecasts.

 

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Ability to Control Operating Expenses. We strive to control our operating expenses. Our operating expenses decreased from $49.1 million in 2011 to $31.7 million in 2012, and increased to $33.3 million in 2013. As we have expanded in the growing video surveillance business, our operating expenses, particularly those incurred in connection with our research and development activities, have increased and we expect the expenses will continue to increase over time. In addition, as most of our operating expenses are denominated in RMB, we expect our operating expenses to continue to increase if the RMB continues to appreciate against the U.S. dollar, our reporting currency.

 

Discussion of Segment Operations

 

We manage our operations through the following two operating segments:

 

·                  Video surveillance product segment, which refers to entities that have been primarily engaged in the design, manufacture and sale of video surveillance products (other than the video processors used in video surveillance products and solutions); and

 

·                  Video processor segment, which refers to entities that have been primarily engaged in the design, manufacture and sale of video processors, including PC camera processors and the video processors used in video surveillance products.

 

The two segments are evaluated regularly by our chief operating decision maker in deciding how to allocate resources and in assessing performance. We do not allocate operating expenses among our products and no measure of assets by segment is used by our chief operating decision maker. The following table sets forth our net revenues, costs of revenue and gross profits by operating segment for the periods indicated.

 

 

 

For the Year ended December 31

 

 

 

2011(1)

 

2012(1)

 

2013

 

 

 

(in thousands of U.S. dollars)

 

 

 

 

 

 

 

 

 

Net revenue

 

 

 

 

 

 

 

Video surveillance solution business

 

12,083

 

17,760

 

43,791

 

Video processor business

 

47,857

 

53,435

 

22,078

 

Intersegment elimination(2)

 

(968

)

(8

)

(1,344

)

 

 

 

 

 

 

 

 

Total net revenue

 

58,972

 

71,187

 

64,525

 

 

 

 

 

 

 

 

 

Cost of revenue

 

 

 

 

 

 

 

Video surveillance solution business

 

8,713

 

14,551

 

29,243

 

Video processor business

 

30,714

 

30,603

 

14,242

 

Intersegment elimination(2)

 

(968

)

(8

)

(1,344

)

 

 

 

 

 

 

 

 

Total cost of revenue

 

38,459

 

45,146

 

42,141

 

 

 

 

 

 

 

 

 

Gross profit

 

 

 

 

 

 

 

Video surveillance solution business

 

3,370

 

3,209

 

14,548

 

Video processor business

 

17,143

 

22,832

 

7,836

 

Intersegment elimination(2)

 

 

 

 

 

 

 

 

 

 

 

 

Total gross profit

 

20,513

 

26,041

 

22,384

 

 

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(1)                  Figures in 2011 were adjusted to reflect the restructuring in investments in, and the deconsolidation of, Visiondigi in 2012. Results of such disposed businesses are presented under “discontinued operations.” See “Item 4. Information on the Company - A. History and Development of the Company.”

 

(2)                  Intersegment elimination relates to our intra-group sales of video surveillance and video processor products.

 

Overview of Financial Results

 

We evaluate our business using a variety of key financial measures discussed below.

 

Net Revenue

 

We generate revenue from sales of a variety of mixed-signal video processors for PC cameras, video surveillance products and other related products. Our net revenue is presented after a deduction of business taxes and related surcharges incurred in connection with our operations in China. The following table sets forth our net revenue derived from various business lines, in amounts and as percentages of total net revenue for the periods indicated.

 

 

 

For the Year Ended December 31,

 

 

 

2011(1)

 

2012(1)

 

2013

 

 

 

Amount

 

% of Total
Net Revenue

 

Amount

 

% of Total
Net Revenue

 

Amount

 

% of Total
Net Revenue

 

 

 

(In thousands of U.S. dollars, except percentages)

 

Net revenue:

 

 

 

 

 

 

 

 

 

 

 

 

 

Video surveillance solution business segment

 

12,083

 

20.5

 

17,760

 

24.9

 

43,791

 

67.9

 

Video processor segment

 

 

 

 

 

 

 

 

 

 

 

 

 

PC camera processor

 

41,535

 

70.4

 

48,778

 

68.5

 

20,401

 

31.6

 

Surveillance processor

 

5,439

 

9.2

 

4,233

 

6.0

 

1,670

 

2.6

 

Other products

 

883

 

1.5

 

424

 

0.6

 

7

 

0.0

 

Sub-total

 

47,857

 

81.1

 

53,435

 

75.1

 

22,078

 

34.2

 

Intersegment elimination(2)

 

(968

)

(1.6

)

(8

)

 

(1,344

)

(2.1

)

Total net revenue

 

58,972

 

100.0

 

71,187

 

100.0

 

64,525

 

100.0

 

 


(1)                  Figures in 2011 were adjusted to reflect the restructuring in investments in, and the deconsolidation of, Visiondigi in 2012. Results of such disposed businesses are presented under “discontinued operations.” See “Item 4. Information on the Company - A. History and Development of the Company.”

 

(2)                  Intersegment elimination relates to our intra-group sales of video surveillance products and video processor products.

 

Cost of Revenue and Gross Profit

 

Our cost of revenue primarily consists of costs associated with fabrication of wafers, assembly, testing and shipping of our video processors, amortization of costs associated with production masks, tooling and costs of third-party products that we sell to our customers, and, for surveillance business, the cost of hardware and software, installation and other services and warranty costs. As we do not have long-term, fixed supply agreements with third-party foundries and assembly and testing companies, our costs for wafer fabrication, assembly and testing are susceptible to changes based on conditions in the global semiconductor market. In 2011, 2012 and 2013, cost of revenue was $38.5 million, $45.1 million and $42.1 million, respectively, and gross profit margin was 34.8%, 36.6% and 34.7%, respectively.

 

Semiconductor products and electronic devices into which they are incorporated are typically sold in high volumes and are subject to rapid declines in average selling prices. We have reduced the prices of many of our products in the past to meet market demand, and expect that we will continue to face market-driven pressures on the pricing of our products in the future. In addition, the Chinese video surveillance market has entered into a period of rapid growth evidenced by increasing market demand and increasing number of competitors that heavily invest in this industry. As a result, the pricing pressure may become more intensive in the future. As our business expands, we plan to focus on improving the scale of production and improving production efficiency in our video surveillance business. In addition, we expect to realize relatively higher levels of pricing for any new, innovative or enhanced products we may introduce from time to time. However, there is no assurance that we may do so on a timely basis, if at all, and there is no assurance that we will be able to maintain or improve our gross profit margins in the future.

 

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Operating Expenses

 

Our operating expenses primarily consist of research and development expenses, sales and marketing expenses and general and administrative expenses, each of which includes share-based employee compensation expenses as described below.

 

Research and Development

 

Research and development expenses consist primarily of salaries, bonuses and benefits for research and development personnel, lease expenses for occupancy associated with research and development, costs of engineering services from contractors and consultants, purchase cost of intellectual property, depreciation of engineering equipment and share-based compensation expenses.

 

We received grants from authorities in the PRC mostly for our surveillance related research and development activities. Such grants amounted to $2.7 million, $13.3 million and $9.0 million in 2011, 2012 and 2013, respectively. Our research and development expenses have been offset by government grants associated with particular research and development projects that we have undertaken. When we apply any portion of a grant to the related project for which qualified expenses have been incurred, our research and development expenses for the period are offset by the amount applied. We applied a total of $1.1 million, $6.7 million and $13.6 million of these grants to research and development projects in 2011, 2012 and 2013, respectively. There is no assurance that we will continue to receive grants from PRC government authorities or any other party in the future.

 

We expect to actively monitor our resources allocated to research and development activities and plan to continue to support our product and solution development activities through a combination of in-house research and development and introduction of technologies and know-how through acquisition or licensing. We intend on maintaining or controlling the research and development expenses in video processor products to focus more resources on our core business lines and our growing surveillance business.

 

Sales and Marketing

 

Sales and marketing expenses consist primarily of salaries, bonuses, benefits, advertising, promotions and related costs for sales and marketing personnel, travel and other expenses related to sales and marketing activities, sales commissions to our distributors in Asia and share-based compensation expenses. We expect that our sales and marketing expenses will continue increase as we continue to develop video surveillance business. We intend on maintaining or controlling sales and marketing expenses in video processor products to focus more resources on our core business lines and our growing surveillance business.

 

General and Administrative

 

General and administrative expenses consist primarily of salaries, bonuses, benefits and related costs for administrative personnel, travel, lease and other expenses for general and administrative purposes, share-based compensation expenses, as well as costs for outside services, including legal and accounting services. We intend on maintaining or controlling general and administrative expenses in video processor products to focus more resources on our core business lines and our growing surveillance business.

 

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Share-based Employee Compensation

 

In 2011, 2012 and 2013, we recognized a total of $2.4 million, $2.1 million and $1.8 million, respectively, of share-based employee compensation expenses.

 

We adopted a 2004 share option plan, or the 2004 Plan, and granted a total of 2,701,200 options to our employees under the 2004 Plan in 2005. Our board of directors and shareholders also adopted a 2005 share incentive plan, or the 2005 Plan. For a description of the 2004 Plan and 2005 Plan, see “Item 6. Directors, Senior Management and Employees—B. Compensation of Directors and Executive Officers—Share Options.” As of December 31, 2011, 2012 and 2013, 29,038,152, 31,614,037 and 34,387,361 options, respectively, were granted to employees under the 2005 Plan. Nil, nil and 597,260 non-employee share options were granted in the years ended December 31, 2011, 2012 and 2013, respectively.

 

We have adopted Accounting Standards Codification, or ASC, 718 Compensation-Stock Compensation, or ASC 718, with effect from January 1, 2006, under which share-based compensation expense is determined based on the fair value of the share option as of the option grant date. We also granted restricted shares and recognized the resulting share-based compensation expenses under ASC 718. Our share-based compensation expense decreased in 2013 as compared to 2012 and 2011, as (i) all share options that we initially granted to certain key employees have become vested, and (ii) we granted less awards in 2013 compared to previous years. We may continue to grant share-based awards in the future.

 

As of December 31, 2013, there was approximately $1 million in unrecognized share-based compensation expenses related to share options under the straight-line method. The unrecognized share-based compensation expense is expected to be recognized over a weighted-average vesting period of 1.74 years. As of December 31, 2013, there was $9 thousand in unrecognized share-based compensation expense related to restricted shares. The unrecognized share-based compensation expense is expected to be recognized over a weighted-average vesting period of 0.51 years. To the extent the actual forfeiture rate is different from original estimates, actual share-based compensation related to these awards may be different from the expectation.

 

Taxation

 

Cayman Islands

 

Under the current laws of the Cayman Islands, we are not subject to tax on our income or capital gains. In addition, no Cayman Islands withholding tax will be imposed on payments of dividends by the company to its shareholders.

 

PRC

 

Enterprise Income Tax. PRC enterprise income tax is calculated based on taxable income determined under PRC accounting principles. In March 2007, the National People’s Congress adopted the New EIT Law, which became effective as of January 1, 2008. Under the New EIT Law, the enterprise income tax rate for domestic and foreign enterprises is unified at 25%, and enterprises established prior to March 16, 2007 that were eligible for preferential tax treatment according to the then effective PRC EIT Law for Foreign Investment Enterprise and Foreign Enterprise tax laws, administrative regulations, as well as circulars with equivalent effect, shall be subject to transitional rules to gradually change their rates to 25%. The New EIT Law and the related Implementation Rules also provide a preferential tax rate of 15% to enterprises that qualify as “high and new technology enterprises.” In accordance with the Implementation Rules of the New EIT Law, the preferential tax rate treatments granted to PRC entities that previously qualified for “high and new technology enterprises” will not automatically be applicable under the new tax regime unless they qualify as “high and new technology enterprises” pursuant to the New EIT Law, its Implementation Rules and relevant working guidance promulgated by the government authorities. Vimicro China is currently recognized as a “high and new technology enterprise by the relevant government authorities under the New EIT Law, and is entitled to a preferential tax rate of 15% for the three years from 2011 to 2013.

 

Under the New EIT Law, an enterprise established outside of the PRC with effective management located in the PRC, is considered a Chinese tax resident enterprise and will normally be subject to the PRC enterprise income tax at the rate of 25% on its global income. If the PRC tax authorities subsequently determine that any of the entities in the group registered outside the PRC should be deemed a resident enterprise, they will be subject to PRC income tax at a rate of 25%.

 

Furthermore, under the New EIT Law, dividends payable by a foreign investment enterprise to its foreign non-resident enterprise investors that were derived from income after January 1, 2008, are subject to a 10% withholding tax, unless such foreign investor’s jurisdiction of incorporation has signed a tax treaty or arrangement for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income with China that provides for a reduced rate of withholding tax. The Cayman Islands, where we are incorporated, does not have such a tax treaty with the PRC. If we are considered a non-resident enterprise, the 10% withholding tax imposed on our dividend income received from Vimicro China, our PRC subsidiary, would reduce our net income and have an adverse effect on our operating results. The New EIT Law also provides that, if a resident enterprise directly invests in another resident enterprise, the dividends received by the investing resident enterprise from the invested enterprise are exempted from income tax, subject to certain conditions. Therefore, if we are classified as a resident enterprise, the dividends that we receive from Vimicro China may be exempted from income tax. However, it remains unclear how the PRC tax authorities will interpret the PRC tax resident treatment of an offshore company, like us.

 

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The amount of income tax payable by Vimicro China in the future will depend on various factors, including, among other things, its results of operations, taxable income, the amount of its deductible research and development expenses, and the statutory tax rate applicable to it. Our effective tax rate depends partially on the extent of each of our subsidiaries’ relative contribution to our consolidated taxable income.

 

Value-added Tax (“VAT”) According to PRC value-added tax policy, all entities and individuals engaged in the sales of goods, the provision of processing, repair and replacement services, and the importation of goods within the territory of the PRC are taxpayers for VAT and shall pay VAT in accordance with the VAT regulations. Vimicro China, Vimicro Tianjin and Vimicro Guiyang as general taxpayers are subject to an output VAT at 17% of the selling price of products sold to customers in China, while the purchase of products by Vimicro China, Vimicro Tianjin and Vimicro Guiyang are subject to an input VAT at the rate of 17%. VAT payable is the net difference between periodic output VAT and deductible input VAT. On November 5, 2008, the PRC State Council passed The Provisional Regulations of the People’s Republic of China on Value-Added Tax, or New VAT Law. In accordance with the New VAT Law and its Implementation Rules, which became effective as of January 1, 2009, input VAT on fixed asset purchases for further production purpose are included in the input VAT for VAT payable purposes.

 

The launch of VAT Reform Pilot Program (i.e. converting from business tax to VAT) in the transportation industry and certain modern services industries in Shanghai was effective from January 1, 2012. Following the Pilot Program in Shanghai, the State Council approved expanding the Pilot Program to eight other provinces and municipalities: Beijing, Tianjin, Jiangsu, Zhejiang (including Ningbo), Anhui, Fujian (including Xiamen), Hubei, Guangdong (including Shenzhen) in batches from September 1, 2012 to the end of 2012. The State Council approved expanding the Pilot Program to the whole country in August 2013. Under the Pilot Program, the entities which provide transportation services and certain modern services within the territory of PRC are subject to VAT instead of business tax. Vimicro China’s transfer of technology, which was subject to business tax prior to the Pilot Program, falls within the VAT reform scope and is subject to the VAT at 6% from September 1, 2012. In addition, the technology transfer services provided to foreign entities are eligible for VAT exemption under the Pilot Program. Vimicro China is entitled to the exemption on income arising from or related to technology transfers, provided relevant technology transfer agreements are registered with the relevant government agencies.

 

In addition, where an entity or an individual outside of the territory of PRC and having no business presence in PRC provided VAT taxable services to a resident enterprise, the service recipient shall act as the withholding agent. Accordingly, Vimicro China is obliged to withhold 6% VAT and surcharge on the payment to Viewtel in connection with the purchase of the research and development services starting from September 1, 2012.

 

Business Tax. According to PRC business tax policy, service income generally is subject to business tax at 5%. Vimicro Corporation is entitled to business tax exemption on income arising from or related to technology transfers provided these technology transfer agreements are registered with the relevant government agencies. Vimicro Corporation also has incidental customer technology service income, which is subject to business tax at 5%.

 

In December 2008, the Ministry of Finance and State Administration of Taxation revised the Business Tax Detailed Implementation Rules, under which all entities or individuals that provide labor services within PRC are mandatory payers of business tax and the “provision of labor services in China” is defined to mean where either the service provider or the service recipient is located in China. Accordingly we incurred additional business tax beginning January 1, 2009 primarily in connection with its PRC subsidiaries’ procurement of overseas intellectual properties and the purchase of the research and development services from Viewtel by Vimicro China.

 

In accordance with the Implementation Rules for the PRC Tentative Regulations on Business Tax, promulgated on December 15, 2008 and effective as of January 1, 2009, service income excluding that derived from providing VAT taxable services is subject to PRC business tax when either the service provider or the service recipient is located in China. The tax rate on the transfer of technology and research and development services was 5% prior to the VAT Pilot Program. However, the income arising from or related to the technology transfer was eligible to the exemption of business tax, provided relevant technology transfer agreements are registered with the relevant government agencies. Vimicro China was entitled to the business tax exemption on its income arising from the transfer of technology and relevant technology consulting services. With regard to the purchase of research and development services from Viewtel, as the withholding tax agent of business tax, Vimicro China withheld business tax and surcharge prior to September 1, 2012.

 

United States

 

Income Tax. Viewtel, our subsidiary in the United States, is subject to state income tax and federal income tax in the United States at varying tax brackets, depending upon taxable income levels. In general, corporations with taxable income of less than $0.4 million receive partial benefit from the graduated rates of 15% and 25% that apply to the first $0.08 million of taxable income. Viewtel incurred an income tax benefit of approximately $11,000 in 2011, income tax expenses of approximately $5,000 in 2012, and income tax benefit of approximately $2,000 in 2013.

 

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Hong Kong

 

Profits Tax. Corporations carrying on any trade or business in Hong Kong are subject to profits tax on their assessable profits arising or derived from Hong Kong from such trade or business.

 

Vimicro Hong Kong, the Hong Kong subsidiary of Vimicro China, has filed non-taxable offshore claims in its Hong Kong profits tax returns since the year of assessment 2005/2006 (for the assessment year ended December 31, 2005). In December 2009, the Hong Kong Inland Revenue Department issued the Departmental Interpretation and Practice Notes No. 21(Revised) to redefine the locality of profits. We believe Vimicro Hong Kong has technical grounds to claim that its profits are sourced offshore from Hong Kong and, where duly substantiated by documentation, it is more likely than not that Vimicro Hong Kong’s offshore claim would be accepted by the Hong Kong Inland Revenue Department and the profits of Vimicro Hong Kong would therefore not be subject to Hong Kong profit tax.

 

Pursuant to the New EIT Law and related implementation rules effective from January 1, 2008, if Vimicro Hong Kong is deemed to be a PRC tax resident, it will be subject to the PRC enterprise income tax at a rate of 25% on its worldwide income. On April 22, 2009, the SAT issued the Notice Regarding the Determination of Chinese-Controlled Offshore Incorporated Enterprises as PRC Tax Resident Enterprises on the Basis of De Facto Management Bodies, or Circular 82, which provides certain specific criteria for determining whether the “de facto management body” of a Chinese-controlled offshore-incorporated enterprise is located in China. In addition, on August 3, 2011, the SAT issued a bulletin to clarify resident status determination, post-determination administration, as well as competent tax authorities. As a result, we believe that Vimicro Hong Kong is more likely than not to be deemed as a PRC tax resident and subject to the PRC EIT rate of 25% on its worldwide income. In 2011, Vimicro Hong Kong reversed PRC income tax expenses related to continuing operations of $0.1 million and $0.2 million for the years ended December 31, 2009 and 2010, and we recognized $1.1 million, $0.3 million and $0.7 million of PRC income tax expenses related to continuing operations for the years ended December 31, 2011, 2012 and 2013, respectively.

 

Withholding Tax. Under current Hong Kong tax laws, an entity established outside of Hong Kong is subject to a 4.95% in 2010/11, 2011/12 and 2012/13 withholding tax on royalty income derived (or deemed to be) from Hong Kong. Vimicro Hong Kong makes royalty payments to Vimicro China for certain technologies licensed from Vimicro China. Vimicro China was previously subject to a 5.25% withholding tax on royalties received from Vimicro Hong Kong, which Vimicro Hong Kong had withheld and used to settle the tax liabilities on behalf of Vimicro China. Upon approval by the relevant PRC tax authorities, the amount of Hong Kong withholding tax paid on the royalty income could be allowed as a foreign tax credit against Vimicro China’s PRC income tax liabilities. In connection with the offshore claim of Vimicro Hong Kong, to the extent that all of Vimicro Hong Kong’s trading income is not taxable in Hong Kong, and no deduction will be claimed for the related royalty fee expenditure and the relevant intellectual property is not used in Hong Kong, the royalty fees are exempted from withholding tax in Hong Kong.

 

Critical Accounting Policies

 

We prepare financial statements in accordance with U.S. GAAP, which requires us to make judgments, estimates and assumptions that affect the reported amounts of our assets and liabilities and the disclosure of our contingent assets and liabilities at the end of each fiscal period and the reported amounts of revenues and expenses during each fiscal period. We continually evaluate these judgments and estimates based on our own historical experience, knowledge and assessment of current business and other conditions, our expectations regarding the future based on available information and assumptions that we believe to be reasonable, which together form our basis for making judgments about matters that are not readily apparent from other sources. Since the use of estimates is an integral component of the financial reporting process, our actual results could differ from those estimates. Some of our accounting policies require a higher degree of judgment than others in their application.

 

Our critical accounting policies, the judgments and other uncertainties affecting application of those policies and the sensitivity of reported results to changes in conditions and assumptions are factors that should be considered when reviewing our financial statements. We believe the following accounting policies involve the most significant judgments and estimates used in the preparation of our financial statements.

 

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Revenue Recognition

 

We recognize revenue from the sales of products and rendering of services when the earnings process has been completed, as evidenced by agreement with the customer, delivery of products and transfer of title has occurred, the fees are fixed or determinable and collectability is reasonably assured, as prescribed by ASC 605, Revenue recognition (“ASC 605”).

 

Multimedia processors

 

Multimedia processor revenue derives from PC and embedded notebook camera multimedia processors, image sensors, and other products. Revenues related to multimedia processors are generally recorded net of business taxes and related surcharges provided all revenue recognition criteria have been met.

 

We use distributors for sales of multimedia processors. We enter into generally short term arrangements with our distributors, which on rare occasions may include certain obligations, such as acceptance or price protection clauses. The distributors make full payment prior to shipping or enjoy credit terms varied from 30 to 90 days. We do not have a history of providing refunds, discounts or other price concessions in connection with price protection clauses that we may provide to a distributor. We believe that such provisions are within our control and expect any benefits provided to the distributor to be insignificant. As such, we believe that it is able to reasonably estimate price concessions as remote, such that the price is fixed and determinable and revenue is recognized upon delivery of the product sold. When we provide an acceptance provision to a distributor, revenue is not recognized until acceptance has been received. We do not have any other post shipment obligations.

 

The cost of multimedia processor revenue primarily consists of costs associated with the fabrication of wafers, assembly, testing and shipping of multimedia processors, amortization of costs associated with production masks and tooling and costs of third-party image sensors that we sell to our customers.

 

Surveillance and security products

 

The surveillance and security products are generally comprised of hardware with essential software and separate installation. The hardware and software components generally include a digital video recorder, camera, server, personal computers and the proprietary software of ViSS with other third party software that supports the operating system. Our software products are bundled together with hardware products so that the software components and non-software components function together to deliver the products’ essential functionality. We market and sell an integrated platform for a unified surveillance, storage and management solution. If the hardware does not contain the software, the surveillance and security solution cannot be separately marketed and sold to customers. Therefore, the surveillance and security products are excluded from being accounted for under software revenue recognition guidance. In addition, we also provide installation services, which includes software testing and equipment set up for the monitoring room. The successful completion of our obligations under these arrangements is often subject to delivery acceptance, satisfactory testing and approval of such products and services. These sales arrangements do not include any general rights of return provisions.

 

The hardware, software and installation in surveillance and security products arrangements are considered multiple accounting units in accordance with ASC 605. The total arrangement consideration is allocated to the individual deliverables on the basis of their relative selling price.

 

The relative selling price method is based on the selling price of vendor-specific objective evidence (“VSOE”) if available, third-party evidence (“TPE”) if VSOE is not available, or management’s estimated selling price (“ESP”) if neither VSOE nor TPE is available for the delivered items. We use the estimated selling price for each deliverable as neither VSOE nor TPE is available from our relatively short history engaged in the surveillance and security business. The objective of ESP is to determine the price at which we would transact a sale if the deliverable were sold on a stand-alone basis.

 

We determine ESP for a deliverable based on the cost plus an estimated profit margin while considering multiple factors including, but not limited to, market conditions, competitive landscape, cost, gross margin objectives and pricing practices. For the hardware and the third-party software component, we purchase these items from third party suppliers. In reference to available market information on the price of hardware and third party software and with our consideration of margins in negotiating the pricing, we established ESP for hardware and the third-party software component. In connection with the installation service component, ESP is based on our internal costs structure and margin with respect to labor costs and market information.

 

For surveillance and security hardware with bundle software, revenue is recognized when customer acceptance is obtained, which occurs when the customer acknowledges receipt of goods and the delivered hardware with bundled software meet vendor-specific criteria. For installation services, we recognize revenue after obtaining acceptance of the related services. We limit the amount of revenue recognition for delivered items up to the non-contingent portion of the payment.

 

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Generally, customers purchasing video surveillance projects pay in installments, with a portion of the payment upfront upon signing the sales contracts, a portion of the payment upon receipt of the surveillance and security products but before installation, and a portion of the payment after installation and upon satisfaction of our customers. Sometimes, a portion of the payment may not be paid until after a certain period following the installation or even during or after the warranty period. To the extent that arrangements contain extended payment terms for which we do not have a history of successfully collecting under, revenue is recognized as payments from the customers become due, if all other revenue recognition criteria have been met. Payments received from customers in advance of shipment are initially recorded as advances from customers and recorded as revenue after all the revenue recognition criteria have been met.

 

The cost of surveillance and security product revenue includes the cost of hardware and software, installation and other services and warranty cost. These costs are deferred as inventory costs until the related revenue is recognized.

 

We also sell hardware with bundled software without installation services and software on a standalone basis. Revenue for these arrangements is recognized when customer acceptance is obtained, which occurs when the customer acknowledges receipt of goods and the hardware with bundled software meet vendor-specific criteria. Standalone software sales were insignificant for the periods presented.

 

We combine a group of contracts and accounts for them as one arrangement if these contracts are entered into at or near the same time with the same entity or related parties.

 

Warranty obligation is provided based on the estimated future warranty payment when the underlying revenue is recognized.

 

Long-lived assets to be disposed of and discontinued operations

 

We account for a long-lived asset or disposal group to be sold in accordance with ASC 360-10, where such long-lived asset or disposal group is classified as held for sale in the period in which all six criteria are met: (1) a plan to sell the asset has been committed to by management; (2) the asset can be sold in its current condition; (3) an active plan has been initiated to find a buyer; (4) it is probable that the asset will be sold and the sale will be completed within one year and will qualify as a completed sale; (5) the sales price is reasonable relative to the asset’s current fair value and the entity is actively marketing the asset; and (6) it is unlikely that the plan to sell the asset will be withdrawn or changed significantly.

 

A long-lived asset or disposal group classified as held for sale is measured at the lower of its carrying amount or fair value less cost to sell, and it is presented separately on the balance sheets. Long-lived assets reclassified as held for sale are not depreciated or amortized. The fair value less cost to sell of the long-lived asset or disposal group is evaluated at each end of the reporting period. As of December 31, 2012 and 2013, there was no long-lived asset or disposal group classified as held for sale.

 

We follow ASC 205-20 in accounting for a component of our company that has been disposed of or is classified as held for sale and has operations and cash flows that can be clearly distinguished from the rest of our company. Such component is reported as discontinued operations when the operations and cash flow of the components have been or will be eliminated from our company as a result of disposal and we will not have any significant involvement in the operation of the component after the disposal. In the period in which a component has been disposed of or classified as held for sale, the results of operations, including any gain or loss after tax recognized in accordance with ASC 360-10, less applicable income taxes, for the periods presented are reclassified into line items of income separately from net income (loss) from continuing operations before extraordinary items (if applicable), in the consolidated statement of operations.

 

Government grants

 

Government grants received from PRC government agencies are recognized as deferred government grants and offset against the corresponding expenses as and when they are incurred for the specific research and development projects or general operation purpose for which these grants are received.

 

Investment in unconsolidated affiliate, at cost

 

Investments in entities which the Group holds less than 20% of the investee’s voting stock and does not exert significant influence is accounted for using the cost method of accounting. Cost accounting measures the original cost on the fair market value of the consideration at the acquisition date and adjusts or other-than-temporary declines in fair value. Cash dividends from the investee are reported as income. The Group held 0.1% equity interest in Vimicro Wuxi with a carrying amount of $2 thousand as of December 31, 2012. The Group disposed 0.1% equity interest of Vimicro Wuxi in September 2013 for $8 thousand to VMF Consulting Company. The Group beneficially held 18.03% equity interest in Vimicro Qingdao with a carrying amount of nil as of December 31, 2012 and 2013. The investment in Vimicro Qingdao was fully impaired in the year ended December 31 2012. The Group held 12.03% equity interest in Visiondigi amounting to nil as of December 31, 2012 and 2013. The investment was fully impaired as of December 31, 2012.

 

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Investment in equity investee

 

Investments in entities over which we hold between 20% and 50% of the equity interest, or over which we have significant influence but does not control are accounted for using the equity method of accounting. Equity accounting involves recognizing our share of the profit or loss for the year in the consolidated statements of comprehensive loss. In September 2012, Vimicro China made an investment in and established Zhongtianxin Science and Technology Co., Ltd. (“Zhongtianxin”) with Shanxi Guoxin Investment (Group) Corporation. We directly holds 49% of equity interest in Zhongtianxin and an additional 2% of equity interest is held by VMF Consulting Company on behalf of Vimicro China as a nominee shareholder. As the noncontrolling shareholder has substantive participating rights including the approval of the annual budget, operation and investment plan, appointment, dismissal and remuneration of the board of directors and the general manager according to the Articles of Association of Zhongtianxin, the Company does not have control over Zhongtianxin. Therefore, we adopt the equity method to account for the investment in Zhongtianxin.

 

We made cash investments of $4,4 million and $0.5 million in Zhongtianxin for the years ended December 31, 2012 and 2013, respectively, and also contributed intellectual properties (“IPs”) with a fair value of $11.8 million, as determined by a third party appraiser, to Zhongtianxin as part of its investment during the year ended December 31, 2013. All the IPs contributed by the Company to Zhongtianxin was developed by us and the related historical research and development expenditures to develop the IPs were fully expensed in our historical consolidated financial statements. As a result, we recorded the contribution of the IPs to Zhongtianxin at carrying amount, which was nil. We recognized its share of loss of $0.1 million and share of profit of $1.4 million (adjusted for basis differences between our cost and the underlying equity in net assets of Zhongtianxin and elimination of intra-entity profits) for the years ended December 31, 2012 and 2013, respectively.

 

Capitalized interests

 

All direct and indirect costs that are related to the construction of fixed assets and incurred before the assets are ready for their intended use are capitalized as construction in progress. Interest expense incurred for qualifying assets are capitalized in accordance with ASC 835-20, Capitalization of Interest. Construction in progress is transferred to specific fixed assets items and depreciation of these assets commences when they are ready for their intended use.

 

Restricted Cash

 

Restricted cash balances comprise cash in bank balances, which are restricted as to withdrawal or usage under the terms of certain contracts or under bank regulations.

 

Accounts receivable and provision for doubtful accounts

 

Accounts receivable are stated at the amount we expect to collect. Provisions are made against accounts receivable to the extent that collection is considered to be doubtful. The provision for doubtful accounts charged for the years ended December 31, 2011, 2012 and 2013 was $1.4 million, $0.7 million and $0.02 million, respectively. Accounts receivable in the consolidated balance sheets are stated net of such provision, if any.

 

Inventories

 

Inventories are stated at the lower of cost or market. The cost is computed on a weighted-average basis. Cost of work in progress and finished goods are comprised of direct materials, direct labor and related manufacturing overhead based on normal operating capacity. Adjustments are made to write down excess or obsolete inventories to their estimated realizable values.

 

Goodwill

 

Goodwill represents the excess of the purchase price over the fair value of the identifiable net assets acquired in a business combination. Goodwill amount is not amortized but tested for impairment at the reporting unit level on an annual basis, or more frequently if events or changes in circumstances indicate that it might be impaired. We determined that it has two reporting units: video processor business and video surveillance solution business. Goodwill arose from the acquisition of the ViSS business and is allocated to the surveillance and security products segment.

 

In 2009, Vimicro Tianjin completed the acquisition of the ViSS business that resulted in goodwill of $2.0 million. We assessed the fair value under the surveillance and security products reporting unit as of December 31, 2011 using the income-based valuation methodology. Under the income approach, forecasted cash flows of a business unit are discounted to a present value using a discount rate commensurate with the risks of those cash flows. Based on the results of the valuation, the assessed fair value was below the carrying value of the surveillance and security products reporting unit as of year-end. We then performed a hypothetical purchase allocation using the fair value of the reporting unit and determined that the goodwill was fully impaired. As a result, we recognized a goodwill impairment charge of $2.2 million for the year ended December 31, 2011 under the caption of “Asset impairment” in the consolidated statements of comprehensive loss. There were no goodwill impairment charges recognized for the years ended December 31, 2012 and 2013, respectively and the carrying amount of goodwill was nil as of December 31, 2012 and 2013.

 

Intangible Assets

 

Intangible assets with finite useful lives, including core technology, trade name and purchased software are amortized over their estimated useful lives using the straight-line method and carried at cost less accumulated amortization with no residual value. The core technology and software were primarily used in the mobile business. Following the disposal of the mobile business in December 2011, we performed an impairment analysis and concluded that there would not be significant cash flows to be generated by these intangibles. Accordingly, we recorded an impairment charge of $2.7 million, nil and nil for the year ended December 31, 2011, 2012 and 2013, respectively, under the caption of “Asset impairment” in the consolidated statements of comprehensive loss.

 

During the years ended December 31, 2011, 2012 and 2013, the amortization expenses of intangible assets were $0.2 million, nil and nil, respectively. The carrying amount of intangible assets was nil as of December 31, 2012 and 2013.

 

Product warranty

 

We provide warranties on our products for a period generally ranging from one to three years from the time of final acceptance or goods delivery. We provide for the expected cost of product warranties at the time that revenue is recognized based on an assessment of past warranty experience and when specific circumstances dictate.

 

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Impairment of Long-lived Assets

 

Impairment of Property, Plant and Equipment and Intangibles

 

We evaluate our long-lived assets or asset group including intangibles with finite lives for impairment whenever events or changes in circumstances (such as a significant adverse change to market conditions that will impact the future use of the assets) indicate the carrying amount of a group of long-lived assets may not be fully recoverable. When these events occur, we evaluate the impairment by comparing the carrying amount of the assets or asset group to future undiscounted cash flows expected to result from the use of the assets and their eventual disposition. If the sum of the expected undiscounted cash flows is less than the carrying amount of the assets or asset group, we recognize an impairment loss based on the excess of the carrying amount of the asset group over its fair value, generally based upon discounted cash flows.

 

Impairment of Investment

 

We review our investments for other-than-temporary impairment whenever events or changes in business circumstances indicate that the carrying value of the investment may not be fully recoverable. Investments identified as having an indication of impairment are subject to further analysis to determine if the impairment is other-than-temporary and this analysis requires estimating the fair value of the investment. In making this determination, We review several factors to determine whether the losses are other-than-temporary, including but not limited to: (i) the length of time the investment was in an unrealized loss position, (ii) the extent to which fair value was less than cost, (iii) the financial condition and near term prospects of the issuer, and (iv) our intent and ability to hold the investment for a period of time sufficient to allow for any anticipated recovery in fair value. The determination of fair value of the investment involves considering factors such as current economic and market conditions, the operating performance of our company including current earnings trends and forecasted cash flows, and other company and industry specific information.

 

Share-based Compensation

 

We apply ASC 718 Compensation-Stock Compensation, or ASC 718. Pursuant to ASC 718, we recognized share-based compensation over the requisite service periods and performance condition for any share options and restricted share grants based on the fair values of share option and restricted share on the dates of grant. For the options that were repriced during the year ended December 31, 2012, in accordance with ASC 718, we recognized additional compensation cost for the excess of fair value of the modified share options issued over the fair value of the original share options at the date of the modification for all the original share options vested as of the modification date. The compensation cost due to the incremental fair value of the modified awards and the remaining balance of the unrecognized compensation cost for the unvested share options are recognized over the remaining requisite service periods of the modified awards. We do not receive any tax benefits or deductions from awards exercised.

 

We have elected to recognize compensation expense using the straight-line method for all employee equity awards granted with graded vesting based on service conditions provided that the amount of compensation cost recognized at any date is at least equal to the portion of the grant-date value of the options that are vested at that date. To the extent the required vesting conditions are not met resulting in the forfeiture of the share-based awards, previously recognized compensation expense relating to those awards are reversed. ASC 718 requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from initial estimates. Share-based compensation expense was recorded net of estimated forfeitures such that expense was recorded only for those share-based awards that are expected to vest.

 

We account for share-based awards issued to non-employees in accordance with the provisions of ASC 718 and ASC 505-50 Equity-Based Payments to Non-Employees, or ASC 505-50. The measurement date is the performance completion date due to a lack of performance commitment. Under ASC 505-50, we use the Black-Scholes option pricing model method to measure the value of options granted to non-employees at each reporting date to determine the appropriate charge to share-based compensation.

 

Depreciation of Property and Equipment

 

We depreciate our property and equipment at rates sufficient to write off their costs less accumulated impairment losses over their estimated useful lives on a straight-line basis. We review the useful lives periodically to ensure that the method and rates of depreciation are consistent with the expected pattern of economic benefits from fixed assets. We estimate the useful lives of the fixed assets based on our historical experience with similar assets, taking into account anticipated technological changes. The depreciation expense in future periods will change if there are significant changes from previous estimates.

 

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Deferred Tax Valuation Allowance

 

We record a valuation allowance to reduce our deferred tax assets if, based on an estimate of our future taxable income and prudent and feasible tax planning strategies, it is more likely than not that we will not be able to utilize our deferred tax asset amounts. Our estimated realization of our deferred tax assets is dependent on many factors, including our ability to generate taxable income within the period during which temporary differences reverse or before our tax loss carry-forwards expire, the outlook for the Chinese economy and overall outlook for our industry. If we make different judgments or adopt different assumptions, material differences could result in the amount and timing of any valuation allowance that is recorded.

 

Treasury Stock

 

Treasury stock consists of shares repurchased by us that are no longer outstanding and are held by us. Treasury stock is accounted for under the cost method.

 

Results of Operations

 

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Comparison of the Year Ended December 31, 2013 and 2012

 

Net Revenue. Our net revenue decreased by $6.7 million, or 9.4%, to $64.5 million in 2013 from $71.2 million in 2012. The decrease was primarily due to a $32.3 million decrease in the net revenue from our video processing business, which reflects a 61.2% decrease from 2012. The decrease in revenue from our video processing business was related to a reduction in the number of orders from our largest customer. The decrease in revenue from our video processing business was partially offset by a $26 million increase in net revenue from our video surveillance business, which reflects a 146.6% increase from 2013. The increase in revenue from our video surveillance business was related to our increased marketing efforts in different cities and industry segments. It also reflects the growing implementation of the SVAC standard for which our products our specially designed.

 

Cost of Revenue. Cost of revenue decreased by $ 3 million, or 6.7%, to $42.1 million in 2013 from $45.1 million in 2012. The decrease was primarily due to a $17.7 million decrease in cost of revenue from our video processing business, which reflects a 57.8% decrease from 2012. The 57.8% decrease in cost of revenue from our video processing business corresponds roughly to the 61.2% decrease in revenue from this business. The decrease in cost of revenues was partially offset by a $14.7 million increase in cost of revenue from our video surveillance business, which reflects a 101.0% increase from 2013.

 

Gross Profit and Gross Margin. Our gross profit decreased by $3.6 million, or 14%, to $22.4 million in 2013 from $26.0 million in 2012. Our gross profit margin decreased to 34.7% in 2013 from 36.6% in 2012. This decrease was related to the growth of our video surveillance business which has historically had a lower gross profit margin than our video processing business. Our gross profit margin for our video surveillance business was 18.1% in 2012 compared to 33.2% In 2013. The increase in the gross profit margin for our video surveillance business was related to increased economies of scale as we have ramped up our video surveillance business. Our gross profit margin for our video processor business was 42.7% in 2012 compared to 35.5% in 2013.

 

Operating Expenses. Operating expenses increased by $1.5 million, or 4.8%, to $33.3 million in 2013 from $31.7 million in 2012.

 

·                  Research and Development. Research and development expenses increased by $2.7 million, or 30.9%, to $11.6 million in 2013 from $8.9 million in 2012. Our gross research and development expenditures before the deduction for government grants relating to research and development activities were $15.6 million in 2012 and $25.2 million in 2013. The increase in our research and development expenses was mainly due to increased expenditures in connection with our developing video surveillance business, including the purchase of intellectual properties.

 

·                  Sales and Marketing. Sales and marketing expenses increased by $0.3 million, or 3.3%, to $9.5 million in 2013 from $9.2 million in 2012. The increase was mainly due to in the expansion of our video surveillance business.

 

·                  General and Administrative. General and administrative expenses decreased by $0.1 million, or 0.8%, to $12.1 million in 2013 from $12.2 million in 2012. The decrease was mainly attributable to (i) the decrease of the bad debts provision which decreased from $1.9 million in 2012 to approximately $0.7 million in 2013; and (ii) a decrease in the provision for impairment of long-term investment from $1.45 million in 2012 to nil in 2013.

 

·                  Asset Impairment. Asset impairment decreased from $1.4 million in 2012 to nil in 2013. We evaluate our long-lived assets, including long-term investments for impairment and recognizes impairment if any event or change in circumstances indicates that the carrying amount of long-lived assets may not be fully recoverable. We recognize a loss based on the excess of the carrying amount of the long-lived asset of concern over its fair value, generally estimated using a upon discounted cash flows method.

 

Income Tax Expense. Income tax expense was approximately $0.7 million in 2013, compared to an income tax expense of approximately $0.2 million in 2012.

 

Other Income. Other income was $1.4 million in 2013, compared to $1.9 million in 2012, the increase was mainly due to foreign exchange gain.

 

Net Profit. As a result of the above, we had a net loss attributable to Vimicro International Corporation of $8.4 million in 2013 compared to $0.6 million in 2012.

 

Comparison of the Year Ended December 31, 2012 and 2011

 

Net Revenue. Our net revenue increased by $12.2 million, or 20.7%, to $71.2 million in 2012 from $59.0 million in 2011. The increase was primarily due to (i) an increase in net revenue from the sales of PC camera processors to $53.4 million in 2012 from $47.9 million in 2011, which reflected a 14% increase in unit shipments in 2012, and (ii) an increase in net revenue from our video surveillance business to $17.8 million in 2012 from $12.1 million in 2011, primarily reflecting our increased sales and marketing efforts in this business line.

 

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Cost of Revenue. Cost of revenue increased by $6.6 million, or 17.1%, to $45.1 million in 2012 from $38.5 million in 2011. The increase was in line with our increase in net revenue. Our gross profit increased by $5.5 million, or 26.8%, to $26.0 million in 2012 from $20.5 million in 2011. Our gross profit margin slightly increased to 36.6% in 2012 from 34.8% in 2011, primarily due to an increase in the sales of PC camera processors as a percentage of our total net revenue. Historically, sales of PC camera processors yielded a relatively higher gross profit margin. The gross profit margin of the video surveillance business decreased while the related sale increased in 2012. The lower gross profit margin relating to the video surveillance business reflected a relatively lower level of profit margins associated with certain new projects and solutions we provided in 2012 as part of our efforts to expand this business line.

 

Operating Expenses. Operating expenses decreased by $17.4 million, or 35.4%, to $31.7 million in 2012 from $49.1 million in 2011.

 

·                  Research and Development. Research and development expenses decreased by $10.1 million, or 53.2%, to $8.9 million in 2012 from $19.0 million in 2011. Our gross research and development expenditures before the deduction for government grants relating to research and development activities were $20.1 million in 2011 and $15.6 million in 2012. The decrease in our research and development expenses was mainly due to (i) an increase of approximately $5.6 million in utilizing government grants in connection with our research and development projects for video surveillance business, and (ii) a decrease of approximately $3.2 million in payroll and welfare expenses, reflecting a decrease in the number of research staff as we execute our plan to dispose of mobile business as well as to enhance our operating efficiency.

 

·                  Sales and Marketing. Sales and marketing expenses decreased by $2.9 million, or 24.0%, to $9.2 million in 2012 from $12.1 million in 2011. The decrease mainly reflected a decrease of $1.6 million in payroll and welfare expenses as we continue to increase our operating efficiency in relation to sales and marketing activities. Such decreases were partially offset by a $0.6 million increase in sales commissions to our distributors.

 

·                  General and Administrative. General and administrative expenses increased by $0.7 million, or 6.1%, to $12.2 million in 2012 from $11.5 million in 2011. The increase was mainly attributable to an increase of $1.0 million in provision for doubtful debt expenses, partially offset by a $0.3 million decrease in fees for legal, accounting and other professional services.

 

·                  Asset Impairment. Asset impairment decreased by $5.2 million to $1.4 million in 2012. We evaluate our long-lived assets, including goodwill and long-term investments for impairment and recognize impairment if any event or change in circumstances indicates that the carrying amount of long-lived assets may not be fully recoverable. We recognize a loss based on the excess of the carrying amount of the asset of concern over its fair value, generally estimated using a discounted cash flows method.

 

Income Tax Expense. Income tax expense was approximately $0.2 million in 2012, compared to an income tax benefit of approximately $0.9 million in 2011.

 

Other Income. Other income was $1.9 million in 2012, compared to $4.4 million in 2011, the decrease was mainly due to (i) a decrease of foreign exchange gain of $1.7 million due to the appreciation of the RMB against the U.S. dollar in 2012, and (ii) a decrease of interest income of $0.4 million due to a decrease of bank deposits in 2012.

 

Net Profit. As a result of the above, we had a net loss attributable to Vimicro International Corporation of $0.6 million in 2012 compared to $28.2 million in 2011.

 

Inflation

 

Since our inception, inflation in China has not materially impacted on our results of operations. According to the National Bureau of Statistics of China, the change in the consumer price index in China was 5.4%, 2.6% and 2.6% in 2011, 2012 and 2013, respectively. Although we have not been materially affected by inflation in the past, we can provide no assurance that we will not be materially affected in the future by higher rates of inflation in China.

 

Foreign Currency

 

The value of the RMB against the U.S. dollar and other currencies may fluctuate and is affected by China’s political and economic conditions and China’s foreign exchange policies. The RMB has experienced significant appreciation against the U.S. dollar since 2005. A portion of our revenue and most of our operating expenses are denominated in RMB, while the majority of our revenue, cost of revenue and non-operating expenses are denominated in U.S. dollars and Hong Kong dollars, which are pegged to the U.S. dollar. We use the U.S. dollar as the reporting currency for our financial statements. Fluctuations in exchange rates, primarily those involving the U.S. dollar, may affect our costs and operating margins as well as our net income and comprehensive income reported in U.S. dollars. We have not used any forward contracts or currency borrowings to hedge our exposure to foreign currency exchange risk.

 

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Recent Accounting Pronouncements

 

In March 2013, the Financial Accounting Standards Board (“FASB”) issued ASU No. 2013-05 (“ASU 2013-05”), Foreign Currency Matters (Topic 830): Parent’s Accounting for the Cumulative Translation Adjustment (“CTA”) upon Derecognition of Certain Subsidiaries or Groups of Assets within a Foreign Entity or of an Investment in a Foreign Entity, which specifies that foreign currency translation adjustments should be released into earnings when an entity ceases to have a controlling financial interest in a subsidiary or group of assets within a consolidated foreign entity and the sale or transfer results in the complete or substantially complete liquidation of the foreign entity. For sales of an equity method investment that is a foreign entity, a pro rata portion of CTA attributable to the investment would be recognized in earnings when the investment is sold. When an entity sells either a part or all of its investment in a consolidated foreign entity, CTA would be recognized in earnings only if the sale results in the parent no longer having a controlling financial interest in the foreign entity. In addition, CTA should be recognized in earnings in a business combination achieved in stages. For public entities, ASU 2013-05 is effective for reporting periods beginning after December 15, 2013, with early adoption permitted. The Company will adopt ASU 2013-05 on January 1, 2014 and does not expect the adoption to have a material impact on its consolidated financial statements.

 

In July 2013, the FASB issued ASU No. 2013-11, Income Taxes (Topic 740), or ASU 2013-11, to provide guidance on the financial statement presentation of an unrecognized tax benefit when a net operating loss carry forward, similar tax loss, or tax credit carry forward exists. This ASU requires an unrecognized tax benefit, or a portion of an unrecognized tax benefit, to be presented in the financial statements as a reduction to a deferred tax asset for a net operating loss carry forward, a similar tax loss, or a tax credit carry forward, with certain exceptions. The modifications to ASC 740 resulting from the issuance of ASU 2013-11 are effective for fiscal years beginning after December 15, 2013 and interim periods within those years. Early adoption is permitted. We have adopted ASU 2013-11 on January 1, 2013. Starting January 1, 2013, we have presented an unrecognized tax benefit or a portion of an unrecognized tax benefit as deduction of deferred tax assets if applicable.

 

B.                     Liquidity and Capital Resources

 

In the past, we financed our operations primarily through sales of our equity securities to private investors, proceeds from our initial public offering as well as through cash generated from our operating activities. We have also received government grants to fund our research and development projects. Our principal use of cash for the year ended December 31, 2013 was to fund our working capital requirements, investments and capital expenditures for construction work. As of December 31, 2012 and 2013, we had $55.5 million and $35.9 million in cash and cash equivalents, respectively.

 

As part of our efforts to further develop and ramp up our video surveillance business, through Vimicro Tianjin, we constructed a new facility for the research, development and production of digital high-definition video surveillance products and solutions. For more information about this project, see “—Capital Expenditures.” In connection with this project, Vimicro Tianjin obtained a credit facility of up to RMB186.0 million ($29.6 million) from China Construction Bank Tianjin Branch. The loan may be drawn down in installments no later than March 2017, based on our actual cash needs and the progression of our projects. The loan will bear an interest rate of 105% of the benchmark interest rate as published by the People’s Bank of China from time to time, adjusted on an annual basis. As of March 31, 2014, we have drawn down RMB80.0 million ($13.1 million) under the facility. We need to repay 30% in 2015 and 35% in 2016 of the principal amounts that have been drawn down under the facility and repay the remaining principal amounts with all accrued interest in 2017. In connection with the facility, Vimicro Tianjin has pledged as collateral the facility under construction and the underlying land use rights. Vimicro Beijing is a guarantor under the facility agreement.

 

Vimicro Tianjin’s facility agreement with China Construction Bank Tianjin Branch contains covenants that impose operating and financing restrictions on it. Such restrictions include:

 

·            restrictions from using the loan for a purpose other than the one stated in the agreement, being the financing of, among other things, research and develop activities and construction projects associated with our video surveillance business;

 

·            restrictions from creating security interests over assets, tangible or intangible, developed through using the loan;

 

·            requirement to obtain prior written consent from the bank with respect to mergers or divestments, transfer of equity interests, investments or incurrence of material indebtedness contemplated by Vimicro Tianjin; and

 

·            requirements to maintain certain financial ratios relating to the indebtedness and contingent liabilities of Vimicro Tianjin.

 

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In addition, Vimicro Beijing also agreed to certain negative covenants, including a requirement to obtain prior written consent from the bank before extending certain major guarantees and restrictions on undertaking significant corporate actions in its capacity as a guarantor under the facility agreement. See “Item 3. Key Information—D. Risk Factors—Risks Related to Our Business—The development and ramping-up plan of our video surveillance operations involves risks.”

 

We expect that our net working capital requirements will increase as we offer longer payment terms to attract and retain large customers, including customers for video surveillance products. In addition, we also expect that that cash required to finance our construction work in connection with our ramping-up plan of our video surveillance business will continue to increase in 2014. We believe that we have sufficient funds to meet our present requirements. If we have additional requirements for capital in the future, we expect to utilize any cash generated from our operations and available funds under our current credit facility. We may offer additional equity or debt securities or incur additional indebtedness to meet such needs.

 

The following table sets forth a summary of our cash flows for the periods indicated:

 

 

 

Year Ended December 31,

 

 

 

2011

 

2012

 

2013

 

 

 

(in thousands of U.S. dollars)

 

Net cash (used in) / provided by operating activities

 

(26,772

)

7,101

 

(14,806

)

Net cash provided by / (used in) investing activities

 

7,042

 

(2,371

)

(6,484

)

Net cash (used in) /provided by financing activities

 

(1,936

)

1,666

 

651

 

Effect of exchange rate changes on cash and cash equivalent

 

1,402

 

(91

)

976

 

Net (decrease) / increase in cash and cash equivalent

 

(20,264

)

6,305

 

(19,663

)

Cash and cash equivalent at beginning of year

 

69,491

 

49,227

 

55,532

 

Cash and cash equivalent at end of year