-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, KVMcQB1Bx+gI9BkOUI5iNRgblYow8E5WsG6zyA1YRyDaM4S1UHGDJ2Egc0fBHING eOpee4eaWTKIYEus8DXP9Q== 0000898430-99-002613.txt : 19990628 0000898430-99-002613.hdr.sgml : 19990628 ACCESSION NUMBER: 0000898430-99-002613 CONFORMED SUBMISSION TYPE: 10-K405 PUBLIC DOCUMENT COUNT: 10 CONFORMED PERIOD OF REPORT: 19990331 FILED AS OF DATE: 19990625 FILER: COMPANY DATA: COMPANY CONFORMED NAME: IMAGE ENTERTAINMENT INC CENTRAL INDEX KEY: 0000216324 STANDARD INDUSTRIAL CLASSIFICATION: SERVICES-ALLIED TO MOTION PICTURE PRODUCTION [7819] IRS NUMBER: 840685613 STATE OF INCORPORATION: CA FISCAL YEAR END: 0331 FILING VALUES: FORM TYPE: 10-K405 SEC ACT: SEC FILE NUMBER: 000-11071 FILM NUMBER: 99652817 BUSINESS ADDRESS: STREET 1: 9333 OSO AVENUE CITY: CHATSWORTH STATE: CA ZIP: 91311 BUSINESS PHONE: 8184079100 MAIL ADDRESS: STREET 1: 9333 OSO AVENUE CITY: CHATSWORTH STATE: CA ZIP: 91311 FORMER COMPANY: FORMER CONFORMED NAME: KEY INTERNATIONAL FILM DISTRIBUTORS INC DATE OF NAME CHANGE: 19830719 10-K405 1 ANNUAL REPORT ON FORM 10-K405 ================================================================================ - -------------------------------------------------------------------------------- SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 _______________________ FORM 10-K [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For The Fiscal Year Ended March 31, 1999 OR [_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For The Transition Period From ...........To ......... Commission File Number 0-11071 _______________________ IMAGE ENTERTAINMENT, INC. (Exact name of registrant as specified in its charter) _______________________ California 84-0685613 (State or other jurisdiction of incorporation) (I.R.S. Employer Identification Number)
9333 Oso Avenue, Chatsworth, California 91311 (Address of principal executive offices, including zip code) (818) 407-9100 (Registrant's telephone number, including area code) Securities registered pursuant to Section 12(b) of the Act: None Securities registered pursuant to Section 12(g) of the Act: Common Stock, no par value Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES ( x ) NO ( ) Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ( x ) At June 1, 1999, 16,445,158 shares of Common Stock were outstanding, and the aggregate market value of the shares of Common Stock held by the registrant's nonaffiliates was approximately $78,837,306 (based upon the closing price of the Common Stock on the NASDAQ National Market System on such date), excluding shares of Common Stock held by the registrant's directors, executive officers and 5% or more shareholders. Their holdings have been excluded in that such persons may be deemed affiliates. This determination of affiliate status is not necessarily a conclusive determination for other purposes. DOCUMENTS INCORPORATED BY REFERENCE Part III - Proxy Statement for Registrant's 1999 Annual Meeting of Shareholders to be filed within 120 days of fiscal year-end. - -------------------------------------------------------------------------------- ================================================================================ IMAGE ENTERTAINMENT, INC. Form 10-K Annual Report For The Fiscal Year Ended March 31, 1999 TABLE OF CONTENTS ----------------- PART I ................................................................................... 1 ITEM 1. Business................................................................... 1 ITEM 2. Properties................................................................. 18 ITEM 3. Legal Proceedings.......................................................... 19 ITEM 4. Submission of Matters to a Vote of Security Holders........................ 21 PART II .................................................................................. 23 ITEM 5. Market for Registrant's Common Equity and Related Stockholder Matters...... 23 ITEM 6. Selected Financial Data.................................................... 24 ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.............................................................. 25 ITEM 7A. Quantitative and Qualitative Disclosures About Market Risk................. 39 ITEM 8. Financial Statements and Supplementary Data................................ 40 ITEM 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure....................................................... 66 PART III ................................................................................. 66 ITEM 10. Directors and Executive Officers of the Registrant......................... 66 ITEM 11. Executive Compensation..................................................... 66 ITEM 12. Security Ownership of Certain Beneficial Owners and Management............. 66 ITEM 13. Certain Relationships and Related Transactions............................. 66 PART IV .................................................................................. 67 ITEM 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K............ 67 SIGNATURES ............................................................................... 69
- -------------------------------------------------------------------------------- PART I - -------------------------------------------------------------------------------- ITEM 1. Business. -------- GENERAL Image Entertainment, Inc. (the "Company") was incorporated in Colorado in April 1975 as Key International Film Distributors, Inc. The Company's present name was adopted in June 1983. The Company reincorporated in California in November 1989. Its principal executive offices are located at 9333 Oso Avenue, Chatsworth, California 91311, and its telephone number is (818) 407-9100. The Company operates in the domestic home video market. The Company has two business segments, wholesale distribution and (through its wholly-owned subsidiary Image Newco, Inc.) retail distribution. See "Subsidiary Activities" below. See also Item 8. "-- Notes to Consolidated Financial Statements -- Note 1. Description of Business and Summary of Significant Accounting Policies -- Segment Information." The Company is primarily a licensee and distributor of optical disc programming. Since 1983, the Company has distributed a broad range of titles on laserdisc ("LD"). The digital video disc ("DVD"), a new, smaller optical disc format that is directly competitive with LD became available to consumers in March 1997, at which time the Company began distributing DVD titles. Although the Company's primary business is the distribution of DVD and LD titles, in 1998 the Company began to distribute certain videocassette ("VHS") and compact disc ("CD") titles as well. See "Distribution of VHS & DTS-Encoded CD Software" below. The Company's DVD sales are rapidly growing. DVD sales represented approximately 38%, 48%, 70% and 73% of the Company's net sales for the first, second, third and fourth quarters of fiscal 1999, respectively. DVDs have become the replacement format of choice among most former LD customers, resulting in the decline in the Company's LD sales. In fiscal 1999, DVD and LD represented approximately 60% and 36% of the Company's net sales, respectively, as compared to fiscal 1998 during which DVD and LD represented approximately 21% and 79% of the Company's net sales, respectively. See Item 7. "-- General -- Coexistence of LD Despite DVD's Success and Future LD Distribution Strategy." The Company's VHS and CD business combined represented approximately 4% of net sales for fiscal 1999. The titles distributed by the Company are produced by motion picture studios and other program suppliers. The Company manufactures and replicates some of these titles under license agreements or other arrangements which generally grant the Company exclusive distribution rights for the United States and Canada. The Company also distributes titles that are purchased in finished, prepackaged form; however, the Company generally does not have exclusive distribution rights to these titles. In preparing its exclusive titles for replication, the Company uses its in- house digital post-production facility to create submasters. DVDs require the added interim steps of authoring and compression, work which the Company does not presently handle in-house but intends to do so in the future. The Company's in-house graphic artists also design the interactive menus which appear on DVDs. The submasters are then delivered to outside replication facilities. The Company's creative services department designs program packaging, advertising and marketing materials. The Company's marketing department implements marketing programs and issues publicity. The Company's sales department solicits orders and provides customer service and support. All product distributed by the Company is shipped from the Company's warehouse and distribution facility in Las Vegas, Nevada. - -------------------------------------------------------------------------------- Image Entertainment, Inc. 1 Currently, there are only approximately 3,000 titles available on DVD, as compared to over 10,000 titles available on LD. The Company distributes all 3,000 DVD titles (approximately 400 of which are the Company's exclusive releases). The Company's exclusive DVD titles are generally obtained from independent program suppliers, not motion picture studios (although the Company has licensed a limited number of catalogue DVD titles from Orion and Universal), and are typically comprised of music videos and concerts, classic catalogue titles, foreign films and special interest programming. The Company releases approximately 30 new exclusive DVD titles each month. Some of the exclusive DVD titles currently available from the Company include Dances With Wolves, The Eagles: Hell Freezes Over (live concert video), The Terminator, Super Speedway (which was filmed in IMAX), and Janet Jackson: Velvet Rope Tour (live concert video). Some of the exclusive DVD titles the Company expects to release in fiscal 2000 include The Golden Age of Rock and Roll (rock music compilation), The Paris Concert for Amnesty International (featuring performances by Bruce Springsteen, Shania Twain, Alanis Morrisette and others) and 50 titles from the prestigious RM Associates Library, which includes operas, ballets, symphonies and other fine arts programming. The Company purchases DVD programming for nonexclusive distribution from all of the motion picture studios, including Columbia/TriStar, Disney, Fox, MGM, New Line, Orion (the Company has an exclusive license to distribute 12 Orion catalogue titles on DVD), Paramount, Universal (the Company has an exclusive license to distribute 50 Universal catalogue titles on DVD) and Warner, and from DVD program suppliers with whom the Company does not have exclusive DVD licenses. See "Acquisition of DVD & LD Programming" below. Although the demand for LDs has continued to drop, not all LD consumers have switched to the DVD format or completely abandoned the LD format. One reason is that certain titles, such as the Disney animated classics and many collectible catalogue titles, have yet to be released on DVD. The Company releases approximately 25 new exclusive LD titles each month. The Company's exclusive LD titles are generally obtained from major motion picture studios such as Disney, Warner and Fox and are typically comprised of blockbuster and other new theatrical releases. Some of the exclusive LD titles currently available from the Company include Peacemaker, Elizabeth and Thin Red Line. Some of the exclusive LD titles the Company expects to release in fiscal 2000 include Saving Private Ryan, Prince of Egypt, Analyze This and The Matrix. The Company is a nonexclusive wholesale distributor of LD programming from Columbia/TriStar and other LD program suppliers with whom the Company does not have exclusive LD licenses. The Company does not distribute LD programming from Paramount or Universal. See "Acquisition of DVD & LD Programming" below. Notwithstanding the competitive impact of DVD on the Company's LD business, the Company believes that the DVD format represents significant growth opportunities for the Company. Since DVD's March 1997 introduction, the Company has successfully applied its LD licensing, production, marketing, creative services and distribution skills to the DVD format. It is the Company's strategy to continue to secure additional rights in both the DVD and LD formats and to explore and exploit licensing and distribution opportunities in both formats. RECENT DEVELOPMENTS In May 1998, the Company announced the closure of its wholly-owned subsidiary, U.S. Laser Video Distributors, Inc., located in New Jersey. The corporate entity was dissolved in February 1999. On December 28, 1998, the Company entered into a Loan and Security Agreement with Foothill Capital Corporation (the "Foothill Agreement"), which provides for revolving advances and the issuance of and guaranty of standby letters of credit under a $12 million revolving credit facility and a series of term loans under a $500,000 capital expenditure term loan facility. Concurrent with funding of the Foothill - -------------------------------------------------------------------------------- 2 Image Entertainment, Inc. Agreement, the Company terminated its $10 million December 1996 Loan Agreement with Union Bank of California, N.A. and repaid all outstanding borrowings under that agreement. See Item 7. " -- Liquidity and Capital Resources -- Financing Activities -- Revolving Credit and Term Loan Facility." On January 6, 1999, the Company completed its public offering and sale of 2.4 million shares of newly-issued common stock to a group of institutional investors and other accredited investors at $5 per share. The net proceeds of the offering (net of placement agent fees and professional services fees) was $10,557,000. See Item 7. "-- Registered Common Stock Sale." On January 11, 1999, the Company, through Image Newco, Inc. ("Image Newco"), a wholly-owned subsidiary of the Company, completed its acquisition of certain assets and liabilities of the Internet/direct-to-consumer DVD and LD software business ("Ken Crane's") of Ken Crane's Magnavox City, Inc. ("KCMC") pursuant to an Asset Purchase Agreement dated as of August 20, 1998 between KCMC and Image Newco (as amended, the "Purchase Agreement"). Ken Crane's is engaged in Internet/direct-to-consumer retailing of DVD and LD entertainment software. See "Subsidiary Activities" below. In May 1999, the Company closed its Chatsworth, California distribution facility and began to ship all product from its new Las Vegas, Nevada warehouse and distribution facility. Once certain software and operational issues related to the transition to the new facility have been resolved, the new facility is expected to be able to ship orders within 24 hours of receipt. See Item 7. " -- New Las Vegas Warehouse and Distribution Facility." The Company's corporate offices remain in Chatsworth. DVD & LD BASICS Introduction. DVD and LD are optical disc entertainment software formats ------------ encoded with audio and visual information. Just as compact discs offer distinct advantages over records and audiotapes, DVDs and LDs offer distinct advantages over VHS, such as higher resolution video, full-fidelity discrete channel digital audio, instant access to any scene, frame-by-frame viewing, greater durability and superior interactive capability. Since both DVD and LD are optical disc-based home video formats, the marketing, sale and distribution of DVDs and LDs are similar. LDs offer a number of features which are similar to DVDs; however, DVDs enjoy the enviable position of being the state-of-the-art delivery system for home entertainment optical disc software. This section discusses DVD and LD basics. For a further discussion of the DVD and LD formats see Item 7. " -- General." Software Availability. Most of the major motion picture studios release --------------------- their theatrical new releases in the DVD format, often concurrently with the title's VHS release. Disney, however, has not announced plans to release its animated classic titles in the DVD format. Warner, an early proponent of the DVD format, is the only studio that has been actively releasing catalogue titles in the DVD format (Warner also controls the rights to MGM, New Line and certain Turner programming). The other studios are selectively releasing a limited number of catalogue titles in the DVD format, preferring to wait until the DVD market matures. In addition to the motion picture studios, several independent program suppliers (including the Company) also release DVD programming. There are approximately 3,000 titles currently available on DVD (approximately 400 of which are the Company's exclusive releases), with approximately 200 new DVD titles released each month (approximately 30 of which are exclusive releases from the Company). Although there are over 10,000 titles currently available on LD, program suppliers (including the Company) have significantly scaled back the number of new titles released in the LD format. Today, the only titles generally released on LD are theatrical new releases and collectible catalogue titles. - -------------------------------------------------------------------------------- Image Entertainment, Inc. 3 Hardware Availability. Consumer electronic manufacturers have shifted away --------------------- from LD hardware to DVD hardware. Pioneer's LD/DVD combination player, which generally retails for approximately $999, is the only hardware player currently manufactured that supports LDs. Virtually all consumer electronic manufacturers (such as Toshiba, Panasonic, Sony, Thomson and Yamaha) manufacture one or more models of DVD players. DVD players generally retail from $299 to $1,299 for the more popular consumer models, and for as much as $5,500 for highly specialized models. Both DVD players and LD/DVD combination players also play CDs. Video Quality. Both DVD and LD are optical disc formats which are read by ------------- a laser beam. DVD's picture is digital while LD's picture is analog. DVD's video image is compressed to fit on a 5" disc while LD's video image is transferred uncompressed to a 12" disc. Both DVD and LD provide picture quality superior to VHS. DVD, LD and VHS offer 500 (if properly compressed), 425 and 240 lines of resolution, respectively. Audio Quality. The audio format offered on all DVDs is Dolby Digital (also ------------- known as "AC-3"), providing up to 5.1 channels of discrete audio. Digital audio is offered on all LDs and many LD titles also offer Dolby Digital. Certain DVDs, primarily music programs, also offer PCM stereo soundtracks similar to those found on LDs and CDs. PCM stereo offers better sound quality, on two- channel stereo programming, than can be realized with two-channel Dolby Digital. DTS Digital Surround ("DTS") (a discrete multichannel format similar to Dolby Digital) and Dolby Stereo Surround are also being offered on certain DVDs and LDs. Consumers must have hardware compatible with Dolby Digital and DTS technology to take advantage of these audio formats. Content Capacity. A DVD has the ability to hold up to 139 minutes of ---------------- compressed programming per side for a total of 266 minutes (almost 4 1/2 hours). Dual-layer DVD technology also exists, allowing for the same storage capacity without requiring the DVD to be turned over. Most DVD releases with run-times in excess of 139 minutes are now encoded on a dual layer disc. A LD can hold 60 minutes of programming per side for a total of 120 minutes (2 hours). Many LD players will automatically play the second side of a LD after a several second delay, while low-end LD players require the LD to be turned over by hand. A LD program with a run-time in excess of two hours requires two discs. Software Features. DVDs and LDs are playback-only formats -- unlike VHS, ----------------- neither format can record. Although there is speculation regarding the availability of a consumer-oriented recordable DVD player, the Company believes that such hardware will not be available for several years. Both DVD and LD offer chapter stops and random/direct program access akin to CD's random track access. DVDs and LDs typically offer programming with entertaining and informative ancillary material such as audio commentaries by film talent, deleted scenes, scripts, photos, alternative endings and multiple versions such as a "director's cut." DVDs additionally offer on-screen interactive menus which allow access to key scenes or chapters, ancillary material and, often times, foreign language subtitles. LDs, on the other hand, typically list such choices on the back of the LD packaging. LDs provide subtitles for foreign films and sometimes offer foreign language alternatives on separate audio tracks. LD titles are generally released in the widescreen version preferred by videophiles. Many DVD releases offer both widescreen and pan-and-scan (full- format) versions on the same disc. DVD technology also allows for PC-compatible features, such as Internet web-links. Whether or not all or any of these features will be included on a particular DVD or LD is determined by the studio or program supplier or, in certain instances, licensees such as the Company. Retail Sale and Pricing. DVDs and LDs are currently priced for the sell- ----------------------- through market as opposed to the rental market (although there is an emerging DVD rental market). Most LD titles sell for between $29.99 and $39.99 and are generally discounted up to 20% by the speciality LD retailers, music chain stores - -------------------------------------------------------------------------------- 4 Image Entertainment, Inc. and mail order/Internet sources that sell LDs. Currently, most DVD titles sell for between $24.99 and $29.99 and are generally discounted up to 20% at retail, although discounts of 30% or more are not uncommon through Internet retailers. Market Penetration. LD hardware and software is not supported by mass- ------------------ market retailers and, as a result, the LD market is an extremely small niche market relative to VHS. Since DVD's introduction, most LD retailers and vendors have added DVD programming to their offerings. Major video/music software discounters and retailers such as Best Buy, Musicland and Tower are the DVD market leaders, with large selections of DVD titles. Mass merchants such as Wal-Mart, Target Stores and Kmart have increased the number of outlets that carry DVD. With increasing DVD hardware penetration and growing consumer interest in DVD, an increasing number of video speciality stores are stocking DVD software for rental and sale. Today, the DVD market is only slightly larger than the LD market was at its 1997 peak; however, the DVD market is growing steadily. If the market for DVD does not grow large enough to justify continued mass-market support, the Company believes DVD will most likely be a niche market relative to the VHS market. ACQUISITION OF DVD & LD PROGRAMMING General. Because the Company does not produce its own DVD and LD ------- programming, its success depends, in part, upon entering into new and renewing existing licenses for programming and, in part, upon its ability to continue purchasing programming on a wholesale distribution basis. There can be no assurance that suppliers of programming will continue to enter into or renew licenses on terms acceptable to the Company. The Company, however, believes that its production, creative services, marketing and distribution expertise will continue to make it an attractive partner for such suppliers. There can also be no assurance that suppliers of programming which the Company distributes on a wholesale distribution basis will continue to sell product to the Company. The Company, however, believes that its reputation, knowledge and expertise in selling optical disc product, strong credit history and volume purchases will continue to make it an attractive distributor for such suppliers. See "Competition" below. Licensed titles accounted for approximately 52% of fiscal 1999 net sales (of which 33% was derived from DVD and 19% was derived from LD), 46% of fiscal 1998 net sales (of which 9% was derived from DVD and 37% was derived from LD) and 56% of fiscal 1997 net sales (the Company did not distribute licensed DVD titles until fiscal 1998). Wholesale distribution accounted for approximately 48% of fiscal 1999 net sales (of which 30% was derived from DVD and 18% was derived from LD), 54% of fiscal 1998 net sales (of which 12% was derived from DVD and 42% was derived from LD) and 44% of fiscal 1997 net sales (of which less than 1% was derived from DVD). License Agreements. The Company enters into licenses whereby it acquires ------------------ from suppliers of programming the right to manufacture and distribute their titles on DVD, LD or both (and in some cases VHS). Licenses can be exclusive or nonexclusive, but are typically exclusive. Licenses either cover specific titles or a licensor's existing library and future releases for a designated term. This latter type of license agreement is commonly referred to as an "output" agreement. Most of the Company's DVD license agreements, although exclusive, are not output agreements, rather they typically cover seven or fewer titles. Most of the Company's recent DVD license agreements also include LD (and sometimes VHS) format rights. When the Company licenses rights, it provides a variety of value-added services relative to the licensed programs, such as creation of the jacket and packaging art work, quality-control, replication and - -------------------------------------------------------------------------------- Image Entertainment, Inc. 5 manufacture of the product, marketing, sales, warehousing and distribution and, in certain instances, the addition of enhancements such as separate audio tracks, commentaries, foreign language tracks, menus and other similar ancillary materials. In return for the grant of rights, the Company pays royalties to its licensors. Royalties are expressed as a percentage of the Company's net revenues from sales. In many cases, the Company pays licensors advances or minimum guarantees which are recoupable against royalties earned on a title-by- title basis or, if cross-collateralized, against all or certain groups of the titles licensed. Advances under most output licenses are paid according to predetermined schedules, regardless of the number and marketability of the titles subsequently available. In entering into licenses and evaluating the required advances, guarantees and other obligations, the Company depends, to a large extent, on its ability to anticipate the public's changing taste in programming and (for output licenses) licensors' future releases. Generally, the Company's license agreements have terms of two to five years and are limited to the United States and Canada. Two of the Company's exclusive DVD license agreements (Orion and Playboy) are terminable by the licensor if DVD hardware penetration reaches certain specified levels. Under most of the Company's output license agreements, the Company has two to five years to select titles and two to five years to distribute a title after its release. While efforts are made to renegotiate and renew licenses prior to expiration, there can be no assurances that license agreements will be renegotiated or renewed. In fiscal 1999, exclusive titles from only two of the Company's licensors accounted for more than 5% of the Company's total net sales: Disney (agreement covers LD titles only) (8% of total net sales and 21.5% of LD-only revenues) and Orion (5.5% of total net sales, 8.7% of DVD-only revenues and 1% of LD-only revenues). Exclusive titles from the following licensors accounted for the largest percentages of fiscal 1998 net sales (the only percentage equal to or in excess of 10% is indicated): Disney (agreement covers LD titles only) (17% of total net sales and 21.5% of LD-only revenues), New Line (agreement covers LD titles only), Warner (agreement covers certain classic MGM/UA and MGM/Turner library LD titles only), Polygram (agreement covers LD titles only) and Playboy (agreements cover DVD and LD titles). Exclusive titles from the following licensors accounted for the largest percentages of fiscal 1997 net sales (only percentages equal to or in excess of 10% are indicated) (the Company did not release any exclusively licensed DVD titles in fiscal 1997): Disney (26.9% of total net sales and 27.1% of LD-only revenues), MGM (10.2%), New Line, Warner (agreement covers certain classic MGM/UA and MGM/Turner library LD titles only) and Hallmark. The decline in total sales of Disney LD titles from 26.9% in fiscal 1997 to 8% in fiscal 1999 is attributable primarily to two factors: (1) DVD sales increased as a percentage of total (DVD and LD) sales from 1% in 1997 to 60% in 1999, resulting in a lower percentage of Disney LD sales to total sales; and (2) the general decline in annual LD sales and the corresponding change in retailer purchasing patterns for LD resulting from DVD's presence in the market. Historically, the Company has not attempted to obtain foreign distribution rights, however, the Company is beginning to pursue foreign license rights for DVD programming, particularly for European distribution. Wholesale Distribution. In addition to its licensing activities, the ---------------------- Company is a wholesale distributor of certain DVD and LD programming that it acquires from certain major motion picture studios and other suppliers. In general, the Company acquires DVD and LD programming for wholesale distribution in finished, prepackaged form, and thus does not provide any creative services with respect to such programming. The Company has three exclusive LD distribution agreements (with Fox, Voyager and Warner) pursuant to which the Company, for a fee, typically provides all of the same value-added services it provides under exclusive license agreements. More typical is the nonexclusive wholesale distribution - -------------------------------------------------------------------------------- 6 Image Entertainment, Inc. arrangement where the program supplier notifies the Company of its upcoming releases and the Company then solicits its customers and places orders for the releases. In acquiring DVDs and LDs for nonexclusive wholesale distribution, the Company is generally required to pay program suppliers within 60 days of delivery. In fiscal 1999, the Company's wholesale distribution of DVD titles from only two companies accounted for more than 5% of net sales: Voyager (5.3%) and Warner (5.2%). Similarly, in fiscal 1999, the Company's wholesale distribution of LD titles from only two companies accounted for more than 5% of net sales: Warner (6%) and Fox (5.5%). Exclusive wholesale distribution under the following agreements accounted for the largest percentage of fiscal 1998 net sales (the only percentage in excess of 10% is indicated): Fox (15%) (agreement covers LD titles only), Voyager (agreement covers LD and certain DVD titles) and Warner (agreement, which commenced in August 1997, covers LD titles only). Exclusive wholesale distribution under the following agreements accounted for the largest percentage of fiscal 1997 net sales (the only percentage in excess of 10% is indicated): Fox (19%) (agreement covers LD titles only) and Voyager (agreement covers LD and certain DVD titles). Pursuit of DVD and LD Rights. The Company intends to continue to actively ---------------------------- pursue DVD and LD license and distribution rights. The Company generally recognizes higher margins and revenues from its exclusive license agreements than its nonexclusive license and wholesale distribution arrangements. The Company will attempt to secure exclusive rights under license agreements, which will most likely require advances and royalty payments. Where the Company is unable to secure either exclusive or nonexclusive license rights, it will attempt to purchase and distribute programming on a wholesale distribution basis. SALES, CUSTOMERS AND CREDIT POLICIES The Company sells both licensed and wholesale DVD and LD product (and on a limited basis VHS and CD product) directly to retailers or through subdistributors subject to the terms of the Company's dealer sales policies. Sales to the Company's four largest customers accounted for approximately 28% of the Company's net sales for fiscal 1999 (no customer accounted for greater than 10% of the Company's fiscal 1999 net sales): Norwalk Record Distributors, Ken (in that order) the Company's top three customers of DVD product for fiscal 1999. Norwalk and Ken Crane's were (in that order) the Company's top two customers of LD product for fiscal 1999. Sales to the following customers accounted for the largest percentages of the Company's fiscal 1998 net sales (no customer purchased DVDs in excess of 10% of fiscal 1998 net sales): Norwalk Record Distributors (10.9%), Ken Crane's (10.6%) and Musicland (10%). LD sales to the following customers accounted for the largest percentage of the Company's fiscal 1997 net sales (only percentages equal to or greater than 10% are indicated) (on a per customer basis, DVD sales, relative to LD sales, were minimal): Musicland (11.2%), Alliance Entertainment (which includes its consolidated subsidiaries Bassin Distributors, one of the Company's top five customers in fiscal 1996, and Abbey Road Distributors, another of the Company's customers) (10.4%), Ken Crane's (10.2%), Norwalk Record Distributors and Trans World Entertainment Corp. The Company does not have any short- or long-term contracts or exclusive dealing arrangements with its major customers. The Company's prospective customers generally submit a credit application followed by a minimum opening order. If the application is accepted, credit terms are assigned. Open account terms generally require payment within 45 to 60 days of delivery. The Company may also require a customer to provide a purchase money security interest, a personal guarantee, a letter of credit and/or other collateral. The provision for doubtful accounts receivable was 0.2% of net sales during fiscal 1999. The assignment of - -------------------------------------------------------------------------------- Image Entertainment, Inc. 7 certain doubtful receivables to third parties at return rates more favorable than anticipated resulted in the Company realizing net recoveries of doubtful accounts receivable of 0.4% of net sales during fiscal 1998. (In fiscal 1999, no receivables were assigned to third parties.) The provision for doubtful accounts receivable was 2.3% of net sales during fiscal 1997 (the significant increase in fiscal 1997 was attributable to the financial difficulties experienced by several of the Company's largest customers). The amount of doubtful accounts receivable actually written off by the Company in fiscal 1999, 1998 and 1997 was approximately $23,000, $894,000 and $650,000, respectively. The allowance for doubtful accounts at March 31, 1999 and 1998 was approximately $525,000 and $404,000, respectively. Although sales are generally considered final, the Company allows customers to return a portion of their stock on a quarterly basis. This allowance generally is non-cumulative, based on the customer's prior quarter purchases and limited on an individual-title basis. On occasion, however, greater return allowances are afforded to certain large customers. The Company has provided for estimated returns as sales are recorded. Stock returns, other than for defective product, amounted to approximately 4.9% of all net sales during fiscal 1999 (including DVD, LD, VHS and CD product), approximately 5.0% of all net sales during fiscal 1998 (including both DVD and LD), and approximately 9.5% of all LDs sold in fiscal 1997 (DVD sales were minimal in fiscal 1997). Returns of defective product have been minimal and are generally covered by manufacturers' warranties. As of June 1, 1999, the Company had approximately $4.5 million of backlog orders (80% from DVD product and 20% from LD product). The Company expects to fill 100% of the backlog orders within the current fiscal year. As of June 15, 1998, the Company had approximately $6.0 million of backlog orders (including pre-orders of $3.3 million for LD new releases and $2.1 million for DVD new releases), 66% from LD product and 34% from DVD product (which was launched in March 1997). DVD & LD MARKETING The Company's marketing strategy is to promote its product, in particular, and the DVD and LD formats, in general. The Company's marketing efforts, which are directed toward consumers and video software and hardware dealers, involve point-of-sale advertising, advertising in trade and consumer publications, national radio advertising campaigns, dealer incentive programs, trade show exhibits and bulletins featuring new releases and in-stock catalogue titles. The Company spent approximately $730,000 for advertising in trade and consumer publications in fiscal 1999 and approximately $500,000 in fiscal 1998. Promotion of each new title generally begins eight to sixteen weeks before the scheduled in-store release with the mailing of the solicitation materials produced in-house. An active telemarketing campaign follows. The Company also maintains a web site on the Internet at www.image- entertainment.com. The web site includes information regarding the Company's exclusive releases, as well as weekly new product announcements and information of general interest to the home video consumer. News releases pertaining to the Company are also posted to the web site. DVD & LD PRODUCTION AND REPLICATION Under a typical license agreement, the licensor delivers a program master and art work to the Company for quality evaluation. If the Company deems the program master acceptable, the Company's in-house post-production facility creates a submaster with specifications for the DVD or LD format. The Company's in-house graphic artists then design the interactive menus which appear on the DVDs. - -------------------------------------------------------------------------------- 8 Image Entertainment, Inc. Prior to replication, DVDs require the additional interim steps of authoring and compression, work which the Company does not presently handle in- house but intends to do so in the future. The Company currently uses any one of several authoring and compression facilities for this work. Pioneer, Warner Advanced Media Operations ("WAMO") and California Video Center performed most of the Company's authoring and compression work in fiscal 1999. After authoring and compression work is completed, the DVD submaster is delivered to an outside manufacturing facility for replication. The Company currently replicates all of its DVDs at WAMO; however, the Company believes it could easily shift its product to any number of DVD replication facilities, such as Panasonic, Pioneer, Technicolor, Nimbus, Sony and Cinram. LD submasters are delivered to the LD manufacturer for replication. The Company currently uses two LD replication facilities: Kuraray in Japan and Pioneer in the United States. The Company believes that these LD manufacturing facilities currently have sufficient aggregate capacity to fulfill the Company's orders. If, however, either manufacturer were unable to supply the Company with LDs, the Company believes it would be able to shift its product to other manufacturers. DVD replication is faster and less expensive than LD replication. It takes approximately two to three weeks from the time the Company places a replication order for DVDs for the DVDs to arrive at the Company, whereas the turnaround time for LDs is approximately three to four weeks. The average per unit replication cost for DVDs is approximately $2.00, whereas the average replication cost for LDs is approximately $8.00; however, the average cost of authoring, compression and production of a DVD title is approximately $6,000 as compared to the $2,000 average cost of mastering a two-sided LD. The Company attempts to solicit orders from its customers prior to submitting replication orders. The Company generally must pay for finished discs within 45 to 90 days of invoicing. The Company's goal is to order for manufacture that number of units of each title which will enable the Company to ship the bulk of the order within 30 days of delivery. Attainment of this goal depends largely upon the Company's ability to predict the popularity of a title. DVD and LD packaging is designed by the Company's creative services staff and sent to a printer for replication. With respect to LDs, the manufacturer will either package and shrink-wrap the LDs and ship the completed product to the Company or ship the LDs in bulk to the Company and the Company will package and shrink-wrap the LDs at its own facility. The Company estimates that 30% of the manufactured LD units are received in finished form and 70% of the manufactured LD units are received in bulk shipments requiring packaging and shrink-wrapping in-house. WAMO currently replicates and packages all of the Company's DVD product, returning the finished DVD product to the Company for distribution. The Company's in-house digital post-production facility and creative services facility (which utilizes computer graphics equipment for the output of high resolution, four-color separations used for DVD and LD package printing) allow the Company to format over 80% of the masters (from all licensors) it would otherwise contract out to post-production facilities and to deliver to printers final, color separated film it would otherwise contract out to outside facilities. DISTRIBUTION OF VHS & DTS-ENCODED CD SOFTWARE In addition to the Company's DVD and LD licensing and distribution activities, the Company distributes DTS-encoded CD music programming, as well as certain programming on VHS. The Company views its distribution of VHS and DTS- encoded CD programming as a compliment to its core LD/DVD business. - -------------------------------------------------------------------------------- Image Entertainment, Inc. 9 In fiscal 1998, the Company began licensing certain niche entertainment programming on VHS for exclusive distribution. When and where feasible, the Company plans to continue to acquire exclusive VHS distribution rights. Such rights are often offered as part of a bundle of rights which include DVD and LD rights. VHS represented approximately 2.2% of the Company's net sales for fiscal 1999. Some of the Company's best selling VHS releases for fiscal 1999 included: Rolling Stones: Bridges to Babylon, Bee Gees: One Night Only, Janet Jackson: Velvet Rope Tour and the Broadway musical Into the Woods. DTS is a multichannel audio format that delivers up to six discrete channels of audio which surrounds the home theater consumer with 360 degrees of sound that better approximates a live concert experience. Special decoder hardware is required to receive the enhanced sound capabilities offered by DTS. In 1997, the Company entered into two exclusive agreements, with Digital Theater Systems, Inc. and Miller Nevada, Ltd., both of which grant to the Company exclusive distribution rights to DTS-encoded CDs. Such CDs represented approximately 1.8% of the Company's net sales for fiscal 1999. Some of the Company's exclusive DTS-encoded CD releases included Eagles: Hell Freezes Over, the motion picture soundtrack Titanic and Steely Dan: Gaucho. The Company also releases certain DTS-encoded LDs. SUBSIDIARY ACTIVITIES Image Newco Acquisition of Ken Crane's. The Company's wholly-owned -------------------------------------- subsidiary, Image Newco, Inc., acquired Ken Crane's on January 11, 1999. Ken Crane's currently operates in one business segment, retail distribution, under the name "Ken Crane's DVD and Laserdisc Superstore." Ken Crane's, which specializes in Internet/direct-to-consumer entertainment software retailing, operates a retail store in Westminster, California and also sells its product via mail order and over the Internet on the www.kencranes.com web site. Prior to its acquisition by Image Newco, Ken Crane's was one of the Company's largest customers. During the Company's 1999 (through the January 11, 1999 acquisition date) and 1998 fiscal years, sales by the Company to Ken Crane's were $5,983,000 and $8,069,000, respectively. The assets acquired by Image Newco included the www.kencranes.com web site, a mail-order business, an approximately 8,000 square foot retail store (located in leased premises in Westminster, California), DVD and LD inventory, and fixed assets and certain other assets used in the operation of Ken Crane's Internet, mail-order and retail store businesses. In addition, Image Newco assumed certain of Ken Crane's trade accounts payable. The acquisition purchase price included $3 million in cash and 258,370 shares of Image common stock, valued at $2 million (based on an agreed upon value of $7.74 per share). The purchase price may be subject to adjustment following the results of the post-closing audit of Ken Crane's. The Company funded the purchase price and its related payments with a portion of the net proceeds raised in the Company's January 6, 1999 public offering of common stock. In connection with the acquisition, Image Newco entered into (1) a five-year employment agreement with Charles K. Crane, II ("Ken Crane, Jr.") (and paid Ken Crane, Jr. a signing bonus of $1.5 million pursuant to that agreement) and (2) one-year consulting agreements with Pamela Crane and Casey Crane (and made a one-time payment of $250,000 to each in connection with those agreements). Ken Crane, Jr. oversees day-to-day operations of Ken Crane's and serves as Vice-President - General Manager of Image Newco. The Company believes that Ken Crane's will generate future operating benefits by providing a wider distribution channel for the Company's products in the form of increased access to Internet, mail order and traditional "bricks and mortar" retail sales. The Company believes that Ken Crane's will be able to take advantage of the growing level of commerce conducted over the Internet. In addition, the Company expects that by late September 1999, the www.kencranes.com web site will be integrated with the Company's new warehouse and distribution facility in Las Vegas, Nevada. The Company believes that integration of the www.kencranes.com web site will increase Ken Crane's ability to fulfill and ship orders quickly and, as a - -------------------------------------------------------------------------------- 10 Image Entertainment, Inc. result, will ensure customer satisfaction and customer loyalty and, ultimately, will increase traffic volume and orders on the web site. The www.kencranes.com web site differs from the Company's current web site at www.image-entertainment.com in that visitors to the www.kencranes.com web site can purchase DVDs and LDs directly from the web site. The www.kencranes.com web site lists retail prices, has "shopping cart" and "check out" features, allows for consumer interaction via e-mail, lists over 10,000 items that can be purchased directly from the site and provides synopses of each such item. Since the Company, unlike Ken Crane's, is a distributor rather than a direct-to-consumer retailer, the Company's www.image-entertainment.com web site does not sell product, but rather simply provides information regarding the Company, its new releases (and suggested retail prices) and other general Company and industry news. In the coming months, the Company intends to rename Image Newco and make a corresponding change to the Ken Crane's retail store name and web site domain name. The Company also intends to upgrade the look, content, feel and organization of the web site, which will include the addition of software enhancements that allow for "one click" ordering and "personalization" based on a consumer's purchasing habits and other information provided by the consumer. The retail store will also be redesigned and remodeled to enhance the efficiency of its customer service/call center area and to provide for more effective product placement. Closure of U.S. Laser. In May 1998, the Company announced the closure of --------------------- its wholly-owned subsidiary U.S. Laser Video Distributors, Inc. The corporate entity was dissolved in February 1999. See Item 7. "-- Closure of U.S. Laser." TRADEMARKS The Company has received Federal registration of the trademark "IMAGE" in the United States Patent and Trademark Office. The Company also uses the trademarks "Vocal Images," "The Music Disc," "The Finest in Laserdiscs" and "The Finest in Home Entertainment" and the service marks "Image Post" and "Image Creative Group." COMPETITION The Company faces competition in the sale of DVDs and LDs to retailers. The Company believes it has a competitive advantage with respect to sales of its exclusive LD and DVD titles because it is the only source of such titles. With respect to LD and DVD titles for which the Company does not have exclusive rights, the Company believes that it has a competitive sales advantage because of the amount and selection of its inventory as well as its pricing. Although the Company's prices may not be as low as those of the studios that sell their own product, this has a limited effect on the Company because the studios only sell to a limited number of purchasers, and most retailers must purchase through a distributor such as the Company. The Company believes it also benefits from the convenience of "one-stop shopping" for retailers who purchase exclusive titles from the Company and can easily purchase additional nonexclusive titles at the same time. The Company also faces competition in securing DVD and LD license and distribution rights. The Company believes that it is able to successfully compete to obtain DVD and LD license and distribution rights because of its reputation and relationships, the quality of its product and its ability to make advance payments against revenues to its suppliers. Finally, the Company faces competition from other forms of in-home entertainment. See "Risk Factors" below. See also Item 7. "-- Risks and Contingencies." - -------------------------------------------------------------------------------- Image Entertainment, Inc. 11 EMPLOYEES At June 1, 1999, the Company had 109 full-time employees and 1 part-time employee, and Ken Crane's had 26 full-time employees and 38 part-time employees. RISK FACTORS This Annual Report on Form 10-K contains certain forward-looking statements which the Company believes are within the meaning of the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements are based on the beliefs of the Company's management as well as assumptions made by and information currently available to the Company's management. When used in this document, the words "anticipate," "believe," "may," "estimate," "expect" and similar expressions, variations of such terms or the negative of such terms as they relate to the Company or its management are intended to identify such forward-looking statements. Such statements are based on management's current expectations and are subject to certain risks, uncertainties and assumptions. Should one or more of these risks or uncertainties materialize, or should underlying assumptions prove incorrect, the Company's actual results, performance or achievements could differ materially from those expressed in, or implied by, any such forward-looking statements. Important factors that could cause or contribute to such difference include those discussed under "Risk Factors" in this Annual Report. You are cautioned not to place undue reliance on such forward-looking statements, which speak only as of their dates. The Company undertakes no obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. The Company has made forward-looking statements in this Item 1. and subsequent Items (including but not limited to Item 7.) of this Annual Report concerning, among other things, (1) the significance of the growth opportunities for the Company represented by the DVD format, (2) the Company's ability to continue to be an attractive licensee and distributor for suppliers, (3) the ability of the Company to correct the new warehouse and distribution facility's shipping delays, (4) the expected dates by which the new warehouse and distribution facility will (a) operate at the efficiency level of the closed Chatsworth facility, (b) operate at its planned efficiency level and (c) integrate the Ken Crane's web site and handle fulfillment shipping for Ken Crane's, (5) whether the Company has a competitive advantage and the factors that contribute to such competitive advantage, (6) the current number of domestic DVD households, (7) the ability of LD and DVD to coexist, (8) the viability of the LD programming market, (9) whether the Company's LD-related assets will continue to have material decreases in net realizable value, (10) the most reasonably likely worst case scenario if the Company does not complete its Year 2000 compliance program in a timely manner, (11) the ability of Ken Crane's to generate future operating benefits by providing a wider distribution channel for the Company's products, (12) the ability of Ken Crane's to take advantage of the growing level of commerce conducted over the Internet, and (13) the Company's ability to fulfill and ship orders quickly as a key feature in ensuring customer satisfaction and customer loyalty that will result in increased traffic volume on the www.kencranes.com web site and an increased volume of orders. The inclusion of such forward-looking information should not be regarded as a representation by the Company, its management or any other person that the future events, plans or expectations contemplated by the Company will be achieved. The Company undertakes no obligation to release publicly any updates or revisions to any such forward-looking statements that may reflect events or circumstances occurring after the date of this Annual Report. Factors that could cause or contribute to such material differences include, but are not limited to, those discussed below. If We Cannot Maintain Relationships with Our Program Suppliers and Vendors, Our Business May Be Adversely Affected. We receive a significant amount of our revenues from the distribution of those - -------------------------------------------------------------------------------- 12 Image Entertainment, Inc. DVDs and LDs for which we have exclusive agreements with program suppliers. We cannot assure you that we will be able to renew these exclusive rights as the existing agreements with each program supplier expire. We also cannot assure you that our current program suppliers will continue to support the DVD and LD formats (particularly LD) in accordance with our exclusive agreements. In addition, we cannot assure you that our current program suppliers will continue to license titles to us on the current terms or that we will be able to establish new program supplier relationships to ensure acquisition of titles in a timely and efficient manner or on an exclusive basis. If we cannot maintain relationships with our program suppliers, on an exclusive basis or otherwise, or our program suppliers do not continue to support the DVD and LD formats we could suffer a material adverse effect on our business, prospects, financial condition and results of operations. If We Cannot Continue to Secure DVD License and Distribution Rights, Our Business May Be Materially Adversely Affected. We cannot assure you that we will be able to continue to secure DVD license and distribution rights on terms acceptable to us. Given the relative newness of the DVD format and its uncertain position in the home video software market, none of the major motion picture studios has granted exclusive licenses for its new releases and most popular catalogue titles. Instead, the major motion picture studios sell this programming directly to retailers, other distributors and us. Given that DVD is positioned to become a replacement for VHS (although it remains to be seen whether this will occur), we also compete with independent licensing and distribution entities from the VHS sector of the home video market. This is different from the LD market (which is an established specialized market) in which we face licensing and distribution competition from significantly fewer sources. We expect to be able to purchase DVD titles on a wholesale basis from all participating program suppliers for sale to our customers but we cannot assure you that we will be able to continue to do so if DVD program suppliers elect to sell direct, increase the number of entities distributing their programming or limit our access to their programming. If We Cannot Continue to Secure LD License and Distribution Rights, Our Future Revenues May Be Negatively Impacted. We cannot assure you that we will be able to continue to secure LD license and distribution rights on terms acceptable to us. We compete directly with Pioneer and other independent licensees for LD distribution rights. Pioneer licenses and distributes LDs and has exclusive LD output license agreements with Paramount and Universal. We also compete with LD subdistributors and Columbia/TriStar, which sells its own programming directly to retailers and to other distributors in addition to its sales to us. We expect to continue to be able to purchase LD titles on a wholesale basis from Columbia/TriStar but we cannot assure you that we will continue to be able to do so if Columbia/TriStar elects to sell direct, increase the number of entities distributing its programming or limit our access to programming. If DVD and LD Cannot Compete Successfully with Other Forms of In-Home Entertainment, Our Future Revenues May Be Negatively Impacted. Both the DVD and LD formats compete with other forms of in-home entertainment, such as VHS, network, syndicated, cable and pay-per-view television and home satellite systems. The DVD and LD formats also compete with new and emerging technologies in the entertainment industry, such as entertainment programming on the Internet, video-on-demand, high-definition television, digital videotape and optical discs with greater storage capacity. These alternate forms of leisure- time entertainment and novel means of video delivery could negatively impact the overall market for DVD and LD sales and us. In addition, emerging technology may allow consumers to download audio or video programming directly to the consumer's home computer from the Internet and store such products on a recordable disc. The development and advancement of such technology into a viable alternative to purchasing DVDs or LDs could have a material adverse effect on our business, prospects, results of operation and financial condition. - -------------------------------------------------------------------------------- Image Entertainment, Inc. 13 Any Reduction in the Amount of Product That Our Largest Customers Purchase from Us May Adversely Affect Our Business. Our aggregate sales to our four largest customers (Norwalk Record Distributors, Ken Crane's -- acquired by a wholly-owned subsidiary of the Company in January 1999, Musicland and DVD Express) accounted for approximately 28% of our net sales for the fiscal year ended March 31, 1999. Any significant delay or reduction in orders from these customers or any nonpayment or late payment of amounts due by these customers could have a material adverse effect on our business, prospects, results of operations and financial condition. We cannot assure you that these customers will continue their current buying patterns or that we will be able to maintain our current relationships with each of them. The Rapid Decline of the LD Industry Has Adversely Affected Our Business. Due to the growth of the market for DVDs, LD programming sales have continued to decrease significantly during the fiscal year ended March 31, 1999. We cannot assure you that the LD market will stabilize at any time in the future or that we will be able to distribute LDs profitably at any time in the future. Inability to Correct Problems That Arise With Our New Warehouse and Distribution Facility Could Have a Material Adverse Effect on Our Business. Any inability to correct the problems we are experiencing or any new problems that may arise relating to our new warehouse and distribution facility in Las Vegas, Nevada could have a material adverse effect on our business, prospects, results of operations and financial condition. Although we have opened our new facility, the facility is not currently operating at its planned level of efficiency. Programmers from the software vendor have been working to finalize the software package and fully train the warehouse personnel. We currently expect that our new facility will reach planned operating efficiency during August 1999. We cannot assure you, however, that our new facility will actually be operating at its planned efficiency level by that date or that the automated systems will operate as planned without further delay. If the DVD Market Does Not Continue to Grow, Our DVD Business May Not Be Profitable. Our business is increasingly dependent on the growth of the market for DVDs, which have not yet received mass market acceptance. We believe that the lack of mass market acceptance of DVD is principally due to the following factors: . the lack of a consumer-priced recordable DVD player; and . the lack of an established rental market. These factors could impede the growth and acceptance of DVD. We cannot assure you that a rental market will develop or that a consumer-priced recordable DVD player (which could lead to greater mass-market appeal) will be available in the future. In addition, we cannot assure you that studios and program suppliers will release a wide variety of new release and catalogue DVD titles to increase availability to the level VHS titles and therefore increase the appeal of the DVD format. If Our DVD or LD Production and Replication Vendors Do Not Continue to Provide Services to Us, Our Production Costs May Increase Significantly. We expect to be able to continue using various outside vendors to author, compress and replicate marketable DVD titles for release under our exclusive DVD license agreements. Despite LD's rapid decline, we also believe that we will be able to find facilities to replicate our LD products. We cannot assure you, however, that our vendors will continue to provide such services at the same or higher level of quality and quantity, or that we will be able to access or afford alternative vendors for such services. - -------------------------------------------------------------------------------- 14 Image Entertainment, Inc. Our Results of Operations Fluctuate Based on Seasonality and Variability. We have generally experienced higher sales of DVDs and LDs in the quarters ended December 31 and March 31 due to increased consumer spending associated with the year-end holidays and because most sales of a title occur in the first few months after its release. Accordingly, our revenues and results of operations may vary significantly from period to period, and the results of any one period may not be indicative of the results of any future periods. This seasonality also causes our revenues to be concentrated in the last two quarters of the fiscal year. In addition to seasonality issues, other factors have contributed to variability in our DVD and LD net sales on a quarterly basis. These factors include: . the popularity of titles in release during the quarter; . our marketing and promotional activities; . our rights and distribution activities; . DVD's negative impact on LD sales; . the extension, termination or non-renewal of existing license and distribution rights; and . general economic changes affecting the buying habits of our customers, particularly those changes affecting consumer demand for DVD and LD hardware and software. If Our Key Personnel Leave Us, Our Business May Be Adversely Affected. Our success greatly depends on the efforts of our executive management, including the President and Chief Executive Officer, Chief Financial Officer, Chief Administrative Officer and General Counsel, and Senior Vice President of Sales, Marketing and Operations. In addition, our ability to operate Ken Crane's successfully depends significantly on the services and contributions of Ken Crane, Jr. Our business and operations may be adversely affected if one or more key executives were to leave the Company or if Ken Crane, Jr. were to leave Ken Crane's. If We Are Unable to Repair, Upgrade or Replace Our Technology Systems Prior to December 1, 1999 or We Experience Technology System Interruptions Due to Year 2000 Non-Compliance, Our Business May Be Adversely Affected. We are aware of the issues associated with the programming code in existing computer systems as the year 2000 approaches. In addition, in December 1998 we entered into the Foothill Agreement, which requires us to be "Year 2000 Compliant" by December 1, 1999. We intend to repair, upgrade or replace all non-compliant hardware, software and equipment affecting our information (including computer hardware and software) and non-information (including facilities, telecommunication systems, distribution center machinery, security systems and video and sound processing equipment) technology systems prior to December 1, 1999. If we are unable to repair, upgrade or replace our technology systems prior to December 1, 1999 or, if at any time after December 1, 1999, we experience year 2000 related problems, and, as a result, we are not "Year 2000 Compliant" under the Foothill Agreement our lender may declare us in default of our agreement with them. We cannot assure you that we will be able to repair, upgrade or replace all our technology systems before the time necessary to avoid year 2000 related problems or to ensure compliance with the requirements of the Foothill Agreement. In addition, we cannot assure you that the repaired, upgraded and replaced systems will actually perform adequately when the year 2000 arrives. If our technology systems do not perform adequately, we plan to address the problem by manually processing and/or outsourcing portions of our customer service, order processing and distribution functions. We cannot assure you that we will be able to manually process or outsource these functions or that we will be able to do so in a cost-efficient manner. If we cannot manually process or outsource these functions, we will temporarily be unable to process orders and to respond to customer inquiries in a timely manner, which could lead to a loss of revenue and customer dissatisfaction. - -------------------------------------------------------------------------------- Image Entertainment, Inc. 15 Any year 2000 compliance problems we experience on or after December 1, 1999 could materially adversely affect our business, results of operations, financial condition and prospects. Any Year 2000 Disruptions Suffered by Our Significant Suppliers and Customers Could Adversely Affect Our Business. We are taking steps to receive assurances from our significant suppliers and customers that they are prepared for any year 2000 related problems that they might experience (see Item 7. "-- Impact of Year 2000 -- Risks and Contingencies -- Significant Suppliers and Customers"). We cannot assure you, however, that our significant suppliers and customers will not suffer business disruptions due to year 2000 related problems. Any business disruptions our significant suppliers or customers experience as a result of year 2000 compliance problems could materially adversely affect our business, results of operations, financial condition and prospects. If We Cannot Compete Successfully in the Internet Commerce Industry, Our Retail Sales May Be Adversely Affected. We cannot assure you that the www.kencranes.com web site will be able to compete successfully against current or future competitors. The market for commerce over the Internet is new, rapidly evolving and intensely competitive. We expect this competition to intensify in the future due in part to the minimal barriers to entry and the relatively low cost to launch a new web site. We compete with a variety of other companies for sales of DVDs and LDs over the Internet. Some of these competitors can devote substantial resources to Internet commerce in the near future. The www.kencranes.com web site also competes with traditional retailers of DVDs and LDs, including mail-order houses and video clubs. We believe that the principal competitive factors we face in selling DVDs and LDs through the www.kencranes.com web site are price, selection, availability, brand recognition, customer service, effectiveness of advertising, technical expertise, convenience, accessibility, quality of search tools, quality of editorial and other site content and reliability and speed of fulfillment. Many of the current and potential competitors of Ken Crane's have large customer bases, greater brand recognition and significantly greater financial, marketing and other resources than we have. In addition, some competitors may be able to obtain merchandise from vendors on more favorable terms, devote greater resources to marketing and promotional campaigns, adopt more aggressive pricing or inventory availability policies and devote more resources to web site and systems development than we can. The www.kencranes.com web site could suffer reduced operating margins and market share and brand recognition based on increased competition. If We Cannot Keep Pace with Rapid Technological Change, Our Retail Sales May Be Adversely Affected. We cannot assure you that we will successfully use new technologies effectively or adapt the www.kencranes.com web site or the systems of our subsidiary to customer requirements or emerging industry standards. The technology used in the Internet commerce industry changes rapidly. This rapid change results in the availability of many new products and services, new industry standards and frequent changes in user and customer requirements and preferences. The success of the www.kencranes.com web site depends, in part, on our ability to do the following: . license leading technologies useful in the Internet sales business; . enhance the www.kencranes.com web site's existing services; . develop new services and technology that address the increasingly sophisticated and varied needs of our customers; and, . respond to technological advances and emerging industry standards and practices on a cost-effective and timely basis. If Internet Commerce Does Not Continue to Grow, Our Internet Sales Business May Be Adversely Affected. We cannot assure you that acceptance and use of the Internet and World Wide Web will continue - -------------------------------------------------------------------------------- 16 Image Entertainment, Inc. to develop or that a sufficiently broad base of consumers will adopt and use the Internet and World Wide Web as a medium of commerce. Potential future revenues and profits from sales over the Internet substantially depend on the widespread acceptance and use of the Internet as an effective medium of commerce by consumers. Rapid growth in the use of and interest in the World Wide Web, the Internet and other on-line services is a recent phenomenon. For the www.kencranes.com web site to be successful, consumers who have historically used traditional means of commerce to purchase merchandise must accept and utilize novel ways of conducting business and exchanging information. If the Internet and other on-line services continue to experience significant growth in the number of users, the frequency of use or bandwidth requirements, the infrastructure for the Internet could be affected by capacity constraints. In addition, the Internet could lose its viability due to delays in the development or adoption of new standards and protocols required to handle increased levels of service activity. Changes in or insufficient availability of telecommunications services to support the Internet also could result in slower response times and could adversely affect usage of the Internet. Our business, prospects, financial condition and results of operations could be materially adversely affected if use of the Internet does not continue to grow or grows more slowly than expected, if the infrastructure for the Internet does not effectively support growth that may occur or if the Internet does not become a viable commercial marketplace. We Face Security Risks in Selling Product over the Internet. Secure transmission of confidential information over public networks is a significant barrier to Internet commerce. Advances in computer capabilities, new discoveries in the field of cryptography or other developments could compromise the security measures we employ to protect customer transaction data. In addition, concerns over the security of transactions conducted on the Internet and the privacy of users in general may inhibit the growth of Internet commerce. To the extent that our activities or the activities of third-party contractors involve the storage and transmission of proprietary information, such as credit card numbers, security breaches could damage our reputation and expose us to a risk of loss or litigation and possible liability. We may be required to expend significant capital and other resources to protect against such security breaches or to alleviate security-related problems and we cannot assure you that our security measures will prevent security breaches. Any compromise of our security systems could have a material adverse effect on our reputation, business, prospects, financial condition and results of operations. We May Experience Capacity Constraints and Other System Development Problems Relating to the Operation of the www.kencranes.com Web Site. A key element of our business strategy is to generate a high level of use of the www.kencranes.com web site. We believe that the satisfactory performance, reliability and availability of the www.kencranes.com web site and the related transaction-processing systems and network infrastructure are critical to our reputation and our ability to attract and retain customers and to maintain adequate customer service levels. We plan to upgrade or replace all of the systems that currently operate the www.kencranes.com web site and to integrate such systems with our new warehouse and distribution facility. Any inability on our part to work out any technical problems in the upgrade or replacement of the www.kencranes.com web site's transaction-processing systems or warehouse and distribution center integration in a timely manner could have a material adverse effect on our business, prospects, financial condition and results of operations. Even if we are able to develop adequate transaction-processing systems and to integrate the www.kencranes.com web site with our warehouse and distribution center in a timely manner, periodic system interruptions may occur on the www.kencranes.com web site. While we believe that we will be able to upgrade or install new hardware and software that will be sufficient to accommodate the anticipated traffic on the www.kencranes.com web site, we cannot assure you that periodic system interruptions will - -------------------------------------------------------------------------------- Image Entertainment, Inc. 17 not occur even after the upgrade or installation. Any substantial increase in the volume of traffic on the www.kencranes.com web site or the number of orders placed by customers will require us to further expand and upgrade our technology, transaction-processing systems and network infrastructure. In addition, we are dependent upon web browser companies and Internet service providers for access to our products and services. Viewers have experienced and may in the future experience difficulties due to system or software failures or incompatibilities not within our control. Any system interruptions that result in the unavailability of the www.kencranes.com web site or reduced order fulfillment performance would reduce the volume of goods sold and the attractiveness of our product and service offerings and could have a material adverse effect on us. Laws Restricting Internet Commerce Could Adversely Affect Our Business. We could be materially adversely affected by any new legislation or regulation or by the application or interpretation of existing laws to the Internet. Federal, state and foreign governmental organizations are currently considering many legislative and regulatory proposals. If a government authority were to adopt laws or regulations that cover Internet-related issues such as user privacy, pricing and characteristics and quality of products and services provided, the growth of the Internet could be adversely affected. This could lead to a decrease in demand for products offered over the Internet, including those that the www.kencranes.com web site offers, and could increase the cost of doing business on the Internet. In addition, we do not know how existing laws governing issues such as property ownership, copyright, trade secret, libel and personal privacy will be applied to the rapidly-changing Internet. If the www.kencranes.com Web Site Experiences System Interruptions Due to Year 2000 Non-Compliance, Our Internet Sales May Be Adversely Affected. We intend to install year 2000 compliant systems for the www.kencranes.com web site when we perform the hardware and software repairs, upgrades or replacements described above. We cannot assure you, however, that we will be able to successfully install the new systems before the time necessary to avoid year 2000 related problems. In addition, we cannot assure you that the new systems will actually perform adequately when the year 2000 arrives. Because the www.kencranes.com web site's systems will depend on other systems that we do not control, any year 2000 compliance problems in such other systems could materially adversely affect the www.kencranes.com web site. Any system interruption in the www.kencranes.com web site resulting from year 2000 compliance problems could materially adversely affect our business, results of operations, financial condition and prospects. ITEM 2. Properties. ---------- The lease for the Company's office space (30,080 square feet) in Chatsworth, California provides for monthly rent of approximately $14,500 (increasing to $17,450 on April 1, 2000) (subject to annual adjustment based on increases in the consumer price index) and will expire on April 30, 2004. The lease (which would have expired on March 31, 2000) was renegotiated in conjunction with the Company's March 1, 1999 lease of 15,440 square feet of additional office space in an adjacent building. The lease for additional space provides for monthly rent of approximately $10,000 (subject to scheduled annual increases for the first three years of the term and an adjustment based on increases in the consumer price index for the fourth year of the term) and will expire on April 30, 2004. The Company owns approximately 17.2 acres of real property in Las Vegas, Nevada. The Company's new 76,000 square foot automated warehouse and distribution facility is located on the back 8.4 acres. The architectural building plans provide for room to expand the facility an additional 74,000 square feet (also on the back 8.4 acres) should the need arise. Further, the Company is holding the front 8.8 acres of the property as an investment and, if needed, for future expansion. Each of the two parcels (the - -------------------------------------------------------------------------------- 18 Image Entertainment, Inc. 8.4 acres and the 8.8 acres) secures bank obligations. See Item 7. "-- Liquidity and Capital Resources -- Financial Activities -- Note Payable to Bank" and "-- Construction Credit Facility" and Item 8. "-- Notes to Consolidated Financial Statements -- Note 8. Debt." Ken Crane's leases approximately 8,102 square feet of combined office, retail and warehouse space in Westminster, California. The lease provides for monthly rent of approximately $14,000 (subject to annual adjustment based on increases in the consumer price index) and will expire on December 22, 2002. ITEM 3. Legal Proceedings. ----------------- On June 18, 1997, the Company filed a complaint in the Superior Court of the State of California, County of Los Angeles (Case No. BC173084), against LEI Partners, L.P. ("LEI") and a number of related entities and individuals, which relates to a dispute concerning, among other things, LEI's payment obligations under two promissory notes issued in connection with a December 31, 1990 purchase agreement documenting the Company's sale of a business segment to LEI (the "Superior Court Action"). The Company has alleged, inter alia, breach of ----- ---- contract, intentional misrepresentation, negligent misrepresentation, conspiracy to defraud, interference with economic relationship, conspiracy to interfere with economic relationship, and conversion. The Company contends that through an intricate conspiracy among sham corporations and partnerships LEI and others defrauded the Company and systematically dissipated and diverted the assets of LEI so that LEI was intentionally rendered incapable of satisfying its obligations under the purchase agreement and the two promissory notes. This fraudulent scheme includes, but is not limited to, the misrepresentation of the gross revenues and pre-tax profits derived from the operation of the acquired business, and the fraudulent concealment and conspiratorial diversion of assets of that business (including the revenues generated by that business) from LEI to persons and entities affiliated with LEI. The complaint seeks compensatory damages of not less than $5 million plus accrued interest, attorney's fees and punitive damages in an amount to be proven at trial. On September 16, 1997, the Company filed a first amended complaint against the same defendants and making the same claims, but providing additional factual details. In response to the complaint, defendant LEI filed a petition to compel arbitration and stay the litigation pending completion of the arbitration, based upon an arbitration provision in one of the two promissory notes in dispute. On September 18, 1997, the court ordered the Company and LEI to arbitrate before the American Arbitration Association ("AAA") in Los Angeles, California, and stayed the remainder of the litigation pending completion of the arbitration. On November 17, 1997, the Company commenced the court ordered arbitration proceedings against LEI, seeking damages in excess of $3.7 million, plus attorney's fees and costs, for breach of the promissory notes. On January 21, 1998, LEI filed an answering statement denying liability. LEI also submitted a counterclaim against the Company and three of its present or former officers or directors, but refused to pay the AAA filing fee, and the AAA rejected the counterclaim. Although LEI's counterclaim was rejected and is not pending, it alleged claims for, inter alia, fraud in the inducement, recission and breach of ----- ---- written contract. The counterclaim maintained that certain of the Company's representations and warranties regarding the value of the acquired business and its projected income were false, and that LEI was therefore fraudulently induced to execute the purchase agreement and the two promissory notes. LEI also maintained that the Company breached a seller non-competition agreement, thereby entitling LEI to an offset against any amount found to be owed under the second promissory note. The counterclaim sought compensatory damages of $1 million plus accrued interest, attorney's fees and costs, and also sought punitive damages in the amount of $2 million. Should the rejected counterclaim of LEI ever be filed or prosecuted, the Company intends to contest vigorously its allegations and purported claims. - -------------------------------------------------------------------------------- Image Entertainment, Inc. 19 On May 4, 1998, LEI and certain other defendants in the Superior Court Action filed voluntary petitions under Chapter 7 of the Bankruptcy Code in the United States Bankruptcy Court for the Central District of California. These bankruptcy filings automatically stayed the prosecution of the court ordered arbitration proceedings against LEI, and the prosecution of the Superior Court Action against LEI and three other defendants. In connection with the bankruptcy proceedings, the Company has availed itself of provisions in the Bankruptcy Code to conduct discovery relating to the acts, conduct, property, liabilities and financial condition of LEI and the other debtors. In July 1998, the Company filed motions to compel LEI and the other debtors and the debtors' accountants to produce documents and appear for examination under Bankruptcy Rule 2004. The Bankruptcy Court granted all of the Company's motions, issuing orders compelling the four debtor entities and their principals (Mark Kreloff and Paul Haigney), as well as the debtors' former accountants (Kress & Rosenbaum Accountancy Corporation and Calvin Leong) to produce documents and appear for Rule 2004 examinations. In connection with the Rule 2004 motions, the Company has obtained and reviewed thousands of pages of documents from the debtors' former accountants and the debtors, relating to the assets, liabilities, and financial condition of the debtors and other matters which may affect the administration of the debtor's estate or their right to a discharge. The Company has also taken Rule 2004 examinations of three of the debtors' former accountants, and has begun, but not completed, Rule 2004 examinations of the debtors and their principals. Effective as of April 30, 1999, the Company entered into a confidential settlement agreement with one of the nondebtor defendants, who has since been dismissed from the Superior Court Action. On May 4, 1999, the Superior Court granted the Company's motion to lift the stay of the Superior Court Action, thereby permitting the Company to prosecute the Superior Court Action against all remaining nondebtor defendants. Once the stay was lifted, the Company added as defendants in the Superior Court Action two additional companies alleged to be affiliated with LEI and its principals. On June 3, 1999, all nondebtor defendants, including the two new defendants, filed an answer to the First Amended Complaint denying liability. Although the defendants alleged affirmative defenses based on the rejected counterclaim that LEI attempted to assert in the arbitration proceeding, they filed no cross-complaint and therefore currently have no claim for affirmative relief against the Company. On May 7, 1999, the debtors filed motions in the Bankruptcy Court objecting to the claims of the Company, attempting to resolve in the Bankruptcy Court the claims pending in the Superior Court Action. On June 10, 1999, the Bankruptcy Court denied the debtors' motions in their entirety and overruled their objections to the Company's claims, proofs of which had not been filed. Before the hearing of the debtors' objections, on May 28, 1999, the trustee in each of the bankruptcy cases filed "no asset reports" for each of the debtors, notifying all creditors not to file proofs of claim, as there appeared to be no assets of any debtor. This also means the trustee places no value on the purported counterclaim of LEI identified in the bankruptcy schedules, and any such counterclaim will most likely never be pursued. Now that the stay has been lifted, the Company intends to complete the Rule 2004 examinations of the debtors and their principals and to continue prosecuting its Superior Court Action by conducting further discovery and preparing the case for trial. In the normal course of business, the Company and its subsidiary (Ken Crane's) are subject to proceedings, lawsuits and other claims, including proceedings under government laws and regulations relating to employment and tax matters. While it is not possible to predict the outcome of these matters, it is the opinion of management, based on consultations with legal counsel, that the ultimate disposition of known proceedings (including the rejected counterclaim in the above-described arbitration proceeding) will not have a material adverse impact on the Company's financial position, results of operations or liquidity. - -------------------------------------------------------------------------------- 20 Image Entertainment, Inc. ITEM 4. Submission of Matters to a Vote of Security Holders. --------------------------------------------------- None. - -------------------------------------------------------------------------------- Image Entertainment, Inc. 21 EXECUTIVE OFFICERS OF THE REGISTRANT Executive officers serve at the pleasure of the Company's board of directors (the "Board"). There is no family relationship between any executive officer or director. The following information sets forth the position and age of the Company's executive officers at June 1, 1999 and their business experience for at least the prior five years: Executive Officer Age Position & Background - ------------------------------------------------------------------------------ Martin W. Greenwald 57 Chairman of the Board, Chief Executive Officer and President since April 1981, and Treasurer since January 1988. Since July 1990, Mr. Greenwald has been a Board Member of the Permanent Charities Committee of the Entertainment Industries, an umbrella organization which coordinates charitable contributions. Cheryl L. Lee 40 Chief Administrative Officer since April 1993 and General Counsel since April 1992; Vice President of Business Affairs from February 1989 to March 1992; prior thereto, Counsel, Theatrical Distribution & Acquisition, Twentieth Century Fox Film Corporation. Ms. Lee received her A.B. degree from Stanford University in 1980 and her J.D. degree from New York University Law School in 1984. Ms. Lee is a member of the California Bar. Jeff M. Framer 38 Chief Financial Officer since April 1993; Controller from September 1990 to March 1993; Senior Manager, KPMG Peat Marwick LLP, from July 1989 to September 1990; and, Manager, KPMG Peat Marwick LLP, from July 1988 to June 1989. Mr. Framer received his B.S. degree in Business Administration and Accounting Theory and Practice from California State University at Northridge in 1984. Mr. Framer is a certified public accountant. David A. Borshell 34 Senior Vice President, Sales, Marketing and Operations since December 1994; Senior Vice President, Operations, from April 1993 to December 1994; Vice President, Operations, from January 1991 to March 1993; Director of Operations from July 1990 to December 1990; Director of Sales from November 1988 to June 1990; and, Account Executive from February 1986 to November 1988.
- -------------------------------------------------------------------------------- 22 Image Entertainment Inc. - -------------------------------------------------------------------------------- PART II - -------------------------------------------------------------------------------- ITEM 5. Market for Registrant's Common Equity and Related Stockholder Matters. --------------------------------------------------------------------- The Company's common stock trades on The Nasdaq Stock Market under the symbol "DISK." The Company's common stock has been included on the Nasdaq National Market since February 19, 1991. The table below presents the quarterly high and low closing prices on the NASDAQ/NMS during the past two fiscal years.
Fiscal Year Ended March 31, 1999 High Low -------------------------------- --------- --------- Quarter ended June 30, 1998 $ 7.50 $ 3.313 Quarter ended September 30, 1998 $ 10.00 $ 3.250 Quarter ended December 31, 1998 $ 10.50 $ 3.125 Quarter ended March 31, 1999 $ 12.00 $ 5.875 Fiscal Year Ended March 31, 1998 High Low -------------------------------- --------- --------- Quarter ended June 30, 1997 $ 4.313 $ 3.50 Quarter ended September 30, 1997 $ 3.938 $ 3.063 Quarter ended December 31, 1997 $ 4.688 $ 3.313 Quarter ended March 31, 1998 $ 4.250 $ 3.063
As of June 1, 1999 there were 1,629 holders of record of the Company's common stock. The closing price on that date was $8.188. The Company has never paid a cash dividend on its common stock and presently intends to retain any future earnings for business development. In addition, the Company is party to loan agreements which impose restrictions on its payment of dividends. - -------------------------------------------------------------------------------- Image Entertainment Inc. 23 ITEM 6. Selected Financial Data. ----------------------- The selected financial data presented below was derived from the consolidated financial statements of the Company and should be read in conjunction with such financial statements, the notes thereto and the other financial information included therein.
Years Ended March 31, ---------------------------------------------------------------------- (In thousands, except per share data) 1999 1998 1997 1996 1995 -------- --------- ----------- --------- ------------ Income Statement Data: - --------------------- Net sales.................................. $ 76,726 $ 75,516 $ 85,650 $ 95,086 $ 85,591 Operating costs and expenses............... 74,048 84,605/(1)/ 83,399/(2)/ 86,926 77,851 Operating income (loss).................... 2,678 (9,089) 2,251 8,160 7,740 Interest expense........................... (966) (662) (415) (155) (1,184) Interest income............................ 84 118 231 337 518 Other expense.............................. -- -- (662)/(3)/ -- -- Amortization of deferred financing costs... -- -- -- -- (111) Net gain on insurance settlement........... -- -- -- -- 742 Income (loss) before income taxes and and extraordinary item..................... 1,796 (9,633) 1,405 8,342 7,705 Income tax (expense) benefit............... (90) 52 (433) (743) (175) Income (loss) before extraordinary item.... 1,706 (9,581) 972 7,599 7,530 Extraordinary item, net of taxes........... -- -- (127)/(4)/ -- (1,219)/(4)/ Net income (loss).......................... $ 1,706 $ (9,581) $ 845 $ 7,599 $ 6,311 Income (loss) per share: Income (loss) before extraordinary item Basic................................. $ .12 $ (.71) $ .07 $ .56 $ .57 Diluted............................... $ .12 $ (.71) $ .07 $ .51 $ .48 Net income (loss) Basic................................. $ .12 $ (.71) $ .06 $ .56 $ .48 Diluted............................... $ .12 $ (.71) $ .06 $ .51 $ .40 Weighted average shares outstanding Basic................................. 14,185 13,471 13,504 13,569 13,255 Diluted............................... 14,309 13,471 13,836 14,802 15,641 March 31, --------------------------------------------------------------------- (In thousands, except per share data) 1999 1998 1997 1996 1995 -------- --------- ----------- --------- ------------ Balance Sheet Data: - ------------------ Total assets............................... $ 56,445 $ 33,781 $ 46,448 $ 39,406 $ 33,491 Total liabilities.......................... 32,113 25,116 28,397 18,880 16,818 Net shareholders' equity................... 24,332 8,665 18,051 20,526 16,673 - ---------------------
(1) Includes noncash charges of $8,133,000 and $4,246,000 to reduce the carrying value of the Company's LD inventory to its net realizable value and provide for estimated losses on LD license and exclusive distribution agreements, respectively. Also includes a nonrecurring charge of $825,000 related to the closure of U.S. Laser, of which $202,000 is composed primarily of fees and expenses associated with facility lease termination and employee severance payments, and $623,000 (a noncash charge) is composed of the write-off of unamortized facility leasehold improvements and goodwill. (2) Includes noncash charges of $1,964,000 and $1,946,000 to reduce the carrying value of the Company's LD inventory to its estimated net realizable value and provide for estimated doubtful accounts receivable, respectively. (3) Other expense represents a nonrecurring charge composed primarily of legal and accounting fees associated with the termination of acquisition negotiations. (4) Extraordinary item is composed of costs associated with early retirement of debt, net of related taxes of $56,000 and $34,000 for fiscal 1997 and 1995, respectively. - -------------------------------------------------------------------------------- 24 Image Entertainment Inc. ITEM 7. Management's Discussion and Analysis of Financial Condition and --------------------------------------------------------------- Results of Operations. --------------------- The Company believes its forward-looking statements made throughout this Management's Discussion and Analysis of Financial Condition and Results of Operations are within the meaning of the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995. Such statements are based on the beliefs of the Company's management as well as assumptions made by and information currently available to the Company's management. When used in this report, the words "anticipate," "believe," "estimate," "may," "expect" and similar expressions, variations of such terms or the negative of such terms as they relate to the Company or its management are intended to identify such forward-looking statements. Such statements are based on management's current expectations and are subject to certain risks, uncertainties and assumptions. Should one or more of these risks or uncertainties materialize, or should the underlying assumptions prove incorrect, the Company's actual results, performance or achievements could differ materially from those expressed in, or implied by, any such forward-looking statements. For a more detailed description of risks and uncertainties that may affect forward-looking statements see Item 1. "-- Risk Factors." GENERAL The Company licenses and distributes a broad range of entertainment programming on DVD and LD. Prior to fiscal 1998, the Company's net sales were derived almost entirely from the distribution of titles in the LD format. In March 1997, DVD was introduced and the Company began distributing DVD programming on a nonexclusive wholesale basis. The Company began releasing exclusively licensed DVD programming in June 1997. In fiscal 1998, DVD and LD represented approximately 21% and 79% of the Company's net sales, respectively. In fiscal 1999, DVD and LD represented approximately 60% and 36% of the Company's net sales, respectively; however, in the last two quarters of fiscal 1999, DVD and LD represented approximately 72% and 23% of the Company's net sales, respectively. The Company also distributes music programming on CDs encoded in the DTS multichannel audio format as well as certain programming on VHS. The DVD Format. The Company believes that DVD has established itself as an -------------- accepted video format. Unanimous movie studio and independent program supplier support, broadening consumer acceptance, increased availability of DVD programming and players, rental programming availability in national video chains and decreasing DVD player prices have contributed to the format's growth. The Electronics Industries Association ("EIA") reported that from March 1997 (the DVD format's introduction date) to May 28, 1999, approximately 2,389,000 DVD players were sold to consumer electronics retailers. Management estimates that there are approximately 1,792,000 domestic DVD households (approximately 75% of the EIA's estimate to allow for DVD player inventory currently unsold and held at retail for sale and for consumer households with multiple DVD players). Although the estimated installed base of domestic DVD households (between 1% and 2% of estimated television households) is low relative to domestic VHS households (between 80% and 90% of estimated television households), DVD player sales are growing. The EIA reported that in their first calendar year of release (March through December 1997), approximately 350,000 DVD players were sold to electronics retailers. For calendar 1998, approximately 1,080,000 DVD players were sold to electronics retailers. For the first 21 weeks of calendar 1999 (ended May 28, 1999), approximately 960,000 DVD players were sold to electronics retailers, a 386% increase over the comparable calendar 1998 period. According to the DVD Video Group (an industry trade group), there are now more than 40 DVD player models marketed under 30 different consumer brands and over 3,000 movie and music titles - -------------------------------------------------------------------------------- Image Entertainment Inc. 25 available on DVD (including hit movies, re-released classics and children's and music programming). According to Video Business, a video industry trade publication, DVD player retail prices are declining and many models are now priced at $299. DVD programming is now widely available for sale and/or rental at video specialty stores (such as Blockbuster Entertainment, Hollywood Entertainment and Suncoast Motion Picture Co.), mass merchants (such as Wal-Mart, Kmart, Best Buy and Circuit City), audio-video combination chains (such as Musicland, Trans World Entertainment, Hastings Books & Records, Tower Records/Video and Wherehouse), discount club stores (such as Costco and Sam's Club) and Internet retailers (such as Kencranes.com (owned by the Company's subsidiary), DVD Express, Amazon.com, and NetFlix.com). According to Video Store Magazine, a video industry trade publication, almost half of the top 100 highest calendar 1998 rental/sell-through revenue generating video specialty stores now carry DVD for rental (with most of the rental revenue coming from the top 10 chains). The Company's DVD Distribution. The Company's net sales of DVD programming ------------------------------ (including both exclusive and nonexclusive distribution) has steadily increased since the format's introduction. For fiscal 1999, DVD sales were $45,911,000, representing approximately 60% of the Company's net sales. The Company's net sales of DVD programming for the quarters ended March 31, 1999 and December 31, September 30 and June 30, 1998 were $16,872,000, $15,943,000, $6,600,000 and $6,496,000, respectively. As a percentage of net sales, DVD net sales were 73%, 70%, 48% and 38%, respectively. The Company released 260 exclusive DVD titles in fiscal 1999, compared to 91 such releases in fiscal 1998. The Company continues to aggressively seek DVD programming for exclusive distribution. The Company has agreements with numerous program suppliers for the exclusive release of titles on DVD. According to VideoScan, which tracks point-of-sale data from an estimated 70 percent of the retail market (includes mass merchants and retailers but not most discount outlets or Internet retailers), the Company's market share of total DVD software unit sales for the period from January 1, 1999 through June 13, 1999 was 3.21%. The Company currently ranks tenth in market share (of 43 companies specifically named) behind Warner Home Video (18.95%), Disney (11.58%), Columbia TriStar (10.06%), Universal Home Entertainment (9.06%), New Line (8.39%), Paramount Home Video (7.68%), MGM (7.24%), Twentieth Century Fox Home Entertainment (5.08%) and Artisan Entertainment (3.25%). Additionally, VideoScan reported the Company's market share of total DVD software unit sales for all of calendar 1998 was 2.96%. The Company ranked ninth in market share behind Warner Home Video (24.13%), Columbia TriStar (14.45%), Universal Home Entertainment (10.79%), MGM (10.33%), Disney (9.01%), New Line (8.34%), Artisan Entertainment (4.52%) and Paramount Home Video (3.97%). It is likely that actual market share data would differ from the above reported sales data had VideoScan captured sales data from all retailers including Internet retailers. The Company distributes DVD programming on a nonexclusive basis from all program suppliers with whom it does not have an exclusive agreement, making it a "one-stop" source for all DVD programming, meaning that customers who purchase exclusive titles from the Company can purchase additional nonexclusive titles at the same time. DVD's Continued Negative Impact on LD sales. The DVD format competes ------------------------------------------- directly with the LD format. Most of the same consumers who were attracted to LD's quality and features are attracted to DVD's offerings. Due to this competition, the LD market is shrinking, as evidenced by the Company's declining LD sales during fiscal 1999 and 1998. LD sales for fiscal 1999 declined 53% to $27,681,000 from $59,289,000 for fiscal 1998 and LD sales for fiscal 1998 declined 30% from $84,908,000 for fiscal 1997. During fiscal 1999 and 1998 the major audio/video software chains, such as Musicland, Tower and Trans - -------------------------------------------------------------------------------- 26 Image Entertainment Inc. World were selling off their LD inventory and employing deeply discounted sale pricing. All of the chains except Tower have exited the LD market and Tower is expected to exit the market soon. Additionally, sales of LD player sales are no longer tracked by the EIA (last reported in calendar 1997). Management believes that DVD's negative impact on the LD business is permanent. See "Fiscal Year Ended March 31, 1998 Compared to Fiscal Year Ended March 31, 1997" below for a detailed discussion of events leading up to significant write-downs of LD related assets in fiscal 1998. Coexistence of LD Despite DVD's Success and Future LD Distribution ------------------------------------------------------------------ Strategy. Although the LD market is shrinking, management believes that LD and DVD will coexist for several years. LD is well-established as a videophile format. With an estimated 1997 peak installed base of over 2 million households, the LD marketplace is not expected to disappear but rather shrink in size (management estimates the current number of installed LD households to be less than 1 million). Also, a disparity in the number of available titles on LD (over 10,000 through Internet and video speciality outlets) versus DVD (over 3,000) remains. Management estimates that it will take DVD several years to reach LD's breadth of title availability. There are many titles (whether popular, less popular, rare or esoteric) currently available only in the LD format and not in the DVD format. In addition, management believes that the DVD/LD combination player currently manufactured by Pioneer Electronics will continue to attract consumers to both formats. Management believes there remains a viable (although shrinking) market for the still-growing library of LD programming. Despite declining sales and the Company's diversification into DVD programming, the Company continues to support the LD format. Due to the declining market for LD, the Company is focusing on "A" title releases and "classic" catalogue re-releases. The Company analyzes the cost-benefit relationship on all potential LD new releases given the declining market and releases only those for which minimum customer pre-orders are met. In addition to distributing through traditional independent speciality video retail distribution channels (now excluding audio/video chains stores such as Tower, Musicland, Trans World and Virgin), the Company is distributing LD inventory through alternative distribution channels, including direct-to- consumer via mail order and over the Internet through its recently-acquired web site. REGISTERED COMMON STOCK SALE On January 6, 1999, the Company completed the sale of 2.4 million shares of newly-issued common stock to a group of institutional investors and other accredited investors at $5 per share. Image Investors, Co., the largest shareholder of the Company and beneficially owned by John W. Kluge and Stuart Subotnick, purchased 600,000 shares of the 2.4 million shares issued. The net proceeds of the offering (net of placement agent fees and professional services fees) were $10,557,000. Approximately $5 million of the net proceeds were used to complete the acquisition of Ken Crane's. See "Acquisition" below. The remainder of the net proceeds was used to pay-down borrowings outstanding under the Company's revolving credit facility with Foothill Capital Corporation. ACQUISITION On January 11, 1999, the Company, through Image Newco, completed its acquisition of Ken Crane's. See Item 1. "-- Subsidiary Activities -- Image Newco Acquisition of Ken Crane's." For financial statement purposes, the one- time signing bonus and consulting payments paid in connection with the acquisition were included in the purchase price of Ken Crane's. The purchase price and other acquisition related payments were funded by a portion of the $10,557,000 net proceeds raised in the sale of 2.4 million shares of the Company's common stock. The acquisition was accounted for using the purchase method of - -------------------------------------------------------------------------------- Image Entertainment Inc. 27 accounting. Accordingly, the acquired assets and assumed liabilities were recorded at their fair market value on the acquisition date. The operating results of Ken Crane's are included in the accompanying consolidated statements of operations for the year ended March 31, 1999 from the date of acquisition. The excess of purchase price over the fair market value of the net assets acquired is classified as goodwill and is being amortized on a straight-line basis over 15 years. CLOSURE OF U.S. LASER In May 1998, the Company announced the closing of its wholly-owned subsidiary U.S. Laser Video Distributors, Inc. ("U.S. Laser"), located in New Jersey. The Company acquired U.S. Laser in June 1995 for $3.1 million in cash. The closure of the subsidiary and its retail store "Digitainment" was finalized on July 15, 1998. The corporate entity was dissolved on February 26, 1999. The closure followed the Company's consolidation of a majority of U.S. Laser's optical disc distribution activities. U.S. Laser's only remaining activities consisted of direct-to-consumer optical disc sales through the "Digitainment" retail store, mail order to a decreasing number of accounts and the Internet. With the decline of industry-wide LD software and hardware sales, offset in part by growing DVD software and hardware sales, the retail store was performing below expectations. The closure of U.S. Laser resulted in nonrecurring pretax charges of $202,000, representing fees and expenses associated with the early termination of a lease and employee severance payments, and $623,000 (a noncash charge) covering the write-off of unamortized leasehold improvements and goodwill. The pretax charges total $825,000 and are included in costs of facility closure expense for the year ended March 31, 1998. NEW LAS VEGAS WAREHOUSE AND DISTRIBUTION FACILITY In May 1999, the Company closed its 48,300 square foot Chatsworth, California distribution facility and transferred all of its warehousing and distribution activities to its new 76,000 square foot Las Vegas, Nevada warehouse and distribution facility located adjacent to McCarran International Airport. Since that time, the new facility's warehouse management system software implementation has proceeded slower than anticipated and the Company has experienced certain related operational inefficiencies. The large quantities of product transferred from the Chatsworth facility to the new facility, the high volume of backlogged orders for that product and new incoming orders have caused and continue to cause unexpected problems in the new facility's systems operations, particularly software programming problems that were not revealed when the system was tested in a simulated environment. These software glitches and certain related operational inefficiencies have prevented the Company from shipping product in a timely manner. Certain of the software glitches have not been corrected in a timely manner because of demand placed upon the software programmers to assist in addressing the day-to-day shipping requirements, thereby further contributing to continued shipping delays. For these reasons, the new facility is currently functioning below its projected operational efficiency level (shipping within 24 hours) and below the efficiency level of the closed Chatsworth facility (which generally shipped within 48 hours after receipt of an order). The Company has addressed these software and operational issues on a priority basis and will continue to do so until these issued are resolved. Despite the fact that product demand remains robust, the transitional problems experienced at the new facility resulted in a shortfall in order fulfillment for the month of May 1999 and may result in a shortfall for the month of June 1999. Additionally, the Company anticipates a related significant rise in shipping expenses (because of higher personnel and freight costs) during its June 1999 quarter. While the Company's backlog of delayed shipments has decreased significantly since its peak in May 1999 (due in part to - -------------------------------------------------------------------------------- 28 Image Entertainment Inc. temporary labor-intensive shipment efforts), the May shortfall and potential June shortfall may prove significant enough to result in a net loss for the Company's June 1999 fiscal quarter. The Company is taking steps to correct the new facility's shipping delays. Management is confident that this situation is temporary. The new facility is operating 24 hours a day, six days a week until these problems are resolved and orders are shipped in a timely manner. The third-party consultants who programmed the Company's warehouse management system software are working and will continue to work on-site to facilitate the software's implementation and improve operational efficiencies. The Company presently anticipates that the software implementation problems will be corrected and that the facility will reach the efficiency level of the Chatsworth facility during July 1999 and its projected operating efficiency level during August 1999. Once 24-hour shipping has been achieved, the Company will focus on its strategy of integrating the fulfillment of Ken Crane's distribution activities out of the new Las Vegas facility. And once the fulfillment shipping for Ken Crane's is achieved, the Company will focus its efforts on seeking third-party retail and Internet fulfillment opportunities. RESULTS OF OPERATIONS The following table presents, as a percentage of net sales, selected consolidated financial data for each of the three preceding fiscal years ended March 31:
Year ended March 31, --------------------------------------- 1999 1998 1997 ---------- ---------- ---------- Net sales: DVD.................................... 59.8% 20.8% 0.9% LD..................................... 36.1 78.5 99.1 Other.................................. 4.1 0.7 -- -------- ---------- --------- Total net sales..................... 100.0% 100.0% 100.0% Cost of sales.............................. 76.1 93.0/(1)/ 79.9/(3)/ -------- --------- --------- Gross margin............................... 23.9 7.0 20.1 Operating costs and expenses: Selling expenses........................ 7.1 6.5 5.5 General and administrative expenses..... 7.8 6.4 8.3 Amortization of production costs........ 5.3 5.0 3.6 Other operating costs and expenses...... 0.1 1.1/(2)/ -- -------- --------- --------- Total operating costs and expenses... 96.5 112.0 97.4 Operating income (loss).................... 3.5 (12.0) 2.6 Other expenses, net........................ 1.2 0.7 1.0 -------- --------- --------- Income (loss) before income taxes and extraordinary item....................... 2.3% (12.8)% 1.6% ======== ========= ========= - -----------------------------------
(1) Includes noncash charges of $8,133,000 and $4,246,000 to reduce the carrying value of the Company's LD inventory to its net realizable value and provides for estimated losses on LD license and exclusive distribution agreements, respectively. (2) Primarily a nonrecurring charge of $825,000 related to the closure of U.S. Laser. (3) Includes noncash charges of $1,964,000 and $1,946,000 to reduce the carrying value of the Company's LD inventory to its estimated net realizable value and provide for estimated doubtful accounts receivable, respectively. - -------------------------------------------------------------------------------- Image Entertainment Inc. 29 FISCAL YEAR ENDED MARCH 31, 1999 COMPARED TO FISCAL YEAR ENDED MARCH 31, 1998 Net sales for fiscal 1999 increased 1.6% to $76,726,000 from $75,516,000 for fiscal 1998. Net sales of DVD programming for fiscal 1999 increased 192% to $45,911,000, or 59.8% of net sales, from $15,700,000, or 20.8% of net sales, for fiscal 1998. Approximately 52% of total DVD net sales for fiscal 1999 were derived from exclusively distributed or licensed programming versus approximately 39% for fiscal 1998. Net sales for fiscal 1999 include 79 days of net sales (since the January 11, 1999 acquisition date) of Ken Crane's. Ken Crane's contributed $701,000 in net sales, after elimination of inter-company sales. Broadening consumer acceptance and increased availability of programming in fiscal 1999 contributed to growth in the Company's DVD sales. During fiscal 1999, the Company distributed a greater number of new release titles on DVD (among which there were a greater number of stronger performing titles) and a greater number of catalogue titles on DVD than in the prior fiscal year. Net sales of LD programming for fiscal 1999 declined 53% to $27,681,000, or 36.1% of net sales, from $59,289,000, or 78.5% of net sales, for fiscal 1998. The DVD format directly competes with the LD format and has adversely affected the LD marketplace. Historically, the largest buyers of LD programming were the major music/video software retail chain stores. The major chain stores have replaced dedicated LD floor space with DVD product. The majority of the Company's LD sales are now to the independent video stores that still promote LD and direct- to-consumer via Internet/mail-order. Other net sales (VHS and CD) for fiscal 1999 increased 495% to $3,134,000, or 4.1% of net sales, from $527,000, or 0.7% of net sales, for fiscal 1998 primarily due to the exclusive distribution of a greater number of stronger performing VHS titles in fiscal 1999 as compared to fiscal 1998. Cost of sales (LD, DVD, CD and VHS) for fiscal 1999 was $58,425,000, or 76.1% of net sales, from $70,256,000, or 93.0% of net sales, for fiscal 1998. The decrease in cost of sales, as a percentage of net sales, for fiscal 1999 was primarily due to the significantly reduced provisions for slow-moving LD inventory of $1,831,000 for fiscal 1999 versus $8,133,000 for fiscal 1998 and estimated losses recorded on LD license and exclusive distribution agreements of $4,246,000 reflected in fiscal 1998. Exclusive of the increased provisions for fiscal 1998 over fiscal 1999, cost of sales for fiscal 1998, as a percentage of net sales, was 79.1%. The improved gross margins for fiscal 1999 reflect the shift in sales mix from LD to DVD programming. Gross margins on exclusive DVD sales are currently higher than on exclusive LD sales, although DVD production costs are much higher than those for LD. Gross margins on nonexclusive DVD sales are comparable to nonexclusive LD sales. DVD replication costs, on a per- title basis, are less than half of LD costs. The Company expects DVD replication costs to decline in the future as the format becomes more widely accepted by consumers and the volume of DVD replication increases. Currently, management does not foresee a continuation of material decreases in the net realizable values of the Company's LD related assets. The Company, however, will continue to evaluate the recoverability of LD-related assets based upon the facts and circumstances at the time of the evaluation and management's reasonable estimate of future events and the Company may at that time be required to record additional charges. The Company's cost of sales, as a percentage of net sales, can vary period to period depending upon the sales mix of higher-margin exclusive programming and lower-margin nonexclusive programming. The sales mix of exclusive and nonexclusive programming and the cost of sales within each category will vary with the availability of and the demand for new and catalogue exclusive and nonexclusive programming. The Company's cost of sales for exclusive programming will vary depending upon specific royalty rates or distribution fees paid to program suppliers and will vary for nonexclusive programming depending upon the cost of the programming from the program suppliers. Selling expenses for fiscal 1999 increased 10.0% to $5,439,000, or 7.1% of net sales, from $4,943,000, or 6.5% of net sales, for fiscal 1998. Exclusive of the selling expenses and net sales - -------------------------------------------------------------------------------- 30 Image Entertainment Inc. contribution of Ken Crane's and U.S. Laser in fiscal 1999 and 1998, selling expenses for fiscal 1999 increased 14.3% to $5,001,000, or 6.5 % of net sales, from $4,374,000, or 5.8% of net sales, for fiscal 1998. The increase in fiscal 1999 selling expenses, as a percentage of net sales, was primarily due to additional personnel and higher personnel costs in the Company's sales department and increased promotional efforts to grow consumer and retailer awareness of the Company's DVD, VHS and CD programming. For comparative purposes, U.S. Laser incurred selling expenses of $99,000 and $604,000 in fiscal 1999 and 1998, respectively. Ken Crane's incurred selling expenses of $339,000 for the 79 day period in fiscal 1999 only. General and administrative expenses for fiscal 1999 increased 24.5% to $6,016,000, or 7.8% of net sales, from $4,832,000, or 6.4% of net sales, for fiscal 1998. Exclusive of the general and administrative expenses and net sales contributions of Ken Crane's and U.S. Laser in fiscal 1999 and 1998 and exclusive of fiscal 1998 recoveries of previously provided for doubtful accounts receivable from certain customers, general and administrative expenses for fiscal 1999 increased 26.2% to $5,662,000, or 7.4% of net sales, from $4,477,000, or 6.1% of net sales, for fiscal 1998. General and administrative costs for fiscal 1999 increased primarily due to higher personnel costs and higher professional fees for legal and investor relations, which were partially offset by a lower provision for doubtful accounts receivable. For comparative purposes, U.S. Laser incurred general and administrative expenses of $128,000 and $823,000 in fiscal 1999 and 1998, respectively. Ken Crane's incurred general and administrative expenses of $226,000 for the 79 day period in fiscal 1999 only. Amortization of production costs for fiscal 1999 increased 8.5% to $4,057,000, or 5.3% of net sales, from $3,740,000, or 5.0% of net sales, for fiscal 1998. The increase in fiscal 1999 amortization costs was due to costs associated with the increased production of exclusive DVD titles and corresponding increased overhead in the Company's creative services and production departments. DVD's production process requires the added interim step of authoring and compression, which is more costly than the mastering of LD titles. In December 1998, as part of its periodic review of the recoverability of capitalized production costs, management changed its estimate of the projected revenue stream from distribution of exclusive DVD titles. This change in estimate was recorded in the December 1998 quarter and prospectively. Had this change in estimate not been made, amortization of production costs for fiscal 1999 would have been higher by approximately $217,000. Additionally, amortization of production costs will vary based upon the mix, timing and number of exclusive DVD and LD titles placed into production. The Company is producing fewer exclusive LD titles as it increases its exclusive DVD production. The Company is planning to purchase authoring and compression equipment to bring this aspect of DVD production in-house and lower per-title DVD production costs. Amortization of goodwill for fiscal 1999 was $111,000, or 0.1% of net sales, and represents goodwill amortization from the acquisition of Ken Crane's. Fiscal 1998 amortization of U.S. Laser goodwill was minimal. Interest expense for fiscal 1999 increased 45.9% to $966,000, or 1.3% of net sales, from $662,000, or 0.9% of net sales, for fiscal 1998. The increase is attributable primarily to higher weighted average debt levels during fiscal 1999 than during fiscal 1998. Interest income for fiscal 1999 decreased 28.8% to 84,000, or 0.1% of net sales, from $118,000, or 0.2% of net sales, for fiscal 1998. The Company had less interest bearing investments during fiscal 1999 than during to fiscal 1998. - -------------------------------------------------------------------------------- Image Entertainment Inc. 31 Income tax expense for fiscal 1999 was $90,000, reflecting an effective combined Federal and state income tax rate of 5%. The effective income tax rate was lower than the statutory rate due to a reduction in the valuation allowance recorded against deferred tax assets. The Company recorded a net income tax benefit of $52,000 in fiscal 1998, representing a carry back to fiscal 1997 of a portion of the net operating loss generated in fiscal 1998. For fiscal 1999, the Company recorded net income of $1,706,000, or $.12 per basic and diluted share, compared to a net loss of $9,581,000, or $.71 per basic and diluted share, for fiscal 1998. FISCAL YEAR ENDED MARCH 31, 1998 COMPARED TO FISCAL YEAR ENDED MARCH 31, 1997 Net sales for the year ended March 31, 1998 declined 11.8% to $75,516,000 from $85,650,000 for the year ended March 31, 1997. Net sales of LD programming for fiscal 1998 declined 30.2% to $59,289,000 from $84,908,000 for fiscal 1997. Net sales of DVD programming, however, increased to $15,700,000 for fiscal 1998 from $742,000 for fiscal 1997. Approximately $6,156,000, or 39%, of total fiscal 1998 DVD sales were derived from exclusively distributed or licensed product. The decline in fiscal 1998 net sales was due to the decline in LD sales, offset in part by net sales from the Company's distribution of exclusive and nonexclusive DVD programming. Cost of sales (DVDs and LDs) for the year ended March 31, 1998 increased to $70,256,000, or 93.0% of net sales, from $68,427,000, or 79.9% of net sales, for fiscal 1997. The increase in cost of sales, as a percentage of net sales, for the March 1998 fiscal year over that of the March 1997 fiscal year was primarily due to the significantly increased provisions for slow-moving LD inventory of $8,133,000 for fiscal 1998 as compared to $1,964,000 for fiscal 1997 and estimated losses on LD license and exclusive distribution agreements of $4,246,000 during fiscal 1998 as compared to none in fiscal 1997. Since DVD's March 1997 launch, management has been making an on-going quarterly assessment of the impact of DVD's growth on the LD market and the recoverability of the Company's LD-related assets. The marketing efforts accompanying DVD's introduction caused considerable confusion at the retail and consumer level as there was much speculation regarding consumer acceptance of and studio support for the new format, the potential breadth of available DVD titles and the audio and video quality afforded by DVD. Although this confusion and speculation had a "chilling effect" on the LD market and lead to an approximate 70% decline in calendar 1997 LD player sales from calendar 1996, not all of the major studios immediately embraced the new format, preferring to wait and see how the DVD market developed. Similarly, wide-spread consumer acceptance of the new format did not materialize and, although the chain stores were more cautious in their LD purchasing, they continued to support the LD format. The Company experienced a 23% decline in LD sales for its June 1997 quarter, as compared to the comparable prior-year period, and a 25% decline for its September 1997 quarter, as compared to the comparable prior-year period; however, the decline for its December 1997 quarter, as compared to the comparable prior-year period, was only 15%. Nonetheless, in response to weakening LD sales the Company recorded write-downs of its LD inventory for each of its June, September and December 1997 quarters totaling $1,870,000 to reduce its carrying value to management's estimate of its net realizable value. In the March 1998 quarter, however, several significant events occurred which indicated to management that DVD's adverse impact on the Company's LD business had dramatically accelerated, leading the Company to record substantially larger write-downs of its LD-related assets than in prior quarters. First, the Company experienced a 56% decline in LD sales in that quarter, as compared to the comparable prior-year period. Additionally, certain chain stores instituted across-the-board price reductions of their LD inventory (with the exception of new releases) and held well-promoted clearance sales. Further, the chain - -------------------------------------------------------------------------------- 32 Image Entertainment Inc. stores informed the Company that they intended to significantly reduce future LD purchases in favor of DVD and permanently replace LD floor space with DVD. Finally, by the end of the fourth quarter, Twentieth Century Fox announced that it would be releasing programming in the DIVX pay-per-play DVD format and it was rumored that participation by Paramount, the last studio "holdout," was imminent (Paramount announced its participation in May 1998). (The DIVX format was discontinued in June 1999 due to lack of studio and retail support). Meanwhile, the studios already participating in the DVD format were actively increasing their output of new releases and catalogue titles. Given the studios' unanimous support of the DVD format, management believed that the number of available DVD titles (both new releases and catalogue titles) would grow more quickly than previously expected and the number of LD only versions of titles would shrink, further negatively impacting LD sales. Additionally, mass-merchants and discounters (Wal-Mart, Target Stores, Sears and Borders Books and Music) announced plans to increase their DVD inventories, which would further grow the DVD market. In management's estimation, the occurrence of these events had significantly accelerated DVD's negative impact on LD and the Company's recoverability of LD inventory and unrecouped royalty and distribution fee advances. Accordingly, the Company recorded pre-tax noncash charges during the fourth quarter ended March 31, 1998 of $6,263,000 to reduce the carrying value of its LD inventory to its estimated net realizable value and $4,246,000 to provide for estimated losses on long-term LD license and exclusive distribution agreements. During the fiscal year ended March 31, 1998, the Company recorded provisions for slow-moving LD inventory and for estimated losses on long-term LD license and exclusive distribution agreements totaling approximately $8,133,000 and $4,246,000, respectively. Management believes that its LD related assets (inventory and royalty and distribution fee advances) at March 31, 1998 were stated at their estimated net realizable values. Selling expenses for fiscal 1998 increased 4.0% to $4,943,000, or 6.5% of net sales, from $4,752,000, or 5.5% of net sales, for fiscal 1997. Fiscal 1998's increase, as a percentage of net sales, was primarily due to higher personnel and distribution costs associated with DVD and DTS distribution and higher freight costs due to increased freight rates over the prior year. General and administrative expenses for fiscal 1998 decreased 31.9% to $4,832,000, or 6.4% of net sales, from $7,097,000, or 8.3% of net sales, for fiscal 1997. Fiscal 1997 figures include a $1,946,000 provision for estimated doubtful accounts receivable related to the then-distressed condition of the retail entertainment software market. Exclusive of the fiscal 1997 charge, general and administrative expenses for fiscal 1998 decreased 6.2% to $4,832,000, or 6.4% of net sales, from $5,151,000, or 6.0% of net sales, for fiscal 1997. The fiscal 1998 decrease in absolute dollars was primarily due to net recoveries of previously provided for doubtful accounts receivable from certain customers totaling $331,000 and lower overhead for U.S. Laser resulting from the consolidation of certain administrative support, offset in part by severance payments to former principals of U.S. Laser totaling $150,000 and higher professional fees for fiscal 1998 versus fiscal 1997. The employment of U.S. Laser's former principals ended in December 1997 as part of the Company's consolidation of a majority of U.S. Laser's distribution activities. Amortization of production costs for fiscal 1998 increased 20.2% to $3,740,000, or 5.0% of net sales, from $3,112,000, or 3.6% of net sales, for fiscal 1997. The increase was primarily attributable to costs associated with the increased production of exclusive DVD titles and corresponding increased overhead in the Company's creative services and production departments. Certain costs of DVD production are higher than that of LD due to the complexity and intricacy of the required processes for DVD. Amortization of production costs varies based upon the mix, timing and number of exclusive DVD and LD titles placed into production. - -------------------------------------------------------------------------------- Image Entertainment Inc. 33 Interest expense for fiscal 1998 increased 59.5% to $662,000, or 0.9% of net sales, from $415,000, or 0.5% of net sales, for fiscal 1997. The increase was attributable to higher average debt levels during fiscal 1998. Interest income for fiscal 1998 decreased 48.9% to $118,000, or 0.2% of net sales, from $231,000, or 0.3% of net sales, for fiscal 1997. The Company had less cash invested during fiscal 1998 than 1997. Further, interest income for fiscal 1997 included interest income on notes receivable from LEI Partners L.P., which defaulted on the notes in November 1996. Other expense for fiscal 1997 consisted of a nonrecurring charge of $662,000, composed primarily of professional fees, relating to the terminated acquisition of Essex Entertainment, Inc., a privately-held independent music company headquartered in New Jersey. The extraordinary charge of $127,000, net of taxes of $56,000, for fiscal 1997 was associated with an early retirement of debt. In December 1996, the Company refinanced its $15 million revolving credit facility with Foothill Capital Corporation with a facility from Union Bank of California, N.A. The charge related to a prepayment penalty paid and amortization of deferred financing costs accelerated as a result of the early retirement ($40,000 represents noncash charges). The Company recorded a net income tax benefit of $52,000 in fiscal 1998, representing a carry back to fiscal 1997 of a portion of the net operating loss generated in fiscal 1998. The effective income tax rate of 30.8% for fiscal 1997 was lower than the statutory rate due to utilization of net operating loss carryforwards for Federal income tax purposes. For fiscal 1998, the Company recorded a net loss of $9,581,000, or $.71 per basic and diluted share, as compared to net income of $845,000, or $.06 per basic and diluted share for fiscal 1997. RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS In June 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards ("SFAS") No. 133 "Accounting for Derivative Instruments and Hedging Activities." SFAS No. 133 is effective for transactions entered into after June 1, 2000. SFAS No. 133 requires that all derivative instruments be recorded on the balance sheet at fair value. Changes in the fair value of derivatives are recorded each period in current earnings or other comprehensive income, depending on whether a derivative is designated as part of a hedge transaction and the type of hedge transaction. The ineffective portion of all hedges will be recognized in earnings. The Company believes that adoption of SFAS No. 133 will not have a material effect on the Company's consolidated results of operations or financial position. In March 1998, the AICPA's Accounting Standards Executive Committee ("AcSEC") issued Statement of Position ("SOP") 98-1, "Accounting for the Costs of Computer Software Developed for Internal Use." SOP 98-1 provides guidance on the capitalization of software for internal use. SOP 98-1 is effective for financial statements for periods beginning after December 15, 1998. The Company will adopt SOP 98-1 in the annual financial statements of the fiscal year ending March 31, 2000. Management believes adoption of SOP 98-1 will not have a material impact on the Company's financial position or results of operations. Costs incurred related to the warehouse management system software for the Nevada facility have been recorded consistent with the provisions of SOP 98-1. AcSEC issued SOP 98-5, "Reporting on the Cost of Start-Up Activities" in April 1998. SOP 98-5 requires that all costs of start-up activities, including organization costs, be expensed as incurred. SOP 98-5 - -------------------------------------------------------------------------------- 34 Image Entertainment Inc. is effective for financial statements for periods beginning after December 15, 1998. The Company will adopt SOP 98-5 in the annual financial statements for the fiscal year ended March 31, 2000. Management believes adoption of SOP 98-5 will not have a material impact on the Company's financial position or results of operations. IMPACT OF YEAR 2000 The Company is aware of the complexity and the significance of the Year 2000 issue. The Company utilizes information systems throughout its business to effectively carry out its day-to-day operations. The Company has established a Year 2000 compliance methodology which comprises five phases: discovery, planning, resolution, testing and implementation. The scope of the Company's compliance program includes information technology systems (computer hardware and software), non-information technology systems (facilities, telecommunication systems, distribution center machinery, security systems and video and sound processing equipment which may include embedded technology) and the Year 2000 readiness of significant third-party suppliers (product manufacturers and suppliers and major service providers such as financial institutions, freight carriers, securities agents and other service providers) and customers. State of Readiness. The Company has completed the discovery and planning ------------------ phases for both its information technology systems and non-information technology systems. Approximately 25% of the systems addressed were found to require some level of remediation or replacement. The Company is currently in the resolution phase with respect to such systems, for which all affected hardware, software and equipment is being repaired, upgraded or replaced. The Company expects to complete the resolution phase for all systems (information technology and non-information technology) by July 31, 1999. The Company expects to have completed the testing and implementation phases by September 30, 1999. Through March 31, 1999, the Company estimates that its resolution and testing phases are approximately 70% complete. Additionally, the Company is conducting a comprehensive Year 2000 supplier/customer readiness assessment with all of its significant third-party suppliers and customers. This assessment consists of distributing a questionnaire to significant third-party suppliers (including those which manufacture/supply approximately 75% of the exclusive optical discs and packaging and finished nonexclusive optical disc programming purchased by the Company) and significant third-party customers (including the Company's largest retail customers). Through March 31, 1999, approximately 50% of the Company's customers and suppliers have responded to the questionnaires, and these responses are being analyzed to determine their progress in addressing the Year 2000 problem; however, the Company's suppliers and customers are under no contractual obligation to provide such information about their Year 2000 compliance. The Company expects to complete its investigation of the state of Year 2000 readiness of significant third party suppliers and customers by September 30, 1999. Costs. Through March 31, 1999, the Company has spent approximately $25,000 ----- on the discovery, planning and resolution phases for both information technology and non-information technology systems. The Company expects the remainder of the Year 2000 remediation process to cost approximately $75,000. The Company believes it has sufficient cash, cash flow and borrowing availability to fund this project. All costs are being expensed as incurred. Risks and Contingencies. ----------------------- Information and Non-Information Technology Systems. In the event the Company does not complete all phases of its Year 2000 compliance program by December 1, 1999, the Company's most reasonably likely worst case scenario would be that it would temporarily have to manually process and/or - -------------------------------------------------------------------------------- Image Entertainment Inc. 35 outsource portions of its customer service, order processing and/or distribution functions. The Company's contingency plans in this area will be finalized after the testing phase of the systems is completed (currently scheduled by September 30, 1999) and will include the manual processes and potential outsourcing of certain functions required to perform critical business functions that could be affected by Year 2000 issues. See Item 1. "-- Risk Factors -- If We Are Unable to Repair, Upgrade or Replace Our Technology Systems Prior to December 1, 1999 or We Experience Technology System Interruptions Due to Year 2000 Non- Compliance, Our Business May Be Adversely Affected." Significant Suppliers and Customers. The Company has no means of ensuring that its significant suppliers and customers will be Year 2000 compliant. Should the Company not receive assurance from their significant suppliers of their expected Year 2000 compliance by September 30, 1999, the Company will begin its contingency planning to identify and utilize alternative sources for its programming and other supplier provided services, where practical. The Company believes there are alternative sources for the manufacturing of its exclusive optical discs and for purchasing its finished nonexclusive catalogue optical disc programming; however, in the case of finished new release nonexclusive optical disc programming, purchases are from sole source suppliers and it may not be possible to alternatively source such product. With respect to its significant customers, the Company believes that retailer demand for optical disc programming is ultimately driven by the end- consumer. Should the Company not receive assurance from their significant customers of their expected Year 2000 compliance by September 30, 1999, the Company will begin its contingency planning to identify those retailers that expect to be Year 2000 compliant and focus Year 2000 sales efforts toward such retailers. See Item 1. "-- Risk Factors -- Any Year 2000 Disruptions Suffered by Our Significant Suppliers and Customers Could Adversely Affect Our Business." Impact of Year 2000 C Ken Crane's. Ken Crane's, acquired by the Company in January 1999, utilizes its own custom computer software to perform order entry, invoicing and cash and inventory management functions. Ken Crane's also utilizes custom computer software to support its Internet web site at www.kencranes.com. Because the software uses 2-digit date fields, it is not Year 2000 compliant. The Company intends to upgrade the existing computer software beginning July 1, 1999 so the software will correctly process dates in the Year 2000. The Company estimates that this upgrade will take two to four weeks of programming time (by the third-party programmer who designed the software) at a total cost of approximately $20,000. See Item 1. "-- Risk Factors -- If the www.kencranes.com Web Site Experiences System Interruptions Due to Year 2000 Non-Compliance, Our Internet Sales May Be Adversely Affected." INFLATION Management believes that inflation is not a material factor in the operation of the Company's business at this time. LIQUIDITY AND CAPITAL RESOURCES The Company's working capital requirements vary primarily with the level of its licensing, production and distribution activities. The principal recurring uses of working capital in operations are for program licensing costs (i.e., royalty payments, including advances, to program suppliers), distribution fee advances, manufacturing and production costs, costs of acquiring finished product for wholesale distribution and selling, general and administrative expenses. Working capital has historically been provided by cash flows from operations, private and public sales of common stock, notes representing short- and long-term debt and bank borrowings. For the fiscal year ended March 31, 1999, operating activities used cash and cash equivalents of $2,651,000, investing activities used cash and cash equivalents of $8,246,000 and - -------------------------------------------------------------------------------- 36 Image Entertainment Inc. financing activities provided cash and cash equivalents of $11,434,000, resulting in a net increase in cash and cash equivalents of $537,000. Sources and Uses of Working Capital, Fiscal 1999 and 1998. For fiscal --------------------------------------------------------- 1999, the Company's net cash used in operating activities was $2,651,000, as compared to net cash provided by operating activities of $516,000 for fiscal 1998. The significant increase in net cash used in operating activities for fiscal 1999 as compared to fiscal 1998 resulted primarily from substantial increases in accounts receivables, DVD inventory purchases and DVD production cost expenditures, which were offset, in part, by an increase in accounts payable (primarily for DVD product purchases). The Company attempts to maintain what it estimates to be adequate levels of DVD inventory on a title specific basis from all product suppliers so that it can service the needs of its broad base of retail consumers as a "one-stop" source for all DVD product. The Company's accounts receivables at March 31, 1999 increased considerably from those at March 31, 1998, resulting from fiscal 1999's increased fourth quarter net sales compared to fiscal 1998's fourth quarter net sales. For fiscal 1999, the Company's net cash used in investing activities increased to $8,246,000 from $384,000 for fiscal 1998. The significant increase in net cash used in investing activities for fiscal 1999 as compared to fiscal 1998 was due to the January 11, 1999 acquisition of Ken Crane's. See Item 1. "-- Subsidiary Activities -- Image Newco Acquisition of Ken Crane's." Additionally, fiscal 1999 capital expenditures were significantly higher than fiscal 1998, primarily related to the Las Vegas, Nevada warehouse and distribution facility costs not financed through the Company's construction credit and distribution equipment lease facilities. See "Financing Activities" below. For fiscal 1999, the Company's net cash provided by financing activities was $11,434,000 compared to net cash used in financing activities of $207,000 in fiscal 1998. The significant increase in net cash provided by financing activities for fiscal 1999 as compared to fiscal 1998 resulted primarily from the Company's fiscal 1999 sale of 2.4 million shares of newly-issued common stock to certain investors. See "Registered Common Stock Sale" above. Additionally, the Company received substantially higher proceeds from the exercise of stock options during fiscal 1999 as compared to fiscal 1998. Proceeds from the stock sale were used to fund the aforementioned acquisition of Ken Crane's as well as pay-down outstanding borrowings under the Company's revolving line of credit with Foothill Capital Corporation. The aforementioned changes for fiscal 1999 cash flow versus fiscal 1998 resulted in net cash and cash equivalents increasing 53% to $1,552,000 at March 31, 1999 from $1,015,000 at March 31, 1998. Management believes that its internal and external sources of funding are adequate to meet anticipated needs for the next 12 months. Should the Company be presented with exclusive DVD distribution opportunities which require significant advance royalty or distribution fee payments, the Company may seek additional debt and/or equity financing. In the June 30, 1998 and September 30, 1998 quarters of fiscal 1999, the Company experienced losses which caused noncompliance with certain financial covenants under certain of its debt agreements such as minimum tangible net worth, maximum total debt to tangible net worth ratio and minimum average quarterly profitability covenants. As a result, the Company had requested and received waivers for its noncompliance from its lenders. On December 28, 1998, the Company refinanced its Union Bank of California revolving credit facility with a revolving credit facility from Foothill Capital Corporation. The revolving credit facility with Foothill Capital Corporation has less restrictive financial covenants than the Union Bank of California facility. Should the Company not be in compliance with future covenants, there is no assurance that the Company's lenders will provide waivers for noncompliance. Without a waiver of - -------------------------------------------------------------------------------- Image Entertainment Inc. 37 noncompliance, the debt would be in default and would potentially cross-default other debt causing such debt to be immediately due and payable. The Company would attempt to refinance its current debt with its existing lender or a new lender at terms which may be less favorable than its current terms, however, there can be no assurance that the Company would be successful in doing so. The Company is currently in compliance with all financial and operating covenants that are measured on an ongoing basis and expects that, at each measurement date in the foreseeable future, it will be in compliance with all financial and operating covenants to be measured at such date. Financing Activities. -------------------- Revolving Credit and Term Loan Facility. On December 28, 1998, the Company entered into a Loan and Security Agreement with Foothill Capital Corporation ("Foothill"). The Foothill Agreement provides for revolving advances and the issuance of and guaranty of standby letters of credit under a $12 million revolving credit facility and a series of term loans under a $500,000 capital expenditure term loan facility. The term of the Foothill Agreement is three years, renewable automatically thereafter for successive one- year periods. At March 31, 1999, the Company had a total of $1,874,000 outstanding under the revolving credit and term loan facilities and had borrowing availability of $8,643,000 and $500,000, respectively, net of amounts utilized for outstanding letters of credit. At March 31, 1999, the Company also had $1.5 million of outstanding standby letters of credit issued or guaranteed by Foothill which were subsequently amended to expire on various dates from November 15, 1999 to June 15, 2000. These letters of credit secure balances due to program suppliers. Concurrent with funding of the Foothill Agreement, the Company terminated its $10 million loan agreement with Union Bank of California, N.A. and repaid all outstanding borrowings under that agreement. Borrowings under that agreement at March 31, 1998 were $2,315,000. Construction Credit Facility. On September 30, 1998, the Company converted an existing construction loan with Bank of America National Trust and Savings Association in Nevada to a revolving line of credit (the "Revolving Line"). Under the Revolving Line, the Company may repay and reborrow principal amounts provided the outstanding borrowings do not exceed the maximum available commitment of $3,434,000, which is reduced quarterly beginning December 31, 1998 by $43,000. The Revolving Line expires January 31, 2008. The Company has the option under the Revolving Line to borrow at the bank's prime rate plus 1.25% or for fixed periods at LIBOR plus either 2.25% or 2.65% depending on the level of the Company's debt service coverage ratio, as defined. At March 31, 1999, $3,348,000 in borrowings were outstanding under the Revolving Line, of which $48,000 were borrowed at prime rate plus 1.25% option (9% at March 31, 1999) and $3,300,000 were borrowed at LIBOR plus 2.65% (7.65% at March 31, 1999). Convertible Subordinated Note Payable. The Company entered into a Credit Agreement with Image Investors Co. ("IIC"), a principal stockholder of the Company owned and controlled by John W. Kluge and Stuart Subotnick, dated as of September 29, 1997, pursuant to which the Company borrowed $5 million from IIC, with interest payable quarterly at 8% per annum, and principal due in five years. The loan is unsecured and subordinated to any obligations to Foothill and is convertible into the Company's common stock at any time during the term at a conversion price of $3.625 per share, the closing price of the Company's common stock on September 29, 1997. Note Payable to Bank. In July 1997, the Company borrowed $1,350,000 under a Business Loan Agreement (the "Business Loan Agreement") with Pioneer Citizens Bank in Nevada. The Business Loan Agreement, as amended, bears interest at prime plus 1.75% (9.5% at March 31, 1999), matures on August 1, 1999 and is secured by a deed of trust on the approximately 8.8 acres of land adjacent to the - -------------------------------------------------------------------------------- 38 Image Entertainment Inc. Company's 8.4 acre warehouse and distribution facility site in Las Vegas, Nevada. In May 1999, the Company repaid $135,000 (10%) of the outstanding principal balance. Distribution Equipment Lease Facility. The Company's March 1997 Lease Intended as Security Agreement (the "Lease") with BankAmerica Leasing and Capital Corporation provided for advances to purchase distribution machinery and equipment utilized in the Company's Nevada warehouse and distribution facility through the delivery, installation and acceptance date of the equipment (the "Advance Rent Period"). The Advance Rent Period ended March 31, 1999. Interest during the Advance Rent Period was at the three-month LIBOR plus 2.5% (7.5% at March 31, 1999). There were $1,775,000 in borrowings outstanding under the Lease at March 31, 1999. The "Base Rent Period" began on the machinery and equipment acceptance date (April 1, 1999). During the Base Rent Period, the outstanding borrowings will be amortized, over 18 consecutive quarterly installments, to a $1 purchase option, with the first such installment due July 1, 1999. The variable implicit interest for each leased unit is the three-month LIBOR plus 2.719% (7.719% at March 31, 1999). Summary. Management believes the Company's long-term operating cash flow ------- and liquidity will depend upon the success and extent of the Company's licensing and distribution of DVD software and, to a lesser extent, the viability of the LD marketplace and the Company's ability to reach the installed LD household base through alternative distribution channels. Future operating cash flow may also be positively affected by the success and extent of the Company's exclusive distribution of complimentary entertainment programming in other video/audio formats. ITEM 7A. Quantitative and Qualitative Disclosures About Market Risk. ---------------------------------------------------------- The Company does not use derivative financial instruments in its operations or investments and does not have operations subject to fluctuations in foreign currency exchange rates. At March 31, 1999, approximately 63% of the Company's obligations to its lenders were subject to future potential fluctuations in interest rates (both in the prime rate as well as in the LIBOR). To date, risks associated with interest rate movements have not been significant and are not expected to be so in the near future. Changes in interest rates which dramatically increase the interest rate on the Company's debt facilities would make it more costly to borrow proceeds under those facilities and may impede the Company's growth strategies if management determines that the costs associated with borrowing funds are too high to implement these strategies. - -------------------------------------------------------------------------------- Image Entertainment Inc. 39 ITEM 8. Financial Statements and Supplementary Data. -------------------------------------------
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS Page Independent Auditors' Report.............................................................. 41 Consolidated Balance Sheets at March 31, 1999 and 1998.................................... 42 Consolidated Statements of Operations for the years ended March 31, 1999, 1998 and 1997... 44 Consolidated Statements of Shareholders' Equity for the years ended March 31, 1999, 1998 and 1997........................................................................ 45 Consolidated Statements of Cash Flows for the years ended March 31, 1999, 1998 and 1997... 46 Notes to Consolidated Financial Statements................................................ 49 Schedule II - Valuation and Qualifying Accounts for the years ended March 31, 1999, 1998 and 1997........................................................................ 68
- -------------------------------------------------------------------------------- 40 Image Entertainment, Inc. INDEPENDENT AUDITORS' REPORT ---------------------------- The Board of Directors and Shareholders Image Entertainment, Inc.: We have audited the accompanying consolidated financial statements of Image Entertainment, Inc. and subsidiaries as listed in the accompanying index. In connection with our audits of the consolidated financial statements, we also have audited the accompanying financial statement schedule, as listed in the accompanying index. These consolidated financial statements and financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedule based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Image Entertainment, Inc. and subsidiaries as of March 31, 1999 and 1998 and the results of their operations and their cash flows for each of the years in the three-year period ended March 31, 1999, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein. /s/ KPMG LLP Los Angeles, California May 21, 1999 - -------------------------------------------------------------------------------- Image Entertainment, Inc. 41 CONSOLIDATED BALANCE SHEETS March 31, 1999 and 1998 ================================================================================ ASSETS
(In thousands) 1999 1998 -------- -------- Cash and cash equivalents $ 1,552 $ 1,015 Accounts receivable, net of allowances of $3,475 - 1999; $4,604 - 1998 11,954 6,978 Inventories (Note 6) 16,691 11,205 Royalty and distribution fee advances 3,173 4,566 Prepaid expenses and other assets 807 1,094 Property, equipment and improvements, net (Notes 7 and 9) 14,494 8,923 Goodwill (Note 3) 7,774 -- ------- ------- $56,445 $33,781 ======= =======
See accompanying notes to consolidated financial statements. - -------------------------------------------------------------------------------- 42 Image Entertainment, Inc. CONSOLIDATED BALANCE SHEETS March 31, 1999 and 1998 ================================================================================ LIABILITIES AND SHAREHOLDERS' EQUITY
(In thousands, except share data) 1999 1998 --------- -------- LIABILITIES: Accounts payable and accrued liabilities $ 16,101 $ 12,303 Accrued royalties and distribution fees 2,665 2,003 Revolving credit facility (Note 8) 1,874 2,315 Construction credit facility (Note 8) 3,348 1,619 Distribution equipment lease facility (Note 9) 1,775 526 Convertible subordinated note payable (Note 8) 5,000 5,000 Note payable (Note 8) 1,350 1,350 -------- -------- Total liabilities 32,113 25,116 -------- -------- Commitments and Contingencies (Notes 3, 8 and 13) SHAREHOLDERS' EQUITY: Preferred stock, $1 par value, 3,366,000 shares authorized; none issued and outstanding -- -- Common stock, no par value, 25 million shares authorized; 16,417,000 and 13,493,000 issued and outstanding in 1999 and 1998, respectively (Notes 2, 3 and 10) 31,725 17,764 Additional paid-in capital 3,064 3,064 Accumulated deficit (10,457) (12,163) -------- -------- Net shareholders' equity 24,332 8,665 -------- -------- $ 56,445 $ 33,781 ======== ========
See accompanying notes to consolidated financial statements. - -------------------------------------------------------------------------------- Image Entertainment, Inc. 43 CONSOLIDATED STATEMENTS OF OPERATIONS For the Years Ended March 31, 1999, 1998 and 1997 ================================================================================
(In thousands, except per share data) 1999 1998 1997 -------- -------- -------- NET SALES $76,726 $75,516 $85,650 OPERATING COSTS AND EXPENSES: Cost of sales (Note 12) 58,425 70,256 68,427 Selling expenses 5,439 4,943 4,752 General and administrative expenses 6,016 4,832 7,097 Costs of facility closure -- 825 -- Amortization of production costs 4,057 3,740 3,112 Amortization of goodwill 111 9 11 ------- ------- ------- 74,048 84,605 83,399 ------- ------- ------- OPERATING INCOME (LOSS) 2,678 (9,089) 2,251 OTHER EXPENSES (INCOME): Interest expense 966 662 415 Interest income (84) (118) (231) Other -- -- 662 ------- ------- ------- 882 544 846 ------- ------- ------- INCOME (LOSS) BEFORE INCOME TAXES AND EXTRAORDINARY ITEM 1,796 (9,633) 1,405 INCOME TAX EXPENSE (BENEFIT) (Note 11) 90 (52) 433 ------- ------- ------- INCOME (LOSS) BEFORE EXTRAORDINARY ITEM 1,706 (9,581) 972 EXTRAORDINARY ITEM - COSTS ASSOCIATED WITH EARLY RETIREMENT OF DEBT, NET OF TAXES -- -- 127 ------- ------- ------- NET INCOME (LOSS) $ 1,706 $ (9,581) $ 845 ======= ======== ======= NET INCOME (LOSS) PER SHARE (Note 5): Income (loss) before extraordinary item -- Basic and diluted $ .12 $ (.71) $ .07 Extraordinary item -- -- (.01) Net income (loss)-- Basic and diluted $ .12 $ (.71) $ .06 ======= ======== ======= Weighted average shares outstanding Basic 14,185 $ 13,471 13,504 Diluted 14,309 $ 13,471 13,836 ======= ======== =======
See accompanying notes to consolidated financial statements. - -------------------------------------------------------------------------------- 44 Image Entertainment, Inc. CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (Notes 2, 3 and 10) For the Years Ended March 31, 1999, 1998 and 1997
========================================================================================================= Common Stock Additional ----------------- Stock Paid-In Accumulated Shares Amount Warrants Capital Deficit (In thousands) ------ ------ ------------ -------- ----------- BALANCES, March 31, 1996 13,556 $21,122 $ (233) $3,064 $ (3,427) Exercise of options 544 49 -- -- -- Stock repurchased (757) (3,529) -- -- -- Amortization of stock warrants -- -- 160 -- -- Net income -- -- -- -- 845 ------- ------- -------- ------- ----------- BALANCES, March 31, 1997 13,343 17,642 (73) 3,064 (2,582) Exercise of options 150 122 -- -- -- Amortization of stock warrants -- -- 73 -- -- Net loss -- -- -- -- (9,581) ------ ------- -------- ------- ----------- BALANCES, March 31, 1998 13,493 17,764 -- 3,064 (12,163) Exercise of options 266 1,404 -- -- -- Issuance of common stock 2,658 12,557 -- -- -- Net income -- -- -- -- 1,706 ------ ------- -------- ------- ----------- BALANCES, March 31, 1999 16,417 $31,725 $ -- $ 3,064 $ (10,457) ====== ======= ======== ======= ===========
See accompanying notes to consolidated financial statements. - -------------------------------------------------------------------------------- Image Entertainment, Inc. 45 CONSOLIDATED STATEMENTS OF CASH FLOWS For the Years Ended March 31, 1999, 1998 and 1997 ================================================================================
(In thousands) 1999 1998 1997 ------- ------- ------- CASH FLOWS FROM OPERATING ACTIVITIES: Net income (loss) $ 1,706 $(9,581) $ 845 Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: Amortization of production costs 4,057 3,740 3,112 Amortization of goodwill 111 9 11 Depreciation and other amortization 725 990 846 Amortization of stock warrants -- 73 160 Amortization of restricted stock units 89 -- -- Provision for estimated doubtful accounts receivable, net of recoveries 144 (331) 1,946 Provision for slow-moving inventories 1,831 8,133 1,964 Provision for estimated losses on LD license and exclusive distribution agreements -- 4,246 -- Loss on disposition of assets -- 460 34 Changes in assets and liabilities associated with operating activities, net of acquired business: Accounts receivable (5,121) 4,112 628 Inventories (4,867) (1,314) (4,207) Royalty and distribution fee advances, net 1,393 (359) (5,284) Production cost expenditures (5,734) (4,121) (3,369) Prepaid expenses and other assets 306 (444) 220 Accounts payable, accrued royalties and liabilities 2,709 (5,097) 523 ------- ------- ------- Net cash provided by (used in) operating activities (2,651) 516 (2,571) ------- ------- ------- CASH FLOWS FROM INVESTING ACTIVITIES: Capital expenditures (2,928) (384) (6,234) Payments for business acquired (5,318) -- -- ------- ------- ------- Net cash used in investing activities (8,246) (384) (6,234) ------- ------- -------
See accompanying notes to consolidated financial statements. - -------------------------------------------------------------------------------- 46 Image Entertainment, Inc. CONSOLIDATED STATEMENTS OF CASH FLOWS (continued) For the Years Ended March 31, 1999, 1998 and 1997 ================================================================================
(In thousands) 1999 1998 1997 -------- -------- -------- CASH FLOWS FROM FINANCING ACTIVITIES: Advances under revolving credit facility $ 33,572 $ 35,330 $ 56,127 Proceeds from issuance of convertible subordinated note payable -- 5,000 -- Proceeds from issuance of note payable -- 1,350 -- Repayment of advances under revolving credit facility (34,013) (41,724) (47,418) Repayment of advances under construction credit facility (86) -- -- Repayment of note payable -- (285) -- Repurchase of warrant and common stock -- -- (3,529) Net proceeds from issuance of common stock 10,557 -- -- Net proceeds from exercise of stock options 1,404 122 49 -------- -------- -------- Net cash provided by (used in) financing activities 11,434 (207) 5,229 -------- -------- -------- NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 537 (75) (3,576) Cash and cash equivalents at beginning of year 1,015 1,090 4,666 -------- -------- -------- Cash and cash equivalents at end of year $ 1,552 $ 1,015 $ 1,090 ======== ======== ======== SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION: Cash paid during the year for: Interest $ 1,049 $ 656 $ 417 Income taxes $ -- $ 90 $ 668 ======== ======== ========
See accompanying notes to consolidated financial statements. - -------------------------------------------------------------------------------- Image Entertainment, Inc. 47 CONSOLIDATED STATEMENTS OF CASH FLOWS (continued) For the Years Ended March 31, 1999, 1998 and 1997 =============================================================================== SUPPLEMENTAL DISCLOSURES OF NONCASH OPERATING, INVESTING AND FINANCING ACTIVITIES: In January 1999, the Company, through Image Newco, Inc., its wholly-owned subsidiary, acquired certain assets and assumed certain liabilities of the Internet/direct-to-consumer DVD and LD software business of Ken Crane's Magnavox City, Inc. for $5,000,000 in cash (of which $500,000 is contingent and held in escrow) and 258,370 shares of the Company's common stock valued at $2,000,000 ($7.74 per share). See "Note 3. Acquisition."
(In thousands) Fair value of assets acquired $ 1,096 Excess of purchase price over fair value of net assets acquired recorded as goodwill 7,885 Cash paid for net assets acquired (including escrowed amount) (5,000) Stock issued for net assets acquired (2,000) Expenses incurred in connection with the acquisition (318) ----- Liabilities assumed $ 1,663 =====
During fiscal 1999 and 1998, the Company borrowed $3,064,000 and $2,145,000, respectively, to fund costs relating to the construction of the Las Vegas, Nevada warehouse and distribution facility. During fiscal 1997, the Company purchased real property in Las Vegas, Nevada for approximately $4,365,000, which included notes payable for approximately $1,235,000. See accompanying notes to consolidated financial statements. - -------------------------------------------------------------------------------- 48 Image Entertainment, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - ------------------------------------------------------------------------------- Note 1. Description of Business and Summary of Significant Accounting Policies. Description of Business and Organization. Image Entertainment, Inc. (the - ---------------------------------------- "Company") was reincorporated in California in November 1989. The Company's primary business is the distribution of programming on optical disc (laserdisc ("LD") and digital video disc ("DVD")) under exclusive and nonexclusive license and wholesale distribution agreements. Principles of Consolidation. The consolidated financial statements include - --------------------------- those of the Company and its wholly-owned subsidiaries, Image Newco, Inc. ("Image Newco" or "Ken Crane's") and U.S. Laser Video Distributors, Inc. ("U.S. Laser") (collectively, the "Company"). All significant inter-company balances and transactions have been eliminated in consolidation. Use of Estimates. The preparation of the Company's consolidated financial - ---------------- statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements. The significant areas requiring the use of management estimates related to allowances for slow-moving inventory, doubtful accounts receivables, unrecouped royalty and distribution fee advances and sales returns. Although these estimates are based on management's knowledge of current events and actions management may undertake in the future, actual results may ultimately differ from those estimates. Fair Value of Financial Instruments. The carrying amounts reflected in the - ----------------------------------- Company's consolidated balance sheets for all financial instruments approximate their respective fair values. Cash and Cash Equivalents. The Company considers all highly liquid investments - ------------------------- purchased with maturities of three months or less to be cash equivalents. Inventories. Inventories consist primarily of finished products for sale which - ----------- are stated at the lower of cost or market, cost being determined on an average cost basis and unamortized capitalized production costs. Royalty and Distribution Fee Advances. Royalty and distribution fee advances - ------------------------------------- represent fixed minimum payments made to program suppliers for exclusive programming distribution rights. A program supplier's share of exclusive program distribution revenues is retained by the Company until the share equals the advance(s) paid to the program supplier. Thereafter, any excess is paid to the program supplier. In the event of an excess, the Company records, as a cost of sales, an amount equal to the program supplier's share of the net distribution revenues. Royalty and distribution fee advances are charged to operations as revenues are earned, and are stated at the lower of unamortized cost or estimated net realizable value on an individual-title or exclusive distribution-agreement basis. If estimated future revenues on an individual- title or agreement basis are not sufficient to recover the amortized balance of royalty and distribution fee advances, such estimated loss is recorded as cost of sales in the period when the loss is estimated. Property, Equipment and Improvements. Property, equipment and improvements are - ------------------------------------ stated at cost less accumulated depreciation and amortization. Major renewals and improvements are capitalized; minor replacements, maintenance and repairs are charged to current operations. Depreciation and amortization are computed by applying the straight-line method over the estimated useful lives of the building (25 years) and machinery, equipment and warehouse management system software (3 - 7 years). Leasehold improvements are amortized over the shorter of the useful life of the improvement or the life of the related lease. - -------------------------------------------------------------------------------- Image Entertainment, Inc. 49 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - -------------------------------------------------------------------------------- Interest costs on the construction of the Las Vegas, Nevada warehouse and facility were capitalized as part of the cost of the facility. Goodwill. The excess of purchase price over the value of the net assets - -------- acquired is amortized on a straight-line basis over a 15-year period. The Company reviews the recoverability of goodwill by determining the ability to recover the unamortized balance of goodwill from expected future operating cash flows on an undiscounted basis. In management's opinion, no impairment exists as of March 31, 1999. Revenue Recognition. Revenue is recognized upon shipment of product. The - ------------------- Company's return policy allows customers to return a percentage of programming purchased on a quarterly basis. The Company provides for estimated sales returns when product is shipped to customers. Major Customers. Customers which individually accounted for more than 10% of - --------------- fiscal year net sales were none for fiscal 1999, approximately 31.5% of fiscal 1998 net sales (Norwalk Records 10.9%, Ken Crane's 10.6%, and Musicland 10.0%) and approximately 31.8% of fiscal 1997 net sales (Musicland 11.2%, Alliance Entertainment 10.4% and Ken Crane's 10.2%). Amortization of Production Costs. The Company amortizes capitalized production - -------------------------------- costs in accordance with the provisions of Statement of Financial Accounting Standards ("SFAS") No. 53. Pursuant to the income forecast method, a percentage of the production costs is charged to expense each month based upon (i) a projected revenue stream resulting from distribution of new and previously released exclusive optical disc programming related to the production costs and (ii) management's estimate of the ultimate net realizable value of the production costs. Estimates of future revenues are reviewed periodically and amortization of production costs is adjusted accordingly. If estimated future revenues are not sufficient to recover the unamortized balance of production costs, such costs are reduced to their estimated net realizable value. Long-Lived Assets. The Company reviews for the impairment of long-lived assets - ----------------- whenever events or changes in circumstances indicate the carrying amount of an asset may not be recoverable. An impairment loss would be recognized when estimated future cash flows expected to result from the use of the asset and its eventual disposition is less than its carrying amount. Income Taxes. The Company accounts for income taxes under the asset and - ------------ liability whereby deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and the future tax benefits derived from operating loss and tax credit carryforwards. Earnings Per Share. Basic earnings (loss) per share is computed using the - ------------------ weighted average number of common shares outstanding during the period. Diluted earnings per share is computed using the combination of dilutive common share equivalents and the weighted average shares outstanding during the period. Comprehensive Income. The Company adopted the provisions of SFAS No. 130, - -------------------- "Reporting Comprehensive Income" on April 1, 1998. Comprehensive income is the change in equity of a business enterprise during a period resulting from transactions and all other events and circumstances from non-owner sources. Other comprehensive income includes foreign currency items, minimum pension liability adjustments and unrealized gains and losses on certain investments in debt and equity securities. The Company did not have components of comprehensive income during the year ended March 31, 1999. - -------------------------------------------------------------------------------- 50 Image Entertainment, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - ------------------------------------------------------------------------------- Stock Options. Prior to April 1, 1996, the Company accounted for its stock - ------------- options in accordance with provisions of Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees," and related interpretations. As such, compensation expense would be recorded on the date of grant only if the current market price of the underlying stock exceeded the exercise price. On April 1, 1996, the Company adopted SFAS No. 123, "Accounting for Stock-Based Compensation," which permits entities to recognize, as expense over the vesting period, the fair value of all stock-based awards on the date of grant. Alternatively, SFAS No. 123 also allows entities to continue to apply the provisions of APB Opinion No. 25 and provide pro forma net income disclosures for employee stock option grants made in 1996 and future years as if the fair- value-based method defined in SFAS No. 123 had been applied. The Company has provided the pro forma disclosure provisions of SFAS No. 123. Segment Information. In 1999, the Company adopted SFAS No. 131 "Disclosures - ------------------- about Segments of an Enterprise and Related Information." SFAS No. 131 supercedes SFAS No. 14, "Financial Reporting for Segments of a Business Enterprise." The adoption of SFAS No. 131 did not affect results of operations or financial position but, in future periods, will affect the disclosure of segment information. With the January 11, 1999 acquisition of Ken Crane's (more fully described in "Note 3. Acquisition"), the Company now operates in two business segments. The largest segment is wholesale distribution of primarily DVD and LD programming. The Company's other business segment - retail sales including direct-to-consumer Internet/mail order distribution - currently has operating results which are not material to the Company's consolidated operating results for the year ended March 31, 1999. Management expects the retail sales segment to grow and be reported separately in the Company's segment information disclosure. For the year ended March 31, 1999, segment information is not presented. Recently Issued Accounting Standards. In June 1998, the Financial Accounting - ------------------------------------ Standards Board issued SFAS No. 133 "Accounting for Derivative Instruments and Hedging Activities." SFAS No. 133 is effective for transactions entered into after June 1, 2000. SFAS No. 133 requires that all derivative instruments be recorded on the balance sheet at fair value. Changes in the fair value of derivatives are recorded each period in current earnings or other comprehensive income, depending on whether a derivative is designated as part of a hedge transaction and the type of hedge transaction. The ineffective portion of all hedges will be recognized in earnings. The Company believes that adoption of SFAS No. 133 will not have a material effect on the Company's consolidated results of operations or financial position. In March 1998, the AICPA's Accounting Standards Executive Committee ("AcSEC") issued Statement of Position ("SOP") 98-1, "Accounting for the Costs of Computer Software Developed for Internal Use." SOP 98-1 provides guidance on the capitalization of software for internal use. SOP 98-1 is effective for financial statements for periods beginning after December 15, 1998. The Company will adopt SOP 98-1 in the annual financial statements of the fiscal year ending March 31, 2000. Management believes adoption of SOP 98-1 will not have a material impact on the Company's financial position or results of operations. Costs incurred related to the warehouse management system software for the Las Vegas, Nevada warehouse and distribution facility have been recorded consistent with the provisions of SOP 98-1. AcSEC issued SOP 98-5, "Reporting on the Cost of Start-Up Activities" in April 1998. SOP 98-5 requires that all costs of start-up activities, including organization costs, be expensed as incurred. SOP 98-5 is effective for financial statements for periods beginning after December 15, 1998. The Company will adopt SOP 98-5 in the annual financial statements of the fiscal year ending March 31, 2000. Management believes adoption of SOP 98-5 will not have a material impact on the Company's financial position or results of operations. - -------------------------------------------------------------------------------- Image Entertainment, Inc. 51 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - ------------------------------------------------------------------------------- Reclassifications. Certain fiscal 1998 and 1997 balances have been reclassified - ----------------- to conform with the fiscal 1999 presentation. Note 2. Registered Common Stock Sale. On January 6, 1999, the Company completed the sale of 2.4 million shares of newly-issued common stock to a group of institutional investors and other accredited investors at $5 per share. Image Investors, Co., the largest shareholder of the Company and beneficially owned by John W. Kluge and Stuart Subotnick, purchased 600,000 shares of the 2.4 million shares issued. The net proceeds of the offering (net of placement agent fees and professional services fees) were $10,557,000. Approximately $5 million of the net proceeds were used to complete the acquisition of Ken Crane's (as defined in "Note 3. Acquisition" below). The remainder of the net proceeds was used to pay-down borrowings outstanding under the Company's revolving credit facility with Foothill Capital Corporation. Note 3. Acquisition. On January 11, 1999, the Company, through Image Newco, completed its acquisition of certain assets and liabilities of the Internet/direct-to-consumer DVD and LD software business ("Ken Crane's") of Ken Crane's Magnavox City, Inc. ("KCMC") pursuant to an Asset Purchase Agreement dated as of August 20, 1998 between KCMC and Image Newco (as amended, the "Purchase Agreement"). Ken Crane's is engaged in Internet/direct-to-consumer retailing of DVD and LD entertainment software and is doing business as "Ken Crane's DVD and Laserdisc Superstore." The assets acquired included the www.kencranes.com web site, a mail-order business, an approximately 8,000 square foot retail store (located in leased premises in Westminster, California), DVD and LD inventory, and fixed assets and certain other assets used in the operation of Ken Crane's Internet, mail-order and retail store businesses. In addition, Image Newco assumed certain trade accounts payable of Ken Crane's. The acquisition purchase price paid to KCMC included $3 million in cash and 258,370 shares of the Company's common stock, valued at $2 million (at $7.74 per share). The value of the 258,370 shares issued to KCMC's was based upon the average price of the Company's common stock for the 20 days preceding the August 20, 1998 signing of the Purchase Agreement. The purchase price may be subject to adjustment following the results of the post-closing audit of Ken Crane's. Approximately $500,000 of the cash portion of the purchase price is in an escrow account, as provided for in the Purchase Agreement, pending resolution of certain deficiencies claimed by the Company in the amount of assets delivered to the Company on the January 11, 1999 closing date. In connection with the acquisition, Image Newco entered into (1) a five-year employment agreement with Charles K. Crane, II ("Ken Crane, Jr.") (and paid a signing bonus of $1.5 million pursuant to that agreement) and (2) one-year consulting agreements with Pamela Crane and Casey Crane (and made a one-time payment of $250,000 to each in connection with those agreements). Ken Crane, Jr. serves as Vice President - General Manager of Image Newco. For financial statement purposes, the one-time payments are included in the purchase price of Ken Crane's. The acquisition was accounted for using the purchase method of accounting. Accordingly, the acquired assets and assumed liabilities were recorded at their fair market value on the acquisition date. The consolidated financial statements reflect a preliminary allocation of the purchase price, including the cash - -------------------------------------------------------------------------------- 52 Image Entertainment, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - ------------------------------------------------------------------------------- portion of purchase price held in escrow, as the purchase price allocation has not been finalized. The excess of purchase price over the fair market value of the net assets acquired is as follows:
(In thousands) Total purchase price: Cash paid, including escrowed amount $ 3,000 Common stock issued 2,000 Payments to Ken Crane Jr. 1,500 Payments to Pamela Crane and Casey Crane 500 Costs of acquisition 318 ------- Total purchase price 7,318 ------- Fair market value of net assets acquired: Inventories 771 Other assets 21 Property and equipment 304 Accounts payable and accrued liabilities assumed (1,663) ------- Net assets acquired (567) ------- Excess purchase price over net assets acquired $ 7,885 =======
The operating results of Ken Crane's are included in the accompanying consolidated statements of operations for the year ended March 31, 1999 from the date of acquisition. The excess of purchase price over the fair market value of the net assets acquired, including $500,000 in contingent purchase price held in escrow, is classified as goodwill and is being amortized on a straight-line basis over 15 years. At March 31, 1999, goodwill, net of accumulated amortization, was $7,774,000. Amortization charged to operations for year ended March 31, 1999 was $111,000. Prior to the acquisition, Ken Crane's was historically one of the Company's largest customers. During the years ended March 31, 1999 (through the January 11, 1999 acquisition date) and 1998, sales by the Company to Ken Crane's were $5,983,000 and $8,069,000, respectively. The following unaudited pro forma consolidated results of operations have been prepared as if the acquisition of Ken Crane's had occurred at the beginning of fiscal 1998.
For the Years Ended March 31, -------------------------------- (In thousands, except per share data) 1999 1998 ---------- ---------- NET SALES $ 83,650 $ 84,155 NET INCOME (LOSS) $ 1,489 $ (10,025) NET INCOME (LOSS) PER SHARE -- BASIC AND DILUTED $ .10 $ (.73) ========== ==========
The pro forma consolidated results do not purport to be indicative of results that would have occurred had the acquisition been in effect for the periods presented, nor do they purport to be indicative of the results that will be obtained in the future. The primary pro forma adjustments primarily reflect elimination of inter-company transactions and amortization of goodwill on a straight-line basis over 15 years. The pro forma information does not give effect to any synergies anticipated by management as a result of the acquisition, in particular improvements in shipping efficiencies and the elimination of redundant shipping, general and administrative expenses and other operating expenses. - -------------------------------------------------------------------------------- Image Entertainment, Inc. 53 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - ------------------------------------------------------------------------------- Note 4. Closure of U.S. Laser. In May 1998, the Company announced the closing of U.S. Laser, located in New Jersey and acquired by the Company in June 1995 for $3.1 million in cash. The closure of the subsidiary and its retail store "Digitainment" was finalized on July 15, 1998. The corporate entity was dissolved on February 26, 1999. The closure followed the Company's consolidation of a majority of U.S. Laser's optical disc distribution activities. U.S. Laser's only remaining activities consisted of direct-to-consumer optical disc sales through the "Digitainment" retail store, mail order to a decreasing number of accounts and the Internet. With the decline of industry-wide LD software and hardware sales, offset in part by growing DVD software and hardware sales, the retail store was performing below expectations. The closure of U.S. Laser resulted in nonrecurring pretax charges of $202,000, representing fees and expenses associated with the early termination of a lease and employee severance payments, and $623,000 (a noncash charge) covering the write-off of unamortized leasehold improvements and goodwill. The pretax charges total $825,000 and are included in costs of facility closure expense for the year ended March 31, 1998. Note 5. Net Income (Loss) per Share Data. The following is a reconciliation of the numerators and denominators used in computing basic and diluted net income (loss) per share for the three years ended March 31, 1999:
(In thousands, except per share data) 1999 1998 1997 --------- -------- -------- Income (loss) before extraordinary item $ 1,706 $ (9,581) $ 972 ========= ======== ======== Net income (loss) $ 1,706 $ (9,581) $ 845 ========= ======== ======== Weighted average common shares outstanding -- basic 14,185 13,471 13,504 ========= ======== ======== Effect of dilutive securities 124 -- 332 --------- -------- -------- Weighted average common shares outstanding -- diluted 14,309 13,471 13,836 ========= ======== ======== Net income (loss) per share: Income (loss) before extraordinary item -- basic and diluted $ .12 $ (.71) $ .07 ========= ======== ======== Extraordinary item -- -- (.01) Net income (loss) -- basic and diluted $ .12 $ (.71) $ .06 ========= ======== ========
Diluted net loss per share for 1998 is based only on the weighted average number of common shares outstanding during the period, as inclusion of common stock equivalents would be antidilutive. The 1,379,000 shares underlying the convertible subordinated note payable were not included in the 1999, 1998 and 1997 diluted net income per share calculations since the impact was antidilutive. Stock options and warrants to purchase 800,000 and 2,007,000 shares of common stock in 1999 and 1997, respectively, were outstanding but not included in the computation of diluted net income per share because the option/warrant exercise price was greater than the average market price of the Company's common stock during those respective periods. - -------------------------------------------------------------------------------- 54 Image Entertainment, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - ------------------------------------------------------------------------------- Note 6. Inventories. Inventories at March 31, 1999 and 1998 are summarized as follows:
(In thousands) 1999 1998 ---------- ---------- LD $ 12,125 $ 15,641 DVD 9,724 2,128 Other 500 577 ---------- ---------- 22,349 18,346 Reserve for slow-moving inventory (9,291) (9,098) ---------- ---------- 13,058 9,248 Production costs, net 3,633 1,957 ---------- ---------- $ 16,691 $ 11,205 ========== ==========
The costs to produce licensed optical disc programming include the cost of converting film prints or tapes into the optical disc format, which includes mastering and ancillary material production for LD and authoring and compression, replica sample, set up charges and ancillary material production for DVD, and packaging artwork costs and the overhead of the Company's creative services and production departments. In December 1998, as part of its periodic review of the recoverability of capitalized production costs, management changed its estimate of the projected revenue stream from distribution of exclusive DVD titles. This change in estimate was recorded in the December 1998 quarter and prospectively. Had this change in estimate not been made, amortization of production costs for fiscal 1999 would have been higher by approximately $217,000. Production costs are net of accumulated amortization of $8,559,000 and $6,013,000 at March 31, 1999 and 1998, respectively. The Company expects to amortize substantially all of the March 31, 1999 production costs by March 31, 2002. Note 7. Property, Equipment and Improvements. Property, equipment and improvements at March 31, 1999 and 1998 are summarized as follows:
(In thousands) 1999 1998 ----------- ---------- Land $ 4,868 $ 4,855 Building 4,337 -- Construction in progress -- 2,644 Machinery, equipment and software 9,279 4,920 Leasehold improvements 824 794 Other 481 280 ----------- ---------- 19,789 13,493 Less accumulated depreciation and amortization 5,295 4,570 ----------- ---------- $ 14,494 $ 8,923 =========== ==========
In December 1997, the Company commenced construction of a 76,000 square foot warehouse and distribution facility located on 8.4 acres of land in Las Vegas, Nevada. The building construction was completed September 30, 1998. Subsequent to September 30, 1998, the Company began receiving and installing custom distribution machinery and equipment. The Company began shipping product on a test-basis from the new facility in March 1999 and began shipping 100% of its product from the new facility on May 3, 1999. For depreciation purposes, the building and distribution facility related machinery, equipment - -------------------------------------------------------------------------------- Image Entertainment, Inc. 55 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - ------------------------------------------------------------------------------- and software were placed into service on May 1, 1999. The Company also owns approximately 8.8 acres of unimproved property located adjacent to the Company's 8.4 acres on which its warehouse and distribution facility is located. The Company is holding this property as an investment, and, if needed, for future expansion. The land is recorded at the lower of cost or fair market value. Depreciation and amortization of property, equipment and improvements was $725,000, $826,000 and $846,000 for fiscal 1999, 1998 and 1997, respectively. Interest capitalized for fiscal 1999 and 1998 was $156,000 and $18,000, respectively. The Company did not capitalize interest during fiscal 1997. Note 8. Debt. Revolving Credit and Term Loan Facility. On December 28, 1998, the Company - --------------------------------------- entered into a Loan and Security Agreement (the "Foothill Agreement") with Foothill Capital Corporation ("Foothill"). The Foothill Agreement provides for revolving advances and the issuance of and guaranty of standby letters of credit under a $12 million revolving credit facility and a series of term loans under a $500,000 capital expenditure term loan facility. The term of the Foothill Agreement is three years, renewable automatically thereafter for successive one- year periods. Borrowings under the Foothill Agreement are secured by substantially all of the Company's assets and bear interest at prime plus 1% (8.75% at March 31, 1999), payable monthly. The borrowing rate may be reduced in the future should the Company meet certain operating performance targets specified in the Foothill Agreement. Funds available for borrowing under the credit facility may not exceed the borrowing base specified in the Foothill Agreement. The borrowing base is calculated as a percentage of eligible trade accounts receivable and eligible DVD inventory and excludes all LD inventory. At March 31, 1999, the Company had a total of $1,874,000 outstanding under the revolving credit and term loan facilities and had borrowing availability of $8,643,000 and $500,000, respectively, net of amounts utilized for outstanding letters of credit. The Foothill Agreement imposes restrictions on such items as encumbrances and liens, payment of dividends, other indebtedness, stock repurchases and capital expenditures. The Foothill Agreement requires the Company to comply with certain financial and operating covenants including a covenant to be Year 2000 compliant by December 1, 1999. At March 31, 1999, the Company was in compliance with all financial and operating covenants. At March 31, 1999, the Company had $1.5 million of outstanding standby letters of credit issued or guaranteed by Foothill which were subsequently amended to expire on various dates from November 15, 1999 to June 30, 2000. These letters of credit secure balances due to program suppliers. Concurrent with funding of the Foothill revolving credit facility, the Company terminated its $10 million loan agreement with Union Bank of California, N.A. and repaid all outstanding borrowings under that agreement. Borrowings under that agreement at March 31, 1998 were $2,315,000. Construction Credit Facility. On September 30, 1998, the Company converted an - ---------------------------- existing construction loan with Bank of America National Trust and Savings Association in Nevada to a revolving line of credit (the "Revolving Line"). Under the Revolving Line, the Company may repay and reborrow principal amounts provided the outstanding borrowings do not exceed the maximum available commitment of $3,434,000, which is reduced quarterly beginning December 31, 1998 by $43,000. The Revolving Line expires January - -------------------------------------------------------------------------------- 56 Image Entertainment, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - ------------------------------------------------------------------------------- 31, 2008. The Company has the option under the Revolving Line to borrow at the bank's prime rate plus 1.25% or for fixed periods at LIBOR plus either 2.25% or 2.65% depending on the level of the Company's debt service coverage ratio, as defined. At March 31, 1999, $3,348,000 in borrowings were outstanding under the Revolving Line, of which $48,000 were borrowed at prime rate plus 1.25% (9% at March 31, 1999) and $3,300,000 were borrowed at LIBOR plus 2.65% (7.65% at March 31, 1999). Borrowings under the Revolving Line are secured by a deed of trust on the approximate 8.4 acres of land in Las Vegas, Nevada on which the Company has constructed its new warehouse and distribution facility, as well as any of the Company's personal property located in Nevada, but excluding inventory held for sale. The Revolving Line contains cross-default provisions to other borrowing agreements and imposes certain restrictions on such items as payment of dividends and stock repurchases. The Revolving Line requires the Company to comply with certain quarterly financial and operating covenants. At March 31, 1999, the Company was in compliance with all financial and operating covenants. Convertible Subordinated Note Payable. The Company entered into a Credit - ------------------------------------- Agreement with Image Investors Co. ("IIC"), a principal stockholder of the Company owned and controlled by John W. Kluge and Stuart Subotnick, dated as of September 29, 1997, pursuant to which the Company borrowed $5 million from IIC, with interest payable quarterly at 8% per annum, and principal due in five years. The loan is unsecured and subordinated to any obligations to Foothill and is convertible into the Company's common stock at any time during the term at a conversion price of $3.625 per share, the closing price of the Company's common stock on September 29, 1997. Note Payable to Bank. In July 1997, the Company borrowed $1,350,000 under a - -------------------- Business Loan Agreement (the "Business Loan Agreement") with Pioneer Citizens Bank in Nevada. The Business Loan Agreement, as amended, bears interest at prime plus 1.75% (9.5% at March 31, 1999), matures on August 1, 1999 and is secured by a deed of trust on the approximately 8.8 acres of land adjacent to the Company's 8.4 acre warehouse and distribution facility site in Las Vegas, Nevada. In May 1999, the Company repaid $135,000 (10%) of the outstanding principal balance. The following is a schedule by year of required minimum debt principal payments and maturities under the Company's debt agreements (revolving credit and term loan and construction credit facilities and its notes payable):
(In thousands) Fiscal Amount ------------ ---------- 2000 $ 1,522 2001 172 2002 2,046 2003 5,172 2004 172 Thereafter 2,488 ------------ ---------- $ 11,572 ==========
Note 9. Distribution Equipment Lease Facility. The Company's Lease Intended as Security Agreement (the "Lease") with BankAmerica Leasing and Capital Corporation provided for advances to purchase distribution machinery and equipment utilized in the - -------------------------------------------------------------------------------- Image Entertainment, Inc. 57 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - ------------------------------------------------------------------------------- Company's Las Vegas, Nevada warehouse and distribution facility through the delivery, installation and acceptance date of the equipment (the "Advance Rent Period"). The Advance Rent Period ended March 31, 1999. Interest during the Advance Rent Period was at the three-month LIBOR plus 2.5% (7.5% at March 31, 1999). There were $1,775,000 in borrowings outstanding under the Lease at March 31, 1999. The "Base Rent Period" began on the machinery and equipment acceptance date (April 1, 1999). During the Base Rent Period, the outstanding borrowings will be amortized, over 18 consecutive quarterly installments, to a $1 purchase option, with the first such installment due July 1, 1999. The variable implicit interest for each leased unit is the three-month LIBOR plus 2.719% (7.719% at March 31, 1999). Under the Lease, the Company may convert to a fixed implicit interest rate. The fixed implicit interest rate will be the bond-equivalent yield per annum for U.S. Treasury obligations with a maturity most closely matching to the nearest month of the remaining average life of the leased equipment plus a spread of 3.137%. Borrowings under the Lease are secured by the underlying equipment leased. The Lease contains cross-default provisions with other borrowing agreements and early termination charges. The Lease requires the Company to meet the same quarterly financial and operating covenants contained in the Revolving Line with Bank of America National Trust and Savings Association above. At March 31, 1999, the Company was in compliance with all financial and operating covenants. Machinery and equipment under capital leases consists of the following:
For the Fiscal Year Ended March 31, ------------------------------------ (In thousands) 1999 1998 --------------- --------------- Machinery and equipment $ 1,775 $ 526 Less accumulated amortization -- -- --------------- --------------- $ 1,775 $ 526 =============== ===============
Future minimum lease payments at March 31, 1999 for property under capital leases are as follows: (In thousands) Year Ending Amount -------------- -------------- 2000 $ 471 2001 471 2002 471 2003 471 2004 234 -------------- Total minimum lease payments 2,118 Less amount representing interest at 7.719% 343 -------------- Present value of minimum lease payments $ 1,775 ==============
- -------------------------------------------------------------------------------- 58 Image Entertainment, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - -------------------------------------------------------------------------------- Note 10. Stock Awards, Options and Warrants. The Company has three employee stock option plans. Incentive stock options may be granted under one plan, and incentive stock options and nonstatutory options under the other two. Under the plans, the exercise price of an incentive stock option may not be less than the fair market value of the common stock on the date of grant. The exercise price of a nonstatutory option generally may not be less than 85% of the fair market value on the date of grant. The term of an option may be no more than 10 years from the date of grant. The Company also has a directors' stock option plan providing for an initial and annual award of participate under the plan. Only nonstatutory options may be granted under the directors' plan. The directors' plan also provides for an exercise price of $0.25 over the fair market value of the common stock on the date of grant for initial grants to directors. Thereafter, the directors' plan provides for an exercise price at fair market value of the common stock of the date of grant, fixed vesting and a ten-year term. In addition to options under the three employee plans and the directors plan, the Company has granted options (including the antidilution rights described below and warrants in connection with program acquisition agreements) to officers, shareholders, creditors and others for various business purposes. In September 1998, the Company's shareholders approved a new incentive plan pursuant to which approximately 1,160,000 shares were available for awards, including options, thereunder. No new options will be granted under the Company's other plans. The new plan provides for awards to employees and directors of the Company. Options (incentive as well as nonqualified), restricted stock units ("RSUs"), stock appreciation rights, performance share awards, stock bonuses, cash bonuses and stock units can be awarded under the new plan. The new plan includes a minimum option price of 85% of the fair market value of a share of common stock relative to the closing price on the date of grant for any non-qualified stock option. The maximum term allowed for an option is 10 years and a RSU shall either vest or be forfeited not more than 10 years from the date of grant. The new plan contemplates annual automatic grants of RSUs payable in shares of the Company's common stock to certain directors of the Company ("Formula Director Awards") in lieu of the 15,000 share option grants under the directors' stock option plan. The new plan also provides that under certain limited circumstances directors who are not also executive officers of the Company may receive discretionary option grants in addition to the Formula Director Awards. The new plan terminates on June 30, 2008. No more than 300,000 shares may be subject to options and stock appreciation rights granted to any one individual in any one calendar year; no more than 500,000 shares may be subject to RSU awards and stock unit awards (including Formula Director Awards), issued initially for nominal or no consideration other than future services, with vesting based on passage of time and continued service; no more than 5,000 shares may be subject to Formula Director Awards granted to any one individual in any one calendar year; and no more than 400,000 shares may be subject to all awards granted to any one individual in any one calendar year. In July 1998 an aggregate 88,358 RSUs were granted to officers of the Company under the new plan. These grants will vest annually in increments of 20% over the five-year period commencing June 30, 1999. Accelerated vesting may occur if certain fiscal earnings before interest, taxes, depreciation and amortization targets are achieved (they were not achieved in fiscal 1999). The number of RSUs awarded to officers was determined by multiplying a specified percentage of base salary by the officer's base salary as of the beginning of the period and dividing the results by the average trading price of the stock determined as of the date of grant ($6.70 per share) to determine the number of RSUs. These RSUs are payable solely in - -------------------------------------------------------------------------------- Image Entertainment, Inc. 59 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - -------------------------------------------------------------------------------- shares. The Company amortizes the total value of the RSUs on the date of grant ($592,000) ratably over the 5-year vesting period as compensation expense. Compensation expense for fiscal 1999 was approximately $89,000. Stock option transactions for the three years ended March 31, 1999 are as follows:
Weighted Per Share Average Price (In thousands, except per share data) Shares Price Range Per Share ---------- ----------- ------------- Outstanding, March 31, 1996 6,007 $ .59-10.25 $5.697 Granted 180 5.813-6.75 6.594 Exercised (544) .743-6.00 3.740 Surrendered (1,427) .817-6.00 5.799 Canceled (1,832) .743-7.25 5.622 ------ ------ Outstanding, March 31, 1997 2,384 .743-10.25 6.208 Granted 30 3.25 3.250 Exercised (150) .743-1.857 1.295 Surrendered (10) 7.00 7.000 Canceled (837) 4.16-7.00 6.073 ------ ------ Outstanding, March 31, 1998 1,417 .743-10.25 6.364 Granted 60 7.94 7.940 Exercised (266) .743-7.25 5.274 Surrendered (99) 4.16 4.160 Canceled (30) .743-7.94 6.182 ------ ------ Outstanding, March 31, 1999 1,082 $.817-10.25 $6.824 ====== ======
Of the options reflected as outstanding on March 31, 1999, 1998 and 1997, options to purchase approximately 999,000, 1,296,000 and 2,243,000 shares of common stock were exercisable, respectively. At March 31, 1999, there were approximately 1,070,000 shares of common stock reserved for issuance under all of the Company's stock option plans. The following table summarizes significant ranges of outstanding and exercisable options at March 31, 1999:
Options Outstanding Options Exercisable ------------------------------------ ------------------------- Weighted Weighted Weighted Average Average Average Range of Shares Remaining Exercise Shares Exercise Exercise Prices (In thousands) Life (Years) Price (In thousands) Price - ------------------ -------------- ----------- -------- -------------- -------- under $4.00 46 2.9 $ 1.621 46 $ 1.621 $4.01 to $6.00 216 3.7 5.535 216 5.535 $6.01 to $8.00 722 6.1 7.261 639 7.285 $8.01 to $10.00 85 5.0 8.647 85 8.647 over $10.00 13 2.8 10.250 13 10.250 ----- ----- 1,082 999 ===== =====
- -------------------------------------------------------------------------------- 60 Image Entertainment, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - -------------------------------------------------------------------------------- A December 29, 1987 stock purchase agreement (the "Agreement") provides for the grant of antidilution rights ("Rights") to various persons (the "Investors"). Each Investor is entitled to Rights in connection with certain issuances of common stock. The Agreement was amended in July 1992 and will expire in July 2002. Upon the exercise of certain options outstanding as of December 29, 1987 (the "Management Options"), each Investor was granted Rights to purchase shares of common stock pursuant to a formula based in part on the percentage of the outstanding shares of common stock owned by the Investor on December 29, 1987. As of March 31, 1999, all Rights to purchase 507,016 shares had been granted (the maximum allowable upon exercise of all the Management Options), Rights to purchase 476,609 shares had been exercised (as to 4,521 shares in fiscal 1999, 19,697 shares in fiscal 1998 and 22,039 shares in fiscal 1997, at per-share exercise prices ranging from $.74 to $1.07) and Rights to purchase 30,407 shares were outstanding. Rights granted in connection with the exercise of a Management Option are exercisable for two years from the date of grant and have a per-share exercise price equal to the greater of (a) $.74 or (b) the exercise price of the Management Option. Upon certain issuances of shares of common stock other than pursuant to the exercise of Management Options, the Investors will be granted additional Rights ("Other Rights") so that the equity interest represented by the Agreement shares held by the Investor (excluding the shares purchased upon the exercise of Rights issued in connection with the exercise of Management Options) will not be diluted. As of March 31, 1999, Other Rights to purchase approximately 851,616 shares of common stock had been exercised (none exercised in fiscal 1999 and 1998 and 433 shares in fiscal 1997). The Company applies APB Opinion No. 25 in accounting for its stock option plans, and accordingly, no compensation cost has been recognized for its stock options in the consolidated financial statements. Had the Company determined compensation cost based on the fair value at the grant date for its stock options under SFAS No. 123, the Company's consolidated net income (loss) and net income (loss) per share would have been decreased (or increased in the case of the net loss) to the pro forma amounts indicated below for the three years ended March 31, 1999:
(In thousands, except per share data) 1999 1998 1997 ------ --------- ----- Consolidated Net Income (Loss): As reported $1,706 $ (9,581) $ 845 Pro forma $1,382 $(10,076) $ 372 ====== ======== ===== Consolidated Net Income (Loss) per Share: As reported Basic and diluted $ .12 $ (.71) $ .06 ====== ======== ===== Pro forma Basic and diluted $ .10 $ (.75) $ .03 ====== ======== =====
The weighted-average fair value of options granted during fiscal 1999, 1998 and 1997 was $4.49, $3.25 and $7.19, respectively, using the Black-Scholes option- pricing model with the following weighted-average assumptions: Fiscal 1999, 1998 and 1997 -- expected volatility of 60%, risk-free interest rates of 5.5% - 6.7%, no expected dividends and an expected life of three to five years. Pro forma consolidated net income (loss) and net income (loss) per share reflects only options granted in fiscal 1999, 1998 and 1997. Therefore, the full impact of calculating compensation cost for stock options under SFAS No. 123 is not reflected in the pro forma consolidated net income (loss) and net income (loss) - -------------------------------------------------------------------------------- Image Entertainment, Inc. 61 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - -------------------------------------------------------------------------------- per share amounts presented above because compensation cost is reflected over the option vesting periods of up to four years and compensation cost for options granted prior to April 1, 1995 are not considered. Note 11. Income Taxes. Income tax expense (benefit) for the three years ended March 31, 1999, all current, are summarized as follows:
(In thousands) 1999 1998 1997 ----- ------ ---- Federal $ 88 $ (55) $ 32 State 2 3 345 ----- ----- ----- $ 90 $ (52) $ 377 ===== ===== =====
The tax effects of temporary differences that give rise to a significant portion of the deferred tax assets at March 31, 1999 and 1998 are presented below:
(In thousands) 1999 1998 -------- -------- Deferred tax assets: Inventory reserves $ 3,946 $ 3,639 Net operating loss carryforwards 728 755 Other 557 818 Installment sales 396 396 Sales returns reserve 313 388 Store closure expenses 44 92 Royalty reserves 174 848 Bad debt reserve 210 162 Tax credits 329 329 ------- ------- Deferred tax assets 6,697 7,427 Less valuation allowance (6,697) (7,372) ------- ------- Net deferred tax assets $ -- $ 55 ======= =======
Expected income tax expense based on Federal statutory rates for the three years ended March 31, 1999 differed from actual tax expense as follows:
(In thousands) 1999 1998 1997 ------ -------- ------ Expected income tax expense (benefit) $ 626 $(3,275) $ 415 State income taxes, net of Federal benefit 73 3 73 Change in valuation allowance (675) 3,206 (28) Other 66 14 (83) ----- ------- ----- $ 90 $ (52) $ 377 ===== ======= =====
Note 12. Other Items - Statements of Operations. Fourth Quarter Adjustments in Fiscal 1998 and 1997. During the fourth quarter - -------------------------------------------------- of fiscal 1998, the Company recorded pretax noncash charges of $6,263,000 and $4,246,000 to reduce the carrying value of its LD inventory to its net realizable value and to provide for estimated losses on LD license and exclusive distribution agreements, respectively. The provisions were in response to a greater than expected decline - -------------------------------------------------------------------------------- 62 Image Entertainment, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - -------------------------------------------------------------------------------- in the Company's quarterly LD sales and the continued adverse effect DVD has had on the LD market. The Company's decision to record these charges in the fourth quarter was based on industry-wide statistics and other relevant published data on DVD and LD trends and the incrementally adverse impact these trends had on the Company's operations during the fourth quarter of fiscal 1998 and would appear to continue having on the Company's operations in the foreseeable future. The charges are reflected as a component of cost of sales in the accompanying consolidated statements of operations for fiscal 1998. Also during the fourth quarter of fiscal 1998, the Company recorded a nonrecurring pretax charge of $825,000 associated with the closure of its subsidiary, U.S. Laser. The charge is reflected as costs of facility closure in the accompanying consolidated statement of operations for fiscal 1998. During the fourth quarter of fiscal 1997, the Company recorded pretax provisions for slow-moving LD inventory and estimated doubtful accounts receivable of $1,214,000 and $792,000, respectively. The charges are reflected as a component of cost of sales and general and administrative expenses, respectively, in the accompanying consolidated statement of operations for fiscal 1997. Acquisition Expenses. During the third quarter of fiscal 1997, the Company - -------------------- recorded a nonrecurring pretax charge of $662,000 consisting primarily of professional fees incurred in connection with negotiations to acquire Essex Entertainment, Inc., a privately held New Jersey-based corporation. Acquisition negotiations were terminated in December 1996. The charge is reflected as other expense in the accompanying consolidated statement of operations for fiscal 1997. Note 13. Commitments and Contingencies. Operating Leases. In March 1999, the Company amended its existing lease for its - ---------------- corporate office space (30,080 square feet) in Chatsworth, California, extending the lease term four years through April 30, 2004. The existing lease provided for monthly rent of approximately $14,500 (subject to annual adjustment based upon increases in the Consumer Price Index("CPI")) and an expiration date of March 31, 2000. Commencing April 1, 2000, monthly rent will be increased to $17,450, with annual upward adjustments based upon the CPI. Concurrent with the March 1999 amendment of its existing lease, the Company leased additional office space (15,440 square feet) adjacent to its corporate office space. The lease term is five years commencing May 1, 1999 and co- terminates with the corporate office space lease on April 30, 2004. Monthly rent for the first annual lease period is $10,000 with annual scheduled rent increases up to a monthly rent of $11,000 in the fourth year of the lease. The scheduled increase during the last year of the lease is based upon the CPI. The lease for the Company's warehouse space (48,300 square feet) in Chatsworth, California provided for monthly rent of $23,500 (subject to annual adjustment based upon increases in the CPI). On February 2, 1998, the Company entered into a Surrender of Lease and Termination Agreement (the "Termination Agreement"). The Termination Agreement provided for the Company to surrender the lease for the warehouse space on August 31, 1998 ("Termination Date"). The Company extended the Termination Date on a month-to-month basis through May 16, 1999. In consideration for the early termination of the lease which would have otherwise terminated on March 31, 2000, the Company paid $50,000 on the Termination Date. Effective May 16, 1999, the Company relocated its warehousing and distribution operations to Nevada. - -------------------------------------------------------------------------------- Image Entertainment, Inc. 63 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - -------------------------------------------------------------------------------- The lease for the Ken Crane's retail facility (8,102 square feet) located in Westminster, California provides for monthly rent of $14,000 (subject to annual adjustment based upon increases in the CPI). The lease terminates on November 22, 2002. Future minimum annual rental payments under operating leases at March 31, 1999 are approximately as follows:
Fiscal Amount ---------- ---------- (In thousands) 2000 $ 492 2001 505 2002 508 2003 439 2004 341 Thereafter 29 ------ $2,314 ======
Rent expense was $487,000, $570,000 and $538,000 for fiscal 1999, 1998 and 1997, respectively. Other. At March 31, 1999, the Company's future obligations for royalty - ----- advances, minimum royalty guarantees and exclusive distribution fee guarantees under the terms of existing licenses and exclusive distribution agreements, respectively, are as follows:
Fiscal Amount ---------- --------- (In thousands) 2000 $ 4,890 2001 445 ------- $ 5,335 =======
In the normal course of business, the Company is subject to proceedings, lawsuits and other claims, including proceedings under government laws and regulations relating to employment and tax matters. While it is not possible to predict the outcome of these matters, it is the opinion of management, based on consultations with legal counsel, that the ultimate disposition of known proceedings will not have a material adverse impact on the Company's financial position, results of operations or liquidity. - -------------------------------------------------------------------------------- 64 Image Entertainment, Inc. NOTES TO FINANCIAL STATEMENTS - -------------------------------------------------------------------------------- Note 14. Quarterly Financial Data. (Unaudited) Summarized quarterly financial data for fiscal 1999 and 1998 is as follows:
Quarter Ended --------------------------------------------------------------------------------------- (In thousands, except per share data) June 30, September 30, December 31, March 31, ------------------ ------------------ ------------------ ------------------- 1998 1997 1998 1997 1998 1997 1999 1998 ------- ------ ------ ------ ------ ------ ------ ------ Net sales $17,140 $16,902 $13,834 $16,412 $22,715 $26,297 $23,037 $ 15,905 Operating income (loss) 367 (34) (532) (68) 1,474 1,467 1,369 (10,454)/(1)/ Income (loss) before extraordinary item 205 (191) (687) (184) 1,129 1,087 1,059 (10,293)/(1)/ Net income (loss) 205 (191) (687) (184) 1,129 1,087 1,059 (10,293)/(1)/ Net income (loss) per share/ (2)/ - Basic $ .02 $ (.01) $ (.05) $ (.01) $ .08 $ .08 $ .07 $ (.76) Diluted $ .02 $ (.01) $ (.05) $ (.01) $ .08 $ .08 $ .06 $ (.76) - ---------------------------
(1) Includes noncash charges of $6,263,000 and $4,246,000 to reduce the carrying value of the Company's LD inventory to its net realizable value and provide for estimated losses on LD license and exclusive distribution agreements, respectively. Also includes nonrecurring charges totaling $825,000 relating to the closure of U.S. Laser. (2) Net income (loss) per share are computed independently for each of the quarters represented in accordance with SFAS No. 128. Therefore, the sum of the quarterly net income (loss) per share may not equal the total computed for the fiscal year or any cumulative interim period. - -------------------------------------------------------------------------------- Image Entertainment, Inc. 65 ITEM 9. Changes in and Disagreements with Accountants on Accounting and --------------------------------------------------------------- Financial Disclosure. -------------------- None. - -------------------------------------------------------------------------------- PART III - -------------------------------------------------------------------------------- ITEM 10. Directors and Executive Officers of the Registrant. -------------------------------------------------- The information required by this item is incorporated by reference from the information contained under the caption entitled "Election of Directors" in the Company's definitive proxy statement to be filed with the Securities and Exchange Commission (the "Commission") in connection with the Company's 1999 Annual Meeting of Shareholders. See also, Part I "Executive Officers of the Registrant." ITEM 11. Executive Compensation. ---------------------- The information required by this item is incorporated by reference from the information contained under the caption entitled "Executive Compensation" in the Company's definitive proxy statement to be filed with the Commission in connection with the Company's 1999 Annual Meeting of Shareholders. ITEM 12. Security Ownership of Certain Beneficial Owners and Management. -------------------------------------------------------------- The information required by this item is incorporated by reference from the information contained under the caption entitled "Security Ownership of Certain Beneficial Owners and Management" in the Company's definitive proxy statement to be filed with the Commission in connection with the Company's 1999 Annual Meeting of Shareholders. ITEM 13. Certain Relationships and Related Transactions. ---------------------------------------------- The information required by this item is incorporated by reference from the information contained under the caption entitled "Certain Relationships and Related Transactions" in the Company's definitive proxy statement to be filed with the Commission in connection with the Company's 1999 Annual Meeting of Shareholders. - -------------------------------------------------------------------------------- 66 Image Entertainment, Inc. - -------------------------------------------------------------------------------- PART IV - -------------------------------------------------------------------------------- ITEM 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K. ---------------------------------------------------------------
(a) THE FOLLOWING DOCUMENTS ARE FILED AS A PART OF THIS REPORT. Page ---- 1. Financial Statements: Independent Auditors' Report............................................................................. 41 Consolidated Balance Sheets at March 31, 1999 and 1998................................................... 42 Consolidated Statements of Operations for the years ended March 31, 1999, 1998 and 1997..................................................................... 44 Consolidated Statements of Shareholders' Equity for the years ended March 31, 1999, 1998 and 1997..................................................................... 45 Consolidated Statements of Cash Flows for the years ended March 31, 1999, 1998 and 1997..................................................................... 46 Notes to Consolidated Financial Statements............................................................... 49 2. Financial Statement Schedule: Schedule II - Valuation and Qualifying Accounts.......................................................... 68 3. Exhibits: See the Exhibit Index on pages i - vi.
(b) REPORTS ON FORM 8-K. On January 22, 1999, the Company filed a Current Report on Form 8-K (the "1-22-99 Report") that reported, pursuant to Item 2 of Form 8-K, that the Company (through Image Newco, Inc.), had completed its acquisition of Ken Crane's, pursuant to the Purchase Agreement. On March 23, 1999, the Company filed a Current Report on Form 8-K/A that amended the 1-22-99 Report to include, pursuant to Item 7 of Form 8-K, (1) audited financial statements of Ken Crane's for the fiscal year ended July 31, 1998 and (2) pro forma consolidated financial statements for the Company and Ken Crane's. - -------------------------------------------------------------------------------- Image Entertainment, Inc. 67 SCHEDULE II -- Valuation and Qualifying Accounts -- For the Years Ended March 31, 1999, 1998 and 1997 ================================================================================
Allowance for Doubtful Accounts -------------------------------------------------------- Additions Balance at Charged to Balance Beginning Costs and Amounts at End (In thousands) of Year Expenses Written-Off of Year --------- ---------- ------------- --------- For the Year Ended March 31, 1999: $ 404 $ 144 $ (23) $ 525 ========= ======== ========= ======== For the Year Ended March 31, 1998: $ 1,629 $ (331) $ (894) $ 404 ======== ======== ========== ======== For the Year Ended March 31, 1997: $ 333 $ 1,946 $ (650) $ 1,629 ======== ======== ========== ======== Allowance for Sales Returns -------------------------------------------------------- Additions Balance at Charged to Balance Beginning Costs and Amounts at End (In thousands) of Year Expenses Written-Off of Year --------- ---------- ------------- --------- For the Year Ended March 31, 1999: $ 4,200 $ 3,146 $ (4,396) $ 2,950 ========= ========== =========== ======== For the Year Ended March 31, 1998: $ 3,180 $ 5,457 $ (4,437) $ 4,200 ======== ========== ========== ======== For the Year Ended March 31, 1997: $ 2,850 $ 9,385 $ (9,055) $ 3,180 ======== ========== ========== ======== Reserve for Slow-Moving Inventory -------------------------------------------------------- Additions Balance at Charged to Balance Beginning Costs and Amounts at End (In thousands) of Year Expenses Written-Off of Year --------- ---------- ------------- --------- For the Year Ended March 31, 1999: $ 9,098 $ 1,831 $ (1,638) $ 9,291 ======== ========== ========== ======== For the Year Ended March 31, 1998: $ 3,070 $ 8,133 $ (2,105) $ 9,098 ======== ========== ========== ======== For the Year Ended March 31, 1997: $ 1,219 $ 1,964 $ (113) $ 3,070 ======== ========== ========== ========
- -------------------------------------------------------------------------------- 68 Image Entertainment, Inc. - -------------------------------------------------------------------------------- SIGNATURES - -------------------------------------------------------------------------------- Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. IMAGE ENTERTAINMENT, INC., a California corporation Dated: June 25, 1999 By:/s/ MARTIN W. GREENWALD ----------------------------------------------- MARTIN W. GREENWALD, Chairman of the Board, Chief Executive Officer, President & Treasurer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Dated: June 25, 1999 /s/ MARTIN W. GREENWALD ----------------------------------------------- MARTIN W. GREENWALD, Chairman of the Board, Chief Executive Officer, President & Treasurer Dated: June 25, 1999 /s/ JEFF M. FRAMER ----------------------------------------------- JEFF M. FRAMER, Chief Financial Officer (Principal Financial and Accounting Officer) Dated: June 25, 1999 /s/ STUART SEGALL ----------------------------------------------- STUART SEGALL, Vice President & Director Dated: June 25, 1999 /s/ IRA EPSTEIN ----------------------------------------------- IRA EPSTEIN, Director Dated: June 25, 1999 /s/ M. TREVENEN HUXLEY ----------------------------------------------- M. TREVENEN HUXLEY, Director - -------------------------------------------------------------------------------- Image Entertainment, Inc. 69 - -------------------------------------------------------------------------------- EXHIBIT INDEX - -------------------------------------------------------------------------------- Exhibit No. Description - ----------- ----------- 2.1 Asset Purchase Agreement dated as of August 20, 1998 by and between Image Newco, Inc. and Ken Crane's Magnavox City, Inc. Filed as Exhibit 2.1 to the Company's Registration Statement on Form S-2 (No.333-65611), effective December 21, 1998, and incorporated by reference herein. 2.1.a First Amendment to Asset Purchase Agreement dated as of October 3, 1998 by and between Image Newco, Inc. and Ken Crane's Magnavox City, Inc. Filed as Exhibit 2.2 to the Company's Registration Statement on Form S-2 (No.333-65611), effective December 21, 1998, and incorporated by reference herein. 3.1 Restated Articles of Incorporation. Filed as Exhibit 3.1 of the Company's Form 10-K for the year ended March 31, 1995, and incorporated by reference herein. 3.2 Bylaws. Filed as Exhibit 3.2 of the Company's Form 10-K for the year ended March 31, 1995, and incorporated by reference herein. 4.1 Specimen Common Stock certificate. Filed as Exhibit 4 to the Company's Registration Statement on Form S-2 (No.333-65611), effective December 21, 1998, and incorporated by reference herein. 4.2* Convertible Subordinated Promissory Note dated October 29, 1997 issued to Image Investors Co. pursuant to that certain Credit Agreement dated as of September 29, 1997 by and between the Company and Image Investors Co. 10.1+ The Company's Restated 1989 Incentive Stock Option Plan, as amended. Filed as Exhibit 10.1 of the Company's Form 10-K for the year ended March 31, 1992, and incorporated by reference herein. 10.2+ The Company's 1990 Stock Option Plan. Filed as Exhibit A of the Company's Proxy Statement dated December 27, 1990, and incorporated by reference herein. 10.3+ The Company's Restated 1992 Stock Option Plan. Filed as Exhibit A of the Company's Proxy Statement dated September 9, 1994, and incorporated by reference herein. 10.4+ The Company's 1994 Eligible Directors Stock Option Plan and Form of Eligible Director Non-Qualified Stock Option Agreement. Filed as Exhibit 10.4 of the Company's Form 10-K for the year ended March 31, 1995, and incorporated by reference herein. 10.5+ The Company's 1998 Incentive Plan. Filed as Exhibit A to the Company's Notice of Annual Meeting and Proxy Statement dated July 29, 1998, and incorporated herein by this reference. - -------------------------------------------------------------------------------- Image Entertainment, Inc. i 10.5.a* Form of Employee (Nonqualified) Stock Option Grant Agreement under the Company's 1998 Incentive Plan. 10.6+ Eligible Director Non-Qualified Stock Option Agreement dated as of July 22, 1998 between the Company and Stuart Segall. Filed as Exhibit 10.9 to the Company's Registration Statement on Form S-2 (No.333-65611), effective December 21, 1998, and incorporated by reference herein. 10.7+ Eligible Director Non-Qualified Stock Option Agreement dated as of September 17, 1998 between the Company and Mark Trevenen Huxley. Filed as Exhibit 10.10 to the Company's Registration Statement on Form S-2 (No.333-65611), effective December 21, 1998, and incorporated by reference herein. 10.8+ Form of Option Agreement dated October 15, 1991 between the Company and Martin W. Greenwald. Filed as Exhibit 10.3 of the Company's 10-Q for the quarter ended September 30, 1991, and incorporated by reference herein. 10.9+ Option granted August 13, 1992 by the Company to Cheryl Lee. Filed as Exhibit 10.12 of the Company's Form 10-K for the year ended March 31, 1994, and incorporated by reference herein. 10.10+ Form of Option granted May 19, 1994 to Jeff Framer, Cheryl Lee and David Borshell. Filed as Exhibit 10.24 to the Company's Form 10-K for the year ended March 31, 1994, and incorporated by reference herein. 10.11+ Form of Termination Agreement between the Company and each of Martin W. Greenwald, Cheryl Lee, Jeff Framer and David Borshell (relating to the termination of their former employment agreements). Filed as Exhibit 10.11 to the Company's Registration Statement on Form S-2 (No.333-65611), effective December 21, 1998, and incorporated by reference herein. 10.12+ Employment Agreement dated as of July 1, 1998 between the Company and Martin W. Greenwald. Filed as Exhibit 10.12 to the Company's Registration Statement on Form S-2 (No.333-65611), effective December 21, 1998, and incorporated by reference herein. 10.13+ Employment Agreement dated as of July 1, 1998 between the Company and Cheryl Lee. Filed as Exhibit 10.13 to the Company's Registration Statement on Form S-2 (No.333-65611), effective December 21, 1998, and incorporated by reference herein. 10.14+ Employment Agreement dated as of July 1, 1998 between the Company and Jeff Framer. Filed as Exhibit 10.14 to the Company's Registration Statement on Form S-2 (No.333-65611), effective December 21, 1998, and incorporated by reference herein. 10.15+ Employment Agreement dated as of July 1, 1998 between the Company and David Borshell. Filed as Exhibit 10.15 to the Company's Registration Statement on Form S-2 (No.333-65611), effective December 21, 1998, and incorporated by reference herein. - -------------------------------------------------------------------------------- ii Image Entertainment, Inc. 10.16+ Form of 1998 Performance Restricted Stock Unit Award Agreement (and related General Provisions) between the Company and each of Martin W. Greenwald, Cheryl Lee, Jeff Framer and David Borshell (appended as Exhibit A to Exhibits 10.12 through 10.15). Filed as Exhibit 10.16 to the Company's Registration Statement on Form S-2 (No.333-65611), effective December 21, 1998, and incorporated by reference herein. 10.17+ Form of Indemnity Agreement between the Company and its directors and officers. Filed as Exhibit F of the Company's Proxy Statement dated September 5, 1989, and incorporated by reference herein. 10.18 Stock Purchase Agreement among the Company, Directors of the Company and various Buyers dated December 29, 1987. Filed as Exhibit 4.3 of the Company's Form 8-K dated December 29, 1987, and incorporated by reference herein. 10.18.a Form of First Amendment, dated July 7, 1992, to the Stock Purchase Agreement among the Company, Directors of the Company and various Buyers dated December 29, 1987. Filed as Exhibit 10.5 of the Company's Form 10-Q for the quarter ended September 30, 1992, and incorporated by reference herein. 10.19 Stock Purchase Agreement among the Company, Directors of the Company and Image Investors Co. dated June 27, 1990. Filed as Exhibit 10.53 of the Company's Form 10-K for the year ended March 31, 1990. The Company and Image Investors Co. are parties to Stock Purchase Agreements dated July 14, 1988, November 30, 1988, January 11, 1989, February 14, 1989, May 10, 1989 and June 20, 1990, which are virtually identical to this Exhibit except for the number of shares of Common Stock purchased, and incorporated by reference herein. 10.20 Stock Purchase Agreement between the Company and Image Investors Co. dated December 30, 1992, including Warrant. Filed as Exhibit 10.6 of the Company's Form 10-Q for the quarter ended December 31, 1992, and incorporated by reference herein. 10.21 Stock Purchase Agreement between the Company and Stuart Segall dated as of July 12, 1995. Filed as Exhibit 10.1 of the Company's Form 10-Q for the quarter ended September 30, 1996, and incorporated by reference herein. 10.22 Stock Purchase Agreement between the Company and Martin W. Greenwald dated as of June 27, 1996. Filed as Exhibit 10.2 of the Company's Form 10-Q for the quarter ended September 30, 1996, and incorporated by reference herein. 10.23 Purchase and Sale Agreement between the Company and LEI Partners, L.P. dated December 31, 1990. Filed as Exhibit 10.1 of the Company's Form 10-Q for the quarter ended December 31, 1990, and incorporated by reference herein. 10.24 Standard Industrial Lease for 9333 Oso Avenue, Chatsworth, California, dated December 1, 1993 and effective April 1, 1994, between the Company and P&R Investment Company. Filed as Exhibit 10.1 of the Company's Form 10-Q for the quarter ended December 31, 1993. - -------------------------------------------------------------------------------- Image Entertainment, Inc. iii 10.24.a* First Amendment dated August 20, 1996 to Standard Industrial Lease for 9333 Oso Avenue, Chatsworth, California, dated December 1, 1993 and effective April 1, 1994, by and between the Company and P&R Investment Company. 10.24.b* Second Amendment dated March 1, 1999 to Standard Industrial Lease for 9333 Oso Avenue, Chatsworth, California, dated December 1, 1993 and effective April 1, 1994, by and between the Company and P&R Investment Company. 10.25* Standard Industrial Lease for 9349 Oso Avenue, Chatsworth, California, dated March 1, 1999 and effective May 1, 1990, between the Company and P&R Investment Company. 10.26 Agreement for Purchase and Sale dated June 5, 1996 between Airport Center Partnership and the Company. Filed as Exhibit 10.19 of the Company's Form 10-K for the year ended March 31, 1996, and incorporated by reference herein. 10.27 Construction Agreement between the Company and Carson Construction Management, Inc. dated as of November 25, 1996. Filed as Exhibit 10.23 of the Company's Form 10-K for the year ended March 31, 1997, and incorporated by reference herein. 10.28 Business Loan Agreement between the Company and Bank of America National Trust and Savings Association dated March 10, 1997. Filed as Exhibit 10.23 to the Company's Form 10-K for the fiscal year ended March 31, 1998, and incorporated by reference herein. 10.28.a Amendment No. 1 dated as of February 4, 1998 to Business Loan Agreement between the Company and Bank of America National Trust and Savings Association dated March 10, 1997. Filed as Exhibit 10.23.a to the Company's Form 10-K for the fiscal year ended March 31, 1998, and incorporated by reference herein. 10.28.b Amendment No. 2 dated as of June 29, 1998 to Business Loan Agreement between the Company and Bank of America National Trust and Savings Association dated March 10, 1997. Filed as Exhibit 10.3 to the Company's Form 10-Q for the quarter ended June 30, 1998, and incorporated by reference herein. 10.29 Lease Intended as Security between the Company and BA Leasing & Capital Corporation dated March 19, 1997. Filed as Exhibit 10.24 to the Company's Form 10-K for the fiscal year ended March 31, 1998, and incorporated by reference herein. 10.29.a (First) Amendment dated March 19, 1997 to Lease Intended as Security between the Company and BA Leasing & Capital Corporation dated March 19, 1997. Filed as Exhibit 10.24.a to the Company's Form 10-K for the fiscal year ended March 31, 1998, and incorporated by reference herein. 10.29.b Second Amendment dated February 8, 1998 to Lease Intended as Security between the Company and BA Leasing & Capital Corporation dated March 19, 1997. Filed as Exhibit 10.24.b to the Company's Form 10-K for the fiscal year ended March 31, 1998, and incorporated by reference herein. - -------------------------------------------------------------------------------- iv Image Entertainment, Inc. 10.29.c Third Amendment dated September 25, 1998 to Lease Intended as Security between the Company and BA Leasing & Capital Corporation dated March 19, 1997. Filed as Exhibit 10.1 to the Company's Form 10-Q for the quarter ended September 30, 1998. 10.30 Loan Agreement between the Company and Union Bank of California, N.A. dated as of December 17, 1996. Filed as Exhibit 10.20 of the Company's Form 10-K for the year ended March 31, 1997, and incorporated by reference herein. 10.30.a Amendment No. 1 dated as of February 5, 1997 to Loan Agreement dated as of December 17, 1996 by and between the Company and Union Bank of California, N.A. Filed as Exhibit 10.20.A of the Company's Form 10-K for the year ended March 31, 1997, and incorporated by reference herein. 10.30.b Amendment No. 2 dated as of February 25, 1997 to Loan Agreement dated as of December 17, 1996 by and between the Company and Union Bank of California, N.A. Filed as Exhibit 10.20.B of the Company's Form 10-K for the year ended March 31, 1997, and incorporated by reference herein. 10.30.c Amendment No. 3 dated as of September 27, 1997 to Loan Agreement dated as of December 17, 1996 by and between the Company and Union Bank of California, N.A. Filed as Exhibit 10.26.c to the Company's Form 10-K for the fiscal year ended March 31, 1998, and incorporated by reference herein. 10.30.d Amendment No. 4 dated as of October 31, 1997 to Loan Agreement dated as of December 17, 1996 by and between the Company and Union Bank of California, N.A. Filed as Exhibit 10.26.d to the Company's Form 10-K for the fiscal year ended March 31, 1998, and incorporated by reference herein. 10.30.e Amendment No. 5 dated as of January 28, 1998 to Loan Agreement dated as of December 17, 1996 by and between the Company and Union Bank of California, N.A. Filed as Exhibit 10.26.e to the Company's Form 10-K for the fiscal year ended March 31, 1998, and incorporated by reference herein. 10.30.f Amendment No. 6 dated as of June 18, 1998 to Loan Agreement dated as of December 17, 1996 by and between the Company and Union Bank of California, N.A. Filed as Exhibit 10.26.f to the Company's Form 10-K for the fiscal year ended March 31, 1998, and incorporated by reference herein. 10.30.g Amendment No. 7 dated as of July 13, 1998 to Loan Agreement dated as of December 17, 1996 by and between the Company and Union Bank of California, N.A. Filed as Exhibit 10.2 to the Company's Form 10-Q for the quarter ended June 30, 1998. 10.30.h Amendment No. 8 dated as of October 23, 1998 to Loan Agreement dated as of December 17, 1996 by and between the Company and Union Bank of California, N.A. Filed as Exhibit 10.2 to the Company's Form 10-Q for the quarter ended September 30, 1998. - -------------------------------------------------------------------------------- Image Entertainment, Inc. v 10.31 Credit Agreement dated as of September 29, 1997 by and between the Company and Image Investors Co. Filed as Exhibit 10.27 to the Company's Form 10-K for the fiscal year ended March 31, 1998, and incorporated by reference herein. 10.32 Loan and Security Agreement dated as of December 28, 1998 by and between the Company and Foothill Capital Corporation, including Capital Expenditure Loan Note and Trademark Security Agreement. Filed as Exhibit 10.1 to the Company's Form 10-Q for the quarter ended December 31, 1998. 21* Subsidiaries of the Registrant. 23* Consent Letter of KPMG, Independent Certified Public Accountants. 27* Financial Data Schedule Fiscal Year Ended March 31, 1999. - -------------------------------------------------------------------------------- * Exhibit(s) not previously filed with the Securities and Exchange Commission. + Management Contracts, Compensatory Plans or Arrangements. - -------------------------------------------------------------------------------- vi Image Entertainment, Inc. EX-4.2 2 PROMISSORY NOTE DTD 10/29/1997 EXHIBIT 4.2 CONVERTIBLE SUBORDINATED PROMISSORY NOTE $5,000,000 New York, New York October 29, 1997 FOR VALUE RECEIVED, the undersigned, Image Entertainment, Inc., a California corporation (Borrower), hereby unconditionally promises to pay to -------- the order of Image Investors Co., a Delaware corporation (the "Lender"), in ------ lawful money of the United States of America and in immediately available funds, on the Termination Date, or such earlier date as payment shall be due, whether by acceleration or otherwise in accordance with the Credit Agreement (as defined below), at such office as the Lender may designate in writing, from time to time, the principal amount of FIVE MILLION DOLLARS ($5,000,000). The Borrower further agrees to pay interest in like money on the unpaid principal amount outstanding at the rates and on the dates specified in subsection 1.4 of the Credit Agreement. This Note (a) is the Note referred to in the Credit Agreement dated as of September 29, 1997 (as amended, supplemented or otherwise modified from time to time, the "Credit Agreement"), between the Borrower and the Lender, (b) is ---------------- entitled to the benefits of and is subject to the provisions of the Credit Agreement, except to the extent such provisions conflict with the provisions of this Note, and (c) is subject to optional and mandatory prepayment in whole or in part as provided in the Credit Agreement. This Note may be converted into shares of common stock of the Borrower in accordance with Subsection 1.7 of the Credit Agreement. As set forth in Subsection 1.11 of the Credit Agreement, the indebtedness represented by this Note is subordinated in accordance with the following provisions (the "Subordination Provisions"): ------------------------ 1. Borrower covenants and agrees, and Lender by its acceptance hereof likewise covenants and agrees, that, to the extent and in the manner hereinafter set forth in Sections 1 through 5 of these Subordination Provisions, the indebtedness represented by this Note and the payment of principal of this Note and interest thereon and any other obligations or claims in respect hereof (including but not limited to any fees or expenses of collection, post-petition interest or claims for indemnity) is hereby expressly made subordinate and subject in right of payment and in reorganization, liquidation or bankruptcy to the prior payment in full of all Senior Indebtedness (defined below). a. "Senior Indebtedness" means all Indebtedness (defined below), whenever created or incurred, under that certain Loan Agreement, dated as of December 17, 1996, between Borrower and Union Bank of California, N.A., as amended and as may be further amended, modified, restated, renewed and extended, other than Indebtedness under the Credit Agreement or this Note or Indebtedness expressly excluded as Senior Indebtedness hereinbelow. i. Union Bank of California may expressly rely on these Subordination Provisions. ii. Notwithstanding anything to the contrary set forth above, "Senior Indebtedness" shall not include any Indebtedness which by the express terms of the agreement or instrument creating, evidencing or governing the same is pari passu with or subordinate in right of payment to the obligations under this Note. b. "Indebtedness" means (A) all indebtedness, obligations and other liabilities (contingent or otherwise) for or in respect of borrowed money or evidenced by bonds, debentures, notes or similar instruments (whether or not the recourse of the lender is to the whole of the assets of Borrower or to only a portion thereof); (B) all reimbursement obligations and other liabilities (contingent or otherwise) of Borrower with respect to letters of credit or bankers' acceptances issued for the account of such person or with respect to interest rate protection agreements or currency exchange agreements; (iii) all obligations and other liabilities (contingent and otherwise) of Borrower with respect to any conditional sale, installment sale or other title retention agreement, purchase money mortgage or security interest, or otherwise to pay the deferred purchase price of property or services (except trade accounts payable and accrued expenses arising in the ordinary course of business) or in respect of any sale and leaseback arrangement; (iv) all obligations and liabilities (contingent or otherwise) in respect of leases by Borrower as lessee which, in conformity with generally accepted accounting principles, are required to be accounted for as 2 capitalized lease obligations on the balance sheet of Borrower; and (v) all direct or indirect guaranties or similar agreements in respect of, and obligations or liabilities (contingent or otherwise) to purchase or otherwise acquire or otherwise to assure a creditor against loss in respect of, indebtedness, obligations or liabilities of others. 2. In the event of (a) any insolvency or bankruptcy case or proceeding, or any receivership, liquidation, reorganization or other similar case or proceeding in connection therewith, relative to Borrower or to its creditors, as such, or to its assets, or (b) any liquidation, dissolution, whether voluntary or involuntary and whether or not involving insolvency or bankruptcy, or (c) any assignment for the benefit of creditors or any other marshaling of assets and liabilities of Borrower, then and in any such event the holder of the Senior Indebtedness shall be entitled to received payment in full of all amounts due or to become due on or in respect of all Senior Indebtedness, before the Lender is entitled to receive any payment on account of principal of or interest or any other amount on or in respect of this Note, and to that end the holder of the Senior Indebtedness shall be entitled to received, for application to the payment thereof, any payment or distribution of any kind or character, whether in cash, property or securities, including any such payment or distribution which may be payable or deliverable by reason of the payment of any other indebtedness of Borrower being subordinated to the payment of this Note, which may be payable or deliverable in respect to this Note in any such case, proceeding, dissolution, liquidation or other winding up or event. 3. If notwithstanding the foregoing provisions of Sections 1 and 2, the Lender shall have received any payment or distribution of assets of Borrower of any kind or character, whether in cash, property or securities, including any such payment or distribution which may be payable or deliverable by reason of the payment of any other indebtedness of Borrower being subordinated to the payment of this Note, before all Senior Indebtedness is paid in full or payment thereof provided for, and if such fact shall, at or prior to the time of such payment or distribution, have been made known to the Lender, any such payment or distribution of assets so received shall be held in trust for the holder of Senior Indebtedness and (x) shall be paid to such holder (pro rata) to the extent necessary to make payment in full in cash or cash equivalent of all Senior Indebtedness (and, in the case of Senior Indebtedness in respect of letters of credit not yet drawn upon, necessary to be fully secured by cash collateral) after giving effect to any concurrent payment or distribution to or for the benefit of such holder or (y) shall be paid over or delivered forthwith to the trustee in bankruptcy, 3 receiver, liquidating trustee, custodian, assignee, agent or other person making payment or distribution of assets of Borrower for application to the payment of all Senior Indebtedness remaining unpaid, to the extent necessary to pay all Senior Indebtedness in full, after giving effect to any concurrent payment or distribution to or for the holder of the Senior Indebtedness. 4. Upon the maturity of any Senior Indebtedness by lapse of time, acceleration or otherwise, then unless such acceleration shall have been rescinded or shall have otherwise ceased to exist, or the time for payment extended, all principal thereof and premium, if any, and interest thereon and all other claims with respect thereto shall first be paid in full, before any payment is made on account of principal of or interest on or any other claim with respect to this Note. Upon any event of default (or upon the receipt by Borrower of written notice of any other event of default) with respect to any Senior Indebtedness, then, unless and until such payment has been made or the event of default shall have been cured or waived in writing or shall have ceased to exist or the holder of the Senior Indebtedness shall have otherwise agreed in writing, no direct or indirect payment shall be made by Borrower with respect to the principal of or interest on or any other amount or claim with respect to this Note. 5. Nothing contained in this Note shall prevent Borrower, at any time except during the pendency of an event of default under any Senior Indebtedness or any case, proceeding, dissolution, liquidation or other winding up, assignment for the benefit of creditors or other marshaling of assets and liabilities of Borrower referred to in Section 2 above, from making payments of principal of or interest on this Note when otherwise due. 6. Subject to the payment in full of all Senior Indebtedness, the Lender shall be subrogated to the extent of the payments or distributions made to the holder of such Senior Indebtedness pursuant to the provisions of these Subordination Provisions to the rights of the holder of such Senior Indebtedness to receive payments and distributions of cash, property and securities applicable to the Senior Indebtedness until the principal of, and interest, if any, on this Note shall be paid in full. For purposes of such subrogation, no payments or distributions to the holder of the Senior Indebtedness of any cash, property or securities to which the Lender would be entitled except for the provisions of these Subordination Provisions, and no payments made pursuant to the provisions of these Subordination Provisions to the holder of Senior Indebtedness by Lender, shall, as among Borrower, its creditors other than holder of Senior 4 Indebtedness and Lender, be deemed to be a payment or distribution by Borrower to or on account of the Senior Indebtedness. 7. The provisions of these Subordination Provisions are and are intended solely for the purpose of defining the relative rights of the Lender of this Note, on the one hand, and the holder of Senior Indebtedness, on the other hand. Such provisions are for the benefit of the holder of Senior Indebtedness (and their successors and assigns) and shall be enforceable by them directly against the Lender (and its successors and assigns) of this Note. These Subordination Provisions shall constitute a continuing offer to all persons who become holder of, or continue to hold, Senior Indebtedness (whether such Senior Indebtedness was created or acquired before or after the issuance of this Note). These Subordination Provisions may not be amended without the consent of each Lender of Senior Indebtedness that may be adversely affected thereby. Nothing contained in these Subordination Provisions or elsewhere in this Note is intended to or shall: (i) impair, as among Borrower, its creditors other than Lenders of Senior Indebtedness and the Lender, the obligation of Borrower, which is absolute and unconditional, to pay to the Lender the principal of and interest on this Note as and when the same shall become due and payable in accordance with its terms; or (ii) affect the relative rights against Borrower of the Lender and creditors of Borrower other than the holder of Senior Indebtedness; or (iii) prevent the Lender from exercising all remedies otherwise permitted by applicable law upon default under this Note, subject to the rights, if any, under or by reason of these Subordination Provisions, of the holder of Senior Indebtedness to receive cash, property and securities otherwise payable or deliverable to or received by Lender. 8. No right of any present or future holder of any Senior Indebtedness to enforce subordination as provided herein shall at any time in any way be prejudiced or impaired by any act or failure to act on the part of Borrower or by any act or failure to act, in good faith, by any such holder, or by any noncompliance by Borrower with the terms of this Note. The holder of Senior Indebtedness may extend, renew, modify or amend the terms of the Senior Indebtedness or any security therefor and release, sell or exchange such security and otherwise deal freely with Borrower, all without affecting the liabilities and obligations of the Lender of this Note. The Lender of this Note by its acceptance authorizes and expressly directs Borrower on the Lender's behalf to take such action as may be necessary or appropriate to effectuate the subordination provided in these Subordination Provisions and appoints the Company as attorney-in-fact for such purpose. 5 Upon the occurrence of any one or more of the Events of Default, all amounts then remaining unpaid on this Note shall become, or may be declared to be, immediately due and payable, all as provided in the Credit Agreement. No delay or omission on the part of the Lender or any holder hereof in exercising its rights under this Note, or delay or omission on the part of the Lender in exercising its rights under the Credit Agreement or under any other Loan Document, or course of conduct relating thereto, shall operate as a waiver of such rights or any other right of the Lender or any holder hereof, nor shall any waiver by the Lender of any such right or rights on any one occasion be deemed a bar to, or waiver of, the same right or rights on any future occasion. Upon an Event of Default, the Borrower agrees to pay or reimburse the Lender for all of its out-of-pocket costs and expenses incurred in connection with the collection of the principal amount of this Note, including reasonable outside attorneys' fees, if this Note is collected by or through an attorney-at- law or under advice therefrom. All parties now and hereafter liable with respect to this Note, whether maker, principal, surety, guarantor, endorser or otherwise, hereby waive presentment, demand, protest and all other notices of any kind. Unless otherwise defined herein, terms defined in the Credit Agreement and used herein shall have the meanings given to them in the Credit Agreement. THIS NOTE SHALL BE GOVERNED BY, AND CONSTRUED AND INTERPRETED IN ACCORDANCE WITH, THE LAW OF THE SATE OF NEW YORK. Image Entertainment, Inc. By: /s/ Martin W. Greenwald --------------------------------- Martin W. Greenwald, President 6 EX-10.5.A 3 FORM OF EMPLOYEE STOCK OPTION GRANT AGMT EXHIBIT 10.5.a IMAGE ENTERTAINMENT, INC. (the "Company") EMPLOYEE (NONQUALIFIED) STOCK OPTION GRANT AGREEMENT ---------------------------------------------------- THIS EMPLOYEE (NONQUALIFIED) STOCK OPTION AGREEMENT (the "Option Agreement") is between the Company and the Optionee named below and evidences the Company's grant to the Optionee of a Nonqualified Stock Option to purchase authorized but unissued shares of the Company's Common Stock. The Option is granted pursuant to and subject to the Company's 1998 Incentive Plan (the "Plan") and the Terms and Conditions for Nonqualified Stock Options Under the 1998 Incentive Plan (the "Terms"), incorporated herein by this reference. Optionee:------------------------ Vesting Schedule/1/,/2/: ------------------------------ Exercise Price Per Share: $-----/1/ ------------------------------ ------------------------------ Number of Shares:----------------/1/ ------------------------------ ------------------------------ Grant Date:---------------------- ------------------------------ ------------------------------ Expiration Date:-----------------/2/ ------------------------------ ----------------------------- _____________________________ /1/Subject to adjustment under Section 6.2 of the Plan. /2/Subject to early termination if the Optionee's employment terminates or in certain other circumstances. See Sections 4 through 6 of the Terms and Sections 1.6 and 6.2 of the Plan for exceptions and additional details regarding possible early termination of the Option. Optionee accepts the Option and agrees to and acknowledges receipt of a copy of the Plan and the Terms. IMAGE ENTERTAINMENT, INC. AGREED AND ACKNOWLEDGED: (a California corporation) _________________________________ By: ____________________________ (Optionee's Signature) Cheryl Lee, CAO & General Counsel _________________________________ (Address) _________________________________ (City, State, Zip Code) TERMS AND CONDITIONS FOR (NONQUALIFIED) OPTIONS GRANTED UNDER THE 1998 INCENTIVE PLAN 1. Exercisability of Option. The Option shall vest and become exercisable in ------------------------ percentage installments of the aggregate number of shares of Common Stock of the Company as set forth in the Option Agreement. The Option may be exercised only to the extent the Option is exercisable and vested. (a) Cumulative Exercisability. To the extent the Optionee does not ------------------------- purchase all the shares that the Optionee may exercise, the Optionee has the right cumulatively thereafter to purchase any shares not so purchased until the Option terminates or expires. (b) No Fractional Shares. Fractional share interests shall be -------------------- disregarded, but may be cumulated. (c) Minimum Exercise. No fewer than 100 shares may be purchased at any ---------------- one time, unless the number purchased is the total number at the time exercisable under the Option. 2. Method of Exercise of Option. To the extent exercisable, the Option may be ---------------------------- exercised by the delivery to the Company of an Exercise Agreement (a form of which is attached as Exhibit A) from the Optionee stating the number of shares to be purchased pursuant to the Option and accompanied by payment in one or a combination of the following methods: (a) by electronic funds transfer, or by certified or cashier's check payable to the order of the Company, in the full amount of the purchase price of the shares and amounts required to satisfy applicable withholding taxes; (b) by a promissory note of the Optionee consistent with the requirements of Sections 1.8 and 6.4 of the Plan if expressly authorized in writing by the Committee; (c) by notice and third party payment in such manner as may be authorized by the Committee; or (d) by the delivery of shares that have been held by the Optionee for at least six months, in accordance with Section 2.2.2(e) of the Plan, unless otherwise provided by the Committee. Other payment methods may be permitted only if expressly authorized by the Committee with respect to this Option or all options under the Plan. The Option is non-transferable and may be exercised only by the Optionee, except as the Committee may otherwise expressly permit. 3. Minimum Required Withholding on Exercise. The Plan provides that the ---------------------------------------- Company may, in its sole discretion, reduce the amount of shares deliverable or other amount payable to the Optionee upon exercise of an Option to satisfy minimum required statutory tax withholding rates. If the Company does elect to permit the Optionee to withhold shares in satisfaction of the tax withholding requirements, the Optionee shall not withhold in excess of the minimum required withholding rate. 4. Continuance of Employment Required. The vesting schedule requires ---------------------------------- continued service through each applicable vesting date as a condition to the vesting of the applicable installment and rights and benefits under this Option Agreement. Partial service, even if substantial, during any vesting period will not entitle the Optionee to any proportionate vesting or avoid or mitigate a termination of rights and benefits upon or following a termination of employment or service as provided in Section 5 below or under the Plan. 1 5. Effect of Termination of Employment or Death. If the Optionee's employment -------------------------------------------- by either the Company or any subsidiary terminates, the Option and all other rights and benefits under this Option Agreement terminate except that the Optionee may, at any time within the following applicable period after the Severance Date, exercise the Option to the extent the Option was exercisable on the Severance Date and has not otherwise expired: (a) Termination by the Company or a subsidiary, other than (1) a Termination for Cause (as defined below), (2) upon a voluntary resignation or retirement or (3) because of a Total Disability or death of the Optionee --- for a period of 3 months (b) Voluntary resignation (other than in anticipation of or in connection with a Termination for Cause) --- for a period of 3 months (c) Retirement --- for a period of 24 months (d) Total Disability or death of the Optionee --- for a period of 24 months In case of a Termination for Cause or a voluntary resignation in anticipation of or in connection with a Termination for Cause, the Option shall terminate immediately, in its entirety. "Termination for Cause" means a termination of service, based upon a finding by the Company, acting in good faith and based on its reasonable belief at the time, that the Optionee: (w) is or has been dishonest, incompetent, or negligent in the discharge of his or her duties to the Company; or has refused to perform stated or assigned duties; or (x) has committed a theft or embezzlement, or a breach of confidentiality or unauthorized disclosure or use of inside information, customer lists, trade secrets or other confidential information, or a breach of fiduciary duty involving personal profit, or a willful or negligent violation of any law, rule or regulation or of Company rules or policy, in any material respect; or has been convicted of a felony or misdemeanor (other than minor traffic violations or similar offenses); or (y) has materially breached any of the provisions of any agreement with the Company or an affiliate; or (z) has engaged in unfair competition with, or otherwise acted intentionally in a manner injurious to the reputation, business or assets of the Company; or has induced a customer to break or terminate any contract with the Company or an affiliate; or has induced any principal for whom the Company or an affiliate acts as agent to terminate such agency relationship. 6. Change in Subsidiary's Status; Leaves of Absence. ------------------------------------------------ (a) If the Optionee is employed by an entity that ceases to be a subsidiary of the Company, this event is deemed for purposes of this Option Agreement to be a termination of the Optionee's employment by the Company other than a Termination for Cause, voluntary resignation, retirement, Total Disability or death of Optionee. (b) Absence from work caused by military service, authorized sick leave or other leave approved in writing by the Company or the Committee shall not be considered a termination of employment by the Company for purposes of Section 5; provided that, unless 2 reemployment upon the expiration of such leave is guaranteed by contract or law, such leave is for a period of not more than 90 days. 7. Notices. Any notice to be given shall be in writing and addressed to the ------- Company at its principal office, to the attention of the Secretary, and to the Optionee at his or her last address of record, or at such other address as either party may hereafter designate in writing to the other for purposes of notices in respect of the Option. 8. Optionee Not a Stockholder. Neither the Optionee nor any other person -------------------------- entitled to exercise the Option shall have any of the rights or privileges of a stockholder of the Company as to any shares of Common Stock until the issuance and delivery to him or her of a certificate evidencing the shares registered in his or her name. No adjustment will be made for dividends or other rights as to a stockholder for which a record date is prior to such date of delivery. 9. No Employment Commitment by Company. Nothing contained in this Option ----------------------------------- Agreement or the Plan constitutes an employment commitment by the Company, affects the Optionee's status as an employee at will who is subject to termination without cause, confers upon the Optionee any right to remain employed by the Company or any subsidiary, interferes in any way with the right of the Company or any subsidiary at any time to terminate such employment, or affects the right of the Company or any subsidiary to increase or decrease the Optionee's other compensation. 10. Effect of Option Agreement. The Option Agreement shall be binding upon and -------------------------- inure to the benefit of any successor or successors of the Company, except to the extent the Committee determines otherwise. 11. Choice of Law. The construction, interpretation, performance and ------------- enforcement of the Option Agreement and the Option shall be governed by the laws of the State of California. 12. Defined Terms. Capitalized terms used herein and not otherwise defined ------------- herein shall have the meaning assigned by the Plan. The Option is not an Incentive Stock Option under the Plan or the Code. 13. Plan. The Option and all rights of Optionee thereunder are subject to, and ---- the Optionee agrees to be bound by, all of the terms and conditions of the provisions of the Plan. Unless otherwise expressly provided in these Terms and Conditions, provisions of the Plan that confer discretionary authority on the Committee do not (and shall not be deemed to) create any additional rights in the Optionee not expressly set forth in the Optionee's Option Agreement or in a written amendment thereto. If there is any conflict or inconsistency between the terms and conditions of the Option Agreement or these Terms and of the Plan, the terms and conditions of the Plan shall govern. 3 EX-10.24 4 LEASE FOR 9333 OSO AVENUE DTD 12/1/1993 EXHIBIT 10.24 STANDARD INDUSTRIAL LEASE -- NET AMERICAN INDUSTRIAL REAL ESTATE ASSOCIATION [LOGO OF AMERICAN INDUSTRIAL REAL ESTATE ASSOCIATION] 1. Parties. This Lease, dated, for reference purposes only, December 1, 1993, ----------------- is made by and between P & R Investment Company, a California General ---------------------------------------------- Partnership (herein called "Lessor") and Image Entertainment, Inc., a Colorado - ----------- ------------------------------------- Corporation (herein called "Lessee"). - ----------- 2. Premises. Lessor hereby leases to Lessee and Lessee leases from Lessor for the term, at the rental, and upon all of the conditions set forth herein, that certain real property situated in the County of Los Angeles State of ----------- California, commonly known as 9333 Oso Avenue, Chatsworth, CA 91311 and - ---------- ------------------------------------- described as an approximately 30,080 square foot industrial building on lots 8 & ------------------------------------------------------------------- 9, Tract 31225, recorded in Book 843, pages 62-65 in the office of the Los - -------------------------------------------------------------------------- Angeles County Recorder's Office and part of lot 7, Tract 31225 as shown on - --------------------------------------------------------------------------- Exhibit "A" attached hereto and made a part hereof by this reference. Said real - -------------------------------------------------------------------- property including the land and all improvements therein, is herein called "the Premises". 3. Term. 3.1 Term. The term of this Lease shall be for Six (6) Years commencing ------------- on April 1, 1994 and ending on March 31, 2000 unless sooner terminated pursuant ------------- -------------- to any provision hereof. See Addendum Paragraph 1 3.2 Delay in Possession. Notwithstanding said commencement date, if for any reason Lessor cannot deliver possession of the Premises to Lessee on said date, Lessor shall not be subject to any liability therefor, nor shall such failure affect the validity of this Lease or the obligations of Lessee hereunder or extend the term hereof, but in such case, Lessee shall not be obligated to pay rent until possession of the Premises is tendered to Lessee; provided, however, that if Lessor shall not have delivered possession of the Premises within sixty (60) days from said commencement date, Lessee may, at Lessee's option, by notice in writing to Lessor within ten (10) days thereafter, cancel this Lease, in which event the parties shall be discharged from all obligations hereunder; provided further, however, that if such written notice of Lessee is not received by Lessor within said ten (10) day period, Lessee's right to cancel this Lease hereunder shall terminate and be of no further force or effect. 3.3 Early Possession. If Lessee occupies the Premises prior to said commencement date, such occupancy shall be subject to all provisions hereof, such occupancy shall not advance the termination date, and Lessee shall pay rent for such period at the initial monthly rate set forth below. See Addendum Paragraph 2 4. Rent. Lessee shall pay to Lessor as rent for the Premises, monthly payments of $13,536.00, in advance, on the first day of each month of the term ---------- ----- hereof. Lessee shall pay Lessor upon the execution hereof $ as rent for --------- Rent for any period during the term hereof which is for less than one month shall be a pro rata portion of the monthly installment. Rent shall be payable in lawful money of the United States to Lessor at the address stated herein or to such other persons or at such other places as Lessor may designate in writing. 5. Security Deposit. Lessee has deposited, as a carry over from the Lease dated 4/10/89, with Lessor $13,536.00 as security for Lessee's faithful ---------- performance of Lessee's obligations hereunder. If Lessee fails to pay rent or other charges due hereunder, or otherwise defaults with respect to any provision of this Lease, Lessor may use, apply or retain all or any portion of said deposit for the payment of any rent or other charge in default or for the payment of any other sum to which Lessor may become obligated by reason of Lessee's default, or to compensate Lessor for any loss or damage which Lessor may suffer thereby. If Lessor so uses or applies all or any portion of said deposit, Lessee shall within ten (10) days after written demand therefor deposit cash with Lessor in an amount sufficient to restore said deposit to the full amount hereinabove stated and Lessee's failure to do so shall be a material breach of this Lease. If the monthly rent shall, from time to time, increase during the term of this Lease, Lessee shall thereupon deposit with Lessor additional security deposit so that the amount of security deposit held by Lessor shall at all times bear the same proportion to current rent as the original security deposit bears to the original monthly rent set forth in paragraph 4 hereof. Lessor shall not be required to keep said deposit separate from its general accounts. If Lessee performs all of Lessee's obligations hereunder, said deposit, or so much thereof as has not theretofore been applied by Lessor, shall be returned, without payment of interest or other increment for its use, to Lessee (or, at Lessor's option, to the last assignee, if any, of Lessee's interest hereunder) at the expiration of the term hereof, and after Lessee has vacated the Premises. No trust relationship is created herein between Lessor and Lessee with respect to said Security Deposit. See Addendum Paragraph 3 6. Use. 6.1 Use. The Premises shall be used and occupied only for Warehousing ----------- distribution and sales of laser video discs and related products or any other - ---------------------------------------------------------------- use which is reasonably comparable and for no other purpose. 6.2 Compliance with Law. (a) Lessor warrants to Lessee that the Premises, in its state existing on the date that the Lease term commences, but without regard to the use for which Lessee will use the Premises, does not violate any covenants or restrictions of record, or any applicable building code, regulation or ordinance in effect on such Lease term commencement date. In the event it is determined that this warranty has been violated, then it shall be the obligation of the Lessor, after written notice from Lessee, to promptly, at Lessor's sole cost and expense, rectify any such violation. In the event Lessee does not give to Lessor written notice of the violation of this warranty within six months from the date that the Lease term commences, the correction of same shall be the obligation of the Lessee at Lessee's sole cost. The warranty contained in this paragraph 6.2(a) shall be of no force or effect if, prior to the date of this Lease, Lessee was the owner or occupant of the Premises, and, in such event, Lessee shall correct any such violation at Lessee's sole cost. (b) Except as provided in paragraph 6.2(a), Lessee shall, at Lessee's expense, comply promptly with all applicable statutes, ordinances, rules, regulations, orders, covenants and restrictions of record, and requirements in effect during the term or any part of the term hereof, regulating the use by Lessee of the Premises. Lessee shall not use nor permit the use of the Premises in any manner that will tend to create waste or a nuisance or, if there shall be more than one tenant in the building containing the Premises, shall tend to disturb such other tenants. 6.3 Condition of Premises. (a) Lessor shall deliver the Premises to Lessee clean and free of debris on Lease commencement date (unless Lessee is already in possession) and Lessor further warrants to Lessee that the plumbing, lighting, air conditioning, heating, and loading doors in the Premises shall be in good operating condition on the Lease commencement date. In the event that it is determined that this warranty has been violated, then it shall be the obligation of Lessor, after receipt of written notice from Lessee setting forth with specificity the nature of the violation, to promptly, at Lessor's sole cost, rectify such violation. Lessee's failure to give such written notice to Lessor within thirty (30) days after the Lease commencement date shall cause the conclusive presumption that Lessor has complied with all of Lessor's obligations hereunder. The warranty contained in this paragraph 6.3(a) shall be of no force or effect if prior to the date of this Lease, Lessee was the owner or occupant of the Premises. (b) Except as otherwise provided in this Lease, Lessee hereby accepts the Premises in their condition existing as of the Lease commencement date or the date that Lessee takes possession of the Premises, whichever is earlier, subject to all applicable zoning, municipal, county and state laws, ordinances and regulations governing and regulating the use of the Premises, and any covenants or restrictions of record, and accepts this Lease subject thereto and to all matters disclosed thereby and by any exhibits attached hereto. Lessee acknowledges that neither Lessor nor Lessor's agent has made any representation or warranty as to the present or future suitability of the Premises for the conduct of Lessee's business. See Addendum Paragraph 4 7. Maintenance, Repairs and Alterations. 7.1 Lessee's Obligations. Lessee shall keep in good order, condition and repair the Premises and every part thereof, structural and non structural, (whether or not such portion of the Premises requiring repair, or the means of repairing the same are reasonably or readily accessible to Lessee, and whether or not the need for such repairs occurs as a result of Lessee's use, any prior use, the elements or the age of such portion of the Premises) including, without limiting the generality of the foregoing, all plumbing, heating, air conditioning, (Lessee shall procure and maintain, at Lessee's expense, an air conditioning system maintenance contract) ventilating, electrical, lighting facilities and equipment within the Premises, fixtures, walls (interior and exterior), foundations, ceilings, roofs (interior and exterior), floors, windows, doors, plate glass and skylights located within the Premises, and all landscaping, driveways, parking lots, fences and signs located on the Premises and sidewalks and parkways adjacent to the Premises. 7.2 Surrender. On the last day of the term hereof, or on any sooner termination, Lessee shall surrender the Premises to Lessor in the same condition as when received, ordinary wear and tear excepted, clean and free of debris. Lessee shall repair any damage to the Premises occasioned Initials: ----- (C) American Industrial Real Estate Association 1980 NET ----- by the installation or removal of Lessee's trade fixtures, furnishings and equipment. Notwithstanding anything to the contrary otherwise stated in this Lease. Lessee shall leave the air lines, power panels, electrical distribution systems, lighting fixtures, space heaters, air conditioning, plumbing and fencing on the premises in good operating condition. 7.3 Lessor's Rights. If Lessee fails to perform Lessee's obligations under this Paragraph 7, or under any other paragraph of this Lease, Lessor may at its option (but shall not be required to) enter upon the Premises after ten (10) days prior written notice to Lessee (except in the case of an emergency, in which case no notice shall be required), perform such obligations on Lessee's behalf and put the same in good order, condition and repair, and the cost thereof together with interest thereon at the maximum rate then alllowable by law shall become due and payable as additional rental to Lessor together with Lessee's next rental installment. 7.4 Lessor's Obligations. Except for the obligations of Lessor under Paragraph 6.2(a) and 6.3(a) (relating to Lessor's warranty). Paragraph 9 (relating to destruction of the premises) and under Paragraph 14 (relating to condemnation of the Premises). It is intended by the parties hereto that Lessor have no obligation, in any manner whatsoever, to repair and maintain the Premises nor the building located thereon nor the equipment therein, whether structural or non structural, all of which obligations are intended to be that of the Lessee under Paragraph 7.1 hereof Lessee expressly waives the benefit of any statute now or hereinafter in effect which would otherwise afford Lessee the right to make repairs at Lessor's expense or to terminate this Lease because of Lessor's failure to keep the premises in good order, condition and repair. See Addendum Paragraph 4(c) 7.5 Alterations and Additions. (a) Lessee shall not, without Lessor's prior written consent make any alterations, improvements, additions, or Utility Installations in, on or about the Premises, except for nonstructural alterations not exceeding $xxx in cumulative costs during the term of this Lease. In any event, whether or not in excess of $xxx cumulative cost, Lessee shall make no change or alteration to the exterior of the Premises nor the exterior of the building(s) on the Premises without Lessor's prior written consent. As used in this Paragraph 7.5 the term "Utility Installation" shall mean carpeting, window coverings, air lines, power panels, electrical distribution systems, lighting fixtures, space heaters, air conditioning, plumbing, and fencing. Lessor may require that Lessee remove any or all of said alterations, improvements, additions or Utility installations at the expiration of the term, and restore the Premises to their prior condition. Lessor may require Lessee to provide Lessor, at Lessee's sole cost and expense, a lien and completion bond in an amount equal to one and one-half times the estimated cost of such improvements, to insure Lessor against any liability for mechanic's and materialmen's liens and to insure completion of the work. Should Lessee make any alterations, improvements, additions or Utility Installations without the prior approval of Lessor, Lessor may require that Lessee remove any or all of the same. (b) Any alterations, improvements, additions or Utility Installations in, or about the Premises that Lessee shall desire to make and which requires the consent of the Lessor shall be presented to Lessor in written form, with proposed detailed plans. If Lessor shall give its consent, the consent shall be deemed conditioned upon Lessee acquiring a permit to do so from appropriate governmental agencies, the furnishing of a copy thereof to Lessor prior to the commencement of the work and the compliance by Lessee of all conditions of said permit in a prompt and expeditious manner. (c) Lessee shall pay, when due, all claims for labor or materials furnished or alleged to have been furnished to or for Lessee at or for use in the Premises, which claims are or may be secured by any mechanics' or materialmen's lien against the Premises, or any interest therein. Lessee shall give Lessor not less than ten (10) days' notice prior to the commencement of any work in the Premises, and Lessor shall have the right to post notices of non- responsibility in or on the Premises as provided by law. If Lessee shall, in good faith, contest the validity of any such lien, claim or demand, then Lessee shall, at its sole expense defend itself and Lessor against the same and shall pay and satisfy any such adverse judgment that may be rendered thereon before the enforcement thereof against the Lessor or the Premises, upon the condition that if Lessor shall require, Lessee shall furnish to Lessor a surety bond satisfactory to Lessor in an amount equal to such contested lien claim or demand indemnifying Lessor against liability for the same and holding the Premises free from the effect of such lien or claim. In addition, Lessor may require Lessee to pay Lessor's attorneys fees and costs in participating in such action if Lessor shall decide it is to its best interest to do so. (d) Unless Lessor requires their removal, as set forth in Paragraph 7.5(a), all alterations, improvements, additions and Utility installations (whether or not such Utility Installations constitute trade fixtures of Lessee), which may be made on the Premises, shall become the property of Lessor and remain upon and be surrendered with the Premises at the expiration of the term. Not withstanding the provisions of this Paragraph 7.5(d). Lessee's machinery and equipment, other than that which is affixed to the Premises so that it cannot be removed without material damage to the Premises, shall remain the property of Lessee and may be removed by Lessee subject to the provisions of Paragraph 7.2. 8. Insurance Indemnity. 8.1 Insuring Party. As used in this Paragraph 8, the term "insuring party" shall mean the party who has the obligation to obtain the Property Insurance required hereunder. The insuring party shall be designated in Paragraph 46 hereof. In the event Lessor is the insuring party , Lessor shall also maintain the liability insurance described in paragraph 8.2 hereof, in addition to, and not in lieu of, the insurance required to be maintained by Lessee under said paragraph 8.2, but Lessor shall not be required to name Lessee as an additional insured on such policy. Whether the insuring party is the Lessor or the Lessee, Lessee shall, as additional rent for the Premises, pay the cost of all insurance required hereunder, except for that portion of the cost attributable to Lessor's liability insurance coverage in excess of $1,000,000 per occurrence. If Lessor is the insuring party Lessee shall, within the ten (10) days following demand by Lessor, reimburse Lessor for the cost of the insurance so obtained. 8.2 Liability Insurance. Lessee shall, at Lessee's expense obtain and keep in force during the term of this Lease a policy of Combined Single Limit, Bodily Injury and Property Damage insurance insuring Lessor and Lessee against any liability arising out of the ownership, use, occupancy or maintenance of the Premises and all areas appurtenant thereto. Such insurance shall be a combined single limit policy in an amount not less than $2,000,000.00 per occurrence. The policy shall insure performance by Lessee of the indemnity provisions of this Paragraph 8. The limits of said insurance shall not, however, limit the liability of Lessee hereunder. 8.3 Property Insurance. (a) The insuring party shall obtain and keep in force during the term of this Lease a policy or policies of insurance covering loss or damage to the Premises, in the amount of the full replacement value thereof, as the same may exist from time to time, which replacement value is now $ 1,500,000. but in --------- no event less than the total amount required by lenders having liens on the Premises, against all perils including within the classification of fire, extended coverage, vandalism, malicious mischief, flood (in the event same is required by a lender having a lien on the Premises), and special extended perils ("all risk" as such term is used in the insurance industry). Said insurance shall provide for payment of loss thereunder to Lessor or to the holders of mortgages or deeds of trust on the Premises. The insuring party shall, in addition, obtain and keep in force during the term of this Lease a policy of rental value insurance covering a period of one year, with loss payable to Lessor, which insurance shall also cover all real estate taxes and insurance costs for said period. A stipulated value or agreed amount endorsement deleting the coinsurance provision of the policy shall be procured with said insurance. If the insuring party shall fail to procure and maintain said insurance the other party may, but shall not be required to, procure and maintain the same, but at the expense of Lessee. If such insurance coverage has a deductible clause, the deductible amount shall not exceed 1,000 per occurrence, and Lessee shall be liable for such deductible amount. (b) If the Premises are part of a larger building, or if the Premises are part of a group of buildings owned by Lessor which are adjacent to the Premises, then Lessee shall pay for any increase in the property insurance of such other building or buildings if said increase is caused by Lessee's acts, omissions, use or occupancy of the Premises. (c) If the Lessor is the insuring party the Lessor will not insure Lessee's fixtures, equipment or tenant improvements unless the tenant improvements have become a part of the Premises under paragraph 7, hereof. But if Lessee is the insuring party the Lessee shall insure its fixtures, equipment and tenant improvements. 8.4 Insurance Policies. Insurance required hereunder shall be in companies holding a "General Policyholders Rating" of at least (A)VI or such other rating as may be required by a lender having a lien on the Premises, as set forth in the most current issue of "Best's Insurance Guide". The insuring party shall deliver to the other party copies of policies of such insurance or certificates evidencing the existence and amounts of such insurance with loss payable clauses as required by this paragraph 8. No such policy shall be cancellable or subject to reduction of coverage or other modification except after thirty (30) days' prior written notice to Lessor. If Lessee is the insuring party Lessee shall, at least thirty (30) days prior to the expiration of such policies, furnish Lessor with renewals or "binders" thereof, or Lessor may order such insurance and charge the cost thereof to Lessee, which amount shall be payable by Lessee upon demand. Lessee shall not do or permit to be done anything which shall invalidate the insurance policies referred to in Paragraph 8.3. If Lessee does or permits to be done anything which shall increase the cost of the insurance policies referred to in Paragraph 8.3, then Lessee shall forthwith upon Lessor's demand reimburse Lessor for any additional premiums attributable to any act or omission or operation of Lessee causing such increase in the cost of insurance. If Lessor is the insuring party, and if the insuring policies maintained hereunder cover other improvements in addition to the Premises, Lessor shall deliver to Lessee a written statement setting forth the amount of any such insurance cost increase and showing in reasonable detail the manner in which it has been computed. 8.5 Waiver of Subrogation. Lessee and Lessor each hereby release and relieve the other, and waive their entire right of recovery against the other for loss or damage arising out of or incident to the perils insured against under paragraph 8.3, which perils occur in, on or about the Premises, whether due to the negligence of Lessor or Lessee or their agents, employees, contractors and /or invitees. Lessee and Lessor shall, upon obtaining the policies of insurance required hereunder, give notice to the insurance carrier or carriers that the foregoing mutual waiver of subrogation is contained in this Lease. 8.6 Indemnity. Lessee shall indemnify and hold harmless Lessor from and against any and all claims arising from Lessee's use of the Premises, or from the conduct of Lessee's business or from any activity, work or things done, permitted or suffered by Lessee in or about the Premises or elsewhere and shall further indemnify and hold harmless Lessor from and against any and all claims arising from any breach or default in the performance of any obligation on Lessee's part to be performed under the terms of this Lease, or arising from any negligence of the Lessee, or any of Lessee's agents, contractors, or employees, and from and against all costs, attorney's fees, expenses and liabilities incurred in the defense of any such claim or any action or proceeding brought thereon; and in case any action or proceeding be brought against Lessor by reason of any such claim, Lessee upon notice from Lessor shall defend the same at Lessee's expense by counsel satisfactory to Lessor. Lessee, as a material part of the consideration to Lessor, hereby assumes all risk of damage to property or injury to persons, in, upon or about the Premises arising from any cause and Lessee hereby waives all claims in respect thereof against Lessor. 8.7 Exemption of Lessor from Liability. Lessee hereby agrees that Lessor shall not be liable for injury to Lessee's business or any loss of income therefrom or for damage to the goods, wares, merchandise or other property of Lessee. Lessee's employees, invitees, customers, or any other person in or about the Premises, nor shall Lessor be liable for injury to the person of Lessee, Lessee's employees, agents or contractors, whether such damage to injury is caused by or results from fire, steam, electricity, gas, water or rain, or from the breakage, leakage, obstruction or other defects of pipes, sprinklers, wires, appliances, plumbing, air conditioning or lighting fixtures, or from any other cause, whether the said damage or injury results from conditions arising upon the Premises or upon other portions of the building of which the Premises are a part, or from other sources or places and regardless of whether the cause of such damage or injury or the means of repairing the same is inaccessible to Lessee. Lessor shall not be liable for any act or neglect of any other tenant, if any, of the building in which the Premises are located. Initials -------------- -------------- 9. Damage of Destruction. 9.1 Definitions. (a) "Premises Partial Damage" shall herein mean damage or destruction to the Premises to the extent that the cost of repair is less than 50% of the then replacement cost of the Premises. "Premises Building Partial Damage shall herein mean damage or destruction to the building of which the Premises are a part to the extent that the cost of repair is less than 50% of the then replacement cost of such building as a whole. (b) "Premises Total Destruction" shall herein mean damage or destruction to the Premises to the extent that the cost of repair is 50% or more of the then replacement cost of the Premises. "Premises Building Total Destruction" shall herein mean damage or destruction to the building of which the Premises are a part to the extent that the cost of repair is 50% or more of the then replacement cost of such building as a whole. (c) "Insured Loss" shall herein mean damage or destruction which was caused by an event required to be covered by the insurance described in paragraph 8. 9.2 Partial Damage - Insured Loss. Subject to the provisions of paragraphs 9.4, 9.5 and 9.6, if at any time during the term of this Lease there is damage which is an Insured Loss and which falls into the classification of Premises Partial Damage or Premises Building Partial Damage, then Lessor shall, at Lessor's expense, repair such damage, but not Lessee's fixtures, equipment, or tenant improvements unless the same have become a part of the Premises pursuant to Paragraph 7.5 hereof as soon as reasonably possible and this Lease shall continue in full force and effect. Notwithstanding the above, if the Lessee is the insuring party, and if the insurance proceeds received by Lessor are not sufficient to effect such repair, Lessor shall give notice to Lessee of the amount required in addition to the insurance proceeds to effect such repair. Lessee shall contribute the required amount to Lessor within ten days after Lessee has received notice from Lessor of the shortage in the insurance. When Lessee shall contribute such amount to Lessor, Lessor shall make such repairs as soon as reasonably possible and this Lease shall continue in full force and effect. Lessee shall in no event have any right to reimbursement for any such amounts so contributed. 9.3 Partial Damage - Uninsured Loss. Subject to the provisions of Paragraphs 9.4, 9.5 and 9.6, if at any time during the term of this Lease there is damage which is not an Insured Loss and which falls within the classification of Premises Partial Damage or Premises Building Partial Damage, unless caused by a negligent or willful act of Lessee (in which event Lessee shall make the repairs at Lessee's expense). Lessor may at Lessor's option either (i) repair such damage as soon as reasonably possible at Lessor's expense, in which event this Lease shall continue in full force and effect, or (ii) give written notice to Lessee within thirty (30) days after the date of the occurrence of such damage of Lessor's intention to cancel and terminate this Lease, as of the date of the occurrence of such damage. In the event Lessor elects to give such notice of Lessor's intention to cancel and terminate this Lease, Lessee shall have the right within ten (10) days after the receipt of such notice to give written notice to Lessor of Lessee's intention to repair such damage at Lessee's expense, without reimbursement from Lessor, in which event this Lease shall continue in full force and effect, and Lessee shall proceed to make such repairs as soon as reasonably possible. If Lessee does not give such notice within such 10-day period this Lease shall be cancelled and terminated as of the date of occurrence of such damage. 9.4 Total Destruction. If at any time during the term of this Lease there is damage, whether or not an Insured Loss, (including destruction required by any authorized public authority), which falls into the classification of Premises Total Destruction or Premises Building Total Destruction, this Lease shall automatically terminate as of the date of such total destruction. 9.5 Damage Near End of Term. (a) If at any time during the last six months of the term of this Lease there is damage, whether or not an Insured Loss, which falls within the classification of Premises Partial Damage, Lessor may at Lessor's option cancel and terminate this Lease as of the date of occurrence of such damage by giving written notice to Lessee of Lessor's election to do so within 30 days after the date of occurrence of such damage. (b) Notwithstanding paragraph 9.5(a), in the event that Lessee has an option to extend or renew this Lease, and the time within which said option may be exercised has not yet expired, Lessee shall exercise such option, if it is to be exercised at all, no later than 20 days after the occurrence of an Insured Loss falling within the classification of Premises Partial Damage during the last six months of the term of this Lease. If Lessee duly exercises such option during said 20 day period, Lessor shall, at Lessor's expense, repair such damage as soon as reasonably possible and this Lease shall continue in full force and effect. If Lessee fails to exercise such option during said 20 day period, then Lessor may at Lessor's option terminate and cancel this Lease as of the expiration of said 20 day period by giving written notice to Lessee of Lessor's election to do so within 10 days after the expiration of said 20 day period, notwithstanding any term of provision in the grant of option to the contrary. 9.6 Abatement of Rent; Lessee's Remedies. (a) In the event of damage described in paragraphs 9.2 or 9.3, and Lessor or Lessee repairs or restores the Premises pursuant to the provisions of this Paragraph 9, the rent payable hereunder for the period during which such damage, repair or restoration continues shall be abated in proportion to the degree to which Lessee's use of the Premises is impaired. Except for abatement of rent, if any, Lessee shall have no claim against Lessor for any damage suffered by reason of any such damage, destruction, repair or restoration. (b) If Lessor shall be obligated to repair or restore the Premises under the provisions of this Paragraph 9 and shall not commence such repair or restoration within 90 days after such obligations shall accrue, Lessee may at Lessee's option cancel and terminate this Lease by giving Lessor written notice of Lessee's election to do so at any time prior to the commencement of such repair or restoration. In such event this Lease shall terminate as of the date of such notice. 9.7 Termination - Advance Payments. Upon termination of this Lease pursuant to this Paragraph 9, and equitable adjustment shall be made concerning advance rent and any advance payments made by Lessee to Lessor. Lessor shall, in addition, return to Lessee so much of Lessee's security deposit as has not theretofore been applied by Lessor. 9.8 Waiver. Lessor and Lessee waive the provisions of any statutes which relate to termination of leases when leased property is destroyed and agree that such event shall be governed by the terms of this Lease. 10. Real Property Taxes. 10.1 Payment of Taxes. Lessee shall pay the real property tax, as defined in paragraph 10.2, applicable to the Premises during the term of this Lease. All such payments shall be made at least ten (10) days prior to the delinquency date of such payment. Lessee shall promptly furnish Lessor with satisfactory evidence that such taxes have been paid. If any such taxes paid by Lessee shall cover any period of time prior to or after the expiration of the term hereof. Lessee's share of such taxes shall be equitably prorated to cover only the period of time within the tax fiscal year during which this Lease shall be in effect, and Lessor shall reimburse Lessee to the extent required. If Lessee shall fail to pay any such taxes, Lessor shall have the right to pay the same, in which case Lessee shall repay such amount to Lessor with Lessee's next rent installment together with interest at the maximum rate then allowable by law. 10.2 Definition of "Real Property Tax". As used herein, the term "real property tax" shall include any form of real estate tax or assessment, general, special, ordinary or extraordinary, and any license fee, commercial rental tax, improvement bond or bonds, levy or tax (other than inheritance, personal income or estate taxes) imposed on the Premises by any authority having the direct or indirect power to tax, including any city, state or federal government, or any school, agricultural, sanitary, fire, street, drainage or other improvement district thereof, as against any legal or equitable interest of Lessor in the Premises or in the real property of which the Premises are a part, as against Lessor's right to rent or other income therefrom, and as against Lessor's business of leasing the Premises. The term "real property tax" shall also include any tax, fee, levy assessment or charge (i) in substitution of, partially or totally, any tax, fee, levy, assessment or charge thereinabove included within the definition of "real property tax," or (ii) the nature of which was hereinbefore included within the definition of "real property tax," or (iii) which is imposed for a service or right not charged prior to June 1, 1978, or, if previously charged, has been increased since June 1, 1978, or (iv) which is imposed as a result of a transfer, either partial or total, of Lessor's interest in the Premises or which is added to a tax or charge hereinbefore included within the definition of real property tax by reason of such transfer, or (v) which is imposed by reason of this transaction, any modifications or changes hereto, or any transfers hereof. 10.3 Joint Assessment. If the Premises are not separately assessed. Lessee's liability shall be an equitable proportion of the real property taxes for all of the land and improvements included within the tax parcel assessed, such proportion to be determined by Lessor from the respective valuations assigned in the assessor's work sheets or such other information as may be reasonably available. Lessor's reasonable determination thereof, in good faith, shall be conclusive. 10.4 Personal Property Taxes. (a) Lessee shall pay prior to delinquency all taxes assessed against and levied upon trade fixtures, furnishings, equipment and all other personal property of Lessee contained in the Premises or elsewhere. When possible, Lessee shall cause said trade fixtures, furnishings, equipment and all other personal property to be assessed and billed separately from the real property of Lessor. (b) If any of Lessee's said personal property shall be assessed with Lessor's real property, Lessee shall pay Lessor the taxes attributable to Lessee within 10 days after receipt of a written statement setting forth the taxes applicable to Lessee's property. 11. Utilities. Lessee shall pay for all water, gas, heat, light, power, telephone and other utilities and services supplied to the Premises, together with any taxes thereon. If any such services are not separately metered to Lessee, Lessee shall pay a reasonable proportion to be determined by Lessor of all charges jointly metered with other premises. See Addendum Paragraph 5 12. Assignment and Subletting. 12.1 Lessor's Consent Required. Lessee shall not voluntarily or by operation of law assign, transfer, mortgage, sublet, or otherwise transfer or encumber all or any part of Lessee's interest in this Lease or in the Premises, without Lessor's prior written consent, which Lessor shall not unreasonably withhold. Lessor shall respond to Lessee's request for consent hereunder in a timely manner and any attempted assignment, transfer, mortgage, encumbrance or subletting without such consent shall be void, and shall constitute a breach of this Lease. 12.2 Lessee Affiliate. Notwithstanding the provisions of paragraph 12.1 hereof, Lessee may assign or sublet the Premises, or any portion thereof, without Lessor's consent, to any corporation which controls, is controlled by or is under common control with Lessee, or to any corporation resulting from the merger or consolidation with Lessee, or to any person or entity which acquires all the assets of Lessee as a going concern of the business that is being conducted on the Premises, provided that said assignee assumes, in full, the obligations of Lessee under this Lease. Any such assignment shall not, in anyway, affect or limit the liability of Lessee under the terms of this Lease even if after such assignment or subletting the terms of this Lease are materially changed or altered without the consent of Lessee, the consent of whom shall not be necessary. 12.3 No Release of Lessee. Regardless of Lessor's consent, no subletting or assignment shall release Lessee of Lessee's obligation or alter the primary liability of Lessee to pay the rent and to perform all other obligations to be performed by Lessee hereunder. The acceptance of rent by Lessor from any other person shall not be deemed to be a waiver by Lessor of any provision hereof. Consent to one assignment or subletting shall not be deemed consent to any subsequent assignment or subletting. In the event of default by any assignee of Lessee or any successor of Lessee, in the performance of any of the terms hereof. Lessor may proceed directly against Lessee without the necessity of exhausting remedies against said assignee, Lessor may consent to subsequent assignments or subletting of this Lease or amendments or modifications to this Lease with assignees. of Lessee, without notifying Lessee, or any successor of Lessee, and without obtaining its or their consent thereto and such action shall not relieve Lessee of liability under this Lease. 12.4 Attorney's Fees. In the event Lessee shall assign or sublet the Premises or request the consent of Lessor to any assignment or subletting or if Lessee shall request the consent of Lessor for any act Lessee proposes to do then Lessee shall pay Lessor's reasonable attorneys fees incurred in connection therewith, such attorneys fees not to exceed $350.00 for each such request. 13. Defaults; Remedies. 13.1 Defaults. The occurrence of any one or more of the following events shall constitute a material default and breach of this Lease by Lessee: (a) The vacating or abandonment of the Premises by Lessee. (b) The failure by Lessee to make any payment of rent or any other payment required to be made by Lessee hereunder, as and when due, where such failure shall continue for a period of three days after written notice thereof from Lessor to Lessee. In the event that Lessor serves Lessee with a Notice to Pay Rent or Quit pursuant to applicable Unlawful Detainer statutes such Notice to Pay Rent or Quit shall also constitute the notice required by this subparagraph. (c) The failure by Lessee to observe or perform any of the covenants, conditions or provisions of this Lease to be observed or performed by Lessee, other than described in paragraph (b) above, where such failure shall continue for a period of 30 days after written notice thereof from Lessor to Lessee; provided, however, that if the nature of Lessee's default is such that more than 30 days are reasonably required for its cure, then Lessee shall not be deemed to be in default if Lessee commenced such cure within said 30-day period and thereafter diligently prosecutes such cure to completion. (d) (i) The making by Lessee of any general arrangement or assignment for the benefit of creditors; (ii) Lessee becomes a "debtor" as defined in 11 U.S.C.(S)101 or any successor statute thereto (unless, in the case of a petition filed against Lessee, the same is dismissed within 60 days); (iii) the appointment of a trustee or receiver to take possession of substantially all of Lessee's assets located at the Premises or of Lessee's interest in this Lease, where possession is not restored to Lessee within 30 days; or (iv) the attachment, execution or other judicial seizure of substantially all of Lessee's assets located at the Premises or of Lessee's interest in this Lease, where such seizure is not discharged within 30 days. Provided, however, in the event that any provision of this paragraph 13.1(d) is contrary to any applicable law, such provision shall be of no force or effect. (e) The discovery by Lessor that any financial statement given to Lessor by Lessee, any assignee of Lessee, any subtenant of Lessee, any successor in interest of Lessee or any guarantor of Lessee's obligation hereunder, and any of them, was materially false. See Addendum Paragraph 6 13.2 Remedies. In the event of any such material default or breach by Lessee, Lessor may at any time thereafter, with or without notice or demand and without limiting Lessor in the exercise of any right or remedy which Lessor may have by reason of such default or breach: (a) Terminate Lessee's right to possession of the Premises by any lawful means, in which case this Lease shall terminate and Lessee shall immediately surrender possession of the Premises to Lessor. In such event Lessor shall be entitled to recover from Lessee all damages incurred by Lessor by reason of Lessee's default including, but not limited to, the cost of recovering possession of the Premises; expenses of reletting, including necessary renovation and alteration of the Premises, reasonable attorney's fees, and any real estate commission actually paid; the worth at the time of award by the court having jurisdiction thereof of the amount by which the unpaid rent for the balance of the term after the time of such award exceeds the amount of such rental loss for the same period that Lessee proves could be reasonably avoided; that portion of the leasing commission paid by Lessor pursuant to Paragraph 15 applicable to the unexpired term of this Lease. (b) Maintain Lessee's right to possession in which case this Lease shall continue in effect whether or not Lessee shall have abandoned the Premises. In such event Lessor shall be entitled to enforce all of Lessor's rights and remedies under this Lease, including the right to recover the rent as it becomes due hereunder. (c) Pursue any other remedy now or hereafter available to Lessor under the laws or judicial decisions of the state wherein the Premises are located. Unpaid installments of rent and other unpaid monetary obligations of Lessee under the terms of this Lease shall bear interest from the date due at the maximum rate then allowable by law. 13.3 Default by Lessor. Lessor shall not be in default unless Lessor fails to perform obligations required of Lessor within a reasonable time, but in no event later than thirty (30) days after written notice by Lessee to Lessor and to the holder of any first mortgage or deed of trust covering the Premises whose name and address shall have theretofore been furnished to Lessee in writing, specifying wherein Lessor has failed to perform such obligation; provided, however, that if the nature of Lessor's obligation is such that more than thirty (30) days are required for performance then Lessor shall not be in default if Lessor commences performance within such 30-day period and thereafter diligently prosecutes the same to completion. 13.4 Late Charges. Lessee hereby acknowledges that late payment by Lessee to Lessor of rent and other sums due hereunder will cause Lessor to incur costs not contemplated by this Lease, the exact amount of which will be extremely difficult to as certain. Such costs include, but are not limited to, processing and accounting charges, and late charges which may be imposed on Lessor by the terms of any mortgage or trust deed covering the Premises. Accordingly, if any installment of rent or any other sum due from Lessee shall not be received by Lessor or Lessor's designee within ten (10) days after such amount shall be due, then, without any requirement for notice to Lessee, Lessee shall pay to Lessor a late charge equal to 6% of such overdue amount. The parties hereby agree that such late charge represents a fair and reasonable estimate of the costs Lessor will incur by reason of late payment by Lessee, Acceptance of such late charge by Lessor shall in no event constitute a waiver of Lessee's default with respect to such overdue amount, nor prevent Lessor from exercising any of the other rights and remedies granted hereunder. In the event that a late charge is payable hereunder, whether or not collected, for three (3) consecutive installments of rent, then rent shall automatically become due and payable quarterly in advance, rather than monthly, notwithstanding paragraph 4 or any other provision of this Lease to the contrary. 13.5 Impounds. In the event that a late charge is payable hereunder, whether or not collected, for three (3) installments of rent or any other monetary obligation of Lessee under the terms of this Lease, Lessee shall pay to Lessor, if Lessor shall so request, in addition to any other payments required under this Lease, a monthly advance installment, payable at the same time as the monthly rent, as estimated by Lessor, for real property tax and insurance expenses on the Premises which are payable by Lessee under the terms of this Lease. Such fund shall be established to insure payment when due, before delinquency, of any or all such real property taxes and insurance premiums. If the amounts paid to Lessor by Lessee under the provisions of this paragraph are insufficient to discharge the obligations of Lessee to pay such real property taxes and insurance premiums as the same become due. Lessee shall pay to Lessor, upon Lessor's demand, such additional sums necessary to pay such obligations. All moneys paid to Lessor under this paragraph may be intermingled with other moneys of Lessor and shall not bear interest. In the event of a default in the obligations of Lessee to perform under this Lease, then any balance remaining from funds paid to Lessor under the provisions of this paragraph may, at the option of Lessor, be applied to the payment of any monetary default of Lessee in lieu of being applied to the payment of real property tax and insurance premiums. 14. Condemnation. If the Premises or any portion thereof are taken under the power of eminent domain, or sold under the threat of the exercise of said power (all of which are herein called "condemnation"), his Lease shall terminate as to the part so taken as of the date the condemning authority takes title or possession, whichever first occurs. If more than 10% of the floor area of the building on the Premises, or more than 25% of the land area of the Premises which is not occupied by any building, is taken by condemnation, Lessee may, at Lessee's option, to be exercised in writing only within ten (10) days after Lessor shall have given Lessee written notice of such taking (or in the absence of such notice, within ten (10) days after the condemning authority shall have taken possession) terminate this Lease as of the date the condemning authority takes such possession. If Lessee does not terminate this Lease in accordance with the foregoing, this Lease shall remain in full force and effect as to the portion of the Premises remaining, except that the rent shall be reduced in the proportion that the floor area of the building taken bears to the total floor area of the building situated on the Premises. No reduction of rent shall occur if the only area taken is that which does not have a building located thereon. Any award for the taking of all or any part of the Premises under the power of eminent domain or any payment made under threat of the exercise of such power shall be the property of Lessor, whether such award shall be made as compensation for diminution in value of the leasehold or for the taking of the fee, or as severance damages; provided, however, that Lessee shall be entitled to any award for loss of or damage to Lessee's trade fixtures and removable personal property. In the event that this Lease is not terminated by reason of such condemnation, Lessor shall to the extent of severance damages received by Lessor in connection with such condemnation, repair any damage to the Premises caused by such condemnation except to the extent that Lessee has been reimbursed therefor by the condemning authority. Lessee shall pay any amount in excess of such severance damages required to complete such repair. 16 Estoppel Certificate. (a) Lessee shall at any time upon not less than ten (10) days' prior written notice from Lessor execute, acknowledge and deliver to Lessor a statement in writing (i) certifying that this Lease is unmodified and in full force and effect (or, if modified, stating the nature of such modification and certifying that this Lease, as so modified, is in full force and effect) and the date to which the rent and other charges are paid in advance, if any, and (ii) acknowledging that there are not, to Lessee's knowledge, any uncured defaults on the part of Lessor hereunder, or specifying such defaults if any are claimed. Any such statement may be conclusively relied upon by any prospective purchaser or encumbrancer of the Premises. (b) At Lessor's option, Lessee's failure to deliver such statement within such time shall be a material breach of this Lease or shall be -4- conclusive upon Lessee (i) that this Lease is in full force and effect, without modification except as may be represented by Lessor, (ii) that there are no uncured defaults in Lessor's performance, and (iii) that not more than one month's rent has been paid in advance or such failure may be considered by Lessor as a default by Lessee under this Lease. (c) If Lessor desires to finance, refinance, or sell the Premises, or any part thereof, Lessee hereby agrees to deliver to any lender or purchaser designated by Lessor such financial statements of Lessee as may be reasonably required by such lender or purchaser. Such statements shall include the past three years financial statements of Lessee. All such financial statements shall be received by Lessor and such lender or purchaser in confidence and shall be used only for the purposes herein set forth. 17. Lessor's Liability. The term "Lessor" as used herein shall mean only the owner or owners at the time in question of the fee title or a lessee's interest in a ground lease of the Premises. In the event of any transfer of such title or interest, Lessor herein named (and in case of any subsequent transfers then the grantor) shall be relieved from and after the date of such transfer of all liability as respects Lessor's obligations thereafter to be performed, provided that any funds in the hands of Lessor or the then grantor at the time of such transfer, in which Lessee has an interest, shall be delivered to the grantee. The obligations contained in this Lease to be performed by Lessor shall, subject as aforesaid, be binding on Lessor's successors and assigns, only during their respective periods of ownership. 18. Severability. The invalidity of any provision of this Lease as determined by a court of competent jurisdiction, shall in no way affect the validity of any other provision hereof. 19. Interest on Past-due Obligations. Except as expressly herein provided, any amount due to Lessor not paid when due shall bear interest at the maximum rate then allowable by law from the date due. Payment of such interest shall not excuse or cure any default by Lessee under this Lease, provided, however, that interest shall not be payable on late charges incurred by Lessee nor on any amounts upon which late charges are paid by Lessee. 20. Time of Essence. Time is of the essence. 21. Additional Rent. Any monetary obligations of Lessee to Lessor under the terms of this Lease shall be deemed to be rent. 22. Incorporation of Prior Agreements; Amendments. This Lease contains all agreements of the parties with respect to any matter mentioned herein. No prior agreement or understanding pertaining to any such matter shall be effective. This Lease may be modified in writing only, signed by the parties in interest at the time of the modification. Except as otherwise stated in this Lease, Lessee hereby acknowledges that neither the real estate broker listed in Paragraph 15 hereof nor any cooperating broker on this transaction nor the Lessor or any employees or agents of any of said persons has made any oral or written warranties or representations to Lessee relative to the condition or use by Lessee of said Premises and Lessee acknowledges that Lessee assumes all responsibility regarding the Occupational Safety Health Act, the legal use and adaptability of the Premises and the compliance thereof with all applicable laws and regulations in effect during the term of this Lease except as otherwise specifically stated in this Lease. 23. Notices. Any notice required or permitted to be given hereunder shall be in writing and may be given by personal delivery or by certified mail, and if given personally or by mail, shall be deemed sufficiently given if addressed to Lessee or to Lessor at the address noted below the signature of the respective parties, as the case may be. Either party may by notice to the other specify a different address for notice purposes except that upon Lessee's taking possession of the Premises, the Premises shall constitute Lessee's address for notice purposes. A copy of all notices required or permitted to be given to Lessor hereunder shall be concurrently transmitted to such party or parties at such addresses as Lessor may from time to time hereafter designate by notice to Lessee. 24. Waivers. No waiver by Lessor or any provision hereof shall be deemed a waiver of any other provision hereof or of any subsequent breach by Lessee of the same or any other provision. Lessor's consent to, or approval of, any act shall not be deemed to render unnecessary the obtaining of Lessor's consent to or approval of any subsequent act by Lessee. The acceptance of rent hereunder by Lessor shall not be a waiver of any preceding breach by Lessee of any provision hereof, other than the failure of Lessee to pay the particular rent so accepted, regardless of Lessor's knowledge of such preceding breach at the time of acceptance of such rent. 25. Recording. Either Lessor or Lessee shall, upon request of the other, execute, acknowledge and deliver to the other a "short form" memorandum of this Lease for recording purposes. 26. Holding Over. If Lessee, with Lessor's consent, remains in possession of the Premises or any part thereof after the expiration of the term hereof, such occupancy shall be a tenancy from month to month upon all the provisions of this Lease pertaining to the obligations of Lessee, but all options and rights of first refusal, if any, granted under the terms of this Lease shall be deemed terminated and be of no further effect during said month to month tenancy. 27. Cumulative Remedies. No remedy or election hereunder shall be deemed exclusive but shall, wherever possible, be cumulative with all other remedies at law or in equity. 28. Covenants and Conditions. Each provision of this Lease performable by Lessee shall be deemed both a covenant and a condition. 29. Binding Effect; Choice of Law: Subject to any provisions hereof restricting assignment or subletting by Lessee and subject to the provisions of Paragraph 17, this Lease shall bind the parties, their personal representatives, successors and assigns. This Lease shall be governed by the laws of the State wherein the Premises are located. 30. Subordination. (a) This Lease, at Lessor's option, shall be subordinate to any ground lease, mortgage, deed of trust, or any other hypothecation or security now or hereafter placed upon the real property of which the Premises are a part and to any and all advances made on the security thereof and to all renewals, modifications, consolidations, replacements and extensions thereof. Notwithstanding such subordination, Lessee's right to quiet possession of the Premises shall not be disturbed if Lessee is not in default and so long as Lessee shall pay the rent and observe and perform all of the provisions of this Lease, unless this Lease is otherwise terminated pursuant to its terms. If any mortgagee, trustee or ground lessor shall elect to have this Lease prior to the lien of its mortgage, deed of trust or ground lease, and shall give written notice thereof to Lessee, this Lease shall be deemed prior to such mortgage, deed of trust, or ground lease, whether this Lease is dated prior or subsequent to the date of said mortgage, deed of trust or ground lease or the date of recording thereof. (b) Lessee agrees to execute any documents required to effectuate an attornment, a subordination or to make this Lease prior to the lien of any mortgage, deed of trust or ground lease, as the case may be. Lessee's failure to execute such documents within 10 days after written demand shall constitute a material default by Lessee hereunder, or, at Lessor's option, Lessor shall execute such documents on behalf of Lessee as Lessee's attorney-in-fact. Lessee does hereby make, constitute and irrevocably appoint Lessor as Lessee's attorney-in-fact and in Lessee's name, place and stead, to execute such documents in accordance with this paragraph 30(b). 31. Attorney's Fees. If either party brings an action to enforce the terms hereof or declare rights hereunder, the prevailing party in any such action, on trail or appeal, shall be entitled to his reasonable attorney's fees to be paid by the losing party as fixed by the court. 32. Lessor's Access. Lessor and Lessor's agents shall have the right to enter the Premises at reasonable times for the purpose of inspecting the same, showing the same to prospective purchasers, lenders, or lessees, and making such alterations, repairs, improvements or additions to the Premises or to the building of which they are a part as Lessor may deem necessary or desirable. Lessor may at any time place on or about the Premises any ordinary "For Sale" signs and Lessor may at any time during the last 120 days of the term hereof place on or about the Premises any ordinary "For Lease" signs, all without rebate of rent or liability to Lessee. 33. Auctions. Lessee shall not conduct, nor permit to be conducted, either voluntarily or involuntarily, any auction upon the Premises without first having obtained Lessor's prior written consent. Notwithstanding anything to the contrary in this Lease, Lessor shall not be obligated to exercise any standard of reasonableness in determining whether to grant such consent. See Addendum Paragraph 7 34. Signs. Lessee shall not place any sign upon the Premises without Lessor's prior written consent except that Lessee shall have the right, without the prior permission of Lessor to place ordinary and usual for rent or sublet signs thereon. 35. Merger. The voluntary or other surrender of this Lease by Lessee, or a mutual cancellation thereof, or a termination by Lessor, shall not work a merger, and shall, at the option of Lessor, terminate all or any existing subtenancies or may, at the option of Lessor, operate as an assignment to Lessor of any or all of such subtenancies. 36. Consents. Except for paragraph 33 hereof, wherever in this Lease the consent of one party is required to an act of the other party such consent shall not be unreasonably withheld. 37. Guarantor. In the event that there is a guarantor of this Lease, said guarantor shall have the same obligations as Lessee under this Lease. 38. Quiet Possession. Upon Lessee paying the rent for the Premises and observing and performing all of the covenants, conditions and provisions on Lessee's part to be observed and performed hereunder, Lessee shall have quiet possession of the Premises for the entire term hereof subject to all of the provisions of this Lease. The individuals executing this Lease on behalf of Lessor represent and warrant to Lessee that they are fully authorized and legally capable of executing this Lease on behalf of Lessor and that such execution is binding upon all parties holding an ownership interest in the Premises. 39. Options. 39.1 Definition. As used in this paragraph the word "Options" has the following meaning: (1) the right or option to extend the term of this Lease or to renew this Lease or to extend or renew any lease that Lessee has on other property of Lessor; (2) the option or right of first refusal to lease the Premises or the right of first offer to lease the Premises or the right of first refusal to lease other property of Lessor or the right of first offer to lease other property of Lessor; (3) the right or option to purchase the Premises, or the right of first refusal to purchase the Premises, or the right of first offer to purchase the Premises or the right or option to purchase other property of Lessor, or the right of first refusal to purchase other property of Lessor or the right of first offer to purchase other property of Lessor. Initials: _____ NET -5- _____ 39.2 Options Personal. Each Option granted to Lessee in this Lease are personal to Lessee and may not be exercised or be assigned, voluntarily or involuntarily, by or to any person or entity other than Lessee, provided, however, the Option may be exercised by or assigned to any Lessee Affiliate as defined in paragraph 12.2 of this Lease. The Options herein granted to Lessee are not assignable separate and apart from this Lease. 39.3 Multiple Options. In the event that Lessee has any multiple options to extend or renew this Lease a later option cannot be exercised unless the prior option to extend or renew this Lease has been so exercised. 39.4 Effect of Default on Options. (a) Lessee shall have no right to exercise an Option, notwithstanding any provision in the grant of Option to the contrary, (i) during the time commencing from the date Lessor gives to Lessee a notice of default pursuant to paragraph 13.1(b) or 13.1(c) and continuing until the default alleged in said notice of default is cured, or (ii) during the period of time commencing on the day after a monetary obligation to Lessor is due from Lessee and unpaid (without any necessity for notice thereof to Lessee) continuing until the obligation is paid, or (iii) at any time after an event of default described in paragraphs 13.1(a), 13.1(d), or 13.1(e) (without any necessity of Lessor to give notice of such default to Lessee), or (iv) in the event that Lessor has given to Lessee three or more notices of default under paragraph 13.1(b), where a late charge has become payable under paragraph 13.4 for each of such defaults, or paragraph 13.1(c), whether or not the defaults are cured, during the 12 month period prior to the time that Lessee intends to exercise the subject Option. (b) The period of time within which an Option may be exercised shall not be extended or enlarged by reason of Lessee's inability to exercise an Option because of the provisions of paragraph 39.4(a). (c) All rights of Lessee under the provisions of an Option shall terminate and be of no further force or effect, notwithstanding Lessee's due and timely exercise of the Option, if, after such exercise and during the term of this Lease, (i) Lessee fails to pay to Lessor a monetary obligation of Lessee for a period of 30 days after such obligation becomes due (without any necessity of Lessor to give notice thereof to Lessee), or (ii) Lessee fails to commence to cure a default specified in paragraph 13.1(c) within 30 days after the date that Lessor gives notice to Lessee of such default and/or Lessee fails thereafter to diligently prosecute said cure to completion, or (iii) Lessee commits a default described in paragraph 13.1(a), 13.1(d), or 13.1(e) (without any necessity of Lessor to give notice of such default to Lessee), or (iv) Lessor gives to Lessee three or more notices of default under paragraph 13.1(b), where a late charge becomes payable under paragraph 13.4 for each such default, or paragraph 13.1(c), whether or not the defaults are cured. 40. Multiple Tenant Building. In the event that the Premises are part of a larger building or group of buildings then Lessee agrees that it will abide by, keep and observe all reasonable rules and regulations which Lessor may make from time to time for the management, safety, care, and cleanliness of the building and grounds, the parking of vehicles and the preservation of good order therein as well as for the convenience of other occupants and tenants of the building. The violations of any such rules and regulations shall be deemed a material breach of this Lease by Lessee. 41. Security Measures. Lessee hereby acknowledges that the rental payable to Lessor hereunder does not include the cost of guard service or other security measures, and that Lessor shall have no obligation whatsoever to provide same. Lessee assumes all responsibility for the protection of Lessee, its agents and invitees from act of third parties. 42. Easements. Lessor reserves to itself the right, from time to time, to grant such easements, rights and dedications that Lessor deems necessary or desirable, and to cause the recordation of Parcel Maps and restrictions, so long as such easements, rights, dedications, Maps and restrictions do not unreasonably interfere with the use of the Premises by Lessee. Lessee shall sign any of the aforementioned documents upon request of Lessor and failure to do so shall constitute a material breach of this Lease. 43. Performance Under Protest. If at any time a dispute shall arise as to any amount or sum of money to be paid by one party to the other under the provisions hereof, the party against whom the obligation to pay the money is asserted shall have the right to make payment "under protest" and such payment shall not be regarded as a voluntary payment, and there shall survive the right on the part of said party to institute suit for recovery of such sum. If it shall be adjudged that there was no legal obligation on the part of said party to pay such sum or any part thereof, said party shall be entitled to recover such sum or so much thereof as it was not legally required to pay under the provisions of this Lease. 44. Authority. If Lessee is a corporation, trust, or general or limited partnership, each individual executing this Lease on behalf of such entity represents and warrants that he or she is duly authorized to execute and deliver this Lease on behalf of said entity. If Lessee is a corporation, trust or partnership, Lessee shall, within thirty (30) days after execution of this Lease, deliver to Lessor evidence of such authority satisfactory to Lessor. 45. Conflict. Any conflict between the printed provisions of this Lease and the typewritten or handwritten provision shall be controlled by the typewritten or handwritten provisions. 46. Insuring Party. The insuring party under this lease shall be the Lessor. 47. Addendum. Attached hereto is an addendum or addenda containing paragraphs 1 through 7 which constitutes a part of this Lease. LESSOR AND LESSEE HAVE CAREFULLY READ AND REVIEWED THIS LEASE AND EACH TERM AND PROVISION CONTAINED HEREIN AND, BY EXECUTION OF THIS LEASE, SHOW THEIR INFORMED AND VOLUNTARY CONSENT THERETO. THE PARTIES HEREBY AGREE THAT, AT THE TIME THIS LEASE IS EXECUTED, THE TERMS OF THIS LEASE ARE COMMERCIALLY REASONABLE AND EFFECTUATE THE INTENT AND PURPOSE OF LESSOR AND LESSEE WITH RESPECT TO THE PREMISES. IF THIS LEASE HAS BEEN FILLED IN IT HAS BEEN PREPARED FOR SUBMISSION TO YOUR ATTORNEY FOR HIS APPROVAL. NO REPRESENTATION OR RECOMMENDATION IS MADE BY THE AMERICAN INDUSTRIAL REAL ESTATE ASSOCIATION OR BY THE REAL ESTATE BROKER OR ITS AGENTS OR EMPLOYEES AS TO THE LEGAL SUFFICIENCY, LEGAL EFFECT, OR TAX CONSEQUENCES OF THIS LEASE OR THE TRANSACTION RELATING THERETO; THE PARTIES SHALL RELY SOLELY UPON THE ADVICE OF THEIR OWN LEGAL COUNSEL AS TO THE LEGAL AND TAX CONSEQUENCES OF THIS LEASE. The parties hereto have executed this Lease at the place on the dates specified immediately adjacent to their respective signatures. Executed at Encino, CA P & R INVESTMENT COMPANY --------------------------- ------------------------------------- on December , 1993 By /s/ Sanford P. Paris ------------------------------------ ------------------------------------ Sanford P. Paris, General Partner Address 16501 Ventura Blvd., #402 By /s/ Max Ramberg - --------------------------------------- ------------------------------------ Max Ramberg, General Partner Encino, CA 91436 (Tel. 818/905-0703) - --------------------------------------- "LESSOR" (Corporate seal) Executed at Chatsworth, CA IMAGE ENTERTAINMENT, INC. --------------------------- -------------------------------------- on December , 1993 By /s/ Martin Greenwald ------------------------------------ ------------------------------------ Martin Greenwald, President Address 9333 Oso Ave. By ------------------------------- ----------------------------------- Chatsworth, CA 91311 (Tel. 818/407-9100) - ---------------------------------------- "LESSEE" (Corporate seal) ADDENDUM to that Lease dated December 1, 1993, by and between P & R INVESTMENT COMPANY, as Lessor and IMAGE ENTERTAINMENT, INC., as Lessee for that property commonly known as 9333 Oso Avenue, Chatsworth, California. This Addendum to the attached Lease, dated December 1, 1993 is hereby incorporated into the Lease and is made a part thereof by this reference. In the event of any conflict or inconsistency between the Lease and this Addendum, the terms of this Addendum shall govern and control the intent of the parties. 1. Possession. Subparagraphs 3.2 Delay in Possession and 3.3 Early ---------- Possession are hereby deleted and the following substituted therefore; The parties acknowledge that Lessee is in possession of the premises under a Lease dated April 10, 1989 by and between these parties. All of the terms and conditions of the April 10, 1989 Lease shall remain in full force and effect until March 31, 1994, at which time it shall TERMINATE and the terms and conditions of this Lease dated December 1, 1993 shall commence so that there shall be no break in occupancy by Lessee. 2. Rent. Paragraph 4 of the Lease is modified by adding the following: ---- Commencing April 1, 1995 and on each and every April 1 thereafter, the monthly rent of $13,536.00 shall be subject to adjustment, upward only, in proportion to that increase, if any in the U.S. Department of Labor, Bureau of Labor Statistics, Consumer Price Index, All Urban Consumers, (Los Angeles/Anaheim/Riverside, All Items, 1982-84=100) hereinafter referred to as "C.P.I." for the previous year (twelve months) period terminating the third month (i.e. January) prior to the date of adjustment (i.e. April). This is used so that the parties will know the latest full year CPI changes by the time the April 1st rent is due. This annually adjusted rent shall commence on April 1 of each year automatically without notice. If notice to Lessee by Lessor is not made by March 1, then the previous rent shall be paid and the additional adjustment paid within ten (10) days of notice to Lessee by Lessor of the actual increase. In the event said Index shall have been discontinued, the most nearly comparable index shall be substituted therefore. 3. Use. Paragraph 6 of the Lease shall be modified by adding the --- following: Page 1 of 4 a. Except in strict compliance with all Environmental Requirements, Lessee shall not cause, permit or suffer any "Hazardous Material" to be brought upon, treated, kept, stored, disposed of, discharged, released, produced, manufactured, generated, refined or used upon, about or beneath the Property or any portion thereof by Lessee, its agents, employees, contractors, tenants or invitees, or any other person. b. Hazardous Material means any substance the presence of which requires reporting, regulation, investigation or remediation under any federal, state or local statute, regulation ordinance, order, action, policy or common law or which is or becomes defined as a "hazardous waste", "hazardous substance", pollutant or contaminant under any federal, state or local statute, regulation, rule or ordinance or amendments thereto including, without limitation, the Comprehensive Environmental Response, Compensation and Liability Act (42 U.S.C. section 9601 et seq.) and/or the Resource Conservation and Recovery Act (42 U.S.C. section 6901 et seq.). 4. Maintenance, Repairs and Alterations. Paragraph 7 of the Lease is ------------------------------------ modified to provide the following: a. Lessee shall remove those office improvements constructed by Lessee if required to do so by the Lessor at Lessee's sole cost and expense at the end of the Lease or any extension thereof. b. In consideration of Lessee's use of part of lot 7 for parking, ingress and egress from the premises at no additional rent or payment of real estate taxes on lot 7, Lessee at its sole cost and expense shall maintain the two planters in front of lot 7 on Oso Avenue for the mutual benefit of the parties. c. The number "$10,000" shall be substituted for the number $2500 in the first and second sentences of Paragraph 7.5. 5. Assignment and Subletting. Paragraph 12 of the Lease shall be modified ------------------------- by adding the following: a. The following additional provisions shall apply to any assignment of the Lease and/or subletting of the Premises: 1) The assignment or sublease to the particular assignee or sublessee must have been approved in writing by Lessor in advance. 2) Lessee shall have made to Lessor a full and complete disclosure of all of the terms, provisions and conditions of the Page 2 of 4 assignment or subletting and shall have furnished to Lessor true and complete copies of all documents used and to be used in connection with the transaction. 3) In the event there is "Overriding Consideration" paid and/or to be paid by the assignee or sublessee to Lessee, one-half of all such Overriding Consideration shall be paid by Lessee (or by the assignee or sublessee at the direction of Lessor) to Lessor after Lessee deducts normal reasonable costs of the assignment or subletting; such as broker commissions, free rent periods, or tenant improvements, providing Lessee substantiates such costs to Lessor in writing. 4) As used herein "Overriding Consideration" shall mean any consideration of whatsoever kind or character whether in money or any other item or items of value and whether in a lump sum or in installments or in any combination thereof paid and/or payable by the assignee or the sublessee in connection with the Premises over and above the monetary sums payable by Lessee to Lessor under the Lease and the performance of Lessee's other obligations under the Lease. In the event that one or more subleases cover less than all of the Premises, Overriding Consideration shall be determined by first making an equitable allocation between the entire Premises and the portion or portions thereof covered by the sublease or subleases. Lessor's allocation made in good faith shall be binding and conclusive upon all parties involved. 5) Lessor shall have the right to communicate with the assignee or sublessee or any other person having relevant information on the subject; and shall have the right from time to time to examine all books, records and documents of Lessee. Lessee shall also use Lessee's best efforts to arrange for Lessor to examine the books, records and documents of any assignee and sublessee. b. In the event of any proposed assignment or subletting under the Lease, if the proposed assignee's or sublessees' activities in or about the Premises involve the use, handling, storage or disposal of any Hazardous Materials (as defined in Paragraph 3b above) (i) it shall be reasonable for Lessor to withhold its consent to such assignment or sublease in light of the risk of contamination posed by such activities unless Lessee satisfies the condition described in the following clause and/or (ii) Lessor may impose an additional condition to such assignment or sublease which requires Lessee to establish beyond a reasonable doubt that such assignee's or sublessee's activities pose no greater risk on contamination to the Premises than do Lessee's permitted activities in view of (a) the quantities, toxicity and other properties of the Hazardous Materials to be used by such assignee or sublessee, (b) the Page 3 of 4 precautions against a release of Hazardous Materials such assignee or sublessee agrees to implement, (c) such assignee's or sublessee's financial condition as it relates to its ability to fund a major clean-up, and (d) such assignee's or sublessee's policy and historical record respecting its willingness to respond to and clean up a release of Hazardous Materials. 6. Lessor's Remedies. In addition to any other remedies of Lessor ----------------- contained in this Lease under the provisions of Paragraph 13.2 hereof, notice is given by the Lessor that additional remedies are available under California law (Civil Code Section 1951.2) and its future amendments or revisions. These Code Sections require Lessor to declare to Lessee in the Lease that Lessor will avail itself of the remedies so prescribed. Lessor hereby gives said notice. 7. Signs. Paragraph 34 of the Lease is modified by adding the following: ----- Lessee shall have the right to place exterior signs on the Premises subject to any applicable laws, code or ordinances and subject to any reasonable rules and regulations adopted for the Building. Lessee shall be solely responsible for maintaining in good conditions its signs and shall remove them and repair any damage caused by such removal on or before the termination of the Lease or any extension thereof. This Addendum to Lease consisting of paragraphs 1 through 7 shall be binding upon the parties hereto and their heirs, administrators, successors and assigns. LESSOR: LESSEE: P & R INVESTMENT COMPANY IMAGE ENTERTAINMENT, INC. by: /s/ Sanford P. Paris by: /s/ Martin W. Greenwald -------------------------------- ------------------------------ Sanford P. Paris, General Partner Martin W. Greenwald, President by: /s/ Max Ramberg -------------------------------- Max Ramberg, General Partner Date: 12/ /93 Date: 12/16/93 -------------------------------- --------------------------- at: Encino, California at: Chatsworth, California LOCATION: LOCATION: --------------------------- --------------------- Page 4 of 4 [FLOOR PLAN OF IMAGE PARKING APPEARS HERE] = IMAGE PARKING - 90 CARS PROVIDED = NON EXCLUSIVE EASEMENT EX-10.24.A 5 1ST AMENDMENT TO 9333 OSO LEASE DTD 12/1/1993 EXHIBIT 10.24.A FIRST AMENDMENT TO LEASE This FIRST AMENDMENT TO LEASE is made and entered into as of this 20/th/ day of August, 1996 by and between P & R INVESTMENT COMPANY, a California General Partnership, (hereinafter referred to as "LESSOR"), and IMAGE ENTERTAINMENT, INC., a California Corporation, (hereinafter referred to as "LESSEE"). WITNESSETH ---------- A. WHEREAS, LESSOR and LESSEE did heretofore on December 1, 1993, enter into a LEASE ("LEASE"), in which LESSOR rented to LESSEE an industrial building commonly known as 9333 Oso Avenue, Chatsworth, CA 91311 whose legal description is: Lots 8 and 9, Tract 31225, recorded in Book 843, pages 62-65 in the office of the Los Angeles County Recorder. for a term of six (6) years commencing on April 1, 1994 and ending on March 31, 2000; and, B. WHEREAS, the parties wish to mutually modify the Lease. NOW, THEREFORE, it is agreed to by and between the parties as follows: 1. The definition of Premises in the LEASE shall be modified to exclude any reference to Lot 7, Tract 31225. It is the intent of the LESSOR to utilize Lot 7 for a new building. 2. Paragraph 4.(b.) of the Addendum to LEASE dated December 1, 1993 is hereby deleted. Parking for the Premises shall be limited to those parking spaces located on Lots 8 and 9, Tract 31225 only as shown on Exhibit A attached hereto and made a part hereof by this reference. 3. In consideration of Lessee's agreeing to this First Amendment to Lease, Lessor shall at its sole cost and expense, remove the chain link enclosures and concrete curbs at the South-West corner of the building and otherwise at Lessee's request. Lessor shall also restrip the parking area of Premises per Exhibit A. 4. Except as herein modified and amended, all of the terms and conditions of said LEASE dated December 1, 1993 shall be and remain in full force and effect. 4. Since LESSEE is a Corporation, each individual executing this FIRST AMENDMENT TO LEASE on behalf of said Corporation represents and warrants that he/she is duly authorized to execute and deliver this FIRST AMENDMENT TO LEASE on behalf of said Corporation. 5. This FIRST AMENDMENT TO LEASE shall bind the parties hereto, their personal representatives, successors and assigns. This FIRST AMENDMENT TO LEASE shall be governed by the laws of the State of California. IN WITNESS WHEREOF, the parties have executed this FIRST AMENDMENT TO LEASE on the day and year first written above. at: Los Angeles, California LESSOR: LESSEE: P & R INVESTMENT CO., by: IMAGE ENTERTAINMENT, INC., by: /s/ SANFORD P. PARIS /s/ CHERYL LEE - ----------------------------- ------------------------------------ Sanford P. Paris, Cheryl Lee, General Partner its Chief Administrative Officer and General Counsel /s/ MAX RAMBERG /s/ DAVID BORSHELL - ----------------------------- ------------------------------------ Max Ramberg, David Borshell, General Partner its Sr. Vice President of Sales, Marketing and Operations EX-10.24.B 6 2ND AMENDMENT TO 9333 OSO LEASE DTD 12/1/1993 EXHIBIT 10.24.b SECOND AMENDMENT TO LEASE This SECOND AMENDMENT TO LEASE is made and entered into as of this 1/ST/ day of March, 1999 by and between P & R INVESTMENT COMPANY, a California General Partnership, (hereinafter referred to as "LESSOR"), and IMAGE ENTERTAINMENT, INC., a California corporation, (hereinafter referred to as "LESSEE"). WITNESSETH ---------- A. WHEREAS, LESSOR and LESSEE did heretofore on December 1, 1993, enter into a LEASE ("LEASE"), in which LESSOR rented to LESSEE an industrial building commonly known as 9333 Oso Avenue, Chatsworth, CA 91311 whose legal description is: Lots 8 and 9, Tract 31225, recorded in Book 843, pages 62-65 in the office of the Los Angeles County Recorder. for a term of six (6) years commencing on April 1, 1994 and ending on March 31, 2000, and; B. WHEREAS, the parties first amended this lease on August 20, 1996. C. WHEREAS, the parties wish to mutually extend the Lease. NOW THEREFORE, it is agreed to by and between the parties as follows: 1. Lease is hereby extended to April 30, 2004. 2. The rent for the extended period of time (April 1, 2000 through April 30, 2004) shall be as follows: Commencing on April 1, 2000 and on each and every April 1 thereafter, the monthly rent of $17,450.00 shall be subject to adjustment, upward only, in proportion to that increase, if any in the U.S. Department of Labor, Bureau of Labor Statistics, Consumer Price Index, All Urban Consumers, (Los Angeles/Anaheim/Riverside, All Items, 1982-84=100) hereinafter referred to as "C.P.I." for the previous year (twelve months) period terminating the third month (i.e. January) prior to the date of adjustment (i.e. April). This is used so that the parties will know the latest full year CPI changes by the time the April 1/st/ rent is due. This annually adjusted rent shall commence on April 1 of each year automatically without notice. If notice to Lessee by Lessor is not made by March 1, then the previous rent shall be paid and the additional adjustment paid within ten (10) days of notice to Lessee by Lessor of the actual increase. In the event said Index shall have been discontinued, the most nearly comparable index shall be substituted therefore. 3. Except as herein modified and amended, all of the terms and conditions of said LEASE dated December 1, 1993 shall be and remain in full force and effect. 4. Since LESSEE is a Corporation, each individual executing this SECOND AMENDMENT TO LEASE on behalf of said Corporation represents and warrants that he/she is duly authorized to execute and deliver this SECOND AMENDMENT TO LEASE on behalf of said Corporation. 5. This SECOND AMENDMENT TO LEASE shall bind the parties hereto, their personal representatives, successors and assigns. This SECOND AMENDMENT TO LEASE shall be governed by the laws of the State of California. IN WITNESS WHEREOF, the parties have executed this SECOND AMENDMENT TO LEASE on the day and year first written above. at: Los Angeles, California LESSOR: LESSEE: P & R INVESTMENT CO., by: IMAGE ENTERTAINMENT, INC., by: /s/ SANFORD P. PARIS /s/ MARTIN W. GREENWALD - ---------------------------- ----------------------------------- Sanford P. Paris, Martin W. Greenwald, General Partner its President and CEO /s/ MAX RAMBERG /s/ DAVID BORSHELL - ---------------------------- ----------------------------------- Max Ramberg, David Borshell, General Partner its Sr. Vice President of Sales, Marketing and Operations EX-10.25 7 LEASE FOR 9349 OSO AVENUE DTD 3/1/1999 EXHIBIT 10.25 STANDARD INDUSTRIAL LEASE - NET AMERICAN INDUSTRIAL REAL ESTATE ASSOCIATION [LOGO OF AMERCIAN INDUSTRIAL REAL ESTATE ASSOCIATION] 1. Parties. This Lease, dated, for reference purposes only, March 1, 1999 ------------------- is made by and between P & R Investment Company, a California General ---------------------------------------------- Partnership (herein called "Lessor) and Image Entertainment, Inc., a California - ----------- --------------------------------------- Corporation (herein called "Lessee"). - ----------- 2. Premises. Lessor hereby leases to Lessee and Lessee leases from Lessor for the term, at the rental, and upon all of the conditions set forth herein, that certain real property situated in the County of Los Angeles State of ----------- California, commonly known as 9349 Oso Avenue, Chatsworth, CA 91311 and - ------------------------------------------------------------------- described as approximately 15,440 square foot concrete tilt up industrial ------------------------------------------------------------ building. - -------- Said real property including the land and all improvements therein, is herein called "the Premises". 3. Term. 3.1 Term. The term of this Lease shall be for Five (5) years commencing on -------------- May 1, 1999 and ending on April 30, 2004 unless sooner terminated pursuant to - ----------- -------------- any provision hereof. See Addendum Paragraph 48. 3.2 Delay in Possession. Notwithstanding said commencement date, if for any reason Lessor cannot deliver possession of the Premises to Lessee on said date, Lessor shall not be subject to any liability therefor, nor shall such failure affect the validity of this Lease or the obligations of Lessee hereunder or extend the term hereof, but in such case, Lessee shall not be obligated to pay rent until possession of the Premises is tendered to Lessee; provided, however, that if Lessor shall not have delivered possession of the Premises within ninety (90) days from said commencement date, Lessee may, at Lessee's option, by notice in writing to Lessor within ten (10) days thereafter, cancel this Lease, in which event the parties shall be discharged from all obligations hereunder; provided further, however, that if such written notice of Lessee is not received by Lessor within said ten (10) day period, Lessee's right to cancel this Lease hereunder shall terminate and be of no further force or effect. 3.3 Early Possession. If Lessee occupies the Premises prior to said commencement date, such occupancy shall be subject to all provisions hereof, such occupancy shall not advance the termination date, and Lessee shall pay rent for such period at the initial monthly rates set forth below. 4. Rent. Lessee shall pay to Lessor as rent for the Premises, monthly payments of $ See Addend, Par. 49, in advance, on the First day of each month of the ---------------------- term hereof. Rent for any period during the term hereof which is for less than one month shall be a pro rata portion of the monthly installment. Rent shall be payable in lawful money of the United States to Lessor at the address stated herein or to such other persons or at such other places as Lessor may designate in writing. 5. Security Deposit. Lessee shall deposit with Lessor upon execution hereof $10,000.00 as security for Lessee's faithful performance of Lessee's - ---------- obligations hereunder. If Lessee fails to pay rent or other charges due hereunder, or otherwise defaults with respect to any provision of this Lease, Lessor may use, apply or retain all or any portion of said deposit for the payment of any rent or other charge in default or for the payment of any other sum to which Lessor may become obligated by reason of Lessee's default, or to compensate Lessor for any loss or damage which Lessor may suffer thereby. If Lessor so uses or applies all or any portion of said deposit, Lessee shall within ten (10) days after written demand therefor deposit cash with Lessor in an amount sufficient to restore said deposit to the full amount hereinabove stated and Lessee's failure to do so shall be a material breach of this Lease. If the monthly rent shall, from time to time, increase during the term of this Lease, Lessee shall thereupon deposit with Lessor additional security deposit so that the amount of security deposit held by Lessor shall at all times bear the same proportion to current rent as the original security deposit bears to the original monthly rent set forth in paragraph 4 hereof. Lessor shall not be required to keep said deposit separate from its general accounts. If Lessee performs all of Lessee's obligations hereunder, said deposit, or so much thereof as has not theretofore been applied by Lessor, shall be returned, without payment of interest or other increment for its use, to Lessee (or, at Lessor's option, to the last assignee, if any, of Lessee's interest hereunder) at the expiration of the term hereof, and after Lessee has vacated the Premises. No trust relationship is created herein between Lessor and Lessee with respect to said Security Deposit. 6. Use. 6.1 Use. The Premises shall be used and occupied only for Warehousing, ----------- distribution and sales of laser discs, video discs, DVD and related products. - ---------------------------------------------------------------------------- See paragraph 50 of Addendum or any other use which is reasonably comparable and - ---------------------------- for no other purpose. 6.2 Compliance with Law. (a) Lessor warrants to Lessee that the Premises, in its state existing on the date that the Lease term commences, but without regard to the use for which Lessee will use the Premises, does not violate any covenants or restrictions of record, or any applicable building code, regulation or ordinance in effect on such Lease term commencement date. In the event it is determined that this warranty has been violated then it shall be the obligation of the Lessor, after written notice from Lessee, to promptly, at Lessor's sole cost and expense, rectify any such violation. In the event Lessee does not give to Lessor written notice of the violation of this warranty within six months from the date that the Lease term commences, the correction of same shall be the obligation of the Lessee at Lessee's sole cost. The warranty contained in this paragraph 6.2 (a) shall correct any such violation at Lessee's sole cost. (b) Except as provided in paragraph 6.2(a), Lessee shall, at Lessee's expense, comply promptly with all applicable statutes, ordinances, rules, regulations, orders, covenants and restrictions of record, and requirements in effect during the term or any part of the term hereof, regulating the use by Lessee of the Premises. Lessee shall not use nor permit the use of the Premises in any manner that will tend to create waste or a nuisance or, if there shall be more than one tenant in the building containing the Premises, shall tend to disturb such other tenants. 6.3 Condition of Premises. (a) Lessor shall deliver the Premises to Lessee clean and free of debris on Lease commencement date (unless Lessee is already in possession) and Lessor further warrants to Lessee that the plumbing, lighting, air conditioning, heating, and loading doors in the Premises shall be in good operating condition on the Lease commencement date. In the event that it is determined that this warranty has been violated, then it shall be the obligation of Lessor, after receipt of written notice from Lessee setting forth with specificity the nature of the violation, to promptly, at Lessor's sole cost, rectify such violation. Lessee's failure to give such written notice to Lessor within thirty (30) days after the Lease commencement date shall cause the conclusive presumption that Lessor has complied with all of Lessor's obligations hereunder. The warranty contained in this paragraph 6.3(a) shall be of no force or effect if prior to the date of this Lease, Lessee was the owner or occupant of the Premises. (b) Except as otherwise provided in this Lease, Lessee hereby accepts the Premises in their condition existing as of the Lease commencement date or the date that Lessee takes possession of the Premises, whichever is earlier, subject to all applicable zoning, municipal, county and state laws, ordinances and regulations governing and regulating the use of the Premises and any covenants or restrictions of record, and accepts this Lease subject thereto and to all matters disclosed thereby and by any exhibits attached hereto. Lessee acknowledges that neither Lessor nor Lessor's agent has made any representation or warranty as to the present or future suitability of the Premises for the conduct of Lessee's business. 7. Maintenance, Repairs and Alterations. 7.1 Lessee's Obligations. Lessee shall keep in good order, condition and repair the Premises and every part thereof, structural and non structural (whether or not such portion of the Premises requiring repair, or the means of repairing the same are reasonably or readily accessible to Lessee, and whether or not the need for such repairs occurs as a result of Lessee's use, any prior use, the elements or the age of such portion of the Premises) including, without limiting the generality of the foregoing, all plumbing, heating, air conditioning, (Lessee shall procure and maintain, at Lessee's expense, an air conditioning system maintenance contract) ventilating, electrical, lighting facilities and equipment within the Premises, fixtures, walls (interior and exterior), foundations, ceilings, roofs (interior and exterior), floors, windows, doors, plate glass and skylights located within the Premises, and all landscaping, driveways, parking lots, fences and signs located on the Premises and sidewalks and parkways adjacent to the Premises. 7.2. Surrender. On the last day of the term hereof, or on any sooner termination, Lessee shall surrender the Premises to Lessor in the same condition as when received, ordinary wear and tear excepted, clean and free of debris. Lessee shall repair any damage to the Premises occasioned (c) American Industrial Real Estate Association 1980 Initials: - 1 - by the installation or removal of Lessee's trade fixtures, furnishings and equipment. Notwithstanding anything to the contrary otherwise stated in this Lease, Lessee shall leave the air lines, power panels, electrical distribution systems, lighting fixtures, space heaters, air conditioning, plumbing and fencing on the premises in good operating condition. 7.3 Lessor's Rights. If Lessee fails to perform Lessee's obligations under this Paragraph 7, or under any other paragraph to this Lease, Lessor may at its option (but shall not be required to) enter upon the Premises after ten (10) days' prior written notice to Lessee (except in the case of an emergency, in which case no notice shall be required), perform such obligations on Lessee's behalf and put the same in good order, condition and repair, and the cost thereof together with interest thereon at the maximum rate then allowable by law shall become due and payable as additional rental to Lessor together with Lessee's next rental installment. 7.4 Lessor's Obligations. Except for the obligations of Lessor under Paragraph 6.2(a) and 6.3(a) (relating to Lessor's warranty), Paragraph 9 (relating to destruction of the Premises) and under Paragraph 14 (relating to condemnation of the Premises), it is intended by the parties hereto that Lessor have no obligation, in any manner whatsoever, to repair and maintain the Premises nor the building located thereon nor the equipment therein, whether structural or non structural, all of which obligations are intended to be that of the Lessee under Paragraph 7.1 hereof. Lessee expressly waives the benefit of any statute now or hereinafter in effect which would otherwise afford Lessee the right to make repairs at Lessor's expense or to terminate this Lease because of Lessor's failure to keep the premises in good order, condition and repair. 7.5 Alterations and Additions. (a) Lessee shall not, without Lessor's prior written consent make any alterations, improvements, additions, or Utility Installations in, on or about the Premises, except for nonstructural alterations not exceeding $2,500 in cumulative costs during the term of this Lease. In any event, whether or not in excess of $10,000.00 in cumulative cost, Lessee shall make no change or alteration to the exterior of the Premises nor the exterior of the building(s) on the Premises without Lessor's prior written consent. As used in this Paragraph 7.5 the term "Utility Installation" shall mean carpeting, window coverings, air lines, power panels, electrical distribution systems, lighting fixtures, space heaters, air conditioning, plumbing and fencing. Lessor may require that Lessee remove any or all of said alterations, improvements, additions or Utility Installations at the expiration of the term, and restore the Premises to their prior condition. Lessor may require Lessee to provide Lessor, at Lessee's sole cost and expense, a lien and completion bond in an amount equal to one and one-half times the estimated cost of such improvements, to insure Lessor against any liability for mechanic's and materialmen's liens and to insure completion of the work. Should Lessee make any alterations, improvements, additions or Utility Installations without the prior approval of Lessor, Lessor may require that Lessee remove any or all of the same. (b) Any alterations, improvements, additions or Utility Installations in, or about the Premises that Lessee shall desire to make and which requires the consent of the Lessor shall be presented to Lessor in written form, with proposed detailed plans. If Lessor shall give its consent, the consent shall be deemed conditioned upon Lessee acquiring a permit to do so from appropriate governmental agencies, the furnishing of a copy thereof to Lessor prior to the commencement of the work and the compliance by Lessee of all conditions of said permit in a prompt and expeditious manner. (c) Lessee shall pay, when due, all claims for labor or materials furnished or alleged to have been furnished to or for Lessee at or for use in the Premises, which claims are or may be secured by any mechanics' or materialmen's lien against the Premises or any interest therein. Lessee shall give Lessor not less than ten (10) days' notice prior to the commencement of any work in the Premises, and Lessor shall have the right to post notices of non- responsibility in or on the Premises as provided by law. If Lessee shall, in good faith, contest the validity of any such lien, claim or demand, then Lessee shall, at its sole expense defend itself and Lessor against the same and shall pay and satisfy any such adverse judgment that may be rendered thereon before the enforcement thereof against the Lessor or the Premises, upon the condition that if Lessor shall require, Lessee shall furnish to Lessor a surety bond satisfactory to Lessor in an amount equal to such contested lien claim or demand indemnifying Lessor against liability for the same and holding the Premises free from the effect of such lien or claim. In addition, Lessor may require Lessee to pay Lessor's attorneys fees and costs in participating in such action if Lessor shall decide it is to its best interest to do so. (d) Unless Lessor requires their removal, as set forth in Paragraph 7.5(a), all alterations, improvements, additions and Utility Installations (whether or not such Utility Installations constitute trade fixtures of Lessee), which may be made on the Premises, shall become the property of Lessor and remain upon and be surrendered with the Premises at the expiration of the term. Notwithstanding the provisions of this Paragraph 7.5(d), Lessee's machinery and equipment, other than that which is affixed to the Premises so that it cannot be removed without material damage to the Premises, shall remain the property of Lessee and may be removed by Lessee subject to the provisions of Paragraph 7.2. 8. Insurance Indemnity. 8.1 Insuring Party. As used in this Paragraph 8, the term "insuring party" shall mean the party who has the obligation to obtain the Property Insurance required hereunder. The insuring party shall be designated in Paragraph 46 hereof. In the event Lessor is the insuring party, Lessor shall also maintain the liability insurance described in paragraph 8.2 hereof, in addition to, and not in lieu of, the insurance required to be maintained by Lessee under said paragraph 8.2, but Lessor shall not be required to name Lessee as an additional insured on such policy. Whether the insuring party is the Lessor or the Lessee, Lessee shall, as additional rent for the Premises, pay the cost of all insurance required hereunder, except for that portion of the cost attributable to Lessor's liability insurance coverage in excess of $1,000,000 per occurrence. If Lessor is the insuring party Lessee shall, within ten (10) days following demand by Lessor, reimburse Lessor for the cost of the insurance so obtained. 8.2 Liability Insurance. Lessee shall, at Lessee's expense obtain and keep in force during the term of this Lease a policy of Combined Single Limit, Bodily Injury and Property Damage insurance insuring Lessor and Lessee against any liability arising out of the ownership, use, occupancy or maintenance of the Premises and all areas appurtenant thereto. Such insurance shall be a combined single limit policy in an amount not less than $1,000,000.00 per occurrence. The policy shall insure performance by Lessee of the indemnity provisions of this Paragraph 8. The limits of said insurance shall not, however, limit the liability of Lessee hereunder. 8.3 Property Insurance. (a) The insuring party shall obtain and keep in force during the term of this Lease a policy or policies of insurance covering loss or damage to the Premises, in the amount of the full replacement value thereof, as the same may exist from time to time, which replacement value is now $750,000.00, but in no event less than the total amount required by lenders having liens on the Premises, against all perils included within the classification of fire, extended coverage, vandalism, malicious mischief, flood (in the event same is required by a lender having a lien on the Premises), and special extended perils ("all risk" as such term is used in the insurance industry). Said insurance shall provide for payment of loss thereunder to Lessor or to the holders of mortgages or deeds of trust on the Premises. The insuring party shall, in addition, obtain and keep in force during the term of this Lease a policy of rental value insurance covering a period of one year, with loss payable to Lessor, which insurance shall also cover all real estate taxes and insurance costs for said period. A stipulated value or agreed amount endorsement deleting the coinsurance provision of the policy shall be procured with said insurance as well as an automatic increase in insurance endorsement causing the increase in annual property insurance coverage by 2% per quarter. If the insuring party shall fail to procure and maintain said insurance the other party may, but shall not be required to, procure and maintain the same, but at the expense of Lessee. If such insurance coverage has a deductible clause, the deductible amount shall not exceed $1,000 per occurrence, and Lessee shall be liable for such deductible amount. (b) If the Premises are part of a larger building, or if the Premises are part of a group of buildings owned by Lessor which are adjacent to the Premises, then Lessee shall pay for any increase in the property insurance of such other building or buildings if said increase is caused by Lessee's acts, omissions, use or occupancy of the Premises. (c) If the Lessor is the insuring party the Lessor will not insure Lessee's fixtures, equipment or tenant improvements unless the tenant improvements have become a part of the Premises under paragraph 7, hereof. But if Lessee is the insuring party the Lessee shall insure its fixtures, equipment and tenant improvements. 8.4 Insurance Policies. Insurance required hereunder shall be in companies holding a "General Policyholders Rating" of at least B plus, or such other rating as may be required by a lender having a lien on the Premises, as set forth in the most current issue of "Best's Insurance Guide". The insuring party shall deliver to the other party copies of policies of such insurance or certificates evidencing the existence and amounts of such insurance with loss payable clauses as required by this paragraph 8. No such policy shall be cancellable or subject to reduction of coverage or other modification except after thirty (30) days' prior written notice to Lessor. If Lessee is the insuring party Lessee shall, at least thirty (30) days prior to the expiration of such policies, furnish Lessor with renewals or "binders" thereof, or Lessor may order such insurance and charge the cost thereof to Lessee, which amount shall be payable by Lessee upon demand. Lessee shall not do or permit to be done anything which shall invalidate the insurance policies referred to in Paragraph 8.3. If Lessee does or permits to be done anything which shall increase the cost of the insurance policies referred to in Paragraph 8.3, then Lessee shall forthwith upon Lessor's demand reimburse Lessor for any additional premiums attributable to any act or omission or operation of Lessee causing such increase in the cost of insurance. If Lessor is the insuring party, and if the insurance policies maintained hereunder cover other improvements in addition to the Premises, Lessor shall deliver to Lessee a written statement setting forth the amount of any such insurance cost increase and showing in reasonable detail the manner in which it has been computed. 8.5 Waiver of Subrogation. Lessee and Lessor each hereby release and relieve the other, and waive their entire right of recovery against the other for loss or damage arising out of or incident to the perils insured against under paragraph 8.3, which perils occur in, on or about the Premises, whether due to the negligence of Lessor or Lessee or their agents, employees, contractors and/or invitees. Lessee and Lessor shall, upon obtaining the policies of insurance required hereunder, give notice to the insurance carrier or carriers that the foregoing mutual waiver of subrogation is contained in this Lease. 8.6 Indemnity. Lessee shall indemnify and hold harmless Lessor from and against any and all claims arising from Lessee's use of the Premises, or from the conduct of Lessee's business or from any activity, work or things done, permitted or suffered by Lessee in or about the Premises or elsewhere and shall further indemnify and hold harmless Lessor from and against any and all claims arising from any breach or default in the performance of any obligation on Lessee's part to be performed under the terms of this Lease, or arising from any negligence of the Lessee, or any of Lessee's agents, contractors, or employees, and from and against all costs, attorney's fees, expenses and liabilities incurred in the defense of any such claim or any action or proceeding brought thereon; and in case any action or proceeding be brought against Lessor by reason of any such claim, Lessee upon notice from Lessor shall defend the same at Lessee's expense by counsel satisfactory to Lessor. Lessee, as a material part of the consideration to Lessor, hereby assumes all risk of damage to property or injury to persons, in, upon or about the Premises arising from any cause and Lessee hereby waives all claims in respect thereof against Lessor. 8.7 Exemption of Lessor from Liability. Lessee hereby agrees that Lessor shall not be liable for injury to Lessee's business or any loss of income therefrom or for damage to the goods, wares, merchandise or other property of Lessee, Lessee's employees, invitees, customers, or any other person in or about the Premises, nor shall Lessor be liable for injury to the person of Lessee, Lessee's employees, agents or contractors, whether such damage or injury is caused by or results from fire, steam, electricity, gas, water or rain, or from any other cause, whether the said damage or injury results from conditions arising upon the Premises or upon other portions of the building of which the Premises are a part, or from other sources or places and regardless of whether the cause of such damage or injury or the means of repairing the same is inaccessible to Lessee. Lessor shall not be liable for any damages arising from any act or neglect of any other tenant, if any, of the building in which the Premises are located. -2- 9. Damage or Destruction. 9.1 Definitions. (a) "Premises Partial Damage" shall herein mean damage or destruction to the Premises to the extent that the cost of repair is less than 50% of the then replacement cost of the Premises. "Premises Building Partial Damage" shall herein mean damage or destruction to the building of which the Premises are a part to the extent that the cost of repair is less than 50% of the then replacement cost of such building as a whole. (b) "Premises Total Destruction" shall herein mean damage or destruction to the Premises to the extent that the cost of repair is 50% or more of the then replacement cost of the Premises. "Premises Building Total Destruction" shall herein mean damage or destruction to the building of which the Premises are a part to the extent that the cost of repair is 50% or more of the then replacement cost of such building as a whole. (c) "Insured Loss" shall herein mean damage or destruction which was caused by an event required to be covered by the insurance described in paragraph 8. 9.2 Partial Damage -- Insured Loss. Subject to the provisions of paragraphs 9.4, 9.5 and 9.6, if at any time during the term of this Lease there is damage which is an Insured Loss and which falls into the classification of Premises Partial Damage or Premises Building Partial Damage, then Lessor shall, at Lessor's expense, repair such damage, but not Lessee's fixtures, equipment or tenant improvements unless the same have become a part of the Premises pursuant to Paragraph 7.5 hereof as soon as reasonably possible and this Lease shall continue in full force and effect. Notwithstanding the above, if the Lessee is the insuring party, and if the insurance proceeds received by Lessor are not sufficient to effect such repair, Lessor shall give notice to Lessee of the amount required in addition to the insurance proceeds to effect such repair. Lessee shall contribute the required amount to Lessor within ten days after Lessee has received notice from Lessor of the shortage in the insurance. When Lessee shall contribute such amount to Lessor, Lessor shall make such repairs as soon as reasonably possible and this Lease shall continue in full force and effect. Lessee shall in no event have any right to reimbursement for any such amounts so contributed. 9.3 Partial Damage -- Uninsured Loss. Subject to the provisions of Paragraphs 9.4, 9.5 and 9.6, if any time during the term of this Lease there is damage which is not an Insured Loss and which falls within the classification of Premises Partial Damage or Premises Building Partial Damage, unless caused by a negligent or willful act of Lessee (in which event Lessee shall make the repairs at Lessee's expense), Lessor may at Lessor's option either (i) repair such damage as soon as reasonably possible at Lessor's expense, in which event this Lease shall continue in full force and effect, or (ii) give written notice to Lessee within thirty (30) days after the date of the occurrence of such damage of Lessor's intention to cancel and terminate this Lease, as of the date of the occurrence of such damage. In the event Lessor elects to give such notice of Lessor's intention to cancel and terminate this Lease, Lessee shall have the right within ten (10) days after the receipt of such notice to give written notice to Lessor of Lessee's intention to repair such damage at Lessee's expense, without reimbursement from Lessor, in which event this Lease shall continue in full force and effect, and Lessee shall proceed to make such repairs as soon as reasonably possible. If Lessee does not give such notice within such 10-day period this Lease shall be cancelled and terminated as of the date of the occurrence of such damage. 9.4 Total Destruction. If at any time during the term of this Lease there is damage, whether or not an Insured Loss, (including destruction required by any authorized public authority), which falls into the classification of Premises Total Destruction or Premises Building Total Destruction, this Lease shall automatically terminate as of the date of such total destruction. 9.5 Damage Near End of Term. (a) If at any time during the last six months of the term of this Lease there is damage, whether or not an Insured Loss, which falls within the classification of Premises Partial Damage, Lessor may at Lessor's option cancel and terminate this Lease as of the date of occurrence of such damage by giving written notice to Lessee of Lessor's election to do so within 30 days after the date of occurrence of such damage. (b) Notwithstanding paragraph 9.5(a), in the event that Lessee has an option to extend or renew this Lease, and the time within which said option may be exercised has not yet expired, Lessee shall exercise such option, if it is to be exercised at all, no later than 20 days after the occurrence of an Insured Loss falling within the classification of Premises Partial Damage during the last six months of the term of this Lease. If Lessee duly exercises such option during said 20 day period, Lessor shall, at Lessor's expense, repair such damage as soon as reasonably possible and this Lease shall continue in full force and effect. If Lessee fails to exercise such option during said 20 day period, then Lessor may at Lessor's option terminate and cancel this Lease as of the expiration of said 20 day period by giving written notice to Lessee of Lessor's election to do so within 10 days after the expiration of said 20 day period, notwithstanding any term or provision in the grant of option to the contrary. 9.6 Abatement of Rent; Lessee's Remedies. (a) In the event of damage described in paragraphs 9.2 or 9.3, and Lessor or Lessee repairs or restores the Premises pursuant to the provisions of this Paragraph 9, the rent payable hereunder for the period during which such damage, repair or restoration continues shall be abated in proportion to the degree to which Lessee's use of the Premises is impaired. Except for abatement of rent, if any, Lessee shall have no claim against Lessor for any damage suffered by reason of any such damage, destruction, repair or restoration. (b) If Lessor shall be obligated to repair or restore the Premises under the provisions of this Paragraph 9 and shall not commence such repair or restoration within 90 days after such obligations shall accure, Lessee may at Lessee's option cancel and terminate this Lease by giving Lessor written notice of Lessee's election to do so at any time prior to the commencement of such repair or restoration. In such event this Lease shall terminate as of the date of such notice. 9.7 Termination -- Advance Payments. Upon termination of this Lease pursuant to this Paragraph 9, an equitable adjustment shall be made concerning advance rent and any advance payments made by Lessee to Lessor. Lessor shall, in addition, return to Lessee so much of Lessee's security deposit as has not theretofore been applied by Lessor. 9.8 Waiver. Lessor and Lessee waive the provisions of any statutes which relate to termination of leases when leased property is destroyed and agree that such event shall be governed by the terms of this Lease. 10. Real Property Taxes. 10.1 Payment of Taxes. Lessee shall pay the real property tax, as defined in paragraph 10.2, applicable to the Premises during the term of this Lease. All such payments shall be made at least ten (10) days prior to the delinquency date of such payment. Lessee shall promptly furnish Lessor with satisfactory evidence that such taxes have been paid. If any such taxes paid by Lessee shall cover any period of time prior to or after the expiration of the term hereof, Lessee's share of such taxes shall be equitably prorated to cover only the period of time within the tax fiscal year during which this Lease shall be in effect, and Lessor shall reimburse Lessee to the extent required. If Lessee shall fail to pay any such taxes, Lessor shall have the right to pay the same, in which case Lessee shall repay such amount to Lessor with Lessee's next rent installment together with interest at the maximum rate then allowable by law. 10.2 Definition of "Real Property Tax". As used herein, the term "real property tax" shall include any form of real estate tax or assessment, general, special, ordinary or extraordinary, and any license fee, commercial rental tax, improvement bond or bonds, levy or tax (other than inheritance, personal income or estate taxes) imposed on the Premises by any authority having the direct or indirect power to tax, including any city, state or federal government, or any school, agricultural, sanitary, fire, street, drainage or other improvement district thereof, as against any legal or equitable interest of Lessor in the Premises or in the real property of which the Premises are a part, as against Lessor's right to rent or other income therefrom, and as against Lessor's business of leasing the Premises. The term "real property tax" shall also include any tax, fee, levy, assessment or charge (i) in substitution of, partially or totally, any tax, fee, levy, assessment or charge hereinabove included within the definition of "real property tax," or (ii) the nature of which was hereinbefore included within the definition of "real property tax," or (iii) which is imposed for a service or right not charged prior to June 1, 1978, or, if previously charged, has been increased since June 1, 1978, or (iv) which is imposed as a result of a transfer, either partial or total, of Lessor's interest in the Premises or which is added to a tax or charge hereinbefore included within the definition of real property tax by reason of such transfer, or (v) which is imposed by reason of this transaction, any modifications or changes hereto, or any transfers hereof. 10.3 Joint Assessment. If the Premises are not separately assessed, Lessee's liability shall be an equitable proportion of the real property taxes for all of the land and improvements included within the tax parcel assessed, such proportion to be determined by Lessor from the respective valuations assigned in the assessor's work sheets or such other information as may be reasonably available. Lessor's reasonable determination thereof, in good faith, shall be conclusive. 10.4 Personal Property Taxes. (a) Lessee shall pay prior to delinquency all taxes assessed against and levied upon trade fixtures, furnishings, equipment and all other personal property of Lessee contained in the Premises or elsewhere. When possible, Lessee shall cause said trade fixtures, furnishings, equipment and all other personal property to be assessed and billed separately from the real property of Lessor. (b) If any of Lessee's said personal property shall be assessed with Lessor's real property, Lessee shall pay Lessor the taxes attributable to Lessee within 10 days after receipt of a written statement setting forth the taxes applicable to Lessee's property. 11. Utilities. Lessee shall pay for all water, gas, heat, light, power, telephone and other utilities and services supplied to the Premises, together with any taxes thereon. If any such services are not separately metered to Lessee, Lessee shall pay a reasonable proportion to be determined by Lessor of all charges jointly metered with other premises. 12. Assignment and Subletting. 12.1 Lessor's Consent Required. Lessee shall not voluntarily or by operation of law assign, transfer, mortgage, sublet, or otherwise transfer or encumber all or any part of Lessee's interest in this Lease or in the Premises, without Lessor's prior written consent, which Lessor shall not unreasonably withhold. Lessor shall respond to Lessee's request for consent hereunder in a timely manner and any attempted assignment, transfer, mortgage, encumbrance or subletting without such consent shall be void, and shall constitute a breach of this Lease. 12.2 Lessee Affiliate. Notwithstanding the provisions of paragraph 12.1 hereof, Lessee may assign or sublet the Premises, or any portion thereof, without Lessor's consent, to any corporation which controls, is controlled by or is under common control with Lessee, or to any corporation resulting from the merger or consolidation with Lessee, or to any person or entity which acquires all the assets of Lessee as a going concern of the business that is being conducted on the Premises, provided that said assignee assumes, in full, the obligations of Lessee under this Lease. Any such assignment shall not, in any way, affect or limit the liability of Lessee under the terms of this Lease even if after such assignment or subletting the terms of this Lease are materially changed or altered without the consent of Lessee, the consent of whom shall not be necessary. 12.3 No Release of Lessee. Regardless of Lessor's consent, no subletting or assignment shall release Lessee of Lessee's obligation or alter the primary liability of Lessee to pay the rent and to perform all other obligations to be performed by Lessee hereunder. The acceptance of rent by Lessor from any other person shall not be deemed to be a waiver by Lessor of any provision hereof. Consent to one assignment or subletting shall not be deemed consent to any subsequent assignment or subletting. In the event of default by any assignee of Lessee or any successor of Lessee, in the performance of any of the terms hereof, Lessor may proceed directly against Lessee without the necessity of exhausting remedies against said assignee. Lessor may consent to subsequent assignments or subletting of this Lease or amendments or modifications to this Lease with assignees See Addendum Paragraph 51. Initials: _________ -- 3 -- of Lessee, without notifying Lessee, or any successor of Lessee, and without obtaining its or their consent thereto and such action shall not relieve Lessee of liability under this Lease. 12.4 Attorney's Fees. In the event Lessee shall assign or sublet the Premises or request the consent of Lessor to any assignment or subletting or if Lessee shall request the consent of Lessor for any act Lessee proposes to do then Lessee shall pay Lessor's reasonable attorneys fees incurred in connection therewith, such attorneys fees not to exceed $350.00 for each such request. 13. Defaults; Remedies. 13.1 Defaults. The occurrence of any one or more of the following events shall constitute a material default and breach of this Lease by Lessee: (a) The vacating or abandonment of the Premises by Lessee. (b) The failure by Lessee to make any payment of rent or any other payment required to be made by Lessee hereunder, as and when due, where such failure shall continue for a period of three days after written notice thereof from Lessor to Lessee. In the event that Lessor serves Lessee with a Notice to Pay Rent or Quit pursuant to applicable Unlawful Detainer statues such Notice to Pay Rent or Quit shall also constitute the notice required by this subparagraph. (c) The failure by Lessee to observe or perform any of the covenants, conditions or provisions of this Lease to be observed or performed by Lessee, other than described in paragraph (b) above, where such failure shall continue for a period of 30 days after written notice thereof from Lessor to Lessee; provided, however, that if the nature of Lessee's default is such that more than 30 days are reasonably required for its cure, then Lessee shall not be deemed to be in default if Lessee commenced such cure within said 30-day period and thereafter diligently prosecutes such cure to completion. (d) (i) The making by Lessee of any general arrangement or assignment for the benefit of creditors; (ii) Lessee becomes a "debtor" as defined in 11 U.S.C. (S) 101 or any successor statute thereto (unless, in the case of a petition filed against Lessee, the same is dismissed within 60 days); (iii) the appointment of a trustee or receiver to take possession of substantially all of Lessee's assets located at the Premises or of Lessee's interest in this Lease, where possession is not restored to Lessee within 30 days; or (iv) the attachment, execution or other judicial seizure of substantially all of Lessee's assets located at the Premises or of Lessee's interest in this Lease, where such seizure is not discharged within 30 days. Provided, however, in the event that any provision of this paragraph 13.1(d) is contrary to any applicable law, such provision shall be of no force or effect. (e) The discovery by Lessor that any financial statement given to Lessor by Lessee, any assignee of Lessee, any subtenant of Lessee, any successor in interest of Lessee or any guarantor of Lessee's obligation hereunder, and any of them, was materially false. See Addendum Paragraph 52 13.2 Remedies. In the event of any such material default or breach by Lessee, Lessor may at any time thereafter, with or without notice or demand and without limiting Lessor in the exercise of any right or remedy which Lessor may have by reason of such default or breach: (a) Terminate Lessee's right to possession of the Premises by any lawful means, in which case this Lease shall terminate and Lessee shall immediately surrender possession of the Premises to Lessor. In such event Lessor shall be entitled to recover from Lessee all damages incurred by Lessor by reason of Lessee's default including, but not limited to, the cost of recovering possession of the Premises; expenses of reletting, including necessary renovation and alteration of the Premises, reasonable attorney's fees, and any real estate commission actually paid; the worth at the time of award by the court having jurisdiction thereof of the amount by which the unpaid rent for the balance of the term after the time of such award exceeds the amount of such rental loss for the same period that Lessee proves could be reasonably avoided; that portion of the leasing commission paid by Lessor pursuant to Paragraph 15 applicable to the unexpired term of this Lease. (b) Maintain Lessee's right to possession in which case this Lease shall continue in effect whether or not Lessee shall have abandoned the Premises. In such event Lessor shall be entitled to enforce all of Lessor's rights and remedies under this Lease, including the right to recover the rent as it becomes due hereunder. (c) Pursue any other remedy now or hereafter available to Lessor under the laws or judicial decisions of the state wherein the Premises are located. Unpaid installments of rent and other unpaid monetary obligations of Lessee under the terms of this Lease shall bear interest from the date due at the maximum rate then allowable by law. 13.3 Default by Lessor. Lessor shall not be in default unless Lessor fails to perform obligations required of Lessor within a reasonable time, but in no event later than thirty (30) days after written notice by Lessee to Lessor and to the holder of any first mortgage or deed of trust covering the Premises whose name and address shall have theretofore been furnished to Lessee in writing, specifying wherein Lessor has failed to perform such obligation; provided, however, that if the nature of Lessor's obligation is such that more than thirty (30) days are required for performance then Lessor shall not be in default if Lessor commences performance within such 30-day period and thereafter diligently prosecutes the same to completion. 13.4 Late Charges. Lessee hereby acknowledges that late payment by Lessee to Lessor of rent and other sums due hereunder will cause Lessor to incur costs not contemplated by this Lease, the exact amount of which will be extremely difficult to ascertain. Such costs include, but are not limited to, processing and accounting charges, and late charges which may be imposed on Lessor by the terms of any mortgage or trust deed covering the Premises. Accordingly, if any installment of rent or any other sum due from Lessee shall not be received by Lessor or Lessor's designee within ten (10) days after such amount shall be due, then, without any requirements for notice to Lessee, Lessee shall pay to Lessor a late charge equal to 6% of such overdue amount. The parties hereby agree that such late charge represents a fair and reasonable estimate of the costs Lessor will incur by reason of late payment by Lessee. Acceptance of such late charge by Lessor shall in no event constitute a waiver of Lessee's default with respect to such overdue amount, nor prevent Lessor from exercising any of the other rights and remedies granted hereunder. In the event that a late charge is payable hereunder, whether or not collected, for three (3) consecutive installments of rent, then rent shall automatically become due and payable quarterly in advance, rather than monthly, notwithstanding paragraph 4 or any other provision of this Lease to the contrary. 13.5 Impounds. In the event that a late charge is payable hereunder, whether or not collected, for three (3) installments of rent or any other monetary obligation of Lessee under the terms of this Lease, Lessee shall pay to Lessor, if Lessor shall so request, in addition to any other payments required under this Lease, a monthly advance installment, payable at the same time as the monthly rent, as estimated by Lessor, for real property tax and insurance expenses on the Premises which are payable by Lessee under the terms of this Lease. Such fund shall be established to insure payment when due, before delinquency, of any or all such real property taxes and insurance premiums. If the amounts paid to Lessor by Lessee under the provisions of this paragraph are insufficient to discharge the obligations of Lessee to pay such real property taxes and insurance premiums as the same become due, Lessee shall pay to Lessor, upon Lessor's demand, such additional sums necessary to pay such obligations. All moneys paid to Lessor under this paragraph may be intermingled with other moneys of Lessor and shall not bear interest. In the event of a default in the obligations of Lessee to perform under this Lease, then any balance remaining from funds paid to Lessor under the provisions of this paragraph may, at the option of Lessor, be applied to the payment of any monetary default of Lessee in lieu of being applied to the payment of real property tax and insurance premiums. 14. Condemnation. If the Premises or any portion thereof are taken under the power of eminent domain, or sold under the threat of the exercise of said power (all of which are herein called "condemnation"), this Lease shall terminate as to the part so taken as of the date the condemning authority takes title or possession, whichever first occurs. If more than 10% of the floor area of the building on the Premises, or more than 25% of the land area of the Premises which is not occupied by any building, is taken by condemnation, Lessee may, at Lessee's option, to be exercised in writing only within ten (10) days after Lessor shall have given Lessee written notice of such taking (or in the absence of such notice, within ten (10) days after Lessor shall have given Lessee written notice of such taking (or in the absence of such notice, within ten (10) days after the condemning authority shall have taken possession) terminate this Lease as of the date the condemning authority takes such possession. If Lessee does not terminate this Lease in accordance with the foregoing, this Lease shall remain in full force and effect as to the portion of the Premises remaining, except that the rent shall be reduced in the proportion that the floor area of the building taken bears to the total floor area of the building situated on the Premises. No reduction of rent shall occur if the only area taken is that which does not have a building located thereon. Any award for the taking of all or any part of the Premises under the power of eminent domain or any payment made under threat of the exercise of such power shall be the property of Lessor, whether such award shall be made as compensation for diminution in value of the leasehold or for taking of the fee, or as severance damages; provided, however, that Lessee shall be entitled to any award for loss of or damage to Lessee's trade fixtures and removable personal property. In the event that this Lease is not terminated by reason of such condemnation, Lessor shall to the extent of severance damages received by Lessor in connection with such condemnation, repair any damage to the Premises caused by such condemnation except to the extent that Lessee has been reimbursed therefor by the condemning authority. Lessee shall pay any amount in excess of such severance damages required to complete such repair. 16. Estoppel Certificate. (a) Lessee shall at any time upon not less than ten (10) days' prior written notice from Lessor execute, acknowledge and deliver to Lessor a statement in writing (i) certifying that this Lease is unmodified and in full force and effect (or, if modified, stating the nature of such modification and certifying that this Lease, as so modified, is in full force and effect) and the date to which the rent and other charges are paid in advance, if any, and (ii) acknowledging that there are not, to Lessee's knowledge, any uncured defaults on the part of Lessor hereunder, or specifying such defaults if any are claimed. Any such statement may be conclusively relied upon by any prospective purchaser or encumbrancer of the Premises. (b) At Lessor's option, Lessee's failure to deliver such statement within such time shall be material breach of this Lease or shall be conclusive upon Lessee (i) that this Lease is in full force and effect, without modification except as may be represented by Lessor, (ii) that there are no uncured defaults in Lessor's performance, and (iii) that not more than one month's rent has been paid in advance or such failure may be considered by Lessor as a default by Lessee under this Lease. (c) If Lessor desires to finance, refinance, or sell the Premises, or any part thereof, Lessee hereby agrees to deliver to any lender or purchaser designated by Lessor such financial statements of Lessee as may be reasonably required by such lender or purchaser. Such statements shall include the past three years' financial statements of Lessee. All such financial statements shall be received by Lessor and such lender or purchaser in confidence and shall be used only for the purposes herein set forth. 17. Lessor's Liability. The term "Lessor" as used herein shall mean only the owner or owners at the time in question of the fee title or a lessee's interest in a ground lease of the Premises, and except as expressly provided in Paragraph 15, in the event of any transfer of such title or interest, Lessor herein named (and in case of any subsequent transfers then the grantor) shall be relieved from and after the date of such transfer of all liability as respects Lessor's obligations thereafter to be performed, provided that any funds in the hands of Lessor or the then grantor at the time of such transfer, in which Lessee has an interest, shall be delivered to the grantee. The obligations contained in this Lease to be performed by Lessor shall, subject as aforesaid, be binding on Lessor's successors and assigns, only during their respective periods of ownership. 18. Severability. The invalidity of any provision of this Lease as determined by a court of competent jurisdiction, shall in no way affect the validity of any other provision hereof. 19. Interest on Past-due Obligations. Except as expressly herein provided, any amount due to Lessor not paid when due shall bear interest at the maximum rate then allowable by law from the date due. Payment of such interest shall not excuse or cure any default by Lessee under this Lease, provided, however, that interest shall not be payable on late charges incurred by Lessee nor on any amounts upon which late charges are paid by Lessee. 20. Time of Essence. Time is of the essence. 21. Additional Rent. Any monetary obligations of Lessee to Lessor under the terms of this Lease shall be deemed to be rent. 22. Incorporation of Prior Agreements; Amendments. This Lease contains all agreements of the parties with respect to any matter mentioned herein. No prior agreement or understanding pertaining to any such matter shall be effective. This Lease may be modified in writing only, signed by the parties in interest at the time of the modification. Except as otherwise stated in this Lease, Lessee hereby acknowledges that neither the real estate broker listed in Paragraph 15 hereof nor any cooperating broker on this transaction nor the Lessor or any employees or agents of any of said persons has made any oral or written warranties or representations to Lessee relative to the condition or use by Lessee of said Premises and Lessee acknowledges that Lessee assumes all responsibility regarding the Occupational Safety Health Act, the legal use and adaptability of the Premises and the compliance thereof with all applicable laws and regulations in effect during the term of this Lease except as otherwise specifically stated in this Lease. 23. Notices. Any notice required or permitted to be given hereunder shall be in writing and may be given by personal delivery or by certified mail, and if given personally or by mail, shall be deemed sufficiently given if addressed to Lessee or to Lessor at the address noted below the signature of the respective parties, as the case may be. Either party may by notice to the other specify a different address for notice purposes except that upon Lessee's taking possession of the Premises, the Premises shall constitute Lessee's address for notice purposes. A copy of all notices required or permitted to be given to Lessor hereunder shall be concurrently transmitted to such party or parties at such addresses as Lessor may from time to time hereafter designate by notice to Lessee. 24. Waivers. No waiver by Lessor or any provision hereof shall be deemed a waiver of any other provision hereof or of any subsequent breach by Lessee of the same or any other provision. Lessor's consent to, or approval of, any act shall not be deemed to render unnecessary the obtaining of Lessor's consent to or approval of any subsequent act by Lessee. The acceptance of rent hereunder by Lessor shall not be a waiver of any preceding breach by Lessee of any provision hereof, other than the failure of Lessee to pay the particular rent so accepted, regardless of Lessor's knowledge of such preceding breach at the time of acceptance of such rent. 25. Recording. Either Lessor or Lessee shall, upon request of the other, execute, acknowledge and deliver to the other a "short form" memorandum of this Lease for recording purposes. 26. Holding Over. If Lessee, with Lessor's consent, remains in possession of the Premises or any part thereof after the expiration of the term hereof, such occupancy shall be a tenancy from month to month upon all the provisions of this Lease pertaining to the obligations of Lessee, but all options and rights of first refusal, if any, granted under the terms of this Lease shall be deemed terminated and be of no further effect during said month to month tenancy. 27. Cumulative Remedies. No remedy or election hereunder shall be deemed exclusive but shall, wherever possible, be cumulative with all other remedies at law or in equity. 28. Covenant and Conditions. Each provision of this Lease performable by Lessee shall be deemed both a covenant and a condition. 29. Binding Effect; Choice of Law. Subject to any provisions hereof restricting assignment or subletting by Lessee and subject to the provisions of Paragraph 17, this Lease shall bind the parties, their personal representatives, successors and assigns. This Lease shall be governed by the laws of the State wherein the Premises are located. 30. Subordination. (a) This Lease, at Lessor's option, shall be subordinate to any ground lease, mortgage, deed of trust, or any other hypothecation or security now or hereafter placed upon the real property of which the Premises are a part and to any and all advances made on the security thereof and to all renewals, modifications, consolidations, replacements and extensions thereof. Notwithstanding such subordination, Lessee's right to quiet possession of the Premises shall not be disturbed if Lessee is not in default and so long as Lessee shall pay the rent and observe and perform all of the provisions of this Lease, unless this Lease is otherwise terminated pursuant to its terms. If any mortgagee, trustee or ground lessor shall elect to have this Lease prior to the lien of its mortgage, deed of trust or ground lease, and shall give written notice thereof to Lessee, this Lease shall be deemed prior to such mortgage, deed of trust, or ground lease, whether this Lease is dated prior or subsequent to the date of said mortgage, deed of trust or ground lease or the date of recording thereof. (b) Lessee agrees to execute any documents required to effectuate an attornment, a subordination or to make this Lease prior to the lien of any mortgage, deed of trust or ground lease, as the case may be. Lessee's failure to execute such documents within 10 days after written demand shall constitute a material default by Lessee hereunder, or, at lessor's option, Lessor shall execute such documents on behalf of Lessee as Lessee's attorney-in-fact. Lessee does hereby make, constitute and irrevocably appoint Lessor as Lessee's attorney-in-fact and in Lessee's name, place and stead, to execute such documents in accordance with this paragraph 30(b). 31. Attorney's Fees. If either party or the broker named herein brings an action to enforce the terms hereof or declare rights hereunder, the prevailing party in any such action, on trail or appeal, shall be entitled to his reasonable attorney's fees to be paid by the losing party as fixed by the court. The provisions of this paragraph shall inure to the benefit of the broker named herein who seeks to enforce a right hereunder. 32. Lessor's Access. Lessor and Lessor's agents shall have the right to enter the Premises at reasonable times for the purpose of inspecting the same, showing the same to prospective purchasers, lenders, or lessees, and making such alterations, repairs, improvements or additions to the Premises or to the building of which they are a part as Lessor may deem necessary or desirable. Lessor may at any time place on or about the Premises any ordinary "For Sale" signs and Lessor may at any time during the last 120 days of the term hereof place on or about the Premises any ordinary "For Lease" signs, all without rebate of rent or liability to Lessee. 33. Auctions. Lessee shall not conduct, nor permit to be conducted, either voluntarily or involuntarily, any auction upon the Premises without first having obtained Lessor's prior written consent. Notwithstanding anything to the contrary in this Lease, Lessor shall not be obligated to exercise any standard of reasonableness in determining whether to grant such consent. 34. Signs. Lessee shall not place any sign upon the Premises without Lessor's prior written consent except that Lessee shall have the right without the prior permission of Lessor to place ordinary and usual for rent or sublet signs thereon. 35. Merger. The voluntary or other surrender of this Lease by Lessee, or a mutual cancellation thereof, or a termination by Lessor, shall not work a merger, and shall, at the option of Lessor, terminate all or any existing subtenancies or may, at the option of Lessor, operate as an assignment to Lessor of any or all of such subtenancies. 36. Consents. Except for paragraph 33 hereof, wherever in this Lease the consent of one party is required to an act of the other party such consent shall not be unreasonably withheld. 37. Guarantor. In the event that there is a guarantor of this Lease, said guarantor shall have the same obligations as Lessee under this Lease. 38. Quiet Possession. Upon Lessee paying the rent for the Premises and observing and performing all of the covenants, conditions and provisions on Lessee's part to be observed and performed hereunder, Lessee shall have quiet possession of the Premises for the entire term hereof subject to all of the provisions of this Lease. The individuals executing this Lease on behalf of Lessor represent and warrant to Lessee that they are fully authorized and legally capable of executing this Lease on behalf of Lessor and that such execution is binding upon all parties holding an ownership interest in the Premises. 39. Options. 39.1 Definition. As used in this paragraph the word "Options" has the following meaning: (1) the right or option to extend the term of this Lease or to renew this Lease or to extend or renew any lease that Lessee has on other property of Lessor; (2) the option or right of first refusal to lease the Premises or the right of first offer to lease the Premises or the right of first refusal to lease other property of Lessor or the right of first offer to lease other property of Lessor; (3) the right or option to purchase the Premises, or the right of first refusal to purchase the Premises, or the right of first offer to purchase the Premises or the right or option to purchase other property of Lessor, or the right of first refusal to purchase other property of Lessor or the right of first offer to purchase other property of Lessor. -5- 39.2 Options Personal. Each Option granted to Lessee in this Lease are personal to Lessee and may not be exercised or be assigned, voluntarily or involuntarily, by or to any person or entity other than Lessee, provided, however, the Option may be exercised by or assigned to any Lessee Affiliate as defined in paragraph 12.2 of this Lease. The Options herein granted to Lessee are not assignable separate and apart from this Lease. 39.3 Multiple Options. In the event that Lessee has any multiple options to extend or renew this Lease a later option cannot be exercised unless the prior option to extend or renew this Lease has been so exercised. 39.4 Effect of Default on Options. (a) Lessee shall have no right to exercise an Option, notwithstanding any provision in the grant of Option to the contrary, (i) during the time commencing from the date Lessor gives to Lessee a notice of default pursuant to paragraph 13.1(b) or 13.1(c) and continuing until the default alleged in said notice of default is cured, or (ii) during the period of time commencing on the day after a monetary obligation to Lessor is due from Lessee and unpaid (without any necessity for notice thereof to Lessee) continuing until the obligation is paid, or (iii) at any time after an event of default described in paragraphs 13.1(a), 13.1(d), or 13.1(e) (without any necessity of Lessor to give notice of such default to Lessee), or (iv) in the event that Lessor has given to Lessee three or more notices of default under paragraph 13.1(b), where a late charge has become payable under paragraph 13.4 for each of such defaults, or paragraph 13.1(c), whether or not the defaults are cured, during the 12 month period prior to the time that Lessee intends to exercise the subject Option. (b) The period of time within which an Option may be exercised shall not be extended or enlarged by reason of Lessee's inability to exercise an Option because of the provisions of paragraph 39.4(a). (c) All rights of Lessee under the provisions of an Option shall terminate and be of no further force or effect, notwithstanding Lessee's due and timely exercise of the Option, if, after such exercise and during the term of this Lease, (i) Lessee fails to pay to Lessor a monetary obligation of Lessee for a period of 30 days after such obligation becomes due (without any necessity of Lessor to give notice thereof to Lessee), or (ii) Lessee fails to commence to cure a default specified in paragraph 13.1(c) within 30 days after the date that Lessor gives notice to Lessee of such default and/or Lessee fails thereafter to diligently prosecute said cure to completion, or (iii) Lessee commits a default described in paragraph 13.1(a), 13.1(d) or 13.1(e) (without any necessity of Lessor to give notice of such default to Lessee), or (iv) Lessor gives to Lessee three or more notices of default under paragraph 13.1(b), where a late charge becomes payable under paragraph 13.4 for each such default, or paragraph 13.1(c), whether or not the defaults are cured. 40. Multiple Tenant Building. In the event that the Premises are part of a larger building or group of buildings then Lessee agrees that it will abide by, keep and observe all reasonable rules and regulations which Lessor may make from time to time for the management, safety, care, and cleanliness of the building and grounds, the parking of vehicles and the preservation of good order therein as well as for the convenience of other occupants and tenants of the building. The violations of any such rules and regulations shall be deemed a material breach of this Lease by Lessee. 41. Security Measures. Lessee hereby acknowledges that the rental payable to Lessor hereunder does not include the cost of guard service or other security measures, and that Lessor shall have no obligation whatsoever to provide same. Lessee assumes all responsibility for the protection of Lessee, its agents and invitees from acts of third parties. 42. Easements. Lessor reserves to itself the right, from time to time, to grant such easements, rights and dedications that Lessor deems necessary or desirable, and to cause the recordation of Parcel Maps and restrictions, so long as such easements, rights, dedications, Maps and restrictions do not unreasonably interfere with the use of the Premises by Lessee. Lessee shall sign any of the aforementioned documents upon request of Lessor and failure to do so shall constitute a material breach of this Lease. 43. Performance Under Protest. If at any time a dispute shall arise as to any amount or sum of money to be paid by one party to the other under the provisions hereof, the party against whom the obligation to pay the money is asserted shall have the right to make payment "under protest" and such payment shall not be regarded as a voluntary payment, and there shall survive the right on the part of said party to institute suit for recovery of such sum. If it shall be adjudged that there was no legal obligation on the part of said party to pay such sum or any part thereof, said party shall be entitled to recover such sum or so much thereof as it was not legally required to pay under the provisions of this Lease. 44. Authority. If Lessee is a corporation, trust, or general or limited partnership, each individual executing this Lease on behalf of such entity represents and warrants that he or she is duly authorized to execute and deliver this Lease on behalf of said entity. If Lessee is a corporation, trust or partnership, Lessee shall, within thirty (30) days after execution of this Lease, deliver to Lessor evidence of such authority satisfactory to Lessor. 45. Conflict. Any conflict between the printed provisions of this Lease and the typewritten or handwritten provisions shall be controlled by the typewritten or handwritten provisions. 46. Insuring Party. The insuring party under this lease shall be the LESSOR. ------ 47. Addendum. Attached hereto is an addendum or addenda containing paragraphs 48 through 55 which constitutes a part of this Lease. - ------- -------- LESSOR AND LESSEE HAVE CAREFULLY READ AND REVIEWED THIS LEASE AND EACH TERM AND PROVISION CONTAINED HEREIN AND, BY EXECUTION OF THIS LEASE, SHOW THEIR INFORMED AND VOLUNTARY CONSENT THERETO. THE PARTIES HEREBY AGREE THAT, AT THE TIME THIS LEASE IS EXECUTED, THE TERMS OF THIS LEASE ARE COMMERCIALLY REASONABLE AND EFFECTUATE THE INTENT AND PURPOSE OF LESSOR AND LESSEE WITH RESPECT TO THE PREMISES. IF THIS LEASE HAS BEEN FILLED IN IT HAS BEEN PREPARED FOR SUBMISSION TO YOUR ATTORNEY FOR HIS APPROVAL. NO REPRESENTATION OR RECOMMENDATION IS MADE BY THE AMERICAN INDUSTRIAL REAL ESTATE ASSOCIATION OR BY THE REAL ESTATE BROKER OR ITS AGENTS OR EMPLOYEES AS TO THE LEGAL SUFFICIENCY, LEGAL EFFECT, OR TAX CONSEQUENCES OF THIS LEASE OR THE TRANSACTION RELATING THERETO; THE PARTIES SHALL RELY SOLELY UPON THE ADVICE OF THEIR OWN LEGAL COUNSEL AS TO THE LEGAL AND TAX CONSEQUENCES OF THIS LEASE. The parties hereto have executed this Lease at the place on the dates specified immediately adjacent to their respective signatures. Executed at Encino, CA P & R Investment Co. ------------------------- ------------------------------------- on 3/1/99 By /s/ Sanford P. Paris Gen. Partner ---------------------------------- ------------------------------------- Address 16501 Ventura Blvd. #402 /s/ Max Ramberg Gen'l Partner ------------------------------ ------------------------------------- - ------------------------------------- "LESSOR" (Corporate seal) Executed at Image Entertainment -------------------------- --------------------------------------- on 3/1/99 /s/ Martin W. Greenwald ----------------------------------- By ------------------------------------ Address 9333 Oso Ave By /s/ David Borshell ------------------------------ ------------------------------------ Chatsworth CA 91311 - ------------------------------------- "LESSEE" (Corporate seal) For these forms write or call the American Industrial Real Estate Association, 350 South Figueroa St., Suite 275, Los Angeles, CA 90071 (213) 687-8777 Form 204n 780 ADDENDUM TO LEASE This ADDENDUM TO LEASE dated March 1, 1999 is by and between P & R INVESTMENT COMPANY, as Lessor, and IMAGE ENTERTAINMENT, INC. as Lessee, for the property commonly known as 9349 Oso Ave, Chatsworth, California. This Addendum is attached to and made a part of, the above referenced Standard Industrial/Commercial Single-Tenant Lease-Net (together with this Addendum, "The Lease"). The provisions of this Addendum shall govern and supersede any, and all, contrary or inconsistent provisions of the preprinted portion of the Lease. 48. CONDITION PRECEDENT: This lease is subject to Lessor entering into an -------------------- acceptable lease termination agreement with the current tenant of the Premises. 49. RENT: Paragraph 4. (Rent) of the Lease is modified by adding the ----- following: A. Lessee shall pay as Base Monthly Rental for each and every month of the period May 1, 1999 (or the Commencement Date of the Lease, whichever is later) through and including June 30, 1999 the sum of $10,000.00. B. Lessee shall pay as Base Monthly Rental for each and every month of the period July 1, 1999 through and including June 30, 2000, the sum of $10,400.00. C. Lessee shall pay as Base Monthly Rental for each and every month of the period July 1, 2000 through and including June 30, 2001, the sum of $10,700.00. D. Lessee shall pay as Base Monthly Rental for each and every month of the period July 1, 2001 through and including June 30, 2002, the sum of $11,000.00. E. Lessee shall pay as Base Monthly Rental for each and every month of the period July 1, 2002 through and including June 30, 2003, the sum of $11,000.00 adjusted upwards only, by the percentage increase in the Consumer Price Index (CPI) (See 49.G. below), from April 2001 to April, 2002. F. Lessee shall pay as Base Monthly Rental for each and every month of the period July 1, 2003 through and including April 30, 2004, the sum calculated in 49.E. above, adjusted upwards only, by the percentage increase in the Consumer Price Index (CPI) (See 49.G. below), from April, 2002 to April, 2003. G. The Consumer Price Index (CPI) referred to above is the Consumer Price Index for All Urban Consumers, Los Angeles-Anaheim-Riverside, All Items, 1982-84=100, as published by the United States Bureau of Labor Statistics. If at the time the Index is needed to determine the rent under this ADDENDUM TO LEASE, and it is no longer maintained or published, then the parties shall select another Index as shall most closely approximate the "Index" in order to calculate the percentage increase over the applicable period. In the event that, within ninety (90) days after the consumer Price Page 1 of 4 Index information is needed, the parties are not able to agree upon such substitute Index to calculate the rental increase, the matter shall be referred for binding and conclusive arbitration at Los Angeles, California, in accordance with the rules and regulations of the American Arbitration Association. 50. USE: Paragraph 6 of the Lease shall be modified by adding the following: - ---------- A. Except in strict compliance with all Environmental Requirements, Lessee shall not cause, permit or suffer any "Hazardous Material" to be brought upon, treated, kept, stored, disposed of, discharged, released, produced, manufactured, generated, refined or used upon, about or beneath the Property or any portion thereof by Lessee, its agents, employees, contractors, tenants or invitees, or any other person. B. Hazardous Material means any substance the presence of which requires reporting, regulation, investigation or remediation under any federal, state or local statute, regulation ordinance, order, action, policy or common law or which is or becomes defined as a "hazardous waste", "hazardous substance", pollutant or contaminant under any federal, state or local statute, regulation, rule or ordinance or amendments thereto including, without limitation, the Comprehensive Environmental Response, Compensation and Liability Act (42 U.S.C. section 9601 et seq.) and/or the Resource Conservation and Recovery Act (42 U.S.C. section 6901 et seq.). 51. ASSIGNMENT AND SUBLETTING: Paragraph 12 of the Lease shall be modified by - -------------------------------- adding the following: A. The following additional provisions shall apply to any assignment of the Lease and/or subletting of the Premises: 1) The assignment or sublease to the particular assignee or sublessee must have been approved in writing by Lessor in advance. 2) Lessee shall have made to Lessor a full and complete disclosure of all of the terms, provisions and conditions of the assignment or subletting and shall have furnished to Lessor true and complete copies of all documents used and to be used in connection with the transaction. 3) In the event there is "Overriding Consideration" paid and/or to be paid by the assignee or sublessee to Lessee, one-half of all such Overriding Consideration shall be paid by Lessee (or by the assignee or sublessee at the direction of Lessor) to Lessor after Lessee deducts normal reasonable costs of the assignment or subletting; such as broker commissions, free rent periods, or tenant improvements, providing Lessee substantiates such cost to Lessor in writing. 4) As used herein "Overriding Consideration" shall mean any consideration of whatsoever kind or character whether in money or any other item or items of value and whether in a lump sum or in installments or in any combination thereof paid and/or payable by the assignee or the sublessee in connection with the Premises over and above the monetary sums payable by Lessee to Lessor under the Lease and the performance of Lessee's others Page 2 of 4 obligations under the Lease. In the event that one or more subleases cover less than all of the Premises, Overriding Consideration shall be determined by first making an equitable allocation between the entire Premises and the portion or portions thereof covered by the sublease or subleases. Lessor's allocation made in good faith shall be binding and conclusive upon all parties involved. 5) Lessor shall have the right to communicate with the assignee or sublessee or any other person having relevant information on the subject; and shall have the right from time to time to examine all books, records and documents of Lessee. Lessee shall also use Lessee's best efforts to arrange for Lessor to examine the books, records and documents of any assignee and sublessee. B. In the event of any proposed assignment or subletting under the Lease, if the proposed assignee's or sublessees' activities in or about the Premises involve the use, handling, storage or disposal of any Hazardous Materials (as defined in Paragraph 3b above) (i) it shall be reasonable for Lessor to withhold its consent to such assignment or sublease in light of the risk of contamination posed by such activities unless Lessee satisfies the condition described in the following clause and/or (ii) Lessor may impose an additional condition to such assignment or sublease which requires Lessee to establish beyond a reasonable doubt that such assignee's or sublessee's activities pose no greater risk on contamination to the Premises than do Lessee's permitted activities in view of (a) the quantities, toxicity and other properties of the Hazardous Materials to be used by such assignee or sublessee, (b) the precautions against a release of Hazardous Materials such assignee or sublessee agrees to implement, (c) such assignee's or sublessee's financial condition as it relates to its ability to fund a major clean-up, and (d) such assignee's or sublessee's policy and historical record respecting its willingness to respond to and clean up a release of Hazardous Materials. 52. LESSOR'S REMEDIES: In addition to any other remedies of Lessor contained - ------------------------- in this Lease under the provisions of Paragraph 13.2 hereof, notice is given by the Lessor that additional remedies are available under California law (Civil Code Section 1951.2) and its future amendments or revisions. These Code Sections require Lessor to declare to Lessee in the Lease that Lessor will avail itself of the remedies so prescribed. Lessor hereby gives said notice. 53. SIGNS: Paragraph 34 of the Lease is modified by adding the following: - ------------- Lessee shall have the right to place exterior signs on the Premises subject to any applicable laws, code or ordinances and subject to any reasonable rules and regulations adopted for the Building. Lessee shall be solely responsible for maintaining in good conditions its signs and shall remove them and repair any damage caused by such removal on or before the termination of the Lease or any extension thereof. 54. Since LESSEE is a Corporation, each individual executing this ADDENDUM TO - --- LEASE on behalf of said Corporation represents and warrants that he/she is duly authorized to execute and deliver this ADDENDUM TO LEASE on behalf of said Corporation. Page 3 of 4 55. This ADDENDUM TO LEASE shall bind the parties hereto, their personal - --- representatives, successors and assigns. This ADDENDUM TO LEASE shall be governed by the laws of the State of California. IN WITNESS WHEREOF, the parties have executed this ADDENDUM TO LEASE on the day and year first written above. at: Los Angeles, California LESSOR: LESSEE: P & R INVESTMENT CO., by: IMAGE ENTERTAINMENT, INC., by: /s/ Sanford P. Paris /s/ Martin Greenwald ____________________________ ______________________________ Sanford P. Paris, Martin Greenwald General Partner President and CEO /s/ Max Ramberg /s/ David Borshell ____________________________ ______________________________ Max Ramberg, David Borshell, General Partner its Sr. Vice President of Sales, Marketing and Operations Page 4 of 4 EX-21 8 SUBSIDIARIES OF THE REGISTRANT EXHIBIT 21 Subsidiaries of the Registrant ------------------------------ Image NewCo., a California Corporation EX-23 9 CONSENT OF KPMG EXHIBIT 23 INDEPENDENT ACCOUNTANTS' CONSENT -------------------------------- Image Entertainment, Inc. Chatsworth, California We consent to incorporation by reference in the registration statements (Nos. 33-43241, 33-55393 and 33-57336) all on Form S-8 of Image Entertainment, Inc. of our report dated May 21, 1999, relating to the consolidated balance sheets of Image Entertainment, Inc. as of March 31, 1999 and 1998, and the related consolidated statements of operations, shareholders' equity, and cash flows for each of the years in the three-year period ended March 31, 1999, and the related schedule, which report appears in the March 31, 1999 annual report on Form 10-K of Image Entertainment, Inc. /s/ KPMG LLP Los Angeles, California June 24, 1999 EX-27 10 FINANCIAL DATA SCHEDULE
5 THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM 10-K MARCH 31, 1999 AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS. 1,000 12-MOS MAR-31-1999 APR-01-1998 MAR-31-1999 1,552 0 15,429 3,475 16,691 0 19,789 5,295 56,445 0 0 0 0 31,725 (7,393) 56,445 76,726 76,726 58,425 58,425 4,057 144 966 1,796 90 1,706 0 0 0 1,706 .12 .12 THE COMPANY HAS AN UNCLASSIFIED BALANCE SHEET DUE TO THE NATURE OF ITS INDUSTRY.
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