-----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, Ra3zR+Ng7CnNuopG++pI/ahuKR4u5JGzvntakLsIZ+ajcGdwj2EdCdnSMc6UqXR6 uFVkGnt203S7lKIK47kwkQ== 0000950150-97-000458.txt : 19970723 0000950150-97-000458.hdr.sgml : 19970723 ACCESSION NUMBER: 0000950150-97-000458 CONFORMED SUBMISSION TYPE: 10-K405 PUBLIC DOCUMENT COUNT: 7 CONFORMED PERIOD OF REPORT: 19961231 FILED AS OF DATE: 19970331 SROS: NONE FILER: COMPANY DATA: COMPANY CONFORMED NAME: THQ INC CENTRAL INDEX KEY: 0000865570 STANDARD INDUSTRIAL CLASSIFICATION: 7372 IRS NUMBER: 133541686 STATE OF INCORPORATION: NY FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K405 SEC ACT: 1934 Act SEC FILE NUMBER: 000-18813 FILM NUMBER: 97568845 BUSINESS ADDRESS: STREET 1: 5016 N PKWY CALABASAS SUITE 100 CITY: CALABASAS STATE: CA ZIP: 91302 BUSINESS PHONE: 8185911310 MAIL ADDRESS: STREET 1: 5019 N PKWY CALABASAS STREET 2: STE 100 CITY: CALABASAS STATE: CA ZIP: 91302 FORMER COMPANY: FORMER CONFORMED NAME: TRINITY ACQUISITION CORP/NY/ DATE OF NAME CHANGE: 19600201 10-K 1 FORM 10-K 1 ================================================================================ SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-K -------------------- (MARK ONE) [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 1996 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 0-18813 T-HQ, INC. (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) -------------------- NEW YORK 13-3541686 (STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.) 5016 NORTH PARKWAY CALABASAS CALABASAS, CA 91302 (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE) REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (818) 591-1310 ----------------- SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: None SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT: Common Stock, $.0001 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 (ss.229.405 of this chapter) is not contained herein, and will not be contained, to the best of Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. X --- As of March 24, 1997, approximately 6,479,000 shares of Common Stock of the Registrant were outstanding and the aggregate market value of voting Common Stock held by non-affiliates was approximately $39,488,000. DOCUMENTS INCORPORATED BY REFERENCE Portions of the T-HQ, Inc. 1997 Notice of Annual Meeting of Stockholders and Proxy Statement, to be filed with the Securities and Exchange Commission within 120 days after the close of the Registrant's fiscal year (incorporated into Part III). ================================================================================ 2 T-HQ, INC. INDEX TO ANNUAL REPORT ON FORM 10-K FILED WITH THE SECURITIES AND EXCHANGE COMMISSION YEAR ENDED DECEMBER 31, 1996 ITEMS IN FORM 10-K
Page Facing page Part I Item 1. Business. 1 Item 2. Properties. 13 Item 3. Legal Proceedings. 13 Item 4. Submission of Matters to a Vote of Security Holders. 14 Part II Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters. 15 Item 6. Selected Financial Data. 16 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. 18 Item 8. Financial Statements and Supplementary Data. 26 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. 26 Part III Item 10. Directors and Executive Officers of the Registrant. 27 Item 11. Executive Compensation. 27 Item 12. Security Ownership of Certain Beneficial Owners and Management. 27 Item 13. Certain Relationships and Related Transactions. 27 Part IV Item 14. Exhibits, Financial Statement Schedule and Reports on Form 8-K. 28 Signatures 32
3 The Annual Report of T-HQ, Inc. (the "Company") on Form 10-K contains statements which constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements appear in a number of places in this Report, including, without limitation "Business" and "Management's Discussion and Analysis of Financial Condition and Results of Operations". Such forward-looking statements include statements regarding the intent, belief or current expectations of the Company and its management with respect to the matters discussed in this Report. Prospective investors are cautioned that any such forward-looking statements involve risks and uncertainties, and that the actual results may differ materially from those in the forward-looking statements as a result of various uncertainties, including, without limitation, uncertainties relating to the interactive entertainment software industry and other factors, as more specifically set forth in the Company's report on Form 8-K, filed on March 28, 1997 with the Securities and Exchange Commission. PART I ITEM 1. BUSINESS INTRODUCTION T-HQ, Inc. (the "Company") develops, publishes and distributes interactive entertainment software ("Software") for the various hardware platforms ("Platform") that collectively dominate the home video game market. The Company currently publishes titles for all major dedicated Platforms manufactured by Sony, Sega and Nintendo (the "Manufacturers"), and in 1997 intends to release titles for the recently introduced Nintendo 64 Platform and multimedia personal computers. The Company currently publishes products in most interactive Software genres, including action, adventure, arcade, fighting, driving, strategy, simulation and sports. The Company's principal customers include Toys "R" Us, Wal-Mart, Target and Best Buy, other national and regional retailers, discount store chains and specialty retailers. The Company's titles are developed both internally and under contract with independent developers, and are typically based on properties licensed from third parties. The Company continually seeks to identify and exploit for development, titles based upon entertainment project (such as movies, television programs and arcade games), sports and entertainment personalities, or popular sports, trends or concepts ("Properties") that have high public visibility or recognition or that reflect the trends of popular culture. Other than titles that the Company may release on CD-ROM for use on multimedia personal computers ("PCs"), all of the Company's products consist of cartridges and CD-ROMs manufactured for the Company by the Manufacturers. The Company achieved a turnaround in 1995, reversing two years of significant losses. Under new leadership, the Company focused its product strategy, improved inventory management and reduced fixed costs. As a result, ToHQ's revenues increased from $13.3 million in 1994 to $33.3 million and $50.3 million in 1995 and 1996, respectively. 1 4 THE INTERACTIVE ENTERTAINMENT INDUSTRY AND TECHNOLOGY The home video game Software market consists both of (i) cartridge-based and CD-ROM-based Software for use solely on dedicated hardware systems manufactured by the Manufacturers, and to a significantly lesser extent, other vendors, and (ii) Software distributed on CD-ROMs for use on PCs. Until 1996, most Software for dedicated Platforms was sold in cartridge form. However, CD-ROMs have become increasingly popular because they have substantially greater data storage capacity and lower manufacturing costs than cartridges. The first modern Platform was introduced by Nintendo in 1985 using "8-bit" technology. "8-bit" means that the central processing unit, or "chip," on which the Software operates is capable of processing data in 8-bit units. Subsequent advances in technology have resulted in continuous increases in the processing power of the chips that power both the Platforms and PCs. As the technology of the hardware has advanced, the Software designed for the Platforms has similarly advanced, with faster and more complex images, more lifelike animation and sound effects and more intricate scenarios. The larger data storage capacity of CD-ROMs enable them to provide richer content and longer play. Portable Platforms manufactured by the Manufacturers are less sophisticated technologically and do not require television monitors. Currently, the non-portable Platforms being marketed are based primarily on 32-bit and 64-bit technology. The following table sets forth the year of release in the United States of each of the Manufacturers' Platforms for which the Company publishes titles and the technology on which such Platforms are based:
DATE OF U.S. MANUFACTURER PRODUCT NAME INTRODUCTION TECHNOLOGY ------------ ------------- ------------ ---------------- Nintendo Game Boy 1989 8-bit (portable) Sega Game Gear 1991 8-bit (portable) Sega Genesis 1989 16-bit Nintendo SNES 1991 16-bit Sega Saturn 1995 32-bit Sony PlayStation 1995 32-bit Nintendo Nintendo 64 1996 64-bit
The Company believes that the success of Software is dependent on the graphic look and feel of the Software, the depth and variation of game play and the popularity of the Property on which the Software is based. As new Platforms are introduced, Software for such Platforms requires new standards of design and technology to fully exploit such Platforms' capabilities and requires that Software developers devote substantial resources to product design and development. 2 5 BUSINESS STRATEGY The Company's objective is to become a leading provider of exciting, high-quality Software that appeals to a broad range of consumers for use on a variety of Platforms. The Company's business strategy is based on the following: - Developing a portfolio of games, primarily for use on advanced Platforms, based on Properties that are proprietary or are exclusively licensed to the Company ("Franchise" Properties). Franchise Properties allow the Company to release titles based on such Properties on a variety of hardware Platforms, to create sequels to such titles and to re-release such titles at secondary and tertiary price points in the future. The Company's exclusively licensed Properties currently consist of BASS Masters Classic, Turner's World Championship Wrestling and Brunswick's Tournament of Champions. Currently, the Company's proprietary products are Pax Imperia: Eminent Domain and Dead Unity. - Identifying and licensing titles originally developed in foreign territories with proven or anticipated consumer acceptance and publishing localized versions for advanced Platforms for distribution in the United States and other countries. This strategy enables the Company to participate in the market for advanced Platform games while limiting risk. In 1996, the Company commenced publishing and distributing Sony PlayStation and Sega Saturn titles under license from foreign independent Software developers, primarily from Japan. In 1997, the Company expects to publish approximately 13 additional titles acquired in such manner, including K1: The Arena Fighters, Ghost in the Shell and Bravo Air Race. - Publishing high quality Software for the large installed base of 16-bit and Game Boy Platforms for so long as the Company believes there is a significant market for such titles. The Company believes that the relatively low cost of development of titles for such Platforms and reduced competition in these markets creates an opportunity to generate continuing sales and profits from these segments of the video game market. Examples of such titles published by the Company include Disney's Toy Story and Disney's Pocahontas and LucasArts' Super Empire Strikes Back and Super Return of the Jedi. Licenses acquired for titles currently under development include Disney's Hunchback of Notre Dame and Disney's Hercules (an animated feature film to be released in 1997). The Company has also entered into agreements with Electronic Arts Inc., a competing independent Software company, pursuant to which the Company develops, publishes and distributes titles based on existing Electronic Arts titles, primarily for SNES and Game Boy. Representative Electronic Arts titles include Madden Football, FIFA International Soccer, NBA Live, NHL Hockey and PGA Tour Golf. - Expanding its presence in foreign markets that demonstrate (through an increasing installed base of Platforms) the potential for commercial success of the Company's titles. To accomplish this strategy, the Company established an office in the United Kingdom in 1992 to oversee its operations in Europe and has developed strategic relationships with 3 6 Japanese publishers, resulting in foreign sales constituting 26% and 30% of the Company's revenues in 1995 and 1996, respectively. - Managing the development and marketing of its titles in a manner that minimizes financial risk. The Company has experienced and expects to continue to experience fluctuations in its revenues, both on a quarterly basis and otherwise, as a result of numerous factors. See "Risk Factors -- Revenue Fluctuations and Seasonality." The Company attempts to minimize its fixed expenses by such means as adjusting the relative use of employees and independent contractors who perform Software development, adopting warehouse and shipping systems that closely link product fulfillment costs to sales volume, and compensating sales representatives based on sales volume. In addition, by implementing strict product ordering and inventory controls, the Company attempts to reduce the risks associated with excessive or obsolete inventory. To further its strategy of obtaining or creating Franchise Properties, the Company has enhanced its development abilities by making certain strategic acquisitions. In 1993, the Company acquired Black Pearl Software, Inc. ("Black Pearl"), an independent Software developer. In August 1996, the Company consummated the acquisition of Heliotrope and retained the services of that company's principals (the "Heliotrope Acquisition") in order to develop and publish Pax Imperia: Eminent Domain for release in 1997 and to develop other strategy games for the PC market. See " -- Software Design and Development." The Company may also rely upon strategic investments to facilitate access to proprietary Software and skilled developers outside the Company. In July 1996, the Company acquired a 25% interest in Inland Productions, Inc. ("Inland"), a recently formed Software developer. Inland is currently developing the Company's PlayStation and Nintendo 64 versions of Turner's World Championship Wrestling and PC and PlayStation versions of BASS Masters Classic. The Company seeks to acquire or invest in other Software development companies to further its development of Proprietary titles. TITLES Since its inception, the Company has released an aggregate of 101 titles as of December 31, 1996, consisting of 32 SNES titles, 36 Game Boy titles, 13 Nintendo Entertainment Systems titles, seven Genesis titles, six Game Gear titles, three Saturn titles and four PlayStation titles. The Company continually seeks to acquire licenses to publish and distribute additional titles. The following tables set forth, for each Platform, the titles (i) released by the Company in 1996 and anticipated to be released in 1997, and (ii) the date of release (or anticipated release) of each title. There can be no assurance that each of the titles anticipated for release in 1997 will be released when scheduled or at all. 4 7
RELEASE TITLES RELEASED IN 1996 CATEGORY PLATFORM DATE ----------------------- -------- -------- ---- Disney's Pocahontas Adventure Game Boy 3/96 In the Hunt Arcade PlayStation 3/96 Saturn 5/96 NBA Live '96 Sports Game Boy 3/96 NHL Hockey '96 Sports Game Boy 4/96 Olympic Summer Games Sports SNES 5/96 Genesis 5/96 Game Boy 6/96 Disney's Toy Story Adventure Game Boy 5/96 SNES (U.K. only) 6/96 BASS Masters Classics: Pro Edition Simulation SNES 6/96 Genesis 12/96 Time Killers Arcade Genesis 7/96 Mohawk & Headphone Jack Adventure SNES 8/96 Battlezone/Super Breakout Arcade Game Boy 8/96 Robopit Action PlayStation 8/96 Saturn 9/96 Alone in the Dark: One-Eyed Jack's Revenge Adventure Saturn 8/96 PlayStation 8/96 Disney's Pinocchio Adventure Game Boy 9/96 Genesis 11/96 SNES (U.K. only) 11/96 PGA European Tour Sports SNES 9/96 Mr. Do! Arcade SNES 9/96 Urban Strike Action Game Boy 10/96 Game Gear 10/96 Floating Runner Action PlayStation 10/96 Disney's Donald Duck and Maui Mallard Adventure SNES (U.K. only) 12/96 Madden '97 Football Sports Game Boy 11/96 FIFA International Soccer '97 Sports Game Boy 11/96 NHL Hockey '97 Sports SNES 11/96 Sim City 2000 Simulation SNES 11/96 College Football USA '97... Sports SNES 12/96
5 8
ANTICIPATED TITLES ANTICIPATED TO BE RELEASED IN RELEASE 1997* CATEGORY PLATFORM DATE ----- -------- -------- ---- K-1: The Arena Fighters Fighting PlayStation Spring '97 WCW vs. The World Fighting PlayStation Spring '97 Disney's Hunchback of Notre Dame Adventure Game Boy Spring '97 Tazmania 2 Adventure Game Boy Spring '97 Demolition Derby XL Driving Saturn Spring '97 Krazy Ivan Action Saturn Spring '97 Super Empire Strikes Back Action SNES Spring '97 Super Return of the Jedi Action SNES Spring '97 Game Boy Spring '97 Strike Point: The Hex Missions Action PlayStation Spring '97 PC Spring '97 Adidas Power Soccer Sports Saturn Summer '97 Brunswick's Tournament of Champions Simulation SNES Summer '97 Disney's Timon & Pumbaa Action SNES Summer '97 Disney's Hercules Adventure Game Boy Summer '97 Ghost in the Shell Action PlayStation Summer '97 Pax Imperia: Eminent Domain Strategy PC Summer '97 Assault Rigs Action Saturn Summer '97 Sentient Action Saturn Summer '97 vs Fighting PlayStation Fall '97 Bravo Air Race Driving PlayStation Fall '97 FIFA World Cup Soccer '98 Sports Game Boy Fall '97 Madden Football '98 Sports Genesis Fall '97 SNES Fall '97 NHL Hockey '98 Sports Genesis Fall '97 SNES Fall '97 NBA Live '98 Sports SNES Fall '97 Genesis Fall '97 BASS Masters Classic: Pro Edition Simulation PlayStation Fall '97 PC Fall '97 World Championship Wrestling Fighting Playstation Fall '97 Nintendo 64 Fall '97 Tenka Action Saturn Fall '97
- - -------------- * Excludes titles the Company expects to release in 1997 but which have not yet been publicly announced. 6 9 INTELLECTUAL PROPERTY LICENSES The Company's strategy includes the creation of exciting games based on licensed Properties that have attained a high level of consumer recognition or acceptance. The Company believes it enjoys excellent relationships with a number of licensors, including Disney, Electronic Arts and LucasArts. The Company pays royalties to its Property licensors that generally range from 2% to 38% of the Company's net sales of the title. The Company must typically pay minimum guaranteed royalties over the license term and advance payments against such guarantees. License fees tend to be higher for Properties with proven popularity and less perceived risk of commercial failure. To the extent competition intensifies for licenses of highly desirable Properties, the Company may encounter difficulty in obtaining these licenses. See " -- Competition." Licenses typically extend for two to three years, may be exclusive for a specific title or line of titles, and may be renewable upon payment of certain minimum royalties or the attainment of specified sales levels. The Company's Property licenses generally grant to the Company exclusive use of the Property for the specified titles, on specified Platforms, within the defined territory and during the license term. However, licensors typically retain the right to exploit the Property for all other purposes, including the right to license the Property for use with other Platforms. Software published by third parties for use with other Platforms based on such Property may compete with titles offered by the Company. PLATFORM LICENSES The Company's business is dependent on its license agreements with the Manufacturers. All of such licenses are for fixed terms and are not exclusive. Each license grants to the Company the right to develop, publish and distribute titles for use on such Manufacturers' Platforms, and requires that such titles be embodied in products that are manufactured solely by such Manufacturer. The following table sets forth information with respect to the Company's Platform Licenses. In some instances, the Company has more than one Platform License for a particular Platform. 7 10
MANUFACTURER PLATFORM NUMBER OF TITLES TERRITORY EXPIRATION DATE(S) - - ------------ -------- ---------------- --------- ------------------ Nintendo SNES 12/contract yr. North America and September and October 1997 Latin America Nintendo SNES 20/contract yr. Europe and certain March and July 1997 Asian countries Nintendo Game Boy 15/contract yr. North America and April and September 1997 Latin America and January 1998 Nintendo Game Boy 10/contract yr. Europe and certain March 1997 and January 1998 Asian countries Sega Genesis 3/contract yr. U.S. and Canada October 1996(1) Sega Game Gear 2/contract yr. U.S. and Canada March 1998(2) Sega Saturn 3/contract yr. U.S. and Canada February 1998(2) Sony PlayStation title-by-title(3) U.S. and Canada June 1998 Sony PlayStation title-by-title(3) Europe December 2005(2)
- - ------------------- (1) The Company has applied for, and consistent with past practice expects to receive, a one- or two-year renewal of such license. (2) Agreement continues year-to-year after such date unless terminated by either party. (3) This Platform License does not set a maximum number of titles that the Company may publish in the designated territory; however, each title must be approved by the Manufacturer prior to development of the Software. The Company has applied for, and expects to receive, a license to publish titles for use on Nintendo's Nintendo 64 Platform, on a title-by-title basis. In November 1996, Nintendo approved the development by the Company of Turner's World Championship Wrestling for this Platform. Sega and Nintendo charge the Company a fixed amount for each cartridge, which amount varies based, in part, on memory capacity and processor power. Sega and Sony similarly charge a per unit amount for each CD-ROM. These charges include a manufacturing, printing and packaging fee as well as a royalty for the use of the Manufacturer's name, proprietary information and technology, and are subject to adjustment by the Manufacturers at their discretion. The Manufacturers have the right to review, evaluate and approve a prototype of each title and all packaging used by the Company in connection with the products. In addition, the Company must indemnify the Manufacturers with respect to all loss, liability and expense resulting from any claim against the Manufacturer involving the development, marketing, sale or use of the Company's titles, including any claims for copyright or trademark infringement brought against the Manufacturer. As a result, the Company bears a risk not only that the Properties upon which the titles are based, but also the information and technology licensed from the Manufacturer and incorporated in the products, may infringe the rights of third parties. While the Company's agreements with its independent Software 8 11 developers and Property licensors typically provide for indemnification of the Company with respect to certain matters, there can be no assurance that, if any claim is brought by a Manufacturer against the Company for indemnification, such developers or licensors would have sufficient resources to in turn indemnify the Company, or that such indemnification would cover the matter that gave rise to the Manufacturer's claim against the Company. Each Platform License may be terminated by the Manufacturer if a breach or default by the Company is not cured by the Company after receipt of written notice thereof from the Manufacturer, or if the Company becomes insolvent. Upon termination of a Platform License for any reason other than a breach or default by the Company, the Manufacturer has the right to purchase from the Company, at the price paid by the Company, any product inventory manufactured by such Manufacturer for the Company that remains unsold for a specified period after such termination. Any such inventory not purchased by the Manufacturer must be destroyed. Upon termination as a result of a breach or default by the Company, any remaining inventory at such time must be destroyed, subject to the right of any institutional lender to the Company to sell such inventory for a specified period. SOFTWARE DESIGN AND DEVELOPMENT Once the Company identifies and acquires a Property from a licensor, the Company designs and develops a game with features intended to exploit the characteristics of the Property and to appeal to the target consumers for such game. The Company's Software development process generally takes one of two forms. Internal Software Development. Prior to the Company's acquisition in 1993 of Black Pearl, an independent Software developer (the "Black Pearl Acquisition"), all of the Company's Software was developed by independent developers. The Black Pearl Acquisition resulted from the Company's determination that the internal development of certain Software permits better control over its quality and timeliness, and this acquisition provided the Company with Software development facilities, personnel and equipment permitting the Company to commence internal Software development. The Company's in-house development team is supervised by the Company's Vice President -- Software Development and is staffed by producers, programmers, Software engineers, artists, animators and game testers. The Heliotrope Acquisition enhanced the Company's internal development capabilities by adding a Software development team and related facilities in Connecticut. The Heliotrope team is currently working with the Company's other development staff to produce Pax Imperia: Eminent Domain for publication on CD-ROM for PCs. The Company uses a variety of advanced hardware and Software development tools, proprietary hardware emulator systems, and various graphics, animation, sound and compression applications. As of December 31, 1996, the Company had 22 development employees. External Software Development. The Company also contracts with independent Software developers to conceptualize and develop titles under the Company's supervision. As of December 31, 1996, the Company had contracted development efforts to 10 such developers. The Company generally pays independent developers certain advances against royalties based on specified development completion milestones. Royalties in excess of the advances are based on 9 12 a fixed amount per unit sold and range from $.25 to $3.50 per unit. The Company generally obtains ownership of the Software code and related documentation. The Company's agreements with its independent Software developers are usually entered into on a title-by-title basis. Although the predominant portion of the Company's titles continue to be developed by independent developers, approximately 27% of the Company's net sales in 1995 and 9% of the Company's net sales for the year ended December 31, 1996 were derived from titles developed by the Company internally. The Company may make strategic investments in independent developers for the purpose of securing access to proprietary Software and talented developers. In June 1996, the Company acquired a 25% interest in Inland, the developer currently working on versions of Turner's World Championship Wrestling and BASS Masters Classics. Upon completion of development, each title is extensively "play-tested" by the Company and sent to the Manufacturer for its review and approval. Related artwork, user instructions, warranty information, brochures and packaging designs are also developed under the Company's supervision. The development cycle for new titles, including the development of the necessary Software, approval by the Manufacturer and production of the initial products, typically has ranged from nine to 18 months. This relatively long development cycle requires the Company to determine whether there will be adequate retailer and consumer demand for a title well in advance of its release. MANUFACTURING Except for certain Genesis cartridges, the Manufacturers are the sole manufacturers of the products sold for use on their respective Platforms. After placing a purchase order with a Manufacturer and opening a letter of credit, the Company sends to the Manufacturer the title's Software code and a prototype, together with related artwork, user instructions, warranty information, brochures and packaging designs, for approval, defect testing and manufacture. The Manufacturers currently deliver cartridges to the Company within 30 to 75 days, and CD-Roms within 15 to 30 days, after their receipt of an order and a corresponding letter of credit, if required. MARKETING, SALES AND DISTRIBUTION The Company depends in large part on the high name recognition of the Properties on which its titles are based to attract customers and to obtain shelf space in stores. The Company's marketing activities are directed by a sales team, led by the Company's Senior Vice President -- Sales, which maintains contact with major retail accounts and manages the activities of the Company's independent regional sales representatives. The Company is required by the Platform Licenses to provide a standard defective product warranty on all of the products sold. Generally, the Company is responsible for 10 13 resolving, at its own expense, any warranty or repair claims. The Company has not experienced any material warranty claims. United States and Canadian Sales. The Company's titles are promoted to retailers by display at trade shows, such as the annual Electronic Entertainment Expo (E3). The Company also conducts print and cooperative retail advertising campaigns for most titles and prepares promotional materials, including product videos, to increase awareness among retailers and consumers. The Company's Game Boy titles licensed from Electronic Arts, such as Madden '96, FIFA Soccer '96, PGA Tour '96 and NHL '96, were included in Electronic Arts' print, television and point-of-purchase advertising. National newspaper and radio promotions included editorial and advertising support in key children's consumer and electronic gaming publications, such as Disney Adventures, Nintendo Power, GamePro, Game Players and Electronic Gaming Monthly. In 1996, the Company's marketing efforts for Olympic Summer Games included a mail-in rebate program with Reebok Shoes. Most of the Company's sales consist of direct sales to retailers. The Company distributes its titles primarily to mass merchandisers and national retail chain stores, including Toys "R" Us, Wal-Mart, Best Buy, Blockbuster Video, Kay Bee Toys, Electronics Boutique and Sears. Sales to the Company's ten largest customers collectively accounted for approximately 52% of the Company's gross sales in 1995 and 54% of the Company's gross sales in 1996. The Company has no written agreement or other understanding with any of its customers that relate to future purchases by such customers, and thus, purchases by such customers may terminate at any time. The Company utilizes electronic data interchange with most of its major domestic customers in order to (i) efficiently receive, process and ship customer product orders, and (ii) accurately track and forecast sell-through of products to consumers in order to determine whether to order additional products from the Manufacturers. The Company ships its products to its domestic customers from a public bonded warehouse in Southern California. The Company's agreements with its independent regional sales representatives set forth the representatives' exclusive territory, types of customers to be solicited, commission rate and payment terms. Such representatives do not have contractual authority to obligate the Company. The domestic retail price for the Company's Software generally ranges between $20 and $70 for SNES, between $15 and $35 for Game Boy, between $20 and $55 for Genesis and between $19 and $59 for PlayStation and Saturn. Foreign Sales. In 1992, the Company commenced the sale of its titles in the United Kingdom, Europe and Australia. The Company sells its titles directly to retailers in the United Kingdom and to distributors for distribution in Europe and in Australia. The Company is the exclusive distributor for Disney's SNES and Game Boy products in the United Kingdom for such titles as Disney's Toy Story, Disney's Pocahontas and Disney's Pinocchio. The Company ships 11 14 its products to its foreign customers from a public bonded warehouse in the United Kingdom. The Company is currently negotiating with distributors for other countries, including Japan. INTELLECTUAL PROPERTY RIGHTS Each product and title typically embody a number of separately protected intellectual Property rights of the Manufacturer, the Property licensors and, to a lesser extent, the Company. The licensors of the Properties own the trademarks, trade names, copyrights and other intellectual Property rights relating to the Property on which the titles are based. The Manufacturer owns the patents and substantially all of the other intellectual Property embodied in the products. While the Company owns the game Software embodied in the products, the Company believes that such Software has little independent economic value. Accordingly, the Company must rely on the Manufacturers and the Property licensors with respect to protection from infringement of these Property rights by third parties. Each of the Manufacturers incorporates security devices in their respective Platforms and products to prevent unlicensed use of its Platforms. In addition, Nintendo requires its licensees to display the "Nintendo Seal of Approval" to notify the public that the title has been approved by Nintendo for use with a Nintendo Platform. COMPETITION The interactive entertainment industry is intensely competitive. The ability of the Company to compete successfully is based on its ability to identify and obtain licenses to commercially marketable Properties, to develop appealing titles, to adapt its development capabilities with new technologies and to secure retail distribution. The Company competes, for both licenses to Properties and the sale of its titles, with the Manufacturers, each of which is the largest developer and marketer of Software for its Platforms. There can be no assurance that these companies will not increase their own development efforts. As a result of their commanding positions in the industry as primary manufacturers of dedicated interactive entertainment hardware and publishers of Software, the Manufacturers generally have better bargaining positions with respect to retail pricing, shelf space and purchases than do any of their licensees, including the Company. The Manufacturers often have lower suggested retail prices for their Software than do their licensees. Each of the Manufacturers has dozens of active licensees, each of which is also a competitor of the Company. Each of the Manufacturers and many of these other competitors (such as Acclaim Entertainment, Inc., Disney Interactive, Inc., Electronic Arts Inc., GT Interactive Software Corp., Microsoft Corporation and Midway Games Inc.) have broader Software lines and greater financial, marketing and other resources than the Company; these competitive advantages enable such competitors to market their Software more aggressively and make higher offers or guarantees in connection with the acquisition of licensed Properties. In addition, as competition for retail shelf space becomes more intense, the Company may need to increase marketing expenditures to maintain sales of its titles; and as competition for popular 12 15 Properties increases, the cost of acquiring licenses for such Properties is likely to increase, resulting in reduced margins. In addition, the market for the Company's products is characterized by significant price competition, and the Company expects that it will face increasing pricing pressures from its current competitors. Accordingly, there can be no assurance that the Company will be able to provide products that compare favorably with the products of the Company's competitors or that competitive pressures will not require the Company to reduce its prices. Any material reduction in the price of the Company's products would negatively affect operating income as a percentage of net revenue and would require the Company to increase unit sales in order to maintain net revenue. The Company believes that large diversified entertainment companies, in addition to large Software companies, are increasing their focus on the interactive entertainment market, which will result in greater competition for the Company. In particular, many of the Company's competitors are developing on-line interactive games and interactive networks that will be competitive with the Company's interactive products. There can be no assurance that the Company will be able to compete successfully against current or future competitors or that competitive pressures faced by the Company will not materially and adversely affect its business, operating results and financial condition. EMPLOYEES As of December 31, 1996, the Company had 48 full-time employees. All but five of such persons are located in the United States. None of the Company's employees is represented by a labor union or covered by a collective bargaining agreement. The Company believes that its relations with its employees are good. ITEM 2. PROPERTIES The Company's executive offices occupy approximately 7,500 square feet of office space at 5016 North Parkway Calabasas, Calabasas, California, pursuant to a lease expiring in July 1998. The Company also leases office space for marketing personnel in Cupertino, California and Epsom, England, and for development personnel in Guilford, Connecticut. The Company believes that its office facilities are adequate. ITEM 3. LEGAL PROCEEDINGS On January 13, 1997, a complaint was filed in Illinois state court by Studio e, Inc. ("Studio e"), a video game Software development company, against Inland, its two principals and the Company. The Company acquired 25% of Inland in June 1996 shortly after its formation for consideration consisting of $300,000 in cash and 52,660 shares of Common Stock with a value at such time of approximately $300,000; and the Company has contracted with Inland for the development of Turner's World Championship Wrestling for the Play Station and Nintendo 64. The complaint alleges, among other things, that the defendants misappropriated trade secrets of 13 16 Studio e, caused delays in the development of one of Studio e's titles, and as a result were responsible for Studio e's loss of future business. The complaint seeks, among other remedies, to enjoin the Company's alleged use of Studio e's trade secrets and damages in an unspecified amount. The complaint makes additional allegations and seeks additional damages and other remedies against Inland and Inland's principals. On March 12, 1997, the Company filed an answer to the complaint denying all allegations of wrongdoing asserted against it. The Company also filed a counterclaim against Studio e alleging trade defamation and libel and intentional interference with prospective economic advantage and a cross-claim for indemnification against Inland. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS There were no matters submitted to a vote of security holders during the fourth quarter of 1996. 14 17 PART II ITEM5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS ALL REFERENCES TO SHARE AND PER SHARE AMOUNTS HAVE BEEN RESTATED TO REFLECT THE ONE-FOR-FIFTEEN REVERSE STOCK SPLIT EFFECTIVE FEBRUARY 15, 1995. Through approximately February 17, 1995, the Company's common stock, $.0001 par value ("Common Stock"), traded on the Nasdaq National Market under the symbol "TOYH." From February 20, 1995 until February 13, 1997, the Common Stock was quoted on the Nasdaq SmallCap Market under the same symbol. On February 14, 1997, the Company's Common Stock began trading on the Nasdaq National Market under the symbol "THQI". The following table sets forth for the periods indicated the high and low closing sales prices of the Common Stock as reported on the Nasdaq National Market or the Nasdaq SmallCap Market.
CLOSING SALES PRICES HIGH LOW 1995 First Quarter 9 3/8 2 3/4 Second Quarter 3 1/8 1 35/64 Third Quarter 4 3/4 1 15/16 Fourth Quarter 6 2 3/4 1996 First Quarter 5 3/16 3 1/2 Second Quarter 6 1/4 3 3/16 Third Quarter 7 9/16 4 1/8 Fourth Quarter 10 3/8 7 1/16
As of March 24, 1997, there were approximately 417 holders of record and 6,059 beneficial owners of the Common Stock. DIVIDEND POLICY The Company has never declared or paid any dividends on the Common Stock and does not intend to pay any cash dividends on the Common Stock in the foreseeable future. The Company intends to retain its earnings, if any, for the future operation and expansion of its business. The Company's agreement with its domestic bank prohibits the Company from declaring or paying any dividend on, or making any distribution in respect of, the Company's capital stock. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Liquidity and Capital Resources." 15 18 SECURITIES ISSUED IN PRIVATE TRANSACTIONS On July 1, 1996, the Company acquired a 25% interest in Inland, a Software developer for home entertainment game systems. The investment consisted of $300,000 in cash and 52,660 shares of Common Sock, and is included in other long-term assets in the accompanying balance sheet. In this transaction the Company relied upon the exemption from registration pursuant to Regulation D of the Securities Act of 1933. The Company has contracted with Inland for the development of 32-bit and 64-bit versions of Turner's World Championship Wrestling and BASS Masters Classic. On July 1, 1996, the Company issued 70,000 shares of Common Stock, at the fair market value of the stock on such date, in settlement of an accrued liability of $229,000 due to a former employee. On August 28, 1996, the Company issued 200,000 options outside of its stock option plan to its president, Brian J. Farrell at an exercise price of $5.00 per share in consideration for his past services and the Company's financial performance. Share prices for these options equal the market price of the Company's Common Stock at the date of the grant. ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA (IN THOUSANDS, EXCEPT PER SHARE DATA) The following selected consolidated financial data of the Company for each of the years ended December 31, 1994, 1995 and 1996 have been derived from and are qualified by reference to the audited consolidated financial statements of the Company included elsewhere herein which have been audited by Deloitte & Touche LLP, independent auditors. The following selected consolidated financial data as of and for the periods ended December 31, 1992 and 1993 were derived from audited financial statements not included elsewhere herein. This selected consolidated financial data should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the Consolidated Financial Statements and Notes thereto included elsewhere herein. 16 19 STATEMENT OF OPERATIONS DATA
Years Ended December 31, ------------------------ 1992 1993 1994 1995 1996 -------- -------- -------- -------- -------- (In thousands, except per share data) Net sales $ 56,478 $ 37,478 $ 13,289 $ 33,250 $ 50,255 -------- -------- -------- -------- -------- Cost and expenses: Cost of sales 31,521 31,415 12,651 19,501 29,301 Royalties 7,179 6,028 2,327 3,641 7,977 Product development 831 1,186 713 761 1,205 Project abandonment -- 5,489 3,754 1,025 610 Selling 4,237 4,843 5,909 2,393 3,441 General and administrative 5,948 7,221 4,806 3,988 4,618 Operating interest -- 529 496 1,184 878 -------- -------- -------- -------- -------- Total costs and expenses 49,716 56,711 30,656 32,493 48,030 -------- -------- -------- -------- -------- Income (loss) from operations 6,762 (19,233) (17,367) 757 2,225 Interest expense - net (76) (420) (112) (134) (316) -------- -------- -------- -------- -------- Income (loss) before income taxes 6,686 (19,653) (17,479) 623 1,909 Provision (benefit) for income taxes 2,640 (3,413) 11 22 8 -------- -------- -------- -------- -------- Net income (loss) $ 4,046 $(16,240) $(17,490) $ 601 $ 1,901 ======== ======== ======== ======== ======== Net income (loss) per share $ 2.79 $ (10.80) $ (8.75) $ .17 $ .39 ======== ======== ======== ======== ======== Weighted-average number of common and common equivalent shares outstanding 1,448 1,504 1,998 3,482 4,911
BALANCE SHEET DATA
Years Ended December 31, ------------------------ 1992 1993 1994 1995 1996 ---- ---- ---- ---- ---- Working capital $25,036 $11,046 $ 3,736 $ 7,082 $ 9,672 Total assets 53,394 22,305 15,531 16,916 22,840 Advance from bank 14,868 -- -- -- 5,355 Long-term debt -- -- -- -- -- Stockholders' equity 26,064 11,627 4,254 7,598 11,048
17 20 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW The Company develops, publishes and distributes Software for the major Platforms sold by the Manufacturers. For the year ended December 31, 1996, sales of Nintendo Software constituted 76% of the Company's sales, Sega Software sales were 14%, and the remaining 10% were derived from sales of Sony PlayStation titles. The Company achieved a turnaround in 1995, reversing two years of significant losses. Under new leadership, the Company focused its product strategy, improved inventory management and reduced fixed costs. As a result, the Company's revenues increased from $13.3 million in 1994 to $33.3 million and $50.3 million in 1995 and 1996, respectively. Although there remains a large installed base of 16-bit Platforms, the Company believes that growth in the Software market will be derived principally from games developed for the more advanced Platforms. Accordingly, the Company intends to devote an increasing portion of its resources to the development of titles for 32-bit and 64-bit Platforms and PCs. The Company's business cycle generally commences with the securing of a license to publish one or more titles based on a Property. Such licenses typically require an advance payment to the licensor and a guarantee of minimum future royalties. See "-- Recovery of Prepaid Royalties, Guarantees and Capitalized Development Costs." After securing the Property, the Company commences Software development for the title. Upon completion of development and approval of the title by the Manufacturer, the Company orders products and generally causes a letter of credit to be opened in favor of the Manufacturer. Products are shipped at the Company's expense to a public warehouse in California for domestic distribution or in the United Kingdom for foreign distribution. The Company has unfilled sales orders the amount of which fluctuates from time to time, commonly referred to as "backlog." However, substantially all of the Company's product orders are fulfilled shortly after they are received. Accordingly, the Company does not believe that the amount of its unfilled sales orders as of the end of a period is a meaningful indicator of sales in future periods. Revenue Fluctuations and Seasonality. The Company has experienced and may continue to experience significant quarterly fluctuations in net sales and operating results due to a variety of factors, including the timing of releases of new titles by the Company, the popularity of both new titles and titles released in prior periods, fluctuations in the mix of titles with varying profit margins, the timing of customer orders, the timing of shipments by the Manufacturers, fluctuations in the size and rate of growth of consumer demand for Software for various Platforms, the timing of the introduction of new Platforms and the accuracy of retailer's forecasts of consumer demand. The Company's expenses are based, in part, on its expectations of future 18 21 revenues and, as a result, operating results would be disproportionately and adversely affected by a decrease in sales or a failure by the Company to meet its sales expectations. In addition, the Software market is highly seasonal, with sales typically significantly higher during the fourth quarter (due primarily to the increased demand for interactive games during the year-end holiday buying season). There can be no assurance that the Company can maintain consistent profitability on a quarterly or annual basis. Profit margins may vary over time as a result of a variety of other factors. Profit margins for cartridge products can vary based on the cost of the memory chip used for a particular title. As Software has grown more complex, the trend in the Software industry has been to utilize chips with greater capacity and thus greater cost. CD-ROMs have significantly lower per unit manufacturing costs than cartridge-based products. However, such savings may be offset by typically higher development costs for titles published on CD-ROMs; such higher costs result from the creation of increased and enhanced content to take advantage of the greater storage capacity available on CD-ROMs. Recovery of Prepaid Royalties, Guarantees and Capitalized Development Costs. The Company typically enters into agreements with licensors of Properties and developers of titles that require advance payments of royalties and/or guaranteed minimum royalty payments. There can be no assurance that the sales of products for which such royalties are paid will be sufficient to cover the amount of these required royalty payments. The Company capitalizes its prepaid royalties, and capitalizes Software development costs upon the establishment of technological feasibility of the title under development. Amortization of these payments and costs is determined on a title-by-title basis based on the greater of (i) the ratio of current gross revenues for a title to the sum of its current and anticipated gross revenues, or (ii) the straight-line method over the estimated remaining economic life of the title. The Company analyzes such capitalized costs quarterly and writes off as project abandonment losses those capitalized payments and costs (and expenses any unpaid guaranteed minimum royalties) when, based on the Company's estimate, future revenues will not be sufficient to recover such costs. As of December 31, 1996, the Company had prepaid royalties and capitalized development costs of approximately $3 million. If the Company were required to write off a material portion of its prepaid royalties or capitalized development costs, the Company's results of operations could be adversely affected. Discounts, Allowances and Returns; Inventory Management. Although the Company's arrangements with its customers generally do not give such customers the right to return products to the Company (other than defective products) or to cancel firm orders, the Company often negotiates accommodations to retailers (and, less often, to distributors) when demand for specific items falls below expectations for the purpose of maintaining its relationships with its customers. Such accommodations consist of acquiescing to the customer's request that not all booked orders be filled or that not all shipped orders be accepted, negotiated price discounts, credits against future orders and, less often, the return of products to the Company. It is the Company's practice to accept all returns of defective or damaged products. 19 22 At the time of product shipment, the Company establishes provisions against the gross revenues generated by such shipment based on estimates of future returns of, other customer accommodations and doubtful accounts that may be granted with respect to, such products, based on the Company's historical experience, retailer inventories of the titles and other factors. For the year ended December 31, 1995 and 1996, provisions of approximately $4.1 million and $5.2 million, respectively, were taken against gross sales made during such periods, and as of December 31, 1996, the Company's aggregate reserve against accounts receivable for returns, customer accommodations and doubtful accounts was approximately $4.4 million. The identification by the Company of slow-moving or obsolete inventory, whether as a result of requests from customers for accommodations or otherwise, would require the Company to establish reserves against such inventory or to write-down the value of such inventory to its estimated net realizable value. In 1993 and 1994, the Company incurred material charges to income as a result of such write-downs, but has not experienced such problems subsequent to those periods. XBAND Modem. Pursuant to an agreement between the Company and Catapult Entertainment, Inc. ("Catapult") entered into in April 1994, the Company was granted exclusive distribution rights for Catapult's modems (the "XBAND Modem") for use in connection with the Genesis and SNES systems in North America. The XBAND Modem enables video game players to compete against each other in real time from different locations through a communications network created and maintained by Catapult. The Company spent approximately $5.8 million through December 31, 1994, in connection with inventory purchases and the marketing and promotion of the XBAND Modem. In May 1995, the Company sold to Catapult the Company's XBAND Modem inventory and related accounts receivable for $3.2 million, of which $1.3 million was paid at such time and the balance was payable over a specified period (less the amount collected by the Company with respect to such receivables). Subsequently, Catapult filed for bankruptcy under Chapter 11 of the U.S. Bankruptcy Code. Under Catapult's plan of reorganization, the Company received approximately 15% of its remaining claim against Catapult, or approximately $200,000, in December 1996. Because the Company determined in May 1995 that receipt of any additional payment by Catapult was highly uncertain, at such time the Company established a reserve in the amount of such remaining payments. As a result, substantially all of the amount received pursuant to the plan of reorganization is reflected in the Company's statement of operations for the year ended December 31, 1996. Net Operating Loss Carryforwards. At December 31, 1995, for federal income tax purposes the Company had reported approximately $17.5 million of NOL carryforwards incurred since 1993. The sale of 1,500,000 shares of Common Stock offered by the Company on February 11, 1997 resulted in an "ownership change" of the Company for purposes of Sections 382 and 383 of the Internal Revenue Code of 1986, as amended. As a result, the amount of the NOL carryforwards available to reduce the Company's federal income tax liability in future years in which the Company has taxable income will be limited to an annual amount equal to (i) the 20 23 fair market value of the Company's capital stock immediately prior to the consummation of the offering on February 11, 1997, multiplied by (ii) the "long-term tax exempt rate" published by the Internal Revenue Service for the month in which the offering was consummated. Based upon a long-term tax exempt rate for February 1997 of 5.48% and an assumed market price of the Common Stock immediately prior to consummation of this offering of $8.56 per share (the last reported sale price of the Common Stock on February 10, 1997), such amount is estimated to be approximately $2,225,000 per year. RESULTS OF OPERATIONS The following table sets forth, for the periods indicated, the components of the Company's net sales and its consolidated operating data as a percentage of net sales:
Years Ended December 31, ------------------------ 1994 1995 1996 ---- ---- ---- Domestic sales 83.6% 74.9% 70.4% Foreign sales 16.4 25.1 29.6 ----- ----- ----- Net sales 100.0% 100.0% 100.0% Costs and expenses: Cost of sales 95.2% 58.6% 58.3% Royalties 17.5 10.9 15.9 Product development 5.4 2.3 2.4 Project abandonment 28.2 3.1 1.2 Selling 44.5 7.2 6.9 General and administrative 36.2 11.9 9.2 Operating interest 3.7 3.6 1.7 ----- ----- ----- Total costs and expenses 230.7 97.6 95.6 ----- ----- ----- Income (loss) from operations (130.7) 2.4 4.4 Interest expense-- net (0.8) (0.5) (0.6) ----- ----- ----- Income (loss) before income taxes (131.5) 1.9 3.8 ----- ----- ----- Net income (loss) (131.6)% 1.8% 3.8% ===== ===== =====
COMPARISON OF THE YEAR ENDED DECEMBER 31, 1996 TO THE YEAR ENDED DECEMBER 31, 1995 The following table sets forth, for the years ended December 31, 1995 and 1996, the titles released during such periods for the Platforms indicated: 21 24
Years Ended December 31, ------------ 1995 1996 PlayStation -- 4 Saturn -- 3 SNES 6 11 Genesis 2 4 Game Boy 10 10 Game Gear 6 1 -- -- Total 24 33 == ==
The Company's net sales increased to $50,255,000 in the year ended December 31, 1996, from $33,250,000 in the same period of 1995, primarily as a result of the increase in the number of new titles released in 1996. For the year ended December 31, 1996, net sales of the Company's Olympic Summer Games, Disney's Toy Story and NHL Hockey 97 titles were $6,631,000 (13.2% of net sales), $5,981,000 (11.9% of net sales) and $4,953,000 (9.9% of net sales), respectively. Foreign net sales grew to $14,856,000, (29.6% of net sales) for the year ended December 31, 1996, from $8,356,000, (26.2% of net sales) in the same period of 1995, as a result of an increase in the number of titles shipped and an increase in unit sales per title. The results for fiscal 1995 included sales of $1,200,000 and cost of sales of $600,000 resulting from the sale of the XBAND Modem inventory to Catapult. See "-- Overview -- XBAND Modem." Cost of sales decreased slightly as a percentage of net sales to 58.3% for the year ended December 31, 1996 as compared to 58.6% of net sales for 1995. The commencement in 1996 of the sale of higher-margin CD-ROM titles was mitigated by increased foreign sales, for which margins are generally lower, and a greater percentage of sales of SNES titles, for which margins are slightly lower. Royalty expense as a percentage of net sales increased to 15.9% for the year ended December 31, 1996 from 10.9% for 1995. License agreements for titles released in 1996 provided for royalties at higher rates, particularly the Company's licenses for Disney's Pocahontas and Disney's Toy Story and its titles for advanced Platforms. For the year ended December 31, 1996, product development expenses increased by $444,000 compared to the year ended December 31, 1995, as a result of increased investment in internal product development during the period as well as increased product packaging costs relating to the increase in titles released in 1996 as compared to 1995. Project abandonment expenses decreased by $415,000 in the year ended December 31, 1996, as compared to the same period of 1995 as a result of the Company bringing more of its scheduled products to market and achieving a greater proportion of its minimum royalty guarantees. 22 25 For the year ended December 31, 1996, selling expenses increased by $1,048,000 compared to the year ended December 31, 1995, as a result of increased marketing efforts for new titles consisting primarily of print and retail cooperative advertising, but remained relatively constant as a percentage of sales at 6.9% of net sales in 1996 as compared to 7.2% in 1995. General and administrative expenses for the year ended December 31, 1996, decreased as a percentage of net sales to 9.2% from 11.9% for the same period of 1995, but increased in dollar terms by $630,000 over 1995. The increased expenses were due in part to a charge of $375,000 in 1996 resulting from the bankruptcy of one of the Company's customers. Additionally, warehousing costs increased in 1996 as a result of the increased sales volume for the period as compared to 1995. Operating interest, which consists of interest and fees paid to the Company's bank and fees paid to other issuers of letters of credit, decreased to $878,000 for the year ended December 31, 1996, from $1,184,000 for the same period of 1995. The decline is the result of the Company's entering into more favorable agreements with the Company's domestic and European letter of credit providers. See "--Liquidity and Capital Resources." COMPARISON OF THE YEAR ENDED DECEMBER 31, 1995 TO THE YEAR ENDED DECEMBER 31, 1994 The Company's net sales increased to $33,250,000 in the year ended December 31, 1995, from $13,289,000 in the year ended December 31, 1994, primarily as a result of an increase in the number of new titles released in 1995. The Company introduced 24 new Software titles in 1995 as compared to ten new titles in 1994. Net sales of the Company's BASS Masters Classic titles constituted $7,054,000, (21.2%) of sales in the year ended December 31, 1995. Approximately $2,941,000 (22.0%) of net sales in 1994 consisted of the Company's The Ren & Stimpy Show titles. Foreign net sales grew to $8,356,000, or 25.1% of net sales in 1995, from $2,175,000, or 16.4% of net sales in 1994, as a result of the increase in the number of new titles released and increased emphasis on sales to foreign customers. The results for fiscal 1995 included sales of $1,200,000 and cost of sales of $600,000 resulting from the sale of the XBAND Modem inventory to Catapult. See "--Overview--XBAND Modem." Cost of sales declined dramatically, as a percentage of net sales, from 1994 to 1995. In 1995, 92% of sales were generated by new titles, which traditionally have higher profit margins, as compared to 56% in 1994. Close-out sales (defined as sales at substantially reduced margins or at a loss) were not material in 1995; however, close-out sales represented approximately 44% of net sales in 1994. The Company attributes the decline in close-out sales to a substantial improvement in the management of its inventory ordering. Cost of sales as a percentage of net sales in 1994 was also adversely affected by a reserve for discounts and allowances for the XBAND Modem in the amount of approximately $2,000,000 established in that year. 23 26 Royalty expense was higher in 1994 than in 1995 because (i) license agreements for titles released in 1994 provided for royalties at higher rates, and (ii) many of the Company's royalty agreements for titles sold in 1994 provided for royalties on a per-unit basis, or provided for royalties payable by the Company on gross sales prices before markdowns and allowances (which, as a consequence of the substantial close-out sales in 1994, resulted in a higher royalty rate). Selling expense as a percentage of net sales decreased to 7.2% in 1995, from 44.5% in 1994, as a result of the higher sales volume in 1995 and the Company's decision to discontinue marketing the XBAND Modem. Selling expense in 1994 included $2,679,000 for the XBAND Modem. The decrease in general and administrative expenses in 1995 compared to 1994 resulted from a continuation of cost reductions, which was offset in part by a charge of $483,000 in 1995 resulting from the bankruptcy of one of the Company's European customers. The lower project abandonment charges in 1995 are the result of the Company bringing a greater portion of its titles in development to market successfully than in 1994. The increase in operating interest in 1995 resulted from an increase in the number of letters of credit opened in 1995, which is directly related to the increase in sales volume, and increased costs of opening letters of credit with lenders other than the Company's bank. LIQUIDITY AND CAPITAL RESOURCES The Company's principal uses of cash are product purchases, guaranteed payments to licensors, advance payments to developers and the costs of internal Software development. In order to purchase products from the Manufacturers, the Company must open letters of credit in their favor. As of December 31, 1996, the Company had obligations with respect to future guaranteed minimum royalties of $3,133,000, substantially all of which was payable within the subsequent twelve months. As of December 31, 1996, the Company had obligations with respect to open letters of credit of $4,409,000. The amount of the Company's accounts receivable is subject to significant seasonal variations due to the seasonality of sales, and is typically highest at the end of the year. As a result, the Company's working capital requirements are greatest during its third and fourth quarters. The Company believes that the proceeds from its recently completed offering, together with funds provided by operations and funds available under the Company's revolving credit facility with a bank (the "Revolving Credit Facility"), will be adequate to meet the Company's anticipated requirements for operating expenses, product purchases, guaranteed payments to licensors and Software development through 1997. However, to the extent accounts receivable, inventories and guarantees and advance payments increase as a result of growth of the 24 27 Company's business, the Company could require additional working capital to fund its operations. The Company does not anticipate making material capital expenditures in 1997. For the year ended December 31, 1996, the Company's net cash used in operating activities was $4,348,000, compared to $3,395,000 and $9,986,000 for the same periods in 1995 and 1994, respectively. For the year ended December 31, 1996, the Company's net cash used in investing activities was $892,000 (primarily as a result of the Heliotrope Acquisition and the Company's purchase of 25% of Inland), compared to $239,000 and $188,000 for the same periods in 1995 and 1994, respectively. For additional information concerning the Company's acquisition and investments, see Note 9 of Notes to Consolidated Financial Statements included elsewhere herein. For the year ended December 31, 1996, the Company's net cash provided by financing activities was $6,067,000, compared to $2,661,000 and $9,833,000, for the same periods in 1995 and 1994, respectively. Financing activities were primarily the receipt of the proceeds from the exercise of warrants and options and bank borrowings in 1996, the issuance of convertible preferred stock in 1995 and the issuance of Common Stock in 1994. Credit Facilities. In July 1996, the Company terminated its factoring and credit agreement and entered into the Revolving Credit Facility. Under the Revolving Credit Facility, the Company may draw down working capital advances and open letters of credit in an aggregate amount not to exceed the lesser of $9,000,000, or an amount equal to the sum of 70% of eligible accounts receivable, 50% of eligible inventory and 51% of the amount of letters of credit opened by the Company in favor of the Manufacturers. The portion of the borrowing base that consists of eligible inventory may not exceed $1,500,000. Advances under the Revolving Credit Facility bear interest at the bank's prime lending rate plus 1.25%. The Company has granted the bank a security interest in its domestic accounts receivable and inventories. The Revolving Credit Facility matures on June 30, 1997, subject to earlier termination. As of December 31, 1996, the Company had advances under the Revolving Credit Facility of $5,355,000 and open letters of credit from its revolving credit lender of $2,726,000. On February 14, 1997, upon completion of the Company's public offering of 1,500,000 shares of Common Stock, the Company repaid advances under its Revolving Credit Facility in the amount of $1,384,000. The Revolving Credit Facility contains customary covenants including, among others, restrictions on the incurrence of debt, encumbrances on or sales of assets, mergers and acquisitions, payments of dividends and capital expenditures. Financial covenants include the maintenance of (i) a current ratio of not less than 1.4 to 1, (ii) profitable operations on a fiscal year basis, (iii) minimum tangible net worth of $7,000,000, (iv) a ratio of debt to tangible net worth of not greater than 1.75 to 1, and (v) minimum working capital of $5,000,000. The Company has also entered into agreements with two additional lenders (the "North American Lender" and the "European Lender") pursuant to which such lenders have agreed to 25 28 issue letters of credit ("L/Cs") on the Company's behalf to the Manufacturers for the purchase of products for the Company's North American operations (up to a maximum of $5,000,000) and the Company's European operations (up to a maximum of $2,500,000), respectively. Each of these lenders receives a fee for the issuance of such L/Cs, and each lender retains title to the products financed by such lender until such time as such products are sold to the Company's customers. The North American Lender has a security interest in the domestic assets of the Company subordinate to the security interest of the Company's bank. The term of the agreement with the North American Lender expires on March 13, 1997, subject to automatic renewals on such date and every nine months thereafter, unless terminated by either party. The European Lender has a first priority security interest in all of the Company's European subsidiary's receivables, inventory and other assets. The agreement with the European Lender may be terminated at any time by such lender. As of December 31, 1996, there were no open letters of credit issued by the North American Lender and open letters of credit in the amount of $1,683,000 issued by the European lender. Public Offering. On February 14, 1997, the Company completed a public offering of 1,500,000 shares of the Company's Common Stock. In conjunction with the offering, the Company granted to the underwriters an overallotment option, exercisable within 30 days of the date of February 11, 1997, to purchase up to 225,000 additional shares of the Common Stock at the public offering price. On March 11, 1997, the underwriters exercised their overallotment option. All of these shares were newly issued and sold on behalf of the Company. The net proceeds of the 1,725,000 shares sold by the Company, of $11.7 million, will be used for general corporate purposes including obtaining new licenses for, and development expenses related to, new titles and the repayment of amounts outstanding under the Company's revolving credit facility. A portion of the proceeds may also be used to fund acquisitions related to the Company's business. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Reference is made to the Financial Statements referred to in the accompanying Index, setting forth the consolidated financial statements of T-HQ, Inc. and subsidiaries, together with the report of Deloitte & Touche LLP dated February 7, 1997(March 11, 1997 as to Note 12). ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. 26 29 PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information required under this Item relating to members of the Board of Directors and Executive Officers of the Company will be included in the Company's 1997 Notice of Annual Meeting of Shareholders and Proxy Statement under the headings "Election of Directors," "Executive Officers," "Key Employees," "Late Filings" and "Director and Officer Holdings," which will be filed within 120 days after the close of the Company's fiscal year, and is incorporated herein by reference. ITEM 11. EXECUTIVE COMPENSATION The information required under this Item relating to executive compensation will be included in the Company's 1997 Notice of Annual Meeting of Shareholders and Proxy Statement under the heading "Executive Compensation," which will be filed within 120 days after the close of the Company's fiscal year, and is incorporated herein by reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required under this Item relating to security ownership of certain beneficial owners and management will be included in the Company's 1997 Notice of Annual Meeting of Shareholders and Proxy Statement under the heading "Principal Shareholders," which will be filed within 120 days after the close of the Company's fiscal year, and is incorporated herein by reference. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required under this Item relating to certain relationships and related transactions will be included in the Company's 1997 Notice of Annual Meeting of Shareholders and Proxy Statement under the headings "Employment Agreements" and "Director and Officer Transactions," which will be filed within 120 days after the close of the Company's fiscal year, and is incorporated herein by reference. 27 30 PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (A) FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES. See Index to Financial Statements. (B) REPORTS ON FORM 8-K. None (C) EXHIBITS. Exhibit Number Title 3.1 Articles of Incorporation (Filed as an exhibit to Registration Statement on Form S-18 (File No. 33-35582-NY) of Trinity, and incorporated herein by reference. Amendments made to documents since original filing were filed as exhibits to the Company's Proxy Statements dated April 24, 1992, April 30, 1993 and April 28, 1994, respectively, and are incorporated herein by reference) 3.2 Bylaws, as amended (Filed as an exhibit to Registration Statement on Form S-18 (File No. 33- 35582-NY) of Trinity, and incorporated herein by reference. Amendments made to documents since original filing were filed as exhibits to the Company's Proxy Statements dated April 24, 1992, April 30, 1993 and April 28, 1994, respectively, and are incorporated herein by reference) 10.1 Amended and Restated 1990 Stock Option Plan, as amended (Filed as Exhibit 10.1 to the Company's Registration Statement on form S-2 (File No. 333-18641) and incorporated herein by reference) 10.2 Confidential Second Renewal License Agreement for Super Nintendo Entertainment System effective October 16, 1995, between Nintendo of America Inc. and the Company (Filed as Exhibit 10.2(a) to the Company's Annual Report on Form 10-K for the year ended December 31, 1995, and incorporated herein by reference) 10.3 Confidential First Renewal License Agreement for Gameboy effective January 1, 1995, between Nintendo of America Inc. and the Company (Filed as Exhibit 10.3(a) to the Company's Annual Report on Form 10-K for the year ended December 31, 1995, and incorporated herein by reference) 10.4 Confidential First Renewal International License Agreement for Super Nintendo Entertainment System effective February 6, 1995, between Nintendo Co., Ltd., and the Company (Filed as Exhibit 10.4(a) to the Company's Annual Report on Form 10-K for the year ended December 31, 1995, and incorporated herein by reference) 28 31 10.5 First Extension Letter dated June 5, 1996, and Second Extension Letter dated September 13, 1996 to Confidential First Renewal International License Agreement for Super Nintendo Entertainment System effective February 6, 1995, between Nintendo Co., Ltd., and the Company (Filed as Exhibit 10.5 to the Company's Registration Statement on Form S-2 (File No. 333-18641) and incorporated herein by reference) 10.6 Confidential First Renewal International License Agreement for Gameboy dated November 6, 1995, between Nintendo Co., Ltd., and the Company (Filed as Exhibit 10.5(a) to the Company's Annual Report on Form 10-K for the year ended December 31, 1995, and incorporated herein by reference) 10.7 Confidential License Agreement for Super Nintendo Entertainment System dated September 28, 1995, between Nintendo of America, Inc. and Black Pearl Software, Inc. (Filed as Exhibit 10.6(a) to the Company's Annual Report on Form 10-K for the year ended December 31, 1995, and incorporated herein by reference) 10.8 Confidential License Agreement for Gameboy dated April 4, 1994, between Nintendo of America, Inc. and Malibu Games, Inc. (Filed as an exhibit to the Company's Registration Statement on Form S-2 (File No. 33-81632) which became effective December 7, 1995, and incorporated herein by reference) 10.9 Confidential First Renewal International License Agreement for Super Nintendo Entertainment System dated as of July 19, 1995, between Nintendo Co., Ltd., and Black Pearl Software, Inc. (Filed as Exhibit 10.8(a) to the Company's Annual Report on Form 10-K for the year ended December 31, 1995, and incorporated herein by reference) 10.10 Addendum dated September 28, 1995, together with Extension Letter dated July 9, 1996, and Second Extension Letter dated November 21, 1996, to Confidential International License Agreement for Game Boy dated July 19, 1993, between Nintendo Co., Ltd., and Black Pearl Software, Inc. (Filed as Exhibit 10.11 to the Company's Registration Statement on form S-2 (File No. 333-18641) and incorporated herein by reference) 10.11 License Agreement for Sega Genesis System dated as of October 20, 1994, between Sega Enterprises, Ltd., and the Company (Filed as Exhibit 10.10(a) to the Company's Annual Report on Form 10-K for the year ended December 31, 1995, and incorporated herein by reference) 10.12 License Agreement for North American Sega Saturn System effective as of February 26, 1996, between Sega Enterprises, Ltd., and the Company (Filed as exhibit 10.13 to the Company's Registration Statement on form S-2 (File No. 333-18641) and incorporated herein by reference) 10.13 Confidential License Agreement for Gameboy effective as of September 28, 1995, between Nintendo of America Inc. and Black Pearl Software, Inc. (Filed as Exhibit 10.7(a) to the Company's Annual Report on Form 10-K for the year ended December 31, 1995, and incorporated herein by reference) 10.14* Employment Agreement of Brian J. Farrell dated as of December 31, 1996, between the Company and Brian J. Farrell 29 32 10.15 Stock Option Agreement dated as of February 15, 1995, between the Company and Brian J. Farrell (Filed as an exhibit to the Registration Statement on Form S-8 (Registration No. 333-00136) filed on January 11, 1996, and incorporated herein by reference) 10.16 401(k) Plan of the Company (Filed as an exhibit to Registration Statement on Form S-18 (File No. 33-35582-NY) of Trinity, and incorporated herein by reference. Amendments made since original filing were filed as exhibits to the Company's Proxy Statements dated April 24, 1992, April 30, 1993 and April 28, 1994, respectively, as are incorporated herein by reference and modification made to this document was filed as an exhibit to the Company's Annual Report on Form 10-K for the year ended December 31, 1991, and incorporated herein by reference) 10.17 Form of Indemnification Agreement (Filed as an exhibit to the Company's Registration Statement on Form S-1 (File No. 33-47767) or Amendment No. 1, Amendment No. 2, Amendment No. 3 or Amendment No. 4 thereto and incorporated herein by reference) 10.18 Security and Loan Agreement dated June 7, 1996, by and between the Company and Imperial Bank (Filed as an exhibit to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1996, and incorporated herein by reference) 10.19 First Amendment to Security and Loan Agreement dated June 7, 1996, by and between the Company and Imperial Bank (Filed as Exhibit 10.20 to the Company's Registration Statement on Form S-2 (File No. 333-18641) and incorporated herein by reference) 10.20+ Conversion, Manufacturing and Distribution Agreement dated as of March 8, 1995, by and between Electronic Arts Inc. and the Company (Filed as Exhibit 10.35 to the Company's Annual Report on Form 10-K for the year ended December 31, 1995, and incorporated herein by reference) 10.21+ Licensed Publisher Agreement dated November 10, 1995, by and between the Company and Sony Computer Entertainment Europe, a division of Sony Electronic Publishing Limited (Filed as Exhibit 10.42 to the Company's Annual Report on Form 10-K for the year ended December 31, 1995, and incorporated herein by reference) 10.22 Licensed Publisher-Supplemental Agreement dated April 11, 1996, by and between the Company and Sony Computer Entertainment Europe, a division of Sony Electronic Publishing Limited (Filed as Exhibit 10.23 to the Company's Registration Statement on form S-2 (File No. 333-18641) and incorporated herein by reference) 10.23 Sony PSX License Agreement dated June 29, 1994, by and between the Company and Sony Computer Entertainment of America, a division of Sony Electronic Publishing Company (Filed as Exhibit 10.24 to the Company's Registration Statement on Form S-2 (File No. 333-18641) and incorporated herein by reference) 10.24 Termination Agreement and Mutual Release dated May 31, 1995, by and between the Company and Catapult Entertainment, Inc. (Filed as an exhibit to the Company's Registration Statement on Form S-2 (File No. 33-81632) which became effective December 7, 1995, and incorporated herein by reference) 30 33 10.25 Stock Purchase Agreement dated as of June 28, 1996, by and between the Company and Inland Productions, Inc. (Filed as an exhibit to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1996, and incorporated herein by reference) 10.26 Stock Purchase Agreement dated as of August 2, 1996, by and between the Company and Heliotrope Studios, Inc. (Filed as an exhibit to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1996, and incorporated herein by reference) 10.27 License Agreement dated July 11, 1994, between the Company and B.A.S.S., Inc. (Filed as Exhibit 10.38 to the Company's Annual Report on Form 10-K for the year ended December 31, 1995, and incorporated herein by reference) 10.28 License Agreement dated December 29, 1995, between the Company and Turner New Media, Inc. (Filed as Exhibit 10.41 to the Company's Annual Report on Form 10-K for the year ended December 31, 1995, and incorporated herein by reference) 10.29 Assignment of Rights dated as of July 23, 1996, between the Company and Blizzard Entertainment (Filed as Exhibit 10.30 to the Company's Registration Statement on Form S-2 (File No. 333-18641) and incorporated herein by reference) 10.30 Financing Contract dated 1994 between Opal Finance Corporation and the Company (Filed as Exhibit 10.31 to the Company's Registration Statement on Form S-2 (File No. 333-18641) and incorporated herein by reference) 10.31* Stock Option Agreement dated as of August 28, 1996, between the Company and Brian J. Farrell 11* Statement of Computation of Net Earnings 21* Subsidiaries of the Registrant 23* Independent Auditor's Consent 27* Financial Data Schedule - - ---------- *Filed herewith. + Confidential treatment requested as to portions of this exhibit. 31 34 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. Dated: March 31, 1997 T-HQ, INC. By: /s/ Brian J. Farrell ------------------------- Brian J. Farrell President Pursuant uo the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Signature Title Date /s/ Brian J. Farrell - - -------------------------- President, Chief Executive Officer, March 31, 1997 Brian J. Farrell and Director /s/ Lawrence Burstein - - -------------------------- Director March 31, 1997 Lawrence Burstein /s/ Bruce Jagid - - -------------------------- Director March 31, 1997 Bruce Jagid /s/ Jeffrey C. Lapin - - -------------------------- Director March 31, 1997 Jeffrey C. Lapin /s/ L. Michael Haller - - -------------------------- Senior Vice President March 31, 1997 L. Michael Haller and Director /s/ Deborah A. Lake - - -------------------------- Vice President Finance March 31, 1997 Deborah A. Lake (Chief Financial Officer) 32 35 T-HQ, INC. INDEX TO FINANCIAL STATEMENTS
Page INDEPENDENT AUDITORS' REPORT F-2 FINANCIAL STATEMENTS Consolidated Balance Sheets -- December 31, 1995 and December 31, 1996 F-3 Consolidated Statements of Operations for each of the Three Years in the Period Ended December 31, 1996 F-4 Consolidated Statements of Shareholders' Equity for each of the Three Years in the Period Ended December 31, 1996 F-5 Consolidated Statements of Cash Flows for each of the Three Years in the Period Ended December 31, 1996 F-6 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS F-8
All other financial statement schedules have been omitted since either (i) the schedule or condition requiring a schedule is not applicable or (ii) the information required by such schedule is contained in the Consolidated Financial Statements and Notes thereto or in Management's Discussion and Analysis of Financial Condition and Results of Operations. F-1 36 INDEPENDENT AUDITORS' REPORT To the Shareholders of T-HQ, Inc., Calabasas, California We have audited the accompanying consolidated balance sheets of T-HQ, Inc. and subsidiaries (the "Company") as of December 31, 1995 and 1996, and the related consolidated statements of operations, shareholders' equity, and cash flows for each of the three years in the period ended December 31, 1996. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 1995 and 1996 and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1996 in conformity with generally accepted accounting principles. DELOITTE & TOUCHE LLP Los Angeles, California February 7, 1997 (March 11, 1997 as to Note 12) F-2 37 T-HQ, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS ASSETS
December 31, --------------------------- 1995 1996 ------------ ------------ Current assets: Cash $ 1,895,000 $ 2,734,000 Accounts receivable -- net 9,362,000 14,186,000 Inventory 1,150,000 1,013,000 Prepaid and deferred royalties 1,776,000 717,000 Software development costs 2,037,000 2,329,000 Income tax refund receivable 27,000 -- Prepaid expenses and other current assets 153,000 485,000 ------------ ------------ Total current assets 16,400,000 21,464,000 Equipment -- net 516,000 581,000 Other long-term assets -- 795,000 ------------ ------------ TOTAL ASSETS $ 16,916,000 $ 22,840,000 ============ ============ LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities: Accounts payable and accrued expenses $ 4,707,000 $ 3,304,000 Accrued royalties 1,752,000 3,133,000 Accrued returns and allowances 2,859,000 -- Advance from bank -- 5,355,000 ------------ ------------ Total current liabilities 9,318,000 11,792,000 Commitments and contingencies -- -- Shareholders' equity: Convertible preferred stock, par value $.01, 5,000 shares authorized Common Stock, par value $.0001, 100,000,000 shares authorized; 4,217,391 shares, and 4,739,883 shares issued and outstanding as of December 31, 1995 and 1996, respectively 4,000 4,000 Additional paid-in capital 33,317,000 34,558,000 Cumulative foreign currency translation adjustment (360,000) (52,000) Accumulated deficit (25,363,000) (23,462,000) ------------ ------------ Total shareholders' equity 7,598,000 11,048,000 ------------ ------------ TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 16,916,000 $ 22,840,000 ============ ============
See notes to consolidated financial statements. F-3 38 T-HQ, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS
FOR THE THREE YEARS ENDED DECEMBER 31, ------------------------------------------ 1994 1995 1996 ------------ ------------ ------------ Net sales $ 13,289,000 $ 33,250,000 $ 50,255,000 Costs and expenses: Cost of sales 12,651,000 19,501,000 29,301,000 Royalties 2,327,000 3,641,000 7,977,000 Product development 713,000 761,000 1,205,000 Project abandonment 3,754,000 1,025,000 610,000 Selling 5,909,000 2,393,000 3,441,000 General and administrative 4,806,000 3,988,000 4,618,000 Operating interest 496,000 1,184,000 878,000 ------------ ------------ ------------ Total costs and expenses 30,656,000 32,493,000 48,030,000 ------------ ------------ ------------ Income (loss) from operations (17,367,000) 757,000 2,225,000 Interest expense, net (112,000) (134,000) (316,000) ------------ ------------ ------------ Income (loss) before income taxes (17,479,000) 623,000 1,909,000 Provision for (benefit from) income taxes 11,000 22,000 8,000 ------------ ------------ ------------ Net income (loss) $(17,490,000) $ 601,000 $ 1,901,000 ------------ ------------ ------------ Net income (loss) per share $ (8.75) $ .17 $ .39 ============ ============ ============
See notes to consolidated financial statements. F-4 39 T-HQ, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY FOR THE THREE YEARS ENDED DECEMBER 31, 1994, 1995 AND 1996
Cumulative Foreign Retained Additional Currency Earnings Preferred Common Common Paid-in Translation (Accumulated Stock Shares Amount Capital Adjustment Deficit) Total --------- --------- ------ ----------- ----------- ------------ ------------ Balance at January 1, 1994 -- 1,509,168 $2,000 $20,825,000 $(726,000) $ (8,474,000) $ 11,627,000 Issuance of Common Stock for cash -- 1,278,148 2,000 9,818,000 -- -- 9,820,000 Exercise of options -- 3,334 -- 13,000 -- -- 13,000 Net loss -- -- -- -- -- (17,490,000) (17,490,000) Foreign currency translation adjustment -- -- -- -- 284,000 -- 284,000 --------- --------- ------ ----------- ----------- ------------ ------------ Balance at December 31, 1994 -- 2,790,650 4,000 30,656,000 (442,000) (25,964,000) 4,254,000 Exercise of warrants and options -- 91,530 -- 48,000 -- -- 48,000 Issuance of preferred stock for cash 3,190 -- -- 2,613,000 -- -- 2,613,000 Conversion of preferred stock to Common Stock (2,865) 1,335,211 -- -- -- -- -- Net income -- -- -- -- -- 601,000 601,000 Foreign currency translation adjustment -- -- -- -- 82,000 -- 82,000 --------- --------- ------ ----------- ----------- ------------ ------------ Balance at December 31, 1995 325 4,217,391 4,000 33,317,000 (360,000) (25,363,000) 7,598,000 Exercise of warrants and options -- 272,115 -- 712,000 -- -- 712,000 Conversion of preferred stock to Common Stock (325) 127,717 -- -- -- -- -- Issuance of stock -- 122,660 -- 529,000 -- -- 529,000 Net income -- -- -- -- -- 1,901,000 1,901,000 Foreign currency translation adjustment -- -- -- -- 308,000 -- 308,000 --------- --------- ------ ----------- ----------- ------------ ------------ Balance at December 31, 1996 -- 4,739,883 $4,000 $34,558,000 $(52,000) $(23,462,000) $ 11,048,000 ========= ========= ====== =========== =========== ============ ============
See notes to consolidated financial statements. F-5 40 T-HQ, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS
Years Ended December 31, ------------------------------------------ 1994 1995 1996 ------------ ------------ ------------ Cash flows from operating activities: Net income (loss) $(17,490,000) $ 601,000 $ 1,901,000 Adjustments to reconcile net income (loss) to net cash used in operating activities: Depreciation and amortization 253,000 240,000 337,000 Provision for doubtful accounts, discounts and returns 3,888,000 4,145,000 5,203,000 Changes in operating assets and liabilities: Accounts receivable (2,127,000) (5,875,000) (7,270,000) Inventory and inventory deposits 3,796,000 779,000 202,000 Prepaid and deferred royalties and Software development costs 1,602,000 2,592,000 2,799,000 Prepaid expenses and other current assets 2,292,000 99,000 (322,000) Income tax refund receivable 2,398,000 201,000 -- Accounts payable and accrued expenses 1,365,000 1,040,000 (1,233,000) Accrued royalties (2,083,000) (3,628,000) (649,000) Accrued returns and allowances (3,898,000) (3,589,000) (5,316,000) Income taxes payable 18,000 -- -- ------------ ------------ ------------ Net cash used in operating activities (9,986,000) (3,395,000) (4,348,000) ------------ ------------ ------------ Cash flows used in investing activities: Other long-term assets -- -- (578,000) Acquisition of equipment (188,000) (239,000) (314,000) ------------ ------------ ------------ Net cash used in investing activities (188,000) (239,000) (892,000) ------------ ------------ ------------ Cash flows from financing activities: Advances from bank -- -- 5,355,000 Proceeds from exercise of warrants and options 13,000 48,000 712,000 Net proceeds from issuance of convertible preferred stock -- 2,613,000 -- Net proceeds from issuance of common stock 9,820,000 -- -- ------------ ------------ ------------ Net cash provided by financing activities 9,833,000 2,661,000 6,067,000 ------------ ------------ ------------ Effect of exchange rate changes on cash 133,000 61,000 12,000 ------------ ------------ ------------ Net increase (decrease) in cash (208,000) (912,000) 839,000 ------------ ------------ ------------ Cash -- beginning of period 3,015,000 2,807,000 1,895,000 ------------ ------------ ------------ Cash -- end of period $ 2,807,000 $ 1,895,000 $ 2,734,000 ============ ============ ============ Supplemental disclosure of cash flow information: Cash paid during the period for income taxes -- $ 22,000 $ 14,000 ============ ============ ============ Cash paid during the period for interest $ 235,000 $ 230,000 $ 375,000 ============ ============ ============
F-6 41 NON-CASH TRANSACTIONS: As of July 1, 1996 the Company issued 70,000 shares of Common Stock in lieu of cash to a former employee of the Company. This transaction resulted in a reduction in accounts payable and accrued expenses and a like increase in additional paid-in capital in the amount of $229,000, the fair value of the stock issued on the date of issuance. Also on July 1, 1996, the Company issued 52,660 shares of Common Stock as part of the purchase price for a 25% interest in Inland Productions, Inc. ("Inland") increasing other long-term investments and additional paid-in capital by $300,000. F-7 42 T-HQ, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. ORGANIZATION Business. T-HQ, Inc., a New York corporation, develops and publishes interactive entertainment software ("Software") for the hardware platforms that collectively dominate the market ("Platforms"). Substantially all of the Company's products are based on licenses for popular cultural trends and high-recognition names ("Properties"). Unless the context otherwise requires, references in this document to "T-HQ" or the "Company" include T-HQ, Inc. and all of its wholly owned subsidiaries. License Agreements. The Company has two license agreements with Sony pursuant to which it has the non-exclusive right to utilize the Sony name and its proprietary information and technology in order to develop and market Software for use with the 32-bit Sony PlayStation in the United States and Canada, and Europe, respectively, which expire in June of 1998 and December of 2005, respectively. The Company has various license agreements with Nintendo pursuant to which it has the non-exclusive right to utilize the Nintendo name and its proprietary information and technology in order to develop and market Software for use with the 16-bit Super Nintendo Entertainment System ("SNES") and with the Nintendo Game Boy portable game console. The license agreements with Nintendo for such hardware Platforms expire at various times through January 1998. In November, 1996, Nintendo approved the development by the Company of Turner's World Championship Wrestling for release on the recently introduced 64-bit Nintendo 64. The Company has various license agreements with Sega pursuant to which it has the non-exclusive right to utilize the Sega name and its proprietary information and technology in order to develop and market Software for use with the 32-bit Sega Saturn, 16-bit Sega Genesis, and the portable Sega Game Gear. The license agreements with Sega for such hardware Platforms expire at various times through 1998. The Company's Software business is dependent on its license agreements with Sony, Nintendo, and Sega. Substantially, all of the Company's Software products are manufactured by Sony, Nintendo, and Sega, who charge the Company a fixed amount for each Software CD-ROM or cartridge manufactured, which charge includes a manufacturing, printing and packaging fee as well as a royalty for the use of their respective names, proprietary information and technology. In addition, the Company must indemnify Sony, Nintendo, or Sega as appropriate, with respect to all loss, liability and expense resulting from any claim against Sony, Nintendo, or Sega involving the development, marketing, sale or use of the Company's Titles, including any claims for copyright or trademark infringement brought against Sony, Nintendo, or Sega. As such, the F-8 43 Company bears the risk that the Properties and information and technology licensed from Sony, Nintendo, or Sega and incorporated in the Software may infringe the rights of third parties. Generally, the Company is entitled to indemnification from its Software developers and Property licensors to cover its indemnification obligations to Sony, Nintendo, or Sega, but no assurance can be given that, if any claim is brought against the Company, said developers and/or licensors will have sufficient resources to indemnify the Company. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Principles of Consolidation. The consolidated financial statements include the accounts of T-HQ, Inc. and its wholly owned subsidiaries. All material intercompany balances and transaction have been eliminated. Foreign Currency Translation. Assets and liabilities of foreign operations are translated at current rates of exchange while results of operations are translated at average rates in effect for the period. Translation gains or losses are shown as a separate component of shareholders' equity. Foreign currency translation gains and losses result from exchange rate changes denominated in currencies other than the U.S. dollar. The Company has not experienced significant foreign currency transaction gains or losses. Fair Values of Financial Instruments. The carrying value of accounts receivable and trade payables approximate the fair value due to their short-term maturities. The carrying value of the Company's advances from its bank is considered to approximate its fair value because the interest rate of this instrument is based on a variable reference rate. Inventory and Inventory Deposits. Inventories, which consist principally of finished products, are stated at the lower of cost (first-in, first-out basis) or market. The Company estimates the net realizable value of slow-moving inventory on a title by title basis, and charges the excess of cost over net realizable value to cost of sales. Inventory deposits are prepayments to Software Manufacturers or deposits to lenders opening letters of credit on behalf of the Company for the manufacture of specific products. Equipment. Equipment is stated at cost. Depreciation is computed using the straight-line method over the estimated useful lives of the assets which range from three to five years. Equipment consists of the following at:
December 31, ----------------------------- 1995 1996 ----------- ----------- Furniture, fixtures and equipment $ 897,000 $ 1,164,000 Leasehold improvements 20,000 20,000 Less accumulated depreciation (401,000) (603,000) ----------- ----------- $ 516,000 $ 581,000 =========== ===========
Depreciation expense for the years ended December 31, 1994, 1995 and 1996 was $209,000, $199,000, and $238,000, respectively. F-9 44 Royalties and Software Development Costs. Advance royalty payments for intellectual Property licenses are recorded as prepaid royalties. All minimum guaranteed royalty payments are initially recorded as an asset (deferred royalties) and as a liability (accrued royalties) at the contractual amount upon execution of the contract. Royalty payments for intellectual Property licenses are classified as current assets to the extent they relate to anticipated sales during the subsequent year. The Company utilizes both independent Software developers (who are paid advances against future royalties) and internal development teams to develop its Software. Under generally accepted accounting principles, such Software development costs are capitalizable when technological feasibility has been established. Technological feasibility for entertainment Software such as the Company's has been established by Sony, Nintendo, and Sega for use with their respective hardware Platforms. Amortization of prepaid royalty and Software development costs, as a part of royalties expense, is provided on a product-by-product basis commencing with the general release of each product, based on the greater of the ratio of current gross revenues for the product to the sum of its current and anticipated gross revenues, or the straight line method over the remaining estimated economic life of the product. The Company also expenses as project abandonment losses advances or capitalized Software development costs when, in management's estimate, future revenues will not be sufficient to recover previously capitalized costs. Such abandonment losses are solely attributable to changes in market conditions or product quality considerations. Software development costs of $935,000, $1,768,000, and $2,390,000 were amortized in 1994, 1995, and 1996, respectively. Project abandonment losses related to Software development costs of $2,743,000, $1,025,000 and $509,000 were charged to expense in 1994, 1995, and 1996, respectively. Research and development costs are expensed as incurred and to date have not been material. Revenue Recognition. Revenue is recognized when the product is shipped, provided that no significant vendor support obligations remain outstanding, and provided that the collection of the resulting receivable is deemed probable by management. Although the Company sells its products on a no-return basis, in certain circumstances the Company may allow returns, price concessions, or allowances on a negotiated basis. The Company estimates such returns and allowances based upon management's evaluation of the Company's historical experience and current industry trends. Such estimates are deducted from gross revenue. Software is sold under a limited 90-day warranty against defects in material and workmanship. To date, the Company has not experienced material warranty claims. (See Note 3). Primary and Fully Diluted Earnings Per Share. Net income (loss) per share has been computed using the weighted-average number of common shares and common share equivalents (which consists of warrants, convertible preferred stock, and options, to the extent they are dilutive). The weighted-average number of common shares and common share equivalents outstanding in the years ended December 31, 1994, 1995, and 1996 were 1,998,000, 3,482,000, and 4,911,000, respectively. The difference between primary and fully diluted earnings per share is not significant. As discussed in Note 12, subsequent to December 31, 1996, the Company raised $11.7 million by issuing Common Stock. If a portion of the proceeds of the offering had been used to eliminate debt under the Company's borrowing agreements during 1996, earnings per share would have been $ .43. F-10 45 Non-monetary Transactions. Prior to 1995, the Company exchanged its products for advertising to facilitate the promotion of the Company's products. The exchanges are valued at the lower of cost or fair market value of products exchanged. The Company recorded expense related to these transactions of $2,061,000 during 1994. Reclassifications. Certain items in the 1994 and 1995 financial statements have been reclassified to conform to the 1996 presentation. Accounting Standard. In March 1995, the Financial Accounting Standards Board issued Statements of Financial Accounting Standards ("SFAS") No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed of." This statement addresses the accounting for the impairment of long lived assets, such as property and equipment, certain identifiable intangibles and goodwill related to those assets. Long-Lived assets and certain indentifiable intangibles are to be reviewed for impairment whenever events or charges in circumstances indicate that the carrying amount may not be recoverable. An impairment loss is recognized when the sum of the future cash flows (undiscounted and without interest charges) is less than the carrying amount of the asset. The effect of the adopting SFAS No. 121 during the year ended December 31, 1996 did not have a material adverse effect on the Company's financial statements. Pervasiveness of Estimates. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. The most significant estimates relate to prepaid and deferred royalties, Software development costs, accrued returns and allowances and the allowance for doubtful accounts. 3. ACCOUNTS RECEIVABLE, FACTORING AGREEMENT, DUE FROM FACTOR AND ACCRUED RETURNS AND ALLOWANCES Until July 18, 1996, the Company had a factoring and credit agreement (the "BNY Agreement") with BNY Financial Corporation ("BNY"), a wholly owned subsidiary of The Bank of New York. On July 18, 1996, the Company terminated its factoring and credit agreement with BNY and entered into a new financing and banking arrangement with Imperial Bank ("Imperial Agreement"). The Imperial Agreement permits the Company to draw down working capital advances and open letters of credit in amounts determined by a formula based on 70% of eligible accounts receivable, 50% of eligible inventory and 50% of the amount of letters of credit opened by the Company in favor of its Manufacturers. The portion of the borrowing base that consists of eligible inventory in the formula may not exceed $1,500,000. The facility provides for maximum borrowings of $9,000,000, with advances bearing interest at the bank's prime rate plus 1.25% (weighted average rate of 9.5% as of December 31, 1996). The Company has granted Imperial Bank a security interest in its domestic accounts receivable and inventories. F-11 46 The Imperial Agreement expires on June 30, 1997. Open letters of credit under the Imperial Agreement totaled $2,726,000 at December 31, 1996. The amended Imperial Agreement contains customary covenants including, among others, restrictions on the incurrence of debt, encumbrances on or sales of assets, mergers and acquisitions, payments of dividends and capital expenditures. Financial covenants include the maintenance of (i) a current ratio of not less than 1.4 to 1, (ii) profitable operations on a fiscal year basis, (iii) minimum tangible net worth of $7,000,000, (iv) a ratio of debt to tangible net worth of not greater than 1.75 to 1, and (v) minimum working capital of $5,000,000. The Company also has lines of credit with two additional lenders pursuant to which such lenders have agreed to issue letters of credit on the Company's behalf to Sony, Nintendo, and Sega for the purchase of Software for the Company's domestic and European operations. The domestic and European lines are $5,000,000 and $2,500,000, respectively. Each of these lenders receives a fee for the issuance of such letters of credit, and each lender retains title to the inventory financed by such lender until such time as that inventory is sold. The domestic lender has a security interest in the domestic assets of the Company, subordinated to Imperial Bank's priority security interest. The current term of the agreement with the domestic lender expires on March 15, 1997, with automatic renewals at such date and every six months thereafter, unless terminated by either party. There were no open letters of credit with the domestic lender at December 31, 1996. The European lender has a first security interest in all of the Company's European subsidiaries' receivables, inventory, and other assets. The agreement may be canceled at any time at the lender's sole discretion. Open letters of credit under the agreement with the European lender were $1,683,000 as of December 31, 1996. Because BNY owned the Company's domestic receivables pursuant to the BNY agreement, prior to the effective date of the Imperial agreement the Company's domestic accounts receivables were presented net of advances from BNY (see table following). In addition, because BNY assumed credit risk for the Company's domestic receivables but did not assume risk of markdowns or allowances, the Company's reserve for such markdowns and allowances was presented as a liability in periods prior to the closing of the Imperial Agreement. Because Imperial does not own the Company's domestic receivables, advances from Imperial are now shown as a liability in the accompanying financial statements, and reserves for markdowns and allowances are now presented as a deduction from the Company's gross receivables. Accounts receivable are due primarily from domestic and foreign retailers and distributors, including mass merchants and specialty stores. Accounts receivable at December 31, 1995 and 1996 are composed of the following: F-12 47
December 31, --------------------------- 1995 1996 ------------ ------------ Receivables assigned to factor $ 7,348,000 $ -- Advances from factor (2,085,000) -- ------------ ------------ Due from factor 5,263,000 -- Accounts receivable -- domestic -- 13,428,000 Other accounts receivable -- primarily foreign 5,739,000 5,004,000 Other receivables 51,000 112,000 Allowance for foreign doubtful accounts (1,380,000) (1,294,000) Allowance for foreign discounts and returns (311,000) (292,000) Allowance for domestic accrued returns and allowances -- (2,772,000) ------------ ------------ Accounts receivable -- net $ 9,362,000 $ 14,186,000 ============ ============
The allowance for foreign doubtful accounts consists of the following:
December 31, --------------------------------------- 1994 1995 1996 ----------- ----------- ----------- Balance at January 1 $ (536,000) $ (827,000) $(1,380,000) Provision for doubtful accounts (256,000) (505,000) (10,000) Actual write-offs (recoveries) (35,000) (48,000) 96,000 ----------- ----------- ----------- Ending balance $ (827,000) $(1,380,000) $(1,294,000) =========== =========== ===========
The allowance for foreign discounts and returns consists of the following:
December 31, ----------------------------------- 1994 1995 1996 --------- --------- --------- Balance at January 1 $(666,000) $(190,000) $(311,000) Provision for discounts and returns (280,000) (766,000) (422,000) Actual write-offs 756,000 645,000 441,000 --------- --------- --------- Ending balance $(190,000) $(311,000) $(292,000) ========= ========= =========
The allowance for domestic accrued returns and allowances, which is recorded as a liability in the accompanying balance sheets for the periods ended December 31, 1994 and 1995 and which is presented as a contra against accounts receivable in the accompanying balance sheet for the period ended December 31, 1996, consists of the following: F-13 48
December 31, --------------------------------------- 1994 1995 1996 ----------- ----------- ----------- Balance at January 1 $(4,120,000) $(3,574,000) $(2,859,000) Provision for discounts and returns (3,352,000) (2,874,000) (4,771,000) Actual write-offs 3,898,000 3,589,000 4,858,000 ----------- ----------- ----------- Ending balance $(3,574,000) $(2,859,000) $(2,772,000) =========== =========== ===========
4. EMPLOYEE PENSION PLAN The Company sponsors for its employees a defined contribution plan intended to qualify under Section 401(k) of the Internal Revenue Code (the "Plan"). The Plan, as amended in 1991, provides that employees may defer up to 12% of annual compensation, and that the Company will make a matching contribution equal to each employee's deferral, up to 4% of compensation. The Company may also contribute funds to the Plan in the form of a profit sharing contribution. Expenses under the Plan were $61,000, $30,000, and $161,000 in 1994, 1995 and 1996, respectively. 5. INCOME TAXES The provision for income taxes consists of the following:
1994 1995 1996 ------- ------- ------- Current Federal $ -- $22,000 $ 2,000 State -- -- 6,000 Foreign 11,000 -- -- ------- ------- ------- 11,000 22,000 8,000 ------- ------- ------- Deferred Federal -- -- -- State -- -- -- ------- ------- ------- Provision for income taxes $11,000 $22,000 $ 8,000 ======= ======= =======
A reconciliation of the provision for income taxes at the federal statutory rate to the provision recorded in the accompanying financial statements is as follows:
1994 1995 1996 ------ ------ ------ Federal provision at statutory rate (35.0)% 35.0% 35.0% Effect of foreign income taxes and other .1 -- -- Effect of net operating loss carryforward (utilized) not utilized 35.0 (31.5) (34.9) ------ ------ ------ 0.1% 3.5% 0.4% ====== ====== ======
F-14 49 The components of deferred tax assets (liabilities) are as follows:
December 31, ----------------------------------------------------- 1995 1996 ------------------------- ------------------------- Federal State Federal State ----------- ----------- ----------- ----------- Deferred tax assets: Allowance for doubtful accounts, Discounts and returns $ 973,000 $ 216,000 $ 943,000 $ 212,000 Net operating loss 5,852,000 1,168,000 5,946,000 1,176,000 License abandonment 539,000 559,000 671,000 151,000 Other -- net 250,000 56,000 121,000 28,000 ----------- ----------- ----------- ----------- Total deferred tax assets 7,614,000 1,999,000 7,681,000 1,567,000 Deferred tax liabilities: -- -- -- Software development costs (893,000) (573,000) (897,000) (202,000) State income taxes (484,000) -- (465,000) -- ----------- ----------- ----------- ----------- Net deferred tax assets 6,237,000 1,426,000 6,319,000 1,365,000 Valuation reserve (6,237,000) (1,426,000) (6,319,000) (1,365,000) ----------- ----------- ----------- ----------- Deferred income taxes $ -- $ -- $ -- $ -- =========== =========== =========== ===========
A valuation reserve has been provided in 1995 and 1996 because of the uncertainty regarding the realization of net deferred tax assets. The valuation reserve decreased $291,000 and $21,000 during 1995 and 1996, respectively. As of December 31, 1995 the Company had federal and state net operating loss carryforwards of $17,488,000 (expiring from years 2008 to 2009) and $12,695,000 (expiring from years 1997 to 1999), respectively, which have not been recorded in the financial statements because of the uncertainty as to realization. The December 31, 1996 tax return has not been prepared as yet and as such, the net operating loss figures have not been updated for the 1996 taxable income. The sale of 1,500,000 shares of Common Stock offered by the Company on February 11, 1997 resulted in an "ownership change" of the Company for purposes of Sections 382 and 383 of the Internal Revenue Code of 1986, as amended (the "Code"). As a result, the amount of the Company's net operating loss carryforward available to reduce the Company's federal income tax liability in future years in which the Company has taxable income will be limited to an annual amount equal to (i) the fair market value of the Company's capital stock immediately prior to the consummation of the offering on February 11, 1997, multiplied by (ii) the "long-term tax exempt rate" published by the Internal Revenue Service for the month in which the offering was consummated. Based upon a long-term tax exempt rate for February 1997 of 5.48% and an assumed market price of the Common Stock immediately prior to consummation of this offering of $8.56 per share (the last reported sale price of the Common Stock on February 10, 1997) such amount is estimated to be approximately $2,225,000 per year. 6. STOCK OPTION PLAN The Company has a stock option plan (the "Option Plan") which provides for the issuance of up to 650,000 shares available for employees, consultants and non-employee F-15 50 directors. An additional 10,656 options were available for grant at December 31, 1996. Stock options granted under the Option Plan may be incentive stock options under the requirements of the Internal Revenue Code, or may be nonstatutory stock options which do not meet such requirements. Options may be granted under the Option Plan to, in the case of incentive stock options, all employees (including officers) of the Company; or, in the case of nonstatutory stock options, all employees (including officers) or non-employee directors of the Company. The exercise price per share of all options granted under the plan in 1994, 1995 and 1996 has been the market price of the stock on the date of the grant. Generally, options granted become exercisable over three years and must be exercised within five years of the date of grant.
Number of Stock Options Shares - - ------------------------------------------------------------ --------- Outstanding at January 1, 1994 ($13.20 -- $82.65 per share) 67,305 Granted at $3.75 -- $17.25 per share 102,423 Exercised at $3.75 per share (3,334) Canceled at $31.95 -- $78.75 per share (62,304) --------- Balance at December 31, 1994 ($13.20 -- $82.65 per share) 104,090 --------- Granted at $2.87 -- $9.30 per share 609,833 Exercised at $2.87 per share (16,666) Canceled at $2.87 -- $17.25 per share (42,666) --------- Balance at December 31, 1995 ($2.87 -- $78.675 per share) 654,591 --------- Granted at $3.50 -- $6.00 per share 141,500 Exercised at $2.87 -- $3.75 per share (120,274) Canceled at $2.87 -- $82.65 per share (185,584) --------- Balance at December 31, 1996 ($2.81 -- $11.70 per share) 490,233 --------- Options exercisable at December 31, 1996 286,744 ---------
Included in the 1994 stock option grants is an option granted to Jack Friedman, the former president of the Company. This option was originally granted on February 24, 1994 at the price of $13.95 per share. Upon the resignation of Mr. Friedman and the re- negotiation of his employment agreement, options previously granted in 1994 were repriced to the then current market price of the stock of $3.75. During 1995, the Company granted 240,000 options outside of the Option Plan, which consisted of 140,000 options at $3.06 to Brian J. Farrell, the Company's president; 70,000 options to a former employee as a part of the employee's severance package (50,000 at $2.81 and 20,000 at $2.25); and 30,000 options at $2.87 to two outside consultants who have subsequently become employees of the Company. In 1996, the Company issued 200,000 options outside of the Option Plan to Mr. Farrell at an exercise price of $5.00 per share. Share exercise prices for these options equal the market price of the Company's Common Stock at the date of the grant. F-16 51 The following table summarizes information about stock options outstanding at December 31, 1996:
NUMBER WEIGHTED AVERAGE WEIGHTED RANGE OF EXERCISE OUTSTANDING AT DECEMBER REMAINING CONTRACTUAL AVERAGE PRICES 31, 1996 LIFE EXERCISE PRICE - - --------------------- ----------------------- --------------------- -------------- $2.81 - $ 3.82 694,576 4 $ 3.15 $5.00 - $ 6.00 270,000 5 5.13 $9.30 - $11.70 6,668 8 10.50 ----------------------- --------------------- -------------- 971,244 4 $ 3.75 ======================= ===================== ==============
SHARES Weighted EXERCISABLE AT DECEMBER Average 31, 1996 Exercise Price ----------------------- ----------------------- 414,641 $ 3.11 116,667 5.13 6,668 10.50 ----------------------- ----------------------- 537,976 $ 3.64 ======================= =======================
All stock options are granted at the fair market value of the Company's Common Stock at the grant date. The weighted average estimated fair value of the options granted in 1995 and 1996 was $599,000 and $778,000, respectively. !The Company applies Accounting Principles Board Opinion No. 25 and related Interpretations in accounting for its stock option plan. Accordingly, no compensation cost for the Company's stock option plan and has been recognized in 1994, 1995 or 1996. Had compensation cost for the Company's stock option plan been determined based on the fair value at the grant dates for awards under the plan consistent with FASB Statement No. 123, Accounting for Stock Based Compensation, the Company's net income and earnings per share for the years ended December 31, 1995 and December 31, 1996 would have been reduced to the pro forma amounts indicated below:
YEARS ENDED -------------------------------------- DECEMBER 31, 1995 DECEMBER 31, 1996 ----------------- ----------------- Net income: As reported $601,000 $ 1,901,000 Pro forma $ 2,000 1,123,000 Net income per common and common equivalent share: As reported $ .17 $ .39 Pro forma $ -- $ .23
The fair market value of options granted under the stock option plan during 1995 and 1996 was determined using the Black-Scholes option pricing model utilizing the following weighted-average assumptions: F-17 52
YEARS ENDED -------------------------- DECEMBER 31, December 31, ------------ ------------ 1995 1996 ------------ ------------ Dividend yield 0% 0% Anticipated volatility 83% 83% Risk-free interest rate 5.3% - 7.51% 5.2% - 6.7% Expected lives 4 years 4 years
7. MAJOR CUSTOMERS AND RELATED PARTY TRANSACTIONS Sales (before returns and allowances) to a major customer represented 18%, 12% and 12% of gross sales in the years ended December 31, 1994, 1995 and 1996, respectively. In 1994 one other customer represented 18% of sales (before returns and allowances). In 1995 another customer represented 10% of sales (before returns and allowances). The Company performs ongoing credit evaluations of its customers and maintains an allowance for potential credit losses. In 1994, 1995 and 1996, the Company paid the law firm of Feder, Kaszovitz, Isaacson, Weber, Skala & Bass, of which Mr. Skala, a director of the Company through January 14, 1997, is a partner, approximately $275,000, $214,000, and $215,000, respectively. As of December 31, 1995 and 1996, the Company had owing to Feder, Kaszovitz, Isaacson, Weber, Skala & Bass approximately $181,000 and $76,000, respectively. In 1996, the Company paid Inland Productions, Inc., a Software developer which the Company acquired 25% interest in on July 1, 1996 (See Note 9), $775,000. As of December 31, 1996, the Company had owing to Inland Productions, Inc. $625,000. 8. CAPITAL STOCK TRANSACTIONS In 1993, the Company entered into an agreement with an independent investor (the "Investor") pursuant to which the Investor posted a standby letter of credit in the principal amount of $5,000,000, in favor of BNY as additional collateral, expiring on February 28, 1994. Effective January 31, 1994, the Company entered into an agreement with the Investor whereby the Investor extended the expiration date of the standby letter of credit to December 31, 1994. As consideration, the Company reduced the exercise price of 100,000 warrants previously granted to the Investor to $12.15 per share (the then current market value of the Company's stock), and granted the Investor an additional 33,334 warrants to purchase the Company's Common Stock at $12.15 per share. In March 1994, the Company sold 133,334 shares of its Common Stock pursuant to Regulation S resulting in net proceeds to the Company of $980,000. In June 1994, the Company sold units consisting of 564,445 shares of Common Stock and warrants to purchase an additional 282,222 shares of Common Stock at $15.00 per share pursuant to Rule 506 of Regulation D of the Securities Act of 1993, as amended ("the Act"), resulting in net proceeds to the Company of $4,624,000. In September, October, and November 1994, the Company sold an aggregate of F-18 53 478,704 shares of Common Stock resulting in net proceeds to the Company of $3,328,000, in sales exempt from the registration requirements of the Act pursuant to Registration S under the Act. In December 1994, the Company sold units consisting of 101,665 shares of Common Stock and warrants to purchase 101,665 shares of Common Stock at $20.25 per share in private placements pursuant to Regulation D under the Act, resulting in net proceeds to the Company of $888,000, (collectively "the Financings"). The net proceeds received by the Company from the Financings were utilized in part in connection with the marketing and inventory purchase commitments related to the launch of the XBAND Videogame Modem (the "XBAND Modem") (See Note 10), and for the completion of certain Software products under development. On July 1, 1995, the Company granted a warrant to the Company's domestic letter of credit lender to purchase 60,000 shares of Common Stock at a price of $1.93 per share. The warrant is exercisable until June 30, 1998. In the months of July, August and September 1995, the Company received aggregate net proceeds of $2,613,000 from the sales of certain of its convertible preferred stock pursuant to Regulation S under the Act. The preferred shares were convertible by the holders thereof into approximately 1,462,000 common shares of the Company. These shares were redeemable at the Company's option upon 30 days' written notice, and earned dividends at the rate of 9% per annum, payable at the Company's option in cash or by issuance of common shares equal to the dividend amount divided by the average market price of the preceding five days. As of December 31, 1995, a total of 1,335,211 shares of Common Stock had been issued in connection with this transaction. As of February 1996, all shares of preferred stock had been converted to Common Stock, a total of 1,462,928 shares of Common Stock were issued in connection with this transaction. As of July 1, 1996, the Company issued 70,000 shares of Common Stock, at the fair market value of the stock on such date, in settlement of an accrued liability of $229,000 due to a former employee. During the years ended December 31, 1995 and 1996, the number of warrants to purchase the Company's Common Stock exercised were 74,864, and 70,000, respectively. The Company received proceeds from the exercise of such warrants totaling $149,000. There were no warrants exercised during the year ended December 31, 1994. At December 31, 1996 outstanding warrants were 706,431 at an average exercise price of $16.81. 9. OTHER LONG-TERM ASSETS On July 1, 1996, the Company acquired a 25% interest in Inland, a Software developer for home entertainment game systems. The investment consisted of $300,000 in cash and 52,660 shares of Common Stock valued at $300,000, and is included in other long-term assets in the accompanying balance sheet. The Company has contracted with Inland for the development of 32-bit and 64-bit versions of Turner's World Championship Wrestling and BASS Masters F-19 54 Classic. The Company's investment exceeds its equity in the underlying net assets by $613,000 which is being amortized over five years. The Company's equity in the operating results of Inland is not material to the results of operations. On August 2, 1996, the Company acquired the business of Heliotrope Studios, Inc. ("Heliotrope"), an interactive Software developer for PC CD-ROM and an assignment of the distribution license and certain work-in-progress for a PC CD-ROM title (Pax Imperia: Eminent Domain) from Blizzard Entertainment, a division of Davidson Associates. In connection with the acquisition, the Company incurred costs of $115,000 and assumed certain liabilities (approximately $150,000) of Heliotrope. The excess of the Company's cost of the acquisition over the estimated fair value of assets acquired (approximately $265,000) has been included as a long-term investment in the accompanying balance sheet. Such excess cost is being amortized over 60 months. Because Heliotrope's assets and operations prior to the acquisition were insignificant, no pro forma information is presented. 10. COMMITMENTS AND CONTINGENCIES XBAND Modem Agreement. On April 23, 1994, the Company entered into a letter of agreement with Catapult Entertainment, Inc. ("Catapult"), pursuant to which ToHQ was the exclusive North American distributor of certain hardware products developed by Catapult. The Company was required to spend a minimum of $3,000,000 in 1994 and a minimum of $2,000,000 in the first quarter of 1995 to market and sell the XBAND Modem, and the Company was also required to finance all inventory purchases. By mutual agreement between the Company and Catapult, approximately $2,679,000 was spent in marketing efforts by the Company through December 31, 1994, on the XBAND Modem. Because of the slow sales of the XBAND Modem and the potential for markdowns and returns, the Company reserved approximately $2,000,000 (by charging such amount against net sales) for such markdowns and reserves in 1994. On May 31, 1995, the Company and Catapult entered into a new agreement related to the marketing and distribution of the XBAND Modem, pursuant to which Catapult purchased the Company's inventory and accounts receivable related to the XBAND Modem for approximately $3,200,000. At the closing of the agreement, Catapult paid approximately $1,100,000 owed by the Company to the manufacturer of the XBAND Modem, and $100,000 to the Company. The remaining amounts owing to the Company were to have been received upon the conclusion of equity financing by Catapult. The Company recorded the cash received at the closing as sales of the XBAND Modem in the year ended December 31, 1995 pursuant to the new agreement. Subsequently, Catapult has filed for bankruptcy under Chapter 11 of the U.S. Bankruptcy Code. Under Catapult's plan of reorganization, the Company received approximately 15% of its remaining claim against Catapult, or approximately $200,000, in December 1996. Because the Company determined in May 1995 that receipt of any additional payment by Catapult was highly uncertain, the Company established a reserve for the remaining payments. As a result, substantially all of the amount received pursuant to such plan of reorganization is reflected in the Company's Statement of Operations for the year ended December 31, 1996. F-20 55 Studio-e Litigation. On January 13, 1997, a complaint was filed in Illinois state court by Studio e, Inc. ("Studio e"), a video game Software development company, against Inland, its two principals and the Company. The Company acquired 25% of Inland in June 1996. (See note 9). The complaint alleges, among other things, that the defendants misappropriated trade secrets of Studio e, caused delays in the development of one of Studio e's titles, and as a result were responsible for Studio e's loss of future business. The complaint seeks, among other remedies, to enjoin the Company's alleged use of Studio e's trade secrets and damages in an unspecified amount. The complaint makes additional allegations and seeks additional damages and other remedies against Inland and Inland's principals. On March 12, 1997, the Company filed an answer to the complaint denying all allegations of wrongdoing asserted against it. The Company also filed a counterclaim against Studio e alleging trade defamation and libel and intentional interference with prospective economic advantage, and a cross-claim for indemnification against Inland. Royalties. At December 31, 1995 and 1996, future minimum guaranteed royalties were $1,752,000 and $3,133,000, respectively. Royalties are classified as current liabilities based upon contractual payment dates. Leases. The Company is committed under operating leases with lease termination dates to February 2001. Minimum future rentals pursuant to these leases as of December 31, 1996 are as follows:
1997 $ 234,000 1998 171,000 1999 76,000 2000 72,000 2001 6,000 ---------- $ 559,000 ==========
Rent expense was $251,000, $184,000, and $183,000 in 1994, 1995 and 1996, respectively. 11. OPERATIONS IN GEOGRAPHIC AREAS The Company is engaged in the development, marketing and distribution of Software products, and formerly was engaged in the development, marketing and distribution of traditional toys and games which is considered to be a single segment. The following information sets forth geographic information on the Company's sales, earnings (losses) from operations and identifiable assets for the years ended December 31, 1994, 1995 and 1996: F-21 56
United States Europe Asia Elimination Consolidated -------- -------- -------- ------------------------ (IN THOUSANDS OF DOLLARS) Year ended December 31, 1994: Sales to unaffiliated customers $ 11,114 $ 2,175 -- -- $ 13,289 Transfers between geographic areas -- -- $ 84 $ (84) -- -------- -------- -------- -------- -------- Total net revenue $ 11,114 $ 2,175 $ 84 $ (84) $ 13,289 ======== ======== ======== ======== ======== Pretax earnings (loss) $(16,017) $ (1,459) $ 108 $ (111) $(17,479) ======== ======== ======== ======== ======== Identifiable assets at December 31, 1994 $ 12,136 $ 3,484 $ 113 $ (202) $ 15,531 ======== ======== ======== ======== ======== Year ended December 31, 1995: Sales to unaffiliated customers $ 24,894 $ 8,356 -- -- $ 33,250 Transfers between geographic areas -- -- -- -- -- -------- -------- -------- -------- -------- Total net revenue $ 24,894 $ 8,356 -- -- $ 33,250 ======== ======== ======== ======== ======== Pretax earnings (loss) $ 1,621 $ (869) $ (4) $ (125) $ 623 ======== ======== ======== ======== ======== Identifiable assets at December 31, 1995 $ 13,681 $ 3,415 $ 2 $ (182) $ 16,916 ======== ======== ======== ======== ======== Year ended December 31, 1996: Sales to unaffiliated customers $ 35,399 $ 14,856 -- -- $ 50,255 Transfers between geographic areas -- -- -- -- -- -------- -------- -------- -------- -------- Total net revenue $ 35,399 $ 14,856 -- -- $ 50,255 ======== ======== ======== ======== ======== Pretax earnings $ 1,222 $ 668 $ 19 -- $ 1,909 ======== ======== ======== ======== ======== Identifiable assets at December 31, 1996 $ 17,163 $ 5,860 -- $ (183) $ 22,840 ======== ======== ======== ======== ========
12. SUBSEQUENT EVENTS On February 14, 1997, the Company completed a public offering of 1,500,000 shares of the Company's Common Stock. In conjunction with the offering, the Company granted to the underwriters an overallotment option, exercisable within 30 days of the date of February 11, 1997, to purchase up to 225,000 additional shares of the Common Stock at the public offering price. On March 11, 1997, the underwriters exercised their overallotment option. All of these shares were newly issued and sold on behalf of the Company. The net proceeds of the 1,725,000 shares sold by the Company, of $11.7 million, will be used for general corporate purposes including obtaining new licenses for, and development expenses related to, new titles and the repayment of amounts outstanding under the Company's revolving credit facility. A portion of the proceeds may also be used to fund acquisitions related to the Company's business. F-22 EX-10.14 2 EMPLOYMENT AGREEMENT OF BRIAN J. FARRELL 1 EXHIBIT 10.14 AMENDED AND RESTATED EMPLOYMENT AGREEMENT DATED AS OF DECEMBER 31, 1996 BY AND BETWEEN T-HQ, INC., a NEW YORK CORPORATION (THE "COMPANY"), AND BRIAN J. FARRELL (THE "EXECUTIVE") ________________________ The parties hereto desire to replace the Executive's existing employment agreement with the Company with this Agreement and to provide for the Executive's continued employment by the Company in accordance with the terms and provisions set forth below: NOW, THEREFORE, the parties agree as follows: 1. EMPLOYMENT: TERM. The Company will continue to employ the Executive, and the Executive will continue to work for the Company, as its President and Chief Executive Officer until December 31, 2001, unless sooner terminated in accordance with Section 7 hereof. Such period, together with the period of any extension or renewal of such employment, is referred to herein as the "Employment Period." 2. DUTIES. During the Employment Period, the Executive shall serve as the President and Chief Executive Officer of the Company and of its subsidiaries and affiliated companies, and perform such further duties as shall, from time to time, be reasonably delegated or assigned to the Executive by the Board of Directors of the Company consistent with his position and abilities. 3. DEVOTION OF TIME. During the Employment Period, the Executive shall: (i) expend substantially all of his working time for the Company; (ii) devote his best efforts, energy and skill to the services of the Company and the promotion of its interests; and (iii) not take part in activities reasonably known by Executive to be detrimental to the best interests of the Company. EXECUTION COPY 2 4. COMPENSATION. 4.1 In consideration for the services to be performed by the Executive during the Employment Period hereunder, the Company shall compensate the Executive at an annual base salary (payable at the normal pay periods of the Company) during the Employment Period of $300,000, commencing January 1, 1997. The base salary shall be subject to annual review commencing at the end of 1997 and at the end of each year thereafter, and may be increased (but not decreased) for subsequent years. 4.2 In addition to the annual base salary payable to the Executive pursuant to the provisions of Section 4.1 hereof, the Executive is also entitled to a bonus for each fiscal year of the Company commencing during the Employment Period, equal to the lesser of (i) $300,000 or (ii) 4.5% of the Company's net income before taxes for such year. Net income before taxes shall be determined by the independent public accountants for the Company in accordance with generally accepted accounting principles consistently applied. 4.3 Executive shall also be eligible for awards of options and any other stock or equity based awards that may be available to executives of the Company. 5. EXPENSES; ADDITIONAL BENEFITS; INDEMNIFICATION. 5.1 The Executive shall receive an automobile allowance for the use of any automobile owned or leased by him, consistent with the Company's past practices. 5.2 The Company shall pay directly, or reimburse the Executive for, all other reasonable and necessary expenses and disbursements incurred by him for and on behalf of the Company in the performance of his duties under this Agreement. For such purpose, the Executive shall submit to the Company itemized reports of such expenses in accordance with the Company's policies. 5.3 The Executive shall be entitled to paid vacations during the Employment Period in accordance with the Company's then prevalent practices for executive employees; provided, however, that Executive shall be entitled to such paid vacations for not less than four (4) weeks per annum. 5.4 The Executive shall be entitled to participate in, and to receive benefits under, any employee benefit plans of the Company (including, without limitation, pension, profit sharing, group life insurance and group medical insurance plans) as may exist from time to time for its executive employees. Subject to the limitation contained in Section 5.7 below, the Company shall make the maximum pension and profit sharing contribution for the Executive legally permitted to be made -2- 3 by an employer and shall permit the Executive to contribute the maximum pension and profit sharing contribution legally permitted to be made by an employee, equaling an aggregate of $30,000 (the current maximum allowable payment) each year during the Employment Period. 5.5 The Company shall provide to Executive, and (subject to the limitation contained in Section 5.7 below) pay the premiums therefor, insurance on Executive's life in an amount equal to $1,500,000 as well as disability insurance for the Executive during the Employment Period and for a period of twelve (12) months thereafter, each of which shall have the coverage reasonably requested by Executive; provided, however, that the foregoing coverage shall be subject to any insurance examinations of Executive required by the insurer. Executive shall designate the beneficiaries under the disability and life insurance policies. 5.6 As a director and officer of the Company, the Executive shall be entitled to the benefits of all provisions of the Articles of Incorporation of the Company, as amended, and the Bylaws of the Company, as amended, that provide for indemnification of officers and directors of the Company. No such provisions shall be amended in any way to limit or reduce the extent of the indemnification available to Executive as an officer or director of the Company. 5.7 The Company's share of the pension and profit sharing contribution referenced in Section 5.4 and insurance premiums referenced in Section 5.5 shall not exceed in any calendar year an aggregate of $30,000. In addition, to the fullest extent permitted by law, the Company shall indemnify and save and hold harmless the Executive from and against any and all claims, demands, liabilities, costs and expenses, including judgments, fines or amounts paid on account thereof (whether in settlement or otherwise), and reasonable expenses, including attorneys' fees actually and reasonably incurred (except only if and to the extent that such amounts shall be finally adjudged to have been caused by Executives willful breach of the express provisions of this Agreement) to the extent that the Executive is made a party to or witness in any action, suit or proceeding, or if a claim or liability is asserted against Executive (whether or not in the right of the Company), by reason of the fact that he was or is a director or officer, or acted in such capacity on behalf of the Company, or by reason of or arising out of or resulting from entering into this Agreement or the rendering of services by the Executive pursuant to this Agreement, whether or not the same shall proceed to judgment or be settled or otherwise brought to a conclusion. The Company shall advance to Executive on demand all reasonable expenses incurred by Executive in connection with the defense or settlement of any such claim, action, suit or proceeding, and Executive hereby undertakes to repay such amounts if and to the extent that it shall be finally adjudged that the Executive is not entitled to be indemnified by the Company under this Agreement or under the provisions of the Articles of Incorporation or Bylaws of the Company as of the date hereof that govern indemnification of officers or directors of the Company (but giving effect to future amendments that broaden or expand any such indemnification and obligations or right more favorably to Executive). Executive shall also be entitled to recover any costs of enforcing his rights under this Section (including, -3- 4 without limitation, reasonable attorneys' fees and disbursements) in the event any amount payable hereunder is not paid within thirty (30) days of written request therefore by Executive. The rights of Executive under this Section shall survive the termination of this Agreement and shall be applicable for so long as Executive may be subject to any claim, demand, liability, cost or expense against which this Section is intended to protect and indemnify him. Notwithstanding anything contained in this Agreement to the contrary, the Company shall, at no cost to the Executive, use its best efforts to at all times include the Executive during the term of the Employment Period and for a period of not less than four (4) years thereafter, as an insured under any directors and officers liability insurance policy maintained by the Company, which policy shall provide such coverage in such amounts as the Board of Directors shall deem appropriate for coverage of all directors and officers of the Company. 6. RESTRICTIVE COVENANT. 6.1 During the Employment Period and thereafter, the Executive shall not reveal, divulge or make known to any person, firm, corporation or other business organization, and shall not directly or indirectly use for his own benefit, or for the benefit of anyone else, any secret or confidential information used by the Company in its business, including, without limitation, (i) pricing information, (ii) the terms of the Company's existing contracts with suppliers, licensors and/or developers, (iii) any material information pertaining to the Company's customers and their requirements, and (iv) any other of the Company's trade secrets, all of which shall be collectively referred to hereafter as the "Confidential Information." 6.2 The services of the Executive are unique, extraordinary and essential to the business of the Company, particularly in view of the Executive's access to Confidential Information. Accordingly, the Executive agrees that if his employment hereunder shall at any time be terminated voluntarily by the Executive, or by the Company for cause (as defined in Section 7.3), the Executive will not at any time within twelve months of such termination, without the prior written approval of the Board of Directors of the Company, directly or indirectly engage in any business activity competitive with the business of the Company. Furthermore, the Executive agrees that, during such twelve month period, he shall not solicit, directly or indirectly or knowingly affect to the Company's detriment any relationship of the Company with any customer, supplier, licensor, developer or employee of the Company or knowingly cause any customer, supplier, licensor or developer to refrain from entrusting additional business to the Company. If the employment of the Executive hereunder is terminated by the Company other than for cause, the restraints on the Executive set forth in the preceding two sentences shall be inapplicable. If this Agreement shall not be renewed by either the Company or by the Executive prior to its scheduled expiration date as recited in Section 1, such restraints will apply for the period from January 1, 2002 through March 31, 2002. -4- 5 6.3 In the event that any of the provisions of Section 6.1 and 6.2 hereof shall be adjudicated to exceed the time, geographic or other limitations permitted by applicable law in any jurisdiction, then such provision shall be deemed reformed in any such jurisdiction to the maximum time, geographic or other limitations permitted by applicable law. 6.4 As used in this Section 6, the term "Company" shall mean and include any and all subsidiaries of the Company which either now exist or which may hereafter be organized. 6.5 The Executive hereby acknowledges and agrees that, in the event he shall violate any provisions of this Section 6, the Company will be without an adequate remedy at law and accordingly, will be entitled to enforce such restrictions by temporary or permanent injunctive or mandatory relief obtained in any action or proceeding instituted in any court of competent jurisdiction without the necessity of proving damages and without prejudice to any other remedies which it may have at law or in equity. 7. EARLIER TERMINATION. 7.1 The Executive's employment hereunder shall automatically be terminated upon the death of the Executive or the Executive's voluntarily leaving the employ of the Company. In addition, the Executive's employment by the Company may be terminated by the Company as follows: (a) Upon thirty (30) days' prior written notice by the Company, in the event of the Executive's disability as set forth in Section 7.2 below; or (b) Upon thirty (30) days' prior written notice by the Company, in the event that the Company terminates the Executive's employment hereunder for cause as set forth in Section 7.3 below. 7.2 The Executive shall be deemed disabled hereunder, if in the opinion of the Board of Directors of the Company, as confirmed by competent medical advice, he shall become physically or mentally unable to perform his duties for the Company hereunder and such incapacity shall have continued for any period of six (6) consecutive months. 7.3 For purposes hereof, "Cause" shall be limited to the following: (a) the Executive's willful malfeasance or gross negligence; (b) any material misrepresentation or concealment of a material fact made by the Executive in connection with this Agreement; or (c) the material breach of any covenant made by the Executive hereunder. Notwithstanding the foregoing, termination by the Company for Cause shall not be effective until and unless (i) in the event of any acts or circumstances alleged to be a basis for termination that is capable of cure by the Executive, the Executive is given written notice -5- 6 by the Board of such alleged acts or circumstances, and such alleged acts or circumstances shall not have been cured by the Executive within 20 days of receipt of such notice to the satisfaction of the Board in the exercise of its reasonable judgment (or, if within such 20-day period the Executive commences and proceeds to take all reasonable actions to effect such cure, within such reasonable additional time period (no longer than 60 days) as may be necessary), (ii) notice of intention to terminate for Cause has been given by the Company within four months after the Board learns of the act, failure or event constituting "Cause" and (iii) the Board has voted (at a meeting of the Board duly called and held as to which termination of Executive is an agenda item) by a majority vote to terminate Executive for Cause after Executive has been given notice of the particular acts or circumstances which are the basis for the alleged termination for Cause and has been afforded at least 20 days notice of the meeting and an opportunity to present his position in writing and the Board has given notice of termination to Executive within three days thereafter, and (iii) if Executive has commenced an expedited arbitration in the manner prescribed below within 15 days after such notice of termination, disputing the Company's right under this Agreement to terminate for Cause, the Arbitrator shall have determined that the Executive is terminable for Cause. Unless a majority of the Board at the time of the giving of such notice of termination is then comprised of persons other than Jeffrey C. Lapin, Bruce Jagid, Lawrence Burstein and L. Michael Haller, then upon the giving of such notice of termination, Executive (x) shall be deemed suspended with pay until he shall be deemed to have been terminated for Cause hereunder or until the Arbitrator shall have determined that Executive is not terminable for Cause and (y) while suspended, Executive shall cease to act as an executive of the Company and shall depart the premises of the Company. If Executive or his representative fails to file a demand for arbitration with the American Arbitration Association and file the requisite fees pursuant to Rule 4 of the national Rules within 15 days of receipt of notice of termination from the Board, and diligently pursue such proceeding in accordance with the procedures set forth in Section 15 hereof, such termination shall be conclusively presumed to have been for Cause. 7.4 In the event that this Agreement shall be terminated due to the Executive's death or disability, then the Company shall within 20 days of such termination pay to the Executive or his personal representative, as the case may be, severance pay in a lump sum amount equal to his then annual base salary, as set forth in Section 4 hereof, for a period of twelve months from the date of such termination. If, however, subject to the provisions of Section 7.5 hereafter, this Agreement shall be terminated for any other reason whatsoever, then the Company shall not obligated to make any severance payments whatsoever to the Executive hereunder, except the compensation set forth in Section 4 hereof which shall have accrued but be unpaid at the effective time of termination. -6- 7 7.5 Notwithstanding any other provision herein, in order to protect the Executive against the possible consequences and uncertainties of a Change of Control (as hereinafter defined) of the Company and thereby induce the Executive to remain in the employ of the Company, the Company agrees that: (a) If the Executive's employment is terminated by the Company other than for "Cause" (as defined in Section 7.3 hereof) at any time subsequent to a Change of Control or if the Executive voluntarily terminates such employment within one hundred eighty (180) days subsequent to a Change of Control (the "Evaluation Period"), then in either such event, the Company shall pay to the Executive within ten (10) days after such termination a lump sum payment in cash in an amount equal to 2.99 times the Executive's base amount (as the term base amount is defined in Section 280G of the Internal Revenue Code of 1986, as amended, and applicable regulations thereunder) at the time of such Change of Control; provided, however, that at the option of the Executive, exercisable upon written notice to the Company within ten (10) days of termination of employment, such payment may be paid in equal monthly installments over an eighteen (18) month period commencing on the first day of the month immediately following that in which the Executive's employment was terminated. For purposes of this Section 7.5, in the event the Executive (during or after the Evaluation Period) shall resign from his employment with the Company subsequent to any change in his title, nature of duties, employee benefits, location or place of employment or working conditions, in each instance without his prior consent, such resignation shall be deemed to be a termination of employment by the Company other than for "Cause." (b) All options, warrants and other rights (collectively, the "Options") to acquire securities of the Company (including those of its subsidiaries and affiliates) ("Securities"), whether pursuant to employee benefit plans or otherwise, which shall have been granted to the Executive prior to a Change of Control shall fully vest and become immediately exercisable upon the occurrence of any such Change of Control. If subsequent to a Change of Control, the Executive's employment is terminated by the Company other than for "Cause or if such employment is voluntarily terminated by the Executive during the Evaluation Period, then in either such event, all Options shall be exercisable by the Executive in accordance with their respective terms, as hereinabove modified. (c) In lieu of exercising or retaining his right to exercise any outstanding Options then held by the Executive, the Executive may elect to surrender to the Company his rights in such outstanding Options (whether or not then exercisable) then held by the Executive, and, upon such surrender the Company shall pay to the Executive an amount in cash per share equal to the aggregate of the difference between (i) the option prices of the aggregate of the difference between (i) the option prices of the Securities is subject to such surrendered Options and (ii) the greater of (A) the average price per share paid in connection with such acquisition of control if such control was acquired by the payment of cash or the then fair market value per option share of the consideration paid for such Securities if such -7- 8 control was acquired for consideration other than cash, (B) the price per share paid in connection with any tender offer of securities leading to control, or (C) the mean between the high and low bid price of such Securities on NASDAQ or any other national securities exchange upon which the Securities shall then be listed on the date of termination of the Executive's employment. (d) As used in this Section 7.5, a "Change of Control" shall be deemed to have occurred upon the passage of (i) ten (10) days following a public announcement that a person or group of affiliated or associated persons have acquired, or obtained the right to acquire, beneficial ownership of thirty percent (30%) or more of such outstanding Share; or (ii) ten (10) days after a person or group of affiliated or associated persons has (A) become the owner of at least 10% of the Share or has filed a Schedule 13D or 13G with the Securities and Exchange Commission and (B) whose ownership interest is deemed by the Company's Board of Directors to cause a material adverse impact of the business or the prospects of the Company. (e) The Company shall pay or reimburse the Executive for all fees and disbursement of counsel, if any, incurred by the Executive as a result of the termination of his employment by the Company following a Change of Control or his voluntary termination of such employment during the Evaluation Period (including, without limitation, those which may be incurred by the Executive in seeking to obtain or reinforce any right or benefit provided by this Agreement). (f) The Executive shall be under no obligation to mitigate the amount of any payment provided for under this Section 7.5 by seeking other employment or otherwise nor shall such amount be offset by any compensation which the Executive may receive from future employment or otherwise. 8. NO REQUIREMENT OF RELOCATION. The Company expressly agrees that the Executive, as a condition of his employment, need not relocate his residence from the community in which he presently resides. Any demand or requirement by the Company that the Executive principally perform his duties at a location or office that requires more than an additional hour of one-way commutation time than the Executive currently experiences shall, in the absence of the Executive's consent (which may be withheld for any reason), constitute a termination without cause by the Company of the Executive's employment thereunder. 9. SERVICES AS DIRECTOR. During the Employment Period, the Executive shall, if elected or appointed, serve as a Director of the Company and/or any subsidiary of the Company upon such terms as shall be mutually agreed upon by the Executive and the Company. -8- 9 10. ASSIGNMENT. This Agreement, as it relates to the employment of the Executive, is a personal contract and the rights and interests of the Executive hereunder may not be sold, transferred, assigned, pledged or hypothecated, except as otherwise set forth herein. This Agreement shall inure to the benefit of and be binding upon the Company and its successors and assigns, including without limitation, any corporation or other entity into which the Company is merged or which acquires all of the outstanding share of the Company's capital stock or all or substantially all of the assets of the Company. 11. RIGHT TO PAYMENTS. The Executive shall not under any circumstances have any option or right to require payments hereunder otherwise than in accordance with the terms hereof. To the extent permitted by law, the Executive shall not have any power of anticipation, alienation or assignment of payments contemplated hereunder, and all rights and benefits of the Executive shall be for the sole personal benefit of the Executive, and no other person shall acquire any right, title or interest hereunder by reason of any sale, assignment, transfer, claim or judgment or bankruptcy proceedings against the Executive. 12. NOTICES. Any notice required or permitted to be given pursuant to this Agreement shall be deemed given three (3) business days after such notice is mailed by certified mail, return receipt required, addressed as follows: (i) if to Executive, at 5016 North Parkway Calabasas, Calabasas, California 91302; and (ii) if to the Company, 5016 North Parkway Calabasas, Calabasas, California 91302, Attention: Vice-President - Finance or at such other address as any such party shall designate by written notice to the other party. 13. GOVERNING LAW. This Agreement shall be governed by and construed and enforced in accordance with the internal laws of California without reference to conflicts of laws, principles or rules. 14. WAIVER. The waiver by either party of a breach of any provision of this Agreement shall not operate or be construed as a Agreement shall be held to be invalid or unenforceable, such invalidity or unenforceability shall attach only to such provision and not in any way affect or render invalid or unenforceable any other provisions of this Agreement, and this Agreement shall be carried out as if such invalid or unenforceable provisions were not embodied therein. -9- 10 15. ARBITRATION. In the event of any controversy, dispute or claim arising out of or related to this Agreement or the Executive's employment by the Company, the parties shall negotiate in good faith in an attempt to reach a mutually acceptable settlement of such dispute. If negotiations in good faith do not result in a settlement of any such controversy, dispute or claim, it shall be finally settled by expedited arbitration in accordance with the National Rules of the American Arbitration Association governing employment disputes, subject to the following: (a) The Arbitrator shall be determined from a list of names of five impartial arbitrators each of whom shall be an attorney experienced in arbitration matters concerning executive employment disputes, supplied by the American Arbitration Association (the "Association") chosen by Executive and the Company each in turn striking a name from the list until one name remains. (b) The Arbitrator shall determine whether and to what extent any party shall be entitled to damages under this Agreement. (c) The Arbitrator shall not have the power to add to nor modify any of the terms or conditions of the this Agreement. The Arbitrator's decision shall not go beyond what is necessary for the interpretation and application of the provision of this Agreement in respect of the issue before the Arbitrator. The Arbitrator shall not substitute his or her judgment for that of the parties in the exercise of rights granted or retained by this Agreement. The Arbitrator's award or other permitted remedy, if any, and the decision shall be based upon the issue as drafted and submitted by the respective parties and the relevant and competent evidence adduced at the hearing. (d) The Arbitrator shall have the authority to award any remedy or relief provided for in this Agreement, in addition to any other remedy or relief (including provisional remedies and relief) that a court of competent jurisdiction could order or grant. In addition, the Arbitrator shall have the authority to decide issues relating to the interpretation, meaning or performance of this Agreement even if such decision would constitute an advisory opinion in a court proceeding or if the issues would otherwise not be ripe for resolution in a court proceeding, and any such decision shall bind the parties in their continuing performance of this Agreement. The Arbitrator's written decision shall be rendered within sixty days of the hearing. The decision reached by the Arbitrator shall be final and binding upon the parties as to the matter in dispute. To the extent that the relief or remedy granted by the Arbitrator is relief or remedy on which a court could enter judgment, a judgment upon the award rendered by the Arbitrator shall be entered in any court having jurisdiction thereof (unless in the case of an award of damages, the full amount of the award is paid within 10 days of its determination by the Arbitrator). Otherwise, the award shall be binding on the parties in connection with their continuing performance of this Agreement and in any subsequent arbitral or judicial proceedings between the parties. -10- 11 (e) The arbitration shall take place in Los Angeles, California. (f) The arbitration proceeding and all filing, testimony, documents and information relating to or presented during the arbitration proceeding shall be disclosed exclusively for the purpose of facilitating the arbitration process and for no other purpose and shall be deemed to be information subject to the confidentiality provisions of this Agreement. (g) The parties shall continue performing their respective obligations under this Agreement notwithstanding the existence of a dispute while the dispute is being resolved unless and until such obligations are terminated or expire in accordance with the provisions hereof. (h) The Arbitrator may order a pre-hearing exchange of information including depositions, interrogatories, production of documents, exchange of summaries of testimony or exchange of statements of position, and the Arbitrator shall limit such disclosure to avoid unnecessary burden to the parties and shall schedule promptly all discovery and other procedural steps and otherwise assume case management initiative and control to effect an efficient and expeditious resolution of the dispute. At any oral hearing of evidence in connection with an arbitration proceeding, each party and its counsel shall have the right to examine its witness and to cross-examine the witnesses of the other party. No testimony of any witness shall be presented in written form unless the opposing party or parties shall have the opportunity to cross-examine such witness, except as the parties otherwise agree in writing. (i) Notwithstanding the dispute resolution procedures contained in this Section 15, either party may apply to any court having jurisdiction (i) to enforce this Agreement to arbitrate, (ii) to seek provisional injunctive relief so as to maintain the status quo until the arbitration award is rendered or the Dispute is otherwise resolved, or (iii) to challenge or vacate any final judgment, award or decision of the Arbitrator that does not comport with the express provisions of this Section 15. 16. ATTORNEYS' FEES The Company shall pay or reimburse the Executive for all reasonable fees and disbursements of the Executives counsel in connection with the negotiation and execution of this Agreement. In addition, in the event of any arbitration or judicial proceeding hereunder, the prevailing party shall be entitled to recover his or its reasonable attorneys fees and costs.. 17. HEADINGS. The Article, Section, paragraph and subparagraph headings are for convenience of reference only and shall not define or limit the provisions hereof. 18. ENTIRE AGREEMENT. -11- 12 This Agreement constitutes the entire agreement between the parties with respect to the subject matter hereof and there are no representations, warranties or commitments except as set forth herein. This Agreement replaces the Executive's existing employment agreement in its entirety and supersedes any other prior and contemporaneous agreements, understandings, negotiations and discussions, whether written or oral, of the parties hereto relating to the transactions contemplated by this Agreement; provided, however, that it is the intention of the parties that this Agreement shall be interpreted and applied in conjunction with the term of any option, warrant or other right not in existence or hereinafter granted to the Executive to acquire shares of capital stock of the Company. In the event of any conflict, however, the terms of this Agreement shall govern and prevail. This Agreement may be amended only in a writing executed by the parties hereto affected by such amendment. IN WITNESS WHEREOF, the undersigned have executed this Agreement as of the date and year first above written. T-HQ, INC., a New York Corporation By: /s/ Deborah A. Lake _______________________________________ Deborah A. Lake Vice President, Finance and Administration /s/ BRIAN J. FARRELL __________________________________________ BRIAN J. FARRELL -12- EX-10.31 3 STOCK OPTION AGREEMENT DATED AS OF AUGUST 28, 1996 1 EXHIBIT 10.31 STOCK OPTION AGREEMENT DATED AS OF AUGUST 28, 1996 BY AND BETWEEN T-HQ, INC., A NEW YORK CORPORATION (THE "COMPANY"), AND BRIAN J. FARRELL (THE "OPTIONEE") This AGREEMENT, dated as of August 28, 1996 is made between T-HQ, INC., a New York corporation, having its principal offices at 5016 North Parkway Calabasas, Calabasas, California 91302, as the Company, and Brian J. Farrell, as Optionee, having an address at 5016 North Parkway Calabasas, Calabasas, California 91302. W I T N E S S E T H 1. Grant of Option. In consideration for and recognition of Optionee's past services to the Company and Optionee's contribution to the improved financial performance and success of the Company, the Company hereby grants to the Optionee, subject to the terms and conditions herein set forth, the right and option (the "Option") to purchase from the Company, all or any part of an aggregate of two hundred thousand (200,000) shares of common stock of the Company, par value $.0001 per share (the "Common Stock"), at the exercise price of $5.00 per share (equaling the market price per share of the Common Stock on the date of this Agreement), such Option to be exercisable as hereinafter provided. 2. Limitation on Exercisability of Option. This Option shall be exercisable by the Optionee, in whole or in part, to the extent of the following number of shares of Common Stock on the dates set forth below: Date After Which Shares Number of Shares Can Be Purchased ---------------- ---------------- 66,667 Shares August 28, 1996 an additional 66,667 Shares August 28, 1997 an additional 66,666 Shares August 28, 1998 Notwithstanding anything to the contrary contained herein, this Option shall automatically vest for the entire number of shares subject to the Option, upon a "Change of Control," as such term is defined in the Optionee's Employment Agreement with the Company, as the same may be amended and restated from time to time. 3. Expiration of Option. This Option shall not be exercisable after 5:00 p.m. (P.D.T.) on August 28, 2006. 2 4. Non-Assignability of Option. Except as specified below, this Option shall not be given, granted, sold, exchanged, transferred, pledged, assigned or otherwise encumbered or disposed of by the Optionee, otherwise than by will or the laws of descent and distribution, and, during the lifetime of the Optionee, shall not be exercisable by any other person, but only by the Optionee. Optionee may designate an individual who shall have the ability and authority to exercise this Option on Optionee's behalf in the event of Optionee's permanent and total disability within the meaning of Section 22(e)(3) of the Internal Revenue Code of 1986, as amended (the "Code"). 5. Method of Exercise of Option. The Option granted hereunder shall be exercised by the delivery by the Optionee to the Company at its principal office (attention of the Secretary) of written notice of the number of shares of Common Stock with respect to which the Option is being exercised, and such notice shall be accompanied by payment of the full option price of such shares. Payment of such option price shall be made by the Optionee's delivery of his check payable to the order of the Company; provided, however, that notwithstanding the foregoing provisions of this Section 5, at the written request of the Optionee, shares acquired pursuant to the exercise of the Option may be paid for in full at the time of exercise by the surrender of shares of Common Stock (with a fair market value on the date of exercise equaling the option price of the shares of Common Stock for which such Option is exercised) held by or for the account of the Optionee at the time of exercise to the extent permitted by subsection (c) (5) of Section 422 of the Code and Section 16(b) of the Exchange Act of 1934, as amended, and the Rules of the Securities and Exchange Commission, without liability to the Company. 6. Death or Termination of Employment or Services. If the employment of the Optionee as an employee with, or the services of the Optionee as a non-employee director for, the Company shall be terminated for any reason, this Option shall continue until its expiration set forth in Section 3 hereof. 7. Investment Representation. The Optionee represents that at the time of any exercise of this Option, to the extent that the offer and sale by the Company of the shares of Common Stock are not registered under the Securities Act of 1933, as amended (the "Securities Act"), such Common Stock will be acquired for investment and not for resale or with a view to the distribution thereof. Upon exercise of the Option and the issuance of any shares thereunder, all certificates representing shares of Common Stock shall bear on the face thereof substantially the following legend: -2- 3 "THESE SECURITIES HAVE NOT BEEN REGISTERED UNDER THE SECURITIES ACT OF 1933, AS AMENDED, OR ANY STATE SECURITIES LAWS. THEY MAY NOT BE SOLD OR OFFERED FOR SALE EXCEPT PURSUANT TO AN EFFECTIVE REGISTRATION STATEMENT AS TO THE SECURITIES UNDER SAID ACT AND ANY APPLICABLE STATE SECURITIES LAW OR AN OPINION OF COUNSEL REASONABLY SATISFACTORY TO T-HQ, INC. THAT SUCH REGISTRATION IS NOT REQUIRED." 7. Registration Rights. (a) If at any time the Company proposes to register equity securities under the Securities Act in connection with the public offering solely for cash on Form S-1, S-2 or S-3, the Company shall promptly give the Optionee written notice of such registration (a "Piggyback Registration"). Upon the written request of the Optionee given within fifteen (15) days following the date of such notice, the Company shall cause to be included in such registration statement and use its best efforts to be registered under the Securities Act all the shares of Common Stock that the Optionee shall have requested to be registered. The Company shall have the absolute right to withdraw or cease to prepare or file any registration statement for any offering referred to in this Section without any obligation or liability to the Optionee. (b) If the underwriters' representative or agent with respect to such registration shall advise the Company in writing that, in its opinion, the amount of shares of Common Stock requested to be included in such registration would materially adversely affect such offering, or the timing thereof, then the Company will include in such registration, to the extent of the amount and class which the Company is so advised can be sold without such material adverse effect in such offering: First, all securities proposed to be sold by the Company for its own account; second, the shares of Common Stock requested to be included in such registration by the Optionee and all other securities being registered pursuant to the exercise of contractual rights comparable to the rights granted in this Agreement pro rata based on the estimated gross proceeds from the sale thereof; and third, all other securities requested to be included in such registration. (c) The Optionee shall be entitled to have his shares of Common Stock included in an unlimited number of Piggyback Registrations pursuant to this Agreement. -3- 4 (d) Whenever required to effect a Piggyback Registration, the Company shall, as expeditiously as practicable: i) Prepare and file with the Commission a registration statement with respect to such shares of Common Stock and use the Company's reasonable efforts to cause such registration statement to become effective. ii) Prepare and file with the Commission such amendments and supplements to such registration statement and the prospectus used in connection with such registration statement as may be necessary to comply with the provisions of the Securities Act and rules thereunder with respect to the disposition of all securities covered by such registration statement. Pending such amendment or supplement the Optionee shall cease making offers or sales of shares pursuant to the prior prospectus. In the event that any shares of Common Stock included in a registration statement subject to, or required by, this Agreement remain unsold at the end of the period during which the Company maintains the effectiveness of such registration statement, the Company may file a post-effective amendment to the registration statement for the purpose of removing such shares from registered status. iii) Furnish to the Optionee, without charge, such numbers of copies of the registration statement, any pre- effective or post-effective amendment thereto, the prospectus, including each preliminary prospectus and any amendments or supplements thereto, in each case in conformity with the requirements of the Securities Act and the rules thereunder, and such other related documents as any the Optionee may reasonably request in order to facilitate the disposition of shares owned by the Optionee. iv) Use its reasonable efforts to register and qualify the securities covered by such registration statement under such other securities or Blue Sky laws of such states or jurisdictions as shall be reasonably requested by any underwriters' representative or agent and the Optionee. v) Cooperate with the Optionee, and the underwriters' representative or agent for such offering in the marketing of the shares of Common Stock, including making available the Company's officers, accountants, counsel, premises, books and records for such purpose, but the Company shall not be required to incur any material out-of-pocket expense pursuant to this sentence. Such obligation shall include making available for inspection by the Optionee, and any of his representatives, all financial and other information as shall be reasonably requested by them, and provide the Optionee the reasonable opportunity to discuss the business affairs of the Company with its principal executives and independent public accountants who have certified the audited -4- 5 financial statements included in such registration statement, in each case all as necessary to enable them to exercise their due diligence responsibility under the Securities Act; provided, however, that information that the Company determines, in good faith, to be confidential and which the Company advises such person in writing, is confidential shall not be disclosed unless such person signs a confidentiality agreement reasonably satisfactory to the Company. vi) Promptly notify the Optionee of any stop order issued or threatened to be issued by the Securities and Exchange Commission in connection therewith and take all reasonable actions required to prevent the entry of such stop order or to remove it if entered. (e) It shall be a condition precedent to the obligations of the Company to take any action pursuant to this Agreement with respect to the shares of Common Stock that the Optionee requests to register: i) Furnish to the Company such information regarding the Optionee, the number and nature of the securities of the Company owned by it, and the intended method of disposition of such securities as shall be required to effect the registration of his shares of Common Stock, and to cooperate with the Company in preparing such registration; ii) Agree to sell his shares to the underwriters at the same price and on substantially the same terms and conditions as the Company or the other persons on whose behalf the registration statement was being filed have agreed to sell their securities, and to execute the underwriting agreement agreed to by the Company. (f) The Optionee, if so requested by the Company or the underwriters' representative or agent in connection with an offering of any securities covered by a registration statement filed by Company, shall not effect any public sale or distribution of shares of Common Stock or any securities convertible into or exchangeable or exercisable for shares of Common Stock, including a sale pursuant to Rule 144 under the Securities Act during the 15-day period prior to, and during the 180-day period beginning on, the date such registration statement is declared effective under the Securities Act by the Commission. -5- 6 9. Adjustments Upon Changes in Capitalization. (a) Except as may be otherwise provided in Section 2 of this Agreement, in the event that the outstanding Common Stock is hereafter changed by reason of reorganization, merger, consolidation, recapitalization, reclassification, stock split-up, combination of shares, stock dividends or the like, an appropriate adjustment shall be made by the Stock Option Committee of the Company's Board of Directors in the aggregate number of shares of Common Stock available under this Agreement and in the number of shares and option price per share subject to the outstanding Option. If the Company shall be reorganized, consolidated or merged with another corporation, or if all or substantially all of the assets of the Company shall be sold or exchanged, the Optionee shall, at the time of issuance of the Common Stock under such a corporate event, be entitled to receive upon the exercise of his Option the same number and kind of shares of Common Stock or the same amount of property, cash or securities as he would have been entitled to receive upon the happening of such corporate event as if he had been, immediately prior to such event, the holder of the number of shares of Common Stock covered by this Option; (b) Any adjustment in the number of shares of Common Stock apply proportionate to only the unexercised portion of the Option granted hereunder. If fractions of a share would result from any such adjustment, the adjustment shall be revised to the next lower whole number of shares. 10. No Rights as Stockholder. The Optionee shall have no rights as a shareholder in respect to the shares of Common Stock as to which this Option shall not have been exercised nor any payment made with respect to such exercise as herein provided. 11. NonStatutory Option. This Option is not intended to be an incentive stock option within the meaning of Section 422 of the Code. 12. Binding Effect. Except as herein otherwise expressly provided, this Agreement shall be binding upon and inure to the benefit of the parties hereto, their legal representatives, successors and assigns. 13. Governing Law. This Agreement shall be governed by and construed in accordance with the internal laws of the State of New York without reference to conflict of laws, principals or rules. 14. Notices. Any notice hereunder shall be delivered by hand or by registered or certified mail, return receipt requested to a party at its address set forth above, subject to the right of either party to designate at any time hereafter, in writing, some other address. 15. Waiver. The waiver by either party of a breach of any provision of this Agreement shall not operate or be construed as a Agreement shall be held to be invalid or -6- 7 unenforceable, such invalidity or unenforceability shall attach only to such provision and not in any way affect or render invalid or unenforceable any other provisions of this Agreement, and this Agreement shall be carried out as if such invalid or unenforceable provisions were not embodied therein. 16. Counterparts. This Agreement may be exercised in counterparts, each of which shall constitute one and the same instrument. -7- 8 IN WITNESS WHEREOF, T-HQ, INC. has caused this Agreement to be executed by an appropriate executive officer and the Optionee has executed this Agreement, both as of the day and year first written. THE COMPANY: T-HQ, INC. /s/Deborah A. Lake ---------------------------------- Name: Deborah A. Lake Title: Vice President - Finance and Administration OPTIONEE: /s/Brian J. Farrell ---------------------------------- Brian J. Farrell -8- EX-11 4 STATEMENT OF COMPUTATION OF NET EARNINGS 1 EXHIBIT 11 T-HQ, INC. STATEMENT OF COMPUTATION OF NET EARNINGS PER COMMON AND COMMON EQUIVALENT SHARES
For the Three Years Ended December 31, ---------------------------------- 1994 1995 1996 ---------- ---------- ---------- Net income (loss) used to compute primary and fully diluted earnings (loss) per share $(17,490,000) $ 601,000 $1,901,000 ------------ ---------- ---------- Weighted average number of shares outstanding 1,998,000 3,327,000 4,525,000 Dilutive effect of stock options and warrants -- 113,000 386,000 Dilutive effect assuming conversion of preferred stock -- 42,000 -- ------------ ---------- ---------- Number of shares used to compute primary and fully diluted earnings (loss) per share 1,998,000 3,482,000 4,911,000 ============ ========== ========== Net earnings (loss) per share $ (8.75) $ .17 $ .39 ============ ========== ==========
EX-21 5 SUBSIDIARIES OF THE REGISTRANT 1 EXHIBIT 21 SUBSIDIARIES OF T-HQ, INC. T-HQ, International Ltd., a United Kingdom Corporation Heliotrope Studios, Inc., a Connecticut Corporation Black Pearl Software, Inc., an Illinois Corporation Malibu Games, Inc., a New York Corporation T-HQ Deutschland GmbH, a German Corporation EX-23 6 INDEPENDENT AUDITOR'S CONSENT 1 Exhibit 23 INDEPENDENT AUDITOR'S CONSENT We consent to the incorporation by reference in Registration Statement Nos. 33-43909, 33-66954, 33-80757, 333-00180, 333-00182, 333-00184, 333-00136, 333-16975 of T-HQ, Inc. on Form S-8 of our report dated February 17, 1997 (March 11, 1997 as to Note 12), appearing in this Annual Report on Form 10-K of T-HQ, Inc. for the year ended December 31, 1996. Deloitte & Touche LLP Los Angeles, California March 28, 1997 EX-27 7 FINANCIAL DATA SCHEDULE
5 THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM (A) THE CONSOLIDATED BALANCE SHEETS, THE CONSOLIDATED STATEMENTS OF OPERATIONS AND CONSOLIDATED STATEMENTS OF CASH FLOWS AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH (B) FINANCIAL STATEMENTS FOUND IN FORM 10-K AS FILED WITH THE SEC ON MARCH 31, 1997. YEAR DEC-31-1996 JAN-01-1996 DEC-31-1996 2,734,000 0 18,544,000 1,294,000 1,013,000 21,464,000 1,184,000 603,000 22,840,000 11,792,000 0 0 0 4,000 11,044,000 22,840,000 50,255,000 50,255,000 29,301,000 29,301,000 18,729,000 10,000 316,000 1,909,000 8,000 1,901,000 0 0 0 1,901,000 .39 .39
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