-----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, WIRXkhnPpgDiW+dWu5N6ZDk4Cs7QciD9gDG/QIST6bizvVigjmwhm62mAVODBiDT Da8eS2XFJoR760jA9qyI3w== 0000929624-00-000434.txt : 20000329 0000929624-00-000434.hdr.sgml : 20000329 ACCESSION NUMBER: 0000929624-00-000434 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 8 CONFORMED PERIOD OF REPORT: 19991231 FILED AS OF DATE: 20000328 FILER: COMPANY DATA: COMPANY CONFORMED NAME: DIGITAL GENERATION SYSTEMS INC CENTRAL INDEX KEY: 0000934448 STANDARD INDUSTRIAL CLASSIFICATION: SERVICES-ADVERTISING AGENCIES [7311] IRS NUMBER: 943140772 STATE OF INCORPORATION: CA FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: SEC FILE NUMBER: 000-27644 FILM NUMBER: 580569 BUSINESS ADDRESS: STREET 1: 875 BATTERY ST STREET 2: STE 1850 CITY: SAN FRANCISCO STATE: CA ZIP: 94111 BUSINESS PHONE: 4155466600 MAIL ADDRESS: STREET 1: 875 BATTERY ST CITY: SAN FRANCISCO STATE: CA ZIP: 94111 10-K 1 FORM 10-K UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, DC 20549 FORM 10-K [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For The Fiscal Year Ended December 31, 1999 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM _____________ TO _____________. COMMISSION FILE NUMBER: 0-27644 Digital Generation Systems, Inc. (Exact Name of Registrant as Specified in its Charter) California 94-3140772 (State or Other Jurisdiction of (I.R.S. Employer Incorporation or Organization) Identification Number)
875 Battery Street San Francisco, California 94111 (Address Of Principal Executive Offices, Including Zip Code) (415) 276-6600 (Registrant's Telephone Number, Including Area Code) Not Applicable (Former Name, Former Address, Former Fiscal Year, If Changed Since Last Report) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Sections 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES [X] NO [ ] Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ ] The aggregate market value of the voting Common Stock held by non-affiliates of the registrant, based upon the closing sale price of the Common Stock on March 15, 2000, as reported on the Nasdaq National Market, was approximately $108,782,282. Shares of Common Stock held by each officer and director of the registrant and by each person who may be deemed to be an affiliate have been excluded. This determination of affiliate status is not necessarily a conclusive determination for other purposes. As of March 15, 2000, the registrant had 27,942,182 shares of Common Stock, without par value, outstanding. DOCUMENTS INCORPORATED BY REFERENCE: The registrant has incorporated by reference into Part III of this Form 10-K portions of its definitive Proxy Statement for its Annual Meeting of Shareholders to be filed within 120 days after the end of the fiscal year, (the "Proxy Statement") and to be held on the date set forth in such Proxy Statement. Except with respect to information specifically incorporated by reference into this Form 10-K, the Proxy Statement is not deemed to be filed as a part hereof. DIGITAL GENERATION SYSTEMS, INC. The discussion in this Report contains forward-looking statements that involve risks and uncertainties. The statements contained in this Report that are not purely historical are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Words such as "anticipates," "believes," "plans," "expects," "future," "intends," and similar expressions are used to identify forward-looking statements. All forward-looking statements included in this document are based on information available to the Company on the date hereof, and we assume no obligation to update any such forward-looking statements. The Company's actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors, including, but not limited to, those discussed in "Management's Discussion and Analysis of Financial Condition and Results of Operations - Certain Business Considerations" as well as those discussed elsewhere in this Report, and the risks discussed in the Company's other United States Securities and Exchange Commission filings. TABLE OF CONTENTS
PART I ITEM 1. BUSINESS....................................................................... 1 Industry Background............................................................ 1 The Company.................................................................... 2 Products and Services.......................................................... 3 The DG Systems Network......................................................... 4 Markets and Customers.......................................................... 5 Sales, Marketing and Customer Service.......................................... 6 Competition.................................................................... 7 Intellectual Property and Proprietary Rights................................... 8 Employees...................................................................... 9 ITEM 2. PROPERTIES..................................................................... 9 ITEM 3. LEGAL PROCEEDINGS.............................................................. 9 ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS............................ 10 ITEM 4A. EXECUTIVE OFFICERS OF THE REGISTRANT........................................... 10 PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS.......... 11 ITEM 6. SELECTED FINANCIAL DATA........................................................ 12 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS..................................................................... 13 Overview....................................................................... 13 Results of Operations.......................................................... 14 Liquidity and Capital Resources................................................ 16 Certain Business Considerations................................................ 17 ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK..................... 25 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTAL DATA..................................... 25 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISLOSURE...................................................................... 25 PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT............................. 26 ITEM 11. EXECUTIVE COMPENSATION......................................................... 26 ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT................. 26 ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS................................. 26 PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K................ 27 EXHIBITS AND REPORTS ON FORM 8-K............................................................. 27 SIGNATURES................................................................................... 31
DIGITAL GENERATION SYSTEMS, INC. PART I ITEM 1. BUSINESS Digital Generation Systems, Inc. ("DG Systems", "DG" or the "Company") operates a nationwide, value-added digital network which links hundreds of advertisers and advertising agencies with more than 7,500 radio and 700 television stations across the United States and Canada. The Company's fault- tolerant Network Operation Center located in San Francisco delivers audio, video, image and data content that comprise transactions between the advertising and broadcast industries. As a result of its September 1998 acquisition of Digital Courier International, Inc., ("DCI"), a provider of electronic distribution and communications services for the radio broadcast industry, the Company is now the most significant provider of audio spot advertising to radio stations, enjoying a market share in excess of 50%. In late 1996, the Company entered the market for the electronic distribution of digital video spots to television stations, cable systems and networks. DG Systems generates its revenues principally from advertising agencies, advertisers, tape duplication vendors and dealers, syndicated programmers and music companies that principally service these markets. The Company believes that its digital network enables rapid, cost- effective and reliable transmission of audio and video broadcast content, and provides higher levels of quality, control and flexibility than physical distribution methods currently available. In July 1997, the Company purchased Starcom Mediatech, Inc. ("Mediatech"), a provider of broadcast video and audio duplication, syndicated program distribution and corporate media duplication services, with facilities in Chicago, Los Angeles and New York, augmenting its November 1996 acquisition of PDR Productions, Inc. ("PDR"), a New York City- based broadcast production services company. As a result of these acquisitions the Company also has become a leading provider of video advertising distribution and is rapidly adding new customers to its digital audio and video network. The Company offers a complete range of post production services, including editing, duplication, color control, close captioning, content review, quality assurance, electronic archiving and format conversions, all of which allow one-stop shopping in the critical advertising markets of New York City, Chicago, and Los Angeles. Industry Background While many radio and television broadcasters now embrace digital technology for much of their production processes and in-station media management, current methods for the distribution of audio and video advertising content are based primarily on the manual duplication and physical delivery of analog tapes. According to industry sources, there are approximately 10,000 commercial radio and 1,100 commercial television stations in the United States. These stations generate revenue principally by selling airtime to advertisers. Advertising is most frequently produced under the direction of advertising agencies for large national or regional advertisers, or by station personnel for advertisers that are local in nature. Advertising is characterized as "network" or "spot", depending on how it is bought and distributed. Network advertising typically is delivered to stations as part of a "network feed" (bundled with network programming), while spot advertising is delivered to stations independently of other programming content. Spot advertising airtime typically is purchased by advertising agencies or media buying firms on behalf of advertisers. Advertisers and their agencies select individual stations or groups of stations to support marketing objectives, which usually are based on the stations' geographic and other demographic characteristics. The actual commercials or "spots" typically are produced at a digital production studio and recorded on digital tape. Variations of the spot intended for specific demographic groups also are produced at this time. The spots undergo a review of quality and content before being cleared for distribution to broadcast stations. Tapes containing the spot and its variations are then duplicated on analog tape, packaged, labeled and shipped to the radio and television stations and cable head-ends specified by the advertiser or its agency. The predominant method for distributing spot advertisements to radio and television stations traditionally has been the physical delivery of analog audio or videotapes. The Company estimates that approximately 30% of radio spots and more than 90% of video spots are delivered by air express services. Many companies, commonly known as "dub and ship houses", are in the business of duplicating audio and video tapes, assembling them according to agency-specified bills of material and packing them for air express delivery. The Company estimates that it has transitioned approximately 60% of the market for audio spot deliveries and approximately 10% of video spot deliveries, to digital distribution. The Company estimates the market sizes for the audio distribution market to be approximately $40 million and approximately $150 million for the video distribution market. 1 The Company DG Systems is a leading provider of electronic and physical distribution and ancillary post-production services for audio and video content to advertising agencies, production studios and broadcast stations throughout the United States. The Company, a California corporation, was incorporated in 1991. The Company has developed a digital network currently serving over 7,500 radio and 725 television stations that is controlled through the Company's San Francisco Network Operating Center ("NOC"). This network enables the rapid, cost-effective and reliable electronic transmission of audio and video spots and other content and provides a high level of quality, accountability and flexibility to both advertisers and broadcasters. With DG Systems' network, transmissions are automatically routed to stations through a computerized on-line transaction and delivery system and arrive at stations in as little as one hour after an order is received. Typically associated traffic (text) instructions are simultaneously transmitted by facsimile to minimize station handling and scheduling errors. Shortly after a spot is delivered to a station, the Company sends the customer a confirmation specifying the time of delivery. Additionally, the Company's digital network delivers close to "master" quality audio or video to broadcast stations, which is equal to or superior to that currently delivered on analog tape. DG Systems generates its revenues from advertising agencies as well as from production studios and dub and ship houses that consolidate and forward the deliveries to broadcast stations. The Company has historically operated and currently operates without substantial backlog. The Company receives distribution orders with specific bills of material, routing and timing instructions provided by the customer. These orders are entered into the Company's computer system either by the customer (through an internet-based order-entry system) or by DG Systems and are scheduled for electronic delivery if a station is on the Company's network, or are scheduled for physical delivery via the Company's various dub and ship facilities if a destination station is not on the network. Audio content is received electronically at the Company's NOC from Record Send Terminals ("RSTs") and, in the case of Digital Courier's network, Client Workstations ("CWs"), that are owned by the Company and deployed primarily in production studios. Audio can also be received using the Company's "iAudio" internet audio collection system. When audio spots are received, Company personnel quality-assure the audio content and then initiate the electronic transaction to transmit various combinations of audio to designated radio stations. Audio transmissions are delivered over standard telephone or ISDN lines to servers that the Company has placed in each radio station. The audio spots are thereafter available to the station on demand. Video content is received electronically at the Company's San Francisco NOC primarily from DG Video Record Transmission Systems ("VRTSs") that are owned by the Company and deployed in production video studios. Video content also can be received at the Company's San Francisco NOC through airfreight carriers or through high-speed communication lines from collection points in locations where VRTSs are not available. When video spots are received, Company personnel quality-assure the spots and release the video to the NOC, where it is combined with the customer's electronic transaction to transmit the various combinations of video to designated television stations. Video transmissions are sent via a high-speed frame relay link to the digital satellite uplink facility over which they are then delivered directly to servers that the Company has placed in television stations and cable interconnects. Audio and video transmissions are received at designated radio and television stations on DG-owned servers, called Receive Playback Terminals ("RPTs"), Client Workstations ("CWs") and ADvantage Digital Video Playback Systems ("DVPS"). The servers enable stations to receive and play back material delivered through the Company's digital distribution network. The units are owned by the Company and typically are installed in the "master control" or production area of the stations. Upon receipt, station personnel generally review the content and transfer the spot to a standardized internal station format for subsequent broadcast. Through its NOC, the Company monitors the spots stored in each RPT, CW, or DVPS and ensures that space is always available for new transmissions. The Company can quickly transmit audio or video at the request of a station or in response to the request of a customer who wishes to alter an existing order, enabling responsiveness not possible in a physical tape distribution system. DG Systems currently offers four primary levels of digital audio distribution services and three levels of video distribution services from its NOC to broadcast advertisers distributing content to broadcast stations: DG Priority, a service which guarantees arrival of the first audio spot on an order within one hour (available for audio only); DG Express, which guarantees arrival within four hours; DG Standard, which guarantees arrival by noon the next day; and DG Economy, which 2 guarantees arrival by noon on the second day. The Company also offers a set of premium services enabling advertisers to distribute audio or video spots provided after normal business hours and, therefore, after overnight parcel delivery service is no longer available. In addition to its standard services, the Company has developed unique products to service four vertical markets with particular time-sensitive delivery needs. "Sweeps" delivery is a specialized service for television stations that wish to advertise on radio with either topical or cooperative content to stimulate viewership during the periods of ratings measurements conducted by the A.C. Nielsen Company. The Company also offers delivery of advertising for daily newspapers seeking to expand their readership based on a dissemination of breaking news during the morning rush hour. The Company distributes first release music singles and uses unique software functionality to insure that the singles are released throughout the country to all stations simultaneously thereby eliminating concerns of favoritism or premature release. Finally, the Company delivers political advertising during election campaigns, providing a rapid response mechanism for candidates and issue groups. The Company also provides audio and video duplication services, syndicated programming distribution services, and a host of other ancillary post production services through its nationwide facilities in New York, Chicago, Louisville and Los Angeles. Products and Services The Company's mission is to become the leading provider of electronic value- added transaction services to the advertising and broadcast industries. Audio Advertising Distribution. Prior to the Company's acquisitions of PDR and Mediatech, substantially all of the Company's revenues were derived from the delivery of radio advertising from advertising agencies, production studios and dub-and-ship houses to radio stations in the United States. In 1998, the Company acquired DCI, and has integrated DCI's network with the Company's existing network to form a single, comprehensive network servicing over 7,500 stations throughout Canada and the United States. Audio services are expected to continue to account for a significant share of the Company's revenues for some time. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Certain Business Considerations -- Dependence on Radio Advertising." The Company also derives revenue from its offering of audio distribution services in the four vertical markets: sweeps; local/regional newspapers; music releases; and political advertising. The Company provides two-way audio transmission services to radio stations within markets, regions and co-owned groups, facilitating the sharing of programming and commercial content. The Company also derives limited revenue today through its studio services, which enable production studios to directly exchange audio files with each other without the intervention of Company personnel. Postproduction Services. The Company's acquisitions of PDR and Mediatech have enabled it to provide digital delivery to a larger base of customers and to provide postproduction services in the three major advertising markets (New York, Los Angeles and Chicago) for a "one-stop shopping solution." The Company continues to focus on value-added postproduction services to complement the Company's digital delivery product. Such services include leading edge digital editing, digital closed captioning, Internet-based encoding, and CD-ROM mastering and duplication. Video Advertising Distribution. The Company believes that the delivery of television advertising is characterized by many of the same challenges facing radio advertisers. The Company introduced its video distribution services in 1996. To date the Company has deployed a video distribution network consisting of over 725 television stations and cable interconnects which currently are on- line and receive video content through the Company's network. The Company is actively marketing and selling its video services to agencies, advertisers and dealers. As many of the Company's radio advertising customers also are active television advertisers, its current customers who already utilize the Company's audio spot distribution services are candidates for or already are utilizing its video services. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Certain Business Considerations - Dependence on Video Advertising Delivery Service Deployment", and "- Dependence on Technological Developments" and " - Competition." Syndicated Program Distribution. The Company also generates revenue by distributing syndicated programming. This service primarily consists of integrating commercials into syndicated programs and either uplinking the completed programs 3 via satellites for distribution to stations nationwide and in Canada or the physical duplication and shipping of shows to stations that do not receive a satellite feed. Corporate Duplication. The Company also generates revenues from the duplication of corporate content. This service primarily consists of large quantity duplication of training, corporate or product information tapes on non- broadcast quality tape stock, such as VHS. Music Distribution. The Company also derives revenues from its "first release music deliveries," in which it offers music labels the capability to electronically distribute first-release music singles simultaneously to selected radio stations. The Company's future growth depends on its successful and timely introduction of new products and services, often in markets that do not currently exist or are just emerging. The Company currently is undertaking efforts to develop new products and services. There can be no assurance, however, that the Company will successfully complete such development or that, if such development is completed, the Company's introduction of these products and services will realize market acceptance or will meet the technical or other requirements of potential customers. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Certain Business Considerations - Dependence on Emerging Markets." The DG Systems Network DG Systems has developed a sophisticated, highly scaleable network communication system to provide network transaction services to the advertising and broadcast industries. Today this system supports two-way communication between advertisers, agencies, production studios and stations via standard telephone lines, ISDN lines, digital data satellite frame relay connections and the Internet. The Company intends to continue employing state-of-the-art communications capabilities, such as XDSL and cable modems, as they become widely available and economically feasible. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Certain Business Considerations - Ability to Manage Growth" and " - Future Capital Needs; Uncertainty of Additional Funding." The Company's network consists of the following: (i) Record Send Terminals and Client Workstations (audio) and Video Record and Transmission Systems (video) owned by the Company and installed primarily at production studios; (ii) NOC at the Company's headquarters used to assemble, process, route and store digital content; and (iii) ADvantage Receive Playback Terminals and Client Workstations (audio) and ADvantage Digital Video Playback Systems (video) owned by the Company and installed at broadcast stations, cable interconnects and broadcast and cable networks. Record Send Terminal and Client Workstation. Both the RST and CW are PC-based audio encoder and communications servers with a full screen monitor and keyboard. The RST accepts audio in either analog or digital format and encodes the audio using an efficient algorithm for transmissions to the Company's NOC in San Francisco. Video Record Transmission System. The VRTS is a video encoder and communications server with a full screen monitor and keyboard. The VRTS accepts video in either analog or digital format and encodes the video using a standard MPEG-2 compression algorithm for transmissions to the Company's Network Operating Center in San Francisco. Network Operating Centers. DG Systems has developed a fault-tolerant client/server on-line transaction system based on relational databases and UNIX servers from Sun Microsystems. The Company has developed software applications incorporating critical operational capabilities such as transaction management, communication facility monitoring, system security, intelligent network routing and customer service databases. The major system components include (i) a transaction scheduling, monitoring and management system, (ii) a media collection, processing and delivery system which is designed to handle audio, video, image and data organizing the delivery content by destination address, and routing those deliveries by the most cost-effective route, and (iii) a high- capacity media storage and archive system that indexes and archives every media file delivered by the Company. ADvantage Receive Playback Terminal. The RPT is a rack-mountable, PC-based communication server and media decoder that enables radio stations to receive and play back audio content delivered through the Company's digital distribution network. The RPT communicates with the Company's network to exchange media and transactional information, 4 and allows users to play back broadcast quality audio on demand. RPT software consists of extensive remote capabilities such as system diagnostics, storage management and remote software upgrade as well as enhanced security features such as user authentication, network access security protocol and media content encryption to prevent unauthorized access. ADvantage Digital Video Playback System. The DVPS is a rack-mountable, PC- based communication server and video decoder that enables television stations and cable systems to receive and play back advertisements delivered through the Company's digital distribution network. The DVPS communicates with the Company's network to exchange media and transactional information, and allows users to play broadcast quality video on demand. The DVPS includes a fully integrated monitor and keyboard and has the disk capacity to store up to 250 30-second spots. DVPS software consists of extensive remote capabilities such as system diagnostics, storage management and remote software upgrades as well as enhanced security features such as user authentication, network access security protocol and media content encryption to prevent unauthorized access. Hughes DirecPC Satellite Interface. The Company has a joint development and deployment agreement with Hughes Network Systems, Inc. for satellite delivery to its network of stations. The Company has developed an electronic interface between its NOC in San Francisco and the Hughes satellite uplink facility. The Company also has integrated the Hughes DirecPC satellite technology into its DVPSs to permit the receipt of media content from satellite as well as from terrestrial connections. Client Workstation. The CW is a rack-mountable or desktop, PC-based communication server and media encoder/decoder that enables radio stations to receive, play back, record and send audio content delivered through the Company's digital distribution network. The CW communicates with the Company's network to exchange media and transactional information, and allows users to record, store and play back broadcast quality audio on demand. CW software consists of extensive remote capabilities such as system diagnostics, storage management and remote software upgrade as well as enhanced security features such as user authentication and a network access security protocol to prevent unauthorized usage of the network. DG's extensive network of digital audio receive playback terminals and video playback systems strategically placed across the country in broadcast stations, its record send terminals, customer workstations and video record transmission systems, coupled with unique encoding, compression and complex communications software, connected via its NOC described above, and an established customer base, create important barriers to entry for potential competitors. The transmission of content is controlled by a very comprehensive transaction scheduling, routing, monitoring and delivery management system that the Company believes would be very difficult to replicate. Additionally, DG's audio and video capabilities now are complemented with facilities in New York City, Chicago, Louisville, and Los Angeles to handle customers' other production services needs. The Company believes that no single competitor today offers DG's audio, video, and production services capabilities that are deliverable locally and nationally via several strategic locations. Markets and Customers A large portion of the Company's current revenue is derived from the delivery of spot radio and television advertising to broadcast stations, cable systems and networks. The Company derives revenue from advertising agencies directly and from its marketing partners, which are typically dub and ship houses that have signed agreements with the Company to consolidate and forward the deliveries of their advertising agency customers to broadcast stations, cable systems and networks via the Company's electronic delivery service in exchange for price discounts from the Company. The advertisements distributed by the Company are representative of the five leading national advertising categories of automotive, retail, business and consumer services, food and related products including soft drinks, and entertainment. The volume of advertising from these segments is subject to substantial seasonal and cyclical variations. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Certain Business Considerations - Potential Fluctuations in Quarterly Results; Seasonality." Through its acquisition of the assets of DCI, the Company has also acquired an additional revenue stream from radio stations by providing distribution between radio stations and radio groups. In addition to its core distribution services, DG Systems has identified vertical-market applications for services where same day delivery is used to promote time-sensitive content. These applications include: 5 Sweeps Promotions. The A.C. Nielsen ratings periods take place during the broadcast months of February, May, September, and November. The Company's services allow local television stations, their affiliated networks and syndicators, whose own advertising rates are based on their Nielsen ratings, to promote viewership of their programs during ratings periods. Station to Station Distribution. Many radio stations produce and distribute commercials and short-form programming to other stations for airplay on the same day, and the Company's network has proven efficient in delivering this content, replacing ground deliveries and couriers. In addition, consolidation in radio ownership has resulted in many of the new radio mega-groups developing facilities for central audio production. The Company's delivery system is used to distribute this production to the group's co-owned stations. Political Campaigns. Radio and television can provide a rapid response mechanism for candidates and issue groups. The Company offers a same-day service for the facilitation of such advertising during political campaigns. In 1998, an election year, the Company delivered 25,000 campaign advertisements, representing over 300 candidates and propositions. The Company also offers the following services: Postproduction Services. Advertising agencies, advertisers, corporations, and public relations firms often require additional services to be performed before a produced element is distributed for broadcast purposes. In addition to the Company's traditional postproduction services - closed captioning, commercial tagging, international standards conversions, and duplication - the Company has developed and introduced digital solutions in the postproduction environment. The new digital services enforce the Company's focus on a fully digital production and distribution environment. Syndication Programming Distribution. Syndicators distribute long form video programming inclusive of advertising to local television stations and cable operators. The Company offers numerous postproduction services to prepare this content for broadcast and distributes it across the country and around the world. Distribution services include both satellite uplink and physical duplication and shipping to those stations which do not or cannot receive the content via satellite. Corporate Duplication. Corporations and other entities develop training, management communications and other general information programs for internal and external distribution for various purposes. The Company provides high volume duplication of such content on non-broadcast quality tape stock, typically VHS. Sales, Marketing and Customer Service Brand Strategy. The Company's brand strategy is to position itself as the standard transaction method for the radio, television, cable, and network broadcast industries. The Company focuses its marketing messages and programs at multiple segments within the advertising and broadcast industries. Each of the segments interacts with the Company for a different reason. Agencies purchase services from the Company on behalf of their advertisers. Production studios facilitate the transmission of audio and video to the Company's NOC. Production studios and dub and ship houses resell delivery services to agencies. Stations join the network to receive the content from their customers, the agencies and advertisers. A key strategy to providing a consistent brand theme at all levels is developing "DG" as a brand identity across these various product and services offerings. Internet/E-Commerce Strategy. The Company introduced its first Internet-based services called DG On-line in 1998 to facilitate the electronic remote entry of work orders and to provide on line tracking of order status by its customers. In 1999, the Company estimates that 30% of its orders were entered electronically via the Internet, versus approximately 11% during 1998. In addition, the Company also offers its "iAudio" Internet audio collection system service which allows audio content to be received from clients via the Internet. Sales. The Company employs a direct sales force that calls on various departments at advertising agencies to communicate the capabilities and comparative advantages of the Company's electronic distribution system and related products and services. In addition, the Company's sales force calls on corporate advertisers who are in a position to either direct or influence agencies in directing deliveries to the Company. A separate staff sells to and services audio and video dealers, who resale the Company's distribution services. Lastly, an insider sales staff represents the Company's services to 6 radio stations. The Company currently has field sales offices in New York, Los Angeles and Chicago, as well as sales personnel in its San Francisco headquarters. The Company's sales force includes field sales, inside sales, and telemarketing. Marketing. The Company's marketing programs are directed toward demand stimulation with an emphasis on popularizing the benefits of digital delivery, including fast turnaround (same day services), increased flexibility, higher quality, problem recovery, and greater reliability and accountability. These marketing programs include direct mail and telemarketing campaigns, newsletters, collateral material (including brochures, data sheets, etc.), application stories, and corporate briefings in major U.S. cities. The Company also engages in public relations activities including trade show participation, the stimulation of articles in the trade and business press, press tours and advertising in advertising and broadcast oriented trade publications. The Company also markets to broadcast stations to arrange for the placement of its RPTs and DVPSs for the receipt only of audio and video advertisements, or Client Workstations, which provide the ability to both receive and to originate distribution of audio to other radio stations. There is currently no charge for a station to receive an advertisement. For radio stations or groups that subscribe to network distribution services utilizing the Client Workstation, the station signs a month-to-month, one-year, or two-year term of service. The Company believes that in combination with its acquisition of the assets of DCI, its combined network provides digital distribution coverage for more than 90% of commercial radio stations and distribution traffic in the United States and Canada. The Company is focusing on the most significant 750 television stations as rated by A.C. Nielsen, along with the major cable interconnects and cable and broadcast networks. Customer Service. The Company's approach to customer service is based on a distributed model designed to provide focused support from key market centered offices, located in Los Angeles, San Francisco, Chicago and New York. Clients work with specific, assigned account coordinators to place production service and distribution orders. National distribution orders are electronically routed to the San Francisco NOC for electronic distribution or, for offline destinations, to the Company's national duplication center in Louisville, Kentucky. The Company's distributed service approach provides direct support in the key market cities enabling the Company to develop closer relationships with clients as well as the ability to support client needs for local production services. The Company also maintains a customer service team dedicated to supporting the needs of radio, television, and network stations. This support is available 7 days a week, 24 hours a day, to respond to station requests for information, traffic instructions or additional media. Providing direct support alleviates the need for client traffic departments to deal with individual stations or the challenges of staffing for off-hours support. The Company's customer service operation centers are linked to the Company's order management and media storage systems, and national distribution network. These resources enable the Company to manage the distribution of client orders to the fulfillment location best suited to meet critical customer requirements as well as providing order status and fulfillment confirmation. This distributed model also provides the Company with significant redundancy and re-route capability, enabling the Company to meet customer needs when weather or other conditions prevent deliveries using traditional courier services. Work orders entered by customers into the CW are shipped automatically through the NOC to their destinations with minimal human intervention. No monitoring is done of the spots, unless the Company is asked to review a spot by a client. These capabilities enable the Company's customers to move to an e-commerce business model as the service is developed more fully. Competition The market for the distribution of advertising and other content to radio and television stations and cable systems is highly competitive. The Company currently competes in the market for the distribution of audio and video advertising spots to broadcast stations, cable systems and networks. The principal competitive factors affecting this market are ease of use, price, timeliness and accuracy of delivery. The Company competes with a variety of dub and ship houses and production studios that have traditionally distributed taped advertising spots via physical delivery. As local distributors, these entities have long-standing ties with advertising agencies that are often difficult for the Company to replace. In addition, these dub and ship houses and production studios 7 often provide an array of ancillary video services, including archival storage and retrieval, closed captioning and format conversions, enabling them to deliver to their advertiser and agency customers a full range of customizable, media postproduction, preparation, distribution and trafficking services. The Company's acquisitions of Mediatech and PDR enable the Company to provide similar services in the three largest domestic advertising markets: New York, Los Angeles and Chicago. The Company plans to continue pursuing potential dub and ship house partners where such partnerships make strategic sense. With the acquisition of DCI, the Company has the only widely deployed electronic system for the delivery of audio advertisements; consequently, it competes largely with physical tape duplication and shipping for audio advertising distribution. In the video marketplace, the Company also competes with dub and ship houses across the country but additionally with a satellite-based real-time video distribution network operated by Vyvx, an operating division of the Williams Communications Group. This network differs from that of the Company in several ways, including limited error checking, lack of digital video as the standard output to the station and lack of a station server to support presentation of video-on-demand to the station. The Company has been able to successfully convince a number of customers of the relative benefits of its system. The Company also anticipates that certain common and/or value-added telecommunications carriers may develop and deploy high bandwidth network services targeted at the advertising and broadcast industries, although none has at this point entered the market for spot distribution. To the extent that the Company is successful in entering new markets, such as delivery of other content to radio and television stations or delivery of data concerning the actual airtime and audience ratings of commercials, it expects to face competition from companies in related communications markets and/or package delivery markets which offer products and services with functionality similar to that offered by the Company's products and services. Telecommunications providers such as AT&T, MCI, and Regional Bell Operating Companies could enter the market as competitors with significantly lower telecommunications transportation costs. The Company also could face competition from entities with package delivery expertise such as Federal Express, United Parcel Service, DHL or Airborne if any such companies enter the electronic data delivery market. Radio Networks such as ABC or Westwood One also could become competitors by selling and transmitting advertisements separately from their network content programming. Many of the Company's current and potential competitors in the markets for audio and video distribution have substantially greater financial, technical, marketing and other resources than the Company. The Company expects that an increasingly competitive environment may result in price reductions that could result in reduced unit profit margins and loss of market share, all of which would have a material adverse effect on the Company's business, results of operations and financial condition. Moreover, the markets for the distribution of audio and video content have become increasingly concentrated in recent years as a result of acquisitions, which are likely to permit many of the Company's competitors to devote significantly greater resources to the development and marketing of new services. There can be no assurance that the Company will be able to compete successfully with new or existing competitors or that competitive pressures faced by the Company will not materially and adversely affect its business, operating results and financial condition. See "Management's Discussion and Analysis of Financial Condition and Results of Operations Certain Business Considerations - Competition." The Company believes it has the broadest coverage in broadcast radio and the largest market share. Intellectual Property and Proprietary Rights The Company primarily relies upon a combination of copyright, trademark and trade secret laws and license agreements to establish and protect proprietary rights in its technologies. The source code for the Company's software is protected both as a trade secret and as an unpublished copyrighted work. Despite these precautions, it may be possible for a third party to copy or otherwise obtain and use the Company's hardware, software or technology without authorization or to develop similar technology independently. In addition, effective copyright and trade secret protection may be unavailable or limited in certain foreign countries. Because the Company's business is characterized by rapid technological change, the Company believes that factors such as the technological and creative skills of its personnel, new computer hardware, software and telecommunications 8 developments, frequent hardware and software enhancements, name recognition, and reliable customer service and support are more important to establishing and maintaining a leadership position than the various legal protections of its technology. The Company believes that its software, trademarks and other proprietary rights do not infringe the proprietary rights of third parties. There can be no assurance, however, that third parties will not assert such infringement by the Company with respect to current or future software, hardware or services. Any such claims, with or without merit, could be time-consuming, result in costly litigation, cause software release delays or might require the Company to enter into royalty or licensing agreements. Such royalty or licensing agreements, if required, may not be available on terms acceptable to the Company. Employees As of December 31, 1999, the Company had a total of 341 employees, including 26 in research and development, 34 in sales and marketing, 239 in operations and manufacturing, and 42 in finance and administration. Of these employees, 315 were located in the United States and 26 were located in Canada. None of the Company's employees are represented by a collective bargaining agreement, and the Company has not experienced a work stoppage. The Company considers its relations with its employees to be good. The Company's business and prospects depend in significant part upon the continued service of its key management, sales and marketing and administrative personnel. The Company does not generally have employment agreements with its key personnel. The loss of key management or technical personnel could materially adversely affect the Company's business, operating results and financial condition. The Company believes that its prospects depend in large part upon its ability to attract and retain highly-skilled managerial, sales and marketing and administrative personnel. Competition for such personnel is intense, and there can be no assurance that the Company will be successful in attracting and retaining such personnel. Failure to attract and retain key personnel could have a material adverse effect on the Company's business, operating results and financial condition. See "Management's Discussion and Analysis of Financial Condition and Results of Operations Certain Business Considerations - Dependence on Key Personnel." ITEM 2. PROPERTIES The Company's headquarters are located at leased office space located at 875 Battery Street in San Francisco, California. The Company's lease is for 19,000 square feet and expires in June 2001. In order to sustain uninterrupted network integrity, the Company has an agreement for non-interruptible access to emergency power and the Company has arranged for alternative fiber optic routes to maintain its fiber connection between its computers and its long distance carrier. However, there can be no assurance that a catastrophic earthquake or other natural disaster could not interrupt the company's operations. The Company maintains a lease, set to expire in 2001, for a 5,000 square foot facility which is used for assembly of its field equipment and for offsite storage. In addition, the Company leases approximately 3,000 square feet in Louisville, Kentucky for its dub and ship facility which expires in 2002; approximately 22,000 square feet in New York City which is occupied by DG East (formerly PDR) and expires in 2006; approximately 13,000 square feet in Los Angeles occupied by DG West (formerly Mediatech) which expires in 2006; 25,000 square feet in Chicago, which is occupied by DG Central (formerly Mediatech) on a month to month rental agreement, pending finalization of a long-term lease; 9,000 square feet occupied by DG North (formerly DCI) in Burnaby, British Columbia (Vancouver, Canada) on a month to month rental agreement; and 10,000 square feet in Dallas which expires in August 2001. The Company believes that these facilities and offices are adequate to meet its requirements for the foreseeable future. ITEM 3. LEGAL PROCEEDINGS The Company is subject, from time to time, to various legal proceedings and claims, either asserted or unasserted, which arise in the ordinary course of business. While the outcome of these claims cannot be predicted with certainty, management does not believe that the outcome of any of these legal matters asserted to date will have a material effect on the Company's consolidated financial condition or results of operations. 9 ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS The Company did not submit any matters to a vote of security holders during the fourth quarter of the fiscal year ended December 31, 1999. ITEM 4A. EXECUTIVE OFFICERS OF THE REGISTRANT The executive officers and directors of the Company and their ages as of December 31, 1999 are as follows:
Name Age Title(s) - ----------------------------------- ------ ------------------------------------------------------- Scott K. Ginsburg (2) 47 Chairman of the Board Matthew E. Devine 51 Chief Executive Officer and Director Omar Choucair 37 Chief Financial Officer Lawrence D. Lenihan, Jr (1) (2) 35 Director Michael G. Linnert (1) 29 Director David M. Kantor (1) (2) 43 Director
(1) Member of the Audit Committee (2) Member of the Compensation Committee Scott K. Ginsburg joined the Company in December 1998 as Chief Executive Officer and Chairman of the Board. In July 1999, Matthew E. Devine assumed the responsibilities of Chief Executive Officer, but Mr. Ginsburg remains the Company's Chairman. He is also the Chairman of Starguide Digital Networks and, most recently, served as Chief Executive Officer and Director of Chancellor Media Corporation (now AMFM Corporation). Mr. Ginsburg founded Evergreen Media Corporation in 1988, and was the co-founder of Statewide Broadcasting, Inc. and H&G Communications, Inc. Mr. Ginsburg earned a B.A. from George Washington University in 1974 and a J.D. from the George Washington University Law Center in 1978. Matthew E. Devine joined the Company in July 1999 as Chief Executive Officer and Director. Prior to joining the Company, Mr. Devine served as Chief Financial Officer of Chancellor Media Corporation (now AMFM Corporation) and served as Chief Financial Officer, Executive Vice President, Treasurer, Secretary and Director for Evergreen Media Corporation. Between 1975 and 1988, Mr. Devine served in various finance positions at AMR Corporation, parent company to American Airlines. Omar A. Choucair joined the Company as Chief Financial Officer in July 1999. Prior to joining the Company, Mr. Choucair served as Vice President of Finance for Chancellor Media (now AMFM Corporation), and served as Vice President of Finance for Evergreen Media before it was acquired by Chancellor Media in 1997. Prior to entering the media industry, Mr. Choucair was a Senior Manager at KPMG LLP, where he specialized in media and telecommunications clients. Mr. Choucair received a B.B.A. from Baylor University and is a Certified Public Accountant. Lawrence D. Lenihan, Jr. has been a member of the Board of Directors of the Company since July 1997. Mr. Lenihan is a Managing Director of Pequot Capital Management, Inc. He joined the predecessor to this firm, Dawson-Samberg Capital Management, in 1996. He is also a Managing Member of the General Partner of Pequot Private Equity Fund II, L.P. Prior to joining Pequot, Mr. Lenihan was a principal at Broadview Associates, LLC, from 1993 to 1996. Prior to joining Broadview, Mr. Lenihan held several positions at IBM, most recently as the leader of an interactive multimedia software product business. Mr. Lenihan graduated from Duke University with a B.S. in Electrical Engineering and he holds an M.B.A. from the Wharton School of Business at the University of Pennsylvania. He currently serves as director of several public and private companies including SkyOnline, Interpacket Group Inc, Performaworks, FlexiGift, Inc., and Mediaplex, Inc. Michael G. Linnert has been a member of the Board of Directors of the Company since July 1999. Mr. Linnert is a General Partner with Technology Crossover Ventures, a venture capital firm, which specializes in emerging Internet and communications companies. He currently serves as a board member of petopia.com. Prior to joining Technology Crossover Ventures, Mr. Linnert was a member of the investment banking division at Goldman, Sachs & Co. Mr. Linnert holds a B.S.E.E. from the University of Notre Dame and an MBA from Stanford Graduate School of Business. 10 David M. Kantor has been a member of the Board of Directors of the Company since August 1999. Mr. Kantor is Senior Vice President for Network Operations of AMFM, Inc. (formerly Chancellor Media Corporation) and manages AMFM Radio Networks. Prior to joining AMFM, he was President of ABC Radio Network, having previously served as Executive Vice President. Prior to joining ABC Radio Network, he held executive positions with Cox Cable and Satellite Music Network. Mr. Kantor holds a B.S. from the University of Massachusetts and an MBA from Harvard Business School. PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED SHAREHOLDER MATTERS The Common Stock of the Company has been traded on the Nasdaq National Market under the symbol DGIT since the Company's initial public offering on February 6, 1996. Prior to that time there was no public market for the Company's Common Stock or other securities. The following table sets forth the high and low closing sales prices of our Common Stock from January 1, 1998 to December 31, 1999. Such prices represent prices between dealers, do no include retail mark-ups, mark-downs or commissions and may not represent actual transactions.
Fiscal Year Ended 1999 Fiscal Year Ended 1998 ------------------------------------ ------------------------------------ High Low High Low ----------------- ----------------- ----------------- ----------------- First Quarter......... $8.13 $3.63 $5.13 $1.56 Second Quarter........ 9.00 4.13 4.38 3.25 Third Quarter......... 6.13 3.38 4.19 2.38 Fourth Quarter........ 7.56 3.25 5.75 2.25
As of December 31, 1999, the Company had issued and outstanding 27,530,170 shares of its Common Stock. As of March 15, 2000, the Company had issued and outstanding 27,942,184 shares of its Common Stock held by 110 shareholders of record. The Company estimates that there are approximately 4,037 beneficial shareholders. In December 1999, the Company's Board of Directors authorized the sale and issuance of Common Stock in a private placement transaction. The Company issued 725,199 common shares to current institutional investors and members of management at a price of $5.17 per share, or an aggregate of $3,750,000. The offers and sales of the Common Stock and warrants to purchase Common Stock were exempt from the registration requirements of the Securities Act of 1933, as amended (the "Act"), pursuant to Section 4(2) thereof. The Company relied on the following criteria to make such exemption available: the number of offerees, the size and manner of the offering, the sophistication of the offerees and the availability of material information. The Company has never declared or paid cash dividends on its capital stock. The Company currently expects to retain its future earnings for use in the operation and expansion of its business and does not anticipate paying any cash dividends in the foreseeable future. See "Management's Discussion and Analysis of Financial Condition and Results of Operations ---Certain Business Considerations Concentration of Stock Ownership", "---Preferential Rights of Outstanding Preferred Stock" and "--- Possible Volatility of Share Price." 11 ITEM 6. SELECTED FINANCIAL DATA Statements of Operations:
Years Ended December 31, ------------------------------------------------------- 1995 1996 1997 1998 1999 --------- --------- ---------- ---------- --------- (in thousands, except per share data) Revenues........................................... $ 5,144 $10,523 $ 29,175 $ 41,270 $48,724 ------- ------- -------- -------- ------- Costs and expenses: Delivery and material costs.................. 1,810 3,084 11,334 14,630 17,857 Customer operations.......................... 2,974 4,164 11,388 14,780 15,138 Sales and marketing.......................... 3,406 3,998 4,417 4,970 4,818 Research and development..................... 1,590 2,092 2,473 2,780 2,577 General and administrative................... 1,380 1,677 3,169 4,314 6,552 Write down of goodwill and fixed assets (1) -- -- -- 17,006 -- Non-recurring charges........................ -- -- -- -- 370 Depreciation and amortization................ 2,345 4,331 9,306 10,266 8,591 ------- ------- -------- -------- ------- Total expenses.......................... 13,505 19,346 42,087 68,746 55,903 ------- ------- -------- -------- ------- Loss from operations............................... (8,361) (8,823) (12,912) (27,476) (7,179) ------- ------- -------- -------- ------- Other income (expense): Interest income and other, net............... 417 1,422 744 253 319 Interest expense............................. (836) (1,726) (2,607) (3,014) (1,903) ------- ------- -------- -------- ------- Net Loss........................................... $(8,780) $(9,127) $(14,775) $(30,237) $(8,763) ======= ======= ======== ======== ======= Basic and diluted net loss per common share (2) $(9.78) $(.87) $(2.52) $(1.97) $(0.33) ======= ======= ======== ======== ======= Weighted average common shares..................... 898 10,488 11,893 16,272 26,653 ======= ======= ======== ======== =======
(1) See Note 3 of Notes to Consolidated Financial Statements (2) See Note 11 of Notes to Consolidated Financial Statements Balance Sheet Data:
December 31, ------------------------------------------------------------------------ 1995 1996 1997 1998 1999 ------------ ----------- --------------- ------------- ------------- (in thousands) Cash, cash equivalents and short-term investments... $ 6,205 $20,597 $ 8,820 $13,025 $ 5,420 Working capital..................................... 4,651 14,200 (879) 7,178 1,236 Property and equipment, net......................... 5,772 12,630 17,566 11,745 8,158 Total assets........................................ 14,459 45,248 60,697 49,792 41,766 Long-term debt, net of current portion.............. 4,540 8,495 11,847 9,307 2,513 Shareholders' equity................................ 6,373 26,839 30,449 23,710 20,553
12 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Overview The Company was incorporated in 1991. Through 1993, the Company was a development-stage company, principally engaged in developing its network, marketing its services to radio stations and advertising agencies, and producing and deploying terminals for use at advertising agencies, production studios and radio stations. In 1994, the Company first generated significant operating revenues from the delivery of audio commercials and the related text traffic instructions to radio stations through a nationwide network established by the Company. The Company has invested heavily in the development of its digital audio network which was nearly complete by the end of 1996. It was at that time that the Company began to promote its digital video technology service revenues from which have grown every year since that time. As the Company's audio and video network coverage has expanded to include an increasing number of radio and television stations, the number of deliveries ordered by customers has increased. At the same time, the number of deliveries performed via electronic delivery has increased relative to the number performed by physical delivery through the Company's dub and ship facility in Louisville, Kentucky. The Company defines a delivery as the transmission, electronic or physical, of a piece or pieces of audio or video content, generally a commercial ("spot") or a set of commercials ("tied spots") to a destination, generally a radio or television station, based on a single order from a customer. Each order usually calls for the delivery of the same spot or spots to multiple destinations, resulting in multiple deliveries. The revenue earned per delivery is dependent upon the type of service ordered, generally defined by the time interval between submission and delivery (Priority, Express, Standard or Economy), the channel from which the order is received (directly from an advertiser or advertising agency or through a dub and ship house), and the quantity of audio or video being delivered (a single spot or multiple tied spots). DG Systems derives revenue from advertising agencies, as well as production studios and dub and ship houses that consolidate and forward deliveries for their agency customers. Because the revenue earned for the delivery of the first spot is significantly greater than the revenue earned for a tied spot and because the Company's per spot electronic transmission cost is relatively constant regardless of volume, electronic deliveries that comprise a single spot are generally more profitable than deliveries which include tied spots. The Company recognizes revenue for each order on the date the content is received by the customer. The Company assembles, owns and maintains Receive Playback Terminals ("RPTs"), which are located in radio stations; Record Send Terminals ("RSTs"), which are located in advertising agencies and production studios; Client Workstations ("CWs") which are located in both radio stations and dealer locations; Video Record Transmission Systems ("VRTSs"), which are located primarily in production studios; and Digital Video Playback Systems ("DVPSs"), which are located in television stations. The capital required to build the network has been obtained through various stock offerings to investors, primarily venture capital firms, leasing agreements, and the Company's initial public offering, which was completed in February 1996. In November 1996, the Company acquired 100% of the capital stock of PDR Productions, Inc. ("PDR"), a New York City based media duplication and distribution company. PDR's primary operations are services typical of the traditional dub and ship house, including the physical duplication and distribution of video content on a wide range of tape formats and performance of a variety of audio and video editing services. The acquisition was accounted for as a purchase and the operating results of PDR have been included in the consolidated results of the Company from the date of the closing of the transaction, November 8, 1996. In July 1997, the Company acquired 100% of the capital stock of Starcom Mediatech, Inc. ("Mediatech"), a wholly owned subsidiary of IndeNet, Inc. ("IndeNet") with operating facilities in Chicago, Los Angeles, New York and Louisville. Mediatech's primary operations, similar to those of PDR, are also services typical of a traditional dub and ship house. Although Mediatech's revenues are generated primarily from the duplication and distribution of short form content, consistent with those of DG Systems prior to this acquisition, Mediatech's revenues also include a significant portion generated from the distribution of long form syndicated programming of both live and previously broadcast television shows. Such services include integrating commercials into syndicated programs and uplinking the completed programs to satellites as well as the physical duplication and distribution of such programs to those stations which do not receive a satellite feed. 13 The acquisition was accounted for as a purchase and the operating results of Mediatech have been included in the consolidated results of the Company from the date of the closing of the transaction, July 18, 1997. In September 1998, the Company acquired the assets of Digital Courier International, Inc. ("DCI"), which has provided the Company with a Canadian network for the delivery of radio advertisements, and two-way sending capability in the US and Canadian market. In late 1998, the Company commenced plans to integrate the acquired DCI assets with the Company's network with the expectation of higher operating efficiencies. The acquisition was accounted for as a purchase and the operating results and balance sheet of DCI have been included in the consolidated results and balances of the Company from the date of the closing of the transaction, September 25, 1998. The Company acquired PDR, Mediatech and DCI with the expectation that the acquisitions would result in enhanced efficiencies for the combined company, including those resulting from the capability of providing digital delivery to new customers and the capability of providing ancillary services to new and existing customers in the markets served by PDR, Mediatech and DCI. See "Management's Discussion and Analysis of Financial Condition and Results of Operations ---Certain Business Considerations --- Uncertainties Relating to Integration of Operations" and "--Dependence on Video Advertising Service Deployment." Results of Operations Revenues Revenues increased from $29,175,000 to $41,270,000 to $48,724,000 for the years ended December 31, 1997, 1998 and 1999, respectively. Revenues increased in 1998 primarily due to the acquisitions of Mediatech in 1997 and DCI in 1998. In addition, the increase is due to certain other factors, including increased volume resulting from greater acceptance of the services offered by the Company and increased availability of an expanded network of Company equipment located in radio and television stations, as well as general price increases. The increase from 1998 to 1999 is due in part to including the results of operations of DCI for an entire year, as well as continued volume and price increases. Delivery and Material Costs Delivery and material costs were $11,334,000, $14,630,000 and $17,857,000 in 1997, 1998 and 1999, respectively. The increase in costs in each period versus the same period of the prior year is primarily due to the increased delivery volume, as well as the acquisition of DCI and Mediatech. These costs include fees paid to other service providers for charges incurred by the Company for the receipt, transmission and delivery of information via the Company's distribution Networking Operating Center ("NOC"), costs for video and audio tapes, packaging and shipping costs required when physically duplicating and distributing a video or audio spot, and direct material and fees paid to other service providers in connection with postproduction services and other services offered by the Company. Delivery and material costs as a percentage of revenues decreased from 39% in 1997 to 35% in 1998 and increased to 37% in 1999. The decrease from 1997 to 1998 is due principally to the improvements in electronic costs of delivery for audio and video distribution as volumes have increased. In 1999, the increase in delivery and materials costs as a percentage or revenues over 1998 is due primarily to increased volumes. The Company expects that delivery costs will increase in absolute dollars and may fluctuate as a percentage of revenues in future periods, influenced principally by volumes, average sales price and scale economies as video deliveries increase in volume. See "Management's Discussion and Analysis of Financial Condition and Results of Operations ---Certain Business Considerations - ---Uncertainties Relating to Integration of Operations," "---Ability to Manage Growth," "---Dependence on Certain Suppliers" and "---Potential Fluctuations in Quarterly Results; Seasonality." 14 Customer Operations Customer operations expenses were $11,388,000, $14,780,000 and 15,138,000 in 1997, 1998 and 1999, respectively. The increase in 1998 versus 1997 is due primarily to increased costs incurred to support the greater volume of deliveries processed through the Company's San Francisco NOC as well as the consolidation of the costs of the former Mediatech and DCI operations. The increase in 1999 versus 1998 is the result of including a full year of costs in 1999 of the former DCI operations and the addition of the personnel necessary to respond to the greater volume of orders and deliveries. Customer operations expenses as a percentage of revenues has decreased from 39% to 36% to 31% in 1997, 1998 and 1999, respectively. These decreases are primarily due to process improvements in orders processed through the Company's NOC, which serves as the primary support for the digital network. The Company continually attempts to improve process flows in an effort to gain scale efficiencies. The Company expects that customer operations expenses will increase in absolute dollars and may fluctuate as a percentage of revenues in future periods. Moreover, the Company believes that in order to compete effectively and manage future growth, the Company will be required to continue to implement changes that improve and increase the efficiency of its customer operations. See "Management's Discussion and Analysis of Financial Condition and Results of Operations ---Certain Business Considerations -- Ability to Maintain and Improve Service Quality" and "-- Ability to Manage Growth." Sales and Marketing Sales and marketing expenses were $4,417,000, $4,970,000 and $4,818,000 in 1997, 1998 and 1999, respectively. The increase in 1998 versus 1997 is due primarily to growth in marketing program costs to increase customer awareness of the Company's services. In addition, sales and marketing expenses increased due to the acquisition of DCI. The decrease in 1999 versus 1998 is due primarily to the consolidation of the Company's sales and marketing efforts among all of its locations. Sales and marketing costs as a percentage of revenue has decreased from 15% to 12% to 10% of revenues for 1997, 1998 and 1999, respectively, due to greater economies of scale. The Company expects to continue to expand sales and marketing programs designed to introduce the Company's existing and future services to the marketplace and to attract new customers for its services. The Company expects that sales and marketing expenses will increase in absolute dollars in future periods and may fluctuate as a percentage of revenue in future periods. See "Management's Discussion and Analysis of Financial Condition and Results of Operations ---Certain Business Considerations -- Dependence on Emerging Markets." Research and Development Research and development expenses were $2,473,000, $2,780,000 and $2,577,000 in 1997, 1998 and 1999, respectively. The increase in 1998 versus 1997 is primarily due to the hiring of additional engineers to develop and enhance the Company's digital services. Research and development expenses in 1998 also increased due to the additional research and development expenses incurred as a result of its acquisition of DCI. The decrease in expenses in 1999 versus 1998 is due primarily to the capitalization of certain salaries and benefits related to internally generated software and the consolidation of the Company's research and development efforts amount all of its locations. As a percent of revenues, research and development expenses have decreased from 8% in 1997 to 7% in 1998 to 5% in 1999. The Company expects that increased research and development expenses will be necessary to remain competitive and that its future success will depend in part upon the technological quality of its products and processes relative to those of its competitors and its ability both to develop new and enhanced products and services. The Company's research and development expenses may increase substantially in absolute dollars and may fluctuate as a percentage of revenues in future periods. General and Administrative General and administrative expenses consist primarily of personnel, consulting fees, and related overhead costs for finance and general management of the Company. General and administrative expenses were $3,169,000, $4,314,000 and 15 $6,552,000 in 1997, 1998 and 1999, respectively. These increases were primarily due to the costs incurred to consolidate and upgrade the Company's order entry, billing and financial reporting systems and the increase in staff as a result of the acquisitions of Mediatech and DCI. As a percent of revenues, general and administrative expenses were 11%, 10% and 13% in 1997, 1998, and 1999, respectively. The Company expects that general and administrative expenses will increase in absolute dollars and may fluctuate as a percentage of revenues in future periods. Depreciation and Amortization Depreciation and amortization expense was $9,306,000 and $10,266,000 and $8,591,000 in 1997, 1998 and 1999, respectively. The increase in expenses in 1998 versus 1997 was due to the continued expansion of the Company's network. The Company acquired the bulk of its assets prior to December 31, 1996; therefore, beginning in fiscal year 1998, there has been a higher percentage of fixed assets which are reaching or have reached the end of their depreciable lives. The decline of depreciation expense in 1999 versus 1998 reflects this fact. The Company's total investment in network equipment has increased from $30.4 million to $33.2 million to $35.3 million at the end of 1997, 1998 and 1999, respectively. Included in depreciation and amortization is amortization expense of $787,000, $1,163,000 and $1,648,000 in 1997, 1998, and 1999, respectively, related to the goodwill and other intangible assets recorded in connection with the acquisitions of PDR Mediatech, and DCI. As discussed in the Notes to the Condensed Consolidated Financial Statements, in September 1998, the Company wrote off the remaining goodwill of its Mediatech subsidiary, approximately $16.7 million, and wrote down Mediatech's fixed assets by an additional $340,000 because it was determined that the carrying values of these assets may not be recoverable. Because of a change in Mediatech's business, it was determined that the value of the investment had permanently declined. The fair value of the Mediatech assets was determined by discounting the related expected future cash flows over the remaining life of the goodwill amortization period of 19 years. The Company expects to continue to invest in the expansion of its network. In particular, the Company is in the process of expanding its infrastructure within the television broadcast industry that will require additional VRTSs and DVPSs to be built and installed in production studios and television stations. The Company expects depreciation and amortization to increase in absolute dollars in proportion to this growth. However, there can be no assurance that the Company will make such investments or that such investments will result in future revenue growth. See "Management's Discussion and Analysis of Financial Position and Results of Operations ---Certain Business Considerations -- Future Capital Needs; Uncertainty of Additional Funding." Interest Income and Interest Expense The Company has derived interest income from the short-term investment of the proceeds received in various stock offerings, including $23.7 million of net proceeds from the private placements of Common Stock in August and December 1998 and $16.4 million of net proceeds from the Series A Convertible Preferred Stock offering in July 1997. Fluctuations in interest income are due to differences in the amounts raised and the timing of each offering as well as the differences in the levels of cash used to fund Company operations and strategic acquisitions and interest rates. The Company expects that interest income will decrease in the future in proportion to the levels of cash used to fund operations and acquisition activity. See "Management's Discussion and Analysis of Financial Position and Results of Operations ---Liquidity and Capital Resources." Interest expense incurred by the Company was $2,607,000, $3,014,000 and $1,903,000 in 1997, 1998 and 1999, respectively. This expense relates primarily to lease agreements used to fund the acquisition of components and equipment needed to develop the network and to provide Company personnel with the capital resources necessary to support the Company's business growth. Total long-term debt outstanding was $19,407,000, $17,533,000 and $10,202,000 at December 31, 1997, 1998 and 1999, respectively. The Company expects that interest expense will fluctuate in the future based on the levels of borrowing. See "Management's Discussion and Analysis of Financial Position and Results of Operations ---Liquidity and Capital Resources." Liquidity and Capital Resources The Company used cash in operating activities of $6.3 million and $4.8 million in 1997 and 1998, respectively, and generated cash from operating activities of $0.2 million in 1999. Cash flows from operating activities improved during 1999 16 as compared to 1998 primarily because revenue increased by 18% and operating expenses increased by only 8%. Cash flows from operating activities improved during 1998 as compared to 1997 primarily due to a 42% increase in revenue in 1998 as compared to 1997, while operating expense (net of the impairment of goodwill and operating assets of its subsidiary), increased by only 23% during 1998 over 1997. Additionally, the Company's accounts receivable balance, net of reserves, increased 24% from 1997; however, revenues increased 42% in 1998 over 1997, reflecting an improvement in cash collections in 1998 over the prior year. The Company's earnings before interest, taxes, depreciation and amortization has improved from a loss of $3.6 million in 1997, to a loss of $204,000 in 1998, to a gain of $1.4 million in 1999. The Company used $5.1 million, $2.2 million and $2.7 million of cash in 1997, 1998 and 1999, respectively, to purchase property and equipment. In addition, $0.4 million, $1.7 million and $2.0 million of property and equipment has been acquired through term lease or credit agreements in 1997, 1998 and 1999, respectively. The capital additions for each of the three years were a result of the Company's continued expansion of its network. In particular, capital additions in 1997 and 1998 were primarily in support its video delivery service plan. The Company completed its initial public offering in February 1996. The net proceeds to the Company in 1996 after underwriting discounts and offering expenses were $29.5 million. The Company raised $16.4 million, net of offering expenses, through its Series A Convertible Preferred Stock offering in 1997. The proceeds from these two offerings have been used in the acquisitions of PDR in November 1996 and Mediatech in July 1997, as well as to fund the acquisition of property and equipment, the payment of lease obligations and to fund the continuing operations of the Company. Approximately $20.5 million has been invested in the purchases of PDR and Mediatech and an additional $2.5 million was used to repay the promissory note payable in November 1997 as a result of the PDR acquisition. In connection with the July 1997 acquisition of Mediatech, the Company also issued 324,355 shares of the Company's Common Stock, $3.8 million of promissory notes, and assumed $5.4 million of term and line of credit debt payable by Mediatech. In August 1998, the Company raised approximately $12.7 million from a private placement of 4.6 million shares of Common Stock and in December 1998 raised approximately $11.0 million from a private placement of 3.8 million shares of Common Stock. The proceeds from these two offerings were used to fund the purchase of DCI in September 1998, as well as to fund the purchase of property and equipment, payment of lease obligations and to fund the continuing operations of the Company. In December 1999, the Company raised an additional $3.8 million from a private placement of 725,199 shares of Common Stock. See the Notes to the Financial Statements. The Company, through its Mediatech subsidiary, made net payments on the Mediatech line of credit of $1,402,000 in 1998. As mentioned above, the maximum available under the Mediatech line is $3,525,000, dependent upon the level of qualifying receivables maintained by Mediatech. There was no balance outstanding under this agreement at December 31, 1999, and the outstanding balance was $1,433,000 at December 31, 1998, which was approximately equal to the maximum amount available under the agreement at that time. The company repaid the outstanding balance of $476,603 on January 17, 2000. Principal payments on long-term debt were $8.0 million, $7.1 million and $9.3 million in 1997, 1998 and 1999, respectively, reflecting the increases in regularly scheduled payments of the increased capital lease liability incurred to finance equipment and property acquisitions. Principal payments in 1997 also included the following scheduled payments: repayment of a $2.5 million promissory note issued in connection with the PDR acquisition, $500,000 of payments on the promissory notes issued in connection with the Mediatech acquisition and $346,000 of payments on other long-term debt of Mediatech assumed by the Company in conjunction with the Mediatech acquisition. The Company currently has no significant capital commitments other than the commitments under capital leases and the debt assumed and notes payable issued in conjunction with the purchase of Mediatech. Based on management's current plans and forecasts, the Company believes that its existing sources of liquidity will satisfy the Company's projected working capital, capital lease and term loan commitments and other cash requirements through the fourth quarter of 2000. See "Certain Business Considerations -- Future Capital Needs; Uncertainty of Additional Funding." Certain Business Considerations The Company's business is subject to the following risks in addition to those described elsewhere in this Report. 17 History of Losses; Future Operating Results Uncertain. DG Systems was founded in 1991 and has incurred net losses since its inception. As of December 31, 1999, the accumulated deficit was $98.8 million. Although the Company has recently experienced growth, a significant portion of such growth is due to acquisitions. In addition, such growth rates may not be sustainable and such growth rates should not be used as an indication of future sales growth, if any, or as an indication of future operating results. The Company's future success also depends in part on continued reductions in delivery and service costs, particularly its ability to continue to automate order processing and to reduce telecommunications costs. High fixed costs of the Company's satellite delivery system and high depreciation expense related to its network equipment contribute heavily to its losses. As a result of the foregoing factors, there can be no assurance that the Company's sales will grow or that the Company's sales will be sustained in future periods. In addition, there can be no assurance that the Company will be able to reduce delivery and service costs, or that it will achieve or sustain profitability in any future period. Dependence on Electronic Video Advertising Delivery Service Deployment. The Company has made a substantial investment in upgrading and expanding its NOC in San Francisco, and in populating television stations with the units necessary for the receipt of electronically delivered video advertising content. However, the Company cannot assure that the placement of these units will cause this service to achieve adequate market acceptance among customers that require video advertising content delivery. The Company's inability to place units in an adequate number of stations or its inability to capture market share among content delivery customers which may be the result of price competition, new product introductions from competitors or otherwise, would seriously harm the Company's business, operating results and financial position. In addition, the Company believes that in order to more fully address the needs of potential video delivery customers it will need to continue to enhance ancillary services that typically are provided by dub and ship houses. These ancillary services include physical archiving, closed captioning, modification of slates and format conversions. Such services will need to be provided on a localized basis in each of the major cities in which the Company provide services directly to agencies and advertisers. The Company currently has the capability to provide such services through its facilities in New York, Los Angeles and Chicago. However, it cannot assure that it will be able to successfully contract for and provide these services in each or any major metropolitan area or that it will be able to provide competitive video distribution services in other U.S. markets. Also, although the Company is taking the steps required to achieve the network capacity and scalability necessary to deliver video content reliably and cost effectively as video advertising delivery volume grows, the Company cannot assure that it will achieve such goals and its failure to do so may seriously harm its business, operating results and financial position. In addition, the Company may be unable to retain current audio delivery customers or attract future audio delivery customers who may ultimately demand delivery of both media content unless it can successfully continue to develop and provide video transmission services. The failure to retain such customers could seriously harm its results of operations and financial condition. Ability to Maintain and Improve Service Quality. The Company's business is dependent on its ability to make cost-effective deliveries to broadcast stations within the time periods requested by customers. Any failure to do so, whether or not within our control, could result in an advertisement not being run and in the station losing air-time which it could have otherwise sold. Although the Company disclaims any liability for lost air-time, claims by stations for lost air-time may nevertheless be asserted in these circumstances and dissatisfied advertisers may refuse to make further deliveries through DG Systems in the event of a significant occurrence of lost deliveries, which would seriously harm its business, financial condition and results of operations. Although the Company maintains insurance against business interruption, such insurance may not be adequate to protect it from significant loss in these circumstances or from the effects of a major catastrophe (such as an earthquake or other natural disaster) which could result in a prolonged interruption of its business. In particular, its NOC is located in the San Francisco Bay area, which has in the past, and may in the future experience significant, destructive seismic activity that could damage or destroy the NOC. In addition, the Company's ability to make deliveries to stations within the time periods requested by customers depends on a number of factors, some of which are outside of its control, including: . Equipment failure; . Interruption in services by telecommunications and satellite service providers; and 18 . The inability to maintain our installed base of RSTs, RPTs, CWs, VRTSs and DVPS units that comprise its distribution network. Failure to make timely deliveries for whatever reason could result in dissatisfied advertisers refusing to make further deliveries through DG Systems which would seriously harm its business, financial condition and results of operations. Dependence on Technological Developments. The market for the distribution of digital audio and video transmissions is characterized by rapidly changing technology. The Company's success will depend, in part, on the technological quality of its products and processes relative to those of its competitors and its ability to develop and introduce new and enhanced products and services at competitive prices and in a timely and cost-effective fashion. Its development efforts have been focused on: . Satellite transmission technology; . Video compression technology; . TV station systems interfaces, . Reliability and throughput enhancements to the network; and . Increasing its percentage of on-line deliveries. The growth of its electronic video delivery services also depends on its ability to obtain reliable and cost-effective satellite delivery capability. Development efforts in satellite transmission technology are oriented to development and deployment of software to lower transmission costs and increase delivery reliability. Development efforts in video compression technology are directed toward integration of emerging broadcast quality compression systems within its existing network, thereby continuing to improve picture quality while maintaining compliance with industry standards. TV station system interface implementation includes various system control protocols and improvements of the system throughput and reliability. The Company has an agreement with Hughes Network Systems, Inc. ("Hughes") which gives us access to Hughes' satellite capacity for electronic delivery of digital audio and video transmissions by that media. The Company has developed and incorporated the software designed to enable the current DVPSs to receive digital satellite transmissions over the Hughes satellite system. However, the Hughes satellite system may not have the capacity to meet its future delivery commitments and broadcast quality requirements on a cost-effective basis, if at all. See "Dependence on Certain Suppliers." The introduction of new products can render existing products obsolete or unmarketable. The Company may not be successful in identifying, developing, contracting for the manufacture of, and marketing product enhancements or new products that respond to technological change. In addition, the Company may experience difficulties that could delay or prevent the successful development, introduction and marketing of any new products or product enhancements, and these products may not adequately meet the requirements of the marketplace and achieve market acceptance. Delays in the introduction of new products and services or enhancements to existing products and services may result in customer dissatisfaction and delay or loss of revenue. The inability to develop and introduce new products and services or enhancements of existing products and services in a timely manner or with a significant degree of market acceptance could seriously harm its business, financial condition and results of operations. Ability to Manage Growth. The Company has experienced growth that has resulted in new and increased responsibilities for management personnel and that has placed and continues to place a significant strain on its operating, management and financial systems and resources. To accommodate this recent growth and to compete effectively and manage future growth, it must continue to implement and improve its operational, financial and management information systems, procedures and controls on a timely basis and to expand, train, motivate and manage its work force. Future Capital Needs; Uncertainty of Additional Funding. The Company intends to continue making capital expenditures to produce and install RSTs, RPTs, CWs, VRTSs, and DVPS units and to introduce additional services. In addition, it continually analyzes the costs and benefits of acquiring certain businesses, products or technologies that it may 19 from time to time identify, and its related ability to finance such acquisitions. The Company anticipates that its existing capital and cash from operations should be adequate to satisfy its capital requirements during 2000. However, the Company cannot assure that it will not require additional capital sooner than currently anticipated or that any such additional funds will be adequate to fund its capital needs, which capital needs depend upon numerous factors, including: . The progress of its product development activities; . The cost of increasing its sales and marketing activities; and . The amount of revenues generated from operations. None of the foregoing factors can be predicted with certainty. In addition, the Company is unable to predict the precise amount of future capital that it will require, particularly if it pursues more acquisitions. Furthermore, it can not assure that either additional financing will be available to it, or if it is available, that such additional financing will be available on acceptable terms. The Company's inability to obtain financing could seriously harm its prospects and future rates of growth. Its inability to obtain additional funding for continuing operations or an acquisition would seriously harm its business, financial condition and results of operations. Consequently, it could be required: . To significantly reduce or suspend its operations; . To seek a merger partner; or . To sell additional securities on terms that are highly dilutive to its existing investors. Dependence on Emerging Markets. The market for the electronic delivery of digital audio and video transmissions by advertisers, advertising agencies, production studios, and video and music distributors to radio and television stations, is relatively new, and alternative technologies are rapidly evolving. The Company's marketing task requires it to overcome buyer inertia related to the diffuse and relatively low level decision making regarding an agency's choice of delivery services and long standing relationships with existing dub and ship vendors. Therefore, it is difficult to predict the rate at which the market for the electronic delivery of digital audio and video transmissions will grow, if such market grows at all. If the market fails to grow, or grows more slowly than anticipated, our business, operating results and financial condition would be seriously harmed. Even if the market does grow, it cannot assure that its products and services will achieve commercial success. Although the Company intends to conform its products and services to meet existing and emerging standards in the market for the electronic delivery of digital audio and video transmissions, it cannot assure that it will be able to conform its products to such standards in a timely fashion, or that it will be able to conform its products to such standards at all. The Company believes that its future growth will depend, in part, on its ability to add these services and additional customers in a timely and cost-effective manner. However, it cannot assure that it will be successful in developing such services, or in obtaining new customers for such services. See "Dependence on New Product Introductions." Furthermore, it cannot assure that it will be successful in obtaining a sufficient number of radio and television stations, radio and television networks, advertisers, advertising agencies, production studios, and audio and video distributors who are willing to bear the costs of expanding and increasing the integration of its network, including its field receiving equipment and rooftop satellite antennae. The Company's marketing efforts to date with regard to its products and services have involved identification and characterization of specific market segments for these products and services with a view to determining the target markets that will be the most receptive to such products and services. The Company cannot assure that it has correctly identified such markets or that its planned products and services will address the needs of such markets. Furthermore, it cannot assure that its technologies, in their current form, will be suitable for specific applications or that further design modifications, beyond anticipated changes to accommodate different markets, will not be necessary. Broad commercialization of its products and services will require it to overcome significant market development hurdles, many of which may not currently be foreseen. Dependence on Radio Advertising. Prior to its acquisitions of PDR and Mediatech, its revenues were derived principally from a single line of business, the delivery of radio advertising spots from advertising agencies, production studios and dub and ship houses to radio stations in the United States. The Company expects the delivery of such services to continue to account for a significant portion of its revenues for some time. A decline in demand for, or average selling prices of, its radio 20 advertising delivery services for any of the following reasons, or otherwise, would seriously harm its business, financial condition and results of operations: . Competition from new advertising media; . New product introductions or price competition from competitors; . A shift in purchases by customers away from its premium services, such as DG Priority or Rush and DG Express or Same Day; and . A change in the technology used to deliver such services. Additionally, the Company is dependent on its relationship with the radio stations in which it has installed communications equipment. Should a substantial number of these stations go out of business, experience a change in ownership, or discontinue the use of its equipment in any way, it could seriously harm its business, financial condition and results of operations. Competition. The Company currently competes in the market for the distribution of audio advertising spots to radio stations and the distribution of video advertising spots to television stations. The principal competitive factors affecting these markets are ease of use, price, timeliness and accuracy of delivery. The Company competes with a variety of dub and ship houses and production studios that have traditionally distributed taped advertising spots via physical delivery. Although such dub and ship houses and production studios do not currently offer electronic delivery, they have long-standing ties to local distributors that will be difficult for us to replace. Some of these dub and ship houses and production studios have greater financial, distribution and marketing resources and have achieved a higher level of brand recognition than it has. In September 1998, the Company acquired substantially all of the assets of DCI, a supplier of electronic distribution and communications services for the radio broadcast industry in the United States and Canada. This acquisition has resulted in: . Expansion of its customer base; . An increase in the number of radio stations included in its network; and . An improvement in its ability to provide a point to point delivery service between the radio stations and groups. . The Company believes that it offers the only nationwide electronic delivery option for audio spot distribution. In the market for the distribution of video content to television stations, it encounters competition from numerous large and small dub and ship houses and production studios, certain of which currently function as marketing partners with DG Systems in the audio distribution market. To the extent that it is successful in entering new markets, such as the delivery of other forms of content to radio and television stations, the Company would expect to face competition from companies in related communications markets and/or package delivery markets. Some of these companies in related markets could offer products and services with functionality similar or superior to that offered by its products and services. Telecommunications providers such as AT&T, MCI Worldcom and Regional Bell Operating Companies could also enter the market as competitors with materially lower electronic delivery transportation costs. The Company could also face competition from entities with package delivery expertise such as Federal Express, United Parcel Service, DHL and Airborne if any such companies enter the electronic data delivery market. Radio networks such as ABC or Westwood One could also become competitors by selling and transmitting advertisements as a complement to their content programming. Many of its current and potential competitors in the markets for audio and video transmissions have substantially greater financial, technical, marketing and other resources than DG Systems. The Company may not be able to compete successfully against current and future competitors based on these and other factors. It expects that an increasingly competitive environment will result in price reductions that could result in lower profits and loss of market share, all of which would seriously harm its business, financial condition and results of operations. Moreover, the market for the distribution of audio and video transmissions has become increasingly concentrated in recent years as a result of acquisitions, which are likely to 21 permit many of its competitors to devote significantly greater resources to the development and marketing of new competitive products and services. The Company expects that competition will increase substantially as a result of these and other industry consolidations and alliances, as well as the emergence of new competitors. Accordingly, it may not be able to compete successfully with new or existing competitors, and the effects of such competition could seriously harm its business, financial condition and results of operations. Risks Associated with Nasdaq National Market Listing. The holders of the registered Common Stock of DG Systems currently enjoy a substantial benefit in terms of liquidity by having such Common Stock listed on the Nasdaq National Market. This benefit would be lost if the Company were to be delisted from the Nasdaq National Market. In the past, the Company has received notice from Nasdaq that it was not in compliance with the requirements for continued listing. The Company believes it is currently in compliance with Nasdaq's continued listing requirements and corporate governance rules. However, it cannot assure that Nasdaq will make such a finding or that it will be able to continue to have its Common Stock listed on the Nasdaq National Market or similar public securities exchange. Year 2000 Impact. We have not experienced any problems with our computer systems relating to such systems being unable to recognize appropriate dates related to the year 2000. We are also not aware of any material problems with our customers or suppliers. Accordingly, we do not anticipate incurring material expenses or experiencing any material operational disruption as a result of any year 2000 issues. Fluctuations in Quarterly Results; Seasonality . The Company's quarterly operating results have in the past and may in the future vary significantly depending on factors such as: . Volume of advertising in response to seasonal buying patterns; . Timing of introductions of new products and services; . Increased competition; . Timing of its promotional efforts; and . General economic factors. For example, the Company has historically experienced lower sales in the first quarter and higher sales in the fourth quarter due to increased customer advertising volumes for the Christmas selling season. As a result, it believes that period to period comparisons of its results of operations are not necessarily meaningful and should not be relied upon as an indication of its future performance. In any single period, its revenues and delivery costs are subject to variation based on changes in the volume and mix of deliveries performed during such period. In particular, its operating results have historically been significantly influenced by the volume of deliveries ordered by television stations during the "Sweeps" rating periods that currently take place in February, May, August and November. The increased volume of these deliveries during such periods and its relatively higher prices for "Sweeps" advertisements have historically increased the total revenues and revenues per delivery and tended to reduce relative delivery costs. The Company's expense levels are based, in part, on its expectations of future sales levels. If sales levels are below expectations, operating results are likely to be seriously harmed. In addition, the Company has historically operated with little or no backlog. The absence of backlog increases the difficulty of predicting sales and operating results. Fluctuations in sales due to seasonality may become more pronounced as its sales growth rate slows. Due to the unique nature of its products and services, it believes that it will incur significant expenses for sales and marketing, including advertising, to educate potential customers about such products and services. Dependence on Key Personnel. The Company's success depends to a significant degree upon the continuing contributions of, and on its ability to attract and retain, qualified management, sales, operations, marketing and technical personnel. The Company has employment agreements with certain of its key executives. In general, the agreements provide for base salaries, bonuses, option grants based on certain performance criteria, and terminations payments. It does not maintain key man life insurance on the lives of any of its key personnel. The competition for qualified personnel, particularly engineering staff, is intense, and it is possible that it may not be able to continue to attract and retain qualified management, 22 sales and technical personnel for the development of its business. If the Company is unable to attract, hire and retain qualified personnel in the future, the success of its business could be impaired, and this could seriously harm its business, operating results and financial condition. Dependence on Certain Suppliers. The Company relies on certain single or limited-source suppliers for integral components used for the assembly of its audio and video units. Although these suppliers are generally large, well- financed organizations, in the event that a supplier were to experience financial or operational difficulties that resulted in a reduction or interruption in component supply to DG Systems, it would delay its deployment of audio and video units. This would have the effect of depressing its business until it was able to establish sufficient component supply through an alternative source. The Company believes that there are currently alternative component manufacturers that could supply the components required to produce its products, but it is not currently pursuing agreements or understandings with such alternative sources. If a reduction or interruption of supply were to occur, it could take a significant period of time for the Company to qualify an alternative subcontractor, redesign its products as necessary and contract for the manufacture of such products. The Company does not have long-term supply contracts with its sole- or limited-source vendors, and it purchases its components on a purchase order basis. The Company has experienced component shortages in the past, and material component shortages or production or delivery delays may occur in the future. The inability to continue to obtain sufficient quantities of components in a timely manner, as required, or to develop alternative sources, as required, could result in delays or reductions in product shipments or product redesigns, which would seriously harm its business, financial condition and results of operations. Pursuant to its development efforts in the area of satellite transmission technology, the Company has successfully completed live field trials of software designed to enhance and enable the current RPTs to receive digital satellite transmissions over the Hughes satellite system. The Company's dependence on Hughes' satellite system entails a number of significant risks. Its business, results of operations and financial condition would be seriously harmed if Hughes were unable for any reason to continue to meet its delivery commitments on a cost-effective basis or if any transmissions failed to satisfy its quality requirements. In the event that the Company was unable to continue to use Hughes' satellite capacity, it would have to identify, qualify and transition deliveries to an acceptable alternative satellite transmission vendor. Such an alternative satellite transmission vendor may not be available in a position to satisfy its delivery requirements on a timely and cost-effective basis, if at all. In the event that such an alternative satellite transmission vendor were available, the identification, qualification and transition process could take up to nine months or longer. The Company obtains its local access telephone transmission services through Teleport Communications Group. It obtains its long distance telephone access through an exclusive contract with MCI Worldcom, which expires in 2001. Any material interruption in the supply or a material adverse change in the price of either local access or long distance carrier service could seriously harm its business, results of operations and financial condition. Dependence on New Product Introductions. The Company's future growth depends on the successful and timely introduction of new products and services in markets that do not currently exist or are just emerging. Its goal is to introduce new services, such as media archiving and the ability to quickly and reliably give an agency the ability to preview and authorize electronic delivery of video advertising spots. The Company may not be able to successfully complete development of such products and services. Even if any such development is completed, it may not be able to introduce these products and services and these products may not realize market acceptance or meet the technical or other requirements of potential customers. The failure to successfully develop and introduce new products and services could seriously harm its business, financial condition and results of operations. Dependence on Proprietary Technology, Protection of Trademarks, Copyrights, and Other Proprietary Information; Risk of Third Party Claims of Infringement. The Company considers its trademarks, copyrights, advertising, and promotion design and artwork to be of value and important to its business. It relies on a combination of trade secret, copyright and trademark laws and nondisclosure and other arrangements to protect its proprietary rights. We do not have any patents or patent applications pending. The Company generally enters into confidentiality or license agreements with its employees, distributors and customers, and limit access to and distribution of its software, documentation and other proprietary information. Despite its efforts to protect its proprietary rights, unauthorized parties may attempt to copy or obtain and use information that it regards as proprietary. The steps that it has taken to protect its proprietary information may not prevent misappropriation of such information and such protection may not preclude competitors from developing confusingly similar 23 brand names or promotional materials or developing products and services similar to those of the Company. In addition, the laws of some foreign countries do not protect its proprietary rights to the same extent as do the laws of the United States. While the Company believes that its trademarks, copyrights, advertising and promotion design and artwork do not infringe upon the proprietary rights of third parties, it may receive future communications from third parties asserting that it is infringing, or may be infringing, on the proprietary rights of third parties. Any such claims, with or without merit, could be time-consuming, require the Company to enter into royalty arrangements or result in costly litigation and diversion of management personnel. If such claims are successful, the Company may not be able to obtain any licenses necessary for the operation of its business or, if obtainable, such licenses may not obtainable on commercially reasonable terms. In the event of a successful claim of infringement and its failure or inability to license the infringed or similar proprietary information, its business, financial condition and results of operations could be seriously harmed. Concentration of Stock Ownership; Antitakeover Provisions. The present executive officers and directors of DG Systems and its respective affiliates own approximately 44% of its Common Stock. As a result, these shareholders will be able to control or significantly influence all matters requiring shareholder approval, including the election of directors and the approval of significant corporate transactions. Such concentration of ownership may have the effect of delaying or preventing a change in control of DG Systems. Furthermore, certain provisions of its Amended and Restated Articles of Incorporation and Bylaws, and of California law, could have the effect of delaying, deferring or preventing a change in control of DG Systems. Registration Rights. In connection with the August and December 1998 and December 1999 private placements of shares of its Common Stock, as further described in "Market for Registrant's Common Stock and Related Shareholder Matters," the Company agreed to prepare and file a Registration Statement on Form S-3 (the "Registration Statement"), with the Securities and Exchange Commission for the purposes of registering the resale of such shares and to list such shares on the Nasdaq National Market. Certain other holders of its Common Stock, including former holders of its Series A Convertible Preferred Stock, previously have been granted demand and piggy-back registration rights, such that such holders were entitled to include their shares in this registration process and any such subsequent registration process. The Registration Statement, effective as of February 12, 1999, registered 15,214,220 shares of its Common Stock. The Company has agreed to use commercially reasonable efforts to keep the Registration Statement effective until the earlier of the date upon which all such shares of Common Stock may be sold by the holders thereof without registration in a single transaction pursuant to Rule 144(k) under the Securities Act of 1933 or until all such shares have been sold. In addition, in connection with the December 9, 1998 issuance of warrants to purchase its Common Stock, as further described in "Market for Registrant's Common Stock and Related Shareholder Matters," the Company granted the holders of such warrants demand registration rights with respect to the shares of Common Stock issuable upon exercise of such warrants. Following the completion of such registration on Form S-3, the additional 15,214,220,shares of DG Systems' Common Stock registered thereunder became freely tradable in the public market, subject to volume limitations applicable to affiliates of DG Systems. Sales of a substantial number of additional shares in the public market could seriously harm the market price of DG System's Common Stock and could impair its future ability to raise capital through the sale of its equity securities. Expansion into International Markets. Although the Company's long-term plans include expansion of its operations to Europe and Asia, it does not at present have network operating center personnel experienced in operating in these locations. Telecommunications standards in foreign countries differ from those in the United States and may require us to incur substantial costs and expend significant managerial resources to obtain any necessary regulatory approvals and to comply with differing equipment interface and installation standards promulgated by regulatory authorities of those countries. Changes in government policies, regulations and telecommunications systems in foreign countries could require its products and services to be redesigned, causing product and service delivery delays that could seriously harm its operating results. The Company's ability to successfully enter these new markets will depend, in part, on its ability to attract personnel with experience in these locations and to attract partners with the necessary local business relationships. However, the Company cannot assure that its products and services will achieve market acceptance in foreign countries. Its inability to successfully establish and expand its international operations may also limit its ability to obtain significant international revenues and could seriously harm its business, operating results and financial condition. Furthermore, international business is subject to a number of country-specific risks and circumstances, including . Different tax laws; 24 . Difficulties in expatriating profits; . Currency exchange rate fluctuations; and . The complexities of administering business abroad. Moreover, to the extent the Company increases its international sales, its business, operating results and financial condition could be seriously harmed by these risks and circumstances, as well as by increases in duties, price controls or other restrictions on foreign currencies, and trade barriers imposed by foreign governments, among other factors. Possible Volatility of Share Price. The trading prices of its Common Stock may be subject to wide fluctuations in response to a number of factors, including: . Variations in operating results; . Changes in earnings estimates by securities analysts; . Announcements of extraordinary events such as litigation or acquisitions; . Announcements of technological innovations or new products or services by DG Systems or its competitors; and . General economic, political and market conditions. In addition, stock markets have experienced extreme price and volume trading volatility in recent years. This volatility has had a substantial effect on the market prices of the securities of many high technology companies for reasons frequently unrelated to the operating performance of specific companies. These broad market fluctuations may adversely affect the market price of its Common Stock. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Company has some operations in Canada and, therefore, is subject to the risk that the Canadian dollar/US dollar exchange rates will adversely impact the Company's results of operations. The Company believes this risk to be immaterial to the Company's results of operations. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information required by this Item is set forth in the Company's Consolidated Financial Statements and the Notes thereto beginning at Page F-1 of this report. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Arthur Andersen LLP resigned as the Company's certifying accountant on October 20, 1999. Effective October 27, 1999, the Company appointed KPMG LLP as the Company's certifying accountant. The change of certifying accountant was approved by the Audit Committee of the Board of Directors. Arthur Andersen's reports on the consolidated financial statements of the Company and its subsidiaries as of and for the years ended December 31, 1998 and1997, were unqualified. There were no disagreements between the Company and Arthur Andersen on any matter of accounting principles or practices, financial statement disclosure, or auditing scope or procedure or reportable events during such periods or through the interim period ended October 20, 1999 (the date of the resignation). 25 PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information required by this Item with respect to the Company's directors is incorporated by reference to the information contained in the section captioned "Proposal One -- Election of Directors" in the definitive proxy statement to be filed with the Securities and Exchange Commission by the Company for its 2000 Annual Meeting of Shareholders (the "Proxy Statement"). The Proxy Statement is anticipated to be filed within 120 days after the end of the Company's fiscal year ended December 31, 1999. For information with respect to executive officers of the Company, see Item 4A of this Annual Report on Form 10- K. ITEM 11. EXECUTIVE COMPENSATION The information required by this item is incorporated by reference from the section captioned "Executive Compensation" contained in the Proxy Statement. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by this item is incorporated by reference from the section captioned "Security Ownership of Certain Beneficial Owners and Management" contained in the Proxy Statement. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by this Item is incorporated by reference to the information contained in the sections captioned "Compensation Committee Interlocks and Insider Participation" and "Certain Transactions with Management" contained in the Proxy Statement. 26 PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) 1. FINANCIAL STATEMENTS The following financial statements are filed as part of this Report:
Page ------- Independent Auditors' Report......................................................................... F-2 Report of Independent Public Accountants............................................................. F-3 Consolidated Balance Sheets, as of December 31, 1999 and 1998........................................ F-4 Consolidated Statements of Operations for the three years ended December 31, 1999.................... F-5 Consolidated Statements of Shareholders' Equity for the three years ended December 31, 1999.......... F-6 Consolidated Statements of Cash Flows for the three years ended December 31, 1999.................... F-7 Notes to Consolidated Financial Statements........................................................... F-8
(a) 2. FINANCIAL STATEMENT SCHEDULES II - Valuation and Qualifying Accounts............................................................... S-1
(a) 3. EXHIBITS
Exhibit Number Exhibit Title - ------------------ ------------------ 3.1.1 (d) Restated Articles of Incorporation of registrant. 3.1.2 (h) Certificate of Determination of Rights of Series A Convertible Preferred Stock of Digital Generation Systems, Inc., filed by the Secretary of State of the State of California on July 16, 1997. 3.2 (b) Bylaws of registrant, as amended to date. 4.1 (b) Form of Lock-Up Agreement. 4.2 (b) Form of Common Stock Certificate. 10.1 (b) 1992 Stock Option Plan (as amended) and forms of Incentive Stock Option Agreement and Non-statutory Stock Option Agreement. 10.2 (b) Form of Directors' and Officers' Indemnification Agreement. 10.3 (b) 1995 Director Option Plan and form of Incentive Stock Option Agreement thereto. 10.4 (b) Form of Restricted Stock Agreement. 10.5.1 (c) Content Delivery Agreement between the Company and Hughes Network Systems, Inc., dated November 28, 1995. 10.5.2 (c) Equipment Reseller Agreement between the Company and Hughes Network Systems, Inc., dated November 28, 1995. 10.6 (b) Amendment to Warrant Agreement between the Company and Comdisco, Inc., dated January 31, 1996. 10.7(j) Special Customer Agreement between the Company and MCI Telecommunications Corporation, dated May 5, 1997. 10.8 (b) Master Lease Agreement between the Company and Comdisco, Inc., dated October 20, 1994, and Exhibits thereto. 10.9 (b) Loan and Security Agreement between the Company and Comdisco, Inc., dated October 20, 1994, and Exhibits thereto. 10.10 (b) Master Equipment Lease between the Company and Phoenix Leasing, Inc., dated January 7, 1993. 10.15 (c) Audio Server Network Prototype Vendor Agreement and Satellite Vendor Agreement between the Company and ABC Radio Networks, dated December 15, 1995.
27
Exhibit Number Exhibit Title - ------------------ ------------------ 10.17 (b) Promissory Note between the Company and Henry W. Donaldson, dated March 18, 1994, December 5, 1994, December 5, 1994, and March 14, 1995. 10.18 (b) Warrant Agreement to purchase Series B Preferred Stock between the Company and Comdisco, Inc., dated as of October 20, 1994. 10.19 (b) Warrant Agreement to purchase Series C Preferred Stock between the Company and Comdisco, Inc., dated as of June 13, 1995. 10.20 (b) Warrant Agreement to purchase Series D Preferred Stock between the Company and Comdisco, Inc., dated as of January 11, 1996. 10.22 (d) Agreement of Sublease for 9,434 rentable square feet at 855 Battery Street, San Francisco, California between the Company and T.Y. Lin International dated September 8, 1995 and exhibits thereto. 10.23 (d) Agreement of Sublease for 5,613 rentable square feet at 855 Battery Street, San Francisco, California between the Company and Law/Crandall, Inc. dated September 29, 1995 and exhibits thereto. 10.24 (e) Digital Generation Systems, Inc. Supplemental Stock Option Plan. 10.25 (e) Stock Purchase Agreement by and among Digital Generation Systems, Inc. and PDR Productions, Inc. and Pat DeRosa dated as of October 15, 1996 and exhibits thereto. 10.26 (f) Amendment to Stock Purchase Agreement dated November 8, 1996, among Digital Generation Systems, Inc., and Pat DeRosa. 10.27 (h) Loan Agreement dated as of January 28, 1997 between Digital Generation Systems, Inc. as Borrower, and Venture Lending and Leasing, Inc. as Lender and exhibits thereto. 10.28 (i) Stock Purchase Agreement, dated as of July 18, 1997, by and between Digital Generation Systems, Inc., a California corporation, IndeNet, Inc., a Delaware Corporation, and exhibits thereto. 10.29 (i) Preferred Stock Purchase Agreement, dated as of July 14, 1997, by and among Digital Generation Systems, Inc. and the parties listed on the Schedule of Purchasers attached, as Exhibit A thereto. 10.30 (i) Amendment to Preferred Stock Purchase Agreement, dated as of July 23, 1997, by and among Digital Generation Systems, Inc. and the purchasers listed on the Exhibit A thereto. 10.31 (k) Loan Agreement dated as of December 1, 1997 between Digital Generation Systems, Inc. as Borrower, and Venture Lending and Leasing, Inc. as Lender and exhibits thereto. 10.32 (k) First Amendment to Loan Agreement dated as of January 28, 1997 between Digital Generation Systems, Inc. as Borrower, and Venture Lending and Leasing, Inc. as Lender and exhibits thereto. 10.33 (l) Common Stock Subscription Agreement for private placement of Company's Common Stock at $2.80 per share. 10.34 (m) Sale and Purchase Agreement, dated September 10, 1998, by and between Grant Thornton Limited, in its capacity as Receiver-Manager of Digital Courier International Corporation and Digital Courier International, Inc. and Digital Generation Systems, Inc. and exhibits thereto. 10.35 (n) Series A Preferred Stock Conversion Agreement dated as of August 12, 1998. 10.36 (p) Amendment and Restatement No. 5 of the Registration Rights Agreement, dated July 14, 1997, by and among the Registrant and certain of its securityholders. 10.37 (p) Amended and Restated Registration Rights Agreement, dated December 9, 1998, by and among the Registrant and certain of its securityholders 10.38 (p) Registration Rights Agreement, dated December 9, 1998, by and among the Registrant and certain of its securityholders. 10.39 (q) Common Stock and Warrant Purchase Agreement dated December 9, 1998 by and among the Registrant and investors listed in Schedule A thereto. 10.40 (q) Common Stock Subscription Agreement dated December 9, 1998 by and among the Registrant and Scott Ginsburg. 10.41 (q) Warrant Purchase Agreement dated December 9, 1998 by and among the Registrant and Scott Ginsburg.
28
Exhibit Number Exhibit Title - ------------------ ------------------ 10.42 (q) Warrant No. 1 to Purchase Common Stock dated December 9, 1998 by and among Registrant and Scott K. Ginsburg. 10.43 (q) Warrant No. 2 to Purchase Common Stock dated December 9, 1998 by and among Registrant and Scott K. Ginsburg 10.44 (a) Registration Rights Agreement, dated December 17, 1999, by and among the Registrant and certain of its securityholders. 10.45 (a) Common Stock Purchase Agreement dated December 17, 1999 by and among the Registrant and investors listed in Schedule A thereto. 11.1 (a) Statements of computation of weighted average common shares. 21.1 (a) Subsidiaries of the Registrant. 23.1 (a) Consent of KPMG LLP. 23.2 (a) Consent of Arthur Andersen, LLP. 27 (a) Financial Data Schedule.
__________ (a) Filed herewith. (b) Incorporated by reference to the exhibit bearing the same number filed with registrant's Registration Statement on Form S-1 (Registration No. 33-80203). (c) Incorporated by reference to the exhibit bearing the same number filed with registrant's Registration Statement on Form S-1 (Registration No. 33-80203). The registrant has received confidential treatment with respect to certain portions of this exhibit. Such portions have been omitted from this exhibit and have been filed separately with the Securities and Exchange Commission. (d) Incorporated by reference to the exhibit bearing the same number filed with registrant's Quarterly Report on Form 10-Q filed May 3, 1996, as amended. (e) Incorporated by reference to the exhibit bearing the same number filed with registrant's Quarterly report on Form 10-Q filed November 13, 1996. (f) Incorporated by reference to the exhibit bearing the same title filed with registrant's Current Report on Form 8-K/A filed January 21, 1997. (g) Incorporated by reference to the exhibit bearing the same number filed with registrant's Annual Report on Form 10-K filed March 18, 1997. (h) Incorporated by reference to the exhibit bearing the same number filed with registrant's quarterly report on Form 10-Q filed May 15, 1997. (i) Incorporated by reference to the exhibit bearing the same title filed with registrant's Form 8-K filed August 1, 1997. (j) Incorporated by reference to the exhibit bearing the same title filed with registrant's Quarterly report on Form 10-Q filed August 14, 1997. Confidential treatment has been requested with respect to certain portions of this exhibit pursuant to a request for confidential treatment filed with the Securities and Exchange Commission. Omitted portions have been filed separately with the Commission. (k) Incorporated by reference to the exhibit bearing the same number filed with registrant's Annual Report on Form 10-K filed March 31, 1998. (l) Incorporated by reference to the exhibit bearing the same title filed with registrant's Quarterly report on Form 10-Q filed May 15, 1998. 29 (m) Incorporated by reference to the exhibit bearing the same title filed with registrant's Quarterly report on Form 10-Q filed August 14, 1998. (n) Incorporated by reference to the exhibit bearing the same title filed with registrant's Current Report on Form 8-K filed October 13, 1998. (o) Incorporated by reference to the exhibit bearing the same title filed with registrant's Quarterly report on Form 10-Q filed November 16, 1998. (p) Incorporated by reference to the exhibit bearing the same title filed with registrant's Registration Report on Form S-3 filed on December 31, 1998. (q) Incorporated by reference to the exhibit bearing the same number filed with registrant's Annual Report on Form 10-K filed March 29, 1999. (b) Reports on Form 8-K Current Report on Form 8-K filed on October 27, 1999 regarding the October 20, 1999 resignation of Arthur Andersen, LLP as the Company's Certified Public Accountants and the October 27, 1999 appointment of KPMG LLP as the Company's Certified Public Accountants. Current Report on Form 8-K filed on August 4, 1999 regarding the appointment of Matthew Devine as the Chief Executive Officer and Omar Choucair as Chief Financial Officer; and the appointment of Matthew Devine and Michael Linnert to the Company's Board of Directors. (c) Exhibits See items 14 (a) (3) above. (d) Financial Statement Schedules See Item 14(a) (2) above. 30 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. DIGITAL GENERATION SYSTEMS, INC. Dated: March 28, 2000 By: /S/ MATTHEW E. DEVINE ----------------------- Matthew E. Devine Chief Executive Officer POWER OF ATTORNEY KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below hereby constitutes and appoints Scott K. Ginsburg as his attorney-in-fact, with full power of substitution for him in any and all capacities, to sign any and all amendments to this report on Form 10-K, and to file the same, with exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission. Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
Signature Title Date - --------------------------------------- -------------------------------------------------- -------------------------- /s/ SCOTT K. GINSBURG Chairman of the Board March 28, 2000 - --------------------------------------- Scott K. Ginsburg and Director (Principal Executive Officer) /s/ MATTHEW E. DEVINE Chief Executive Officer March 28, 2000 - --------------------------------------- Matthew E. Devine and Director /s/ OMAR A. CHOUCAIR Chief Financial Officer March 28, 2000 - --------------------------------------- Omar A. Choucair (Principal Financial and Accounting Officer) /s/ DAVID M. KANTOR Director March 28, 2000 - --------------------------------------- David M. Kantor /s/ MICHAEL G. LINNERT Director March 28, 2000 - --------------------------------------- Michael G. Linnert /s/ LAWRENCE D. LENIHAN, JR. Director March 28, 2000 - --------------------------------------- Lawrence D. Lenihan, Jr.
31 DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES INDEX TO CONSOLIDATED FINANCIAL STATEMENTS ------------------------------------------ Independent Auditors' Report.................................................................................. F-2 Report of Independent Public Accountants....................................................................... F-3 Consolidated Balance Sheets as of December 31, 1999 and 1998................................................... F-4 Consolidated Statements of Operations for the three years ended December 31, 1999.............................. F-5 Consolidated Statements of Shareholders' Equity for the three years ended December 31, 1999.................... F-6 Consolidated Statements of Cash Flows for the three years ended December 31, 1999.............................. F-7 Notes to Consolidated Financial Statements..................................................................... F-8
F-1 DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES INDEPENDENT AUDITORS' REPORT The Board of Directors Digital Generation Systems, Inc.: We have audited the accompanying consolidated balance sheet of Digital Generation Systems, Inc. and subsidiaries as of December 31, 1999, and the related consolidated statements of operations, shareholders' equity and cash flows for the year then ended. In connection with our audit of the consolidated financial statements, we have also audited the financial statement schedule as listed in the accompanying index for the year ended December 31, 1999. These consolidated financial statements and financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audit. We conducted our audit 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 audit provides a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Digital Generation Systems, Inc. and subsidiaries as of December 31, 1999, and the results of their operations and their cash flows for the year then ended, in conformity with generally accepted accounting principles. Also in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. KPMG LLP Dallas, Texas February 25, 2000 F-2 DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To Digital Generation Systems, Inc.: We have audited the accompanying consolidated balance sheet of Digital Generation Systems, Inc. (a California Corporation) and subsidiaries as of December 31, 1998, and the related consolidated statements of operations, shareholders' equity and cash flows for the years ended December 31, 1998 and 1997. These financial statements and the schedule referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Digital Generation Systems, Inc. and subsidiaries as of December 31, 1998, and the results of its operations and its cash flows for the years ended December 31, 1998 and 1997, in conformity with generally accepted accounting principles. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedule listed under Item 14(a)2 is presented for purposes of complying with the Securities and Exchange Commission's rules and is not a required part of the basic financial statements. Information included in this schedule for the years ended December 31, 1998 and 1997 has been subjected to the auditing procedures applied in our audits of the basic financial statements and, in our opinion, fairly states in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. ARTHUR ANDERSEN, LLP San Francisco, California January 26, 1999 F-3 DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (in thousands, except share amounts)
December 31, December 31, 1999 1998 ------------------ ----------------- ASSETS CURRENT ASSETS: Cash and cash equivalents $ 5,420 $ 13,025 Accounts receivable, less allowance for doubtful accounts of $1,659 in 1999 and $1,895 in 1998 12,799 9,995 Prepaid expenses and other 1,717 933 -------- -------- Total current assets 19,936 23,953 -------- -------- PROPERTY AND EQUIPMENT, at cost: Network equipment 35,304 33,211 Office furniture and equipment 5,833 3,730 Leasehold improvements 793 542 -------- -------- 41,930 37,483 Less - Accumulated depreciation and amortization (33,772) (25,738) -------- -------- Property and equipment, net 8,158 11,745 -------- -------- GOODWILL AND OTHER ASSETS, net 13,672 14,094 -------- -------- $ 41,766 $ 49,792 ======== ======== LIABILITIES AND SHAREHOLDERS' EQUITY CURRENT LIABILITIES: Accounts payable $ 7,781 $ 3,035 Accrued liabilities 3,230 4,081 Line of credit -- 1,433 Current portion of long-term debt 7,689 8,226 -------- -------- Total current liabilities 18,700 16,775 -------- -------- LONG-TERM DEBT, net of current portion 2,513 9,307 -------- -------- COMMITMENTS AND CONTINGENCIES (Note 5) SHAREHOLDERS' EQUITY: Convertible preferred stock, no par value - Authorized - - 15,000,000 shares Outstanding - - none -- -- Common Stock, no par value - Authorized - - 100,000,000 shares at December 31, 1999; 40,000,000 shares at December 31, 1998 Outstanding - - 27,530,170 shares at December 31, 1999 and 26,239,520 shares at December 31, 1998 119,519 114,131 Receivable from issuance of common stock (194) (369) Accumulated other comprehensive income 52 9 Accumulated deficit (98,824) (90,061) -------- -------- Total shareholders' equity 20,553 23,710 -------- -------- $ 41,766 $ 49,792 ======== ========
The accompanying notes are an integral part of these consolidated financial statements. F-4 DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (in thousands, except per share amounts)
Years Ended December 31, ------------------------------------------------------------- 1999 1998 1997 ------------------- ------------------- ------------------- REVENUES $48,724 $ 41,270 $ 29,175 ------- -------- -------- COSTS AND EXPENSES: Delivery and material costs 17,857 14,630 11,334 Customer operations 15,138 14,780 11,388 Sales and marketing 4,818 4,970 4,417 Research and development 2,577 2,780 2,473 General and administrative 6,552 4,314 3,169 Write down of goodwill and fixed assets (Note 3) -- 17,006 -- Non-recurring charges 370 -- -- Depreciation and amortization 8,591 10,266 9,306 ------- -------- -------- Total expenses 55,903 68,746 42,087 ------- -------- -------- LOSS FROM OPERATIONS (7,179) (27,476) (12,912) OTHER INCOME (EXPENSE): Interest income and other, net 319 253 744 Interest expense (1,903) (3,014) (2,607) ------- -------- -------- NET LOSS $(8,763) $(30,237) $(14,775) ======= ======== ======== BASIC AND DILUTED NET LOSS PER COMMON SHARE (Note 11) $(0.33) $(1.97) $(2.52) ======= ======== ======== WEIGHTED AVERAGE COMMON SHARES 26,653 16,272 11,893 ======= ======== ========
The accompanying notes are an integral part of these consolidated financial statements. F-5 DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (In thousands, except share and per share amounts)
Convertible Receivable Accumulated Preferred stock Common stock From Other ---------------------- -------------------- Issuance of Comprehensive Shares Amount Shares Amount Common stock Income (Loss) ----------- --------- ---------- -------- ------------- -------------- BALANCE AT DECEMBER 31, 1996 -- -- 11,653,625 $ 55,138 $(175) $ -- Issuance of Series A preferred stock, net of issuance costs of $1,100 4,950,495 $ 16,400 -- -- -- -- Preferred stock deemed dividend -- (15,161) -- -- -- -- Issuance of Common Stock in connection with acquisition of Mediatech -- -- 324,355 1,906 -- -- Exercise of stock options -- 144,699 79 -- -- Net loss -- -- -- -- -- -- ------------------------------------------------------------------------------ BALANCE AT DECEMBER 31, 1997 4,950,495 31,561 12,122,679 57,123 (175) -- Conversion of Series A preferred stock to Common Stock, net of issuance costs of $486 (4,950,495) (31,561) 4,950,495 31,075 -- -- Preferred stock deemed dividend resulting from conversion of Series A preferred stock -- -- 495,035 1,764 -- -- Issuance of common stock in private placements, net of issuance costs of $370 -- -- 8,432,499 23,480 -- -- Warrants issued in relation to common stock private placement -- -- -- 12 -- -- Issuance of restricted stock for promissory note -- -- 50,000 194 (194) -- Exercise of stock options -- -- 164,701 371 -- -- Stock issued for services -- -- 10,000 80 -- -- Purchase of shares through ESPP -- -- 14,111 32 -- -- Foreign currency translation adjustment -- -- -- -- -- 9 Net loss -- -- -- -- -- -- -------------------------------------------------------------------------------- BALANCE AT DECEMBER 31, 1998 -- -- 26,239,520 114,131 (369) 9 Issuance of common stock in private placement -- -- 725,199 3,750 -- -- Exercise of Warrants -- -- 11,967 -- -- -- Forgiveness of promissory note -- -- -- -- 175 -- Exercise of stock options -- -- 507,686 1,518 -- -- Purchase of shares through ESPP -- -- 45,798 120 -- -- Foreign currency translation adjustment -- -- -- -- -- 43 Net loss -- -- -- -- -- -- -------------------------------------------------------------------------------- BALANCE AT DECEMBER 31, 1999 -- $ -- 27,530,170 $119,519 $(194) $52 ================================================================================
Total Accumulated Shareholders' Comprehensive Deficit Deficit Loss ------------ -------------- -------------- BALANCE AT DECEMBER 31, 1996 $(28,124) $(28,124) Issuance of Series A preferred stock, net of issuance costs of $1,100 -- 16,400 -- Preferred stock deemed dividend $(15,161) -- -- Issuance of Common Stock in connection with acquisition of Mediatech -- 1,906 -- Exercise of stock options -- 79 -- Net loss (14,775) (14,775) $(14,775) --------------------------------------------- BALANCE AT DECEMBER 31, 1997 (58,060) 30,449 (14,775) ============= Conversion of Series A preferred stock to Common Stock, net of issuance costs of $486 -- (486) -- Preferred stock deemed dividend resulting from conversion of Series A preferred stock (1,764) -- -- Issuance of common stock in private placements, net of issuance costs of $370 -- 23,480 -- Warrants issued in relation to common stock private placement -- 12 -- Issuance of restricted stock for promissory note -- -- -- Exercise of stock options -- 371 -- Stock issued for services -- 80 -- Purchase of shares through ESPP -- -- -- Foreign currency translation adjustment -- 9 9 Net loss (30,237) (30,237) (30,237) --------------------------------------------- BALANCE AT DECEMBER 31, 1998 (90,061) 23,710 (30,228) ============= Issuance of common stock in private placement -- 3,750 -- Exercise of Warrants -- -- -- Forgiveness of promissory note -- 175 -- Exercise of stock options -- 1,518 -- Purchase of shares through ESPP -- 120 -- Foreign currency translation adjustment -- 43 43 Net loss (8,763) (8,763) (8,763) --------------------------------------------- BALANCE AT DECEMBER 31, 1999 $(98,824) $ 20,553 $ (8,720) =============================================
The accompanying notes are an integral part of these consolidated financial statements. F-6 DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands)
Years Ended December 31, --------------------------------- 1999 1998 1997 --------- ---------- ---------- CASH FLOWS FROM OPERATING ACTIVITIES: Net loss $(8,763) $(30,237) $(14,775) Adjustments to reconcile net loss to net cash used in operating activities: Depreciation and amortization 8,106 9,103 8,519 Amortization of goodwill and intangibles 486 1,163 787 Write-down of goodwill and fixed assets (Note 3) -- 17,006 -- Common stock issued for services -- 80 -- Provision for doubtful accounts 538 1,142 246 Changes in operating assets and liabilities -- Accounts receivable (3,512) (1,953) (122) Prepaid expenses and other assets (659) (213) (212) Accounts payable and accrued liabilities 3,957 (882) (751) ------- -------- -------- Net cash provided by (used in) operating activities 153 (4,791) (6,308) ------- -------- -------- CASH FLOWS FROM INVESTING ACTIVITIES: Purchases of short-term investments -- (2,013) (8,810) Maturities of short-term investments -- 3,000 18,738 Acquisition of Mediatech, net of cash acquired -- -- (13,921) Proceeds from the sale of property, plant and equipment 75 -- -- Acquisition of DCI -- (9,131) -- Purchase of property and equipment (2,653) (2,162) (5,131) ------- -------- -------- Net cash used in investing activities (2,578) (10,306) (9,124) ------- -------- -------- CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from issuance of common stock, net 5,563 23,975 79 Proceeds from issuance of convertible preferred stock -- -- 16,400 Costs of converting preferred stock to common stock -- (486) -- Proceeds from line of credit 1,148 13,365 7,686 Payments on line of credit (2,581) (14,767) (8,027) Proceeds from short-term loans -- -- 6,000 Repayment of short-term loans -- -- (6,000) Proceeds from issuance of long-term debt -- 5,233 5,419 Payments on long-term debt (9,308) (7,106) (7,974) ------- -------- -------- Net cash (used in) provided by financing activities (5,178) 20,214 13,583 ------- -------- -------- EFFECT OF EXCHANGE RATE CHANGES ON CASH 2 (75) -- NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS (7,605) 5,192 (1,849) CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD 13,025 7,833 9,682 ------- -------- -------- CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 5,420 $ 13,025 $ 7,833 ======= ======== ======== SUPPLEMENTAL CASH FLOW INFORMATION: Interest paid $ 2,199 $ 2,777 $ 2,502 ======= ======== ========
The accompanying notes are an integral part of these consolidated financial statements. F-7 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. The Company: Digital Generation Systems, Inc. (the "Company") was incorporated in 1991. The Company operates a nationwide multimedia network designed to provide media distribution and related services to the broadcast industry by linking content providers to radio and television stations. The Company is primarily a provider of electronic and physical distribution of audio and video spot advertising to radio and television stations. The Company primarily generates its revenues from advertising agencies and production studios. The Company is subject to certain risks that include, but are not limited to: the continued development of technology to enhance the delivery and variety of the Company's services in the most cost-effective manner, including the successful integration of the operations of its recently acquired subsidiaries; the ability to compete successfully against current and future competitors; and dependence on key personnel and the need for additional financing to fund operations and its capital expenditure requirements. The Company obtains certain components used in the assembly of the units which are placed at radio and television stations and production studios from a few single or limited source suppliers and obtains its primary long distance telephone access through an exclusive contract with a telephone service provider which expires in 2001. Any material interruption in these services could have a material adverse effect on the Company's business. Although the Company believes that alternate vendors can be obtained, the transition to alternative vendors could have a material adverse impact on the Company's costs and shipping schedules. 2. Summary of Significant Accounting Policies: Consolidation The consolidated financial statements include the accounts of the Company and its subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation. Use of Estimates The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities 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. Foreign Currencies Assets and liabilities recorded in foreign currencies are translated at the exchange rate on the balance sheet date. Translation adjustments resulting from this process are included in other comprehensive income. Revenue, costs, and expenses are translated at average rates of exchange prevailing during the year. Gains (losses) on foreign currency transactions of ($28,000) and $10,000 for the years ended December 31, 1999 and 1998, respectively, are included in interest income and other, net in the consolidated statements of operations. Research and Development Research and development costs are charged to expense as incurred. Goodwill Goodwill, which represents the excess of purchase price over the fair value of net identifiable assets acquired, is amortized on a straight-line basis over the expected periods to be benefited, generally 20 years. The company assesses the recoverability of this intangible asset by determining whether the amortization of the goodwill balance over its remaining life can be recovered through undiscounted future operating cash flows of the acquired operation. The amount of goodwill F-8 DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS impairment, if any, is measured based on projected discounted future operating cash flows using a discount rate reflecting the Company's average cost of funds. The assessment of the recoverability of goodwill will be impacted if estimated future operating cash flows are not achieved. Impairment of Long-Lived Assets Long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying value of assets may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to future net cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets. Assets to be disposed of are reported at the lower of the carrying amount or fair value less costs to sell. Cash and Cash Equivalents Cash and cash equivalents consist of liquid investments with original maturities of three months or less. As of December 31, 1999 and December 31, 1998, cash equivalents consist principally of U.S. Treasury Bills. Property and Equipment Network equipment includes the network operating center, record send terminals, receive playback terminals, video record transmission systems, digital video playback systems and the related terminal and system components as well as audio and video taping and dubbing equipment. The Company records its property and equipment at cost and depreciates it on a straight-line basis over its estimated useful life, generally three years. Equipment held under capital leases and leasehold improvements are amortized straight-line over the shorter of the lease term or estimated useful life of the asset. Revenue Recognition Revenues for distribution services which are digitally transmitted are recognized for each transaction on the date audio, video or related information is successfully transmitted from the Company's operating facilities to the destination ordered. Revenues for distribution services of analog audio or videotapes are recognized as the tapes are shipped. Income Taxes Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. Stock Option Plans The Company applies the intrinsic value-based method of accounting prescribed by Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees," and related interpretations, in accounting for its fixed plan stock options. As such, compensation expense would be recorded on the date of grant only if the current market price of the underlying stock exceeded the exercise price. SFAS No. 123, "Accounting for Stock-Based Compensation," established accounting and disclosure requirements using a fair value-based method of accounting for stock-based employee compensation plans. As allowed by SFAS No. 123, the Company has elected to continue to apply the intrinsic value- based method of accounting described above, and has adopted the disclosure requirements of SFAS No. 123. F-9 DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Concentration of Credit Risk Financial instruments that potentially subject the Company to a concentration of credit risk consist principally of cash and cash equivalents and accounts receivable. The Company believes that a concentration of credit risk with respect to accounts receivable is limited because its customers are geographically dispersed and the end users (the customer's clients) are diversified across industries. The Company's receivables are principally from advertising agencies, dub and ship houses, and syndicated programmers. The Company's revenues are not contingent on its customers' sales or collections. However, the timing of collections from its customers is affected by the billing cycle in which the customer bills its end-users (the customer's clients). The Company provides reserves for credit losses. Supplemental Cash Flow Information Non-cash investing and financing activities for 1999, 1998 and 1997 consisted of the following (in thousands):
Years Ended December 31, ------------------------- 1999 1998 1997 ------- ------- ------- Property and equipment financed with capitalized lease obligations......... $1,977 $ 1,663 $ 400 Long-term debt used to finance Mediatech acquisition....................... -- -- 3,850 Common Stock issued to finance Mediatech acquisition....................... -- -- 1,906 Preferred stock deemed dividend............................................ -- 1,764 15,161 Conversion of preferred stock to Common Stock.............................. -- 31,561 -- Common Stock issued for services........................................... -- 80 --
Reclassifications Certain reclassifications were made to the 1997 and 1998 condensed consolidated financial statements to conform to the 1999 presentation. 3. Acquisitions: Mediatech On July 18, 1997, the Company acquired 100% of the capital stock of Starcom Mediatech, Inc. ("Mediatech"), a wholly owned subsidiary of IndeNet, Inc. ("IndeNet"), for final consideration totaling approximately $25.2 million ("Mediatech Acquisition"). The consideration consisted of approximately $14.0 million in cash, 324,355 shares of the Company's Common Stock and $9.2 million of debt. Mediatech is a media duplication and distribution company whose principal offices are located in Chicago, Illinois. The Mediatech acquisition was accounted for as a purchase. The excess of purchase price and acquisition costs over the fair value of net assets acquired of approximately $17.8 million was included in Goodwill and Other Assets. The operating results of Mediatech have been included in the consolidated results of the Company from the date of the closing of the transaction, July 18, 1997. Due to a change in Mediatech's business, in September 1998 the Company wrote off the remaining goodwill resulting from the Mediatech acquisition ($16.7 million) and a portion of the fixed assets ($340,000), as it was determined that their carrying values were not recoverable. F-10 DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DCI On September 25, 1998, the Company acquired substantially all of the property and assets of Digital Courier International, Inc. ("DCI"), including all accounts receivable, inventories, contracts, equipment, real property leases and other related assets. DCI is in the business of supplying electronic distribution and communications services for the radio broadcast industry in the United States and Canada. The Company paid $13.5 million in Canadian dollars (approximately US $9.06 million) for DCI. The DCI acquisition was accounted for as a purchase. The excess of purchase price and acquisition costs over the fair value of assets acquired of approximately $6.2 million is included in Goodwill and Other Assets in the accompanying consolidated balance sheets, and is being amortized over a twenty year period. The operating results of DCI have been included in the consolidated results and balances of the Company from the date of the closing of the transaction. Pro Forma Results The following table reflects unaudited pro forma combined results of operations of the Company on the basis that the acquisitions of both Mediatech and DCI had taken place at the beginning of the fiscal years presented:
Years Ended December 31, ------------------------------------ 1999 1998 ----------------- ----------------- Revenues.................................................................................. $48,724 $ 44,506 Net loss.................................................................................. (8,763) (35,277) Basic and diluted net loss per common share............................................... $ (0.33) $ (3.10)
The unaudited pro forma combined results of operations are not necessarily indicative of the actual results that would have occurred had the acquisitions of Mediatech and DCI been consummated at the beginning of 1998, or of future operations of the combined companies. 4. Accrued Liabilities: Accrued liabilities consist of the following (in thousands):
December 31, -------------------------------- 1999 1998 --------------- --------------- Telecommunications costs........... $ 4 $ 715 Employee compensation.............. 1,115 897 Legal and professional fees........ 135 557 Other.............................. 1,976 1,912 ------ ------ $3,230 $4,081 ====== ======
5. Commitments and Contingencies: The Company leases its facilities and certain equipment under non-cancelable operating leases. As of December 31, 1999, future minimum annual payments under these leases are as follows (in thousands):
Years Ending December 31, - --------------------------------------- 2000................................... $1,485 2001................................... 898 2002................................... 535 2003................................... 503 2004................................... 503 Thereafter............................. 953 ------ $4,877 ======
F-11 DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Rent expense totaled approximately $1,432,000, $1,391,000 and $1,540,000 in 1999, 1998 and 1997, respectively. In addition, as of December 31, 1999, the Company had non-cancelable future minimum purchase commitments with its primary telephone service provider. These commitments range between $4.6 million and $6.2 million per year and extend through December 2001. The Company is subject to legal proceedings and claims, either asserted or unasserted, which arise in the ordinary course of business from time to time. While the outcome of these claims cannot be predicted with certainty, management does not believe that the outcome of any of the pending legal matters will have a material adverse effect on the Company's results of operations, financial position or liquidity. The Company has employment agreements with certain of its key executives. In general, the agreements provide for base salaries, bonuses, option grants based on certain performance criteria, and termination payments. 6. Line of Credit: Mediatech is party to a financing agreement with a bank which provides a revolving line of credit to fund the working capital requirements of Mediatech. The agreement is collateralized by a security agreement covering substantially all of the assets of Mediatech. The interest rate on advances under the agreement is the bank's reference rate, approximately equal to the prime rate, plus 2.25%. There was no balance outstanding under this agreement at December 31, 1999 and this Line of Credit was terminated in January 2000. 7. Long-Term Debt: The Company has used several lease and loan agreements to finance the purchase of certain property and equipment. Borrowings are secured by the equipment. The cost of equipment under lease and term loan obligations at December 31, 1999 and 1998 was $14,321,000 and $22,588,000, respectively. Related accumulated depreciation at December 31, 1999 and 1998 was $10,135,000 and $15,644,000, respectively. The primary lease term has expired for certain of the equipment under lease. Such equipment continues to be leased on a month to month basis. These loans have repayment terms of 36 to 60 months and the Company has the option at the end of the terms to purchase the equipment at mutually agreed upon prices not to exceed 10 to 20% of the equipment's original cost. As of December 31, 1999, approximately $0.1 million remained available under these agreements to fund future capital requirements. In December 1997 the Company entered an agreement to finance an additional $2.0 million of equipment purchases and $3.5 million of working capital through a long-term facility. At December 31, 1999, $5.4 million has been financed through this agreement. The agreement has repayment terms consistent with those discussed in the preceding paragraph. In August 1999 the Company entered into an agreement to finance an additional $2.0 million of equipment purchases through a long-term facility with a repayment term of 24 months. The cost of equipment under this lease obligation at December 31, 1999 was $2.0 million. Related accumulated depreciation at December 31, 1999 was $0.2 million. Mediatech has long-term debt outstanding per the terms of a promissory note signed in February 1997. The remaining principal balance of the note was $1.1 million at December 31, 1999. The note bears interest at the bank's reference rate, approximately equal to the prime rate, plus 2.25% (10.75% at December 31, 1999) and principal and interest payments are due monthly. This note is payable to the same creditor that provided the line of credit discussed in Note 6 and is collateralized by substantially all of the assets of Mediatech. F-12 DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Future minimum lease and long-term debt payments as of December 31, 1999, are as follows (in thousands):
Years Ending December 31, Lease Long-term - ------------------------- Payments Debt 2000.................................................................... $ 6,694 $1,690 2001.................................................................... 2,373 297 ------- ------ Total minimum debt payments............................................. 9,067 $1,987 Less - Amount representing interest (effective interest ====== rates ranging from 9 percent to 19 percent)................. (852) ------- Present value of minimum lease payments................................. 8,215 Less -- Current portion................................................. (5,999) ------- Long-term portion....................................................... $ 2,216 =======
8. Capital Stock: In July and August 1998, the Company's Board of Directors authorized the issuance of up to $ 13.0 million of Common Stock in a private placement transaction. The Company issued 4,589,287 common shares to current institutional and closely associated investors at $2.80 per share. Proceeds to the Company, net of issuance costs, was approximately $12.7 million. In December 1998, the Company's Board of Directors authorized the issuance of up to $11.0 million of Common Stock in a private placement transaction. The Company issued 2,920,134 common shares to Scott Ginsburg, the Company's Chief Executive Officer, at $3.25 per share. In addition, the Company authorized the sale and issuance of up to $3.0 million of Common Stock in a private placement transaction. The Company issued 923,078 common shares to current institutional and closely associated investors at a price of $3.25 per share. In December 1999, the Company's Board of Directors authorized the issuance of Common Stock in a private placement transaction. The company issued 725,199 common shares to current institutional and closely associated investors at a price of $5.17 per share. In December 1999, the Company wrote off a note receivable from an executive officer in the amount of $175,000 that was issued in connection with a restricted stock purchase agreement, pursuant to which the executive officer purchased an aggregate of 487,500 shares of the Company's Common Stock. A charge to expense of $175,000 was recorded in 1999 for this transaction. The Company and an employee are parties to a restricted stock purchase agreement, pursuant to which the Company loaned the employee money under a nonrecourse note and the employee purchased an aggregate of 50,000 shares of the Company's Common Stock. As of December 31, 1999, all of these restricted shares held by the employee were subject to the Company's right to repurchase within the terms of the stock purchase agreement. Series A Convertible Preferred Stock During 1997, the Company issued 4,950,495 shares of Series A Convertible Preferred Stock (the "Series A Preferred"). There was a beneficial conversion feature associated with the Series A Preferred Stock. The difference between the publicly traded price per share and the sales price per share has been reflected as a deemed dividend to the preferred shareholders in the accompanying consolidated statements of shareholders' equity. This deemed dividend results in an increase in loss attributable to common shareholders in the computation of basic and diluted loss per share for the year ended December 31, 1997. In July 1998, the Series A Preferred Stock was converted to Common Stock per the terms of the Series A Preferred Stock Conversion Agreement effective August 14, 1998. The conversion of the Series A Preferred Stock to Common Stock resulted in an additional deemed dividend to the preferred shareholders. This deemed dividend results in an increase in loss attributable to common shareholders in the computation of basic and diluted earnings per share for the year ended December 31, 1998. F-13 DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Warrants The Company has issued warrants in connection with certain financing and leasing transactions and common stock offerings. All of the outstanding warrants are convertible into common stock. A summary of outstanding warrants at December 31, 1999, 1998 and 1997 and changes during the years then ended follows:
1999 1998 1997 --------------------- -------------------- ------------------- Wtd Avg Wtd Avg Wtd Avg Warrants Ex. Price Warrants Ex. Price Warrants Ex. Price ---------- --------- --------- --------- -------- --------- Outstanding at beginning of the year 3,926,244 $3.55 492,177 $5.69 193,025 $5.58 Granted -- -- 3,470,067 3.25 299,152 5.77 Exercised (71,174) 2.70 -- -- -- -- --------- ----- --------- ----- ------- ----- Outstanding at end of the year 3,891,070 $3.57 3,962,244 $3.55 492,177 $5.69 ========= ===== --------- ===== ======= =====
The warrants outstanding at December 31, 1999 expire on various dates from 2001 through 2006. The warrants exercised in 1999 were done by exchanging the entire warrant for shares of common stock equal to the net value of the warrant. 9. Stock Plans: The Company has three Stock Option Plans: 1992 Stock Option Plan Under the Company's 1992 Stock Option Plan, (the "1992 Plan"), the Company may issue up to 4,950,000 shares of Common Stock to employees, officers, directors and consultants. At the Company's Annual Shareholders' Meeting in September 1999, the shareholders approved an increase of 2,000,000 shares from the previously authorized total of 2,950,000. The exercise price and terms of the options granted is determined by the Board of Directors, provided that such price cannot be less than the fair value of the Common Stock on the date of grant for incentive stock options or, in the case of non-statutory options, less than 85 percent of the fair value of the Common Stock on the date of grant. The options generally vest over four years. The 1992 Plan provides that, in the event of a change in control of the Company, executive officers of the Company will receive accelerated vesting for a portion of their unvested option shares. The term of the options granted is seven years. No options have been granted at less than fair value under this plan. 1996 Supplemental Option Plan In 1996, the Company's Board of Directors adopted the 1996 Supplemental Option Plan. Under this Plan, the Company may issue up to 750,000 shares of Common Stock to employees, officers, directors and consultants. The exercise price and terms of the options granted are determined by the Board of Directors. The options generally vest over four years. The term of the options granted is seven years. 1995 Director Option Plan In 1995, the Company's Board of Directors adopted the 1995 Director Option Plan (the "Director Plan"). A total of 300,000 shares of Common Stock has been reserved for issuance under the Director Plan. At the Company's Annual Shareholders' Meeting in September 1999, the shareholders approved an increase of 200,000 shares from the previously authorized total of 100,000. The Director Plan provides that each future non-employee director of the Company will be automatically granted an option to purchase 10,000 shares of Common Stock (the "First Option") on the date on which the optionee first becomes a non-employee director of the Company and an additional option to purchase 2,500 shares of Common Stock (the "Subsequent Option") on each anniversary date thereafter. The exercise price per share of all options granted under the Director Plan shall be equal to the fair market value of a share of the Company's Common Stock on the date of grant. Shares subject to the First Option vest over 36 months, and the Subsequent Option shares vest over 12 months beginning with the month following the second anniversary of its date of grant. The terms of the options granted is ten years. F-14 DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Accounting for Stock Option Compensation Expense The Company applies the principles of APB Opinion No. 25 and related interpretations in accounting for the its stock option plans. Had compensation cost for the Company's stock option plans been determined based on the fair value at the date of grant of the stock options consistent with the method of SFAS No. 123, the Company's net loss (in thousands) and loss per share would have been changed to the pro forma amounts indicated below:
1999 1998 1997 ------------- ------------- ------------- Net Loss As reported $ (8,763) $(30,237) $(14,775) Pro forma $(11,689) $(32,409) $(15,876) Basic and diluted net loss per common share As reported $ (0.33) $ (1.97) $ (2.52) Pro forma $ (0.44) $ (2.10) $ (2.61)
The fair value of each option grant is estimated on the date of grant using the multiple option approach of the Black-Scholes option pricing model with the following assumptions used for grants in 1999, 1998 and 1997, respectively; risk-free interest rates of 6.4%, 4.7% and 7.8%; a dividend yield of 0%; and volatility factors of the expected market price of the Company's common stock of 112%, 194% and 75%. A summary of the Company's fixed stock option plans at December 31, 1999, 1998 and 1997 and changes during the years then ended is presented below:
1999 1998 1997 ----------------------- ----------------------- ------------------------ Wtd Avg Ex. Wtd Avg Ex. Wtd Avg Ex. Shares Price Shares Price Shares Price ---------- ----------- ---------- ----------- ----------- ----------- Outstanding at beginning of the year 3,087,031 $3.78 2,682,707 $4.21 1,806,355 $5.29 Granted 2,024,500 4.95 1,270,250 3.12 2,187,000 4.94 Exercised (507,686) 2.99 (164,701) 2.25 (144,699) 0.55 Canceled (573,006) 4.50 (701,225) 4.61 (1,165,949) 7.71 --------- ----- --------- ----- ---------- ----- Outstanding at end of the year 4,030,839 $4.36 3,087,031 $3.78 2,682,707 $4.21 ========= ===== ========== ===== ========== ===== Exercisable at end of the year 1,262,767 $3.90 1,159,767 $3.79 543,653 $2.74 Weighted average fair value of options granted $3.55 $2.85 $2.69
The following table summarizes information about stock options outstanding at December 31, 1999:
Options Outstanding Options Exercisable - -------------------------------------------------------------------------------------- ---------------------------------- Number Weighted-Average Weighted-Average Number Weighted-Average Range of Exercise Prices Outstanding Remaining Contractual Life Exercise Price Exercisable Exercise Price - --------------------------- ----------- -------------------------- ---------------- ---------------- ---------------- $0.20 - $2.65 381,673 4.70 $1.87 232,974 $1.42 $2.75 - $5.00 1,714,916 5.15 $3.75 821,088 $4.02 $5.125 - $10.125 1,934,250 6.18 $5.40 208,705 $6.21 --------- --------- $0.20 - $10.125 4,030,839 1,262,767 ========= =========
As of December 31, 1999, there were 937,804 shares available for future grant under the stock option plans. 10. Income Taxes There was no income tax expense (benefit) in 1999, 1998, or 1997 due to the existence of net operating losses and a full valuation allowance for related deferred tax assets. F-15 DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Components of deferred tax assets at December 31, 1999 and 1998 are as follows (in thousands):
1999 1998 ------------- ------------- Net operating loss carryforwards.......................................... $ 16,992 $ 16,338 Cumulative temporary differences.......................................... 3,841 3,366 Research and development credit........................................... 768 768 -------- -------- Total gross deferred tax asset............................................ 21,601 20,472 Less valuation allowance.................................................. (21,601) (20,472) -------- -------- Net deferred tax assets................................................... $ -- $ -- ============ ============
The net operating loss and research and development credit carryforwards of approximately $48 million and $768,000, respectively, will expire on various dates from 2007 to 2019. Utilization of these carryforwards may be annually limited if there is a change in the Company's ownership, as defined by the Internal Revenue Code. A valuation allowance has been recorded for the entire deferred tax asset as a result of uncertainties regarding the realization of the asset including the limited operating history of the Company, the lack of profitability to date and the variability of operating results. 11. Net Loss Per Share Under Statement of Financial Accounting Standards (SFAS) No. 128 "Earnings per Share," the Company is required to compute earnings per share under two different methods (basic and diluted). Basic earnings per share is calculated by dividing net income (loss) attributable to common shareholders by the weighted average shares of Common Stock outstanding during the period. Diluted earnings per share is calculated by dividing net income (loss) attributable to common shareholders by the weighted average shares of outstanding Common Stock and Common Stock equivalents during the period. Due to losses, inclusion of Common Stock equivalents would be anti-dilutive. Therefore, basic and diluted earnings per share for the Company are the same. For the year ended December 31, 1998, the net loss per share was computed as net loss of $30,237,000 plus $1,764,000 relating to the preferred stock deemed dividend (Note 8) divided by the weighted average common shares outstanding. For the year ended December 31, 1997, the net loss per share was computed as net loss of $14,775,000 plus $15,161,000 relating to the preferred stock deemed dividend (Note 8) divided by the weighted average common shares outstanding. 12. Segment Information The Company operates predominantly in one industry segment: digital and physical distribution and post-production services for audio and video content, and its operations are managed primarily by geographic areas. The Company has defined its operating segments based on these geographic areas. The information in the following tables is derived directly from the internal financial reporting used for corporate management purposes. The expenses, assets and liabilities attributable to corporate activity are not allocated to the operating segments. As of December 31, 1999, 5% of operating assets are located outside of the United States. At December 31, 1998 and 1997, the balance sheet information for the Company's Los Angles segment was maintained as part of the Chicago segment and was impractical to break out separately.
For the Year Ended December 31, 1999 In $000's -------------------------------------------------------------------------- San Francisco New York Chicago Los Angeles Vancouver Consolidated -------------- -------- -------- ----------- ---------- ------------- Revenue $ 16,340 $12,037 $13,605 $2,219 $ 4,523 $48,724 Net income (loss) $(12,458) $ 2,877 $ 1,805 $ 240 $(1,227) $(8,763) Total identifiable assets $ 15,875 $10,081 $ 4,943 $1,996 $ 8,871 $41,766
F-16 DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
For the Year Ended December 31, 1998 In $000's ----------------------------------------------------------------------------- San Francisco New York Chicago Los Angeles Vancouver Consolidated -------------- -------- ---------- ------------ ---------- ------------- Revenue $ 15,976 $10,125 $ 10,829 $2,842 $1,498 $ 41,270 Net income (loss) $(10,910) $ 1,265 $(19,975) $ (191) $ (426) $(30,237) Total identifiable assets $ 22,737 $10,060 $ 7,514 $ -- $9,481 $ 49,792
For the Year Ended December 31, 1997 In $000's -------------------------------------------------------------------------- San Francisco New York Chicago Los Angeles Vancouver Consolidated -------------- -------- --------- ----------- --------- ------------- Revenue $ 13,461 $8,384 $ 7,330 $ -- $ -- $ 29,175 Net income (loss) $(12,745) $ 410 $(2,440) $ -- $ -- $(14,775) Total identifiable assets $ 29,997 $2,485 $28,214 $ -- $ -- $ 60,697
13. Pretax Savings Plan The Company has a 401(k) retirement plan for full-time U.S. based employees. Employees who are at least 21 years of age and have completed at least six months of service are eligible to participate in the plan. Employees may contribute up to 20% of gross pay with a maximum dollar limit for 1998 of $10,000. The employer contribution is made at the end of the plan year in an amount set by corporate resolution, based on participants' compensation. The Company made no contributions to the plan in 1999, 1998 or 1997 to the plan. 14. New Accounting Pronouncements In June 1998, the Financial Accounting Standards Board issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities". This new standard requires companies to record derivatives on the balance sheet as assets or liabilities, measured at fair value. Under SFAS No. 133, gains or losses resulting from changes in the values of derivatives are to be reported in the statement of operations or as a deferred item, depending on the use of the derivatives and whether they qualify for hedge accounting. The Company is required to adopt SFAS No. 133 in the first quarter of 2001. To date, the Company has not engaged in any hedging activity and does not expect adoption of this new standard to have a significant impact on the Company. F-17 DIGITAL GENERATION SYSTEMS, INC. SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS
Balance at Additions Beginning of Charged to Balance at Classification Period Operations Other (a) Writeoffs End of Period - ------------------------------- ----------------- ---------------- -------------- -------------- -------------- Allowance for Doubtful Accounts Year Ended: December 31, 1997.............. $ 257,000 $ 246,000 $259,000 $(177,000) $ 585,000 December 31, 1998.............. $ 585,000 $1,142,000 $186,000 $ (18,000) $1,895,000 December 31, 1999.............. $1,895,000 $ 538,000 $ - $(774,000) $1,659,000
(a) Additions resulting from acquisitions of Mediatech in 1997 and DCI in 1998. S-1 EX-10.44 2 REGISTRATION RIGHTS AGREEMENT EXHIBIT 10.44 REGISTRATION RIGHTS AGREEMENT THIS REGISTRATION RIGHTS AGREEMENT is made as of the 17th day of December, 1999, by and between Digital Generation Systems, Inc., a California corporation (the "Company"), and each of the persons listed on Schedule A hereto (collectively, the "Holders"). RECITALS -------- WHEREAS, the Company issued 725,199 shares of its Common Stock (the "Common Shares") to certain of the Holders in a private placement transaction pursuant to that certain Common Stock Purchase Agreement dated December 17, 1999 (the "Purchase Agreement"); and WHEREAS, in order to induce the Holders to invest funds in the Company and to enter into the Purchase Agreement, the Company and the Holders agreed to enter into this Agreement and hereby agree that this Agreement shall govern the rights of the Holders to cause the Company to register the Common Shares and certain other matters as set forth herein. NOW, THEREFORE, THE PARTIES HEREBY AGREE AS FOLLOWS: 1. Registration Rights. The Company covenants and agrees as ------------------- follows: 1.1 Definitions. For purposes of this Section 1: ----------- (a) The term "Act" means the Securities Act of 1933, as amended. (b) The term "1934 Act" shall mean the Securities Exchange Act of 1934, as amended. (c) The terms "register," "registered," and "registration" refer to a registration effected by preparing and filing a registration statement or similar document in compliance with the Act, and the declaration or ordering of effectiveness of such registration statement or document. (d) The term "Registrable Securities" means the Common Shares and any Common Stock of the Company issued as a dividend or other distribution with respect to the Common Shares. (e) The term "Rule 144" shall mean Rule 144 promulgated under the Act, as amended, or any similar successor rule thereto that may be promulgated by the SEC. (f) The term "SEC" shall mean the Securities and Exchange Commission. 1.2 S-3 Registration. ---------------- (a) The Company shall use diligent efforts to prepare and file, on or before December 31, 2000, a registration statement on Form S-3 and any related qualification or compliance with respect to all of the Common Shares owned by the Holders so as to permit or facilitate the sale and distribution of the Holders' Common Shares. (b) Notwithstanding the foregoing, the Company shall not be obligated to effect any such registration, qualification or compliance, pursuant to this Section 1.2: (i) if Form S-3 is not available for such offering by the Holders; (ii) if the Company shall furnish to the Holders a certificate signed by the chief executive officer or the president of the Company stating that in the good faith judgment of the board of directors of the Company, it would be seriously detrimental to the Company and its shareholders for such Form S-3 registration to be effected at such time, in which event the Company shall have the right to defer the filing of the Form S-3 registration statement for a period of not more than sixty (60) days after such date, provided that such right to defer filing shall be exercised by the Company not more than once in any twelve (12) month period; or (iii) in any jurisdiction in which the Company would be required to execute a general consent to service of process in effecting such registration, qualification or compliance unless the Company is already subject to service in such jurisdiction and except as may be required by the Act. (c) Subject to the foregoing, the Company shall effect such registration, qualification, or compliance (including, without limitation, the execution of an undertaking to file post-effective amendments, appropriate qualification under applicable blue sky (except that in no event shall the Company be required to qualify to do business as a foreign corporation in any jurisdiction where it would not, but for the requirements of this paragraph (c), be required to be so qualified, to subject itself to taxation in any such jurisdiction or to consent to general service of process in any such jurisdiction) or other state securities laws and appropriate compliance with applicable regulations issued under the Act and any other governmental requirements or regulations) covering the Common Shares and other securities so entitled to be registered as soon as practicable in accordance with the terms hereof. 1.3 Obligations of the Company. When required under Section 1 -------------------------- to effect the registration of the Registrable Securities, the Company shall: (a) Prepare and file with the SEC, a registration statement on Form S-3 with respect to such Registrable Securities and use all commercially reasonable efforts to cause such registration statement to become effective, and, subject to the provisions below, use commercially reasonable efforts to keep such registration statement effective until the earlier of (A) the date on which all of the Common Shares held by each Holder can be sold without registration in a single transaction pursuant to Rule 144(k) of the Act, or (B) the date on which all of the Common Shares have been sold to the public. 2 (b) If at any time after a registration statement becomes effective, the Company advises the Holders in writing that the registration statement shall contain any untrue statement of a material fact or omit to state any material fact required to be stated therein or necessary to make the statements therein not misleading, or any prospectus comprising a part of such registration statement shall contain any untrue statement of a material fact or omit to state any material fact required to be stated therein or necessary to make the statements therein, in light of the circumstances under which they were made, not misleading or the occurrence or existence of any pending corporate development that, in the reasonable discretion of the Company, makes it appropriate to suspend the availability of the registration statement and the related prospectus, the Company shall give notice to the Holders that the availability of the registration statement is suspended and the Holders shall suspend any further sale of Registrable Securities pursuant to the registration statement until the Holders have been informed in writing that the registration statement is available. The Company shall be entitled to exercise its right to suspend the availability of the registration statement for a period of not more than sixty (60) days in any three (3) month period, not to exceed in the aggregate ninety (90) days in any twelve (12) month period. (c) Subject to subsections 1.3(a) and (b), prepare and file with the SEC 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 Act with respect to the disposition of all securities covered by such registration statement. (d) Furnish to the Holders requesting registration such numbers of copies of a prospectus, including a preliminary prospectus, in conformity with the requirements of the Act, and such other documents as they may reasonably request in order to facilitate the disposition of Registrable Securities owned by them. (e) Use commercially reasonable efforts to register and qualify the securities covered by such registration statement under such other securities or Blue Sky laws of such jurisdictions as shall be reasonably requested by the Holders; provided that the Company shall not be required in connection therewith or as a condition thereto to qualify to do business or to file a general consent to service of process in any such states or jurisdictions, unless the Company is already subject to service in such jurisdiction and except as may be required by the Act. 1.4 Information from Holders. It shall be a condition precedent ------------------------ to the obligations of the Company to take any action pursuant to this Section 1 with respect to the Registrable Securities of a Holder that such Holder shall furnish to the Company the information requested on Appendix 1.4 hereto, which shall include such information regarding itself, himself or herself, any of the Registrable Securities held by it, him or her, and the intended method of disposition of such securities, and such other information as shall be reasonably requested by the Company and required to effect the registration of any of the Registrable Securities. 1.5 Expenses of Registration. All expenses of the Holders, ------------------------ except underwriting discounts (if any) or commissions, including (without limitation) all registration, filing and qualification fees, printers' and accounting fees, and fees and disbursements of counsel for the Company shall be borne by the Company; provided, however, that the Company shall not be required to pay any professional fees incurred by any of the Holders. 3 1.6 Assignment of Registration Rights. The registration rights --------------------------------- provided pursuant to Section 1.2 are not assignable. 1.7 Indemnification. With respect to all Registrable Securities --------------- included in the registration statement referred to in this Section 1: (a) To the extent permitted by law, the Company will indemnify and hold harmless each Holder, the partners or officers, directors and shareholders of each Holder, and each person, if any, who controls such Holder within the meaning of the Act or the 1934 Act, against any losses, claims, damages or liabilities (joint or several) to which they may become subject under the Act, the 1934 Act or any state securities laws, insofar as such losses, claims, damages, or liabilities (or actions in respect thereof) arise out of or are based upon any of the following statements, omissions or violations (collectively, a "Violation"): (i) any untrue statement or alleged untrue statement of a material fact contained in such registration statement, including any preliminary prospectus or final prospectus contained therein or any amendments or supplements thereto, (ii) any omission or alleged omission to state therein a material fact required to be stated therein, or necessary to make the statements therein not misleading, or (iii) any violation or alleged violation by the Company of the Act, the 1934 Act, any state securities laws or any rule or regulation promulgated under the Act, the 1934 Act or any state securities laws; and the Company will reimburse each such Holder or controlling person for any legal or other expenses reasonably incurred by them in connection with investigating or defending any such loss, claim, damage, liability or action; provided, however, that the indemnity agreement contained in this subsection l.7(a) shall not apply to amounts paid in settlement of any such loss, claim, damage, liability or action if such settlement is effected without the consent of the Company (which consent shall not be unreasonably withheld), nor shall the Company be liable in any such case for any such loss, claim, damage, liability or action to the extent that it arises out of or is based upon a Violation that occurs in reliance upon and in conformity with written information furnished expressly for use in connection with such registration by any such Holder or controlling person; provided further, however, that the foregoing indemnity agreement with respect to any preliminary prospectus shall not inure to the benefit of any Holder, or any person controlling such Holder, from whom the person asserting any such losses, claims, damages or liabilities purchased shares in the offering, if a copy of the prospectus (as then amended or supplemented if the Company shall have furnished any amendments or supplements thereto) was not sent or given by or on behalf of such Holder to such person, if required by law so to have been delivered, at or prior to the written confirmation of the sale of the shares to such person, and if the prospectus (as so amended or supplemented) would have cured the defect giving rise to such loss, claim, damage or liability. (b) To the extent permitted by law, each Holder will indemnify and hold harmless the Company, each of its directors, each of its officers, each person, if any, who controls the Company within the meaning of the Act, any other Holder selling securities in such registration statement and any controlling person of any such other Holder, against any losses, claims, damages or liabilities (joint or several) to which any of the foregoing persons may become subject, under the Act, the 1934 Act or any state securities laws, insofar as such losses, claims, damages or liabilities (or actions in respect thereto) arise out of or are based upon any Violation, in each case to the extent (and only to the extent) that such Violation occurs in reliance upon and in conformity with written information furnished by Holder expressly for use in connection with such 4 registration; and Holder will reimburse any person intended to be indemnified pursuant to this subsection l.7(b), for any legal or other expenses reasonably incurred by such person in connection with investigating or defending any such loss, claim, damage, liability or action; provided, however, that the indemnity agreement contained in this subsection l.7(b) shall not apply to amounts paid in settlement of any such loss, claim, damage, liability or action if such settlement is effected without the consent of the Holder (which consent shall not be unreasonably withheld), provided that in no event shall any indemnity under this subsection l.7(b) exceed the net proceeds from the offering received by Holder. (c) Promptly after receipt by an indemnified party under this Section 1.7 of notice of the commencement of any action (including any governmental action), such indemnified party will, if a claim in respect thereof is to be made against any indemnifying party under this Section 1.7, deliver to the indemnifying party a written notice of the commencement thereof and the indemnifying party shall have the right to participate in, and, to the extent the indemnifying party so desires, jointly with any other indemnifying party similarly noticed, to assume the defense thereof with counsel mutually satisfactory to the parties; provided, however, that an indemnified party (together with all other indemnified parties which may be represented without conflict by one counsel) shall have the right to retain one separate counsel, with the fees and expenses to be paid by the indemnifying party, if representation of such indemnified party by the counsel retained by the indemnifying party would be inappropriate due to actual or potential differing interests between such indemnified party and any other party represented by such counsel in such proceeding. (d) If the indemnification provided for in this Section 1.7 is held by a court of competent jurisdiction to be unavailable to an indemnified party with respect to any loss, liability, claim, damage, or expense referred to therein, then the indemnifying party, in lieu of indemnifying such indemnified party hereunder, shall contribute to the amount paid or payable by such indemnified party as a result of such loss, liability, claim, damage, or expense in such proportion as is appropriate to reflect the relative fault of the indemnifying party on the one hand and of the indemnified party on the other in connection with the statements or omissions that resulted in such loss, liability, claim, damage, or expense as well as any other relevant equitable considerations. The relative fault of the indemnifying party and of the indemnified party shall be determined by reference to, among other things, whether the untrue or alleged untrue statement of a material fact or the omission to state a material fact relates to information supplied by the indemnifying party or by the indemnified party and the parties' relative intent, knowledge, access to information, and opportunity to correct or prevent such statement or omission. (e) The obligations of each Holder under this Section 1.7 shall survive the completion of any offering of Registrable Securities in the registration statement under this Section 1, and otherwise. 5 1.8 Termination of Registration Rights. The registration rights ---------------------------------- provided in this Section 1 shall terminate with respect to a particular Holder if all Registrable Securities held by such Holder may be sold pursuant to Rule 144 in any three (3) month period. Upon the termination of registration rights pursuant to this Section 1.8, the Company shall have the right to withdraw the registration statement, or any portion thereof, covering Registrable Securities. 2. Miscellaneous. ------------- 2.1 General. Nothing in this Agreement, express or implied, is ------- intended to confer upon any party other than the parties hereto any rights, remedies, obligations, or liabilities under or by reason of this Agreement, except as expressly provided in this Agreement. 2.2 Governing Law. This Agreement shall be governed by and ------------- construed under the laws of the State of California as applied to agreements among California residents entered into and to be performed entirely within California. 2.3 Counterparts. This Agreement may be executed in two or more ------------ counterparts, each of which shall be deemed an original, but all of which together shall constitute one and the same instrument. 2.4 Titles and Subtitles. The titles and subtitles used in this -------------------- Agreement are used for convenience only and are not to be considered in construing or interpreting this Agreement. 2.5 Notices. Unless otherwise provided, any notice required or ------- permitted under this Agreement shall be given in writing and shall be deemed effectively given upon personal delivery to the party to be notified or upon delivery by confirmed facsimile transmission, nationally recognized overnight courier service, or upon deposit with the United States Post Office, by registered or certified mail, postage prepaid and addressed to the party to be notified at the address indicated for such party on the signature page hereof, or at such other address as such party may designate by ten (10) days' advance written notice to the other parties. 2.6 Expenses. If any action at law or in equity is necessary to -------- enforce or interpret the terms of this Agreement, the prevailing party shall be entitled to reasonable attorneys' fees, costs and necessary disbursements in addition to any other relief to which such party may be entitled. 2.7 Amendments and Waivers. Any term of this Agreement may be ---------------------- amended and the observance of any term of this Agreement may be waived (either generally or in a particular instance and either retroactively or prospectively), only with the written consent of the Company and the Holders holding a majority of the Registrable Securities. 2.8 Severability. If one or more provisions of this Agreement ------------ are held to be unenforceable under applicable law, such provision shall be excluded from this Agreement and the balance of the Agreement shall be interpreted as if such provision were so excluded and shall be enforceable in accordance with its terms. 6 2.9 Entire Agreement. This Agreement constitutes the full and ---------------- entire understanding and agreement between the parties with regard to the subject matter hereof. 2.10 Issuance of Common Shares. The Holders hereby consent ------------------------- to the issuance of the Common Shares pursuant to the terms set forth in the Purchase Agreement. The Holders further agree to take any and all actions reasonably necessary to evidence and effect such consent, including, but not limited to, executing any necessary shareholder consents or proxies and voting all voting securities of the Company then held by such Holder at any shareholder meeting in favor of approving the aforementioned issuances. 7 IN WITNESS WHEREOF, the parties have executed this Agreement as of the date first above written. DIGITAL GENERATION SYSTEMS, INC.: By:____________________________________ Matthew E. Devine Chief Executive Officer Address: Digital Generation Systems, Inc. 875 Battery Street San Francisco, CA 94111 8 HOLDERS: PEQUOT PRIVATE EQUITY FUND, L.P. By: Pequot Capital Management, Inc., as Investment Manager By:________________________ David J. Malat, Chief Financial Officer Address: 500 Nyala Farm Road Westport, Connecticut 06880 9 PEQUOT OFFSHORE PRIVATE EQUITY FUND, INC. By: Pequot Capital Management, Inc., as Investment Manager By:_______________________ David J. Malat Chief Financial Officer Address: 500 Nyala Farm Road Westport, Connecticut 06880 10 TCV II, V.O.F. By: Technology Crossover Management II, L.L.C., Its: Investment General Partner By:________________________ Robert C. Bensky Chief Financial Officer Address: 56 Main Street, Suite 210 Copy: Technology Crossover Ventures Millburn, New Jersey 07041 575 High Street, Suite 400 Attention: Robert C. Bensky Palo Alto, California 94301 Fax: (973) 467-5323 Attention: Michael G. Linnert Fax: (650) 614-8222 11 TECHNOLOGY CROSSOVER VENTURES II, L.P. By: Technology Crossover Management II, L.L.C., Its: General Partner By:_______________________ Robert C. Bensky Chief Financial Officer Address: 56 Main Street, Suite 210 Copy: Technology Crossover Ventures Millburn, New Jersey 07041 575 High Street, Suite 400 Attention: Robert C. Bensky Palo Alto, California 94301 Fax: (973) 467-5323 Attention: Michael G. Linnert Fax: (650) 614-8222 12 TCV II (Q), L.P. By: Technology Crossover Management II, L.L.C., General Partner By:___________________________ Robert C. Bensky Chief Financial Officer Address: 56 Main Street, Suite 210 Copy: Technology Crossover Ventures Millburn, New Jersey 07041 575 High Street, Suite 400 Attention: Robert C. Bensky Palo Alto, California 94301 Fax: (973) 467-5323 Attention: Michael G. Linnert Fax: (650) 614-8222 13 TCV II STRATEGIC PARTNERS, L.P. By: Technology Crossover Management II, L.L.C. Its: General Partner By:_______________________ Robert C. Bensky Chief Financial Officer Address: 56 Main Street, Suite 210 Copy: Technology Crossover Ventures Millburn, New Jersey 07041 575 High Street, Suite 400 Attention: Robert C. Bensky Palo Alto, California 94301 Fax: (973) 467-5323 Attention: Michael G. Linnert Fax: (650) 614-8222 14 TECHNOLOGY CROSSOVER VENTURES II, C.V. By: Technology Crossover Management II, L.L.C., Its: Investment General Partner By:_________________________ Robert C. Bensky Chief Financial Officer Address: 56 Main Street, Suite 210 Copy: Technology Crossover Ventures Millburn, New Jersey 07041 575 High Street, Suite 400 Attention: Robert C. Bensky Palo Alto, California 94301 Fax: (973) 467-5323 Attention: Michael G. Linnert Fax: (650) 614-8222 15 _______________________________________ Scott K. Ginsburg Address: 5221 North O'Connor Boulevard, Suite 950 Irving, Texas 75039 16 _________________________________________ Matthew E. Devine Address: 5221 North O'Connor Boulevard, Suite 950 Irving, Texas 75039 17 SCHEDULE A Pequot Private Equity Fund, L.P. 500 Nyala Farm Road Westport, Connecticut 06880 Pequot Offshore Private Equity Fund, Inc. 500 Nyala Farm Road Westport, Connecticut 06880 TCV II, V.O.F. 56 Main Street, Suite 210 Millburn, NJ 07041 Technology Crossover Ventures II, L.P. 56 Main Street, Suite 210 Millburn, NJ 07041 TCV II (Q), L.P. 56 Main Street, Suite 210 Millburn, NJ 07041 TCV II Strategic Partners, L.P. 56 Main Street, Suite 210 Millburn, NJ 07041 Technology Crossover Ventures II, C.V. 56 Main Street, Suite 210 Millburn, NJ 07041 Scott K. Ginsburg 5221 North O'Connor Boulevard, Suite 950 Irving, Texas 75039 Matthew E. Devine 5221 North O'Connor Boulevard, Suite 950 Irving, Texas 75039 18 APPENDIX 1.4 ------------ SHAREHOLDER INFORMATION QUESTIONNAIRE: All information furnished below by the undersigned for use in the Registration Statement on Form S-3 is, and on the date such shares registered thereunder, will be true, correct, and complete in all material respects, and does not, and on the date on which the undersigned sells such shares, will not, contain any untrue statement of a material fact or omit to state any material fact necessary to make such information not misleading. By completing and returning this information statement, the undersigned hereby consents to the use of his or her name, address, and share ownership information in the Form S-3 of Digital Generation Systems, Inc. Date. - ---- Fill in Date: ______________________________ Name. Print: - ---- Print and sign name or names ______________________________ exactly as name or names appear on share certificate. If ______________________________ certificate is held in more than one name, all must sign. Sign: ______________________________ ______________________________ Address. - ------- Fill in your address: ______________________________ ______________________________ ______________________________ 19 D. Stock Owned. ----------- Fill in number of shares of Of Record Beneficially Common Stock owned of record and beneficially. ________ ___________ Aggregate Number of Shares of Common Stock to be Registered on Form S-3: - ----------------------------------------------------------------------- _____________ Shares F. Status. ------ The signatory hereto is an individual ( ), partnership ( ), corporation ( ), or other, as more fully described below ( ). The signatory is not acting in a fiduciary capacity or as a nominee in selling shares in the public offering, except as indicated below. ______________________________________________________________________________ ______________________________________________________________________________ ______________________________________________________________________________ 20 EX-10.45 3 COMMON STOCK PURCHASE AGREEMENT EXHIBIT 10.45 DIGITAL GENERATION SYSTEMS, INC. COMMON STOCK PURCHASE AGREEMENT THIS COMMON STOCK PURCHASE AGREEMENT is made as of the 17/th/ day of December, 1999, by and among Digital Generation Systems, Inc., a California corporation (the "Company"), and the investors, severally and not jointly, listed on Schedule A hereto, each of which is herein referred to as an "Investor." WHEREAS, the Company desires to sell, and the Investors desire to purchase, shares of the Company's Common Stock (the "Common Shares") with an aggregate purchase price of three million seven hundred fifty thousand four dollars and two cents ($3,750,004.02) and at a price per share equal to five dollars and seventeen and one-tenth cents ($5.171) (the "Purchase Price"). NOW, THEREFORE, THE PARTIES HEREBY AGREE AS FOLLOWS: 1. Purchase and Sale of the Common Shares. --------------------------------------- 1.1 Sale and Issuance of the Common Shares. --------------------------------------- (a) On or prior to the Closing (as defined below), the Company shall have authorized the sale and issuance to the Investors of the Common Shares. (b) Subject to the terms and conditions of this Agreement, each Investor agrees, severally and not jointly, to purchase at the Closing, and the Company agrees to sell and issue to each Investor at the Closing, that number of Common Shares set forth opposite such Investor's name on Schedule A hereto for the purchase price set forth opposite such Investor's name on Schedule A hereto. 1.2 Closing. The purchase and sale of the Common Shares shall take ------- place at the offices of the Company at 10:00 A.M., on December 17, 1999, or at such other time and place as the Company and Investors acquiring in the aggregate more than half of the Common Shares mutually agree upon orally or in writing (which time and place are designated as the "Closing"). At the Closing (or as soon thereafter as is practicable) the Company shall deliver to each Investor a certificate representing the Common Shares that such Investor is purchasing, against payment of the purchase price therefor by check or wire transfer. 2. Representations and Warranties of the Company. The Company hereby --------------------------------------------- represents and warrants to each Investor that: 2.1 Authorization. All corporate action on the part of the Company, ------------- its officers, directors and stockholders necessary for the authorization, execution and delivery of this Agreement and the Registration Rights Agreement, in the form attached hereto as Exhibit A (the "Registration Rights Agreement"), the performance of all obligations of the Company hereunder and thereunder, and the authorization, issuance, sale and delivery of the Common Shares being sold hereunder has been taken or will be taken prior to the Closing, and this Agreement and the Registration Rights Agreement constitute valid and legally binding obligations of the Company, enforceable in accordance with their respective terms, except (i) as limited by applicable bankruptcy, insolvency, reorganization, moratorium, and other laws of general application affecting enforcement of creditors' rights generally, (ii) as limited by laws relating to the availability of specific performance, injunctive relief, or other equitable remedies, and (iii) to the extent the indemnification provisions contained in the Registration Rights Agreement may be limited by applicable federal or state securities laws. 2.2 Valid Issuance of Common Shares. The Common Shares that are ------------------------------- being purchased by the Investors hereunder, when issued, sold and delivered in accordance with the terms of this Agreement for the consideration expressed herein, will be duly and validly issued, fully paid, and nonassessable, and will be free of restrictions on transfer other than restrictions on transfer under this Agreement and the Registration Rights Agreement and under applicable state and federal securities laws. 2.3 Offering. Subject in part to the truth and accuracy of each -------- Investor's representations set forth in Section 3 of this Agreement, the offer, sale and issuance of the Common Shares as contemplated by this Agreement are exempt from the registration requirements of any applicable state and federal securities laws, and neither the Company nor any authorized agent acting on its behalf will take any action hereafter that would cause the loss of such exemption. 2.4 Additional Information. The Company has filed in a timely manner ---------------------- all documents that the Company was required to file under the Securities Exchange Act of 1934, as amended (the "Exchange Act"), during the twelve (12) months preceding the date of this Agreement (the "SEC Filings"). The SEC Filings complied in all material respects with the requirements of the Exchange Act or the Securities Act of 1933, as amended (the "Act"), as the case may be, as of their respective filing or effective dates, and the information contained therein was true and correct in all material respects as of the date or effective date of such documents, and each of the SEC Filings, as of such date, did not contain an untrue statement of material fact or omit to state a material fact required to be stated therein or necessary to make the statements therein, in light of the circumstances under which they were made, not misleading. 3. Representations and Warranties of the Investors. Each Investor hereby ----------------------------------------------- represents and warrants that: 3.1 Authorization. Such Investor has full power and authority to ------------- enter into this Agreement and the Registration Rights Agreement, and each such Agreement constitutes its valid and legally binding obligation, enforceable in accordance with its terms except (i) as limited by applicable bankruptcy, insolvency, reorganization, moratorium, and other laws of general application affecting enforcement of creditors' rights generally, (ii) as limited by laws relating to the availability of specific performance, injunctive relief, or other equitable remedies, and (iii) to the extent the indemnification provisions contained in the Registration Rights Agreement may be limited by applicable federal or state securities laws. 3.2 Purchase Entirely for Own Account. This Agreement is made with --------------------------------- such Investor in reliance upon such Investor's representation to the Company, which by such Investor's 2 execution of this Agreement such Investor hereby confirms, that the Common Shares to be received by such Investor will be acquired for investment for such Investor's own account, not as a nominee or agent, and not with a view to the resale or distribution of any part thereof, and that such Investor has no present intention of selling, granting any participation in, or otherwise distributing the same. By executing this Agreement, such Investor further represents that such Investor does not have any contract, undertaking, agreement or arrangement with any person to sell, transfer or grant participations to such person or to any third person, with respect to the Common Shares. 3.3 Disclosure of Information. Such Investor believes it has ------------------------- received all the information it considers necessary or appropriate for deciding whether to purchase the Common Shares. Such Investor further represents that it has had an opportunity to ask questions and receive answers from the Company regarding the terms and conditions of the offering of the Common Shares and the business, properties, prospects and financial condition of the Company. 3.4 Investment Experience. Such Investor is an investor in --------------------- securities of companies in the development stage and acknowledges that it is able to fend for itself, can bear the economic risk of its investment, and has such knowledge and experience in financial or business matters that it is capable of evaluating the merits and risks of the investment in the Common Shares. If other than an individual, such Investor also represents it has not been organized for the purpose of acquiring the Common Shares. 3.5 Accredited Investor. Such Investor is an "accredited investor" ------------------- within the meaning of Securities and Exchange Commission ("SEC") Rule 501 of Regulation D, as presently in effect. 3.6 Restricted Securities. Such Investor understands that the Common --------------------- Shares are characterized as "restricted securities" under the federal securities laws inasmuch as they are being acquired from the Company in a transaction not involving a public offering and that under such laws and applicable regulations such securities may be resold without registration under the Act only in certain limited circumstances. In this connection, such Investor represents that it is familiar with SEC Rule 144, as presently in effect, and understands the resale limitations imposed thereby and by the Act. 3.7 Further Limitations on Disposition. Without in any way limiting ---------------------------------- the representations set forth above, such Investor further agrees not to make any disposition of all or any portion of the Common Shares unless and until the transferee has agreed in writing for the benefit of the Company to be bound by this Section 3 and the Registration Rights Agreement provided and to the extent this Section 3 and such agreement are then applicable, and: (a) There is then in effect a Registration Statement under the Act, covering such proposed disposition and such disposition is made in accordance with such Registration Statement; or 3 (b) (i) Such Investor shall have notified the Company of the proposed disposition and shall have furnished the Company with a detailed statement of the circumstances surrounding the proposed disposition, and (ii) if reasonably requested by the Company, such Investor shall have furnished the Company with an opinion of counsel, reasonably satisfactory to the Company that such disposition will not require registration of such shares under the Act. It is agreed that the Company will not require opinions of counsel for transactions made pursuant to SEC Rule 144 except in unusual circumstances. (c) Notwithstanding the provisions of Paragraphs (a) and (b) above, no such registration statement or opinion of counsel shall be necessary for a transfer by an Investor that is a partnership to a partner of such partnership or a retired partner of such partnership who retires after the date hereof, or to the estate of any such partner or retired partner or the transfer by gift, will or intestate succession of any partner to his or her spouse or to the siblings, lineal descendants or ancestors of such partner or his or her spouse, if the transferee agrees in writing to be subject to the terms hereof to the same extent as if he or she were an original Investor hereunder. 3.8 Legends. It is understood that the certificates evidencing the ------- Common Shares may bear one or all of the following legends: (a) "These securities have not been registered under the Securities Act of 1933, as amended. They may not be sold, offered for sale, pledged or hypothecated in the absence of a registration statement in effect with respect to the securities under such Act or an opinion of counsel satisfactory to the Company that such registration is not required or unless sold pursuant to Rule 144 of such Act." (b) Any legend required by the laws of the State of California, including any legend required by the California Department of Corporations and Sections 417 and 418 of the California Corporations Code. (c) Any legend required by applicable blue sky law. 4. Conditions of Investors' Obligations at Closing. The obligations of ----------------------------------------------- each Investor under Section 1 of this Agreement are subject to the fulfillment on or before the Closing of each of the following conditions, the waiver of which shall not be effective against any Investor who does not consent thereto: 4.1 Representations and Warranties. The representations and ------------------------------ warranties of the Company contained in Section 2 shall be true on and as of the Closing with the same effect as though such representations and warranties had been made on and as of the date of such Closing. 4.2 Performance. The Company shall have performed and complied with ----------- all agreements, obligations and conditions contained in this Agreement that are required to be performed or complied with by it on or before the Closing. 4 4.3 Qualifications. All authorizations, approvals, or permits, if -------------- any, of any governmental authority or regulatory body of the United States or of any state that are required in connection with the lawful issuance and sale of the Common Shares pursuant to this Agreement shall be duly obtained and effective as of the Closing. 4.4 Proceedings and Documents. All corporate and other proceedings ------------------------- in connection with the transactions contemplated at the Closing and all documents incident thereto shall be reasonably satisfactory in form and substance to Investors' special counsel, and they shall have received all such counterpart original and certified or other copies of such documents as they may reasonably request. 4.5 Registration Rights Agreement. The Company and each Investor ----------------------------- shall have entered into the Registration Rights Agreement. 4.6 Minimum Funding. The Investors shall collectively deliver to the --------------- Company the aggregate Purchase Price. 4.7 Lock-Up. The Directors of the Company who are not parties hereto ------- shall have executed and delivered to the Company letters to the effect that they shall be bound by restrictions substantially similar to the restrictions set forth in Section 6.1 hereof. 5. Conditions of the Company's Obligations at Closing. The obligations -------------------------------------------------- of the Company to each Investor under this Agreement are subject to the fulfillment on or before the Closing of each of the following conditions by that Investor: 5.1 Representations and Warranties. The representations and ------------------------------ warranties of the Investors contained in Section 3 shall be true on and as of the Closing with the same effect as though such representations and warranties had been made on and as of the Closing. 5.2 Payment of Purchase Price. The Investor shall have delivered the ------------------------- purchase price specified in Section 1.1. 5.3 Qualifications. All authorizations, approvals, or permits, if -------------- any, of any governmental authority or regulatory body of the United States or of any state that are required in connection with the lawful issuance and sale of the Common Shares pursuant to this Agreement shall be duly obtained and effective as of the Closing. 6. Miscellaneous. ------------- 6.1 Lock-Up. Each Investor agrees, severally and not jointly, that ------- without the prior written consent of the Board of Directors, the Investor will not, directly or indirectly, sell, offer to sell, contract to sell, solicit an offer to buy, grant any option for the purchase or sale of, assign, pledge, distribute or otherwise transfer, dispose of or encumber any shares of the Company's 5 Common Stock, or any options, rights, warrants or other securities convertible into or exercisable or exchangeable for the Company's Common Stock or evidencing any right to purchase or subscribe for shares of the Company's Common Stock, whether or not beneficially owned by the undersigned, for a period of 180 days after the Closing. Each Investor agrees to cause its Affiliates (as defined under the Securities Act of 1933) to comply with the foregoing restrictions. To the extent that any Investor or other person referred to above is subsequently relieved of the foregoing restrictions, all Investors will be relieved from such restriction on a pro rata basis. In furtherance of the foregoing, the Company and ChaseMellon Shareholder Services, L.L.C., as Transfer Agent for the Company's Common Stock, are hereby authorized to decline to make any transfer of securities if such transfer would constitute a violation or breach of the provisions hereof. Each Investor hereby consents to the placing of a stop-transfer order with the Transfer Agent for such 180-day period with respect to any of the shares of the Company's Common Stock registered in the name of such Investor or his Affiliates or beneficially owned by such Investor or his Affiliates. 6.2 Survival of Warranties. The warranties, representations and ---------------------- covenants of the Company and Investors contained in or made pursuant to this Agreement shall survive the execution and delivery of this Agreement and the Closing and shall in no way be affected by any investigation of the subject matter thereof made by or on behalf of the Investors or the Company. 6.3 Successors and Assigns. Except as otherwise provided herein, the ---------------------- terms and conditions of this Agreement shall inure to the benefit of and be binding upon the respective successors and assigns of the parties (including transferees of any Common Shares). Nothing in this Agreement, express or implied, is intended to confer upon any party other than the parties hereto or their respective successors and assigns any rights, remedies, obligations, or liabilities under or by reason of this Agreement, except as expressly provided in this Agreement. 6.4 Governing Law. This Agreement shall be governed by and construed ------------- under the laws of the State of California as applied to agreements among California residents entered into and to be performed entirely within California. 6.5 Counterparts. This Agreement may be executed in two or more ------------ counterparts, each of which shall be deemed an original, but all of which together shall constitute one and the same instrument. 6.6 Titles and Subtitles. The titles and subtitles used in this -------------------- Agreement are used for convenience only and are not to be considered in construing or interpreting this Agreement. 6.7 Notices. Unless otherwise provided, any notice required or ------- permitted under this Agreement shall be given in writing and shall be deemed effectively given upon personal delivery to the party to be notified, deposit with a nationally recognized overnight courier, confirmed facsimile or upon deposit with the United States Post Office, by registered or certified mail, postage prepaid and addressed to the party to be notified at the address or addresses indicated for such party 6 on the signature page hereof, or at such other address as such party may designate by ten (10) days' advance written notice to the other parties. 6.8 Finder's Fee. Each party represents that it neither is nor will ------------ be obligated for any finders' fee or commission in connection with this transaction. Each Investor agrees to indemnify and to hold harmless the Company from any liability for any commission or compensation in the nature of a finders' fee (and the costs and expenses of defending against such liability or asserted liability) for which such Investor or any of its officers, partners, employees, or representatives is responsible. The Company agrees to indemnify and hold harmless each Investor from any liability for any commission or compensation in the nature of a finders' fee (and the costs and expenses of defending against such liability or asserted liability) for which the Company or any of its officers, employees or representatives is responsible. 6.9 Expenses. Irrespective of whether the Closing is effected, each -------- party shall pay all costs and expenses that it incurs with respect to the negotiation, execution, delivery and performance of this Agreement. If any action at law or in equity is necessary to enforce or interpret the terms of this Agreement or the Registration Rights Agreement, the prevailing party shall be entitled to reasonable attorney's fees, costs and necessary disbursements in addition to any other relief to which such party may be entitled. 6.10 Amendments and Waivers. Any term of this Agreement may be ---------------------- amended and the observance of any term of this Agreement may be waived (either generally or in a particular instance and either retroactively or prospectively), only with the written consent of (a) the Company and (b) the holders of two-thirds (2/3) of the Common Shares. Any amendment or waiver effected in accordance with this paragraph shall be binding upon each holder of any securities purchased under this Agreement at the time outstanding (including securities into which such securities are convertible), each future holder of all such securities, and the Company. 6.11 Severability. If one or more provisions of this Agreement are ------------ held to be unenforceable under applicable law, such provision shall be excluded from this Agreement and the balance of the Agreement shall be interpreted as if such provision were so excluded and shall be enforceable in accordance with its terms. 6.12 Corporate Securities Law. THE SALE OF THE SECURITIES THAT ARE ------------------------ THE SUBJECT OF THIS AGREEMENT HAS NOT BEEN QUALIFIED WITH THE COMMISSIONER OF CORPORATIONS OF THE STATE OF CALIFORNIA AND THE ISSUANCE OF SUCH SECURITIES OR THE PAYMENT OR RECEIPT OF ANY PART OF THE CONSIDERATION FOR SUCH SECURITIES PRIOR TO SUCH QUALIFICATION IS UNLAWFUL, UNLESS THE SALE OF SECURITIES IS EXEMPT FROM QUALIFICATION BY SECTION 25100, 25102 OR 25105 OF THE CALIFORNIA CORPORATIONS CODE. THE RIGHTS OF ALL PARTIES TO THIS AGREEMENT ARE EXPRESSLY CONDITIONED UPON SUCH QUALIFICATION BEING OBTAINED, UNLESS THE SALE IS SO EXEMPT. 7 6.13 Entire Agreement. This Agreement and the documents referred to ---------------- herein constitute the entire agreement among the parties and no party shall be liable or bound to any other party in any manner by any warranties, representations, or covenants except as specifically set forth herein or therein. 8 IN WITNESS WHEREOF, the parties have executed this Agreement as of the date first above written. DIGITAL GENERATION SYSTEMS, INC. By: ------------------------------- Matthew E. Devine Chief Executive Officer Address: 875 Battery Street San Francisco, CA 94111 9 INVESTOR: PEQUOT PRIVATE EQUITY FUND, L.P. By: Pequot Capital Management, Inc., as Investment Manager By: --------------------------------------- David J. Malat, Chief Financial Officer Address: 500 Nyala Farm Road Westport, Connecticut 06880 PEQUOT OFFSHORE PRIVATE EQUITY FUND, INC. By: Pequot Capital Management, Inc., as Investment Manager By: --------------------------------------- David J. Malat, Chief Financial Officer Address: 500 Nyala Farm Road Westport, Connecticut 06880 10 TCV II, V.O.F. By: Technology Crossover Management II, L.L.C., Its: Investment General Partner By: ------------------------------- Robert C. Bensky Chief Financial Officer Address: 56 Main Street, Suite 210 Copy: Technology Crossover Ventures Millburn, New Jersey 07041 575 High Street, Suite 400 Attention: Robert C. Bensky Palo Alto, California 94301 Fax: (973) 467-5323 Attention: Michael G. Linnert Fax: (650) 614-8222 TECHNOLOGY CROSSOVER VENTURES II, L.P. By: Technology Crossover Management II, L.L.C., Its: General Partner By: -------------------------------- Robert C. Bensky Chief Financial Officer Address: 56 Main Street, Suite 210 Copy: Technology Crossover Ventures Millburn, New Jersey 07041 575 High Street, Suite 400 Attention: Robert C. Bensky Palo Alto, California 94301 Fax: (973) 467-5323 Attention: Michael G. Linnert Fax: (650) 614-8222 11 TCV II (Q), L.P. By: Technology Crossover Management II, L.L.C., General Partner By: ------------------------------------ Robert C. Bensky Chief Financial Officer Address: 56 Main Street, Suite 210 Copy: Technology Crossover Ventures Millburn, New Jersey 07041 575 High Street, Suite 400 Attention: Robert C. Bensky Palo Alto, California 94301 Fax: (973) 467-5323 Attention: Michael G. Linnert Fax: (650) 614-8222 TCV II STRATEGIC PARTNERS, L.P. By: Technology Crossover Management II, L.L.C. Its: General Partner By: ------------------------------- Robert C. Bensky Chief Financial Officer Address: 56 Main Street, Suite 210 Copy: Technology Crossover Ventures Millburn, New Jersey 07041 575 High Street, Suite 400 Attention: Robert C. Bensky Palo Alto, California 94301 Fax: (973) 467-5323 Attention: Michael G. Linnert Fax: (650) 614-8222 12 TECHNOLOGY CROSSOVER VENTURES II, C.V. By: Technology Crossover Management II, L.L.C., Its: Investment General Partner By: --------------------------------- Robert C. Bensky Chief Financial Officer Address: 56 Main Street, Suite 210 Copy: Technology Crossover Ventures Millburn, New Jersey 07041 575 High Street, Suite 400 Attention: Robert C. Bensky Palo Alto, California 94301 Fax: (973) 467-5323 Attention: Michael G. Linnert Fax: (650) 614-8222 13 ------------------------ Scott K. Ginsburg Address: 5221 North O'Connor Boulevard Suite 950 Irving, Texas 75039 14 ------------------------ Matthew E. Devine Address: 5221 North O'Connor Boulevard Suite 950 Irving, Texas 75039 15 Schedule A Schedule of Investors
Aggregate Purchase Price of Number of Name and Address Common Shares Common Shares ---------------- ----------------- ------------- Pequot Private Equity Fund, L.P. $1,109,525.96 214,567 500 Nyala Farm Road Westport, Connecticut 06880 Pequot Offshore Private Equity $ 140,475.39 27,166 Fund, Inc. 500 Nyala Farm Road Westport, Connecticut 06880 TCV II, V.O.F. $ 11,655.43 2,254 56 Main Street, Suite 210 Millburn, NJ 07041 Technology Crossover Ventures II, $ 358,779.49 69,383 L.P. 56 Main Street, Suite 210 Millburn, NJ 07041 TCV II (Q), L.P. $ 275,836.65 53,343 56 Main Street, Suite 210 Millburn, NJ 07041 TCV II Strategic Partners, L.P. $ 48,953.86 9,467 56 Main Street, Suite 210 Millburn, NJ 07041 Technology Crossover Ventures II, $ 54,776.40 10,593 C.V. 56 Main Street, Suite 210 Millburn, NJ 07041 Scott K. Ginsburg $1,250,001.34 241,733 5221 North O'Connor Boulevard Suite 950 Irving, Texas 75039 Matthew E. Devine $ 499,999.50 96,693 5221 North O'Connor Boulevard Suite 950 Irving, Texas 75039 TOTAL $3,750,004.02 725,199 ============= =======
16 EX-11.1 4 STATEMENTS OF COMPUTATION OF EARNINGS Exhibit 11.1 DIGITAL GENERATIONS SYSTEMS, INC. STATEMENTS OF COMPUTATION OF WEIGHTED AVERAGE COMMON SHARES (in thousands, except for per share amounts)
Year Ended Year Ended Year Ended December 31, December 31, December 31, 1999 1998 1997 ---------------------------------------- Net Loss $ (8,763) $ (30,237) $ (14,775) ======================================== Weighted Average common shares outstanding 26,653 16,272 11,893 ======================================== Basic and diluted net loss per common share (1) $ (0.33) $ (1.97) $ (2.52) ========================================
(1) For the year ended December 31, 1998, the net loss per share was computed as a net loss of $30,237,000 plus $1,764,000 relating to the preferred stock deemed dividend divided by the weighted average common shares outstanding. For the year ended December 31, 1997, the net loss per share was computed as net loss of $14,775,000 plus $15,161,000 relating to the preferred stock deemed divided by the weighted average common shares outstanding. (See Note 8 to the Consolidated Financial Statements) EX-21.1 5 SUBSIDIARIES OF THE REGISTRANT Exhibit 21.1 SUBSIDIARIES OF THE REGISTRANT The registrant's subsidiaries are PDR Productions, Inc., a New York Corporation; Mediatech, Inc., a Delaware Corporation; and DG Systems North, Inc., a Yukon Territory, Canada Corporation. EX-23.1 6 CONSENT OF KPMG LLP Exhibit 23.1 CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS We consent to incorporation by reference in the registration statements (Nos. 333-25701 and 333-60611) on Form S-8 and registration statement (No. 333-70045) on Form S-3 of Digital Generation Systems, Inc. of our report dated February 25, 2000, relating to the consolidated balance sheet of Digital Generation Systems, Inc. and subsidiaries as of December 31, 1999, and the related consolidated statements of operations, shareholders' equity, and cash flows for the year then ended, and the related schedule, which report appears in the December 31, 1999 annual report on Form 10-K of Digital Generation Systems, Inc. KPMG LLP Dallas, Texas March 28, 2000 EX-23.2 7 CONSENT OF ARTHUR ANDERSEN, LLP Exhibit 23.2 CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation of our reports incorporated by reference in this Form 10-K, into the Company's previously filed Registration Statements on Form S-3, File No. 333-70045, and Form S-8, File No. 333-04676, and Form S-8, File No. 333-25701. ARTHUR ANDERSEN LLP San Francisco, California March 27, 2000 EX-27 8 FINANCIAL DATA SCHEDULE
5 1,000 12-MOS 12-MOS DEC-31-1999 DEC-31-1998 JAN-01-1999 JAN-01-1998 DEC-31-1999 DEC-31-1998 5,420 13,025 0 0 14,458 11,890 (1,659) (1,895) 489 368 19,936 23,953 41,930 37,483 (33,772) (25,738) 41,766 49,792 18,700 16,775 0 0 0 0 0 0 119,519 114,131 (98,966) (90,421) 41,766 49,792 48,724 41,270 48,724 41,270 32,995 29,410 55,903 51,740 0 0 0 0 (1,584) (2,761) (8,763) (30,237) 0 0 (8,763) (30,237) 0 0 0 0 0 0 (8,763) (30,237) (.33) (1.97) (.33) (1.97)
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