-----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, S8AkA6zUB0wPAi00XHPLu35xEtfTfEitY7et9kbmbidmgeUQeEZBFbZK1hDxKv8X far/cXQcwaohHD5KUpGogw== 0000950149-97-000563.txt : 19970319 0000950149-97-000563.hdr.sgml : 19970319 ACCESSION NUMBER: 0000950149-97-000563 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 7 CONFORMED PERIOD OF REPORT: 19961231 FILED AS OF DATE: 19970318 SROS: NASD 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: 1934 Act SEC FILE NUMBER: 000-27644 FILM NUMBER: 97558678 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 DIGITAL GENERATION SYSTEMS, INC. FORM 10-K 1 ================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-K [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 1996 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM TO . COMMISSION FILE NUMBER: 0-27644 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) SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: NONE SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT: COMMON STOCK 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 stock held by non-affiliates of the registrant, based upon the closing sale price of the Common Stock February 25, 1997 as reported on the Nasdaq National Market of $5.375 per share, was approximately $41,843,176. Shares of Common Stock held by each officer and director 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 February 25, 1997, the registrant had 11,686,175 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, to the extent stated herein, portions of its Proxy Statement for the Annual Meeting of Stockholders to be held on April 11, 1997 (the "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. ================================================================================ 2 DIGITAL GENERATION SYSTEMS, INC. This report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Actual results could differ materially from those indicated in the forward-looking statements as a result of certain factors, including those set forth under "Certain Business Considerations" in "Management's Discussion and Analysis of Financial Condition and Results of Operations" and elsewhere in, or incorporated by reference into, this report. The registrant has attempted to identify forward-looking statements in this report by placing an asterisk (*) following each sentence containing such statements. 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 Research and Development........................................................... 7 Competition........................................................................ 7 Intellectual Property and Proprietary Rights....................................... 8 Employees.......................................................................... 8 ITEM 2. PROPERTIES.................................................................... 8 ITEM 3. LEGAL PROCEEDINGS............................................................. 9 ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS........................... 9 ITEM 4A. EXECUTIVE OFFICERS OF THE REGISTRANT......................................... 9 PART II ITEM 5. MARKET FOR REGISTRANTS COMMON EQUITY AND RELATED STOCKHOLDER 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.................................................... 18 Certain Business Considerations.................................................... 19 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA................................... 26 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.................................................................... 26 PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT........................... 26 ITEM 11. EXECUTIVE COMPENSATION....................................................... 27 ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT............... 27 ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS............................... 27 PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K.............. 27 SIGNATURES.............................................................................. 30
3 PART I ITEM 1: BUSINESS Digital Generation Systems, Inc. ("DG Systems" or the "Company") operates a nationwide multimedia network designed to provide electronic delivery and related services to the broadcast industry by linking content providers to radio and television stations. The Company is the leading provider of electronic distribution of audio spot advertising to radio stations, and has entered the market for distribution of video spots to television stations, cable systems and networks. DG Systems derives its revenues from advertising agencies, production studios and other service providers that have traditionally relied upon physical delivery methods. The Company's network currently reaches over 5,000 radio stations and 200 television stations in the U.S. through the Company's scalable, fault-tolerant network operating center. The Company believes that its network enables the rapid, cost-effective and reliable transmission of broadcast content, and provides higher levels of quality, accountability and flexibility than current distribution methods. The Company has expanded the scope of its electronic distribution services to address television and cable advertising, music, network advertising and other content, and in November 1996 the Company purchased PDR Productions, Inc. ("PDR"), a provider of video and audio duplication, distribution and editing services based in New York City. INDUSTRY BACKGROUND While the radio and television broadcast industries have adopted digital technology for much of their production processes and certain of their in-station functions, current methods for the distribution of audio and video advertising content are primarily based on the physical delivery and manual processing of analog tapes. According to industry sources, there are approximately 10,000 commercial radio and 1,200 commercial television stations in the United States. These stations generate revenue principally by selling air time to advertisers. Advertising is most frequently produced either by a third party, such as a recording studio under the direction of an advertising agency, or, less frequently, by station personnel. Advertising is characterized as "network" or "spot", depending on how it is bought and distributed. Network advertising is typically delivered to stations together with network programming, while spot advertising is delivered to stations independent of programming. Spot advertising air time is purchased by advertising agencies or their representatives on behalf of advertisers who select individual stations or groups of stations to support marketing objectives, which are usually based on the stations' geographic and other demographic characteristics. Less frequently, advertisers purchase air time directly from stations, rather than using independent advertising agencies. While advertisers and their agencies are purchasing air time, their creative teams are developing the content for the spots to be broadcast. The actual spot is typically produced at a production studio and recorded on tape. Variations of the spot intended for specific demographic groups are also recorded at this time. The spot undergoes a review of its quality and content before it is cleared for transmission to broadcast stations. The tapes containing the spot and its variations are then duplicated, packaged and shipped to radio and television stations and cable headends specified by the advertiser or its agency. The predominant method for distributing spot advertisements to radio and television stations has been the physical delivery of analog audio or video tapes. The Company estimates that more than 50% of radio spots and more than 90% of video spots are currently delivered by air express services. The remainder are produced within individual stations, delivered by local delivery services or picked up by station employees from the originating studio. Many companies, commonly known as "dub and ship houses", are in the business of copying audio and video tapes and packaging them for air express delivery. The Company estimates that approximately four million audio tapes and approximately five million video tapes were delivered via air express to radio and television stations in 1996 through the efforts of approximately 400 production studios and dub and ship houses. 1 4 THE COMPANY DG Systems is a leading provider of electronic distribution 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. DG Systems has developed a digital network currently serving over 5,000 radio stations and 200 television stations that is controlled through the Company's network operating center. This network enables the rapid, accurate, 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. The associated trafficking 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 generally superior to that currently delivered on analog tape. DG Systems derives revenue 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 orders with specific routing and timing instructions provided by the customer. These orders are then entered into the Company's computer system and scheduled for electronic delivery, if a station is on the Company's network, or physical delivery via the Company's Louisville, Kentucky, dub and ship facility, if the station is not. Audio content is delivered electronically to the Company's network operating center from Record Send Terminals ("RSTs") that are owned by the Company and deployed primarily in production studios. When an audio spot is received, Company personnel currently review the audio and then initiate the electronic transaction to transmit the audio to the designated radio stations. Audio transmissions are currently delivered over standard telephone or ISDN lines. Video content is delivered electronically to the Company's network operating center from DG Video Transmission Systems ("VTSs") that are owned by the Company and deployed primarily in production studios. Video content can also be delivered to the Company's network operating center through air freight carriers such as United Parcel service and Federal Express or through high-speed fiber networks from collection points in locations where VTSs are not available. When a video spot is received, Company personnel initiate the electronic transaction to transmit the video to designated television stations. Video transmissions are sent via high speed frame relay links to the Hughes Network Systems satellite uplink facility in Germantown, Maryland and are then delivered to television stations and cable headends via the Hughes DirecPC digital satellite system. Audio transmissions are received at designated radio stations on Receive Playback Terminals ("RPTs"), which are owned by the Company and typically installed in the production area of the stations. Video transmissions are received at designated television stations and cable systems on DirecPC satellite receipt capable ADvantage Digital Video Playback Systems ("DVPSs"), which are owned by the Company and typically installed in the production area of the stations. Upon receipt, station personnel generally review the content and transfer the spot to the broadcast system for later broadcast. Through its network operating center, the Company monitors the spots stored in each RPT or DVPS and ensures that space is always available for new transmissions. The Company can quickly retransmit deliveries at the request of a station or in response to the request of a customer who wishes to alter an existing order. DG Systems currently offers three primary levels of service to broadcast advertisers distributing content to radio or television stations: DG Express, which guarantees arrival within four hours; DG Standard, which guarantees arrival by noon the next day; and DG Economy, which guarantees arrival by noon on the second day. In addition, the Company offers DG Priority, an audio spot delivery service which guarantees arrival of the first spot on an order within one hour. The Company also offers a set of premium services enabling advertisers to distribute audio or video spots after the normal cutoff times. The Company does not charge for late deliveries or retransmissions. 2 5 In addition to its standard services, the Company addresses three vertical markets with particular time-sensitive delivery needs. "Sweeps" delivery is a specialized service to television stations that wish to advertise on radio to stimulate viewership during the periods of ratings conducted by the A.C. Nielsen Company in February, May, August, and November of each year. 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. Finally, the Company delivers political advertising during election campaigns, providing a rapid response mechanism for candidates and issue groups. The Company provides additional ancillary services, including audio and video editing, physical archiving, closed captioning, modification of slates, and format conversions to the New York City market through its wholly owned subsidiary, PDR. PRODUCTS AND SERVICES The Company's mission is to become the leading provider of electronic delivery and related, value added services to broadcast advertisers. The Company also seeks to achieve brand name recognition as the industry standard for digital delivery of audio and video content. Audio Advertising Distribution. The Company's revenues to date have been derived principally from one major 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, and such services are expected to continue to account for a significant share of the Company's revenues for some time.* See "The Company" and "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 three vertical markets, sweeps; local/regional newspapers; and political advertising. See "The Company." Finally, the Company derives limited revenue today through its Studio Bridge and Studio Exchange services, which enable production studios to directly exchange audio files with each other without the intervention of Company personnel. These studio-to-studio services are offered according to two different pricing methods: unlimited transmissions for a fixed monthly fee or pay-as-you-go on a per transaction basis. 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 the third quarter of 1996. To date, the Company has deployed a video distribution network consisting of over 200 television stations and cable systems, which are currently on-line and able to receive video content through the Company's network, and is actively marketing and selling the video services to agencies, advertisers and dealers. As substantially all of the Company's radio and advertising customers are also active television advertisers, the Company is marketing and selling these services to many of its current customers who already utilize the Company's audio spot distribution services. In order to build a significant video business, the Company believes that it must continue to expand its network of on-line television stations and cable systems, as well as sign up agencies and dealers to distribute their broadcast advertisements through DG Systems' network. To obtain deliveries directly from agencies, the Company must also develop and market a set of ancillary, pre-distribution services in each major market. There can be no assurance that the Company will overcome the technological and operational barriers as well as competitive threats in a time frame required to become one of the industry's leading supplier of such 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." 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 release of a new album by an established musical artist is often the focus of a marketing campaign culminating in the simultaneous release of a hit single to radio stations in key markets. Music labels share the concerns of advertisers and agencies regarding the timeliness and reliability of delivery, and in addition seek to maximize publicity by employing a secure delivery system that ensures all selected 3 6 radio stations will receive the single just in time for the scheduled release but prevent it from being aired before that time. In addition, new or "up and coming" artists backed by major record labels seek the opportunity to market their music to radio stations through innovative means, including simultaneous, first-release distribution. The Company to date has provided first-release music deliveries for over thirty different artists. The typical first-release music distribution has been to a larger group of radio stations than the average advertising spot. While this business has provided the Company with significant promotional opportunities and marketing exposure, it has not contributed a substantial share of the Company's revenues in any fiscal period and the Company does not expect that first release music delivery services will generate a large share of the Company's revenues or profits in the future. The Company's future growth depends on its successful and timely introduction of new products and services in markets that do not currently exist or are just emerging. The Company is currently undertaking efforts to develop new products and services. However, and there can be no assurance that the Company will successfully complete such development or that even if such development is completed, the Company's planned 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 Energy Markets." THE DG SYSTEMS NETWORK The Company's network consists of the following: (i) Record Send Terminals (audio) and Video Transmission Systems (video) owned by the Company and installed primarily at production studios; (ii) a network operating center at the Company's headquarters used to process, route and store digital content; and (iii) Receive Playback Terminals (audio) and Digital Video Playback Systems (video) owned by the Company and installed at broadcast stations. Record Send Terminal. The RST is a PC-based media encoder and communications server with a full screen monitor and keyboard. The RST accepts audio in either analog or digital format and encodes the audio using an efficient compression algorithm for transmissions to the Company's network operating center. Video Transmission System. The VTS is a workstation-based video encoder and communications server with a full screen monitor and keyboard. The VTS accepts video in either analog or digital format and encodes the video using an MPEG 2 compression algorithm for transmissions to the Company's network operating center. Network Operating Center. DG systems has developed a fault-tolerant client/server on-line transaction system based on Sun Microsystems' SparcServers. The Company has developed software applications incorporating critical operation 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 delivery system 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. DG Systems has developed a sophisticated, highly scaleable network communication system to provide network transaction services to the targeted stations. Today this system supports two-way communication to remote stations via standard telephone lines, satellite, ISDN and frame relay connections. The Company intends to add additional communications capabilities, such as Internet, beginning in 1997. The modular system design and use of industry standard technology enables system capacity to be increased easily and quickly. DG Systems can maintain over 400 simultaneous connections today and expects this capacity to double by the end of 1997.* 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." Receive Playback Terminal. The RPT is a rack-mountable, PC-based communication server and media decoder which enables radio stations to receive and play back digital audio content delivered through the 4 7 Company's digital distribution network. The RPT communicates with the Company's network to exchange media and transactional information, and allows users to playback 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. Digital Video Playback System. The DVPS is a rack-mountable, PC-based communication server and media decoder which enables television stations and cable systems to receive and play back television advertisements and other digital video content 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 playback broadcast quality media 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 upgrade 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 the Company's network of stations. The Company has developed an electronic interface between its network operating center and the Hughes satellite uplink facility. The Company has also worked with Hughes to integrate the Hughes DirecPC satellite technology into its RPTs and DVPSs to permit the receipt of media content from satellite as well as from terrestrial connections. MARKETS AND CUSTOMERS Substantially all 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 by billing advertising agencies directly and by billing its marketing partners, which are 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 and amusements. 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." In addition to its core distribution services, DG Systems has identified vertical-market applications for audio distribution services where same day delivery is used to promote time-sensitive content. These applications include: Sweeps Promotions. The A.C. Nielsen ratings periods take place during the broadcast months of February, May, August, and November. The Company's services allow local television stations, their affiliated networks and/or syndicators, whose own advertising rates are based on their Nielsen ratings, to promote viewership of their programs during ratings periods. In 1996, more than 70 television stations used the Company's sweeps delivery service. Political Campaigns. Using radio during election campaigns provides a rapid response mechanism for candidates and issue groups. The Company offers same-day service to facilitate such advertising during political campaigns. Newspaper Headlines. Newspapers use the Company's services to deliver topical radio commercials to run during the morning or afternoon drive times in local markets to encourage readership for local newspapers. The producer typically reads a special early edition of the paper. Stories are selected on the basis of topical content with the best chance of encouraging listeners to become readers. The spot is written, recorded, mixed 5 8 and transmitted to DG Systems for distribution to local radio stations. Delivery guarantees are typically between one and two hours depending on the market. SALES, MARKETING AND CUSTOMER SERVICE Brand Strategy. The Company's brand strategy is to position itself as the standard delivery method for advertising and short-form content for the radio and television broadcast industry. The Company focuses its marketing messages, advertising and programs at multiple segments within the broadcast industry. 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 network operating center. Production studios and dub and ship houses resell delivery services to agencies. Stations join the network and receive the content. A key strategy to providing a consistent brand theme at all levels is developing "DG" as a brand identity across the product and services offerings. Sales. The Company employs a direct sales force that calls on creative, marketing and traffic departments at advertising agencies to communicate the capabilities and comparative advantages of the Company's electronic distribution system and the related products and services. In addition, the Company's sales force calls on corporate advertisers who may be in a position to influence agencies in directing deliveries to the Company. The Company currently has field sales offices in New York, Los Angeles, Chicago and Washington D.C., as well as sales personnel in its San Francisco headquarters. Members of the Company's sales force are compensated through salary and incentive commissions. The Company's sales force includes field sales, inside sales (serving as account coordinators and supporting field sales efforts), and telemarketing (for identifying and qualifying leads). 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, 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 partial sponsorship of the annual Mercury Awards of the Radio Advertising Bureau. The Company also engages in limited print 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. The service contract offers the station free use of the RPT or DVPS, but each station is generally required to pay for a dedicated phone or ISDN line to support the transmissions. For higher-volume stations, each station is requested to pay the cost of an ISDN connection, the cost of which can vary from $35 to $400 per month, depending on the regional carrier's pricing and service combination. In certain instances the Company agrees to pay for the initial installation of such phone or ISDN lines, and may also pay for several month's worth of maintenance costs during limited promotional periods. For the major television network affiliates in the top markets, the Company may elect to pay for monthly maintenance of the phone or ISDN lines on an ongoing basis. According to industry sources, there are over 5,200 commercial radio stations that are located in Arbitron-rated "Areas of Dominant Influence," which are the geographic areas in which national advertisers are most active. The Company believes its installed base of RPTs serving over 5,000 radio stations, over 95% of which are located in these areas, provides it with an important competitive advantage. The Company is similarly focusing on the largest 100 television markets as rated by A.C. Nielsen, along with the major cable interconnects in the largest U.S. markets. Customer Service. The Company also has a customer service staff which is available between the hours of 5 a.m. and 8 p.m., Pacific time. This staff supports not only the Company's customers but also the broadcast stations who receive the deliveries. Customer service calls may concern such matters as the placing, revision or cancellation of orders, inquiries by agencies or studios about the audio or video portion of the order, inquiries 6 9 from studios about technical problems with RSTs or VTSs, inquiries by broadcast station personnel about their inclusion in particular orders, the status of particular orders, and problems with RPTs or DVPSs. RESEARCH AND DEVELOPMENT The Company has devoted, and intends to devote in the future, a significant portion of its resources to product development programs.* As of December 31, 1996 the Company had 16 employees engaged in product development. The Company's products development expenses for fiscal 1996, 1995 and 1994 were approximately $2,092,000, $1,590,000 and $1,048,000, respectively, and represented 20%, 31%, and 43%, respectively, of the Company's revenues. See "Products and Services", "The DG Systems Network" and "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Certain Business Considerations -- Dependence on New Product Introductions" and "-- Dependence on Technological Developments." The Company has an agreement with ABC Radio Networks ("ABC") to jointly develop and field trial an extension to the Company's existing network, including satellite transmission capabilities, through which ABC could electronically distribute advertising and programming to ABC's affiliate radio stations. If the development and trial is successful, further negotiations between the Company and ABC would be required regarding deployment of the satellite electronic distribution network. 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, and timeliness and accuracy of delivery. The Company competes with a variety of dub and ship houses, including publicly-held VDI Media, and production studios that have traditionally distributed taped advertising spots via physical delivery. These entities have long-standing ties to local distributors that will be difficult for the Company to replace. In addition, these dub and ship houses and production studios 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 post production, preparation, distribution and trafficking services. In order to effectively compete with such local, full-service providers, the Company will need to develop or contract for a range of ancillary services for its customers on a localized basis. Moreover, Digital Courier International Corporation has begun deployment of a system to electronically deliver audio content in Canada and the United States, and several other companies have announced such systems. The Company competes in the market for electronic video distribution services with IndeNet, Inc. and Vyvx Advertising Distribution Services ("VADS"), a subsidiary of The Williams Companies, Inc. In November 1996, VADS acquired CycleSat, Inc., a provider of satellite video delivery services, from Winnebago Industries, Inc. CycleSat also operates a dub and ship business in New York City that competes with the Company's subsidiary, PDR. To the extent that the Company is successful in entering new markets, such as delivery of other content to radio and television stations, it would expect to face competition from companies in related communications markets and/or package delivery markets which could offer products and services with functionality similar or superior 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 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 separately from their network content programming. In addition, Applied Graphics Technologies, Inc., a provider of digital pre-press services, has indicated its intention to provide electronic distribution services and acquired Spotlink, a dub and ship house, 7 10 in December 1996. Although Spotlink revenues were less than 5% of the Company's revenues in 1996, the Company considers Spotlink to be a significant customer for the Company's audio delivery service. There can be no assurance that Spotlink will continue to be a customer of the Company, and the loss of Spotlink as a customer could have a material adverse effect on the Company's operating results. Many of the Company's current and potential competitors in the markets for audio and video transmissions have substantially greater financial, technical, marketing and other resources and larger installed customer bases than the Company. There can be no assurance that the Company will be able to compete successfully against current and future competitors based on these and other factors. The Company expects that an increasingly competitive environment will 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 transmissions 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 competitors. 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." 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. The Company does not hold any patents. 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 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 The Company had 184 employees as of December 31, 1996, including 111 in customer operations, 30 in sales and marketing, 16 in engineering and research and development, and 27 in administration. The Company's employees are not represented by any collective bargaining organization, and the Company has never experienced a work stoppage. ITEM 2. PROPERTIES The Company has leased it's headquarters facility located at a multi-tenant office building located at 875 Battery Street in San Francisco, California. The Company's lease is for 15,000 square feet and expires in 2001. The Company has an agreement for non-interruptible access to emergency power and the Company has arranged for alternative routes to maintain its fiber connection between its computers and its long distance 8 11 carrier. However, there can be no assurance that a catastrophic earthquake or other natural disaster could not interrupt the Company's operations. The Company also leases approximately 5,000 square feet on a nearby ground-floor location used for assembly of its field equipment and for offsite storage which expires in 2001. In addition, the Company leases approximately 3,000 square feet in Louisville, Kentucky for its dub and ship facility and approximately 22,000 square feet in New York City which is occupied by PDR. The Company leases additional facilities and offices for sales and customer service in California, Illinois, New York, and Washington, D.C. The Company believes that these facilities and offices and additional or alternative space available to it are adequate to meet its requirements for the foreseeable future. ITEM 3. LEGAL PROCEEDINGS The Company is subject 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 will have a material adverse effect on the Company's consolidated results of operations or consolidated financial position.* ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None ITEM 4A. EXECUTIVE OFFICERS OF THE REGISTRANT The executive officers and directors of the Company and their ages as of December 31, 1996, are as follows:
NAME AGE POSITION - -------------------------- --- ----------------------------------------- Henry W. Donaldson 51 President, Chief Executive Officer and Director Ken K. Cheng 41 Senior Vice President, Chief Operating Officer Jeffrey A. Byrne 41 Vice President, Marketing Jon E. Reese 55 Vice President, Sales Gregory G. Schott 32 Vice President, Operations Thomas P. Shanahan 50 Vice President, Finance and Chief Financial Officer Kevin R. Compton(1) 38 Director Jeffrey M. Drazan(2) 37 Director Richard H. Harris(2) 67 Director Leonard S. Matthews(1)(2) 74 Director
- --------------- (1) Member of the Audit Committee (2) Member of the Compensation Committee Henry W. Donaldson joined the Company in March 1993, and since such date has served as it President and Chief Executive Officer and as a Director of the Board of Directors. He was formerly President of the Data Communications Division of Rexel, Inc. (formerly Willcox & Gibbs), a distributor of electrical parts and supplies, from September 1989 through January 1993. Mr. Donaldson holds a B.A. in Mathematics from Hamilton College. Ken K. Cheng joined the Company in December 1993 and as Vice President, Engineering. Mr. Cheng was appointed Senior Vice President and Chief Operating Officer in June 1996 and has served as such since that date. From December 1988 to December 1993, Mr. Cheng was Director of Engineering at Network Equipment Technologies. Mr. Cheng holds a B.Sc. in Applied Mathematics from Queen's University, Kingston, Ontario, Canada and an M.B.A from Santa Clara University. 9 12 Jeffrey A. Byrne joined the Company in March 1996 and since such date has served as Vice President, Marketing. From July 1986 to June 1992, Mr. Byrne was Senior Director of Marketing for MIPS Computer Systems, Inc. From June 1992 to May 1993, Mr. Byrne was Director of Marketing for Novell, Inc. From May 1993 to March 1996, Mr. Byrne was Vice President of Worldwide Marketing for Dataquest, Inc. Mr. Byrne holds a B.S. in Mathematical Sciences from Stanford University and an M.B.A. from Harvard University. Jon E. Reese joined the Company in August 1994 as a consultant and has served as Vice President, Sales since January 1995. Mr. Reese was Vice President of Sales and Marketing of DCI from February 1991 to May 1994. Mr. Reese holds a B.S. in Accounting and Sales from Bloomburg University. Gregory G. Schott joined the Company in July 1994 as Director of Operations. Mr. Schott later served as Director of Business Development from December 1995 to June 1996 and since such date has served as Vice President, Operations. From June 1991 to July 1994, Mr. Schott was a consultant with the Boston Consulting Group. Mr. Schott holds a B.S. in Mechanical Engineering from North Carolina State University and an M.B.A. from Stanford University. Thomas P. Shanahan joined the Company in November 1994, and since such date has served as its Chief Financial Officer. From May 1987 to February 1992, Mr. Shanahan was Chief Financial Officer of SBT Corporation. From March 1992 to April 1993, Mr. Shanahan was Chief Financial Officer of Ultra Network Technologies, Inc. From May 1993 to October 1994, he was Chief Financial Officer of Sherpa Corporation. Mr. Shanahan holds a B.A. in Economics from Stanford University and an M.B.A. from Harvard University. Kevin R. Compton has been a member of the Board of Directors of the Company since March 1994. Mr. Compton has been a general partner of Kleiner, Perkins, Caufield & Byers, a venture capital investment firm, since December 1990. Mr. Compton currently serves as a director of Global Village Communication, Inc., a networking hardware and software company, Citrix Systems, a developer of server software, and on numerous private boards. He holds a B.S. in Business Administration from the University of Missouri. Jeffrey M. Drazan has been a member of the Board of Directors of the Company since July 1992. Mr. Drazan has been a general partner of Sierra Ventures, a venture capital investment firm, since 1985. Mr. Drazan currently serves on the boards of public companies FaxSav and Retix. Mr. Drazan holds a B.S.E. in Engineering from Princeton and an M.B.A. from New York University. Richard H. Harris has been a member of the Board of Directors of the Company since July 1992. Since July 1992, Mr. Harris has been President and Owner of Harris Classical Broadcasting, operating two FM audio stations in Milwaukee, Wisconsin. From May 1984 to May 1986, Mr. Harris was Chairman of the Radio Advertising Bureau. From June 1964 to April 1991, Mr. Harris held various senior management positions with Westinghouse Broadcasting Company, including Chairman of the Radio Group. Mr. Harris holds a B.A. in Communications and Economics from the University of Denver and is a graduate of the Advanced Management Program at Harvard University. Leonard S. Matthews has been a member of the Board of Directors of the Company since April 1993. From January 1979 to January 1989, Mr. Matthews was President and Chief Executive Officer of the American Association of Advertising Agencies. Previously, Mr. Matthews had been president of two of the world's leading advertising agencies, Leo Burnett and Young & Rubicam. From May 1992 to the present, Mr. Matthews has been Chairman of the Board of Next Century Media, an interactive television company. Mr. Matthews holds a B.S. in Business Administration & Marketing from Northwestern University. 10 13 PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER 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.
HIGH LOW ------ ------ FISCAL YEAR ENDED DECEMBER 31, 1996: First Quarter (from February 6, 1996).................... $12.25 $8.375 Second Quarter........................................... $13.25 $8.125 Third Quarter............................................ $10.25 $7.750 Fourth Quarter........................................... $11.00 $7.625
As of February 20, 1997, the Company had issued and outstanding 11,685,873 shares of its Common Stock held by 173 shareholders of record. The Company estimates that there are approximately 2,000 beneficial shareholders. 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; Potential Issuance of Preferred Stock; Anti-Takeover Provisions" and "-- Possible Volatility of Share Price." 11 14 ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA STATEMENTS OF OPERATIONS:
YEAR ENDED DECEMBER 31, ------------------------------------------------------- 1992 1993 1994 1995 1996 ------- ------- ------- ------- ------- (IN THOUSANDS, EXCEPT PER SHARE DATA) Revenues................................. $ 11 $ 315 $ 2,432 $ 5,144 $10,523 ------- ------- ------- ------- ------- Costs and expenses: Delivery and material costs............ 16 200 953 1,810 3,084 Customer operations.................... 54 735 1,886 2,974 4,164 Sales and marketing.................... 102 1,126 2,248 3,406 3,998 Research and development............... 590 505 1,048 1,590 2,092 General and administrative............. 511 672 1,054 1,380 1,677 Depreciation and amortization.......... 36 329 913 2,345 4,331 ------- ------- ------- ------- ------- Total expenses................. 1,309 3,567 8,102 13,505 19,346 ------- ------- ------- ------- ------- Loss from operations..................... (1,298) (3,252) (5,670) (8,361) (8,823) Other income (expense): Interest income........................ 12 35 129 417 1,422 Interest expense....................... (5) (58) (71) (836) (1,726) ------- ------- ------- ------- ------- Net Loss................................. $(1,291) $(3,275) $(5,612) $(8,780) $(9,127) ======= ======= ======= ======= ======= Pro forma net loss per share............. $ (.94) $ (.79) ======= ======= Pro forma weighted average common and common equivalent shares............... 9,360 11,594 ======= =======
BALANCE SHEET DATA:
DECEMBER 31, ------------------------------------------------------- 1992 1993 1994 1995 1996 ------- ------- ------- ------- ------- Cash, cash equivalents and short-term investments............................ $ 1,159 $ 495 $ 9,221 $ 6,205 $20,597 Working capital.......................... 1,904 115 8,755 4,651 14,200 Property and equipment, net.............. 452 1,455 3,175 5,772 12,630 Total assets............................. 2,643 2,222 13,572 14,459 45,248 Long-term debt, net of current portion... -- 303 1,573 4,540 8,495 Shareholders' equity..................... 2,382 1,358 10,502 6,373 26,839
12 15 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW The Company was incorporated in 1991. Though 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. In the third quarter of 1996, the Company began delivery of video commercials to television stations. As the network 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 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 (Express, Standard, or Economy), the channel from which the order is received (directly from an 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 currently offers three primary levels of electronic delivery of digital audio and video content through the network operating center located in San Francisco, California: DG Express, guaranteed arrival within four hours; DG Standard, guaranteed arrival by noon the next day; and DG Economy, guaranteed arrival by noon on the second day. The Company does not charge for late deliveries. 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. The Company provides volume discounts for volume deliveries. Because the revenue earned for delivery of the first spot is significantly greater than the revenue earned from a tied spot and because the Company's per spot electronic transmission cost is relatively constant regardless of volume, deliveries that comprise a single spot are generally more profitable that deliveries which include tied spots. The Company recognizes revenue for each order on the date the content is transmitted to the destination ordered. The Company assembles, owns and maintains Receive Playback Terminals ("RPTs"), which are located in the radio stations, Record Send Terminals ("RSTs"), which are located in advertising agencies and production studios, Video Transmission Systems ("VTSs"), 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 preferred 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 common stock of PDR Productions, Inc. ("PDR"), a New York City media duplication and distribution company (see the Notes to Consolidated Financial Statements and the Company's Current Report on Form 8-K/A filed January 21, 1997). PDR's primary operations are services typical of a traditional dub and ship house, including the physical duplication and delivery 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. The operating results of PDR are included in the consolidated results of the Company from the date of the closing of the transaction, November 8, 1996. See "Certain Business Considerations -- Uncertainties Relating to Integration of Operations." 13 16 RESULTS OF OPERATIONS The following presents the statements of operations of the Company expressed as a percentage of total revenues and the related operating data for the periods indicated.
YEAR ENDED DECEMBER 31, --------------------------- 1994 1995 1996 ------ ------ ----- STATEMENTS OF OPERATIONS: Revenues................................................ 100.0% 100.0% 100.0% Cost and expenses: Delivery and material costs.......................... 39.2 35.2 29.3 Customer operations.................................. 77.5 57.8 39.6 Sales and marketing.................................. 92.4 66.2 38.0 Research and development............................. 43.1 30.9 19.9 General and administrative........................... 43.4 26.8 15.8 Depreciation and amortization........................ 37.5 45.6 41.2 ------ ------ ----- Total Expenses.................................. 333.1 262.5 183.8 ------ ------ ----- Loss from operations.................................... (233.1) (162.5) (83.8) Other income (expense): Interest income...................................... 5.2 8.1 13.5 Interest expense..................................... (2.9) (16.3) (16.4) ------ ------ ----- Net loss................................................ (230.8)% (170.7)% (86.7)% ====== ====== =====
Revenues The Company has standard pricing for delivery of audio to radio stations based on a published rate card. The rate card contains pricing for the first spot and associated traffic instructions on a delivery, for additional tied spots, and for incidental services such as delivery of traffic instructions without audio and delivery of audio to customers to be used for promotional communications. Revenues earned from such incidental services have not been significant to date. The Company negotiates prices with larger customers and offers discounts to those customers who offer substantial, recurring volumes of business. The Company offers discounts to its marketing partners who consolidate and forward the deliveries of their agency customers. Late in the third quarter of 1996, the Company began offering delivery of video commercials to television stations and, in November 1996, the Company acquired PDR Productions, Inc., whose operations consist primarily of video duplication and distribution. The retail list prices for delivery of the first video spot are 50% to 100% greater than those for audio delivery and can be significantly higher, depending on the level of value added services (editing, close captioning, etc.) that may be included in an order. Such deliveries accounted for less than 5% of the Company's delivery volume in 1996. Revenues increased from $2,432,000 to $5,144,000 to $10,523,000 in 1994, 1995, and 1996, respectively. These increases in revenues were primarily due to the increased volume of deliveries. The Company made 180,000, 390,000 and 784,000 deliveries in 1994, 1995 and 1996, respectively. The Company believes that the substantial delivery and revenue increases since 1994 are the result of a number of factors, particularly increased acceptance by advertisers of the services offered by the Company and the increased availability of an expanded network of Company terminals located in radio and television stations. Average revenue per delivery decreased from $13.51 in 1994 to $13.19 in 1995. This reduction is attributable primarily to an increase in the proportion of deliveries made through the Company's dealer channel, those customers and marketing partners who consolidate and forward deliveries of their agency customers. All deliveries performed in 1994 and 1995 were deliveries of audio content. Average revenue per delivery increased from $13.19 in 1995 to $13.42 in 1996. Although average revenue per audio delivery decreased from $13.19 in 1995 to $12.72 in 1996, primarily due to volume discounts offered to both direct and indirect customers, the addition of video delivery and other services revenue, approximately 9% of total 14 17 revenues in 1996, resulted in an increased average revenue per delivery. As the percentage of video deliveries increases, the average revenue per delivery is expected to increase.* Delivery and Material Costs Delivery costs consist of fees paid to other service providers for charges incurred by the Company in the receipt, transmission and delivery of information via the Company's distribution network. For operations to date, delivery expenditures have principally been for the telephone transmission of deliveries performed electronically and for the air freight incurred in the physical delivery of tapes to locations not directly linked to the DG network operating center. Material costs consist primarily of audio and video tape and the related packaging. Delivery and material costs were $953,000, $1,810,000 and $3,084,000, or 39%, 35% and 29% of revenues for 1994, 1995 and 1996, respectively. The increases in costs are primarily due to the increased volumes of deliveries. Delivery and material costs as a percentage of revenues were reduced from 39% in 1994 to 35% in 1995 due to volume rate agreement improvements obtained from certain service providers, the implementation of ISDN transmission technologies by certain high volume users which reduced the average time necessary to transmit a minute of audio over a phone line and the cost benefits resulting from allocating the fixed telephone service and connection costs over a greater volume of deliveries. Delivery and material costs as a percentage of revenues has decreased from 35% in 1995 to 29% in 1996. This reduction is primarily due to reduced telecommunication expenses per electronic delivery. These reductions are the result of a rate reduction obtained from the Company's primary long distance telephone service provider, implementation of ISDN transmission technologies by additional high volume users, and more efficient access to long distance carriers due to equipment and switching improvements made by the Company. In addition, the proportion of deliveries being performed electronically increased from 75% in 1995 to 82% in 1996. These improvements in the long distance telephone rate and delivery efficiency were partially offset by increased materials costs per delivery resulting primarily from the physical deliveries made by PDR. The Company expects that delivery costs will increase in absolute dollars and may fluctuate as a percentage of revenues in future periods.* See "Certain Business Considerations -- Potential Fluctuations in Quarterly Results; Seasonality." Customer Operations Customer operations expenses consist primarily of salaries and the related overhead costs incurred in performing deliveries and providing services, including order entry, customer service and assembly and maintenance of network equipment including the Company's RPTs, RSTs, VTSs, DVPSs, tape dubbing and editing equipment, and the network operating center. Customer operations expenses were $1,886,000, $2,974,000 and $4,164,000 in 1994, 1995 and 1996, respectively. These increases were the result of adding the personnel necessary to respond to the greater volume of orders and deliveries made by customers and the increased volume of requests for remote terminals made by radio stations, production studios, and advertising agencies. Customer operations expenses as a percentage of revenues has decreased from 78% to 58% to 40% in 1994, 1995 and 1996, respectively, as the Company has realized the benefits of economies of scale from the increased delivery volume and improved the efficiency of its processing procedures through increased experience with the system and the hiring of additional qualified management. 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 which improve and increase the efficiency of its customer operations.* See "Certain Business Considerations -- Ability to Maintain and Improve Service Quality" and "-- Ability to Manage Growth." 15 18 Sales and Marketing Sales and marketing expenses include salaries, incentive compensation, professional fees and the related overhead costs incurred in promoting and marketing the Company and its services to customers and radio and television stations. Sales and marketing expenses were $2,248,000, $3,406,000 and $3,998,000, or 92%, 66% and 38% of revenues for 1994, 1995 and 1996, respectively. These increases were the result of additional costs incurred in introducing the Company's service to the marketplace, including the salaries of expanded sales and marketing forces, increased incentive compensation resulting from increased revenues and increased marketing program activity. The increase in expenses in 1995 versus 1994 is primarily due to an increase in the number of marketing personnel and programs. These programs include trade show participation, printing and circulation of brochures and informational literature, advertising and other Company promotional expenses. The increase in expenses in 1996 versus 1995 is due to additional personnel and the expansion of promotional programs to meet the Company's growth objectives. The Company expects to continue to expand sales and marketing programs designed to introduce the Company's services to the marketplace and to attract new customers for its services.* See "Certain Business Considerations -- Dependence on Emerging Markets." 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.* Research and Development Research and development expenses consist primarily of salaries, testing costs, consulting fees, and the related overhead incurred in the development and enhancement of the delivery system used to distribute information via the DG Systems' network. Research and development costs are expensed as incurred until technological feasibility is established, after which any additional costs are capitalized, in accordance with Statement of Financial Accounting Standards No. 86, "Accounting for the Costs of Computer Software to be Sold, Leased or Otherwise Marketed." To date, no software development costs ave been capitalized by the Company as the capitalizable amounts have been immaterial. Research and development expenses were $1,048,000, $1,590,000 and $2,092,000, in 1994, 1995 and 1996, respectively. Research and development expenses increased from $1,048,000 or 43% of revenues in 1994 to $1,590,000, or 31% of revenues in 1995. This increase in absolute dollars was due primarily to increased spending on the development and implementation of the second generation of the electronic delivery system and research on potential new methods of delivery and new services to be offered. Research and development expenses increased to $2,092,000, or 20% of revenues, in 1996, primarily due to the hiring of additional staff, including increased compensation and recruiting fees, and the development and testing costs associated with preparing the delivery system for the transmission of video content as well as the continued costs of research on potential new methods of delivery and new services to be offered . The Company expects that research and development expenses will 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 and related overhead costs for finance and general management of the Company. General and administrative expenses were $1,054,000, $1,380,000 and $1,677,000 in 1994, 1995 and 1996, respectively. These increases were primarily due to the addition of staff to support the growth of the Company's business. Although general and administrative expenses have increased in absolute dollars, these expenses as a percentage of revenues have decreased from 43% to 27% to 16% in 1994, 1995 and 1996, 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 expenses are attributable primarily to the Company's distribution network, including RPTs, RSTs, DVPSs , VTSs, video dubbing and editing equipment and the network operating 16 19 center. This equipment is expensed over the estimated useful life, generally three years. Depreciation and amortization expense was $913,000, $2,345,000 and $4,331,000 in 1994, 1995 and 1996, respectively. These increases were due to the continued expansion of the Company's network. The Company's total investment in network equipment has increased from $3.6 million to $7.9 million to $18.0 million at the end of 1994, 1995 and 1996, respectively. In particular the number in units located at broadcast stations has significantly increased in both 1995 and 1996, and over $1.3 million of equipment additions were made to the network operating center in 1996. In total, the Company made capital additions of approximately $6.0 million in 1996 in support of its video delivery service plan. 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 VSTs 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 "Certain Business Considerations -- Future Capital Need; Uncertainty of Additional Funding." In 1995, the Company adopted the provision of Statement of Financial Accounting Standard No. 121 "Accounting for the Impairment of Long-lived Assets to be Disposed of." Such adoption did not have a significant effect on the Company's financial position or results of operations. Interest Income and Interest Expense The Company has derived interest income from the short term investment of the proceeds received in various convertible preferred stock offerings made in 1992 through 1995 and from the investment of the $29.5 million of net proceeds from its initial public offering which was completed in February 1996. Interest income was $129,000, $417,000, and $1,422,000 in 1994, 1995, and 1996, respectively. The increases in interest income were due to differences in the amounts raised and the timing of each offering as well as the differences in the levels of cash used in Company operations. The Company expects that interest income will decrease in the future in proportion to the levels of cash used in the Company's operations.* See "Liquidity and Capital Resources". Interest expense incurred by the Company of $71,000, $836,000 and $1,726,000 in 1994, 1995 and 1996, respectively, has been due 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. Debt outstanding under these agreements has increased from $2.3 million to $6.3 million to $12.2 million at the end of 1994, 1995 and 1996, respectively. The increased interest expense in 1995 versus 1994 was due to leasing activity under an agreement made in the fourth quarter of 1995, which was used to refinance much of the capital additions made in 1994 and to fund substantially all capital equipment additions made in 1995. The increased expense in 1996 versus 1995 is due to the continued increase in lease liability resulting from the Company's financing of capital additions made throughout 1995 and 1996. The Company expects that interest expense will increase in the future based on the increased levels of borrowing.* See "Liquidity and Capital Resources." 17 20 QUARTERLY RESULTS OF OPERATIONS The following table presents unaudited quarterly statements of operations for the Company. The information has been prepared by the Company on a basis consistent with the Company's audited financial statements and includes all adjustments, consisting of only normal recurring adjustments that management considers necessary for a fair presentation of the information for the periods presented. The Company's quarterly operating results have in the past and may in the future vary significantly depending on factors such as the volume of advertising in response to seasonal buying patterns, the timing of new product and service introductions, increased competition, the timing of the Company's promotional efforts, general economic factors, and other 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 November television sweeps rating period and Christmas selling season. As a result, the Company 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 future performance.
THREE MONTHS ENDED ----------------------------------------------------------------------------------------- MARCH 31, JUNE 30, SEPT. 30, DEC. 31, MARCH 31, JUNE 30, SEPT. 30, DEC. 31, 1995 1995 1995 1995 1996 1996 1996 1996 --------- -------- --------- -------- --------- -------- --------- -------- (IN THOUSANDS, EXCEPT OPERATING DATA) STATEMENTS OF OPERATIONS: Revenues........................... $ 983 $ 1,289 $ 1,146 $ 1,726 $ 1,894 $ 2,359 $ 2,265 $ 4,005 -------- -------- -------- -------- -------- -------- -------- -------- Costs and expenses: Delivery and material costs...... 330 446 466 568 595 732 694 1,063 Customer operations.............. 689 712 731 842 920 948 904 1,392 Sales and marketing.............. 789 797 880 940 983 970 905 1,140 Research and development......... 413 362 407 408 498 510 519 565 General and administrative....... 356 329 322 373 384 396 407 490 Depreciation and amortization.... 443 530 637 735 838 936 1,181 1,376 -------- -------- -------- -------- -------- -------- -------- -------- Total expenses............... 3,020 3,176 3,443 3,866 4,218 4,492 4,610 6,026 -------- -------- -------- -------- -------- -------- -------- -------- Loss from operations............... (2,037) (1,887) (2,297) (2,140) (2,324) (2,133) (2,345) (2,021) Other income (expense): Interest income.................. 97 84 132 104 263 434 399 326 Interest expense................. (173) (200) (221) (242) (327) (388) (451) (560) -------- -------- -------- -------- -------- -------- -------- -------- Net loss........................... $(2,113) $(2,003) ($2,386) $(2,278) $(2,388) $(2,087) $(2,397) $ (2,255) ======== ======== ======== ======== ======== ======== ======== ======== Net loss per share................. $ (0.23) $ (0.22) $ (0.25) $ (0.23) $ (0.20) $ (0.18) $ (0.21) $ (0.19) ======== ======== ======== ======== ======== ======== ======== ======== Weighted average common and common equivalent shares................ 9,125 9,133 9,550 9,731 11,675 11,482 11,575 11,642 ======== ======== ======== ======== ======== ======== ======== ========
LIQUIDITY AND CAPITAL RESOURCES From its inception through December 31,1995, the Company had financed its operations and met its capital expenditure requirements primarily from the proceeds of private sales of convertible preferred and common stock and through capital lease agreements. Through December 31, 1995, the Company had raised $25.5 million from the sale of preferred and common stock and had funded $7.6 million of capital expenditures with long term lease agreements. In 1996, the Company raised net proceeds of $29.6 million from the sale of common stock, primarily through it's initial public offering, and an additional $8.0 million of capital equipment additions were funded through capital lease agreements. At December 31, 1996, the Company's current sources of liquidity included cash and cash equivalents of $9.7 million, short-term investments of $10.9 million and $0.4 million available for capital expenditures remaining under a lease agreement expiring in March 1997. The Company expects to fully utilize the funding available under the existing lease agreement. In January 1997, the Company negotiated an agreement to finance an additional $6.0 million of equipment purchases through a long-term credit facility. See the Notes to Consolidated Financial Statements. The Company's operating activities have used cash of $5.3 million in 1994, $6.6 million in 1995 and $4.3 million in 1996. The increased use of cash in 1995 versus 1994 is primarily due to the increased operating expenses and increased operating losses incurred by the Company in 1995. Net cash used in operating activities decreased in 1996 versus 1995, primarily as a result of a reduced net loss, exclusive of depreciation and amortization. 18 21 The Company used $2.2 million and $2.4 million of cash in 1994 and 1996, respectively to purchase property and equipment. In 1995, substantially all of the Company's equipment additions were financed through capital lease agreements. In addition, $.5 million, $5.0 million, and $8.0 million of property and equipment has been acquired through term lease agreements in 1994, 1995 and 1996, respectively. Also, an additional $1.6 million of equipment originally purchased by the Company in 1994 was later financed through a term note agreement in that year. The increasing levels of investment in property and equipment are primarily due to the Companies continued expansion of its network. In particular, the Company either leased or purchased capital equipment of approximately $6.0 million in 1996 to support its video delivery service plan. The Company completed its initial public offering in February 1996. The net proceeds to the Company, after underwriting discounts and offering expenses, were $29,490,000. As of December 31, 1996, $10.9 million of the proceeds were invested in short-term investments, $6.5 million had been invested in the purchase of PDR, cash held in cash and cash equivalents had increased $3.5 million from the prior year end, and the remainder had been used to fund the acquisition of property and equipment, the payment of lease obligations and the continuing operations of the Company. In November 1996 the Company acquired 100% of the stock of PDR. The purchase price consisted of the $6.5 million of cash mentioned above and a $2.5 million promissory note due one year from the closing of the transaction. See the Notes to the Consolidated Financial Statements. Principal payments on long-term debt were $.2 million, $1.0 million and $2.1 million in 1994, 1995, and 1996, respectively, reflecting the increases in regularly scheduled repayment of the increased capital lease liability incurred to finance equipment and property acquisitions. The Company currently has no significant capital commitments other than the commitments under capital leases and the note payable issued in conjunction with the purchase of PDR. 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 at least through 1997.* See "Certain Business Considerations -- Future Capital Needs; Uncertainty of Additional Funding." CERTAIN BUSINESS CONSIDERATIONS The Company's business is subject to the following risks and uncertainties, in addition to those described elsewhere in this report. History of Losses; Future Operating Results Uncertain. The Company was founded in 1991 and has been unprofitable since its inception and expects to continue to generate net losses for a minimum of the next twelve months. As of December 31, 1996, the Company's accumulated deficit was $28.1 million. The Company has had difficulty in accurately forecasting its future sales and operating results due to its limited operating history. Accordingly, although the Company has recently experienced significant growth in sales, such growth rates may not be sustainable and should not be used as an indication of future sales growth, if any, or of future operating results. The Company's future success will depend in part on obtaining continued reductions in delivery and service costs, particularly continued automation of order processing and reductions in telecommunications costs.* There can be no assurance the Company's sales will grow or be sustained in future periods or that the Company will achieve or sustain profitability in any future period. Potential 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 the volume of advertising in response to seasonal buying patterns, the timing of new product and service introductions, increased competition, the timing of the Company's promotional efforts, general economic factors, and other 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, the Company 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 future performance. In any period, the Company's revenues and delivery costs are subject to variation based on changes in the volume and mix of deliveries performed during the period. In particular, the Company's operating results have historically been significantly influenced by the volume of deliveries ordered by television stations during the "Sweeps" rating periods that currently 19 22 take place in February, May, August and November. The increased volume of these deliveries during such periods and the Company's pricing for "Sweeps" advertisements have historically increased the total revenues and revenues per delivery of the Company and tended to reduce delivery costs as a percentage of revenues. 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 materially adversely affected. 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 the growth rate of the Company's sales slows. Due to the unique nature of the Company's products and services, the Company believes that it will incur significant expenses for sales and marketing, including advertising, to educate potential customers about such products and services.* Dependence on Radio Advertising. The Company's revenues to date have been 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, and such services are expected to continue to account for a substantial majority of the Company's revenues for some time.* A decline in demand for, or average selling prices of, the Company's radio advertising delivery services, whether as a result of competition from new advertising media, new product introductions or price competition from competitors, a shift in purchases by customers away from the Company's premium services such as DG Express, technological change or otherwise, would have a material adverse effect on the Company's business, operating results and financial condition. Additionally, the Company is dependent upon its relationship with and continued support of the radio stations in which it has installed communications equipment. Should a substantial number of these stations go out of business or experience a change in ownership, it could materially adversely affect the Company's business, operating results and financial condition Dependence on Video Advertising Delivery Service Deployment. The Company has made a substantial investment in upgrading and expanding its network operating center and populating television stations with the units necessary for the delivery of video advertising content. However there can be no assurance that this service offering will achieve market acceptance. The inability to place units in an adequate number of stations or the inability to capture market share as a result of price competition or new product introductions from competitors would have a material adverse effect on 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 customers it will need to develop a set of ancillary services which are typically provided today by dub and ship houses. These ancillary services, which include physical archiving, closed captioning, modification of slates and format conversions, will need to be provided on a localized basis in each of the major cities in which the Company provides services directly to agencies and advertisers. The Company currently has the capability to provide such services to the New York City market through PDR. However, there can be no assurance that the Company will successfully contract for and provide these services in each major metropolitan area or be able to provide competitive video distribution services throughout the major U.S. markets. Unless the Company can successfully continue to develop and provide video transmission services, it may be unable to retain current or attract future audio delivery customers who may ultimately demand delivery of both media content. Uncertainties Relating to Integration of Operations. DG Systems acquired PDR with the expectation that this would result in synergies for the combined company. Achieving the anticipated benefits of the PDR acquisition will depend in part upon whether the integration of the two companies' organizations and businesses is achieved in an efficient, effective and timely manner; however, there can be no assurance that this will occur. The successful integration and expansion of the Company's business following its acquisition of PDR requires communication and cooperation among the senior executives and key technical personnel of DG Systems and PDR. Given the inherent difficulties involved in completing a business combination, there can be no assurance that such cooperation will occur or that the integration of the respective organizations will be successful and will not result in disruptions in one or more sectors of the Company's business. Failure to effectively accomplish the integration of the two companies' operations could have a material adverse effect on DG Systems' results of operations and financial condition. In addition, there can be no assurance that the market will favorably view DG Systems' offering of duplication, distribution and editing services through PDR 20 23 or that DG Systems will realize any of the other anticipated benefits of the PDR acquisition. As a result of the acquisition, certain DG Systems customers may perceive PDR to be a competitor, and this could affect such customers' willingness to do business with DG Systems in the future. The loss of significant customers could have a material adverse effect on DG Systems' results of operations and financial condition. Dependence on New Product Introductions. The Company's future growth depends on its successful and timely introduction of new products and services in markets that do not currently exist or are just emerging. The Company's goals are to introduce new services, such as media archiving and the ability to quickly and reliably give an agency the ability to preview and authorize delivery of video advertising spots. The Company is also designing, developing and field testing, together with ABC Radio Networks, an extension to the Company's existing network, including satellite transmission capabilities, through which ABC could electronically distribute advertising and programming to ABC's affiliate radio stations. The Company, however, has not yet completed the field trials of these products or services, and there can be no assurance that the Company will successfully complete any such field trials or development, or that if such development or field trials are completed, the Company's planned introduction of these products and services will realize market acceptance or will meet the technical or other requirements of potential customers. 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, long standing relationships with existing dub and ship vendors, and, currently, a service offering which is limited in comparison to the offerings of some 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 at all. If the market fails to grow, or grows more slowly than anticipated, the Company's business, operating results and financial condition will be materially adversely affected. Even if the market does grow, there can be no assurance that the Company's 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, there can be no assurance that the Company will be able to conform its products to such standards in a timely fashion, or 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, and there can be no assurance that the Company will be successful in developing such services, in obtaining new customers, or 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 installing and supporting the Company's field receiving equipment, including rooftop satellite antennae. The Company's limited marketing efforts to date with regard to the Company's 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. There can be no assurance that the Company has correctly identified such markets or that its planned products and services will address the needs of such markets. Furthermore, there can be no assurance that the Company's 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 the Company's products and services will require the Company to overcome significant market development hurdles, many of which may not currently be foreseen. Dependence on Technological Developments. The market for the distribution of digital audio and video transmissions is characterized by rapidly changing technology. The Company's ability to remain competitive and its future success will depend in significant 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 and to introduce such products and services at competitive prices and in a timely and cost-effective fashion. The Company's development efforts have been focused on the areas of satellite transmission 21 24 technology, video compression technology and reliability and throughput enhancement of the network. The Company's ability to successfully roll out and expand its electronic video delivery services depends on its ability to maintain reliable satellite delivery capability. Work in satellite technology is oriented to development and deployment of software to lower transmission costs and increase delivery reliability. Work in video compression technology is directed toward integration of emerging broadcast quality compression systems, which further improve picture quality while increasing the compression ratio, with the Company's existing network. The Company has an agreement with Hughes Network Systems, Inc. ("Hughes") which allows the Company to use Hughes' satellite capacity for electronic delivery of digital audio and video transmissions by that media. The Company has developed and incorporated software designed to enable the current RPTs to receive digital satellite transmissions over the Hughes satellite system. There can be no assurance that the Hughes satellite system will have the capacity to meet the Company's future delivery commitments and broadcast quality requirements. In addition, the Company has entered into an agreement with ABC Radio Networks ("ABC") to jointly develop an extension to the Company's existing network, including satellite transmission capabilities, through which ABC could electronically distribute advertising, news, and programming to ABC's affiliate radio stations. There can be no assurance that the Company will successfully complete the testing or deployment of the audio server network for ABC. In addition, there can be no assurance that ABC will successfully develop and deploy an enhanced satellite network with the capacity to meet the delivery and audio quality requirements of the audio server network. The introduction of products embodying new technologies can render existing products obsolete or unmarketable. There can be no assurance that the Company will be successful in identifying, developing, contracting for the manufacture of, and marketing product enhancements or new products that respond to technological change, that the Company will not experience difficulties that could delay or prevent the successful development, introduction and marketing of these products, or that its new products and product enhancements will adequately meet the requirements of the marketplace and achieve market acceptance. Delays in the commencement of commercial availability of new products and services and enhancements to existing products and services may result in customer dissatisfaction and delay or loss of revenue. If the Company is unable, for technological or other reasons, to develop and introduce new products and services or enhancements of existing products and services in a timely manner or if new versions of existing products do not achieve a significant degree of market acceptance, there could be a material adverse effect on the Company's 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 the Company 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 the Company. Moreover, Digital Courier International Corporation has begun deployment of a system to electronically deliver audio content in Canada and the United States and several other companies have announced such systems. As a result, there can be no assurance that the Company will be able to compete effectively against these competitors merely on the basis of ease of use, timeliness and accuracy of delivery. In the market for the electronic distribution of digital video transmissions to television stations, the Company encounters competition from VADS, Indenet and VDI Media, in addition to dub and ship houses and production studios, certain of which currently function as marketing partners with the Company in the audio distribution market. To the extent that the Company is successful in entering new markets, such as the delivery of other forms of content to radio and television stations, it would expect to face competition from companies in related communications markets and/or package delivery markets which could offer products and services with functionality similar or superior to that offered by the Company's products and services. Telecommunications providers such as AT&T, MCI and Regional Bell Operating Companies could also enter 22 25 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. In addition, Applied Graphics Technologies, Inc., a provider of digital pre-press services, has indicated its intention to provide electronic distribution services and acquired Spotlink, a dub and ship house, in December 1996. Although Spotlink revenues were less than 5% of the Company's revenues in 1996, the Company considers Spotlink to be a significant customer for the Company's audio delivery service. There can be no assurance that Spotlink will continue to be a customer of the Company, and the loss of Spotlink as a customer could have a material adverse effect on the Company's operating results. Many of the Company's current and potential competitors in the markets for audio and video transmissions have substantially greater financial, technical, marketing and other resources and larger installed customer bases than the Company. There can be no assurance that the Company will be able to compete successfully against current and future competitors based on these and other factors. The Company expects that an increasingly competitive environment will 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 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 permit many of the Company's 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. 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. Ability to Maintain and Improve Service Quality. The Company's business is dependent on its ability to make deliveries to broadcast stations within the time periods requested by customers. Any failure to do so, whether or not within the control of the Company, 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, there can be no assurance that claims by stations for lost air-time would not be asserted in these circumstances or that dissatisfied advertisers would refuse to make further deliveries through the Company in the event of a significant occurrence of lost deliveries, either of which would have a material adverse effect on the Company's business, results of operations and financial condition. Although the Company maintains insurance against business interruption, there can be no assurance that such insurance will be adequate to protect the Company from significant loss in these circumstances or that a major catastrophe (such as an earthquake or other natural disaster) would not result in a prolonged interruption of the Company's business. In particular, the Company's network operating center 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 Company's network operating center. 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 service providers, and the Company's inability to maintain its installed base of RSTs, RPTs and video units that comprise its distribution network. The result of the Company's failure to make timely deliveries for whatever reason could be that dissatisfied advertisers would refuse to make further deliveries through the Company which would have a material adverse effect on the Company's business, results of operations and financial condition. Ability to Manage Growth. The Company has recently experienced a period of rapid growth that has resulted in new and increased responsibilities for management personnel and has placed and continues to place a significant strain on the Company's management, operating and financial systems and resources. To accommodate this recent growth and to compete effectively and manage future growth, if any, the Company will be required to 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. 23 26 In particular, the Company believes that to achieve these objectives it must complete its automation of the customer order entry process and the integration of the delivery fulfillment process into the customer billing system. There can be no assurance that the Company's personnel, systems, procedures and controls will be adequate to support the Company's existing and future operations. Any failure to implement and improve the Company's operational, financial and management systems or to expand, train, motivate or manage employees could have a material adverse effect on the Company's business, operating results and financial condition. Future Capital Needs; Uncertainty of Additional Funding. The Company intends to continue making capital expenditures to produce and install RSTs, RPTs, and video units and to introduce additional services.* Based on current plans and assumptions relating to the timing of its operations, the Company anticipates that the net proceeds of its initial public offering, completed in February 1996, together with its existing capital and cash from operations, will be adequate to satisfy its capital requirements through at least December 1997.* There can be no assurance, however, that the net proceeds of the Company's initial public offering and such other sources of funding will be sufficient to satisfy the Company's future capital requirements. Based on its current business plan, the Company anticipates that it will eventually use the entire proceeds of its initial public offering and there can be no assurance that other sources of funding will be adequate to fund the Company's capital needs, which depend upon numerous factors, including the progress of the Company's product development activities, the cost of increasing the Company's sales and marketing activities and the amount of revenues generated from operations, none of which can be predicted with certainty. There can be no assurance that the Company will not require additional capital sooner than currently anticipated. In addition, the Company is unable to predict the precise amount of future capital that it will require and there can be no assurance that any additional financing will be available to the Company on acceptable terms, or at all. The inability to obtain required financing would have a material adverse effect on the Company's business, financial condition and results of operations. Consequently, the Company could be required to significantly reduce or suspend its operations, seek a merger partner or sell additional securities on terms that are highly dilutive to existing investors. Expansion into International Markets. Although the Company's 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 the Company to incur substantial costs and expend significant managerial resources to obtain any necessary regulatory approvals and 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 the Company's products and services to be redesigned, causing product and service delivery delays that could materially adversely affect the Company's 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.* There can be no assurance, however, that the Company's products and services will achieve market acceptance in foreign countries. The inability of the Company to successfully establish and expand its international operations may also limit its ability to obtain significant international revenues and could materially adversely affect the business, operating results and financial condition of the Company. Furthermore, international business is subject to a number of country-specific risks and circumstances, including different tax laws, 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, the Company's business, operating results and financial condition could be materially adversely affected 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. 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 competition for qualified personnel is intense and the loss of any of such persons, as well as the failure to recruit additional key personnel in a timely manner, could adversely affect the Company. There can be no assurance that the Company will be able to continue to attract and retain 24 27 qualified management, sales and technical personnel for the development of its business. The Company generally has not entered into employment or noncompetition agreements with any of its employees. The Company does not maintain key man life insurance on the lives of any of its key personnel. The Company's failure to attract and retain key personnel could have a material adverse effect on its business, operating results and financial condition. Dependence on Certain Suppliers. The Company relies on certain single or limited-source suppliers for certain integral components used for the assembly of the Company's RSTs, RPTs and video units. Although the Company's 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 the Company, it would delay the Company's deployment of RSTs, RPTs and video units which would have the effect of depressing the Company's business until the Company established sufficient component supply through an alternative source. The Company believes that there are alternative component manufacturers that could supply the components required to produce the Company's products, but the Company 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 purchases its components on a purchase order basis. The Company has experienced component shortages in the past and there can be no assurance that material component shortages or production or delivery delays will not occur in the future. The inability in the future 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 materially and adversely affect the Company's business, operating results and financial condition. 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 entails a number of significant risks. The Company's business, results of operations and financial condition would be materially adversely affected if Hughes were unable for any reason to continue meeting the Company's delivery commitments or if any transmissions failed to satisfy the Company's quality requirements. In the event that the Company were unable to continue to use Hughes' satellite capacity, the Company would have to identify, qualify and transition deliveries to an acceptable alternative satellite transmission vendor. This identification, qualification and transition process could take nine months or longer, and no assurance can be given that an alternative satellite transmission vendor would be available to the Company or be in a position to satisfy the Company's delivery requirements on a timely and cost-effective basis. The Company obtains its local access telephone transmission services through Teleport Communications Group. The Company obtains its long distance telephone access through an exclusive contract with MCI which expires in 1997. The Company is currently negotiating with MCI and other long distance carriers to reach agreement on terms for providing this service in the future. Any material interruption in the supply or a material adverse change in the price of either local access or long distance carrier service could have a material adverse effect on the Company's business, results of operations and financial condition. 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. The Company relies on a combination of trade secret, copyright and trademark laws and nondisclosure and other arrangements to protect its proprietary rights. The Company does not have any patents or patent applications pending. Despite the Company's efforts to protect its proprietary rights, unauthorized parties may attempt to copy or obtain and use information that the Company regards as proprietary. There can be no assurance that the steps taken by the Company to protect its proprietary information will prevent misappropriation of such information and such protection may not preclude competitors from developing confusingly similar 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 the Company's proprietary rights to the same extent 25 28 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, there can be no assurance that the Company will not receive future communications from third parties asserting that the Company's trademarks, copyrights, advertising and promotion design and artwork infringe, or may infringe, 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. No assurance can be given that any necessary licenses can be obtained or that, if obtainable, such licenses can be obtained on commercially reasonable terms. In the event of a successful claim of infringement against the Company and failure or inability of the Company to license the infringed or similar proprietary information, the Company's business, operating results and financial condition could be materially adversely affected. Concentration of Stock Ownership; Potential Issuance of Preferred Stock; Anti-Takeover Provisions. The present executive officers and directors of the Company and their affiliates own approximately 36% of the Company's 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 approval of significant corporate transactions. Such concentration of ownership may have the effect of delaying or preventing a change in control of the Company. In addition, the Company's Board of Directors has the authority to issue up to 5,000,000 shares of Preferred Stock and to determine the price, rights, preferences, privileges and restrictions thereof, including voting rights, without any further vote or action by the Company's shareholders. Although the Company has no current plans to issue any shares of Preferred Stock, the rights of the holders of Common Stock would be subject to, and may be adversely affected by, the rights of the holders of any Preferred Stock that may be issued in the future. Issuance of Preferred Stock could have the effect of delaying, deferring or preventing a change in control of the Company. Furthermore, certain provisions of the Company's Articles of Incorporation and Bylaws and of California law could have the effect of delaying, deferring or preventing a change in control of the Company. Possible Volatility of Share Price. The trading prices of the Company's 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 the Company or its competitors, as well as 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 the Company's Common Stock. 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 Not applicable. 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 filed with the Securities and Exchange Commission by the Company for its 1997 26 29 annual meeting of shareholders (the "Proxy Statement"). For information with respect to executive officers of the Company, see Item 4A of this report. ITEM 11. EXECUTIVE COMPENSATION The information required by this Item is incorporated by reference to the information contained in the section captioned "Executive Compensation" in the Proxy Statement. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by this Item is incorporated by reference to the information contained in 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. 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 ---- Report of Arthur Andersen LLP, Independent Public Accountants....... F-2 Consolidated Balance Sheets......................................... F-3 Consolidated Statements of Operations............................... F-4 Consolidated Statements of Shareholders' Equity..................... F-5 Consolidated Statements of Cash Flows............................... F-6 Notes to Consolidated Financial Statements.......................... F-7 (a) 2. FINANCIAL STATEMENT SCHEDULES II -- Valuation and Qualifying Accounts............................. S-1
(a) 3. EXHIBITS
EXHIBIT NUMBER EXHIBIT TITLE ------ ---------------------------------------------------------------------------- 3.1 (d) Restated Articles of Incorporation of registrant. 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 Nonstatutory 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.
27 30
EXHIBIT NUMBER EXHIBIT TITLE ------ ---------------------------------------------------------------------------- 10.6 (b) Amendment to Warrant Agreement between the Company and Comdisco, Inc., dated January 31, 1996. 10.7.1(c) Corporate Service Plan Agreement between the Company and MCI Telecommunications dated March 23, 1994. 10.7.2(c) First Amendment to Corporate Service Plan Agreement between the Company and MCI Corporation, Telecommunications Corporation, dated November 2, 1995. 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. 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 September 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. 11.1 (a) Statements of computation of weighted average and pro forma common shares and equivalents. 21.1 (a) Subsidiaries of the Registrant. 23.1 (a) Consent of Independent Public Accountants. 27 (a) Financial Data Schedule.
- --------------- + Management contract or compensatory plan or arrangement required to be filed as an exhibit in this form pursuant to Item 14(c) of this report. (a) Filed herewith. (b) Incorporated by reference to the exhibit bearing the same number filed with the 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 the 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. 28 31 (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 number filed with registrant's Current Report on Form 8-K/A filed January 21, 1997. (b) REPORTS ON FORM 8-K Current Report on Form 8-K filed November 22, 1996, reporting that registrant had acquired all of the outstanding stock of PDR Productions, Inc., on November 8, 1996. Current Report on Form 8-K filed October 31, 1996, reporting that registrant had entered into a definitive agreement to acquire 100% of the stock of PDR Productions, Inc. (c) EXHIBITS See items 14 (a)(3) above (d) FINANCIAL STATEMENT SCHEDULES Financial Statement Schedules. See Item 14(a) (2) above. 29 32 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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 17, 1997 By: /s/ HENRY W. DONALDSON ------------------------------------ Henry W. Donaldson President and Chief Financial Officer POWER OF ATTORNEY KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below hereby constitutes and appoints Henry W. Donaldson 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/ HENRY W. DONALDSON President, Chief Executive March 17, 1997 - --------------------------------------------- Officer and Director Henry W. Donaldson (Principal Executive Officer) /s/ THOMAS P. SHANAHAN Chief Financial Officer March 17, 1997 - --------------------------------------------- (Principal Financial and Thomas P. Shanahan Accounting Officer) /s/ KEVIN R. COMPTON Director March 17, 1997 - --------------------------------------------- Kevin R. Compton /s/ JEFFREY M. DRAZAN Director March 17, 1997 - --------------------------------------------- Jeffrey M. Drazan /s/ RICHARD H. HARRIS Director March 17, 1997 - --------------------------------------------- Richard H. Harris /s/ LEONARD S. MATTHEWS Director March 17, 1997 - --------------------------------------------- Leonard S. Matthews
30 33 DIGITAL GENERATION SYSTEMS, INC. INDEX TO CONSOLIDATED FINANCIAL STATEMENTS Report of Independent Public Accountants.............................................. F-2 Consolidated Balance Sheets as of December 31, 1995 and 1996.......................... F-3 Consolidated Statement of Operations for the three years ended December 31, 1996...... F-4 Consolidated Statement of Shareholders' Equity for the three years ended December 31, 1996................................................................................ F-5 Consolidated Statements of Cash Flows for the three years ended December 31, 1996..... F-6 Notes to Consolidated Financial Statements............................................ F-7
F-1 34 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To Digital Generation Systems, Inc.: We have audited the accompanying consolidated balance sheets of Digital Generation Systems, Inc. (a California Corporation) and subsidiary as of December 31, 1996 and 1995, and the related consolidated statements of operations, shareholders' equity and cash flows for each of the three years in the period ended December 31, 1996. These financial statements 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 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 subsidiary as of December 31, 1996 and 1995, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1996, in conformity with generally accepted accounting principles. 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 part of the basic financial statements. This schedule 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 Jose, California January 28, 1997 F-2 35 DIGITAL GENERATION SYSTEMS, INC. CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT SHARE AMOUNTS)
DECEMBER 31, DECEMBER 31, ASSETS 1996 1995 ------------ ------------ CURRENT ASSETS: Cash and cash equivalents........................................ $ 9,682 $ 6,205 Short-term investments........................................... 10,915 -- Accounts receivable, less allowance for doubtful accounts of $257 in 1996 and $135 in 1995...................................... 3,349 1,368 Prepaid expenses and other....................................... 168 624 -------- -------- Total current assets..................................... 24,114 8,197 -------- -------- PROPERTY AND EQUIPMENT, at cost: Network equipment................................................ 17,974 7,931 Office furniture and equipment................................... 2,093 1,373 Leasehold improvements........................................... 353 83 -------- -------- 20,420 9,387 Less -- Accumulated depreciation and amortization................ (7,790) (3,615) -------- -------- Property and equipment, net................................... 12,630 5,772 -------- -------- GOODWILL AND OTHER ASSETS, net..................................... 8,504 490 -------- -------- $ 45,248 $ 14,459 ======== ======== LIABILITIES AND SHAREHOLDERS' EQUITY CURRENT LIABILITIES: Accounts payable................................................. $ 1,546 $ 596 Accrued liabilities.............................................. 2,174 1,203 Note payable from acquisition of PDR............................. 2,500 -- Current portion of long-term debt................................ 3,694 1,747 -------- -------- Total current liabilities................................ 9,914 3,546 -------- -------- LONG-TERM DEBT, net of current portion............................. 8,495 4,540 -------- -------- COMMITMENTS AND CONTINGENCIES (Note 5) SHAREHOLDERS' EQUITY: Convertible preferred stock, no par value -- Authorized -- 5,000,000 shares at December 31, 1996 and 7,873,322 shares at December 31, 1995 Outstanding -- none outstanding at December 31, 1996 and 7,273,759 shares at December 31, 1995; aggregate liquidation preference of $25,433 at December 31, 1995................... -- 25,321 Common stock, no par value -- Authorized -- 30,000,000 shares Outstanding -- 11,653,625 shares at December 31, 1996 and 1,112,204 shares at December 31, 1995........................ 55,138 224 Receivable from issuance of common stock......................... (175) (175) Accumulated deficit.............................................. (28,124) (18,997) -------- -------- Total shareholders' equity............................... 26,839 6,373 -------- -------- $ 45,248 $ 14,459 ======== ========
The accompanying notes are an integral part of these consolidated financial statements. F-3 36 DIGITAL GENERATION SYSTEMS, INC. CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
YEARS ENDED DECEMBER 31, ------------------------------- 1996 1995 1994 ------- ------- ------- REVENUES...................................................... $10,523 $ 5,144 $ 2,432 ------- ------- ------- COSTS AND EXPENSES: Delivery and material costs................................. 3,084 1,810 953 Customer operations......................................... 4,164 2,974 1,886 Sales and marketing......................................... 3,998 3,406 2,248 Research and development.................................... 2,092 1,590 1,048 General and administrative.................................. 1,677 1,380 1,054 Depreciation and amortization............................... 4,331 2,345 913 ------- ------- ------- Total expenses...................................... 19,346 13,505 8,102 ------- ------- ------- LOSS FROM OPERATIONS.......................................... (8,823) (8,361) (5,670) OTHER INCOME (EXPENSE): Interest income............................................. 1,422 417 129 Interest expense............................................ (1,726) (836) (71) ------- ------- ------- NET LOSS...................................................... $(9,127) $(8,780) $(5,612) ======= ======= ======= PRO FORMA NET LOSS PER SHARE.................................. $ (0.79) $ (0.94) ======= ======= PRO FORMA WEIGHTED AVERAGE COMMON AND COMMON EQUIVALENT SHARES...................................................... 11,594 9,360 ======= =======
The accompanying notes are an integral part of these consolidated financial statements. F-4 37 DIGITAL GENERATION SYSTEMS, INC. CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
CONVERTIBLE RECEIVABLE PREFERRED STOCK COMMON STOCK FROM TOTAL --------------------- -------------------- ISSUANCE OF ACCUMULATED SHAREHOLDERS' SHARES AMOUNT SHARES AMOUNT COMMON STOCK DEFICIT EQUITY ---------- -------- ---------- ------- ------------ ----------- ------------- BALANCE AT DECEMBER 31, 1993.......... 3,009,799 $ 5,955 478,084 $ 8 $ -- ($ 4,605) $ 1,358 Issuance of common stock at $.20 to $.30 per share for services rendered.......................... -- -- 66,925 18 -- -- 18 Exercise of stock options at $.20 per share......................... -- -- 15,824 3 -- -- 3 Sale of common stock at $.20 to $.30 per share to a related party...... -- -- 325,000 77 (77) -- -- Sale of Series B preferred stock at $2.70 per share, net of issuance costs of $18...................... 2,222,217 5,982 -- -- -- -- 5,982 Sale of Series C preferred stock at $6.00 per share, net of issuance costs of $10...................... 1,460,494 8,753 -- -- -- -- 8,753 Net loss............................ -- -- -- -- -- (5,612) (5,612) ---------- -------- ---------- -------- ----- -------- ------- BALANCE AT DECEMBER 31, 1994.......... 6,692,510 20,690 885,833 106 (77) (10,217) 10,502 Issuance of common stock at $.30 to $.60 per share for services rendered.......................... -- -- 32,686 13 -- -- 13 Exercise of stock options at $.20 to $.30 per share.................... -- -- 31,185 7 -- -- 7 Sale of common stock at $.60 per share to a related party.......... -- -- 162,500 98 (98) -- -- Sale of Series D preferred stock at $8.00 per share, net of issuance costs of $19...................... 581,249 4,631 -- -- -- -- 4,631 Net loss............................ -- -- -- -- -- (8,780) (8,780) ---------- -------- ---------- -------- ----- -------- ------- BALANCE AT DECEMBER 31, 1995.......... 7,273,759 25,321 1,112,204 224 (175) (18,997) 6,373 Conversion of preferred stock to common stock...................... (7,273,759) (25,321) 7,273,759 25,321 -- Issuance of common stock in connection with initial public offering, less $1,200 in issuance costs............................. -- -- 3,000,000 29,490 -- -- 29,490 Warrants exercised for common stock............................. -- -- 29,161 -- -- -- -- Exercise of stock options at $.20 to $7.00 per share................... -- -- 238,501 103 -- -- 103 Net loss............................ -- -- -- -- -- (9,127) (9,127) ---------- -------- ---------- -------- ----- -------- ------- BALANCE AT DECEMBER 31, 1996.......... -- $ -- 11,653,625 $55,138 ($ 175) ($ 28,124) $26,839 ========== ======== ========== ======== ===== ======== =======
The accompanying notes are an integral part of these consolidated financial statements. F-5 38 DIGITAL GENERATION SYSTEMS, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS)
YEARS ENDED DECEMBER 31, -------------------------------- 1996 1995 1994 -------- ------- ------- CASH FLOWS FROM OPERATING ACTIVITIES: Net loss................................................... $ (9,127) $(8,780) $(5,612) Adjustments to reconcile net loss to net cash used in operating activities: Depreciation and amortization........................... 4,260 2,345 913 Amortization of goodwill and intangibles................ 71 -- -- Stock issued for services rendered...................... -- 13 18 Provision for doubtful accounts......................... 97 137 129 Changes in operating assets and liabilities -- Accounts receivable................................... (779) (604) (882) Prepaid expenses and other assets..................... (27) (841) (153) Accounts payable and accrued liabilities.............. 1,241 1,128 323 -------- ------- ------- Net cash used in operating activities.............. (4,264) (6,602) (5,264) -------- ------- ------- CASH FLOWS FROM INVESTING ACTIVITIES: Purchase of short-term investments......................... (33,138) -- -- Maturities of short-term investments....................... 22,223 -- -- Acquisition of PDR, net of cash acquired................... (6,394) Acquisition of property and equipment...................... (2,417) (13) (2,164) -------- ------- ------- Net cash used in investing activities.............. (19,726) (13) (2,164) -------- ------- ------- CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from issuance of common stock..................... 29,593 7 3 Proceeds from issuance of convertible preferred stock...... -- 4,631 11,787 Proceeds from bridge financing and other notes payable..... -- -- 4,582 Payments on long-term debt................................. (2,126) (1,039) (218) -------- ------- ------- Net cash provided by financing activities.......... 27,467 3,599 16,154 -------- ------- ------- NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS......... 3,477 (3,016) 8,726 CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR............... 6,205 9,221 495 -------- ------- ------- CASH AND CASH EQUIVALENTS AT END OF YEAR..................... $ 9,682 $ 6,205 $ 9,221 ======== ======= =======
The accompanying notes are an integral part of these consolidated financial statements. F-6 39 DIGITAL GENERATION SYSTEMS, INC. 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 electronic delivery and related services to the broadcast industry by linking content providers to radio and television stations. The Company is a provider of electronic distribution of audio spot advertising to radio stations. The Company derives its revenues from advertising agencies, production studios and other service providers that have traditionally relied upon physical delivery methods. 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; 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 retirements. 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 long distance telephone access through an exclusive contract with a telephone service provider which expires in 1997. 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. In addition, as required by Statement of Financial Accounting Standards No. 121 "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of," the Company regularly evaluates the remaining life and recoverability of its network equipment. The Company adopted the provisions of this statement in 1995. The adoption did not have a significant effect on the Company's financial position and results of operations. Given the emerging nature of its markets, it is possible that the Company's estimate that it will recover the net carrying value of the equipment from future operations could change in the future. 2. ACQUISITION: On November 8, 1996 the Company completed the acquisition of 100% of the stock of PDR Productions, Inc., ("PDR"), a media duplication and distribution company located in New York City, for consideration totaling $9.0 million. The consideration was $6.5 million in cash and a $2.5 million promissory note with interest payable at 8%. The note and accrued interest are due in November 1997. The acquisition was accounted for as a purchase. The net book value of assets and liabilities acquired was approximately $1.5 million. The excess of purchase price and acquisition costs over the net book value of assets acquired (including customer list, covenant not to compete and goodwill) of approximately $7.9 million, has been included in Goodwill and Other Assets in the accompanying consolidated balance sheet and is being amortized over a twenty year period. Amortization expense of approximately $71,000 is included in the consolidated statement of operations for the year ended December 31, 1996. The operating results of PDR are included in the consolidated results of the Company from the date of the closing of the transaction, November 8, 1996. The following table reflects unaudited pro forma combined results of operations of the Company and PDR on the basis that the acquisition had taken place at the beginning of the first fiscal year presented:
TWELVE MONTHS ENDED ----------------------------- DECEMBER 31, DECEMBER 31, 1996 1995 ------------ ------------ (IN THOUSANDS EXCEPT PER SHARE DATA) Revenues........................................... $ 16,932 $ 13,008 Net Loss........................................... $ (9,794) $ (9,713) Net Loss per Share................................. $ (.84) $ (1.04) Number of Shares used in Computation............... 11,594 9,360
F-7 40 DIGITAL GENERATION SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) The unaudited pro forma combined results of operations are not necessarily indicative of the actual results that would have occurred had the acquisition been consummated at the beginning of 1995 or of future operations of the combined companies under the ownership and management of the Company. 3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: CONSOLIDATION The consolidated financial statements include the accounts of the Company and its subsidiary, PDR, after elimination of intercompany accounts and transactions. USE OF ESTIMATES IN PREPARATION OF FINANCIAL STATEMENTS 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. CASH AND CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS In accordance with the Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities", the Company has classified all marketable debt securities as held-to-maturity and have valued these investments using the amortized cost method. Cash and cash equivalents consist of liquid investments with original maturities of three months or less. Short-term investments are marketable securities with original maturities greater than three months and less than one year. As of December 31, 1996 and 1995, cash and cash equivalents consist principally of U.S. Treasury bills and various money market accounts; as a result, the amortized purchase cost approximates the fair market value. As of December 31, 1996, short-term investments consist principally of U.S. Treasury bills and commercial paper and amortized cost approximates the fair market value of these instruments at the balance sheet date. PROPERTY AND EQUIPMENT Network equipment includes the network operating center, Record Send Terminals, Receive Playback Terminals, Video 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 depreciates its property and equipment on a straight-line basis over their estimated useful lives, generally three years. PRO FORMA NET LOSS PER SHARE Net loss per share for the twelve months ended December 31, 1996 and December 31, 1995 is computed on a pro forma basis. Pro forma net loss per share is computed using the weighted average number of common and common equivalent shares outstanding during the period. Common equivalent shares consist of convertible preferred stock (using the "if converted" method) and stock options and warrants (using the treasury stock method). As the Company has incurred losses since inception, common equivalent shares have been excluded from the computation as their effect is antidilutive; however, pursuant to Securities and Exchange Commission requirements, such computations include all common and common equivalent shares issued within the 12 months preceding the February 1996 Form S-1 filing date as if they were outstanding F-8 41 DIGITAL GENERATION SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) through the end of the quarter in which the offering was completed, using the treasury stock method. Convertible preferred stock outstanding during the period are included (using the "if converted" method) in the computation as common equivalent shares even though the effect is antidilutive. Historical earnings per share prior to 1995 have not been presented since such amounts are not deemed meaningful due to the significant change in the Company's capital structure that occurred in connection with the Company's initial public offering. SOFTWARE DEVELOPMENT COSTS Under the criteria set forth in Statement of Financial Accounting Standards No. 86, "Accounting for the Costs of Computer Software to be Sold, Leased, or Otherwise Marketed," capitalization of software development costs begins upon the establishment of technological feasibility of the product. The establishment of technological feasibility and the ongoing assessment of the recoverability of these costs requires considerable judgment by management with respect to certain external factors, including, but not limited to, anticipated future gross product revenues, estimated economic life, changes in software and hardware technology and the losses that the Company has incurred to date. Amounts that could have been capitalized under this statement after consideration of the above factors were immaterial and, therefore, no software development costs have been capitalized by the Company to date. REVENUE RECOGNITION Revenues are recognized for each transaction on the date the audio, video or related information is successfully transmitted from the network operating center to the destination ordered. For the year ended December 31, 1994, one customer accounted for 10% of revenues. DELIVERY AND MATERIAL COSTS Delivery costs consist of fees paid to other service providers for charges incurred by the Company in the receipt, transmission and delivery of information via the Company's distribution network. Material costs consist primarily of audio and video tape and the related packaging used in delivery. CUSTOMER OPERATIONS Customer operations expenses consist primarily of salaries and the related overhead costs incurred in performing deliveries and providing services, including order entry, customer service and assembly and maintenance of the Company's network equipment. CONCENTRATION OF CREDIT RISK Financial instruments which potentially subject the Company to a concentration of credit risk consist principally of cash and cash equivalents, short-term investments and accounts receivable. The Company has an investment policy that limits the amount of credit exposure to any one issuer and restricts these investments to issuers evaluated as credit worthy. The Company believes that a concentration of credit risk with respect to accounts receivable is limited because its customers are geographically disbursed and the end-users (the customer's clients) are diversified across industries. The Company's receivables are principally from advertising agencies and dub and ship houses. 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 and such losses have been insignificant. F-9 42 DIGITAL GENERATION SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) SUPPLEMENTAL CASH FLOW INFORMATION Noncash investing and financing activities consisted of the following (in thousands):
FOR THE YEAR ENDED DECEMBER 31, ----------------------------- 1996 1995 1994 ------- ------ ------ Property and equipment financed with capitalized lease obligations........................................... $ 8,028 $5,019 $ 467 Conversion of preferred stock to common stock........... 25,321 -- -- Acquisition of PDR financed with note payable........... 2,500 -- -- Conversion of convertible promissory notes, notes payable and accrued interest to convertible preferred stock................................................. -- -- 2,948 Common stock issued for notes receivable................ -- 98 77 Common stock issued for services rendered............... -- 13 18
RECLASSIFICATIONS Certain amounts in the prior years have been reclassified to conform with the current year presentation. 4. ACCRUED LIABILITIES: Accrued liabilities consist of the following (in thousands):
DECEMBER 31, ----------------- 1996 1995 ------ ------ Telecommunications costs................................... $ 621 $ 77 Employee compensation...................................... 334 287 Legal and consulting fees.................................. 321 329 Other...................................................... 898 510 ------ ------ $2,174 $1,203 ====== ======
5. COMMITMENTS: The Company leases its facilities and certain equipment under noncancelable operating leases. As of December 31, 1996, future minimum annual rental payments under these leases are as follows (in thousands):
YEAR ENDING DECEMBER 31, -------------------------------------------------------------------- 1997................................................................ $ 742 1998................................................................ 739 1999................................................................ 788 2000................................................................ 781 2001................................................................ 587 ------ $3,637 ======
Rent expense totaled approximately $477,000, $361,000 and $288,000 in 1996, 1995 and 1994 respectively. In addition, as of December 31, 1996 the Company has noncancelable future minimum purchase commitments with its primary telephone service provider. These commitments total approximately $1.3 million and extend through June 1997. F-10 43 DIGITAL GENERATION SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) AUDIO SERVER NETWORK DEVELOPMENT AGREEMENT In December 1995, the Company entered into an agreement with a major radio network (the "Partner") to develop and deploy an Audio Server Network ("ASN") prototype. The Company and the Partner continue to jointly develop and deploy prototypes and several network products have been delivered to the affiliate stations with prototype units. Negotiations to reach a long term deployment agreement, whereby the Partner would potentially be granted warrants to purchase common stock of the Company, are dependent upon further evaluation by both parties of the results of field trials of the prototypes. The development costs, which will be shared equally between the Company and its Partner, are limited to $400,000 each. Through December 31, 1996, the related development costs were approximately $400,000 in total, or $200,000 each for the Company and the Partner. 6. LONG-TERM DEBT: The Company has several lease lines to finance the purchase of certain property and equipment. Borrowings are secured by the leased equipment. The cost of equipment under lease and term loan obligations at December 31, 1996 and 1995 was $15,648,000 and $7,620,000, respectively. Related accumulated depreciation at December 31, 1996 and 1995 was $5,791,000 and $1,979,000, respectively. The term on the lease lines is generally 42 months for each drawdown and the Company has the option at the end of the lease term to purchase the leased equipment at a mutually agreed price not to exceed 20% of the equipment's original cost. As of December 31, 1996, approximately $397,000 of the lease lines remained available to fund future capital requirements. These lease lines expire in March 1997. In October 1994, the Company signed a $1.6 million secured term note to finance the purchase of certain equipment. The note is due in monthly installments of $46,000 throughout April 1998, with a final payment of the remainder due in May 1998. In January 1997, the Company negotiated an agreement to finance an additional $6.0 million of equipment purchases through a long-term credit facility. The agreement includes a commitment to issue warrants to purchase 112,500 shares of the Company's Common Stock at a price of $8.00 per share. The value of the warrants at the date of issuance was nominal; therefore no value was assigned to the warrants for accounting purposes. Future minimum lease and term loan payments as of December 31, 1996, are as follows (in thousands):
YEAR ENDING DECEMBER 31, ------------------------------------------------------------------- 1997............................................................... $ 5,228 1998............................................................... 5,191 1999............................................................... 3,528 2000............................................................... 1,147 ------- Total minimum lease payments....................................... 15,094 Less -- Amount representing interest (effective interest rates ranging from 13 percent to 18 percent)........................... (2,905) ------- Present value of minimum lease payments............................ 12,189 Less -- Current portion............................................ 3,694 ------- Long-term portion.................................................. $ 8,495 =======
Interest paid was $1,716,000, $766,000 and $84,000 in 1996, 1995 and 1994, respectively. F-11 44 DIGITAL GENERATION SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 7. CAPITAL STOCK: In January 1996, the shareholders approved a one-for-two reverse split of the Company's preferred and common stock. All share and per share amounts in the accompanying financial statements have been adjusted retroactively to give effect to this reverse stock split. In February 1996, the Company completed the initial public offering of its common stock. The Company sold 3,000,000 shares for net proceeds of $29,490,000. Concurrent with the closing of the initial public offering all outstanding shares of convertible preferred stock and warrants to purchase 29,161 shares of preferred stock were converted into an equivalent number of shares of common stock. Convertible Preferred Stock and Warrants In conjunction with the initial public offering of the Company's Common Stock, all outstanding shares of Convertible Preferred Stock were automatically converted into Common Stock upon the closing of the Offering. Additionally, warrants to purchase 29,161 shares of preferred stock were converted into an equivalent number of shares of common stock. A summary of outstanding Convertible Preferred Stock, net of issuance costs, as of December 31, 1995 is as follows (in thousands, except share data):
DECEMBER 31, 1995 --------------------- SHARES AMOUNT --------- ------- Series A............................................... 3,009,799 $ 5,955 Series B............................................... 2,222,217 $ 5,982 Series C............................................... 1,460,494 $ 8,753 Series D............................................... 581,249 $ 4,631 --------- ------- 7,273,759 $25,321 ========= =======
Warrants In connection with certain financing and leasing transactions made in 1993 through 1996, the Company issued warrants to purchase at fair market value an aggregate of 35,000 shares of Series A preferred stock at a range of $2.00 to $3.00 per share in January 1993 and April 1994, 71,174 shares of Series B preferred stock at $2.70 per share in October 1994, 60,000 shares of Series C preferred stock at $6.00 per share in June 1995 and 67,500 shares of Series D preferred stock at $8.00 per share in January 1996. As of December 31, 1995, warrants to purchase 15,000 shares of Series C preferred stock were canceled pursuant to the terms of the warrant agreement. A total of 29,161 of the Series A warrants were exercised in return for surrender of the remaining 5,839 warrants upon the closing of the Company's initial public offering in February 1996. The remaining Series B, C and D warrants, which expire on the earlier of ten years from the date of the related warrant agreement or five years from the effective date of the Company's initial public offering, were converted to warrants for common stock of the Company as per the conversion terms of the agreements. The value of the warrants at the date of issuance was nominal; therefore, no value was assigned to the warrants for accounting purposes. In December 1996, the Company issued 9,351 warrants to purchase common stock at $8.02 per share in connection with an increase in an existing lease line. The warrants expire in 2006. The value of the warrants at date of issuance was nominal; therefore no value was assigned to the warrants for accounting purposes. F-12 45 DIGITAL GENERATION SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) COMMON STOCK As of December 31, 1996, the Company has reserved the following shares of common stock for future issuance:
NUMBER OF SHARES --------- 1992 Stock option plan.......................................... 1,460,156 1996 Supplemental Stock option plan............................. 750,000 Stock warrants.................................................. 193,025 1995 Director option plan....................................... 75,000 Common stock to be issued as incentives to certain dealers and distributors................................................. 20,000 --------- Total reserved shares................................... 2,498,181 =========
The Company has issued 358,000 shares of common stock at prices ranging from $.20 to $.30 per share to certain key individuals under restricted stock purchase agreements. The agreements provide the Company with an option to repurchase the unvested portion of each individual's shares at cost in the event of his or her termination. These shares vest monthly over a period of four to five years from the date of purchase. As of December 31, 1996, 189,633 shares, ranging from $.20 to $.30, are subject to repurchase. 8. STOCK PLANS: The Company has three fixed stock option plans: 1992 STOCK OPTION PLAN Under the Company's 1992 Stock Option Plan (the "1992 Plan"), the Company may issue up to 1,750,000 shares of common stock to employees, officers, directors and consultants. 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 nonstatutory options, less than 85 percent of the fair value of the common stock on the date of grant. The options generally vest over four to five years. The term of the options granted is seven years. In January 1996, the Board of Directors amended the 1992 Plan to provide 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. 1996 SUPPLEMENTAL OPTION PLAN In July 1996, the Company's Board of Directors adopted the 1996 Supplemental Option Plan (the "1996 Plan"). Under the 1996 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 is 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 September 1995, the Company's Board of Directors adopted the 1995 Director Option Plan (the "Director Plan"). A total of 75,000 shares of common stock has been reserved for issuance under the Director Plan. The Director Plan provides that each future nonemployee 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 nonemployee director of the Company and an additional option to purchase 2,500 shares of common stock (the "Subsequent Option") on the next anniversary. The exercise price per share of F-13 46 DIGITAL GENERATION SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 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 of the option. 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 term of the options granted is ten years. ACCOUNTING FOR STOCK OPTION COMPENSATION EXPENSE Effective January 1, 1996, the Company adopted the disclosure provisions of Financial Accounting Standards No. 123 ("SFAS No. 123"), "Accounting for Stock-Based Compensation". The adoption did not have a significant effect on the Company's results of operations as the Company continues to apply the principles of APB Opinion No. 25 and related interpretations in accounting for the Company's stock option plans. Accordingly, no compensation cost has been recognized for the activity under the stock option plans. Had compensation cost for the Company's 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 and earnings per share would have been reduced to the pro forma amounts indicated below (in thousands except per share amounts):
1996 1995 -------- ------- Net Loss.................................. As reported $ (9,127) $(8,780) Pro forma $(10,174) $(8,831) Loss per share............................ As reported $ (0.79) $ (0.94) Pro forma $ (0.88) $ (0.94)
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 1996 and 1995; risk-free interest rates, based upon the grant dates, ranging from 5.2% to 7.8%; expected dividend yields of zero percent; expected lives of one year from the vesting date; expected volatility of zero percent prior to the filing date of the Company's February 1996 initial public offering and sixty-five percent for grants made subsequent to the filing. A summary of the Company's fixed stock option plans at December 31, 1996, 1995 and 1994 and changes during the years then ended is presented below:
1996 1995 1994 -------------------- -------------------- ------------------- WEIGHTED WEIGHTED WEIGHTED AVERAGE AVERAGE AVERAGE EXERCISE EXERCISE EXERCISE SHARES PRICE SHARES PRICE SHARES PRICE --------- -------- --------- -------- -------- -------- Outstanding at beginning of the year............................... 1,456,500 $ 1.73 550,500 $ 0.26 309,750 $ 0.20 Granted.............................. 842,500 9.14 965,000 2.48 559,250 0.26 Exercised............................ (238,501) 0.43 (31,185) 0.20 (15,824) 0.20 Canceled............................. (254,144) 2.20 (27,815) 0.26 (302,676) 0.26 --------- ----- --------- ----- -------- ----- Outstanding at end of the year....... 1,806,355 $ 5.29 1,456,500 $ 1.73 550,500 $ 0.26 --------- ----- --------- ----- -------- ----- Exercisable at end of the year....... 378,797 $ 2.29 194,112 $ 0.34 58,083 $ 0.20 Weighted average fair value of options granted.................... $ 4.41 $ 0.44
F-14 47 DIGITAL GENERATION SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) The following table summarizes information about stock options outstanding at December 31, 1996:
OPTIONS OUTSTANDING OPTIONS EXERCISABLE - ---------------------------------------------------------------------------- --------------------------------- NUMBER NUMBER OUTSTANDING AT WEIGHTED-AVERAGE EXERCISABLE RANGE OF DECEMBER 31, REMAINING WEIGHTED-AVERAGE DECEMBER 31, WEIGHTED-AVERAGE EXERCISE PRICES 1996 CONTRACTUAL LIFE EXERCISE PRICE 1996 EXERCISE PRICE - --------------- -------------- ---------------- ---------------- ------------ ---------------- $0.20-$2.00 656,189 4.89 $ 0.63 254,838 $ 0.60 $5.00-$8.875 444,666 6.02 $ 5.94 116,007 $ 5.55 $9.00-$10.125 705,500 6.58 $ 9.23 7,952 $ 9.00 --------- ------- $0.20-$10.125 1,806,355 378,797 ========= =======
As of December 31, 1996, there were 478,801 shares available for future grant under the stock option plans. Subsequent to December 31, 1996, 8,647 options were canceled and the Board of Directors granted 210,000 options pursuant to the 1992 Stock Option Plan to employees at $4.56 per share. Subsequent to December 31, 1996, 3,500 options were canceled and the Board of Directors granted options pursuant to the 1996 Supplemental Option Plan to purchase 10,000 shares at $7.25 per share and 243,000 shares at $4.56 per share. 9. INCOME TAXES: In 1993, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes." This statement provides for an asset and liability approach under which deferred income taxes are provided based upon enacted tax laws and rates applicable to the periods in which the taxes become payable. The provision for income taxes differs from the statutory U.S. federal income tax rate due to the following:
YEAR ENDED DECEMBER 31, ------------------------- 1996 1995 1994 ----- ----- ----- Provision at U.S. statutory rate.................... 34.0% 34.0% 34.0% State income taxes, net of federal benefit.......... 6.1 6.1 6.1 Change in valuation allowance....................... (40.1) (40.1) (40.1) ----- ----- ----- --% --% --% ----- ----- -----
Components of the net deferred income tax asset are as follows:
1996 1995 -------- ------- Deferred income tax assets: Net operating loss carryforwards...................... $ 8,670 $ 5,606 Cumulative temporary differences...................... 1,782 1,403 Capitalized start-up costs............................ 37 81 Research and development credit....................... 324 140 Valuation allowance, equity............................. (292) -- Valuation allowance, provision for income taxes......... (10,521) (7,230) -------- ------- Net deferred income tax asset........................... $ -- $ -- ======== =======
F-15 48 DIGITAL GENERATION SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) The net operating loss carryforwards expire on various dates through December 31, 2011. 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. Valuation allowances have 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. The portion of the valuation allowance which will affect equity and which will not be available to offset future provisions of income tax is stated in the above table as "Valuation allowance, equity". 10. 401 (K) PLAN: Since January 1, 1994, the Company has maintained a 401 (k) retirement plan for full-time employees. The employer contribution will be made at the end of the plan year in an amount set by corporate resolution, based on participants' compensation. The Company made no contribution to the plan in 1996, 1995 and 1994. F-16 49 DIGITAL GENERATION SYSTEMS, INC. SCHEDULE II -- VALUATION AND QUALIFYING ACCOUNTS
BALANCE AT ADDITIONS CHARGED BALANCE AT CLASSIFICATION BEGINNING OF PERIOD TO OPERATIONS OTHER(A) WRITEOFFS END OF PERIOD - ----------------------------- ------------------- ----------------- --------- --------- ------------- Allowance for Doubtful Accounts Year Ended: December 31, 1994....... $ 10,000 $ 129,000 $ -- $ (66,000) $ 73,000 December 31, 1995....... $ 73,000 $ 137,000 $ -- $ (75,000) $ 135,000 December 31, 1996....... $ 135,000 $ 97,000 $ 25,000 $ -- $ 257,000
- --------------- (a) Addition resulting from receivables related to the acquisition of PDR Productions, Inc. S-1 EX-10.1 2 1992 STOCK OPTION PLAN (AS AMENDED) 1 EXHIBIT 10.1 DIGITAL GENERATION SYSTEMS, INC. 1992 STOCK OPTION PLAN (AS AMENDED JANUARY 23, 1997) 1. PURPOSES OF THE PLAN. The purposes of this Stock Option Plan are to attract and retain the best available personnel for positions of substantial responsibility, to provide additional incentive to the Employees and Consultants of the Company and to promote the success of the Company's business. Options granted hereunder may be either Incentive Stock Options or Nonstatutory Stock Options, at the discretion of the Board and as reflected in the terms of the written option agreement. 2. DEFINITIONS. As used herein, the following definitions shall apply: (a) "Board" shall mean the Committee, if one has been appointed, or the Board of Directors of the Company, if no Committee is appointed. (b) "Code" shall mean the Internal Revenue Code of 1986, as amended. (c) "Committee" shall mean the Committee appointed by the Board of Directors in accordance with paragraph (a) of Section 4 of the Plan, if one is appointed. (d) "Common Stock" shall mean the Common Stock of the Company. (e) "Company" shall mean Digital Generation Systems, Inc., a California corporation. (f) "Consultant" shall mean any person who is engaged by the Company or any Parent or Subsidiary to render consulting services and is compensated for such consulting services, and any director of the Company whether compensated for such services or not. (g) "Continuous Status as an Employee or Consultant" shall mean the absence of any interruption or termination of service as an Employee or Consultant. Continuous Status as an Employee or Consultant shall not be considered interrupted in the case of sick leave, military leave, or any other leave of absence approved by the Board; provided that such leave is for a period of not more than 90 days or reemployment upon the expiration of such leave is guaranteed by contract or statute. (h) "Employee" shall mean any person, including officers and directors, employed by the Company or any Parent or Subsidiary of the Company. The payment of a director's fee by the Company shall not be sufficient to constitute "employment" by the Company. (i) "Executive Officer" shall mean an officer of the Company at or above the level of vice president. (j) "Incentive Stock Option" shall mean an Option intended to qualify as an incentive stock option within the meaning of Section 422A of the Code. (k) "Nonstatutory Stock Option" shall mean an Option not intended to qualify as an Incentive Stock Option. (l) "Option" shall mean a stock option granted pursuant to the Plan. (m) "Optioned Stock" shall mean the Common Stock subject to an Option. (n) "Optionee" shall mean an Employee or Consultant who receives an Option. (o) "Parent" shall mean a "parent corporation", whether now or hereafter existing, as defined in Section 424(e) of the Code. (p) "Plan" shall mean this 1992 Stock Option Plan. (q) "Share" shall mean a share of the Common Stock, as adjusted in accordance with Section 11 of the Plan. 2 (r) "Subsidiary" shall mean a "subsidiary corporation", whether now or hereafter existing, as defined in Section 424(f) of the Code. 3. STOCK SUBJECT TO THE PLAN. Subject to the provisions of Section 11 of the Plan, the maximum aggregate number of shares which may be optioned and sold under the Plan is 2,450,000 shares of Common Stock. The Shares may be authorized, but unissued, or reacquired Common Stock. If an Option should expire or become unexercisable for any reason without having been exercised in full, the unpurchased Shares which were subject thereto shall, unless the Plan shall have been terminated, become available for future grant under the Plan. Notwithstanding any other provision of the Plan, shares issued under the Plan and later repurchased by the Company shall not become available for future grant or sale under the Plan. 4. ADMINISTRATION OF THE PLAN. (a) Procedure. (i) Multiple Administrative Bodies. The Plan may be administered by different Committees with respect to different groups of Employees and Consultants. (ii) Section 162(m). To the extent that the Board determines it to be desirable to qualify Options granted hereunder as "performance-based compensation" within the meaning of Section 162(m) of the Code, the Plan shall be administered by a Committee of two or more "outside directors" within the meaning of Section 162(m) of the Code. (iii) Rule 16b-3. To the extent desirable to qualify transactions hereunder as exempt under Rule 16b-3, the transactions contemplated hereunder shall be structured to satisfy the requirements for exemption under Rule 16b-3. (iv) Other Administration. Other than as provided above, the Plan shall be administered by (A) the Board or (B) a Committee, which committee shall be constituted to satisfy applicable laws. (b) Powers of the Board. Subject to the provisions of the Plan, the Board shall have the authority, in its discretion: (i) to grant Incentive Stock Options or Nonstatutory Stock Options; (ii) to determine, upon review of relevant information, the fair market value of the Common Stock; (iii) to determine the exercise price per share of Options to be granted, which exercise price shall be determined in accordance with Section 8 of the Plan; (iv) to determine the Employees or Consultants to whom, and the time or times at which, Options shall be granted and the number of shares to be represented by each Option; (v) to interpret the Plan; (vi) to prescribe, amend and rescind rules and regulations relating to the Plan; (vii) to determine the terms and provisions of each Option granted (which need not be identical) and, with the consent of the holder thereof, modify or amend each Option; (viii) to accelerate or defer (with the consent of the Optionee) the exercise date of any Option, consistent with the provisions of Section 5 of the Plan; (ix) to authorize any person to execute on behalf of the Company any instrument required to effectuate the grant of an Option previously granted by the Board; (x) to reduce the exercise price of any Option to the then current Fair Market Value if the Fair Market Value of the Common Stock covered by such Option shall have declined since the date the Option was granted; (xi) to allow Optionees to satisfy withholding tax obligations by electing to have the Company withhold from the Shares to be issued upon exercise of an Option that number of Shares having a Fair Market Value equal to the amount required to be withheld. The Fair Market Value of the Shares to be withheld shall be determined on the date that the amount of tax to be withheld is to be determined. All elections by an Optionee to have Shares withheld for this purpose shall be made in such form and under such conditions as the Board may deem necessary or advisable; and (xii) to make all other determinations deemed necessary or advisable for the administration of the Plan. (c) Effect of Board's Decision. All decisions, determinations and interpretations of the Board shall be final and binding on all Optionees and any other holders of any Options granted under the Plan. (2) 3 5. ELIGIBILITY; LIMITATIONS. (a) Nonstatutory Stock Options may be granted only to Employees and Consultants. Incentive Stock Options may be granted only to Employees. An Employee or Consultant who has been granted an Option may, if he is otherwise eligible, be granted an additional Option or Options. (b) No Incentive Stock Option may be granted to an Employee which, when aggregated with all other incentive stock options granted to such Employee by the Company or any Parent or Subsidiary, would result in Shares having an aggregate fair market value (determined for each Share as of the date of grant of the Option covering such Share) in excess of $100,000 becoming first available for purchase upon exercise of one or more incentive stock options during any calendar year. (c) Section 5(b) of the Plan shall apply only to an Incentive Stock Option evidenced by an "Incentive Stock Option Agreement" which sets forth the intention of the Company and the Optionee that such Option shall qualify as an incentive stock option. Section 5(b) of the Plan shall not apply to any Option evidenced by a "Nonstatutory Stock Option Agreement" which sets forth the intention of the Company and the Optionee that such Option shall be a Nonstatutory Stock Option. (d) The Plan shall not confer upon any Optionee any right with respect to continuation of employment or consulting relationship with the Company, nor shall it interfere in any way with his right or the Company's right to terminate his employment or consulting relationship at any time, with or without cause. (e) The following limitations shall apply to grants of Options: (i) No Employee or Consultant shall be granted, in any fiscal year of the Company, Options to purchase more than 250,000 Shares. (ii) In connection with his or her initial service, an Employee or Consultant may be granted Options to purchase up to an additional 500,000 Shares which shall not count against the limit set forth in subsection (i) above. (iii) The foregoing limitations shall be adjusted proportionately in connection with any change in the Company's capitalization as described in Section 11(a). (iv) If an Option is cancelled in the same fiscal year of the Company in which it was granted (other than in connection with a transaction described in Section 11(a)), the cancelled Option will be counted against the limits set forth in subsections (i) and (ii) above. For this purpose, if the exercise price of an Option is reduced, the transaction will be treated as a cancellation of the Option and the grant of a new Option. 6. TERM OF PLAN. The Plan shall become effective upon the earlier to occur of its adoption by the Board of Directors or its approval by the shareholders of the Company as described in Section 17 of the Plan. It shall continue in effect for a term of ten (10) years unless sooner terminated under Section 13 of the Plan. 7. TERM OF OPTION. The term of each Incentive Stock Option shall be ten (10) years from the date of grant thereof or such shorter term as may be provided in the Incentive Stock Option Agreement. The term of each Nonstatutory Stock Option shall be ten (10) years and one (1) day from the date of grant thereof or such shorter term as may be provided in the Nonstatutory Stock Option Agreement. However, in the case of an Option granted to an Optionee who, at the time the Option is granted, owns stock representing more than ten percent (10%) of the voting power of all classes of stock of the Company or any Parent or Subsidiary, (a) if the Option is an Incentive Stock Option, the term of the Option shall be five (5) years from the date of grant thereof or such shorter term as may be provided in the Incentive Stock Option Agreement, or (b) if the Option is a Nonstatutory Stock Option, the term of the Option shall be five (5) years and one (1) day from the date of grant thereof or such shorter term as may be provided in the Nonstatutory Stock Option Agreement. (3) 4 8. EXERCISE PRICE AND CONSIDERATION. (a) The per Share exercise price for the Shares to be issued pursuant to exercise of an Option shall be such price as is determined by the Board, but shall be subject to the following: (i) In the case of an Incentive Stock Option (A) granted to an Employee who, at the time of the grant of such Incentive Stock Option, owns stock representing more than ten percent (10%) of the voting power of all classes of stock of the Company or any Parent or Subsidiary, the per Share exercise price shall be no less than 110% of the Fair Market Value (as defined in Section 8(b)) per Share on the date of grant. (B) granted to any Employee, the per Share exercise price shall be no less than 100% of the Fair Market Value (as defined in Section 8(b)) per Share on the date of grant. (ii) In the case of a Nonstatutory Stock Option (A) In the case of a Nonstatutory Stock Option, the per Share exercise price shall be determined by the Board. In the case of a Nonstatutory Stock Option intended to qualify as "performance-based compensation" within the meaning of Section 162(m) of the Code, the per Share exercise price shall be no less than 100% of the Fair Market Value (as defined in Section 8(b)) per Share on the date of grant. (B) Notwithstanding the foregoing, Options may be granted with a per Share exercise price of less than 100% of the Fair Market Value (as defined in Section 8(b)) per Share on the date of grant pursuant to a merger or other corporate transaction. (b) The fair market value of the Common Stock (the "Fair Market Value") shall be determined by the Board as follows: (i) If the Common Stock is listed on any established stock exchange or a national market system, including without limitation the Nasdaq National Market or The Nasdaq SmallCap Market of The Nasdaq Stock Market, its Fair Market Value shall be the closing sales price for such stock (or the closing bid, if no sales were reported) as quoted on such exchange or system for the last market trading day prior to the time of determination, as reported in The Wall Street Journal or such other source as the Board deems reliable; (ii) If the Common Stock is regularly quoted by a recognized securities dealer but selling prices are not reported, the Fair Market Value of a Share of Common Stock shall be the mean between the high bid and low asked prices for the Common Stock on the last market trading day prior to the day of determination, as reported in The Wall Street Journal or such other source as the Board deems reliable; or (iii) In the absence of an established market for the Common Stock, the Fair Market Value shall be determined in good faith by the Board. (c) Form of Consideration. The Board shall determine the acceptable form of consideration for exercising an Option, including the method of payment. In the case of an Incentive Stock Option, the Board shall determine the acceptable form of consideration at the time of grant. Such consideration may consist entirely of: (i) cash; (ii) check; (iii) promissory note; (iv) other Shares which (A) in the case of Shares acquired upon exercise of an option, have been owned by the Optionee for more than six months on the date of surrender, and (B) have a Fair Market Value on the date of surrender equal to the aggregate exercise price of the Shares as to which said Option shall be exercised; (4) 5 (v) consideration received by the Company under a cashless exercise program implemented by the Company in connection with the Plan; (vi) a reduction in the amount of any Company liability to the Optionee, including any liability attributable to the Optionee's participation in any Company-sponsored deferred compensation program or arrangement; (vii) any combination of the foregoing methods of payment; or (viii) such other consideration and method of payment for the issuance of Shares to the extent permitted by applicable laws. 9. EXERCISE OF OPTION. (a) Procedure for Exercise; Rights as a Shareholder. Any Option granted hereunder shall be exercisable at such times and under such conditions as determined by the Board, including performance criteria with respect to the Company and/or the Optionee, and as shall be permissible under the terms of the Plan. An Option may not be exercised for a fraction of a Share. An Option shall be deemed to be exercised when written notice of such exercise has been given to the Company in accordance with the terms of the Option by the person entitled to exercise the Option and full payment for the Shares with respect to which the Option is exercised has been received by the Company. Full payment may, as authorized by the Board, consist of any consideration and method of payment allowable under Section 8 of the Plan. Until the issuance (as evidenced by the appropriate entry on the books of the Company or of a duly authorized transfer agent of the Company) of the stock certificate evidencing such Shares, no right to vote or receive dividends or any other rights as a shareholder shall exist with respect to the Optioned Stock, notwithstanding the exercise of the Option. The Company shall issue (or cause to be issued) such stock certificate promptly upon exercise of the Option. No adjustment will be made for a dividend or other right for which the record date is prior to the date the stock certificate is issued, except as provided in Section 11 of the Plan. Exercise of an Option in any manner shall result in a decrease in the number of Shares which thereafter may be available, both for purposes of the Plan and for sale under the Option, by the number of Shares as to which the Option is exercised. (b) Termination of Status as an Employee or Consultant. In the event of termination of an Optionee's Continuous Status as an Employee or Consultant (as the case may be), such Optionee may, but only within thirty (30) days (or such other period of time, not exceeding three (3) months in the case of an Incentive Stock Option or six (6) months in the case of a Nonstatutory Stock Option, as is determined by the Board, with such determination in the case of an Incentive Stock Option being made at the time of grant of the Option) after the date of such termination (but in no event later than the date of expiration of the term of such Option as set forth in the Option Agreement), exercise his Option to the extent that he was entitled to exercise it at the date of such termination. To the extent that he was not entitled to exercise the Option at the date of such termination, or if he does not exercise such Option (which he was entitled to exercise) within the time specified herein, the Option shall terminate. (c) Disability of Optionee. Notwithstanding the provisions of Section 9(b) above, in the event of termination of an Optionee's Continuous Status as an Employee or Consultant as a result of his total and permanent disability (as defined in Section 22(e)(3) of the Code), he may, but only within six (6) months (or such other period of time not exceeding twelve (12) months as is determined by the Board, with such determination in the case of an Incentive Stock Option being made at the time of grant of the Option) from the date of such termination (but in no event later than the date of expiration of the term of such Option as set forth in the Option Agreement), exercise his Option to the extent he was entitled to exercise it at the date of such termination. To the extent that he was not entitled to exercise the Option at the date of termination, or if he does not exercise such Option (which he was entitled to exercise) within the time specified herein, the Option shall terminate. (5) 6 (d) Death of Optionee. In the event of the death of an Optionee: (i) during the term of the Option who is at the time of his death an Employee or Consultant of the Company and who shall have been in Continuous Status as an Employee or Consultant since the date of grant of the Option, the Option may be exercised, at any time within six (6) months following the date of death (but in no event later than the date of expiration of the term of such Option as set forth in the Option Agreement), by the Optionee's estate or by a person who acquired the right to exercise the Option by bequest or inheritance, but only to the extent of the right to exercise that would have accrued had the Optionee continued living and remained in Continuous Status as an Employee or Consultant six (6) months after the date of death, subject to the limitation set forth in Section 5(b); or (ii) within thirty (30) days (or such other period of time not exceeding three (3) months as is determined by the Board, with such determination in the case of an Incentive Stock Option being made at the time of grant of the Option) after the termination of Continuous Status as an Employee or Consultant, the Option may be exercised, at any time within six (6) months following the date of death (but in no event later than the date of expiration of the term of such Option as set forth in the Option Agreement), by the Optionee's estate or by a person who acquired the right to exercise the Option by bequest or inheritance, but only to the extent of the right to exercise that had accrued at the date of termination. 10. NON-TRANSFERABILITY OF OPTIONS. Unless determined otherwise by the Board, an Option may not be sold, pledged, assigned, hypothecated, transferred, or disposed of in any manner other than by will or by the laws of descent or distribution and may be exercised, during the life time of the Optionee, only by the Optionee. If the Board makes an Option transferable, such Option shall contain such additional terms and conditions as the Board deems appropriate. 11. ADJUSTMENTS UPON CHANGES IN CAPITALIZATION DISSOLUTION, LIQUIDATION, MERGER, ASSET SALE OR CHANGE IN CONTROL. (a) Changes in Capitalization. Subject to any required action by the shareholders of the Company, the number of shares of Common Stock covered by each outstanding Option, and the number of shares of Common Stock which have been authorized for issuance under the Plan but as to which no Options have yet been granted or which have been returned to the Plan upon cancellation or expiration of an Option, as well as the price per share of Common Stock covered by each such outstanding Option, shall be proportionately adjusted for any increase or decrease in the number of issued shares of Common Stock resulting from a stock split, reverse stock split, stock dividend, combination or reclassification of the Common Stock, or any other increase or decrease in the number of issued shares of Common Stock effected without receipt of consideration by the Company; provided, however, that conversion of any convertible securities of the Company shall not be deemed to have been "effected without receipt of consideration." Such adjustment shall be made by the Board, whose determination in that respect shall be final, binding and conclusive. Except as expressly provided herein, no issuance by the Company of shares of stock of any class, or securities convertible into shares of stock of any class, shall affect, and no adjustment by reason thereof shall be made with respect to, the number or price of shares of Common Stock subject to an Option. (b) Dissolution or Liquidation. In the event of the proposed dissolution or liquidation of the Company, the Board shall notify the Optionee at least fifteen (15) days prior to such proposed action. To the extent an Option has not been previously exercised, such Option shall terminate prior to consummation of such proposed dissolution or liquidation. (c) Merger or Asset Sale. Subject to the provisions of Section 11(d) hereof, in the event of a merger of the Company with or into another corporation, or the sale of substantially all of the assets of the Company, each outstanding Option shall be assumed or an equivalent option substituted by the successor corporation or a Parent or Subsidiary of the successor corporation. In the event that the successor corporation refuses to assume or substitute for the Option, the Board shall notify the Optionee that the Option shall be exercisable to the extent that the Optionee is otherwise entitled to exercise the Option for a period of fifteen (15) days from the date of such notice, and the Option shall terminate upon the expiration of such period. For the purposes of (6) 7 this paragraph, the Option shall be considered assumed if, following the merger or sale of assets, the option confers the right to purchase or receive, for each Share of Optioned Stock subject to the Option immediately prior to the merger or sale of assets, the consideration (whether stock, cash, or other securities or property) received in the merger or sale of assets by holders of Common Stock for each Share held on the effective date of the transaction (and if holders were offered a choice of consideration, the type of consideration chosen by the holders of a majority of the outstanding Shares); provided, however, that if such consideration received in the merger or sale of assets was not solely common stock of the successor corporation or its Parent, the Board may, with the consent of the successor corporation, provide for the consideration to be received upon the exercise of the Option, for each Share of Optioned Stock subject to the Option, to be solely common stock of the successor corporation or its Parent equal in fair market value to the per share consideration received by holders of Common Stock in the merger or sale of assets. (d) Change in Control. In the event of a "Change in Control" of the Company, as defined in Subsection (e) below, then the following provisions shall apply: (i) For each Optionee who is an Executive Officer and has any Option outstanding on the date of such Change in Control which is not yet fully exercisable and fully vested as of the date of such Change in Control, such Option shall become exercisable and vested on the date of such Change in Control with respect to fifty percent (50%) of the Shares covered by such Option which are not exercisable or vested on the date of such Change in Control without reference to this subsection (an "Outstanding Option"); (ii) Each Outstanding Option held by an Executive Officer which is vested and exercisable on the date of such Change in Control shall be assumed by the successor corporation (if any) or by a Parent or Subsidiary of the successor corporation (if any); (iii) Each Outstanding Option held by an Executive Officer which is vested and exercisable on the date of such Change in Control shall remain exercisable by the Optionee for a period of at least fifteen (15) days from the date of the Change in Control; (iv) Each Optionee who is an Executive Officer with an Outstanding Option which is vested and exercisable on the date of such Change in Control shall be provided with written notice of the period of exercisability provided for in subsection (d)(iii) above promptly after the date of the Change in Control by the Company or by the entity surviving after the Change in Control. (e) Definition of "Change in Control". For purposes of this Section 11, a "Change in Control" means the happening of any of the following: (i) when any "person" or "group" of persons, as such terms are used in Sections 13(d) and 14(d) of the Exchange Act (other than the Company, a Subsidiary or a Company employee benefit plan, including any trustee of such plan acting as trustee) is or becomes the "beneficial owner" (as defined in Rule 13d-3 under the Exchange Act), directly or indirectly, of securities of the Company representing more than fifty percent (50%) of the combined voting power of the Company's then outstanding securities entitled to vote generally in the election of directors; provided that "person" shall not include any person (or any person acting as a group) which, as of the date of the adoption of this 1992 Stock Option Plan, is the "beneficial owner" of securities of the Company representing more than fifty percent (50%) of the combined voting power of the Company's outstanding securities entitled to vote generally in the election of directors; or (ii) a merger or consolidation of the Company with any other corporation, other than a merger or consolidation which would result in the voting securities of the Company outstanding immediately prior thereto continuing to represent (either by remaining outstanding or by being converted into voting securities of the surviving entity) at least fifty percent (50%) of the total voting power represented by the voting securities of the Company or such surviving entity outstanding immediately after such merger or consolidation; or (iii) a change in the composition of the Board of Directors of the Company, during any twenty-four month period, as a result of which fewer than a majority of the directors are Incumbent Directors. (7) 8 "Incumbent Directors" shall mean directors who either (A) are directors of the Company as of the date the Plan is approved by the shareholders, or (B) are elected, or nominated for election, to the Board of Directors of the Company with the affirmative votes of at least a majority of the Incumbent Directors at the time of such election or nomination (but shall not include an individual not otherwise an Incumbent Director whose election or nomination is in connection with an actual or threatened proxy contest relating to the election of directors to the Company). 12. TIME OF GRANTING OPTIONS. The date of grant of an Option shall, for all purposes, be the date on which the Board makes the determination granting such Option. Notice of the determination shall be given to each Employee or Consultant to whom an Option is so granted within a reasonable time after the date of such grant. 13. AMENDMENT AND TERMINATION OF THE PLAN. (a) Amendment and Termination. The Board may amend or terminate the Plan from time to time in such respects as the Board may deem advisable; provided that, the following revisions or amendments shall require approval of the shareholders of the Company in the manner described in Section 17 of the Plan: (i) any increase in the number of Shares subject to the Plan, other than in connection with an adjustment under Section 11 of the Plan; (ii) any change in the designation of the class of persons eligible to be granted Options; or (b) Shareholder Approval. If any amendment requiring shareholder approval under Section 13(a) of the Plan is made subsequent to the first registration of any class of equity securities by the Company under Section 12 of the Exchange Act, such shareholder approval shall be solicited as described in Section 17 of the Plan. (c) Effect of Amendment or Termination. Any such amendment or termination of the Plan shall not affect Options already granted and such Options shall remain in full force and effect as if this Plan had not been amended or terminated, unless mutually agreed otherwise between the Optionee and the Board, which agreement must be in writing and signed by the Optionee and the Company. 14. CONDITIONS UPON ISSUANCE OF SHARES. Shares shall not be issued pursuant to the exercise of an Option unless the exercise of such Option and the issuance and delivery of such Shares pursuant thereto shall comply with all relevant provisions of law, including, without limitation, the Securities Act of 1933, as amended, the Exchange Act, the rules and regulations promulgated thereunder, and the requirements of any stock exchange upon which the Shares may then be listed, and shall be further subject to the approval of counsel for the Company with respect to such compliance. As a condition to the exercise of an Option, the Company may require the person exercising such Option to represent and warrant at the time of any such exercise that the Shares are being purchased only for investment and without any present intention to sell or distribute such Shares if, in the opinion of counsel for the Company, such a representation is required by any of the aforementioned relevant provisions of law. 15. RESERVATION OF SHARES. The Company, during the term of this Plan, will at all times reserve and keep available such number of Shares as shall be sufficient to satisfy the requirements of the Plan. The inability of the Company to obtain authority from any regulatory body having jurisdiction, which authority is deemed by the Company's counsel to be necessary to the lawful issuance and sale of any Shares hereunder, shall relieve the Company of any liability in respect of the failure to issue or sell such Shares as to which such requisite authority shall not have been obtained. 16. OPTION AGREEMENT. Options shall be evidenced by written option agreements in such form as the Board shall approve. 17. SHAREHOLDER APPROVAL. (a) Continuance of the Plan shall be subject to approval by the shareholders of the Company within twelve (12) months before or after the date the Plan is adopted. (8) 9 (b) If and in the event that the Company registers any class of equity securities pursuant to Section 12 of the Exchange Act, any required approval of the shareholders of the Company obtained after such registration shall be solicited substantially in accordance with Section 14(a) of the Exchange Act and the rules and regulations promulgated thereunder. (c) If any required approval by the shareholders of the Plan itself or of any amendment thereto is solicited at any time otherwise than in the manner described in Section 17(b) hereof, then the Company shall, at or prior to the first annual meeting of shareholders held subsequent to the later of (1) the first registration of any class of equity securities of the Company under Section 12 of the Exchange Act or (2) the granting of an Option hereunder to an officer or director after such registration, do the following: (i) furnish in writing to the holders entitled to vote for the Plan substantially the same information which would be required (if proxies to be voted with respect to approval or disapproval of the Plan or amendment were then being solicited) by the rules and regulations in effect under Section 14(a) of the Exchange Act at the time such information is furnished; and (ii) file with, or mail for filing to, the Securities and Exchange Commission four copies of the written information referred to in subsection (i) hereof not later than the date on which such information is first sent or given to shareholders. 18. INFORMATION TO OPTIONEES. The Company shall provide to each optionee, durnig the period for which such optionee has one or more options outstanding, copies of all annual reports and other information which are provided to all shareholders of the Company. The Company shall not be required to provide such information if the issuance of options under the Plan is limited to key employees whose duties in connection with the Company assure their access to equivalent information. (9) EX-10.3 3 1995 DIRECTOR OPTION PLAN 1 EXHIBIT 10.3 DIGITAL GENERATION SYSTEMS, INC. 1995 DIRECTOR OPTION PLAN (AS AMENDED JANUARY 23, 1997) 1. PURPOSES OF THE PLAN. The purposes of this 1995 Director Option Plan are to attract and retain the best available personnel for service as Outside Directors (as defined herein) of the Company, to provide additional incentive to the Outside Directors of the Company to serve as Directors, and to encourage their continued service on the Board. All options granted hereunder shall be nonstatutory stock options. 2. DEFINITIONS. As used herein, the following definitions shall apply: (a) "Board" means the Board of Directors of the Company. (b) "Code" means the Internal Revenue Code of 1986, as amended. (c) "Common Stock" means the Common Stock of the Company. (d) "Company" means Digital Generation Systems, Inc., a California corporation. (e) "Continuous Status as a Director" means the absence of any interruption or termination of service as a Director. (f) "Director" means a member of the Board. (g) "Employee" means any person, including officers and Directors, employed by the Company or any Parent or Subsidiary of the Company. The payment of a Director's fee by the Company shall not be sufficient in and of itself to constitute "employment" by the Company. (h) "Exchange Act" means the Securities Exchange Act of 1934, as amended. (i) "Fair Market Value" means, as of any date, the value of Common Stock determined as follows: (i) If the Common Stock is listed on any established stock exchange or a national market system, including without limitation the Nasdaq National Market of the National Association of Securities Dealers, Inc. Automated Quotation ("NASDAQ") System, the Fair Market Value of a Share of Common Stock shall be the closing sales price for such stock (or the closing bid, if no sales were reported) as quoted on such system or exchange (or the exchange with the greatest volume of trading in Common Stock) on the date of determination, as reported in The Wall Street Journal or such other source as the Board deems reliable; (ii) If the Common Stock is quoted on the NASDAQ System (but not on the National Market thereof) or regularly quoted by a recognized securities dealer but selling prices are not reported, the Fair Market Value of a Share of Common Stock shall be the mean between the high bid and low asked prices for the Common Stock on the date of determination, as reported in The Wall Street Journal or such other source as the Board deems reliable, or; (iii) In the absence of an established market for the Common Stock, the Fair Market Value thereof shall be determined in good faith by the Board. (j) "Option" means a stock option granted pursuant to the Plan. (k) "Optioned Stock" means the Common Stock subject to an Option. (l) "Optionee" means an Outside Director who receives an Option. 2 (m) "Outside Director" means a Director who is neither (i) an Employee, nor (ii) an affiliate of an institutional investor in the Company, provided that, upon the date of the first annual meeting of shareholders following an initial public offering, this subpart (ii) shall no longer be applicable. (n) "Parent" means a "parent corporation," whether now or hereafter existing, as defined in Section 424(e) of the Code. (o) "Plan" means this 1995 Director Option Plan. (p) "Share" means a share of the Common Stock, as adjusted in accordance with Section 10 of the Plan. (q) "Subsidiary" means a "subsidiary corporation," whether now or hereafter existing, as defined in Section 424(f) of the Internal Revenue Code of 1986. 3. STOCK SUBJECT TO THE PLAN. Subject to the provisions of Section 10 of the Plan, the maximum aggregate number of Shares which may be optioned and sold under the Plan is 100,000 Shares of Common Stock (the "Pool"). The Shares may be authorized, but unissued, or reacquired Common Stock. If an Option expires or becomes unexercisable without having been exercised in full, the unpurchased Shares which were subject thereto shall become available for future grant or sale under the Plan (unless the Plan has terminated); provided, however, that Shares that have actually been issued under the Plan shall not be returned to the Plan and shall not become available for future distribution under the Plan. 4. ADMINISTRATION AND GRANTS OF OPTIONS UNDER THE PLAN. (a) Procedure for Grants. All grants of Options to Outside Directors under this Plan shall be automatic and nondiscretionary and shall be made strictly in accordance with the following provisions: (i) No person shall have any discretion to select which Outside Directors shall be granted Options or to determine the number of Shares to be covered by Options granted to Outside Directors. (ii) Each Outside Director shall be automatically granted an Option to purchase 10,000 Shares (the "First Option") on the date on which the later of the following events occurs: (A) the effective date of this Plan, as determined in accordance with Section 6 hereof, or (B) the date on which such person first becomes an Outside Director, whether through election by the shareholders of the Company or appointment by the Board to fill a vacancy; provided, however, that no First Option shall be granted to an Outside Director who, immediately prior to becoming an Outside Director, was a Director. (iii) After the First Option has been granted to an Outside Director, such Outside Director shall thereafter be automatically granted an Option to purchase 2,500 Shares (a "Subsequent Option") on the anniversary date of the First Option. (iv) Notwithstanding the provisions of subsections (ii) and (iii) hereof, any exercise of an Option made before the Company has obtained shareholder approval of the Plan in accordance with Section 16 hereof shall be conditioned upon obtaining such shareholder approval of the Plan in accordance with Section 16 hereof. (v) The terms of a First Option granted hereunder shall be as follows: (A) the term of the First Option shall be ten (10) years. (B) the options granted thereunder shall be exercisable only while the Outside Director remains a Director of the Company, except as set forth in Section 8 hereof. (C) the exercise price per Share shall be the fair market value per Share on the date of grant. In the event that the date of grant is not a trading day, the exercise price per Share shall be the Fair Market Value on the next trading day immediately following the date of grant, or, in the event there is no trading market for the Shares at the date of grant, at the Fair Market Value of such Shares as determined by the Board of Directors. -2- 3 (D) the First Option shall become exercisable as to 1/36th of the Shares on the first day of each month following the grant date, provided that the Optionee continues to serve as a Director on such dates. (vi) The terms of a Subsequent Option granted hereunder shall be as follows: (A) the term of the Subsequent Option shall be ten (10) years. (B) the Subsequent Option shall be exercisable only while the Outside Director remains a Director of the Company, except as set forth in Section 8 hereof. (C) the exercise price per Share shall be the fair market value per Share on the date of grant. In the event that the date of grant is not a trading day, the exercise price per Share shall be the Fair Market Value on the next trading day immediately following the date of grant or, in the event there is no trading market for the Shares at the date of grant, at the Fair Market Value of such Shares as determined by the Board of Directors. (D) the Subsequent Option shall become exercisable as to 1/12th of the Shares subject to the Subsequent Option on the first day of each month following the second anniversary of its date of grant, provided that the Optionee continues to serve as a Director on such dates. (vii) In the event that any Option granted under the Plan would cause the number of Shares subject to outstanding Options plus the number of Shares previously purchased under Options to exceed the Pool, then the remaining Shares available for Option grant shall be granted under Options to the Outside Directors on a pro rata basis. No further grants shall be made until such time, if any, as additional Shares become available for grant under the Plan through action of the Board or the shareholders to increase the number of Shares which may be issued under the Plan or through cancellation or expiration of Options previously granted hereunder. 5. ELIGIBILITY. Options may be granted only to Outside Directors. All Options shall be automatically granted in accordance with the terms set forth in Section 4 hereof. An Outside Director who has been granted an Option may, if he or she is otherwise eligible, be granted an additional Option or Options in accordance with such provisions. The Plan shall not confer upon any Optionee any right with respect to continuation of service as a Director or nomination to serve as a Director, nor shall it interfere in any way with any rights which the Director or the Company may have to terminate his or her directorship at any time. 6. TERM OF PLAN. The Plan shall become effective upon the earlier to occur of its adoption by the Board or its approval by the shareholders of the Company as described in Section 16 of the Plan. It shall continue in effect for a term of ten (10) years unless sooner terminated under Section 11 of the Plan. 7. FORM OF CONSIDERATION. The consideration to be paid for the Shares to be issued upon exercise of an Option, including the method of payment, shall consist of (i) cash, (ii) check, (iii) other shares which (x) in the case of Shares acquired upon exercise of an Option, have been owned by the Optionee for more than six (6) months on the date of surrender, and (y) have a Fair Market Value on the date of surrender equal to the aggregate exercise price of the Shares as to which said Option shall be exercised, (iv) delivery of a properly executed exercise notice together with such other documentation as the Company and the broker, if applicable, shall require to effect an exercise of the Option and delivery to the Company of the sale or loan proceeds required to pay the exercise price, or (v) any combination of the foregoing methods of payment. 8. EXERCISE OF OPTION. (a) Procedure for Exercise; Rights as a Shareholder. Any Option granted hereunder shall be exercisable at such times as are set forth in Section 4 hereof; provided, however, that no Options shall be exercisable until shareholder approval of the Plan in accordance with Section 16 hereof has been obtained. An Option may not be exercised for a fraction of a Share. -3- 4 An Option shall be deemed to be exercised when written notice of such exercise has been given to the Company in accordance with the terms of the Option by the person entitled to exercise the Option and full payment for the Shares with respect to which the Option is exercised has been received by the Company. Full payment may consist of any consideration and method of payment allowable under Section 7 of the Plan. Until the issuance (as evidenced by the appropriate entry on the books of the Company or of a duly authorized transfer agent of the Company) of the stock certificate evidencing such Shares, no right to vote or receive dividends or any other rights as a shareholder shall exist with respect to the Optioned Stock, notwithstanding the exercise of the Option. A share certificate for the number of Shares so acquired shall be issued to the Optionee as soon as practicable after exercise of the Option. No adjustment shall be made for a dividend or other right for which the record date is prior to the date the stock certificate is issued, except as provided in Section 10 of the Plan. Exercise of an Option in any manner shall result in a decrease in the number of Shares which thereafter may be available, both for purposes of the Plan and for sale under the Option, by the number of Shares as to which the Option is exercised. (b) Termination of Continuous Status as a Director. In the event an Optionee's Continuous Status as a Director terminates (other than upon the Optionee's death or total and permanent disability (as defined in Section 22(e)(3) of the Code)), the Optionee may exercise his or her Option, but only within three (3) months following the date of such termination, and only to the extent that the Optionee was entitled to exercise it on the date of such termination (but in no event later than the expiration of its ten (10) year term). To the extent that the Optionee was not entitled to exercise an Option on the date of such termination, and to the extent that the Optionee does not exercise such Option (to the extent otherwise so entitled) within the time specified herein, the Option shall terminate. (c) Disability of Optionee. In the event Optionee's Continuous Status as a Director terminates as a result of total and permanent disability (as defined in Section 22(e)(3) of the Code), the Optionee may exercise his or her Option, but only within twelve (12) months following the date of such termination, and only to the extent that the Optionee was entitled to exercise it on the date of such termination (but in no event later than the expiration of its ten (10) year term). To the extent that the Optionee was not entitled to exercise an Option on the date of termination, or if he or she does not exercise such Option (to the extent otherwise so entitled) within the time specified herein, the Option shall terminate. (d) Death of Optionee. In the event of an Optionee's death, the Optionee's estate or a person who acquired the right to exercise the Option by bequest or inheritance may exercise the Option, but only within twelve (12) months following the date of death, and only to the extent that the Optionee was entitled to exercise it on the date of death (but in no event later than the expiration of its ten (10) year term). To the extent that the Optionee was not entitled to exercise an Option on the date of death, and to the extent that the Optionee's estate or a person who acquired the right to exercise such Option does not exercise such Option (to the extent otherwise so entitled) within the time specified herein, the Option shall terminate. 9. NON-TRANSFERABILITY OF OPTIONS. Unless otherwise provided by the Administrator, the Option may not be sold, pledged, assigned, hypothecated, transferred, or disposed of in any manner other than by will or by the laws of descent or distribution and may be exercised, during the lifetime of the Optionee, only by the Optionee. If the Board makes an Option transferable, such Option shall contain such additional terms and conditions as the Board deems appropriate. 10. ADJUSTMENTS UPON CHANGES IN CAPITALIZATION, DISSOLUTION, MERGER, ASSET SALE OR CHANGE OF CONTROL. (a) Changes in Capitalization. Subject to any required action by the shareholders of the Company, the number of Shares covered by each outstanding Option, the number of Shares which have been authorized for issuance under the Plan but as to which no Options have yet been granted or which have been returned to the Plan upon cancellation or expiration of an Option, as well as the price per Share covered by each such outstanding Option, and the number of Shares issuable pursuant to the automatic grant provisions of Section 4 hereof shall be proportionately adjusted for any increase or decrease in the number of issued Shares resulting -4- 5 from a stock split, reverse stock split, stock dividend, combination or reclassification of the Common Stock, or any other increase or decrease in the number of issued Shares effected without receipt of consideration by the Company; provided, however, that conversion of any convertible securities of the Company shall not be deemed to have been "effected without receipt of consideration." Except as expressly provided herein, no issuance by the Company of shares of stock of any class, or securities convertible into shares of stock of any class, shall affect, and no adjustment by reason thereof shall be made with respect to, the number or price of Shares subject to an Option. (b) Dissolution or Liquidation. In the event of the proposed dissolution or liquidation of the Company, to the extent that an Option has not been previously exercised, it shall terminate immediately prior to the consummation of such proposed action. (c) Merger or Asset Sale. In the event of a merger of the Company with or into another corporation, or the sale of substantially all of the assets of the Company, each outstanding Option may be assumed or an equivalent option may be substituted by the successor corporation or a Parent or Subsidiary of the successor corporation. In the event that the successor corporation does not agree to assume the Option or to substitute an equivalent option, each outstanding Option shall become fully vested and exercisable, including as to Shares as to which it would not otherwise be exercisable. If an Option becomes fully vested and exercisable in the event of a merger or sale of assets, the Board shall notify the Optionee that the Option shall be fully exercisable for a period of thirty (30) days from the date of such notice, and the Option shall terminate upon the expiration of such period. For the purposes of this paragraph, the Option shall be considered assumed if, following the merger or sale of assets, the Option confers the right to purchase, for each Share of Optioned Stock subject to the Option immediately prior to the merger or sale of assets, the consideration (whether stock, cash, or other securities or property) received in the merger or sale of assets by holders of Common Stock for each Share held on the effective date of the transaction (and if holders were offered a choice of consideration, the type of consideration chosen by the holders of a majority of the outstanding Shares). 11. AMENDMENT AND TERMINATION OF THE PLAN. (a) Amendment and Termination. Except as set forth in Section 4, the Board may at any time amend, alter, suspend, or discontinue the Plan, but no amendment, alteration, suspension, or discontinuation shall be made which would impair the rights of any Optionee under any grant theretofore made, without his or her consent. (b) Effect of Amendment or Termination. Any such amendment or termination of the Plan shall not affect Options already granted and such Options shall remain in full force and effect as if this Plan had not been amended or terminated. 12. TIME OF GRANTING OPTIONS. The date of grant of an Option shall, for all purposes, be the date determined in accordance with Section 4 hereof. 13. CONDITIONS UPON ISSUANCE OF SHARES. Shares shall not be issued pursuant to the exercise of an Option unless the exercise of such Option and the issuance and delivery of such Shares pursuant thereto shall comply with all relevant provisions of law, including, without limitation, the Securities Act of 1933, as amended, the Exchange Act, the rules and regulations promulgated thereunder, state securities laws, and the requirements of any stock exchange upon which the Shares may then be listed, and shall be further subject to the approval of counsel for the Company with respect to such compliance. As a condition to the exercise of an Option, the Company may require the person exercising such Option to represent and warrant at the time of any such exercise that the Shares are being purchased only for investment and without any present intention to sell or distribute such Shares, if, in the opinion of counsel for the Company, such a representation is required by any of the aforementioned relevant provisions of law. Inability of the Company to obtain authority from any regulatory body having jurisdiction, which authority is deemed by the Company's counsel to be necessary to the lawful issuance and sale of any Shares hereunder, shall relieve the Company of any liability in respect of the failure to issue or sell such Shares as to which such requisite authority shall not have been obtained. -5- 6 14. RESERVATION OF SHARES. The Company, during the term of this Plan, will at all times reserve and keep available such number of Shares as shall be sufficient to satisfy the requirements of the Plan. 15. OPTION AGREEMENT. Options shall be evidenced by written option agreements in such form as the Board shall approve. 16. SHAREHOLDER APPROVAL. Continuance of the Plan shall be subject to approval by the shareholders of the Company at or prior to the first annual meeting of shareholders held subsequent to the granting of an Option hereunder. Such shareholder approval shall be obtained in the degree and manner required under applicable state and federal law. -6- EX-11.1 4 STATEMENT RE: COMPUTATION OF PRO FORMA SHARES 1 EXHIBIT 11.1 DIGITAL GENERATION SYSTEMS, INC. STATEMENTS OF COMPUTATION OF PRO FORMA COMMON SHARES AND EQUIVALENTS (IN THOUSANDS, EXCEPT FOR PER SHARE AMOUNTS)
YEAR ENDED YEAR ENDED DECEMBER 31, DECEMBER 31, 1996 1995 ------------ ------------ Net loss........................................................... $ (9,127) $ (8,780) ========== ========== Weighted average common shares outstanding......................... 9,389 898 Weighted average common equivalent shares: Weighted average preferred stock outstanding..................... 1,819 6,942 Adjustments to reflect requirements of the Securities and Exchange Commission's Staff Accounting Bulletin No. 83: Common stock issuances........................................... 49 195 Preferred stock issuances........................................ 145 581 Preferred stock warrants......................................... 5 18 Common stock option grants....................................... 187 726 ------------ ------------ Pro forma total weighted average common shares and equivalents..... 11,594 9,360 ========== ========== Pro forma net loss per share....................................... $ (.79) $ (.94) ========== ==========
EX-21.1 5 SUBSIDIARIES OF THE REGISTRANT 1 EXHIBIT 21.1 SUBSIDIARIES OF THE REGISTRANT The registrant's only subsidiary is PDR Productions, Inc., a New York corporation. EX-23.1 6 CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS 1 EXHIBIT 23.1 CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation of our report included in this Form 10-K, into the Company's previously filed Registration Statement on Form S-8, File No. 333-04676. ARTHUR ANDERSEN LLP San Jose, California March 17, 1997 EX-27 7 FINANCIAL DATA SCHEDULE
5 1,000 12-MOS DEC-31-1996 JAN-01-1996 DEC-31-1996 9,682 10,915 3,606 (257) 0 24,114 20,420 (7,790) 45,248 9,914 8,495 0 0 55,138 (28,299) 45,248 0 10,523 0 19,346 0 97 1,726 (9,127) 0 (9,127) 0 0 0 (9,127) (.79) (.79)
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