ITEM 1 - BUSINESS
Certain information contained in this Report constitutes forward-looking statements which involve risks and uncertainties including, but not limited to, information with regard to our revenues, earnings, spending, margins, cash flow, orders, inventory, products, actions, plans, strategies and objectives. The words “believes,” “anticipates,” “plans,” “expects,” “endeavors, “may,” “will,” “intends,” “estimates,” and similar expressions are intended to identify forward-looking statements. These forward-looking statements involve risks and uncertainties, and our actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors, including, but not limited to, those set forth under “Risk Factors” and elsewhere in this Report.
OVERVIEW
We develop and publish interactive entertainment software products. We currently publish titles for the most popular interactive entertainment hardware platforms, such as Sony’s PlayStation and PlayStation 2, Nintendo’s Gamecube, Nintendo 64, Game Boy Color and Game Boy Advance, Microsoft’s Xbox, portable handheld devices manufactured by Palm and Handspring, and for personal computers or PCs. We were incorporated in California in October 1999 under the name Bay Area Multimedia, Inc. We reincorporated in Delaware in September 2000 and changed our name to BAM! Entertainment, Inc. in December 2000. We commenced operations in October 1999 and shipped our first products in June 2000.
We license properties from a wide variety of sources, and publish titles based on the motion picture, sports and television properties of our licensors. We have entered into strategic license arrangements with entertainment and media companies that have developed well-known characters and brands and that are producing popular properties that are expected to form the basis of some of our future products. Our agreements with licensors and developers generally require us to make advance royalty payments, and we may be required to spend money on advertising and promotion. We generally pay royalties based on net revenues.
We design and develop our titles through third parties with whom we have established relationships. We believe that the development cycle for new titles is long, typically ranging from 12 to 24 months, except for Nintendo’s Game Boy Advance for which the development cycle typically ranges from six to nine months. After development of the initial product, we believe that it may take between six to 12 additional months to develop the product for, or port the product to, a different hardware platform.
We have offices in both the United States and Europe. International operations outside of North America are conducted through our office in England, where we perform international sales and marketing activities and manage local third-party developers. Domestically, we sell our products to mass merchandisers such as Toys “R” Us, Target, Kmart, Wal-Mart and Best Buy, specialty chains such as GameStop and Electronics Boutique, and independent distributors. Internationally, we sell our products through mass merchandisers, distributors and sub-distributors. Our products are manufactured exclusively by third parties.
We have experienced recurring net losses from inception (October 7, 1999) through June 30, 2003. During the year ended June 30, 2003, we used cash in operating activities of $10.5 million and incurred a net loss of $36.2 million. As of June 30, 2003, we had cash and cash equivalents of $1.1 million and an accumulated deficit of $59.8 million. These factors, among others, raise substantial doubt about our ability to continue as a going concern for a reasonable period of time. The consolidated financial statements do not include any adjustments relating to the recoverability and classification of assets or the amounts and classification of recorded liabilities that might be necessary should we be unable to continue as a going concern.
During the year ended June 30, 2003, we undertook measures to reduce spending and restructured our operations. In February 2003 we retained, through July 31, 2003, the investment banking firm of Gerard Klauer Mattison & Co., Inc. to assist us in reviewing a range of potential strategic alternatives, including mergers, acquisitions and additional financing. No transactions arose from this assistance or were consummated during this period. We may need to either consummate one or a combination of the potential strategic alternatives, or otherwise obtain capital via sale or license of certain of our assets, in order to satisfy our future liquidity requirements. Current market
conditions present uncertainty as to our ability to effectuate any merger or acquisition or secure additional financing, as well as our ability to reach profitability. There can be no assurances that we will be able to effectuate any such merger or acquisition or secure additional financing, or obtain favorable terms on such financing if it is available, or as to our ability to achieve positive cash flow from operations. Continued negative cash flows create significant uncertainty about our ability to implement our operating plan and we may have to further reduce the scope of our planned operations. If cash and cash equivalents, together with cash generated from operations, are insufficient to satisfy our liquidity requirements, we will not have sufficient resources to continue operations for the next six months.
As of June 30, 2003, we had $4.0 million, $1.1 million and $89,000 of capitalized development costs, current and long-term prepaid royalties and licensed assets, respectively, related to software development projects in progress. Should we be unable to effectuate either a merger or acquisition or secure sufficient additional financing, part or all of these development projects in progress might have to be abandoned and the related costs would have to be written off.
In September 2003, we entered into a six month Agreement (the “Agreement”) with a finance company, pursuant to which the finance company extends us a line of credit facility to fund domestic inventory purchases. We may sell the inventory purchased under the Agreement and are required to remit customer receipts from those sales directly to the finance company up to the amounts funded by them. We retain collections in excess of the amounts funded by the finance company, are responsible for collecting the customer receivables, and bear the risk of loss on all uncollectible accounts. Under the Agreement, the finance company’s aggregate outstanding funding is limited to $3.2 million. We are required to pay the finance company’s expenses under the contract, a facility fee equal to 5.0% of the funds advanced by the finance company, and interest at prime plus 0.5%. The Agreement terminates on March 31, 2004 and any sums outstanding become repayable on that date. We may repay any sums advanced prior to the due date of payment without penalty. Our factoring agreement with a different finance company was mutually terminated in September 2003.
Products
The following tables set forth the titles we have released since inception:
(1)
This title has been released to consumers in North America only.
(2)
This title has been released to consumers in Europe only.
Strategic relationships
We have entered into strategic relationships with entertainment and media companies that have developed well-known characters and brands and that are producing popular properties that are expected to form the basis of future products.
The Cartoon Network. Between March 2000 and February 2003, we entered into four non-exclusive license agreements that give us the right to develop and distribute interactive entertainment software based on Warner Bros.’ Powerpuff Girls, Dexter’s Laboratory, Samurai Jack and Ed, Edd, n Eddy properties on a multi-national basis. The Powerpuff Girls, Dexter’s Laboratory, Samurai Jack and Ed, Edd, n Eddy television shows are aired on AOL Time Warner’s Cartoon Network. Under these agreements, we are obligated to pay royalties based on a percentage of net sales of the titles and are obligated to advertise and promote the titles on the Cartoon Network. Our license agreement for Samurai Jack terminated in August 2003.
We believe that the Cartoon Network has significant brand awareness among six to 11 year olds. According to the Cartoon Network, their programs are viewed in 82 million homes in the United States and 145 countries around the world. We participate in promotional programs with the Cartoon Network and certain retailers who advertise on the Cartoon Network in connection with the release of our products.
Franchise Films. In April 2000, we entered into a strategic arrangement with Franchise Films, Inc. Our agreement gives us the exclusive, first look right to review screenplays acquired by the studio, develop titles based on films produced from those screenplays and distribute them worldwide. Our agreement expires upon the later of three years or the theatrical release of the tenth film on which we base a product. Franchise Films has also agreed to provide us with free access to any publicity and advertising materials it prepares and granted us the right to use these materials to promote and advertise our products. Under the agreement, we agreed to pay Franchise Films royalties based on the net sales of the titles based on the films we select and we are obligated to issue 68,738 shares of our common stock following the theatrical release of each film for which we have developed a title, up to a maximum of 687,375 shares. We have released titles for the Sony PlayStation 2 and Nintendo Game Boy Advance based on the film title Driven, which was released in April 2001. We have also released two Nintendo Game Boy Advance titles based on Ecks v Sever, a film released in September 2002.
Sports Illustrated For Kids. In May 2000, we signed a strategic arrangement with Time, Inc. for the development of titles utilizing the Sports Illustrated For Kids brand name. Our four-year, non-exclusive license gives us the right to publish titles based on popular sports that are appropriate for children ages seven to 17 and to distribute those titles on a multi-national basis. Our agreement gives us the right to access a portion of their subscriber base for market research purposes. Under the agreement, we are obligated to pay a royalty based on the gross wholesale price of the titles and advertise and promote the titles in the magazine. In September 2001 we released our first two titles under this collaboration for Nintendo’s Game Boy Advance, Sports Illustrated for Kids Baseball and Sports Illustrated for Kids Football.
Aardman Animations Ltd. In January 2002, we entered into a licensing and publishing partnership with Aardman Animations Limited, creators of Wallace & Gromit and Chicken Run. Our five-year agreement gives us an exclusive right to develop titles based on Aardman’s intellectual property and to distribute them worldwide. Under the agreement we will have to pay royalties to Aardman calculated as a percentage of sales of the developed products, and we are required to issue them warrants to purchase up to 50,000 shares of common stock, in pre-determined multiples of either 5,000 or 10,000 shares, upon the occurrence of certain pre-determined events. We have commenced development of Wallace & Gromit titles for Sony’s PlayStation 2, Nintendo’s GameCube and Game Boy Advance, Microsoft’s Xbox and personal computers and plan to release these titles in the fall of 2003. We have exercised our right to develop products on Creature Comforts, a TV series soon to be shown on British television.
Riverdeep Inc. In June 2002, we entered into a licensing and publishing agreement with Riverdeep Inc., owners of the property rights to Carmen Sandiego. Our agreement gives us an exclusive right to develop titles based on Carmen Sandiego for all platforms except personal computers, and to distribute them worldwide. Under the agreement we will have to pay royalties to Riverdeep calculated as a percentage of sales of the developed products. The agreement expires four years after the first commercial distribution of the first title, or June 2004 if no title is released prior to that date. Our first title is planned to be released in Fiscal 2004.
Ovation Entertainment LLC. In May 2002, we entered into a licensing and publishing agreement with Southpaw Media Group Inc. The agreement was assigned to Ovation Entertainment LLC in July 2002 and amended in August 2003 following litigation between the parties. Our agreement gives us the exclusive, first look right to review screenplays to be produced by the studio, develop titles based on any films, made for television movies, or television series produced from those screenplays, and distribute them worldwide. Our agreement expires upon the later of five years or either the theatrical release or television air-date of the tenth film or television series on which we base a product, but in no event later than eight years from the date of the agreement, unless seven films or television series have been released or aired, respectively, within seven years from the date of the agreement, in which event the agreement would expire at the end of the seventh year. Under the agreement, we will have to pay royalties calculated as a percentage of sales of the developed products, and we granted a warrant to purchase up to 200,000 shares of our common stock, of which 15,000 became immediately exercisable upon the signing of the agreement and the remaining 185,000 only become exercisable upon the occurrence of certain future events. Upon expiration of the agreement, any unexercised warrants will cease to be exercisable.
Spyglass Entertainment Group. In October 2000, we entered into a strategic arrangement with Spyglass Entertainment Group, L.P. The agreement was mutually terminated in June 2003. The agreement gave us an exclusive right of first refusal to develop titles based on films produced by the studio and to distribute them worldwide. In addition, Spyglass Entertainment Group agreed to provide us with free access to any publicity and advertising materials it prepared and we had the right to use these materials to promote and advertise our titles. Under the agreement, we granted Spyglass Entertainment Group a warrant to purchase up to 470,000 shares of our common stock and agreed to pay the studio royalties based on the net sales of titles based on its films. We released titles under the agreement for Sony’s PlayStation 2, Microsoft’s Xbox, and Nintendo’s Game Boy Advance and GameCube based on Reign of Fire, a film released in August 2002.
Software product design and development
We believe our success will depend in large part on our ability to design and develop innovative interactive entertainment software based on popular content, design and develop sequels to our more popular products and offer previously released products on additional hardware platforms. We pair members of our internal production staff with external software developers who have varying design and development capabilities, which we believe provides us with flexibility to develop titles in a timely, cost-effective manner. Our software producers take responsibility for the selection of the title concept, evaluation of the capabilities of the software developer who will prepare the graphics, artwork and computer code for the title, and the publication, marketing and distribution of the completed title. The external software developers are responsible for the completion of technical milestones such as creation of particular graphics, artwork and sound designs.
Title production and development
At June 30, 2003, our in-house production staff consisted of five employees, two of whom work in our San Jose office, and three of whom work in our Bath, England office. Our in-house production staff includes four software producers who are responsible for monitoring the progress of our independent third-party software developers with whom we contract to create titles. Our production staff evaluates the work of each of the external software developers through design review, progress evaluation, milestone review and quality checks. Each milestone submission is reviewed by our in-house production staff to ensure compliance with the product’s design specifications.
Product development
When we elect to develop a concept or property externally, we contract with an independent third-party software developer to develop the title under the supervision of our internal software production staff. When we develop a title with an independent software developer, we select a title concept and then evaluate whether the independent developer has sufficient expertise to create the software code, animation and graphics for that title. After we evaluate the independent developer’s capabilities and decide to produce that title with the developer, our production team prepares a budget, list of development milestones and a sales and marketing plan. The independent developer then begins to prepare the software code, graphics and animation for the title. When the final milestone has been met and our production staff is satisfied that the title is ready for publication, we publish, distribute and market the title.
Our production staff also works with independent software developers to modify, or port, existing titles for distribution in a certain country or across additional platforms. When we decide to port an existing title in this manner, our internal production staff prepares a list of development milestones and a budget and marketing plan for the title. Our internal production staff then works with the independent software developer to ensure that the milestones are met and the title is ported to a new platform or readied for distribution to a new country.
Our agreements with independent software developers are typically entered into on a title-by-title basis and provide for the payment of the greater of a fixed amount or royalties based on actual sales. We generally pay independent software developers installments of the fixed advance based on the achievement of specific development milestones established by our production staff at the outset of the development process. Royalties in excess of the fixed advance are generally based on either a fixed amount per unit sold or as a percentage of the per unit sales price. We generally obtain ownership of the software code and related documentation from our independent software developers. In instances where we do not retain sole ownership of the source code, the owner may use or license the code for development of other software products that may compete directly with our products and we may not have sufficient rights in the source code to produce derivative products. Upon completion of the development process, each title is play-tested by us and sent to the manufacturer for its testing, review and approval. Related artwork, user instructions, warranty information, brochures and packaging designs are also developed by third parties under our supervision.
We believe that the development process for an original, externally-developed product for a next generation hardware platform typically takes 12 to 24 months, and for an original, externally-developed product for the Nintento Game Boy Advance platform, six to nine months. This process is shorter for existing products currently used on 32-bit and 64-bit hardware platforms. We believe that it takes approximately six to 12 months to develop an existing title as a product for a different hardware platform.
Marketing, sales and distribution
Our marketing, sales and distribution efforts are designed to broaden product distribution and increase the penetration of our products in domestic and international markets. We rely in part on the name recognition of the motion picture, sports and television cartoon properties on which many of our products are based to attract consumers and obtain shelf space from mass merchandisers. We supplement our domestic direct sales efforts with third-party distributors. As of June 30, 2003, our sales and marketing staff consisted of ten employees, seven of whom work in our San Jose, California headquarters and three of whom work in our Bath, England office.
Our marketing department implement marketing programs and campaigns for each of our titles. In preparation for a product launch, our marketing activities may include print and cooperative retail advertising campaigns, game reviews in consumer and trade publications, pre-release giveaways, and retail in-store promotions including demonstrations, videos, over-size displays and posters. We have selectively included in our marketing efforts radio, television and Internet advertising campaigns. We also allocate a portion of each of our product’s sales and marketing budget for cooperative advertising and market development with retailers. Many of our titles are launched with a multi-tiered marketing campaign that is developed on an individual basis to promote product awareness, customer pre-orders and consumer sell-through.
We seek to extend the life cycle and financial return of many of our products by marketing those products differently throughout the product’s life. Although the product life cycle for each title varies based on a number of factors, including the quality of the title, the number and quality of competing titles, and in certain instances seasonality, we typically consider a title as back catalog six months after its initial release. We utilize marketing programs appropriate for the particular title, which generally includes progressive sales price reductions over time to increase the product’s longevity in the retail channel as we shift advertising support to newer releases.
Domestic activities
We sell our products primarily to mass merchandisers and, to a lesser extent, to third-party distributors. Our principal customers include Toys “R” Us, Kmart, Wal-Mart, GameStop, Best Buy, Electronics Boutique and Target. We do not have any written agreements or other understandings with any of our customers that relate to future purchases, so our customers could reduce or terminate their purchases from us at any time. Revenues from our four
largest customers collectively accounted for approximately 48% of our net revenues for the year ended June 30, 2003, as compared to approximately 48% of our net revenues for the year ended June 30, 2002 and 52% for the year ended June 30, 2001.
We believe that we provide terms of sale comparable to competitors in our industry. We sell our products to retailers and distributors through independent regional sales representatives who operate on a commission basis. The sales staff is largely responsible for generating retail demand for our products by presenting new products to our customers in advance of the products’ scheduled release dates. They do this by providing technical advice with respect to the products and by working closely with retailers and distributors to sell the products. In addition, we provide technical support for our products through our customer support department. We typically ship our products within a short period of time after acceptance of purchase orders from distributors and other customers. Accordingly, we do not have a material backlog of unfilled orders and net sales in any quarter are substantially dependent on orders booked in that quarter. To date we have not experienced any material warranty claims.
We utilize an electronic data interchange with most of our major domestic customers to efficiently receive, process and ship customer product orders and to accurately track and forecast sell-through of our products to consumers in order to determine whether to order additional products from manufacturers.
International activities
Our international sales and marketing activities are currently conducted from our office located in Bath, England.
Our first international titles were introduced during the year ended June 30, 2001. We pursue our international sales by localizing our products for various international markets and releasing localized versions of many of our products simultaneously with the commercial release of corresponding titles in North America.
In July 2003, we entered into a distribution agreement with Acclaim Entertainment Ltd (“Acclaim”) whereby Acclaim exclusively distribute certain forthcoming products of ours in PAL territories. PAL is the television standard for the United Kingdom, continental Europe and Australia. Acclaim will be responsible for the manufacture, sale, distribution and marketing of the products and will pay us based on net receipts from the sales made by them. The agreement obligates Acclaim to pay us minimum guarantee advances both before and after product release dates, but such payments are reduced upon late delivery of a product, and fully repayable upon cancellation of the product.
Prior to entering into the distribution agreement with Acclaim, we had entered, in February 2001, into a two-year exclusive license agreement with Ubi Soft Entertainment S.A. (“Ubi Soft”), a French distributor of entertainment and educational multimedia, to distribute, market, and sell certain of our interactive software products in the Nintendo Game Boy Color format on a multi-national basis. The agreement obligated Ubi Soft to make minimum purchases at a set price per title. In July 2001, we expanded our relationship with Ubi Soft and signed a distribution agreement establishing them as the exclusive distributor of all of our interactive entertainment software products across all hardware platform formats in a number of European countries. Under this agreement, which expired on July 31, 2003, we were obligated to pay a distribution fee based on a percentage of the net revenues from sales of all products in the territory, and assist with marketing the products.
The Ubi Soft distribution agreement excluded the United Kingdom, where we sold our products primarily to mass merchandisers and, to a lesser extent, to third-party distributors. Our principal customers included Game, Dixons, Toys “R” Us, WH Smiths, EUK, and HMV. Our sales staff was largely responsible for generating retail demand for our products by presenting new products to our customers in advance of the products’ scheduled release dates. They did this by providing technical advice with respect to the products and by working closely with retailers and distributors to sell the products. We typically shipped our products within a short period of time after acceptance of purchase orders from distributors and other customers. Accordingly, we did not have a material backlog of unfilled orders and net sales in any quarter were substantially dependent on orders booked in that quarter.
The Acclaim distribution agreement signed in July 2003 excludes products from our existing catalogue. We will continue to sell these products directly to mass merchandisers or third-party distributors in the United Kingdom, and continental Europe.
Revenues from our international customers collectively accounted for approximately 24% of our net revenues for the year ended June 30, 2003, as compared to 11% for the year ended June 30, 2002 and 10% for the year ended June 30, 2001.
Manufacturing
Nintendo and Sony are the sole manufacturers of the software products sold for use on their respective hardware platforms. We begin the manufacturing process by placing a purchase order for the manufacture of our products with Nintendo or Sony and opening either a letter of credit in favor of the manufacturer or utilizing our line of credit with the manufacturer. We then send software code and a prototype of the product to the manufacturer, together with related artwork, user instructions, warranty information, brochures and packaging designs for approval, defect testing and manufacture.
Microsoft appoints approved third-party manufacturers to manufacture software for its hardware platform. Microsoft also offers us the opportunity to enter into one or more kit licenses, pursuant to which Microsoft would license software development tools and hardware to assist us in the development of titles prior to sending these titles to authorized third-party manufacturers for replication.
The amounts charged by the manufacturers include a manufacturing, printing and packaging fee, as well as a royalty for the use of the manufacturer’s name, proprietary information and technology. All of these fees are subject to adjustment by the manufacturers at their discretion. Nintendo charges us a fixed amount for each cartridge that includes the royalty. This amount varies based, in part, on the memory capacity of the cartridges. Sony charges us a royalty for every disk manufactured. The manufacturers have the right to review, evaluate, approve and reject a prototype of each title and the title’s packaging and marketing materials.
Competition
The interactive entertainment software industry is intensely competitive and is characterized by the frequent introduction of new hardware platforms and titles. Our competitors vary in size from small companies to large corporations, including the manufacturers of the hardware platforms. We must obtain a license from and compete with the hardware platform manufacturers in order to develop and sell titles for their respective hardware platforms, with each such manufacturer typically being the largest publisher and seller of software products for its own hardware platforms. As a result of their commanding positions in the interactive entertainment industry as the manufacturers of hardware platforms and publishers of titles for their own hardware platforms, these manufacturers generally have better bargaining positions with respect to retail pricing, shelf space and purchases than do any of their licensees.
In addition to the hardware platform manufacturers, we compete with other interactive entertainment software companies. Significant competitors include Acclaim Entertainment, Inc., Activision, Inc., Bandai America Incorporated, Capcom USA, Inc., Eidos PLC, Electronic Arts Inc., Infogrames Entertainment SA., Konami Corporation of America, Inc., Midway Games Inc., Namco Ltd., Sega Enterprises, Inc. (USA), Take-Two Interactive Software, Inc., THQ, Inc., Ubi Soft Entertainment and Vivendi Universal S.A. Many of these competitors are large corporations that have significantly greater financial, marketing, personnel and product development resources than us. Due to these greater resources, certain of these competitors are able to undertake more extensive marketing campaigns, adopt more aggressive pricing policies, pay higher fees to licensors of desirable motion picture, television, sports and character properties and pay more to third-party software developers than we can. Any significant increase in the development, marketing and sales efforts of our competitors could harm our business.
Intellectual property
Our business relies on the hardware platform manufacturers and our non-exclusive licenses with them to publish titles and manufacture our products for their hardware platforms. Our existing hardware platform licenses for Nintendo’s Game Boy Color and Game Boy Advance, Nintendo 64, Nintendo GameCube, Sony’s PlayStation and PlayStation 2, and Microsoft’s Xbox grant us the right to develop, publish and distribute titles for use on the respective hardware platforms. Each of these hardware platform licenses requires that we obtain approval for the publication of new titles on a title-by-title basis and licenses with Nintendo and Sony require that our titles be manufactured solely by the respective manufacturer and licenses with Microsoft require that we use certain approved third party manufacturers. License agreements relating to these rights generally extend for a term of two to three years. The agreements are terminable upon the occurrence of a number of factors, including: (1) breach of the agreement by us; (2) our bankruptcy or insolvency; or (3) our entry into a relationship with, or acquisition by, a competitor of the manufacturer. We cannot assure you that we will be able to obtain new or maintain existing licenses on acceptable terms, or at all.
Upon termination of a hardware platform license for any reason other than our breach or default, the manufacturer has the right to purchase from us, at the price paid by us, any product inventory manufactured by such manufacturer that remains unsold for a specified period after termination. We must destroy any such inventory not purchased by the manufacturer. Upon termination as a result of our breach or default, we must destroy any remaining inventory, subject to the right of any of our institutional lenders to sell such inventory for a specified period.
We hold copyrights on our products, product literature and advertising and other materials. We rely on common law trademark rights to our name and our logo. We do not currently hold any patents. We outsource all of our product development to third-party developers and typically retain all intellectual property rights related to such projects. No third-party developer has challenged our ownership interest in the intellectual property rights to projects we have outsourced, but it is always possible that a third-party developer could issue such a challenge and prevail. We also license products developed by third parties and pay royalties on the sale of such products.
We regard our products as proprietary and rely primarily on a combination of copyright, trademark and trade secret laws, confidentiality and nondisclosure agreements and other methods to protect our proprietary rights. We require our employees, consultants and other outside individuals and entities, including employees of third-party developers, to execute confidentiality and nondisclosure agreements upon the start of employment, consulting or other contractual relationships with us. These agreements provide that all confidential information developed or made known to the individual or entity during the course of the relationship is to be kept confidential and not disclosed to third parties except in specific circumstances. However, our ability to police these individuals and entities and enforce these agreements is costly and uncertain.
We also rely on existing copyright laws to prevent unauthorized distribution of our products. However, existing copyright laws afford only limited protection. Policing unauthorized use of our products is difficult and software piracy can be a persistent problem, especially in certain international markets. We are aware that unauthorized copying occurs within our industry and if a significant amount of unauthorized copying of our interactive entertainment software products were to occur, our business would be harmed. In addition, the laws of some countries in which our products are or may be distributed either do not protect our products and intellectual property rights to the same extent as the laws of the United States, or these laws are weakly enforced. Legal protection of our rights may be ineffective in these countries, and as we leverage our products using emerging technologies, such as the Internet and online services, our ability to protect our intellectual property rights, and to avoid infringing the intellectual property rights of others, becomes more difficult. In addition, intellectual property laws are less clear with respect to such emerging technologies. Accordingly, existing intellectual property laws may not provide adequate protection to our products that are developed in connection with emerging technologies.
As the number of titles in the interactive entertainment software industry increases and the features and content of these titles further overlap, interactive entertainment software developers may increasingly become subject to infringement claims. Although we make reasonable efforts to ensure that our products do not violate the intellectual property rights of others, we cannot assure you that claims of infringement will not be made. Any such claims, with or without merit, can be time consuming and expensive to defend and we cannot assure you that infringement claims
against us will not result in costly litigation or require us to license the intellectual property rights of third parties, either of which could harm us.
We may also be subject to legal proceedings and claims from time to time in the ordinary course of business, including claims of alleged infringement of the trademarks and other intellectual property rights of third parties. For example, we are aware that other parties are utilizing the “BAM” mark, or marks that incorporate the letters “BAM,” in businesses similar to ours, and those parties may have rights to such mark that are superior to ours. These parties could challenge our rights to use the name “BAM” in their markets. In this event, we could be required to stop using the name in particular markets or to obtain a license from these parties to use it in such markets.
Our agreements with third-party software developers and property licensors typically provide for us to be indemnified with respect to certain matters. However, if any claim is brought by a hardware manufacturer or other party against us, our software developers or property licensors may not have sufficient resources to, in turn, indemnify us. In addition, these parties’ indemnification of us may not cover the matter that gives rise to the original claim, and in either case, our business could be harmed.
Employees
As of June 30, 2003, we employed 32 full-time employees, comprising ten in sales and marketing, five in research and development, and 17 in management, general and administration. Of the 32 employees, 20 are located in the United States, and 12 are located in England. None of the employees are represented by a labor union, and we have experienced no work stoppages. We believe our employee relations are good.
RISK FACTORS
In addition to the other information in this Report, the following factors should be considered in evaluating us and our business.
RISKS RELATED TO OUR FINANCIAL RESULTS
If we are unable to successfully enter into a merger, acquisition or obtain additional financing, we may not have sufficient cash to continue operations for the next six months.
In February 2003 we retained, through July 31, 2003, the investment banking firm of Gerard Klauer Mattison & Co., Inc. to assist us in reviewing a range of potential strategic alternatives, including mergers, acquisitions and additional financing. No transactions arose from this assistance or were consummated during this period. We may need to either consummate one or a combination of the potential strategic alternatives, or otherwise obtain capital via sale or license of certain of our assets, in order to satisfy our future liquidity requirements. Current market conditions present uncertainty as to our ability to effectuate any such merger or acquisition or secure additional financing, as well as our ability to reach profitability. There can be no assurances that we will be able to effectuate any such merger or acquisition or secure additional financing, or obtain favorable terms on such financing if it is available, or as to our ability to achieve positive cash flow from operations. Continued negative cash flows create significant uncertainty about our ability to implement our operating plan and we may have to further reduce the scope of our planned operations. If cash and cash equivalents, together with cash generated from operations, are insufficient to satisfy our liquidity requirements, we will not have sufficient resources to continue operations for the next six months.
Because we have a limited operating history, it is difficult to evaluate an investment in our common stock.
We were organized in October 1999 and released our first interactive entertainment software product in June 2000. It is difficult to evaluate our future prospects and an investment in our common stock because we have a limited operating history and the market for our products is rapidly evolving. Our prospects are uncertain and must be considered in light of the risks, expenses and difficulties frequently encountered by companies in the early stage of development.
Our future performance will depend upon a number of factors, including our ability to:
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secure additional financing and fund purchases of inventory;
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expand our domestic and international customer base;
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secure popular entertainment properties upon which to base future products;
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develop and enhance products in response to new interactive entertainment hardware platform releases, customer demand and competitive market conditions;
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expand our interactive entertainment software development and sales and marketing capabilities;
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expand our international operations;
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attract, retain and motivate qualified personnel; and
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maintain adequate control of our expenses.
We have a history of operating losses and may never achieve profitability.
We incurred net losses of $36.2 million in the year ended June 30, 2003, $15.7 million for the year ended June 30, 2002 and $1.6 million for the year ended June 30, 2001. We will need to generate significant revenues and control expenses to achieve profitability. There can be no assurance that our revenues will grow in the future or that we will achieve sufficient revenues for profitability.
Our revenues fluctuate due to seasonal demand and the nature of the interactive entertainment industry.
We have experienced and may continue to experience significant quarterly fluctuations in net sales and operating results. The interactive entertainment industry is highly seasonal, with sales typically higher during the fourth and first calendar quarters. This is due primarily to the increased demand for games during and immediately following the holiday buying season. Our failure or inability to introduce products on a timely basis to meet seasonal fluctuations in demand will, and historically have, harmed our business and operating results.
Our expense levels are based, in part, on our expectations regarding future sales. Therefore, our operating results would be, and historically have been, harmed by a decrease in sales, price erosions, and a failure to meet our sales expectations. Uncertainties associated with interactive entertainment software development, lengthy manufacturing lead times, production delays and the approval process for products by hardware manufacturers and other licensors make it difficult to predict the quarter in which our products will ship.
These and other factors could harm our business and have a material adverse effect on our operating results.
Product development schedules are frequently unpredictable and make estimating quarterly results difficult.
Product development schedules for software products, particularly for new hardware platforms such as Sony’s PlayStation 2, Nintendo’s GameCube and Microsoft’s Xbox, are difficult to predict because they involve creative processes, use of new development tools for new platforms and the learning process, research and development, and experimentation associated with development for new technologies. Our revenues and earnings are dependent on our ability to meet our product release schedules, and our failure to meet those schedules have resulted in, and may again result in, revenues and earnings that fall short of analysts’ expectations for any individual quarter and the fiscal year.
Our earnings will be affected upon the issuance of shares of our common stock pursuant to third-party entertainment property license agreements.
Pursuant to a license agreement with a production company, we are obligated to issue 68,738 shares of our common stock after the release of any film for which we elect to produce interactive entertainment software products, up to 10 films or 687,375 shares of common stock. To date, we have elected to produce titles for three films and have issued 137,476 shares under this agreement for an aggregate value of $816,000. We are required to issue these shares when the films are released and will then incur a non-cash charge. We cannot estimate the aggregate dollar amount of these future non-cash charges as they will be based on our share price at a future point in time, but they may be substantial. All of the non-cash charges on the shares issued to date under the agreement had been amortized as of June 30, 2003.
In connection with the issuance of warrants pursuant to a separate license agreement with another production company, we incurred a non-cash charge of $97,000. We had amortized $8,000 of this charge as of June 30, 2003. The remaining charge will be amortized upon release of the software products on which the warrants are issued, over the life of the products, expected to be between three and six months. Under the agreement, additional warrants to purchase up to an additional 15,000 shares may be issued, contingent upon certain future events occurring. Upon issuance of the warrants we will incur an additional non-cash charge. We cannot estimate the aggregate dollar amount of these future non-cash charges as they are based on our share price at future points in time. Each of these future charges will affect our gross margins and profitability.
In connection with the issuance of warrants pursuant to a first look agreement with another production company, we granted a warrant to purchase up to 200,000 shares of our common stock, of which 15,000 became immediately exercisable upon the signing of the agreement. The remaining 185,000 will only become exercisable, in multiples of either 4,625 or 13,875 shares, upon certain future events occurring relating to the development and release of products. Upon the warrant for 15,000 shares becoming exercisable, we incurred a non-cash charge of $29,000, which has been fully amortized as of June 30, 2003. We will incur additional non-cash charges as the remaining 185,000 shares become exercisable. Upon release of the software products on which the warrants are exercisable, we will amortize the non-cash charges over the life of the products, which are expected to be between three and six months. We cannot estimate the aggregate dollar amount of these future non-cash charges as they will be based on our share price at future points in time. Each of these future charges will affect our gross margins and profitability.
RISKS RELATED TO OUR BUSINESS
Our ability to effectuate a financing transaction to fund our operations could impair the value of your investment, and we cannot assure you that we will be able to meet our future capital requirements.
If we are not acquired by or merge with another entity or if we are not able to raise additional capital via sale or license of certain of our assets, we may need to consummate a financing transaction pursuant to which we receive additional liquidity. This additional financing may take the form of us raising additional capital through public or private equity offerings or debt financing. We cannot be certain that additional capital will be available to us on favorable terms, or at all. If we cannot effectuate a financing transaction to raise needed funds on acceptable terms, we will not be able to develop or enhance our products, take advantage of future opportunities or respond to competitive pressures or unanticipated requirements. To the extent we raise additional capital by issuing equity securities, our stockholders will likely experience substantial dilution. Also, any new equity securities may have greater rights, preferences or privileges than our existing common stock. A material shortage of capital will require us to take drastic steps such as reducing our level of operations, disposing of selected assets or seeking protection under federal bankruptcy laws.
We depend on a relatively limited number of products for a significant portion of our revenues.
A significant portion of our revenues is derived each quarter from a relatively limited number of products that were released in that quarter or the or in the immediately preceding quarter. During the year ended June 30, 2003, sales of four products each accounted for between 9% and 13% of our net revenues. During the year ended June 30, 2002, sales of four products each accounted for between 7% and 11% of our net revenues, while during the year ended June 30, 2001, sales of four products each accounted for between 14% and 28% of our net revenues. We expect that a limited number of products will continue to produce a disproportionately large amount of our net revenues. Due to this dependence on a limited number of brands, the failure of one or more products to achieve anticipated results could, and in the past has, significantly harmed our business and operating results.
Our market is characterized by changing consumer preferences and short product life cycles. To compete effectively we must continually introduce new products that achieve market acceptance.
The interactive entertainment software market is characterized by short product life cycles, changing consumer preferences and frequent introduction of new products. We believe that our success will be dependent on the production of successful titles on a continuous basis. We cannot assure you that new products introduced by us will achieve significant market acceptance or that such acceptance, if achieved, will be sufficient to permit us to recover development and other associated costs. Consumer preferences for interactive entertainment software products are continually changing and are difficult to predict. Even the most successful titles remain popular for only limited periods of time, often less than six months. The life cycle of a game generally consists of a relatively high level of sales during the first few months after introduction, followed by a decline in sales, and sales price erosion. Accordingly, we expect that substantially all of our net sales for a particular year will be generated by titles released in that year and in the latter part of the prior year.
The development cycle for new titles is long and during this time the market appeal of a title may decline.
We believe the development cycle for new titles is long, typically ranging from 12 to 24 months. After development of the initial product, we believe it may take between six and 12 additional months to develop the product for additional hardware platforms. In order to distribute a product, we must develop and test the necessary game software, obtain approval from the manufacturer and licensor if required, and have the initial order of cartridges or disks manufactured. During the development cycle, the market appeal of a title or of a property on which the title is based may decline. If market acceptance is not achieved, we may, and historically have, granted markdown allowances to maintain our relationship with retailers and our access to distribution channels. Because we introduce a relatively limited number of new products in a given period, the failure of one or more of our products to achieve market acceptance could and have harmed our business.
The introduction of new interactive entertainment hardware platforms creates risks relating to the development of titles for those hardware platforms.
The interactive entertainment industry is also characterized by rapid technological change. For example, the 128-bit hardware platform was released within five years of the release of the 64-bit hardware platform. As a result, we must continually anticipate these changes and adapt our offerings to emerging hardware platforms and evolving consumer preferences. Generally, because of the length of the development cycle, our development efforts must begin well in advance of the release of new hardware platforms in order to introduce titles on a timely basis with the release of such hardware platforms. Further, we have no control over the release dates of new hardware platforms or the number of units that will be shipped upon such release. It is difficult to ensure that our schedule for releasing new titles will coincide with the release of the corresponding hardware platforms. Additionally, if fewer than expected units of a new hardware platform are produced or shipped, such as occurred with Microsoft’s Xbox and Nintendo’s Gamecube and Game Boy Advance, developers of titles for those hardware platforms may experience lower than expected sales.
The introduction of new hardware platforms and technologies can also render existing titles obsolete and unmarketable. Generally, as more advanced hardware platforms are introduced, consumer demand for titles for older hardware platforms diminishes. In addition, a broad range of competing and incompatible emerging technologies may lead consumers to postpone buying decisions until a particular hardware platform gains widespread acceptance. As a result of such reduced consumer demand for titles on older hardware platforms, our titles for older hardware platforms may not generate sufficient sales to make our titles profitable.
The development of software products is complex and time consuming and may not lead to marketable titles.
The development of software products is complex and time consuming. Our development efforts may not lead to marketable titles or titles that generate sufficient revenues to recover their development and marketing costs, especially if a hardware platform does not reach or sustain an expected level of acceptance. This risk may increase in the future, as continuing increases in development costs require corresponding increases in net sales in order for us to achieve profitability.
The technological advancements of the most popular hardware platforms also allow more complex software products. As software products become more complex, the risk of undetected errors in products when first introduced increases. We cannot assure you that, despite testing, errors will not be found in new products or releases after shipments have been made, resulting in loss of or delay in timely market acceptance, product returns, loss of revenues and damage to our reputation. In the past, we have experienced delays in the introduction of new titles and we anticipate that we will experience similar delays in the future in connection with the introduction of additional new titles, including products currently under development. Because net revenues associated with the initial shipments of a new product generally constitute a high percentage of the total net revenues associated with the life of a product, any delay in the introduction of, or the presence of a defect in, one or more new products could harm the ultimate success of the products or our business and operating results.
The costs of developing and marketing products for existing and anticipated interactive entertainment hardware platforms can be substantial and could harm our business.
The costs associated with the introduction of products for new hardware platforms, such as Sony’s PlayStation 2, Nintendo’s GameCube and Microsoft’s Xbox, could harm our business as we believe the costs of developing and publishing titles for these hardware platforms require greater financial and technical resources than prior development and publishing efforts. Additionally, during periods of new technology introductions, forecasting our revenues and earnings is more difficult than in more stable or rising product markets.
If interactive entertainment hardware platforms fail to achieve significant market acceptance, it may harm our business.
Our sales are dependent on, among other factors, the popularity and unit sales of the interactive entertainment hardware platforms of the various manufacturers. The interactive entertainment industry has experienced periods of significant growth in consumer interest and popularity, followed by periods in which consumer demand for interactive entertainment products has slowed. Unexpected shortfalls in the market acceptance of a particular hardware platform, such as occurred with Microsoft’s Xbox and Nintendo’s Gamecube and Game Boy Advance, can and have significantly harmed consumer demand for titles released or scheduled for release for that hardware platform. Therefore, we are dependent upon the successful marketing efforts of the manufacturers of the various hardware platforms to meet financial expectations.
Over 48% of our net revenues are derived from sales to our four largest customers. We could be adversely affected if any of them reduced or terminated their purchases from us or did not pay their obligations to us.
Revenues from our four largest customers collectively accounted for 48% of our net revenues for the year ended June 30, 2003, as compared to 48% of our net revenues for the year ended June 30, 2002, and 52% of our revenues for the year ended June 30, 2001. As of June 30, 2003, four customers each accounted for between 8% and 19% of our gross trade accounts receivable, as of June 30, 2002, four customers each accounted for between 8% and 12% of our gross trade accounts receivable and as of June 30, 2001, four customers each accounted for between 9% and 23% of our gross trade accounts receivable. We have no written agreements or other understandings with any of our customers that relate to future purchases. Therefore, purchases by these customers or any others could be reduced or terminated at any time. A substantial reduction or a termination of purchases by any of our largest customers would harm us.
Substantially all of our sales are made on credit, which exposes us to bad debt risk.
Our sales are typically made on credit, with terms that vary depending upon the customer and other factors. While we attempt to carefully monitor the creditworthiness of our customers and distributors, we bear the risk of their inability to pay our receivables and of any delay in payment. A business failure by any of our largest customers, such as occurred with Kmart in January 2002, would harm us, as could a business failure by any of our distributors or other retailers.
Product returns and markdown allowances could harm our business.
We have experienced, and are exposed to the risk of product returns and markdown allowances with respect to our customers. The decrease in demand for products based upon older hardware platforms may lead to a high level of these product returns and markdown allowances. We also allow distributors and retailers to return defective and damaged products in accordance with negotiated terms. Product returns and markdown allowances that exceed our expectations could harm our business.
We cannot publish our interactive entertainment software titles without the approval of hardware manufacturers. Our ability to continue to develop and market our titles is dependent on the hardware manufacturers continuing to do business with us.
We are wholly dependent on the manufacturers of interactive entertainment hardware platforms and our ability to obtain or maintain non-exclusive licenses with them, both for the rights to publish and to manufacture titles for their
hardware platforms. We are required to obtain a license to develop and publish titles for each hardware platform for which we develop and publish titles. Each license specifies the territory to which it applies, and such licenses range from as broad as multi-national distribution to as narrow as approval on a title-by-title basis. Our existing hardware platform licenses for Sony’s PlayStation and PlayStation 2, Nintendo’s Game Boy Color and Game Boy Advance, Nintendo 64, Nintendo GameCube, and Microsoft’s Xbox require that we obtain approval for the publication of new titles on a title-by-title basis. As a result, the number of titles we are able to publish for these hardware platforms, along with our ability to time the release of these titles is dependent upon decisions made by third party manufacturers. Accordingly, our revenues from titles for these hardware platforms may be limited. Should any manufacturer choose not to renew or extend our license agreement at the end of its current term, or if the manufacturer were to terminate our license for any reason, we would be unable to publish additional titles for that manufacturer’s hardware platform.
We are dependent on Sony and Nintendo for the manufacture of products that we develop for their hardware platforms.
When we develop interactive entertainment software titles for a hardware platform offered by Sony or Nintendo, the products are manufactured exclusively by that hardware manufacturer. Our hardware platform licenses with Sony and Nintendo provide that the manufacturer may change prices for the manufacturing of products at any time. In addition, these licenses include other provisions that give the manufacturer substantial control over our costs and the release of new titles. Since each of the manufacturers is also a publisher of games for its own hardware platforms and manufactures products for all of its other licensees, a manufacturer may give priority to its own products or those of our competitors in the event of insufficient manufacturing capacity. We would be materially harmed by unanticipated delays in the manufacturing and delivery of products.
If we cannot retain our key personnel and attract and retain additional key personnel, our business will be harmed.
We depend to a significant extent on the contributions and industry experience of our key personnel, in particular our Chief Executive Officer, Raymond C. Musci, and our Vice Chairman, Anthony R. Williams. If we fail to retain the services of our key personnel, our ability to secure additional licenses and develop and sell new products might be impaired. In addition, our future success will also depend upon our ability to continue to attract, motivate and retain highly qualified employees and third-party contractors, particularly software design and development personnel and outside sales representatives. Competition for highly skilled employees is intense and we may not be successful in attracting and retaining such personnel.
We are dependent upon licenses to properties originated and owned by third parties for the development of our titles.
Many of our titles, such as those from our Powerpuff Girls series, Dexter’s Laboratory series, Ecks v Sever and Reign of Fire are based upon entertainment properties licensed from third parties. We cannot assure you that we will be able to obtain new licenses, or renew existing ones, on reasonable terms, if at all. If we are unable to obtain licenses for the properties which we believe offer significant consumer appeal, we would be required to obtain licenses for less popular properties or would have to develop all of our titles based upon internally developed concepts.
To the extent a licensed property is less popular than we anticipate, or is unsuccessful, sales of titles based on that property may be negatively impacted.
We have in the past experienced unsuccessful releases of titles based on properties that we licensed from third parties. Titles based on less popular properties, or on internally developed concepts, typically require greater marketing expense in order to establish brand identity and may not achieve broad market acceptance or prove to be successful.
We are dependent on third-party interactive entertainment software developers for developing and completing our titles.
We rely on third-party interactive entertainment software developers for the development of our interactive entertainment software titles. Quality third-party developers are continually in high demand. For this reason, we cannot assure you that the third-party software developers who have developed titles for us in the past will continue to be available to develop software for us in the future. Due to the limited number of third-party software developers and the lack of control that we exercise over them, we cannot assure you that these developers will complete titles for us on a timely basis or within acceptable quality standards, if at all.
Our future success is highly dependent on our proprietary software and intellectual property.
We rely primarily on a combination of copyright, trademark and trade secret laws, employee and third-party nondisclosure agreements and other methods to protect our proprietary rights. We require our employees, consultants and other outside individuals and entities to execute confidentiality and nondisclosure agreements upon the start of employment, consulting or other contractual relationships with us. However, our ability to police these individuals and entities and enforce these agreements is costly and uncertain. We are aware that unauthorized copying occurs within our industry. If a significantly greater amount of unauthorized copying of our interactive entertainment software products were to occur, our business would be harmed. We generally obtain ownership of the software code and related documentation from third-party software developers. In instances where we do not retain sole ownership of the source code, the owner may use or license the code for development of other software products that may compete directly with our products and we may not have sufficient rights in the source code to produce derivative products.
We rely on existing copyright laws to prevent unauthorized distribution of our products. Existing copyright laws afford only limited protection. Policing unauthorized use of our products is difficult, and software piracy is a persistent problem, especially in international markets. In addition, the laws of some countries in which our products are or may be distributed either do not protect our products and intellectual property rights to the same extent as the laws of the United States or are weakly enforced. Legal protection of our rights may be ineffective in these countries. Any unauthorized use of our proprietary information could result in costly and time-consuming litigation to enforce our proprietary rights.
Other parties may assert claims against us that we are infringing upon their intellectual property rights and we are required to indemnify hardware manufacturers from certain claims in exchange for the right to purchase titles and manufacture our software for their hardware application.
We cannot be certain that our products do not infringe upon the intellectual property rights of others. We may be subject to legal proceedings and claims from time to time in the ordinary course of our business, including claims of alleged infringement of the intellectual property rights of third parties. If our products violate third-party proprietary rights, we cannot assure you that we would be able to obtain licenses to continue offering such products on commercially reasonable terms, or at all. In addition, we must indemnify the hardware manufacturers with respect to all loss, liability and expense resulting from any claim against them involving the development, marketing, sale or use of our products. This includes any claims for copyright or trademark infringement brought against them. As a result, we bear the risk that the properties upon which our software titles are based, or that the information and technology licensed from the hardware manufacturer and incorporated in our software, may infringe the rights of third parties. Any claims against us or the parties we indemnify relating to the infringement of third-party proprietary rights, even if not meritorious, could result in the expenditure of significant financial and managerial resources. Their claims could also result in injunctions preventing us from offering these products. Such claims could severely harm our financial condition and ability to compete.
We face risks associated with doing business in foreign countries, including our ability to generate international demand for our products.
We intend to increase our international revenues. We cannot assure you that we will be able to generate international market demand for our products. International sales and operations are subject to a number of risks, including:
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international consumer acceptance of existing and proposed titles;
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the impact of possible recessions in foreign economies;
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our ability to protect our intellectual property;
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the time and costs associated with translating and localizing products for foreign markets;
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foreign currency fluctuations;
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unexpected changes in regulatory requirements;
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difficulties and costs of staffing and managing foreign operations, or licensing to foreign entities ; and
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political and economic instability.
A significant downturn in general economic condition which results in a reduction in discretionary spending has reduced, and may continue to reduce, demand for our products and could harm our business.
Our product sales are affected by a retail customer’s ability and desire to spend disposable income on the purchase of our software titles. Any significant downturn in general economic conditions which results in a reduction of discretionary spending could result in a reduction in demand for our products and could harm our business. The United States economy is currently undergoing a period of slowdown, which some observers view as a recession. The United States and world economic condition has been worsened by the terrorist attacks on September 11, 2001. Moreover, any further terrorist activities, or the effect of the United States’ political, economic or military response to such activities, could result in the further deterioration of the United States and world economy. Such industry downturns have been, and may continue to be, characterized by diminished product demand and erosion of average selling prices. A continued economic downturn or recession would have a significant adverse effect on our operating results in future periods.
Our officers and directors own a substantial amount of our common stock and therefore have substantial influence over our operations and can significantly influence matters requiring stockholder approval.
Our officers and directors beneficially own approximately 50% of our common stock. As a result, they have the ability to control all matters requiring approval by our stockholders, including the election and removal of directors, approval of significant corporate transactions and the decision of whether a change in control will occur.
RISKS RELATED TO OUR INDUSTRY
Competition within the interactive entertainment software industry is intense and poses an ongoing threat to the success of our business.
The interactive entertainment industry is intensely competitive. Many of our competitors have greater name recognition among consumers and licensors of entertainment properties, broader product lines and greater financial, marketing and other resources than us. Accordingly, these competitors may be able to market their products more effectively, make larger offers or guarantees in connection with the acquisition of licensed entertainment properties, adopt more aggressive pricing policies or pay more to third-party developers. We believe that other technology, entertainment and media companies are increasing their focus on the interactive entertainment software market, which might result in greater competition for us. In addition, many of our competitors are developing online interactive entertainment software products and interactive networks that will be competitive with our interactive entertainment software products.
Competitive pressures could have the following effects on us:
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as competition for popular entertainment properties increases, our cost of acquiring licenses for those properties may increase, resulting in reduced margins;
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we might not be able to achieve full distribution of our products with our customers;
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as competition for retail shelf space becomes more intense, we may need to increase our marketing expenditures to maintain sales of our interactive entertainment software titles; and
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we could be required to reduce the wholesale unit prices of our titles.
Competition for limited shelf space and promotional resources among interactive entertainment software publishers is intense and poses an ongoing threat to the success of our business.
There is intense competition among developers and publishers of interactive entertainment software products for high quality retail shelf space and promotional support from retailers. As the number of titles and hardware platforms increases, competition for shelf space will intensify and may require us to increase our marketing expenditures. Due to increased competition for limited shelf space, retailers and distributors are in an increasingly better position to negotiate favorable terms of sale, including price discounts, price protection, marketing and display fees and product return policies. Our products constitute a relatively small percentage of any retailer’s sales volume, and we cannot assure you that retailers will continue to purchase our products or to provide our products with adequate levels of shelf space and promotional support. As a result of their positions in the industry, the manufacturers of interactive entertainment hardware platforms generally have better bargaining positions with respect to retail pricing, shelf space and retailer accommodations than do any of their licensees, including us.
Government restrictions including the possible adoption of an interactive entertainment software rating system could harm our business.
Legislation is periodically introduced at the state and federal levels in the United States and in foreign countries to establish a system for providing consumers with information about graphic violence and sexually explicit material contained in interactive entertainment software products. Under such a system, interactive entertainment software publishers would be expected to comply by identifying particular products within defined rating categories. In addition, these publishers would be required to communicate these ratings to consumers through appropriate package labeling and through advertising and marketing presentations consistent with each product’s rating. Many foreign countries have laws which permit governmental entities to censor the content of products, including interactive entertainment software. In some instances, we may be required to modify our products to comply with the requirement of such governmental entities, which could delay the release of those products in such countries. These delays could harm our business. We currently voluntarily submit our products to industry-created review boards and publish their ratings on our game packaging. Some retailers may refuse to carry titles that bear an unacceptable rating. We believe that mandatory government-run interactive entertainment software products rating systems eventually will be adopted in many countries which represent significant markets or potential markets for us. Due to the uncertainties in the implementation of such a rating system, confusion in the marketplace may occur. We are unable to predict what effect, if any, such a rating system would have on our business.
Potential opposition by consumer advocacy groups to certain software content could harm our business.
Consumer advocacy groups have in the past opposed sales of interactive entertainment software products containing graphic violence and sexually explicit content. These groups have pressed for legislation in these areas and engaged in public demonstrations and media campaigns. While to date such actions have not harmed our business, we cannot assure you that these groups will not target our products in the future. If that occurs, we may be required to significantly change or discontinue one or more of our titles.
RISKS RELATED TO OUR COMMON STOCK
Our stock price has been volatile and we expect it to continue to be volatile.
Prior to our initial public offering in November 2001, there was no public market for our common stock. Since our initial public offering the market price of our common stock has been volatile. We have experienced a decline in the market price of our common stock from the initial public offering price. The stock market has experienced significant price and volume fluctuations that affected the market price for the common stock of many technology, communications and entertainment and media companies. These market fluctuations were sometimes unrelated or disproportionate to the operating performance of these companies. Any significant stock market fluctuations in the future, irrespective of our actual performance or prospects, could result in a further decline in the market price of our common stock.
If our common stock is delisted from The Nasdaq SmallCap Market, the liquidity and price of our common stock may be adversely affected.
Our common stock is listed on The Nasdaq SmallCap Market. In order for our common stock to continue to be listed on The Nasdaq SmallCap Market, however, we must continue to satisfy specified listing maintenance standards established by Nasdaq, including (i) required levels of total assets, net tangible assets, stockholders’ equity or revenues, (ii) minimum market value of our public float and (iii) a minimum bid price per share.
We transferred to The Nasdaq SmallCap Market from The Nasdaq National Market on March 27, 2003. Nasdaq advised us at the time of transfer that we met all the specified listing requirements of The Nasdaq SmallCap Market with the exception of the minimum $1.00 bid price per share requirement and that we had until November 17, 2003 to regain compliance with this requirement. On September 29, 2003 Nasdaq advised us that we had regained compliance with the Rule, and that we now met all the specified listing requirements of Nasdaq SmallCap Market.
If our common stock is delisted from The Nasdaq SmallCap Market, our common stock would trade on the Over-The-Counter Bulletin Board, which is viewed by most investors as a less desirable and less liquid marketplace. Thus, delisting from The Nasdaq SmallCap Market could adversely affect the liquidity and price of our common stock and could have a long-term impact on our ability to raise additional capital in the future.
Anti-takeover provisions in our charter documents and in Delaware law could prevent or delay a change in control and, as a result, negatively impact our stockholders.
Provisions of our certificate of incorporation and bylaws may discourage, delay or prevent a merger or acquisition or make removal of incumbent directors or officers more difficult. These provisions may discourage takeover attempts and bids for our common stock at a premium over the market price. These provisions include:
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the ability of our board of directors to alter our bylaws without stockholder approval;
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the restriction on the ability of stockholders to call special meetings;
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the restriction on the ability of our stockholders to act by written consent;
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the establishment of advance notice requirements for nominations for election to our board of directors or for proposing matters that can be acted on by stockholders at stockholders meetings; and
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the establishment of a classified board of directors with staggered, three-year terms, which prevents a majority of the board from being elected at one time.
In addition, we are subject to Section 203 of the Delaware General Corporation Law, which prohibits a publicly held Delaware corporation from engaging in a merger, asset or stock sale or other transaction with an interested stockholder for a period of three years following the date such person became an interested stockholder, unless prior approval of our board of directors is obtained or as otherwise provided. These provisions of Delaware law also may discourage, delay or prevent someone from acquiring or merging with us without obtaining the prior approval of our board of directors, which may cause the market price of our common stock to decline.
SPECIAL NOTE ON FORWARD LOOKING STATEMENTS AND REPORTS PREPARED BY
ANALYSTS
This Report contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, including statements with regards to our revenues, earnings, spending, margins, cash flow, orders, inventory, products, actions, plans, strategies and objectives. Forward-looking statements include, without limitation, any statement that may predict, forecast, indicate or simply state future results, performance or achievements, and may contain the words “believe,” “anticipate,” “expect,” “estimate,” “intend,” “plan,” “project,” “will be,” “will continue,” “will,” “result,” “could,” “may,” “might,” or any variations of such words with similar meanings. Any such statements are subject to risks and uncertainties that would cause our actual results to differ materially from those which are management’s current expectations or forecasts. Such information is subject to the risk that such expectations or forecasts, or the assumptions underlying such exceptions or forecasts, become inaccurate. In addition, the risks included here are not exhaustive. Other sections of this Report may include additional factors which could adversely impact our business and financial performance. Moreover, we operate in a very competitive and rapidly changing environment. New risk factors emerge from time to time and we cannot predict all such risk factors, nor can we assess the impact of all such risk factors on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward looking statements. Given these risks and uncertainties, investors should not place undue reliance on forward-looking statements as a prediction of actual results. Investors should also be aware that while we do, from time to time, communicate with securities analysts, we do not disclose any material non-public information or other confidential commercial information to them. Accordingly, individuals should not assume that we agree with any statement or report issued by any analyst, regardless of the content of the report. Thus, to the extent that reports issued by securities analysts contain any projections, forecasts or opinions, such reports are not our responsibility.
ITEM 2
ITEM 2 - PROPERTIES
Our headquarters are located in San Jose, California, where we occupy approximately 9,533 square feet of office space under a lease that expires in April 2005. We also lease approximately 3,500 square feet for our international sales office located in Bath, England. This lease expires in September 2008. In June 2002, we entered into a lease for 3,214 square feet in London where our internal development studio was located until it was disposed of in January 2003. At that time we granted a sublease, subject to landlord’s consent, on those premises. This lease expires in June 2012, although we have the right to terminate the lease at our option in 2007. We believe that our facilities are adequate for our current needs and suitable additional or substitute space will be available in the future to replace our existing facilities, if necessary, or accommodate expansion of our operations.
ITEM 3
ITEM 3 - LEGAL PROCEEDINGS
On April 1, 2003, Amaze Entertainment, Inc. asserted counterclaims against us in an action captioned BAM! ENTERTAINMENT INC. v. AMAZE ENTERTAINMENT, INC. et. al. that we commenced in the Superior Court of California, County of Santa Clara (Case No. CV814820) on February 18, 2003, and which Amaze had removed to the United States District Court for the Northern District of California (Case No. C03 01286 PVT) on or about March 24, 2003. Our action asserted claims for, inter alia, relief based on rescission, breach of contract, declaratory relief, and money paid and received with regard to an agreement for a video game titled “Crushed Baseball” that Amaze Entertainment was developing for us. Amaze Entertainment’s counterclaims alleged breach of contract and unjust enrichment with regard to each of the “Crushed Baseball” development agreement and a separate development agreement for another video game titled “Samurai Jack.” The counterclaims seeked, inter alia, compensatory damages of approximately $3.5 million and additional damages to be proven at trial. On July 11, 2003 Amaze and Bam agreed to compromise and settle all claims either asserted or that could be asserted in connection with the dispute and to mutually release any and all future claims and contentions they have against each other. This compromise requires Amaze to make Bam two payments, one in July 2003 and one in October 2003. Bam has received the first of these two payments. Under the terms of the settlement, the agreement to settle would have been terminated and considered null and void if Amaze had given Bam notice by August 13, 2003 that it has failed to enter into an agreement with Warner Bros. Consumer Products Inc. allowing Amaze to commercially exploit the Samurai Jack product. Amaze did not give such notice by August 13, 2003, and to Bam’s knowledge, the settlement agreement is in effect. The settlement agreement stipulates that upon payment by Amaze to Bam of the sum due in October 2003, the parties will execute a stipulation for dismissal of the legal actions. Accordingly, the litigation remains unsettled at this time, and management believes it is too early to predict the outcome.
On March 27, 2003, a complaint captioned OVATION ENTERTAINMENT, LLC v. BAM! ENTERTAINMENT, INC. et. al. was filed against us in the Superior Court of California, County of Los Angeles (Case No. SCO76530). The complaint alleged, inter alia, claims of breach of contract and fraud against us in connection with an exclusive first look agreement, which was assigned to Ovation Entertainment by the licensor originally party to the agreement, for content relating to motion pictures and television projects to be licensed to us for development in connection with video games. The lawsuit sought, inter alia, compensatory damages believed to be in excess of $1 million and interest thereon, exemplary or punitive damages, and attorneys’ fees. On August 4, 2003, Ovation and Bam agreed to settle the litigation by amending the terms of the agreement, and the legal action was dismissed on August 25, 2003. Bam does not believe that the amendment will have a material adverse effect on Bam’s financial position or results of operations.
We occasionally become involved in litigation arising from the normal course of business. Other than the foregoing, we believe that any liability with respect to pending legal actions, individually or in the aggregate, will not have a material adverse effect on our business, financial condition or results of operations.
ITEM 4
ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to our security holders to be voted during the last quarter of the fiscal year ended June 30, 2003.
PART II
ITEM 5
ITEM 5 - MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Price range of common stock
Our common stock began trading on the Nasdaq National Market on November 15, 2001 after we completed the initial public offering of 5,750,000 shares of our common stock at $8.00 per share. Our common stock, which trades under the symbol “BFUN,” was transferred to The Nasdaq SmallCap Market on March 27, 2003. The following table sets forth, for the periods indicated, the high and low sale prices for our common stock:
As of September 17, 2003, there were 162 holders of records of our common stock (including holders who are nominees for an undetermined number of beneficial owners). These figures do not include beneficial owners who hold shares in nominee name.
Dividends
We have never declared or paid any cash dividends on our capital stock. We anticipate that we will retain any earnings to support operations and to finance the growth and development of our business. Therefore, we do not expect to pay cash dividends on our capital stock in the foreseeable future. Any future determination relating to our dividend policy will be made at the discretion of our board of directors and will depend on a number of factors, including future earnings, capital requirements, financial conditions, contractual obligations, future prospects and other factors the board of directors may deem relevant.
Change in securities and use of proceeds.
Our authorized capital stock consists of 100,000,000 shares of common stock, par value $0.001 per share and 10,000,000 shares of authorized preferred stock, par value $0.001 per share. As of June 30, 2003, there were 14,678,290 shares of our common stock issued and outstanding, and no shares of our preferred stock issued and outstanding.
In November 2001, we completed the initial public offering (the “Offering”) of 5,750,000 shares of our common stock. The managing underwriters in the Offering were Jefferies & Company, Inc. and Morgan Keegan & Company, Inc. (the “Underwriters”). The shares of common stock sold in the Offering were registered under the Securities Act of 1933, as amended, on a registration statement on Form S-1 (Reg. No. 333-62436) (the “Registration Statement”) that was declared effective by the Securities and Exchange Commission (the “SEC”) on November 14, 2001.
The Offering was terminated after all 5,750,000 shares (including 750,000 shares sold pursuant to the exercise of the Underwriters’ over-allotment option) registered under the Registration Statement were sold by us at a purchase price of $8.00 per share. The aggregate price of the Offering amount registered and sold was $46.0 million. In connection with the Offering, we paid an aggregate of approximately $3.2 million in underwriting discounts and commissions to the Underwriters. Expenses incurred in connection with the Offering, other than underwriting discounts and commissions, totaled approximately $3.6 million.
After deducting the underwriting discounts and commissions and the estimated expenses incurred in connection with the Offering, we received net proceeds of approximately $39.2 million. These proceeds had been fully utilized as of June 30, 2003 as follows:
Recent sales of unregistered securities
During the year ended June 30, 2003, we issued unregistered securities as described below. None of these transactions involved any underwriters, underwriting discounts or commissions, or any public offering, and we believe that each transaction was exempt from the registration requirements of the Securities Act of 1933, as amended, by virtue of Section 4(2) thereof and/or Regulation D promulgated thereunder. All persons had adequate access, through their relationships with us, to information about us.
In connection with an agreement entered into with a production company during January 2002, we agreed to issue to the production company warrants to purchase up to 50,000 shares of our common stock, in pre-determined multiples of either 5,000 or 10,000 shares, upon the occurrence of certain pre-determined events. Warrants are to be issued at the average closing price of our stock for the five days immediately prior to the date of issue, have a five year term from date of issue, and are fully vested and are immediately exercisable upon issuance. In July 2002, we issued a warrant to purchase 5,000 shares of our common stock at an exercise price of $2.04 per share under this agreement, and in May 2003, we issued another warrant to purchase 10,000 shares of our common stock at an exercise price of $0.38 per share under this agreement.
In January 2003, we issued a warrant to a developer to purchase up to 10,000 shares of common stock at an exercise price of $0.30. The warrant was issued at the average closing price of our stock for the five days immediately prior to the date of issue, has a five year term from date of issue, is fully vested and is immediately exercisable upon issuance.
In September 2002, we issued 68,738 shares of our common stock to a production company pursuant to a license agreement.
ITEM 6
ITEM 6 - SELECTED CONSOLIDATED FINANCIAL DATA
The following selected consolidated statement of operations data for the years ended June 30, 2003, 2002, and 2001 and the consolidated balance sheet data as of June 30, 2003 and 2002 are derived from our audited consolidated financial statements and notes thereto, included elsewhere herein, and are audited by Deloitte & Touche LLP, independent public accountants, as set forth in their report included later in this Report. The consolidated balance sheet as of June 30, 2001 is derived from audited financial statements that are not included in this Report. The following data should be read in conjunction with our consolidated financial statements, including the notes thereto, and “Management’s discussion and analysis of financial condition and results of operations” included elsewhere in this Report.
(1)
The diluted net loss per share computation excludes potential shares of common stock issuable upon exercise of options and warrants to purchase common stock, as their effect would be antidilutive. See Notes 1 and 12 of notes to consolidated financial statements for a detailed explanation of the determination of the shares used in computing basic and diluted net loss per share.
ITEM 7
ITEM 7 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Certain information contained in the following Management’s Discussion and Analysis of Financial Condition and Results of Operations constitute forward-looking statements within the meaning of the Securities Act and the Securities Exchange Act, which can be identified by the use of forward-looking terminology such as “believes,” “anticipates,” “plans,” “expects,” “endeavors,” “may,” “will,” “intends,” “estimates,” and similar expressions are intended to identify forward-looking statements. These forward-looking statements involve risks and uncertainties, and our actual results may differ materially from the results discussed in the forward-looking statements as a result of certain factors set forth in “Risk Factors” and elsewhere in this Report.
OVERVIEW
We develop and publish interactive entertainment software products. We currently publish titles for the most popular interactive entertainment hardware platforms, such as Sony’s PlayStation and PlayStation 2, Nintendo’s Gamecube, Nintendo 64, Game Boy Color and Game Boy Advance, Microsoft’s Xbox, portable handheld devices manufactured by Palm and Handspring, and for personal computers or PCs. We were incorporated in California in October 1999 under the name Bay Area Multimedia, Inc. We reincorporated in Delaware in September 2000 and changed our name to BAM! Entertainment, Inc. in December 2000. We commenced operations in October 1999 and shipped our first products in June 2000.
We license properties from a wide variety of sources, and publish titles based on the motion picture, sports and television properties of our licensors. We have entered into strategic license arrangements with entertainment and media companies that have developed well-known characters and brands and that are producing popular properties that are expected to form the basis of some of our future products. Our agreements with licensors and developers generally require us to make advance royalty payments, and we may be required to spend money on advertising and promotion. We generally pay royalties based on net revenues.
We design and develop our titles through third parties with whom we have established relationships. We believe that the development cycle for new titles is long, typically ranging from 12 to 24 months, except for Nintendo’s Game Boy Advance for which the development cycle typically ranges from six to nine months. After development of the initial product, we believe that it may take between six to 12 additional months to develop the product for, or port the product to, a different hardware platform.
We have offices in both the United States and Europe. International operations outside of North America are conducted through our office in England, where we perform international sales and marketing activities and manage local third-party developers. Domestically, we sell our products to mass merchandisers such as Toys “R” Us, Target, Kmart, Wal-Mart and Best Buy, specialty chains such as GameStop and Electronics Boutique, and independent distributors.
Internationally, in July 2003 we entered into a distribution agreement with Acclaim Entertainment Ltd (“Acclaim”) whereby Acclaim will exclusively distribute certain forthcoming products of ours in PAL territories. PAL is the television standard for the United Kingdom, continental Europe and Australia. Prior to entering this agreement we sold our products internationally through mass merchandisers, distributors and sub-distributors. Catalogue products will continue to be sold through mass merchandisers, distributors and sub-distributors.
Our products are manufactured exclusively by third parties.
We have experienced recurring net losses from inception (October 7, 1999) through June 30, 2003. During the year ended June 30, 2003, we used cash in operating activities of $10.5 million and incurred a net loss of $36.2 million. As of June 30, 2003, we had cash and cash equivalents of $1.1 million and an accumulated deficit was $59.8 million. These factors, among others, raise substantial doubt about our ability to continue as a going concern for a reasonable period of time. The consolidated financial statements do not include any adjustments relating to the recoverability and classification of assets or the amounts and classification of recorded liabilities that might be necessary should we be unable to continue as a going concern.
During the year ended June 30, 2003, we undertook measures to reduce spending and restructured our operations. In February 2003 we retained, through July 31, 2003, the investment banking firm of Gerard Klauer Mattison & Co., Inc. to assist us in reviewing a range of potential strategic alternatives, including mergers, acquisitions and additional financing. No transactions arose from this assistance or were consummated during this period. We may need to either consummate one or a combination of the potential strategic alternatives, or otherwise obtain capital via sale or license of certain of our assets, in order to satisfy our future liquidity requirements. Current market conditions present uncertainty as to our ability to effectuate any merger or acquisition or secure additional financing, as well as our ability to reach profitability. There can be no assurances that we will be able to effectuate any such merger or acquisition or secure additional financing, or obtain favorable terms on such financing if it is available, or as to our ability to achieve positive cash flow from operations. Continued negative cash flows create significant uncertainty about our ability to implement our operating plan and we may have to further reduce the scope of our planned operations. If cash and cash equivalents, together with cash generated from operations, are insufficient to satisfy our liquidity requirements, we will not have sufficient resources to continue operations for the next six months.
As of June 30, 2003, we had $4.0 million, $1.1 million and $89,000 of capitalized development costs, current and long-term prepaid royalties and licensed assets, respectively, related to software development projects in progress. Should we be unable to effectuate either a merger or acquisition or to secure sufficient additional financing, part or all of these development projects in progress might have to be abandoned and the related costs would have to be written off.
RESULTS OF OPERATIONS
The following table sets forth the condensed consolidated results of operations as a percentage of net revenues for the years ended June 30, 2003, 2002, and 2001. The selected consolidated statement of operations data is derived from our audited consolidated financial statements included elsewhere in this Form 10-K.
(1)
Excludes amortization of deferred stock compensation.
Net revenues
Net revenues were $35.7 million, $50.7 million and $25.4 million for the years ended June 30, 2003, 2002, and 2001, respectively.
Revenues were lower in the year ended June 30, 2003 over the year ended June 30, 2002 because of fewer titles released and lower sales volumes. Revenues increased in the year ended June 30, 2002 over the year ended June 30, 2001 because we released more titles and sold increased volumes of product.
We released 20 new products in the year ended June 30, 2003 compared to 23 new products during the year ended June 30, 2002, and 11 new products in the year ended June 30, 2001.
To date, a substantial portion of our net revenues has been derived from sales of a limited number of products. For example, sales of four products each accounted for between 9% and 13% of our net revenues during the year ended June 30, 2003, sales of four products each accounted for between 7% and 11% of our net revenues during the year ended June 30, 2002, and sales of four products each accounted for between 14% and 28% of our net revenues during the year ended June 30, 2001.
The following table sets forth our net revenues by customer representing more than 10% of each period’s net revenues for the years ended June 30, 2003, 2002, and 2001:
Net revenues by geographical region for the years ended June 30, 2003, 2002, and 2001 is summarized below:
Cost of revenues
Cost of goods sold was $23.1 million, or 65% of net revenues for the year ended June 30, 2003, compared to $29.8 million, or 59% of net revenues for the year ended June 30, 2002, and $14.8 million, or 59% of net revenues, for the year ended June 30, 2001.
Cost of goods sold were, in absolute dollars, lower in the year ended June 30, 2003 over the year ended June 30, 2002 because of decreased sales volumes. In absolute dollars, Cost of goods sold increased in the year ended June 30, 2002 over the year ended June 30, 2001 because of increased sale volumes of products. The increase as a percentage of revenue in both years was due to a number of factors, including increased price protection and product returns reserved against sales, increased sales of surplus inventories at discounted prices, and lower introductory prices on certain titles.
Royalties, software costs, and license costs were $18.7 million, or 52% of net revenues, for the year ended June 30, 2003, compared to $12.1 million, or 24% of net revenues, for the year ended June 30, 2002 and $2.9 million, or 11% of net revenues, for the year ended June 30, 2001. The increase in these costs in absolute dollars was because we launched more products for sophisticated hardware systems than in previous years, and expensed prepaid royalty costs where we considered future recoverability of such costs unlikely. Sophisticated hardware system products cost more to develop than products for handheld devices. The increase in these costs as a percentage of revenues was due to the aforementioned factors, along with increased price protection and product returns reserved against sales.
Project abandonment costs were $9.6 million, or 27% of net revenues, for the year ended June 30, 2003, compared to $693,000, or 1% of net revenues, for the year ended June 30, 2002 and zero for the year ended June 30, 2001. The increase in these costs in absolute dollars and as a percentage of revenues for the year ended June 30, 2003 over the year ended June 30, 2002 was due to increased numbers of projects being abandoned, and projects being abandoned at a later stage of development.
Research and development
Research and development expenses were $2.9 million, or 8% of net revenues, for the year ended June 30, 2003, compared to $2.5 million, or 5% of net revenues, for the year ended June 30, 2002, and $1.1 million, or 4% of net revenues, for the year ended June 30, 2001. The increase each year in absolute dollars and as a percentage of revenues was primarily because of increased headcount and third party testing costs.
Sales and marketing
Sales and marketing expenses were $9.2 million, or 26% of net revenues, for the year ended June 30, 2003, compared to $11.5 million, or 23% of net revenues, for the year ended June 30, 2002, and $4.3 million, or 17% of net revenues, for the year ended June 30, 2001. The decrease in absolute dollars in the year ended June 30, 2002 over the year ended June 30, 2001 was primarily because of reduced advertising and marketing activities, reduced headcount and decreased sales commissions on lower net revenues. The increase in absolute dollars in the year ended June 30, 2002 over the year ended June 30, 2001 was as a result of increased advertising and marketing activities for the 2001 holiday season, expanded marketing activities in Europe and increased headcount.
General and administrative
General and administrative expenses were $7.2 million, or 20% of net revenues, for the year ended June 30, 2003, compared to $6.3 million, or 12% of net revenues, for the year ended June 30, 2002, and $2.0 million, or 8% of net revenues, for the year ended June 30, 2001. The increase in absolute dollars in the year ended June 30, 2003 over the year ended June 30, 2002 was primarily due to increased costs associated with being a public company, increased professional fees and facilities costs, increased insurance costs including $900,000 credit insurance costs on sales made to Kmart over the 2002 holiday season, and increased travel costs. In the year ended June 30, 2003 we increased the allowance for doubtful accounts receivable against our Kmart long-term receivable by $547,000. The increase in absolute dollars in the year ended June 30, 2002 over the year ended June 30, 2001 was due to the hiring of additional personnel, increased professional fees and facilities costs, increased travel costs, and increased allowances for doubtful accounts receivables including a $1.1 million allowance against our long-term receivable from Kmart.
Amortization of deferred stock compensation
Amortization of deferred stock compensation was $418,000, or 1% of net revenues, for the year ended June 30, 2003, compared to $1.2 million, or 2% of net revenues, for the year ended June 30, 2002, and $618,000, or 2% of net revenues for the year ended June 30, 2001. Amortization of deferred stock compensation resulted from using the accelerated amortization method to account for compensatory stock options granted to employees and directors during the six months ended September 30, 2001.
Restructuring costs
Restructuring costs were $426,000, or 1% of net revenues, for the year ended June 30, 2003 compared to zero for each of the years ended June 30, 2002 and 2001. We initiated a restructuring of our operations in November 2002. Restructuring costs comprised headcount reduction severance payments of $261,000, and costs of $165,000 incurred upon the disposal of our London development studio. As part of the restructuring, we wrote off $1.3 million of capitalized development costs during the year ended June 30, 2003, and included such in Cost of Revenue-Project abandonment costs.
Other expense, net
Interest income was $148,000 for the year ended June 30, 2003, compared to $328,000, or 1% of net revenues for the year ended June 30, 2002, and $58,000 for the year ended June 30, 2001. Interest income in each period relates to interest earned on funds deposited in money market accounts. Interest income decreased in the year ended June 30, 2003 over the year ended June 30, 2002 as less funds were held on deposit as a result of funds being used by operations. Interest income increased in the year ended June 30, 2002 over the year ended June 30, 2001 as a result of funds raised in our initial public offering completed in November 2001 being held on deposit.
Interest expense was $594,000, or 2% of net revenues, for the year ended June 30, 2003, compared to $2.6 million, or 5% of net revenues, for the year ended June 30, 2002, and $1.3 million, or 5% of net revenues, for the year ended June 30, 2001. Interest expense decreased in the year ended June 30, 2003 over the year ended June 30, 2002 as a result of our operating under a less expensive short-term operating line subsequent to February 1, 2002. The increase in interest expense in the year ended June 30, 2002 over the year ended June 30, 2001 was primarily as a result of funding increased inventory purchases through short-term borrowings.
Net other income (expense) was $151,000 income for the year ended June 30, 2003, compared to $38,000 expense for the year ended June 30, 2002, and $18,000 income in the year ended June 30 2001, and comprised exchange gains and losses.
Redeemable convertible preferred stock dividend
In the year ended June 30, 2001, we recorded a non-cash charge of approximately $5.5 million, or 22% of net revenues, relating to the beneficial conversion feature of shares of our Series C Preferred Stock issued in May 2001.
Net loss attributable to common shareholders
We incurred a net loss attributable to common stockholders of $36.2 million, $15.7 million, and $7.1 million for the years ended June 30, 2003, 2002, and 2001, respectively.
LIQUIDITY AND CAPITAL RESOURCES
In November 2001, we completed our initial public offering, raising $39.2 million net of expenses and underwriters’ discounts. Subsequent to the offering, we have used the proceeds of the initial public offering, cash generated from the sale of products, a product financing arrangement with a finance company, and short-term liabilities to finance our operations. Prior to the initial public offering, we financed our operations primarily through the private sale of equity securities, cash generated from the sale of products, a product financing arrangement with a finance company, the issuance of promissory notes to stockholders, a commercial line of credit and short-term liabilities.
Net cash used in operating activities was $10.5 million for the year ended June 30, 2003, compared to $27.1 million for the year ended June 30, 2002, and $10.3 million for the year ended June 30, 2001. Net cash used in operating activities was the result of net losses and increases in net operating assets, comprising accounts receivable, inventories, prepaid royalties, capitalized software costs and licensed assets, and accruals.
Net cash provided from investing activities was $8.0 million for the year ended June 30, 2003, compared to net cash used in investing activities of $7.4 million for the year ended June 30, 2002, and $2.2 million for the year ended June 30, 2001. Net cash provided from investing activities for the year ended June 30, 2003 consisted primarily of the sale of short-term investments. Net cash used in investing activities during the year ended June 30, 2002 consisted primarily of the purchase of short-term investments and property and equipment, and for the year ended June 30, 2001 consisted of the purchase of property and equipment and other assets.
Net cash used in financing activities was $1.4 million for the year ended June 30, 2003, compared to net cash provided by financing activities of $36.9 million for the year ended June 30, 2002, and $13.7 million for the year ended June 30, 2001. Net cash used in financing activities during the year ended June 30, 2003 comprised mostly
net repayments of short-term borrowings. Net cash provided by financing activities during the year ended June 30, 2002 comprised mostly net proceeds on the sale of 5.75 million shares of common stock in our initial public offering completed in November 2001, plus the issuance of common stock arising from the exercise of warrants and options, offset by net repayments under a finance agreement with a finance company. Net cash provided by financing activities during the year ended June 30, 2001, consisted primarily of the sale of redeemable convertible preferred stock, net borrowings on finance agreements and a line of credit with our bankers.
In October 1999, we issued 580,962 shares of common stock to our principal stockholder at a price of $0.001 per share. Also, in October 1999, we issued 274,950 shares of common stock at $0.11 per share to consultants in exchange for services performed valued at approximately $30,000. In each of November 1999 and January 2000, we issued our principal stockholder convertible promissory notes in the principal amount of $500,000, and in May 2000 issued him an additional convertible promissory note in the principal amount of $47,000 for operating capital. Each note bore interest at 7% per annum with principal and accrued interest due on demand after one year from the date of issuance. Each note was automatically convertible into shares of our Series A Preferred Stock upon the initial closing of our Series A Preferred Stock financing. In June 2000, the notes were converted and our principal stockholder was issued 482,625 shares of our Series A Preferred Stock for $1.0 million; these shares are convertible into 2,268,338 shares of our common stock. In June 2000, inclusive of shares issued to our principal stockholder upon the conversion, we sold and issued 976,220 shares of our Series A Preferred Stock for $2.1 million; at the same time we issued the Series A Preferred Stock, we issued 614,060 shares of our common stock at $0.11 per share for $59,000 in cash and for services valued at $7,000. In December 2000, we sold and issued 294,620 shares of our Series B Preferred Stock for $5.2 million. In May 2001, we sold and issued 245,659 shares of our Series C Preferred Stock for $5.5 million.
In November 2001 we sold 5.75 million shares of common stock in our initial public offering. At that date, the 976,220 Series A Preferred Stock, 294,620 Series B Preferred Stock, and 245,659 Series C Preferred Stock converted into 7,127,528 shares of our common stock.
During the year ended June 30, 2003, 26,796 shares of common stock were issued under the employee share purchase plan for proceeds of $27,000. During the year ended June 30, 2002, 20,562 shares of common stock were issued upon exercise of stock options for proceeds of $9,000, 4,956 shares of common stock were issued under the employee share purchase plan for proceeds of $25,000, and a warrant to purchase 141,000 shares of common stock was exercised for proceeds of $529,000.
In September 2003, we entered into a six month Agreement (the “Agreement”) with a finance company, pursuant to which the finance company extends a line of credit facility to fund our domestic inventory purchases. We may sell the inventory purchased under the Agreement and are required to remit customer receipts from those sales directly to the finance company up to the amounts funded by them. We retain collections in excess of the amounts funded by the finance company, we are responsible for collecting the customer receivables, and we bear the risk of loss on all uncollectible accounts.
Under the Agreement, the finance company’s aggregate outstanding funding is limited to $3.2 million. We are required to pay the finance company’s expenses under the contract, a facility fee equal to 5.0% of the funds advanced by the finance company, and interest at prime plus 0.5%. The Agreement terminates on March 31, 2004 and any sums outstanding become repayable on that date. We may repay any sums advanced prior to the due date of payment without penalty.
The finance company has a security interest in our accounts receivable and inventory.
Prior to entering into the Agreement, we had entered into a two year factoring agreement (the “Factoring Agreement”) with a different finance company in February 2002, pursuant to which we assigned our North American receivables to the finance company. The finance company was responsible for collecting customer receivables, and upon collection, remitted the funds to us, less a service fee. Under the Factoring Agreement, we could obtain advances, subject to the finance company’s discretion and our compliance with certain liquidity covenants, in the form of cash or as collateral for letters of credit, up to a maximum of 75% of outstanding domestic receivables at any point in time. The Factoring Agreement was mutually terminated in September 2003.
Under the terms of the Factoring Agreement, we paid a service fee on all receivables assigned, with a minimum annual fee of $150,000, interest at prime plus 1% on all cash sums advanced. Upon the termination of the Factoring Agreement, the minimum annual fee for the second year of the Factoring Agreement was waived, and we paid a termination payment of $25,000. All fees were included in interest expense. We bore the collection risk on the accounts receivable that were assigned, unless the finance company approved the receivable at the time of assignment, in which case the finance company bore the risk. The finance company had a security interest in our accounts receivable, inventory, fixed assets and intangible assets.
As of June 30, 2003 we did not meet the Factoring Agreement’s liquidity covenants and had no sums advanced under the Factoring Agreement. As of June 30, 2002, we had advances of $1,359,000 outstanding under the Factoring Agreement.
Prior to entering into the Factoring Agreement, we had entered into a finance agreement (the “Finance Agreement”) with a different finance company, whereby we assigned purchase orders entered into with our customers to the finance company and requested the finance company purchase finished goods to fulfill such customer purchase orders.
The Finance Agreement, entered into in February 2000, specified that the finance company’s funding commitment with respect to a customer purchase order should not exceed 60% of the retail purchase order price. Under the Finance Agreement the finance company’s aggregate outstanding funding (i.e., advance of funds or purchase of finished goods to fulfill customer purchase orders) was limited to $5.0 million. We were responsible for collecting customer receivables, bore the risk of loss on all uncollectible accounts, and we were required to remit customer receipts directly to the finance company up to the amounts funded by the finance company. We retained collections in excess of the amounts funded by the finance company.
Under the initial terms of the Finance Agreement, we were required to pay the finance company’s expenses under the contract, a deal fee (consisting of a transaction and initiation fee equal to 5.0% of the face amounts of letters of credit issued or other funds advanced by the finance company), a daily maintenance fee of 0.067%, a materials advance fee at prime rate plus 4.0% and a late payment fee where applicable; all of which are included in interest expense.
In August 2001, we amended the Finance Agreement, initially increasing the aggregate outstanding funding amount to $10.0 million, and then decreasing the transaction and initiation fee to 3% until the earlier of the termination of the agreement or December 31, 2001, if our initial public offering had not occurred by that date. We completed our initial public offering in November 2001. In connection with this latter amendment and the execution of a $7.0 million factoring arrangement with an affiliate of the finance company, we issued a warrant to the finance company to purchase 100,000 shares at an exercise price of $8.00.
Upon the signing of the Finance Agreement, we paid the finance company a security deposit of $90,000. An extension payment of $50,000 was made when the contract was amended in December 2000, and a further amendment fee of $120,000 was incurred when the contract was amended in August 2001. These costs were recorded as interest expense.
Outstanding borrowings under the Finance Agreement were collateralized by our inventories, accounts receivable, fixed assets and intangible assets.
The Finance Agreement and the factoring line with the affiliate terminated in February 2002, and all outstanding amounts funded were fully repaid.
As of June 30, 2003, 2002, and 2001 we had outstanding letters of credit issued of $0, $2.3 million, and $2.0 million, respectively.
As of June 30, 2003 we had cash and cash equivalents of $1.1 million and no short-term investments. As of June 30, 2002 we had cash and cash equivalents of $4.7 million and short-term investments of $8.2 million, and as of June 30, 2001, we had cash and cash equivalents of $2.2 million and no short-term investments.
In August 2003, we entered into a promissory note with one of our directors whereby the director loaned us $250,000. The loan, which bears interest at 6% per annum, is repayable on or before October 31, 2003.
During the year ended June 30, 2003, we used cash in operating activities of $10.5 million and incurred a net loss of $36.2 million. As of June 30, 2003, we had cash and cash equivalents of $1.1 million and an accumulated deficit of $59.8 million. During the year ended June 30, 2003, we undertook measures to reduce spending and restructured our operations. In February 2003 we retained, through July 31, 2003, the investment banking firm of Gerard Klauer Mattison & Co., Inc. to assist us in reviewing a range of potential strategic alternatives, including mergers, acquisitions and additional financing. No transactions arose from this assistance or were consummated during this period. We may need to either consummate one or a combination of the potential strategic alternatives, or otherwise obtain capital via sale or license of certain of our assets, in order to satisfy our future liquidity requirements. Current market conditions present significant uncertainty as to our ability to effectuate any merger or acquisition or secure additional financing, as well as our ability to reach profitability. There can be no assurances that we will be able to effectuate any such merger or acquisition or secure additional financing, or obtain favorable terms on such financing if it is available, or as to our ability to achieve positive cash flow from operations. Continued negative cash flows create uncertainty about our ability to implement our operating plan and we may have to further reduce the scope of our planned operations. If cash and cash equivalents, together with cash generated from operations, are insufficient to satisfy our liquidity requirements, we will not have sufficient resources to continue operations for the next six months.
Excluding assets under capital leases, capital expenditures were $338,000 for the year ended June 30, 2003, compared to $908,000 for the year ended June 30, 2002, and $421,000 for the year ended June 30, 2001. We did not have any material commitments for capital expenditures at any of those dates.
Our principal commitments at June 30, 2003 comprised operating leases, capital leases, guaranteed royalty payments, contractual marketing commitments and factoring agreement minimum annual fees. At June 30, 2003, we had commitments to spend $1.1 million under operating and capital leases, net of sub-leases, prepay $500,000 million for royalties under agreements with various content providers, spend $1.1 million in advertising on the networks and websites of these content providers and incur $104,000 in factoring agreement annual fees. Of these amounts, $2.0 million must be paid no later than June 30, 2004. Guaranteed royalty payments will be applied against any royalties that may become payable to the content providers.
CRITICAL ACCOUNTING POLICIES
Financial Reporting Release No. 60 requires all companies to include a discussion of critical accounting policies or methods used in the preparation of financial statements. Note 1 of the Notes to the Consolidated Financial Statements includes a summary of the significant accounting policies and methods used in the preparation of our consolidated financial statements. The following is a brief discussion of the more significant accounting policies and methods used by us. In addition, Financial Reporting Release No. 61 also requires all companies to include a discussion addressing, among other things, liquidity, off-balance sheet arrangements, contractual obligations and commercial commitments.
Use of estimates
The consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America. Certain of our accounting policies require the application of significant judgment by management in selecting the appropriate assumptions for calculating financial estimates. These estimates affect the reported amounts of assets and liabilities at the dates of the financial statements and reported amounts of revenues and expenses during the reporting periods. By their nature, these judgments are subject to an inherent degree of uncertainty. The most significant estimates and assumptions relate to revenue recognition, adequacy of allowances for returns and price protection, doubtful accounts receivable, and cooperative advertising, carrying values of inventories, the future recoverability of prepaid royalties, capitalized software costs and licensed assets, and foreign currency translation.
Net revenues
We derive our revenues from shipment of finished products to our customers. Under certain conditions, we may allow customers to exchange and return our products and from time to time provide price protection or allow returns on certain unsold merchandise in the form of a credit against amounts due from the customer. Net revenues from product sales are reflected after deducting the estimated cost of allowances for returns and price protection as well as discounts given. These estimates are based upon currently known circumstances and historical results. The calculation of net revenues will be affected by many factors, including pricing strategies, the channels through which products are distributed, product maturity, exchange and return provisions and price protection.
We recognize revenue in accordance with Statement of Position 97-2, Software Revenue Recognition, and related interpretations, when persuasive evidence of an arrangement exists, delivery has occurred, the price has been fixed or is determinable and collectibility has been reasonably assured.
Our sales are typically made on credit, with terms that vary depending upon the customer and other factors. If a sale is made on credit, and a significant portion of the fee is due after our normal payment terms, which are normally 30 to 90 days from invoice date, we account for the fee as not being fixed or determinable and will not recognize revenue until such time as the fee becomes due. While we attempt to carefully monitor the creditworthiness of our customers and distributors, we bear the risk of their inability to pay our receivables and of any delay in payment. If the collectibility of a receivable becomes uncertain after revenue has been recognized, we will record an allowance for doubtful accounts against our accounts receivable.
When we recognize revenue, we account for the estimate of future returns and price protection on the sale as allowances against receivables. We also estimate cooperative marketing costs on the sale and account for these costs as a marketing expense and as an allowance against receivables. We continually monitor, reassess and adjust the adequacy of all these allowances, along with the allowance for doubtful accounts, based on known circumstances, historical results, commitments made, anticipated events and anticipated commitments. Adjustments to these allowances will affect the reported amounts of revenues and expenses during the reporting periods the adjustments are made.
We expect that substantially all of our net revenues for a particular quarter will be generated by titles released in that quarter or in the immediately prior quarter. The market for interactive entertainment software is characterized by short product life cycles, changing consumer preferences and frequent introduction of new products. The life cycle of a title generally consists of a relatively high level of sales during the first few months after introduction, followed by a decline in sales, with only a small percentage of sales occurring more than six months after release.
We have experienced, and are likely to continue to experience, quarterly fluctuations in net revenues. We believe the factors which influence these fluctuations include (i) the timing of our introduction of new products, (ii) the level of consumer acceptance of new and existing products, (iii) general economic and industry conditions that affect consumer spending and retail purchasing, (iv) the timing of the placement, cancellation or pickup of customer orders, (v) the timing of expenditures in anticipation of increased sales, (vi) actions by competitors, (vii) location of product releases, and (viii) the number of titles released in the period and the hardware platforms on which they are released. The timing of our introduction of new products is affected by uncertainties associated with software development, lengthy manufacturing lead times, production delays and the approval process for products by hardware manufacturers and other licensors. The interactive entertainment industry is highly seasonal, with net revenues typically significantly higher during the fourth and first calendar quarters, due primarily to the increased demand for titles during the year-end holiday buying season. A failure or inability to introduce products on a timely basis to meet seasonal increases in demand will harm our business and operating results. Due to these and other factors, the operating results for any particular quarter are not necessarily indicative of the results for the entire fiscal year.
Cost of revenues
Cost of revenues consists of cost of goods sold and royalties, software costs, license costs and project abandonment.
Cost of goods sold. Cost of goods sold includes manufacturing costs of finished goods, freight, inventory management costs and inventory obsolescence costs. Cost of goods sold will vary depending on the volume of products manufactured and shipped, the mix of products sold and the shipping channel used.
Royalties, software costs, and license costs. Royalties, software costs, and license costs include royalties paid to software licensors, software amortization and amortization of non-cash charges related to warrants and rights to acquire our common stock issued to certain production companies. These costs will be affected in particular periods by many factors, including the specific terms or agreements under which royalties are paid to third parties, the commercial acceptance of products, the cost of developing a product and the timing of stock and warrants issued pursuant to the terms of our license agreements.
Our agreements with licensors and developers generally require us to make advance royalty payments and pay royalties based on product sales, which may have guaranteed minimum payments. Prepaid royalties are amortized commencing upon the product release at the greater of the contractual royalty rate based on actual product sales, or the ratio of current revenues to total projected revenues. We evaluate the future recoverability of prepaid royalties on a quarterly basis and expense costs if and when they are deemed unrecoverable. We cannot assure you that the sales of products for which these royalties are paid or guaranteed payments are made will be sufficient to cover the amount of these required payments.
Commencing upon product release, we amortize capitalized software development costs. We capitalize software development costs subsequent to establishing technological feasibility of a title. Technological feasibility is evaluated on a product-by-product basis. For products where proven game engine technology exists, this may be early in the development cycle. Prior to establishing technological feasibility, software development costs are expensed to research and development, and to cost of revenues subsequent to establishing technological feasibility. The following criteria are used to evaluate recoverability of software development costs: historical performance of comparable products; the commercial acceptance of prior products released on a given hardware platform; orders for a product prior to its release and actual development costs of a product as compared to forward-looking projections. Amortization of software development costs is based on the greater of the proportion of current revenues to total projected revenues or the straight-line method over the estimated product life, generally three to six months. We analyze our capitalized costs quarterly and take write-offs when, based on our estimates, future individual product revenues will not be sufficient to recover our investment.
Project abandonment costs. If we terminate a development project prior to completion, we expense the capitalized software development costs and licensed assets costs to project abandonment.
Research and development
Research and development expenses relate to the design and development of new interactive entertainment software products. Payments made to independent software developers under development agreements are capitalized to software development costs once technological feasibility is established or if the development costs have an alternative future use. Prior to establishing technological feasibility, software development costs are expensed to research and development and to cost of revenues subsequent to confirmation of technological feasibility. Internal development costs are capitalized to software development costs once technological feasibility is established. Technological feasibility is evaluated on a product-by-product basis. For products where proven game engine technology exists, this may occur early in the development cycle.
ITEM 7(a) - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market risk
Market risk is the potential loss arising from the adverse changes in market rates and prices, such as interest rates and foreign currency exchange rates. Changes in interest rates and, in the future, changes in foreign currency exchange rates have and will have an impact on our results of operations.
Interest rate fluctuations. We do not consider our cash and cash equivalents to be subject to interest rate risk due to the short maturities of the instruments in which we have invested. We are exposed to interest rate risk on our product financing arrangement with a finance company. We do not enter into derivative securities or other financial instruments for trading or speculative purposes. We estimate that a 10% change in interest rates would have impacted our results of operations by less than $50,000 for the year ended June 30, 2003.
Foreign exchange rate fluctuations. We face market risk to the extent that changes in foreign currency exchange rates affect our non-U.S. Dollar functional currency foreign operations. The functional currency for our foreign operations is the applicable local foreign currency. The translation of the applicable foreign currencies into U.S. Dollars is performed for balance sheet accounts using exchange rates in effect at the balance sheet date and for revenue and expense accounts using a weighted-average exchange rate during the period. The gains or losses resulting from such translation are reported as a separate component of equity as accumulated other comprehensive loss, whereas gains or losses resulting from foreign currency transactions are included in results of operations. We do not engage in hedging activities with respect to foreign exchange rate fluctuations.
Recently issued new accounting pronouncements
In June 2001, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 141, Business Combinations, and SFAS No. 142, Goodwill and Other Intangible Assets. SFAS No. 141 requires that all business combinations initiated after June 30, 2001 be accounted for under the purchase method and addresses the initial recognition and measurement of goodwill and other intangible assets acquired in a business combination. SFAS No. 142 addresses the initial recognition and measurement of intangible assets acquired outside of a business combination and the accounting for goodwill and other intangible assets subsequent to their acquisition. SFAS No. 142 provides that intangible assets with finite useful lives be amortized and that goodwill and intangible assets with indefinite lives not be amortized, but will instead be tested at least annually for impairment. We adopted SFAS No. 142 on July 1, 2002. We did not carry any goodwill or other intangibles on our balance sheets as of June 30, 2003 or 2002, and therefore the adoption of SFAS No. 142 did not have a material effect on our financial position or operating results.
In June 2001, the FASB issued SFAS No. 143, Accounting for Asset Retirement Obligations. SFAS No. 143 addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. This statement is effective for fiscal years beginning after June 15, 2002, however earlier application is permitted. We adopted SFAS No. 143 on July 1, 2002. The adoption of this statement did not have a material effect on our financial position or operating results.
In August 2001, the FASB issued SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, which addresses financial accounting and reporting for the impairment or disposal of long-lived assets. While SFAS No. 144 supersedes SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of, it retains many of the fundamental provisions of SFAS No. 121. SFAS No. 144 also supersedes the accounting and reporting provisions of APB No. 30, Reporting the Results of Operations-Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions, for the disposal of a segment of a business. However, it retains the requirement in APB No. 30 to report separately discontinued operations and extends that reporting to a component of an entity that either has been disposed of (by sale, abandonment, or in a distribution to owners) or is classified as held for sale. We adopted SFAS No 144 on July 1, 2002. The adoption of SFAS No. 144 did not have a material effect on our financial position or results of operations.
In June 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities, which addresses accounting for restructuring and similar costs. SFAS No. 146 supersedes previous accounting guidance, principally Emerging Issues Task Force (“EITF”) 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit on Activity (including Certain Costs Incurred in a Restructuring). We were required to adopt SFAS No. 146 for restructuring activities initiated after December 31, 2002, and we adopted SFAS No. 146 on January 1, 2003. SFAS No. 146 requires that the liability for costs associated with an exit or disposal activity be recognized when the liability is incurred. Under EITF 94-3, a liability for an exit cost was recognized at the date of our commitment to an exit plan. SFAS No. 146 also established that the liability should initially be measured and recorded at fair value. The adoption of SFAS No. 146 did not have a material effect on our financial position or results of operations.
In November 2002, the FASB issued FIN No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others. The interpretation elaborates on the existing disclosure requirements for most guarantees, including loan guarantees such as standby letters of credit. It also clarifies that at the time a company issues a guarantee, the company must recognize an initial liability for the fair value, or market value, of the obligations it assumes under the guarantee and must disclose that information in its interim and annual financial statements. The provisions related to recognizing a liability at inception of the guarantee for the fair value of the guarantor’s obligations do not apply to product warranties or to guarantees accounted for as derivatives. The disclosure requirements are effective for financial statements of interim or annual periods ending after December 15, 2002, and the initial recognition and initial measurement provisions apply on a prospective basis to guarantees issued or modified after December 31, 2002. We adopted FIN No. 45 on January 1, 2003. The adoption of FIN No. 45 did not have a material effect on our financial position or results of operations.
In December 2002, the FASB issued SFAS No. 148, Accounting for Stock-Based Compensation - Transition and Disclosure. SFAS No. 148 amends SFAS No. 123, Accounting for Stock-Based Compensation. Although it does not require use of fair value method of accounting for stock-based employee compensation, it does provide alternative methods of transition. It also amends the disclosure provisions of SFAS No.123 and APB No. 28, Interim Financial Reporting, to require disclosure in the summary of significant accounting policies of the effects of an entity’s accounting policy with respect to stock-based employee compensation on reported net income and earnings per share in annual and interim financial statements. SFAS No. 148’s amendment of the transition and annual disclosure requirements is effective for fiscal years ending after December 15, 2002. The amendment of disclosure requirements of APB No. 28 is effective for interim periods beginning after December 15, 2002. We adopted SFAS No. 148 and APB No.28 on January 1, 2003.
In January 2003, the FASB issued FIN No. 46, Consolidation of Variable Interest Entities-an interpretation of ARB No. 51. FIN No. 46 addresses the consolidation of variable interest entities (“VIEs”). A VIE is a corporation, partnership, trust or other legal structure used for business purposes that either does not have equity investors with substantive voting rights or has equity investors that do not provide sufficient financial resources for the entity to support its activities. A VIE often holds financial assets and may either be passive or engage in activities such as research and development or other activities on behalf of other companies. FIN No. 46 requires a VIE to be consolidated by a company if that company is subject to a majority of the VIE’s risk of loss or if it is entitled to receive a majority of the VIE’s residual returns or both. The company that consolidates a VIE is referred to as the primary beneficiary of that entity. The consolidation requirements of FIN No. 46 apply to VIEs created after January 31, 2003. For VIEs existing prior to January 31, 2003, consolidation requirements are effective in the first fiscal year or interim period beginning after June 15, 2003. Certain disclosure requirements apply in all financial statements issued after January 31, 2003 regardless of when the VIE was established. We adopted FIN No. 46 on January 31, 2003. The adoption of FIN No. 46 did not have a material effect on our financial position or results of operations.
In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity, which requires mandatorily redeemable financial instruments to be classified as liabilities, the result of which requires related expense to be classified as interest expense rather than minority interest on a prospective basis. SFAS No. 150 is effective in the three months ended June 30, 2003 for financial instruments entered into or modified after May 31, 2003, and is otherwise effective July 1, 2003 for previously issued instruments. SFAS No. 150 is not expected to have a material impact on our financial position or results of operations.
ITEM 8
ITEM 8 - CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The information required by this Item 8 is incorporated by reference to our Consolidated Financial Statements and Independent Auditors’ Report beginning at page of this Report.
ITEM 9
ITEM 9 - CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A
ITEM 9A - CONTROLS AND PROCEDURES
(a)
Evaluation of disclosure controls and procedures
The term “disclosure controls and procedures” refers to the controls and procedures of a company that are designed to ensure that information required to be disclosed by a company in the reports that it files under Rules 13a - 14 of the Securities Exchange Act of 1934 (the “Exchange Act”) is recorded, processed, summarized and reported within required time periods. As of the end of the period covered by this Annual Report on Form 10-K (the “Evaluation Date”), we carried out an evaluation under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer of the effectiveness of our disclosure controls and procedures. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that, as of the Evaluation Date, such controls and procedures were effective in ensuring that required information will be disclosed on a timely basis in our periodic reports filed under the Exchange Act.
(b)
Changes in internal controls
There were no significant changes to our internal controls or in other factors that could significantly affect our internal controls subsequent to the Evaluation Date.
PART III
ITEM 10
ITEM 10 - DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required by this Item 10 is hereby incorporated by reference from our definitive proxy statement, to be filed pursuant to Regulation 14A within 120 days after the end of our 2003 fiscal year.
ITEM 11
ITEM 11 - EXECUTIVE COMPENSATION
The information required by this Item 11 is hereby incorporated by reference from our definitive proxy statement, to be filed pursuant to Regulation 14A within 120 days after the end of our 2003 fiscal year.
ITEM 12
ITEM 12 - SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by this Item 12 is hereby incorporated by reference from our definitive proxy statement, to be filed pursuant to Regulation 14A within 120 days after the end of our 2003 fiscal year.
ITEM 13
ITEM 13 - CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by this Item 13 is hereby incorporated by reference from our definitive proxy statement, to be filed pursuant to Regulation 14A within 120 days after the end of our 2003 fiscal year.
PART IV
ITEM 15
ITEM 15 - EXHIBITS, FINANCIAL STATEMENTS SCHEDULES AND REPORTS ON FORM 8-K
*
The Registrant has applied with the Secretary of the Securities and Exchange Commission for confidential treatment of certain information pursuant to Rule 24b-2 of the Securities Exchange Act of 1934. The Registrant has filed separately with its application a copy of the exhibit including all confidential information, which may be made available for public inspection pending the Securities and Exchange Commission’s review of the application in accordance with Rule 24b-2.
**
Confidential treatment has been granted by the Securities and Exchange Commission with respect to certain information in the exhibit pursuant to either Rule 406 of the Securities Act of 1933 or Rule 24b-2 of the Securities Exchange Act of 1934, as the case may be. Such information was omitted from the filing and filed separately with the Secretary of the Securities and Exchange Commission.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of San Jose, State of California, on September 29, 2003.
Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons in the capacities and on the dates indicated.
BAM! Entertainment, Inc.
Index to Consolidated Financial Statements
INDEPENDENT AUDITORS’ REPORT
To the Board of Directors and Stockholders of
BAM! Entertainment, Inc.:
We have audited the accompanying consolidated balance sheets of BAM! Entertainment, Inc. and its subsidiaries (the “Company”) as of June 30, 2003 and 2002, and the related consolidated statements of operations, stockholders’ equity (deficit) and comprehensive loss, and cash flows for each of the three years in the period ended June, 30, 2003. Our audits also included the financial statement schedule listed in item 15(a). These financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on the financial statements and financial statement schedule based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such financial statements present fairly, in all material respects, the financial position of the Company as of June 30, 2003 and 2002, and the results of its operations and its cash flows for each of the three years in the period ended June, 30, 2003 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.
These condensed financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 1 to the financial statements, the Company has incurred a substantial net loss for the year ended June 30, 2003 of $36.2 million and has used cash in operating activities of $10.5 million. As of June 30, 2003, the Company had cash and cash equivalents of $1.1 million and its accumulated deficit was $59.8 million. These factors, among others, raise substantial doubt about the Company’s ability to continue as a going concern for a reasonable period of time. Management’s plan concerning this matter is also described in Note 1. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.
DELOITTE & TOUCHE LLP
San Jose, California
September 26, 2003
BAM! ENTERTAINMENT, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(in thousands, except share data)
See notes to consolidated financial statements
BAM! ENTERTAINMENT, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts)
See notes to consolidated financial statements
BAM! ENTERTAINMENT, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (DEFICIT) AND COMPREHENSIVE
LOSS (in thousands, except share amounts)
[Additional columns below]
[Continued from above table, first column(s) repeated]
See notes to consolidated financial statements
BAM! ENTERTAINMENT, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
See notes to consolidated financial statements
BAM! ENTERTAINMENT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
For the years ended June 30, 2003, 2002, and 2001
1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Organization and Business - BAM! Entertainment, Inc. and subsidiaries (the “Company”) is a developer and publisher of interactive entertainment software products for popular interactive entertainment hardware platforms and personal computers. The Company licenses popular properties that have consumer recognition and appeal from a wide variety of sources and publishes software based on their motion picture, television, sports and cartoon character properties. The Company sells its software to mass merchandisers and independent distributors.
Principles of Consolidation - These consolidated financial statements include the Company and its wholly-owned subsidiaries in the United Kingdom. All intercompany transactions and balances have been eliminated in consolidation.
Going Concern and Liquidity Uncertainties - These consolidated financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. As shown in these consolidated financial statements, during the year ended June 30, 2003, the Company used cash in operating activities of $10.5 million and incurred a net loss of $36.2 million. As of June 30, 2003, the Company had cash and cash equivalents of $1.1 million and its accumulated deficit was $59.8 million. These factors, among others, raise substantial doubt about the Company’s ability to continue as a going concern for a reasonable period of time. The consolidated financial statements do not include any adjustments relating to the recoverability and classification of assets or the amounts and classification of recorded liabilities that might be necessary should the Company be unable to continue as a going concern.
During the year ended June 30, 2003, the Company undertook measures to reduce spending and restructured its operations. In February 2003 the Company retained, through July 31, 2003, the investment banking firm of Gerard Klauer Mattison & Co., Inc. to assist it in reviewing a range of potential strategic alternatives, including mergers, acquisitions and additional financing. No transactions arose from this assistance or were consummated during this period. The Company may need to either consummate one or a combination of the potential strategic alternatives, or otherwise obtain capital via sale or license of certain of its assets, in order to satisfy its future liquidity requirements. The Company is also not in compliance with the liquidity covenants under its current line of credit, and may not be able to obtain advances under the line until it is back in compliance. The Company currently has no funds advanced to it under the agreement. If the Company is unsuccessful in its efforts to comply with the liquidity requirements of its line of credit, or obtain another line of credit to replace the existing line, it may not be able to fund inventory purchases in the future. Current market conditions present uncertainty as to the Company’s ability to effectuate any merger or acquisition or secure additional financing, as well as its ability to reach profitability. There can be no assurances that the Company will be able to effectuate any such merger or acquisition or secure additional financing, or obtain favorable terms on such financing if it is available, or as to the Company’s ability to achieve positive cash flow from operations. Continued negative cash flows create significant uncertainty about the Company’s ability to implement its operating plan and the Company may have to further reduce the scope of its planned operations. If cash and cash equivalents, together with cash generated from operations, are insufficient to satisfy the Company’s liquidity requirements, the Company will not have sufficient resources to continue operations for the next six months.
As of June 30, 2003, the Company had $4.0 million, $1.1 million and $89,000 of capitalized development costs, current and long-term prepaid royalties and licensed assets, respectively, related to software development projects in progress. Should the Company not be able to effectuate either a merger or acquisition or to secure sufficient additional financing, part or all of these development projects in progress might have to be abandoned and the related costs would have to be written off.
Reclassifications - Certain 2002 and 2001 amounts have been reclassified to conform with 2003 presentation. Such reclassifications had no effect on net revenues, net loss or shareholders’ equity.
Stock Split - On August 15, 2001, the Company effected a common stock split of 4.7 to one with an adjusted par value of $0.001 and increased the number of authorized shares of common stock to 100,000,000 shares and preferred stock to 10,000,000 shares. All common share and per share amounts in these consolidated financial statements have been adjusted to give effect to this stock split.
Foreign Currency Translation - The functional currency for the Company’s foreign operations is the applicable local currency. The translation of the applicable foreign currencies into U.S. dollars is performed for balance sheet accounts using exchange rates in effect at the balance sheet date and for revenue and expense accounts using a weighted-average exchange rate during the period. The gains or losses resulting from such translation are reported as a separate component of equity as accumulated other comprehensive income (loss), whereas gains or losses resulting from foreign currency transactions are included in results of operations.
Use of Estimates - The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Such estimates include, but are not limited to: allowances for price protection, uncollectible accounts receivable, sales returns and cooperative advertising; inventory valuations; recoverability of prepaid royalties, capitalized software costs and licensed assets; depreciation and amortization; taxes and contingencies. Actual results could differ from those estimates.
Certain Significant Risks - Financial instruments which potentially subject the Company to concentrations of credit risk consist primarily of cash and cash equivalents and accounts receivable. Cash and cash equivalents are held with financial institutions and consist primarily of cash in bank accounts. The Company generates revenue primarily from large retailers in the United States and generally does not require its customers to provide collateral or other security to support accounts receivable. To reduce credit risk, management performs ongoing credit evaluations of its customers’ financial condition and maintains allowances for estimated potential bad debt losses.
The Company participates in a dynamic high-technology industry and believes that changes in any of the following areas could have a material adverse effect on the Company’s future financial position, results of operations or cash flows: ability to obtain future financing; advances and trends in new technologies and industry standards; competitive pressures in the form of new and more popular products by competitors; changes in the overall demand by customers and consumers for products offered by the Company; unexpected quantities of product returns and price protection allowances; changes in certain strategic relationships or customer relationships; the loss of significant customers; litigation or claims against the Company based on intellectual property, patent, product, regulatory or other factors; the inability to procure the necessary third-party licenses or proprietary software needed to develop its products; risks associated with changes in domestic and international economic and/or political conditions or regulations; risks associated with regulation within the industry; availability of necessary product components; the Company’s ability to attract and retain employees necessary to support its growth; the Company’s reliance on senior management; the Company’s limited operating history; inability to manage the growth of the business; delays and cost overruns on products under development; risks associated with development of products by third-party developers; failure to anticipate changing consumer preferences; dependence on hardware manufacturers for the provision of the platforms necessary to generate revenue; the Company’s inability to protect its proprietary rights or to avoid claims from other companies; short product life cycles; and the reliance on platform manufacturers in manufacturing the Company’s products.
Cash and Cash Equivalents - The Company considers all highly liquid debt instruments purchased with maturities at the date of purchase of three months or less to be cash equivalents. The recorded carrying amounts of the Company’s cash and cash equivalents approximate their fair market value due to their short maturities.
Short-term investments - The Company invests excess cash in what the Company believes to be high quality and easily marketable instruments to ensure that cash is readily available for use in its current operations. Accordingly, all marketable securities are classified as “available-for-sale” in accordance with the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 115. All investments are reported at fair market value with the
related unrealized holding gains and losses reported as a component of accumulated other comprehensive income (loss).
Inventories - Inventories, which consist of finished goods, are stated at the lower of cost (based upon the first-in, first-out method) or market value. The Company estimates the net realizable value of slow moving inventories on a product-by-product basis and charges the excess of cost over net realizable value to cost of revenues.
Property and Equipment - Property and equipment are stated at cost. Depreciation is computed using the straight-line method over the estimated useful lives of the assets of three years.
Prepaid Royalties - Advance royalty payments for intellectual property licenses are capitalized and recorded as prepaid royalties. Royalty payments for intellectual property licenses are classified as current assets to the extent they relate to anticipated sales during the subsequent year and long-term assets if the sales are anticipated after one year. Royalty payments are based on sales and royalties are generally payable on a quarterly basis. Prepaid royalties are amortized to cost of revenues commencing upon the product release at the greater of the contractual royalty rate based on actual product sales, or the ratio of current revenues to total projected revenues. The Company evaluates the future recoverability of prepaid royalties on a quarterly basis and expenses them to costs of revenue if and when they are deemed unrecoverable.
Capitalized Software Costs and Licensed Assets - The Company utilizes independent software developers (who are paid advances against future royalties) to develop its software. The Company accounts for prepaid royalties relating to development agreements and capitalized software costs in accordance with SFAS No. 86, Accounting for the Costs of Computer Software to be Sold, Leased, or Otherwise Marketed. Payments made to independent software developers under development agreements are capitalized to software development costs once technological feasibility is established or if the development costs have an alternative future use. Prior to establishing technological feasibility, software development costs are expensed to research and development and to cost of revenues subsequent to technological feasibility. Technological feasibility is evaluated on a product-by-product basis. For products where proven game engine technology exists, this may occur early in the development cycle.
Commencing upon product release, capitalized software development costs are amortized to royalties, software costs, and license costs. Software development costs are expensed to royalties, software costs, and license costs if and when they are deemed unrecoverable. The following criteria are used to evaluate recoverability of software development costs: the commercial acceptance of prior products released on a given hardware platform; orders for a product prior to its release; and actual development costs of a product as compared to forward-looking projections. Amortization of such costs is based on the greater of the proportion of current revenues to total projected revenues, or the straight-line method over the estimated product life (generally three to six months). The Company evaluates the future recoverability of capitalized amounts on a quarterly basis. Research and development costs are expensed as incurred.
If the Company terminates a development project prior to completion, it expenses the capitalized software development costs and licensed assets costs to project abandonment.
Fair Value of Financial Instruments - The Company’s financial instruments include cash equivalents, short-term investments and short-term debt. Cash equivalents and short term-investments are stated at fair market value, based on quoted market prices. The recorded carrying amount of the Company’s short-term debt approximates fair value since such debt instruments bear interest at rates which approximate market rates.
Long-Lived Assets - The Company evaluates long-lived assets, such as property and equipment and certain identifiable intangibles for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by comparison of the carrying amount of an asset to future undiscounted net cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets, as defined in SFAS No. 144, Accounting for the Impairment or Disposal of Long- Lived Assets.
Income Taxes - The Company accounts for income taxes under an asset and liability approach. Deferred income taxes reflect the impact of temporary differences between assets and liabilities recognized for financial reporting purposes and such amounts recognized for income tax reporting purposes, and operating loss and other tax credit carryforwards measured by applying currently enacted tax laws. Valuation allowances are provided when necessary to reduce net deferred tax assets to an amount that is more likely than not to be realized in the future.
Stock-Based Compensation - The Company accounts for stock-based awards to employees using the intrinsic value method in accordance with Accounting Principles Board Opinion (APB) No. 25, Accounting for Stock Issued to Employees, and to nonemployees using the fair value method in accordance with SFAS No. 123, Accounting for Stock-Based Compensation and in accordance with Emerging Issues Task Force (“EITF”) 96-18, Accounting for Equity Instruments That Are Issued To Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services. SFAS No. 148, Accounting for Stock-Based Compensation - Transition and Disclosure requires disclosure in the summary of significant accounting policies of the effects of an entity’s accounting policy with respect to stock-based employee compensation on reported net income and earnings per share in annual and interim financial statements. The Company adopted SFAS No. 148 on January 1, 2003.
Since the Company continues to account for its stock-based awards to employees using the intrinsic value method in accordance with APB No. 25, SFAS No. 123 requires the disclosure of pro forma net income (loss) as if the Company had adopted the fair value method. Under APB 25, stock-based compensation is based on the difference, if any, on the date of grant, between the fair value of the Company’s stock and the exercise price. Unearned compensation is amortized using the multiple option award valuation and amortization approach method and expensed over the vesting period of the respective options.
The following table illustrates the effect on net loss and net loss per share if the company had applied the fair value recognition provisions of SFAS 123 to stock-based employee compensation. For purposes of SFAS 123 pro forma disclosures, the estimated fair value of the options is amortized to expense over the options’ vesting period (in thousands):
Redeemable Convertible Preferred Stock Dividend - Beneficial conversion charges arise in connection with financing arrangements where the Company has issued redeemable convertible preferred stock at a discount to the deemed fair market value of the common stock of the Company at the commitment date, which is generally the date of issuance. Depending on the nature and purpose of the arrangement, the Company values the beneficial conversion feature by subtracting the related effective conversion price from the deemed fair value of the Company’s common stock, and then multiplying the difference by the number of shares of common stock that would be issued upon conversion. The value of the beneficial conversion
feature and accretes this value over the expected period that the redeemable convertible preferred stock becomes convertible.
Revenue Recognition - The Company recognizes revenue in accordance with Statement of Position 97-2, Software Revenue Recognition, and related interpretations, when persuasive evidence of an arrangement exists, delivery has occurred, the price has been fixed or is determinable and collectibility has been reasonably assured. This occurs when finished goods in the form of software on a cartridge, CD-ROM or similar media are shipped to the customer. Under certain conditions, the Company may allow customers to exchange and return its products and from time to time provide price protection or allow returns on certain unsold merchandise in the form of a credit against amounts due from the customer. On a product by product basis, revenue from product sales is reflected net of the allowance for returns and price protection. The Company estimates the amount of future returns, and price protection based upon current known circumstances and historical results.
Cost of Revenues - Cost of revenues includes manufacturing costs of the finished goods, freight, inventory management costs, royalties incurred, software amortization, project abandonment, and amortization of non-cash charges related to warrants and rights to acquire common stock issued to production companies.
Advertising - Advertising and sales promotion costs are generally expensed as incurred, except for television airtime and print media costs associated with media companies which are deferred and charged to expense as the airtime or advertising space is used for the first time. Advertising costs were $3,076,000, $5,701,000 and $2,160,000 for the years ended June 30, 2003, 2002, and 2001, respectively.
Net Loss per Share - Basic earnings/(loss) per share (EPS) excludes dilution and is computed by dividing net earnings/(loss) attributable to common shareholders by the weighted average number of common shares outstanding for the period excluding the weighted average common shares subject to repurchase. Diluted EPS reflects the potential dilution that could occur if securities or other contracts to issue common stock (redeemable convertible preferred stock, common stock options and warrants using the treasury stock method) were exercised or converted into common stock. Potential common shares in the diluted EPS computation are excluded in net loss periods as their effect would be antidilutive.
Comprehensive Income (Loss) - In fiscal 2000, the Company adopted SFAS No. 130, Reporting Comprehensive Income, which requires that an enterprise report, by major components and as a single total, the change in its net assets during the period from nonowner sources. Comprehensive loss for the years ended June 30, 2003, 2002 and 2001 have been disclosed within the statement of stockholders’ equity (deficit).
Recently Adopted and Issued Accounting Pronouncements - In June 2001, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 141, Business Combinations, and SFAS No. 142, Goodwill and Other Intangible Assets. SFAS No. 141 requires that all business combinations initiated after June 30, 2001 be accounted for under the purchase method and addresses the initial recognition and measurement of goodwill and other intangible assets acquired in a business combination. SFAS No. 142 addresses the initial recognition and measurement of intangible assets acquired outside of a business combination and the accounting for goodwill and other intangible assets subsequent to their acquisition. SFAS No. 142 provides that intangible assets with finite useful lives be amortized and that goodwill and intangible assets with indefinite lives not be amortized, but will instead be tested at least annually for impairment. The Company was required to adopt SFAS No. 142 no later than for its fiscal year beginning July 1, 2001. The Company did not carry any goodwill or other intangibles on its balance sheet as of June 30, 2002, and the adoption of SFAS No. 142 did not have a material effect on the Company’s consolidated financial position or results of operations.
In June 2001, the FASB issued SFAS No. 143, Accounting for Asset Retirement Obligations. SFAS No. 143 addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. This statement is effective for fiscal years beginning after June 15, 2002, however earlier application is permitted. The Company adopted SFAS No. 143 on July 1, 2002. The adoption of this statement did not have a material effect on the Company’s consolidated financial position or results of operations.
In August 2001, the FASB issued SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, which addresses financial accounting and reporting for the impairment or disposal of long-lived assets. While SFAS No. 144 supersedes SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of, it retains many of the fundamental provisions of SFAS No. 121. SFAS No. 144 also supersedes the accounting and reporting provisions of APB No. 30, Reporting the Results of Operations-Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions, for the disposal of a segment of a business. However, it retains the requirement in APB No. 30 to report separately discontinued operations and extends that reporting to a component of an entity that either has been disposed of (by sale, abandonment, or in a distribution to owners) or is classified as held for sale. The Company adopted SFAS No 144 on July 1, 2002. The adoption of SFAS No. 144 did not have a material effect on the Company’s consolidated financial position or results of operations.
In June 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities, which addresses accounting for restructuring and similar costs. SFAS No. 146 supersedes previous accounting guidance, principally EITF 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit on Activity (including Certain Costs Incurred in a Restructuring). The Company was required to adopt SFAS No. 146 for restructuring activities initiated after December 31, 2002, and the Company adopted SFAS No. 146 on January 1, 2003. SFAS No. 146 requires that the liability for costs associated with an exit or disposal activity be recognized when the liability is incurred. Under EITF 94-3, a liability for an exit cost was recognized at the date of a commitment to an exit plan. SFAS No. 146 also established that the liability should initially be measured and recorded at fair value. The adoption of SFAS No. 146 did not have a material effect on the Company’s consolidated financial position or results of operations.
In November 2002, the FASB issued FIN No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others. The interpretation elaborates on the existing disclosure requirements for most guarantees, including loan guarantees such as standby letters of credit. It also clarifies that at the time a company issues a guarantee, the company must recognize an initial liability for the fair value, or market value, of the obligations it assumes under the guarantee and must disclose that information in its interim and annual financial statements. The provisions related to recognizing a liability at inception of the guarantee for the fair value of the guarantor’s obligations do not apply to product warranties or to guarantees accounted for as derivatives. The disclosure requirements are effective for financial statements of interim or annual periods ending after December 15, 2002, and the initial recognition and initial measurement provisions apply on a prospective basis to guarantees issued or modified after December 31, 2002. The Company adopted FIN No. 45 on January 1, 2003. The adoption of FIN No. 45 did not have a material effect on the Company’s consolidated financial position or results of operations.
In December 2002, the FASB issued SFAS No. 148, Accounting for Stock-Based Compensation - Transition and Disclosure. SFAS No. 148 amends SFAS No. 123, Accounting for Stock-Based Compensation. Although it does not require use of fair value method of accounting for stock-based employee compensation, it does provide alternative methods of transition. It also amends the disclosure provisions of SFAS No.123 and APB No. 28, Interim Financial Reporting, to require disclosure in the summary of significant accounting policies of the effects of an entity’s accounting policy with respect to stock-based employee compensation on reported net income and earnings per share in annual and interim financial statements. SFAS No. 148’s amendment of the transition and annual disclosure requirements is effective for fiscal years ending after December 15, 2002. The amendment of disclosure requirements of APB No. 28 is effective for interim periods beginning after December 15, 2002. The Company adopted SFAS No. 148 and APB No.28 on January 1, 2003.
In January 2003, the FASB issued FIN No. 46, Consolidation of Variable Interest Entities-an interpretation of ARB No. 51. FIN No. 46 addresses the consolidation of variable interest entities (“VIEs”). A VIE is a corporation, partnership, trust or other legal structure used for business purposes that either does not have equity investors with substantive voting rights or has equity investors that do not provide sufficient financial resources for the entity to support its activities. A VIE often holds financial assets and may either be passive or engage in activities such as research and development or other activities on behalf of other companies. FIN No. 46 requires a VIE to be consolidated by a company if that company is subject to a majority of the VIE’s risk of loss or if it is entitled to receive a majority of the VIE’s residual returns or both. The company that consolidates a VIE is referred to as the primary beneficiary of that entity. The consolidation requirements of FIN No. 46 apply to VIEs created after January
31, 2003. For VIEs existing prior to January 31, 2003, consolidation requirements are effective in the first fiscal year or interim period beginning after June 15, 2003. Certain disclosure requirements apply in all financial statements issued after January 31, 2003 regardless of when the VIE was established. The Company adopted FIN No. 46 on January 31, 2003. The adoption of FIN No. 46 did not have a material effect on the Company’s consolidated financial position or results of operations.
In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity, which requires mandatorily redeemable financial instruments to be classified as liabilities, the result of which requires related expense to be classified as interest expense rather than minority interest on a prospective basis. SFAS No. 150 is effective in the three months ended June 30, 2003 for financial instruments entered into or modified after May 31, 2003, and is otherwise effective July 1, 2003 for previously issued instruments. SFAS No. 150 is not expected to have a material impact on the Company’s consolidated financial position or results of operations.
2. SHORT TERM INVESTMENTS
The Company has classified all of its short-term investments as available-for-sale securities, as the sale of such securities may be required prior to maturity to implement management strategies. As of June 30, 2003, the Company did not hold any short-term investments. As of June 30, 2002, the Company’s short-term investments comprised U.S. Government Securities of $3,402,000, Corporate Notes of $1,058,000 and Foreign Debt Securities of $3,725,000, with original maturities ranging between 90 days and two years. Unrealized holding gains on the portfolio as of June 30, 2002 were $52,000.
3. PREPAID ROYALTIES
Prepaid royalties consisted of the following at June 30:
Long term prepaid royalties are included in Other Assets.
4. PROPERTY AND EQUIPMENT, NET
Property and equipment consisted of the following at June 30:
Included in furniture, equipment and leasehold improvements are assets leased under capital lease agreements of $80,000 and $0 as of June 30, 2003 and 2002, respectively. Total accumulated depreciation on assets leased under capital lease agreements were $29,000 and $0 as of June 30, 2003 and 2002, respectively.
5. RECEIVABLES
Trade accounts receivable
Accounts receivable, net of allowances, is comprised of the following at June 30:
Long-term receivable
On January 22, 2002 Kmart, a customer of the Company, filed voluntary petitions for reorganization under Chapter 11 of the U.S. Bankruptcy Code. On January 22, 2002 the Company had an accounts receivable balance from Kmart of $1.7 million. The Company was an unsecured creditor, and as such was at risk of not recovering in full its accounts receivable balance. Accordingly, in the year ended June 30, 2002 the Company recorded an allowance of $1.1 million against the receivable. As Kmart stated that at earliest it would complete its reorganization in May 2003, the Company classified the receivable, net of allowance, as a long-term asset.
In the year ended June 30, 2003 Management reevaluated and increased the allowance to cover the full accounts receivable balance.
Subsequent to January 22, 2002 Kmart arranged debtor-in-possession financing and the Company sold product to Kmart under this arrangement. The Company also purchased credit insurance for sales made to Kmart during October and November 2002 at a cost of $900,000. Credit insurance costs are included in general and administrative expense.
Accounts receivables under the debtor-in-possession financing were classified as current assets.
Kmart completed its reorganization and emerged from Chapter 11 on May 6, 2003. Under its plan of reorganization Kmart will distribute Kmart Corporation common stock to the unsecured creditors on a pro-rata basis, at an approximate recovery rate of 9.7% on approved payables. Kmart has yet to distribute to the Company any of this common stock, and is unable to state when it will make such distribution or how much the distribution to the Company will be. Accordingly, the Company did not account for any potential recoverable sums as of June 30, 2003.
6. OTHER ASSETS
Other assets as of June 30, 2003 and 2002 comprise rent deposits of $54,000 and $30,000, respectively, and long term prepaid royalties of $0 and $1.8 million, respectively.
7. SHORT-TERM BORROWINGS
In September 2003, the Company entered into a six month Agreement (the “Agreement”) with a finance company, pursuant to which the finance company extends a line of credit facility to fund domestic inventory purchases to the Company. The Company may sell the inventory purchased under the Agreement and is required to remit customer receipts from those sales directly to the finance company up to the amounts funded by them. The Company retains
collections in excess of the amounts funded by the finance company, is responsible for collecting the customer receivables, and bears the risk of loss on all uncollectible accounts.
Under the Agreement, the finance company’s aggregate outstanding funding is limited to $3.2 million. The Company is required to pay the finance company’s expenses under the contract, a facility fee equal to 5.0% of the funds advanced by the finance company, and interest at prime plus 0.5%. The Agreement terminates on March 31, 2004 and any sums outstanding become repayable on that date. The Company may repay any sums advanced prior to the due date of payment without penalty.
The finance company has a security interest in the Company’s accounts receivable and inventory.
Prior to entering into the Agreement, the Company had entered into a two year factoring agreement (the “Factoring Agreement”) with a different finance company in February 2002, pursuant to which the Company assigned its North American receivables to the finance company. The finance company was responsible for collecting customer receivables, and upon collection, remitted the funds to the Company, less a service fee. Under the Factoring Agreement, the Company could obtain advances, subject to the finance company’s discretion and the Company’s compliance with certain liquidity covenants, in the form of cash or as collateral for letters of credit, up to a maximum of 75% of outstanding domestic receivables at any point in time. The Factoring Agreement was mutually terminated in September 2003.
Under the terms of the Factoring Agreement, the Company paid a service fee on all receivables assigned, with a minimum annual fee of $150,000, interest at prime plus 1% on all cash sums advanced. Upon the termination of the Factoring Agreement, the minimum annual fee for the second year of the Factoring Agreement was waived, and the Company paid a termination payment of $25,000. All fees were included in interest expense. The Company bore the collection risk on the accounts receivable that were assigned, unless the finance company approved the receivable at the time of assignment, in which case the finance company bore the risk. The finance company had a security interest in the Company’s accounts receivable, inventory, fixed assets and intangible assets.
As of June 30, 2003 the Company did not meet the Factoring Agreement’s liquidity covenants and had no sums advanced under the Factoring Agreement. As of June 30, 2002, the Company had advances of $1,359,000 outstanding under the Factoring Agreement.
Prior to entering into the Factoring Agreement, the Company had entered into a finance agreement (the “Finance Agreement”) with a different finance company, whereby it assigned purchase orders entered into with customers to the finance company and requested the finance company purchase finished goods to fulfill such customer purchase orders.
The Finance Agreement, entered into in February 2000, specified that the finance company’s funding commitment with respect to a customer purchase order should not exceed 60% of the retail purchase order price. Under the Finance Agreement the finance company’s aggregate outstanding funding (i.e., advance of funds or purchase of finished goods to fulfill customer purchase orders) was limited to $5.0 million. The Company was responsible for collecting customer receivables, bore the risk of loss on all uncollectible accounts, and was required to remit customer receipts directly to the finance company up to the amounts funded by the finance company. The Company retained collections in excess of the amounts funded by the finance company.
Under the initial terms of the Finance Agreement, the Company was required to pay the finance company’s expenses under the contract, a deal fee (consisting of a transaction and initiation fee equal to 5.0% of the face amounts of letters of credit issued or other funds advanced by the finance company), a daily maintenance fee of 0.067%, a materials advance fee at prime rate plus 4.0% and a late payment fee where applicable; all of which are included in interest expense.
In August 2001, the Company amended the Finance Agreement, initially increasing the aggregate outstanding funding amount to $10.0 million, and then decreasing the transaction and initiation fee to 3% until the earlier of the termination of the agreement or December 31, 2001, if the Company’s initial public offering had not occurred by that date. The Company completed its initial public offering in November 2001. In connection with this latter
amendment and the execution of a $7.0 million factoring arrangement with an affiliate of the finance company, the Company issued a warrant to the finance company to purchase 100,000 shares at an exercise price of $8.00.
Upon the signing of the Finance Agreement, the Company paid the finance company a security deposit of $90,000. An extension payment of $50,000 was made when the contract was amended in December 2000, and a further amendment fee of $120,000 was incurred when the contract was amended in August 2001. These costs were recorded as interest expense.
Outstanding borrowings under the Finance Agreement were collateralized by the Company’s inventories, accounts receivable, fixed assets and intangible assets.
The Finance Agreement and the factoring line with the affiliate terminated in February 2002, and all outstanding amounts funded were fully repaid.
As of June 30, 2003 the Company had no outstanding letters of credit issued on its behalf. As of June 30, 2002, the Company had outstanding letters of credit issued on its behalf of $2,286,000.
8. REDEEMABLE CONVERTIBLE PREFERRED STOCK AND COMMON STOCK
Redeemable Convertible Preferred Stock
Under the Company’s certificate of incorporation, as amended on August 15, 2001, the Company is authorized to issue 10,000,000 shares of redeemable convertible preferred stock. The Company issued 976,220 shares of Series A redeemable convertible preferred stock on June 30, 2000 for cash, services and through the conversion of promissory notes. On December 28, 2000, the Company issued 294,620 shares of Series B redeemable convertible preferred stock and on May 24, 2001, the Company issued 245,659 shares of Series C redeemable convertible preferred stock. Upon completion of the Company’s initial public offering in November 2001, each outstanding share of the Company’s issued redeemable convertible preferred stock automatically converted into 4.7 shares of the Company’s common stock.
Common Stock
In October 1999, the Company issued 580,962 shares of common stock to its founder in exchange for a note receivable from the founder. Also in October 1999, the Company issued 274,950 shares at $0.11 per share to consultants in exchange for services performed valued at $30,000.
In June 2000, an additional 614,060 shares were issued at $0.11 per share in exchange for cash of $59,000 and services valued at $7,000.
In November 2001, the Company completed its initial public offering, selling 5,750,000 common shares at $8.00 per share. Upon the closing, each outstanding share of the Company’s redeemable convertible preferred stock automatically converted into 4.7 shares of the Company’s common stock, resulting in the issuance of 7,127,528 shares of common stock.
As more fully described in Note 16, in September 2002 the Company issued 68,738 shares of common stock pursuant to a license agreement with a production company. The Company capitalized the cost of this issuance at the fair market value of the common stock, equal to $70,000, and fully amortized this amount to “royalties, software costs, and license costs” during the year ended June 30, 2003. The Company had previously issued 68,738 shares of common stock pursuant to this license agreement in April 2001. The Company capitalized the cost of this issuance at the fair market value of the common stock, equal to $746,000, and fully amortized this amount to “royalties, software costs, and license costs” during the year ended June 30, 2002.
During the year ended June 30, 2003, 26,796 shares of common stock were issued under the Company’s employee share purchase plan. During the year ended June 30, 2002, 20,562 shares of the Company’s common stock were
issued upon exercise of stock options, 4,956 shares of common stock were issued under the Company’s employee share purchase plan, and 141,000 shares of the Company’s common stock were issued upon exercise of a warrant.
Warrants
Warrants to purchase a total of 878,450 and 853,450 shares of common stock were outstanding as of June 30, 2003 and 2002, respectively.
Under an agreement (the “Agreement”) entered into with a production company during October 2000, the Company obtained the exclusive right of first refusal, for a period of five years, to develop products based on films produced by the production company and to distribute them worldwide. The Agreement was mutually terminated in June 2003. Under the Agreement the production company provided the Company with free access to any publicity materials it prepared. In exchange for these rights, the Company paid royalties to the production company calculated as a percentage of sales of the developed products. Also, in connection with the Agreement the Company issued the production company warrants to purchase 470,000 shares of common stock at an exercise price of $1.06 per share. The warrants expire in September 2006. Under the warrant agreement, 50% of the warrants became vested and exercisable upon execution of the Agreement, while the remaining warrants became vested in equal portions in December 2000, representing the dates on which the production company delivered, in accordance with the Agreement, written notice that a specific film will be available to be exploited by the Company and when the Company exercised its right of first refusal for another film under the Agreement. The fair value of these warrants at the grant date was estimated to be $708,000, using the Black-Scholes option pricing model with the following assumptions: expected term equal to six years; risk-free interest rate of 5.8%; volatility of 95%; and no dividends during the expected term. Of this amount $354,000 relates to 50% of the warrants that vested upon execution of the Agreement and was being amortized on a straight-line basis over the five-year term of the Agreement. During the years ended June 30, 2003, 2002, and 2001, $53,000, $71,000 and $48,000, respectively, was amortized to royalties, software costs, and license costs. Upon termination of the Agreement in June 2003, all previously unamortized sums, totaling $182,000, were amortized to project abandonment costs. The remaining 50% of the warrants vested in December 2000 and the fair value of these warrants of $556,000 were capitalized to prepaid royalties, capitalized software costs and licensed assets. The fair value of this 50% of the warrants was estimated at the date of vesting using the Black-Scholes option pricing model with the following assumptions: expected term equal to six years; risk-free interest rate of 5.0%; volatility of 95%; and no dividends during the expected term. During the year ended June 30, 2003, $278,000 was amortized to royalties, software costs, and license costs on the release of a subject title, and the remaining $278,000 was amortized to project abandonment costs on the termination of a development project prior to completion.
In connection with the Series B redeemable convertible preferred stock offering, the Company issued warrants to a service provider to purchase 141,000 shares of its common stock at an exercise price of $3.76 per share. The warrants expired on the earlier of either (i) December 2003, (ii) upon the completion of a public offering of common stock with aggregate proceeds greater than $15,000,000 and at a price per share not less than $15.96 per share or (iii) upon the completion of a subsequent private equity financing or in the event of a change in control, sale or disposition of substantially all of the Company’s assets or recapitalization, reclassification or reorganization of the Company’s stock resulting in aggregate proceeds greater than $10,000,000 and at a price per share not less than $7.45 per share. The value of these warrants at the grant date was estimated using the Black-Scholes option pricing model with the following assumptions: expected term equal to three years; risk-free interest rate of 5.1%; volatility of 95%; and no dividends during the expected term. The fair value of these warrants of $283,000 was recorded as an issuance cost against the proceeds of the Series B redeemable convertible preferred stock offering. The warrant was exercised during the year ended June 30, 2002.
In connection with the Series C redeemable convertible preferred stock offering, the Company issued warrants to a service provider to purchase 16,450 shares of its common stock at an exercise price of $4.80 per share. In November 2001, this warrant was amended to increase the exercise price to $16.50 per share. The warrants expire in May 2006. The value of these warrants at the grant date was estimated using the Black-Scholes option pricing model with the following assumptions: expected term equal to five years; risk-free interest rate of 5.1%; volatility of 95%; and no dividends during the expected term. The fair value of these warrants of $159,000 was recorded as an issuance cost against the proceeds of the Series C redeemable convertible preferred stock offering.
The Company calculated the beneficial conversion feature related to the issuance of the 245,659 shares of Series C redeemable convertible preferred stock, in accordance with EITF 00-27 “Application of Issue No. 98-5 to Certain Convertible Instruments” as follows:
•
The Company calculated the difference between the aggregate deemed fair market value of the common stock into which the Series C redeemable convertible preferred stock is convertible of $13,200,000, and the aggregate purchase price paid for the Series C redeemable convertible preferred stock of $5,540,000, i.e. $7,660,000, and limited the amount of the deemed dividend that will be recorded against the accumulated deficit to the gross amount of proceeds allocated to these shares of Series C redeemable convertible preferred stock to $5,540,000 in accordance with paragraph 6 of EITF 98-5 “Accounting for Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion Ratios”
•
Since the shares of Series C redeemable convertible preferred stock were immediately convertible at the date of issue, the Company recorded the amount of the deemed dividend in the financial statements for the year ended June 30, 2001.
In May 2001, in exchange for legal services rendered by a service provider in connection with a proposed initial public offering, the Company issued warrants to purchase 47,000 shares of its common stock at an exercise price of $4.80 per share. The warrants expire in May 2006. The value of these warrants at the grant date was estimated using the Black-Scholes option pricing model with the following assumptions: expected term equal to five years; risk-free interest rate of 5.1%; volatility of 95%; and no dividends during the expected term. The fair value of these warrants of $456,000 was capitalized to other assets and was recorded as an issuance cost in connection with the Company’s initial public offering.
In connection with a Finance Agreement, as described in Note 7, the Company issued a warrant in August 2001 to a finance company to purchase 100,000 shares at an exercise price equal to $8 per share, being the initial public offering price. The fair value of the warrant was initially estimated to be $806,000 at the time of issuance of the warrant, then subsequently remeasured at $485,000 at the time of the initial public offering using the Black-Scholes option pricing model with the following assumptions: expected term equal to three years; risk-free interest rate of 2.9%; volatility of 95%; and no dividends during the expected term, The fair value was capitalized to prepaid expenses and was amortized to interest expense over the term of the Finance Agreement, which ended in February 2002. During the year ended June 30, 2002, the $485,000 was amortized to interest expense.
In connection with an agreement entered into with a production company during January 2002, the Company obtained the exclusive right of first refusal, for a period of five years, to develop products based on certain properties owned by the production company and to distribute them worldwide. In exchange for these rights, the Company will have to pay royalties to the production company calculated as a percentage of sales of the developed products. Also, in connection with the agreement, the Company is required to issue to the production company warrants to purchase up to 50,000 shares of common stock, in pre-determined multiples of either 5,000 or 10,000 shares, upon the occurrence of certain pre-determined events. Warrants will be issued at the average closing price of the Company’s stock for the five days immediately prior to the date of issuance, have a five year term from date of issuance, are fully vested and are immediately exercisable upon issuance. The Company has issued warrants to purchase 35,000 shares of common stock under this agreement as follows: January 2002 - warrant to purchase 10,000 shares, March 2002 - warrant to purchase 10,000 shares, July 2002 - warrant to purchase 5,000 shares, and May 2003 - warrant to purchase 10,000 shares. The fair value of the warrant to purchase 10,000 shares issued in January 2002 was estimated to be $42,000 at the grant date, using the Black-Scholes option pricing model with the following assumptions: expected term equal to five years; risk-free interest rate of 4.3%; volatility of 95%; and no dividends during the expected term. The fair value of the warrant to purchase 10,000 shares issued in March 2002 was estimated to be $44,000 at the grant date, using the Black-Scholes option pricing model with the following assumptions: expected term equal to five years; risk-free interest rate of 4.8%; volatility of 95%; and no dividends during the expected term. The fair value of the warrant to purchase 5,000 shares issued in July 2002 was estimated to be $8,000 at the grant date, using the Black-Scholes option pricing model with the following assumptions: expected term equal to five years; risk-free interest rate of 4.7%; volatility of 88%; and no dividends during the expected term. The fair value of the warrant to purchase 10,000 shares issued in May 2003 was estimated to be $3,000 at the grant date, using the Black-Scholes option pricing model with the following assumptions: expected term equal to five years; risk-free interest rate of 2.3%; volatility of 139%; and no dividends during the expected
term. The fair values of the warrants were capitalized to prepaid royalties, capitalized software costs and licensed assets and will be amortized over the life of the products (generally between three and six months) to which they relate when these products are released. As the remaining 15,000 warrants contingently issuable under this arrangement are dependent upon the occurrence of certain pre-determined events, the Company will only measure the value of these warrants in accordance with EITF 96-18 Accounting for Equity Instruments That Are Issued To Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services if and when the warrants are issued. When the software product is released, the Company will amortize the non-cash charge over the life of the product, which is expected to be between three and six months. The Company cannot estimate the aggregate dollar amount of these future non-cash charges as they are based on the Company’s share price at a future point in time. During the year ended June 30, 2003, $8,000 was amortized to project abandonment costs. No costs were amortized to royalties, software costs, and license costs during the years ended June 30, 2002 and 2001.
In May 2002, in connection with a licensing and publishing agreement entered into with a publishing company, the Company granted to the production company a warrant, with a ten year term from the date of issue, to purchase up to 200,000 shares of its common stock at an exercise price of $2.60, of which 15,000 became immediately exercisable upon the signing of the agreement, and the remaining 185,000 only become exercisable in multiples of 4,625 shares upon each election by the Company to produce a title based on any films, made for television movies, or television series produced from screenplays to be produced by the publishing company, up to a maximum ten titles, and multiples of 13,875 shares upon the theatrical release or television air-date of each film for which the Company develops a title. Upon expiration of the agreement, any unexercised warrants will cease to be exercisable. The agreement was assigned to another production company in July 2002. The agreement expires upon the later of five years or either the theatrical release or television air-date of the tenth film or television series on which the Company bases a product, but in no event later than eight years from the date of the agreement, unless seven films or television series have been released or aired, respectively, seven years from the date of the agreement, in which event the agreement would expire at such time. The fair value of the 15,000 shares immediately exercisable upon the signing of the agreement was estimated to be $29,000 at the grant date, using the Black-Scholes option pricing model with the following assumptions: expected term equal to five years; risk-free interest rate of 4.6%; volatility of 95%; and no dividends during the expected term.
The fair value of the remaining 185,000 shares will be calculated as and when shares become exercisable and will be capitalized to prepaid royalties, capitalized software costs and licensed assets. As the warrants contingently exercisable under this arrangement are dependent upon the occurrence of certain pre-determined events, the Company will only measure the value of these warrants in accordance with EITF 96-18 Accounting for Equity Instruments That Are Issued To Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services if and when the warrants become exercisable. When the software product is released, the Company will amortize the non-cash charge over the life of the product, which is expected to be between three and six months. The Company cannot estimate the aggregate dollar amount of these future non-cash charges as they are based on the Company’s share price at a future point in time. The Company fully amortized the licensed asset of $29,000 to royalties, software costs, and license costs during the year ended June 30, 2003. No costs were amortized to royalties, software costs, and license costs during the years ended June 30, 2002 and 2001.
In January 2003, the Company issued a warrant to a developer to purchase up to 10,000 shares of common stock. The warrant was issued at the average closing price of the Company’s stock for the five days immediately prior to the date of issue, has a five year term from date of issue, and is fully vested and is immediately exercisable upon issuance. The fair value of the warrant was estimated to be $4,000 at the grant date, using the Black-Scholes option pricing model with the following assumptions: expected term equal to five years; risk-free interest rate of 4.0%; volatility of 125%; and no dividends during the expected term. The fair value of the warrant was expensed to research and development in the year ended June 30, 2003.
Stock Plans
Under the Company’s 2000 Stock Incentive Plan adopted on July 10, 2000, and amended in May 2001, August 2001 and August 2002, the Company may grant options to purchase or directly issue up to 3,500,000 shares of common stock to employees, directors and consultants at prices not less than the fair market value (as determined by the Board of Directors) at the date of grant for incentive stock options and not less than 85% of fair market value at the
date of grant for nonstatutory stock options. These options generally vest over a four-year period and expire ten years from the date of grant.
In August 2001, the Company adopted the 2001 Stock Incentive Plan (UK Part) (the “UK Plan”) as Schedule A to the 2000 Stock Incentive Plan. The UK Plan provides for the grant of stock options to UK employees who satisfy certain criteria. The UK Plan contains certain restrictions intended to comply with UK taxation laws, including restrictions on exercise, limitations on the size of options grants, requirements with respect to changes in capitalization and other matters.
The Board of Directors, in their determination of fair market value on the date of grant, takes into consideration many factors including, but not limited to, the Company’s stock price on the Nasdaq SmallCap Market, the Company’s financial performance, current economic trends, actions by competitors, market maturity, emerging technologies, near-term backlog and, in certain circumstances, valuation analyses performed by independent appraisers. These valuation analyses utilize generally accepted valuation methodologies such as the income and market approaches to valuing the Company’s business.
Stock option activity, including stock option activity outside the plan, is summarized as follows:
During the years ended June 30, 2003, 2002, and 2001, the Company granted stock options outside the plan to acquire 0, 268,800, and 0 shares, respectively. There were stock options outside the plan to acquire 268,800 shares outstanding as of both June 30, 2003 and 2002.
Additional information regarding options outstanding as of June 30, 2003 is as follows:
As of June 30, 2003 and 2002 there were 1,443,632 and 38,895 shares, respectively, of common stock available for future grant under the plan.
Employee Stock Purchase Plan
The Company adopted an employee stock purchase plan on August 9, 2001. Under the plan, during consecutive six-month offering periods, eligible employees are allowed to have salary withholdings of up to 15% of their compensation to purchase shares of common stock at a price equal to 85% of the lower of the market value of the stock at the beginning of the offering period or at the end of the purchase period. The initial offering period commenced upon the effective date of the initial public offering of the Company’s common stock. For the first offering period, shares of common stock were purchased at a price equal to 85% of the lower of the price per share in the initial public offering or the market value on the purchase date. The Company initially reserved 705,000 shares of common stock under this plan. In the year ended June 30, 2003, the Company issued 26,796 shares of common stock under the plan. In the year ended June 30, 2002, the Company issued 4,956 shares of common stock under the plan.
As of June 30, 2003 and 2002 there were 673,248 and 700,044 shares, respectively, of common stock available for issuance under the plan.
Deferred Stock Compensation
As discussed in Note 1, the Company accounts for its stock-based awards to employees using the intrinsic value method in accordance with APB No. 25. Accordingly, the Company records deferred stock compensation equal to the difference between the grant price and deemed fair value of the Company’s common stock on the date of grant. Deferred stock compensation is being amortized to expense over the vesting period of the options, generally four years, using a multiple option award valuation approach, which results in accelerated amortization of the expense resulting in amortization of deferred stock compensation of $418,000, $1,223,000, and $618,000 for the years ended June 30, 2003, 2002, and 2001, respectively. Deferred stock compensation aggregated $(90,000) credit for the year ended June 30, 2003 and was comprised of deferred stock compensation credits arising on stock option cancellations in the year as a result of using a multiple option award valuation and amortization approach. Deferred stock compensation aggregated $(84,000) credit for the year ended June 30, 2002 and was comprised of $129,000 of deferred stock compensation on new option grants less $213,000 of deferred stock compensation credits arising on stock option cancellations in the year as a result of using a multiple option award valuation and amortization approach. Deferred stock compensation aggregated $2,714,000 for the year ended June 30, 2001.
During the year ended June 30, 2003, the Company made three grants of options to purchase a total of 17,000 shares of common stock to a consultant at a weighted average exercise price of $0.63 per share. These options vested on the date of grant and expire ten years from the date of grant, or three months after the consultant ceases to provide service if earlier. The Company expensed the fair value of these options at the grant dates which was estimated to be
$12,000 using the Black-Scholes option pricing model with the following assumptions: expected term equal to 10 years; risk-free interest rate between 3.0% and 3.1%; volatility between 101% and 125%; and no dividends during the expected term. The consultant ceased providing service in May 2003.
During the year ended June 30, 2002, the Company granted options to purchase 5,875 shares of common stock to a consultant at a weighted average exercise price of $11.70 per share. These options vested on the date of grant and expire ten years from the date of grant, or three months after the consultant ceases to provide service if earlier. The Company expensed the fair value of these options at grant date which was estimated to be $62,000 using the Black-Scholes option pricing model with the following assumptions: expected term equal to 10 years; risk-free interest rate of 5.0%; volatility of 95%; and no dividends during the expected term.
9. COST OF REVENUES - ROYALTIES, SOFTWARE COSTS, LICENSE COSTS, AND PROJECT ABANDONMENT
Cost of Revenues - Royalties, software costs, and license costs include amortization of non-cash licensed assets of $431,000, $817,000 and $48,000 for the years ended June 30, 2003, 2002, and 2001, respectively.
Royalties, software costs, and license costs include amortization of impaired royalties of $2,171,000, $0 and $0 for the years ended June 30, 2003, 2002, and 2001, respectively.
Project abandonment costs include amortization of non-cash licensed assets of $467,000, $0 and $0 for the years ended June 30, 2003, 2002, and 2001, respectively.
During the years ended June 30, 2003, 2002 and 2001, the Company amortized $14,675,000, $9,600,000 and $954,000, respectively, of capitalized software costs as part of royalties, software costs, and licensed assets, and recorded $9,133,000, $693,000 and $0, respectively, of capitalized software costs as part of project abandonment costs.
10. RESTRUCTURING COSTS
In November 2002, the Company initiated a restructuring of its operations. As part of the restructuring, the Company reduced its headcount across all departments, by a total of 30 employees, and certain members of the Company’s management also agreed to a reduction of salary for the period December 2002 through June 2003. As compensation for the reduction, those members of management taking the salary reduction were granted stock options in the Company. The Company's Chief Executive Officer was granted a total of 116,978 options, and other management were granted a total of 174,167 options, under this arrangement. The Company also transferred, under UK law, an additional 12 product development employees to VIS Entertainment plc upon the sale of its London based studio in January 2003.
Restructuring costs, which included employee severance payments, write down costs on property and equipment, and legal fees associated with the disposal of the London based studio, for the year ended June 30, 2003, were as follows (in thousands):
As part of this restructuring, during the year ended June 30, 2003 the Company wrote off $1.302 million of capitalized development costs and included such costs in Cost of Revenues - Project Abandonment costs.
11. INCOME TAXES
Income taxes were $0 for the each of the years ended June 30, 2003, 2002, and 2001.
Significant components of the Company’s net deferred tax assets consist of the following as of June 30:
The Company established a 100% valuation allowance at June 30, 2003 and 2002 due to the uncertainty of realizing future tax benefits from its net operating loss carryforwards and other deferred tax assets.
At June 30, 2003, the Company has federal and state net operating loss carryforwards of approximately $27,821,000 and $23,280,000, respectively, expiring through 2023 and 2013, respectively. Foreign net operating loss carryforwards at June 30, 2003 are approximately $6,001,000. During the years ended June 30, 2003, 2002, and 2001, the Company utilized $0, $373,000 and $370,000 of federal net operating losses, respectively, to offset taxable income.
Current federal and California laws include substantial restrictions on the utilization of net operating losses and credits in the event of an “ownership change” of a corporation. Accordingly, the Company’s ability to utilize net operating loss and tax credit carryforwards may be limited as a result of such “ownership change.” Such a limitation could result in the expiration of carryforwards before they are utilized.
The Company’s effective tax rate differs from the federal statutory rate as follows:
12. COMPUTATION OF LOSS PER SHARE
The following table sets forth the computations of basic and diluted loss per share:
The following table summarizes common stock equivalents that are not included in the denominator used in the diluted net loss per share calculation because to do so would be antidilutive for the periods indicated:
13. EMPLOYEE BENEFIT PLANS
In January 2000, the Company adopted a 401(k) tax deferred savings plan (the 401(k) Plan) to provide for retirement of its employees. Employee contributions are limited to a maximum amount subject to IRS guidelines in any calendar year. The Company may make matching contributions and employer profit sharing contributions at the Board of Directors’ discretion. For the years ended June 30, 2003, 2002, and 2001, the Company made employer contributions to the 401(k) Plan of $207,000, $125,000, and $41,000, respectively.
In March 2001 the Company’s UK subsidiary set up a Group Personal Pension Plan to provide for retirement of its employees. Employee contributions are limited to a maximum amount subject to the UK Inland Revenue guidelines. For participants, the UK subsidiary contributes three percent of basic salary plus a half percent for each additional one percent contribution in excess of three percent. For the years ended June 30, 2003, 2002, and 2001, the Company’s UK subsidiary made employer contributions to the Group Personal Pension Plan of $82,000, $84,000, and $22,000, respectively.
14. BUSINESS SEGMENT AND GEOGRAPHIC INFORMATION
As defined by the requirements of SFAS No. 131, Disclosures About Segments of an Enterprise and Related Information, the Company operates in one reportable segment: the development and publishing of interactive entertainment products.
Financial information by geographical region is summarized below:
15. CUSTOMER CONCENTRATIONS
The following table summarizes net revenues and accounts receivable for customers which accounted for 10% or more of net revenues or gross trade accounts receivable:
16. COMMITMENTS, CONTINGENCIES, GUARANTEES AND LEGAL PROCEEDINGS
Commitments, Contingencies and Guarantees
Under an agreement entered into between the Company and a production company, the Company has a first look right to review screenplays acquired by the production company and to develop products based on films produced from those screenplays. In exchange for these rights, the Company will have to pay royalties to the production company calculated as a percentage of sales of the developed products. For each film (up to a total of ten films) that the Company selects, 68,738 fully vested and non-forfeitable shares of common stock will be issued following the theatrical release of each film for which the Company has developed a product, up to a maximum of 687,375 shares of common stock. As the shares contingently issuable under this arrangement are dependent upon the theatrical release of the film for which the Company has elected to develop products, the Company will only measure the value of these shares in accordance with EITF 96-18 Accounting for Equity Instruments That Are Issued To Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services if and when this contingency is satisfied. If the software product is released after the release of the film, the Company will amortize the non-cash charge over the life of the product, which is expected to be between three and six months. If the software product is released prior to the release of the film, the Company will at each interim period assess whether it is probable that the value of the shares issuable is recoverable through future sales of the product to which it relates. If this is probable, the non-cash charge will be amortized to licensed costs over the life of the product, while the Company will expense the non-cash charge at the time of the issuance of the shares if it is not probable that the value of the shares issued is recoverable through future sales of the product to which these shares relate. The Company cannot estimate the aggregate dollar amount of these future non-cash charges as they are based on the Company’s share price at a future point in time. As of June 30, 2003 and 2002 the Company has elected to produce software products for three films pursuant to this agreement. One of these films had its theatrical release during the year ended June 30, 2001 and another had its theatrical release during the year ended June 30, 2002. Accordingly, the Company has issued 137,476 shares of common stock to the production company to date. The Company is not required to issue stock on the remaining film until such time as the film is released, which is anticipated to be in the summer of calendar year 2004.
In connection with an agreement entered into with a production company during January 2002, the Company obtained the exclusive right of first refusal, for a period of five years, to develop products based on certain properties
owned by the production company and to distribute them worldwide. In exchange for these rights, the Company will have to pay royalties to the production company calculated as a percentage of sales of the developed products. Also, in connection with the agreement, the Company is required to issue to the production company warrants to purchase up to 50,000 shares of common stock, in pre-determined multiples of either 5,000 or 10,000 shares, upon the occurrence of certain pre-determined events. Warrants will be issued at the average closing price of the Company’s stock for the five days immediately prior to the date of issuance, have a five year term from date of issuance, are fully vested and are immediately exercisable upon issuance. The Company has issued warrants to purchase 35,000 shares of common stock under this agreement as follows: January 2002 - warrant to purchase 10,000 shares, March 2002 - warrant to purchase 10,000 shares, July 2002 - warrant to purchase 5,000 shares, and May 2003 - warrant to purchase 10,000 shares. As the remaining 15,000 warrants contingently issuable under this arrangement are dependent upon the occurrence of certain pre-determined events, the Company will only measure the value of these warrants in accordance with EITF 96-18 Accounting for Equity Instruments That Are Issued To Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services if and when the warrants are issued. When the software product is released, the Company will amortize the non-cash charge over the life of the product, which is expected to be between three and six months. The Company cannot estimate the aggregate dollar amount of these future non-cash charges as they are based on the Company’s share price at a future point in time.
In May 2002, in connection with a licensing and publishing agreement entered into with a publishing company, the Company granted the production company a warrant, with a ten year term from the date of issue, to purchase up to 200,000 shares of its common stock at an exercise price of $2.60, of which 15,000 became immediately exercisable upon the signing of the agreement, and the remaining 185,000 only become exercisable in multiples of 4,625 shares upon each election by the Company to produce a title based on any films, made for television movies, or television series produced from screenplays to be produced by the publishing company, up to a maximum ten titles, and multiples of 13,875 shares upon the theatrical release or television air-date of each film for which the Company develops a title. Upon expiration of the agreement, any unexercised warrants will cease to be exercisable. The agreement expires upon the later of five years, and the earlier of either the theatrical release or television air-date of the tenth film or television series on which the Company bases a product, and eight years. The fair value of the remaining 185,000 shares will be calculated as and when shares become exercisable and will be capitalized to prepaid royalties, capitalized software costs and licensed assets. As the warrants contingently exercisable under this arrangement are dependent upon the occurrence of certain pre-determined events, the Company will only measure the value of these warrants in accordance with EITF 96-18 Accounting for Equity Instruments That Are Issued To Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services if and when the warrants become exercisable. When the software product is released, the Company will amortize the non-cash charge over the life of the product, which is expected to be between three and six months. The Company cannot estimate the aggregate dollar amount of these future non-cash charges as they are based on the Company’s share price at a future point in time. The agreement was assigned by the production company to another production company in July 2002. Under various licensing agreements entered into between the Company and content providers, the Company had contractual marketing commitments to spend $4,450,000 and $6,150,000 in advertising on the content providers’ networks and online mediums as of June 30, 2003 and 2002, respectively. As of June 30, 2003 and 2002, the Company had made payments totaling $3,337,000 and $3,202,000, respectively, under these agreements. Future minimum annual advertising payments under these contractual marketing commitments are as follows:
In connection with a number of licensing and developing agreements, the Company is required to pay guaranteed minimum royalties with respect to these agreements. As of June 30, 2003 and 2002, the Company had capitalized payments totaling $5,865,000 and $4,422,000 respectively under these agreements. These guaranteed amounts will be applied against future royalties that may become payable to the respective licensors under the agreement. Future minimum annual royalty payments under these contractual licensing and developing commitments are as follows:
Under a two year factoring agreement as described in Note 7, which commenced in February 2002, a minimum annual service fee of $150,000 is payable to the factoring company. The fee becomes payable based on the volume of receivables factored. As of June 30, 2003 the Company had a commitment to incur a further $104,000 in minimum annual service fees prior to February 2004.
The Company leases facilities under various noncancelable operating leases. Future minimum annual rental payments under the lease agreements, net of sub-lease income, are as follows:
The Company leases equipment under various noncancelable capital leases. Future minimum annual rental payments under the lease agreements are as follows:
Rent expense for the years ended June 30, 2003, 2002, and 2001, was $518,000, $389,000, and $135,000, respectively.
As of June 30, 2003 and 2002, a finance company had a continuing security interest in the Company’s domestic accounts receivable, inventory, fixed assets and intangible assets against advances made under a factoring agreement between the finance company and the Company. The Company accounts for all cash advances made under the agreement as a current liability and for outstanding letters of credit as a contingent liability. As of June 30, 2003 and 2002, the Company had letters of credit outstanding under the agreement of $0 and $2.3 million, respectively.
The Company offers a limited warranty on products sold. The Company does not maintain a general warranty reserve as estimated future warranty costs are accounted for in price protection and return reserves accrued at the time of sale of the Company’s products.
Legal Proceedings
From time to time the Company may be involved in litigation relating to claims arising out of its operations in the ordinary course of business. As of June 30, 2003, the Company was party to the following legal proceedings:
On April 1, 2003, Amaze Entertainment, Inc. asserted counterclaims against the Company in an action captioned BAM! ENTERTAINMENT INC. v. AMAZE ENTERTAINMENT, INC. et. al. that the Company commenced in the Superior Court of California, County of Santa Clara (Case No. CV814820) on February 18, 2003, and which Amaze had removed to the United States District Court for the Northern District of California (Case No. C03 01286 PVT) on or about March 24, 2003. The Company's action asserted claims for, inter alia, relief based on rescission, breach of contract, declaratory relief, and money paid and received with regard to an agreement for a video game titled “Crushed Baseball” that Amaze Entertainment was developing for the Company. Amaze Entertainment’s counterclaims alleged breach of contract and unjust enrichment with regard to each of the “Crushed Baseball” development agreement and a separate development agreement for another video game titled “Samurai Jack.” The counterclaims seeked, inter alia, compensatory damages of approximately $3.5 million and additional damages to be proven at trial. On July 11, 2003 Amaze and Bam agreed to compromise and settle all claims either asserted or that could be asserted in connection with the dispute and to mutually release any and all future claims and contentions they have against each other. This compromise requires Amaze to make Bam two payments, one in July 2003 and one in October 2003 of $325,000 each. Bam has received the first of these two payments. No income related to either of these payments has been recorded as of June 30, 2003. Under the terms of the settlement, the agreement to settle would have been terminated and considered null and void if Amaze had given Bam notice by August 13, 2003 that it has failed to enter into an agreement with Warner Bros. Consumer Products Inc. allowing Amaze to commercially exploit the Samurai Jack product. Amaze did not give such notice by August 13, 2003, and to Bam’s knowledge, the settlement agreement is in effect. The settlement agreement stipulates that upon payment by Amaze to Bam of the sum due in October 2003, the parties will execute a stipulation for dismissal of the legal actions. Accordingly, the litigation remains unsettled at this time, and management believes it is too early to predict the outcome.
On March 27, 2003, a complaint captioned OVATION ENTERTAINMENT, LLC v. BAM! ENTERTAINMENT, INC. et. al. was filed against the Company in the Superior Court of California, County of Los Angeles (Case No. SCO76530). The complaint alleged, inter alia, claims of breach of contract and fraud against the Company in connection with an exclusive first look agreement, which was assigned to Ovation Entertainment by the licensor originally party to the agreement, for content relating to motion pictures and television projects to be licensed to the Company for development in connection with video games. The lawsuit sought, inter alia, compensatory damages believed to be in excess of $1 million and interest thereon, exemplary or punitive damages, and attorneys’ fees. On August 4, 2003, Ovation and Bam agreed to settle the litigation by amending the terms of the agreement, and the legal action was dismissed on August 25, 2003. Bam does not believe that the amendment will have a material adverse effect on Bam’s financial position or results of operations.
17. RELATED PARTY TRANSACTIONS
In October 1999, the Company issued 580,962 shares of common stock to an officer in exchange for a note receivable from the officer. The note was repaid in April 2001.
In November 1999 the Company entered into an agreement to lease its principal facilities under a noncancelable operating lease. As a condition of this agreement, an officer of the Company entered into a separate agreement with the lessor to guarantee the Company’s obligations under the agreement. The guarantee was terminated in April 2002.
In February 2000, the Company entered into an agreement with a financing company to finance the purchase of materials required to produce products. As a condition of this agreement, an officer of the Company entered into a separate agreement with the financing company to guarantee the Company’s obligations under the agreement. The guarantee lapsed in February 2002.
In November 2000, the Company entered into a revolving note agreement with a bank. The note was secured by a personal guarantee from an officer of the Company and by a security interest in a money market account maintained at the bank in the name of a director of the Company. The guarantee and security interest lapsed in December 2000.
The Company incurred legal services of $56,000, $290,000 and $195,000 for the years ended June 30, 2003, 2002, and 2001, respectively, to a law firm whose partner served as a Director of the Company from October 1999 through November 2002 and who currently serves as Secretary of the Company.
18. QUARTERLY FINANCIAL DATA (unaudited)
19. SUBSEQUENT EVENTS
In July 2003, the Company entered into a distribution agreement with Acclaim Entertainment Ltd (“Acclaim”) whereby Acclaim agreed to distribute, on an exclusive basis, certain forthcoming products of the Company in PAL territories. PAL is the television standard for the United Kingdom, continental Europe and Australia. Acclaim will be responsible for the manufacture, sale, distribution and marketing of the products and will pay the Company based on net receipts from the sales made by them.
In August 2003, Robert W. Holmes, Jr. and Steven J. Massarsky both resigned from the Board of Directors to pursue other interests.
In August 2003, the Company entered into a Promissory Note with a Director whereby the Director loaned the Company $250,000. The loan, which bears interest at 6% per annum, is repayable on or before October 31, 2003.
In September 2003, the Company entered into a six month Agreement (the “Agreement”) with a finance company, pursuant to which the finance company extends a line of credit facility to fund domestic inventory purchases to the Company. The Company may sell the inventory purchased under the Agreement and is required to remit customer receipts from those sales directly to the finance company up to the amounts funded by them. The Company retains collections in excess of the amounts funded by the finance company, is responsible for collecting the customer receivables, and bears the risk of loss on all uncollectible accounts. Under the Agreement, the finance company’s aggregate outstanding funding is limited to $3.2 million. The Company is required to pay the finance company’s expenses under the contract, a facility fee equal to 5.0% of the funds advanced by the finance company, and interest at prime plus 0.5%. The Agreement terminates on March 31, 2004 and any sums outstanding become repayable on that date. The Company may repay any sums advanced prior to the due date of payment without penalty. The Company’s factoring agreement with a different finance company was mutually terminated in September 2003.
See also Note 16 - Legal Proceedings for a description of other subsequent events.
SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS
S-1