Back to GetFilings.com
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
----------------
FORM 10-K
(Mark One)
[X]ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT
OF 1934
For the fiscal year ended: December 31, 2000
OR
[_]TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the transition period from to
Commission File Number 000-25977
----------------
LIQUID AUDIO, INC.
(Exact name of Registrant as specified in its charter)
Delaware 77-0421089
(State or other jurisdiction of (I.R.S. Employer Identification Number)
incorporation or organization)
2221 Broadway Redwood City, California 94063
(address of principal executive offices) (zip code)
Registrant's telephone number, including area code: (650) 549-2000
----------------
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act: Common Stock,
$0.001 par value
----------------
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [_]
Indicate by check mark if disclosure of delinquent filers pursuant to item
405 of Regulation S-K is not contained herein, and will not be contained, to
the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [_]
The aggregate market value of voting stock held by non-affiliates of the
Registrant was approximately $44,919,341 as of December 31, 2000 based on the
closing price of the Common Stock as reported on The Nasdaq Stock Market for
that date. Shares of Common Stock held by each executive officer and director
and by each person who owns 5% or more of the outstanding Common Stock have
been excluded in that such persons may be deemed to be affiliates. The
determination of affiliate status is not necessarily a conclusive determination
for other purposes. There were 22,556,554 shares of the Registrant's Common
Stock issued and outstanding on March 14, 2001.
DOCUMENTS INCORPORATED BY REFERENCE
Certain sections of Liquid Audio, Inc.'s definitive Proxy Statement for the
2001 Annual Meeting of Stockholders, scheduled to be held on June 1, 2001, are
incorporated by reference in Part III of this Form 10-K to the extent stated
herein.
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
TABLE OF CONTENTS
Page
----
PART I
ITEM 1. BUSINESS...................................................... 1
ITEM 1A. COMPANY RISK FACTORS.......................................... 12
ITEM 2. PROPERTIES.................................................... 22
ITEM 3. LEGAL PROCEEDINGS............................................. 22
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS........... 23
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS....................................................... 24
ITEM 6. SELECTED FINANCIAL DATA....................................... 26
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS..................................... 27
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.... 35
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA................... 36
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING
AND FINANCIAL DISCLOSURE...................................... 36
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT............ 37
ITEM 11. EXECUTIVE COMPENSATION........................................ 41
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
MANAGEMENT.................................................... 41
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS................ 41
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM
8-K........................................................... 42
PART I
ITEM 1. BUSINESS
This Annual Report on Form 10-K and the documents incorporated herein by
reference contain forward-looking statements that have been made in reliance on
the provisions of the Private Securities Litigation Reform Act of 1995. These
forward-looking statements are based on current expectations, estimates and
projections about our industry, management's beliefs, and certain assumptions
made by management. Words such as "anticipates," "expects," "intends," "plans,"
"believes," "seeks" and "estimates" and similar expressions are intended to
identify forward-looking statements. These statements are not guarantees of
future performance and actual actions or results may differ materially. These
statements are subject to certain risks, uncertainties and assumptions that are
difficult to predict, including those noted in the documents incorporated
herein by reference. We undertake no obligation to update publicly any forward-
looking statements as a result of new information, future events or otherwise,
unless required by law. Readers should, however, carefully review the risk
factors included herein and in other reports or documents filed by us from time
to time with the Securities and Exchange Commission.
The Company
We provide a leading open platform that enables the digital delivery of
music over the Internet. Our software products and services give artists and
record companies the ability to create, syndicate and sell recorded music with
copy protection and copyright management through websites and retailers.
Through our Liquid Music Network, a network of over 1,000 third party music
related websites and retailers, we help artists and record companies
distribute, promote and sell their recorded music. From the growing catalog of
syndicated music which is available through our Liquid Music Network affiliates
and online stores using our Retail Integration and Fulfillment System,
consumers can preview and purchase digital music. Consumers then can transfer
downloaded music to recordable compact discs and to digital audio devices
manufactured by consumer electronics companies. Our solution is based on an
open technical architecture that is designed to support multiple leading
digital music formats, including Liquid Audio, MP3 and Microsoft Windows Media.
Numerous record companies and recording artists have used our distribution
system to sell music, including labels such as Artemis Records, Avex, Inc., BMG
Entertainment, EMI Music Group, Warner Music Group and Zomba Records Group, and
artists such as David Bowie, Lenny Kravitz, Aimee Mann, "N SYNC and Britney
Spears.
The Liquid Audio Platform
We provide a variety of products and services to enable the publication and
distribution, syndication, promotion and sale of downloadable digital music
files over the Internet:
. Publication and Distribution. We offer services to encode content as
secure digital music files and have the ability to encode up to
approximately 20,000 individual music samples per day. Our system hosts
digital music files and distributes them through a network of music
websites.
. Syndication. Our distribution system syndicates music content to a
network of 1,000 affiliates that make up the Liquid Music Network,
including music websites and websites operated by music retailers. In
addition, our system enables digital music delivery through kiosks
located in retail stores.
. Promotion and Sale. We offer services to manage the secure promotion,
transfer and sale of digital music, including reporting on digital music
sales. Our Liquid Player software, a desktop software application, allows
the consumer to preview or purchase and download digital recorded music.
Liquid Player also enables the output of digital music to recordable
compact discs and digital audio devices. To enable online sales, we
provide a set of e-commerce services, including credit card processing,
the remittance of royalty payments and detailed transaction reports. In
addition, we provide promotional services that help build market
awareness for content available through our network.
1
Our solution provides the following benefits:
. Increased Revenues and Lower Costs. Through our solution, record
companies and artists can generate increased revenues by offering
their entire catalog of existing music, as well as singles and
periodic releases, for sale online. Our products and services provide
a cost-effective way to digitally offer entire music catalogs to
consumers, thus reducing the costs associated with physical
manufacturing, warehousing and shipping.
. Superior Consumer Experience. Our solution enables consumers to
preview, purchase, download and export a wide variety of near compact
disc quality music online. We make it simple to search for, sample
and buy selected digital recorded music from a rapidly growing
inventory. Our Liquid Player also enables digital music to be
transferred to a compact disc by means of a recordable compact disc
device and output to digital audio devices. We further simplify the
user experience by supporting multiple music download formats,
including Liquid Audio, Windows Media and MP3.
. Security and Compliance. Our digital rights management (DRM) system
protects against piracy by authenticating, limiting and tracking the
number of copies made of a digitally delivered sound recording. Our
platform also includes patented territory restriction capabilities
that enable the sale over the Internet of digital recorded music in
compliance with geographic distribution limitations.
. Multiple Formats and Digital Rights Management Systems. Our multi-
format distribution solution is based on an open architecture and can
publish, syndicate and sell content using leading download formats,
including Liquid Audio, Windows Media and MP3. We also support
several leading DRM systems, including Liquid Audio, Windows Media
and Sony OpenMG.
. Global Reach. Our platform allows the Internet to be used as a global
distribution channel for artists, record companies and retailers.
This is particularly significant to independent record labels who
have limited access to traditional retail distribution channels.
Strategic Relationships and Customers
We plan to continue to build relationships with key third parties engaged in
the encoding, hosting, distribution, promotion, syndication and sale of digital
music. We believe that these relationships will enhance our ability to provide
a rich variety of music to consumers. Such relationships can be separated into
three major areas, the three C's--content, channel and consumer.
Content Provider Relationships. In the content area, several labels make
music available for sale and promotion through our distribution system and
network.
. BMG Entertainment. We entered into a digital music distribution agreement
with BMG Entertainment whereby BMG will use our technology and
distribution services to promote and sell albums from BMG's recording
artists through Liquid Audio kiosks at participating retailers in the
United States and Europe.
. edel music. In Europe, we entered into a digital music distribution
agreement with edel music whereby edel will use our technology and
distribution services to promote and sell albums from edel's recording
artists through kiosks at participating retailers.
. EMI Recorded Music. Under an agreement with Virgin Holdings, Inc., an
affiliate of EMI Recorded Music, in July 2000 we started to sell EMI
songs and albums through designated music destination and retail sites,
including CDNOW and towerrecords.com.
. Warner Music Group. Under an agreement with Warner Music Group, in
November 2000 we started to sell Warner songs and albums through our
Liquid Music Network.
. Zomba Records Group. Zomba has made songs and albums from some of the
most popular artists available for sale through the Liquid Music Network.
These artists include Britney Spears and "N SYNC.
2
. Independent Labels. Many independent record labels have chosen to make
their catalogs available online using our solution. These labels include
Artemis Records, Avex, Beggars Banquet, Del-Fi Records, Rounder Records,
Strictly Rhythm, Sub Pop Records, Twin/Tone Records and Vanguard Records.
As of December 31, 2000, record labels have chosen to promote and sell
more than 140,000 digital music recordings through our Liquid Music
Network. This compares to approximately 50,000 digital music recordings
at the beginning of 2000.
Channel Partners. Our distribution channel has grown to 1,000 outlets,
including some of the most popular music websites.
. Amazon.com. Under our agreement with Amazon.com, we are encoding, hosting
and delivering promotional music downloads for the free downloads section
of Amazon.com's music website, which is designed to increase compact disc
sales.
. Best Buy. Leading retailer Best Buy uses our Retail Integration and
Fulfillment System (RIFFS) to sell music from our catalog of content on
its bestbuy.com website.
. CDNOW. CDNOW uses RIFFS to promote and sell digital music to consumers
through its online retail website, cdnow.com. The website began offering
music from our catalog of content for sale in February 2000.
. Musicland. Musicland is using RIFFS for its destination sites,
SamGoody.com, Suncoast.com, OnCue.com and MediaPlay.com, and started
selling music from our catalog of content in August 2000.
. Towerrecords.com. Under an agreement with its parent company MTS, Inc.,
Tower Records is using RIFFS to promote and sell digital music to
consumers through its online retail website, towerrecords.com. The
website began offering music content for sale in October 1999.
. Yahoo! Yahoo! Inc. has integrated Liquid Audio music samples using our
music clips service on the Yahoo! Shopping and Yahoo! Music websites.
Consumer Adoption. We distribute music to millions of consumers in concert
with technology companies whose innovative products complement our digital
music distribution system. These include the following:
. AOL. We have developed a software "plug-in" that enables the AOL Nullsoft
Winamp player software to purchase and play music encoded in our format.
The plug-in will be distributed by AOL on the winamp.com website, its
other websites and ours.
. ARM. We have entered into an agreement with ARM to create a turnkey
platform for the development of secure digital audio devices. We will
work together to integrate our Secure Portable Player Platform (SP3) onto
the ARM architecture. This integration will make it easier for consumer
electronics and wireless device manufacturers to create new products,
using the same chip set platforms they are already using, that support
the playback of secure digital downloads distributed by us.
. Microsoft. To maximize the number of consumers getting music through our
distribution network, we added support for the Windows Media format. We
encoded and distribute more than 50,000 songs and 1 million music
previews in the Windows Media format. We deployed Windows Media-based
servers in our data centers to host and distribute that content to
retailers in our Liquid Music Network. We operate clearinghouse functions
for the Windows Media DRM system and are adding support for Windows Media
to Liquid Player.
. RealNetworks Inc. We have developed software "plug-ins" that enable
RealNetwork's RealPlayer G2 and RealJukebox software to play music
encoded in our format. The plug-ins, which are distributed by
RealNetworks, enable music in our Liquid Music Network to be previewed by
RealPlayer G2 users and securely downloaded by RealJukebox users.
. Sony. Sony delivers a custom-branded version of our Liquid Player
software to consumers with certain compact disc recorder (CD-R) devices
they sell in the United States and United Kingdom, as
3
well as to customers of its VAIO Music Clip and Memory Stick Walkman
devices. Additionally, we enable the distribution of content using Sony's
ATRAC3 and OpenMG technologies.
. Texas Instruments Inc. We collaborated with Texas Instruments to develop
a reference design based on our SP3 specification for secure music
delivery. Texas Instruments uses our SP3 reference design in chipsets to
enable future flash memory-based consumer electronics devices to be
compatible with our platform.
. Digital Audio Device Manufacturers. We are also collaborating with the
following companies to develop digital audio devices that interoperate
with our SP3 specification:
Aiwa PocketPyro Porteson
Digitalw@y Company, Ltd. RHAS TEL Company, Ltd.
e.Digital Corporation Saewon Telecom Ltd.
Haitai Electronics Co., Ltd. Sanyo Corporation
IOData RHAS TEL Company, Ltd.
Jungmyung Telecom TDK
Mpuls3 Toshiba Corporation
International Relationships
We believe that relationships with key partners outside the United States
are important to establish a complementary international distribution
infrastructure. Because personal computers have not achieved high levels of
penetration in most international markets, our emphasis in these markets has
been and will continue to be on enabling the distribution of digital music
through physical kiosks and other consumer-oriented technologies. Our
international relationships include the following:
. Liquid Audio Europe. We formed a wholly-owned subsidiary based in London.
Liquid Audio Europe is focused on selling our products and services to
markets in the United Kingdom, France, German, Italy and other European
countries. Several customers in Europe have adopted RIFFS.
. Liquid Audio Japan. In Japan, along with local investors, we established
Liquid Audio Japan. Liquid Audio Japan is the exclusive reseller and
distributor of our software products, and the exclusive music
distribution services provider, in Japan.
. Liquid Audio Korea. In Korea, Liquid Audio and local partners established
Liquid Audio Korea in 1998. Liquid Audio Korea is currently focused on
kiosk-based retail applications of our technology. These applications
allow consumers to preview and purchase custom compact discs and other
transportable media from retail entertainment centers. Liquid Audio Korea
released these kiosks in the first retail entertainment center in October
1999.
. Liquid Audio Greater China. For the Hong Kong and Taiwan markets, Liquid
Audio and local partners established Liquid Audio Greater China in 2000.
Liquid Audio Greater China and its subsidiaries have the opportunity to
deploy and resell Liquid Audio's secure music delivery services and
software products in Hong Kong and Taiwan.
. Liquid Audio South East Asia. In south east Asia, Liquid Audio and a
local partner are in the process of establishing Liquid Audio South East
Asia. Liquid Audio South East Asia will form affiliates in Singapore,
Thailand, the Philippines, Australia and New Zealand. We expect these
affiliates to be the exclusive reseller of our software products, and the
exclusive music distribution services provider, in those local markets.
4
Customers
We license our software and services to a variety of customers from various
market segments. A selected list of our customers includes the following, each
of which accounted for more than $10,000 of our revenues in 2000:
BMG North America Microsoft
Cube Napster
Duty Free Shops Random House
EMI Music Distribution Sony Electronics Inc.
HMV Sony UK
Launch.com Tower Records
In 1998, SKM Group accounted for 34% of our total net revenues. In 1999,
Adaptec, Super Stage and Liquid Audio Korea accounted for 31%, 30% and 12% of
our total net revenues, respectively. In 2000, Liquid Audio Japan and Liquid
Audio South East Asia through our strategic partner accounted for 42% and 11%
of our total net revenues, respectively.
Promotional Relationships. Numerous record labels and recording artists have
used our products and services to promote new releases and create consumer
awareness. These mutually beneficial promotional efforts have generated little
or no direct revenue for us, individually or in the aggregate. The following
table represents a partial list of artists and record labels for whom we have
provided promotional services:
Record Labels
- --------------------------------------------------------------------------------
Angel Records Arista Records Inc. Atlantic Records
Blue Note Records Capitol Records Dreamworks Records
Elektra Records EMI Recorded Music Epic Records
Geffen Records Giant/Revolution GRP
Hollywood Records Interscope Records Island Records/Def Jam
Jive LaFace Records Maverick Records
MCA Records Mercury Nashville RCA Records
Reprise Records Rhino Records Smithsonian Folkways
Tommy Boy Records TVT Records V2 Records
Virgin Warner Music Group Wind-up Entertainment
Zomba Records Group
Recording Artists
- ------------------------------------------------------------------------------
Aaron Neville Al Jarreau Alanis Morissette
A Perfect Circle Beck Ben Harper
Brian Setzer Orchestra Britney Spears Carlos Santana
Creed Crosby, Stills, Nash & Young The Dave Matthews Band
David Bowie Duran Duran Elton John
Emmylou Harris Enya Everclear
Faith Hill Hanson (Hed) Planet Earth
Herbie Hancock Hole Jamie O'Neal
Jimi Hendrix Joni Mitchell Kenny G
Led Zeppelin Lee Ann Womack Lenny Kravitz
Madonna matchbox twenty Moby
Natalie Merchant Nelly Furtado N'SYNCH
Page/Plant P.O.D. Sarah McLachlan
Scorpions Sinead O'Connor Snoop Dog
Tori Amos XTC
5
Products and Services
Our platform includes software products and services that enable the secure
digital delivery and sale of recorded music over the Internet. Our products and
services can be separated into three major areas: publishing and distribution,
syndication and consumer delivery.
Publishing and Distribution
Encoding Services. These services prepare music by artists and record
companies for publishing. We use software tools to set rules by which the
content can be used by consumers. Such software tools use security features,
including digital rights management (DRM), encryption and watermarking, to
provide copy protection. Our software tools also enable us to attach
descriptive text, such as lyrics or album liner notes, graphics such as compact
disc cover art, and copyright information to the music file. These are scalable
services and we have developed an automated high capacity encoding production
service that is currently able to encode up to approximately 20,000 individual
sample sound recordings per day.
Hosting Services. These services can store and serve digital music for
recording artists and labels. Content owners can use our services to feature
music links on their websites and promote and sell music. Since launching these
services in December 1997, more than 10,800 artists have used our hosting
services. These artists have made more than 140,000 songs available for
downloading either through the Liquid Music Network or their own websites.
Distribution Services. Content owners can leverage our distribution services
to deliver music through a network of more than 1,000 affiliates that offer our
music. They can also leverage these services to begin selling their music from
their own website.
Promotion Services. We provide promotional services that leverage the
Internet to help build awareness of artists and increase consumer traffic to
retail and music sites. Liquid Promotions include Internet advertisements,
promotional Internet events such as Liquid Live performances and featured
placement of artists' music on hundreds of websites.
Clearinghouse Services. Through our multi-format clearinghouse, we can clear
online financial transactions and manage rights reporting for music downloads
that are protected by either the Liquid Audio or Windows Media DRM solutions.
Our clearinghouse tracks streaming, downloading and purchase information and
records it in tamper-resistant logs. This information is used for commerce
management and to generate reports and invoices for the appropriate copyright
owners.
Music Meeting. Music Meeting is an Internet music auditioning service for
radio stations. We have partnered with Radio & Records (R&R) to develop,
promote and sell this service, which permits radio stations to retrieve
promotional copies of new songs via real-time stream or secure digital download
from the R&R ONLINE website. Using our digital music delivery software, Music
Meeting allows a radio station program director to audition and download new
music, organize new releases and get updates on a record's airplay progress via
R&R's various music charts. This service began in January 2001.
Syndication
Liquid Store. The Liquid Music Network, launched in July 1998, is a music
distribution network of more than 1,000 affiliates including music-related and
retail websites. We provide these music-related websites with the Liquid Store,
a ready-made online music store, including its own shopping cart, through which
consumers can preview, purchase and download digital recorded music from our
catalog of content. Liquid Music Network affiliates simply sign up for the
service and add hyperlinks to their home page to begin selling digital music.
Retail Integration and Fulfillment System (RIFFS). Liquid Audio's RIFFS
solution enables the sale of secure digital music through existing e-commerce
websites. RIFFS enables online retailers to seamlessly sell
6
our music catalog right alongside physical goods through their existing
shopping carts. Participating retailers can merchandise and offer any of the
music downloads we distribute. We host the music and transparently fulfill
digital delivery to the consumer. Regular reports let websites track download
and sales activity.
Liquid Commerce. For websites that have a search engine but are not e-
commerce enabled, we offer a pre-built online shopping cart that websites can
use to custom brand and leverage to sell music. Websites can supplement their
existing content with music from our catalog of content.
Digital Music Kiosks. We provide retailers with the ability to digitally
deliver music in brick-and-mortar stores using our platform through kiosks
located in entertainment centers or other retail locations. These digital music
kiosks let consumers preview and purchase custom compilations of songs and
transfer them to a personalized compact disc right in the store. The first
kiosk installation opened in Korea in October 1999. We have also sold kiosks to
customers in the United States, United Kingdom, Austria, Japan and Singapore.
Consumer Delivery
Liquid Player. Our Liquid Player is a consumer desktop software application
that enables users to stream, download and purchase digital music. To enhance
the consumer experience, our Liquid Player presents lyrics, liner notes and
album art with the music. Once content is downloaded, our Liquid Player can be
used to organize the content into playlists. Our Liquid Player can be easily
customized with faceplates to tie into the logo and branding of our partners'
websites and is available for both PC and Macintosh platforms. The product can
be downloaded free of charge from our website and currently is distributed by
the hundreds of websites in our Liquid Music Network. An enhanced version of
the product, Liquid Player Plus, adds capabilities for transferring digital
music to a recordable compact disc or outputting music to digital audio devices
for later playback. Delivered in 2000, Liquid Player Plus is the first Secure
Digital Music Initiative (SDMI) compliant digital music solution for original
equipment manufacturers (OEMs) who license the product for a fee to bundle with
their products, including digital audio devices, CD-R devices and personal
computers. SDMI is sponsored by the Recording Industry Association of America
(RIAA) to develop an open standard for the secure digital delivery and use of
recorded music.
Plug-ins. To expand our consumer base, we integrate our music delivery
system with those from several of our partners. We provide plug-in software for
AOL WinAmp, RealNetworks RealPlayer and RealJukebox to enable consumers using
these software products to preview and purchase content we distribute.
Technology
We have developed a technology platform and systems infrastructure that is
designed to optimize the digital delivery of music. Our platform is based on
four principal technology layers: component technologies, system technologies,
network services and content syndication. We have developed and deployed
technology in all of these layers to provide specific advantages for our music
delivery products and services. We have invested significant amounts toward
research and development to date. Our expenses in this area totaled
approximately $4.1 million, $11.7 million and $22.9 million in 1998, 1999 and
2000, respectively.
Component Technologies. Our platform begins with component technologies,
which include digital rights management, portable device platform, multi-format
distribution container, watermarking and audio compression.
. Digital Rights Management (DRM). Our DRM solution protects content
delivered online through a digital identification and rights reporting
system. Consumers can use our FastTrack Security technology to enjoy
secure music on one computer or use our Liquid Passport to move their
music to multiple machines while still providing anti-piracy protections.
. Consumer Electronics Technology. Our Secure Portable Player Platform
(SP3) provides content management and protection technology for consumer
electronic devices. We have developed specific
7
technologies to enable music to be securely copied to portable digital
audio devices. The SP3 system also provides a technology interface that
facilitates compatibility with other digital rights management systems.
. Multi-Format Distribution Container. We have developed a master media
container that facilitates the delivery of media through our system. This
container structure is designed to permit extension to other media types,
such as third-party formats or video. The container is optimized for
music distribution and includes multiple images that can be used to
preview and purchase media content in multiple formats including Liquid
Audio, MP3 and soon, Windows Media, and at multiple resolutions. The
multi-format nature of the container also facilitates compatibility
across systems. This container also facilitates the real-time insertion
of information such advertising and promotions.
. Watermarking. Watermarking embeds indelible and inaudible digital
information into the audio waveform. We have developed our own
watermarking technology that is specifically designed to operate in
conjunction with compression technologies. The embedded information is
useful for identifying and tracking audio usage and cannot be removed
without destroying the recorded music.
. Audio Compression. Audio compression reduces the bandwidth required to
stream and download music over network connections. Our format-neutral
music distribution system supports the delivery of music using several
leading compression technologies: Dolby Digital AC-3, AAC, Sony ATRAC3,
MS-Audio and MP3. We have developed a version of Dolby Digital technology
(AC-3) that is optimized for online music distribution. We have also
added extensions to the AAC audio compression technology that further
improve audio quality. In addition, we have developed an exclusive,
proprietary lossless compression algorithm that is useful for
professional audio applications.
System Technologies. Our system technologies build on top of the base
features provided through our component technologies to enable our digital
music delivery services.
. Liquid Server. Our Liquid Server software is the heart of our platform
and manages and delivers encoded music files for streaming or
downloading. We have built transaction, security and copyright management
functionality into the Liquid Server. We have integrated this software
with a variety of e-commerce and database software applications so that a
large volume of digital music and associated information can be securely
sold or distributed through the Internet.
. Territory Restrictions. We have been awarded a patent by the U.S. Patent
Office for the territory restrictions capabilities in our platform. This
technology identifies the approximate geographic location of consumers.
We use this technology to enforce rules for content access related to
territory. This enforcement is necessary since complex worldwide music
licensing arrangements often preclude the sale of some content in
specific territories.
. Open Interfaces. We have developed interfaces to third-party systems for
commerce, databases and general purpose media delivery. Our commerce
interfaces allow our platform to take advantage of many payment methods
from credit cards to micro-payment solutions. The database interfaces
allow our system to dynamically update time sensitive information, such
as pricing, without requiring expensive re-encoding of content. Our
third-party system interfaces permit us to connect and provide
compatibility with general purpose media delivery systems such as those
provided by RealNetworks and Microsoft Corporation.
. Secure Protocols. We have created secure protocols for communication
between all parts of the system. Secure communications are necessary to
prevent theft of content as it moves through the system. Secure links
exist between the Liquid Server and content creation tools for
publishing, the server and Liquid Player for consumer downloading, and
the server and clearinghouse for transaction reporting.
. Device Interfaces. We have developed SP3, which provides a set of
security interfaces and techniques for secure digital audio devices. SP3
is an open specification for use by many device manufacturers. SP3 is
consistent with the goals of the SDMI and is in use by several leading
device manufactures.
8
Network Services and Content Syndication. The implementation of our
component and system technologies enables us to provide our network services
and content syndication offerings. Our network services are driven out of the
Liquid Operations Center, which operates primarily as a processing, security,
copyright management and rights reporting center. Our content syndication
services encompass RIFFS, the Liquid Store and kiosks.
We believe that our technology architecture and our advanced stage of
development and deployment provide distinct competitive advantages. We are
currently developing the sixth generation of our digital music delivery
products. The advantages of our technology are summarized below:
. Content Distribution Technology. We have developed systems and technology
to manage the distribution of content to online merchants such as
retailers and service providers. This distribution technology automates
and controls the terms for which content is made available to consumers
via online retailers and service providers. This system also provides
distribution tracking that facilitates customer support for online
merchants.
. Automated Encoding, Publication and Content Management. We have created
technologies that improve the efficiency of online music distribution and
reduce operating costs. Our content encoding system allows us to format
large amounts of quality audio content for online use in a timely and
cost effective manner. We also have developed a content management system
that automates the services that are necessary for content creators to
publish and manage their content. We have also developed database
technology that permits us to manage the large volume of content in our
distribution system.
. Open Technical Architecture. An open system design is important because
standard formats are not yet available for online music distribution. Our
technology has been designed to provide an open and flexible solution
that can adapt to many competing compression technologies and formats,
including Sony ATRAC3, MP3 and soon, Microsoft Windows Media, as well as
future changes that may occur in digital music distribution. Our open
system design allows the integration of new technologies while
maintaining compatibility with existing content. In addition, our
flexible architecture allows us to continue to integrate technologies
such as audio compression and audio watermarking as they continue to
improve in the future.
. Robust and Scalable System Architecture. A comprehensive and robust
system architecture is important to meet the demands that may result from
large scale consumer adoption. We have developed a broad range of
technologies that enables efficient music distribution services. We have
developed specific technologies that permit our system to scale across
multiple systems and locations. This technology provides unique
advantages for efficiently delivering music and other media to a global
audience. We have also developed technology that allows us to extend our
system beyond online applications to include physical locations for sales
of music via kiosks, broadening our reach to include both online and
traditional consumers.
. Superior Audio Quality. We believe consumers will pay for quality music,
and we believe that we have consistently provided superior audio quality
for digital music. We employ specific techniques and optimize industry
algorithms to improve sound quality. We believe that our use of
standardized compression algorithms such as AAC, MP3 and soon, Windows
Media, provides greater compatibility than proprietary audio compression
solutions.
Sales and Marketing
Our sales and marketing efforts are principally concentrated on selling our
products and services, developing complementary business opportunities,
aggregating digital music recordings for syndication and sale, and broadening
our content syndication reach by expanding the number and geographic reach of
music and retail websites in our Liquid Music Network. We sell our products and
services to artists, record companies, websites and online retailers through a
62-person sales and marketing organization. These employees are located in
Redwood City, Los Angeles, New York and London. Our software products and
9
services are also bundled and distributed by third-party manufacturers of
various computer hardware and software products.
We use a variety of marketing programs to create market awareness and
generate demand for our products and services. Our marketing activities include
event-based promotions with popular recording artists and record labels, web
advertising and sponsorships, press tours, participation in trade events and
conferences, and other public relations activities.
In addition to maintaining relationships with worldwide rights societies and
expanding the distribution opportunities for our products and services, our
business development group works to develop new international markets and
business opportunities for our products and services. We believe that
establishing strategic relationships in each of the major international markets
will accelerate the international deployment of our products and services.
Intellectual Property
Our success will depend in part on our ability to protect our proprietary
software and other intellectual property. To protect our proprietary rights we
rely generally on patent, copyright, trademark and trade secret laws,
confidentiality agreements with employees and third parties, and license
agreements with consultants, vendors and customers. Despite these protections a
third party could, without authorization, copy or otherwise obtain and use our
products or technology to develop similar technology independently.
Our agreements with employees, consultants and others who participate in
product and service development activities may be breached, we may not have
adequate remedies for any breach, and our trade secrets may become known or
independently developed by competitors.
We currently have 17 patents pending in the United States and four patents
pending in other countries relating to our product architecture and technology
and hold seven patents. Those patents expire between October 2015 and October
2018. We have had claims allowed on two of our patent applications. Any pending
or future patent applications may not be granted, existing or future patents
may be challenged, invalidated or circumvented, and the rights granted under a
patent that has issued or any patent that may issue may not provide competitive
advantages to us. Many of our current and potential competitors dedicate
substantially greater resources to protection and enforcement of intellectual
property rights, especially patents. If a blocking patent has issued or issues
in the future, we would need either to obtain a license or to design around the
patent. We may not be able to obtain a required license on acceptable terms, if
at all, or to design around the patent. See "Legal Proceedings."
We pursue the registration of our trademarks and service marks in the United
States and in other countries, although we have not secured registration of all
our marks. A significant portion of our marks begin with the word "Liquid." We
are aware of other companies that use "Liquid" in their marks, alone or in
combination with other words, and we do not expect to be able to prevent all
third-party uses of the word "Liquid." In addition, the laws of some foreign
countries do not protect our proprietary rights to the same extent as do the
laws of the U.S., and effective patent, copyright, trademark and trade secret
protection may not be available in these jurisdictions. We license our
proprietary rights to third parties, and these licensees may fail to abide by
compliance and quality control guidelines with respect to our proprietary
rights or take actions that would harm our business.
To license many of our products, we rely in part on "shrinkwrap" and
"clickwrap" licenses that are not signed by the end user and, therefore, may be
unenforceable under the laws of certain jurisdictions. As with other software
products, our products are susceptible to unauthorized copying and uses that
may go undetected. Policing unauthorized use is difficult.
We attempt to avoid infringing known proprietary rights of third parties in
our product and service development efforts. We have not, however, conducted,
and do not conduct comprehensive patent searches to
10
determine whether the technology used in our products infringes patents held
by third parties. In addition, it is difficult to proceed with certainty in a
rapidly evolving technological environment in which there may be numerous
patent applications pending, many of which are confidential when filed, with
regard to similar technologies. If we were to discover that our products
violate third-party proprietary rights, we might not be able to obtain
licenses to continue offering these products without substantial
reengineering. Effort to undertake this reengineering might not be successful,
licenses might be unavailable on commercially reasonable terms, if at all, and
litigation might not be avoided or settled without substantial expense and
damage awards.
Any claims relating to the infringement of third-party proprietary rights,
even if not meritorious, could result in the expenditure of significant
financial and managerial resources and could result in injunctions preventing
us from distributing certain products and services. These claims could harm
our business. We also rely on technology that we license from third parties,
including software that is integrated with internally developed software and
used in our products and services, to perform key functions. Third-party
technology licenses may not continue to be available to us on commercially
reasonable terms. The loss of any of these technologies could harm our
business. Moreover, although we are generally indemnified against claims that
third-party technology infringes the proprietary rights of others, this
indemnification may be unavailable for all types of intellectual property
rights, for example, patents may be excluded, and in some cases the scope of
indemnification is limited. Even if we receive broad indemnification, third-
party indemnitors are not always well capitalized and may not be able to
indemnify us in the event of infringement, resulting in substantial exposure
to us. Infringement or invalidity claims may arise from the incorporation of
third-party technology, and our customers may make claims for indemnification.
These claims, even if not meritorious, could result in the expenditure of
significant financial and managerial resources in addition to potential
product and service redevelopment costs and delays, all of which could harm
our business. Sightsound, Inc. and Intouch Group, Inc. have recently claimed
that our products infringe their patent rights. See "Legal Proceedings."
Competition
Competition among companies in the business of delivering digital music
over the Internet is intense. We compete against a number of technology
companies that are offering or plan to offer products, services or
technologies for the delivery of digital music over the Internet. The number
of websites competing for the attention and spending of consumers and
advertisers has increased, and we expect it to continue to increase. We may
also compete with consumer electronics companies as they begin to market
Internet music player devices. New or current competitors may emerge that are
more successful than us. See "Company Risk Factors--The Market for Digital
Delivery of Music Over the Internet is Highly Competitive, and if We Cannot
Compete Effectively, Our Revenues Might Decline."
We compete with providers of infrastructure technology, products and
services such as Preview Systems, SuperTracks and Loudeye Technologies, and
aggregators of digital music content for delivery over the Internet and kiosks
such as eMusic, Amplified.com and RedDot.net.
We believe that the primary competitive factors in our market are the
following:
. price and cost of products and services;
. quantity and variety of digital recorded music content;
. ease of consumer experience;
. the number and quality of music-related and retail websites;
. brand awareness;
. ability to adapt to changes in component technologies and consumer
preferences;
. fidelity and quality of sound of digital recorded music; and
. ability to ensure secure digital delivery of recorded music.
11
We believe our products and services offer significant advantages over those
of our competitors:
. our music catalog features over 10,800 artists and 1,200 individual
record labels. We believe that we offer more artists and more labels than
most digital music distribution services;
. through our Liquid Music Network, we believe we have the potential to
reach more music consumers than other digital music delivery solutions;
. our platform offers better copy protection and copyright management than
Windows Media or MP3-based solutions;
. our open architecture will allow us to adapt to changing component
technologies; and
. the fidelity and sound quality of music encoded by our products and
services are superior to competitive systems due to optimizations we
perform on audio compression technologies used in our products and
services.
Additionally, music community websites, such as Napster and MP3.com, may
attract consumers who want to download music from the Internet. These websites
compete directly with our affiliates. To the extent that consumers download
digital music from these websites rather than from our affiliates, our business
may be harmed. Additionally, some of these music community websites are
developing business models that compete directly with us, whereby they will
also provide infrastructure technology and aggregate digital music content for
delivery over the Internet. To the extent that retailers choose such websites
for the distribution technology and aggregated content rather than ours, our
business may be harmed. Finally, there are other companies, such as IBM,
Microsoft, RealNetworks and InterTrust Technologies Corporation, that provide
component software technologies that facilitate the digital delivery of goods
over the Internet, including music. To the extent that the market standardizes
on these technologies and we are unable to incorporate these components into
our music delivery services, our business may be harmed.
Employees
As of December 31, 2000, we had 218 full-time employees, including 62 in
sales and marketing, 86 in research and development, 37 in general and
administrative and 33 in operations. We consider our relationships with
employees to be good. None of our employees is covered by collective bargaining
agreements.
ITEM 1A. COMPANY RISK FACTORS
Our Limited Operating History in the New Market of Digital Delivery of Music
over the Internet Increases the Possibility that the Value of Your Investment
Will Decline
We incorporated in January 1996. We did not start generating revenues until
the first quarter of 1997. In early 1999 we began to place greater emphasis on
developing and marketing our digital music delivery services. Accordingly, we
are still in the early stages of development and have only a limited operating
history upon which you can evaluate our business. You should evaluate our
chances of financial and operational success in light of the risks,
uncertainties, expenses, delays and difficulties associated with starting a new
business, many of which may be beyond our control.
We Have a History of Losses, We Expect Losses to Continue and We Might Not
Achieve or Maintain Profitability
Our accumulated deficit as of December 31, 2000 was approximately $73.9
million. We had net losses of approximately $24.2 million and $33.7 million in
1999 and 2000, respectively. Given the level of our planned operating and
capital expenditures, we expect to continue to incur losses and negative cash
flows through at least 2002. Even if we ultimately do achieve profitability, we
may not be able to sustain or increase profitability on a quarterly or annual
basis. If our revenues grow more slowly than we anticipate, or if our operating
12
expenses exceed our expectations and cannot be adjusted accordingly, our
business will be harmed. See "Selected Financial Data" and "Management's
Discussion and Analysis of Financial Condition and Results of Operations."
Fluctuations in Our Quarterly Revenues and Operating Results Might Lead to
Reduced Prices for Our Stock
Our quarterly results of operations have varied in the past, and you should
not rely on quarter-to-quarter comparisons of our results of operations as an
indication of our future performance. In some future periods, our results of
operations are likely to be below the expectations of public market analysts
and investors. In this event, the price of our common stock would likely
decline. Factors that have caused our results to fluctuate in the past and that
are likely to affect us in the future include the following:
. competition for consumers from traditional retailers as well as providers
of online music services;
. the announcement and introduction of new products and services by us and
our competitors;
. our ability to increase the number of websites that will use our platform
for digital music delivery;
. the timing of our partners' introduction of new products and services for
digital music sales; and
. variability and length of the sales cycle associated with our product and
service offerings.
In addition, other factors may also affect us, including:
. market adoption and growth of sales of digitally downloaded recorded
music over the Internet;
. our ability to attract significant numbers of music recordings to be
syndicated in our format;
. our ability to provide reliable and scalable service, including our
ability to avoid potential system failures;
. market acceptance of new and enhanced versions of our products and
services; and
. the price and mix of products and services we offer.
Some of these factors are within our control and others are outside of our
control.
Several of Our Customers Have Had Limited Operating Histories, Are Unprofitable
and Might Have Difficulty Meeting Their Payment Obligations to Us
Several of our significant customers, including our international partners
Liquid Audio Japan, Liquid Audio Korea, Liquid Audio Greater China and Liquid
Audio South East Asia through our strategic partner, have had limited operating
histories and have not achieved profitability. We believe that this will be
true of other customers in the future. As of December 31, 2000, 60% and 96% of
our trade accounts receivable and receivables from related parties,
respectively, or $789,000 and $1.2 million, respectively, were more than 30
days past due. You should evaluate the ability of these companies to meet their
payment obligations to us in light of the risks, expenses and difficulties
encountered by companies with limited operating histories. If one or more of
our customers were unable to pay for our services in the future, or paid more
slowly than we anticipate, recognition of revenue might be delayed and our
business might be harmed.
If Our Relationships with Our International Partners Terminate, Our Revenues
Might Decline
We derive a portion of our revenues from business development fees from
relationships with our international partners, including Liquid Audio Korea,
Liquid Audio Japan, Liquid Audio Greater China and Liquid Audio South East Asia
through our strategic partner. These relationships vary in size and scope. If
one of these relationships does not generate a similar amount of revenue in
subsequent periods or if a party is
13
unable to make its scheduled payments to us, then our business could be harmed.
Furthermore, the commercial terms for these relationships could cause our
revenues to vary from period-to-period, which might result in unpredictability
of our revenues.
Our Revenues Would Be Negatively Effected by the Loss of a Significant Customer
We have derived, and we believe that we will continue to derive, a
substantial portion of our net revenues from a limited number of customers and
projects. Our ten largest customers for 1999 and 2000 represented approximately
86% and 78%, respectively, of our total net revenues. The loss of any
significant customer or any significant reduction of total net revenues
generated by significant customers, without an increase in revenues from other
sources, would harm our business. The volume of products or services we sell to
specific customers is likely to vary year to year, and a major customer in one
year may not use our services in a subsequent year. A customer's decision not
to use our services in a subsequent year might harm our business.
If Standards for the Secure, Digital Delivery of Recorded Music Are Not
Adopted, the Piracy Concerns of Record Companies and Artists Might Not Be
Satisfied, and They Might Not Use Our Platform for Digital Delivery of Their
Music
Because other digital recorded music formats, such as MP3, do not contain
mechanisms for tracking the source or ownership of digital recordings, users
are able to download and distribute unauthorized or "pirated" copies of
copyrighted recorded music over the Internet. This piracy is a significant
concern to record companies and artists, and is the reason many record
companies and artists are reluctant to digitally deliver their recorded music
over the Internet. The Secure Digital Music Initiative (SDMI) is a committee
formed by the Recording Industry Association of America (RIAA) to propose a
standard format for the secure digital delivery and use of recorded music. If a
standard format is not adopted, however, unsecure copies of recorded music may
continue to be available on the Internet, and record companies and artists
might not permit the digital delivery of their music. Additionally, as long as
pirated recordings are available, many consumers will choose free pirated
recordings rather than paying for legitimate recordings. Accordingly, if a
standard format for the secure digital delivery of music is not adopted, our
business might be harmed.
We have designed our current products to be adaptable to different music
industry and technology standards. Numerous standards in the marketplace,
however, could cause confusion as to whether our products and services are
compatible. If a competitor were to establish the dominant industry standard,
our business would be harmed.
We Might Need Additional Capital in the Future and Additional Financing Might
Not Be Available
We currently anticipate that our available cash resources and financing
available under existing lease agreements will be sufficient to meet our
anticipated working capital and capital expenditure requirements for the
foreseeable future. However, we may need to raise additional funds through
public or private debt or equity financing in order to:
. take advantage of opportunities, including more rapid international
expansion or acquisitions of complementary businesses or technologies;
. develop new products or services; or
. respond to competitive pressures.
Any additional financing we may need may not be available on terms favorable
to us, or at all. If adequate funds are not available or are not available on
acceptable terms, we might not be able to take advantage of unanticipated
opportunities, develop new products or services, or otherwise respond to
unanticipated competitive pressures, and our business could be harmed. Our
forecast of the period of time through which our
14
financial resources will be adequate to support our operations is a forward-
looking statement that involves risks and uncertainties, and actual results
could vary materially as a result of a number of factors, including those set
forth in this "Risk Factors" section. See "Management's Discussion and Analysis
of Financial Condition and Results of Operations."
Our Future Success Depends on Our Key Personnel
Our future success depends to a significant extent on the continued service
of our key technical, sales and senior management personnel and their ability
to execute our growth strategy. The loss of the services of any of our senior
level management, or other key employees, could harm our business. Our future
performance will depend, in part, on the ability of our executive officers to
work together effectively. Our executive officers may not be successful in
carrying out their duties or running our company. Any dissent among executive
officers could impair our ability to make strategic decisions quickly in a
rapidly changing market.
Our future success also depends on our ability to attract, retain and
motivate highly skilled employees. Competition for employees in our industry is
intense. Although we provide compensation packages that include incentive stock
options, cash incentives and other employee benefits, the volatility and
current market price of our common stock may make it difficult for us to
attract, assimilate and retain highly qualified employees in the future. We
have from time to time in the past experienced, and we expect to continue to
experience in the future, difficulty in hiring and retaining highly skilled
employees with appropriate qualifications.
We Depend on Proprietary Rights to Develop and Protect Our Technology
Our success and ability to compete substantially depends on our internally
developed technologies and trademarks, which we protect through a combination
of patent, copyright, trade secret and trademark laws. Patent applications or
trademark registrations may not be approved. Even if they are approved, our
patents or trademarks may be successfully challenged by others or invalidated.
If our trademark registrations are not approved because third parties own these
trademarks, our use of these trademarks would be restricted unless we enter
into arrangements with the third-party owners, which might not be possible on
commercially reasonable terms or at all.
The primary forms of intellectual property protection for our products and
services internationally are patents and copyrights. Patent protection
throughout the world is generally established on a country-by-country basis. To
date, we have applied for four patents outside the United States. Copyrights
throughout the world are protected by several international treaties, including
the Berne Convention for the Protection of Literary and Artistic Works. Despite
these international laws, the level of practical protection for intellectual
property varies among countries. In particular, United States government
officials have criticized countries such as China and Brazil for inadequate
intellectual property protection. If our intellectual property is infringed in
any country without a high level of intellectual property protection, our
business could be harmed.
We generally enter into confidentiality or license agreements with our
employees, consultants and corporate partners, and generally control access to
and distribution of our technologies, documentation and other proprietary
information. Despite our efforts to protect our proprietary rights from
unauthorized use or disclosure, parties may attempt to disclose, obtain or use
our solutions or technologies. The steps we have taken may not prevent
misappropriation of our solutions or technologies, particularly in foreign
countries where laws or law enforcement practices may not protect our
proprietary rights as fully as in the United States. See "Business--
Intellectual Property."
We have licensed, and we may license in the future, certain proprietary
rights to third parties. While we attempt to ensure that the quality of our
brand is maintained by our business partners, they may take actions that could
impair the value of our proprietary rights or our reputation. In addition,
these business partners may not take the same steps we have taken to prevent
misappropriation of our solutions or technologies.
15
We Face and Might Face Intellectual Property Infringement Claims that Might Be
Costly to Resolve
From time to time, we receive letters from corporations and other entities
suggesting that we review patents to which they claim rights or claiming that
we infringe on their patent rights. Such claims may result in our being
involved in litigation. Although we do not believe we infringe the proprietary
rights of any party, we cannot assure you that parties will not assert
additional claims in the future or that any claims will not be successful. We
could incur substantial costs and diversion of management resources to defend
any claims relating to proprietary rights, which could harm our business. In
addition, we are obligated under certain agreements to indemnify the other
party for claims that we infringe on the proprietary rights of third parties.
If we are required to indemnify parties under these agreements, our business
could be harmed. If someone asserts a claim against us relating to proprietary
technology or information, we might seek licenses to this intellectual
property. We might not be able to obtain licenses on commercially reasonable
terms, or at all. The failure to obtain the necessary licenses or other rights
might harm our business. See "Legal Proceedings."
Companies Might Not Develop or Consumers Might Not Adopt Devices That Will Play
Digitally Downloaded Music
We believe that the market for digitally recorded music delivered over the
Internet will not develop significantly until consumers are able to enjoy this
music other than solely through the use of a personal computer. Several
consumer electronics companies have introduced or announced plans to introduce
devices that will allow digital music delivered over the Internet to be played
away from the personal computer. If companies fail to introduce additional
devices, consumers do not adopt these devices or our products and services are
incompatible with these devices, our business would be harmed. In addition,
digital music can be transferred to a compact disc, but that transfer requires
a compact disc recorder (CD-R). Many desktop computer manufacturers offer CD-Rs
in their computers. If companies do not continue to offer CD-Rs in their
computers, consumers do not adopt CD-Rs or our products and services are
incompatible with CD-Rs, our business might be harmed.
If We Do Not Increase the Number of Websites that Use Our Platform, Our
Business Will Not Grow
In order to grow our business, we need to increase the number of websites,
including websites operated by music retailers, that use our technology and our
syndicated content to digitally deliver recorded music. To increase the number
of websites, we must do the following:
. offer competitive products and services that meet industry standards;
. attract more music content;
. make it easy and cost-effective for music-related websites to sell
digital music;
. develop relationships with online retailers, music websites, online
communities, broadband providers and Internet broadcasters; and
. develop relationships with international music websites, retailers and
broadband providers.
Any failure to achieve one or more of these objectives would harm our
business. We may not be successful in achieving any of these objectives.
If Artists and Record Labels Are Not Satisfied that They Can Securely,
Digitally Deliver Their Music Over the Internet, We Might Not Have Sufficient
Content to Attract Consumers
Our success depends on our ability to aggregate a sufficient amount and
variety of digital recorded music for syndication. In particular, until a
significant number of artists and their record labels adopt a strategy of
digitally delivering music over the Internet, the growth of our business might
be limited. We currently do not
16
create our own content; rather, we rely on record companies and artists for
digital recorded music to be syndicated using our format. We believe record
companies will remain reluctant to distribute their recorded music digitally
unless they are satisfied that the digital delivery of their music over the
Internet will not result in the unauthorized copying and distribution of that
music. If record companies do not believe that recorded music can be securely
delivered over the Internet, they will not allow the digital distribution of
their recorded music and we might not have sufficient content to attract
consumers. If we cannot offer a sufficient amount and variety of digital
recorded music for syndication, our business might be harmed.
Due to the Many Factors that Influence Market Acceptance, Consumers Might Not
Accept Our Platform
Our success will depend on growth in consumer acceptance of our platform as
a method for digital delivery of recorded music over the Internet. Factors that
might influence market acceptance of our platform include the following, over
which we have little or no control:
. the availability of sufficient bandwidth on the Internet to enable
consumers to download digital recorded music rapidly and easily;
. the willingness of consumers to invest in computer technology that
facilitates the downloading of digital music;
. the cost of time-based Internet access;
. the number, quality and variety of digital recordings available for
purchase through our system relative to those available through other
online digital delivery companies, digital music websites, music swapping
or sharing websites or through traditional physical delivery of
recordings;
. the availability of portable devices to which digital recorded music can
be transferred;
. the fidelity and quality of the sound of the digital recorded music; and
. the level of consumer comfort with the process of downloading and paying
for digital music over the Internet, including ease of use and lack of
concern about transaction security.
The Market for Digital Delivery of Music Over the Internet is Highly
Competitive, and if We Cannot Compete Effectively, Our Ability to Generate
Meaningful Revenues Would Suffer Dramatically
Competition among companies in the business of digital delivery of music
over the Internet is intense. If we do not compete effectively or if we
experience pricing pressures, reduced margins or loss of market share resulting
from increased competition, our business might be harmed.
Competition is likely to increase as new companies enter the market and
current competitors expand their products and services or merge with other
competitors. Many of these potential competitors are likely to enjoy
substantial competitive advantages, including the following:
. larger audiences;
. larger technical, production and editorial staffs;
. greater brand recognition;
. access to more recorded music content;
. a more established Internet presence;
. a larger advertiser base; and
. substantially greater financial, marketing, technical and other
resources.
See "Business--Competition."
17
New Competitors Could Enter the Industry with Alternative Business Models,
Which, if Successful, Could Harm Our Business
New companies may enter our market with alternative business models. For
example, companies may provide free music downloading from a website, earning
revenues on an advertising or subscription basis. This model could be more
attractive to consumers. If we are unable to compete with such companies or
adapt our business model, products or services to a more consumer-favorable
model, our business could be harmed.
If Our Platform Does Not Provide Sufficient Rights Reporting Information,
Record Companies and Artists Are Unlikely to Digitally Deliver Their Recorded
Music Using Our Platform
Record companies and artists must be able to track the number of times their
recorded music is downloaded so that they can make appropriate payments to
music rights organizations, such as the American Society of Composers, Authors
and Publishers, Broadcast Music Incorporated and SESAC, Inc. If our products
and services do not accurately or completely provide this rights reporting
information, record companies and artists might not use our platform to
digitally deliver their recorded music, and our business might be harmed.
Our Business Might Be Harmed if We Fail to Price Our Products and Services
Appropriately
The price of Internet products and services is subject to rapid and frequent
change. We may be forced, for competitive or technical reasons, to reduce or
eliminate prices for certain of our products or services. If this happens, our
business might be harmed.
Our Business Might Be Harmed if Challenges Against Intellectual Property Laws
by New Digital Music Delivery Technologies Are Successful
New music sharing technologies allowing users to locate and download copies
of digital music stored on the hard drives of other users without payment have
been introduced into the market. Because some digital recorded music formats,
such as MP3, do not contain mechanisms for tracking the source of ownership of
digital recordings, users are able to download copies of copyrighted recorded
music over the Internet without being required to compensate the owners of
these copyrights. These downloads are a significant concern to record companies
and artists. The Recording Industry Association of America has filed a suit
seeking a permanent injunction against the use of these file-sharing
technologies for exchange of copyrighted works. Several recording artists have
also taken action against companies providing music sharing technology. If the
injunction is denied, and it is determined that this file sharing technology is
non-infringing, record companies and artists may limit their use of the
Internet to sell and distribute their copyrighted materials. Even if the
technology is determined to be infringing, it may be difficult to prevent this
type of file sharing because of the non-centralized character of these
technologies. As long as free shared copies are available, legally or
illegally, consumers may choose not to pay for downloads from retail and other
music delivery sites in our Liquid Music Network, which could harm our
business.
We Might Not Be Able to Scale Our Technology Infrastructure to Meet Demand for
Our Products and Services
Our success will depend on our ability to scale our technology
infrastructure to meet the demand for our products and services. Adding this
new capacity will be expensive, and we might not be able to do so successfully.
In addition, we might not be able to protect our new or existing data centers
from unexpected events as we scale our systems. To the extent that we do not
address any capacity constraints effectively, our business would be harmed.
18
We Might Not Be Successful in Our Attempts to Keep Up With Rapid Technological
Change and Evolving Industry Standards
The markets for our products and services are characterized by rapidly
changing technology, evolving industry standards, changes in customer needs,
emerging competition, and frequent new product and service introductions. Our
future success will depend, in part, on our ability to:
. use leading technologies effectively;
. continue to develop our strategic and technical expertise;
. enhance our current products and services;
. develop new products and services that meet changing customer needs;
. advertise and market our products and services; and
. influence and respond to emerging industry standards and other
technological changes.
This must be accomplished in a timely and cost-effective manner. We may not
be successful in effectively using new technologies, developing new products or
services or enhancing our existing products or services on a timely basis.
These new technologies or enhancements may not achieve market acceptance. Our
pursuit of necessary technological advances may require substantial time and
expense. Finally, we may not succeed in adapting our services to new
technologies as they emerge.
We Might Not Be Successful in the Development and Introduction of New Products
and Services
We depend in part on our ability to develop new or enhanced products and
services in a timely manner and to provide new products and services that
achieve rapid and broad market acceptance. We may fail to identify new product
and service opportunities successfully and develop and bring to market new
products and services in a timely manner. In addition, product innovations may
not achieve the market penetration or price stability necessary for
profitability.
As the online medium continues to evolve, we plan to leverage our technology
by introducing complementary products and services as additional sources of
revenue. Accordingly, we may change our business model to take advantage of new
business opportunities, including business areas in which we do not have
extensive experience. For example, we will continue to devote significant
resources to the development of digital music delivery services, as well as our
software licensing business. If we fail to develop these or other businesses
successfully, our business would be harmed.
We Might Experience Delays in the Development of New Products and Services
We must continue to innovate and develop new versions of our software to
remain competitive in the market for digital delivery of recorded music
solutions. Our software products and services development efforts are
inherently difficult to manage and keep on schedule. Our failure to manage and
keep those development projects on schedule might harm our business.
Our Products and Services Might Contain Errors
We offer complex products and services. They may contain undetected errors
when first introduced or when new versions are released. If we market products
and services that have errors or that do not function properly, then we may
experience negative publicity, loss of or delay in market acceptance, or claims
against us by customers, any of which might harm our business.
We Might Have Liability for the Content of the Recorded Music That We Digitally
Deliver
Because we digitally deliver recorded music to third parties, we might be
sued for negligence, copyright or trademark infringement or other reasons.
These types of claims have been brought, sometimes successfully,
19
against providers of online products and services in the past. Others could
also sue us for the content that is accessible from our website through links
to other websites. These claims might include, among others, claims that by
hosting, directly or indirectly, the websites of third parties, we are liable
for copyright or trademark infringement or other wrongful actions by these
third parties through these websites. Our insurance may not adequately protect
us against these types of claims and, even if these claims do not result in
liability, we could incur significant costs in investigating and defending
against these claims.
We have taken steps to prevent these claims. For example, we have
arrangements with companies that use our hosting services that will allow us to
delete potentially infringing or misappropriating materials quickly and
securely. We also have put into place indemnification agreements with music
content providers, where practicable. Under the Digital Millennium Copyright
Act of 1999, Internet service providers are insulated from several types of
these claims, upon compliance with the requirement that they appoint an agent
to receive claims relating to their service, and we have appointed an agent.
System Failures or Delays Might Harm Our Business
Our operations depend on our ability to protect our computer systems against
damage from fire, water, power loss, telecommunications failures, computer
viruses, vandalism and other malicious acts, and similar unexpected adverse
events. Our corporate headquarters are located in northern California.
California is currently experiencing power outages due to a shortage in the
supply of power within the state. Although we maintain a comprehensive disaster
recovery plan, if the power outages increase in severity, they could disrupt
our operations. Interruptions or slowdowns in our services have resulted from
the failure of our telecommunications providers to supply the necessary data
communications capacity in the time frame we required, as well as from
deliberate acts. Despite precautions we have taken, unanticipated problems
affecting our systems could in the future cause temporary interruptions or
delays in the services we provide. Our customers might become dissatisfied by
any system failure or delay that interrupts our ability to provide service to
them or slows our response time. Sustained or repeated system failures or
delays would affect our reputation, which would harm our business. Slow
response time or system failures could also result from straining the capacity
of our software or hardware due to an increase in the volume of products and
services delivered through our servers. While we carry business interruption
insurance, it might not be sufficient to cover any serious or prolonged
emergencies, and our business might be harmed.
We Might Be Unable to License or Acquire Technology
We rely on certain technologies that we license or acquire from third
parties, including Dolby Laboratories Licensing Corporation, Fraunhofer
Institut, RSA Data Security, Inc. and Thomson Consumer Electronics Sales GmbH.
These technologies are integrated with our internally developed software and
used in our products, to perform key functions and to enhance the value of our
platform. These third-party licenses or acquisitions may not continue to be
available to us on commercially reasonable terms or at all. Any inability to
acquire these licenses or software on commercially reasonable terms might harm
our business.
Difficulties Presented by International Economic, Political, Legal, Accounting
and Business Factors Could Harm Our Business in International Markets
A key component of our strategy is to expand into international markets. The
following risks are inherent in doing business on an international level and we
have little or no control over them:
. unexpected changes in regulatory requirements;
. export restrictions;
. export controls relating to encryption technology;
. longer payment cycles;
20
. problems in collecting accounts receivable;
. political and economic instability; and
. potentially adverse tax consequences.
In addition, other factors that may also affect us and over which we have
some control include the following:
. difficulties in staffing and managing international operations;
. differences in music rights reporting structures; and
. seasonal reductions in business activity.
We have entered into individual agreements in Japan, Korea, greater China
and south east Asia, and we may enter into similar arrangements in the future
in other countries. We also established a wholly-owned subsidiary in the
United Kingdom. One or more of the factors listed above may harm our present
or future international operations and, consequently, our business.
Our Management and Internal Systems Might Be Inadequate to Handle the
Potential Growth of Our Personnel
To manage future growth, our management must continue to improve our
operational and financial systems and expand, train, retain and manage our
employee base. Our management may not be able to manage our growth
effectively. If our systems, procedures and controls are inadequate to support
our operations, our expansion would be halted and we could lose our
opportunity to gain significant market share. Any inability to manage growth
effectively may harm our business.
Risks Related to Our Industry
Internet Security Concerns Could Hinder E-Commerce
A significant barrier to e-commerce and communications over the Internet
has been the need for secure transmission of confidential information.
Internet usage may not increase at the rate we expect unless some of those
concerns are adequately addressed and found acceptable by the market. Internet
usage could also decline if any well-publicized compromise of security occurs.
We may incur significant costs to protect against the threat of security
breaches or to alleviate problems caused by these breaches. Protections may
not be available at a reasonable price or at all. If a third person were able
to misappropriate a user's personal information, users could bring claims
against us.
Imposition of Sales and Other Taxes On E-Commerce Transactions Might Hinder E-
Commerce
We do not collect sales and other taxes when we sell our products and
services over the Internet. State or local governments may seek to impose
sales tax collection obligations on out-of-state companies, such as ours,
which engage in or facilitate e-commerce. A number of proposals have been made
at the state and local level that would impose additional taxes on the sale of
products and services through the Internet. These proposals, if adopted, could
substantially impair the growth of e-commerce and could reduce our opportunity
to derive profits from e-commerce. Moreover, if any state or local government
or foreign country were to successfully assert that we should collect sales or
other taxes on the exchange of products and services on our system, our
business might be harmed.
In 1998, Congress passed the Internet Freedom Act, which imposes a three-
year moratorium on state and local taxes on Internet-based transactions. We
cannot assure you that this moratorium will be extended. Failure to renew this
moratorium would allow various states to impose taxes on e-commerce, which
might harm our business.
21
Demand for Our Products and Services Might Decrease if Growth in the Use of the
Internet Declines
Our future success substantially depends upon the continued growth in the
use of the Internet. The number of users on the Internet may not increase and
commerce over the Internet may not become more accepted and widespread for a
number of reasons, including the following, over which we have little or no
control:
. actual or perceived lack of security of information, such as credit card
numbers;
. lack of access and ease of use;
. inconsistent quality of service and lack of availability of cost-
effective, high speed service;
. possible outages due to damage to the Internet;
. excessive governmental regulation; and
. uncertainty regarding intellectual property rights.
If the necessary infrastructure, products, services or facilities are not
developed, or if the Internet does not grow as a commercial medium, our
business would be harmed.
Government Regulation of the Internet Might Harm Our Business
The applicability to the Internet of existing laws governing issues such as
property ownership, libel and personal privacy is uncertain. In addition,
governmental authorities may seek to further regulate the Internet with respect
to issues such as user privacy, pornography, acceptable content, e-commerce,
taxation, and the pricing, characteristics and quality of products and
services. Finally, the global nature of the Internet could subject us to the
laws of a foreign jurisdiction in an unpredictable manner. Any new legislation
regulating the Internet could inhibit the growth of the Internet and decrease
the acceptance of the Internet as a communications and commercial medium, which
might harm our business.
In addition, the growing use of the Internet has burdened the existing
telecommunications infrastructure and has caused interruptions in telephone
service. Telephone carriers have petitioned the government to regulate the
Internet and impose usage fees on Internet service providers. Any regulations
of this type could increase the costs of using the Internet and impede its
growth, which could in turn decrease the demand for our services or otherwise
harm our business.
ITEM 2. PROPERTIES
Our headquarters are located in 11,400 square feet of leased office space in
Redwood City, California. The lease term extends to April 14, 2002 with a
three-year renewal, at our option. We lease an office suite near our
headquarters in Redwood City on a month-to-month basis, for additional office
space and storage needs. We lease an additional 18,200 square feet of office
space near our headquarters. The lease term for this additional space extends
to November 15, 2002 with two five-year renewals, at our option. We lease an
additional 26,800 square feet of office space near our headquarters. The lease
term for this additional space extends to August 31, 2002 with a three-year
renewal, at our option.
ITEM 3. LEGAL PROCEEDINGS
In February 2000, Sightsound, Inc. notified one of our customers that it
intended to add the customer as a party to a pending patent litigation in the
United States District Court for the Eastern District of Pennsylvania
(Pittsburgh). The litigation alleges infringement of unspecified claims of
three patents (United States Patent Nos. 5,191,573; 5,675,734 and 5,996,440).
Damages have not been specified. Our customer has agreed to be added to the
case, subject to a revision in the trial schedule. Our customer has requested
indemnification, including defense costs, from us, based upon the terms of our
contract with them. Based on this request, we are negotiating an agreement with
our customer under which we would (i) assume control of the defense, (ii) pay
22
the expenses of the defense and (iii) reserve certain rights as to
indemnification. During negotiation of this agreement we have agreed to assume
the costs of the defense for our customer. These costs could be significant.
There is no assurance that we will enter into this agreement. If we do not
reach an agreement with our customer and the defense is not successful, our
customer might seek full indemnification from us for the damages, if any. There
can be no assurance regarding the outcome of the litigation. If there is a
finding of infringement, we may be required to indemnify our customer as to the
full amount of the damages.
On March 31, 2000, Intouch Group, Inc. (Intouch) filed a lawsuit against us
in the Northern District of California alleging patent infringement. On April
26, 2000, Intouch filed an amended complaint, which was served on us shortly
thereafter. The complaint names us and Amazon.com International, Inc.,
Listen.com, Inc., Entertaindom LLC, Discovermusic.com, Inc. and Muze, Inc. It
alleges that we infringe or induce infringement of, the claims of United States
Patent Nos. 5,237,157 and 5,963,916 by operating a website and/or a kiosk that
allows interactive previewing of portions of pre-recorded music products. The
complaint seeks unspecified damages and injunctive relief. On May 30, 2000, we
filed our answer to Intouch's first amended complaint. The action is currently
in discovery, and the trial date has been set for January 11, 2002. We believe
that we have meritorious defenses to Intouch's claims and we intend to
vigorously defend against such claims. However, we cannot assure you that we
will be successful in defending these lawsuits. If there is a finding of
infringement, we might be required to pay substantial damages to Intouch and
could be enjoined from selling any of our products or services that are held to
infringe Intouch's patents unless and until we are able to negotiate a license
from them.
On August 14, 2000, a former employee filed a charge of discrimination with
the California Department of Fair Employment and Housing against us, and
several of our employees and former employees. The charge alleges sexual
harassment and unlawful retaliation. We believe, after consultation with
counsel, that these claims are without merit, and we intend to defend ourselves
vigorously. However, should a lawsuit be filed and decided adversely to us, we
may have to pay damages.
From time to time we receive letters from corporations or other business
entities notifying us of alleged infringement of patents held by them or
suggesting that we review patents to which they claim rights. These
corporations or entities often indicate a willingness to discuss licenses to
their patent rights.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
There were no submissions of matters to a vote of security holders during
the quarter ended December 31, 2000.
23
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Market Price of Common Stock
Our common stock has been quoted on the Nasdaq National Market under the
symbol "LQID" since July 8, 1999. The following table presents, for the periods
indicated, the high and low closing prices per share of the common stock as
reported on the Nasdaq National Market.
High Low
------ ------
Year Ended December 31, 1999
Third Quarter (since July 8, 1999)........................ $40.44 $20.88
Fourth Quarter............................................ 45.13 26.25
Year Ended December 31, 2000
First Quarter............................................. 34.06 13.25
Second Quarter............................................ 19.00 6.69
Third Quarter............................................. 14.50 4.25
Fourth Quarter............................................ 6.00 2.16
The closing price per share of the common stock at March 15, 2001 was $2.13.
As of February 28, 2001, there were approximately 131 holders of record of our
common stock. Because many shares of our common stock are held by brokers and
other institutions on behalf of stockholders, we are unable to estimate the
total number of stockholders represented by these record holders.
Dividend Policy
We have never declared or paid any dividends on our common stock. We do not
anticipate paying any cash dividends in the foreseeable future. We currently
intend to retain future earnings, if any, to finance operations and the
expansion of our business. Any future determination to pay cash dividends will
be at the discretion of the board of directors and will depend upon our
financial condition, operating results, capital requirements and other factors
the board of directors deems relevant.
Recent Sales of Unregistered Securities
1. In February 2000, we issued 1,426 shares of common stock to a record
label upon the exercise of a warrant to purchase common stock. The
shares were purchased using the warrant's net exercise provision.
Accordingly, we did not receive any cash upon exercise of the warrant;
the shares were purchased by the acceptance of a lesser number of shares
in exchange for not having to pay the exercise price.
2. In April 2000, we issued 4,072 shares of common stock to a former
consultant in consideration for the purchase of certain intellectual
property.
3. In April 2000, we issued 30,000 shares of common stock to another former
consultant in connection with a legal settlement.
4. In May 2000, we issued 25,156 shares of common stock to an online
retailer upon the exercise of a warrant to purchase common stock. The
shares were purchased using the warrant's net exercise provision in the
same manner described in item 1 above.
5. In July 2000, we issued 150,000 shares of common stock to a major record
label in exchange for a letter agreement to promote the distribution of
digital music over the Internet using our technology.
24
6. In December 2000, we issued 50,000 shares of common stock and a warrant
to purchase up to an additional 233,300 shares of common stock to
another major record label in connection with an agreement to distribute
its music through kiosks.
No underwriters were employed in connection with any of the transactions set
forth above.
The issuances of securities described in items 1, 2, 4, 5 and 6 were deemed
to be exempt from registration under the Securities Act of 1933, as amended, in
reliance on Section 4(2) of the Securities Act, as transactions by an issuer
not involving a public offering. The issuance of securities described in item 3
was deemed to be exempt from registration under the Securities Act in reliance
on Section 3(a)(10) of the Securities Act, as a transaction involving an exempt
security in which the terms and conditions of the issuance were approved, after
a hearing upon the fairness of such terms and conditions, by a court. The
recipients of securities in each such transaction represented their intention
to acquire the securities for investment only and not with a view to or for
sale in connection with any distribution thereof and appropriate legends were
affixed to the share certificates and other instruments issued in such
transactions. All recipients either received adequate information about us or
had access, through employment or other relationships, to such information.
25
ITEM 6. SELECTED FINANCIAL DATA
The following selected financial data should be read in conjunction with our
consolidated financial statements and related notes and "Management's
Discussion and Analysis of Financial Condition and Results of Operations"
included elsewhere in this document.
Period From
January 30,
1996
(inception)
Year Ended December 31, Through
-------------------------------------------- December 31,
2000 1999 1998 1997 1996
---------- ---------- --------- --------- ------------
(in thousands, except share and per share data)
Statement of Operations
Data:
Net revenues:
License................ $ 1,284 $ 1,537 $ 1,235 $ 246 $ --
Services............... 2,977 733 268 10 --
Business development
(related party)....... 7,307 2,137 1,300 -- --
---------- ---------- --------- --------- -------
Total net revenues.... 11,568 4,407 2,803 256 --
---------- ---------- --------- --------- -------
Cost of net revenues:
License................ 290 235 310 302 --
Services............... 2,722 1,122 242 91 --
Business development
(related party)....... 75 79 2 -- --
Non-cash cost of
revenues.............. 28 25 36 15 --
---------- ---------- --------- --------- -------
Total cost of net
revenues............. 3,115 1,461 590 408 --
---------- ---------- --------- --------- -------
Gross profit (loss)..... 8,453 2,946 2,213 (152) --
---------- ---------- --------- --------- -------
Operating expenses:
Sales and marketing.... 17,114 10,217 4,035 2,820 237
Non-cash sales and
marketing............. 314 783 741 304 8
Research and
development........... 22,917 11,706 4,109 1,880 692
Non-cash research and
development........... 80 371 210 127 23
General and
administrative........ 7,131 2,770 1,642 898 327
Non-cash general and
administrative........ 13 190 254 88 --
Strategic marketing-
equity instruments.... 1,935 3,130 -- -- --
---------- ---------- --------- --------- -------
Total operating
expenses............. 49,504 29,167 10,991 6,117 1,287
---------- ---------- --------- --------- -------
Loss from operations.... (41,051) (26,221) (8,778) (6,269) (1,287)
Other income (expense),
net.................... 8,236 2,015 239 53 23
Equity in net loss of
investment............. (870) -- -- -- --
---------- ---------- --------- --------- -------
Net loss................ $ (33,685) $ (24,206) $ (8,539) $ (6,216) $(1,264)
========== ========== ========= ========= =======
Net loss per share:
Basic and diluted...... $ (1.52) $ (2.28) $ (3.60) $ (4.95) $(14.93)
Weighted average
shares................ 22,133,403 10,615,566 2,370,564 1,256,114 84,635
December 31,
----------------------------------------------------------
2000 1999 1998 1997 1996
---------- ---------- --------- --------- ------------
(in thousands)
Balance Sheet Data:
Cash and cash
equivalents............ $ 96,398 $ 138,692 $ 14,143 $ 2,387 $ 864
Short-term investments.. 27,378 19,157 3,001 -- --
Working capital......... 119,089 152,030 15,060 858 660
Total assets............ 138,210 166,109 19,913 3,275 1,086
Long-term debt, less
current portion........ 564 1,321 969 218 103
Mandatorily redeemable
convertible preferred
stock.................. -- -- 29,801 8,247 2,001
Total stockholders'
equity (deficit)....... 128,674 157,745 (14,133) (6,879) (1,228)
26
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following Management's Discussion and Analysis contains forward-looking
statements within the meaning of Federal securities laws. You can identify
these statements because they use forward-looking terminology such as "may,"
"will," "expect," "anticipate," "estimate," "continue," "believe" and "intend"
or other similar words. These words, however, are not the exclusive means by
which you can identify these statements. You can also identify forward-looking
statements because they discuss future expectations, contain projections of
results of operations or of financial conditions, characterize future events or
circumstances or state other forward-looking information. We have based all
forward-looking statements included in Management's Discussion and Analysis on
information currently available to us, and we assume no obligation to update
any such forward-looking statements. Although we believe that the expectations
reflected in such forward-looking statements are based on reasonable
assumptions, actual results could differ materially from those projected in the
forward-looking statements. Potential risks and uncertainty include, among
others, those set forth in the "Risk Factors" section.
Overview
We are a leading provider of software products and services that enable
artists, record companies and retailers to create, syndicate and sell music
digitally over the Internet. Our products and services are based on an open
technical architecture that is designed to support a variety of digital music
formats. From our inception in January 1996 through early 1997, we devoted
substantially all of our efforts to product development, raising capital and
recruiting personnel. We first generated revenues in the first quarter of 1997
through the licensing of our Liquifier Pro, Liquid Server and Liquid Player
software products. In November 1997, we introduced a subscription-based hosting
service for digital recorded music using our technology. In July 1998, to
enhance consumer access to the music we were hosting, we launched the Liquid
Music Network (LMN), a syndicated network that currently links over 1,000
affiliated music-related and music retailer websites.
In early 1999, we began to place greater emphasis on developing and
marketing our digital music delivery services. Since that time, we have
invested significant resources to increase our distribution reach by expanding
the LMN, building our syndicated music catalog available for sale, actively
participating in standards initiatives and establishing our international
presence. We also have established international initiatives within the Pacific
Rim and a subsidiary in Europe to lay the groundwork for offering digital music
download services to consumers in these markets. As a provider of digital music
delivery services, we expect our revenue sources to expand beyond software
license sales to include hosting service fees and sales of digital recorded
music. Revenues from digital music sales and transaction fees from our music
delivery services represented less than 6% of total net revenues in 2000 and
less than 1% of total net revenues in 1999 and 1998. Our Liquid Music Network
began offering syndicated music through music retailer websites in the third
quarter of 1999.
To date, we have derived our revenues primarily from the licensing of
software products and service fees associated with business development
contracts. Business development revenues primarily consist of license and
maintenance fees from agreements under which we give our strategic related
partners the right to license and use our digital recorded music delivery
technology. These U.S. dollar-denominated, non-refundable fees are allocated
among the various elements of the contract based on vendor specific objective
evidence (VSOE) of fair value. When VSOE of fair value exist for the
undelivered elements, primarily maintenance, we account for the license portion
based on the "residual method" as prescribed by SOP No. 98-9, "Modification of
SOP 97-2 with Respect to Certain Transactions." When VSOE of fair value does
not exist for the undelivered elements, we recognize the total fee from a
business development contract ratably over the term of the contract. We also
license our software products to record companies, artists and websites.
Software license revenues are recognized when persuasive evidence of an
arrangement exists, the fee is fixed and determinable, collection is probable
and delivery has occurred. Services revenues from maintenance fees related to
our licensed software products and hosting fees from record companies and
artists are recognized over the service period, typically one year. We intend
to increase our services revenues by significantly expanding our hosting and
music
27
delivery services. Revenue derived from hosting services include subscription
fees from artists for encoding and storing music files, e-commerce services and
transaction reporting. Music delivery services revenue include transaction fees
from sales of digital recorded music through our LMN website affiliates and
fees from music retailers and websites related to the sample digital music
clips delivery service. Revenue from kiosk sales consist of software licenses
and services revenue from equipment and kiosk-related services. We bear full
credit risk with respect to substantially all sales.
Business development revenues as a percentage of total net revenues were
63%, 48% and 46% in 2000, 1999 and 1998, respectively. Liquid Audio Korea (LAK)
stopped making its contractual payments as scheduled. LAK is undergoing a
recapitalization through the addition of new investment partners so that it can
continue making its payments to us. Until such time contractual payments are
resumed, we are deferring recognition of revenue from LAK. In late 2000, Liquid
Audio Greater China and Liquid Audio South East Asia through our strategic
partner did not make their contractual payments as scheduled. We are pursuing
collection for the missed payments. No revenue will be recognized until
payments are on schedule.
In 2000, approximately 53% of total net revenues came from sales to two
customers, Liquid Audio Japan and Liquid Audio South East Asia through our
strategic partner. In 1999, approximately 73% of total net revenues came from
sales to three customers, Adaptec, Inc., Super Stage, Inc. and Liquid Audio
Korea. In 1998, approximately 34% of total net revenues came from sales to one
customer, SKM Group. International revenues represented approximately 69%, 49%
and 65% of total net revenues in 2000, 1999 and 1998, respectively. We expect
international revenues will continue to represent a significant portion of our
total net revenues.
We have a limited operating history upon which investors may evaluate our
business and prospects. Since inception we have incurred significant losses,
and as of December 31, 2000 we had an accumulated deficit of approximately
$73.9 million. We expect to incur additional losses and continued negative cash
flow from operations through at least 2002. Our revenues may not increase or
even continue at their current levels or we may not achieve or maintain
profitability or generate cash from operations in future periods. Our prospects
must be considered in light of the risks, expenses and difficulties frequently
encountered by companies in their early stages of development, particularly
companies in new and rapidly evolving markets such as the digital delivery of
recorded music. We may not be successful in addressing these risks, and our
failure to do so would harm our business.
28
Results of Operations
The following table sets forth, for the periods presented, certain data
derived from our statement of operations as a percentage of total net revenues.
The operating results in any period are not necessarily indicative of the
results that may be expected for any future period.
Year Ended
December 31,
------------------
2000 1999 1998
---- ---- ----
Net revenues:
License.................................................. 11 % 35 % 44 %
Services................................................. 26 17 10
Business development (related party)..................... 63 48 46
---- ---- ----
Total net revenues..................................... 100 100 100
---- ---- ----
Cost of net revenues:
License.................................................. 3 5 11
Services................................................. 23 25 9
Business development (related party)..................... 1 2 --
Non-cash cost of revenues................................ -- 1 1
---- ---- ----
Total cost of net revenues............................. 27 33 21
---- ---- ----
Gross profit............................................... 73 67 79
---- ---- ----
Operating expenses:
Sales and marketing...................................... 148 232 144
Non-cash sales and marketing............................. 2 18 26
Research and development................................. 198 266 146
Non-cash research and development........................ 1 8 8
General and administrative............................... 62 63 59
Non-cash general and administrative...................... -- 4 9
Strategic marketing-equity instruments................... 17 71 --
---- ---- ----
Total operating expenses............................... 428 662 392
---- ---- ----
Loss from operations....................................... (355) (596) (313)
Other income (expense), net................................ 72 47 8
Equity in net loss of investment........................... (8) -- --
---- ---- ----
Net loss................................................... (291)% (549)% (305)%
==== ==== ====
Years Ended December 30, 2000, 1999 and 1998
Total Net Revenues
Total net revenues increased 162% to $11.6 million in 2000 from $4.4 million
in 1999. Total net revenues increased 57% in 1999 from $2.8 million in 1998.
License. License revenues decreased 16% to $1.3 million in 2000 from $1.5
million in 1999. License revenues increased 24% in 1999 from $1.2 million in
1998. The decrease in 2000 and increase in 1999 relates principally to Liquid
Player license fees received under an agreement with a customer. Under this
agreement, we received $1.5 million in license fees over a 14-month period.
These fees were recognized as license revenue over the license period, which
ended on December 31, 1999. The decrease in 2000 from Liquid Player license
fees were partially offset by an increase in license fees related to digital
music kiosk sales. Due to our shift in marketing emphasis from software
licensing to digital music delivery services, however, revenues from licensing
of our Liquifier Pro and Liquid Server software decreased in 1999 from 1998,
which partially offset the increase in Liquid Player revenues described above.
29
Services. Services revenues increased 306% to $3.0 million in 2000 from
$733,000 in 1999. Services revenues increased 174% in 1999 from $268,000 in
1998. The increase in 2000 was due to increases in encoding services, kiosk-
related equipment and services, digital music and transaction fees from our
music delivery services and promotion and advertising services. The increase in
1999 was due to increased maintenance and hosting fees and the addition to
revenues from promotion and advertising services, sample music clips service
and mu