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, 2001
 
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
(State or other jurisdiction of incorporation or
organization)
  
77-0421089
(I.R.S. Employer Identification Number)
800 Chesapeake Drive, Redwood City, California
(address of principal executive offices)
  
94063
(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
Preferred Stock Purchase Rights
 
 
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 $44,632,535 as of December 31, 2001 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 22,710,335 shares of the Registrant’s Common Stock issued and outstanding on March 13, 2002.

TABLE OF CONTENTS
 
         
Page
PART I
ITEM 1.
      
1
ITEM 1A.
      
12
ITEM 2.
      
23
ITEM 3.
      
23
ITEM 4.
      
24
PART II
ITEM 5.
      
25
ITEM 6.
      
26
ITEM 7.
      
27
ITEM 7A.
      
38
ITEM 8.
      
38
ITEM 9.
      
38
PART III
ITEM 10.
      
39
ITEM 11.
      
43
ITEM 12.
      
45
ITEM 13.
      
47
PART IV
ITEM 14.
      
48

PART I
 
ITEM 1.    BUSINESS
 
This Annual Report on Form 10-K 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. 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
 
Liquid Audio, Inc. was incorporated in California in January 1996 and reincorporated in Delaware in April 1999. In July 1999, we completed our initial public offering of common stock. Our principal executive offices are located at 800 Chesapeake Drive, Redwood City, California 94063, and our telephone number is (650) 549-2000.
 
We provide a leading open platform that enables the digital delivery of media over the Internet. Today, 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 leading third party music related websites, OEMs, 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 (“RIFFS”), and Liquid Store, 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 Atlantic Records, BMG Entertainment, EMI Music Group, Sup Pop Records, Warner Music Group and Zomba Records Group, and artists such as Backstreet Boys, Enya, Mick Jagger, Jewel, matchbox twenty and ‘N SYNC.
 
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 approximately 20,000 individual music samples per day. Our system hosts digital music files and distributes them through a network of music websites, and soon, through a digital music subscription service.
 
 
•
 
Syndication.    Our distribution system syndicates music content to a network of leading retail, music and original equipment manufacturer (“OEM”) websites, including Amazon.com, BestBuy, CDNOW, Palm and Sony.
 
 
•
 
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, purchase and download digital recorded music. Soon, our

1

Liquid Player will include the capability of purchasing digital music through our digital music subscription service. 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.
 
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 growing inventory. Our Liquid Player will soon have the capability of purchasing digital music through our digital music subscription service. 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, Microsoft Windows Media and MP3.
 
 
•
 
Security and Compliance.    Our digital rights management (“DRM”) system protects copyright owners 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 and DRMs, including Liquid Audio, Microsoft Windows Media, MP3 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 that have limited access to traditional retail distribution channels. Our patented territory restriction technology identifies the approximate geographic location of consumers to enforce content rules worldwide.
 
Strategic Relationships and Customers
 
We plan to continue to build relationships with key third parties engaged in the creation and distribution 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.
 
 
•
 
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. Under a separate agreement, we plan to sell music from EMI CMG, the world’s largest Christian music company, through our digital music subscription service scheduled to be delivered in spring 2002.
 
 
•
 
Sony Music.    We are encoding, hosting and delivering promotional downloads from Sony Music on Amazon.com’s website, through our agreement with Amazon.com.

2

 
 
•
 
Universal Music Group.     We are encoding, hosting and delivering promotional downloads from Universal Music Group on Amazon.com’s website, through our agreement with Amazon.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.
 
 
•
 
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, edel music, Rounder Records, Strictly Rhythm, Sub Pop Records, Twin/Tone Records and Vanguard Records. As of December 31, 2001, record labels have chosen to promote and sell more than 180,000 digital music recordings through our Liquid Music Network. This compares to approximately 140,000 digital music recordings at the beginning of 2001.
 
Channel Partners.    Our distribution channel continues to grow and includes some of the most popular music websites on the Internet today.
 
 
•
 
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 the Liquid Store commerce solution and offers a custom branded version of Liquid Player software 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.
 
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 Time Warner.    We 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 is distributed by AOL on the winamp.com website, its other websites and ours.
 
 
•
 
ARM.    We entered into an agreement with ARM, a microprocessor design company, to create a turnkey platform enabling devices supporting secure digital audio devices, using our Secure Portable Player Platform (“SP3”). This integration has made 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.
 
 
•
 
Cirrus Logic, Inc.    Cirrus Logic became the first company to integrate the ARM/Liquid Audio SP3 solution into their chipsets. They are using their reference design to enable flash memory-based consumer electronics devices to be compatible with our platform.
 
 
•
 
Microsoft.    To maximize the number of consumers getting music through our distribution network, we added support for the Microsoft Windows Media format. To date, we have encoded and distribute more than 51,000 songs in the Windows Media format. We also 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 added support for Windows Media to our Liquid Player software.
 
 
•
 
Palm, Inc.    We provide Palm handheld users with a solution for accessing digital music. Palm licenses both SP3 and the Liquid Store to create the Palm Music Connection, a new song download

3

website that gives Palm m100 series handheld users immediate access to thousands of secure digital downloads from a wide variety of artists and genres.
 
 
•
 
Plextor Corp.    Plextor delivers a custom-branded version of our Liquid Player software with its compact disc recorder/rewriteable (“CD-R/RW”) drives. Plextor also uses the Liquid Store to facilitate the secure distribution and sale of audio content on its website.
 
 
•
 
RealNetworks Inc.    We developed software “plug-ins” that enable users of RealNetwork’s RealPlayer G2, RealJukebox and RealOne Player software to playback music encoded in our format using their existing software. To date, more than 9 million users have downloaded the plug-ins.
 
 
•
 
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 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
     
Palm, Inc.
e.Digital Corporation
     
PocketPyro Porteson
IOData
     
Sanyo Corporation
Mpuls3
     
TDK
 
International Offices
 
We believe that offices outside the United States are important to establish a complementary international distribution infrastructure. Our international offices 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 distribute Liquid Player or have adopted Liquid Store.
 
 
•
 
Japan.    We recently established a new office in Tokyo to directly service and build new relationships with label, retail and consumer electronics companies.
 
Information regarding financial data by geographic area, as well as information regarding operating segments, is set forth in Part II, Item 8 on this Form 10-K in the Notes to Consolidated Financial Statements at Note 1, “Segment Information,” which information is hereby incorporated by reference.
 
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 2001:
ARM
   
Plextor Corporation
Country Music Hall of Fame
   
Rhino Records
EMI Music Distribution
   
Sony Electronics Inc.
Microsoft
   
Sony UK
Palm, Inc.
   
Warner Music Group

4

 
In 1999, Adaptec, Super Stage and Liquid Audio Korea accounted for 31%, 30% and 12% of our total net revenues, respectively. In 2000, Cyber Music Entertainment, formerly Liquid Audio Japan, and Liquid Audio South East Asia through our strategic partner accounted for 42% and 11% of our total net revenues, respectively. In 2001, Cyber Music Entertainment and Liquid Audio Greater China accounted for 39% and 22% 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
American Gramaphone
  
Arista Records
  
Artist Direct
Atlantic Records
  
Blue Note Records
  
BMG Distribution
Capitol Records
  
Columbia Records
  
Dreamworks Records
Elektra Records
  
EMI Recorded Music
  
Epic Records
Geffen Records
  
Hollywood Records
  
Interscope Records
Island Records/Def Jam
  
Jive
  
Matador
Maverick Records
  
MCA Records
  
Mercury Nashville
RCA Records
  
Reprise Records
  
Rhino Records
Roadrunner
  
Sony
  
Sparrow
Tommy Boy Records
  
TVT Records
  
Universal Music Group
V2 Records
  
Verve
  
Virgin
Warner Music Group
  
Wind-up Entertainment
  
Zomba Records Group
 
Recording Artists
Barenaked Ladies
  
Basement Jaxx
  
Bjork
Blink 182
  
Boz Scaggs
  
Brad Melhdau
Britney Spears
  
Bush
  
Busta Rhymes
Charlie Haden
  
Custom
  
Dave Matthews Band
De La Soul
  
Depeche Mode
  
Diana Krall
Drowning Pool
  
Dwight Yokam
  
Elvis Costello
Enya
  
Green Day
  
Ice Cube
Joe
  
Josh Groban
  
Lee Greenwood
Mannheim Steamroller
  
Melissa Etheridge
  
Mystikal
Natalie Merchant
  
New Order
  
Nickelback
No Doubt
  
Pink Floyd
  
P.O.D.
Powerman 5000
  
R. Kelley
  
Radiohead
Ramones
  
Randy Travis
  
REM
Rod Stewart
  
Steven Curtis Chapman
  
Sugar Ray
The Grateful Dead
  
The Strokes
  
Toby Keith
Uncle Kracker
  
Willie Nelson
  
ZOEgirl
 
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.
 
Further information regarding products and services may be found in Part II, Item 8 of this Form 10-K in the Notes to Consolidated Financial Statements at Note 1, “Segment Information,” which information is hereby incorporated by reference.

5

 
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 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 16,000 artists have used our hosting services. These artists have made more than 180,000 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 leading retail and music websites. They can also leverage these services to begin selling their music from their own website.
 
Subscription Services.    We are currently developing a turnkey solution for artists and content owners that wish to sell digital downloads through online subscription services. This service offering leverages our existing publishing and distribution services, player technology and commerce platform. Scheduled to be launched in spring 2002, our initial consumer offering will feature an integrated Liquid Player and exclusive major label content that can be output to recordable compact discs and portable digital audio devices.
 
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. Our Promotions Manager is a web-based application that provides record labels and retailers with real-time access to digital music promotions and related customization features and merchandising resources.
 
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 Microsoft 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 (“Ramp;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 Ramp;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 Ramp;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 leading music-related and retail websites and OEM customers. We provide these 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 our

6

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.
 
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 websites in our Liquid Music Network. An enhanced version of the product, Liquid Player Plus, is available to consumers for $19.95 and 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 distributed through leading consumer device manufacturers and through our Liquid Music Network of retail and music websites. In spring of this year, our Liquid Player will include the capability to purchase digital music through our digital music subscription service.
 
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, RealJukebox and RealOne Player 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 $11.7 million, $22.9 million and $17.0 million in 1999, 2000 and 2001, 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 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

7

multiple formats including Liquid Audio, MP3, Microsoft Windows Media and Sony ATRAC3, 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 patented 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: AAC, Sony ATRAC3, MS-Audio and MP3. We have 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 Secure Digital Music Initiative (“SDMI”) and is in use by several leading device manufactures. 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.
 
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 and the Liquid Store.

8

 
We believe that our technology architecture and our advanced stage of development and deployment provide distinct competitive advantages. We are currently developing the seventh 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 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.
 
 
•
 
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 Microsoft 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, OEMs and online retailers through a 24-person sales and marketing organization. These employees are located in Redwood City, Los Angeles, New York, London and Tokyo. Our software products and 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-based consumer outreach including a weekly music e-mail, press tours, participation in key trade events and conferences and other public relations activities.

9

 
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 nine patents pending in the United States and eight patents pending in other countries relating to our product architecture and technology and hold fourteen 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 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.

10

 
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., Intouch Group, Inc. and Network Commerce, Inc. have 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. 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 Full Audio, RioPort and Loudeye Technologies, providers of digital music subscription services such as Listen.com, MusicNet and pressplay and providers of music player software such as MusicMatch, RealOne or Microsoft Windows Media Player.
 
We believe that the primary competitive factors in our market are the following:
 
 
•
 
quantity and variety of digital recorded music content;
 
 
•
 
copyright licenses associated with digital recorded music;
 
 
•
 
the number and quality of music-related and retail websites;
 
 
•
 
ease of consumer experience;
 
 
•
 
number of music players distributed;
 
 
•
 
price and cost of products and services;
 
 
•
 
ability to ensure secure digital delivery of recorded music;
 
 
•
 
ability to adapt to changes in component technologies and consumer preferences;
 
 
•
 
brand awareness; and
 
 
•
 
fidelity and quality of sound of digital recorded music.
 
We believe our products and services offer significant advantages over those of our competitors:
 
 
•
 
our music catalog features over 16,000 artists and 1,600 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;

11

 
 
•
 
our Liquid Player can be customized by our OEM customers to match their own branding initiatives. This customization enables our OEM customers to maintain and extend their relationships with their customers and provide both a branded Liquid Store and the ability to feature their own product offerings within the Liquid Player. Currently, no other company offering a digital music player or jukebox provides these features and instead redirect users to their own website;
 
 
•
 
our platform offers better copy protection and copyright management than Microsoft 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 Morpheus/Music City, WinMX and others, may attract consumers who want to share or 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, there are other companies, such as IBM, Microsoft, RealNetworks, RioPort 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, 2001, we had 105 full-time employees, including 24 in sales and marketing, 52 in research and development, 17 in general and administrative and 12 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 in the new market of digital delivery of music, 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, 2001 was approximately $111.1 million. We had net losses of approximately $24.2 million, $33.7 million and $37.2 million in 1999, 2000 and 2001, 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 mid-2003. 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 expenses exceed our expectations and cannot be adjusted accordingly, our business and operating results will be harmed.

12

 
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 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, 2001, 69% or $315,000 of our accounts receivable from third parties and 100% or $1.6 million of our account receivables from related parties, 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 operating results will be harmed.
 
Our Business Might Be Harmed if We Fail to Price Our Products and Services Appropriately
 
We have recently decided to focus on providing a subscription-based service offering and a licensing-based offering for our customers. We have limited experience in pricing such new models, and failure to properly price and adjust these new pricing models may result in a loss of customers which would have an adverse effect on our business and operating results. Moreover, 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 we are forced to reduce or eliminate prices, it would diminish our revenues and impact our margins, which will harm our business.
 
If We Do Not Establish Relationships with Additional International Partners, Our Revenues Might Decline
 
In the past, we derived a significant 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. We recently terminated our relationships with these partners. Consequently, we do not expect additional revenue will be generated from them. If we are unable to establish additional relationships with international partners, and if such additional relationships do not generate a significant amount of revenue in future periods, then our future revenues could be lower than we anticipate and our business and operating results could be harmed. Furthermore, the commercial terms for these new relationships could cause our revenues to vary from period-to-period, which might result in unpredictability of our revenues.
 
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, such as our subscription-based service offering and server-based license offering, 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.

13

 
We Depend on Proprietary Rights to Develop and Protect Our Te