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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-K

(Mark one)

For the fiscal year ended March 31, 2004 or

For the transition period from                                                                               to                                                                              

Commission File Number: 72870

SONIC SOLUTIONS

(Exact name of registrant as specified in its charter)

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.                 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 127.

Yes x         No ¨

The aggregate market value of the voting stock held by non-affiliates of the registrant on September 30, 2003, based upon the closing price of the Common Stock on the NASDAQ National Market for such date was approximately $272,030,000. ¹

The aggregate market value of the voting stock held by non-affiliates of the registrant on June 7, 2004, based upon the closing price of the Common Stock on the NASDAQ National Market for such date, was approximately $481,545,000. ²

Documents incorporated by reference: Portions of the Registrant’s proxy statement to be filed pursuant to Regulation 14A within 120 days after Registrant’s fiscal year end of March 31, 2004 are incorporated herein by reference into Part II, Item 5 and Part III of this annual report.

The number of outstanding shares of the registrant’s Common Stock on June 7, 2004 was 22,124,766.

¹            Excludes 1,871,443 shares held by directors, officers and ten percent or greater shareholders on September 30, 2003. Exclusion of such shares should not be construed to indicate that any such person possesses the power, direct or indirect, to direct or cause the direction of the management or policies of the registrant or that such person is controlled by or under common control with the registrant.

²            Excludes 1,187,994 shares held by directors, officers and ten percent or greater shareholders on June 7, 2004. Exclusion of such shares should not be construed to indicate that any such person possesses the power, direct or indirect, to direct or cause the direction of the management or policies of the registrant or that such person is controlled by or under common control with the registrant.

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Forward Looking Statements

This report, including the documents incorporated by reference in this document, includes forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. We have based these forward-looking statements on our current expectations and projections about future events. Our actual results could differ materially from those discussed in, or implied by, these forward-looking statements. Forward-looking statements are identified by words such as “believe,” “anticipate,” “expect,” ‘intend,” “plan,” “will,” “may” and other similar expressions. In addition, any statements that refer to expectations, projections or other characterizations of future events or circumstances are forward-looking statements. Forward-looking statements include, but are not necessarily limited to, those relating to:

Factors that could cause actual results or conditions to differ from those anticipated by these and other forward-looking statements include those more fully described in the “Risk Factors” section under the Management’s Discussion and Analysis of Financial Condition and Results of Operations in Item 7 below. We are not obligated to update or revise these forward-looking statements to reflect new events or circumstances. You should assume that the information appearing in this document is accurate only as of the date on the front cover of this document. Our business, financial condition, results of operations and prospects may have changed since that date.

A Note on Dates

Quantities or results referred to as “to date” or “as of this date” mean as of or to March 31, 2004, unless otherwise specifically noted. References to “FY” refer to the Company’s fiscal year ending on March 31 of the designated year. For example, “FY 2004” refers to the fiscal year ending March 31, 2004. Other references to “years” mean calendar years.

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PART I

Item 1.    BUSINESS

Overview

We develop and market computer based tools:

Most of the products we sell consist entirely of computer software, though some of the tools we sell include “plug-in” computer hardware. We also license the software technology underlying our tools to other companies to incorporate in products they develop.

We divide our business into three categories:

We often refer to our desktop products and our technology products collectively as our consumer products.

We were incorporated in California in 1986 and completed our initial public offering in 1994. Our principal executive headquarters are located at 101 Rowland Way, Suite 110, Novato, California 94945. Our telephone number is (415) 893-8000.

Our website address is www.sonic.com. Our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act are available free of charge through our website as soon as reasonably practicable after they are electronically filed with, or furnished to, the Securities and Exchange Commission.

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DVD-Video and our Business

Many of our products involve the creation or playback of DVD-Video discs or related formats.

The DVD-Video optical disc format, introduced in 1996, offers high quality video, surround audio, and extensive interactivity on a Compact Disc-sized disc.

DVD-Video is built upon the DVD-ROM standard, which specifies a disc capable of storing a significantly greater amount of digital information than the earlier Compact Disc (“CD”) format. A single-layer DVD-ROM disc holds 4.7 Gigabytes of data, while a CD-ROM holds approximately 650 Megabytes of data, or less than one seventh of the capacity of the DVD format. DVD discs can be manufactured with two information layers on one side of the disc to store a total of 8.5 Gigabytes. They can also be manufactured with two information-carrying sides, for a maximum of 17.0 Gigabytes on a single disc (two sides, two layers on each side). The Compact Disc is limited to a single information layer on only one side of the disc. The DVD-Video format utilizes this large capacity to offer content publishers and video consumers a wide range of features and options:

Since its introduction, DVD-Video has been very popular with consumers. Based on published industry statistics, DVD-Video has proven to be the most rapidly adopted consumer electronics format of all time. By the end of 2003, almost 500 million DVD players had been shipped world-wide, including “set-top” players, video game console based players, and personal computer based software players. In the United States more than 50% of all homes had DVD players by the end of 2003, and during 2003 more than three billion DVD-Video discs were replicated world-wide.

Our products are used to encode video, audio and graphics elements in the particular formats supported by the DVD-Video specification, to prescribe and specify the disc navigation, that is, the interactive behavior of the DVD title in response to user commands, and then to weave or “multiplex” together the encoded elements and navigation information in the particular manner required by the DVD-Video format. Sometimes, particularly in professional settings, this process is referred to as “DVD Authoring.” In other instances, particularly in consumer settings, it is referred to as “DVD Creation.”

There are some other optical disc audio and video formats, some related to DVD-Video that are supported by some of our products. Video CD (“VCD”) is a CD-ROM based format utilizing relatively low resolution MPEG-1 video. Super Video CD (“SVCD”) is a kind of compromise between DVD-Video and Video CD. It

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utilizes a CD-ROM carrier, and low-bit-rate MPEG-2 Video. DVD-Audio is a sister format to DVD-Video, emphasizing more audio-related features. To date, DVD-Audio has had only limited success, with a relatively small compatible player population (almost all of which also play standard DVD-Video discs) and only a limited number of titles (almost all of which include a standard DVD-Video title of the same content on the same physical disc). CD-Audio (“CD-A”) is the original digital audio format, introduced in 1982, that made 5.25” optical discs the standard for distributing recorded music. CD-ROM is the data format that was introduced in 1985, and began to create a personal computer data application for Compact Disc technology.

CD and DVD discs are available in both read-only, pre-manufactured versions, as well as in recordable versions. Recordable discs figure prominently in our Desktop business because they create demand among a large portion of the PC industry for disc creation software. There are a number of variations in recordable discs: CD-R, DVD-R, and DVD+R refer to recordable discs that can be written, only once and CD-RW, DVD-RW, and DVD+RW refer to recordable discs that can be erased after writing to be written on again with different data. The “-” and “+” symbols refer to somewhat different physical recording strategies for DVD recording promoted by different consortia of companies that developed the underlying recording technology.

Professional Products

We currently offer a number of professional product lines including DVD Creator, DVD Fusion, Sonic Scenarist, DVD Producer and Reel DVD. DVD Creator and DVD Fusion are designed to run on versions of the Macintosh personal computer manufactured by Apple Computer. Sonic Scenarist, DVD Producer, and Reel DVD are designed to run on personal computers equipped with versions of the Windows operating system manufactured by Microsoft Corporation.

Professional Customers

Our professional customers are mainly facilities that process and prepare audio, video and film programming and who provide DVD authoring services as part of their offering. Most of the titles authored by our professional customers involve entertainment, educational and/or business content.

Some of our professional customers are independent organizations that supply services to audio and video content holders and publishers, while some are in-house facilities that are owned by particular content holders or publishers. Our professional customers range in size from relatively small organizations with few employees to larger facilities with hundreds of employees. Among our customers are facilities that are independent, privately owned companies, as well as facilities which are part of much larger public, private, or non-profit organizations. While we have concluded corporate purchasing agreements with certain customer organizations that have multiple facilities, even within such organizations decisions to purchase and deploy our products are usually made at the individual facility level.

Professional DVD Production

Our tools enable professional customers to prepare DVD-Video titles. The tools we sell support some or all of the following processes:

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Professional Product Lines

We offer our professional products on both major PC platforms — Macintosh and Windows.

Macintosh Based Professional DVD Products: DVD Creator and DVD Fusion

We offer a range of professional DVD production tools for use on the Macintosh, under the DVD Creator and DVD Fusion trade names. Generally speaking, DVD Creator systems offer more extensive capabilities at a somewhat higher price points to more specialized professionals while DVD Fusion systems are designed for greater ease of use and are targeted at less specialized video professionals at somewhat lower price points. The two product lines share common technology and can perform many of the same functions. We offer both lines in a variety of configurations so that customers can specify a system suited to their particular needs and style of operation.

DVD Creator

DVD Creator is a high-end professional DVD authoring system which we introduced in 1996. DVD Creator is intended for use by “Hollywood” class professionals. It offers superior audio and video encoding, a convenient and efficient workflow, and a high degree of creative control over the authoring process. It is designed to support a “mastering” model, where a piece of video content is completely finished and the main objective is to publish that content on as a DVD-Video disc. The archetypical project for DVD Creator is release of a major feature film on DVD. We also offer a number of software and some hardware options to our DVD Creator system packages.

DVD Fusion

DVD Fusion is a lower priced professional DVD authoring system. DVD Fusion is targeted at video professionals who serve corporate and multimedia applications. In most of these settings video content is sourced and edited specifically for inclusion on a DVD-Video disc. Thus, DVD Fusion is designed to integrate with popular professional non-linear video editing systems provided by companies such as Avid and Media 100.

To date we have shipped a combined total of more than 22,000 DVD Creator and DVD Fusion systems to customers in various locations around the world.

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Windows Based Professional DVD Products: Scenarist, ReelDVD, DVD Producer, DVD-Audio Creator

Scenarist

Scenarist is a tool for DVD-Video authoring targeted at “Hollywood” video professionals. Scenarist gives authoring professionals a great degree of control over the interactivity and feature set of DVD titles they produce. It offers extensive “scripting” capabilities that can be used by DVD-Video production facilities to automate much of the work involved in producing multiple versions of the same title. For example, it can be used to release movie on DVD-Video that will be released in different parts of the world with different language audio and subtitle tracks. It can also be used in producing various DVD-Video titles that share a common “look and feel,” for example, a set of classic movie titles being released as part of a series.

We acquired Scenarist in 2001 from Daikin Industries of Japan. Scenarist, which was the first commercially available DVD-Video authoring tool, enjoys significant acceptance among high end authoring facilities. Because Scenarist’s formatting engine has the longest and broadest experience in the industry, the product is acknowledged by many professionals as the DVD-Video production industry’s “benchmark” for stable production of standard DVD-Video titles.

Generally speaking, Scenarist is targeted at the upper end of the same market targeted by DVD Creator. Since the introduction of Scenarist in 1996, to date, approximately 1,900 copies of Scenarist have been sold.

ReelDVD

ReelDVD is a DVD-Video authoring tool intended for video professionals who are not experts in the DVD-Video specification but who still need significant flexibility in utilizing the features of the DVD-Video specification.

ReelDVD is available as a standalone software application as well in a system packaged with a hardware MPEG video encoder. In addition to selling ReelDVD to end users, we have marketed it through OEM agreements with other companies who include or “bundle” it with their products.

ReelDVD was introduced in 2000. Since its introduction, approximately 17,226 copies of ReelDVD have been shipped.

DVD Producer

DVD Producer is a DVD-Video authoring tool which we introduced at the National Association of Broadcasters in April 2002. DVD Producer is intended for video professionals in the corporate and multimedia segments who wish to produce high quality professional-looking DVD-Video titles, but who need an easy-to-use system that supports a streamlined and efficient workflow. DVD Producer includes a number of Sonic technologies that make it unnecessary for customers to have deep knowledge of the DVD-Video specification, but still lets them author discs supporting advanced navigation capabilities consumers associate with Hollywood caliber titles.

DVD Producer is available both as a standalone application software and also in a system packaged with a hardware MPEG video encoder.

DVD Producer began shipping in May of 2002. Approximately 1,110 copies of DVD Producer have been shipped to date.

DVD-Audio Creator

DVD-Audio is a sister format to DVD-Video. The DVD-Audio specification was developed between 1996 and 1999 by an industry group called DVD Forum in consultation with the music recording industry. The DVD Forum released Version 1.0 of the new DVD-Audio specification in April 1999. The first commercially released players compatible with the new format became available in late 1999. We announced support for this

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new specification in the fall of 1998, and began delivery of the first software packages supporting preliminary and limited DVD-Audio authoring early in 1999. We called this product DVD Audio Creator. In April 2001 we announced an agreement with Matsushita to integrate DVD-Audio authoring developed by them into DVD Audio Creator.

Professional DVD Market and Strategy

Market Segments for Professional DVD Production Systems

We divide the professional DVD production market into three segments:

Customers in this segment tend to cluster in major film and video production centers including Hollywood/Los Angeles, New York City, Chicago, London, Paris, Tokyo, Taipei, etc. Customers in this segment demand the very highest quality in terms of processing output, strict adherence to standards, and are very concerned with the overall efficiency of the production process since projects are often produced on tight schedules. We estimate that there are a few thousand facilities and organizations in this segment worldwide.

Customers in this segment are typically more budget constrained than customers in the “Hollywood” segment. In certain instances, however, production values and budgets equal or even exceed those typically encountered in the Hollywood segment. They tend to be geographically more dispersed. While efficiency of production is an important requirement of such customers, compatibility with other existing recording and post-production equipment is a major concern of customers in this segment. We estimate based on various industry statistics that there are potentially more than 100,000 facilities and organizations in this segment worldwide.

Competition

The DVD-Video format has generated significant interest among professional system suppliers. A number of companies currently provide MPEG-2 video encoding capabilities, audio encoding capabilities and authoring systems for the professional user. We believe that more companies will participate in this market in the future.

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A number of companies produce products which compete with all or part of our professional product offerings. These companies include or have included:

A number of these companies have financial or organizational resources significantly greater than ours and/or greater familiarity than we do with certain technologies involved in DVD production.

Strategy

We expect that our professional DVD business will account for a significant portion of our overall business in the future. Our DVD strategy will continue to be based on the following elements:

Sales and Distribution

We sell our professional products through a field sales force in combination with a network of professional audio/video dealers. As of May 31, 2004, we employed 8 people in our field sales organization for professional products. Sales personnel are based in our headquarters office in Novato, California as well as in our offices in London (covering Europe) and in Tokyo (covering the Pacific Rim). We have other sales personnel based out of home offices in Los Angeles, Utah, Washington and Taipei. Our field sales force includes sales managers and sales engineers. Most of our field sales personnel operate under compensation arrangements in which a substantial portion of their compensation is contingent upon performance relative to revenue targets.

The vast majority of our professional product sales involve one of our dealers. Dealers play an important role in our sales and support efforts. They stimulate demand in their regions, prospect for and qualify potential new customers, give product demonstrations, close sales, and assist in post-sale installation, training and support. Dealers very often sell peripheral equipment along with our products so that customers can obtain a complete workstation configuration from one source.

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We have dealers for our professional products in most areas of the world. As of May 31, 2004, we had 28 dealers in the Americas, 43 in Europe, Africa and the Middle East and 24 dealers in the Pacific Rim. We generally do not grant contractual exclusivity to our dealers, though as a matter of practice, depending on the dealer’s territory and competence, we may maintain only one dealer in a particular region.

Recruiting and maintaining dealers can be a difficult process. Because our products are sophisticated, our dealers need to be technically proficient and very familiar with professional audio and video production work. Dealer organizations sometimes have limited financial resources, and may experience business reversals for reasons unrelated to our product lines. The attractive dealers in a region may also carry competing products.

Customer Support

Customer support is important to professional users. This is why we offer our customers the SonicCare^™ maintenance program. Customers purchase annual SonicCare service contracts from us that may (depending on customer choice of options) provide for:

Customers typically add a one-year SonicCare option to their initial system purchase and a significant number of customers renew SonicCare after their first year.

To administer SonicCare, we employ a staff of product support specialists at our Novato headquarters and in our field offices. We provide unlimited telephone support during scheduled support hours to all customers under SonicCare. Customer support calls also provide us with an important means of understanding customer requirements for future product enhancements. We also undertake customer calling programs in which customers are contacted by a customer support representative to assess their level of satisfaction and to acquaint them with new product offerings.

Outlook

While we expect our professional DVD creation products to continue to account for a significant portion of our revenues in the future, we do not expect this business to experience revenue growth in the near term. Professional DVD facilities began equipping to prepare DVD titles as early as 1997, and significant expansion of DVD creation capacity occurred during 1998, 1999 and 2000. While the number of DVD discs replicated will continue to grow in future years, we do not expect that the number of titles published will expand as dramatically, hence we do not expect increases in the rate of capacity expansion by DVD production facilities. This means that we do not expect significant increases in sales of our professional DVD creation products.

High Definition DVD

During the past year, there have been a number of developments pointing toward introduction of a high definition video optical disc format within the foreseeable future. While we believe there have been a number of proposals along this line, three seem most likely to actually launch as consumer formats: (1) DVD-HD, a proposed standard developed by the DVD Forum, the trade association that developed and now controls the DVD specification; (2) Blu-Ray Disc, a proposal developed by a consortium of companies led by Sony Corporation; and (3) EVD, a proposal developed by an organization associated with the Chinese government.

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While there are significant differences among the proposals, all three proposals, in their most advanced forms, incorporate a blue reading laser, in contrast to the red laser used by DVD (and CD) players. The shorter wavelength blue light permits smaller “pits” to be recorded, thereby increasing the information capacity of the disc; roughly speaking, quadrupling the amount of data that can be recorded on the disc.

At the present time, none of these proposed standards is fully complete and ready for commercial introduction, but industry observers expect each to move to completion in the near future. It seems likely that one or more of these formats will launch and that consumer players and some amount of “Hollywood” content will be available for them by the end of 2005. If one or more of these proposed standards does achieve commercial launch, we anticipate that we will produce professional authoring systems for them. This may have the effect of increasing the opportunities available to our professional products business. If one or more of these formats begins to enjoy widespread adoption by consumers, our professional customers may undertake to re-equip a significant portion of their facilities to produce titles in the new format(s). Our professional revenues could significantly increase if such a trend develops. However, there can be no assurances that one or more of these formats will achieve widespread adoption or that if they do, our products will capitalize on such a trend.

Professional Audio Products — SonicStudio Spin Off

For a number of years we developed and marketed a line of professional audio workstations under the SonicStudio trade name. On March 21, 2002, we executed an agreement to form a new company, SonicStudio LLC in partnership with a limited liability corporation controlled by two individuals – Eric Jorde and Jeff Wilson. Under the terms of the agreement, we transferred our SonicStudio workstation business to SonicStudio LLC, and licensed this company to utilize the technology underlying SonicStudio in the professional audio workstation market. The book value of net assets and liabilities transferred to SonicStudio LLC, including receivables, inventory, fixed assets, and net of customer service liabilities was $235,661. Certain employees transferred from Sonic to join SonicStudio LLC.

Under the terms of the agreement, SonicStudio LLC compensated us for the Sonic Studio business with a three year note for $500,000. The note, which does not carry interest, will be repaid to us with a percentage royalty based on sales received by SonicStudio LLC, plus any share of profits paid by them to us. Once the note is retired, Sonic will continue to retain a 15% interest in SonicStudio LLC.

As we had discussed in our prior year’s Annual Report for FY 2003, we took these actions because we understood the market for professional audio workstations designed for use by CD mastering engineers in the recording industry (the segment addressed by the SonicStudio product line) to be quite depressed and unlikely to present us with any growth opportunities for the foreseeable future.

During fiscal year 2004, the business prospects for SonicStudio LLC deteriorated. Accordingly, we wrote down the book value of our investment in SonicStudio LLC to zero.

Desktop Products

Our desktop products are software tools that permit customers to combine audio, video and graphic elements to make regulation DVD-Video, DVD-ROM, CD-ROM, CD-Audio and Video CD discs. They also permit customers to play back DVD-Video discs on their computers, and to backup their PC data onto disc and tape backup devices. At the present time, we offer our desktop products under a variety of trade names, including RecordNow!^®, Backup My PC^™, CinePlayer^™, PrimeTime^™, DVDit^® and MyDVD^®.

DVDit

In April 1999 we introduced DVDit — a simplified DVD-video creation tool. DVDit is designed to permit easy authoring of fully spec-compliant DVD titles by customers who do not have extensive knowledge of the DVD specifications, and whose projects do not require the same specialized features required by “Hollywood” professional users. DVDit is positioned to be purchased by consumers, “prosumers” and “desktop” professionals. We currently anticipate that the latest version of DVD-it – DVDit Version 5 – will be released to the market in June 2004.

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DVDit is intended to address the needs of a broad range of customers who wish to create DVD-Video discs. Among DVDit’s end user customers are:

MyDVD

We introduced MyDVD in the fall of 2000. MyDVD is specifically designed as a DVD creation tool for use by consumers.

MyDVD is designed to permit easy authoring of DVD titles by consumers who have virtually no knowledge of the DVD specification, but who wish to turn their videos into professional looking DVD titles. We currently offer MyDVD in various versions, including MyDVD 5.2, MyDVD SlideShow, MyDVD 5.2 Deluxe, and MyDVD Studio Deluxe 5.2. Our belief is that as DVD recorders become widely available, consumers will begin to utilize DVD recording for a number of purposes, such as recording favorite home videos, recording favorite video broadcasts, creating highly convenient and portable copies of videos downloaded from the internet, and for copying videos published on VHS cassette or DVD. We do not advocate violation of copyright laws by our customers. None of our products contain software designed to circumvent the operation of encryption or other protection systems (for example the “CSS” encryption system commonly used by DVD-Video publishers to prevent digital copying of their published video content.)

PrimeTime

PrimeTime is an application designed to operate with Windows XP Media Center Edition PCs. Media Center PCs are personal computers, typically configured with a remote control and infrared sensor, an advanced graphics card, a TV tuner, a hardware video encoder, and a DVD recorder. Windows XP Media Center Edition is a special version of the Windows XP operating system that permits consumers to use Media Center PCs more like a consumer electronics device with a “10 Foot” remote-control based interface, rather than the traditional PC keyboard and mouse “2 Foot” interface.

PrimeTime operates with Media Center PCs to permit consumers to easily record onto regulation DVD-Video discs programming previously captured from cable television broadcasts. PrimeTime adds a “10 Foot” user interface to Sonic’s underlying DVD creation technology permitting consumers to create DVDs from the comfort of their easy chairs, using a conventional-looking remote control.

We offer PrimeTime in various versions, including a bundled version for PC OEMs as well as a basic and Deluxe version.

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Cineplayer

CinePlayer turns a Windows PC equipped with a device capable of reading a DVD-ROM into the full-featured DVD player. We acquired CinePlayer as part of the acquisition by us of the Ravisent business from Axeda (see below under “Prior Acquisitions”).

CinePlayer includes a high featured DVD player enhanced with a number of features not available to consumers in traditional consumer electronics “set-top” players, such as the ability to capture screen shots from DVDs, or to integrate playback with DVD creation tools like Sonic MyDVD.

We offer CinePlayer in various versions including CinePlayer 1.5 Basic and CinePlayer 1.5 Surround as well as in various OEM bundled versions.

RecordNow!

RecordNow! is a line of CD/DVD mastering software applications. Using RecordNow!, users can transfer audio and data to recordable CDs or DVDs. Data is written in standard ISO-9660 or UDF formats, making the disc readable on virtually any computer system. Audio is written in standard CD-Audio format, making the discs produced playable on virtually every CD-Audio player in the world. We offer RecordNow! in different versions, including a basic version intended for bundling with CD recorders and DVD/CD recorders, as well as advanced versions, RecordNow! Deluxe and RecordNow! Deluxe Suite. The enhanced versions incorporate various additional features, for example, the ability to encode audio in the MP3 format for use in compatible players.

Backup My PC

Backup MyPC is a data backup software application designed to assist computer users with preserving their valuable computer data in the event of a hardware failure or user error. Backup MyPC allows users to create backup discs or tapes, and to restore data to their PCs either selectively, or for a complete system restoration. The application incorporates a number of features to assist users in making backups an automatic process, and for making the backup process easier for users to deal with. We offer Backup MyPC in two versions: Simple Backup, which includes a limited feature set and which is oriented toward PC and drive OEMs who wish to bundle the software; and Backup MyPC, which includes a full feature set and is oriented toward retail purchasers.

Desktop Product Strategy

Our Desktop products are intended to take advantage of a number of trends in the PC and consumer electronics industries:

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Based on these trends, we believe that manipulation of digital video, along with other digital media types such as digital audio, on PCs will become an important activity for many consumers. We believe that the availability of low cost DVD recording capabilities will accelerate this trend. DVDit, MyDVD and all of our Desktop products are designed to serve the needs of general consumers who require easy-to-use DVD, CD and digital media playback and creation software.

Sales and Distribution for Desktop Products

As of May 31, 2004, we had 36 sales and marketing professionals responsible for our Desktop Products, located at our headquarters in Novato as well as in field and home offices in various locations around the world. These professionals plan the development “road map” for our products, develop marketing materials to position the products, and develop and conclude agreements with the various channel partners we utilize to reach end users for our products.

We distribute our Desktop Products through four main channels: “bundling” arrangements with other companies; web store sales; specialized dealers and traditional “bricks and mortar” computer and electronics retail stores.

We believe that the vast majority of consumers will first become aware of DVD creation software when they purchase a video device, for example a CD recorder, video input plug-in card, or, especially, a DVD recorder, and when they begin to use the software that comes bundled with the device. These new users will then add to their software capabilities via upgrades, in most cases through web transactions. Later, when the DVD creation software category has become established, consumers who are now used to the concept of DVD creation will shop for DVD creation software in traditional retail channels.

OEM Bundling

Our primary channel for reaching customers with our desktop applications software is “bundling” arrangements with various other companies in which copies of DVDit, MyDVD, CinePlayer, PrimeTime, RecordNow!, and/or Backup My PC are included or “bundled” with shipments of those companies’ products. These companies (we refer to them as “Bundle Partners”) are motivated to include our software as a value-

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added offering for their customers and they usually pay us a royalty on each copy of our software shipped with their products. We are motivated to enter into bundling arrangements because they generate revenue for us as well as create a large installed base of customers to whom we can sell upgraded or enhanced versions of our products (through our other channels, particularly through our Web Store).

We have bundling arrangements with a variety of Bundle Partners and product types. The products with which our software is bundled include professional video editing systems, professional video capture and display cards, consumers video capture and interface cards, DVD recorders, CD recorders, PC models including DVD recorders, PC models including CD recorders, and PC models positioned as “multimedia” PCs.

Most of our bundle deals permit us to capture customer registrations or to invite the customer to click to our web site. We usually do not provide end user support as part of our bundling arrangements, but rely on our Bundle Partners to support the end user customers. We typically do provide “second line” support to our Bundle Partners to enable them to provide “first line” support of our products to their consumer-customers.

The following are a representative list of companies with whom we have current bundling arrangements and/or with whom we bundled our software during the 2004 fiscal year:

Non-traditional Bundling Arrangements

We have lately begun concluding non-traditional bundling arrangements with some of our OEMs. In particular, we have embarked on a new program with one of our major OEMs, Dell, in which we are developing a number of versions of our products specifically for that OEM’s customers. The versions include a base version to be included with the OEM’s products, and enhanced versions. The enhanced versions will be marketed by the OEM’s sales force and by us to obtain favorable end user upgrade decisions at the “point of sale,” that is the time and place at which end user customers purchase a PC or other device, as well as after the point of sale. If the OEM offers an upgrade, then the base version can be delivered by them to their consumer customers without royalty to us. Revenue from upgrade sales, if any, is split between the OEM and us. We will be contributing significant resources to this effort including (i) extra development resources to develop the various product versions required by the program, (ii) enhanced first line customer support activities, and (iii) enhanced marketing obligations, among others.

While we believe that upgrade rates and resulting revenues, will more than compensate for the lack of royalty revenues deriving from shipments of the base versions of our products and for our increased resource commitment, we have had only limited experience with this business model at this time, and actual results may be disappointing. In that case, our revenues and our results of operations as well as our stock price, could be negatively affected. During the quarter ended December 31, 2003 Dell began transitioning to this new model, and this transition continued during the quarter ended March 31, 2004.

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We believe that non-traditional bundling arrangements are attractive, because they may provide a solution to the pressure that most OEMs exert on software providers like Sonic to lower prices over time. We believe that such arrangements may allow us to continue to increase our revenues even though OEM bundle unit prices decline and growth in unit volumes shipped eventually slows. We plan to pursue a number of such initiatives in the future with Dell and with other OEMs, both with respect to Point of Sale and After Point of Sale activities. However, there are no assurances that any additional revenue we derive from these new bundling arrangements will keep pace with the potential loss of revenue from the continuing decline in unit prices and unit volumes, as well as compensate us for the additional expenditures we will incur and additional efforts we will dedicate to make these arrangements successful.

Web Store

We have established web-based retail stores for our Desktop Products (as well as some of our Professional Products, for example, ReelDVD, that are priced in a range that is typically sold over the web). Our Web Store is intended both to meet retail demand for our Desktop Products as well as to service upgrade orders for our products, in particular, upgrade orders for software distributed by our bundle partners.

We currently have separate Web Stores for Europe, North America and Japan. We currently “outsource” operations of parts of our Web Stores through arrangements we have with Digital River, Element Five, and Sanshin Denki. Under these arrangements, our outsource partners typically provide the servers which list our products and handle purchase transactions through their secure web sites.

We currently believe that our Web Store operations have substantial growth potentials in the next few years and that our Web Store sales may represent an increasing percentage of our overall consumer application software revenues. With this in mind we are currently devoting a significant amount of our resources on building an enhanced web marketing capability.