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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

x   QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

For the Quarterly Period Ended June 30, 2002

OR

o    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

Commission File Number 0-23137

REALNETWORKS, INC.
(Exact name of registrant as specified in its charter)

(206) 674-2700
(Registrant’s telephone number, including area code)

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 [   ]

The number of shares of the registrant’s Common Stock outstanding as of July 19, 2002 was 160,548,148.

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REALNETWORKS, INC.

FORM 10-Q

FOR THE QUARTER ENDED JUNE 30, 2002

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

REALNETWORKS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except per share data)

See accompanying notes to condensed consolidated financial statements

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REALNETWORKS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
AND COMPREHENSIVE LOSS
(in thousands, except per share data)

See accompanying notes to condensed consolidated financial statements

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REALNETWORKS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)

See accompanying notes to condensed consolidated financial statements

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REALNETWORKS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1 — SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

(a) Description of Business

     RealNetworks, Inc. and subsidiaries (RealNetworks or Company) is a leading global provider of software products and services for Internet media delivery. The Company develops and markets software products and services designed to enable users of personal computers and other consumer electronic devices to send and receive audio, video and other multimedia services using the Web.

     Inherent in the Company’s business are various risks and uncertainties, including its limited operating history and the limited history of commerce on the Internet. The Company’s success may depend in part upon the emergence of the Internet and corporate intranets as a communications medium, the acceptance of the Company’s technology and services by the marketplace and the Company’s ability to generate license, service and advertising revenues from the use of its technology and services on the Internet.

(b) Basis of Presentation

     The accompanying unaudited condensed consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation.

     These financial statements reflect all adjustments, consisting only of normal, recurring adjustments that, in the opinion of the Company’s management, are necessary for a fair presentation of the results of operations for the periods presented. Operating results for the quarter and six months ended June 30, 2002 are not necessarily indicative of the results that may be expected for any subsequent quarter or for the year ending December 31, 2002. Certain information and disclosures normally included in financial statements prepared in conformity with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission.

     These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and related notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2001.

(c) Cash, Cash Equivalents and Short-Term Investments

     Cash, cash equivalents and short-term investments are comprised of the following (in thousands):

     Restricted cash equivalents represent (a) a restricted escrow account of $10,000,000 established in connection with a lease agreement for the Company’s corporate headquarters that will be maintained for the term of the lease, and (b) cash equivalents held as collateral against a $7,300,000 line of credit with a bank which represents collateral on the lease of a building located near the Company’s corporate headquarters.

     The majority of short-term investments mature within twelve months from the date of purchase.

     The Company has classified all marketable debt and equity securities for which there is a determinable fair market value and there are no restrictions on the Company’s

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ability to sell within the next twelve months as available-for-sale. Available-for-sale securities are carried at fair value, with unrealized gains and losses reported as a separate component of shareholders’ equity, net of applicable income taxes. Realized gains and losses and declines in value judged to be other-than-temporary on available-for-sale securities are included in other income (expense). The cost basis for determining realized gains and losses on available-for-sale securities is determined using the specific identification method. In instances where there are multiple cost bases for the same security, the Company uses the average cost method in determining the cost of the security sold.

(d) Other Investments

     The Company has investments that are accounted for under the cost method of accounting. The cost method is used to account for equity investments in companies in which the Company holds less than a 20 percent voting interest, does not exercise significant influence and the related securities do not have a quoted market price.

     The Company also has investments that are accounted for under the equity method of accounting. Under the equity method of accounting, the Company’s share of the investee’s earnings or loss is included in the Company’s consolidated operating results. In cases where the Company has loaned the investee funds and is the only source of financing, the Company may record more than its relative share of the investee’s losses.

(e) Revenue Recognition

     The Company recognizes revenue pursuant to the requirements of Statement of Position No. 97-2, “Software Revenue Recognition” (SOP 97-2), as amended by Statement of Position No. 98-9, “Software Revenue Recognition with Respect to Certain Arrangements.”

     Under SOP 97-2, revenue attributable to an element in a customer arrangement is recognized when persuasive evidence of an arrangement exists and delivery has occurred, provided the fee is fixed or determinable, collectibility is probable and the arrangement does not require significant customization of the software. If at the outset of the customer arrangement, the Company determines that the arrangement fee is not fixed or determinable or that collectibility is not probable, the Company defers the revenue and recognizes the revenue when the arrangement fee becomes due and payable.

     For multiple element arrangements when Company-specific objective evidence of fair value exists for all of the undelivered elements of the arrangement, but does not exist for one or more of the delivered elements in the arrangement, the Company recognizes revenue under the residual method. Under the residual method, at the outset of the arrangement with a customer, the Company defers revenue for the fair value of its undelivered elements such as consulting services and product support and upgrades, and recognizes the revenue for the remainder of the arrangement fee attributable to the elements initially delivered, such as software licenses, when the criteria in SOP 97-2 have been met. If specific objective evidence does not exist for an undelivered element in a software arrangement, which, for the Company, typically relates to the development of complex content delivery networks which include software licenses, consulting services and product support, revenue is recognized over the term of the support period commencing upon delivery of the Company’s technology to the customer.

     Revenue from software license agreements with original equipment manufacturers (OEM) is recognized when the OEM delivers its product incorporating the Company’s software to the end user. In the case of prepayments received from an OEM, the Company generally recognizes revenue based on the actual products sold by the OEM. If the Company provides ongoing support to the OEM in the form of future upgrades, enhancements or other services over the term of the contract, revenue is recognized ratably over the term of the contract.

     Service revenues include GoldPass/RealOne media subscription services, payments under support and upgrade contracts, fees from consulting services and streaming media content hosting. Media subscription service revenues are recognized ratably over the period that services are provided. Support and upgrade revenues are recognized ratably over the term of the contract, which typically is twelve months. Other service revenues are recognized when the services are performed.

     Fees generated from advertising appearing on the Company’s Web sites, and from advertising included in the Company’s products and e-commerce and other links in the RealPlayer, RealJukebox and GoldPass/RealOne products, are recognized as revenue over the terms of the contracts. The Company may guarantee a minimum number of advertising impressions, click-throughs or other criteria on the Company’s Web sites or products for a

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specified period. To the extent these guarantees are not met, the Company defers recognition of the corresponding revenues until guaranteed delivery levels are achieved.

(f) Net Income (Loss) Per Share

     Basic net income (loss) per share is computed by dividing net loss by the weighted average number of common shares outstanding during the period. Diluted net income per share is computed by dividing net income by the weighted average number of common and dilutive common equivalent shares outstanding during the period.

     Excluded from the computation of diluted net income (loss) per share for the quarter and six months ended June 30, 2002 are options and warrants to acquire approximately 33,123,000 shares of common stock with a weighted-average exercise price of $7.84. Also excluded in the quarter and six months ended June 30, 2002, are approximately 407,000 shares of common stock issued in acquisitions that are subject to repurchase by the Company at a nominal price in certain circumstances. Excluded from the computation of diluted net loss per share for the quarter and six months ended June 30, 2001 are options and warrants to acquire 21,231,000 shares of common stock with a weighted-average exercise price of $9.07. Also excluded in the quarter and six months ended June 30, 2001, are approximately 274,000 shares of common stock issued in acquisitions that are subject to repurchase by the Company at a nominal price in certain circumstances. Such potentially dilutive securities are excluded, as their effects are anti-dilutive.

(g) Derivative Financial Instruments

     The Company conducts business internationally in several currencies. As such, it is exposed to adverse movements in foreign currency exchange rates. A portion of this risk is managed using derivative financial instruments, but fluctuations could impact the Company’s results of operations and financial position. The Company’s foreign currency exchange risk management program reduces, but does not eliminate, the impact of currency exchange rate movements.

     Generally, the Company’s practice is to manage the majority of its material foreign exchange exposures associated with short-term intercompany balances through the use of foreign currency forward exchange contracts. These contracts require the Company to exchange currencies at rates agreed upon at the contract’s inception. Because the impact of movements in currency exchange rates on forward contracts offsets the related impact on the short-term intercompany balances, these financial instruments help alleviate the risk that might otherwise result from certain changes in currency exchange rates. The Company does not designate its foreign exchange forward contracts related to short-term intercompany accounts as hedges and, accordingly, the Company adjusts these instruments to fair value through results of operations. However, the Company may periodically hedge a portion of its foreign exchange exposures associated with material firmly committed transactions and long-term investments.

     All derivatives, whether designated in hedging relationships or not, are recorded on the balance sheet at fair value. If the derivative is designated a hedge, then depending on the nature of the hedge, changes in fair value will either be offset against the change in fair value of the hedged assets, liabilities, or firm commitments through results of operations, or be recognized in other comprehensive income until the hedged item is recognized in results of operations.

     At June 30, 2002, the following foreign currency contracts were outstanding and recorded at fair value (in thousands):

     No derivative instruments were outstanding at June 30, 2002, which were designated as hedges for accounting purposes.

(h) Comprehensive Loss

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     The Company’s comprehensive loss for the quarters and six months ended June 30, 2002 and 2001 consisted of net loss, net unrealized gains and losses on investments and the gross amount of foreign currency translation adjustments. The tax effect of the foreign currency translation adjustments and unrealized gains and losses on investments has been taken into account if applicable.

     The components of accumulated other comprehensive income are as follows (in thousands):

(i) New Accounting Policies

     The Company adopted Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets” (SFAS 142) effective January 1, 2002. The impact of adopting SFAS 142 is discussed in Note 3.

     In October 2001, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (SFAS 144), which is effective for fiscal years beginning after December 15, 2001. SFAS 144 supersedes certain provisions of APB Opinion No. 30 “Reporting the Results of Operations-Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions” and supersedes SFAS 121. The Company adopted SFAS 144 as of January 1, 2002. The adoption of SFAS 144 did not affect the Company’s consolidated financial position or results of operations.

NOTE 2 — SEGMENT INFORMATION

     The Company has one reporting segment, media delivery, for which the Company receives revenues from its customers. The Company’s Chief Operating Decision Maker is considered to be the Company’s Senior Strategy Committee (SSC), which is comprised of the Company’s Chief Executive Officer, President, and Senior Vice Presidents. The SSC reviews financial information presented on a consolidated basis accompanied by disaggregated information about products and services and geographical regions for purposes of making decisions and assessing financial performance. The SSC does not review discrete financial information regarding profitability of the Company’s different products or services and, therefore, the Company has only one operating segment as defined by Statement of Financial Accounting Standards No. 131, “Disclosure About Segments of an Enterprise and Related Information.”

     The Company’s customers consist primarily of end users located in the United States and various foreign countries. Revenues by geographic region are as follows (in thousands):

     The Company generates revenues among four different product types: consumer, subscription services, systems and advertising. Consumer revenues are derived from sales of the Company’s RealPlayer Plus, RealJukebox Plus and RealEntertainment Center Plus products, revenues from support and maintenance services that the Company sells to customers who purchase these products and third-party products, including games.

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Subscription services revenues consist of the Company’s RealOne and related subscription services. Systems revenues are derived from sales of the Company’s RealServers and related authoring and publishing tools, support and maintenance services sold to customers who purchase these products, broadcast hosting services provided through the Company’s Real Broadcast Network and consulting services the Company offers to its customers. Advertising revenues are derived from sales of advertising on the Company’s Web sites and client software and within the media streams that the Company hosts on behalf of its corporate customers.

     Revenues from external customers by product type are as follows (in thousands):

     Long-lived assets by geographic location are as follows (in thousands):

NOTE 3 — BUSINESS COMBINATIONS, GOODWILL AND INTANGIBLE ASSETS

     In April 2002, the Company acquired, for cash and common stock valued at approximately $5.1 million, a privately held company engaged in the business of developing Internet media software and technology. The purchase price includes amounts payable to certain former shareholders of the acquired company who are eligible to receive additional cash and common stock valued at approximately $3.1 million over a thirty-month period provided that they remain employed by RealNetworks during such period. These costs will be recognized as compensation cost over the related employment period. The acquisition was accounted for as a purchase transaction and, accordingly, RealNetworks’ results include the results for the acquired company since the transaction date. Goodwill of $2.3 million and acquired technology of $0.9 million were recorded as a result of the acquisition. The Company had previously made an equity investment in the acquired company and its investment balance at the time of acquisition was included in the purchase price allocation. Pro forma results are not presented, as they are not material to the Company’s overall financial statements.

     Goodwill amortization, acquisition charges and stock based compensation are as follows (in thousands):

     In July 2001, the FASB issued Statement of Financial Accounting Standards No. 141, “Business Combinations” (SFAS 141), and SFAS 142. SFAS 141 requires that the purchase method of accounting be used for all business combinations initiated after June 30, 2001

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as well as all purchase method business combinations completed after June 30, 2001. SFAS 141 also specifies certain criteria that intangible assets acquired in a purchase method business combination must meet in order to be recognized and reported apart from goodwill. SFAS 142 requires that goodwill and intangible assets with indefinite useful lives no longer be amortized, but instead be tested for impairment at least annually in accordance with the provisions of SFAS 142. SFAS 142 also requires that intangible assets with definite useful lives be amortized over their respective estimated useful lives to their estimated residual values, and reviewed for impairment in accordance with Statement of Financial Accounting Standards No. 121, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of” (SFAS 121), which was superceded by SFAS 144.

     The provisions of SFAS 141 were adopted effective June 30, 2001. No business combinations were completed during the period from July 1, 2001 to December 31, 2001. Goodwill and intangible assets acquired in business combinations completed before July 1, 2001 have been amortized through December 31, 2001.

     As of January 1, 2002, the Company had no recorded intangible assets apart from goodwill of $57.8 million, net of accumulated amortization. During the quarter ended March 31, 2002, the Company completed its transitional goodwill impairment test. Based upon the Company’s analysis, there was no impairment of goodwill upon adoption of SFAS 142 on January 1, 2002. The Company plans to conduct its annual impairment testing during the fourth quarter of each year. As of June 30, 2002, goodwill net of accumulated amortization was $60.1 million and acquired technology was $0.9 million.

     Net loss and loss per share for the quarter and six months ended June 30, 2001 adjusted to exclude goodwill amortization expense are as follows (in thousands, except per share data):

     Net loss and loss per share for the years 2001, 2000 and 1999 adjusted to exclude goodwill amortization expense are as follows (in thousands, except per share data):

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NOTE 4 — OTHER INVESTMENTS

     RealNetworks has made minority equity investments for business and strategic purposes through the purchase of voting capital stock of companies. The Company’s investments in publicly traded companies are accounted for as available-for-sale, carried at current market value and are classified as long-term as they are strategic in nature. The Company periodically evaluates whether declines in fair value, if any, of its investments are other-than-temporary. This evaluation consists of a review of qualitative and quantitative factors. For investments with publicly quoted market prices, these factors include the time period and extent for which the quoted market price is less than its accounting basis. The Company also considers other factors to determine whether declines in fair value are other-than-temporary, such as the investee’s financial condition, results of operations and operating trends. The evaluation also considers publicly available information regarding the investee companies. For investments in private companies with no quoted market price, the Company considers similar qualitative and quantitative factors and also considers the implied value from any recent rounds of financing completed by the investee. During 2001, certain of the Company’s investments were written down to fair value based upon the Company’s analysis that the declines in fair value were other-than-temporary resulting in an impairment charge of $22.8 million for the quarter and six months ended June 30, 2001 and additional charges in the last six months of 2001. Based upon an evaluation of the facts and circumstances at June 30, 2002, the Company determined that other-than-temporary declines in fair value had occurred for three of its publicly traded investments. As a result, impairment charges of $704,000 were recorded in the quarter and six months ended June 30, 2002 to reflect changes in the fair value of these investments in results of operations.

     As of June 30, 2002, the Company owned marketable equity securities of a Japanese company, representing approximately 14% of the investee’s outstanding shares, accounted for as available-for-sale securities. The market value of these shares has significantly increased from the Company’s original cost resulting in a carrying value at June 30, 2002 of $36.9 million. The increase over the Company’s cost basis, net of tax effects, is reflected as a component of accumulated other comprehensive income. During the quarter and six months ended June 30, 2002, the Company sold a portion of its holdings recognizing a gain of $2.4 million which was reclassified from accumulated other comprehensive income to net loss. Excluding the effect of this sale, the fair value of the Company’s investment declined by $32.3 million during the six months ended June 30, 2002. This decline is reflected as a component of other comprehensive loss. The market for the investee’s shares is relatively limited, the share price is volatile and the investment is strategic in nature. Accordingly, there can be no assurance that a gain of this magnitude, or any gain, can be realized through the disposition of these shares.

NOTE 5 — INVESTMENT IN MUSICNET

     In 2001, the Company announced the formation of MusicNet, Inc. (MusicNet), a venture with four media companies to create a platform for online music subscription services. MusicNet, which previously was a subsidiary of the Company, issued additional shares of capital stock in April and July 2001 reducing the Company’s ownership interest. The Company’s investment in MusicNet is accounted for under the equity method of accounting. As a result, the Company records in its statement of operations its equity share in MusicNet’s net income (loss) which was a loss of $1.3 million and $3.5 million for the quarter and six months ended June 30, 2002, respectively. The Company anticipates that MusicNet will continue to incur losses in the foreseeable future. As of June 30, 2002, the Company’s ownership interest in MusicNet was approximately 36.8% and the carrying value for its investment was approximately $5.7 million. In the quarter and six months ended June 30, 2002, the Company recognized approximately $322,000 and $738,000, respectively, of revenue related to agreements with MusicNet and was reimbursed $0 and $124,000 for the quarter and six months ended June 30, 2002, respectively, for certain administrative services provided to MusicNet on a transitional basis which has been accounted for as a reduction of related expenses.

NOTE 6 — LOSS ON EXCESS OFFICE FACILITIES

     In October 2000, the Company entered into a 10-year lease agreement for additional office space located near its corporate headquarters in Seattle, Washington. During 2001, the Company re-evaluated its facilities requirements and, as a result, decided to permanently sublet all of this office space. The market for office space significantly declined from the date the Company entered into this lease. As a result, the Company recorded losses of $22.2 million, of which $16.6 million was recorded during the quarter and six months ended June 30, 2001, representing approximately $15.2 million of rent and operating expenses over the remaining life of the lease, net of expected sublease income and approximately $7.0 million for the write-down of leasehold improvements to their estimated fair value. The Company’s estimates are based upon many factors including projections of sublease rates and the time period required to locate tenants. Although

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the Company believes its estimates are reasonable, additional losses may result if actual experience differs from projections. The Company did not identify any factors which caused it to revise its estimates during the quarter and six months ended June 30, 2002.

     A summary of activity for the accrued loss on excess office facilities is as follows (in thousands):

NOTE 7 — REPURCHASE OF COMMON STOCK

     The Company’s Board of Directors authorized the repurchase of up to an aggregate of $50 million of the Company’s outstanding common stock. Any purchases of common stock under the share repurchase program will be made from time-to-time, in the open market, through block trades or otherwise. Depending on market conditions and other factors, these purchases may be commenced or suspended at any time without prior notice. During the six months ended June 30, 2002, the Company repurchased approximately 1.4 million shares at an average cost of $5.71 per share for a total of $8.2 million. Since the program’s inception, the Company has repurchased approximately 3.9 million shares at an average cost of $5.44 per share.

NOTE 8 — LITIGATION

     In August 1998, Venson M. Shaw and Steven M. Shaw filed a lawsuit against the Company and co-defendant Broadcast.com in the United States District Court for the Northern District of Texas — Dallas Division. The plaintiffs allege that the Company, individually and in combination with Broadcast.com, infringes on a certain patent by making, using, selling and/or offering to sell software products and services directed to media delivery systems for the Internet and corporate intranets. The plaintiffs seek to enjoin the Company from the alleged infringing activity and to recover damages in an amount no less than a reasonable royalty. The Company may be required to indemnify Broadcast.com under the terms of its license agreement. The plaintiffs filed a similar claim based on the same patent and seeking similar remedies as a separate lawsuit against Microsoft and Broadcast.com in the same court. The court has consolidated the lawsuit against Microsoft and Broadcast.com with the lawsuit against the Company and Broadcast.com. If the plaintiffs prevail in their claims, the Company could be required to pay damages or other royalties, in addition to complying with injunctive relief, which could have a material adverse effect on the Company’s operating results. Although no assurance can be given as to the outcome of this lawsuit, the Company believes that the allegations in this action are without merit, and intends to vigorously defend itself against these claims. Accordingly, no amounts have been accrued for this matter at June 30, 2002. The Company believes the ultimate outcome will not have a material adverse effect on its financial position or results of operations.

     Between November 1999 and March 2000, fourteen lawsuits were filed against the Company in federal and/or state courts in California, Illinois, Pennsylvania, Texas and Washington. The plaintiffs have voluntarily dismissed all of the state court cases with the exception of the case pending in California. The remaining actions, which seek to certify classes of plaintiffs, allege breach of contract, invasion of privacy, deceptive trade practices, negligence, fraud and violation of certain federal and state laws in connection with various communications features of the Company’s RealPlayer and RealJukebox products. Plaintiffs are seeking both damages and injunctive relief. The Company has filed answers denying the claims and has filed suit in Washington State Court to compel the state court plaintiffs to arbitrate the claims as required by the Company’s End User License Agreements. The Washington State Court has granted the Company’s motion to compel arbitration. However, the California trial court has entered an order stating that it is not bound by the Washington court’s decision. That order is currently under review by the California Court of Appeal. On February 10, 2000, the federal Judicial Panel on Multidistrict Litigation transferred all pending federal cases to the federal district court for the Northern District of Illinois. On the same day, that court granted RealNetworks’ motion to stay the court proceedings because the claims are subject to arbitration under RealNetworks’ End User License Agreement. Although no assurance can be given as to the outcome of these lawsuits, the Company believes that the allegations in these actions are without merit, and intends to vigorously defend itself. Accordingly, no amounts have been accrued for this matter as of June 30, 2002. The Company believes the ultimate outcome will not have a material adverse effect on its financial position or results of operations. If the plaintiffs prevail in their claims, the Company could be

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required to pay damages or other penalties in addition to complying with injunctive relief, which could harm the Company’s business and its operating results.

     From time to time RealNetworks is, and expects to continue to be, subject to legal proceedings and claims in the ordinary course of its business, including employment claims, contract-related claims and claims of alleged infringement of third-party patents, trademarks and other intellectual property rights. These claims, even if not meritorious, could force the Company to spend significant financial and managerial resources. The Company currently has a number of such claims threatened against it relating to intellectual property infringement or employment, though it believes these claims are without merit. The Company is not aware of any legal proceedings or claims that the Company believes will have, individually or taken together, a material adverse effect on the Company’s business, prospects, financial condition or results of operations. However, the Company may incur substantial expenses in defending against third party claims. In the event of a determination adverse to the Company, the Company may incur substantial monetary liability, and/or be required to change its business practices. Either of these could have a material adverse effect on the Company’s financial position and results of operations.

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

     The discussion in this report contains forward-looking statements that involve risks and uncertainties. We have identified a number of these forward-looking statements in the section below entitled “Special Note Regarding Forward-Looking Statements.” RealNetworks’ actual results could differ materially from those discussed below. Factors that could cause or contribute to such differences include, but are not limited to, those identified below, and those discussed in the section titled “Factors that May Affect Our Business, Future Operating Results and Financial Condition”, included elsewhere in this Report. You should also carefully review the risk factors set forth in other reports or documents that RealNetworks files from time to time with the Securities and Exchange Commission, particularly our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q and any Current Reports on Form 8-K.

OVERVIEW

     RealNetworks is a leading global provider of software products and services for Internet media delivery. We develop and market software products and services designed to enable users of personal computers and other consumer electronic devices to send and receive audio, video and other multimedia services using the World Wide Web.

     We were incorporated in February 1994 and were in the development stage until July 1995, when we released the commercial version of RealAudio Version 1.0, the first version of our RealPlayer products. In August 1996, we began selling RealPlayer Plus, a premium version of our RealPlayer product. Since its initial release, RealPlayer has been available for download free of charge from our websites. In December 1997, we released the commercial version of RealSystem Version 5.0, a streaming media solution that included RealAudio and RealVideo technology. In September 1999, we released the commercial versions of RealJukebox and RealJukebox Plus, a personal music management system. In August 2000, we released the gold version of RealPlayer 8, RealJukebox 2 and launched RealPlayer GoldPass, a for-pay media subscription service available to RealPlayer Plus customers. In December 2000, we released RealSystem iQ, a new foundational architecture for digital media delivery which increases the reliability of Internet broadcasts, scales to large audiences, and provides enhanced flexibility and cost-effectiveness for media delivery network deployments. In March 2001, we introduced RealArcade, a new end-to-end platform for the digital distribution of PC games benefiting both developers and consumers. In June 2001, we launched RealSystem Media Commerce Suite, a platform for Internet media commerce that is intended to provide a universal platform for secure distribution of digital movies, music, and other content. In December 2001, we launched RealOne, the successor to our GoldPass service, which incorporates our RealPlayer and RealJukebox products together with a new media browser and value-added services to create a multi-dimensional media experience for consumers. In June 2002, we launched RealOne Europe, a European edition of our RealOne subscription service.

We report revenues in three categories:

	•		Software license fees, which include revenues from sales of our RealPlayer Plus, RealJukebox Plus, RealEntertainment Center Plus, RealServers and related authoring and publishing tools, both directly to customers and indirectly through OEM channels, and sales of third-party products, including games.
	•		Service revenues, which include revenues from RealPlayer Gold Pass/RealOne subscription services, including our RealOne Music subscription service, support and maintenance services that we sell to customers who purchase our RealPlayer Plus, RealJukebox Plus, RealEntertainment Center Plus, RealServers and related authoring and publishing tools, broadcast hosting services we provide through our Real Broadcast Network and consulting services we offer to our customers.
	•		Advertising revenues, which are derived from sales of advertising on our Web sites and client software and within the media streams that we host on behalf of our corporate customers.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

     Our critical accounting policies and estimates are as follows:

	•		Revenue recognition
	•		Estimating sales returns and the allowance for doubtful accounts
	•		Estimating losses on excess office facilities

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	•		Determining whether declines in the fair value of investments are other-than-temporary and estimating fair market value of investments in privately held companies
	•		Valuation of goodwill

     Revenue Recognition

     As described below, significant management judgments and estimates must be made and used in connection with the revenue recognized in any accounting period. Material differences may result in the amount and timing of our revenue for any period if our management made different judgments or utilized different estimates.

     We recognize revenue pursuant to the requirements of Statement of Position No. 97-2, “Software Revenue Recognition” (SOP 97-2), as amended by Statement of Position No. 98-9, “Software Revenue Recognition with Respect to Certain Arrangements.” Under SOP 97-2, revenue attributable to an element in a customer arrangement is recognized when persuasive evidence of an arrangement exists and delivery has occurred, provided the fee is fixed or determinable, collectibility is probable and the arrangement does not require significant customization of the software.

     For all sales, except those completed via credit card transactions through the Internet, we use either a binding purchase order or signed agreement, depending on the nature of the transaction, as evidence of an arrangement. For sales made via the Internet, we use the customer’s authorization to charge their credit card as evidence of an arrangement. Sales through our distributors are evidenced by a master agreement governing the relationship together with binding purchase orders on a transaction by transaction basis.

     For software license fees in single element arrangements and multiple element arrangements which do not include customization or consulting services, delivery typically occurs when the product is made available to the customer for download or when products are shipped to customers. For service and advertising revenues, delivery typically occurs when services have been performed.

     At the time of each transaction, we assess whether the fee associated with our revenue transactions is fixed and determinable and whether or not collection is reasonably assured. We assess whether the fee is fixed and determinable based on the payment terms associated with the transaction. If a significant portion of a fee is due after our normal payment terms, is based upon a variable matrix such as a minimum level of distribution or is subject to refund, we account for the fee as not being fixed and determinable. In these cases, we defer revenue and recognize it when it becomes due and payable.

     We assess the probability of collection based on a number of factors, including past transaction history and the current financial condition of the customer. We do not request collateral from our customers but often require payments before or at the time products and services are delivered. If we determine that collection of a fee is not reasonably assured, we defer revenue until the time collection becomes reasonably assured, which is generally upon receipt of cash.

     For multiple element arrangements, when company-specific objective evidence of fair value exists for all of the undelivered elements of the arrangement, but does not exist for one or more of the delivered elements in the arrangement, we recognize revenue under the residual method. Under the residual method, at the outset of the arrangement with a customer, we defer revenue for the fair value of its undelivered elements such as consulting services and product support and upgrades, and recognize the revenue for the remainder of the arrangement fee attributable to the elements initially delivered, such as software licenses, when the criteria in SOP 97-2 have been met. Company-specific objective evidence is established for support and upgrades of standard products for which no installation or customization is required based upon the amounts we charge when support and upgrades are sold separately. Company-specific objective evidence is established for consulting and installation services based on the hourly rates we charge for our employees when they are performing these services provided we have the ability to accurately estimate the hours required to complete a project based upon our experience with similar projects. For multiple element arrangements involving installation or customization, company-specific objective evidence is established for support and maintenance arrangements if our customers have an optional annual renewal rate specified in the arrangement and the rate is substantive.

     If specific objective evidence does not exist for an undelivered element in a software arrangement, which, for us, typically relates to the development of complex content delivery networks which include software licenses, consulting services and product support, revenue is recognized over the term of the support period commencing upon delivery of our technology to the customer. In these cases, delivery is defined as when

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the content delivery network is installed and operating in accordance with contract specifications.

     Revenue from software license agreements with original equipment manufacturers (OEM) is recognized when the OEM delivers its product incorporating our software to the end user. In the case of prepayments received from an OEM, we typically recognize revenue based on the actual products sold by the OEM. If we provide ongoing support to the OEM in the form of future upgrades, enhancements or other services over the term of the contract, revenue is recognized ratably over the term of the contract.

     Service revenues include payments under GoldPass/RealOne media subscription services, support and upgrade contracts and fees from consulting services and streaming media content hosting. Media subscription service revenues are recognized ratably over the period that services are provided. Support and upgrade revenues are recognized ratably over the term of the contract, which typically is twelve months. Other service revenues are recognized when the services are performed.

     Fees generated from advertising are recognized as advertising is delivered over the terms of the contracts. We may guarantee a minimum number of advertising impressions, click-throughs or other criteria on our Web sites or products for a specified period. To the extent these guarantees are not met, we defer recognition of the corresponding revenues until guaranteed delivery levels are achieved.

     Sales Returns and the Allowance for Doubtful Accounts

     The preparation of our consolidated financial statements requires us to make estimates and assumptions that affect the reported amount of assets and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reported period. Specifically, we must make estimates of potential future product returns related to current period product revenue. We analyze historical returns, current economic trends, and changes in customer demand and acceptance of our products when evaluating the adequacy of the sales returns and other allowances. Significant judgments and estimates must be made and used in connection with establishing reserves for sales returns and the allowance for doubtful accounts in any accounting period. Material differences may result in the amount and timing of our revenue for any period if we made different judgments or utilized different estimates. Similarly, we must make estimates of the uncollectability of our accounts receivables. We specifically analyze the age of accounts receivable and analyze historical bad debts, customer concentrations, customer credit-worthiness and current economic trends when evaluating the adequacy of the allowance for doubtful accounts.

     Loss on Excess Office Facilities

     We have made significant estimates in determining the appropriate amount of accrued loss on excess office facilities. The significant factors we considered in making our estimates are discussed in the following pages under “Loss on excess office facilities.”

     Impairment of Investments

     As part of the process of preparing our consolidated financial statements we periodically evaluate whether any declines in the fair value of our investments are other-than-temporary. Significant judgments and estimates must be made to assess whether an other-than-temporary decline in fair value of investments has occurred and to estimate the fair value of investments in privately held companies. See “Other Income (Expense), Net” in the following pages for a discussion of the factors we considered in evaluating whether declines in fair value of our investments were other-than-temporary and the factors we considered in estimating the fair value of investments in private companies.

     Valuation of Goodwill

     We assess the impairment of goodwill on an annual basis or whenever events or changes in circumstances indicate that the fair value of the reporting unit to which goodwill relates is less than the carrying value. Factors we consider important which could trigger an impairment review include the following:

	•		Poor economic performance relative to historical or projected future operating results;
	•		Significant negative industry, economic or company specific trends;
	•		Changes in the manner of our use of the assets or the plans for our business; and
	•		Loss of key personnel.

     If we were to determine that the fair value of a reporting unit was less than its carrying value, including goodwill, based upon the annual test or the existence of one or more of the above indicators of impairment, we measure impairment based on a comparison of

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the implied fair value of reporting unit goodwill with the carrying amount of goodwill. The implied fair value of goodwill is determined by allocating the fair value of a reporting unit to its assets (recognized and unrecognized) and liabilities in a manner similar to a purchase price allocation. The residual fair value after this allocation is the implied fair value of reporting unit goodwill. To the extent the carrying amount of reporting unit goodwill is greater than the implied fair value of reporting unit goodwill, we would record an impairment charge for the difference.

RESULTS OF OPERATIONS

REVENUES

     Software License Fees. Software license fees were $17.3 million for the quarter ended June 30, 2002, a decrease of 39% from $28.1 million for the quarter ended June 30, 2001. Software license fees were $41.6 million for the six months ended June 30, 2002, a decrease of 28% from $57.7 million for the six months ended June 30, 2001. We believe that the decreases were due to continued cutbacks in capital and information technology spending by our customers and potential customers as a result of macro-economic conditions. The current economic environment has also resulted in many current and potential customers delaying or foregoing purchases and has caused sales cycles to increase and become less predictable. In particular, customers and potential customers in the systems software and telecommunication industries have become increasingly cautious in their buying decisions due to the difficult macroeconomic conditions in those industries. The macroeconomic environment has also impacted sales to, and the rate of adoption of our systems software products by, customers in the corporate enterprise, broadcast hosting and non-PC device manufacturer market segments. No assurance can be given when, or if, customers in these markets, particularly telecommunications customers, will return to previous capital spending levels. Also, we have continued to focus our consumer promotional activities to feature our RealOne subscription services, which has resulted in a shift of revenue from software license fees to service revenues. Additionally, the English language version of our RealPlayer Plus and RealJukebox Plus products, which have previously contributed significantly to software license fees, are now combined in our RealOne subscription offering, the revenue from which is included in service revenues. In June 2002, we also launched a European edition of our RealOne subscription service which we anticipate will have a similar impact on European software license fees.

     On July 22, 2002, we announced the introduction of Helix, an open, comprehensive platform and community to enable the creation of digital media products and applications for multiple formats, operating systems and devices. In addition, we announced the introduction of the Helix Universal Server, our server product built on the Helix Platform that supports every major digital media format. Because these initiatives and products were introduced so recently, we are unable to predict the effect of the introduction on our operating results.

     Service Revenues. Service revenues were $24.9 million for the quarter ended June 30, 2002, an increase of 65% from $15.1 million for the quarter ended June 30, 2001. Service revenues were $46.3 million for the six months ended June 30, 2002, an increase of 52% from $30.4 million for the six months ended June 30, 2001. The increases in service revenues were primarily attributable to growth in subscribers to our RealOne subscription services, which we launched in December 2001 as the successor to our GoldPass subscription services, partially offset by decreases in other product offerings including content hosting revenues. Our subscription services accounted for approximately $17.8 million and $5.9 million of service revenues for the quarters ended June 30, 2002 and 2001, respectively, and $31.4 million and $10.1 million for the six months ended June 30, 2002 and 2001, respectively. We believe the decreased revenues in our other product offerings, including content hosting, are due primarily to the macro-economic conditions described above in “Software License Fees.”

     Advertising. Advertising revenues were $1.6 million for the quarter ended June 30, 2002, a decrease of 66% from $4.7 million for the quarter ended June 30, 2001. Advertising revenues were $3.2 million for the six months ended June 30, 2002, a decrease of 69% from $10.2 million for the six months ended June 30, 2001. We believe the decreases in advertising revenues were due to the continued depressed environment for Internet advertising, which resulted in lower volumes and average advertising rates.

REVENUES BY PRODUCT TYPE

     Consumer. Consumer revenues are derived from sales of our RealPlayer Plus, RealJukebox Plus and RealEntertainment Center Plus products, revenues from support and maintenance services that we sell to customers who purchase these products and third-party products, including games. Consumer revenues were $7.2 million in the quarter ended June 30, 2002, a decrease of 34% from $10.9 million in the quarter ended June 30, 2001. Consumer revenues were $16.7 million in the six months ended June 30, 2002, a decrease of 33% from $24.9 million in the six months ended June 30, 2001. The decreases were primarily due to a change in focus of our promotional activities to feature our RealOne subscription services over our traditional consumer products. Additionally, as discussed above, the English language version of our RealPlayer Plus and RealJukebox Plus products, which have previously contributed significantly to consumer revenues, are now combined in our RealOne subscription offering, the revenue from which is included in subscription services. In June 2002, we also launched a European edition of our RealOne subscription service which we anticipate will have a similar impact on European consumer revenues.

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     Subscription Services. Subscription services revenues, which consist of our RealOne subscription services, were $17.8 million in the quarter ended June 30, 2002, an increase of 202% from $5.9 million in the quarter ended June 30, 2001. Subscription services revenues were $31.4 million in the six months ended June 30, 2002, an increase of 210% from $10.1 million in the six months ended June 30, 2001. The increases were primarily attributable to the increased focus of our promotional activities on our RealOne subscription services, formerly named GoldPass until the fourth quarter of 2001. We believe that the continued increase in the content available to RealOne subscribers has resulted in a broader reach among consumers, thereby leading to greater consumer adoption rates and higher revenues. For example, newly available on our subscription services since the quarter ended June 30, 2001, is content from partners such as ABCNEWS.com, NASCAR, CBS SURVIVOR INSIDER, CNN, E! Networks, FOXSports.com and others. Additionally, in June 2002 we launched a European edition of our RealOne subscription service with premium content from partners such as BBC, Champions League Soccer from UEFA, Big Brother 3, CNN Europe and MTV Europe. Our subscription services offerings represent a relatively new business model for Internet media delivery and a new business model for us. We cannot predict how these subscription offerings will perform in the future or at what rate subscription revenues will grow, if at all.

     Systems. Systems revenues are derived from sales of our RealServers and related authoring and publishing tools, support and maintenance services that we sell to customers who purchase these products, broadcast hosting services we provide through our Real Broadcast Network and consulting services we offer to our customers. Systems revenues were $17.1 million in the quarter ended June 30, 2002, a decrease of 35% from $26.4 million in the quarter ended June 30, 2001. Systems revenues were $39.8 million in the six months ended June 30, 2002, a decrease of 25% from $53.0 million in the six months ended June 30, 2001. We believe the decreases were due to continued cutbacks in capital and information technology spending by our customers and potential customers as a result of macro-economic conditions. The current economic environment has also resulted in many current and potential customers delaying or foregoing purchases and has caused sales cycles to increase and become less predictable. In particular, customers and potential customers in the systems software and telecommunication industries have become increasingly cautious in their buying decisions due to the difficult macroeconomic conditions in those industries. The macroeconomic environment has also impacted sales to, and the rate of adoption of our systems software products by, customers in the corporate enterprise, broadcast hosting and non-PC device manufacturer market segments. No assurance can be given when, or if, customers in these markets, particularly telecommunications customers, will return to previous capital spending levels.

     On July 22, 2002, we announced the introduction of Helix, an open, comprehensive platform and community to enable the creation of digital media products and applications for multiple formats, operating systems and devices. In addition, we announced the introduction of the Helix Universal Server, our server product built on the Helix Platform that supports every major digital media format. Because these initiatives and products were introduced so recently, we are unable to predict the effect of the introduction on our operating results.

     Advertising. Advertising revenues were $1.6 million for the quarter ended June 30, 2002, a decrease of 66% from $4.7 million for the quarter ended June 30, 2001. Advertising revenues were $3.2 million for the six months ended June 30, 2002, a decrease of 69% from $10.2 million for the six months ended June 30, 2001. See “Revenues — Advertising” above for analysis.

GEOGRAPHIC REVENUES

     International revenues represented 25% of total net revenues for the quarter ended June 30, 2002, compared to 31% for the quarter ended June 30, 2001. International revenues represented 29% of total net revenues for the six months ended June 30, 2002, compared to 31% for the six months ended June 30, 2001. International revenues decreased as a percentage of total net revenues in the first six months of 2002 primarily due to the significantly increased U.S.-based subscription services revenue coupled with a significant decline in revenues generated in Latin America as a result of adverse financial conditions generally in Latin America. Revenues generated in Europe were 12% of total net revenues for the quarter ended June 30, 2002, compared to 14% for the quarter ended June 30, 2001, and revenues generated in Asia and the rest of the world were 13% of total net revenues for the quarter ended June 30, 2002, compared to 17% for the quarter ended June 30, 2001. Revenues generated in Europe were 16% of total net revenues for the six months ended June 30, 2002 and 2001, and revenues generated in Asia and the rest of the world were 14% of total net revenues for the six months ended June 30, 2002, compared to 15% for the six months ended June 30, 2001. At June 30, 2002, accounts receivable due from international customers represented approximately 23% of trade accounts receivable. The functional currency of our foreign subsidiaries is the local currency of the country in which the subsidiary operates. Results of operations of our foreign subsidiaries are translated from local currency into U.S. dollars based on average monthly exchange rates. We currently manage a portion of our foreign currency exposures through the use of foreign currency exchange forward contracts and therefore are still subject to some risk of changes in exchange rates. Our foreign currency exchange risk management program reduces, but does not eliminate, the impact of currency exchange rate movements. The costs of both domestic and international revenues are substantially the same.

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DEFERRED REVENUES

     Deferred revenue is comprised of the unrecognized revenue related to support contracts, prepayments under OEM arrangements, and other prepayments for which the earnings process has not been completed. Revenue from contracts with customers developing content delivery networks is generally recognized over the term of the arrangement commencing upon the customer’s deployment of our technology in their network. Because many of the agreements related to the content delivery networks have been with companies that have had limited operating histories, we have historically required prepayments from such customers to mitigate our credit risk. Cash prepayments associated with these contracts are recorded as deferred revenue and amounted to $19.4 million and $27.2 million at June 30, 2002 and December 31, 2001, respectively. The decrease in deferred revenue for the quarter and six months ended June 30, 2002 is primarily due to recognition of revenue on existing contracts at a higher rate than prepayments received from customers for new systems contracts. We believe the decrease in new systems contracts in recent periods results from current macro-economic conditions which have resulted in cutbacks in capital and information technology spending by our customers and potential customers.

COST OF REVENUES

     Cost of Software License Fees. Cost of software license fees includes costs of product media, duplication, manuals, packaging materials, amounts paid for licensed technology, fees paid to third-party vendors for order fulfillment and royalties paid on sales of games and other third-party products. Cost of software license fees was $1.6 million for the quarter ended June 30, 2002, a decrease of 26% from $2.2 million for the quarter ended June 30, 2001, but increased as a percentage of software license fees to 9% for the quarter ended June 30, 2002 from 8% for the quarter ended June 30, 2001. Cost of software license fees was $3.8 million for the six months ended June 30, 2002, a decrease of 7% from $4.1 million for the six months ended June 30, 2001, but increased as a percentage of software license fees to 9% for the six months ended June 30, 2002 from 7% for the six months ended June 30, 2001. The decrease in costs was due primarily to lower sales which reduced royalty and other product fulfillment costs. The increase in cost of software license fees as a percentage of software license fees revenue was due to a lower percentage of software license fee revenue from systems licenses, which typically have higher margins than other components of software license fees.

     Cost of Service Revenues. Cost of service revenues includes the cost of in-house and contract personnel providing support and consulting services, expenses incurred in providing our streaming media hosting services and cost of content included in our RealOne subscription service offerings. Cost of service revenues was $9.0 million for the quarter ended June 30, 2002, an increase of 51% from $6.0 million for the quarter ended June 30, 2001, but decreased as a percentage of service revenues to 36% for the quarter ended June 30, 2002 from 40% for the quarter ended June 30, 2001. Cost of service revenues was $18.3 million for the six months ended June 30, 2002, an increase of 64% from $11.1 million for the six months ended June 30, 2001, and increased as a percentage of service revenues to 39% for the six months ended June 30, 2002 from 37% for the six months ended June 30, 2001. The increase in costs was primarily due to costs associated with content included in our RealOne subscription services, which has fixed and variable components, as well as increased customer service and technical support costs associated with our subscription services. Costs of content include our agreements with Major League Baseball, the National Basketball Association, ABCNEWS.com, NASCAR, CBS SURVIVOR INSIDER, CNN, E! Networks, FOXSports.com and other providers of subscription services media content. These increases in costs were partially offset by credits we received during the quarter ended June 30, 2002, for previous overbilling by bandwidth service providers. The costs associated with the content agreements are expensed over the contract terms. The decrease as a percentage of service revenues for the quarter ended June 30, 2002 was due to the bandwidth credits mentioned above. The increase in percentage of service revenues for the six months ended June 30, 2002 was due to shifts in product mix towards our subscription services, which are characterized by relatively higher costs of revenues than our other service offerings.

     Our RealOne subscription services are a relatively new and growing portion of our business and are characterized by relatively higher costs of revenues than our other products and services, primarily due to the cost of licensing media content to provide these services. As a result, if this portion of our business continues to grow as a percentage of revenues, we anticipate that our cost of service revenues may grow at an increased rate relative to net revenues and thereby may lead to reductions in our gross margins in the future.

     Cost of Advertising. Cost of advertising includes the cost of personnel associated with maintenance of programming services, content creation and maintenance, fees paid to third parties for content included on our Web sites and ad delivery services. Cost of advertising was $0.4 million for the quarter ended June 30, 2002, a decrease of 77% from

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$1.7 million for the quarter ended June 30, 2001, and decreased as a percentage of advertising revenues to 25% for the quarter ended June 30, 2002 from 36% for the quarter ended June 30, 2001. Cost of advertising was $1.1 million for the six months ended June 30, 2002, a decrease of 68% from $3.5 million for the six months ended June 30, 2001, but increased as a percentage of advertising revenues to 36% for the six months ended June 30, 2002 from 35% for the six months ended June 30, 2001. The decrease in costs was primarily due to lower sales volumes and shifting programming personnel to other areas of our business. The decrease in percentage terms for the quarter ended June 30, 2002 was due to the costs decreasing at a faster rate than the decrease in advertising revenues. The increase in percentage terms for the six months ended June 30, 2002 was due to fixed expenses decreasing at a slower rate than the decrease in advertising revenues.

OPERATING EXPENSES

     Research and Development. Research and development expenses consist primarily of salaries and related personnel costs, consulting fees associated with product development and costs of technology acquired from third parties to incorporate into products currently under development. To date, all research and development costs have been expensed as incurred because technological feasibility for software products is generally not established until substantially all development is complete. Research and development expenses, excluding non-cash stock based compensation, were $12.8 million for the quarter ended June 30, 2002, a decrease of 12% from $14.4 million for the quarter ended June 30, 2001, and decreased as a percentage of total net revenues to 29% for the quarter ended June 30, 2002 from 30% for the quarter ended June 30, 2001. Research and development expenses, excluding non-cash stock based compensation, were $24.6 million for the six months ended June 30, 2002, a decrease of 21% from $31.1 million for the six months ended June 30, 2001, and decreased as a percentage of total net revenues to 27% for the six months ended June 30, 2002 from 32% for the six months ended June 30, 2001. The decreases in expenses were primarily due to the effects of a reduction in personnel, contract labor and related personnel costs in the third quarter of 2001 as part of an overall plan to reduce costs. The decrease in percentage terms was primarily a result of expenses decreasing at a faster rate than the decrease in net revenues.

     Sales and Marketing. Sales and marketing expenses consist primarily of salaries and related personnel costs, sales commissions, consulting fees, trade show expenses, advertising costs and costs of marketing collateral. Sales and marketing expenses, excluding non-cash stock based compensation, were $19.0 million for the quarter ended June 30, 2002, an increase of 4% from $18.2 million for the quarter ended June 30, 2001, and increased as a percentage of total net revenues to 43% for the quarter ended June 30, 2002 from 38% for the quarter ended June 30, 2001. Sales and marketing expenses, excluding non-cash stock based compensation, were $36.7 million for the six months ended June 30, 2002, a decrease of 5% from $38.5 million for the six months ended June 30, 2001, but increased as a percentage of total net revenues to 40% for the six months ended June 30, 2002 from 39% for the six months ended June 30, 2001. The increase in expenses for the quarter ended June 30, 2002 was primarily due to increased marketing and promotional activities, such as advertising and tradeshow expenses, partially offset by the effects of reductions in personnel and contract labor in the third quarter of 2001. The decrease in expenses for the six months ended June 30, 2002 was primarily due to the effects of reductions in personnel and contract labor in the third quarter of 2001 and continued decreases in other expenses as part of an overall plan to reduce costs. The increase in percentage terms for the quarter ended June 30, 2002 was a result of sales and marketing expenses increasing while revenues decreased, while the increase in percentage terms for the six months ended June 30, 2002 was a result of sales and marketing expenses decreasing at a slower rate than the rate of the decline in net revenues.

     General and Administrative. General and administrative expenses consist primarily of salaries, related personnel costs, and fees for professional and temporary services. General and administrative expenses were $5.5 million for the quarter ended June 30, 2002, an increase of 5% from $5.3 million for the quarter ended June 30, 2001, and increased as a percentage of total net revenues to 13% for the quarter ended June 30, 2002 from 11% for the quarter ended June 30, 2001. General and administrative expenses were $10.0 million for the six months ended June 30, 2002, a decrease of 7% from $10.7 million for the six months ended June 30, 2001, and were 11% of total net revenues for the six months ended June 30, 2002, unchanged from the six months ended June 30, 2001. The increase in expenses for the quarter ended June 30, 2002 was primarily due to increased legal expenses, partially offset by a reduction in personnel, contract labor and related personnel costs. The decrease in expenses for the six months ended June 30, 2002 was primarily due to the effects of a reduction in personnel and contract labor in the third quarter of 2001 as part of an overall plan to reduce costs. The increase in percentage terms for the quarter ended June 30, 2002 was due to expenses increasing while net revenues declined.

     Goodwill Amortization, Acquisition Charges and Stock-Based Compensation. Goodwill amortization and acquisition charges for the quarter ended June 30, 2002 were $0 and were

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$12.5 million during the quarter ended June 30, 2001. Goodwill amortization and acquisition charges for the six months ended June 30, 2002 were $0 and were $25.2 million during the six months ended June 30, 2001. During the quarter ended March 31, 2002, we completed our transitional goodwill impairment test as required under SFAS 142. Based upon our analysis, we determined that no goodwill impairment had occurred as of January 1, 2002, upon adoption of SFAS 142. Under SFAS 142, goodwill is no longer amortized, but instead tested for impairment at least annually.

     In April 2002, we acquired, for cash and common stock valued at approximately $5.1 million, a privately held company engaged in the business of developing Internet media software and technology. The purchase price includes amounts payable to certain former shareholders of the acquired company who are eligible to receive additional cash and common stock valued at approximately $3.1 million over a thirty-month period provided that they remain employed by RealNetworks during such period. These costs will be recognized as compensation cost over the related employment period. The acquisition was accounted for as a purchase transaction and, accordingly, our results include the results for the acquired company since the transaction date. Goodwill of $2.3 million and acquired technology of $0.9 million were recorded as a result of the acquisition. We had previously made an equity investment in the acquired company and its investment balance at the time of acquisition was included in the purchase price allocation. Pro forma results are not presented, as they are not material to our overall financial statements.

     Stock-based compensation for the quarter ended June 30, 2002 was an expense of $368,000, compared to a benefit of $(25.0) million for the quarter ended June 30, 2001. Stock-based compensation for the six months ended June 30, 2002 was an expense of $532,000, compared to a benefit of $(10.3) million for the six months ended June 30, 2001. The difference was primarily due to the voluntary resignation of certain former employees in the quarter ended June 30, 2001 resulting in a reversal of previously recognized stock compensation expense.

NEW ACCOUNTING POLICIES

     The impact of our adoption of SFAS 142 is discussed above.

     In October 2001, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (SFAS 144), which is effective for fiscal years beginning after December 15, 2001. SFAS 144 supersedes certain provisions of APB Opinion No. 30 “Reporting the Results of Operations-Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions” and supersedes SFAS 121. We adopted SFAS 144 as of January 1, 2002. The adoption of SFAS 144 did not affect our consolidated financial position or results of operations.

OTHER INCOME (EXPENSE), NET

     Other income (expense), net consists primarily of interest earnings on our cash, cash equivalents and short-term investments, our equity share in the net losses of MusicNet and gains and losses on our equity investments.

     For the quarter and six months ended June 30, 2002, interest income declined from the comparable periods in 2001. The decrease was primarily due to lower effective interest rates and lower investment balances.

     MusicNet is a venture formed with four media companies to create a platform for online music subscription services. MusicNet, which previously was a subsidiary, issued additional shares of capital stock in April and July 2001 thereby reducing our ownership interest to approximately 36.8%. We account for our interest in MusicNet using the equity method of accounting. As a result, we record in our statement of operations our equity share in MusicNet’s net income (loss) which was a loss of $1.3 million and $3.5 million for the quarter and six months ended June 30, 2002, respectively. We anticipate that MusicNet will continue to incur losses in the foreseeable future. The carrying value for our investment in MusicNet is approximately $5.7 million as of June 30, 2002. In the quarter and six months ended June 30, 2002, we recognized approximately $322,000 and $738,000, respectively, of revenue related to agreements with MusicNet and were reimbursed $0 and $124,000 for the quarter and six months ended June 30, 2002, respectively, for certain administrative services provided to MusicNet on a transitional basis which has been accounted for as a reduction of related expenses.

     We have made minority equity investments for business and strategic purposes through the purchase of voting capital stock of companies. Our investments in publicly traded companies are accounted for as available-for-sale, carried at current market value and are classified as long-term as they are strategic in nature. We periodically evaluate whether any declines in fair value of our investments are other-than-temporary. This

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evaluation consists of a review of qualitative and quantitative factors. For investments with publicly quoted market prices, these factors include the time period and extent that the quoted market price is less than its accounting basis. We consider additional factors to determine whether declines in fair value are other-than-temporary, such as the investee’s financial condition, results of operations and operating trends. The evaluation also considers publicly available information regarding the investee companies. For investments in private companies with no quoted market price, we consider similar qualitative and quantitative factors and also consider the implied value from any recent rounds of financing completed by the investee. During 2001, certain of these investments were written down to fair value based upon our analysis that the declines in fair value were other-than-temporary resulting in an impairment charge of $22.8 million for the quarter and six months ended June 30, 2001 and additional charges in the last six months of 2001. Based upon an evaluation of the facts and circumstances during the quarter and six months ended June 30, 2002, we determined that other-than-temporary declines in fair value had occurred for three of our publicly traded investments. As a result, impairment charges of $704,000 were recorded in the quarter and six months ended June 30, 2002 to reflect changes in the fair value of these investments in the results from operations.

     As of June 30, 2002, we owned marketable equity securities of a Japanese company, representing approximately 14% of the outstanding shares which are accounted for as available-for-sale securities. The market value of these shares has significantly increased from the original cost resulting in a carrying value at June 30, 2002 of $36.9 million. The increase over our cost basis, net of tax effects, is reflected as a component of accumulated other comprehensive income. During the quarter and six months ended June 30, 2002, we sold a portion of our holdings recognizing a gain of $2.4 million which was reclassified from accumulated other comprehensive income to net loss. Excluding the effect of this sale, the fair value of our investment declined by $32.3 million during the six months ended June 30, 2002. The market for this investee’s shares is relatively limited, the share price is volatile and our investment is strategic in nature. Accordingly, there can be no assurance that a gain of this magnitude, or any gain can be realized through the disposition of these shares.

INCOME TAXES

     For the quarter and six months ended June 30, 2002, we recorded income tax benefits of $1.1 million and $2,000, respectively. The income tax benefit recognized during the quarter ended June 30, 2002 primarily resulted from changes to our estimates of our effective tax rate and projected income for 2002. The income tax benefit recognized during the six months ended June 30, 2002 is based upon our projected income tax rate and expected levels of income for 2002. For the quarter and six months ended June 30, 2001, we recorded an income tax benefit of $4.8 million and $3.5 million, respectively, due primarily to the future tax benefit to be received on the loss on excess office facilities when the losses become deductible for income tax purposes. During the same periods, we also recorded a loss for other-than-temporary impairments on investments. We did not record a related income tax benefit for this loss, which can only be utilized to offset future capital gains, as we did not have any significant sources of capital gain income during that time. As of June 30, 2002, we had net operating loss carryforwards of approximately $460 million, substantially all of which result from employee stock options, the realization of which would increase shareholders’ equity.

LOSS ON EXCESS OFFICE FACILITIES

     In October 2000, we entered into a 10-year lease agreement for additional office space located near our corporate headquarters in Seattle, Washington. During 2001, we re-evaluated our facilities requirements and, as a result, decided to permanently sublet all of this office space and recorded losses of $22.2 million, of which $16.6 million was recorded during the quarter and six months ended June 30, 2001, representing approximately $15.2 million of rent and operating expenses over the remaining life of the lease, net of expected sublease income and approximately $7.0 million for the write-down of leasehold improvements to their estimated fair value. Our estimates are based upon many factors including projections of sublease rates and the time period required to locate tenants. Although we believe our estimates are reasonable, additional losses may result if actual experience differs from projections. We did not identify any factors which caused us to revise our estimates during the quarter and six months ended June 30, 2002. As of June 30, 2002, $10.5 million was accrued for the loss on excess office facilities.

LIQUIDITY AND CAPITAL RESOURCES

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     Net cash used in operating activities was $3.0 million for the six months ended June 30, 2002 and net cash used in operating activities was $0.6 million for the six months ended June 30, 2001. Net cash used in operating activities for the six months ended June 30, 2002 resulted primarily from net loss of $507,000 and decreases in deferred revenue of $5.8 million and accrued and other liabilities of $2.3 million, partially offset by non-cash depreciation expense of $5.9 million and equity in net losses of equity method investments of $3.8 million. Net cash used in operating activities for the six months ended June 30, 2001 resulted primarily from net loss of $43.6 million, an increase in prepaid expenses and other assets of $1.6 million and decreases in deferred revenue of $8.5 million and accrued and other liabilities of $3.7 million, partially offset by non-cash depreciation expense of $6.0 million, $22.8 million for impairment of investments and $15.7 million from the loss on excess office facilities.

     Net cash provided by investing activities was $4.4 million for the six months ended June 30, 2002. This was primarily the result of the sales and maturities of short-term investments and proceeds from the sales of other investments, partially offset by purchases of short-term investments and equipment and leasehold improvements and cash used for acquisitions. Net cash used by investing activities was $37.0 million for the six months ended June 30, 2001. This was primarily the result of the net purchase of short-term investments and equipment and leasehold improvements.

     Net cash used in financing activities was $3.2 million for the six months ended June 30, 2002. This was primarily due to our repurchase of approximately $9.5 million of our common stock, partially offset by exercises of employee stock options. Net cash provided by financing activities was $6.2 million for the six months ended June 30, 2001. This was due to net proceeds from the exercise of stock options.

     In September 2001, we announced a share repurchase program. Our Board of Directors authorized the repurchase of up to an aggregate of $50 million of our outstanding common stock. Any purchases of common stock under our share repurchase program will be made from time-to-time, in the open market, through block trades or otherwise. Depending on market conditions and other factors, these purchases may be commenced or suspended at any time without prior notice. During the six months ended June 30, 2002, we repurchased approximately 1.4 million shares at an average cost of $5.71 per share.

     At June 30, 2002, we had $352 million in cash, cash equivalents, short-term investments and restricted cash equivalents. Our principal commitments were substantially the same as those at December 31, 2001. We believe that our current cash, cash equivalents and short-term investments will be sufficient to meet our anticipated cash needs for working capital and capital expenditures for at least the next 12 months.

     We do not hold derivative financial instruments or equity securities in our short-term investment portfolio. Our cash equivalents and short-term investments consist of high quality securities, as specified in our investment policy guidelines. The policy limits the amount of credit exposure to any one non-U.S. Government or non-U.S. Agency issue or issuer to a maximum of 5% of the total portfolio. These securities are subject to interest rate risk and will decrease in value if interest rates increase. Because we have historically had the ability to hold our fixed income investments until maturity, we would not expect our operating results or cash flows to be significantly affected by a sudden change in market interest rates in our securities portfolio.

FACTORS THAT MAY AFFECT OUR BUSINESS, FUTURE OPERATING RESULTS AND FINANCIAL CONDITION

     You should carefully consider the risks described below together with all of the other information included in this quarterly report on Form 10-Q. The risks and uncertainties described below are not the only ones facing our company. If any of the following risks actually occurs, our business, financial condition or operating results could be harmed. In such case, the trading price of our common stock could decline, and you could lose all or part of your investment.

WE HAVE A RELATIVELY LIMITED OPERATING HISTORY, WHICH MAKES IT DIFFICULT TO EVALUATE OUR BUSINESS

     We were incorporated in February 1994 and have a relatively limited operating history. We have limited financial results on which you can assess our future success. Our prospects must be considered in light of the risks, expenses and difficulties frequently encountered by growing companies in new and rapidly evolving markets, such as the streaming media software and media delivery systems markets in which we operate.

To address the risks and uncertainties faced by our business, we must:

•

establish and maintain broad market acceptance of our products and services and convert that acceptance into direct and indirect sources of revenues;

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	•		maintain and enhance our brand name;
	•		continue to timely and successfully develop new products, product features and services and increase the functionality and features of existing products;
	•		successfully respond to competition from Microsoft and others, including competition from emerging technologies and solutions; and
	•		develop and maintain strategic relationships to enhance the distribution, features and utility of our products and services.

     Our business strategy may be unsuccessful and we may be unable to address the risks we face in a cost-effective manner, if at all. If we are unable to successfully address these risks our business will be harmed.

WE HAVE A HISTORY OF LOSSES

     We have incurred significant losses since our inception. As of June 30, 2002, we had an accumulated deficit of approximately $220 million. We had a net loss for the quarter and six months ended June 30, 2002, and for the years ended December 31, 2001 and 2000, and we may not generate sufficient revenues to be profitable on a quarterly or annual basis in the future. We devote significant resources to developing, enhancing, selling and marketing our products and services. As a result, we will need to generate significant revenues to be profitable in the future.

OUR OPERATING RESULTS ARE LIKELY TO FLUCTUATE SIGNIFICANTLY, WHICH MAY CAUSE OUR STOCK PRICE TO FLUCTUATE

     As a result of our relatively brief operating history and the rapidly changing and uncertain nature of the markets in which we compete, our quarterly and annual revenues and operating results are likely to fluctuate from period-to-period, and period-to-period comparisons are not likely to be meaningful. These fluctuations are caused by a number of factors, many of which are beyond our control. Our future operating results could fall below the expectations of public market analysts or investors, which would likely significantly reduce the market price of our common stock. Fluctuations in our operating results will likely increase the volatility of our stock price.

     Our research and development and sales and marketing efforts, and other business expenditures generally, are partially based on predictions regarding certain developments for media delivery and digital media distribution. To the extent that these predictions prove inaccurate, our revenues may not be sufficient to offset these expenditures, and our operating results may be harmed.

OUR BUSINESS HAS BEEN AND MAY CONTINUE TO BE AFFECTED BY ADVERSE ECONOMIC CONDITIONS

     In recent periods, many of our current and prospective customers have experienced financial difficulties. As a result, some of these companies have ceased or consolidated operations, some are continuing to experience financial difficulty, and sales cycles for some of our customers and potential customers have become longer and less predictable than in the past. In particular, customers and potential customers in the systems software and telecommunication industries have become increasingly cautious in their buying decisions due to the difficult macroeconomic conditions in those industries. The macroeconomic environment has also impacted sales to, and the rate of adoption of our systems software products by, customers in the corporate enterprise, broadcast hosting and non-PC device manufacturer market segments. No assurance can be given when, or if, customers in these markets, particularly telecommunications customers, will return to previous capital spending levels. In the event that a substantial number of our current or potential customers experience financial difficulties in the future, the rate of adoption of our products may be slowed, our ability to increase or maintain sales to such customers will be adversely affected and our ability to generate revenues from these companies will also be adversely impacted.

THERE ARE A NUMBER OF RISKS ASSOCIATED WITH OUR RECENTLY ANNOUNCED HELIX INITIATIVE

     On July 22, 2002, we announced the introduction of Helix, an open, comprehensive platform and community to enable the creation of digital media products and applications for multiple formats, operating systems and devices. In addition, we announced the introduction of the Helix Universal Server, our server product built on the Helix Platform that supports every major digital media format.

     Because these initiatives and products were introduced so recently, there are a number of risks associated with them, including the risks typically associated with the introduction of new products and technologies. There can be no assurance that the industry will adopt the Helix Platform or the Helix Community, or that third parties will develop and introduce technologies or products based on them. Further, there can be no assurance that new or existing customers will license the Helix Universal Server. While we have invested substantial resources in the development of these initiatives and products, there can be no assurance that they will be accepted by the market, that we will derive substantial revenue from such initiatives and products or that the introduction of Helix and the Helix Universal Server will not adversely affect the sales of our existing products.

WE MAY BE UNABLE TO SUCCESSFULLY COMPETE WITH MICROSOFT AND OTHER COMPANIES IN THE MEDIA DELIVERY MARKET

     The market for software and services for media delivery over the Internet is relatively new, constantly changing and intensely and increasingly competitive. As media delivery evolves into a central component of the Internet experience, more companies are entering the market for, and expending increasing resources to develop, media delivery software and services. We expect that competition will continue to intensify. Increased competition could hurt our business and the trading price of our stock. Increased

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competition may also result in price reductions, reduced margins, loss of customers, and a change in our business and marketing strategies, any of which could harm our business.

     Many of our current and potential competitors have longer operating histories, greater name recognition, more employees and significantly greater financial, technical, marketing, public relations and distribution resources than we do. In addition, new competitors with potentially unique or more desirable products or services are entering the market all the time. The competitive environment may require us to make changes in our products, pricing, licensing, services or marketing to maintain and extend our current brand and technology franchise. Price concessions or the emergence of other pricing, licensing and distribution strategies or technology solutions of competitors may diminish our revenues, impact our margins or lead to a reduction in our market share, any of which will harm our business. Other changes we have to make in response to competition could cause us to expend significant financial and other resources, disrupt our operations, strain relationships with partners, or release products and enhancements before they are thoroughly tested, any of which could harm our operating results and stock price.

     Microsoft is a principal competitor in the development and distribution of digital media and media distribution technology. Microsoft currently competes with us in the market for digital media servers and players, content creation tools, digital rights management, and other technology and services related to digital distribution of media, and has announced its intention to compete with our RealOne service in the market for subscription services. Microsoft’s commitment to and presence in the media delivery industry has increased and we expect that Microsoft will continue to increase competitive pressure in the overall market for digital media and media distribution.

     Microsoft distributes its competing streaming media server, player and tools products by bundling them with its Windows operating systems and NT servers at no additional cost or otherwise making them available free of charge. Microsoft’s practices have caused, and may continue to cause, pricing pressure on our revenue generating products and services. Microsoft’s practices have led in some cases, and could continue to lead to, longer sales cycles, decreased sales, loss of existing and potential customers and reduced market share. In addition, we believe that Microsoft has used and may continue to use its monopoly position in the computer industry and its financial resources to secure preferential or exclusive distribution and bundling contracts for its media delivery technologies and products with third parties such as ISPs, content delivery networks, online service providers, content providers, entertainment companies, media companies, broadcasters, VARs and OEMs, including third parties with whom we have relationships. Microsoft has also invested significant sums of money in, has provided substantial financial incentives to, or offered or conditioned placement on or through the Windows operating system, the Internet Explorer Web browser and Microsoft’s MSN service to certain of our current and potential customers and content suppliers, and we expect this trend to continue, which may cause those customers to stop using or reduce their use of our products and services and which may cause those content suppliers to withhold desirable media content from us or end users of our products and services. Such arrangements, together with Microsoft’s aggressive marketing of its Windows operating systems, server products and digital media products, may reduce our share of the streaming media and digital distribution market.

     Microsoft’s Windows Media Player competes with our media player products. Certain versions of the Windows Media Player are available for download from Microsoft’s Web site for free, and the Windows Media Player is integrated into Microsoft’s recently introduced Windows XP operating system and the Windows 98, Windows 2000 and Windows ME operating systems, the Internet Explorer Web browser, and Microsoft’s MSN service. With Windows XP, Microsoft no longer offers a stand-alone version of the latest version of Windows Media Player, which is commingled into Windows XP so that it cannot be removed by OEMs or end users. Windows XP, a significant focus of which is media delivery, gives very prominent and persistent placement to Microsoft’s Windows Media Player, Windows Media Guide, music services, and other media delivery services in the operating system and on the end user’s desktop. In some cases, the Windows Media Player may override default playback settings set by end users or by us. New versions of Internet Explorer and MSN Explorer also prominently feature and promote Windows Media. We expect that by leveraging its monopoly position in operating systems and tying streaming or digital media into its operating systems and its Web browser, Microsoft will distribute substantially more copies of the Windows Media Player, and attract more content providers to use Microsoft’s technology in the future than it has in the past and may be able to attract more users to its streaming or digital media products. In addition, Microsoft does not allow our products to take full advantage of the features and functionality of Windows XP that it makes available to the Windows Media Player. In light of Microsoft’s efforts and dominant position in operating systems, our market position may be difficult to sustain.

     Microsoft’s Windows Media Player also competes with our RealJukebox products and with the personal music management features of the RealOne Player. Microsoft has also

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invested in other digital distribution technologies that compete with RealJukebox and with the RealOne Player. The Windows Media Player supports the Windows Media format, but not RealNetworks’ media formats. Microsoft also licenses Windows Media Technologies, a platform for authoring, delivering and playing digital media intended to compete with RealSystem, and supports and promotes other third party products competitive to our products. In addition, Microsoft provides servers that support Windows Media Technologies at no additional cost to customers who purchase its Windows servers, whereas we offer most versions of our competitive servers for sale. In some cases, Microsoft conditions use of the Windows Media Digital Rights Management and security technologies supported by Windows XP to support for Windows Media formats and use of Windows Media Player and servers. We compete with Microsoft in the market for digital rights management technologies. We expect Microsoft and other competitors to devote significantly greater resources to product development in the music management and digital media categories in the future.

     Microsoft also competes with us to attract broadcasters and owners of high quality or popular content to promote and deliver such content in Microsoft’s formats, in some cases on an exclusive or preferential basis. While we have rights to play back certain content in Microsoft formats through our player products under a limited set of conditions, we may not secure necessary rights from Microsoft to enable our products to play back all such content or content in Microsoft’s newest formats at all, or on commercially reasonable terms. Our player products may be disadvantaged if they cannot play content in Windows Media formats or content that is secured by the Windows Media Digital Rights Management technology, or if such content providers do not also make their content available in RealNetworks’ media formats using digital rights management systems supported by us. In some cases, we believe Microsoft uses its financial resources and monopoly leverage to obtain rights to such content, and to incent content providers to prepare their content in Microsoft’s formats. In addition, Microsoft has recently announced its intention to compete with our RealOne subscription service, and may use similar incentives to induce content providers to offer content for its proposed subscription service. Microsoft’s commitment to and presence in the media delivery industry has increased and we believe that Microsoft will continue to increase competitive pressure in the overall market for streaming media and media distribution.

     In addition to Microsoft, we face competition from other companies that develop and market streaming media products. For example, Apple Computer offers the QuickTime streaming media technology, including a free media player and a free streaming media server, and licenses for free source code to the server under the conditions of Apple’s end user license agreement. Apple also offers competitive music management software and hardware. Apple has recently begun to devote significant resources to developing and marketing digital media products and we expect they will continue to do so to enable them to compete vigorously with us in the marketplace. Apple has also enlisted the open source code development community to assist its development of competitive products. Companies such as AOL Time Warner and Yahoo! and many smaller competitors also offer various products that compete with our player products and content subscription services. In connection with the deployment of our RealSystem iQ software in AOL’s Internet service, we also licensed our RealPlayer technology to AOL for use with its own Internet service media player application. Such licensing may impact the number of end users of our player products if AOL users only use AOL applications. As more companies enter the market with products that compete with our servers, players and tools, the competitive landscape could change rapidly to our disadvantage.

     Our streaming media and media delivery products also face competition from “fast download” media delivery technologies such as AVI, QuickTime and MP3. We also face competition from peer-to-peer file sharing services, which allow computer users to connect with each other and directly access and copy many types of program files, including music and other media, from one another’s hard drives, such as Morpheus and KaZaA, and a variety of other similar services that have arisen since certain services of Napster were shut down by court order. Such services allow consumers to directly access an expansive array of free content without relying on content providers to make the content available for streaming or digital download, and without relying on products such as the RealOne Player or RealJukebox to be able to play, record and store such content. These services also compete with our for-pay RealOne Music subscription service. Other fast download or non-streaming IP-based content distribution methods are likely to emerge and could compete with our products and services, which could harm our business.

OUR SUBSCRIPTION SERVICES MAY NOT BE SUCCESSFUL

     In August 2000, we introduced our RealPlayer GoldPass subscription service, which provided customers access to a combination of premium software, services and content in exchange for a monthly fee. In December 2001, we launched RealOne, the successor to our GoldPass subscription service, which incorporates features of our RealPlayer and RealJukebox products together in a new version of our player products, the RealOne Player. Members of RealOne also have access to premium subscription content and are able to take

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advantage of certain enhanced features of the RealOne Player. These subscription services are a relatively unproven business model for delivering media over the Internet and represent a new business model for us. It is too early to predict whether consumers will accept RealOne, whether the gross margins resulting from RealOne will be consistent with our historical gross margins or whether the service will otherwise be financially viable. To date, gross margins associated with the subscription service are significantly lower than gross margins in our business historically, and we expect this trend will continue. RealOne competes with both traditional and online entertainment service providers and we anticipate increasing competition for online subscription service revenues from a wide range of companies, including AOL Time Warner, Microsoft and Yahoo!. Many of these providers have significantly more resources, including access to content, and experience in providing subscription or similar services to customers.

     In order to increase our subscription service revenues, we must continue to obtain premium digital content in order to increase subscriptions and overall customer satisfaction. To date, a limited amount of premium digital content has been made available for delivery over the Internet that can only be accessed through a for-pay service and not for free. If we are unable to obtain premium digital content on commercially reasonable terms, or at all, or if we do not successfully market our subscription services to our end users, our business could be harmed. In addition, the slower than anticipated adoption of broadband may impact the desirability of our services as users encounter low-quality content over slower connections.

IF WE DON’T CONTINUE TO ADD SUBSCRIBERS TO OUR SUBSCRIPTION SERVICES OR IF WE EXPERIENCE EXCESSIVE RATES OF SUBSCRIBER CHURN, OUR REVENUES AND BUSINESS WILL BE HARMED.

     Our RealOne subscription service has become an increasingly important source of our total revenues. The growth in subscribers represents a major growth opportunity for us and also creates substantial risks. In order to increase our subscriber numbers and subscription revenues, we must continue to add new subscribers each quarter while minimizing the rate of loss of existing subscribers. If our marketing and promotional activities fail to add significant numbers of new subscribers or if too many RealOne subscribers cancel their membership, our revenues and business will suffer.

     Many of our subscribers are subscribers to our standalone premium subscription service products, some of which are seasonal in nature, such as our Major League Baseball and NASCAR offerings. We have limited experience with these types of offerings and cannot predict how the seasonal nature of these offerings will impact our subscriber growth rates or future subscriber retention levels. No assurance can be given that these standalone subscribers will remain subscribers to our subscription services at the end of any season or that they will renew their subscriptions for following seasons. In addition, our Major League Baseball offering has been a key contributor to subscriber acquisition and retention. If the current labor dispute between Major League Baseball and the Major League Baseball Players Association results in a work stoppage, no assurance can be given as to the impact the work stoppage will have on the success of our subscription services offerings and our ability to retain existing subscribers and to attract new subscribers could be materially harmed.

OUR ONLINE MUSIC SERVICES INITIATIVES MAY NOT BE SUCCESSFUL

     In 2001, we announced the formation of a joint venture called MusicNet with four leading media companies to create a technology platform for online music subscription services. We also entered into an agreement with MusicNet to license the MusicNet platform and service for sale to our own customers. In December 2001, we began offering the RealOne Music subscription service, a for-pay, limited usage music subscription service based on the MusicNet platform. The business models, technologies and market for online music subscription services are new and unproven. Consumers may not accept certain features of our current RealOne Music subscription offering, including the inability to copy or “burn” RealOne Music content onto CD’s, the expiration of a subscriber’s rights to access RealOne Music content at the end of each month of the subscription, and the availability of a limited selection of content from certain major record labels. If RealOne Music is unable to improve the features of its music service offering, it may not achieve market acceptance and our financial results and business prospects could be harmed. In addition, we record in our statement of operations our equity share in MusicNet’s net income (loss) which was a loss of $1.3 million and a loss of $3.5 million for the quarter and six months ended June 30, 2002, respectively. We anticipate that MusicNet will continue to incur losses in the foreseeable future. No assurance can be made that MusicNet will ever contribute net income to our statement of operations or that losses recorded from MusicNet will not increase in the future.

     Our music subscription services will face competition from traditional offline music distribution competitors and from other new online music services, including pressplay, a joint venture formed between two leading media companies that are not

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participants in MusicNet, the Rhapsody music service recently launched by Listen.com, and other online efforts of the leading media companies, including the recent announcements by Universal Music Group and Sony Music Entertainment of their intentions to begin making downloads from their catalogs available for purchase online at reduced prices without restrictions on CD-burning or portability. RealOne Music also faces competition from “free” peer-to-peer services. Competing services, like pressplay and Rhapsody, may be able to obtain more or better music content or may be able to license such content on more favorable terms than MusicNet, which could harm the ability of MusicNet and our music subscription services to compete effectively in the marketplace. MusicNet also is a licensee of our technology and has used our digital music architecture to build its technology platform. If MusicNet is not successful and other online music subscription services do not license our technology, our business could be harmed.

     The Antitrust Division of the U.S. Department of Justice and certain European antitrust regulatory authorities have recently commenced investigations into music licensing and other business practices related to online music businesses, including the business of MusicNet. If the business of MusicNet is harmed or materially modified as a result of these investigations, our financial results and business prospects could be harmed.

WE MAY BE UNABLE TO SUCCESSFULLY COMPETE IN OTHER PARTS OF OUR BUSINESS

     Media Hosting. Our media hosting service, the Real Broadcast Network, competes with a variety of companies that provide streaming media hosting and broadcast services. These companies include Akamai, Digital Island, Yahoo! Broadcast Services and other emerging broadcast networks. Some of these competitors have cost or other advantages over our services and offer other services which Real Broadcast Network does not offer, such as creating corporate intranet portals or broadcast hosting in media formats not supported by Real Broadcast Network. We may not establish or sustain our competitive position in this market segment. In recent periods, many of the customers of the Real Broadcast Network have either gone out of business or reduced their usage of our media hosting services. Some of our media hosting competitors are also customers on whom we rely to help drive product download traffic to our Web sites through their broadcast events. We also sell servers and tools to companies that compete with Real Broadcast Network. If our relationship with these companies becomes more competitive, such companies may reduce their level of usage and purchases of our products or services.

     Web Site Destinations, Content and Advertising. Our Web sites and the Real.com Network compete for user traffic and Internet advertising revenues with a wide variety of Web sites, Internet portals and ISPs. In particular, aggregators of audio, video and other media, such as Yahoo! Broadcast Services and Microsoft’s Windows Media Guide, compete with us. We cannot be certain that advertisers will place advertising with us or that revenues derived from such advertising will be meaningful. Internet advertising revenues across the industry have decreased substantially since the second half of 2000 and our advertising revenues have substantially declined since that time. We cannot predict when, or if, advertising revenues will return to previous levels. In addition, certain of our advertising customers have ceased operations. If we lose advertising customers, fail to attract new customers, are forced to reduce advertising rates or otherwise modify our rate structure to retain or attract customers, or if we lose Web site traffic, our business could be harmed.

WE MAY NOT BE SUCCESSFUL IN THE MARKET FOR DOWNLOADABLE MEDIA AND PERSONAL MUSIC MANAGEMENT SYSTEMS

     The market for products that enable the downloading of media and that provide a personal music management system is relatively new and still evolving. We may be unable to develop a revenue model or sufficient demand to take advantage of this market opportunity. We cannot predict whether consumers will adopt RealJukebox or the RealOne Player as their primary application to play, record, download and manage their digital music. There are a number of competitive products on the market that offer certain of the music management features currently offered by RealJukebox and by the RealOne Player. These products include WinAmp Player, MusicMatch Jukebox, Sonique Player, Liquid Player, AOL and Windows Media Player. Given the size and importance of the general market for music distribution, competitors will likely release additional products that directly compete with RealJukebox and the RealOne Player, which could harm our business. Our competitors may develop new features and technology not available in RealJukebox or the RealOne Player, including advanced codecs and digital rights management technology, which could harm our business.

     RealJukebox and the RealOne Player also face competition from the emergence of widespread peer-to-peer file sharing services and programs such as Morpheus and KaZaA, and a variety of other similar services that have arisen since certain services of Napster were shut down by court order. Such services allow consumers to directly access an

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expansive array of content without relying on content providers to make the content available for streaming or digital download, and without relying on products such as our RealJukebox or our RealOne Player to be able to play, record and store such content. Our inability to achieve widespread acceptance for our digital music architecture or our player products or to create new revenue streams from the new market segments, including digital music content, could harm the prospects for our business.

     We must also provide digital rights management solutions and other security mechanisms in order to address concerns of content providers, and we cannot be certain that we can develop, license or acquire such solutions, or that content licensors or consumers will accept them. In addition, consumers may be unwilling to accept the use of digital rights management technologies that limit their use of content, especially with large amounts of free content readily available.

OUR INDUSTRY IS EXPERIENCING CONSOLIDATION THAT MAY INTENSIFY COMPETITION

     The Internet and media distribution industries are undergoing substantial change which has resulted in increasing consolidation and a proliferation of strategic transactions. Many companies in these industries have been going out of business or are being acquired by competitors. As a result, we are increasingly competing with larger competitors that have substantially greater resources than we do. We expect this consolidation and strategic partnering to continue. Acquisitions or strategic relationships could harm us in a number of ways. For example:

	•		competitors could acquire or enter into relationships with companies with which we have strategic relationships and discontinue our relationship, resulting in the loss of distribution opportunities for our products and services or the loss of certain enhancements or value-added features to our products and services;
	•		competitors could obtain exclusive access to desirable multimedia content and prevent that content from being available in our formats, thus decreasing the use of our products and services to distribute and experience the content that audiences most desire, and hurting our ability to attract advertisers to our Web sites and product offerings;
	•		suppliers of important or emerging technologies could be acquired by a competitor or other company which could prevent us from being able to utilize such technologies in our offerings, and disadvantage our offerings relative to those of competitors;
	•		a competitor could be acquired by a party with significant resources and experience that could increase the ability of the competitor to compete with our products and services; and
	•		other companies with related interests could combine to form new, formidable competition, which could preclude us from obtaining access to certain markets or content, or which could dramatically change the market for our products and services.

     Any of these events could put us at a competitive disadvantage which could cause us to lose customers, revenue and market share. They could also force us to expend greater resources to meet new or additional competitive threats, which could also harm our operating results.

WE RELY ON CONTENT PROVIDED BY THIRD PARTIES TO INCREASE MARKET ACCEPTANCE OF OUR PRODUCTS AND SERVICES

     If third parties do not develop or offer compelling content to be delivered over the Internet, or grant necessary licenses to us or our customers to distribute or perform such content, our business will be harmed and our products and services may not achieve or sustain broad market acceptance. We rely on third-party content providers, such as radio and television stations, record labels, media companies, Web sites and other companies, to develop and offer content in our formats that can be delivered using our server products and played back using our player products. We also rely on third-party content for our RealOne subscription service. In some cases, we pay substantial fees to obtain content for the RealOne service. In order to provide a compelling subscription service, we must be able to offer unique and in some cases exclusive content and programming to our customers. We face competition in the market for subscription content services by companies such as AOL Time Warner, Microsoft and Yahoo!, who may have greater access to content or the ability to pay higher fees to content providers. We cannot guarantee that third-party content providers will continue to rely on our technology or offer compelling content in our formats, nor can we guarantee that we will be able to secure licenses to

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their content at all or at commercially reasonable rates, to encourage and sustain broad market acceptance of our products and services. The failure to do so would harm our business.

     While we have a number of short-term agreements with third parties to provide content from their Web sites in our formats, most third parties are not obligated to develop or offer content using our technology. In addition, some third parties have entered into and may in the future enter into agreements with our competitors, principally Microsoft, to develop or offer all or a substantial portion of their content in our competitors’ formats and using their digital rights management technology. This may prevent such content from being playable through our products. Microsoft has substantially more resources than us that may enable it to secure preferential and even exclusive relationships with content providers, including preferential placement on or through the Windows Operating System, Internet Explorer or MSN. There could be less demand for and use of our products if Microsoft or another competitor were to secure preferential or exclusive relationships with the leading content providers, Web sites or broadcasters.

     Our success also depends on the availability of third-party content, especially music, that current users of our RealJukebox and RealOne Player can lawfully and easily access, record and play back. Our products may not achieve or sustain market acceptance if third parties are unwilling to offer their content for free download, streaming or purchase by users of our player products. Current concerns regarding the secure distribution of music over the Internet, and the difficulties and high costs associated with obtaining necessary or desirable licensing rights, are contributing to the delay or unavailability of music content for distribution.

WE MAY NOT SUCCESSFULLY DEVELOP NEW PRODUCTS AND SERVICES

     Our growth depends on our ability to continue to develop leading edge media delivery and digital distribution products and services. Our business and operating results would be harmed if we fail to develop products and services that achieve widespread market acceptance or that fail to generate significant revenues or gross profits to offset our development and operating costs. We may not timely and successfully identify, develop and market new product and service opportunities. If we introduce new products and services, they may not attain broad market acceptance or contribute meaningfully to our revenues or profitability. In addition, competitive or technological developments may require us to make substantial, unanticipated investments in new products and technologies, and we may not have sufficient resources to make these investments. If we are unable to be a technological leader in our market our business is likely to be harmed.

     Because the markets for our products and services are changing rapidly, we must develop new offerings quickly. We have experienced development delays and cost overruns in our development efforts in the past and we may encounter such problems in the future. Delays and cost overruns could affect our ability to respond to technological changes, evolving industry standards, competitive developments or customer requirements. Our products also may contain undetected errors that could cause increased development costs, loss of revenues, adverse publicity, reduced market acceptance of our products or services or lawsuits by customers.

     RealJukebox and the RealOne Player support or will support a variety of audio formats, including RealAudio, MP3, Liquid Audio, Windows Media Audio and IBM’s EMMS. However, technical formats and consumer preferences evolve very rapidly, and we may be unable to adequately address consumer preferences or fulfill the market demand to the extent it exists. We may be unable to license technologies, like codecs, that obtain widespread consumer and developer use which would harm consumer and developer acceptance of our products and services. In addition, our codecs and formats may not continue to be in demand or desirable as other third party codecs and formats become more readily available.

WE DEPEND ON KEY PERSONNEL WHO MAY NOT CONTINUE TO WORK FOR US

     Our success substantially depends on the continued employment of our executive officers and key employees, particularly Robert Glaser, our founder, Chairman of the Board and Chief Executive Officer. The loss of the services of Mr. Glaser or our other executive officers or key employees could harm our business. If any of these individuals were to leave RealNetworks, we could face substantial difficulty in hiring qualified successors and could experience a loss in productivity while any such successor obtains the necessary training and experience. A number of our key employees have reached or will soon reach the five-year anniversary of their RealNetworks hiring date and, as a result, will have become or will shortly become fully vested in their initial stock option grants. While most personnel are typically granted additional five-year stock options subsequent to their hire date to provide additional incentive to remain at RealNetworks, the initial option

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grant is typically the largest and an employee may be more likely to leave our employ upon completion of the vesting period for the initial option grant. None of our executive officers has a contract that guarantees employment. We do not maintain “key person” life insurance policies. If we do not succeed in retaining and motivating existing personnel, our business could be harmed.

OUR FAILURE TO ATTRACT, TRAIN OR RETAIN HIGHLY QUALIFIED PERSONNEL COULD HARM OUR BUSINESS

     Our success also depends on our ability to attract, train and retain qualified personnel in all areas, especially those with management and product development skills. In particular, we must hire additional experienced management personnel to help us continue to grow and manage our business, and skilled software engineers to further our research and development efforts. At times, we have experienced difficulties in hiring personnel with the proper training or experience, particularly in technical and media areas. Competition for qualified personnel is intense, particularly in high-technology centers such as the Pacific Northwest, where our corporate headquarters are located. If we do not succeed in attracting new personnel or in retaining and motivating our current personnel, our business could be harmed.

     In making employment decisions, particularly in the Internet and high-technology industries, our current employees and prospective job candidates often consider the value of stock options they hold or that they may receive in connection with their employment. As a result of recent volatility in our stock price, we may be disadvantaged in competing with companies that have not experienced similar volatility or that have not yet sold their stock publicly.

POTENTIAL ACQUISITIONS INVOLVE RISKS WE MAY NOT ADEQUATELY ADDRESS

     As part of our business strategy, we have acquired technologies and businesses in the past, and expect that we will to continue to do so in the future. The failure to adequately address the financial, legal and operational risks raised by acquisitions of technology and businesses could harm our business. Acquisition or business combination transactions are accompanied by a number of significant risks. Financial risks related to acquisitions may harm our financial position, reported operating results or stock price, and include:

	•		potentially dilutive issuances of equity securities;
	•		use of cash resources;
	•		the incurrence of additional debt and contingent liabilities;
	•		large write-offs and difficulties in assessment of the relative percentages of in-process research and development expense that can be immediately written off as compared to the amount which must be amortized over the appropriate life of the asset; and
	•		amortization expenses related to other intangible assets.

     Acquisitions also involve operational risks that could harm our existing operations or prevent realization of anticipated benefits from an acquisition. These operational risks include:

	•		difficulties in assimilating the operations, products, technology, information systems or personnel of the acquired company;
	•		diversion of management’s attention from other business concerns and the potential disruption of our ongoing business;
	•		the difficulty of incorporating acquired technology or content and rights into our products and services and unanticipated expenses related to such integrations;
	•		impairment of relationships with our employees, affiliates, advertisers and content providers;
	•		inability to maintain uniform standards, controls, procedures and policies;
	•		the assumption of known and unknown liabilities of the acquired company;
	•		entrance into markets in which we have no direct prior experience; and
	•		subsequent loss of key employees of the acquired company.