DIGITAL GENERATION SYSTEMS INC - 10-K Annual Report

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549

FORM 10-K

[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934

For The Fiscal Year Ended December 31, 2000

OR

[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM _____________ TO
_____________.

COMMISSION FILE NUMBER: 0-27644

Digital Generation Systems, Inc.
(Exact Name of Registrant as Specified in its Charter)

Delaware 94-3140772
(State or Other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification Number)

5221 North O'Connor Boulevard, Suite 950
Irving, Texas 75039
(Address Of Principal Executive Offices, Including Zip Code)

(972) 402-4800
(Registrant's Telephone Number, Including Area Code)

Not Applicable
(Former Name, Former Address, Former Fiscal Year, If Changed Since Last Report)

Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to the Section 12 (g) of the Act: Common Stock
($0.01 par value)

Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Sections 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months and (2) has been subject to such filing
requirements for the past 90 days. YES [X] NO [_]

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of the registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [_]

The aggregate market value of the Common Stock held by non-affiliates of the
registrant, based upon the closing sale price of the Common Stock on March 15,
2001, as reported on the Nasdaq National Market, was approximately $140,312,000.
Shares of Common Stock held by each officer and director of the registrant and
by each person who may be deemed to be an affiliate have been excluded. This
determination of affiliate status is not necessarily a conclusive determination
for other purposes.

As of March 15, 2001, the registrant had 70,156,000 shares of Common Stock
outstanding.

DOCUMENTS INCORPORATED BY REFERENCE:

The registrant has incorporated by reference into Part III of this Form 10-K
portions of its definitive Proxy Statement for its 2001 Annual Meeting of
Shareholders to be filed within 120 days after the end of the fiscal year (the
"Proxy Statement"), which meeting will be held on the date set forth in the
Proxy Statement. Except with respect to information specifically incorporated by
reference into this Form 10-K, the Proxy Statement is not deemed to be filed as
a part hereof.

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DIGITAL GENERATION SYSTEMS, INC.

The discussion in this Report contains forward-looking statements that involve
risks and uncertainties. The statements contained in this Report that are not
purely historical are forward-looking statements within the meaning of Section
27A of the Securities Act of 1933, as amended, and Section 21E of the Securities
Exchange Act of 1934, as amended. Words such as "anticipates," "believes,"
"plans," "expects," "future," "intends," and similar expressions are used to
identify forward-looking statements. All forward-looking statements included in
this document are based on information available to the Company on the date
hereof, and we assume no obligation to update any such forward-looking
statements, except as required by law. The Company's actual results could differ
materially from those anticipated in these forward-looking statements as a
result of certain factors, including, but not limited to, those discussed in
"Management's Discussion and Analysis of Financial Condition and Results of
Operations - Certain Business Considerations" as well as those discussed
elsewhere in this Report, and the risks discussed in the Company's other United
States Securities and Exchange Commission filings.

TABLE OF CONTENTS

PART I

ITEM 1. BUSINESS..................................................................... 1
Industry Background.......................................................... 2
The Companies................................................................ 3
Products and Services........................................................ 4
The DG Systems Network....................................................... 5
The StarGuide Network........................................................ 6
Markets and Customers........................................................ 8
Sales, Marketing and Customer Service........................................ 9
Competition.................................................................. 11
Intellectual Property and Proprietary Rights................................. 12
Employees.................................................................... 13
ITEM 2. PROPERTIES................................................................... 13
ITEM 3. LEGAL PROCEEDINGS............................................................ 13
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.......................... 13
ITEM 4A. EXECUTIVE OFFICERS OF THE REGISTRANT......................................... 14

PART II

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS........ 17
ITEM 6. SELECTED FINANCIAL DATA...................................................... 17
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS................................................................... 19
Overview..................................................................... 19
Results of Operations........................................................ 19
Liquidity and Capital Resources.............................................. 21
Certain Business Considerations.............................................. 22
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK................... 36
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTAL DATA................................... 36
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
DISLOSURE.................................................................... 36

PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT........................... 36
ITEM 11. EXECUTIVE COMPENSATION....................................................... 36
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT............... 36
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS............................... 36

PART IV

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K.............. 37
EXHIBITS AND REPORTS ON FORM 8-K........................................................ 37
SIGNATURES.............................................................................. 41

DIGITAL GENERATION SYSTEMS, INC.

PART I

ITEM 1. BUSINESS

DG Systems, Inc. ("DG Systems") operates a nationwide, value-added digital
network which links hundreds of advertisers and advertising agencies with more
than 7,500 radio and 800 television stations across the United States and
Canada. DG Systems' fault-tolerant Network Operation Center located in San
Francisco delivers audio, video, image and data content that comprise
transactions between the advertising and broadcast industries.

DG Systems is the most significant distributor of audio spot advertising to
radio stations, enjoying a market share in excess of 50%. In late 1996, DG
Systems entered the market for the electronic distribution of digital video
spots to television stations, cable systems and networks. DG Systems' revenues
derive mainly from advertising agencies, advertisers, tape duplication vendors
and dealers, syndicated programmers and music companies that principally service
these markets. DG Systems believes that its digital network enables rapid, cost-
effective and reliable transmission of audio and video broadcast content, and
provides higher levels of quality, control and flexibility than physical
distribution methods currently available. In July 1997, DG Systems purchased
Starcom Mediatech, Inc. ("Mediatech"), a provider of broadcast video and audio
duplication, syndicated program distribution and corporate media duplication
services, with facilities in Chicago, Los Angeles and New York, augmenting its
November 1996 acquisition of PDR Productions, Inc. ("PDR"), a New York City-
based broadcast production services company. As a result of these acquisitions,
DG Systems also has become a leading provider of video advertising distribution
and is adding new customers to its digital audio and video network. DG Systems
offers a complete range of post-production services, including editing,
duplication, color control, close captioning, content review, quality assurance,
electronic archiving and format conversions, all of which allow one-stop
shopping in the critical advertising markets of New York City, Chicago and Los
Angeles.

On January 18, 2001, DG Systems completed its merger with StarGuide Digital
Networks, Inc. ("StarGuide") pursuant to the Agreement and Plan of Merger by and
among DG Systems, SG Nevada Merger Sub Inc., a wholly owned subsidiary of DG
Systems ("Merger Sub"), and StarGuide. The merger has been accounted for as a
reverse acquisition, and accordingly, historical results of the combined company
will be that of StarGuide and the Company's results of operations will be
included subsequent to the consummation date. On March 7, 2001, DG Systems
completed its purchase of the 50% interest in Musicam Express ("Musicam") owned
by Westwood One, Inc. and Infinity Broadcasting Corporation in exchange for
690,000 shares of common stock plus the assumption of outstanding bank debt and
other liabilities of Musicam.

Upon the completion of the merger, each share of StarGuide common stock
converted into the right to receive 1.7332 shares of common stock of the
Company. Under the merger agreement, StarGuide's options and warrants were
assumed by the Company based on the same exchange ratio.

StarGuide is a leading designer and provider of high-speed digital information
transmission and distribution systems. StarGuide's patented technology--digital
distribution, compression, and transmission systems combined with satellite and
Internet technologies--allow StarGuide to achieve high-quality, economical,
flexible, and high-throughput information flow without the need for point-to-
point connections, regardless of digital formatting or compression protocols.
Integrated into many of StarGuide's systems are StarGuide's proprietary digital
audio compression and decompression, or "codec," techniques and products.

StarGuide's satellite transmission systems combine varying types of
information into one single transmission, maximizing the amount of information
transmitted through the satellite in a more cost-effective and reliable manner
than other distribution systems available on the market. The systems are also
readily upgradeable, secure, and able to direct transmissions, or components of
transmissions, to multiple points simultaneously. StarGuide's transmission
systems are capable of receiving any type of digitized media including audio,
simultaneous audio, video, text and data from a variety of sources including
satellite, high-bandwidth connections such as ISDN or T1 lines, and other wired
and wireless systems.

StarGuide has developed a patented store-and-forward system called Transportal
2000(TM), a cost-effective, reliable, high-speed electronic media delivery
system that serves the broadcast industry with Internet connectivity, compatible
StarGuide satellite transmission and terrestrial overlays, automatic fall-back
dub and ship service, and automated confirmation of delivery. This proprietary
automated media distribution system is being deployed across the radio
broadcasting industry. StarGuide will seek to expand its presence in the
broadcasting industry and will target new market opportunities for high-quality,
high-throughput digital information systems.

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Building on its experience and technology in digital content distribution,
StarGuide also seeks to become the leading provider of Internet-related video
and audio content delivery through the commercial application of its patented
CoolCast(TM) technology. Using this technology, millions of viewers and
listeners can simultaneously access high-quality content through personal
computers. Streaming video and audio content, delivered via satellite to
Internet points of presence, can be accessed by subscribers through broadband
connections capable of supporting CoolCast(TM) technology. Subscribers can thus
enjoy this streaming content in conjunction with CoolCast(TM)-enabled web-sites,
without the degradation of signal quality typically caused by the congestion of
the Internet backbone. StarGuide believes that its CoolCast(TM) service
represents an efficient means to meet the growing demand for broadband video and
audio delivery to Internet users.

Industry Background

DG Sytems

While many radio and television broadcasters now embrace digital technology
for much of their production processes and in-station media management, current
methods for the distribution of audio and video advertising content are based
primarily on the manual duplication and physical delivery of analog tapes.
According to industry sources, there are approximately 10,000 commercial radio
and 1,100 commercial television stations in the United States. These stations
generate revenue by selling airtime to advertisers. Advertising is most
frequently produced under the direction of advertising agencies for large
national or regional advertisers, or by station personnel for advertisers that
are local in nature. Advertising is characterized as "network" or "spot,"
depending on how it is bought and distributed. Network advertising typically is
delivered to stations as part of a "network feed" (bundled with network
programming), while spot advertising is delivered to stations independently of
other programming content.

Spot advertising airtime typically is purchased by advertising agencies or
media buying firms on behalf of advertisers. Advertisers and their agencies
select individual stations or groups of stations to support marketing
objectives, which usually are based on the stations' geographic and other
demographic characteristics. The actual commercials or "spots" typically are
produced at a digital production studio and recorded on digital tape. Variations
of the spot intended for specific demographic groups also are produced at this
time. The spots undergo a review of quality and content before being cleared for
distribution to broadcast stations. Tapes containing the spot and its variations
are then duplicated on analog tape, packaged, labeled and shipped to the radio
and television stations and cable head-ends specified by the advertiser or its
agency.

The predominant method for distributing spot advertisements to radio and
television stations traditionally has been physical delivery of analog audio or
videotapes. DG Systems estimates that approximately 30% of radio spots and more
than 85% of video spots are delivered by air express services. Many companies,
commonly known as "dub and ship houses," are in the business of duplicating
audio and video tapes, assembling them according to agency-specified bills of
material and packing them for air express delivery. DG Systems estimates that it
has transitioned approximately 60% of the market for audio spot deliveries and
approximately 10% of video spot deliveries, to digital distribution. DG Systems
estimates the market sizes for the audio distribution market to be approximately
$40 million and approximately $150 million for the video distribution market.

StarGuide

Increasing demand for reliable and rapid means of information transfer in the
broadcast, scientific, education, entertainment, home-computing, and
telecommunications industries has driven a number of technical innovations in
recent years. In particular, digital distribution technologies are increasingly
used for distributing information in forms such as audio, video, text, and data.
Digitized information can be stored, manipulated, transmitted, and reproduced
more easily, more rapidly, with less degradation, and in greater volumes than
traditional analog or hard copy information.

Prominent among digital distribution system developments in recent years has
been the growth of the Internet. The Internet, however, suffers from significant
bandwidth, security, reliability, and other constraints.

To meet their growing need for solutions that offer reliable, high-quality
digital information distribution, some companies have deployed their own
terrestrial-based local and wide area computer networks. These systems are
typically very costly to deploy, use, and maintain. Additionally, upgrading
these systems to keep abreast of technical innovations can be particularly
difficult and costly.

Other digital communication and transmission technologies, such as private-
network satellite systems, can offer more cost-effective and reliable solutions
for the digital-transmission requirements of data-intensive businesses,
including radio and

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television broadcasting. Satellite distribution can be particularly effective at
meeting the needs of point-to-multipoint transmission, or "multicasting," and
other broadcasting applications.

StarGuide has developed proprietary software and hardware systems that can
address the need for data distribution services that are both economically and
technologically suitable to various commercial applications. Many of these
systems are currently deployed and in service, and StarGuide continues to
upgrade its technology, and to deploy additional units in the marketplace.

The Companies

DG Systems

DG Systems is a leading provider of electronic and physical distribution of
and ancillary post-production services for, audio and video content to
advertising agencies, production studios and broadcast stations throughout the
United States and Canada. DG Systems was incorporated in 1991. DG Systems has
developed a digital network currently serving over 7,500 radio and 800
television stations that is controlled through DG Systems' San Francisco Network
Operating Center, or "NOC". This network enables the rapid, cost-effective and
reliable electronic transmission of audio and video spots and other content and
provides a high level of quality, accountability and flexibility to both
advertisers and broadcasters. With DG Systems' network, transmissions are
automatically routed to stations through a computerized on-line transaction and
delivery system and arrive, in text format, at stations in as little as one hour
after an order is received. Typically, associated traffic instructions are
simultaneously transmitted by facsimile to minimize station handling and
scheduling errors. Shortly after a spot is delivered to a station, DG Systems
sends the customer a confirmation specifying the time of delivery. Additionally,
DG Systems' digital network delivers close to "master" quality audio or video to
broadcast stations, which is equal to or superior to that currently delivered on
analog tape.

DG Systems generates its revenues from advertising agencies as well as from
production studios and dub and ship houses that consolidate and forward the
deliveries to broadcast stations. DG Systems has historically operated and
currently operates without substantial backlog. DG Systems receives distribution
orders with specific bills of material, routing and timing instructions provided
by the customer. These orders are entered into DG Systems' computer system
either by the customer (through an internet-based order-entry system) or by DG
Systems, and are scheduled for electronic delivery if a station is on DG
Systems' network, or are scheduled for physical delivery via DG Systems' various
dub and ship facilities if a destination station is not on the network.

Audio content is received electronically at DG Systems' NOC from Record Send
Terminals and Client Workstations, that are owned by DG Systems and deployed
primarily in production studios. Audio content also can be received at DG
Systems' San Francisco NOC on media shipped via airfreight carriers where Record
Send Terminals are not available. In addition, audio can be received using DG
Systems' "iAudio" internet audio collection system. When audio spots are
received, company personnel quality-assure the audio content and then initiate
the electronic transaction to transmit various combinations of audio to
designated radio stations. Audio transmissions are delivered over standard
telephone or ISDN lines to servers that DG Systems has placed in each radio
station on the network. The audio spots are thereafter available to the station
on demand.

Video content is received electronically at DG Systems' San Francisco NOC
primarily from DG Systems' Video Record Transmission Systems that are owned by
DG Systems and deployed in production video studios. Video content also can be
received at DG Systems' San Francisco NOC on media shipped via airfreight
carriers or through high-speed communication lines from collection points in
locations where Video Record Transmission Systems are not available. When video
spots are received, company personnel quality-assure the spots and release the
video to the NOC, where it is combined with the customer's electronic
transaction to transmit the various combinations of video to designated
television stations. Video transmissions are sent via a high-speed frame relay
link to the digital satellite uplink facility over which they are then delivered
directly to servers that DG Systems has placed in television stations and cable
interconnects.

Audio and video transmissions are received at designated radio and television
stations on DG Systems-owned servers, called Receive Playback Terminals, Client
Workstations and ADvantage Digital Video Playback Systems. The servers enable
stations to receive and play back material delivered through DG Systems' digital
distribution network. The units are owned by DG Systems and typically are
installed in the "master control" or production area of the stations. Upon
receipt, station personnel generally review the content and transfer the spot to
a standardized internal station format for subsequent broadcast. Through its
NOC, DG Systems monitors the spots stored in each Receive Playback Terminal,
Client Workstation and Digital Video Playback System and ensures that space is
always available for new transmissions. DG Systems can quickly transmit audio or
video at the request of a

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station or in response to the request of a customer who wishes to alter an
existing order, enabling responsiveness not possible in a physical tape
distribution system.

DG Systems currently offers four primary levels of digital audio distribution
services and three levels of video distribution services from its NOC to
broadcast advertisers distributing content to broadcast stations: DG Priority, a
service which guarantees arrival of the first audio spot on an order within one
hour (available for audio only); DG Express, which guarantees arrival within
four hours; DG Standard, which guarantees arrival by noon the next day; and DG
Economy, which guarantees arrival by noon on the second day. DG Systems also
offers a set of premium services enabling advertisers to distribute audio or
video spots provided after normal business hours and, therefore, after overnight
parcel delivery service is no longer available.

In addition to its standard services, DG Systems has developed unique products
to service four vertical markets with particular time-sensitive delivery needs.
"Sweeps" delivery is a specialized service for television stations that wish to
advertise on radio with either topical or cooperative content to stimulate
viewership during the periods of ratings measurements conducted by the A.C.
Nielsen Company. DG Systems also offers delivery of advertising for daily
newspapers seeking to expand their readership based on a dissemination of
breaking news during the morning rush hour. DG Systems distributes first release
music singles and uses unique software functionality to insure that the singles
are released throughout the country to all stations simultaneously thereby
eliminating concerns of favoritism or premature release. Finally, DG Systems
delivers political advertising during election campaigns, providing a rapid
response mechanism for candidates and issue groups.

DG Systems also provides audio and video duplication services, syndicated
programming distribution services, and a host of other ancillary post-production
services through its facilities in New York, Chicago, Louisville and Los
Angeles.

StarGuide

StarGuide is a leading designer of high-speed digital audio information
transmission and distribution systems. Through StarGuide's proprietary store-
and-forward system, Transportal 2000(TM), StarGuide has developed a high-speed
electronic media delivery system serving the broadcast industry. StarGuide also
seeks to become a leading provider of Internet-related video and audio content
delivery through its proprietary CoolCast(TM) system. The CoolCast(TM) system
allows viewers to access high-quality audio and video streaming content through
their personal computers.

StarGuide's satellite transmission systems combine varying types of
information into one single transmission, maximizing the amount of information
transmitted through the satellite in a more cost-effective and reliable manner
than other distribution systems available on the market. The systems are also
readily upgradeable, secure, and able to direct transmissions, or components of
transmissions, to multiple points simultaneously. StarGuide's transmission
systems are capable of receiving various types of digitized media including
audio, simultaneous audio, video, text and data from a variety of sources
including satellite, high-bandwidth connections such as ISDN or T1 lines, and
other wired and wireless systems.

Products and Services

DG Systems' mission is to become the leading provider of electronic value-
added transaction services to the advertising and broadcast industries.

Audio Advertising Distribution. Prior to DG Systems' acquisitions of PDR and
Mediatech, substantially all of DG Systems' revenues were derived from the
delivery of radio advertising from advertising agencies, production studios and
dub-and-ship houses to radio stations in the United States. In 1998, DG Systems
acquired Digital Courier International, Inc. ("DCI"), and has integrated DCI's
network with DG Systems' existing network to form a single, comprehensive
network servicing over 7,500 radio stations throughout Canada and the United
States. Audio services are expected to continue to account for a significant
share of DG Systems' revenues for some time. DG Systems also derives revenue
from its offering of audio distribution services in the four vertical markets:
sweeps; local/regional newspapers; music releases; and political advertising. DG
Systems provides two-way audio transmission services to radio stations within
markets, regions and co-owned groups, facilitating the sharing of programming
and commercial content. DG Systems also derives limited revenue through its
studio services, which enable production studios to directly exchange audio
files with each other without the intervention of Company personnel.

Post-production Services. DG Systems' acquisitions of PDR and Mediatech have
enabled it to provide digital delivery to a larger base of customers and to
provide post-production services in the United States' three major advertising
markets (New York, Los

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Angeles and Chicago) for a "one-stop shopping solution." DG Systems continues to
focus on value-added postproduction services to complement DG Systems' digital
delivery products. Such services include editing, duplication, color control,
close captioning, content review, quality assurance, electronic archiving and
format conversions.

Video Advertising Distribution. DG Systems believes that the delivery of
television advertising is characterized by many of the same challenges facing
radio advertisers. DG Systems introduced its video distribution services in
1996. To date, DG Systems has deployed a video distribution network consisting
of over 800 television stations and cable interconnects, which currently are on-
line and receive video content through DG Systems' network. DG Systems is
actively marketing and selling its video services to agencies, advertisers and
dealers. As many of DG Systems' radio advertising customers also are active
television advertisers, its current customers who already utilize DG Systems'
audio spot distribution services are candidates for or already are utilizing its
video services.

Syndicated Program Distribution. DG Systems also generates revenue by
distributing syndicated programming. This service primarily consists of
integrating commercials into syndicated programs and either uplinking the
completed programs via satellites for distribution to stations nationwide and in
Canada or the physical duplication and shipping of shows to stations that do not
receive a satellite feed.

Corporate Duplication. DG Systems also generates revenues from the duplication
of corporate content. This service primarily consists of large quantity
duplication of training, corporate or product information tapes on non-broadcast
quality tape stock, such as VHS.

Music Distribution. DG Systems also derives revenues from its "first release
music deliveries," in which it offers music labels the capability to
electronically distribute first-release music singles simultaneously to selected
radio stations.

DG Systems' future growth depends on its successful and timely introduction of
new products and services, often in markets that do not currently exist or are
just emerging. DG Systems currently is undertaking efforts to develop new
products and services. However, DG Systems may not be able to complete such
development successfully, and, even if the development is completed, DG Systems'
introduction of these products and services may not realize market acceptance or
meet the technical or other requirements of potential customers.

The DG Systems Network

DG Systems has developed a sophisticated, highly scaleable network
communication system to provide network transaction services to the advertising
and broadcast industries. Today this system supports two-way communication
between advertisers, agencies, production studios and stations via standard
telephone lines, ISDN lines, digital data satellite frame relay connections and
the Internet. DG Systems intends to continue employing state-of-the-art
communications capabilities, such as xDSL and cable modems, as they become
widely available and economically feasible.

DG Systems' network consists of the following:

. Record Send Terminals, Client Workstations (audio), and Video Record
Transmission Systems (video) owned by DG Systems and installed primarily at
production studios;
. NOC at DG Systems' headquarters used to assemble, process, route and store
digital content;
. Receive Playback Terminals, Client Workstations (audio), and Digital Video
Playback Systems (video) owned by DG Systems and installed at broadcast
stations, cable interconnects and broadcast and cable networks; and
. Hughes Satellite Interface used to receive and deliver media content.

Record Send Terminal and Client Workstation. Both the Record Send Terminal and
Client Workstation are PC-based audio encoder and communication servers with a
full screen monitor and keyboard. The Record Send Terminal accepts audio in
either analog or digital format and encodes the audio using an efficient
algorithm for transmissions to DG Systems' NOC in San Francisco. The Client
Workstation is a rack-mountable or desktop, PC-based communication server and
media encoder/decoder that enables radio stations to receive, play back, record
and send audio content delivered through DG Systems' digital distribution
network. The Client Workstation communicates with DG Systems' network to
exchange media and transactional information, and allows users to record, store
and play back broadcast quality audio on demand. Client Workstation software
consists of extensive

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remote capabilities such as system diagnostics, storage management and remote
software upgrade as well as enhanced security features such as user
authentication and a network access security protocol to prevent unauthorized
usage of the network.

Video Record Transmission System. The Video Record Transmission System is a
video encoder and communications server with a full screen monitor and keyboard.
The Video Record Transmission System accepts video in either analog or digital
format and encodes the video using a standard MPEG-2 compression algorithm for
transmissions to DG Systems' NOC in San Francisco.

Network Operating Centers. DG Systems has developed a fault-tolerant
client/server on-line transaction system based on relational databases and UNIX
servers from Sun Microsystems. DG Systems has developed software applications
incorporating critical operational capabilities such as transaction management,
communication facility monitoring, system security, intelligent network routing
and customer service databases. The major system components include (1) a
transaction scheduling, monitoring and management system, (2) a media
collection, processing and delivery system which is designed to handle audio,
video, image and data organizing the delivery content by destination address,
and routing those deliveries by the most cost-effective route, and (3) a high-
capacity media storage and archive system that indexes and archives every media
file delivered by DG Systems.

ADvantage Receive Playback Terminal. The Receive Playback Terminal is a rack-
mountable, PC-based communication server and media decoder that enables radio
stations to receive and play back audio content delivered through DG Systems'
digital distribution network. The Receive Playback Terminal communicates with DG
Systems' network to exchange media and transactional information, and allows
users to play back broadcast quality audio on demand. Receive Playback Terminal
software consists of extensive remote capabilities such as system diagnostics,
storage management and remote software upgrade as well as enhanced security
features such as user authentication, network access security protocol and media
content encryption to prevent unauthorized access.

ADvantage Digital Video Playback System. The Digital Video Playback System is
a rack-mountable, PC-based communication server and video decoder that enables
television stations and cable systems to receive and play back advertisements
delivered through DG Systems' digital distribution network. The Digital Video
Playback System communicates with DG Systems' network to exchange media and
transactional information, and allows users to play broadcast quality video on
demand. The Digital Video Playback System includes a fully integrated monitor
and keyboard and has the disk capacity to store up to 250 30-second spots.
Digital Video Playback System software consists of extensive remote capabilities
such as system diagnostics, storage management and remote software upgrades as
well as enhanced security features such as user authentication, network access
security protocol and media content encryption to prevent unauthorized access.

Hughes DirecPC Satellite Interface. DG Systems has a joint development and
deployment agreement with Hughes Network Systems for satellite delivery to its
network of stations. DG Systems has developed an electronic interface between
its NOC in San Francisco and the Hughes satellite uplink facility. DG Systems
also has integrated the Hughes DirecPC satellite technology into its Digital
Video Playback Systems to permit the receipt of media content from satellite as
well as from terrestrial connections.

DG Systems' extensive network of digital audio Receive Playback Terminals and
Digital Video Playback Systems strategically placed across the country in
broadcast stations, its Record Send Terminals, Client Workstations and Video
Record Transmission Systems, coupled with unique encoding, compression and
complex communications software, connected via its NOC described above, and an
established customer base, create important barriers to entry for potential
competitors. The transmission of content is controlled by a very comprehensive
transaction scheduling, routing, monitoring and delivery management system that
DG Systems believes would be very difficult to replicate. Additionally, DG
Systems' audio and video capabilities now are complemented with facilities in
New York City, Chicago, Louisville, and Los Angeles to handle customers' other
production services needs. DG Systems believes that no single competitor today
offers DG Systems' audio, video, and production services capabilities that are
deliverable locally and nationally via several strategic locations.

The StarGuide Network

StarGuide Digital Media Transmission Solutions. StarGuide has developed
proprietary, integrated hardware and software transmission systems that provide
high-quality, reliable, cost-effective, variable-speed distribution of digitized
media. StarGuide's systems are flexible; they can be used to distribute
digitized audio, video, text and data, from various formats. In addition,
StarGuide's systems may be used with other wired or wireless transmission
systems, including satellite systems. StarGuide has focused initially on
providing these solutions for the media and broadcast industries.

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StarGuide's transmission systems are also "scalable," to accommodate data
streams of varying sizes and transmission speed requirements. As a result, a
StarGuide transmission system allows the broadcaster to vary, and minimize or
maximize as desired, the amount of bandwidth utilized by the system for each
transmission in real time, thus providing "bandwidth-on-demand" and savings in
bandwidth-related costs.

In the United States radio industry, StarGuide has deployed its digital
transmission systems to radio stations owned by or affiliated with Jacor, ABC
Radio, Clear Channel, Infinity, Westwood One, CBS, Bloomberg, Jones Broadcast
Programming, One-On-One Sports, and Voice of America. Abroad, StarGuide has
deployed its digital transmission systems for Osaka-Yusen (Japan), the Shenzhen
Stock Exchange (China), and other entities in Australia, New Zealand, and South
America.

StarGuide has also built a line of high-quality audio compression and
decompression products for use in the media, recording, telecommunications, and
broadcasting industries. StarGuide has sold its audio compression/decompression
products to leading companies and institutions in the United States and abroad.
StarGuide has also deployed these products in conjunction with its deployment of
satellite transmission systems in the United States radio industry.

The core of the StarGuide transmission system is StarGuide's patented MX3
Multiplexer and the StarGuide Receiver. The MX3 Multiplexer can accept up to 120
simultaneous digital, audio, video, or data services in various digital formats.
The StarGuide Multiplexer then breaks up these differing digital service streams
and re-orders and consolidates the various data streams into a single data
stream. The system can then cost-effectively transmit this data stream in a
single transmission signal, via satellites or other wired or wireless
communications vehicles. The MX3 Multiplexer does so in a highly efficient
manner, resulting in less consumption of costly bandwidth capacity on the
satellites than other transmission systems on the market, such as DVB systems.

Upon receipt of a transmission, the patented StarGuide Receiver re-assembles
and transmits data packets into their respective types of digital information
streams (audio, video, text, or data). StarGuide's receivers are flexible and
adaptable, employing low cost insertion cards that are installed in any of a
number of slots in the receivers, thus adapting the capabilities of the
receivers to varying needs of broadcasters who use them.

Current StarGuide receiver insertion cards include:

. eDAS (Ethernet Enabled Digital Audio Storage) Card: a unique, patented
store-and-forward card that allows a "live" broadcast through the StarGuide
Receiver to be automatically mixed with pre-transmitted audio or video
clips or advertising spots, thus allowing broadcasters to realize or
regionalize national programs or advertisements distributed through the
StarGuide transmission system;

. 10/100 Based-T Ethernet Interface Card: a unique, patented card that allows
StarGuide Receivers to receive and route digital content, particularly
Internet Protocol content, directly onto a 10 or 100 Based-T local or wide
area computer network;

. Musicam(R) MPEG Layer II Digital Audio Decoder Card: a proprietary audio
decoder card that provides CD quality audio and additional network control
capabilities for broadcasters who use the StarGuide transmission systems to
transmit radio broadcasts or other audio content;

. Relay Expansion Card: a system card that allows a broadcaster to remotely
control a network through the StarGuide Receiver; and

. MPEG2 Digital Video Decoder Card: a video decoder card that provides VCR
quality video and additional network control capabilities for broadcasters
who use the StarGuide transmission systems to transmit video broadcasts or
other video content.

StarGuide's transmission systems are controlled by StarGuide's Windows-based,
propriety Network Management Control System, or NMCS, which allows a system
operator to maintain and control the entire transmission system locally or
remotely. The StarGuide NMCS allows the system operator to control both the use
of satellite bandwidth by the system and the accessing of transmitted data by
the individual StarGuide Receivers in the field.

7

StarGuide also has developed a StarGuide DVB Multiplexer and mating StarGuide
DVB Receiver. StarGuide developed its StarGuide DVB transmission system for
applications requiring transmission in compliance with the DVB standard.
StarGuide's DVB system is being deployed throughout Japan by Osaka-Yusen.

StarGuide Digital Media Distribution System Solutions. StarGuide has developed
a comprehensive automated digital content store-and-forward delivery system
called the Transportal 2000(TM). StarGuide's patented Transportal 2000(TM)
system combines the best features of satellite delivery with Internet-based,
point-to-point terrestrial connections, along with traditional manual dub-and-
ship service, to provide a reliable, flexible, and economical digital content
delivery system. The Transportal 2000(TM) system includes automated digital
content packaging along with package-tracking and confirmation of delivery
reporting, which can be accessed by the user locally or remotely via the
Internet.

The Transportal 2000(TM) System can be used with or without simultaneous
delivery through real time satellite broadcasts. The Transportal 2000(TM) System
also may be utilized with StarGuide's eDAS technology, to distribute and
automatically insert locally or regionally-tailored content, such as
regionalized spot advertisements, into national broadcasts being transmitted
through the system.

Markets and Customers

A large portion of DG Systems' current revenue is derived from the delivery of
spot radio and television advertising to broadcast stations, cable systems and
networks. DG Systems derives revenue from advertising agencies directly and from
its marketing partners, which are typically dub and ship houses that have signed
agreements with DG Systems to consolidate and forward the deliveries of their
advertising agency customers to broadcast stations, cable systems and networks
via DG Systems' electronic delivery service in exchange for price discounts from
DG Systems. The advertisements distributed by DG Systems are representative of
the five leading national advertising categories of automotive, retail, business
and consumer services, food and related products including soft drinks, and
entertainment. The volume of advertising from these segments is subject to
substantial seasonal and cyclical variations. Through its acquisition of the
assets of DCI, DG Systems has also acquired an additional revenue stream from
radio stations by providing distribution between radio stations and radio
groups.

In addition to its core distribution services, DG Systems has identified
vertical-market applications for services where same day delivery is used to
promote time-sensitive content. These applications include:

Sweeps Promotions. The A.C. Nielsen ratings periods take place during the
broadcast months of February, May, September, and November. DG Systems' services
allow local television stations, their affiliated networks and syndicators,
whose own advertising rates are based on their Nielsen ratings, to promote
viewership of their programs during ratings periods.

Station to Station Distribution. Many radio stations produce and distribute
commercials and short-form programming to other stations for airplay on the same
day, and DG Systems' network has proven efficient in delivering this content,
replacing ground deliveries and couriers. In addition, consolidation in radio
ownership has resulted in many of the new radio mega-groups developing
facilities for central audio production. DG Systems' delivery system is used to
distribute this production to the group's co-owned stations.

Political Campaigns. Radio and television can provide a rapid response
mechanism for candidates and issue groups. DG Systems offers a same-day service
for the facilitation of such advertising during political campaigns.

DG Systems also offers the following services:

Post-production Services. Advertising agencies, advertisers, corporations, and
public relations firms often require additional services to be performed before
a produced element is distributed for broadcast purposes. In addition to DG
Systems' traditional post-production services - closed captioning, commercial
tagging, international standards conversions, and duplication - DG Systems has
developed and introduced digital solutions in the postproduction environment.
The new digital services enforce DG Systems' focus on a fully digital production
and distribution environment.

8

Syndication Programming Distribution. Syndicators distribute long form video
programming inclusive of advertising to local television stations and cable
operators. DG Systems offers numerous postproduction services to prepare this
content for broadcast and distributes it across the Unites States and Canada.
Distribution services include both satellite uplink and physical duplication and
shipping to those stations, which do not or cannot receive the content via
satellite.

Corporate Duplication. Corporations and other entities develop training,
management communications and other general information programs for internal
and external distribution for various purposes. DG Systems provides high volume
duplication of such content on non-broadcast quality tape stock, typically VHS.

StarGuide maintains established relationships with producers and broadcasters
such as Infinity, Westwood One, Clear Channel, ABC Radio, Jacor, CBS, Bloomberg,
Jones Broadcast Programming, One-on-One Sports and Voice of America. In
connections with these relationships, StarGuide has sold or has contracts to
sell over 6,000 of its StarGuide II Receiver systems, and has contracts to sell
roughly 6,000 of its StarGuide III Receiver systems. In addition, StarGuide's
audio codecs are recognized and used throughout the radio production and
broadcast industries. StarGuide seeks to expand its presence in the broadcast
industry by providing Transportal 2000 (TM) integrated digital transmission and
distribution systems, upgrades and enhancements of such systems, and customized
software solutions to radio stations and other communication segments such as
television networks. StarGuide also intends to utilize its existing
relationships as reference points and to leverage its technology to develop new
customers in the broadcast industry as well as deploy its delivery services for
content, streaming media and applications to various industries.

Sales, Marketing and Customer Service

Brand Strategy. DG Systems' brand strategy is to position itself as the
standard transaction method for the radio, television, cable, and network
broadcast industries. DG Systems focuses its marketing messages and programs at
multiple segments within the advertising and broadcast industries. Each of the
segments interacts with DG Systems for a different reason. Agencies purchase
services from DG Systems on behalf of their advertisers. Production studios
facilitate the transmission of audio and video to DG Systems' NOC. Production
studios and dub and ship houses resell delivery services to agencies. Stations
join the network to receive the content from their customers: the agencies and
advertisers.

Internet/E-Commerce Strategy. DG Systems introduced its first Internet-based
services called DG On-line in 1998 to facilitate the electronic remote entry of
work orders and to provide on-line tracking of order status by its customers. DG
Systems estimates that approximately 30% of its orders were entered
electronically via the Internet during 2000 and 1999, versus approximately 11%
during 1998. In addition, DG Systems also offers its "iAudio" Internet audio
collection system service which allows audio content to be received from clients
via the Internet.

Sales. DG Systems employs a direct sales force that calls on various
departments at advertising agencies to communicate the capabilities and
comparative advantages of DG Systems' electronic distribution system and related
products and services. In addition, DG Systems' sales force calls on corporate
advertisers who are in a position to either direct or influence agencies in
directing deliveries to DG Systems. A separate staff sells to and services audio
and video dealers, who resell DG Systems' distribution services. An inside sales
staff also represents DG Systems' services to radio stations. DG Systems
currently has field sales offices in New York, Los Angeles and Chicago, as well
as sales personnel in its San Francisco office. DG Systems' sales force includes
field sales, inside sales, and telemarketing.

Marketing. DG Systems' marketing programs are directed to stimulate demand
with an emphasis on popularizing the benefits of digital delivery, including
fast turnaround (same day services), increased flexibility, higher quality, and
greater reliability and accountability. These marketing programs include direct
mail and telemarketing campaigns, newsletters, collateral material (including
brochures, data sheets, etc.), application stories, and corporate briefings in
major United States cities. DG Systems also engages in public relations
activities including trade show participation, the stimulation of articles in
the trade and business press, press tours and advertisements in advertising and
broadcast oriented trade publications.

DG Systems also markets to broadcast stations to arrange for the placement of
its Receive Playback Terminals and Digital Video Playback Systems for the
receipt only of audio and video advertisements, or Client Workstations, which
provide the ability to both receive and to originate distribution of audio to
other radio stations. There is currently no charge for a station to receive an
advertisement. For radio stations or groups that subscribe to network
distribution services utilizing the Client Workstation, the station agrees to a
month-to-month, one-year or two-year term of service.

9

DG Systems believes that in combination with its acquisition of the assets of
DCI, its combined network provides digital distribution coverage for more than
90% of commercial radio stations and distribution traffic in the United States
and Canada. DG Systems is focusing on the most significant television stations
as rated by A.C. Nielsen, along with the major cable interconnects and cable and
broadcast networks.

Customer Service. DG Systems' approach to customer service is based on a
distributed model designed to provide focused support from key market centered
offices, located in Los Angeles, San Francisco, Chicago and New York. Clients
work with specific, assigned account coordinators to place production service
and distribution orders. National distribution orders are electronically routed
to the San Francisco NOC for electronic distribution or, for off-line
destinations, to DG Systems' national duplication center in Louisville,
Kentucky. DG Systems' distributed service approach provides direct support in
key market cities enabling DG Systems to develop closer relationships with
clients as well as the ability to support client needs for local production
services. DG Systems also maintains a customer service team dedicated to
supporting the needs of radio, television, and network stations. This support is
available 7 days a week, 24 hours a day, to respond to station requests for
information, traffic instructions or additional media. Providing direct support
alleviates the need for client traffic departments to deal with individual
stations or the challenges of staffing for off-hours support. DG Systems'
customer service operation centers are linked to DG Systems' order management
and media storage systems, and national distribution network. These resources
enable DG Systems to manage the distribution of client orders to the fulfillment
location best suited to meet critical customer requirements as well as providing
order status and fulfillment confirmation. This distributed model also provides
DG Systems with significant redundancy and re-route capability, enabling DG
Systems to meet customer needs when weather or other conditions prevent
deliveries using traditional courier services.

Work orders entered by customers into Client Workstations are shipped
automatically through the NOC to their destinations with minimal human
intervention. No monitoring is done of the spots, unless DG Systems is asked to
review a spot by a client. These capabilities enable DG Systems' customers to
move to an e-commerce business model as the service is developed more fully.

StarGuide presently markets and sells its transmission and distribution
systems and audio compression products directly to corporate and commercial end-
users, distributors, and to radio stations and networks. StarGuide currently
employs three salespersons who promote and sell the StarGuide integrated
transmission and distribution systems and promote the digital distribution
services provided to the radio broadcast industry. StarGuide also employs seven
salespersons who market and sell StarGuide's audio compression products.
StarGuide currently maintains relationships with distributors marketing and
selling StarGuide's audio compression products in Europe, Asia, South America,
and Australia. StarGuide is presently expanding these relationships to include
the distribution of StarGuide transmission and information management systems.
StarGuide supplies its completely integrated Transportal 2000(TM) digital
distribution system to the United States radio broadcast industry through its
ownership in Musicam Express.

StarGuide currently engages in several promotional and other activities to
generate interest in its systems and to consummate sales. For example, StarGuide
participates actively in trade shows, and participated in the following shows in
2000: National Association of Broadcasters ("NAB") and the NAB Radio Show, Audio
Engineering Society, CommunicAsia (in Singapore), as well several regional
exhibitions throughout the United States. StarGuide seeks to maximize its
visibility at trade shows by hosting a customer booth and providing
complimentary product literature describing StarGuide's systems. StarGuide also
conducts several on-site demonstrations with technical and other senior level
personnel and regularly contacts potential customers who have indicated an
interest in utilizing StarGuide's systems or products.

To support CoolCast(TM) marketing and deployment efforts, StarGuide employs
four marketing and technical personnel who regularly meet with content provider
and ISP representatives to introduce and demonstrate CoolCast(TM) and negotiate
CoolCast(TM)-related agreements. StarGuide technical support personnel also work
with StarGuide's content and distribution partners in installation and operation
of CoolCast(TM) components.

An important element of StarGuide's sales and marketing strategy is to support
its sales efforts with comprehensive technical support. Technical personnel
often accompany sales personnel when meeting with prospective customers and aid
in the implementation of StarGuide's products. Customer feedback received
through the sales process is incorporated into the product development process
and allows StarGuide to upgrade its service and support capabilities.

10

Competition

The market for the distribution of advertising and other content to radio and
television stations and cable systems is highly competitive. DG Systems
currently competes in the market for the distribution of audio and video
advertising spots to broadcast stations, cable systems and networks. The
principal competitive factors affecting this market are ease of use, price,
timeliness and accuracy of delivery.

DG Systems competes with a variety of dub and ship houses and production
studios that have traditionally distributed taped advertising spots via physical
delivery. As local distributors, these entities have long-standing ties with
advertising agencies that are often difficult for DG Systems to replace. In
addition, these dub and ship houses and production studios often provide an
array of ancillary video services, including archival storage and retrieval,
closed captioning and format conversions, enabling them to deliver to their
advertiser and agency customers a full range of customizable, media
postproduction, preparation, distribution and trafficking services. DG Systems'
acquisitions of Mediatech and PDR enable DG Systems to provide similar services
in the three largest domestic advertising markets: New York, Los Angeles and
Chicago. DG Systems plans to continue pursuing potential dub and ship house
partners where such partnerships make strategic sense.

With the acquisition of DCI, DG Systems has a widely deployed electronic
system for the delivery of audio advertisements; consequently, it competes
largely with physical tape duplication and shipping for audio advertising
distribution.

In the video marketplace, DG Systems also competes with dub and ship houses
across the country but additionally with a satellite-based real-time video
distribution network operated by Vyvx, an operating division of the Williams
Communications Group. DG Systems has been able to successfully transfer a number
of customers to its system. DG Systems also anticipates that certain common
and/or value-added telecommunications carriers may develop and deploy high
bandwidth network services targeted at the advertising and broadcast industries,
although no such carriers have yet entered the market for spot distribution.

To the extent that DG Systems is successful in entering new markets, such as
delivery of other content to radio and television stations or delivery of data
concerning the actual airtime and audience ratings of commercials, it expects to
face competition from companies in related communications markets and/or package
delivery markets which offer products and services with functionality similar to
that offered by DG Systems' products and services. Telecommunications providers
such as AT&T, MCI, and Regional Bell Operating Companies could enter the market
as competitors with significantly lower telecommunications transportation costs.
DG Systems also could face competition from entities with package delivery
expertise such as Federal Express, United Parcel Service, DHL or Airborne if any
such companies enter the electronic data delivery market. Radio networks such as
ABC or Westwood One also could become competitors by selling and transmitting
advertisements separately from their network content programming.

Many of DG Systems' current and potential competitors in the markets for audio
and video distribution have substantially greater financial, technical,
marketing and other resources than DG Systems. DG Systems expects that an
increasingly competitive environment may result in price reductions that could
result in reduced unit profit margins and loss of market share, all of which
would have a material adverse effect on DG Systems' business, results of
operations and financial condition. Moreover, the markets for the distribution
of audio and video content have become increasingly concentrated in recent years
as a result of acquisitions, which are likely to permit many of DG Systems'
competitors to devote significantly greater resources to the development and
marketing of new services. DG Systems may not be able to compete successfully
with new or existing competitors. Additionally, competitive pressures faced by
DG Systems may materially and adversely affect its business, operating results
and financial condition.

StarGuide is aware of other companies that are focusing or may in the future
focus significant resources on developing and marketing products and services
that will compete with StarGuide. StarGuide believes that its ability to compete
successfully depends on a number of factors, both within and outside of its
control, including: (1) the price, quality and performance of StarGuide's and
its competitors' products; (2) the timing and success of new product
introductions by StarGuide and its competitors; (3) the emergence of new
technologies; (4) the number and nature of StarGuide's competitors in a given
market; (5) the assertion of intellectual property rights; and (6) general
market and economic conditions.

StarGuide expects competition to continue to intensify as existing and new
competitors begin to offer products, services, or systems that compete with
StarGuide's products. StarGuide's current or future competitors, many of whom,
individually or together with their affiliates, have substantially greater
financial resources, research, and development resources, distribution,
marketing,

11

and other capabilities than StarGuide, may apply these resources and
capabilities to compete successfully against StarGuide. A number of the markets
in which StarGuide sells its products are also served by technologies that
currently are more widely accepted than StarGuide's. Although StarGuide believes
that its products and services are less expensive to use and more functional
than competing products and services that rely on other technologies, it is
uncertain whether StarGuide's potential customers will be willing to make the
initial capital investment that may be necessary to convert to StarGuide's
products and services. The success of StarGuide's systems against these
competing technologies depends in part upon whether StarGuide's systems can
offer significant improvements in productivity and sound quality in a cost-
effective manner. It is uncertain whether StarGuide's competitors will be able
to develop systems compatible with, or that are alternatives to, StarGuide's
proprietary technology or systems. It is also not certain that StarGuide will be
able to compete successfully against current or future competitors or that
competitive pressures faced by StarGuide will not materially adversely affect
its business, operating results, and financial condition.

Intellectual Property and Proprietary Rights

DG Systems primarily relies upon a combination of copyright, trademark and
trade secret laws and license agreements to establish and protect proprietary
rights in its technologies. The source code for DG Systems' software is
protected both as a trade secret and as an unpublished copyrighted work. Despite
these precautions, it may be possible for a third party to copy or otherwise
obtain and use DG Systems' hardware, software or technology without
authorization or to develop similar technology independently. In addition,
effective copyright and trade secret protection may be unavailable or limited in
certain foreign countries.

Because DG Systems' business is characterized by rapid technological change,
DG Systems believes that factors such as the technological and creative skills
of its personnel, new computer hardware, software and telecommunications
developments, frequent hardware and software enhancements, name recognition, and
reliable customer service and support are more important to establishing and
maintaining a leadership position than the various legal protections of its
technology.

DG Systems believes that its software, trademarks and other proprietary rights
do not infringe the proprietary rights of third parties. However, third parties
might assert such infringement by DG Systems with respect to current or future
software, hardware or services. Any such claims, with or without merit, could be
time-consuming, result in costly litigation, cause software release delays or
might require DG Systems to enter into royalty or licensing agreements. Such
royalty or licensing agreements, if required, may not be available on terms
acceptable to DG Systems.

StarGuide has pursued a policy of actively identifying and protecting its
intellectual property rights. StarGuide currently has eleven patents issued and
three others allowed and awaiting issuance. StarGuide has more than thirty-six
other patent applications pending domestically and abroad. StarGuide also has
four trademark registrations and seventy-six copyright registrations. StarGuide
has many other copyright registrations pending and is in the process of filing
additional patent applications and applications for copyright registrations.

StarGuide licenses certain aspects of its technology to and from third
parties. For example, StarGuide has licensed a number of companies for use of
its digital audio compression technology. Present licensees of this technology
include Comstream, General Instruments, Lucent, and Wegener Communications.
StarGuide has also granted a limited license with respect to its CoolCast
technology to ZoomTown.com in connection with its contract to deploy CoolCast
within the ZoomTown.com network.

The success of StarGuide's business depends in part upon its ability to
protect trade secrets, obtain or license patents, and operate its business
without infringing on the rights of others. Although StarGuide believes that its
patents, trademarks, and copyrights have value, StarGuide's patents, trademark
and copyright registrations, or any additional patents, trademarks, and
copyrights obtained in the future, may not provide meaningful protection from
competition. StarGuide believes its success will depend primarily upon the
experience, creative skills, technical expertise, and marketing and sales
abilities of its personnel. The value of StarGuide's products depends
substantially on StarGuide's technical innovation in fields in which there are
currently many patent filings. StarGuide believes that as new patents are issued
or infringement of others' patents are brought to StarGuide's attention by the
holders of such patents, it may be necessary for StarGuide to withdraw products
from the market, negotiate a license from such patent holders, redesign its
products or pay damages assessed as a result of litigation. Although StarGuide
believes that its products and other proprietary rights do not infringe upon the
proprietary rights of third parties, third parties may assert infringement
claims against StarGuide, and whether StarGuide would prevail in defending such
claims is uncertain.

12

Employees

As of December 31, 2000, DG Systems had a total of 339 employees, including 26
in research and development, 36 in sales and marketing, 248 in operations and
manufacturing, and 29 in finance and administration. Of these employees, 330
were located in the United States and 9 were located in Canada. None of DG
Systems' employees are represented by a collective bargaining agreement, and DG
Systems has not experienced a work stoppage. DG Systems considers its relations
with its employees to be good. As of December 31, 2000, StarGuide employed 107
people on a full-time basis. Of these employees, 12 were in sales and marketing,
38 in operations, 23 in product development, and 34 in finance and
administrative functions. None of StarGuide's employees are represented by a
labor union, and management believes its employee relations are good.

DG Systems' and StarGuide's businesses and prospects depend in significant
part upon the continued service of its key management, sales and marketing and
administrative personnel. DG Systems does not generally have employment
agreements with its key personnel. The loss of key management or technical
personnel could materially adversely affect DG Systems' business, operating
results and financial condition. DG Systems believes that its prospects depend
in large part upon its ability to attract and retain highly skilled managerial,
sales and marketing and administrative personnel. Competition for such personnel
is intense, and DG Systems may not be successful in attracting and retaining
such personnel. Failure to attract and retain key personnel could have a
material adverse effect on DG Systems' business, operating results and financial
condition.

ITEM 2. PROPERTIES

Principal executive offices of DG Systems are at 5221 North O'Connor Boulevard
in Irving, Texas. The Irving offices include 10,000 square feet of leased space,
for which the lease expires in August 2001. DG Systems also has administrative
offices and its NOC at leased office space located at 875 Battery Street in San
Francisco, California. DG Systems' lease at this site is for 19,000 square feet
and expires in June 2001. To sustain uninterrupted network integrity, DG Systems
has an agreement for non-interruptible access to emergency power and DG Systems
has arranged for alternative fiber optic routes to maintain its fiber connection
between its computers and its long distance carrier. However, a catastrophic
earthquake or other natural disaster could interrupt DG Systems' operations. DG
Systems maintains an additional lease in San Francisco, set to expire in 2001,
for a 5,000 square foot facility, which is used for assembly of its field
equipment and for offsite storage. In addition, DG Systems leases approximately
3,000 square feet in Louisville, Kentucky for its dub and ship facility which
expires in 2002; approximately 22,000 square feet in New York City which is
occupied by DG East (formerly PDR) and expires in 2006; approximately 13,000
square feet in Los Angeles occupied by DG West (formerly Mediatech) which
expires in 2006; 25,000 square feet in Chicago, which is occupied by DG Central
(formerly Mediatech) which expires on December 31, 2003; and 5,000 square feet
occupied by DG North (formerly DCI) in Burnaby, British Columbia (Vancouver,
Canada) which expires on March 31, 2003.

StarGuide has executive offices in Reno, Nevada, under a lease that expired on
September 30, 2000 and is on a month-to-month contract. In addition, StarGuide
leases office space in Holmdel, New Jersey, San Diego, California, and
Louisville, Kentucky. The terms of these leases expire at various dates between
October 31, 2000 and August 31, 2004.

ITEM 3. LEGAL PROCEEDINGS

The Company is subject, from time to time, to various legal proceedings and
claims, either asserted or unasserted, which arise in the ordinary course of
business. While the outcome of these claims cannot be predicted with certainty,
management does not believe that the outcome of any of these legal matters
asserted to date will have a material effect on the financial condition or
results of operations of the Company.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

The 2000 Annual Meeting of Shareholders of the Company was held on November
21, 2000 (the "Annual Meeting"). The following matters were voted upon at the
Annual Meeting: (i) approval of the Agreement and Plan of Merger, dated July 7,
2000, by and among DG Systems, SG Nevada Merger Sub Inc. and StarGuide; (ii) the
recincorporation of the Company from California to Delaware; (iii) amendment to
the Company's Articles of Incorporation to increase the number of authorized
shares of common stock to 200,000,000 in the event the proposal to reincorporate
as a Delaware corporation was not approved; (iv) amendment to the Company's
1992 Stock Option Plan to increase the number of shares available for issuance;
(v) ratification of the appointment of KPMG LLP as independent auditors of the
Company for the fiscal year ending December 31, 2000; (vi) to elect a board of
directors for the ensuing year. The results of the vote were as follows:

13

- --------------------------------------------------------------------------------
Votes Against/ Broker
Matter Votes For Withheld Abstentions Non-Votes
- --------------------------------------------------------------------------------

1. Agreement and Plan of
Merger with StarGuide Digital
Networks, Inc. 17,339,548 1,029,275 544,202 0
- --------------------------------------------------------------------------------
2. Reincorporation of the
Company from California to
Delaware 16,652,373 2,247,234 13,148 0
- --------------------------------------------------------------------------------
3. Amend the number of
authorized shares outstanding
if reincorporation was not
approved 17,043,743 1,851,423 17,859 0
- --------------------------------------------------------------------------------
4. Amend the Company's 1992
Stock Option Plan 24,210,416 1,383,897 0 0
- --------------------------------------------------------------------------------
5. Ratify the Appointment
of KPMG LLP 16,612,032 2,283,559 17,434 0
- --------------------------------------------------------------------------------
6. Elect Directors
Scott K. Ginsburg 24,210,166 1,384,417 0 0
Matthew E. Devine 24,209,416 1,384,897 0 0
Lawrence D. Lenihan, Jr. 24,097,073 1,497,240 0 0
Michael G. Linnert 24,200,171 1,394,142 0 0
David M. Kantor 24,210,416 1,383,897 0 0
- --------------------------------------------------------------------------------

ITEM 4A. OFFICERS OF THE REGISTRANT

The executive officers and directors of the Company and their ages as of
December 31, 2000 are as follows:

Name Age Title(s)
---- --- --------

Scott K. Ginsburg (2) 48 Chairman of the Board
Matthew E. Devine 51 Chief Executive Officer and Director
Omar A. Choucair 38 Chief Financial Officer and Director
Dan F. Dent 52 Chief Operating Officer
Lawrence D. Lenihan, Jr (2) 35 Director
Michael G. Linnert 29 Director
David M. Kantor (2) 44 Director
Cappy R. McGarr (1) 49 Director
Jeffrey A. Dankworth 46 Director
Eric L. Bernthal 54 Director
Robert J. Schlegel (1) 51 Director
Kevin Howe (1) 52 Director

(1) Member of the Audit Committee
(2) Member of the Compensation Committee

Scott K. Ginsburg joined the Company in December 1998 as Chief Executive
Officer and Chairman of the Board. In July 1999, Matthew E. Devine assumed the
responsibilities of Chief Executive Officer, but Mr. Ginsburg remains the
Company's Chairman. Most recently Mr.Ginsburg served as Chief Executive Officer
and Director of Chancellor Media Corporation (now AMFM Corporation). Mr.
Ginsburg founded Evergreen Media Corporation in 1988, and was the co-founder of
Statewide Broadcasting, Inc. and H&G Communications, Inc. Mr. Ginsburg earned a
B.A. from George Washington University in 1974 and a J.D. from the George
Washington University Law Center in 1978.

Matthew E. Devine joined the Company in July 1999 as Chief Executive Officer
and Director. Prior to joining the Company, Mr. Devine served as Chief
Financial Officer of Chancellor Media Corporation (now AMFM Corporation) and
served as Chief Financial Officer, Executive Vice President, Treasurer,
Secretary and Director for Evergreen Media Corporation. Between 1975 and 1988,
Mr. Devine served in various finance positions at AMR Corporation, parent
company to American Airlines.

Omar A. Choucair joined the Company as Chief Financial Officer in July 1999.
Prior to joining the Company, Mr. Choucair served as Vice President of Finance
for Chancellor Media (now AMFM Corporation), and served as Vice President of
Finance for Evergreen Media before it was acquired by Chancellor Media in 1997.
Prior to entering the media industry, Mr. Choucair was a Senior Manager at KPMG
LLP, where he specialized in media and telecommunications clients. Mr. Choucair
received a B.B.A. from Baylor University and is a Certified Public Accountant.
Mr. Choucair became a Director in February 2001.

14

Dan F. Dent joined the Company as Vice President, Operations in September 1999
and became Chief Operating Officer in May 2000. From 1993 until joining DG
Systems, Mr. Dent served as Vice President/General Manager of CCI/Triad, a
retail software manufacturer. From 1977 until 1993, Mr. Dent served in various
engineering and customer service management positions at Motorola and Tektronix,
Inc.

Lawrence D. Lenihan, Jr. has been a member of the Board of Directors of the
Company since July 1997. Mr. Lenihan is a Managing Director of Pequot Capital
Management, Inc. He joined the predecessor to this firm, Dawson-Samberg Capital
Management, in 1996. He is also a Managing Member of the General Partner of
Pequot Private Equity Fund II, L.P. Prior to joining Pequot, Mr. Lenihan was a
principal at Broadview Associates, LLC from 1993 to 1996. Prior to joining
Broadview, Mr. Lenihan held several positions at IBM, most recently as the
leader of an interactive multimedia software product business. Mr. Lenihan
graduated from Duke University with a B.S. in Electrical Engineering and he
holds an M.B.A. from the Wharton School of Business at the University of
Pennsylvania. He currently serves as a director of several public and private
companies including SkyOnline, Interpacket Group Inc., Performaworks, FlexiGift,
Inc., and Mediaplex, Inc.

Michael G. Linnert has been a member of the Board of Directors of the Company
since July 1999. Mr. Linnert is a General Partner with Technology Crossover
Ventures, a venture capital firm, which specializes in emerging Internet and
communications companies. He currently serves as a board member of petopia.com.
Prior to joining Technology Crossover Ventures, Mr. Linnert was a member of the
investment banking division at Goldman, Sachs & Co. Mr. Linnert holds a
B.S.E.E. from the University of Notre Dame and an MBA from Stanford Graduate
School of Business.

David M. Kantor has been a member of the Board of Directors of the Company
since August 1999. Mr. Kantor is Senior Vice President for Network Operations
of AMFM, Inc. (formerly Chancellor Media Corporation) and manages AMFM Radio
Networks. Prior to joining AMFM, he was President of ABC Radio Network, having
previously served as Executive Vice President. Prior to joining ABC Radio
Network, he held executive positions with Cox Cable and Satellite Music Network.
Mr. Kantor holds a B.S. from the University of Massachusetts and an MBA from
Harvard Business School.

Cappy R. McGarr has been a member of the board since February 2001. Mr.
McGarr is the founder and President of McGarr Capital Management, a firm
specializing in managing domestic and offshore hedge funds. He received
Bachelor of Arts, Bachelor of Journalism and Master of Business Administration
degrees from the University of Texas at Austin. Upon completing his graduate
degree in 1970, McGarr was employed by Goldman, Sachs & Co. He serves on the
Board of Trustees of The John F. Kennedy Center for the Performing Arts and the
Board of Directors of the Lyndon Baines Johnson Foundation. He also serves as
Chairman of DASHPAC, Senate Democratic Leader Tom Daschle's Political Action
Committee.

Jeffrey A. Dankworth has been President and a Director of StarGuide since
1995. Prior to co-founding StarGuide in 1994, Mr. Dankworth was an entrepreneur
in the entertainment media and professional sports industries where he led the
development of various media joint ventures in professional sports including the
NFL Quarterback Club. As an attorney, Mr. Dankworth has extensive experience in
various areas of business development, including the negotiation and management
of media partnerships, licensing programs, and joint ventures. Between 1984 and
1994, Mr. Dankworth was Of Counsel with the law firm of Mitchell, Silberberg &
Knupp and prior to that was an associate with the law firm of Gibson, Dunn &
Crutcher (1981-1984).

Eric L. Bernthal has been a member of the board since February 2001. Mr.
Bernthal is the Managing Partner of the Washington, DC office of Latham &
Watkins, a law firm with more than 1,000 attorneys worldwide. He has practiced
corporate and telecommunications law for 30 years, specializing in transactional
and regulatory matters. Mr. Bernthal has represented companies in the media,
communications, health care, consumer products and retail industries. Mr.
Bernthal has been a partner in Latham & Watkins since 1986. Prior to joining
Latham, Mr. Bernthal was an associate and then a partner in the Washington, DC
law firm of Arent, Fox, Kintner, Plotkin & Kahn, from 1972 to 1986. He served on
that law firm's Executive Committee for five years. Mr. Bernthal served as law
clerk to the Honorable Ruggero J. Aldisert of the United States Court of Appeals
for the Third Circuit in Philadelphia from 1970 to 1972. He earned an
undergraduate degree from Columbia University in 1967 and a graduate degree from
George Washington University Law Center.

Robert J. Schlegel has been a member of the board since February 2001. Mr.
Schlegel is the CEO of The Pavestone Company. Mr. Schlegel also built a health
care company that included more than 2,000 employees and 2,200 nursing
retirement care beds in 13 Texas facilities. Mr. Schlegel has been actively
involved in the Dallas community with the Trinity Christian Academy, the Cox
School of Business at Southern Methodist University, the Salvation Army,
Students in Free Enterprise, the Alzheimer's Association, the Dallas Symphony,
the Young Presidents' Organization and his own foundation, the Schlegel horizons
Foundation. Mr. Schlegel graduated with a B.A. degree in Economics from Wilfrid
Laurier University in 1972.

15

Kevin Howe is the Managing Partner of Mercury Ventures. Mercury Ventures
manages 3 different funds that invest in emerging technology companies that
focus on Internet applications. Mr. Howe serves on the board of three publicly
traded technology firms that are listed on the NASDAQ and London exchanges. Mr.
Howe also sits on the boards of five privately held technology firms. In 1985,
he co-founded DacEasy, an early leader in packaged application software. In
1987, Howe led the sale of DacEasy to Insilco (a Fortune 500 company). In 1991,
Mr. Howe led the carve-out of DacEasy from Insilco and subsequent sale to Sage
Group, plc. which had market capitalization of over $7 billion. He was CEO of
the US operations responsible for operations and acquisitions until 1999. He
remains a director of Sage. In 1993, Mr. Howe also co-founded Martin Howe
Associates, which was an early leader in the merchant credit card processing
industry and a pioneer in wireless solutions. The company was sold in 1997 to
PMT, a NASDAQ quoted company. Mr. Howe received his MBA from SMU in 1976.

16

PART II

ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED SHAREHOLDER MATTERS

The Common Stock of the Company has been traded on the Nasdaq National Market
under the symbol DGIT since the Company's initial public offering on February 6,
1996. Prior to that time there was no public market for the Company's Common
Stock or other securities.

The following table sets forth the high and low closing sales prices of our
Common Stock from January 1, 1999 to December 31, 2000. Such prices represent
prices between dealers, do no include retail mark-ups, mark-downs or commissions
and may not represent actual transactions.

Fiscal Year Ended 2000 Fiscal Year Ended 1999
---------------------- ----------------------
High Low High Low
---------------------- ----------------------

First Quarter....... $10.06 $6.38 $8.13 3.63

Second Quarter...... 8.25 4.25 9.00 4.13

Third Quarter....... 6.97 4.13 6.13 3.38

Fourth Quarter...... 4.69 1.66 7.56 3.25

As of December 31, 2000, the Company had issued 28,258,786 and outstanding
28,235,869 shares of its Common Stock. As of March 15, 2001, the Company had
issued and outstanding 70,156,000 shares of its Common Stock held by 100
shareholders of record. The Company estimates that there are approximately 3,350
beneficial shareholders.

In December 1999, the Company's Board of Directors authorized the sale and
issuance of Common Stock in a private placement transaction. The Company issued
725,199 common shares to institutional investors and members of management at a
price of $5.17 per share, or an aggregate of $3,750,000. The offers and sales of
the Common Stock and warrants to purchase Common Stock were exempt from the
registration requirements of the Securities Act of 1933, as amended (the "Act"),
pursuant to Section 4(2) thereof. The Company relied on the following criteria
to make such exemption available: the number of offerees, the size and manner of
the offering, the sophistication of the offerees and the availability of
material information.

The Company has never declared or paid cash dividends on its capital stock.
The Company currently expects to retain any future earnings for use in the
operation and expansion of its business and does not anticipate paying any cash
dividends in the foreseeable future.

ITEM 6. SELECTED FINANCIAL DATA

The following selected historical consolidated financial data should be read
in conjunction with DG Systems' consolidated financial statements and related
notes and DG Systems' "Management's Discussion and Analysis of Financial
Condition and Results of Operations." The consolidated statement of operations
data for each of the three years ended December 31, 1998, 1997 and 1996 and the
consolidated balance sheet data at December 31, 1998, 1997 and 1996 are derived
from the consolidated financial statements of DG Systems, which have been
audited by Arthur Andersen LLP, independent public accountants. The consolidated
statement of operations data for the years ended December 31, 2000 and 1999 and
the consolidated balance sheet data at December 31, 2000 and 1999 is derived
from the consolidated financial statements of DG Systems, which were audited by
KPMG LLP, independent public accountants.

17

Years ended December 31,
----------------------------------------------------------------------
Statement of Operations: 2000 1999 1998 1997 1996
---- ---- ---- ---- ----
(in thousands, except per share amounts)

Revenues $54,711 48,724 41,270 29,175 10,523
----------------------------------------------------------------------

Costs and expenses:
Delivery and material costs 13,966 17,857 14,630 11,334 3,084
Customer operations 16,330 15,138 14,780 11,388 4,164
Sales and marketing 4,448 4,818 4,970 4,417 3,998
Research and development 3,112 2,577 2,780 2,473 2,092
General and administrative 7,838 6,552 4,314 3,169 1,677
Write-down of goodwill and fixed assets - - 17,006 - -
Non-recurring charges - 370 - - -
Depreciation and amortization 7,095 8,591 10,266 9,306 4,331
----------------------------------------------------------------------
Total expenses 52,789 55,903 68,746 42,087 19,346
----------------------------------------------------------------------

Income (loss) from operations 1,922 (7,179) (27,476) (12,912) (8,823)
Other income (expense):
Interest and other income, net 134 319 253 744 1,422
Interest expense (900) (1,903) (3,014) (2,607) (1,726)
----------------------------------------------------------------------
Net income (loss) $ 1,156 (8,763) (30,237) (14,775) (9,127)
======================================================================

Basic and diluted net income
(loss) per common share $ 0.04 (0.33) (1.97) (2.52) (0.87)
======================================================================

Weighted average common and
common share equivalents outstanding:
Basic 28,103 26,653 16,272 11,893 10,488
======================================================================
Diluted 30,045 26,653 16,272 11,893 10,488
======================================================================

Balance Sheet Data:
December 31,
---------------------------------------------------------------
2000 1999 1998 1997 1996
------- ------ ------ ------ ------
(in thousands)

Cash, cash equivalents and short term investments $ 3,539 5,420 13,025 8,820 20,597
Working capital 7,513 1,236 7,178 (879) 14,200
Property and equipment, net 6,066 8,158 11,745 17,566 12,630
Total assets 36,387 41,766 49,792 60,697 45,248
Long-term debt, net of current portion 1,729 2,513 9,307 11,847 8,495
Shareholders' equity 24,185 20,553 23,710 30,449 26,839

18

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

Overview

DG Systems ("the Company")was incorporated in 1991. DG Systems has invested
heavily in the development of its digital audio and video networks. As DG
Systems' audio and video network coverage has expanded to include an increasing
number of radio and television stations, the number of deliveries ordered by
customers has increased. At the same time, the number of deliveries performed
via electronic delivery has increased relative to the number performed by
physical delivery through DG Systems' dub and ship facility in Louisville,
Kentucky.

DG Systems defines a delivery as the transmission, electronic or physical, of
a piece or pieces of audio or video content, generally a commercial ("spot") or
a set of commercials ("tied spots") to a destination, generally a radio or
television station, based on a single order from a customer. Each order usually
calls for the delivery of the same spot or spots to multiple destinations,
resulting in multiple deliveries. The revenue earned per delivery is dependent
upon the type of service ordered, generally defined by the time interval between
submission and delivery (Priority, Express, Standard or Economy), the channel
from which the order is received (directly from an advertiser or advertising
agency or through a dub and ship house), and the quantity of audio or video
being delivered (a single spot or multiple tied spots). DG Systems derives
revenue from advertising agencies, as well as production studios and dub and
ship houses that consolidate and forward deliveries for their agency customers.
Because the revenue earned for the delivery of the first spot is significantly
greater than the revenue earned for a tied spot and because DG System's per spot
electronic transmission cost is relatively constant regardless of volume,
electronic deliveries that comprise a single spot are generally more profitable
than deliveries which include tied spots. DG Systems recognizes revenue for each
order on the date the content is received by the customer.

DG Systems assembles, owns and maintains Receive Playback Terminals, which are
located in radio stations; Record Send Terminals, which are located in
advertising agencies and production studios; Client Workstations, which are
located in both radio stations and dealer locations; Video Record Transmission
Systems, which are located primarily in production studios; and Digital Video
Playback Systems, which are located in television stations. The capital required
to build the network has been obtained through various stock offerings to
investors, primarily venture capital firms, leasing agreements, and DG System's
initial public offering, which was completed in February 1996.

During July 2000, the Board of Directors of DG Systems unanimously approved an
Agreement and Plan of Merger, dated as of July 7, 2000, which provided for the
merger of DG Systems and StarGuide. In the merger, the holders of StarGuide
common stock received for each share of StarGuide common stock 1.7332 shares of
DG System's common stock. The merger, which was consummated in January 2001, has
been accounted for as a reverse acquisition, and accordingly, historical results
of the combined company will be that of StarGuide and the Company's results of
operations will be included subsequent to the consummation date.

Results of Operations

Revenues

Revenues increased from $41,270,000 to $48,724,000 to $54,711,000 for the
years ended December 31, 1998, 1999 and 2000, respectively.

The increase in revenues from 1998 to 1999 is due in part to including the
results of operations of an acquisition, Digital Courier International, Inc.
("DCI"), for an entire year, as well as continued volume and price increases.
The increase from 1999 to 2000 is generally a result of greater acceptance of
the Company's video delivery and postproduction services and the expanded
network of Company equipment located in radio and television stations along with
general price increases.

Delivery and Material Costs

Delivery and material costs were $14,630,000, $17,857,000 and $13,966,000 in
1998, 1999 and 2000, respectively. As a percentage of revenues, delivery and
material costs increased from 35% in 1998 to 37% in 1999 and decreased to 26% in
2000. The increase in costs from 1998 to 1999 is primarily due to the increased
delivery volume, as well as the acquisition of DCI. The

19

decrease from 1999 to 2000 is primarily the result of the elimination of
duplicate telecommunications costs resulting from the Company's integration of
the Vancouver NOC into the San Francisco NOC. Telecommunications costs were
$10.3 million and $7.0 million for the years ended December 31, 1999 and 2000,
respectively. Delivery and material costs include telecommunications costs
associated with online video and audio deliveries, the cost of video and audio
tapes and the related packaging and shipping costs required when physically
duplicating and distributing a video or audio spot. In addition, delivery and
material costs include the direct material and fees paid to other service
providers in connection with postproduction services and other services offered
by the Company.

Customer Operations

Customer operations expenses were $14,780,000, $15,138,000 and 16,330,000 in
1998, 1999 and 2000, respectively. The increase in 1999 versus 1998 is the
result of including a full year of costs in 1999 of the former DCI operations
and the addition of the personnel necessary to respond to the greater volume of
orders and deliveries. The increase from 1999 to 2000 is due to the additional
personnel required to handle the increased video delivery volumes and orders.

As a percentage of revenues, customer operations expenses has decreased from
36% to 31% to 30% in 1998, 1999 and 2000, respectively. These decreases are
primarily due to process improvements associated with integrating the Company's
San Francisco NOC and customer service center during 2000. The Company
continually attempts to improve process flows in an effort to gain scale
efficiencies.

Sales and Marketing

Sales and marketing expenses were $4,970,000, $4,818,000 and $4,448,000 in
1998, 1999 and 2000, respectively. Sales and marketing costs as a percentage of
revenue has decreased from 12% to 10% to 8% of revenues for 1998, 1999 and 2000,
respectively. The decrease in 1999 versus 1998 is due primarily to the
consolidation of the Company's sales and marketing efforts among all of its
locations. The decrease from 1999 to 2000 is a result of improved efficiency of
the Company's sales and marketing efforts and the continued consolidation of the
Company's sales and marketing efforts among all of its locations.

Research and Development

Research and development expenses were $2,780,000, $2,577,000 and $3,112,000
in 1998, 1998 and 2000, respectively. The decrease in expenses in 1999 versus
1998 is due primarily to the capitalization of certain salaries and benefits for
personnel involved in developing software used to integrate the Company's NOC
with that of its Vancouver subsidiary and efficiencies derived from the
consolidation of the Company's research and development efforts amount all of
its locations. The increase from 1999 to 2000 was due to a decreased amount of
capitalized salaries and benefits due to the completion of the integration of
the NOC's. As a percent of revenues, research and development expenses
decreased from 7% in 1998 to 5% in 1999 and increased to 6% in 2000.

General and Administrative

General and administrative expenses consist primarily of personnel, consulting
fees, and related overhead costs for finance and general management of the
Company. General and administrative expenses were $4,314,000, $6,552,000 and
$7,838,000 in 1998, 1999 and 2000, respectively. The increase in 1999 was
primarily due to the costs incurred to consolidate and upgrade the Company's
financial systems, the increase in staff as a result of the acquisition of DCI
and the increased use of temporary labor and professional fees associated with
staffing open positions. The increase in 2000 is due to normal inflationary
increases and increased bad debt expense ($1,412,000 in 2000 compared to
$538,000 in 1999). As a percent of revenues, general and administrative
expenses were 10%, 13% and 14% in 1998, 1999, and 2000, respectively.

Depreciation and Amortization

Depreciation and amortization expense was $10,266,000, $8,591,000 and
$7,095,000 in 1998, 1999 and 2000, respectively. The decreases in depreciation
expense is due to an increasing percentage of fixed assets reaching the end of
their depreciable lives, the bulk of which were acquired prior to December 31,
1997.

20

Included in depreciation and amortization is goodwill amortization of
$1,163,000, $486,000 and $717,000 in 1998, 1999, and 2000, respectively, related
to the previous acquisitions. As discussed in the Notes to the Consolidated
Financial Statements, in September 1998, the Company wrote off goodwill of
approximately $16.7 million because it was determined that the carrying values
were not recoverable.

Interest Income and Interest Expense

The Company has derived interest income from the short-term investment of the
proceeds received in various stock offerings. Fluctuations in interest income
are due to differences in the amounts raised and the timing of each offering as
well as the differences in the levels of cash used to fund Company operations
and strategic acquisitions and interest rates.

Interest expense incurred by the Company was $3,014,000, $1,903,000 and
$900,000 in 1998, 1999 and 2000, respectively. This expense relates primarily to
long-term debt and lease agreements used to fund the acquisition of components
and equipment needed to develop the network and to provide Company personnel
with the capital resources necessary to support the Company's business growth.
Total long-term debt outstanding was $10,202,000 and $5,612,000 at December 31,
1999 and 2000, respectively.

Liquidity and Capital Resources

The Company used cash in operating activities of $4.8 million in 1998 and
generated cash from operating activities of $0.2 million and $4.6 million in
1999 and 2000, respectively. Cash flows from operating activities improved
during 1999 as compared to 1998 primarily because revenue increased by 18% and
operating expenses increased by only 9%. Cash flows from operating activities
improved during 2000 as compared to 1999 primarily due to a 12% increase in
revenue, combined with a decrease in operating expense of 7% from 1999 to 2000.
The Company's earnings before interest, taxes, depreciation and amortization was
$1.4 million in 1999 and $9.0 million in 2000 (negative $0.2 million in 1998).

The Company used $2.2 million, $2.7 million and $2.7 million of cash in 1998,
1999 and 2000, respectively, to purchase property and equipment. In addition,
$1.7 million, $2.0 million and $1.6 million of property and equipment has been
acquired through term lease or credit agreements in 1998, 1999 and 2000,
respectively. The capital additions for each of the three years were a result of
the Company's continued expansion of its network. In particular, capital
additions during 1998 were primarily in support of its video delivery service
plan.

During April 2000, the Company entered into a long term loan and security
agreement for a revolving credit facility providing borrowings up to a maximum
of $11 million. The credit facility is secured primarily by accounts receivable
and has a term of three years. The amount available to the Company is based on
eligible receivables less outstanding letters of credit, as defined in the
revolving credit facility agreement. The interest rate on advances is the bank's
reference rate, approximately equal to prime, plus 1.50%. As of December 31,
2000, $1.6 million was outstanding under the credit facility and an additional
$3.2 million was available for borrowing.

Principal payments on long-term debt were $7.1 million, $9.3 million and $7.8
million in 1998, 1999 and 2000, respectively, reflecting the increases in
regularly scheduled payments of the increased capital lease liability incurred
to finance equipment and property acquisitions. Scheduled debt repayments for
2001 are $3.9 million.

The Company has raised cash through the sale of common and preferred stock in
the past, most recently in 1999. Proceeds from the sale of stock have been used
to fund acquisitions, make capital expenditures, repay debt and fund continuing
operations. There can be no assurances that the Company could raise additional
funds through the sale of common or preferred stock in the future.

The Company currently has no significant capital commitments other than the
commitments under capital leases. The Company also has ongoing commitments with
its telephone service provider to spend a minimum of $3.6 million in each of
2001 and 2002. Based on management's current plans and forecasts, the Company
believes that its existing sources of liquidity will satisfy the Company's
projected working capital and capital lease commitments and other cash
requirements through the foreseeable future.

21

Certain Business Considerations

DG Systems and StarGuide have a history of losses and their future operating
results are uncertain.

DG Systems was founded in 1991 and has been unprofitable since its inception.
We could continue to generate net losses in the near future. As of December 31,
2000, DG Systems' accumulated deficit was $98.7 million. Historical revenue
growth rates may not be sustainable and you should not use these growth rates as
an indication of future revenue growth, if any, or as an indication of future
operating results. Our future success also depends in part on obtaining
continued reductions in delivery and service costs, particularly DG Systems'
ability to continue to automate order processing and to reduce
telecommunications costs. As a result of the foregoing factors, DG Systems'
revenues may not grow or may not be sustained in future periods. In addition, we
may not be able to reduce delivery and service costs or achieve or sustain
profitability in any future period.

StarGuide has not yet achieved profitability and based on StarGuide's limited
operating history, future profitability is uncertain. StarGuide's predecessor
was organized on November 2, 1994. StarGuide has not yet achieved profitability
and we do not expect it to do so for several years. As of December 31, 2000,
StarGuide's accumulated deficit was approximately $60 million. StarGuide cannot
assure you that it will be able to achieve profitability in the future.
Accordingly, StarGuide has only a limited operating history upon which an
evaluation of StarGuide and its prospects can be based. StarGuide's prospects
must be considered in light of the risks, expenses, and difficulties frequently
encountered by companies in new and rapidly evolving markets. To address these
risks, StarGuide must, among other things, respond to competitive developments,
continue to attract, retain and motivate qualified persons, continue to upgrade
its technologies, and begin to commercialize products incorporating such
technologies. StarGuide may not be successful in addressing any or all of these
risks and may not be able to achieve or sustain profitability. The operating
history of StarGuide makes the prediction of future results of operations
impossible. StarGuide's operating results may in the future vary significantly
depending on a variety of factors. In response to competitive pressures,
StarGuide may take certain pricing or marketing actions that could have a
material adverse effect on StarGuide's business, financial condition and results
of operations.

DG Systems' and StarGuide's businesses are targeted at developing markets. If
these markets do not continue to develop, or do not accept DG System's or
StarGuide's products and services, the businesses could be adversely affected.

The market for the electronic delivery of digital audio and video
transmissions by advertisers, advertising agencies, production studios, and
video and music distributors to radio and television stations, is relatively
new, and alternative technologies are rapidly evolving. Successful development
of our target markets requires us to overcome buyer inertia related to the
diffuse and relatively low level decision making regarding an agency's choice of
delivery services and long-standing relationships with existing dub and ship
vendors. Therefore, it is difficult to predict the rate at which the market for
the electronic delivery of digital audio and video transmissions will grow, if
it grows at all. If the market fails to grow, or grows more slowly than we
anticipate, DG Systems' business, operating results and financial condition
would be seriously harmed. Even if the market does grow, DG Systems' products
and services may not achieve commercial success. Although we intend to conform
DG Systems' products and services to meet existing and emerging standards in the
market for the electronic delivery of digital audio and video transmissions, we
may not be able to conform DG Systems' products to such standards in a timely
fashion, if at all. We believe that DG Systems' future growth will depend, in
part, on DG Systems' ability to add these services and additional customers in a
timely and cost-effective manner. However, we may not be successful in
developing such services or in obtaining new customers for such services.
Furthermore, we may not be successful in obtaining a sufficient number of radio
and television stations, radio and television networks, advertisers, advertising
agencies, production studios, and audio and video distributors who are willing
to bear the costs of expanding and increasing the integration of DG Systems'
network, including DG Systems' field receiving equipment and rooftop satellite
antennae.

Our marketing efforts to date with regard to DG Systems' products and services
have involved identification and characterization of specific market segments
for these products and services with a view to determining the target markets
that will be the most receptive to such products and services. We may not have
correctly identified such markets and DG Systems' planned products and services
may not address the needs of such markets. Furthermore, DG Systems'
technologies, in their current form, may not be suitable for specific
applications and further design modifications, beyond anticipated changes to
accommodate different markets, may be necessary. Broad commercialization of DG
Systems' products and services will require us to overcome significant market
development hurdles, many of which we cannot predict.

22

StarGuide's products are targeted at developing markets; if these markets
do not continue to develop, or if new customers do not accept StarGuide's
products, its business could be adversely affected. To date, StarGuide's
products have been purchased primarily by customers in the broadcast industry.
In order to achieve sustained growth, the market for StarGuide's products must
continue to develop and StarGuide must expand this market to include additional
applications within the broadcast market and develop new products and new
applications for existing products in new markets such as distance learning and
training, finance, and retail. StarGuide believes that its products and services
are among the first commercial products to serve the convergence of several
industry segments, including digital networking, telecommunications, compression
products, and Internet services. However, StarGuide's products may not be
accepted by the market. In addition, it is possible that:

. the convergence of several industry segments may not continue;

. markets may not develop as a result of such convergence; or

. if markets develop, such markets may not develop either in a direction
beneficial to StarGuide's products or product positioning or within the
time frame in which StarGuide expects to launch new products and product
enhancements.

Because the convergence of digital networking, telecommunications, compression
products, and Internet services is new and evolving, we cannot predict the
growth rate, if any, and the size of the potential market for our products. If
markets for our products fail to develop, develop more slowly than expected, or
become served by numerous competitors, or if our products do not achieve the
anticipated level of market acceptance, our business, operating results and
financial condition will be materially adversely affected.

If DG Systems and StarGuide are not able to develop new products and
services to respond to rapid technological changes, their businesses will be
adversely affected.

The market for the distribution of digital audio and video transmissions is
characterized by rapidly changing technology. Our success will depend, in part,
on the technological quality of DG Systems' products and processes relative to
those of DG Systems' competitors and DG Systems' ability to develop and
introduce new and enhanced products and services at competitive prices and in a
timely and cost- effective fashion. Our development efforts have been focused
on:

. satellite transmission technology;

. internet transmission technology;

. video compression technology;

. TV station systems interfaces; and

. reliability and throughput enhancements to our network.

The growth of DG Systems' electronic video delivery services also depends
on DG Systems' ability to obtain reliable and cost-effective satellite delivery
capability. Development efforts in satellite transmission technology are
oriented to development and deployment of software to lower transmission costs
and increase delivery reliability. Development efforts in video compression
technology are directed toward integration of emerging broadcast quality
compression systems within DG Systems' existing network, thereby continuing to
improve picture quality while maintaining compliance with industry standards. TV
station system interface implementation includes various system control
protocols and improvements of the system throughput and reliability. We have an
agreement with Hughes Network Systems, Inc. giving us access to their satellite
capacity for electronic delivery of digital audio and video transmissions by
satellite. We have developed and incorporated the software designed to enable
some of our current video delivery systems to receive digital satellite
transmissions over the Hughes satellite system. However, the Hughes satellite
system may not have the capacity to meet DG Systems' future delivery commitments
and broadcast quality requirements on a cost-effective basis, if at all.

The introduction of new products can render existing products obsolete or
unmarketable. We may not be successful in identifying, developing, contracting
for the manufacture of, and marketing product enhancements or new products that
respond to technological change. In addition, we may experience difficulties
that could delay or prevent the successful development,

23

introduction and marketing of any new products or product enhancements, and
these products may not adequately meet the requirements of the marketplace and
achieve market acceptance. If we experience delays in introducing new products
and services or enhancements to existing products and services our customers may
begin to use products and services of our competitors resulting in a loss of
revenue. If we are unable to develop and introduce new products and services or
enhancements of existing products and services in a timely manner and with a
significant degree of market acceptance, our business, financial condition and
results of operations will be seriously damaged.

If StarGuide is not able to develop new products and services to respond to
rapid technological changes, its business will be adversely affected.
StarGuide's success will depend to a substantial degree upon its ability to
develop and introduce in a timely manner new products and product enhancements
for new and existing markets that incorporate technological changes and
innovations, meet changing customer or regulatory requirements, or meet emerging
industry standards. StarGuide expects to make significant investments in
research and development and to acquire complementary businesses and product
lines in an effort to continue to enhance existing products, develop new
products which incorporate new and existing technologies, and achieve market
acceptance for such products. However, StarGuide may not successfully develop
new products or product enhancements or, if developed, such new products or
product enhancements may not be developed in time to capture market
opportunities or achieve a significant sustainable level of market acceptance in
new and existing markets. The development of new, technologically advanced
products and product enhancements is a complex and uncertain process requiring
accurate anticipation of technological and market trends. Furthermore, new or
enhanced products offered by StarGuide may contain defects when they are first
introduced or released. Any inability on the part of StarGuide to successfully
define, develop, and introduce new products and product enhancements or to
successfully anticipate market requirements may adversely affect StarGuide's
growth potential and results of operations. In addition, development and
manufacturing schedules for technology products are difficult to predict, and
StarGuide may not achieve timely initial customer shipments of new products.
Further, the distribution channels, technical requirements, and levels and bases
of competition in other markets may be different than those in StarGuide's
current market. StarGuide may not be able to compete favorably in those other
markets.

If DG Systems is not able to maintain and improve service quality, its
business and results of operations will be adversely affected.

DG Systems depends on making cost-effective deliveries to broadcast
stations within the time periods requested by our customers. If we are
unsuccessful, for whatever reason, a station might be prevented from selling
air-time which it otherwise could have sold. Although we disclaim any liability
for lost air-time, stations may nevertheless assert claims for lost air-time in
these circumstances and dissatisfied advertisers may refuse to make further
deliveries through DG Systems in the event of a significant occurrence of lost
deliveries, either of which would seriously harm DG Systems' business, financial
condition and results of operations. Although we maintain insurance against
business interruption, such insurance may not be adequate to protect us from
significant loss in these circumstances or from the effects of a major
catastrophe (such as an earthquake or other natural disaster) which could result
in a prolonged interruption of DG Systems' business. In particular, DG Systems'
NOC is located in the San Francisco Bay area, which has in the past and may in
the future experience significant, destructive seismic activity that could
damage or destroy DG Systems' network operating center. In addition, our ability
to make deliveries to stations within the time periods requested by customers
depends on a number of factors, some of which are outside of our control,
including:

. equipment failure;

. interruption in services by telecommunications service providers; and

. our inability to maintain our installed base of audio and video units
that comprise our distribution network.

Failure to make timely deliveries for whatever reason could result in
dissatisfied advertisers refusing to make further deliveries through DG Systems,
which would seriously harm DG Systems' business, financial condition and results
of operations.

The markets in which DG Systems and StarGuide operate are highly
competitive and the companies may be unable to compete successfully against new
entrants and established companies with greater resources.

DG Systems currently competes in the market for the distribution of audio
advertising spots to radio stations and the distribution of video advertising
spots to television stations. The principal competitive factors affecting these
markets are ease of use, price, timeliness and accuracy of delivery. We compete
with a variety of dub and ship houses and production studios that have

24

traditionally distributed taped advertising spots via physical delivery.
Although such dub and ship houses and production studios generally do not offer
electronic delivery, they have long-standing ties to local distributors that may
be difficult for us to replace. Some of these dub and ship houses and production
studios have greater financial, distribution and marketing resources and have
achieved a higher level of brand recognition than we have.

In the market for the distribution of video content to television stations,
we encounter competition from numerous large and small dub and ship houses and
production studios, certain of which currently function as marketing partners
with DG Systems in the audio distribution market.

To the extent that we are successful in entering new markets, such as the
delivery of other forms of content to radio and television stations, we would
expect to face competition from companies in related communications markets
and/or package delivery markets. Some of these companies in related markets
could offer products and services with functionality similar or superior to
ours. Telecommunications providers such as AT&T, MCI Worldcom and Regional Bell
Operating Companies could also enter the market as competitors with materially
lower electronic delivery transportation costs. We could also face competition
from entities with package delivery expertise such as Federal Express, United
Parcel Service, DHL and Airborne if any such companies enter the electronic data
delivery market. Radio networks such as ABC or Westwood One could also become
competitors by selling and transmitting advertisements as a complement to their
content programming.

Many of DG Systems' current and potential competitors in the markets for
audio and video transmissions have substantially greater financial, technical,
marketing and other resources and larger installed customer bases than DG
Systems. We may not be able to compete successfully against current and future
competitors based on these and other factors. We expect that an increasingly
competitive environment will result in price reductions that could result in
lower profits and loss of market share, all of which would seriously harm DG
Systems' business, financial condition and results of operations. Moreover, the
market for the distribution of audio and video transmissions has become
increasingly concentrated in recent years as a result of acquisitions, which are
likely to permit many of DG Systems' competitors to devote significantly greater
resources to the development and marketing of new competitive products and
services. We expect that competition will increase substantially as a result of
these and other industry consolidations and alliances, as well as the emergence
of new competitors. Accordingly, we may not be able to compete successfully with
new or existing competitors, and the effects of such competition could seriously
harm DG Systems' business, financial condition and results of operations.

The markets in which StarGuide operates are highly competitive and
StarGuide may be unable to compete successfully against new entrants and
established companies with greater resources.

StarGuide believes that its ability to compete successfully depends on a
number of factors, both within and outside of its control, including:

. the price, quality and performance of StarGuide's and its competitors'
products;

. the timing and success of new product introductions by StarGuide and
its competitors;

. the emergence of new technologies;

. the number and nature of StarGuide's competitors in a given market;

. the assertion of intellectual property rights by others; and

. general market and economic conditions.

StarGuide is aware of other companies that are focusing and may commit
significant resources on developing and marketing products and services that
will compete with StarGuide. StarGuide expects competition to continue to
intensify as existing and new competitors begin to offer products, services, or
systems that compete with StarGuide's products. StarGuide's current or future
competitors, many of whom have substantially greater financial resources,
research and development resources, distribution, marketing and other
capabilities than StarGuide, may apply these resources and capabilities to
compete successfully against StarGuide. A number of the markets in which
StarGuide sells its products are also served by technologies that are currently
more widely accepted. StarGuide's potential customers may not be willing to make
the initial capital investment necessary to convert to

25

StarGuide's products and services. The success of StarGuide's systems against
these competing technologies depends in part upon whether StarGuide's systems
can offer significant improvements in productivity and sound quality in a cost-
effective manner. Competitors may be able to develop systems compatible with, or
that are alternatives to, StarGuide's proprietary technology or systems.
StarGuide may not be able to compete successfully against current or future
competitors and competitive pressures faced by StarGuide may adversely affect
our business, operating results and financial condition.

Any failure of DG Systems or StarGuide to manage growth could adversely
affect their businesses.

We have experienced rapid growth over the past several years that has
resulted in new and increased responsibilities for management personnel and that
has placed and continues to place a significant strain on DG Systems' operating,
management and financial systems and resources. To accommodate this growth and
to compete effectively and manage future growth, if any, we must continue to
implement and improve DG Systems' operational, financial and management
information systems, procedures and controls on a timely basis and to expand,
train, motivate and manage DG Systems' work force.

Our personnel, systems, procedures and controls may not be adequate to
support DG Systems' existing and future operations. Any failure to implement and
improve DG Systems' operational, financial and management systems or to expand,
train, motivate or manage DG Systems' employees could seriously harm DG Systems'
business, financial condition and results of operations.

Any failure of StarGuide to manage its growth could adversely affect its
business. To fully exploit the market for its products and services, StarGuide
must rapidly execute its strategy of acquiring complementary businesses and
product lines and further develop StarGuide's products while managing
anticipated growth by implementing effective planning and operating processes.
To manage its anticipated growth, StarGuide must:

. continue to implement and improve its operational, financial, and
management information systems;

. hire and train additional qualified personnel;

. continue to expand and upgrade its core technologies; and

. effectively manage multiple relationships with various customers,
joint venture and technological partners and other third parties.

Demands on StarGuide's resources have grown rapidly with StarGuide's
expansion, and StarGuide may in the future experience difficulties meeting the
demand for its products and services. Although StarGuide believes that it has
made adequate allowances for the costs and risks associated with this expansion,
our systems, procedures or controls may not be adequate to support StarGuide's
operations and its management may not be able to achieve the rapid execution
necessary to fully exploit the market for StarGuide's products and services. Any
failure of StarGuide to manage its growth effectively could have a material
adverse effect on our business, financial condition and results of operations.

DG Systems' and StarGuide's sales cycles reflect seasonal buying patterns
that can adversely affect operating results and lead to potential fluctuations
in quarterly results.

DG System's quarterly operating results have in the past and may in the
future vary significantly depending on factors such as:

. volume of advertising as a result of seasonal buying patterns;

. timing of introductions of new products and services;

. increased competition;

. timing of promotional efforts; and

. general economic factors.

26

For example, we have historically experienced lower sales in the first
quarter and higher sales in the fourth quarter due to increased customer
advertising volumes for the Christmas selling season. As a result, we believe
that period-to-period comparisons of DG Systems' results of operations are not
necessarily meaningful and should not be relied upon as an indication of DG
Systems' future performance. In any single period, DG Systems' revenues and
delivery costs are subject to variation based on changes in the volume and mix
of deliveries performed during such period. In particular, DG Systems' operating
results have historically been significantly influenced by the volume of
deliveries ordered by television stations during the "Sweeps" rating periods
that currently take place in February, May, August and November. The increased
volume of these deliveries during such periods and DG Systems' relatively higher
prices for "Sweeps" advertisements have historically increased the total
revenues and revenues per delivery and tended to reduce relative delivery costs.

Our expense levels are based, in part, on DG Systems' expectations of
future revenue levels. If revenue levels are below expectations, operating
results are likely to be seriously harmed. In addition, we have historically
operated with little or no backlog. The absence of backlog increases the
difficulty of predicting revenues and operating results. Fluctuations in
revenues due to seasonality may become more pronounced as DG Systems' revenue
growth rate slows. Due to the unique nature of DG Systems' products and
services, we believe that we will incur significant expenses for sales and
marketing, including advertising, to educate potential customers about such
products and services.

StarGuide's lengthy sales cycles can adversely affect operating results and
lead to potential fluctuations in quarterly performance. Due to the complexity
and substantial cost associated with providing integrated product solutions to
provide audio, video, data and other information across a variety of media and
platforms, licensing and selling StarGuide's products to customers typically
involves a significant technical evaluation and commitment of cash and other
resources. In addition, there are frequently delays associated with educating
customers as to the productive applications of StarGuide's products, complying
with customers' internal procedures for approving large expenditures, and
evaluating and accepting new technologies that affect key operations. In
addition, certain of StarGuide's foreign customers have lengthy purchasing
cycles that may increase the amount of time it takes StarGuide to place its
products with these customers. For these and other reasons, the sales cycle
associated with the licensing and selling of StarGuide's products is lengthy and
subject to a number of significant risks, including customers' budgetary
constraints and internal acceptance evaluations, both of which are beyond
StarGuide's control. Because of the lengthy sales cycle and the large size of
customers' average orders, if revenue projected from a specific customer for a
particular quarter is not realized in that quarter, StarGuide's operating
results for that quarter could be materially adversely affected. Due to the
length of the sales cycle and other factors, we expect StarGuide's results of
operations to continue to fluctuate on an annual and quarterly basis as a result
of a number of factors, some of which are outside the control of StarGuide,
which affect revenue, gross margin and operating expenses. We expect revenues to
vary significantly as a result of:

. the timing of product purchases and introductions;

. fluctuations in the rate of development of new markets and new
applications for StarGuide's products;

. the degree of market acceptance of new and enhanced versions of
StarGuide's products;

. the level of use of networking satellite and other transmission
systems;

. increased competition;

. fluctuations in seasonal revenue; and

. the general strength of domestic and international economic
conditions.

Further, to the extent that some of StarGuide's costs are relatively fixed,
such as personnel and facilities costs, any unanticipated shortfall in revenue
in any fiscal quarter would have an adverse effect on StarGuide's results of
operations in that quarter. StarGuide's quarterly results may also be affected
by fluctuation in demand for and decline in the average selling prices of its
systems and by increases in the costs of critical components used in
manufacturing its systems.

DG Systems and StarGuide depend on their key personnel to manage the
business effectively, and if the companies are unable to retain their key
employees or hire additional qualified personnel, their ability to compete could
be harmed.

27

Our success depends in substantial part upon the continued contributions of
its senior management team, including Scott K. Ginsburg, Chairman, Matthew E.
Devine, Chief Executive Officer, Omar A. Choucair, Chief Financial Officer,
Jeffrey A. Dankworth, StarGuide's President and Robert C. Ryan, StarGuide's Vice
President and Intellectual Property Counsel, and upon our ability to attract and
retain qualified management, sales, operations, marketing and technical
personnel. The loss of the services of any of these individuals or other key
personnel could have a material adverse effect on our business, financial
condition and results of operations. DG Systems' future success also depends
upon its ability to attract and retain additional highly qualified management,
technical, sales and marketing personnel. DG Systems believes there is, and will
continue to be, intense competition for personnel with experience in the markets
applicable to DG Systems' products and services. DG Systems may not be able to
retain its key personnel or attract, assimilate or retain other highly qualified
technical and management personnel in the future. The loss of the services of
key personnel, or the inability to attract additional qualified personnel as
needed, could have a material adverse effect upon our business, financial
condition and results of operations.

DG Systems and StarGuide depend upon single or limted-source suppliers, and
its ability to produce audio and video distribution equipment could be impacted
if those relationships were discontinued.

DG Systems relies on certain single or limited-source suppliers for
integral components used for the assembly of DG Systems' audio and video units.
Although these suppliers are generally large, well-financed organizations, in
the event that a supplier were to experience financial or operational
difficulties that resulted in a reduction or interruption in component supply to
DG Systems, it would delay DG Systems' deployment of audio and video units. This
would have the effect of depressing DG Systems' business until we were able to
establish sufficient component supply through an alternative source. We believe
that there are currently alternative component manufacturers that could supply
the components required to produce DG Systems' products, but we are not
currently pursuing agreements or understandings with such alternative sources.
If a reduction or interruption of supply were to occur, it could take a
significant period of time for us to qualify an alternative subcontractor,
redesign its products as necessary and contract for the manufacture of such
products. We do not have long-term supply contracts with DG Systems' single or
limited-source vendors, and we purchase DG Systems' components on a purchase
order basis. We have experienced component shortages in the past, and material
component shortages or production or delivery delays may occur in the future.
The inability to continue to obtain sufficient quantities of components in a
timely manner, as required, or to develop alternative sources, as required,
could result in delays or reductions in product shipments or product redesigns,
which would seriously harm our business, financial condition and results of
operations.

Our dependence on Hughes' satellite system entails a number of significant
risks. Our business, results of operations and financial condition would be
seriously harmed if Hughes were unable for any reason to continue to meet DG
Systems' delivery commitments on a cost-effective basis or if any transmissions
failed to satisfy DG Systems' quality requirements. In the event that we were
unable to continue to use Hughes' satellite capacity, we would have to identify,
qualify and transition deliveries to an acceptable alternative satellite
transmission vendor. Such an alternative satellite transmission vendor may not
be available in a position to satisfy DG Systems' delivery requirements on a
timely and cost-effective basis, if at all. In the event that such an
alternative satellite transmission vendor were available, the identification,
qualification and transition process could take up to nine months or longer.

We obtain DG Systems' local access transmission services and long distance
telephone access through an exclusive contract with MCI Worldcom, which expires
on December 31, 2002. Any material interruption in the supply or a material
adverse change in the price of either local access or long distance carrier
service could seriously harm our business, results of operations and financial
condition.

StarGuide faces risks associated with its dependence upon suppliers.
StarGuide relies on other companies to supply certain services and key
components of its products. StarGuide's suppliers also sell products to
StarGuide's competitors and may in the future become competitors of StarGuide.
StarGuide's suppliers may enter into exclusive arrangements with StarGuide's
competitors, stop selling their products or components to StarGuide at
commercially reasonable prices or completely stop selling their products or
components to StarGuide. Although StarGuide believes that all of the services
and products that it currently purchases from outside suppliers are presently
available from other sources, if in the future StarGuide were unable to obtain
certain services or components, or develop alternative sources for those
services or components, it could result in delays and increased costs in
producing StarGuide's products and providing StarGuide's services. This, in
turn, could have a material adverse effect on our business, financial condition,
and results of operations.

DG Systems and StarGuide may not be able to secure additional financing to
satisfy future capital needs.

28

DG Systems intends to continue making capital expenditures to produce and
install various equipment required by our customers to receive our services and
to introduce additional services. We also expect to make capital expenditures
related to the acquisition of the StarGuide business. In addition, we will
continue to analyze the costs and benefits of acquiring certain additional
businesses, products or technologies that we may from time to time identify, and
DG Systems' related ability to finance these acquisitions. Assuming that we do
not pursue one or more additional acquisitions funded by internal cash reserves,
we anticipate that existing capital, cash from operations, and funds available
under existing line of credit agreements should be adequate to satisfy DG
Systems' capital requirements through the foreseeable future. We may require
additional capital sooner than currently anticipated and may not be able to
obtain additional funds adequate for our capital needs. Our capital needs depend
upon numerous factors, including:

. the progress of DG Systems' product development activities;

. the progress of product development activities related to StarGuide
products;

. the cost of increasing DG Systems' sales and marketing activities; and

. the amount of revenues generated from operations.

We cannot predict any of the foregoing factors with certainty. In addition,
we cannot predict the precise amount of future capital that we will require,
particularly if we pursue one or more additional acquisitions. Furthermore,
additional financing may not be available to us, or if it is available, it may
not be available on acceptable terms. Our inability to obtain financing for
additional acquisitions on acceptable terms may prevent us from completing
advantageous acquisitions and consequently could seriously harm our prospects
and future rates of growth. Our inability to obtain additional funding for
continuing operations or an acquisition would seriously harm our business,
financial condition and results of operations. Consequently, we could be
required to:

. significantly reduce or suspend our operations;

. seek an additional merger partner; or

. sell additional securities on terms that are highly dilutive to our
existing investors.

StarGuide must continue to enhance and expand its network in order to
maintain a competitive position and continue to meet increasing demands for
high-quality, readily available service at competitive prices. StarGuide's
ability to grow depends, to a significant extent, on its ability to continually
expand its operations, and thus on significant capital equipment expenditures.
We anticipate that we will need to raise additional funds through public or
private debt or equity financings in order to undertake further expansion of our
operations, acquire complementary businesses or technologies, develop new
services, or otherwise respond to competitive pressures. If additional funds are
raised through the issuance of equity securities, the percentage ownership of
current shareholders may be reduced. Additional financing may not be available
to us, or, if available, may not be on terms favorable to us. If adequate funds
are unavailable or are unavailable on acceptable terms, we may be unable to
expand our operations, develop new services, or otherwise respond to competitive
pressures. Such inability could have a material adverse effect on our business,
financial condition, and results of operations.

Dependence on New Product Introductions.

DG Systems' future growth depends on the successful and timely introduction
of new products and services in markets that do not currently exist or are just
emerging. Our goal is to introduce new services, such as media asset management
and the means for a customer quickly and reliably to preview and authorize
electronic delivery of video advertising spots. We may not successfully complete
the development of such products and services. Even if we complete this
development, we may not be able to introduce these products and services and
they may not realize market acceptance or meet the technical or other
requirements of potential customers. Our failure to successfully develop and
introduce new products and services could seriously harm our business, financial
condition and results of operations.

29

StarGuide's success will depend to a substantial degree upon its ability to
develop and introduce in a timely manner new products and product enhancements
for new and existing markets that incorporate technological changes and
innovations, meet changing customer or regulatory requirements, or meet emerging
industry standards. StarGuide expects to make significant investments in
research and development and to acquire complementary businesses and product
lines in an effort to continue to enhance existing products, develop new
products which incorporate new and existing technologies, and achieve market
acceptance for such products. However, StarGuide may not successfully develop
new products or product enhancements or, if developed, such new products or
product enhancements may not be developed in time to capture market
opportunities or ahieve a significant sustainable level of market acceptance in
new and existing markets. The development of new, technologically advanced
products products and product enhancements is a complex and uncertain process
requiring accurate anticipation of technological and market trends. Furthermore,
new or enhanced products offered by StarGuide may contain defects when they are
first introduced or released. Any inability on the part of StarGuide to
successfully define, develop and introduce new products and product enhancements
or to successfully anticipate market requirements amy adversely affect
StarGuide's growth potential and results of operations. In addition, development
and manufacturing schedules for technology products are difficult to predict,
and StarGuide may not achieve timely initial customer shipments of new products.
Further, the distribution channels, technical requirements, and levels and bases
of competition in other markets may be different than those in StarGuide's
current market. StarGuide may not be able to compete favorably in those other
markets.

DG Systems' and StarGuide's businesses may be adversely affected if they
are not able to protect their intellectual property rights from third-party
challenges. DG Systems and StarGuide cannot assure that their intellectual
property does not infringe on the proprietary rights of third parties.

DG Systems considers our trademarks, copyrights, advertising and promotion
design and artwork to be of value and important to our business. We rely on a
combination of trade secret, copyright and trademark laws and nondisclosure and
other arrangements to protect our proprietary rights. We do not have any patents
or patent applications pending. We generally enter into confidentiality or
license agreements with our employees, distributors and customers, and limit
access to and distribution of our software, documentation and other proprietary
information. Despite our efforts to protect our proprietary rights, unauthorized
parties may attempt to copy or obtain and use information that we regard as
proprietary. The steps that we have taken to protect our proprietary information
may not prevent misappropriation of such information and such protection may not
preclude competitors from developing confusingly similar brand names or
promotional materials or developing products and services similar to ours. In
addition, the laws of some foreign countries do not protect our proprietary
rights to the same extent as do the laws of the United States. While we believe
that our trademarks, copyrights, advertising and promotion design and artwork do
not infringe upon the proprietary rights of third parties, we may still receive
future communications from third parties asserting that we are infringing, or
may be infringing, on the proprietary rights of third parties. Any such claims,
with or without merit, could be time-consuming, require us to enter into royalty
arrangements, or result in costly litigation and diversion of management
personnel. If such claims are successful, we may not be able to obtain licenses
necessary for the operation of our business or, if obtainable, such licenses may
not be available on commercially reasonable terms. In the event of a successful
claim of infringement and our failure or inability to license the infringed or
similar proprietary information, our business, financial condition and results
of operations could be seriously harmed.

StarGuide's business will be adversely affected if it is not able to
protect its intellectual property rights from third-party challenges. The
success of StarGuide's business depends to a large extent upon its ability to
protect trade secrets, obtain or license patents, and operate its business
without infringing on the rights of others. StarGuide currently has numerous
patents issued, and more than thirty other patent applications pending in the
United States and abroad. StarGuide also has several trademark and copyright
registrations. StarGuide is in the process of filing additional patent
applications and applications for copyright registration. StarGuide currently
licenses certain aspects of its technology to and from third parties. Although
StarGuide believes that its patents, trademarks and copyrights have value,
StarGuide's patents, trademark and copyright registrations, or any additional
patents, trademarks or copyrights obtained in the future, may not provide
meaningful protection from competition. The value of StarGuide's products
depends substantially on StarGuide's technical innovation in fields in which
there are currently many patent filings. StarGuide believes that as new patents
are issued or as infringement of others' patents are brought to StarGuide's
attention by the holders of such patents, StarGuide may be required to withdraw
products from the market, negotiate licenses from such patent holders, redesign
its products, or pay damages assessed as a result of litigation. Such events
could have a material adverse effect on our business, financial condition, and
results of operations. Although StarGuide believes that its products and other
proprietary rights do not infringe upon the proprietary rights of third parties,
third parties may assert infringement claims against StarGuide and such claims
may be successful. StarGuide could incur substantial costs and diversion of
management

30

resources with respect to the defense of any claims relating to proprietary
rights, which could have a material adverse effect on our business, financial
condition, and results of operations.

Provisions of DG Systems' charter documents may have certain anti-takeover
effects that could prevent a change in control even if the change would be
beneficial to DG Systems' shareholders

Certain provisions of our articles of incorporation and by-laws, and of
Delaware law, could have the effect of delaying, deferring or preventing a
change in control of DG Systems, even if doing so would be beneficial to DG
Systems' shareholders.

DG Systems' stock price is volatile.

The market price of DG Systems common stock, like that of the shares of many
other high-technology companies, has been and is likely to continue to be
volatile. Some of the factors that may cause the market price of DG Systems
common stock to fluctuate significantly, include:

. the addition or departure of key DG Systems personnel;

. variations in DG Systems' quarterly operating results;

. announcements by DG Systems or its competitors of significant contracts,
new or enhanced products or service offerings, acquisitions, distribution
partnerships, joint ventures or capital
commitments;

. changes in financial estimates by securities analysts;

. DG Systems' sales of common stock or other securities in the future;

. changes in market valuations of networking, Internet and
telecommunications companies;

. fluctuations in stock market prices and trading volumes generally;

. sale of shares of DG Systems common stock by significant holders; and

. changes in general economic conditions, including interest rate levels.

If the realized benefits of the merger with StarGuide do not meet the
expectations of financial or industry analysts, the market price of DG Systems
common stock may decline.

The market price of DG Systems common stock may decline as a result of the
merger if:

. the integration of DG Systems and StarGuide is unsuccessful;

. DG Systems does not achieve the perceived benefits of the merger as
rapidly or to the extent anticipated by financial or industry analysts;
or

. the effect of the merger on our financial results is not consistent with
the expectations of financial or industry analysts.

Sales of substantial amounts of DG Systems common stock in the public market
could materially affect the market price of DG Systems common stock.

Sales of substantial amounts of common stock could materially adversely
affect the market price of DG Systems common stock. DG Systems issued 41,196,828
shares of common stock to StarGuide shareholders as a result of the merger.
Approximately 23,428,457 shares of DG Systems common stock outstanding are
freely tradeable and approximately 63,360,673 additional shares of DG Systems
common stock outstanding after the merger become freely tradable at various
times over the 180-day lock-up period. The sale of substantial amounts of these
shares (including shares issued upon exercise of outstanding options) may cause
substantial fluctuations in the price of DG Systems common stock. In addition,
once the lock-up period expires completely, sales

31

of a substantial number of shares of DG Systems common stock within a short
period of time could cause DG Systems' stock price to fall. The sale of these
shares also could impair DG Systems' ability to raise capital through the sale
of additional stock.

Insiders have substantial control over DG Systems which could limit others'
ability to influence the outcome of key transactions, including changes in
control.

The executive officers and directors of DG Systems and their respective
affiliates own approximately 44% of DG Systems' common stock. As a result, these
shareholders are able to control or significantly influence all matters
requiring shareholder approval, including the election of directors and the
approval of significant corporate transactions. Such concentration of ownership
may have the effect of delaying or preventing a change in control of DG Systems
even if a change of control is in the best interest of all shareholders.

DG Systems may face challenges in integrating DG Systems and StarGuide and,
as a result, may not realize the expected benefits of the merger.

Integrating the operations and personnel of DG Systems and StarGuide will be
a complex process. DG Systems is uncertain that the integration will be
completed rapidly or that it will achieve the anticipated benefits of the
merger. The successful integration of DG Systems and StarGuide will require,
among other things, integration of DG Systems' and StarGuide's products and
services, network operations and engineering, assimilation of sales and
marketing groups, integration of the companies' information and software
systems, coordination of employee retention, hiring and training, and
coordination of ongoing and future research and development efforts. The
diversion of the attention of management and any difficulties encountered in the
process of combining the companies could cause the disruption of, or a loss of
momentum in the activities of the combined company's business. Further, the
process of combining DG Systems and StarGuide could negatively affect employee
morale and the ability of DG Systems to retain some of its or StarGuide's key
employees after the merger.

As a result of the merger, the combined company will incur significant
consolidation and integration expenses that we cannot accurately estimate at
this time, which may negatively affect our financial condition and operating
results.

These costs could include the possible relocation of certain operations from
San Francisco and Reno as well as the loss of benefits from favorable office
leases. Actual integration costs may substantially exceed DG Systems' estimates
and may have an adverse effect on our financial condition and operating results.

DG Systems' business is highly dependent on electronic video advertising
delivery service deployment.

We have made a substantial investment in upgrading and expanding DG Systems'
Network Operating Center, or "NOC", and in populating television stations with
the units necessary for the receipt of electronically delivered video
advertising content. However, we cannot assure you that the placement of these
units will cause this service to achieve adequate market acceptance among
customers that require video advertising content delivery. Our inability to
place units in an adequate number of stations or DG Systems' inability to
capture market share among content delivery customers, which may be the result
of price competition, new product introductions from competitors or otherwise,
would seriously harm our business, operating results and financial position.

In addition, we believe that to more fully address the needs of potential
video delivery customers we will need to develop a set of ancillary services
that typically are provided by dub and ship houses. These ancillary services
include physical archiving, closed-captioning, modification of slates, and
format conversions. We will need to provide these services on a localized basis
in each of the major cities in which we provide services directly to agencies
and advertisers. We currently have the capability to provide such services
through DG Systems' facilities in New York, Los Angeles and Chicago. However, we
may not be able to contract successfully for and provide these services in those
markets or any other major metropolitan area and we may not be able to provide
competitive video distribution services in other United States markets. Also,
although we are taking the steps we believe are required to achieve the network
capacity and scalability necessary to deliver video content reliably and cost
effectively as video advertising delivery volume grows, we may not achieve such
goals, and our failure to do so may seriously harm our business, operating
results and financial position. In addition, we may be unable to retain current
audio delivery customers or attract future audio delivery customers who may
ultimately demand delivery of both media content unless we can successfully
continue to develop and provide video transmission services. The failure to
retain such customers could seriously harm our results of operations and
financial condition.

32

DG Systems faces risks associated with being delisted from the Nasdaq
National Market.

The holders of the registered common stock of DG Systems currently enjoy a
substantial benefit in terms of liquidity by having such common stock listed on
the Nasdaq National Market. This benefit would be lost if we were to be delisted
from the Nasdaq National Market. While we believe we are in compliance with
Nasdaq's continued listing requirements and corporate governance rules, we
cannot assure you that this is the case or that we will be able to continue to
have DG Systems' registered common stock listed on the Nasdaq National Market or
a similar public securities exchange.

DG Systems' business is highly dependent on radio and television advertising;
if demand for, or margins from, our radio an television advertising delivery
services declines, our business will be adversely affected.

We expect that a significant portion of our revenues will continue to be
derived from the delivery of radio and television advertising spots from
advertising agencies, production studios and dub and ship houses to radio
stations in the United States. A decline in demand for, or average selling
prices of, DG Systems' radio and television advertising delivery services for
any of the following reasons, or otherwise, would seriously harm our business,
financial condition and results of operations:

. competition from new advertising media;

. new product introductions or price competition from competitors;

. a shift in purchases by customers away from DG Systems' premium
services; and

. a change in the technology used to deliver such services.

Additionally, we are dependent on our relationship with the radio and
television stations in which we have installed communications equipment. Should
a substantial number of these stations go out of business, experience a change
in ownership, or discontinue the use of DG Systems' equipment in any way, it
would seriously harm our business, financial condition and results of
operations.

StarGuide's inability to enter into or develop strategic relationships in its
key industry segments could adversely impact our operating results.

StarGuide's strategy depends in part on the development of strategic
relationships with leading companies in key industry segments, including media
broadcasters and digital system providers. StarGuide may not be able to
successfully form or enter into such relationships, which may adversely affect
StarGuide's ability to generate sales of its products or services in those
segments. Specific product lines are dependent to a significant degree on
strategic alliances and joint ventures formed with other companies. This is
particularly true with StarGuide's CoolCast(TM) service, which depends on
relationships with providers of audio and video content and providers of
broadband Internet access. StarGuide may not be able to obtain exclusive
contracts with Internet service providers for deployment of its CoolCast(TM)
service within their networks, and it is possible that many Internet service
providers will allow StarGuide's competitors to install equipment at their sites
and to provide similar broadband services within their networks.

StarGuide's business will suffer if it is not able to overcome the numerous
risks associated with the use of complex technology.

The networks and the individual components within networks used in providing
StarGuide's distribution and CoolCast(TM) services are highly complex.
StarGuide's services may be subject to errors and defects in software or
hardware. Additional problems in delivery of service could result from a variety
of causes, including human error, physical or electronic security breaches,
natural disasters, power loss, sabotage, or vandalism. Despite precautions
StarGuide may take, or its efforts to remedy such problems or defects, they
could result in loss of or delay in revenues and loss of market share; loss of
customers; failure to attract new customers or achieve market acceptance;
diversion of development resources; loss of credibility; increased service
costs; or legal action by StarGuide's customers. In addition, because some
equipment involved in providing StarGuide's information distribution and
CoolCast(TM) services are located in the facilities of others, such as broadcast
affiliates, Internet

33

service providers and broadband access providers, StarGuide must rely on third
parties to care for equipment needed to provide StarGuide's services.

The future growth and profitability of StarGuide is highly dependent on the
success of its CoolCast(TM) service.

StarGuide's business plans and future growth are highly dependent on the
successful deployment of StarGuide's CoolCast(TM) service. CoolCast(TM) is still
in a preliminary stage of development, and has not yet been fully deployed
commercially. The success of CoolCast(TM) depends in part on the strength of the
intellectual property associated with the CoolCast(TM) technology, which has not
been fully established or tested. In addition, CoolCast(TM) is subject to
significant competition from other companies seeking to establish businesses
based on delivery of audio and video content in conjunction with Internet web
sites. StarGuide believes that the technology on which certain of the competing
services depend may infringe on StarGuide's CoolCast(TM) related intellectual
property, but there is no certainty that this is the case or that StarGuide will
be able to prevent such competition on that basis. The rights required to
deliver content using StarGuide's CoolCast(TM) technology, which is in
connection with Internet traffic, may be separate from the rights to deliver
such content over the airwaves, by satellite or by cable. In some cases,
providers of such content to StarGuide may not have such necessary rights, which
may be retained by original creators or programmers of the content. We cannot
assure you that StarGuide will be able to secure the necessary rights to make
CoolCast(TM) commercially viable. In addition, StarGuide may be required to
enter into licenses or other agreements with rights-holders other than the
companies that directly provide the content to StarGuide, which may increase
costs. Deployment of CoolCast(TM) is also highly dependent on development and
utilization of broadband last-mile networks, such as those employing
asynchronous digital subscriber lines. The development of these networks must be
completed by entities other than StarGuide, such as telephone local exchange
carriers. There is no certainty that this will occur, or that it will occur
within a timeframe needed to allow CoolCast(TM) to meet its business objectives.
There currently is no economic model for CoolCast(TM) that is proven to generate
a profit, and StarGuide may not be able to establish a successful economic
model. The inability of StarGuide to accomplish any of the following could
inhibit the profitability of CoolCast(TM) and could have a material adverse
effect on our business, financial condition and results of operations:

. protecting CoolCast(TM) intellectual property from infringement;

. competing effectively in the market for delivery of Internet-related
content;

. obtaining necessary rights to video or audio content (or avoiding the
requirement to expend significant capital in obtaining such rights);

. gaining access to sufficient operational broadband delivery networks; or

. establishing a workable and profitable business model for CoolCast(TM).

StarGuide may enter into or seek to enter into business combinations and
acquisitions which may be difficult to integrate, disrupt StarGuide's business,
dilute shareholder value or divert management attention.

StarGuide's business strategy includes the acquisition of complementary
businesses and product lines. Any such acquisitions would be accompanied by the
risks commonly encountered in such acquisitions including:

. the difficulty of assimilating the operations and personnel of the
acquired companies;

. the potential disruption of StarGuide's business;

. the inability of StarGuide's management to maximize the financial and
strategic position of StarGuide by the successful incorporation of
acquired technology and rights into StarGuide's product and service
offerings;

. the maintenance of uniform standards, controls, procedures and policies;

. the potential loss of key employees of acquired companies; and

34

. the impairment of relationships with employees and customers as a result
of changes in management and operational structure.

StarGuide may not be able to successfully complete any acquisition or, if
completed, the acquired business or product line may not be successfully
integrated with StarGuide's operations, personnel or technologies. Any inability
of StarGuide to successfully integrate the operations, personnel, and
technologies associated with an acquired business and/or product line with the
operations and product lines of StarGuide may materially and adversely affect
StarGuide's business and results of operation.

StarGuide faces risks associated with international sales that could
adversely impact its business.

StarGuide derives a portion of its revenues from sales outside of the United
States. StarGuide has increased and plans to continue to increase its
international sales and marketing efforts, and expects that revenues derived
from international sales will continue to grow as a percentage of revenues.
There are a number of risks inherent in our international business activities,
including:

. unexpected changes in United States or other government policies
concerning the import and export of goods, services and technology and
other regulatory requirements, tariffs and other trade barriers;

. costs and risks of localizing products for foreign countries;

. longer accounts receivable payment cycles;

. potentially adverse tax consequences; and

. limits on repatriation of earnings and the burdens of complying with or
enforcing contracts under a wide variety of foreign laws.

Fluctuations in currency exchange rates could materially affect revenues
denominated in currencies other than the United States dollar and cause a
reduction in revenues derived from sales in a particular country. The financial
stability of foreign markets could also affect StarGuide's international sales.
These factors may adversely affect our results of operations. In addition,
StarGuide's earnings abroad may be subject to taxation by more than one
jurisdiction, which could adversely affect our earnings. Each of these factors
could have an adverse effect on our business, financial condition, and results
of operations.

StarGuide faces various risks associated with purchasing satellite capacity.

As part of StarGuide's strategy of providing transmittal of audio, video,
data, and other information using satellite technology, StarGuide periodically
purchases satellite capacity from third parties owning satellite systems.
Although StarGuide attempts to match expenditures in this area against
anticipated revenues from sales of StarGuide's products to customers, StarGuide
may not be successful at estimating anticipated revenues, and actual revenues
from sales of StarGuide's products may not exceed StarGuide's expenditures for
satellite capacity. In addition, purchases of satellite capacity require a
significant amount of capital. Any inability on the part of StarGuide to
purchase satellite capacity or to achieve revenues sufficient to offset the
capital expended to purchase satellite capacity, may have a material adverse
effect on our business, financial condition, and results of operations.

Certain of StarGuide's products depend on satellites; any satellite failure
could result in interruptions of StarGuide's service which could adversely
impact our business, financial results and reputation.

Certain of StarGuide's products rely on signals from satellites. Satellites
and their ground support systems are complex electronic systems subject to
weather conditions, electronic and mechanical failures, and possible sabotage.
The satellites have limited design lives and are subject to damage by the
hostile space environment in which they operate. The repair of damaged or
malfunctioning satellites is nearly impossible. If a significant number of
satellites were to become inoperable, there could be a substantial delay before
they are replaced with new satellites. In addition, satellite transmission can
be disrupted by natural phenomena causing atmospheric interference, such as
sunspots. A reduction in the number of operating satellites or an extended
disruption of satellite transmissions would impair the current utility of the
accessible satellite network and the growth of current and additional market
opportunities, both of which would adversely affect our business, financial
condition, and results of operations.

35

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The Company has some operations in Canada and, therefore, is subject to the
risk that the Canadian dollar/US dollar exchange rates will adversely impact the
Company's results of operations. The Company believes this risk to be
immaterial to the Company's results of operations.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

The information required by this Item is set forth in the Company's
Consolidated Financial Statements and the Notes thereto beginning at Page F-1 of
this report.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE

Arthur Andersen LLP resigned as the Company's certifying accountant on
October 20, 1999. Effective October 27, 1999, the Company appointed KPMG LLP as
the Company's certifying accountant. The change of certifying accountant was
approved by the Audit Committee of the Board of Directors.

Arthur Andersen's reports on the consolidated financial statements of the
Company and its subsidiaries as of and for the years ended December 31, 1998
and1997, were unqualified. There were no disagreements between the Company and
Arthur Andersen on any matter of accounting principles or practices, financial
statement disclosure, or auditing scope or procedure or reportable events during
such periods or through the interim period ended October 20, 1999 (the date of
the resignation).

PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

The information required by this Item with respect to the Company's directors
is incorporated by reference to the information contained in the section
captioned "Proposal One -- Election of Directors" in the Proxy Statement. See
Item 4A of this report for the information with respect to executive officers of
the Company.

ITEM 11. EXECUTIVE COMPENSATION

The information required by this Item is incorporated by reference to the
section captioned "Executive Compensation" contained in the Proxy Statement.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

The information required by this Item is incorporated by reference to the
section captioned "Security Ownership of Certain Beneficial Owners and
Management" contained in the Proxy Statement.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

The information required by this Item is incorporated by reference to the
information contained in the sections captioned "Compensation Committee
Interlocks and Insider Participation" and "Certain Transactions with Management"
contained in the Proxy Statement.

36

PART IV

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K

(a) 1. FINANCIAL STATEMENTS

The following financial statements are filed as part of this Report:

Page
----

Indpendent Auditors' Report...................................................................... F-2
Report of Independent Public Accountants......................................................... F-3
Consolidated Balance Sheets as of December 31, 2000 and 1999..................................... F-4
Consolidated Statements of Operations for the three years ended December 31, 2000................ F-5
Consolidated Statements of Shareholders' Equity for the three years ended December 31, 2000...... F-6
Consolidated Statements of Cash Flows for the three years ended December 31, 2000................ F-7
Notes to Consolidated Financial Statements....................................................... F-8

2. FINANCIAL STATEMENT SCHEDULES

II - Valuation and Qualifying Accounts.......................................................... S-1

3. EXHIBITS

Exhibit Number Exhibit Title
- -------------- -------------

3.1.1 (d) Restated Articles of Incorporation of registrant.

3.1.2 (h) Certificate of Determination of Rights of Series A
Convertible Preferred Stock of Digital Generation Systems,
Inc., filed by the Secretary of State of the State of
California on July 16, 1997.

3.2 (b) Bylaws of registrant, as amended to date.

4.1 (b) Form of Lock-Up Agreement.

4.2 (b) Form of Common Stock Certificate.

10.1 (b) 1992 Stock Option Plan (as amended) and forms of Incentive
Stock Option Agreement and Non-statutory Stock Option
Agreement.

10.2 (b) Form of Directors' and Officers' Indemnification Agreement.

10.3 (b) 1995 Director Option Plan and form of Incentive Stock Option
Agreement thereto.

10.4 (b) Form of Restricted Stock Agreement.

10.5.1 (c) Content Delivery Agreement between the Company and Hughes
Network Systems, Inc., dated November 28, 1995.

10.5.2 (c) Equipment Reseller Agreement between the Company and Hughes
Network Systems, Inc., dated November 28, 1995.

10.6 (b) Amendment to Warrant Agreement between the Company and
Comdisco, Inc., dated January 31, 1996.

10.7(j) Special Customer Agreement between the Company and MCI
Telecommunications Corporation, dated May 5, 1997.

10.8 (b) Master Lease Agreement between the Company and Comdisco,
Inc., dated October 20, 1994, and Exhibits thereto.

10.9 (b) Loan and Security Agreement between the Company and
Comdisco, Inc., dated October 20, 1994, and Exhibits
thereto.

10.18 (b) Warrant Agreement to purchase Series B Preferred Stock
between the Company and Comdisco, Inc., dated as of October
20, 1994.

10.19 (b) Warrant Agreement to purchase Series C Preferred Stock
between the Company and Comdisco, Inc.,

37

Exhibit Number Exhibit Title
- -------------- -------------

dated as of June 13, 1995.

10.20 (b) Warrant Agreement to purchase Series D Preferred Stock
between the Company and Comdisco, Inc., dated as of January
11, 1996.

10.22 (d) Agreement of Sublease for 9,434 rentable square feet at 855
Battery Street, San Francisco, California between the
Company and T.Y. Lin International dated September 8, 1995
and exhibits thereto.

10.23 (d) Agreement of Sublease for 5,613 rentable square feet at 855
Battery Street, San Francisco, California between the
Company and Law/Crandall, Inc. dated September 29, 1995 and
exhibits thereto.

10.24 (e) Digital Generation Systems, Inc. Supplemental Stock Option
Plan.

10.25 (e) Stock Purchase Agreement by and among Digital Generation
Systems, Inc. and PDR Productions, Inc. and Pat DeRosa dated
as of October 15, 1996 and exhibits thereto.

10.26 (f) Amendment to Stock Purchase Agreement dated November 8,
1996, among Digital Generation Systems, Inc., and Pat
DeRosa.

10.28 (i) Stock Purchase Agreement, dated as of July 18, 1997, by and
between Digital Generation Systems, Inc., a California
corporation, IndeNet, Inc., a Delaware Corporation, and
exhibits thereto.

10.29 (i) Preferred Stock Purchase Agreement, dated as of July 14,
1997, by and among Digital Generation Systems, Inc. and the
parties listed on the Schedule of Purchasers attached, as
Exhibit A thereto.

10.30 (i) Amendment to Preferred Stock Purchase Agreement, dated as of
July 23, 1997, by and among Digital Generation Systems, Inc.
and the purchasers listed on the Exhibit A thereto.

10.33 (l) Common Stock Subscription Agreement for private placement of
Company's Common Stock at $2.80 per share.

10.35 (n) Series A Preferred Stock Conversion Agreement dated as of
August 12, 1998.

10.36 (p) Amendment and Restatement No. 5 of the Registration Rights
Agreement, dated July 14, 1997, by and among the Registrant
and certain of its securityholders.

10.37 (p) Amended and Restated Registration Rights Agreement, dated
December 9, 1998, by and among the Registrant and certain of
its securityholders

10.38 (p) Registration Rights Agreement, dated December 9, 1998, by
and among the Registrant and certain of its securityholders.

10.39 (q) Common Stock and Warrant Purchase Agreement dated December
9, 1998 by and among the Registrant and investors listed in
Schedule A thereto.

10.40 (q) Common Stock Subscription Agreement dated December 9, 1998
by and among the Registrant and Scott Ginsburg.

10.41 (q) Warrant Purchase Agreement dated December 9, 1998 by and
among the Registrant and Scott Ginsburg.

10.42 (q) Warrant No. 1 to Purchase Common Stock dated December 9,
1998 by and among Registrant and Scott K. Ginsburg.

10.43 (q) Warrant No. 2 to Purchase Common Stock dated December 9,
1998 by and among Registrant and Scott K. Ginsburg

10.44 (r) Registration Rights Agreement, dated December 17, 1999, by
and among the Registrant and certain of its securityholders.

10.45 (r) Common Stock Purchase Agreement dated December 17, 1999 by
and among the Registrant and investors listed in Schedule A
thereto.

10.46 (r) Loan and security agreement, dated as of April 6, 2000
between Digital Generation Systems, Inc. as Borrower, and
Foothill Capital Corporation as Lender and exhibits thereto.

10.47 (a) Securities Purchase Agreement, dated as of April 4, 2000 by
and among StarGuide Digital Networks, Inc., Infinity
Networks, Inc. and Westwood One, Inc., and MUSICAM Express,
L.L.C.

21.1 (a) Subsidiaries of the Registrant.

23.1 (a) Consent of KPMG LLP.

23.2 (a) Consent of Arthur Andersen LLP.

_______________

(a) Filed herewith.

38

(b) Incorporated by reference to the exhibit bearing the same number filed
with registrant's Registration Statement on Form S-1 (Registration No.
33-80203).

(c) Incorporated by reference to the exhibit bearing the same number filed
with registrant's Registration Statement on Form S-1 (Registration No.
33-80203). The registrant has received confidential treatment with
respect to certain portions of this exhibit. Such portions have been
omitted from this exhibit and have been filed separately with the
Securities and Exchange Commission.

(d) Incorporated by reference to the exhibit bearing the same number filed
with registrant's Quarterly Report on Form 10-Q filed May 3, 1996, as
amended.

(e) Incorporated by reference to the exhibit bearing the same number filed
with registrant's Quarterly report on Form 10-Q filed November 13,
1996.

(f) Incorporated by reference to the exhibit bearing the same title filed
with registrant's Current Report on Form 8-K/A filed January 21, 1997.

(g) Incorporated by reference to the exhibit bearing the same number filed
with registrant's Annual Report on Form 10-K filed March 18, 1997.

(h) Incorporated by reference to the exhibit bearing the same number filed
with registrant's quarterly report on Form 10-Q filed May 15, 1997.

(i) Incorporated by reference to the exhibit bearing the same title filed
with registrant's Form 8-K filed August 1, 1997.

(j) Incorporated by reference to the exhibit bearing the same title filed
with registrant's Quarterly report on Form 10-Q filed August 14, 1997.
Confidential treatment has been requested with respect to certain
portions of this exhibit pursuant to a request for confidential
treatment filed with the Securities and Exchange Commission. Omitted
portions have been filed separately with the Commission.

(k) Incorporated by reference to the exhibit bearing the same number filed
with registrant's Annual Report on Form 10-K filed March 31, 1998.

(l) Incorporated by reference to the exhibit bearing the same title filed
with registrant's Quarterly report on Form 10-Q filed May 15, 1998.

(m) Incorporated by reference to the exhibit bearing the same title filed
with registrant's Quarterly report on Form 10-Q filed August 14, 1998.

(n) Incorporated by reference to the exhibit bearing the same title filed
with registrant's Current Report on Form 8-K filed October 13, 1998.

(o) Incorporated by reference to the exhibit bearing the same title filed
with registrant's Quarterly report on Form 10-Q filed November 16,
1998.

(p) Incorporated by reference to the exhibit bearing the same title filed
with registrant's Registration Report on Form S-3 filed on December
31, 1998.

(q) Incorporated by reference to the exhibit bearing the same number filed
with registrant's Annual Report on Form 10-K filed March 29, 1999.

(r) Incorporated by reference to the exhibit bearing the same number filed
with registrant's Quarterly report on Form 10-Q filed May 11, 2000.

(b) Reports on Form 8-K

39

Current Report on Form 8-K/A filed on March 29, 2001 regarding the January
2001 merger with StarGuide Digital Networks, Inc.

(c) Exhibits

See items 14 (a) (3) above.

(d) Financial Statement Schedules
See Item 14(a) (2) above.

40

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the registrant has duly caused this report to be signed on its
behalf by the undersigned thereunto duly authorized.

DIGITAL GENERATION SYSTEMS, INC.

Dated: March 29, 2001 By: /s/ MATTHEW E. DEVINE
----------------------
Matthew E. Devine
Chief Executive Officer

POWER OF ATTORNEY

KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears
below hereby constitutes and appoints Scott K. Ginsburg as his attorney-in-fact,
with full power of substitution for him in any and all capacities, to sign any
and all amendments to this report on Form 10-K, and to file the same, with
exhibits thereto, and other documents in connection therewith, with the
Securities and Exchange Commission.

Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.

Signature Title Date
- --------- ----- ----

/s/ SCOTT K. GINSBURG Chairman of the Board March 29, 2001
- --------------------------------------- and Director (Principal Executive Officer)
Scott K. Ginsburg

/s/ MATTHEW E. DEVINE Chief Executive Officer March 29, 2001
- ---------------------------------------
Matthew E. Devine and Director

/s/ OMAR A. CHOUCAIR Chief Financial Officer and Director March 29, 2001
- --------------------------------------- (Principal Financial and Accounting Officer)
Omar A. Choucair

/s/ DAN F. DENT Chief Operating Officer March 29, 2001
- ---------------------------------------
Dan. F. Dent

/s/ DAVID M. KANTOR Director March 29, 2001
- ---------------------------------------
David M. Kantor

/s/ MICHAEL G. LINNERT Director March 29, 2001
- ---------------------------------------
Michael G. Linnert

/s/ LAWRENCE D. LENIHAN, JR. Director March 29, 2001
- ---------------------------------------
Lawrence D. Lenihan, Jr.

/s/ CAPPY MCGARR Director March 29, 2001
- ---------------------------------------
Cappy McGarr

41

Signature Title Date
- --------- ----- ----

/s/ JEFFREY A. DANKWORTH Director March 29, 2001
- ---------------------------------------
Jeffrey A. Dankworth

/s/ ERIC L. BERNTHAL Director March 29, 2001
- ---------------------------------------
Eric L. Bernthal

/s/ ROBERT J. SCHLEGEL Director March 29, 2001
- ---------------------------------------
Robert J. Schlegel

/s/ KEVIN HOWE Director March 29, 2001
- ---------------------------------------
Kevin Howe

42

DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
------------------------------------------

Independent Auditors' Report................................................................................. F-2
Report of Independent Public Accountants..................................................................... F-3
Consolidated Balance Sheets as of December 31, 2000 and 1999................................................. F-4
Consolidated Statements of Operations for the three years ended December 31, 2000............................ F-5
Consolidated Statements of Shareholders' Equity for the three years ended December 31, 2000.................. F-6
Consolidated Statements of Cash Flows for the three years ended December 31, 2000............................ F-7
Notes to Consolidated Financial Statements................................................................... F-8

F - 1

DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES
INDEPENDENT AUDITORS' REPORT

The Board of Directors
Digital Generation Systems, Inc.:

We have audited the accompanying consolidated balance sheets of Digital
Generation Systems, Inc. and subsidiaries as of December 31, 2000 and 1999, and
the related consolidated statements of operations, shareholders' equity and cash
flows for the years then ended. In connection with our audits of the
consolidated financial statements, we have also audited the financial statement
schedule as listed at Item 14(a)2 for the years ended December 31, 2000 and
1999. These consolidated financial statements and financial statement schedule
are the responsibility of the Company's management. Our responsibility is to
express an opinion on these financial statements and financial statement
schedule based on our audits.

We conducted our audits in accordance with auditing standards generally
accepted in the United States of America. Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of Digital
Generation Systems, Inc. and subsidiaries as of December 31, 2000 and 1999, and
the results of their operations and their cash flows for the years then ended,
in conformity with accounting principles generally accepted in the United States
of America. Also in our opinion, the related financial statement schedule, when
considered in relation to the basic consolidated financial statements taken as a
whole, presents fairly, in all material respects, the information set forth
therein.

KPMG LLP

Dallas, Texas
February 15, 2001

F - 2

DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS

To Digital Generation Systems, Inc.:

We have audited the accompanying consolidated statements of operations,
shareholders' equity and cash flows of Digital Generation Systems, Inc. (a
California Corporation) and subsidiaries for the year ended December 31, 1998.
These financial statements and the schedule referred to below are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements and schedule based on our audit.

We conducted our audit in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audit provides a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in
all material respects, the results of operations and cash flows of Digital
Generation Systems, Inc. and subsidiaries for the year ended December 31, 1998,
in conformity with generally accepted accounting principles.

Our audit was made for the purpose of forming an opinion on the basic
financial statements taken as a whole. The schedule listed under Item 14(a)2 is
presented for purposes of complying with the Securities and Exchange
Commission's rules and is not a required part of the basic financial statements.
Information included in this schedule for the year ended December 31, 1998 has
been subjected to the auditing procedures applied in our audits of the basic
financial statements and, in our opinion, fairly states in all material respects
the financial data required to be set forth therein in relation to the basic
financial statements taken as a whole.

ARTHUR ANDERSEN LLP

San Francisco, California
January 26, 1999

F - 3

DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(in thousands, except share amounts)

December 31, December 31,
2000 1999
------------------------- -------------------------
ASSETS

CURRENT ASSETS:
Cash and cash equivalents $ 3,539 $ 5,420
Accounts receivable (less allowance for doubtful
accounts of $2,907,000 in 2000 and $1,659,000 in 1999) 12,874 12,799
Prepaid expenses and other 1,573 1,717
--------------- --------------
Total current assets 17,986 19,936
--------------- --------------

PROPERTY AND EQUIPMENT, at cost:
Network equipment 38,836 35,304
Office furniture and equipment 6,514 5,833
Leasehold improvements 860 793
--------------- --------------
46,210 41,930
Less - Accumulated depreciation and amortization (40,144) (33,772)
--------------- --------------

Property and equipment, net 6,066 8,158
--------------- --------------

GOODWILL AND OTHER ASSETS, net 12,335 13,672
--------------- --------------
Total assets $ 36,387 $ 41,766
=============== ==============

LIABILITIES AND SHAREHOLDERS' EQUITY

CURRENT LIABILITIES:
Accounts payable $ 3,019 $ 7,781
Accrued liabilities 3,571 3,230
Current portion of long-term debt 3,883 7,689
--------------- --------------
Total current liabilities 10,473 18,700
--------------- --------------

LONG-TERM DEBT, net of current portion 1,729 2,513
--------------- --------------

SHAREHOLDERS' EQUITY:
Convertible preferred stock, no par value - -
Authorized -- 15,000,000 shares
Issued -- none - -
Common stock, no par value --
Authorized -- 100,000,000 shares;
28,258,786 issued and 28,235,869 outstanding at
December 31, 2000 and 27,530,170 issued and
outstanding at December 31, 1999 122,959 119,519
Treasury Stock, at cost (101) -
Receivables from issuance of common stock (93) (194)
Accumulated deficit (98,658) (98,824)
Accumulated other comprehensive income 78 52
--------------- --------------
Total shareholders' equity 24,185 20,553
--------------- ----------------
Total liabilities and shareholders' equity $ 36,387 $ 41,766
=============== ================

The accompanying notes are an integral part of these financial statements.

F-4

DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts)

For the years ended December 31,
---------------------------------------------------
2000 1999 1998
-------------- ------------ -------------

REVENUES $54,711 $48,724 $ 41,270
-------------- ------------ ------------
COSTS AND EXPENSES:
Delivery and material costs 13,966 17,857 14,630
Customer operations 16,330 15,138 14,780
Sales and marketing 4,448 4,818 4,970
Research and development 3,112 2,577 2,780
General and administrative 7,838 6,552 4,314
Write-down of goodwill and fixed assets - - 17,006
Non-recurring charges - 370 -
Depreciation and amortization 7,095 8,591 10,266
-------------- ------------ ------------
Total expenses 52,789 55,903 68,746
-------------- ------------ ------------

INCOME (LOSS) FROM OPERATIONS 1,922 (7,179) (27,476)

OTHER INCOME (EXPENSE):
Interest and other income, net 134 319 253
Interest expense (900) (1,903) (3,014)
-------------- ------------ ------------

NET INCOME (LOSS) $ 1,156 $(8,763) $ (30,237)
============== ============ ============

BASIC AND DILUTED NET INCOME (LOSS)
PER COMMON SHARE $ 0.04 $ (0.33) $ (1.97)
WEIGHTED AVERAGE COMMON AND COMMON
SHARES OUTSTANDING:
BASIC 28,103 26,653 16,272
============== ============ ============
DILUTED 30,045 26,653 16,272
============== ============ ============

The accompanying notes are an integral part of these financial statements.

F-5

DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
(In thousands)

Convertible Receivable
Preferred Stock Common Stock Treasury Stock from
--------------- ------------ -------------- Issuance of
Common
Shares Amount Shares Amount Shares Amount Stock
------ ------ ------ ------ ------ ------ --------

BALANCE AT DECEMBER
31, 1997 4,950 31,561 12,123 57,123 - - (175)
Conversion of
Series A
preferred stock
to Common Stock,
net of issuance
costs of $486 (4,950)(31,561) 4,950 31,075 - - -

Preferred stock
deemed dividend
resulting from
conversion of
Series A
preferred stock - - 495 1,764 - - -
Issuance of
common stock in
private placements,
net of issuance
costs of $370 - - 8,432 23,480 - - -
Warrants issued
in relation to
common stock
private placement - - - 12 - - -

Issuance of
restricted stock
for promissory
note - - 50 194 - - (194)
Exercise of stock
options - - 165 371 - - -
Stock issued for
services - - 10 80 - - -
Purchase of
shares through
ESPP - - 14 32 - - -
Foreign currency
translation
adjustment - - - - -
Net loss
- - - - -
------------- ---------------- --------------- ----------
BALANCE AT DECEMBER
31, 1998 - - 26,239 114,131 - - (369)

Issuance of
common stock in
private placement - - 725 3,750 - - -

Exercise of
warrants - - 12 - - - -
Forgiveness of
promissory note - - - - - - 175
Exercise of stock
options - - 508 1,518 - - -
Purchase of
shares through
ESPP - - 46 120 - - -
Foreign currency
translation
adjustment - - - - - - -

Net loss - - - - - - -
------------- ---------------- --------------- ----------
BALANCE AT DECEMBER
31, 1999 - - 27,530 119,519 - - (194)

Treasury stock
Exercise of stock - - - - 23 (101) 101
options - - 681 2,291 - - -
Increase in fair
value of warrants
due to change in
measurement date - - - 990 - - -
Purchase of
shares through
ESPP - - 48 159 - - -
Foreign currency
translation
adjustment - - - - - - -

Net income - - - - - - -
------------- ---------------- --------------- ----------
BALANCE AT DECEMBER
31, 2000 - - 28,259 122,959 23 (101) (93)
============= ================ =============== ==========

Accumulated
Other Total
Comprehensive Accumulated Shareholders' Comprehensive
Income Deficit Deficit Income (Loss)
------ ------- ------- ------------

BALANCE AT DECEMBER
31, 1997 - (58,060) 30,449
Conversion of
Series A
preferred stock
to Common Stock,
net of issuance
costs of $486 - - (486) -

Preferred stock
deemed dividend
resulting from
conversion of
Series A
preferred stock - (1,764) - -
Issuance of
common stock in
private placements,
net of issuance
costs of $370 - - 23,480 -
Warrants issued
in relation to
common stock
private placement - - 12 -

Issuance of
restricted stock
for promissory
note - - - -
Exercise of stock
options - - 371 -
Stock issued for
services - - 80 -
Purchase of
shares through
ESPP - - 32 -
Foreign currency
translation
adjustment 9 - 9 9
Net loss
- (30,237) (30,237) (30,237)
--------- -------- ------------ ---------
BALANCE AT DECEMBER
31, 1998 9 (90,061) 23,710 (30,228)
=========
Issuance of
common stock in
private placement - - 3,750

Exercise of
warrants - - -
Forgiveness of
promissory note - - 175
Exercise of stock
options - - 1,518
Purchase of
shares through
ESPP - - 120
Foreign currency
translation
adjustment 43 - 43 43

Net loss - (8,763) (8,763) (8,763)
--------- -------- ------------ ---------
BALANCE AT DECEMBER
31, 1999 52 (98,824) 20,553 (8,720)
======
Treasury stock - - -
Exercise of stock
options - - 2,291
Increase in fair
value of warrants
due to change in
measurement date - (990) -
Purchase of
shares through
ESPP - - 159
Foreign currency
translation
adjustment 26 - 26 26

Net income - 1,156 1,156 1,156
--------- -------- ------------ ---------
BALANCE AT DECEMBER
31, 2000 78 (98,658) 24,185 1,182
========= ======== ============ =========

The accompanying notes are an integral part of these financial
statements.

F-6

DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)

For the Years Ended December 31,
--------------------------------
2000 1999 1998
-------------------------------------------------------

CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss) 1,156 (8,763) (30,237)
Adjustments to reconcile net income (loss) to net cash provided by
(used in) operating activities:
Depreciation and amortization of property and equipment 6,377 8,106 9,103
Amortization of goodwill and intangibles 718 486 1,163
Write-down of goodwill and fixed assets - - 17,006
Common stock issued for services - - 80
Provision for doubtful accounts 1,412 538 1,142
Loss on retirement of property and equipment 6 - -
Changes in operating assets and liabilities --

Accounts receivable (1,487) (3,512) (1,953)

Prepaid expenses and other assets 789 (659) (213)
Accounts payable and accrued liabilities (4,421) 3,957 (882)
---------------- ----------------- ------------------
Net cash provided by (used in) operating activities 4,550 153 (4,791)
---------------- ----------------- ------------------

CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of property and equipment (2,719) (2,653) (2,162)
Proceeds from sale of property and equipment - 75 -
Purchases of short-term investments - - (2,013)
Maturities of short-term investments - - 3,000
Acquisition of DCI - - (9,131)
---------------- ----------------- ------------------
Net cash used in investing activities (2,719) (2,578) (10,306)
---------------- ----------------- ------------------

CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from issuance of common stock 2,450 5,563 23,975
Costs of converting preferred stock to common stock - - (486)
Proceeds from line of credit 43,473 1,148 13,365
Payments on line of credit (41,873) (2,581) (14,767)
Proceeds from issuance of long-term debt - - 5,233
Payments on long-term debt (7,762) (9,308) (7,106)
---------------- ----------------- ------------------
Net cash provided by (used in) financing activities (3,712) (5,178) 20,214
---------------- ----------------- ------------------

EFFECT OF EXCHANGE RATE CHANGES - (2) 75

NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS (1,881) (7,605) 5,192

CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD 5,420 13,025 7,833
---------------- ----------------- ------------------
CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 3,539 $ 5,420 $ 13,025
================ ================= ==================

SUPPLEMENTAL CASH FLOW INFORMATION:
Interest paid $ 938 $ 2,199 $ 2,777
================ ================= ==================

The accompanying notes are an integral part of these consolidated
financial statements.

F-7

DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. The Company:

Digital Generation Systems, Inc. (the "Company") was incorporated in 1991.
The Company operates a nationwide multimedia network designed to provide media
distribution and related services to the broadcast industry by linking content
providers to radio and television stations. The Company is primarily a provider
of electronic and physical distribution of audio and video spot advertising to
radio and television stations. The Company primarily generates its revenues from
advertising agencies and production studios.

The Company is subject to certain risks that include, but are not limited
to: the continued development of technology to enhance the delivery and variety
of the Company's services in the most cost-effective manner, including the
successful integration of the operations of its subsidiaries; the ability to
compete successfully against current and future competitors; and dependence on
key personnel and the need for additional financing to fund its capital
expenditure requirements. The Company obtains certain components used in the
assembly of the units which are placed at radio and television stations and
production studios from a few single or limited source suppliers and obtains its
primary long distance telephone access through an exclusive contract with a
telephone service provider which expires in 2002. Any material interruption in
these services could have a material adverse effect on the Company's business.
Although the Company believes that alternate vendors can be obtained, the
transition to alternative vendors could have a material adverse impact on the
Company's costs and shipping schedules.

2. Summary of Significant Accounting Policies:

Consolidation

The consolidated financial statements include the accounts of the Company
and its subsidiaries. All significant intercompany balances and transactions
have been eliminated in consolidation.

Use of Estimates

The preparation of financial statements in conformity with accounting
principles generally accepted in the United States of America requires
management to make estimates and assumptions that affect the reported amounts of
assets and liabilities and disclosure of contingent assets and liabilities at
the date of the financial statements and the reported amounts of revenues and
expenses during the reporting period. Actual results could differ from those
estimates.

Foreign Currencies

Assets and liabilities of the Company's foreign subsidiary are translated at
the exchange rate on the balance sheet date. Revenue, costs and expenses are
translated at average rates of exchange prevailing during the year. Translation
adjustments resulting from this process are included in other comprehensive
income. Gains (losses) on foreign currency transactions of approximately
($10,000), ($28,000) and $10,000 for the years ended December 31, 2000, 1999 and
1998, respectively, are included in interest income and other, net in the
consolidated statements of operations.

Research and Development

Research and development costs are charged to expense as incurred.

F-8

DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Goodwill

Goodwill, which represents the excess of purchase price over the fair value
of net identifiable assets acquired, is amortized on a straight-line basis over
the expected periods to be benefited, generally 20 years. Accumulated
amortization of goodwill at December 31, 2000 and 1999 was $3.2 million and $2.5
million, respectively. The Company assesses the recoverability of this
intangible asset by determining whether the amortization of the goodwill balance
over its remaining life can be recovered through undiscounted future operating
cash flows of the acquired operation. The amount of goodwill impairment, if any,
is measured based on projected discounted future operating cash flows using a
discount rate reflecting the Company's average cost of funds. The assessment of
the recoverability of goodwill will be impacted if estimated future operating
cash flows are not achieved. In 1998, the Company recorded a goodwill impairment
of $16.7 million related to a previous acquisition.

Impairment of Long-Lived Assets

Long-lived assets are reviewed for impairment whenever events or changes in
circumstances indicate that the carrying value of assets may not be recoverable.
Recoverability of assets to be held and used is measured by a comparison of the
carrying amount of an asset to future net cash flows expected to be generated by
the asset. If such assets are considered to be impaired, the impairment to be
recognized is measured by the amount by which the carrying amount of the assets
exceeds the fair value of the assets. Assets to be disposed of are reported at
the lower of the carrying amount or fair value less costs to sell.

Cash and Cash Equivalents

Cash and cash equivalents consist of liquid investments with original
maturities of three months or less. As of December 31, 2000 and 1999, cash
equivalents consist principally of U.S. Treasury Bills.

Property and Equipment

Network equipment includes the network operating center, record send
terminals, receive playback terminals, video record transmission systems,
digital video playback systems and the related terminal and system components as
well as audio and video taping and dubbing equipment. The Company records its
property and equipment at cost and depreciates it on a straight-line basis over
its estimated useful life, generally three years. Equipment held under capital
leases and leasehold improvements are amortized straight-line over the shorter
of the lease term or estimated useful life of the asset.

The cost of equipment under capital lease at December 31, 2000 and 1999 was
$15,893,000 and $14,321,000, respectively. Related accumulated depreciation at
December 31, 2000 and 1999 was $14,041,000 and $10,135,000, respectively.

Revenue Recognition

Revenues for distribution services which are digitally transmitted are
recognized for each transaction on the date audio, video or related information
is successfully transmitted from the Company's operating facilities to the
destination ordered. Revenues for distribution services of analog audio or
videotapes are recognized as the tapes are shipped.

Income Taxes

Income taxes are accounted for under the asset and liability method. Deferred
tax assets and liabilities are recognized for the future tax consequences
attributable to differences between financial statement carrying amounts of
existing assets and liabilities and their respective tax bases and operating
loss and tax credit carryforwards. Deferred tax assets and liabilities are
measured using enacted tax rates expected to apply to taxable income in the
years in which those temporary differences are expected to be recovered or
settled. The effect on deferred tax assets and liabilities of a change in tax
rates is recognized in income in the period that includes the enactment date.

F-9

DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Stock Option Plans

The Company applies the intrinsic value-based method of accounting prescribed
by Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock
Issued to Employees," and related interpretations, in accounting for its fixed
plan stock options. As such, compensation expense would be recorded on the date
of grant only if the current market price of the underlying stock exceeded the
exercise price. SFAS No. 123, "Accounting for Stock-Based Compensation,"
established accounting and disclosure requirements using a fair value-based
method of accounting for stock-based employee compensation plans. As allowed by
SFAS No. 123, the Company has elected to continue to apply the intrinsic value-
based method of accounting described above, and has adopted the disclosure
requirements of SFAS No. 123.

Financial Instruments and Concentration of Credit Risk

Financial instruments that potentially subject the Company to a concentration
of credit risk consist principally of cash and cash equivalents and accounts
receivable. The Company believes that a concentration of credit risk with
respect to accounts receivable is limited because its customers are
geographically dispersed and the end users (the customer's clients) are
diversified across industries. The Company's receivables are principally from
advertising agencies, dub and ship houses, and syndicated programmers. The
Company's revenues are not contingent on its customers' sales or collections.
However, the timing of collections from its customers is affected by the billing
cycle in which the customer bills its end-users (the customer's clients). The
Company provides reserves for credit losses.

The carrying values of accounts receivable and accounts payable approximate
fair value due to their short maturities. The carrying value of long-term debt
approximates fair value due to the variable rate of interest.

Supplemental Cash Flow Information

Non-cash investing and financing activities for 2000, 1999 and 1998 consisted
of the following (in thousands):

Years Ended December 31,
-------------------------------------------------
2000 1999 1998
----------- ----------- ----

Property and equipment financed with capital lease obligations.... $ 1,572 $ 1,977 $ 1,663
Preferred stock deemed dividend................................... -- -- 1,764
Conversion of preferred stock to common stock..................... -- -- 31.561
Common stock issued for services.................................. -- -- 80

3. Acquisition:

On September 25, 1998, the Company acquired substantially all of the
property and assets of Digital Courier International, Inc. ("DCI"), including
all accounts receivable, inventories, contracts, equipment, real property leases
and other related assets. DCI is in the business of supplying electronic
distribution and communications services for the radio broadcast industry in the
United States and Canada.

The Company paid $13.5 million in Canadian dollars (approximately US $9.06
million) for DCI. The DCI acquisition was accounted for as a purchase. The
excess of purchase price and acquisition costs over the fair value of assets
acquired of approximately $6.2 million is included in Goodwill and Other Assets
in the accompanying consolidated balance sheets, and is being amortized over a
twenty year period. The operating results of DCI have been included in the
consolidated results and balances of the Company from the date of the closing of
the transaction.

F-10

DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

4. Accrued Liabilities:

Accrued liabilities consist of the following (in thousands):

December 31,
-----------------------
2000 1999
----------- -----------
Telecommunications costs........... $ 514 $ 4
Employee compensation.............. 933 1,115
Legal and professional fees........ 341 135
Other.............................. 1,783 1,976
------ ------
$3,571 $3,230
====== ======
5. Commitments and Contingencies:

The Company leases its facilities and certain equipment under non-cancelable
capital and operating leases. At December 31, 2000, future minimum annual
payments under capital leases are $3,787,000 in 2001 and $130,000 in 2002. The
present value of obligations under capital lease was $3,868,000, of which
$3,739,000 is classified as a current liability. As of December 31, 2000, future
minimum annual payments under operating leases are as follows: 2001 -$1,435,000;
2002 -$936,000; 2003 - $844,000; 2004 - $462,000; 2005 - $449,000 and
thereafter - $449,000.

Rent expense totaled approximately $1,587,000, $1,432,000 and $1,391,000 in
2000, 1999 and 1998, respectively.

As of December 31, 2000, the Company had non-cancelable future minimum
purchase commitments with its primary telephone service provider. These
commitments total $3.6 million per year and extend through December 2002.

The Company is subject to legal proceedings and claims, either asserted or
unasserted, which arise in the ordinary course of business from time to time.
While the outcome of these claims cannot be predicted with certainty, management
does not believe that the outcome of any of the pending legal matters will have
a material adverse effect on the Company's results of operations, financial
position or liquidity.

6. Related Party Transactions

During 2000, the Company charged approximately $342,000 to StarGuide Digital
Networks, Inc. ("StarGuide", a related company) for shared costs related to
shared office space, common utilities and equipment and was charged $658,000 by
StarGuide for payroll, insurance and travel costs related to shared employees.
At December 31, 2000, the Company had a net payable to StarGuide of
approximately $443,000.

7. Long-Term Debt:

During April 2000, the Company entered into a revolving credit facility
providing borrowings up to a maximum of $11 million. The credit facility is
secured primarily by accounts receivable and has a term of three years. The
amount available to the Company is based on eligible receivables less
outstanding letters of credit, as defined in the revolving credit facility
agreement. The interest rate on advances is the bank's reference rate,
approximately equal to prime, plus 1.50% (11.0% at December 31, 2000). As of
December 31, 2000, $1.6 million was outstanding under the revolving credit
facility and an additional $3.2 million was available for borrowing.

The Company has occasionally used long-term debt to finance purchases of
property and equipment. At December 31, 2000, $144,000 of related long-term
debt was outstanding, all of which is current.

F-11

DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

8. Capital Stock:

In July and August 1998, the Company's Board of Directors authorized the
issuance of up to $ 13.0 million of Common Stock in a private placement
transaction. The Company issued 4,589,287 common shares to institutional and
closely associated investors at $2.80 per share. Proceeds to the Company, net of
issuance costs, was approximately $12.7 million.

In December 1998, the Company's Board of Directors authorized the issuance of
up to $11.0 million of Common Stock in a private placement transaction. The
Company issued 2,920,134 common shares to Scott Ginsburg, the Company's Chief
Executive Officer, at $3.25 per share. In addition, the Company authorized the
sale and issuance of up to $3.0 million of Common Stock in a private placement
transaction. The Company issued 923,078 common shares to institutional and
closely associated investors at a price of $3.25 per share.

In December 1999, the Company's Board of Directors authorized the issuance of
Common Stock in a private placement transaction. The Company issued 725,199
common shares to institutional and closely associated investors at a price of
$5.17 per share.

In December 1999, the Company wrote off a note receivable from an executive
officer in the amount of $175,000 that was issued in connection with a
restricted stock purchase agreement, pursuant to which the executive officer
purchased an aggregate of 487,500 shares of the Company's Common Stock. A
charge to expense of $175,000 was recorded in 1999 for this transaction.

The Company and an employee were parties to a restricted stock purchase
agreement, pursuant to which the Company loaned the employee money under a
nonrecourse note and the employee purchased an aggregate of 50,000 shares of the
Company's Common Stock. During 2000, the Company exercised its right to
repurchase 22,917 of these restricted shares, within the terms of the stock
purchase agreement, in exchange for forgiveness of the portion of the note
subject to the stock purchase agreement. The transaction was accounted for as a
purchase of treasury stock.

Series A Convertible Preferred Stock

During 1997, the Company issued 4,950,495 shares of Series A Convertible
Preferred Stock (the "Series A Preferred"). In July 1998, the Series A Preferred
Stock was converted to Common Stock per the terms of the Series A Preferred
Stock Conversion Agreement effective August 14, 1998. The conversion of the
Series A Preferred Stock to Common Stock resulted in a deemed dividend to the
preferred shareholders and increased the loss attributable to common
shareholders in the computation of basic and diluted earnings per share for the
year ended December 31, 1998.

Warrants

The Company has issued warrants in connection with certain financing and
leasing transactions and Common Stock offerings. All of the outstanding
warrants are convertible into Common Stock. A summary of outstanding warrants
at December 31, 2000, 1999 and 1998 and changes during the years then ended
follows:

2000 1999 1998
------------------------- ---------------------------- --------------------------
Wtd Avg Ex Wtd Avg Ex Wtd Avg Ex
Warrants Price Warrants Price Warrants Price
----------- ------------ ------------ ------------- ------------- ------------

Oustanding at beginning of the year 3,891,070 $ 3.57 3,962,244 $ 3.55 492,177 $ 5.69
Granted - - - - 3,470,067 3.25
Exercised - - (71,174) 2.70 - -
----------- ------------ ------------ ------------- ------------- ------------
Outstanding at end of the year 3,891,070 $ 3.57 3,891,070 $ 3.57 3,962,244 $ 3.55
=========== ============ ============ ============= ============= ============

F-12

DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

The warrants outstanding at December 31, 2000 expire on various dates from
2001 through 2006. The warrants exercised in 1999 were done by exchanging the
entire warrant for shares of Common Stock equal to the net value of the warrant.
Certain of the warrants issued to investors had performance hurdles that were
required to be met in order for the warrants to become exercisable. In 2000,
these performance hurdles were removed, resulting in a new measurement date for
accounting purposes. A charge to accumulated deficit of $990,000 was recognized
for the increase in fair value associated with the modified warrants.

9. Stock Plans:

The Company has three Stock Option Plans:

1992 Stock Option Plan

Under the Company's 1992 Stock Option Plan, (the "1992 Plan"), the Company
may issue up to 14,950,000 shares of Common Stock to employees, officers,
directors and consultants. The exercise price and terms of the options granted
are determined by the Board of Directors, provided that such price cannot be
less than the fair value of the Common Stock on the date of grant for incentive
stock options or, in the case of non-statutory options, less than 85 percent of
the fair value of the Common Stock on the date of grant. The options generally
vest over four years. The 1992 Plan provides that, in the event of a change in
control of the Company, executive officers of the Company will receive
accelerated vesting for a portion of their unvested option shares. The term of
the options granted is seven years. No options have been granted at less than
fair value under this plan.

1996 Supplemental Option Plan

In 1996, the Company's Board of Directors adopted the 1996 Supplemental
Option Plan. Under this plan, the Company may issue up to 750,000 shares of
Common Stock to employees, officers, directors and consultants. The exercise
price and terms of the options granted are determined by the Board of Directors.
The options generally vest over four years. The term of the options granted is
seven years.

1995 Director Option Plan

In 1995, the Company's Board of Directors adopted the 1995 Director Option
Plan (the "Director Plan"). A total of 300,000 shares of Common Stock has been
reserved for issuance under the Director Plan. The Director Plan provides that
each future non-employee director of the Company will be automatically granted
an option to purchase 10,000 shares of Common Stock (the "First Option") on the
date on which the optionee first becomes a non-employee director of the Company
and an additional option to purchase 2,500 shares of Common Stock (the
"Subsequent Option") on each anniversary date thereafter. The exercise price per
share of all options granted under the Director Plan shall be equal to the fair
market value of a share of the Company's Common Stock on the date of grant.
Shares subject to the First Option vest over 36 months, and the Subsequent
Option shares vest over 12 months beginning with the month following the second
anniversary of its date of grant. The term of the options granted is ten years.

Accounting for Stock Option Compensation Expense

The Company applies the principles of APB Opinion No. 25 and related
interpretations in accounting for the its stock option plans. Had compensation
cost for the Company's stock option plans been determined based on the fair
value at the date of grant of the stock options consistent with the method of
SFAS No. 123, the Company's net income (loss) (in thousands) and net income
(loss) per share would have been reduced to the pro forma amounts indicated
below:

F-13

DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

2000 1999 1998
------- -------- --------

Net Income (Loss) As Reported $ 1,156 $ (8,763) $(30,237)
Pro Forma $(2,605) $(11,689) $(32,409)

Basic and diluted net income (loss) per share As Reported $ 0.04 $ (0.33) $ (1.97)
Pro Forma $ (0.09) $ (0.44) $ (2.10)

The fair value of each option grant is estimated on the date of grant using
the multiple option approach of the Black-Scholes option pricing model with the
following assumptions used for grants in 2000, 1999 and 1998, respectively;
risk-free interest rates of 6.4%, 6.4% and 4.7%; a dividend yield of 0%;
expected life of five years; and volatility factors of the expected market price
of the Company's Common Stock of 113%, 112% and 194%.

A summary of the Company's fixed plan stock options at December 31, 2000, 1999
and 1998 and changes during the years then ended is presented below:

2000 1999 1998
------------------------- -------------------------- -------------------------
Wtd Avg Ex Wtd Avg Ex Wtd Avg Ex
Shares Price Shares Price Shares Price
---------- ---------- ---------- ---------- ---------- ----------

Oustanding at beginning of the
year 4,030,839 $ 4.36 3,087,031 $ 3.78 2,682,707 $ 4.21
Granted 498,501 5.46 2,024,500 4.95 1,270,250 3.12
Exercised (680,880) 3.36 (507,686) 2.99 (164,701) 2.25
Canceled (420,852) 4.06 (573,006) 4.50 (701,225) 4.61
---------- ---------- ---------- ---------- ---------- ----------
Outstanding at end of the year 3,427,608 $ 4.78 4,030,839 $ 4.36 3,087,031 $ 3.78
========== ========== ========== ========== ========== ==========
Exercisable at end of the year 1,671,426 $ 4.53 1,262,767 $ 3.90 1,159,767 $ 3.79
Weighted average fair value of
options granted $ 4.63 $ 3.55 $ 2.85

The following table summarizes information about stock options outstanding at
December 31, 2000:

Options Outstanding Options Exercisable
- ------------------------------------------------------------------------------------------ -----------------------------
Weighted-Average Weighted- Weighted-
Number Remaining Average Number Average
Range of Exercise Prices Outstanding Contractual Life Exercise Price Exercisable Exercise Price
- ------------------------ ----------- ---------------- -------------- ----------- --------------

$0.20 - $ 2.65 167,089 4.54 years $2.50 167,089 $2.50
$2.75 - $5.00 1,247,637 4.59 years $3.91 769,035 $4.10
$5.125 - $10.125 2,012,882 5.40 years $5.50 735,302 $5.44
------------- ---------
$0.20 - $10.125 3,427,608 1,671,426
============= =========

As of December 31, 2000, there were 10,792,583 shares available for future
grant under the stock option plans.

F-14

DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

10. Income Taxes:

Net income for the year ended December 31, 2000 will be offset by net
operating losses, therefore no tax expense has been provided. There was no
income tax expense (benefit) in 1999 or 1998 due to the existence of net
operating losses and a full valuation allowance for related deferred tax assets.

Components of deferred tax assets at December 31, 2000 and 1999 are as follows
(in thousands):

2000 1999
-------- ---------
Net operating loss carryforwards $ 14,297 $ 16,992
Cumulative temporary differences 6,366 3,841
Research and development credit 768 768
-------- ---------
Total gross deferred tax asset 21,431 21,601
Less valuation allowance (21,431) (21,601)
-------- ---------
Net deferred tax assets $ --- $ ---
======== =========

The net operating loss and research and development credit carryforwards of
approximately $42 million and $768,000, respectively, will expire on various
dates from 2007 to 2019. Utilization of these carryforwards may be annually
limited if there is a change in the Company's ownership, as defined by the
Internal Revenue Code.

A valuation allowance has been recorded for the entire deferred tax asset as a
result of uncertainties regarding the realization of the asset including the
lack of sustained profitability to date and the variability of operating
results.

11. Net Income (Loss) Per Share:

Under Statement of Financial Accounting Standards (SFAS) No. 128 "Earnings per
Share," the Company is required to compute earnings per share under two
different methods (basic and diluted). Basic earnings per share is calculated by
dividing net income (loss) attributable to common shareholders by the weighted
average shares of Common Stock outstanding during the period. Diluted earnings
per share is calculated by dividing net income attributable to common
shareholders by the weighted average shares of outstanding Common Stock and
Common Stock equivalents during the period. Due to losses for the years ended
December 31, 1999 and 1998, inclusion of Common Stock equivalents would be anti-
dilutive. Therefore, basic and diluted loss per share for the Company are the
same.

For the year ended December 31, 1998, the net loss per share was computed as
net loss of $30,237,000 plus $1,764,000 relating to the preferred stock deemed
dividend (Note 8) divided by the weighted average common shares outstanding.

A reconciliation of net income (loss) per basic and diluted share for the
three years ended December 31, 2000 follows (in thousands, except for per share
amounts):

F-15

DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

2000 1999 1998
---- ---- ----
Basic:
Net income (loss) applicable to common
shareholders $ 1,156 $(8,763) $(32,001)

Weighted average shares outstanding 28,103 26,653 16,272
------- ------- --------
Net income (loss) per share $ 0.04 $ (0.33) $ (1.97)
======= ======= ========

Diluted:

Net income (loss) applicable to common
shareholders $ 1,156 $(8,763) $(32,001)
------- ------- --------

Weighted average shares outstanding 28,103 26,653 16,272

Add: Common share equivalents 1,942 - -

------- ------- --------
Total shares 30,045 26,653 16,272
------- ------- --------
Net income (loss) per share $ 0.04 $ (0.33) $ (1.97)
======= ======= ========

For the year ended December 31, 2000, common stock equivalents of 1,942,000
relate to outstanding warrants and stock options as determined by applying the
treasury stock method. For 2000, 1,436,747 options were excluded from the
computation of diluted earnings per share because the exercise price exceeded
the average fair value for the year.

12. Segment Information:

The Company operates in the media distribution industry and its operations are
managed primarily by geographic areas. The Company has defined its operating
segments based on these geographic areas.

The information in the following tables is derived directly from the internal
financial reporting used for corporate management purposes and segments are
assessed based on net income (loss).The expenses, assets and liabilities
attributable to corporate activity are allocated to the San Francisco operating
segment. During 2000, the Vancouver operating facility was closed, with all
assets and activities integrated into San Francisco. As of December 31, 1999, 5%
of operating assets are located outside of the United States (none at December
31, 2000). At December 31, 1998, the balance sheet information for the Company's
Los Angeles segment was maintained as part of the Chicago segment and was
impractical to break out separately.

Year ended December 31, 2000
(in thousands)
--------------------------------------------------------------------------
San Francisco New York Chicago Los Angeles Vancouver Consolidated
------------- -------- ------- ----------- --------- ------------

Revenue $ 23,630 $ 12,592 $15,344 $ 3,145 $ - $ 54,711

Net income (loss) $ (6,802) $ 1,971 $ 5,582 $ 405 $ - $ 1,156

Total assets $ 24,038 $ 8,929 $ 2,337 $ 1,083 $ - $ 36,387

F-16

DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Year ended December 31, 1999
(in thousands)
------------------------------------------------------------------------------
San Francisco New York Chicago Los Angeles Vancouver Consolidated
------------- -------- ------- ----------- --------- ------------

Revenue $ 16,340 $ 12,037 $ 13,605 $ 2,219 $ 4,523 $ 48,724

Net income (loss) $ (12,458) $ 2,877 $ 1,805 $ 240 $ (1,227) $ (8,763)

Total assets $ 15,875 $ 10,081 $ 4,943 $ 1,996 $ 8,871 $ 41,766

Year ended December 31, 1998
(in thousands)
------------------------------------------------------------------------------
San Francisco New York Chicago Los Angeles Vancouver Consolidated
------------- -------- ------- ----------- --------- ------------

Revenue $ 15,976 $10,125 $ 10,829 $ 2,842 $ 1,498 $ 41,270

Net income (loss) $(10,910) $ 1,265 $(19,975) $ (191) $ (426) $ (30,237)

Total assets $ 22,737 $10,060 $ 7,514 $ - $ 9,481 $ 49,792

13. Pretax Savings Plan:

The Company has a 401(k) retirement plan for full-time U.S. based employees.
Employees who are at least 21 years of age and have completed at least six
months of service are eligible to participate in the plan. Employees may
contribute up to 20% of gross pay with a maximum dollar limit for 2000 of
$15,000. The employer contribution is made at the end of the plan year in an
amount set by corporate resolution, based on participants' compensation. The
Company made no contributions to the plan in 2000, 1999 or 1998.

14. New Accounting Pronouncement:

In June 1998, the Financial Accounting Standards Board issued SFAS No. 133,
"Accounting for Derivative Instruments and Hedging Activities", as amended. This
new standard requires companies to record derivatives on the balance sheet as
assets or liabilities, measured at fair value. Under SFAS No. 133, gains or
losses resulting from changes in the values of derivatives are to be reported in
the statement of operations or in other comprehensive income, depending on the
use of the derivatives and whether they qualify for hedge accounting. The
Company is required to adopt SFAS No. 133 in the first quarter of 2001. The
Company does not engage in hedging activity and does not have any significant
derivatives. Accordingly, adoption of this new standard will not have a
significant impact on the Company.

15. Merger:

During October 2000, the Board of Directors of the Company unanimously
approved an Agreement and Plan of Merger, dated as of July 7, 2000, which
provided for the merger of SG Nevada Merger Sub Inc. ("SG Nevada"), a wholly-
owned subsidiary of the Company, with and into StarGuide. In this merger, the
holders of StarGuide common stock received for each share of StarGuide Common
Stock approximately 1.7332 shares of the Company's Common Stock and the holders
of Company Common Stock will continue to hold their shares. Final approval of
the merger was obtained at the annual meeting on November 21, 2000 and was
consummated effective January 1, 2001. SG Nevada ceased to exist as a separate
entity and StarGuide has continued as the surviving corporation and a wholly-
owned subsidiary of the Company. The merger has been accounted for as a reverse
acquisition, and accordingly, historical results of the combined company will be
that of StarGuide and the Company's results of operations will be included
subsequent to the consummation date.

F-17

DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES

SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS

Balance at Additions
Beginning of Charged to Balance at
Classification Period Operations Other Writeoffs End of Period
- -------------- ------ ---------- ---- --------- -------------

Allowance for Doubtful Accounts
Year Ended:

December 31, 1998 585,000 1,142,000 186,000 (a) (18,000) 1,895,000

December 31, 1999 1,895,000 538,000 - (774,000) 1,659,000

December 31, 2000 1,659,000 1,412,000 - (164,000) 2,907,000

(a) Additions resulting from acquisitions of DCI in 1998.

S-1