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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 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, 1996
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)
CALIFORNIA 94-3140772
(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NUMBER)
875 BATTERY STREET
SAN FRANCISCO, CALIFORNIA 94111
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES, INCLUDING ZIP CODE)
(415) 276-6600
(REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)
SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: NONE
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT: COMMON STOCK
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 (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. YES _X_ NO __
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of 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 voting stock held by non-affiliates of
the registrant, based upon the closing sale price of the Common Stock February
25, 1997 as reported on the Nasdaq National Market of $5.375 per share, was
approximately $41,843,176. Shares of Common Stock held by each officer and
director 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 February 25, 1997, the registrant had 11,686,175 shares of Common
Stock, without par value, outstanding.
DOCUMENTS INCORPORATED BY REFERENCE:
The registrant has incorporated by reference into Part III of this Form
10-K, to the extent stated herein, portions of its Proxy Statement for the
Annual Meeting of Stockholders to be held on April 11, 1997 (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.
This report contains forward-looking statements within the meaning of
Section 27A of the Securities Act of 1933 and Section 21E of the Securities
Exchange Act of 1934. Actual results could differ materially from those
indicated in the forward-looking statements as a result of certain factors,
including those set forth under "Certain Business Considerations" in
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" and elsewhere in, or incorporated by reference into, this report.
The registrant has attempted to identify forward-looking statements in this
report by placing an asterisk (*) following each sentence containing such
statements.
TABLE OF CONTENTS
PART I
ITEM 1: BUSINESS...................................................................... 1
Industry Background................................................................ 1
The Company........................................................................ 2
Products and Services.............................................................. 3
The DG Systems Network............................................................. 4
Markets and Customers.............................................................. 5
Sales, Marketing and Customer Service.............................................. 6
Research and Development........................................................... 7
Competition........................................................................ 7
Intellectual Property and Proprietary Rights....................................... 8
Employees.......................................................................... 8
ITEM 2. PROPERTIES.................................................................... 8
ITEM 3. LEGAL PROCEEDINGS............................................................. 9
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS........................... 9
ITEM 4A. EXECUTIVE OFFICERS OF THE REGISTRANT......................................... 9
PART II
ITEM 5. MARKET FOR REGISTRANTS COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.......... 11
ITEM 6. SELECTED FINANCIAL DATA....................................................... 12
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS.................................................................... 13
Overview........................................................................... 13
Results of Operations.............................................................. 14
Liquidity and Capital Resources.................................................... 18
Certain Business Considerations.................................................... 19
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA................................... 26
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
DISCLOSURE.................................................................... 26
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT........................... 26
ITEM 11. EXECUTIVE COMPENSATION....................................................... 27
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT............... 27
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS............................... 27
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K.............. 27
SIGNATURES.............................................................................. 30
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PART I
ITEM 1: BUSINESS
Digital Generation Systems, Inc. ("DG Systems" or the "Company") operates a
nationwide multimedia network designed to provide electronic delivery and
related services to the broadcast industry by linking content providers to radio
and television stations. The Company is the leading provider of electronic
distribution of audio spot advertising to radio stations, and has entered the
market for distribution of video spots to television stations, cable systems and
networks. DG Systems derives its revenues from advertising agencies, production
studios and other service providers that have traditionally relied upon physical
delivery methods. The Company's network currently reaches over 5,000 radio
stations and 200 television stations in the U.S. through the Company's scalable,
fault-tolerant network operating center. The Company believes that its network
enables the rapid, cost-effective and reliable transmission of broadcast
content, and provides higher levels of quality, accountability and flexibility
than current distribution methods. The Company has expanded the scope of its
electronic distribution services to address television and cable advertising,
music, network advertising and other content, and in November 1996 the Company
purchased PDR Productions, Inc. ("PDR"), a provider of video and audio
duplication, distribution and editing services based in New York City.
INDUSTRY BACKGROUND
While the radio and television broadcast industries have adopted digital
technology for much of their production processes and certain of their
in-station functions, current methods for the distribution of audio and video
advertising content are primarily based on the physical delivery and manual
processing of analog tapes. According to industry sources, there are
approximately 10,000 commercial radio and 1,200 commercial television stations
in the United States. These stations generate revenue principally by selling air
time to advertisers. Advertising is most frequently produced either by a third
party, such as a recording studio under the direction of an advertising agency,
or, less frequently, by station personnel. Advertising is characterized as
"network" or "spot", depending on how it is bought and distributed. Network
advertising is typically delivered to stations together with network
programming, while spot advertising is delivered to stations independent of
programming.
Spot advertising air time is purchased by advertising agencies or their
representatives on behalf of advertisers who select individual stations or
groups of stations to support marketing objectives, which are usually based on
the stations' geographic and other demographic characteristics. Less frequently,
advertisers purchase air time directly from stations, rather than using
independent advertising agencies. While advertisers and their agencies are
purchasing air time, their creative teams are developing the content for the
spots to be broadcast. The actual spot is typically produced at a production
studio and recorded on tape. Variations of the spot intended for specific
demographic groups are also recorded at this time. The spot undergoes a review
of its quality and content before it is cleared for transmission to broadcast
stations. The tapes containing the spot and its variations are then duplicated,
packaged and shipped to radio and television stations and cable headends
specified by the advertiser or its agency.
The predominant method for distributing spot advertisements to radio and
television stations has been the physical delivery of analog audio or video
tapes. The Company estimates that more than 50% of radio spots and more than 90%
of video spots are currently delivered by air express services. The remainder
are produced within individual stations, delivered by local delivery services or
picked up by station employees from the originating studio. Many companies,
commonly known as "dub and ship houses", are in the business of copying audio
and video tapes and packaging them for air express delivery. The Company
estimates that approximately four million audio tapes and approximately five
million video tapes were delivered via air express to radio and television
stations in 1996 through the efforts of approximately 400 production studios and
dub and ship houses.
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THE COMPANY
DG Systems is a leading provider of electronic distribution services for
audio and video content to advertising agencies, production studios and
broadcast stations throughout the United States. The Company, a California
corporation, was incorporated in 1991. DG Systems has developed a digital
network currently serving over 5,000 radio stations and 200 television stations
that is controlled through the Company's network operating center. This network
enables the rapid, accurate, 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 at stations in
as little as one hour after an order is received. The associated trafficking
instructions are simultaneously transmitted by facsimile to minimize station
handling and scheduling errors. Shortly after a spot is delivered to a station,
the Company sends the customer a confirmation specifying the time of delivery.
Additionally, the Company's digital network delivers close to "master" quality
audio or video to broadcast stations, which is generally superior to that
currently delivered on analog tape.
DG Systems derives revenue from advertising agencies as well as from
production studios and dub and ship houses that consolidate and forward the
deliveries to broadcast stations. The Company has historically operated and
currently operates without substantial backlog. The Company receives orders with
specific routing and timing instructions provided by the customer. These orders
are then entered into the Company's computer system and scheduled for electronic
delivery, if a station is on the Company's network, or physical delivery via the
Company's Louisville, Kentucky, dub and ship facility, if the station is not.
Audio content is delivered electronically to the Company's network
operating center from Record Send Terminals ("RSTs") that are owned by the
Company and deployed primarily in production studios. When an audio spot is
received, Company personnel currently review the audio and then initiate the
electronic transaction to transmit the audio to the designated radio stations.
Audio transmissions are currently delivered over standard telephone or ISDN
lines.
Video content is delivered electronically to the Company's network
operating center from DG Video Transmission Systems ("VTSs") that are owned by
the Company and deployed primarily in production studios. Video content can also
be delivered to the Company's network operating center through air freight
carriers such as United Parcel service and Federal Express or through high-speed
fiber networks from collection points in locations where VTSs are not available.
When a video spot is received, Company personnel initiate the electronic
transaction to transmit the video to designated television stations. Video
transmissions are sent via high speed frame relay links to the Hughes Network
Systems satellite uplink facility in Germantown, Maryland and are then delivered
to television stations and cable headends via the Hughes DirecPC digital
satellite system.
Audio transmissions are received at designated radio stations on Receive
Playback Terminals ("RPTs"), which are owned by the Company and typically
installed in the production area of the stations. Video transmissions are
received at designated television stations and cable systems on DirecPC
satellite receipt capable ADvantage Digital Video Playback Systems ("DVPSs"),
which are owned by the Company and typically installed in the production area of
the stations. Upon receipt, station personnel generally review the content and
transfer the spot to the broadcast system for later broadcast. Through its
network operating center, the Company monitors the spots stored in each RPT or
DVPS and ensures that space is always available for new transmissions. The
Company can quickly retransmit deliveries at the request of a station or in
response to the request of a customer who wishes to alter an existing order.
DG Systems currently offers three primary levels of service to broadcast
advertisers distributing content to radio or television stations: 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. In addition, the Company offers DG Priority, an audio spot
delivery service which guarantees arrival of the first spot on an order within
one hour. The Company also offers a set of premium services enabling advertisers
to distribute audio or video spots after the normal cutoff times. The Company
does not charge for late deliveries or retransmissions.
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In addition to its standard services, the Company addresses three vertical
markets with particular time-sensitive delivery needs. "Sweeps" delivery is a
specialized service to television stations that wish to advertise on radio to
stimulate viewership during the periods of ratings conducted by the A.C. Nielsen
Company in February, May, August, and November of each year. The Company 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. Finally, the Company delivers political advertising during election
campaigns, providing a rapid response mechanism for candidates and issue groups.
The Company provides additional ancillary services, including audio and
video editing, physical archiving, closed captioning, modification of slates,
and format conversions to the New York City market through its wholly owned
subsidiary, PDR.
PRODUCTS AND SERVICES
The Company's mission is to become the leading provider of electronic
delivery and related, value added services to broadcast advertisers. The Company
also seeks to achieve brand name recognition as the industry standard for
digital delivery of audio and video content.
Audio Advertising Distribution. The Company's revenues to date have been
derived principally from one major line of business, the delivery of radio
advertising spots from advertising agencies, production studios and dub and ship
houses to radio stations in the United States, and such services are expected to
continue to account for a significant share of the Company's revenues for some
time.* See "The Company" and "Management's Discussion and Analysis of Financial
Condition and Results of Operations -- Certain Business Considerations --
Dependence on Radio Advertising." The Company also derives revenue from its
offering of audio distribution services in three vertical markets, sweeps;
local/regional newspapers; and political advertising. See "The Company."
Finally, the Company derives limited revenue today through its Studio Bridge and
Studio Exchange services, which enable production studios to directly exchange
audio files with each other without the intervention of Company personnel. These
studio-to-studio services are offered according to two different pricing
methods: unlimited transmissions for a fixed monthly fee or pay-as-you-go on a
per transaction basis.
Video Advertising Distribution. The Company believes that the delivery of
television advertising is characterized by many of the same challenges facing
radio advertisers. The Company introduced its video distribution services in the
third quarter of 1996. To date, the Company has deployed a video distribution
network consisting of over 200 television stations and cable systems, which are
currently on-line and able to receive video content through the Company's
network, and is actively marketing and selling the video services to agencies,
advertisers and dealers. As substantially all of the Company's radio and
advertising customers are also active television advertisers, the Company is
marketing and selling these services to many of its current customers who
already utilize the Company's audio spot distribution services.
In order to build a significant video business, the Company believes that
it must continue to expand its network of on-line television stations and cable
systems, as well as sign up agencies and dealers to distribute their broadcast
advertisements through DG Systems' network. To obtain deliveries directly from
agencies, the Company must also develop and market a set of ancillary,
pre-distribution services in each major market. There can be no assurance that
the Company will overcome the technological and operational barriers as well as
competitive threats in a time frame required to become one of the industry's
leading supplier of such services. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations -- Certain Business
Considerations -- Dependence on Video Advertising Delivery Service Deployment",
and "-- Dependence on Technological Developments" and "-- Competition."
Music Distribution. The Company 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. The release of a new album by an established musical
artist is often the focus of a marketing campaign culminating in the
simultaneous release of a hit single to radio stations in key markets. Music
labels share the concerns of advertisers and agencies regarding the timeliness
and reliability of delivery, and in addition seek to maximize publicity by
employing a secure delivery system that ensures all selected
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radio stations will receive the single just in time for the scheduled release
but prevent it from being aired before that time. In addition, new or "up and
coming" artists backed by major record labels seek the opportunity to market
their music to radio stations through innovative means, including simultaneous,
first-release distribution. The Company to date has provided first-release music
deliveries for over thirty different artists. The typical first-release music
distribution has been to a larger group of radio stations than the average
advertising spot. While this business has provided the Company with significant
promotional opportunities and marketing exposure, it has not contributed a
substantial share of the Company's revenues in any fiscal period and the Company
does not expect that first release music delivery services will generate a large
share of the Company's revenues or profits in the future.
The Company's future growth depends on its successful and timely
introduction of new products and services in markets that do not currently exist
or are just emerging. The Company is currently undertaking efforts to develop
new products and services. However, and there can be no assurance that the
Company will successfully complete such development or that even if such
development is completed, the Company's planned introduction of these products
and services will realize market acceptance or will meet the technical or other
requirements of potential customers. See "Management's Discussion and Analysis
of Financial Condition and Results of Operations -- Certain Business
Considerations -- Dependence on Energy Markets."
THE DG SYSTEMS NETWORK
The Company's network consists of the following: (i) Record Send Terminals
(audio) and Video Transmission Systems (video) owned by the Company and
installed primarily at production studios; (ii) a network operating center at
the Company's headquarters used to process, route and store digital content; and
(iii) Receive Playback Terminals (audio) and Digital Video Playback Systems
(video) owned by the Company and installed at broadcast stations.
Record Send Terminal. The RST is a PC-based media encoder and
communications server with a full screen monitor and keyboard. The RST accepts
audio in either analog or digital format and encodes the audio using an
efficient compression algorithm for transmissions to the Company's network
operating center.
Video Transmission System. The VTS is a workstation-based video encoder and
communications server with a full screen monitor and keyboard. The VTS accepts
video in either analog or digital format and encodes the video using an MPEG 2
compression algorithm for transmissions to the Company's network operating
center.
Network Operating Center. DG systems has developed a fault-tolerant
client/server on-line transaction system based on Sun Microsystems'
SparcServers. The Company has developed software applications incorporating
critical operation capabilities such as transaction management, communication
facility monitoring, system security, intelligent network routing and customer
service databases. The major system components include (i) a transaction
scheduling, monitoring and management system, (ii) a media delivery system
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 (iii) a high-capacity media storage and archive system that indexes
and archives every media file delivered by the Company.
DG Systems has developed a sophisticated, highly scaleable network
communication system to provide network transaction services to the targeted
stations. Today this system supports two-way communication to remote stations
via standard telephone lines, satellite, ISDN and frame relay connections. The
Company intends to add additional communications capabilities, such as Internet,
beginning in 1997. The modular system design and use of industry standard
technology enables system capacity to be increased easily and quickly. DG
Systems can maintain over 400 simultaneous connections today and expects this
capacity to double by the end of 1997.* See "Management's Discussion and
Analysis of Financial Condition and Results of Operations -- Certain Business
Considerations -- Ability to Manage Growth" and "-- Future Capital Needs;
Uncertainty of Additional Funding."
Receive Playback Terminal. The RPT is a rack-mountable, PC-based
communication server and media decoder which enables radio stations to receive
and play back digital audio content delivered through the
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Company's digital distribution network. The RPT communicates with the Company's
network to exchange media and transactional information, and allows users to
playback broadcast quality audio on demand. RPT 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.
Digital Video Playback System. The DVPS is a rack-mountable, PC-based
communication server and media decoder which enables television stations and
cable systems to receive and play back television advertisements and other
digital video content delivered through the Company's digital distribution
network. The DVPS communicates with the Company's network to exchange media and
transactional information, and allows users to playback broadcast quality media
on demand. The DVPS includes a fully integrated monitor and keyboard and has the
disk capacity to store up to 250 30-second spots. DVPS 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.
Hughes DirecPC Satellite Interface. The Company has a joint development and
deployment agreement with Hughes Network Systems, Inc. for satellite delivery to
the Company's network of stations. The Company has developed an electronic
interface between its network operating center and the Hughes satellite uplink
facility. The Company has also worked with Hughes to integrate the Hughes
DirecPC satellite technology into its RPTs and DVPSs to permit the receipt of
media content from satellite as well as from terrestrial connections.
MARKETS AND CUSTOMERS
Substantially all of the Company's current revenue is derived from the
delivery of spot radio and television advertising to broadcast stations, cable
systems and networks. The Company derives revenue by billing advertising
agencies directly and by billing its marketing partners, which are dub and ship
houses that have signed agreements with the Company to consolidate and forward
the deliveries of their advertising agency customers to broadcast stations,
cable systems and networks via the Company's electronic delivery service in
exchange for price discounts from the Company. The advertisements distributed by
the Company 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 and amusements. The
volume of advertising from these segments is subject to substantial seasonal and
cyclical variations. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations -- Certain Business Considerations --
Potential Fluctuations in Quarterly Results; Seasonality."
In addition to its core distribution services, DG Systems has identified
vertical-market applications for audio distribution 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, August, and November. The Company's services
allow local television stations, their affiliated networks and/or syndicators,
whose own advertising rates are based on their Nielsen ratings, to promote
viewership of their programs during ratings periods. In 1996, more than 70
television stations used the Company's sweeps delivery service.
Political Campaigns. Using radio during election campaigns provides a rapid
response mechanism for candidates and issue groups. The Company offers same-day
service to facilitate such advertising during political campaigns.
Newspaper Headlines. Newspapers use the Company's services to deliver
topical radio commercials to run during the morning or afternoon drive times in
local markets to encourage readership for local newspapers. The producer
typically reads a special early edition of the paper. Stories are selected on
the basis of topical content with the best chance of encouraging listeners to
become readers. The spot is written, recorded, mixed
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and transmitted to DG Systems for distribution to local radio stations. Delivery
guarantees are typically between one and two hours depending on the market.
SALES, MARKETING AND CUSTOMER SERVICE
Brand Strategy. The Company's brand strategy is to position itself as the
standard delivery method for advertising and short-form content for the radio
and television broadcast industry. The Company focuses its marketing messages,
advertising and programs at multiple segments within the broadcast industry.
Each of the segments interacts with the Company for a different reason. Agencies
purchase services from the Company on behalf of their advertisers. Production
studios facilitate the transmission of audio and video to the Company's network
operating center. Production studios and dub and ship houses resell delivery
services to agencies. Stations join the network and receive the content. A key
strategy to providing a consistent brand theme at all levels is developing "DG"
as a brand identity across the product and services offerings.
Sales. The Company employs a direct sales force that calls on creative,
marketing and traffic departments at advertising agencies to communicate the
capabilities and comparative advantages of the Company's electronic distribution
system and the related products and services. In addition, the Company's sales
force calls on corporate advertisers who may be in a position to influence
agencies in directing deliveries to the Company. The Company currently has field
sales offices in New York, Los Angeles, Chicago and Washington D.C., as well as
sales personnel in its San Francisco headquarters. Members of the Company's
sales force are compensated through salary and incentive commissions. The
Company's sales force includes field sales, inside sales (serving as account
coordinators and supporting field sales efforts), and telemarketing (for
identifying and qualifying leads).
Marketing. The Company's marketing programs are directed toward demand
stimulation 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 U.S. cities. The Company also engages in public
relations activities including trade show participation, the stimulation of
articles in the trade and business press, press tours and partial sponsorship of
the annual Mercury Awards of the Radio Advertising Bureau. The Company also
engages in limited print advertising in advertising and broadcast oriented trade
publications.
The Company also markets to broadcast stations to arrange for the placement
of its RPTs and DVPSs. The service contract offers the station free use of the
RPT or DVPS, but each station is generally required to pay for a dedicated phone
or ISDN line to support the transmissions. For higher-volume stations, each
station is requested to pay the cost of an ISDN connection, the cost of which
can vary from $35 to $400 per month, depending on the regional carrier's pricing
and service combination. In certain instances the Company agrees to pay for the
initial installation of such phone or ISDN lines, and may also pay for several
month's worth of maintenance costs during limited promotional periods. For the
major television network affiliates in the top markets, the Company may elect to
pay for monthly maintenance of the phone or ISDN lines on an ongoing basis.
According to industry sources, there are over 5,200 commercial radio
stations that are located in Arbitron-rated "Areas of Dominant Influence," which
are the geographic areas in which national advertisers are most active. The
Company believes its installed base of RPTs serving over 5,000 radio stations,
over 95% of which are located in these areas, provides it with an important
competitive advantage. The Company is similarly focusing on the largest 100
television markets as rated by A.C. Nielsen, along with the major cable
interconnects in the largest U.S. markets.
Customer Service. The Company also has a customer service staff which is
available between the hours of 5 a.m. and 8 p.m., Pacific time. This staff
supports not only the Company's customers but also the broadcast stations who
receive the deliveries. Customer service calls may concern such matters as the
placing, revision or cancellation of orders, inquiries by agencies or studios
about the audio or video portion of the order, inquiries
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from studios about technical problems with RSTs or VTSs, inquiries by broadcast
station personnel about their inclusion in particular orders, the status of
particular orders, and problems with RPTs or DVPSs.
RESEARCH AND DEVELOPMENT
The Company has devoted, and intends to devote in the future, a significant
portion of its resources to product development programs.* As of December 31,
1996 the Company had 16 employees engaged in product development. The Company's
products development expenses for fiscal 1996, 1995 and 1994 were approximately
$2,092,000, $1,590,000 and $1,048,000, respectively, and represented 20%, 31%,
and 43%, respectively, of the Company's revenues. See "Products and Services",
"The DG Systems Network" and "Management's Discussion and Analysis of Financial
Condition and Results of Operations -- Certain Business Considerations --
Dependence on New Product Introductions" and "-- Dependence on Technological
Developments."
The Company has an agreement with ABC Radio Networks ("ABC") to jointly
develop and field trial an extension to the Company's existing network,
including satellite transmission capabilities, through which ABC could
electronically distribute advertising and programming to ABC's affiliate radio
stations. If the development and trial is successful, further negotiations
between the Company and ABC would be required regarding deployment of the
satellite electronic distribution network.
COMPETITION
The market for the distribution of advertising and other content to radio
and television stations and cable systems is highly competitive. The Company
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, and
timeliness and accuracy of delivery.
The Company competes with a variety of dub and ship houses, including
publicly-held VDI Media, and production studios that have traditionally
distributed taped advertising spots via physical delivery. These entities have
long-standing ties to local distributors that will be difficult for the Company
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 post
production, preparation, distribution and trafficking services. In order to
effectively compete with such local, full-service providers, the Company will
need to develop or contract for a range of ancillary services for its customers
on a localized basis. Moreover, Digital Courier International Corporation has
begun deployment of a system to electronically deliver audio content in Canada
and the United States, and several other companies have announced such systems.
The Company competes in the market for electronic video distribution
services with IndeNet, Inc. and Vyvx Advertising Distribution Services ("VADS"),
a subsidiary of The Williams Companies, Inc. In November 1996, VADS acquired
CycleSat, Inc., a provider of satellite video delivery services, from Winnebago
Industries, Inc. CycleSat also operates a dub and ship business in New York City
that competes with the Company's subsidiary, PDR.
To the extent that the Company is successful in entering new markets, such
as delivery of other content to radio and television stations, it would expect
to face competition from companies in related communications markets and/or
package delivery markets which could offer products and services with
functionality similar or superior to that offered by the Company's products and
services. Telecommunications providers such as AT&T, MCI, and Regional Bell
Operating Companies could enter the market as competitors with materially lower
electronic delivery transportation costs. The Company 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
separately from their network content programming. In addition, Applied Graphics
Technologies, Inc., a provider of digital pre-press services, has indicated its
intention to provide electronic distribution services and acquired Spotlink, a
dub and ship house,
7
10
in December 1996. Although Spotlink revenues were less than 5% of the Company's
revenues in 1996, the Company considers Spotlink to be a significant customer
for the Company's audio delivery service. There can be no assurance that
Spotlink will continue to be a customer of the Company, and the loss of Spotlink
as a customer could have a material adverse effect on the Company's operating
results.
Many of the Company's 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 the
Company. There can be no assurance that the Company will be able to compete
successfully against current and future competitors based on these and other
factors. The Company expects that an increasingly competitive environment will
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 the
Company's business, results of operations and financial condition. Moreover, the
markets for the distribution of audio and video transmissions have become
increasingly concentrated in recent years as a result of acquisitions, which are
likely to permit many of the Company's competitors to devote significantly
greater resources to the development and marketing of new competitors. There can
be no assurance that the Company will be able to compete successfully with new
or existing competitors or that competitive pressures faced by the Company will
not materially and adversely affect its business, operating results and
financial condition. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations -- Certain Business Considerations --
Competition."
INTELLECTUAL PROPERTY AND PROPRIETARY RIGHTS
The Company 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 the Company's 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 the Company's 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. The Company does not hold any patents.
Because the Company's business is characterized by rapid technological
change, the Company 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.
The Company believes that its software, trademarks and other proprietary
rights do not infringe the proprietary rights of third parties. There can be no
assurance, however, that third parties will not assert such infringement by the
Company 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 the Company to enter
into royalty or licensing agreements. Such royalty or licensing agreements, if
required, may not be available on terms acceptable to the Company.
EMPLOYEES
The Company had 184 employees as of December 31, 1996, including 111 in
customer operations, 30 in sales and marketing, 16 in engineering and research
and development, and 27 in administration. The Company's employees are not
represented by any collective bargaining organization, and the Company has never
experienced a work stoppage.
ITEM 2. PROPERTIES
The Company has leased it's headquarters facility located at a multi-tenant
office building located at 875 Battery Street in San Francisco, California. The
Company's lease is for 15,000 square feet and expires in 2001. The Company has
an agreement for non-interruptible access to emergency power and the Company has
arranged for alternative routes to maintain its fiber connection between its
computers and its long distance
8
11
carrier. However, there can be no assurance that a catastrophic earthquake or
other natural disaster could not interrupt the Company's operations. The Company
also leases approximately 5,000 square feet on a nearby ground-floor location
used for assembly of its field equipment and for offsite storage which expires
in 2001. In addition, the Company leases approximately 3,000 square feet in
Louisville, Kentucky for its dub and ship facility and approximately 22,000
square feet in New York City which is occupied by PDR. The Company leases
additional facilities and offices for sales and customer service in California,
Illinois, New York, and Washington, D.C. The Company believes that these
facilities and offices and additional or alternative space available to it are
adequate to meet its requirements for the foreseeable future.
ITEM 3. LEGAL PROCEEDINGS
The Company is subject 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 will have a material
adverse effect on the Company's consolidated results of operations or
consolidated financial position.*
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None
ITEM 4A. EXECUTIVE OFFICERS OF THE REGISTRANT
The executive officers and directors of the Company and their ages as of
December 31, 1996, are as follows:
NAME AGE POSITION
- -------------------------- --- -----------------------------------------
Henry W. Donaldson 51 President, Chief Executive Officer and
Director
Ken K. Cheng 41 Senior Vice President, Chief Operating
Officer
Jeffrey A. Byrne 41 Vice President, Marketing
Jon E. Reese 55 Vice President, Sales
Gregory G. Schott 32 Vice President, Operations
Thomas P. Shanahan 50 Vice President, Finance and Chief
Financial Officer
Kevin R. Compton(1) 38 Director
Jeffrey M. Drazan(2) 37 Director
Richard H. Harris(2) 67 Director
Leonard S. Matthews(1)(2) 74 Director
- ---------------
(1) Member of the Audit Committee
(2) Member of the Compensation Committee
Henry W. Donaldson joined the Company in March 1993, and since such date
has served as it President and Chief Executive Officer and as a Director of the
Board of Directors. He was formerly President of the Data Communications
Division of Rexel, Inc. (formerly Willcox & Gibbs), a distributor of electrical
parts and supplies, from September 1989 through January 1993. Mr. Donaldson
holds a B.A. in Mathematics from Hamilton College.
Ken K. Cheng joined the Company in December 1993 and as Vice President,
Engineering. Mr. Cheng was appointed Senior Vice President and Chief Operating
Officer in June 1996 and has served as such since that date. From December 1988
to December 1993, Mr. Cheng was Director of Engineering at Network Equipment
Technologies. Mr. Cheng holds a B.Sc. in Applied Mathematics from Queen's
University, Kingston, Ontario, Canada and an M.B.A from Santa Clara University.
9
12
Jeffrey A. Byrne joined the Company in March 1996 and since such date has
served as Vice President, Marketing. From July 1986 to June 1992, Mr. Byrne was
Senior Director of Marketing for MIPS Computer Systems, Inc. From June 1992 to
May 1993, Mr. Byrne was Director of Marketing for Novell, Inc. From May 1993 to
March 1996, Mr. Byrne was Vice President of Worldwide Marketing for Dataquest,
Inc. Mr. Byrne holds a B.S. in Mathematical Sciences from Stanford University
and an M.B.A. from Harvard University.
Jon E. Reese joined the Company in August 1994 as a consultant and has
served as Vice President, Sales since January 1995. Mr. Reese was Vice President
of Sales and Marketing of DCI from February 1991 to May 1994. Mr. Reese holds a
B.S. in Accounting and Sales from Bloomburg University.
Gregory G. Schott joined the Company in July 1994 as Director of
Operations. Mr. Schott later served as Director of Business Development from
December 1995 to June 1996 and since such date has served as Vice President,
Operations. From June 1991 to July 1994, Mr. Schott was a consultant with the
Boston Consulting Group. Mr. Schott holds a B.S. in Mechanical Engineering from
North Carolina State University and an M.B.A. from Stanford University.
Thomas P. Shanahan joined the Company in November 1994, and since such date
has served as its Chief Financial Officer. From May 1987 to February 1992, Mr.
Shanahan was Chief Financial Officer of SBT Corporation. From March 1992 to
April 1993, Mr. Shanahan was Chief Financial Officer of Ultra Network
Technologies, Inc. From May 1993 to October 1994, he was Chief Financial Officer
of Sherpa Corporation. Mr. Shanahan holds a B.A. in Economics from Stanford
University and an M.B.A. from Harvard University.
Kevin R. Compton has been a member of the Board of Directors of the Company
since March 1994. Mr. Compton has been a general partner of Kleiner, Perkins,
Caufield & Byers, a venture capital investment firm, since December 1990. Mr.
Compton currently serves as a director of Global Village Communication, Inc., a
networking hardware and software company, Citrix Systems, a developer of server
software, and on numerous private boards. He holds a B.S. in Business
Administration from the University of Missouri.
Jeffrey M. Drazan has been a member of the Board of Directors of the
Company since July 1992. Mr. Drazan has been a general partner of Sierra
Ventures, a venture capital investment firm, since 1985. Mr. Drazan currently
serves on the boards of public companies FaxSav and Retix. Mr. Drazan holds a
B.S.E. in Engineering from Princeton and an M.B.A. from New York University.
Richard H. Harris has been a member of the Board of Directors of the
Company since July 1992. Since July 1992, Mr. Harris has been President and
Owner of Harris Classical Broadcasting, operating two FM audio stations in
Milwaukee, Wisconsin. From May 1984 to May 1986, Mr. Harris was Chairman of the
Radio Advertising Bureau. From June 1964 to April 1991, Mr. Harris held various
senior management positions with Westinghouse Broadcasting Company, including
Chairman of the Radio Group. Mr. Harris holds a B.A. in Communications and
Economics from the University of Denver and is a graduate of the Advanced
Management Program at Harvard University.
Leonard S. Matthews has been a member of the Board of Directors of the
Company since April 1993. From January 1979 to January 1989, Mr. Matthews was
President and Chief Executive Officer of the American Association of Advertising
Agencies. Previously, Mr. Matthews had been president of two of the world's
leading advertising agencies, Leo Burnett and Young & Rubicam. From May 1992 to
the present, Mr. Matthews has been Chairman of the Board of Next Century Media,
an interactive television company. Mr. Matthews holds a B.S. in Business
Administration & Marketing from Northwestern University.
10
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PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER 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.
HIGH LOW
------ ------
FISCAL YEAR ENDED DECEMBER 31, 1996:
First Quarter (from February 6, 1996).................... $12.25 $8.375
Second Quarter........................................... $13.25 $8.125
Third Quarter............................................ $10.25 $7.750
Fourth Quarter........................................... $11.00 $7.625
As of February 20, 1997, the Company had issued and outstanding 11,685,873
shares of its Common Stock held by 173 shareholders of record. The Company
estimates that there are approximately 2,000 beneficial shareholders.
The Company has never declared or paid cash dividends on its capital stock.
The Company currently expects to retain its future earnings for use in the
operation and expansion of its business and does not anticipate paying any cash
dividends in the foreseeable future.
See "Management's Discussion and Analysis of Financial Condition and
Results of Operations -- Certain Business Considerations -- Concentration of
Stock Ownership; Potential Issuance of Preferred Stock; Anti-Takeover
Provisions" and "-- Possible Volatility of Share Price."
11
14
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
STATEMENTS OF OPERATIONS:
YEAR ENDED DECEMBER 31,
-------------------------------------------------------
1992 1993 1994 1995 1996
------- ------- ------- ------- -------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
Revenues................................. $ 11 $ 315 $ 2,432 $ 5,144 $10,523
------- ------- ------- ------- -------
Costs and expenses:
Delivery and material costs............ 16 200 953 1,810 3,084
Customer operations.................... 54 735 1,886 2,974 4,164
Sales and marketing.................... 102 1,126 2,248 3,406 3,998
Research and development............... 590 505 1,048 1,590 2,092
General and administrative............. 511 672 1,054 1,380 1,677
Depreciation and amortization.......... 36 329 913 2,345 4,331
------- ------- ------- ------- -------
Total expenses................. 1,309 3,567 8,102 13,505 19,346
------- ------- ------- ------- -------
Loss from operations..................... (1,298) (3,252) (5,670) (8,361) (8,823)
Other income (expense):
Interest income........................ 12 35 129 417 1,422
Interest expense....................... (5) (58) (71) (836) (1,726)
------- ------- ------- ------- -------
Net Loss................................. $(1,291) $(3,275) $(5,612) $(8,780) $(9,127)
======= ======= ======= ======= =======
Pro forma net loss per share............. $ (.94) $ (.79)
======= =======
Pro forma weighted average common and
common equivalent shares............... 9,360 11,594
======= =======
BALANCE SHEET DATA:
DECEMBER 31,
-------------------------------------------------------
1992 1993 1994 1995 1996
------- ------- ------- ------- -------
Cash, cash equivalents and short-term
investments............................ $ 1,159 $ 495 $ 9,221 $ 6,205 $20,597
Working capital.......................... 1,904 115 8,755 4,651 14,200
Property and equipment, net.............. 452 1,455 3,175 5,772 12,630
Total assets............................. 2,643 2,222 13,572 14,459 45,248
Long-term debt, net of current portion... -- 303 1,573 4,540 8,495
Shareholders' equity..................... 2,382 1,358 10,502 6,373 26,839
12
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ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
OVERVIEW
The Company was incorporated in 1991. Though 1993, the Company was a
development-stage company, principally engaged in developing its network,
marketing its services to radio stations and advertising agencies, and producing
and deploying terminals for use at advertising agencies, production studios and
radio stations. In 1994, the Company first generated significant operating
revenues from the delivery of audio commercials and the related text traffic
instructions to radio stations through a nationwide network established by the
Company. In the third quarter of 1996, the Company began delivery of video
commercials to television stations. As the network 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 the Company's dub and ship facility in Louisville,
Kentucky.
The Company 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 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 (Express, Standard, or Economy), the channel from which the order
is received (directly from an 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 currently offers three primary levels of
electronic delivery of digital audio and video content through the network
operating center located in San Francisco, California: DG Express, guaranteed
arrival within four hours; DG Standard, guaranteed arrival by noon the next day;
and DG Economy, guaranteed arrival by noon on the second day. The Company does
not charge for late deliveries. 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. The Company provides volume
discounts for volume deliveries. Because the revenue earned for delivery of the
first spot is significantly greater than the revenue earned from a tied spot and
because the Company's per spot electronic transmission cost is relatively
constant regardless of volume, deliveries that comprise a single spot are
generally more profitable that deliveries which include tied spots. The Company
recognizes revenue for each order on the date the content is transmitted to the
destination ordered.
The Company assembles, owns and maintains Receive Playback Terminals
("RPTs"), which are located in the radio stations, Record Send Terminals
("RSTs"), which are located in advertising agencies and production studios,
Video Transmission Systems ("VTSs"), which are located primarily in production
studios, and Digital Video Playback Systems ("DVPSs") which are located in
television stations. The capital required to build the network has been obtained
through various preferred stock offerings to investors, primarily venture
capital firms, leasing agreements, and the Company's initial public offering
which was completed in February 1996.
In November 1996, the Company acquired 100% of the common stock of PDR
Productions, Inc. ("PDR"), a New York City media duplication and distribution
company (see the Notes to Consolidated Financial Statements and the Company's
Current Report on Form 8-K/A filed January 21, 1997). PDR's primary operations
are services typical of a traditional dub and ship house, including the physical
duplication and delivery of video content on a wide range of tape formats and
performance of a variety of audio and video editing services. The acquisition
was accounted for as a purchase. The operating results of PDR are included in
the consolidated results of the Company from the date of the closing of the
transaction, November 8, 1996. See "Certain Business
Considerations -- Uncertainties Relating to Integration of Operations."
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RESULTS OF OPERATIONS
The following presents the statements of operations of the Company
expressed as a percentage of total revenues and the related operating data for
the periods indicated.
YEAR ENDED DECEMBER 31,
---------------------------
1994 1995 1996
------ ------ -----
STATEMENTS OF OPERATIONS:
Revenues................................................ 100.0% 100.0% 100.0%
Cost and expenses:
Delivery and material costs.......................... 39.2 35.2 29.3
Customer operations.................................. 77.5 57.8 39.6
Sales and marketing.................................. 92.4 66.2 38.0
Research and development............................. 43.1 30.9 19.9
General and administrative........................... 43.4 26.8 15.8
Depreciation and amortization........................ 37.5 45.6 41.2
------ ------ -----
Total Expenses.................................. 333.1 262.5 183.8
------ ------ -----
Loss from operations.................................... (233.1) (162.5) (83.8)
Other income (expense):
Interest income...................................... 5.2 8.1 13.5
Interest expense..................................... (2.9) (16.3) (16.4)
------ ------ -----
Net loss................................................ (230.8)% (170.7)% (86.7)%
====== ====== =====
Revenues
The Company has standard pricing for delivery of audio to radio stations
based on a published rate card. The rate card contains pricing for the first
spot and associated traffic instructions on a delivery, for additional tied
spots, and for incidental services such as delivery of traffic instructions
without audio and delivery of audio to customers to be used for promotional
communications. Revenues earned from such incidental services have not been
significant to date. The Company negotiates prices with larger customers and
offers discounts to those customers who offer substantial, recurring volumes of
business. The Company offers discounts to its marketing partners who consolidate
and forward the deliveries of their agency customers.
Late in the third quarter of 1996, the Company began offering delivery of
video commercials to television stations and, in November 1996, the Company
acquired PDR Productions, Inc., whose operations consist primarily of video
duplication and distribution. The retail list prices for delivery of the first
video spot are 50% to 100% greater than those for audio delivery and can be
significantly higher, depending on the level of value added services (editing,
close captioning, etc.) that may be included in an order. Such deliveries
accounted for less than 5% of the Company's delivery volume in 1996.
Revenues increased from $2,432,000 to $5,144,000 to $10,523,000 in 1994,
1995, and 1996, respectively. These increases in revenues were primarily due to
the increased volume of deliveries. The Company made 180,000, 390,000 and
784,000 deliveries in 1994, 1995 and 1996, respectively. The Company believes
that the substantial delivery and revenue increases since 1994 are the result of
a number of factors, particularly increased acceptance by advertisers of the
services offered by the Company and the increased availability of an expanded
network of Company terminals located in radio and television stations.
Average revenue per delivery decreased from $13.51 in 1994 to $13.19 in
1995. This reduction is attributable primarily to an increase in the proportion
of deliveries made through the Company's dealer channel, those customers and
marketing partners who consolidate and forward deliveries of their agency
customers. All deliveries performed in 1994 and 1995 were deliveries of audio
content. Average revenue per delivery increased from $13.19 in 1995 to $13.42 in
1996. Although average revenue per audio delivery decreased from $13.19 in 1995
to $12.72 in 1996, primarily due to volume discounts offered to both direct and
indirect customers, the addition of video delivery and other services revenue,
approximately 9% of total
14
17
revenues in 1996, resulted in an increased average revenue per delivery. As the
percentage of video deliveries increases, the average revenue per delivery is
expected to increase.*
Delivery and Material Costs
Delivery costs consist of fees paid to other service providers for charges
incurred by the Company in the receipt, transmission and delivery of information
via the Company's distribution network. For operations to date, delivery
expenditures have principally been for the telephone transmission of deliveries
performed electronically and for the air freight incurred in the physical
delivery of tapes to locations not directly linked to the DG network operating
center. Material costs consist primarily of audio and video tape and the related
packaging.
Delivery and material costs were $953,000, $1,810,000 and $3,084,000, or
39%, 35% and 29% of revenues for 1994, 1995 and 1996, respectively. The
increases in costs are primarily due to the increased volumes of deliveries.
Delivery and material costs as a percentage of revenues were reduced from 39% in
1994 to 35% in 1995 due to volume rate agreement improvements obtained from
certain service providers, the implementation of ISDN transmission technologies
by certain high volume users which reduced the average time necessary to
transmit a minute of audio over a phone line and the cost benefits resulting
from allocating the fixed telephone service and connection costs over a greater
volume of deliveries. Delivery and material costs as a percentage of revenues
has decreased from 35% in 1995 to 29% in 1996. This reduction is primarily due
to reduced telecommunication expenses per electronic delivery. These reductions
are the result of a rate reduction obtained from the Company's primary long
distance telephone service provider, implementation of ISDN transmission
technologies by additional high volume users, and more efficient access to long
distance carriers due to equipment and switching improvements made by the
Company. In addition, the proportion of deliveries being performed
electronically increased from 75% in 1995 to 82% in 1996. These improvements in
the long distance telephone rate and delivery efficiency were partially offset
by increased materials costs per delivery resulting primarily from the physical
deliveries made by PDR.
The Company expects that delivery costs will increase in absolute dollars
and may fluctuate as a percentage of revenues in future periods.* See "Certain
Business Considerations -- Potential Fluctuations in Quarterly Results;
Seasonality."
Customer Operations
Customer operations expenses consist primarily of salaries and the related
overhead costs incurred in performing deliveries and providing services,
including order entry, customer service and assembly and maintenance of network
equipment including the Company's RPTs, RSTs, VTSs, DVPSs, tape dubbing and
editing equipment, and the network operating center.
Customer operations expenses were $1,886,000, $2,974,000 and $4,164,000 in
1994, 1995 and 1996, respectively. These increases were the result of adding the
personnel necessary to respond to the greater volume of orders and deliveries
made by customers and the increased volume of requests for remote terminals made
by radio stations, production studios, and advertising agencies. Customer
operations expenses as a percentage of revenues has decreased from 78% to 58% to
40% in 1994, 1995 and 1996, respectively, as the Company has realized the
benefits of economies of scale from the increased delivery volume and improved
the efficiency of its processing procedures through increased experience with
the system and the hiring of additional qualified management.
The Company expects that customer operations expenses will increase in
absolute dollars and may fluctuate as a percentage of revenues in future
periods.* Moreover, the Company believes that in order to compete effectively
and manage future growth, the Company will be required to continue to implement
changes which improve and increase the efficiency of its customer operations.*
See "Certain Business Considerations -- Ability to Maintain and Improve Service
Quality" and "-- Ability to Manage Growth."
15
18
Sales and Marketing
Sales and marketing expenses include salaries, incentive compensation,
professional fees and the related overhead costs incurred in promoting and
marketing the Company and its services to customers and radio and television
stations. Sales and marketing expenses were $2,248,000, $3,406,000 and
$3,998,000, or 92%, 66% and 38% of revenues for 1994, 1995 and 1996,
respectively. These increases were the result of additional costs incurred in
introducing the Company's service to the marketplace, including the salaries of
expanded sales and marketing forces, increased incentive compensation resulting
from increased revenues and increased marketing program activity. The increase
in expenses in 1995 versus 1994 is primarily due to an increase in the number of
marketing personnel and programs. These programs include trade show
participation, printing and circulation of brochures and informational
literature, advertising and other Company promotional expenses. The increase in
expenses in 1996 versus 1995 is due to additional personnel and the expansion of
promotional programs to meet the Company's growth objectives.
The Company expects to continue to expand sales and marketing programs
designed to introduce the Company's services to the marketplace and to attract
new customers for its services.* See "Certain Business Considerations --
Dependence on Emerging Markets." The Company expects that sales and marketing
expenses will increase in absolute dollars in future periods and may fluctuate
as a percentage of revenue in future periods.*
Research and Development
Research and development expenses consist primarily of salaries, testing
costs, consulting fees, and the related overhead incurred in the development and
enhancement of the delivery system used to distribute information via the DG
Systems' network. Research and development costs are expensed as incurred until
technological feasibility is established, after which any additional costs are
capitalized, in accordance with Statement of Financial Accounting Standards No.
86, "Accounting for the Costs of Computer Software to be Sold, Leased or
Otherwise Marketed." To date, no software development costs ave been capitalized
by the Company as the capitalizable amounts have been immaterial. Research and
development expenses were $1,048,000, $1,590,000 and $2,092,000, in 1994, 1995
and 1996, respectively. Research and development expenses increased from
$1,048,000 or 43% of revenues in 1994 to $1,590,000, or 31% of revenues in 1995.
This increase in absolute dollars was due primarily to increased spending on the
development and implementation of the second generation of the electronic
delivery system and research on potential new methods of delivery and new
services to be offered. Research and development expenses increased to
$2,092,000, or 20% of revenues, in 1996, primarily due to the hiring of
additional staff, including increased compensation and recruiting fees, and the
development and testing costs associated with preparing the delivery system for
the transmission of video content as well as the continued costs of research on
potential new methods of delivery and new services to be offered .
The Company expects that research and development expenses will increase
substantially in absolute dollars and may fluctuate as a percentage of revenues
in future periods.*
General and Administrative
General and administrative expenses consist primarily of personnel and
related overhead costs for finance and general management of the Company.
General and administrative expenses were $1,054,000, $1,380,000 and $1,677,000
in 1994, 1995 and 1996, respectively. These increases were primarily due to the
addition of staff to support the growth of the Company's business. Although
general and administrative expenses have increased in absolute dollars, these
expenses as a percentage of revenues have decreased from 43% to 27% to 16% in
1994, 1995 and 1996, respectively. The Company expects that general and
administrative expenses will increase in absolute dollars and may fluctuate as a
percentage of revenues in future periods.*
Depreciation and Amortization
Depreciation and amortization expenses are attributable primarily to the
Company's distribution network, including RPTs, RSTs, DVPSs , VTSs, video
dubbing and editing equipment and the network operating
16
19
center. This equipment is expensed over the estimated useful life, generally
three years. Depreciation and amortization expense was $913,000, $2,345,000 and
$4,331,000 in 1994, 1995 and 1996, respectively. These increases were due to the
continued expansion of the Company's network. The Company's total investment in
network equipment has increased from $3.6 million to $7.9 million to $18.0
million at the end of 1994, 1995 and 1996, respectively. In particular the
number in units located at broadcast stations has significantly increased in
both 1995 and 1996, and over $1.3 million of equipment additions were made to
the network operating center in 1996. In total, the Company made capital
additions of approximately $6.0 million in 1996 in support of its video delivery
service plan.
The Company expects to continue to invest in the expansion of its network.*
In particular, the Company is in the process of expanding its infrastructure
within the television broadcast industry that will require additional VSTs and
DVPSs to be built and installed in production studios and television stations.*
The Company expects depreciation and amortization to increase in absolute
dollars in proportion to this growth.* However, there can be no assurance that
the Company will make such investments or that such investments will result in
future revenue growth. See "Certain Business Considerations -- Future Capital
Need; Uncertainty of Additional Funding." In 1995, the Company adopted the
provision of Statement of Financial Accounting Standard No. 121 "Accounting for
the Impairment of Long-lived Assets to be Disposed of." Such adoption did not
have a significant effect on the Company's financial position or results of
operations.
Interest Income and Interest Expense
The Company has derived interest income from the short term investment of
the proceeds received in various convertible preferred stock offerings made in
1992 through 1995 and from the investment of the $29.5 million of net proceeds
from its initial public offering which was completed in February 1996. Interest
income was $129,000, $417,000, and $1,422,000 in 1994, 1995, and 1996,
respectively. The increases in interest income were due to differences in the
amounts raised and the timing of each offering as well as the differences in the
levels of cash used in Company operations. The Company expects that interest
income will decrease in the future in proportion to the levels of cash used in
the Company's operations.* See "Liquidity and Capital Resources".
Interest expense incurred by the Company of $71,000, $836,000 and
$1,726,000 in 1994, 1995 and 1996, respectively, has been due primarily to 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. Debt outstanding under these
agreements has increased from $2.3 million to $6.3 million to $12.2 million at
the end of 1994, 1995 and 1996, respectively. The increased interest expense in
1995 versus 1994 was due to leasing activity under an agreement made in the
fourth quarter of 1995, which was used to refinance much of the capital
additions made in 1994 and to fund substantially all capital equipment additions
made in 1995. The increased expense in 1996 versus 1995 is due to the continued
increase in lease liability resulting from the Company's financing of capital
additions made throughout 1995 and 1996. The Company expects that interest
expense will increase in the future based on the increased levels of borrowing.*
See "Liquidity and Capital Resources."
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20
QUARTERLY RESULTS OF OPERATIONS
The following table presents unaudited quarterly statements of operations
for the Company. The information has been prepared by the Company on a basis
consistent with the Company's audited financial statements and includes all
adjustments, consisting of only normal recurring adjustments that management
considers necessary for a fair presentation of the information for the periods
presented. The Company's quarterly operating results have in the past and may in
the future vary significantly depending on factors such as the volume of
advertising in response to seasonal buying patterns, the timing of new product
and service introductions, increased competition, the timing of the Company's
promotional efforts, general economic factors, and other factors. For example,
the Company has historically experienced lower sales in the first quarter and
higher sales in the fourth quarter, due to increased customer advertising
volumes for the November television sweeps rating period and Christmas selling
season. As a result, the Company believes that period to period comparisons of
its results of operations are not necessarily meaningful and should not be
relied upon as an indication of future performance.
THREE MONTHS ENDED
-----------------------------------------------------------------------------------------
MARCH 31, JUNE 30, SEPT. 30, DEC. 31, MARCH 31, JUNE 30, SEPT. 30, DEC. 31,
1995 1995 1995 1995 1996 1996 1996 1996
--------- -------- --------- -------- --------- -------- --------- --------
(IN THOUSANDS, EXCEPT OPERATING DATA)
STATEMENTS OF OPERATIONS:
Revenues........................... $ 983 $ 1,289 $ 1,146 $ 1,726 $ 1,894 $ 2,359 $ 2,265 $ 4,005
-------- -------- -------- -------- -------- -------- -------- --------
Costs and expenses:
Delivery and material costs...... 330 446 466 568 595 732 694 1,063
Customer operations.............. 689 712 731 842 920 948 904 1,392
Sales and marketing.............. 789 797 880 940 983 970 905 1,140
Research and development......... 413 362 407 408 498 510 519 565
General and administrative....... 356 329 322 373 384 396 407 490
Depreciation and amortization.... 443 530 637 735 838 936 1,181 1,376
-------- -------- -------- -------- -------- -------- -------- --------
Total expenses............... 3,020 3,176 3,443 3,866 4,218 4,492 4,610 6,026
-------- -------- -------- -------- -------- -------- -------- --------
Loss from operations............... (2,037) (1,887) (2,297) (2,140) (2,324) (2,133) (2,345) (2,021)
Other income (expense):
Interest income.................. 97 84 132 104 263 434 399 326
Interest expense................. (173) (200) (221) (242) (327) (388) (451) (560)
-------- -------- -------- -------- -------- -------- -------- --------
Net loss........................... $(2,113) $(2,003) ($2,386) $(2,278) $(2,388) $(2,087) $(2,397) $ (2,255)
======== ======== ======== ======== ======== ======== ======== ========
Net loss per share................. $ (0.23) $ (0.22) $ (0.25) $ (0.23) $ (0.20) $ (0.18) $ (0.21) $ (0.19)
======== ======== ======== ======== ======== ======== ======== ========
Weighted average common and common
equivalent shares................ 9,125 9,133 9,550 9,731 11,675 11,482 11,575 11,642
======== ======== ======== ======== ======== ======== ======== ========
LIQUIDITY AND CAPITAL RESOURCES
From its inception through December 31,1995, the Company had financed its
operations and met its capital expenditure requirements primarily from the
proceeds of private sales of convertible preferred and common stock and through
capital lease agreements. Through December 31, 1995, the Company had raised
$25.5 million from the sale of preferred and common stock and had funded $7.6
million of capital expenditures with long term lease agreements. In 1996, the
Company raised net proceeds of $29.6 million from the sale of common stock,
primarily through it's initial public offering, and an additional $8.0 million
of capital equipment additions were funded through capital lease agreements. At
December 31, 1996, the Company's current sources of liquidity included cash and
cash equivalents of $9.7 million, short-term investments of $10.9 million and
$0.4 million available for capital expenditures remaining under a lease
agreement expiring in March 1997. The Company expects to fully utilize the
funding available under the existing lease agreement. In January 1997, the
Company negotiated an agreement to finance an additional $6.0 million of
equipment purchases through a long-term credit facility. See the Notes to
Consolidated Financial Statements.
The Company's operating activities have used cash of $5.3 million in 1994,
$6.6 million in 1995 and $4.3 million in 1996. The increased use of cash in 1995
versus 1994 is primarily due to the increased operating expenses and increased
operating losses incurred by the Company in 1995. Net cash used in operating
activities decreased in 1996 versus 1995, primarily as a result of a reduced net
loss, exclusive of depreciation and amortization.
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The Company used $2.2 million and $2.4 million of cash in 1994 and 1996,
respectively to purchase property and equipment. In 1995, substantially all of
the Company's equipment additions were financed through capital lease
agreements. In addition, $.5 million, $5.0 million, and $8.0 million of property
and equipment has been acquired through term lease agreements in 1994, 1995 and
1996, respectively. Also, an additional $1.6 million of equipment originally
purchased by the Company in 1994 was later financed through a term note
agreement in that year. The increasing levels of investment in property and
equipment are primarily due to the Companies continued expansion of its network.
In particular, the Company either leased or purchased capital equipment of
approximately $6.0 million in 1996 to support its video delivery service plan.
The Company completed its initial public offering in February 1996. The net
proceeds to the Company, after underwriting discounts and offering expenses,
were $29,490,000. As of December 31, 1996, $10.9 million of the proceeds were
invested in short-term investments, $6.5 million had been invested in the
purchase of PDR, cash held in cash and cash equivalents had increased $3.5
million from the prior year end, and the remainder had been used to fund the
acquisition of property and equipment, the payment of lease obligations and the
continuing operations of the Company. In November 1996 the Company acquired 100%
of the stock of PDR. The purchase price consisted of the $6.5 million of cash
mentioned above and a $2.5 million promissory note due one year from the closing
of the transaction. See the Notes to the Consolidated Financial Statements.
Principal payments on long-term debt were $.2 million, $1.0 million and
$2.1 million in 1994, 1995, and 1996, respectively, reflecting the increases in
regularly scheduled repayment of the increased capital lease liability incurred
to finance equipment and property acquisitions.
The Company currently has no significant capital commitments other than the
commitments under capital leases and the note payable issued in conjunction with
the purchase of PDR. The Company believes that its existing sources of liquidity
will satisfy the Company's projected working capital, capital lease and term
loan commitments and other cash requirements at least through 1997.* See
"Certain Business Considerations -- Future Capital Needs; Uncertainty of
Additional Funding."
CERTAIN BUSINESS CONSIDERATIONS
The Company's business is subject to the following risks and uncertainties,
in addition to those described elsewhere in this report.
History of Losses; Future Operating Results Uncertain. The Company was
founded in 1991 and has been unprofitable since its inception and expects to
continue to generate net losses for a minimum of the next twelve months. As of
December 31, 1996, the Company's accumulated deficit was $28.1 million. The
Company has had difficulty in accurately forecasting its future sales and
operating results due to its limited operating history. Accordingly, although
the Company has recently experienced significant growth in sales, such growth
rates may not be sustainable and should not be used as an indication of future
sales growth, if any, or of future operating results. The Company's future
success will depend in part on obtaining continued reductions in delivery and
service costs, particularly continued automation of order processing and
reductions in telecommunications costs.* There can be no assurance the Company's
sales will grow or be sustained in future periods or that the Company will
achieve or sustain profitability in any future period.
Potential Fluctuations in Quarterly Results; Seasonality. The Company's
quarterly operating results have in the past and may in the future vary
significantly depending on factors such as the volume of advertising in response
to seasonal buying patterns, the timing of new product and service
introductions, increased competition, the timing of the Company's promotional
efforts, general economic factors, and other factors. For example, the Company
has 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, the Company believes that period to
period comparisons of its results of operations are not necessarily meaningful
and should not be relied upon as an indication of future performance. In any
period, the Company's revenues and delivery costs are subject to variation based
on changes in the volume and mix of deliveries performed during the period. In
particular, the Company's operating results have historically been significantly
influenced by the volume of deliveries ordered by television stations during the
"Sweeps" rating periods that currently
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22
take place in February, May, August and November. The increased volume of these
deliveries during such periods and the Company's pricing for "Sweeps"
advertisements have historically increased the total revenues and revenues per
delivery of the Company and tended to reduce delivery costs as a percentage of
revenues. The Company's expense levels are based, in part, on its expectations
of future sales levels. If sales levels are below expectations, operating
results are likely to be materially adversely affected. In addition, the Company
has historically operated with little or no backlog. The absence of backlog
increases the difficulty of predicting sales and operating results. Fluctuations
in sales due to seasonality may become more pronounced as the growth rate of the
Company's sales slows. Due to the unique nature of the Company's products and
services, the Company believes that it will incur significant expenses for sales
and marketing, including advertising, to educate potential customers about such
products and services.*
Dependence on Radio Advertising. The Company's revenues to date have been
derived principally from a single line of business, the delivery of radio
advertising spots from advertising agencies, production studios and dub and ship
houses to radio stations in the United States, and such services are expected to
continue to account for a substantial majority of the Company's revenues for
some time.* A decline in demand for, or average selling prices of, the Company's
radio advertising delivery services, whether as a result of competition from new
advertising media, new product introductions or price competition from
competitors, a shift in purchases by customers away from the Company's premium
services such as DG Express, technological change or otherwise, would have a
material adverse effect on the Company's business, operating results and
financial condition. Additionally, the Company is dependent upon its
relationship with and continued support of the radio stations in which it has
installed communications equipment. Should a substantial number of these
stations go out of business or experience a change in ownership, it could
materially adversely affect the Company's business, operating results and
financial condition
Dependence on Video Advertising Delivery Service Deployment. The Company
has made a substantial investment in upgrading and expanding its network
operating center and populating television stations with the units necessary for
the delivery of video advertising content. However there can be no assurance
that this service offering will achieve market acceptance. The inability to
place units in an adequate number of stations or the inability to capture market
share as a result of price competition or new product introductions from
competitors would have a material adverse effect on the Company's business,
operating results and financial position. In addition, the Company believes that
in order to more fully address the needs of potential customers it will need to
develop a set of ancillary services which are typically provided today by dub
and ship houses. These ancillary services, which include physical archiving,
closed captioning, modification of slates and format conversions, will need to
be provided on a localized basis in each of the major cities in which the
Company provides services directly to agencies and advertisers. The Company
currently has the capability to provide such services to the New York City
market through PDR. However, there can be no assurance that the Company will
successfully contract for and provide these services in each major metropolitan
area or be able to provide competitive video distribution services throughout
the major U.S. markets. Unless the Company can successfully continue to develop
and provide video transmission services, it may be unable to retain current or
attract future audio delivery customers who may ultimately demand delivery of
both media content.
Uncertainties Relating to Integration of Operations. DG Systems acquired
PDR with the expectation that this would result in synergies for the combined
company. Achieving the anticipated benefits of the PDR acquisition will depend
in part upon whether the integration of the two companies' organizations and
businesses is achieved in an efficient, effective and timely manner; however,
there can be no assurance that this will occur. The successful integration and
expansion of the Company's business following its acquisition of PDR requires
communication and cooperation among the senior executives and key technical
personnel of DG Systems and PDR. Given the inherent difficulties involved in
completing a business combination, there can be no assurance that such
cooperation will occur or that the integration of the respective organizations
will be successful and will not result in disruptions in one or more sectors of
the Company's business. Failure to effectively accomplish the integration of the
two companies' operations could have a material adverse effect on DG Systems'
results of operations and financial condition. In addition, there can be no
assurance that the market will favorably view DG Systems' offering of
duplication, distribution and editing services through PDR
20
23
or that DG Systems will realize any of the other anticipated benefits of the PDR
acquisition. As a result of the acquisition, certain DG Systems customers may
perceive PDR to be a competitor, and this could affect such customers'
willingness to do business with DG Systems in the future. The loss of
significant customers could have a material adverse effect on DG Systems'
results of operations and financial condition.
Dependence on New Product Introductions. The Company's future growth
depends on its successful and timely introduction of new products and services
in markets that do not currently exist or are just emerging. The Company's goals
are to introduce new services, such as media archiving and the ability to
quickly and reliably give an agency the ability to preview and authorize
delivery of video advertising spots. The Company is also designing, developing
and field testing, together with ABC Radio Networks, an extension to the
Company's existing network, including satellite transmission capabilities,
through which ABC could electronically distribute advertising and programming to
ABC's affiliate radio stations. The Company, however, has not yet completed the
field trials of these products or services, and there can be no assurance that
the Company will successfully complete any such field trials or development, or
that if such development or field trials are completed, the Company's planned
introduction of these products and services will realize market acceptance or
will meet the technical or other requirements of potential customers.
Dependence on Emerging Markets. 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.
The Company's marketing task requires it to overcome buyer inertia related to
the diffuse and relatively low level decision making regarding an agency's
choice of delivery services, long standing relationships with existing dub and
ship vendors, and, currently, a service offering which is limited in comparison
to the offerings of some 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 at all. If the market fails to grow,
or grows more slowly than anticipated, the Company's business, operating results
and financial condition will be materially adversely affected. Even if the
market does grow, there can be no assurance that the Company's products and
services will achieve commercial success. Although the Company intends to
conform its products and services to meet existing and emerging standards in the
market for the electronic delivery of digital audio and video transmissions,
there can be no assurance that the Company will be able to conform its products
to such standards in a timely fashion, or at all. The Company believes that its
future growth will depend, in part, on its ability to add these services and
additional customers in a timely and cost-effective manner, and there can be no
assurance that the Company will be successful in developing such services, in
obtaining new customers, or 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 installing and supporting the Company's field receiving
equipment, including rooftop satellite antennae.
The Company's limited marketing efforts to date with regard to the
Company's 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. There can be no assurance that the Company has
correctly identified such markets or that its planned products and services will
address the needs of such markets. Furthermore, there can be no assurance that
the Company's technologies, in their current form, will be suitable for specific
applications or that further design modifications, beyond anticipated changes to
accommodate different markets, will not be necessary. Broad commercialization of
the Company's products and services will require the Company to overcome
significant market development hurdles, many of which may not currently be
foreseen.
Dependence on Technological Developments. The market for the distribution
of digital audio and video transmissions is characterized by rapidly changing
technology. The Company's ability to remain competitive and its future success
will depend in significant part upon the technological quality of its products
and processes relative to those of its competitors and its ability both to
develop new and enhanced products and services and to introduce such products
and services at competitive prices and in a timely and cost-effective fashion.
The Company's development efforts have been focused on the areas of satellite
transmission
21
24
technology, video compression technology and reliability and throughput
enhancement of the network. The Company's ability to successfully roll out and
expand its electronic video delivery services depends on its ability to maintain
reliable satellite delivery capability. Work in satellite technology is oriented
to development and deployment of software to lower transmission costs and
increase delivery reliability. Work in video compression technology is directed
toward integration of emerging broadcast quality compression systems, which
further improve picture quality while increasing the compression ratio, with the
Company's existing network. The Company has an agreement with Hughes Network
Systems, Inc. ("Hughes") which allows the Company to use Hughes' satellite
capacity for electronic delivery of digital audio and video transmissions by
that media. The Company has developed and incorporated software designed to
enable the current RPTs to receive digital satellite transmissions over the
Hughes satellite system. There can be no assurance that the Hughes satellite
system will have the capacity to meet the Company's future delivery commitments
and broadcast quality requirements.
In addition, the Company has entered into an agreement with ABC Radio
Networks ("ABC") to jointly develop an extension to the Company's existing
network, including satellite transmission capabilities, through which ABC could
electronically distribute advertising, news, and programming to ABC's affiliate
radio stations. There can be no assurance that the Company will successfully
complete the testing or deployment of the audio server network for ABC. In
addition, there can be no assurance that ABC will successfully develop and
deploy an enhanced satellite network with the capacity to meet the delivery and
audio quality requirements of the audio server network.
The introduction of products embodying new technologies can render existing
products obsolete or unmarketable. There can be no assurance that the Company
will be successful in identifying, developing, contracting for the manufacture
of, and marketing product enhancements or new products that respond to
technological change, that the Company will not experience difficulties that
could delay or prevent the successful development, introduction and marketing of
these products, or that its new products and product enhancements will
adequately meet the requirements of the marketplace and achieve market
acceptance. Delays in the commencement of commercial availability of new
products and services and enhancements to existing products and services may
result in customer dissatisfaction and delay or loss of revenue. If the Company
is unable, for technological or other reasons, to develop and introduce new
products and services or enhancements of existing products and services in a
timely manner or if new versions of existing products do not achieve a
significant degree of market acceptance, there could be a material adverse
effect on the Company's business, financial condition and results of operations.
Competition. The Company 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. The Company competes with a variety of dub and ship houses and
production studios that have traditionally distributed taped advertising spots
via physical delivery. Although such dub and ship houses and production studios
do not currently offer electronic delivery, they have long-standing ties to
local distributors that will be difficult for the Company 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 the Company. Moreover, Digital Courier International
Corporation has begun deployment of a system to electronically deliver audio
content in Canada and the United States and several other companies have
announced such systems. As a result, there can be no assurance that the Company
will be able to compete effectively against these competitors merely on the
basis of ease of use, timeliness and accuracy of delivery.
In the market for the electronic distribution of digital video
transmissions to television stations, the Company encounters competition from
VADS, Indenet and VDI Media, in addition to dub and ship houses and production
studios, certain of which currently function as marketing partners with the
Company in the audio distribution market. To the extent that the Company is
successful in entering new markets, such as the delivery of other forms of
content to radio and television stations, it would expect to face competition
from companies in related communications markets and/or package delivery markets
which could offer products and services with functionality similar or superior
to that offered by the Company's products and services. Telecommunications
providers such as AT&T, MCI and Regional Bell Operating Companies could also
enter
22
25
the market as competitors with materially lower electronic delivery
transportation costs. The Company 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. In addition, Applied Graphics Technologies, Inc., a provider of
digital pre-press services, has indicated its intention to provide electronic
distribution services and acquired Spotlink, a dub and ship house, in December
1996. Although Spotlink revenues were less than 5% of the Company's revenues in
1996, the Company considers Spotlink to be a significant customer for the
Company's audio delivery service. There can be no assurance that Spotlink will
continue to be a customer of the Company, and the loss of Spotlink as a customer
could have a material adverse effect on the Company's operating results.
Many of the Company's 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 the
Company. There can be no assurance that the Company will be able to compete
successfully against current and future competitors based on these and other
factors. The Company expects that an increasingly competitive environment will
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 the
Company's business, results of operations and financial condition. 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 the Company's competitors to devote significantly
greater resources to the development and marketing of new competitive products
and services. The Company expects that competition will increase substantially
as a result of these and other industry consolidations and alliances, as well as
the emergence of new competitors. There can be no assurance that the Company
will be able to compete successfully with new or existing competitors or that
competitive pressures faced by the Company will not materially and adversely
affect its business, operating results and financial condition.
Ability to Maintain and Improve Service Quality. The Company's business is
dependent on its ability to make deliveries to broadcast stations within the
time periods requested by customers. Any failure to do so, whether or not within
the control of the Company, could result in an advertisement not being run and
in the station losing air-time which it could have otherwise sold. Although the
Company disclaims any liability for lost air-time, there can be no assurance
that claims by stations for lost air-time would not be asserted in these
circumstances or that dissatisfied advertisers would refuse to make further
deliveries through the Company in the event of a significant occurrence of lost
deliveries, either of which would have a material adverse effect on the
Company's business, results of operations and financial condition. Although the
Company maintains insurance against business interruption, there can be no
assurance that such insurance will be adequate to protect the Company from
significant loss in these circumstances or that a major catastrophe (such as an
earthquake or other natural disaster) would not result in a prolonged
interruption of the Company's business. In particular, the Company's network
operating center 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 the Company's network operating center. In addition, the
Company's 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 its control, including equipment failure, interruption in services by
telecommunications service providers, and the Company's inability to maintain
its installed base of RSTs, RPTs and video units that comprise its distribution
network. The result of the Company's failure to make timely deliveries for
whatever reason could be that dissatisfied advertisers would refuse to make
further deliveries through the Company which would have a material adverse
effect on the Company's business, results of operations and financial condition.
Ability to Manage Growth. The Company has recently experienced a period of
rapid growth that has resulted in new and increased responsibilities for
management personnel and has placed and continues to place a significant strain
on the Company's management, operating and financial systems and resources. To
accommodate this recent growth and to compete effectively and manage future
growth, if any, the Company will be required to continue to implement and
improve its operational, financial and management information systems,
procedures and controls on a timely basis and to expand, train, motivate and
manage its work force.
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26
In particular, the Company believes that to achieve these objectives it must
complete its automation of the customer order entry process and the integration
of the delivery fulfillment process into the customer billing system. There can
be no assurance that the Company's personnel, systems, procedures and controls
will be adequate to support the Company's existing and future operations. Any
failure to implement and improve the Company's operational, financial and
management systems or to expand, train, motivate or manage employees could have
a material adverse effect on the Company's business, operating results and
financial condition.
Future Capital Needs; Uncertainty of Additional Funding. The Company
intends to continue making capital expenditures to produce and install RSTs,
RPTs, and video units and to introduce additional services.* Based on current
plans and assumptions relating to the timing of its operations, the Company
anticipates that the net proceeds of its initial public offering, completed in
February 1996, together with its existing capital and cash from operations, will
be adequate to satisfy its capital requirements through at least December 1997.*
There can be no assurance, however, that the net proceeds of the Company's
initial public offering and such other sources of funding will be sufficient to
satisfy the Company's future capital requirements. Based on its current business
plan, the Company anticipates that it will eventually use the entire proceeds of
its initial public offering and there can be no assurance that other sources of
funding will be adequate to fund the Company's capital needs, which depend upon
numerous factors, including the progress of the Company's product development
activities, the cost of increasing the Company's sales and marketing activities
and the amount of revenues generated from operations, none of which can be
predicted with certainty. There can be no assurance that the Company will not
require additional capital sooner than currently anticipated. In addition, the
Company is unable to predict the precise amount of future capital that it will
require and there can be no assurance that any additional financing will be
available to the Company on acceptable terms, or at all. The inability to obtain
required financing would have a material adverse effect on the Company's
business, financial condition and results of operations. Consequently, the
Company could be required to significantly reduce or suspend its operations,
seek a merger partner or sell additional securities on terms that are highly
dilutive to existing investors.
Expansion into International Markets. Although the Company's plans include
expansion of its operations to Europe and Asia, it does not at present have
network operating center personnel experienced in operating in these locations.*
Telecommunications standards in foreign countries differ from those in the
United States and may require the Company to incur substantial costs and expend
significant managerial resources to obtain any necessary regulatory approvals
and comply with differing equipment interface and installation standards
promulgated by regulatory authorities of those countries. Changes in government
policies, regulations and telecommunications systems in foreign countries could
require the Company's products and services to be redesigned, causing product
and service delivery delays that could materially adversely affect the Company's
operating results. The Company's ability to successfully enter these new markets
will depend, in part, on its ability to attract personnel with experience in
these locations and to attract partners with the necessary local business
relationships.* There can be no assurance, however, that the Company's products
and services will achieve market acceptance in foreign countries. The inability
of the Company to successfully establish and expand its international operations
may also limit its ability to obtain significant international revenues and
could materially adversely affect the business, operating results and financial
condition of the Company. Furthermore, international business is subject to a
number of country-specific risks and circumstances, including different tax
laws, difficulties in expatriating profits, currency exchange rate fluctuations,
and the complexities of administering business abroad. Moreover, to the extent
the Company increases its international sales, the Company's business, operating
results and financial condition could be materially adversely affected by these
risks and circumstances, as well as by increases in duties, price controls or
other restrictions on foreign currencies, and trade barriers imposed by foreign
governments, among other factors.
Dependence on Key Personnel. The Company's success depends to a significant
degree upon the continuing contributions of, and on its ability to attract and
retain, qualified management, sales, operations, marketing and technical
personnel. The competition for qualified personnel is intense and the loss of
any of such persons, as well as the failure to recruit additional key personnel
in a timely manner, could adversely affect the Company. There can be no
assurance that the Company will be able to continue to attract and retain
24
27
qualified management, sales and technical personnel for the development of its
business. The Company generally has not entered into employment or
noncompetition agreements with any of its employees. The Company does not
maintain key man life insurance on the lives of any of its key personnel. The
Company's failure to attract and retain key personnel could have a material
adverse effect on its business, operating results and financial condition.
Dependence on Certain Suppliers. The Company relies on certain single or
limited-source suppliers for certain integral components used for the assembly
of the Company's RSTs, RPTs and video units. Although the Company's 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 the Company, it would delay the
Company's deployment of RSTs, RPTs and video units which would have the effect
of depressing the Company's business until the Company established sufficient
component supply through an alternative source. The Company believes that there
are alternative component manufacturers that could supply the components
required to produce the Company's products, but the Company is 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 the Company to qualify an alternative subcontractor, redesign
its products as necessary and contract for the manufacture of such products. The
Company does not have long-term supply contracts with its sole- or
limited-source vendors and purchases its components on a purchase order basis.
The Company has experienced component shortages in the past and there can be no
assurance that material component shortages or production or delivery delays
will not occur in the future. The inability in the future 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 materially and adversely affect the
Company's business, operating results and financial condition.
Pursuant to its development efforts in the area of satellite transmission
technology, the Company has successfully completed live field trials of software
designed to enhance and enable the current RPTs to receive digital satellite
transmissions over the Hughes satellite system. The Company's dependence on
Hughes entails a number of significant risks. The Company's business, results of
operations and financial condition would be materially adversely affected if
Hughes were unable for any reason to continue meeting the Company's delivery
commitments or if any transmissions failed to satisfy the Company's quality
requirements. In the event that the Company were unable to continue to use
Hughes' satellite capacity, the Company would have to identify, qualify and
transition deliveries to an acceptable alternative satellite transmission
vendor. This identification, qualification and transition process could take
nine months or longer, and no assurance can be given that an alternative
satellite transmission vendor would be available to the Company or be in a
position to satisfy the Company's delivery requirements on a timely and
cost-effective basis.
The Company obtains its local access telephone transmission services
through Teleport Communications Group. The Company obtains its long distance
telephone access through an exclusive contract with MCI which expires in 1997.
The Company is currently negotiating with MCI and other long distance carriers
to reach agreement on terms for providing this service in the future. Any
material interruption in the supply or a material adverse change in the price of
either local access or long distance carrier service could have a material
adverse effect on the Company's business, results of operations and financial
condition.
Dependence on Proprietary Technology, Protection of Trademarks, Copyrights,
and Other Proprietary Information; Risk of Third Party Claims of
Infringement. The Company considers its trademarks, copyrights, advertising, and
promotion design and artwork to be of value and important to its business. The
Company relies on a combination of trade secret, copyright and trademark laws
and nondisclosure and other arrangements to protect its proprietary rights. The
Company does not have any patents or patent applications pending. Despite the
Company's efforts to protect its proprietary rights, unauthorized parties may
attempt to copy or obtain and use information that the Company regards as
proprietary. There can be no assurance that the steps taken by the Company to
protect its proprietary information will 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 those of the Company. In addition, the laws of some
foreign countries do not protect the Company's proprietary rights to the same
extent
25
28
as do the laws of the United States. While the Company believes that its
trademarks, copyrights, advertising and promotion design and artwork do not
infringe upon the proprietary rights of third parties, there can be no assurance
that the Company will not receive future communications from third parties
asserting that the Company's trademarks, copyrights, advertising and promotion
design and artwork infringe, or may infringe, on the proprietary rights of third
parties. Any such claims, with or without merit, could be time-consuming,
require the Company to enter into royalty arrangements or result in costly
litigation and diversion of management personnel. No assurance can be given that
any necessary licenses can be obtained or that, if obtainable, such licenses can
be obtained on commercially reasonable terms. In the event of a successful claim
of infringement against the Company and failure or inability of the Company to
license the infringed or similar proprietary information, the Company's
business, operating results and financial condition could be materially
adversely affected.
Concentration of Stock Ownership; Potential Issuance of Preferred Stock;
Anti-Takeover Provisions. The present executive officers and directors of the
Company and their affiliates own approximately 36% of the Company's Common
Stock. As a result, these shareholders will be able to control or significantly
influence all matters requiring shareholder approval, including the election of
directors and approval of significant corporate transactions. Such concentration
of ownership may have the effect of delaying or preventing a change in control
of the Company. In addition, the Company's Board of Directors has the authority
to issue up to 5,000,000 shares of Preferred Stock and to determine the price,
rights, preferences, privileges and restrictions thereof, including voting
rights, without any further vote or action by the Company's shareholders.
Although the Company has no current plans to issue any shares of Preferred
Stock, the rights of the holders of Common Stock would be subject to, and may be
adversely affected by, the rights of the holders of any Preferred Stock that may
be issued in the future. Issuance of Preferred Stock could have the effect of
delaying, deferring or preventing a change in control of the Company.
Furthermore, certain provisions of the Company's Articles of Incorporation and
Bylaws and of California law could have the effect of delaying, deferring or
preventing a change in control of the Company.
Possible Volatility of Share Price. The trading prices of the Company's
Common Stock may be subject to wide fluctuations in response to a number of
factors, including variations in operating results, changes in earnings
estimates by securities analysts, announcements of extraordinary events such as
litigation or acquisitions, announcements of technological innovations or new
products or services by the Company or its competitors, as well as general
economic, political and market conditions. In addition, stock markets have
experienced extreme price and volume trading volatility in recent years. This
volatility has had a substantial effect on the market prices of the securities
of many high technology companies for reasons frequently unrelated to the
operating performance of specific companies. These broad market fluctuations may
adversely affect the market price of the Company's Common Stock.
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
Not applicable.
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 definitive
proxy statement filed with the Securities and Exchange Commission by the Company
for its 1997
26
29
annual meeting of shareholders (the "Proxy Statement"). For information with
respect to executive officers of the Company, see Item 4A of this report.
ITEM 11. EXECUTIVE COMPENSATION
The information required by this Item is incorporated by reference to the
information contained in the section captioned "Executive Compensation" 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
information contained in 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.
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
----
Report of Arthur Andersen LLP, Independent Public Accountants....... F-2
Consolidated Balance Sheets......................................... F-3
Consolidated Statements of Operations............................... F-4
Consolidated Statements of Shareholders' Equity..................... F-5
Consolidated Statements of Cash Flows............................... F-6
Notes to Consolidated Financial Statements.......................... F-7
(a) 2. FINANCIAL STATEMENT SCHEDULES
II -- Valuation and Qualifying Accounts............................. S-1
(a) 3. EXHIBITS
EXHIBIT
NUMBER EXHIBIT TITLE
------ ----------------------------------------------------------------------------
3.1 (d) Restated Articles of Incorporation of registrant.
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 Nonstatutory 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.
27
30
EXHIBIT
NUMBER EXHIBIT TITLE
------ ----------------------------------------------------------------------------
10.6 (b) Amendment to Warrant Agreement between the Company and Comdisco, Inc., dated
January 31, 1996.
10.7.1(c) Corporate Service Plan Agreement between the Company and MCI
Telecommunications dated March 23, 1994.
10.7.2(c) First Amendment to Corporate Service Plan Agreement between the Company and
MCI Corporation, Telecommunications Corporation, dated November 2, 1995.
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.
10.10 (b) Master Equipment Lease between the Company and Phoenix Leasing, Inc., dated
January 7, 1993.
10.15 (c) Audio Server Network Prototype Vendor Agreement and Satellite Vendor
Agreement between the Company and ABC Radio Networks, dated December 15,
1995.
10.17 (b) Promissory Note between the Company and Henry W. Donaldson, dated March 18,
1994, December 5, 1994, December 5, 1994, and March 14, 1995.
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., dated as of September 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.
11.1 (a) Statements of computation of weighted average and pro forma common shares
and equivalents.
21.1 (a) Subsidiaries of the Registrant.
23.1 (a) Consent of Independent Public Accountants.
27 (a) Financial Data Schedule.
- ---------------
+ Management contract or compensatory plan or arrangement required to be filed
as an exhibit in this form pursuant to Item 14(c) of this report.
(a) Filed herewith.
(b) Incorporated by reference to the exhibit bearing the same number filed with
the 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
the 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.
28
31
(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 number filed with
registrant's Current Report on Form 8-K/A filed January 21, 1997.
(b) REPORTS ON FORM 8-K
Current Report on Form 8-K filed November 22, 1996, reporting that
registrant had acquired all of the outstanding stock of PDR Productions, Inc.,
on November 8, 1996.
Current Report on Form 8-K filed October 31, 1996, reporting that
registrant had entered into a definitive agreement to acquire 100% of the stock
of PDR Productions, Inc.
(c) EXHIBITS
See items 14 (a)(3) above
(d) FINANCIAL STATEMENT SCHEDULES
Financial Statement Schedules. See Item 14(a) (2) above.
29
32
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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 17, 1997 By: /s/ HENRY W. DONALDSON
------------------------------------
Henry W. Donaldson
President and Chief Financial
Officer
POWER OF ATTORNEY
KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature
appears below hereby constitutes and appoints Henry W. Donaldson 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/ HENRY W. DONALDSON President, Chief Executive March 17, 1997
- --------------------------------------------- Officer and Director
Henry W. Donaldson (Principal Executive
Officer)
/s/ THOMAS P. SHANAHAN Chief Financial Officer March 17, 1997
- --------------------------------------------- (Principal Financial and
Thomas P. Shanahan Accounting Officer)
/s/ KEVIN R. COMPTON Director March 17, 1997
- ---------------------------------------------
Kevin R. Compton
/s/ JEFFREY M. DRAZAN Director March 17, 1997
- ---------------------------------------------
Jeffrey M. Drazan
/s/ RICHARD H. HARRIS Director March 17, 1997
- ---------------------------------------------
Richard H. Harris
/s/ LEONARD S. MATTHEWS Director March 17, 1997
- ---------------------------------------------
Leonard S. Matthews
30
33
DIGITAL GENERATION SYSTEMS, INC.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Report of Independent Public Accountants.............................................. F-2
Consolidated Balance Sheets as of December 31, 1995 and 1996.......................... F-3
Consolidated Statement of Operations for the three years ended December 31, 1996...... F-4
Consolidated Statement of Shareholders' Equity for the three years ended December 31,
1996................................................................................ F-5
Consolidated Statements of Cash Flows for the three years ended December 31, 1996..... F-6
Notes to Consolidated Financial Statements............................................ F-7
F-1
34
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To Digital Generation Systems, Inc.:
We have audited the accompanying consolidated balance sheets of Digital
Generation Systems, Inc. (a California Corporation) and subsidiary as of
December 31, 1996 and 1995, and the related consolidated statements of
operations, shareholders' equity and cash flows for each of the three years in
the period ended December 31, 1996. 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 based on
our audits.
We conducted our audits 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 audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly,
in all material respects, the financial position of Digital Generation Systems,
Inc. and subsidiary as of December 31, 1996 and 1995, and the results of its
operations and its cash flows for each of the three years in the period ended
December 31, 1996, in conformity with generally accepted accounting principles.
Our audits were 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 part of the basic financial statements. This
schedule 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 Jose, California
January 28, 1997
F-2
35
DIGITAL GENERATION SYSTEMS, INC.
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARE AMOUNTS)
DECEMBER 31, DECEMBER 31,
ASSETS 1996 1995
------------ ------------
CURRENT ASSETS:
Cash and cash equivalents........................................ $ 9,682 $ 6,205
Short-term investments........................................... 10,915 --
Accounts receivable, less allowance for doubtful accounts of $257
in 1996 and $135 in 1995...................................... 3,349 1,368
Prepaid expenses and other....................................... 168 624
-------- --------
Total current assets..................................... 24,114 8,197
-------- --------
PROPERTY AND EQUIPMENT, at cost:
Network equipment................................................ 17,974 7,931
Office furniture and equipment................................... 2,093 1,373
Leasehold improvements........................................... 353 83
-------- --------
20,420 9,387
Less -- Accumulated depreciation and amortization................ (7,790) (3,615)
-------- --------
Property and equipment, net................................... 12,630 5,772
-------- --------
GOODWILL AND OTHER ASSETS, net..................................... 8,504 490
-------- --------
$ 45,248 $ 14,459
======== ========
LIABILITIES AND SHAREHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable................................................. $ 1,546 $ 596
Accrued liabilities.............................................. 2,174 1,203
Note payable from acquisition of PDR............................. 2,500 --
Current portion of long-term debt................................ 3,694 1,747
-------- --------
Total current liabilities................................ 9,914 3,546
-------- --------
LONG-TERM DEBT, net of current portion............................. 8,495 4,540
-------- --------
COMMITMENTS AND CONTINGENCIES (Note 5)
SHAREHOLDERS' EQUITY:
Convertible preferred stock, no par value --
Authorized -- 5,000,000 shares at December 31, 1996 and
7,873,322 shares at December 31, 1995
Outstanding -- none outstanding at December 31, 1996 and
7,273,759 shares at December 31, 1995; aggregate liquidation
preference of $25,433 at December 31, 1995................... -- 25,321
Common stock, no par value --
Authorized -- 30,000,000 shares
Outstanding -- 11,653,625 shares at December 31, 1996 and
1,112,204 shares at December 31, 1995........................ 55,138 224
Receivable from issuance of common stock......................... (175) (175)
Accumulated deficit.............................................. (28,124) (18,997)
-------- --------
Total shareholders' equity............................... 26,839 6,373
-------- --------
$ 45,248 $ 14,459
======== ========
The accompanying notes are an integral part of these consolidated financial
statements.
F-3
36
DIGITAL GENERATION SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
YEARS ENDED DECEMBER 31,
-------------------------------
1996 1995 1994
------- ------- -------
REVENUES...................................................... $10,523 $ 5,144 $ 2,432
------- ------- -------
COSTS AND EXPENSES:
Delivery and material costs................................. 3,084 1,810 953
Customer operations......................................... 4,164 2,974 1,886
Sales and marketing......................................... 3,998 3,406 2,248
Research and development.................................... 2,092 1,590 1,048
General and administrative.................................. 1,677 1,380 1,054
Depreciation and amortization............................... 4,331 2,345 913
------- ------- -------
Total expenses...................................... 19,346 13,505 8,102
------- ------- -------
LOSS FROM OPERATIONS.......................................... (8,823) (8,361) (5,670)
OTHER INCOME (EXPENSE):
Interest income............................................. 1,422 417 129
Interest expense............................................ (1,726) (836) (71)
------- ------- -------
NET LOSS...................................................... $(9,127) $(8,780) $(5,612)
======= ======= =======
PRO FORMA NET LOSS PER SHARE.................................. $ (0.79) $ (0.94)
======= =======
PRO FORMA WEIGHTED AVERAGE COMMON AND COMMON EQUIVALENT
SHARES...................................................... 11,594 9,360
======= =======
The accompanying notes are an integral part of these consolidated financial
statements.
F-4
37
DIGITAL GENERATION SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
CONVERTIBLE RECEIVABLE
PREFERRED STOCK COMMON STOCK FROM TOTAL
--------------------- -------------------- ISSUANCE OF ACCUMULATED SHAREHOLDERS'
SHARES AMOUNT SHARES AMOUNT COMMON STOCK DEFICIT EQUITY
---------- -------- ---------- ------- ------------ ----------- -------------
BALANCE AT DECEMBER 31, 1993.......... 3,009,799 $ 5,955 478,084 $ 8 $ -- ($ 4,605) $ 1,358
Issuance of common stock at $.20 to
$.30 per share for services
rendered.......................... -- -- 66,925 18 -- -- 18
Exercise of stock options at $.20
per share......................... -- -- 15,824 3 -- -- 3
Sale of common stock at $.20 to $.30
per share to a related party...... -- -- 325,000 77 (77) -- --
Sale of Series B preferred stock at
$2.70 per share, net of issuance
costs of $18...................... 2,222,217 5,982 -- -- -- -- 5,982
Sale of Series C preferred stock at
$6.00 per share, net of issuance
costs of $10...................... 1,460,494 8,753 -- -- -- -- 8,753
Net loss............................ -- -- -- -- -- (5,612) (5,612)
---------- -------- ---------- -------- ----- -------- -------
BALANCE AT DECEMBER 31, 1994.......... 6,692,510 20,690 885,833 106 (77) (10,217) 10,502
Issuance of common stock at $.30 to
$.60 per share for services
rendered.......................... -- -- 32,686 13 -- -- 13
Exercise of stock options at $.20 to
$.30 per share.................... -- -- 31,185 7 -- -- 7
Sale of common stock at $.60 per
share to a related party.......... -- -- 162,500 98 (98) -- --
Sale of Series D preferred stock at
$8.00 per share, net of issuance
costs of $19...................... 581,249 4,631 -- -- -- -- 4,631
Net loss............................ -- -- -- -- -- (8,780) (8,780)
---------- -------- ---------- -------- ----- -------- -------
BALANCE AT DECEMBER 31, 1995.......... 7,273,759 25,321 1,112,204 224 (175) (18,997) 6,373
Conversion of preferred stock to
common stock...................... (7,273,759) (25,321) 7,273,759 25,321 --
Issuance of common stock in
connection with initial public
offering, less $1,200 in issuance
costs............................. -- -- 3,000,000 29,490 -- -- 29,490
Warrants exercised for common
stock............................. -- -- 29,161 -- -- -- --
Exercise of stock options at $.20 to
$7.00 per share................... -- -- 238,501 103 -- -- 103
Net loss............................ -- -- -- -- -- (9,127) (9,127)
---------- -------- ---------- -------- ----- -------- -------
BALANCE AT DECEMBER 31, 1996.......... -- $ -- 11,653,625 $55,138 ($ 175) ($ 28,124) $26,839
========== ======== ========== ======== ===== ======== =======
The accompanying notes are an integral part of these consolidated financial
statements.
F-5
38
DIGITAL GENERATION SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
YEARS ENDED DECEMBER 31,
--------------------------------
1996 1995 1994
-------- ------- -------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss................................................... $ (9,127) $(8,780) $(5,612)
Adjustments to reconcile net loss to net cash used in
operating activities:
Depreciation and amortization........................... 4,260 2,345 913
Amortization of goodwill and intangibles................ 71 -- --
Stock issued for services rendered...................... -- 13 18
Provision for doubtful accounts......................... 97 137 129
Changes in operating assets and liabilities --
Accounts receivable................................... (779) (604) (882)
Prepaid expenses and other assets..................... (27) (841) (153)
Accounts payable and accrued liabilities.............. 1,241 1,128 323
-------- ------- -------
Net cash used in operating activities.............. (4,264) (6,602) (5,264)
-------- ------- -------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of short-term investments......................... (33,138) -- --
Maturities of short-term investments....................... 22,223 -- --
Acquisition of PDR, net of cash acquired................... (6,394)
Acquisition of property and equipment...................... (2,417) (13) (2,164)
-------- ------- -------
Net cash used in investing activities.............. (19,726) (13) (2,164)
-------- ------- -------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from issuance of common stock..................... 29,593 7 3
Proceeds from issuance of convertible preferred stock...... -- 4,631 11,787
Proceeds from bridge financing and other notes payable..... -- -- 4,582
Payments on long-term debt................................. (2,126) (1,039) (218)
-------- ------- -------
Net cash provided by financing activities.......... 27,467 3,599 16,154
-------- ------- -------
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS......... 3,477 (3,016) 8,726
CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR............... 6,205 9,221 495
-------- ------- -------
CASH AND CASH EQUIVALENTS AT END OF YEAR..................... $ 9,682 $ 6,205 $ 9,221
======== ======= =======
The accompanying notes are an integral part of these consolidated financial
statements.
F-6
39
DIGITAL GENERATION SYSTEMS, INC.
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
electronic delivery and related services to the broadcast industry by linking
content providers to radio and television stations. The Company is a provider of
electronic distribution of audio spot advertising to radio stations. The Company
derives its revenues from advertising agencies, production studios and other
service providers that have traditionally relied upon physical delivery methods.
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; the ability to
compete successfully against current and future competitors; and dependence on
key personnel and the need for additional financing to fund operations and its
capital expenditure retirements. 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
long distance telephone access through an exclusive contract with a telephone
service provider which expires in 1997. 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. In addition, as required by Statement of
Financial Accounting Standards No. 121 "Accounting for the Impairment of
Long-Lived Assets and for Long-Lived Assets to be Disposed Of," the Company
regularly evaluates the remaining life and recoverability of its network
equipment. The Company adopted the provisions of this statement in 1995. The
adoption did not have a significant effect on the Company's financial position
and results of operations. Given the emerging nature of its markets, it is
possible that the Company's estimate that it will recover the net carrying value
of the equipment from future operations could change in the future.
2. ACQUISITION:
On November 8, 1996 the Company completed the acquisition of 100% of the
stock of PDR Productions, Inc., ("PDR"), a media duplication and distribution
company located in New York City, for consideration totaling $9.0 million. The
consideration was $6.5 million in cash and a $2.5 million promissory note with
interest payable at 8%. The note and accrued interest are due in November 1997.
The acquisition was accounted for as a purchase. The net book value of assets
and liabilities acquired was approximately $1.5 million. The excess of purchase
price and acquisition costs over the net book value of assets acquired
(including customer list, covenant not to compete and goodwill) of approximately
$7.9 million, has been included in Goodwill and Other Assets in the accompanying
consolidated balance sheet and is being amortized over a twenty year period.
Amortization expense of approximately $71,000 is included in the consolidated
statement of operations for the year ended December 31, 1996. The operating
results of PDR are included in the consolidated results of the Company from the
date of the closing of the transaction, November 8, 1996.
The following table reflects unaudited pro forma combined results of
operations of the Company and PDR on the basis that the acquisition had taken
place at the beginning of the first fiscal year presented:
TWELVE MONTHS ENDED
-----------------------------
DECEMBER 31, DECEMBER 31,
1996 1995
------------ ------------
(IN THOUSANDS EXCEPT PER
SHARE DATA)
Revenues........................................... $ 16,932 $ 13,008
Net Loss........................................... $ (9,794) $ (9,713)
Net Loss per Share................................. $ (.84) $ (1.04)
Number of Shares used in Computation............... 11,594 9,360
F-7
40
DIGITAL GENERATION SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
The unaudited pro forma combined results of operations are not necessarily
indicative of the actual results that would have occurred had the acquisition
been consummated at the beginning of 1995 or of future operations of the
combined companies under the ownership and management of the Company.
3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:
CONSOLIDATION
The consolidated financial statements include the accounts of the Company
and its subsidiary, PDR, after elimination of intercompany accounts and
transactions.
USE OF ESTIMATES IN PREPARATION OF FINANCIAL STATEMENTS
The preparation of financial statements in conformity with generally
accepted accounting principles 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.
CASH AND CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS
In accordance with the Statement of Financial Accounting Standards No. 115,
"Accounting for Certain Investments in Debt and Equity Securities", the Company
has classified all marketable debt securities as held-to-maturity and have
valued these investments using the amortized cost method. Cash and cash
equivalents consist of liquid investments with original maturities of three
months or less. Short-term investments are marketable securities with original
maturities greater than three months and less than one year. As of December 31,
1996 and 1995, cash and cash equivalents consist principally of U.S. Treasury
bills and various money market accounts; as a result, the amortized purchase
cost approximates the fair market value. As of December 31, 1996, short-term
investments consist principally of U.S. Treasury bills and commercial paper and
amortized cost approximates the fair market value of these instruments at the
balance sheet date.
PROPERTY AND EQUIPMENT
Network equipment includes the network operating center, Record Send
Terminals, Receive Playback Terminals, Video 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 depreciates its property and
equipment on a straight-line basis over their estimated useful lives, generally
three years.
PRO FORMA NET LOSS PER SHARE
Net loss per share for the twelve months ended December 31, 1996 and
December 31, 1995 is computed on a pro forma basis. Pro forma net loss per share
is computed using the weighted average number of common and common equivalent
shares outstanding during the period. Common equivalent shares consist of
convertible preferred stock (using the "if converted" method) and stock options
and warrants (using the treasury stock method). As the Company has incurred
losses since inception, common equivalent shares have been excluded from the
computation as their effect is antidilutive; however, pursuant to Securities and
Exchange Commission requirements, such computations include all common and
common equivalent shares issued within the 12 months preceding the February 1996
Form S-1 filing date as if they were outstanding
F-8
41
DIGITAL GENERATION SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
through the end of the quarter in which the offering was completed, using the
treasury stock method. Convertible preferred stock outstanding during the period
are included (using the "if converted" method) in the computation as common
equivalent shares even though the effect is antidilutive. Historical earnings
per share prior to 1995 have not been presented since such amounts are not
deemed meaningful due to the significant change in the Company's capital
structure that occurred in connection with the Company's initial public
offering.
SOFTWARE DEVELOPMENT COSTS
Under the criteria set forth in Statement of Financial Accounting Standards
No. 86, "Accounting for the Costs of Computer Software to be Sold, Leased, or
Otherwise Marketed," capitalization of software development costs begins upon
the establishment of technological feasibility of the product. The establishment
of technological feasibility and the ongoing assessment of the recoverability of
these costs requires considerable judgment by management with respect to certain
external factors, including, but not limited to, anticipated future gross
product revenues, estimated economic life, changes in software and hardware
technology and the losses that the Company has incurred to date. Amounts that
could have been capitalized under this statement after consideration of the
above factors were immaterial and, therefore, no software development costs have
been capitalized by the Company to date.
REVENUE RECOGNITION
Revenues are recognized for each transaction on the date the audio, video
or related information is successfully transmitted from the network operating
center to the destination ordered. For the year ended December 31, 1994, one
customer accounted for 10% of revenues.
DELIVERY AND MATERIAL COSTS
Delivery costs consist of fees paid to other service providers for charges
incurred by the Company in the receipt, transmission and delivery of information
via the Company's distribution network. Material costs consist primarily of
audio and video tape and the related packaging used in delivery.
CUSTOMER OPERATIONS
Customer operations expenses consist primarily of salaries and the related
overhead costs incurred in performing deliveries and providing services,
including order entry, customer service and assembly and maintenance of the
Company's network equipment.
CONCENTRATION OF CREDIT RISK
Financial instruments which potentially subject the Company to a
concentration of credit risk consist principally of cash and cash equivalents,
short-term investments and accounts receivable. The Company has an investment
policy that limits the amount of credit exposure to any one issuer and restricts
these investments to issuers evaluated as credit worthy.
The Company believes that a concentration of credit risk with respect to
accounts receivable is limited because its customers are geographically
disbursed and the end-users (the customer's clients) are diversified across
industries.
The Company's receivables are principally from advertising agencies and dub
and ship houses. 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 and such losses have
been insignificant.
F-9
42
DIGITAL GENERATION SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SUPPLEMENTAL CASH FLOW INFORMATION
Noncash investing and financing activities consisted of the following (in
thousands):
FOR THE YEAR
ENDED DECEMBER 31,
-----------------------------
1996 1995 1994
------- ------ ------
Property and equipment financed with capitalized lease
obligations........................................... $ 8,028 $5,019 $ 467
Conversion of preferred stock to common stock........... 25,321 -- --
Acquisition of PDR financed with note payable........... 2,500 -- --
Conversion of convertible promissory notes, notes
payable and accrued interest to convertible preferred
stock................................................. -- -- 2,948
Common stock issued for notes receivable................ -- 98 77
Common stock issued for services rendered............... -- 13 18
RECLASSIFICATIONS
Certain amounts in the prior years have been reclassified to conform with
the current year presentation.
4. ACCRUED LIABILITIES:
Accrued liabilities consist of the following (in thousands):
DECEMBER 31,
-----------------
1996 1995
------ ------
Telecommunications costs................................... $ 621 $ 77
Employee compensation...................................... 334 287
Legal and consulting fees.................................. 321 329
Other...................................................... 898 510
------ ------
$2,174 $1,203
====== ======
5. COMMITMENTS:
The Company leases its facilities and certain equipment under noncancelable
operating leases. As of December 31, 1996, future minimum annual rental payments
under these leases are as follows (in thousands):
YEAR ENDING DECEMBER 31,
--------------------------------------------------------------------
1997................................................................ $ 742
1998................................................................ 739
1999................................................................ 788
2000................................................................ 781
2001................................................................ 587
------
$3,637
======
Rent expense totaled approximately $477,000, $361,000 and $288,000 in 1996,
1995 and 1994 respectively.
In addition, as of December 31, 1996 the Company has noncancelable future
minimum purchase commitments with its primary telephone service provider. These
commitments total approximately $1.3 million and extend through June 1997.
F-10
43
DIGITAL GENERATION SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
AUDIO SERVER NETWORK DEVELOPMENT AGREEMENT
In December 1995, the Company entered into an agreement with a major radio
network (the "Partner") to develop and deploy an Audio Server Network ("ASN")
prototype. The Company and the Partner continue to jointly develop and deploy
prototypes and several network products have been delivered to the affiliate
stations with prototype units. Negotiations to reach a long term deployment
agreement, whereby the Partner would potentially be granted warrants to purchase
common stock of the Company, are dependent upon further evaluation by both
parties of the results of field trials of the prototypes. The development costs,
which will be shared equally between the Company and its Partner, are limited to
$400,000 each. Through December 31, 1996, the related development costs were
approximately $400,000 in total, or $200,000 each for the Company and the
Partner.
6. LONG-TERM DEBT:
The Company has several lease lines to finance the purchase of certain
property and equipment. Borrowings are secured by the leased equipment. The cost
of equipment under lease and term loan obligations at December 31, 1996 and 1995
was $15,648,000 and $7,620,000, respectively. Related accumulated depreciation
at December 31, 1996 and 1995 was $5,791,000 and $1,979,000, respectively. The
term on the lease lines is generally 42 months for each drawdown and the Company
has the option at the end of the lease term to purchase the leased equipment at
a mutually agreed price not to exceed 20% of the equipment's original cost. As
of December 31, 1996, approximately $397,000 of the lease lines remained
available to fund future capital requirements. These lease lines expire in March
1997.
In October 1994, the Company signed a $1.6 million secured term note to
finance the purchase of certain equipment. The note is due in monthly
installments of $46,000 throughout April 1998, with a final payment of the
remainder due in May 1998.
In January 1997, the Company negotiated an agreement to finance an
additional $6.0 million of equipment purchases through a long-term credit
facility. The agreement includes a commitment to issue warrants to purchase
112,500 shares of the Company's Common Stock at a price of $8.00 per share. The
value of the warrants at the date of issuance was nominal; therefore no value
was assigned to the warrants for accounting purposes.
Future minimum lease and term loan payments as of December 31, 1996, are as
follows (in thousands):
YEAR ENDING DECEMBER 31,
-------------------------------------------------------------------
1997............................................................... $ 5,228
1998............................................................... 5,191
1999............................................................... 3,528
2000............................................................... 1,147
-------
Total minimum lease payments....................................... 15,094
Less -- Amount representing interest (effective interest rates
ranging from 13 percent to 18 percent)........................... (2,905)
-------
Present value of minimum lease payments............................ 12,189
Less -- Current portion............................................ 3,694
-------
Long-term portion.................................................. $ 8,495
=======
Interest paid was $1,716,000, $766,000 and $84,000 in 1996, 1995 and 1994,
respectively.
F-11
44
DIGITAL GENERATION SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
7. CAPITAL STOCK:
In January 1996, the shareholders approved a one-for-two reverse split of
the Company's preferred and common stock. All share and per share amounts in the
accompanying financial statements have been adjusted retroactively to give
effect to this reverse stock split.
In February 1996, the Company completed the initial public offering of its
common stock. The Company sold 3,000,000 shares for net proceeds of $29,490,000.
Concurrent with the closing of the initial public offering all outstanding
shares of convertible preferred stock and warrants to purchase 29,161 shares of
preferred stock were converted into an equivalent number of shares of common
stock.
Convertible Preferred Stock and Warrants
In conjunction with the initial public offering of the Company's Common
Stock, all outstanding shares of Convertible Preferred Stock were automatically
converted into Common Stock upon the closing of the Offering. Additionally,
warrants to purchase 29,161 shares of preferred stock were converted into an
equivalent number of shares of common stock.
A summary of outstanding Convertible Preferred Stock, net of issuance
costs, as of December 31, 1995 is as follows (in thousands, except share data):
DECEMBER 31, 1995
---------------------
SHARES AMOUNT
--------- -------
Series A............................................... 3,009,799 $ 5,955
Series B............................................... 2,222,217 $ 5,982
Series C............................................... 1,460,494 $ 8,753
Series D............................................... 581,249 $ 4,631
--------- -------
7,273,759 $25,321
========= =======
Warrants
In connection with certain financing and leasing transactions made in 1993
through 1996, the Company issued warrants to purchase at fair market value an
aggregate of 35,000 shares of Series A preferred stock at a range of $2.00 to
$3.00 per share in January 1993 and April 1994, 71,174 shares of Series B
preferred stock at $2.70 per share in October 1994, 60,000 shares of Series C
preferred stock at $6.00 per share in June 1995 and 67,500 shares of Series D
preferred stock at $8.00 per share in January 1996. As of December 31, 1995,
warrants to purchase 15,000 shares of Series C preferred stock were canceled
pursuant to the terms of the warrant agreement. A total of 29,161 of the Series
A warrants were exercised in return for surrender of the remaining 5,839
warrants upon the closing of the Company's initial public offering in February
1996. The remaining Series B, C and D warrants, which expire on the earlier of
ten years from the date of the related warrant agreement or five years from the
effective date of the Company's initial public offering, were converted to
warrants for common stock of the Company as per the conversion terms of the
agreements. The value of the warrants at the date of issuance was nominal;
therefore, no value was assigned to the warrants for accounting purposes.
In December 1996, the Company issued 9,351 warrants to purchase common
stock at $8.02 per share in connection with an increase in an existing lease
line. The warrants expire in 2006. The value of the warrants at date of issuance
was nominal; therefore no value was assigned to the warrants for accounting
purposes.
F-12
45
DIGITAL GENERATION SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
COMMON STOCK
As of December 31, 1996, the Company has reserved the following shares of
common stock for future issuance:
NUMBER OF
SHARES
---------
1992 Stock option plan.......................................... 1,460,156
1996 Supplemental Stock option plan............................. 750,000
Stock warrants.................................................. 193,025
1995 Director option plan....................................... 75,000
Common stock to be issued as incentives to certain dealers and
distributors................................................. 20,000
---------
Total reserved shares................................... 2,498,181
=========
The Company has issued 358,000 shares of common stock at prices ranging
from $.20 to $.30 per share to certain key individuals under restricted stock
purchase agreements. The agreements provide the Company with an option to
repurchase the unvested portion of each individual's shares at cost in the event
of his or her termination. These shares vest monthly over a period of four to
five years from the date of purchase. As of December 31, 1996, 189,633 shares,
ranging from $.20 to $.30, are subject to repurchase.
8. STOCK PLANS:
The Company has three fixed stock option plans:
1992 STOCK OPTION PLAN
Under the Company's 1992 Stock Option Plan (the "1992 Plan"), the Company
may issue up to 1,750,000 shares of common stock to employees, officers,
directors and consultants. The exercise price and terms of the options granted
is 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 nonstatutory options, less than 85 percent of the
fair value of the common stock on the date of grant. The options generally vest
over four to five years. The term of the options granted is seven years. In
January 1996, the Board of Directors amended the 1992 Plan to provide 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.
1996 SUPPLEMENTAL OPTION PLAN
In July 1996, the Company's Board of Directors adopted the 1996
Supplemental Option Plan (the "1996 Plan"). Under the 1996 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 is 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 September 1995, the Company's Board of Directors adopted the 1995
Director Option Plan (the "Director Plan"). A total of 75,000 shares of common
stock has been reserved for issuance under the Director Plan. The Director Plan
provides that each future nonemployee 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 nonemployee
director of the Company and an additional option to purchase 2,500 shares of
common stock (the "Subsequent Option") on the next anniversary. The exercise
price per share of
F-13
46
DIGITAL GENERATION SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
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 of the
option. 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
Effective January 1, 1996, the Company adopted the disclosure provisions of
Financial Accounting Standards No. 123 ("SFAS No. 123"), "Accounting for
Stock-Based Compensation". The adoption did not have a significant effect on the
Company's results of operations as the Company continues to apply the principles
of APB Opinion No. 25 and related interpretations in accounting for the
Company's stock option plans. Accordingly, no compensation cost has been
recognized for the activity under the stock option plans. Had compensation cost
for the Company's 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 loss and earnings per share would have been reduced to the pro
forma amounts indicated below (in thousands except per share amounts):
1996 1995
-------- -------
Net Loss.................................. As reported $ (9,127) $(8,780)
Pro forma $(10,174) $(8,831)
Loss per share............................ As reported $ (0.79) $ (0.94)
Pro forma $ (0.88) $ (0.94)
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 1996 and 1995; risk-free interest
rates, based upon the grant dates, ranging from 5.2% to 7.8%; expected dividend
yields of zero percent; expected lives of one year from the vesting date;
expected volatility of zero percent prior to the filing date of the Company's
February 1996 initial public offering and sixty-five percent for grants made
subsequent to the filing.
A summary of the Company's fixed stock option plans at December 31, 1996,
1995 and 1994 and changes during the years then ended is presented below:
1996 1995 1994
-------------------- -------------------- -------------------
WEIGHTED WEIGHTED WEIGHTED
AVERAGE AVERAGE AVERAGE
EXERCISE EXERCISE EXERCISE
SHARES PRICE SHARES PRICE SHARES PRICE
--------- -------- --------- -------- -------- --------
Outstanding at beginning of the
year............................... 1,456,500 $ 1.73 550,500 $ 0.26 309,750 $ 0.20
Granted.............................. 842,500 9.14 965,000 2.48 559,250 0.26
Exercised............................ (238,501) 0.43 (31,185) 0.20 (15,824) 0.20
Canceled............................. (254,144) 2.20 (27,815) 0.26 (302,676) 0.26
--------- ----- --------- ----- -------- -----
Outstanding at end of the year....... 1,806,355 $ 5.29 1,456,500 $ 1.73 550,500 $ 0.26
--------- ----- --------- ----- -------- -----
Exercisable at end of the year....... 378,797 $ 2.29 194,112 $ 0.34 58,083 $ 0.20
Weighted average fair value of
options granted.................... $ 4.41 $ 0.44
F-14
47
DIGITAL GENERATION SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
The following table summarizes information about stock options outstanding
at December 31, 1996:
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
- ---------------------------------------------------------------------------- ---------------------------------
NUMBER NUMBER
OUTSTANDING AT WEIGHTED-AVERAGE EXERCISABLE
RANGE OF DECEMBER 31, REMAINING WEIGHTED-AVERAGE DECEMBER 31, WEIGHTED-AVERAGE
EXERCISE PRICES 1996 CONTRACTUAL LIFE EXERCISE PRICE 1996 EXERCISE PRICE
- --------------- -------------- ---------------- ---------------- ------------ ----------------
$0.20-$2.00 656,189 4.89 $ 0.63 254,838 $ 0.60
$5.00-$8.875 444,666 6.02 $ 5.94 116,007 $ 5.55
$9.00-$10.125 705,500 6.58 $ 9.23 7,952 $ 9.00
--------- -------
$0.20-$10.125 1,806,355 378,797
========= =======
As of December 31, 1996, there were 478,801 shares available for future
grant under the stock option plans.
Subsequent to December 31, 1996, 8,647 options were canceled and the Board
of Directors granted 210,000 options pursuant to the 1992 Stock Option Plan to
employees at $4.56 per share.
Subsequent to December 31, 1996, 3,500 options were canceled and the Board
of Directors granted options pursuant to the 1996 Supplemental Option Plan to
purchase 10,000 shares at $7.25 per share and 243,000 shares at $4.56 per share.
9. INCOME TAXES:
In 1993, the Company adopted Statement of Financial Accounting Standards
No. 109, "Accounting for Income Taxes." This statement provides for an asset and
liability approach under which deferred income taxes are provided based upon
enacted tax laws and rates applicable to the periods in which the taxes become
payable.
The provision for income taxes differs from the statutory U.S. federal
income tax rate due to the following:
YEAR ENDED DECEMBER 31,
-------------------------
1996 1995 1994
----- ----- -----
Provision at U.S. statutory rate.................... 34.0% 34.0% 34.0%
State income taxes, net of federal benefit.......... 6.1 6.1 6.1
Change in valuation allowance....................... (40.1) (40.1) (40.1)
----- ----- -----
--% --% --%
----- ----- -----
Components of the net deferred income tax asset are as follows:
1996 1995
-------- -------
Deferred income tax assets:
Net operating loss carryforwards...................... $ 8,670 $ 5,606
Cumulative temporary differences...................... 1,782 1,403
Capitalized start-up costs............................ 37 81
Research and development credit....................... 324 140
Valuation allowance, equity............................. (292) --
Valuation allowance, provision for income taxes......... (10,521) (7,230)
-------- -------
Net deferred income tax asset........................... $ -- $ --
======== =======
F-15
48
DIGITAL GENERATION SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
The net operating loss carryforwards expire on various dates through
December 31, 2011. 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.
Valuation allowances have been recorded for the entire deferred tax asset
as a result of uncertainties regarding the realization of the asset including
the limited operating history of the Company, the lack of profitability to date
and the variability of operating results. The portion of the valuation allowance
which will affect equity and which will not be available to offset future
provisions of income tax is stated in the above table as "Valuation allowance,
equity".
10. 401 (K) PLAN:
Since January 1, 1994, the Company has maintained a 401 (k) retirement plan
for full-time employees. The employer contribution will be made at the end of
the plan year in an amount set by corporate resolution, based on participants'
compensation. The Company made no contribution to the plan in 1996, 1995 and
1994.
F-16
49
DIGITAL GENERATION SYSTEMS, INC.
SCHEDULE II -- VALUATION AND QUALIFYING ACCOUNTS
BALANCE AT ADDITIONS CHARGED BALANCE AT
CLASSIFICATION BEGINNING OF PERIOD TO OPERATIONS OTHER(A) WRITEOFFS END OF PERIOD
- ----------------------------- ------------------- ----------------- --------- --------- -------------
Allowance for Doubtful
Accounts
Year Ended:
December 31, 1994....... $ 10,000 $ 129,000 $ -- $ (66,000) $ 73,000
December 31, 1995....... $ 73,000 $ 137,000 $ -- $ (75,000) $ 135,000
December 31, 1996....... $ 135,000 $ 97,000 $ 25,000 $ -- $ 257,000
- ---------------
(a) Addition resulting from receivables related to the acquisition of PDR
Productions, Inc.
S-1